Private Equity International Keynote Interview with John Stewart, Founding and Managing Partner at MiddleGround Capital

Even in capital-intensive sectors, a systematic approach to operational improvements can drive value creation without relying on leverage, says MiddleGround Capital managing partner John Stewart.

Q: Capital-intensive industries such as manufacturing might not appeal to every private equity investor. Where are the value creation opportunities in these businesses?

As a private equity investor, there is a great opportunity to make manufacturing processes and production much, much more efficient – especially if you have experience managing the operations of big, multinational companies. That is why we find the likes of mid-market manufacturing, B2B, and specialty distribution businesses so attractive. My background is in the automotive sector. I entered the workforce as an hourly line worker for Toyota and moved up the ranks during an 18-year career with the company, ultimately becoming general manager for the company’s largest European division. During that period, I was immersed in what’s called the Toyota Production System (TPS), which is the foundation for the lean manufacturing systems that all modern manufacturers now deploy. It also draws heavily on the principles of Kaizen, which is a process of continual improvement.

I carried those ideas with me when I moved into private equity in 2007, joining New York-based firm Monomoy Capital, and then founding MiddleGround Capital in 2018. What fascinated me was how many industrial businesses there were, particularly in the lower mid-market, that simply weren’t using sophisticated technology in manufacturing processes.

For instance, many mid-market manufacturers do not take advantage of modern enterprise resource planning systems or any kind of data analytics to improve production processes. There are so many companies in the US lower mid-market that are still using technologies that are pre-1970.

When you can bring experience from a company like Toyota, which is using the latest technology and systems, you can identify so much opportunity in lower mid-market manufacturing to upgrade technology and processes. That’s a really useful toolbox, and it can add a lot of meaningful value.

Q: How does investing in more capital-intensive businesses fit into a PE underwriting process?

It’s about being systematic. In our case, the TPS principles inform everything we do, including the deal-sourcing process. For instance, when it comes to deal target assessments, the team follows a 45-step process, going through every line item of the profit and loss account and balance sheet to identify areas where there is scope to make operational improvements and add value.

This approach to underwriting does differ from the typical leveraged buyout approach to underwriting, where the focus is on looking at EBITDA or pro-forma EBITDA and then modelling how much leverage can be put on the business.

One of the things I’ve learned is that in manufacturing, especially in the lower mid-market, more than 85 percent of these businesses are cyclical, and that the worst thing that you can do for a cyclical business is to put too much debt in at the wrong point in the cycle.

We do use leverage, but on average will put in equity of between 55 percent and 60 percent in each deal, versus the PE average of between 35 percent and 40 percent. We have also done several platform company deals with 100 percent equity, but still underwriting to a 3x multiple return.

Q: When using limited or no debt in a deal structure, what can be done throughout a hold period to drive value on exit? What does that value creation playbook look like?

Detailed pre-deal due diligence is the starting point for drawing up a value creation plan. It is a very systematic and process-driven approach. Due diligence will highlight where there are gaps in a company’s operations, and a value creation plan is developed accordingly.

The specifics of each value creation plan are unique – value creation is not a cookie-cutter exercise – but the process for identifying the potential for operational improvement is broadly the same across companies. The value creation plan provides a roadmap to advance the portfolio company, which can involve everything from optimising operations and utilising technology to improving working capital management, procurement, inventory management, and supply chain management.

This ultimately builds a more efficient business, which translates into equity value for investors. The aim is always for the plan to generate 25 percent or more of the return that we are underwriting to. It is an extra lever for increasing value, independent from growth and leverage.

Q: Can you share any other examples of ways to add operational value to a midmarket portfolio company?

It’s easy to say a business can secure better terms with its vendors, but it’s difficult to execute. Suppliers have standard terms and conditions – there has to be a value proposition for both sides for a supplier to offer better terms.

For example, if you acquire a family-owned business with revenues of $250 million that is buying $100 million of steel each year from 12 different vendors, you might be able to help that business to consolidate its supply chain and negotiate better terms.

Across our portfolio, we have exposure to more than 200 factories. We know who all the steel producers are, we know which ones are better to deal with, and we know that instead of working with 12 suppliers, you can work with four or five to secure better terms and pricing. There is a lot of detail and nuance that goes into that, from assessing supplier relationships and understanding what savings can be made, through to supply chain consolidation and working with certain vendors over others.

Inventory is another area where we regularly see an opportunity for value creation. For the average local mid-market company, around 15 to 20 percent of the inventory on the books is actually excess and obsolete. Improving processes and accounting procedures can rectify that and truly release value that’s sitting on the balance sheet.

Identifying operational inefficiencies and changing processes requires boots on the ground and industry experience. We spend a lot of time in portfolio company plants, and around 40 percent of our team are people from operational backgrounds who have worked in factories. That’s the best route to value creation for these kinds of companies.

Q: From an investor’s point of view, what’s the appeal of diverging from the classic leveraged buyout approach?

On a dollar-per-dollar basis, it’s about putting less leverage on a business, while still underwriting to returns comparable to other firms. We find that it’s a real kind of sweat-equity model, because we are underwriting things that we can do for ourselves.

That means that we can consistently return capital to investors across market cycles, because the value drivers are things we can control. Ultimately, then, the value creation opportunity is not at the mercy of capital market cycles.

Original article linked here.