Peter Taft is a general partner with Cleveland and Menlo Park, Calif.-based Morgenthaler. He has been actively involved in many of the firm’s successful management buyout and leveraged build-up investments, including Cambridge International, American Paper Group and Gatan International (acquired by Roper Industries). Morgenthaler invests in profitable, stand-alone middle-market companies, and divisions or subsidiaries of larger corporations, focusing on industrial growth markets and communications, as well as on the information, health care and business services sectors. Last week, Leslie Green, editor of Buyouts, spoke to Taft about investing in Old Economy companies.
What does “Old Economy” mean to you?
Out here in the Midwest, in the heartland, there are a lot of manufacturing companies and a lot of manufacturing activity. But the general way I think people have characterized Old Economy companies is as those old fashioned companies that actually make a profit and sell a product.
What are your thoughts on changes to Old Economy investing because of the recession?
We have seen a dramatic change in business over the last several years as the country has hit an economic slowdown. There are two categories that have been hit the hardest in this economy: telecom and manufacturing. For many private equity investors that have gotten into this business within the last 10 years, they have not experienced a downturn or a slowdown until now. This has been a good test for investment models and it’s been a good test for manufacturing companies. Our CEOs have said this has been difficult for them because it has forced them to look at their business in a whole new way, cut out excess costs and become more efficient. At the same time, companies, going through this from time to time, get healthier, too. It shakes out the weaker competitors and provides an opportunity for an organization to get stronger.
It’s been tough for manufacturing. Hopefully, good times or stronger times, in terms of demand, are coming.
Why was manufacturing one of the areas to get hit the hardest?
What was driving demand and growth during the last five years or so was a strong investment in corporate infrastructure and capacity. People were investing in their companies. In part, they were doing that defensively. People were terrified the little Internet start-ups were going to steal the margin on their competitive position. As a result, they spent defensively to avoid a threat to their business. The other part of that was because times were good and capital was relatively inexpensive, companies were spending aggressively to increase their capacity so they could fill future demand and take share from their competitors. Any time you have that sort of cumulative effect, when the slowdown comes, demand is slower. There was excess capacity and excess inventories. There was a correction that needed to be done, and all that rippled back to the world that we live in, which is middle-market manufacturing companies. They’ve seen some slowdown in their top line and have had to manage expenses accordingly.
It’s pretty typical, but the headline is that for the last 10 years there’s been little of this and now, no surprise, we have a cyclical turn in the economy. It’s like people forgot for a while that the economy had cycles.
Are you of the belief that we’re coming out of the recession?
I think so. I will say that as I talk to people who are lending money to companies or advising companies, people are still waiting for empirical evidence that things are getting better. They’re feeling more optimistic today than they were a month or two ago, and I’m certainly a firm believer in monetary and fiscal policy, and I think the changes that have been made certainly will have an effect, but they take a while to get traction. If in a month or two we haven’t seen some real indications of year-over-year pick-up in orders, bookings, things like that – across a broad sector in the portfolio – and hear anecdotally from people that things are better, I’d be concerned.
Did you change your investment strategy at all to continue to do deals during the downturn?
We really have continued to maintain the same focus – we do buyouts in three sectors: manufacturing, communications-related business and health care. Because we are focusing across the different sectors, at any one time those sectors may be more or less attractive than the others and we move accordingly. Our deal flow is what changed. We certainly saw a significant change in our deal flow in 2001 – the drop was more in the quality of the opportunities than the quantity. We probably saw 10% fewer deals last year than the year before, but the quality of the ones we saw was down. Our hypothesis was that the good companies that didn’t have to sell took a hiatus, decided they wouldn’t sell if they had been contemplating it before. They delayed. If they were in the market they pulled back. The ones in the market were the ones that didn’t have a choice.
Historically, any time there’s a change in the markets, there’s a six-month lag between perception and reality in the way it affects sellers. It took six to nine months of lower multiples, six to nine months of burn-in period, until sellers recognize we weren’t going back to the ways of 1999 and early 2000.
By the time we got to the fourth quarter last year, deal flow quality began to improve. What we call our bulls-eye deal flow, in our zone of the kinds of companies we like to buy, is now up almost 30% year over year. That’s what we’re seeing in terms of new opportunities.
Is the lending market going to cooperate?
We’ve assumed we’re going to get market multiples from our bankers. We’re looking at a transaction right now, it’s under letter of intent, and we did better than we forecasted with the bank financing, which maybe means things are improving. We exceeded expectations and that’s a good thing. I think it’s indicative of the fact that capital markets are stabilizing.
What are some other things you’re seeing in the market?
Two things. One, in the last 12 months we’ve seen a lot more corporate divestiture opportunities. Those are up probably 40% from last year.
Another thing that has struck us is that nearly half the deals we’re talking to now are family-owned businesses exploring a recapitalization as opposed to an outright sale. I think part of this may be the greater understanding of what a recap can do for them in terms of diversifying their assets and participate in the growth of the company on an ongoing basis.
Another part of this is the impact of Sept. 11 on human behavior. It caused a number of owners of businesses to realize that there’s human mortality and there’s business risk. There’s a higher level of business risk than we had previously even contemplated before that day that needs to be factored into things. If you have all your assets tied into a single business, there’s significant risk there. People have begun to react to that by saying maybe this is the time to bring in a partner that can help the business and diversify my assets and continue to grow the business so it’s more secure. It’s profound how much more people are talking about these sorts of issues and reflecting on them.