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Newsletter 28, May 2009  (No comments so far)

No Way out

The impact of the downturn on distributors will be significant

The article "NO WAY OUT" was published in ICIS Business News and on www.icis.com on May 26th 2009.

"NO WAY OUT"

The impact of the downturn on distributors will be significant 

Until 2008, an economic myopia prevented many companies from grasping the fact that Wall Street predicaments would soon adversely impact the real economy.  Numerous premonitory signs regarding the economic bubble that developed between 2005 and 2007 were ignored. This seriously aggravated the consequences of the systemic crisis that now affects the global economy. As much as Wall Street and the financial world influenced the real economy before the crisis, it is the on-going economic restructuring and a return to normality in the financial sector that will influence the chemical industry in the future and end the recession. 

We are entering into a new business environment marked by significant industry restructuring in various sectors including the steel, automotive, pulp and paper industries as well as an overall decreasing demand for chemical products and related services. As disposable income declines and personal saving rates increase, overall spending will decrease. Shifting demand patterns will adversely affect the building, automotive, tourism and luxury goods sectors, to name a few.

No longer is the priority for distributors to serve indiscriminately all customers but to select the right customers present in less cyclical and still growing markets, like personal care, food and feed industries and pharmaceuticals. The emphasis is moving now toward quicker cash generation cycles based on shorter supply chains, lower inventories and reduced payment terms. During the first quarter of 2009, European chemical distributors’ revenues and results declined on average by 20%.

One of the distributors’ main concerns is related to the strength and reliability of their supplier mix. The filing for bankruptcy protection of Netherlands-based LyondellBasell, and Tronox and Chemtura in the US, dominated the chemical industry during the early part of the year.

Additionally, the widely publicized financial difficulties faced by Hungary’s Borsodchem, US-headquartered Hexion, INEOS in the UK or Canada’s Nova added to the concerns which distributors have about their suppliers’ long term commitment to their industry. In addition, the sale and restructuring of some businesses by producers could also affect the distributors’ ability to ensure reliable supply to their own customers. These developments severely impact chemical distributors as the bankruptcy of the tenth largest US distributor JLM Industries shows it. More than ever, the quality and stability of the distributors’ supplier mix is one of the most critical aspects to be managed carefully and wisely.

The financial difficulties faced by some of their many small and medium size customers and converters increase the distributors’ overall business risks, particularly when credit insurers, like Euler Hermes or Coface, reduce the insurance coverage they granted to them  previously. In many cases, coverage was cut to 50% of the past agreed levels. This action creates a deflationary aspect on distributors’ revenues. Company insolvency cases are increasing significantly. They appear now in several sectors down the chemical supply chain like in the automotive, retail, steel, polymer and paper industries.

It is obvious that things will not come back to what was enjoyed until last year. In the new business environment, flexible distributors with a wide product mix, good assets in place, strong supplier and customer mixes and limited indebtedness will be able to grow their market share.

• Private Equity in reflux

Table 1
Private equity owned distributors

Distributor	Owners	Transaction Amount (M€)	EBITDA Year of deal	EBITDA multiplier	Date of transaction	2007 global distribution sales (M€)
Azelis	3i	315	37	8.5	12.07 Tertiary	914
Brenntag	BC Partners	3500	360	9.7	07.06 Tertiary	6700
Druckchemie	3i	133	16	8.3	04.08 Secondary	70
IMCD	ABN Equity	320	38	8.6	06.05 Secondary	922
Neochimiki	Carlyle	749	83	9	06.08 LBO	400
Solvadis	Orlando SSP	NA	NA	NA	06.04 LBO	600
Quaron	Bencis	60	8	7.5	06.02 LBO	250
Safic Alcan	ING Parcom	115	13	9	12.07 Secondary	250
Unipex    $	AXA PE	155 (M$)	18 (M$)	8.6	04.08 LBO	220 M$
Univar	CVC	1500	175	8.6	10.07 LBO	5.900
Warwick £	CFPE	129 (M£)	16	8.1	09.08 LBO	90 M€

As we can see it in the table, private equity made major acquisitions in chemical distribution and now controls about 30% of the sector revenues and several of the leading players. France, with 80% of the players owned by private equity ranks at the top.
 
Between 2005 and 2008, 80% of the M&A in chemical distribution were completed by private equity-controlled distributors in primary, secondary and tertiary placements.
What appeared to have been a blessing for this sector is now becoming a real challenge. The distribution companies mentioned are all highly leveraged as they were acquired with earnings before interest, tax, depreciation and amortization (EBITDA) multiples of  8-10. Accordingly, they were overloaded with debt that is no longer supported by the current profit levels. In addition, tension in several companies between owners and management is often simmering when private equity owners request payments of high management fees and impose staff reduction plans. 

