Economy and Environment and Government and Manufacturing & Technology

VC expert: Businesses enjoy 'seller's market': In Q&A, private-equity veteran Scolnik discusses industry trends

April 30, 2007

With $116.5 million in capital under management, Hammond Kennedy Whitney & Co. Inc. is Indiana's largest private equity firm focused on mergers and acquisitions. It regularly creates $5 million to $15 million deals to buy small and middle-market manufacturing companies with low risk of technical obsolescence.

Founded in 1903, HKW maintains its headquarters in New York, but the bulk of its operations and activities are in Indiana. Its portfolio includes the Indianapolis-based centrifuge-maker CentraSep Technologies and corrugated sheet manufacturer Flutes Inc.; Elkhart-based RV windshield distributor Duncan Systems Inc.; Muncie-based combustion equipment-maker Maxon Corp.; and Mishawaka-based plastic components-maker NylonCraft Inc.

Investment banker Glenn Scolnik joined HKW in 1993 and became its president and CEO in 1998. From 1978 to 1992, he worked as a merg ers-and-acquisitions attorney for locally based Sommer Barnard PC. During those years, he was HKW's outside counsel.

IBJ recently interviewed Scolnik for a discussion of the overall shape of private equity and current trends in M&A. The following is an edited transcript of the conversation:

IBJ: Private equity markets have been awash in capital for several years. Is the trend likely to continue? Is it easier now than in years past to raise money and get M&A deals done?

SCOLNIK: The trend will continue. It clearly will continue for many years.

The reason is, there's been tremendous amounts of capital raised in the last several years, and '07 is probably going to set the all-time record, which previously was set in '06, which itself broke the record from '05.

These funds [generally] have commitments for a six-year period, so the capital will be out there for at least six years. New fund raising will still be strong, but it might not continue at the record pace.

IBJ: Why might fund raising slow down nationally?

SCOLNIK: No. 1, the economic expan- SCOLNIK Continued from page 19

sion may stop. We might get a recession. That tends to affect investors' willingness to put money into private equity.

Also, venture capital is starting a comeback; it's starting to gain traction. I look at [M&A] buyouts and venture capital as the two big sources of capital in private equity. Venture capital really took a big dive when the dot-com crash occurred. Money raised in the late '90s did poorly. But it's starting to come back, and the two tend to compete.

IBJ: What's attracting so much money into private equity?

SCOLNIK: You can only go so far with public equities. And an intelligent [private equity] investment manager can generate great returns, if you pick the right manag er. But the counter to that is there's actually more firms out there raising money than ever before. There's splinter groups. There's new groups.

And many invest their funds quickly, and are back to the market sooner than expected. Oftentimes, when private equity firms go back to raise more money, they get progressively larger. So, 10 years ago, you might have 10 firms out raising money. If those 10 are raising money today, they would be raising twice as much. There's more money available, but there's also more requests for that money.

IBJ: How is the M&A market today different than it was a decade or two ago?

SCOLNIK: The landscape for us particularly hasn't changed that dramatically. We're looking to buy companies with $20 [million] to $100 million in revenue. The increase in capital raised for that sector hasn't increased at the same rate as it has for larger companies.

But what it means for bigger companies is there's much, much more competition. And there's much more pressure on private equity firms to get their money to work. They've got to do deals. Investors don't want to commit their capital and pay a management fee to see their money sit on the sidelines. They want action, and they get it. There's huge pressure to get money to work.

IBJ: What do M&A funds do to increase the value of the businesses in their portfolios?

SCOLNIK: Private equity funds are working harder and smarter to improve the operations of the businesses they buy.

The little-known fact about private equity is the good private equity firms actually are very beneficial for the companies they acquire. Very beneficial. That sometimes gets lost in the publicity.

The better firms bring financial resources, strategic planning, operational improvements, introductions to new markets geographically, and product-line extensions that improve the business. You have to do that really to be a top-notch firm and get top-notch returns. And most firms have an industry expertise in a particular sector they can bring to bear.

IBJ: How are these national trends affecting Indiana?

SCOLNIK: We feel it. There are companies for sale in Indiana every day, and there are private equity firms here every day. Owners of Indiana businesses appreciate the fact that there's tons of capital available to buy their companies. It's definitely a seller's market.

We bid on companies in Indiana every year, and there's competition in a typical case, mostly from other private equity firms from outside Indiana.

IBJ: Please explain how the difference between financial and strategic buyers is reshaping M&A.

SCOLNIK: Well, there are more financial buyers than there used to be. No doubt about that. And more buyers on the sale of a business generally means more competition. When there's more competition, there's higher prices. That's part of what's driving this seller's market.

In theory, strategic buyers should be able to outbid financial buyers. When a company buys a competitor because it wants to extend its market, there's going to be cost savings or synergies. There will be revenue enhancements just from combining those companies.

But financial buyers are very aggressive. They have to put that money to work. They have more money, and there's more of 'em. Also, debt markets are very aggressive right now. All of that is feeding this frenzy that's resulted in all-timehigh purchase price multiples. It's as high as it's ever been in our industry.

Years ago, when we bought a company, we would try to professionalize the management team and improve the operations so it would one day be attractive to strategic buyers, because they were by far the most active buyer in the market.

Today, you're trying to do a lot of the same things, but we find we're just as likely to sell to a financial buyer as a strategic buyer.

