Even investors and finance professionals say they are feeling the pinch from the widespread labor shortage.
The inability of companies to readily find technically skilled labor limits their ability to grow, even with the greater ability today to access capital — and that affects how investors can put their money to work.
That perspective was among the views offered during a recent roundtable conversation hosted by MiBiz on growth capital in West Michigan. Joining the conversation were:
- Rajesh Kothari, managing director of Cascade Partners LLC, an investment banking and private investment firm that sponsored the roundtable discussion.
- John Pollock, managing director of LV2 Equity Partners LLC, a private equity firm.
- John Porterfield, regional president of Comerica Inc.
- Paula Sorrell, vice president of entrepreneurship, innovation and venture capital at the Michigan Economic Development Corp.
- Donald Wierenga, senior vice president at Centennial Securities Co.
- Todd Witmer, senior vice president of commercial banking at Fifth Third Bank.
Here are some of the highlights from what they had to say.
What’s the biggest emerging need out there right now and what kind of activity are you seeing?
Witmer: I would say that there’s not enough activity, certainly, from the lending perspective. If there’s not M&A activity, you don’t necessarily have companies coming to you … to borrow more, outside of their equipment financing. We have customers that have really healed and come out of the other side of the downturn and (are) doing very well and are actually using cash a lot more than actually having to borrow. So I’d love to see more growth and more M&A activity, which would generate more borrowing and more lending on our side.
I think people are definitely more cautious. We were more cautious as lenders and (when) you come out the other side of the type of downturn that we had, folks are a little more cautious about debt. I don’t think they are afraid to borrow but only if it’s really the right opportunity.
Wierenga: Our specialty area is basically profitable companies looking to expand, and while I’m seeing a lot of interest in doing that, everybody’s trying to hold on to their equity. What we do is provide preferred notes or some other convertible items so our investors get a chance to participate in the equity, and we’re not seeing a lot of firms right now that want to give up equity. I think they are very confident of what’s happening right now, they’re going to grow their companies and they’re trying to keep it all.
Pollock: We’re seeing a lot of business owners, entrepreneurs, baby boomers approaching 60 and want to exit — and many of these individuals wanted to exit five or six years ago and decided for a whole slew of reasons it didn’t make any sense at the time. That’s where, in our space (private equity), we’re seeing the bulk of volume today. As far as need, in our space, which is lower-end to middle-market and heavily manufacturing, without question, hands down, it’s labor. It’s technically skilled workers, and I would define that from the middle management, quality middle-level engineer and down. It is incredibly tight right now. We’re actually right now having to turn down business because (companies can’t find talent). … Apprenticeship programs are gone.
Kothari: We had to open a shop in Indiana (for a portfolio company) because — and I can’t believe I would ever say it — we could not get machinists in Michigan. I had to open a shop in Indiana to meet the demand and so we weren’t turning away orders. It’s nuts.
Porterfield: I fully agree. Skilled labor is a very big constraint out there. The other thing that’s needed, from my perspective, is … good advice to get some of these businesses to seriously consider selling. Business owners are wanting to hang on for the highest dollar when they do exit or when they do sell the company. (Getting them to sell) could create more activity. Whether it’s private equity money or senior bank debt, there is plenty of capital out there, and there could be — given the stage we’re at in the economic recovery — more transactions happening than are happening.
Kothari: There are definitely more dollars than there are assets, so you’re seeing valuations that we’ve never seen before. We say we invest, but we’ve done one add-on acquisition in two years because at these valuations, we can’t deploy the capital.
Pollock: When multiples get to a certain level, you can’t make the math work. You can’t grow that fast enough organically to get a return. You justify it in the back of your mind, ‘Well, I’m going to acquire and keep adding on through acquisition,’ and that feeds the fire until eventually you just can’t do it anymore.
From the state’s perspective, what’s changed and what are the needs?
Sorrell: When we talk about what’s different now and what the needs are, we have to talk about where we were 10 years ago. What we saw roughly 10, 12 years ago was we had roughly 50 tech companies in the state. Now we track almost 3,000 tech companies. We had $200 million (in venture capital) under management, and now we have $1.7 billion under management. We had four venture funds at that time, and now we’re at 37. So when we look at the progress that’s been made, it’s been significant.
