As noted in the first part of this series, there is more M&A activity in the distribution sector than ever before, and it shows no signs of slowing. While many companies are looking to compete in an increasingly consolidated setting, others are ready to sell or combine forces with another organization.
In the first quarter of 2021, trade publication Industrial Distribution reported on 44 acquisitions and mergers in the industrial supply and distribution industry. The pace of transactions has nearly caught up to the 20 or so announcements per month that was common before the pandemic first immobilized parts of the business world.
Some distribution leaders looking to sell are ready to cash out or simply capitalize on generous offers so they can retire or start a new business. But not all sellers want to move on from their business. Owners may feel their chances of success will improve if they join one of the big distributors or a smaller company in their target market, and want to remain with the company post-acquisition.
Whatever the motivation, we’re here to help distributors through the complex, often time-consuming process of generating interest in and selling their companies. We’ll first detail why private equity has taken such an interest in the distribution industry, then offer suggestions for making your company an attractive acquisition target. We’ll also explain what distributors can do to maximize their value, including the role of a carefully-selected team of experts and technology.
Brent Grover: distribution consultant, fellow at the National Association of Wholesaler-Distributors (NAW)
An experienced distributor, Grover is a fellow at NAW’s Institute for Distribution Excellence, the nation's premier distribution-focused research lab.
Ben Belzer: President and COO at Tool Components Inc.
Tool Components Inc. is a family-run industrial distributor based in Southern California with customers nationwide.
Ritesh Chaturbedi: COO at Systemax
Systemax is a value-added distributor of industrial products and MRO supplies via sales channels including ecommerce sites and relationship marketers.
Ben Argov: president at International Wine Accessories (IWA)
IWA is a distributor and retailer of wine products and accessories. The California-based company manufactures products in the U.S. and imports others from around the world.
If you read through the Industrial Distribution reports on mergers and acquisitions, you’ll notice two primary types of buyers: other distributors and private equity firms. Private equity is a major part of the story behind consolidation in the industry.
For years, private equity groups didn’t see distributors as a promising investment. They had tight margins and a return on sales often in the low single digits. It seemed like there were plenty of other, better investment opportunities, said Brent Grover. When Grover sold his distribution company, National Paper & Packaging, to a private equity group in 1999 after 25 years, it was hardly the norm.
But that view has since changed. Private equity activity in the distribution space picked up after the 2008 financial crisis and has only gained steam since. Private equity leaders realized that distributors could in fact be very profitable despite the low return on sales thanks to a high asset turnover ratio, which measures the efficiency with which a business uses assets to generate sales. It’s not unusual for distributors to have an asset turnover ratio of four (that is, four dollars in sales for every dollar of assets), according to Grover, which beats that of many other types of businesses. Manufacturers, for instance, typically have an asset turnover ratio around two or two and a half, meaning they would require a larger upfront investment to produce the same revenue as a distributor.
Distributors are more efficient because their operations don’t require many fixed assets. A pure distributor doesn’t need the specialized, pricey machines often necessary to manufacture goods. Instead, it uses widely available equipment like forklifts and trucks to move products around the facility and deliver them to customers. The primary assets of a distribution company are inventory and accounts receivable.
The realization that these businesses could produce revenue efficiently pulled in more private equity players.
“A distributor earning a paltry net 3% pre-tax return on sales might as well be earning a 30% return on equity, which is very compelling to a private equity fund,” said Grover. “They found they could buy small distributors at relatively attractive prices, put them together to make a large distributor and leverage the increased size of the business, because typically larger companies sell for higher multiples than smaller companies.”
“[PE firms] found they could buy small distributors at relatively attractive prices, put them together to make a large distributor and leverage the increased size of the business.”
Decreasing interest rates and increasing availability of money from lenders over the past decade or so have encouraged private equity to strengthen its foothold in the distribution industry. These two factors allow PE firms to get larger loans at a reasonable price, which means they can afford to pay more for distributors than they historically have.
The current scenario reminds Grover of 1999, when he sold his family’s business. Then, like now, it was a seller’s market with valuations that applied “unheard-of multiples.” But within a few years, the dot-com bubble burst, the 9/11 attacks shook the country, and just as the economy recovered, the financial crisis hit. Those events brought multiples and valuations down.
“Whether it’s the business market or the real estate market, everything is just, in my opinion, inflated so high that offers being made are so tempting that I’m sure it’s very easy for a small shop to roll up, get paid out and move on,” said Belzer.
