Investing in Customer Concentrated Businesses
September 15, 2020
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:
- High barriers to entry: specialized skills are required to perform much of the work within the industry, the intricate internal structures of utility companies make servicing utility companies complex for small to medium suppliers
- Long-term customer relationships: the high barriers to entry prohibit many new players from entering the market leading to long-term relationships and contracts with customers
- Infrastructure spend outlook: the electric and gas utility sector is forecasted to spend hundreds of billions on maintenance and new infrastructure in response to updating outdated infrastructure and to increasing demand from population growth
Having favorable characteristics like the ones listed above are critical to help secure financing and to insulate the company from economic volatility.
Longer-Term Hold Period
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.
Certification Sales Advantages
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.
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