What we need in the future is just an understanding that there is still a strong need for Series A and Series B funding rounds because we get annually $1.6 billion in federal research dollars that come in to our universities every year. That can either be exported to other states as these technologies and these companies leave, or we can anchor them here with strong Series A and Series B. At the time, it was kind of given that if you got venture capital 10 years ago, you were probably going to leave the state. We’ve seen that trend significantly reverse.
What kinds of challenges are you encountering despite all the options for capital?
Kothari: One of the things we’ve seen in the marketplace is many businesses and entrepreneurs don’t really understand the range of choices they have. Most people think, ‘Well, I either go to the bank or I sell my business to private equity, and those are my two choices.’ The reality is that there are so many more choices and options for them — more so today than ever before — whether to grow their business or to transition ownership so that they can grow and de-risk. They have the traditional banks and they have buyout private equity.
How is access to growth capital these days?
Kothari: There is so much more variety, from the venture investor, the angel groups and the high-net worth private investors. We used to run data and talk about all of the dollars that went out of state and how much more now is staying. You walk through the capital structure and we have our angels, we have our early-stage ventures, we have mezzanine funds, we have fundless sponsors, and we have high-net worth investors, we have traditional private equity, and we have our senior lenders, and we have specialty finance options. I can go back and tell you 10, 15 years ago, you have two or three of those options and all of them you had to go out of state for.
Sorrell: What we’re seeing in the Series B is, if we look at all the different venture deals that are done, and last year was a record year for the number of deals (in Michigan), 60 percent of them were syndicated. We’re seeing a lot of syndicating with firms outside of the state. If you look at kind of where we’ve gone, this past year we had a decline in in-state venture capital and the growth was in out-of-state venture capital. We spend a lot of time and effort also attracting that capital here, but that’s not what we’re kind of seeing for Series B. If there are larger capital needs, then they are going out (of state).
Kothari: People are coming (into Michigan), all the national players. Folks are recognizing all of those characteristics and those value attributes we’ve all liked and talked about. Others are beginning to realize that it’s a little crazy in California, doing this in Boston isn’t quite so much fun anymore, and they have to put the dollars to work. … We’ve proven it — that’s the best part. We’ve proven great returns. We’re at least trying to do a better job of educating, ‘Hey, there are a lot of options.’
Sorrell: We’re a fraction of what you see on the coasts (for venture capital). Our largest home-grown fund here is $140 million, which is still very small by coastal standards. Our largest funds in the state are not headquartered in Michigan. They are headquartered somewhere else and they have an office here because they know we have deals to do.
Are there any specific areas that these investors are targeting?
Kothari: Investors are excited about manufacturing again.
Sorrell: We’re seeing more funds that are based on materials, and advanced transportation is really hot right now. We’re seeing lots of firms where we’re not reaching out, necessarily. They’re reaching in and saying, ‘We want to set up a shop in Michigan.’
Have any alternative forms of financing gained traction?
Kothari: Today, the alternative financing sources — the box that they get to play in keeps getting squeezed, not by their design but by regulatory changes. For us, growing up, this was a manufacturing town. The (tech) businesses that Paula’s talking about aren’t capital intensive the same way. I don’t have to go out and buy a $250,000 injection-molding machine. I have to fund working capital, I have to fund losses because I can’t put the machine in and start stamping out product and all of a sudden I have revenue. I have to spend two years developing it, designing it, creating it, and then I finally get to sell it.
Porterfield: I don’t know if many of you are seeing unitranche credit facilities [a form of debt that combines senior and subordinated debt] be much more available today. There’s a lot of complexity that goes along with that. It’s kind of doing term A and term B together in a big agreement that may be hard to negotiate, but that was an option that I don’t think was available prior to the last downturn.
Kothari: (It was) not as available as it is today. We just did a $40 million refinance for a business with a unitranche facility and we had 20 proposals and we reached out to 120 institutions — and it was some of the cheapest debt I have ever seen.
Witmer: The great thing about capitalism is when the banks get squeezed and when we were squeezed over the years, groups step up and they’ll commit to the whole unitranche and then they’ll go find the players for each one of those pieces. You can find the capital and there are a lot of smart people out there who will find ways to work around the current environment we’re in.
Where are you seeing money flow today that it didn’t in previous years?
