This article is sponsored by MiddleGround Capital.
What are some of the challenges facing mid-market industrial companies in the current macroeconomic and geopolitical environment?
We see three primary challenges. The first is supply chain disruption. Suppliers to our industrial portfolio companies are struggling to provide us with the materials that we need.
Meanwhile, our suppliers’ costs are rising, which means they are looking to pass that cost on to our assets. Our assets, of course, cannot afford to take the brunt of that inflation, so they have to pass the cost on to their customers, in turn.
The second challenge involves the labour market. There has been a great deal of change in the wake of the pandemic regarding what people are looking for from their working lives. That is making it very difficult, not only to hire, but also to retain staff. Turnover is extremely high.
Finally, in light of inflation and other ongoing macroeconomic factors, customer order patterns are more unpredictable than we have seen in a long time. This trend has extended to the automotive industry, where customers are typically very sophisticated and have good visibility on their releases. Orders are shifting up and down on a weekly basis and it is difficult to be sufficiently agile to meet those demands while remaining cost efficient.
Are there opportunities to gain market share in these turbulent times? And how, as a PE owner, are you supporting your businesses in their attempts to do so?
There is absolutely the opportunity to gain a competitive advantage in a period of market dislocation. One key area of focus for us is ensuring our businesses are reliable and communicative components of the supply chain. We endeavour to keep our customers well informed. We are open and honest about our ability to provide what they need and in what timescale, as well as the cost implications of doing so.
We also work with our portfolio companies on their product profitability and their raw material pricing strategy. Where possible, we work with them to put systems in place that automatically pass on raw material price increases. Having that index ensures there is no debate with customers. But equally, we are always willing to participate in customer conversations around pricing when appropriate. In the vast majority of cases, the customer is ultimately understanding of the situation we are facing.
In particular, MiddleGround has strong relationships in the automotive industry, which we bring to bear whenever possible. I genuinely believe that if we can be consistent, communicative and reliable suppliers then we can gain market share from our competitors.
Are your portfolio companies also benefiting from the trend towards nearshoring production?
I think our portfolio companies are in a strong position to take advantage of the production that is moving back to America from low-cost countries, such as China, Indonesia, Vietnam and India. We are seeing that nearshoring and onshoring trend among our customer base and believe it will drive revenue growth in the months and years to come.
What will onshoring mean for your operations? Will there be a greater focus on automation, for example, in order to compensate for higher labour costs?
Optimising net working capital will be important, which means having ordering programmes in place that break down inventory by raw materials and finished goods in each location. There will be a focus on automation as well, certainly. At MiddleGround, we have an internal team of five automation experts looking at opportunities across the portfolio.
It is not all about cost reduction, however. While automation has historically been thought of in terms of reducing processes, the outlook is now rather different. We are operating in an environment where it is extremely challenging to hire and retain workers. Automation is therefore essential to maintaining consistent supply.
Has the pandemic and subsequent supply chain dislocation created interesting buying opportunities?
During covid, we saw a number of opportunities to acquire companies in the automotive sector that may have not come to fruition without the pandemic taking place, and we remain confident that those have been good investments. They are businesses in the right place within the automotive supply chain and we will continue to support them until the automotive industry gets back on its feet.
What sectors or investment themes within your target industries do you believe are benefiting from the environment we are experiencing today?
The onshoring trend is opening up a number of new investment opportunities. We have backed several companies that manufacture small metal components, including connectors and springs, for example. Those are parts that are subject to significant delays when coming from overseas and so there is a strong drive towards shortening the supply chain and bringing production closer to the customer. The supply of metal has been severely limited, so if you do have product available, you are able to command a high price.
Another sector that is booming is housing – both in terms of new construction and the remodelling of homes – and we have a number of portfolio companies benefiting from those trends. We are also looking at a couple of opportunities involving companies that have benefited from a surge in outdoor recreation, including biking, camping and boating. During the pandemic, people were unable to get together to carry out their usual recreational activities and so these outdoor, family-based hobbies proliferated as a result.
In addition to combating short-term supply chain and labour market challenges, how are you working with portfolio companies to build long-term resilience?
First and foremost, we are focusing on people. As of 1 January 2021, we dictated to all our portfolio companies that the minimum base wage must be $15 an hour. That instantly had a stabilising effect on the workforce. We are now working together with our companies to reach a $25 an hour minimum wage by 2025, and plans are already being put in place to make that happen. Those plans include continued efficiency improvements, including automation.
We are also laser focused on free cashflow from the very beginning of the investment life cycle, ensuring companies can generate the cash they need to pay down debt by optimising net working capital. We are very conservative with the debt load we put in place at the point of acquisition, so companies do not have huge interest payments or restrictive covenants, and we believe that this positions them optimally to manage their business through challenging times.
We continue to invest in our portfolio companies when it makes sense. Indeed, we have asked all of our companies to put together a list of facility improvements they would like to make. Again, that goes back to providing a good working environment, as well as ensuring automation is used appropriately to drive efficiencies. We also invest in order to grow with our customers.
What role does ESG play in your approach to value creation?
We believe it is important for our portfolio companies to be industry leaders when it comes to ESG. It is integral to our underwriting process. We have ESG committees on all our boards and we put ESG key performance indicators in place at every business that we own, measuring progress against those targets and reporting that progress to investors.
We also have an internal ESG team, so we are actively dedicating in-house resources to ensuring we drive ESG improvements. We do this because, ultimately, we believe good ESG leads to the long-term sustainability of our businesses and of the planet.
Why do you think private equity is suited to supporting and growing industrial businesses in this challenging environment?
Private equity has the advantage of being able to take a long-term view, in contrast to the public markets where there is scrutiny on a quarterly basis. That allows us to make the investments that we need to get through more testing times in the economic cycle.
Private equity is also able to bring valuable resources to bear. MiddleGround, for example, has an extensive team of around 20 internal operating partners, at least 15 of whom have over two decades of manufacturing experience. These are people who have been in the position that our portfolio company management teams are in today and can support them through challenging times. Of course, our operating partners are also able to help identify and execute on opportunities that market dislocation can create as well.
This resource is particularly important in the lower mid-market, where we operate. These companies simply do not have the manpower to run the business on a day-to-day basis and embark on significant value-creation initiatives as well.
Finally, private equity’s portfolio approach also brings benefits, in that it enables us to get companies together to share their challenges and successes. We regularly arrange conferences to enable our executives to learn from one another. That is an invaluable value-creation tool.
Scot Duncan is a founding partner at MiddleGround Capital, where he is responsible for overseeing the firm’s operations team