LMM Deal Digest: May 2023
Customer concentration – something you’ll rarely ever see on an investor’s M&A criteria checklist. And for good reason, too. Losing one customer from a concentrated customer base can have a profound impact on a business’ bottom line. BUT, in the right situations, and with the right capital partner, investing in businesses with a concentrated customer base can prove to be a great long-term investment strategy. How and when can it work?
Strategically selecting to invest in an industry where customer concentration is more of an inherent characteristic of the players versus just a singularly customer concentrated company may provide benefits that outweigh the concentration risk. An example of a sector that is well positioned for this strategy is the electric and gas utility industry.
Many of the suppliers and service providers in the electric and gas utility industry have a concentrated customer base since utilities are natural monopolies that often have exclusive control of electric and gas services in a geographic region. Given the monopolistic nature of the market, many utility suppliers will have only a handful of customers. However, the electric and gas industry offers other favorable investment characteristics despite the lack of diversity of customers. Those include:
Having favorable characteristics like the ones listed above are critical to help secure financing and to insulate the company from economic volatility.
The eventual goal is to diversify the customer base of a customer concentrated company. Having a longer-term hold period gives you the time to achieve this through organic growth and add-on acquisitions. A traditional private equity fund may be too time constrained to achieve the necessary growth during their fund lifecycle but a fundless sponsor or independent sponsor has the ability to curate an investor group with more patient capital that can wait for the company’s growth. It’s a strategy that takes more time but the multiple expansion on the investment makes the patience well worth the wait.
Another unique capability that may only be accessible to some capital partners is the ability to certify a company with a minority or women-owned designation (MBE or WBE certification). Few private equity firms have found a way to make these designations work and there is a gating factor that the capital partner must have the ability to qualify for the designation. Assuming that a certification can be maintained or achieved with the capital partner’s ownership, it can become a unique value-added tool to create company value. These certifications can be leveraged as door openers, however, it’s not automatic. Deep relationships and high qualifications are often still needed to walk through the door. For companies that supply to Fortune 500 companies and/or government entities, an MBE or WBE can make current revenue “more sticky” if there are industry or regulatory expectations to achieve certain levels of diversity spend with suppliers.
When Mike LaFata, founder of LaFata Contract Services (“LCS”), based in King of Prussia, PA, first thought about selling his business, he never imagined that becoming an MBE supplier would be the cornerstone of an accretive, 1 + 1 = 3 partnership. When Mike initially met my firm, IMB Partners (“IMB,” formerly known as IMB Development Corporation), on a balmy summer day, we asked if he knew the power that an MBE certification can hold in his industry. As a non-minority owner, Mike admitted that he was not fully aware of the magnitude of the potential impact such certifications could have on the future success of LCS, a supplier to the electric and gas utility industry with one end customer.
Shortly following the discussion, Mike attended a large supplier utility conference where several sessions were convened on diverse supplier spending. Many large utility companies lead the nation in procurement dollars spent with diverse suppliers and are active in developing and growing diverse suppliers of scale. The seed that we planted sprung to life for Mike and the two companies subsequently closed a transaction in January 2018 with IMB taking a majority position in the company.
After the transaction closed, IMB certified LCS as an MBE. Since that time, we have tactfully used a top-down and bottom-up approach to sales using the MBE which has resulted in:
Overall, LCS has experienced a 68% increase in revenue in just over a two-year span of time since the transaction closed. This partnership is just getting started but the near-term results highlight the possibilities that a value-added capital partner can create with a customer concentrated company servicing an industry with high barriers to entry and a positive long-term outlook.
Founded in 2010, IMB Partners is a private equity independent sponsor focused on making control investments and partnering with management teams of lower middle market companies to build businesses that service electric and gas utilities and government agencies. We invest our own capital and on behalf of over 25 institutional investors, family offices, and high net worth individuals. We seek new platform companies with $5-25 million in EBITDA with add-ons as low as $1 million. View Profile