Industrial PE to reassess supply chain as pandemic reveals vulnerabilities

Firms backing industrials companies will modify investment strategies in the post coronavirus world, with those who can likely to increase US operations and downsize overseas operations in the supply chain.

As vulnerabilities of supply chains emerge in the coronavirus pandemic, investors and dealmakers expect to see an acceleration in the localization of supply chains and a more intensive due diligence process.

Although the severity and extent of the covid-19 impact on manufacturers remains uncertain, the expectation is the supply chain will come under increasing pressure.

Sponsors are likely to change the way they source and assess potential investments after the pandemic-related dislocation begins to ease, several sources told PE Hub.

“I don’t think PE investors think too much about the supply chain,” said Hugh MacArthur, who leads Bain’s Global Private Equity Practice. “They want a very high service level and a low cost,” he said.

But that’s changing, according to MacArthur. “Now we are realizing that PE investors also need to play defense,” MacArthur said. Sponsors in the aftermath of coronavirus will examine how efficiently a company handles risks and the vulnerabilities in the supply chain before executing acquisitions.

For PE-backed manufacturing companies, in almost every case, there is either demand destruction or delay, added Pete Guarraia, who leads Bain’s Global Supply Chain Practice.

For example, products like airline seats will see their demand destroyed, whereas heavy equipment manufacturers will see delays in demand.

Moving local

To a large degree, the health of a manufacturing company coming out of the crisis depends on how it’s sourcing materials. Simply put, if a company in an effort to run leaner operations is overly reliant on one region, such as China, losses incurred from delays in shipments will be hard to mitigate.

“At this point we are not seeing much of an impact,” said Scot Duncan, a partner at MiddleGround Capital, which invests in B2B companies in the industrial and supply chain sectors. “[But] I think that there’s more to come; the interruptions in the supply chain are just starting to come.”

MiddleGround portfolio company, Steel Craft, makes bolts, bearings and fittings internationally and large components locally, and thus could feel that impact, Duncan said.

As a result of coronavirus-related economic volatility, investors are now starting to look at the true inherent cost of the supply chain, said John Neuner, co-head of M&A at Harris Williams.

Supply chain vendors were historically picked based on cost targets, [but] there are a lot more factors that people have to think about today, according to Neuner.

Global tariff concerns had already changed the economics around global supply chains and created more reasons to reconsider local sourcing, he said. “If you were sourcing internationally, you were already looking into that [supply chain risks] during tariffs,” well before the economy came to a halt due to the virus, said Neuner.

With the holdup in overseas production due to coronavirus, local vendors are even more likely to draw the interest of PE firms and their manufacturing businesses in their own regions.

For example, when Arctaris Impact Investors in December snapped up Recaro Automotive Seating, an automobile seat supplier, the firm already had plans to increase Recaro’s US operations and downsize overseas operations.

In any economic environment, Arctaris is going to look at supply chains in terms of reliability and pricing, said Jonathan Tower, a managing partner at the firm. “But the burden of proof is now three to five times more,” he said.

Not that simple

Supply chains, especially in the auto sector, are not that simple. In many cases, portfolio companies will have a “supplier to a supplier.”

An engine maker, for example, depends on a Tier-1 supplier for a custom component which in turn depends on another vendor for micro-fittings such as nuts and screws.

Many second or third-order suppliers are concentrated in China due to lower costs, and that creates a bottleneck, which can turn into a supply-chain vulnerability really fast even if one order fails to get fulfilled.

At the same time, there’s also the looming threat of more tariff activity on China after the pandemic is over, according to Bill Peluchiwski, co-head of the industrials group at Houlihan Lokey. “From my discussion with the Chinese teams, they are worried about some level of retaliation,” said Peluchiwski.

When the markets normalize and deal flow resumes, investors playing the offensive strategy are less likely to pick manufacturers that are dependent on a single region or maybe even China.

That said, for some manufacturers, it’s not always easy or even possible to find alternate vendors.

For example, Palladium Equity Partners-backed Kymera, a specialty materials manufacturer, sources copper locally, vanadium from Brazil, and raw materials from other regions like China, Bahrain and Australia.

The diversified supply chain helps in the case of plant shutdowns, but oftentimes raw material sourcing is so specific to regions that it’s unlikely to change, according to Adam Shebitz, a partner at Palladium.

Looking ahead

While the supply chain disruption is still in the early days, the unforeseen demand drops or supply chain delays are already being reflected in the forecasted sales figures of PE-backed manufacturers.

“As of right now we are starting to see more than a 10 percent reduction in our sales forecast,” said one sponsor who invests in the sector.

The reduction could worsen to as much as 25 percent, the sponsor said, until workforces recover and the supply chain is refueled.

The outlook on valuations of industrial companies post coronavirus remains fuzzy, but sources say the new risk factor may add a different perspective for dealmaking in one of private equity’s more active sectors of investment.

Last year, private equity firms announced 324 deals in the industrials space – the highest count since 2015 – with an aggregate deal value of over $32 billion, according to data provided by Bain & Co. Large investors in the space have included Energy Capital Partners, Global Infrastructure Partners and Carlyle Group, to name just a few.

For PE investors on the back end of the crisis, the escalating supply chain challenges are likely to lead to more time and resources spent evaluating potential investment opportunities.

“It raises the bar in terms of due diligence that we would have to perform,” said Arctaris’ Tower, referencing the supply chain resilience factor that will play a role in investment going forward.

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