Since starting an investment company in Australia earlier this year, I have spent a lot of time with local entrepreneurs, exposing myself to new businesses and really keeping my finger on the pulse. While Australia’s mining boom may have slowed, the country is looking to make strides in other areas – namely agriculture, tourism and technology.
Outside of these areas, one space that has particularly caught my attention is Australia’s SME sector. My interest is driven by a trend that first became apparent amongst retiring business owners that I know personally. That is, many retiring owners have built strong operating businesses with track records extending into the decades; however many do not have actionable succession or exit strategies in place.
Retiring Owners
To put things in perspective, SMEs account for 57% of Australia’s GDP and employ 7 million people. Demographically, a large number of Australian SMEs are owned by the "baby boomer" generation, those 5.5 million people born between 1946 and 1965. It is this same generation where many are entering retirement without having a clear path to exit or a succession plan to ensure continuity of the business.
This demographic shift can be seen as an opportunity for high net-worth investors and family offices willing to devise a direct investment strategy and acquire sound SME operating businesses with proven operating track records, intact management and further capacity to grow. The rationale is driven by being able to acquire such businesses at relatively low EBITDA multiples, while using leverage and retained earnings to further enhance the return profile of the underlying business.
This strategy is most applicable to SMEs with annual turnover between the $2 million - $10 million and an EBITDA margin of at least 10%, where there is sufficient cash flow to service debt and allow for reinvestment to capture "low-hanging fruit" growth prospects.
Ripe for Disruption
Moreover, the types of businesses that are ripe for disruption come from traditional sectors such as manufacturing, construction and distribution, where there has been little technology adoption and a general lack of energy within the organization due to ageing owners (and sometimes employees) not having an impetus for revitalization.
The opportunity can be compounded by the lack of competing capital targeting the SME sector since the private equity landscape in Australia is predominantly focused on larger deal sizes of $20 million and above, leaving very few private equity firms pursuing SMEs.
Inherent Risks
However, for a country where a large part of household wealth is concentrated in property, the proposition of acquiring and operating an SME would appear to be unintuitive and inherently risky. Such a strategy is not suited for passive investors or those who intend to be "hands off" given the considerable levels of time and energy required.
Further, buying into an operating business will require equity capital that will typically equate to half the value of the business, that is assuming one is willing to take on acquisition finance. Hence, the required capital outlay is also significant.
Equally, investors must closely scrutinize the reason for why the owners are looking to sell. While in many instances, the owners may simply be looking to retire, there is clear risk of information asymmetry when buying into a business that may have legacy issues under previous ownership. Similarly, investment holding period and overall exit strategy also needs to be assessed carefully.
All things considered, I can see only a small subset of investors having the appetite to take on such a strategy, with high net-worth investors and family offices being best suited where there is an opportunity to build dedicated investment teams to spearhead a direct investment strategy.
Return Expectations
Given the array of variables involved, such as price (in relation to EBITDA multiple), Loan-to-Value Ratio (LVR) and EBITDA margin of the underlying business, it would not be appropriate to try and set specific return expectations or time horizon. However, given the time and investment required to execute this such strategy, the underlying returns will obviously need to outperform similar investments from within the private equity sector seen to have a comparable risk profile.
Ultimately, the success and outcome of such a strategy comes down to the type of business. Rather than looking for businesses that require a turnaround, I am most focused on businesses where an acquisition is providing a means of continuity and the business is well positioned for future growth.
