The article "Private Equity comes under pressure in chemical distribution" was published in ICIS Chemical Business on January 7th 2008. It highlights the main issues which are likely to impact the chemical distribution sector in the coming months. It is the result of detailed research and analysis carried out between July and November 2007.
Merger and acquisition activity in the chemical distribution market has seen private equity money pouring in. Yet the sector faces tougher regulatory scrutiny and rocketing debt serving costs.
Private Equity players have come to dominate the global chemical distribution sector, but cartel investigations in Europe and the increasing cost of debt means the sector will be under pressure in 2008. Private equity interest in this sector stems from the facts that the European distributor scene is less consolidated and more fragmented than in North America. A fast track ”Buy and Build” strategy is easy to implement as many targets are available. Several European countries offer a favorable tax environment to private equity investors and competition agencies only recently started to look into the chemical distribution market dynamics.
Recent financing projects in chemical distribution are marked by boundless financial creativity. These projects are highly leveraged and financed with minimum equity and mezzanine funds. There is confusion between value creation and debt expansion, as the reported growing values match up with mounting debt levels.
The first vital priority for distributors owned by equity investors is to pay debt interest charges. They generally seek to push the outstanding debts to the next owners. Next, the investors exit by selling the distribution companies within three to five years.
The private equity route can be solid, as long as the acquired asset value increases and the companies can cope with the interest charges. It may become shaky once the value of the company decreases or when debt expenses increase.
Private vs. strategic buyers
Financial investors look at acquisitions in a different manner than strategic investors. They don’t really care about multiples, as they generally don’t pay back the debt principal. Financial buyers focus on the amount of debt interest a company can carry, and its cash generation potential. (See table 2)
Some cash-milking steps listed on table 1 are conventional, and others are more creative, like asset revaluation, tax optimization, debt and equity restructuring or buying asset-rich competitors. The appeal to get control of well performing, asset rich distributors explains the recent battles around Univar and Chemcentral.
Although 80% of recent chemical distribution merger and acquisition (M&A) transactions involved private equity, they are highly leveraged and loaded with pricey debts. The situation could become shaky due to debt rate increases, the credit squeeze, the weaker dollar and the looming recession.
The topic of competition laws and governance is now on top of most European chemical distributors and producers’ minds. Industry cartels are not new in Europe, occasionally they were tolerated, and sometimes, they were even legal. The EU cartel authorities want to eradicate them totally and they have so far been quite successful. Dominance is part of the chemical industry picture. But only abuses of dominance are banned. Fines are also a good source of income for the European Commission. Information exchange between producers and distributors should only cover market trends, market statistics, technical information, supply chain and people management issues. It should not cover prices, payment terms, specific customer information and inventory or production levels. (Table 3: legally authorized vertical information exchange)
This scenario is likely to influence producers’ policies. Commodity and specialty distribution markets have evolved as a result of recent consolidation trends. Oligopsony (few buyers on the market) and oligopoly (few sellers) now exist in several European bulk distributor markets.
When producers started selling to fewer distributors, they contributed inadvertently to the creation of oligopsony or oligopoly market situations, which investors relish as they subsequently enjoy higher returns, lower buying prices and higher selling prices. This is a true backlash effect, which most chemical producers didn’t predict.
For specialty chemicals, there are many more distributors and consequently more channel options for producers. However, the number of specialty distributors decreases due to consolidation. Ultimately, the specialty markets could have the same oligopsony situations as bulk chemicals.
Specialty markets look more fragmented than they are in reality. In most regional industry segments like paints and coatings, adhesives and sealants, cosmetics, food additives, the top five distributors hold around 50-60% of the pertinent markets.
Producers have a major influence on the evolution and development of the distributor markets. They control and manage distributor prices and rebates. They can outsource more quantities or customers to distribution or sell more directly. They can select or deselect distributors, particularly when distributors are taken over. Several private equity investors tend to overlook the producers’ major influence on distributors which is the chemical distribution sector key feature.
Private Equity should beware
For private equity, chemical distribution is founded on a misleading description: supply and demand is atomized and fewer competitors are in a position to buy interchangeable chemicals from easily substitutable suppliers. This simplistic view may well bring mistrust and antagonism between producers and PE owned distributors. To cope with financial volatility and frequent changes of ownership, producers are inclined not to put all eggs in one basket, and to keep enough leverage to influence distributors’ strategic options.
Producers are learning to cope with oligopsony by managing distributor relationships tightly and centrally, particularly the pricing aspects. In addition, they put in place supply chain optimization programs in order to remain in control of product flows from the sites to the end customers. While still muddled, the issue of information exchange between producers and distributors is an additional undefined concern. Several European producers are unwilling to exchange information that could expose them to legal responsibility, particularly in customer data and pricing.
Due to private equity major inroads into distribution, we find ourselves now at a turning point. The pervasive private equity model faces testing times. It is likely to be affected by the credit squeeze, doubtful exit prospects and new competition rules. As a new scenario occurs, investors will benefit from a more predictable environment, where consolidation opportunities will continue to emerge. Distributors who aren’t in a dominant position or in a credit squeeze will eventually replace other companies whose M&A plans are restricted.
Marc Fermont
Leysin, December 18th 2007
- Loose instruments without warning signs "Covenant Lite loans" Financial Times 07.25.07.
- Everything you want to know about LMBO. Citygroup. 11.2006
- EU antitrust pitfalls of confidential exchanges between competitors. Pierre Kirch & Daniele Nardi. Privacy and Data Security Law Journal. 06.2007
- "Chemical Distribution Metamorphosis". Marc Fermont. NACD annual congress Puerto Rico.11.2007
Andrew Banforth