Private Equity’s Next Crush

Family-owned wineries in the northwestern United States are ripe for the picking, and private equity funds are getting ready for the harvest.

Besides being the fastest-growing, most profitable and one of the most competitive wine consuming markets in the world, the United States has the largest wine industry in the world, accounting for more than $30 billion in annual sales, according to research by Silicon Valley Bank. Most wineries in the United States are in the beginning stages of a tremendous transition as the original owners are preparing for retirement. As owners are faced with the challenges of how to transition their wineries while retaining part ownership and control, private equity funds are in a unique position to partner with these owners by providing financing, strategic planning and operational expertise and even a competitive advantage.

Driving The Transition

According to a survey conducted by Silicon Valley Bank and Scion Advisors in January, more than half of the family-run wineries in the northwestern region of the United States are expecting to go through a “change of control” event within the next 10 years and almost a quarter of the industry expects to transition within five years, according to Silicon Valley Bank. That suggests significant investment opportunities given the estimated 2,400 wineries across California, Oregon and Washington. The expected sales of these wineries stem from a number of factors, including the age of the current owners, stage in the business life-cycle, and general economic conditions in the United States.

More than 80 percent of the respondents to the survey are first-generation owners, having formed or acquired their wineries subsequent to 1975. A majority of these owners are at the age where they are ready to cash out of the business and pass the wineries to the next generation. The problem is that these owners have not planned for a transition and now the businesses face serious issues. According to the survey, 77 percent of owners have no financial plan for a transition, and 80 percent have not completed estate planning. This lack of planning has opened the door to third parties wishing to invest in these wineries because, upon a transfer of equity interests by the owners, there will likely be significant tax liabilities owed and a current or subsequent shortage of cash. In order to adjust, the wineries will need to obtain financing beyond what they have currently in place.

Having been family-run operations for more than 30 years, a majority of California wineries have reached a stage in their business growth where the family-run business model is no longer sufficient to meet the challenges of the industry and provide profitability. In order to compete in today’s growing market, these businesses need financing to build infrastructure, strategic planning to provide sustainability, and operational expertise to bring brands to market. Currently, the majority of wineries do not have the financial means to hire an experienced CEO or other key personnel and only 18 percent have a board of directors or advisors in place, according to the survey. Most family-run wineries do not have the expertise and depth to deal with all of the issues of the expanding and rapidly-evolving wine industry such as dealing with property rights, negotiating contracts, structuring corporate mergers and acquisitions, and working with financing sources. The wineries that successfully transition will be the ones that find the backing necessary to grow beyond the family-run business model.

Economic Conditions

The tightening conditions in the U.S. economy have made it more important than ever for wineries to not only produce great wine but to execute a strategic plan that will allow them to be profitable. Even though the decline in the U.S. dollar has caused the price of foreign wine to increase, creating some cushion for domestic producers for the moment, U.S. wine producers will still need to consider three big factors: competition from an increasing number of brands entering the market, their ability to obtain proper representation from distributors that are continuously consolidating, and the opportunities and costs associated with direct-to-consumer marketing.

There are almost 5,000 U.S. wineries producing approximately 7,000 brands, making it increasingly difficult to market and sell wine effectively, according to Silicon Valley Bank—see chart, this page. The largest hurdle for small to mid-sized wineries is a shortage of national distributors willing and able to represent them. The number of distributors keeps decreasing due to consolidations, and those remaining are seeking either wine producers with high-volume production that is efficient to sell or an established brand that is easy to market, according to Silicon Valley Bank. According to estimates from Gomberg, Fredrickson & Associates, the top 10 wine producers account for nearly 82 percent of total domestic shipments, leaving close to 5,000 wineries competing for the other 18 percent of available space in the wholesale channels, according to Silicon Valley Bank. One must conclude that small and mid-sized producers must either increase the volume of wine they have available for sale or bring in the expertise to build and establish a very recognizable brand to gain the attention of the distributors, both of which create an increased need for capital.