Of course, private equity firms are not the only ones investing in this industry. Twenty-seven percent of the largest distributors in the U.S. have bought at least one other distributor, compared to 20% before the Great Recession, according to research from McKinsey. Some large distributors are investing in startup or fast-growing distributors either directly or through a venture capital arm. For example, manufacturing and technology giant Honeywell started Honeywell Ventures in 2017, and a year later Ferguson, the biggest distributor of plumbing and heating products, launched Ferguson Ventures.
These agreements offer another revenue stream for the big guys, while smaller distributors benefit from the capital, name and scale of their investor, said Chaturbedi.
In some cases, the buyer comes to you — in part one of this series, Belzer said he hears from interested parties almost every day — but not everyone is so lucky.
Ultimately, the same traits that make businesses successful in a hypercompetitive environment also make them attractive acquisition targets. Of course, there are certain traits you can’t control, like your company’s location: An acquirer may want to establish a presence in a certain region and decide buying another company is the best way to do that. However, there are also ways to move your name up the list of potential targets by developing traits you can control.
Depending on whether you’re almost ready to sell or just beginning to think about acquisition opportunities in the distant future, some of these tips will be more relevant than others. So, we’ve organized them by roughly how long they take to implement: short-term (a few months), medium-term (six months to a year) and long-term (more than one year).
Grover recommends joining trade associations and buying groups (where smaller businesses come together to take advantage of large-volume purchasing discounts), as both can both help you make valuable connections and get your name out there. For example, maybe a fellow member who’s not ready to sell will connect you to a group that was interested in acquiring his company.
Simply paying the membership fee for these groups isn’t enough. Distributors need to be active participants, attending meetings and perhaps taking leadership roles within these organizations.
Even though valuations for distributors are already at record highs, in large part because of lending conditions, Grover said one of the biggest mistakes sellers make is setting an unrealistic asking price for their company. Finding the right number is not a simple exercise, and it’s best to consult with experts to find a price that is acceptable to both ownership and the market. (More on that in the next section.)
“It’s an art, it’s a science, and it takes experience to do it well,” Grover said of determining a company’s value.
Acquirers don’t want to buy a business that’s not well-run and needs a lot of work — and if they do, they will expect to purchase it at a much lower price because of the work required.
“It’s like selling your house,” Grover said. “If you have a wet basement, better fix that. If your kitchen needs to be updated, update it.”
Those necessary fixes vary by business: Examples include getting your receivables up to date so you know which customers owe you money and how much, improving your inventory management practices or ensuring you have accurate, easily accessible financial information. And if there are any unresolved issues with money owed to other parties, you need to shore those up before searching for buyers.
Identify the traits that make your distribution business different from competitors and what unique value you’d bring to a buyer. Maybe you excel at ecommerce, have an expansive product catalog or can deliver items same-day to an entire region. Focusing on that strength will increase both the interest you receive and your value.
“Ideally, to convince somebody to buy versus build, you’ve got to have something that they can’t build even if they wanted to. That’s your core competitive advantage,” Argov.
IWA, started when Argov and two fellow investment bankers bought a wine cabinet manufacturer in 2004, has since added five other companies to its portfolio. IWA focused on acquiring businesses with strong “brand value” — they had well-known brand names and healthy customer bases, and they had existed for some time.
For example, IWA added WineKeeper and Rogar — brands that sold wine preservation systems and wine openers, respectively — to its portfolio of exclusive brands, so it could control pricing and distribution. Later, the company bought Epic Products — which had a foothold in the B2B market — because it wanted to expand its reach there.
Increasing competition and a shift in B2B purchasing preferences, outlined in part one, have pushed many distributors to rethink the way they do business. Today, innovation is critical to surviving and succeeding in this sector. And your innovation quotient could also make you stand out from other companies an acquirer might be considering.
“How innovative are you in terms of how your business model is laid out?” Chaturbedi said. “Do you have multiple revenue sources, do you have multiple ways of attracting customers, do you have multiple ways of tackling a particular problem? … That flexibility of business modeling becomes very important in terms of valuation, as well.”
Although sales were down in 2020 for many distribution businesses, that’s not an excuse for stalled innovation. In some cases, organizations actually have more cash than usual despite the drop in sales because they’ve caught up on receivables, have less inventory on hand and may have received a pandemic-related loan, Grover noted.
“I would urge those companies to use those funds to invest in the business and make it more attractive to a buyer,” he said. “You’ve learned in this experience that customers don’t really value salespeople as much as we always thought they did, and we’ve learned that they’re very willing to do business electronically.”
“I would urge those companies [with government loans] to use those funds to invest in the business and make it more attractive to a buyer.”
