The New Boogeyman

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February 21, 2024

Don’t look under the bed. Private Equity might be lurking.

Private equity (PE) has become the boogeyman for buying groups and purchasing cooperatives – and for good reason: acquisitions of family-owned members have risen dramatically over the last five years and the impact on groups has been mixed at best. According to a Bloomberg report, smaller firms, typically founder-owned businesses valued at under $100 million, currently account for the biggest share of acquisitions by PE funds. These acquisitions include distribution, lumber yards, HVAC and plumbing companies, veterinarians, and dental practices – often those types of organizations that come together to form a buying group or purchasing cooperative.

With family-owned members being replaced by PE-owned members at a growing rate, buying groups and purchasing cooperatives are still figuring out the impact. Can PE-owned businesses continue to operate as members of the group? The consensus is that it is too soon to tell, but it is fair to say that groups are nervous.

What is Private Equity?

Private equity describes investment partnerships that buy and manage companies before selling them. PE investors act differently than venture capitalists, who provide a cash infusion to small startups in hopes that they grow and prosper. PE firms take controlling stakes in companies then try to repackage them, speed up their growth, and – theoretically – make them work better. Then, they sell them to another firm, take them public, or find another way to make a return on their investment.

How do they make groups work better?

PE firms tend to purchase smaller businesses and consolidate them into a larger business platform or a regional chain to make money. PE firms often tend to invest in the short term to get a return on their investment in just a few years.

The basic business model is simple. A PE firm uses their own money, investors’ money, and often borrowed money to buy companies. Debt can be the key to these deals. Debt used to finance an acquisition reduces the equity commitment and increases the potential return on that investment but with increased risk.

Private equity hopes that the acquired company will earn enough and grow fast enough to pay down the debt to a healthy amount. In addition, PE firms often have a percentage fee structure. An example would be a 2% management fee from their investors plus a 20% performance fee on the money they make from their deals.

Why Do Members Sell To Private Equity?

Because they (often) have no other choice or because the valuations offered by PE represent life changing wealth.

Over half of all privately owned businesses are owned by people over the age of 55. As the “Silver Tsunami” of retirements continues, owners are looking to sell their business as the main part of their retirement plan. Many are finding it difficult to find a buyer or match the high offers from PE when they are ready to sell.

Many business owners do not have a succession plan in place. While 30% of family businesses survive the transition from first to second generation ownership, only 12% survive the transition from second to third generation. 47% of family business owners expecting to retire in five years do not have a successor. They don’t see a future leader within their family or among the current executive team. The next generation is often hesitant to take over a company in a market with an uncertain future.

It is worth noting that PE doesn’t always mean taking over the business entirely. Recapitalization models exist where independent members can sell part of their business while retaining majority ownership. This provides a way for independents to free up some of their private capital while retaining control of the role they want to play in the business.

Why Does PE Target Wholesale Distribution?

Over the past 15 years, PE investment in wholesale distribution has been increasing.

Distributors convert most of their profit into cash flow, which allows private equity buyers to immediately begin repaying debt financing. The asset composition of wholesale distributors – primarily receivables and inventory – makes them a lower risk than other industries with high-cost, highly specialized fixed assets.

The distribution space also tends to be highly fragmented, composed of countless small companies distributing a very specific category of products to customers in a particular niche. This allows PE to acquire several companies with similar or complimentary products, combine them and benefit from economies of scale.

In short, wholesale distribution, typically, is a stable business serving many small accounts and therefore difficult to screw up.

How Can Buying Groups Live With PE?

Losing independently owned members to private equity has become a fact of life for buying groups and purchasing cooperatives. What does this mean in practice for groups?

If the PE member leaves, the group is left with fewer members, less overall purchase volume and often less rebates for the members who are left.

If the PE member stays, they may not have the same loyalty to the group as their previous owners. Operating with a short-term mentality, private equity may not see the value in contributing funds to the group, investing in programs that help all members, or being engaged at all. Debt taken on during the acquisition may limit the member’s future investments. As consolidation increases their purchasing power, there is a greater risk of them creating their own deals and buying outside of the group.

It can also get complicated if PE acquires members belonging to multiple groups. In these cases, the consolidated business can access private data from competing groups, including rebate deals. This conflict of interest is often enough to warrant kicking them out of the group.

Groups may also worry that given PE’s propensity to sell within a few years, they may face more risk and uncertainty around these members in the not too distant future.

Despite these risks, some groups have chosen to embrace PE-owned members.

If a PE-owned member is committed to buying through the group, they can often be treated like any other member. Often the challenge is simply getting the PE team to understand why the group exists. Groups can work with PE managers and educate them about the role of the group and demonstrate the value of membership. If possible, take them through a new member on-boarding process.

Demonstrating clear value and streamlining processes is key. If PE sees group membership as an asset rather than a liability, the relationship will survive. Take the time to understand their specific goals and help them meet them.

Track their monthly purchases and look for any changes. Be proactive if you see a decline.

If living with PE doesn’t seem to be the answer, groups can take steps to deter members from selling to PE. The key seems to be succession planning. Aging owners need a profitable alternative to selling their business to PE. There are steps that groups can take to foster these alternatives:

Existing Together

There is no reason that PE owned members cannot exist productively within a buying group. Like the boogeyman, the fear of what’s under the bed can be worse than what is actually there. Despite the risks associated with PE, many groups have fared very well from PE’s involvement and certainly many owners have had their lifetime of hard work rewarded handsomely by these organizations. There is risk whenever a member changes ownership, and it can be argued that a PE acquisition of a member is no different than any member acquisition.

Groups must recognize that private equity, consolidation, aging owners, and succession planning are all entwined. Concentrating on making members successful and helping them transfer their business profitably to other independent owners is the best defense against losing members to PE.

That said, efforts should be considered to determine new business models or partnerships where the mutual interests of PE back businesses and independents can be exploited. Perhaps it is PE that will force groups to go beyond their current business model and look at other strategies to make members more competitive and more successful.

The long-term impact of PE and its accompanying consolidation is still unknown, although buying groups and purchasing cooperatives are understandably nervous. Perhaps it will take a new way of thinking from both buying groups and their newly acquired PE backed members to prove a working relationship can lead to a win-win. It may be too soon to declare PE to be the boogeyman, but groups are right to be checking under the bed.

Written by Steve Seguin

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LBMX offers a business-to-business marketplace platform, helping independent businesses, their buying groups, and suppliers buy better and sell more. Its Private Group Marketplace for Groups has transformed billing and ordering, rebate management, real-time analytics, e-commerce and product information management across the building materials, HVAC, plumbing, sporting goods, industrial supply, manufacturing, and agricultural industries. Its LBMX Supply Cloud platform allows suppliers to look at their industrial distribution customers through one lens, offering full EDI, PIM, Analytics and Payments.

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