Chart: Number Of Distributors In Relation To Rands Sold

Source: 2008-2009 STate of the Wine Industry, Silicon Valley Bank, May 2008

The alternative to selling wine through a national distributor is selling directly to consumers. Stonebridge Research estimates that the direct-to-consumer portion of the U.S. market represents a mere 3 percent, which suggests that it is difficult to sell large volumes of wine this way. Even so, as a small to mid-sized winery, dealing with national distributors has been, and continues to be, difficult, so many of these wineries sell their products directly to consumers. The use of the Internet has made reaching a large market easier than in the past and has opened the door to selling large volumes of wine without a distributor. The problems with the direct-to-consumer approach have been increased sales and shipping costs, challenges in keeping up with Internet-based marketing, and sales tactics and maneuvering the legal state and federal regulatory framework. The result of the increased costs is a higher-priced bottle of wine compared to a bottle sold through a distributor, according to Silicon Valley Bank.

Role Of Private Equity

According to the survey, the majority of wine owners would prefer to keep their wineries in the family, but under the right circumstances are open to the possibility of selling to, or receiving investments from, a third party. The transitioning phase of the wine industry and the current state of the economy provide a good opportunity for private equity funds to enter this market. Skyrocketing fuel costs and the weak U.S. dollar have caused the price of foreign wine to increase, providing a window of opportunity for investors to enter the market. While there is less competition from abroad, private equity funds can take advantage of the transitioning wine industry by providing the following: 1) financing to both address outstanding liabilities and build infrastructure; 2) strategic planning to provide long-term sustainability; 3) operational expertise to build and market a brand; and 4) economies of scale by purchasing multiple wineries under the same investment platform to provide leverage with national distributors for selling the product.

Wineries are approaching their limit in terms of borrowing from banks and traditional lenders. This leaves a number of options for wine owners, such as obtaining financing from mezzanine lenders who lend at higher EBITDA multiples than these particular banks, and selling an equity interest in their companies to a third party. Moreover, mezzanine lenders would provide financing to wineries without taking a controlling equity interest. This could provide necessary capital to wineries for intergenerational liquidity issues, and to support internal growth, while providing solid investment opportunities for funds given that winery acquisition multiples are relatively high, ranging from 12x-19x EBITDA, or more.

Private equity funds could be a great fit as third-party equity purchasers of wineries when compared to strategic buyers. Private equity funds can structure buyout transactions such that the wineries obtain the additional funding necessary to address any outstanding liabilities, such as taxes, and provide for internal growth, while the current owners and their families can retain some form of ownership and control over the business. The result is a partnership between the fund and the family with both parties’ interests aligned. Private equity funds would also bring in their teams of consultants, bankers, attorneys and accountants to provide a strategic business plan and the operational expertise to execute it.

In contrast, a strategic buyer may not be as good a fit for the family since strategic buyers might consolidate the assets and operations of their targets to take advantage of operational synergies. This could result in cost savings for the wineries, while perhaps sacrificing the uniqueness of the brands and control by the current families. These owners will likely have a harder time finding a place in the corporate landscape, so opportunities for family members could be too limited.

Avoiding Bottle Shock

The legal framework of operating a winery is complex because, not only do wineries have to address regular legal business issues, they have to maneuver through industry- specific issues including complex state and federal regulations. Family-operated wineries do not necessarily have the expertise or staff of sophisticated advisors that private equity funds have that will provide guidance on these issues. Some of the regular business issues include business succession, financing, insurance, intellectual property, labor and employment and tax. Further, wineries face extensive industry-specific issues made even more involved by the fact that both state and federal laws regulate many aspects of this industry. The list of legal issues specific to the wine industry is extensive and includes dealing with environmental regulations, water rights, property and development permits and unique contracts and licenses.

That said, as wineries enter a new phase in their life cycle, it is likely that we will see significant activity from private equity funds in the wine industry. The industry presents a unique opportunity for funds to enter a nearly untapped, primarily family-owned, multi-billion dollar marketplace by providing necessary financing and expertise to such wineries. At the same time, current wine owners may have the ability to retain some financial interest and perhaps even partial control over operations and their brands, making for a noble partnership.

James L. Kelly is a partner at Nixon Peabody LLP, where he represents private equity sponsors, their portfolio companies, and financial institutions. Associates Ami-Cietta Duche and Michael Mueller also made signficant contributions to this article.