While the chemical space may not sound like the most appealing area to pursue, for buyout shops looking to make some money, the sector is not a bad option.
“If you think about deal flow in the market recently, the reason you see [chemical] companies getting a lot of attention is that the cyclical industries have not picked up as much in terms of deal flow,” said USBancorp Piper Jaffray Vice President Robert Frost. “These are non-cyclical companies, and in the new world order that’s not a bad thing. [Private equity] investors would rather sleep well at night. They want solid companies with good market positions and stable and predictable cash flows.”
In a recently released report on the specialty chemicals industry, USBancorp Piper Jaffray attributed the popularity of chemical deals to the industry’s fragmentation, its cash flow stability and the ongoing restructuring efforts of businesses in the sector. Additionally, the report cited data compiled from McKinsey & Co. showing that, on average, net returns for LBOs in the chemicals sector generally outperform net returns in other industries (see graph).
Frost noted that the stronger hit rate for the sector was a direct result of its relative stability. “You didn’t see the blowups in the chemicals world, and on a relative basis, that asset class performed relatively well,” he said.
Indeed, the popularity of the space can be seen in the size of the transactions that have occurred this past year. The Blackstone Group, Apollo Management and GS Capital Partners’ $4.3 billion purchase of Ondeo Nalco tops the list, but other notable deals include Bain Capital’s $983 million LBO of Sigma Kalon; Texas Pacific Group’s $800 million purchase of Kraton Polymers; Soros Private Equity’s $256 million buyout of PolymerLatex; and Arsenal Capital Partners’ $65 million acquisition of Rutherford Chemicals.
While some sectors, such as health care or technology, typically need some sort of specialization from the buyout shops that participate in the space, chemical deals are not shut off to the generalized funds. “It definitely has its advantages to have industry experience, but there is a rationale [to buy these assets] even if you don’t have deep industry knowledge,” Frost said. “The stability of these assets lends itself to the LBO model and the financial engineering play makes sense for these companies.”
One aspect that could be viewed as a hindrance to investing in the chemicals arena would be its exposure to potential environmental liabilities. And while Frost concedes this aspect is certainly important to a firm’s due diligence, it is also one of the main drivers of the industry’s consolidation. “The cost and infrastructure needed to comply with environmental regulations is one of the dynamics that support further consolidation,” he said. “There definitely are some benefits of scale.”
The valuations of chemical companies have been somewhat wobbly the past few years, ranging anywhere from 6.9 times EBITDA to 9.3 times EBITDA since 2000. The instability of those numbers is driven primarily from the lack of strategic acquirers, but recently the corporates have started to ramp up their M&A activity, and Frost expects them to be active from here on out.
However, strategics re-entering the market should not temper the private equity enthusiasm. The highly differentiated subsectors of the chemicals industry discourage the corporate buyers from consolidating across the industry. In the specialty chemicals space alone, the industry covers adhesives and sealants, electronic chemicals, plastic additives and catalysts.
Frost believes, at least as far as the specialty chemicals segment is concerned, “The industry is so niche oriented and fragmented and there are so many sectors that are not consolidated, the specialty chemical world should remain a fertile playground for the private equity buyers for some time.” He adds, “There’s nobody that plays across all segments in specialty chemicals. The end-markets and distribution channels are so different segment to segment, that it doesn’t make sense for a strategic buyer to make acquisitions across every segment.”
Moreover, not everybody believes the strategics are showing that much aggression-at least not enough to scare off the financial sponsors. Terrence Mullen, a managing director with Arsenal, says, “We are seeing them in the auctions, but we feel they are not as aggressive as they have been in the past. Their stock prices are not trading at the lofty multiples they were before, and many of these specialty chemical companies went through a meaningful period of acquisitions in the late nineties and are still digesting those.”
Still, whether the strategics re-enter the market in force or not, most believe there are enough opportunities in the specialty chemicals sector to accommodate every one. And even as the chemical deals usually sit in the shadows of the higher profile retail or consumer product transactions, as long as they generate returns, buyout players will be drawn to the sector. The industry’s high margins, differentiated products and high barriers to entry will likely ensure the space remains on the buyout players’ radar for some time to come.
“It’s a core focus area for us,” Mullen adds. “We believe the specialty chemical industry has strong long-term growth trends. It’s attractive to buyouts because of its niche markets, and you can find a number of companies that have good long-term growth, strong margins and key competitive advantages.”