When Ripplewood Holdings acquired Maytag last month, Ralph Hake, the appliance maker’s CEO, took special note of Ripplewood’s “extensive operating expertise in Asia and Europe.” He didn’t exactly come out and say it, but the design was clear: marry Ripplewood’s global capabilities with Maytag’s global inadequacies and Ripplewood should make a profit while Maytag lives to see another day.
The appliance manufacturer has been languishing for years now, and its struggle is emblematic of many other domestic manufacturers. The company, strangled by oppressive union contracts, has the highest cost structure in its industry. Even with low interest rates and robust housing activity, Maytag still can’t seem to find its bearing and the company is slowly starting to see its floor space disappear among the retailers. Best Buy has stopped selling Maytag products altogether, while Home Depot has cut back on the company’s plot to accommodate for the arrival of Asian imports, such as LG Electronics.
If this sounds new to anyone, let this serve as the introduction to the dreaded “China threat.” Rising costs domestically, coupled with foreign competition, particularly from Asia, have conspired to squeeze margins, creating a negative synergy that makes U.S. manufacturers even less equipped to compete with their Far East rivals.
In the past, most private equity firms wanted to keep as far away from the “China threat” as possible. If a company sold to the OEMs, there was the understanding that it was just a matter of time before someone cheaper came along. Trying to fight it was considered a losing battle.
However, there are more PE firms that are taking this threat head on, and using it as a way to bring strategic value to the companies they acquire by helping them to capitalize on the Chinese marketplace. Firms are initiating joint ventures in China on behalf of their portfolios. They’re setting up greenfield operations in Asian outposts. And slowly, their portfolio companies are finding that they too can be the low-cost supplier to the markets they serve, or at the very least compete with the low-cost supplier. As a number of pros have quipped recently, buyout shops are targeting U.S. manufacturers and trying to make those businesses become the “China threat.”
Part of this is the result of a more proactive stance buyout shops assume today. Firms are paying high enough multiples that there needs to be some operational improvements in order to drive returns, and pursuing a globalization strategy is one way to do so. Moreover, for many domestic PE firms, targeting companies in their own backyards and using those businesses to gain entry into China and other Asian outposts, gives them exposure to the rapid growth in Asia without necessarily carrying the risk of direct investments.
Indeed, the topic of how U.S. firms can gain exposure to Asia while keeping their direct investment activity at home was one of the main themes at the recent Asian Venture Capital Journal conference in Chicago, which featured private equity firms like W.L. Ross & Co., Castle Harlan, Rhone Group, AEA Investors, Cambridge Capital Partners, Blue Point Capital Partners and Texas Pacific Group.
“It doesn’t matter where you’re investing, if you don’t have an Asian strategy, you don’t have a complete game plan,” Morgenthaler Partner’s John Lutsi, a general partner at the firm, says.
Nobody’s Savior, But Cost Savings Impress
Unlike the Maytag acquisition, most buyout firms are not using this strategy as way to throw a life-vest out to domestic businesses that need a China strategy. The consensus among buyout pros is that developing a China plan should stem from trying to capture potential upside for their portfolio companies.
Texas Pacific Group’s William Price, a co-founder of the firm, tells Buyouts, “Most of the companies we look at are profitable already. We’ll just look at Asia as a way to maintain or grow the margins by moving the company down the cost curve and improving the economics of the business as we own it. There are very few cases where people will look at a company that’s failing in the U.S. and move it to Asia as a way to fix it.”
Price has taken this approach in a number of TPG’s investments and has seen results that clearly justify the course. He considers the firm’s acquisitions of Seagate Technology and MEMC to be just as much “Asian” investments as domestic deals, even though the companies are headquartered in California and Montana, respectively. And proof that globalization pays off, TPG was able to realize a return multiple of 7x its investment on the Seagate transaction, and has notched an 86x return on MEMC, according to reports.
As a rule of thumb, when it comes to cost savings, industry pros generally deem that whenever a company’s direct labor, as a percentage of sales, exceeds 10%, there may be a case for outsourcing production to China. If that number is below 10%, such a move would not justify the execution risk, given that rising energy costs and transportation expenditures would make it negligible to the bottom line.
The Top-Line Intrigue
The common misconception when discussing offshoring opportunities is that PE firms are bringing companies overseas to simply cut down on costs, when in fact the long-term draw to offshoring is more to gain an entry into the Asian marketplace. Energy costs continue to rise in China, while employee costs, with increasing demand, could also start to swell. As these expenditures grow, companies will need more than just expense reduction to justify the move.
Lutsi says, “The question is, Are you viewing Asia as a threat or as an opportunity?’ We don’t want to go over there just to export products back into the United States. There’s a huge domestic market developing there and we want to position our companies to take advantage of that.”
He further describes that as the OEMs set up shop overseas to target the growing marketplace, they will eventually demand an Asian presence from its suppliers as well.
“We look at offshoring more as opportunity to increase growth,” John Reinke, a principal at Milwaukee-based Facilitator Capital, says. “It’s not just an expense game anymore. You look at the costs of developing additional capacity and the payback doesn’t really justify it here [in the U.S]. Not when you can go to China [to enter that marketplace] and do so with much lower fixed costs and more variability in terms of production.”
With that said, though, not everything is a fit for the Chinese market. Lutsi says that right now the most pressing need in the region is for products that sell into the infrastructure space. Manufacturers that make parts for trucks, heavy duty transmissions, and the developing agriculture sector are just a few of the businesses that could find demand in the region. Also, specific to China, Lutsi adds that the auto part manufacturers should also see a pop in demand in the coming years as the Chinese government has demanded that local content rules be in place by 2010.
Chinese Medicine Still No Cure All
Despite all of the buzz that surrounds offshoring, there are still some obvious hurdles. Few firms have developed a turnkey solution to setting up operations in China. It requires a lot of travel, people on the ground and perhaps most important, reliable locals to manage the operations. Jim Hoover, the president and CEO at aerospace manufacturer Primus Inc., told an audience at the AVCJ conference that when his company entered the Chinese marketplace, it actually spent more time searching for a general manager to run the operations than it did seeking out a business to partner with.
Many that have been there equate the emerging Chinese marketplace to the Wild West, where laws-specifically patent laws-do not really exist. Hoover, at the same conference, noted that Primus won’t offshore products if the company is worried about divulging patented secrets, while Lutsi adds, “China represents reverse engineering at its best.”
Others, meanwhile, also cite that when investors initiate a global strategy, they had better be ready to wait it out. Some pros have said that it can extend the hold time on portfolio companies to as long as seven years.
And even as PE groups seem to be rushing into China, pros that have been warn that doing business there is not for the weak. “It’s something we’ve really worked toward,” Facilitator’s Reinke says. “It’s one thing to say you have an Asian sourcing strategy or a supply network. Anyone can turn the switch on overnight and hire an agent. [As a private equity firm], if you have people that can add value and actively manage the supply chain, then that’s adding real value.”