Strategics often aren't as dependent on the management team. They oftentimes don't have an equity component for that management team. Financial buyers, on the other hand, are more dependent on management. They really want management to invest in the new deal. Therefore, a lot of managers that we work with really would prefer a financial buyer to a strategic buyer, because there's opportunity for them.

IBJ: Indiana's state government is getting more directly involved in private equity through vehicles like the $155 million Indiana Investment Fund. What are the pros and cons of the state's strategy?

SCOLNIK: The pros of that fund-it allows PERF [the Indiana Public Employees' Retirement Fund] and TRF [the Indiana State Teachers' Retirement Fund] to put money to work in the small to middle end of the market.

My whole life in private equity has been preaching, and the stats bear it out in spades, that the returns in the small and middle end are higher than in the high end. But PERF is a huge endowment. They're too big to invest in small firms. This is a vehicle for them to tap into those returns, and I think it's great for them and for the retirees who are dependent on those investment results.

There's also some collateral benefits, to the extent that the fund invests in Indiana private equity firms and mezzanine funds that target Indiana. Most of that money will go to work inside the state of Indiana. It tends to keep those companies, certainly their ownership, in the state longer.

IBJ: Do in-state restrictions discourage a private equity fund's opportunity to earn spectacular returns?

SCOLNIK: We invest a lot of money inside Indiana, but it's just because we're here. We're trying to maximize our returns. Because we're here, we hear about more Indiana deals than, say, Ohio or Nevada deals. Our network is in Indiana. And we'll put our returns up against anybody, quite frankly.

IBJ: Community leaders fear losing headquarters in M&A deals. Should they be worried?

SCOLNIK: The first thing I'd say is, out-of-state ownership is not usually a bad thing. For example, if an out-of-state private equity firm comes into this state and buys an Indiana company, they typically would not move that operation. It's rare for them to close down that plant. So all the jobs would remain. The business would still be here, and the [private equity fund's] focus is to grow the business. That's how you get a return. They might invest in equipment, extend product lines. They'll try to improve the operation, maybe expand it.

Out-of-state private financial buyers are usually not bad at all, quite frankly. Now out-of-state strategic buyers might want to consolidate something from Alabama. Or vice versa. But in terms of keeping company headquarters here, I don't know if that's as important as keeping the operation here.

Indiana can do a lot of things to improve its odds. It can improve the business environment, taxes on business income, or the state's regulatory burden.

It's tremendously expensive to move a business, so you have to have a compelling reason to do that. But it's a global economy, and you have to be able to compete. So the best way to keep firms here is to let them participate in the global economy. If that means they have to source a part in a foreign country to remain competitive, let them do that. They've got to compete in the freemarket system to survive in the long term. Any barriers, in the long run, won't be beneficial.

IBJ: Do you have any advice for entrepreneurs when they approach privateequity firms for capital investments?

SCOLNIK: There's a couple of different ways to approach that question. First, they should ask themselves, why do they need the money? You need to clearly understand why you need it.

Is the money needed inside the business, or in the pocket of the entrepreneur? It could be an entrepreneur who wants to cash in some chips. There's nothing wrong with that.

Investors like us need [to buy] more than half the shares of a company. We need to control our fate. But an entrepreneur can sell 60 percent of his stake, take some chips off the table. His net worth may be all tied up in that one asset. Now he can take some cash and diversify it into other markets. Most financial planners would say that's a good thing.

If he doesn't want to give up control, he should seek advice. Venture capital or debt capital are available for growth. Remember, the most expensive type of financing is equity. The second is mezzanine, and the cheapest is senior debt. But the risks are inverse to that.

My advice is to hire a professional. I hate to be an advertisement for investment banks, but good and talented investment banks always pay for themselves, and most people don't understand that. My partners are going to kick me for that one, because investment banks tend to drive up the price.

There are a variety of objectives when someone goes to sell a business. He doesn't want to sell too cheaply, but there are other factors. What kind of operator will the new owner be? What's his reputation? What's the impact on employees or the community?

IBJ: How are the retirements of the baby boomer generation affecting the M&A industry?

SCOLNIK: The number of changes in control transactions has been very high in the last few years, and is continuing. This is one of the best times, if not the best time, to sell a business. If an owner of a business came to me and said, "We've just had two record years. I'm going to want to sell in the next five years," I'd have to tell them sell today.

And you can't really say it's going to continue for a long period of time. One of the things driving [sales] multiples is that debt markets are very aggressive. Lenders are giving high amounts relative to the EBITDA [earnings before interest, taxes, depreciation and amortization] stream. If you have a little bit of a decrease in the national economy, lenders will pull in the reins a little bit and those multiples will come down. It doesn't even have to be a recession. So now is a tremendous time to sell a business.

IBJ: Any closing thoughts about the current state of M&A?

SCOLNIK: I always feel like I need to point out that nobody loses in a private equity transaction. It has some negative connotations if you read the Wall Street Journal. But if a company is for sale and is sold to a private equity firm, the seller gets what it wants. The private equity firm gets what it wants. And then the private equity firm works with the management team to make money together. I can't find anything that's negative in that.

The amount of money going into these deals is a good and positive thing. Nothing is absolute, but we should be glad there's all this money going into private equity. The end result is a stronger economy and stronger companies. Isn't it better to have companies who can compete better globally? Increases in earnings increases job security.

It's a very competitive world, and you have to keep improving. Private equity firms know that very well.
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