The chemical distributor business model is strong and will definitely continue to create value for both customers and suppliers. However, several leading distributors owned by private equity must as well assume now the task of dealing with their investors’ difficulties.  

Private Equity firms are confronted with three challenges, namely to keep their own investors’ trust and confidence, maintain the support of their bankers and ensure that the companies they own don’t breach their credit covenants. Shares in publicly quoted private equity companies like Blackstone, KKR, 3i and Electra last year lost around 60% of their value. Several private equity firms manage equity investments from other financial institutions like hedge funds or funds of funds which have their own liquidity issues and may want to cash in their investments earlier. Private Equity inability to raise new funds and the withdrawal requests they face from their partners create for them major difficulties which may force them to sell some of the assets they own at distressed prices.

Bankers also have their own issues to resolve. They are constrained by the implementation of the Basel II regulations to strengthen their balance sheets with their own funds. They cannot take anymore over-stretched credit risks and they have partly lost the possibility to syndicate their loans’ financial risks with other bankers. These aspects negatively impact debt availability and the cost of borrowing. These limitations affect both private equity firms and corporate customers. In recessions, companies owned by private equity run the risk of breaching their credit covenants. In such an instance, there are three options available for the owners: declare bankruptcy, recapitalize their companies or restructure their debts. Most stakeholders prefer the third option as private equity sponsors are often reluctant to inject new capital into the companies they own. Debt restructuring is a costly and complex exercise particularly when debt levels are high and dispersed among many financial institutions which have conflicting interests, as we saw it recently in the Chrysler case.

If the recession lasts much longer, we think that some companies listed in Table 1 could have to restructure debt, which is the best option available to private equity firms to resolve the high leverage issue. Other available options like bankruptcy or distressed sale to a vulture fund are a last resort.

• Barriers to exit

Private equity investors plan their exits within three to seven years of their initial investment, depending on the maturity of their funds and their investors’ support. Some private owners of distribution companies are also eventually considering exiting the business because of succession issues, declining business performance or the need to further invest in the business.

When credit was unrestricted and cheap, investment decisions were mostly made on the basis of loose financial criteria like EBITDA multiples, cash flow growth plans and projected ability to pay back debts. In the future, investors’ emphasis will focus more on distributors’ tangible asset valuations, competitive position, organizational strengths and ability to withstand the impact of downward cycles.

Table 2
Barriers to exiting chemical distribution

• Difficult IPO’s to manage
• Lack of strategic buyers for large companies
• No funds available for secondary or tertiary placements
• Poor performance during recession
• Covenant breaches
• “Buy and Build” restrictions
• Decreasing valuation of intangible assets
• Too high acquisition prices and inflated EBITDA multiples
• Increasing insourcing of producers’ direct deliveries
• Limited growth opportunities
• Uncertain outcome of antitrust judicial procedures

The owners of Univar and Brenntag announced their intention to soon float the industry leaders through initial public offerings. This is a reasonable goal, considering the size of both companies. Before 2000, several companies like Univar, Ellis and Everard, Holland Chemical International, Lambert Rivière, Stinnes were publicly traded. At the time, those companies’ shares underperformed the market. Their share values only increased when they were expected to be taken over by new investors. Distributors’ shares were thinly traded, had a low visibility, virtually no analyst coverage and few investors bought them.

Chemical distribution shares were perceived to be part of the chemical industry and penalized by their apparent cyclaclicity. In 2002, the Univar capitalization was around €600m or about half of what Royal Vopak NV earlier invested in the distribution business. An IPO is a long and tedious process where the initial investors are often constrained to retain part of their equity for a longer lock-up period, as a large IPO for the whole company equity is likely to prevent them to achieve their financial goals.

For the time being and in our view at least until 2012, IPO’s are difficult or impossible to realize due to investors’ reluctance to increase their equity exposure. Private Equity’s preferred exits from chemical distribution tended to be secondary or tertiary placements. These exits are out of fashion as bankers became aware that such placements contributed to the speculative financial bubble which finally burst last year.

Contrary to the pharmaceutical industry where strategic investors like Merck, Pfizer-both US based- or Swiss Roche made the headlines this year on the M&A markets, there are no strategic buyers on the horizon likely to buy some of the larger distributors. Therefore the past preferred exit routes for investors in chemical distribution companies seem to be blocked and financial investors may have to stay present in the sector for a longer period. Moreover, several aspects like legal restrictions on “Buy and Build” strategies, reduced  performance during the downturn, limited growth opportunities, poor market positioning could be ancillary features likely to have a deflationary impact on the valuation of the companies to be sold. These restrictions affect less the small and medium-sized distributors which may remain attractive targets for their more dynamic competitors. 

Chemical distributors face now a more challenging business environment where past management practices need to be reviewed in order to set new strategies to confront a more difficult, uncertain and demanding future.

Marc Fermont 

mfermont@districonsult.com
Leysin, June 1st 2009