How the weak economy favours medium sized companies

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Rick Grantham | Director | Deal Leaders Africa | mail me


South Africa’s medium-sized businesses have generally proven to be more resilient to the prolonged weakness in the economy, and now are more likely to weather successfully the fall-out from COVID-19 lockdown, than their smaller or larger counterparts.

According to research by the Department of Small Business Development, between 2008 and 2016 the contribution of small and very small businesses to SA’s GDP fell by 13%, while the contribution by medium and large businesses rose by 6%.

The smaller companies, those with revenues of R20-R100 million, are often sub-scale. Many are profitable, but they are only generating enough profits to look after their private shareholders, not enough to provide the working capital they need to grow to their full potential.

Large companies struggle to adapt to the weak economy

As those private shareholders get older and more risk averse, the problem of growth is exacerbated by their unwillingness to re-invest the right amount of capital to stay on the growth curve. If they had a sufficient cash injection or a suitable partner, they would be able to grow and thrive.

The large listed companies have struggled to adapt to the weak economy. Exposed to market fluctuations, their price: earnings ratios have suffered, making growth by acquisition harder.



Managements have become more conservative, since they answer to a large group of public shareholders and are required to be transparent about their strategies.

Medium-sized businesses, with turnovers of R150-800 million, are generally nimbler and more opportunistic.

In this environment, many of them are experiencing solid growth, generating good profits and have the capital to take advantage of opportunities. They are eating into the market share of the bigger players.

The most obvious example of this can be seen in the construction sector, where the large listed players are literally falling by the wayside. But it is also evident among suppliers into the building and construction space, including hardware and materials, as well as a broad range of distribution businesses.

Opportunities for medium sized companies

Typically, all businesses go through different growth phases, and each phase needs suitable investment. In the early stages, a business needs time and energy, as well as cash. As it grows it needs more financial investment for its next stages of growth.

Business owners in their fifties or sixties are often starting to look at retirement and drawing cash out of the business, resulting in flattening growth and a more exposed business. Too many business owners try to sell at this point. They should have brought in the right partner earlier, when the business really needed the investment in growth.

The cash injection for business growth should not come from the founder throughout its lifecycle. As the business becomes more mature, it should be accessing investment from external sources.

Debt is often the preferred alternative to equity in situations like this, but debt is very dependent on the business’s balance sheet and could be risky for pre-retirement owners.

Business owners are often looking for the right balance between wealth (their wealth), business growth and ultimately their retirement or exit. They tend to think debt is more likely to put this balance at risk than deliver an immediate positive result. Adding debt to a business seldom provides an immediate increase in the business owner’s wealth, but securing an equity investor can achieve exactly that.

Bringing in an equity partner

What often surprises private investors is how the right partner not only brings a cash investment, but also the synergies required to drive that growth.

The owner should have realised before he or she reached pre-retirement that it was time for a full or partial exit, and that the business may well experience phenomenal growth in the process.

Bringing in an equity partner often has the added benefit of allowing the business owner to take some cash off the table, thereby growing his or her wealth, and reducing risk.

Potential investors in SA’s privately-owned business sector are responding to the impact of COVID-19 and lockdowns in two ways.

Some, who are financially exposed, need to hold back on making further investments. But others are more bullish than ever, seeing this as an opportunity to invest in resilient growth sectors, or businesses that are likely to emerge stronger than before, particularly with the involvement of the right investors.

This is borne out in a May 15 study by Bain & Co, who found that the private equity industry as a whole was hard hit by COVID-19, with global transactions falling by 60% in April 2020 compared with January 2020.

However, at the same time, ‘there’s never been more dry powder in the market to do deals,’ with $2.6 trillion sitting in unspent capital.


 



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