Kothari: The highest valuations in the market today are coming in kind of non-traditional (sectors). Aerospace manufacturing — 14 to 15 times EBITDA deals are trading at.
Sorrell: We’re seeing a lot of materials (for) vehicle light-weighting. We also see a lot of light-weighting of vehicle interiors, which also translates to the furniture industry. So there are a lot of cross-functional technologies that are now making their way into Michigan companies.
You’ve talked about a lack of understanding about options for capital that are available today. Why don’t businesses know about the full slate of opportunities? What can you do about it?
Witmer: A lot of them just haven’t been exposed to them. You have people running their business and (when) they wake up in the morning, that’s what they’re focused on. … They’re not sitting around figuring out all of the different options they have to partially recap their company or do this or do that. If you’re a senior lender, we’re not exactly in there telling them we’d love for them to borrow more for us. Obviously, we can do a partial recap and invest their funds and so forth, and you have a lot of different parties go after the same limited number of opportunities. But if you’re a business owner, they’re just not educated. Five or six years ago, we were learning what (the unitranche credit facility) was. So I don’t expect an owner to really understand what that means.
Kothari: If you’re not playing in it every day, you don’t know, and depending on whom you’re talking to, they have their thing to sell. You used to go to the bank and you get all of your financing from the bank. Today, we talked about all the different people you can talk to. While that’s seven different people I can talk to … I’ll just keep doing what I’m doing. I’ll go run my business and I’ll make cash and not worry about that.
Sorrell: Even today, there’s still a huge learning curve with venture capital and tech companies and the needs and growth patterns. I think it confuses a lot of people, and unnecessarily so.
Pollock: Most entrepreneurs and business owners, they view capital as a commodity. There are so many other things they are dealing with in the day-to-day running of the business that capital is just another vendor to them. The bank’s just another vendor until they need to make an exit, and then all of a sudden they need to educate themselves.
How do you fix that problem? It’s like any business fundamental: You surround yourself with good advisers that can help you plan strategically when you need to use certain things. But I think there’s a lack of education and a lack of priority.
Would we have this greater array of capital options, especially venture capital and angel funding, if Michigan didn’t go through the decade-long recession?
Pollock: Maybe, to a small extent, there’s some merit to that statement. But I think finance is no different than any other industry. Over time, things evolve and people find opportunity like a unitranche or the specialty finance companies that are out there. … I think business people, whether it’s in finance or manufacturing or anything, are going to look at what’s going on in the industry, what are the needs, and find the opportunities and create some mechanism. That’s always happened in finance. I think we went through a period where it accelerated a little bit. I mean, private equity’s only 35 years old in and of itself, technically.
Porterfield: I don’t know if we had to go through the big downturn. What I did see the big downturn create was different time horizons. … Rather than a three-year exit window, (private equity was) forced to look at five years — or they were forced to look at different time horizons, which I think probably helped create other finance opportunities. You see mezzanine lenders come and go, you see ABL lenders (asset-based lenders) doing different things at different times. I think everybody just kind of changed their model to look for opportunity, which created more funding sources. Is that a direct function of the downturn? I don’t know.
Kothari: But what is a direct function of creating some of these options is our politically correct, misaligned regulatory process. Banks are being squeezed as a result of Dodd-Frank in a way that makes no sense because they are completely regulated. But I can go to a private equity fund and get five times leverage with no problem from sophisticated investors. The banks are sophisticated investors … who do this for a living, and we’re going to constrain them. But in turn, we’re going to go and let grandma put her money — $25,000 that she can’t afford to lose — into something that is completely unregulated and is completely unmonitored?
Sorrell: I want to talk about the positive side of crowdfunding.
Kothari: Crowdfunding is great. It’s just this disconnect in the regulatory framework.
Sorrell: Go look at other countries that have had crowdfunding for a while. The difference that they see is that previously underserved markets, particularly women and minority-owned businesses, are now accessing capital through crowdfunding, where before they were potentially locked out or didn’t have the same success rates. And the same goes for venture capital. It’ll be interesting to see how it plays out (in the U.S.).
Kothari: It will change. Some grandma’s going to lose (her) retirement. How do you think we got to Dodd-Frank?
We keep hearing that the Fed may move interest rates up this year. What’s that going to do to credit and capital?
