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MiddleGround Capital on the art of the automotive deal

How has covid-19 impacted the automotive supply chain and the opportunities that you see in the sector?
MiddleGround Capital founding partner John StewartJohn Stewart: MiddleGround invests in B2B companies in the industrial and specialty distribution sectors in the North American lower middle market. We established MiddleGround in 2018 after leaving our prior firm and closed our first fund above its hard-cap at $460 million in August 2019. Since 2018, we have built our team out to 27 professionals and made eight investments in six portfolio companies, having deployed over 60 percent of Fund I as of August. Scot and I have a deep background in the automotive industry, having met at Toyota Motor Company and working there together for 13 years before moving into private equity.

 

We are now planning for Fund II and fundraising for an overflow vehicle to invest alongside our main funds in the automotive/mobility sector. Numerous investors have told us they feel like they missed an opportunity to participate in the recent public market recovery and are looking for ways to invest in areas that are still rebounding from the impact of the pandemic. We see the automotive industry as a great opportunity in this regard.

Prior to the covid-19 shutdown, we had already spent over a year working to identify the most attractive areas to invest within auto. Once covid-19 hit, it accelerated everything because the global shutdown of the automotive industry was unprecedented.

When this happened, a massive amount of capital was removed at a time when the industry was transitioning from a transportation industry to a mobility industry, impacting the original equipment manufacturers (OEMs) and all of the supply base. The industry has been heavily focused on making investments around disruptive trends that require massive funding. Dura Automotive Systems, which we acquired in August, is a classic example of this issue. Dura has successfully transitioned out of certain declining, legacy products and won several hundred million dollars’ worth of new products that require substantial investment. These include battery trays for hybrid and electric vehicles which will require building three new facilities and hiring over 1,200 employees in the next two years.

Due to availability of liquidity pre-covid, many automotive suppliers had become dependent on leverage as part of their operating models. With no other source of capital, companies turned toward the credit markets to fund acquisitions and capital projects with exposure to these new trends. After several years of accessible debt, the companies’ balance sheets ballooned. When covid-19 hit, many businesses found themselves substantially over-levered due to the reduction in earnings caused by the shutdown and have survived the last few months due to the working capital cycle. Some businesses have the ability to fund the ramp up, while others do not. Even if they can, they don’t have the capital to continue to invest in the industry transformation at the same pace as they did before covid. This presents a real opportunity for private equity investors that understand the industry and the changes occurring.

Rhondia Black: Not unlike elsewhere, covid-19 has highlighted the risks in the supply chain and the need for businesses to make sure they can keep those products moving. The opportunity for investors now, post-covid, is to find good businesses and fund their growth for the covid recovery, as well as aligning around the other key trends impacting the industry.

What trends are reshaping the market and driving your investment thesis?
JS: The automotive industry is going through a transformation unlike anything anybody has seen before and becoming a new industry all together, the industry of mobility. Mobility companies are focusing on the ways of meeting all of the mobility needs of a person – everything that is needed to move from point A to B. Traditional automotive OEMs have prioritized capital investment to respond to four emerging trends: the electrification of the powertrain, the lightweighting of vehicles using alternative materials to drive energy efficiency, autonomous driving and connected cars. These four trends are influencing the industry today at a blistering pace.

Another factor forcing the industry to evolve its operating model is the magnitude of fresh capital investment in the industry. Tesla was definitely a disruptor to the traditional automotive business, but the real influencers today are new entrants such as Google, Amazon and Apple, who are investing billions of dollars to define the future of mobility. These new entrants and their massive investments in technology have focused the industry like nothing previously seen.

To keep up with all the latest trends and advancements, we have assembled an expert advisory panel made up of leaders and executives from all areas of the industry with over 150 years of additional knowledge from the industry. Many of our panel members are on the front lines of the changes all across the globe and help us to identify and evaluate new business opportunities as well as provide strategic direction to our senior management teams as members of the board of directors.

MiddleGround Capital partner Scot DuncanThere are also macro drivers at play. One is regulatory change. For example, California is leading the US in demanding lower vehicle emissions, saying every vehicle sold in California needs to be zero emissions by 2035. We see similar mandates all over the world. Increased regulation for zero emissions is driving powertrain electrification, which is one of the first trends to emerge. Another macro driver is the social movement. Today, there is a whole generation of young people who are concerned about doing business with companies that treat their employees and the environment well. Companies that don’t adapt are going to have a real challenge.

Scot Duncan: From a capital investment perspective, the issue is that companies need capital to survive but also need to invest heavily to transform their capabilities around these trends. The covid crisis is terrible timing for automotive because companies are over-levered and looking to invest in their technologies and factories, as well as having to deal with the shutdown.

What does a right-sized capital structure look like in the automotive sector today?
JS: Even pre-covid, we would often invest between 45-50 percent equity in each of our deals. For the deals that we have completed post-covid, we are using equity for the majority of the capital structure. For Dura, we funded 100 percent equity at close, and the business had less than $20 million of net debt.

About 50 percent of our investment went on to the balance sheet as cash. We’re talking about an $800 million Tier 1 automotive supplier with very little debt. For a successful rebound from covid, the company needs liquidity to both fund the recovery of the industry to pre-pandemic levels and invest in new technologies and new programs it has already booked with its customers. If you load these companies up with debt, they will not have the capital needed to invest in their future. They need to invest, so excessive leverage only creates problems down the road. This is a bit different from a typical private equity model, which is why our knowledge of the industry gives us an advantage, because we can understand the value of making those investments over the longer term.

What is the outlook for the sector going into 2021, and what kind of activity do you expect to see going forward?
JS: We see this as the beginning of a window of opportunity. In automotive, there was a massive liquidity sink in the industry at a critical time. Companies like Shiloh Industries are in bankruptcy protection, not because they are poorly performing companies but because prior leadership relied too heavily on leverage to manage and grow the business.

What doesn’t change is the fact that investment is still needed and it’s not going to come from lenders, so there is a great opportunity for private equity. There’s going to be a lot of activity in the space, with the OEMs scrambling because they have also been impacted and they don’t have the liquidity to bail out the supply chain. Over the next 12-18 months, we see a lot of opportunity for firms that understand the space and are willing to take a calculated risk to invest in businesses that are truly transforming.

Can you walk us through some of the mechanics of an automotive deal?

JS: Our recent investment in Dura Automotive Systems is a very good example of what we are talking about. Dura is a global designer and manufacturer of highly engineered automotive systems, focused on mechatronics, lightweight structures and exterior trims. Its products include shift-by-wire actuators, advanced driver assistance systems, electric vehicle battery trays and mechatronic control systems, which it supplies to leading automotive OEMs and Tier 1 partners worldwide. That means Dura is, and will continue to be, a force in an industry undergoing major transformation, developing next-generation products that support those four disruptive trends.

By 2025, over 60 percent of Dura’s business will be aligned with the electrification trend. Dura has proven it can successfully develop new technologies and boasts a five-year forecast that is more than 85 percent booked business. When you look at it from that perspective, there is a real growth story to Dura and other companies similarly positioned in the supply chain.

We acquired majority ownership of Dura from Bardin Hill Investment Partners, which had seen the company through a challenging restructuring during the pandemic. With less debt available today than 10-12 months ago, some private equity sponsors that rely on high leverage to create returns are challenged. At MiddleGround, we don’t heavily lever our businesses and instead rely on our expertise and ability to make operational improvements to create value.