Good reasons for local investors to look to the US middle market
Foreign buyers can invest in sector driving the American economy without betting the farm, writes Sheon Karol
As a South African expatriate and frequent visitor, I am struck that South African businesses have expanded, organically or by acquisition, into western Europe, Australia and Africa but have not really exploited the US market.
South African acquirers have travelled "in the realms of gold, and many goodly states and kingdoms seen", yet have barely dipped their toes into the US.
It’s worthwhile to consider why this is the case and why it need not continue.
The relative absence of SA from the US market could stem from a variety of factors. One could be the comparatively greater cultural familiarity with other markets, such as the UK.
It also may be due in part to a reluctance to engage American braggadocio. There also may be a perception that the "American market" is monolithic, with outsized opportunities too cumbersome, complex or expensive to pursue. Due to the unfavourable currency exchange rate, for example, few South African companies would choose to buy a large, listed US company.
But there’s an alternative: the middle market. This vibrant category holds a rich variety of assets and a broad range of company sizes in multiple sectors and niches.
The National Centre for the Middle Market defines "middle-market companies" as those with annual revenue of between $10m and $1bn.
Their current performance is significant. In the third quarter of 2017, middle-market companies showed steady 7% year-over-year revenue growth and 6.4% growth in employment.
According to the centre, "although the middle market represents just 3% of all US companies, it accounts for a third of US private sector GDP and jobs. It is the engine that is driving the US economy." In the fourth quarter of 2017, earnings at private middle-market companies in the US grew at their fastest pace since 2012.
Accordingly, foreign buyers are seeking an increased presence in this market. A foreign acquirer can invest in a stable country with a successful economy without betting the farm if it buys in the middle market.
A SWEET SPOT FOR ACQUISITIONS MIGHT BE A PURCHASE PRICE OF $20M TO $50M FOR A NICHE COMPANY.
For South Africans, the difficulty and the promise of the US middle market derive from the same factor: the US middle market is "inefficient". Most of the companies in this sector are not publicly traded and therefore pricing is inexact. A true understanding of opportunities requires diligent, specialised research and trusted relationships within the arena.
The dynamics frequently fit a profile. Middle-market business owners often started from scratch or have developed family businesses. The sale of their businesses is often their first (and last) mergers and acquisitions transaction. Buyers on the other hand have more mergers and acquisitions experience and resources. So many sellers look to support from outside advisers to get the best deal and to consummate the transaction.
Buyers pay a premium for businesses as earnings before interest, tax, depreciation and amortisation increase. The premium rises for niche businesses. My view is that South Africans should seek niche businesses with strategies that fit the local business landscape, rather than simply duplicating a formula successful in SA.
For example, South African acquirers for a time thought Australia was a home game. It has become evident that, even with cultural similarities, a foreign country is still an away game. It is necessary to shift perspectives — or one’s lens.
South Africans, like other foreign buyers, have an understandable fear of acquiring a distant business. The challenges are apparent and well known. Fortunately, there is an aspect of middle-market business ownership that, if correctly handled, can help allay concern.
Many business proprietors want to "take money off the table" but are reluctant to sell because they still have a passion and vision for their business. This can present a golden opportunity, especially when passion and vision come with special operational expertise, trust relationships with third parties, market insights and sound intuitions.
Buyers can be well served by keeping the former owners involved for a period. No one knows their niche as well. We often advise buyers to insist on the sellers retaining a portion of the equity for a period so the sellers have skin in the game and can provide intangible business knowledge. About 25,000 US companies have annual revenues of $100m to $500m and about 350,000 companies have revenues of $5m to $100m.
A sweet spot for acquisitions by South Africans might be a purchase price of $20m to $50m for a niche company with a business owner who would retain about 20% of the equity for a two-to three-year transition period, during which the buyer develops the successor leadership group.
Let’s consider a few guidelines. South Africans are indeed playing an away game but they can become comfortable with the foreign pitch by focusing on a few key principles.
Professional costs in the US are high. The buyer should consider approaching due diligence in a tiered fashion so that low-probability targets can be eliminated at an early point.
For example, the buyer can focus the initial due diligence on gating issues, rather than taking the customary blunderbuss route. Due to the exchange rate issue, South Africans should be wary of buying companies that are likely to require significant capital expenditures in future from the acquirer to remain competitive.
I cannot stress too strongly the need to understand from the outset the regulatory, tax and legal considerations for the particular industry and company. Always appreciate that the law is more intertwined in US business than in SA. On a positive note, South Africans can enhance post-acquisition success by focusing on targets that will benefit from expansion beyond their home markets. This is not a difficult quest as few US middle-market companies explore foreign markets.
The forecast for the US middle market is robust. The Trump tax changes are expected to stimulate merger and acquisition activity. Less discussed, but also advantageous, is the business deregulation proceeding without much fanfare via executive orders and staffing changes. Small and middle-market companies will be the primary beneficiaries because regulation has weighed particularly heavily on them. US middle-market mergers and acquisitions have been highly active in the past few years and this is likely to continue in 2018.
These are ample reasons to learn more about the "goodly states and kingdoms" in the US. To overlook them now could well mean lost opportunity.
• Karol is an MD with The DAK Group, a boutique US investment bank.