Pollock: You can’t overstate the effect interest rate levels are having on the flow of capital right now. We are at historically unprecedented levels. That drives unique financing mechanisms. As soon as (rates go up) — and they would have to go up a bit to move the dial — then things will change. Right now, you can’t put money in the bank because you’re looking for places to put it to get some sort of return. That feeds on itself and drives these things.
Witmer: We’ve been talking about it for a good two years now that interest rates were going to rise. We’re still thinking that happens later this year.
Porterfield: It seems to me like it’s been five years we’ve been saying rates were going to go up. I have no idea when that’s going to happen. There’s guidance that it’s going to happen in the second half of this year. I don’t know how realistic that is. It hasn’t happened for so long, I don’t have a lot of confidence to say when it will happen.
Wierenga: It seems to change on every jobs number. Every month, the jobs numbers come out and it’s either ‘now we can do it in June’ or ‘we better wait until September’ or ‘maybe it’s not going to happen at all this year.’
What happens when rates do eventually go up?
Witmer: That’s probably the thing that worries me the most. If you look back to underwriting a long time ago, we’d have to do an interest sensitivity model where we’d take a look at where interest rates are today and if they go up by X percent, what does that do to the company and their debt service? If you did that to … companies that are borrowing, there’d be a lot of companies that would struggle with that. We’ve kept them artificially low for too long. Back in the ’70s and ’80s, there was a period we kept them too low, and when they started to rise, we really felt the impact to that.
Kothari: The reason this economy’s been working so well, albeit slowly, is because it’s been very measured growth. People are not making the stupid mistakes that they all were making in 2006 and 2007. Valuations are very, very high. They are higher than they were in ’06 and ’07, which is the tippy-top the last time, but the market was way more frenzied because we were doing stupid things. We’re not necessarily doing the smartest things, but we are at least thoughtful. … and say, ‘If interest rates grow meaningfully, that’s going to put a damper on the valuations and that’s going to slow down all of these other things that are driving the activity today.’ It is a black swan event. We talk to our CEOs about managing your business in a 10-percent interest rate environment. We haven’t done that in 10, 15 years.
If rates do move this year, do you see them moving much?
Witmer: Slow and measured. I just do not see where you’re looking at a 50-basis point rise in rates at any given (increase). I think it’s going to be very slow … a quarter of a point here, a quarter of a point there.
Kothari: Unless there’s an exogenous event. That’s the wildcard — if Europe takes off, collapses; if China takes off, collapses. You need an exogenous event for rates to change dramatically. If inflation accelerates and that negative exogenous event takes off, that is the only thing that pushes rates up.
Have you seen any businesses try to hedge against possible rate increases in any way?
Porterfield: We’ve seen some companies expand that put up more square footage than they needed two or three years ago because it was darn cheap to do it and contractors weren’t nearly as busy. But that was more of a financial decision than what might happen with rates. And (these are) successful companies that will weather a storm if rates go up.
Witmer: We recently had a very well-heeled customer that’s looking at expansion and growth capital and actually did not need to borrow now but borrowed $10 million on a term loan. They paid their revolver down to zero and they’re sitting on some cash because now’s a great time to borrow at very low rates. Then you swap it out at a fixed rate. It’s a very good move for them at this point.
Given the rate volatility, what’s your advice for a company that may need to borrow in the next 12 to 18 months to support an expansion or capital purchase? Should they accelerate their plans or hold steady?
Porterfield: My view is that those who wish or want to (expand) have expanded. The savvy money has really been spent. It’s been more a matter of construction costs and the costs of equipment they may be installing. The interest-rate risk can always be managed, if they wish, via a swap, a fixed rate. They can buy that insurance, but many of them choose not to buy that insurance because in the meantime, they’re paying the lowest rate possible. … We have continuing dialog with customers about why you might want to fix or swap some of your interest rate risk. There’s more activity, there’s more listening going on, (but) we haven’t seen a lot of triggers pulled yet on that swap.
Kothari: The reality is that most folks have figured out they’re going to do what’s in the best interests of their business, and everybody is still proceeding cautiously. They are not building out beyond what they really can see and have firmly in their hands. It’s not a build-it-and-they-will-come strategy. People aren’t doing that today.