Successful Succession

Few could have predicted the impact that the global financial crisis would have on the metal recycling industry. The rapid and dramatic declines in demand for and prices of a wide range of recycled metals have left many closely held and family-owned businesses wondering not only how to manage their businesses going forward, but also whether they will be able to contemplate an exit strategy at any point in the foreseeable future.

There is little doubt that the markets have most certainly made transactions more challenging. That being said, contrary to what many assume, the M&A and capital markets are still accessible by privately held middle-market businesses, and transactions will continue in the medium term. However, given the unique environment in which we find ourselves, we would urge metals recycling business owners to be thoughtful, plan ahead and prepare as much as possible.

There are a number of very valuable actions that owners can take now to make their businesses more attractive and/or to maximize the likelihood of a successful transaction down the road.

First, don’t underestimate the importance of planning. Surprisingly, many business owners fail to plan for succession, typically out of some combination of fear, denial or other personal considerations. The best way to ensure a successful transition, though, is to identify your personal objectives and your individual time line. Oftentimes, this is best accomplished in consultation with family members or a close trusted family or business advisor. The objectives always vary and are unique to each and every business owner, but they provide an important framework to begin to map out a transaction strategy.

From a planning perspective, it is ideal if we can begin developing a relationship with potential clients anywhere from 12 to 24 months in advance of their anticipated liquidity/exit date. This degree of advanced planning allows owners to implement certain changes or improvements within their businesses that will facilitate a transaction further down the road. This may entail putting some management information systems in place, filling in key management positions or getting a new facility or a new product/service line up and running smoothly. Advanced planning also gives business owners the potential opportunity to capitalize on strong M&A and capital market conditions.

While we don’t advise clients to attempt to "time" the market when embarking upon a transaction, having the flexibility to speed up or slow down a sale can result in an improved purchase price or a slightly accelerated closing at times.

The other reason why advanced planning is so important is that it is not always that easy for a founder or primary shareholder to achieve liquidity and retirement on the same exact timetable. Oftentimes, the founder is so important to the day-to-day business or to particular relationships that the new owner needs him or her to continue to work for the company after the sale for a defined time to ensure that the business is transitioned smoothly. This is very common in the metals recycling industry, where the founder is often heavily involved in every area of the business and often has close personal relationships with industrial scrap suppliers, mills and foundries and other brokers/dealers.

This was exactly the case with a family-owned recycling client that we assisted at the beginning of 2008. The primary shareholder was part of the third generation running a group of three processing yards in the Southeastern U.S. Our client, who was actively involved in all aspects of the day-to-day operations, was reaching an age where he was seeking to transition to the next phase of his life and wanted to begin to enjoy the benefits of what he had helped to build. The business also represented a significant portion of his and his family’s net worth, and he was keen to achieve an appropriate level of asset diversification. While he had two grown sons, both had chosen to pursue different career paths and did not share their father’s passion for the metals recycling business—something many scrap metal businesses are currently encountering, unfortunately. As a result, the primary shareholder had no logical successor and knew that he would need to continue working for the company under an employment arrangement after the transaction closed. While the duration of our client’s employment agreement was fairly short (about 12 months), it was a critical component of the transaction and highlights the importance of understanding and planning for potentially different timetables for a liquidity event and for heading off into the sunset for retirement.

It is for this reason that we regularly advise clients to make themselves redundant to the business. Again, advanced planning in this area is critical. If you know that your succession time horizon is two to three years from now, then you’ll want to make sure that you’re taking advantage of that time to groom your replacement and/or to train people within your existing management team to handle all of the key functions that you currently handle. Sometimes, it may be necessary to recruit someone into the organization to fill this role. Don’t underestimate the amount of time this may take. You’ll want and need to ensure that your employees, customers, vendors and other constituents are comfortable with this person or these people and that they’ve been time-tested.

A financial statement audit is another valuable investment that a metal recycling company can make in advance of pursuing a liquidity event. This is a foreign concept for many family-owned recycling firms, who may be accustomed to operating conservatively without debt.

However, given the current conditions in the financing markets, few if any transactions will get completed without an audit. This is just a market reality. Indeed, many acquirers will seek to use debt to finance some part of the purchase price or at a minimum they will want to have a credit facility in place to access post-closing to buy inventory.

In the wake of the largest financial market crisis in this country’s history, banks and lenders have dramatically tightened their credit standards and escalated their due diligence requirements for new loans. Moreover, recycling industry participants also are likely to be viewed with a good deal of caution as a result of the unprecedented volatility in scrap metal prices during 2008 and concerns over potential fraudulent or unethical business practices within the industry. Getting an audit done will help lenders ultimately get comfortable with the value of the underlying assets and inventory as well as help would-be acquirers get comfortable with the quality of the company’s historical earnings. Because an audit requires time and planning, better to begin this process well in advance of an anticipated transaction. If you wait until a buyer or lender presses you for it, it will dramatically slow down the transaction and potentially give these groups ammunition that might be used against you in the negotiations.

With ample time to implement changes before an exit event, we also encourage our metals clients to look at ways to stabilize or smooth out their revenues and profits. It is not unusual for scrap metal firms to have a material dependence on one or two key vendors or customers. This is often how they have grown over time. From a transaction standpoint, however, this type of risk often poses due diligence challenges and, more importantly, negatively impacts valuation. Anything that can be done to reduce or mitigate such concentration through increased diversification of customers or suppliers leading up to a sale will enhance the transaction value and facilitate the closing.

Another way to make your business more attractive in this regard is to consider using hedging tools. Many buyers have a difficult time evaluating recycling businesses, particularly those whose earnings fluctuate significantly from period to period or that look as if they may be the result of well-timed commodity gains. In contrast, hedging can significantly eliminate this kind of earnings uncertainty and instead highlight the value-added aspects of your company.

While there have been tools for nonferrous processors to hedge their aluminum, copper, stainless and other metals price exposure, importantly there are now ways for more traditional ferrous scrap processors to hedge their ferrous price risk. Indeed, the LME (London Metal Exchange) recently began trading a billet futures contract that is strongly correlated to many of the key ferrous scrap grades. While scrap processors have been slow to begin using this type of hedging strategy, we believe that it can and will be increasingly valuable for recycling firms throughout the next several years, since few if any industry experts feel that predicting scrap prices will get any easier for the foreseeable future.

Owners of metal recycling firms should also be mindful of their capital expenditures. These should be carefully planned and limited to necessary maintenance investments. Large expansion-oriented capital expenditures (such as a shredder) will take significant time to generate meaningful cash flows and returns, and, as a result, owners face the risk that they will not receive the value of this investment from would-be acquirers. These types of large expenditures should not be undertaken if the owner’s timetable is short and does not allow for the business to fully reap the benefits in terms of incremental profits.

Succession planning remains vitally important for owners of metals recycling firms. If anything, the huge swings within the scrap metal market this past year and the uncertainty within the global financial markets have made the succession planning process even more critical. While the transaction environment will continue to be challenging for some time, the metals recycling sector ultimately has a strong and sustainable growth profile that will continue to attract buyers and investors.

Liquidity opportunities will continue to present themselves to family-owned and closely held scrap metal recycling firms. Importantly, if they’re planning ahead, the owners of these companies will have opportunities to make their businesses more attractive to buyers and to increase the probability of a successful transaction down the road.