While certainly not a quick fix, a proven customer acquisition strategy will help distributors stand out, Chaturbedi said. It is one of the few traits a competitor can’t quickly replicate.
You can build your strategy with an online sales channel comprising the digital tools that customers want as they increasingly buy online — not just ecommerce sites but also apps and other self-service tools for account management, including the ability to view available credit, pay invoices, request quotes, track orders and more. Distributors need analytical capabilities that are both extensive and, wherever possible, use real-time data. That helps companies understand customer behavior and trends and personalize the ecommerce experience for various buyers, Chaturbedi said.
Smaller distributors can also separate themselves from the pack by catering to the shifting needs of their customer bases. For example, their nimbleness may make it easier for them to quickly deliver products to a customer or source a new line of goods suddenly in-demand.
For the most part, the above tactics will help you get the maximum value for your company. The organization that is well-run and managed, has a proven customer acquisition strategy and leans into its strengths will obviously be worth more than one that doesn’t meet that criteria. That distributor will develop a reputation as the market leader, and when buyers ask around, your name will inevitably come up.
In your company’s acquisition quest, “it’s not what you say about yourself; it’s what other people say about you,” Grover said.
If your company has received unsolicited interest over the years, Grover recommends keeping a list of potential purchasers that have reached out, with their contact information. This requires some foresight — if you think you might sell at some point, don’t immediately hang up the phone when they call. Down the line, you’ll be thankful you took this small step.
Once they’ve identified the right buyer and it’s time to negotiate, owners should assemble a team to guide them through the process. That team should consist of a CPA and attorney with significant M&A experience and an advisor who has worked on similar deals with distributors, according to Grover. Too often, businesses turn to the people they’ve used for decades to handle their financial and legal work.
“Not getting good advice means [distributors] rely on their long-time attorney who may be a friend, who may not have experience selling companies,” Grover said. “Your CPA firm you’ve used for many years may not have experience structuring transactions for companies that are selling. That’s key, because your objective is to end up with as much money in your pocket after taxes [as possible], and CPAs have a lot to do with structuring deals the right way.”
Distributors will more than make up for the money they spend on these professionals — collectively, they often take 2-4% of the selling price — by getting more value for their organizations.
A team with a background in M&A also increases the chances of the deal actually going through. Consider that around 70-90% of mergers and acquisitions fail, per Harvard Business Review, and a good chunk fall through even after a signed letter of intent.
Finally, don’t discount technology’s role in all of this. Technology is not a cure-all, but it can provide essential information with which to identify areas in need of improvement and execute many of the tactics we’ve outlined. Software can help you get your house in order and fix that leaky basement, to use an earlier analogy.
For example, if a distributor is trying to lower its customer acquisition cost, it might consider segmenting its audience through a CRM system so it can send more personalized messages that will drive better returns. Supply chain management software will allow you to identify areas of your operations in which costs are too high or productivity has dropped, then apply innovative solutions. Accounting software presents leaders with critical financial documents on-demand when due diligence begins.
“In terms of maximizing value if you’re trying to position yourself for a sale, technology allows you to show that the business can live on without you and won’t fall apart after the sale,” Argov said. “Additionally, technology will allow you to operate more efficiently, and with better margins, you become a more attractive target and will generate a higher sale price.”
The Digital Supply Chain Explained: A digital supply chain provides a look into the workings of your supply chain. New technologies collect, monitor and analyze data to make predictions and recommend actions in real time.
Every bit of profitability matters. The median multiple used to calculate a distributor’s value in dozens of small deals Grover reviewed was six (and it usually increases with business size). So, a small increase can make a big difference when applying a multiple to your company’s EBITDA.
Of course, this is not a recommendation to start gutting departments and slashing expenses wherever possible in the name of short-term gains. Investors will catch on to what you’re doing, and it won’t have the desired impact on your valuation.
It’s a good time to sell if your distribution business has proven it can adapt to today’s challenges and find ways to attract and retain customers. There is tremendous interest from private equity firms and others in acquiring these businesses, and distributors are selling for impressive prices.
Our sources agreed there will always be room for large and small organizations but midsize distributors may start to disappear in the next five to 10 years.
“The middle of the bell curve is going to get collapsed,” Chaturbedi said. “So there will be few very, very big players, maybe 10 or 12, and there’s going to be a huge, long tail of small, niche players. ... Some of those might be acquired through time, some of those might have their own acquisitions to expand their niche areas.”
Generally, traits that make distributors successful as independent businesses also position them as attractive acquisition targets and increase their value. So, owners and leaders in distribution must commit to initiatives and tools that will separate their companies from the pack, whether they want to sell today, in five years or never.