Rising After You Fall
“The greatest accomplishment is not in never falling, but in rising again after you fall.” ~ Vince Lombardi ~
As a microcap LBO fund with a twenty year investment history we have had our fair share of great deals, good deals, average deals, and then those where selective amnesia comes in handy. In an industry where wipe-outs happen, we have been fortunate to avoid them. Perhaps counter-intuitively, we spend a greater amount of time analyzing the causality behind suboptimal investments than reflecting on our successes. Being served a piece of humble pie every now and then has made us smarter investors and more skilled partners to our portfolio managers.
Best-selling author Jim Collins has been known for his research in identifying attributes allowing companies to make the leap from good to great. Recently he took a turn to the dark side in his new book, “How The Mighty Fall And Why Some Companies Never Give In” turning the question around in order to understand the decline and fall of once-great companies. Before descending into the depths of decline he offered the reader this metaphor: “I’ve come to see institutional decline like a staged disease: harder to detect but easier to cure in the early stages, easier to detect but harder to cure in the later stages. An institution can look strong on the outside but already be sick on the inside, dangerously on the cusp of a precipitous fall.”
While reading this book, I couldn’t help but compare it to our experience with Amrep, a specialty chemical manufacturer and distributor and former MCM I portfolio company. As I was turning each page it seemed as if Collins had raided our office, hacked into our server, and used our firm’s experience as a basis to write four out of the five stages of decline.
Stage 1: Hubris Born of Success:
Great enterprises can become insulated by success; accumulated momentum can carry an enterprise forward, for a while, even if its leaders make poor decisions or lose discipline. Collins says Stage 1 kicks in when people become arrogant, regarding success virtually as an entitlement, and they lose sight of the true underlying factors that created success in the first place.
Amrep, at the time of our acquisition was a $48 million leading provider of turn-key private label chemical programs, had grown steadily for several years and counted a number of industry leaders as customers. The company reflected the personality of its CEO, a sales driven executive reliant on his business instincts which rarely let him or the company down. Our investment approach embraces companies with competitive advantages, yet are not without certain weaknesses or “flat sides”, which if effectively addressed can accelerate shareholder value. In Amrep’s case, they had under-invested in operational talent skilled in lean manufacturing principals. Consequently, the company was more prone to miss an occasional customer delivery date and carry more inventory than was needed. During one of our early meetings with Amrep’s CEO we identified this “flat side” and encouraged the CEO to make the necessary HR investment(s) to improve operations. He assured us Amrep already employed lean and led the industry in virtually all customer service attributes including delivery times. The attitude was, “we are good at everything and please don’t tell us different”. It wasn’t until growth, both organic and acquisitive, did the company’s operational shortcomings become readily apparent through ballooning inventories and late deliveries to pissed off customers.
Stage 2: Undisciplined Pursuit of More: Hubris from Stage 1 leads right into Stage 2, the undisciplined pursuit of more – more scale, more growth, more acclaim, more of whatever those in power see as “success.” Companies in Stage 2 stray from the disciplined creativity that led them to greatness in the first place, making undisciplined leaps into areas where they cannot be great or growing faster than they can achieve with excellence, or both. Big does not equal great, and great does not equal big.
In 2003, Amrep was approached by a large distribution organization seeking a partner to acquire its in house liquid janitorial chemical line, approximately 400 SKUs, and enter into a long-term private label supply agreement with annual estimated revenue of $10-12 million. We counseled management to ensure Amrep’s bid include adequate margins without assumption of any operational leverage or cost synergies. We were assured this was the case. Much to our chagrin we later came to realize our “successful” bid included razor thin margins and further increased the complexity inherent in the business stressing our less than optimal operational execution.
Stage 3: Denial of Risk and Peril: As companies move into Stage 3, internal warning signs begin to mount, yet external results remain strong enough to “explain away” disturbing data or to suggest the difficulties are “temporary” or “cyclic” and “nothing is fundamentally wrong.” In Stage 3, leaders discount negative data, amplify positive data, and put a positive spin on ambiguous data.
By mid-2003, Amrep made the necessary investments and began supplying the product. Disconcertingly, although revenue increased to $112 million, Amrep’s EBITDA dropped from $8 million in 2002 to $6 million in 2003 and customer service suffered. The board was reassured the drop in profitability and service levels was “temporary” and attributable to the “learning curve” which assuredly was now behind the Company. In 2004 revenue hit $120 million but EBITDA dropped further to $5 million and service levels remained sub-par, while inventories increased by $2 million.
Stage 4: Grasping for Salvation: The cumulative peril and/or risks-gone-bad of Stage 3 assert themselves, throwing the enterprise into a sharp decline visible to all. The critical question is how does leadership respond? By lurching for a quick salvation or by getting back to the disciplines that brought about greatness in the first place? Those who grasp for salvation fall into Stage 4.
Ultimately, the Company’s poor performance led to the dismissal of the CEO and Amrep’s board of directors tried introducing the necessary operational turnaround support to perform triage. We fired one of our silver bullets and hired a CEO adept at turning around under-performing companies. However, after stopping the hemorrhaging his management style had become caustic to the organization positioning Amrep one step closer to capitulation.
Stage 5: Capitulation to Irrelevance or Death:
The longer a company remains in Stage 4, repeatedly grasping for silver bullets the more likely it will spiral downward. In Stage 5, accumulated setbacks and expensive false starts erode financial strength and individual spirit to such an extent that leaders abandon all hope of building a great future. In some cases, their leaders just sell out; in other cases, the institution atrophies into utter insignificance; and in the most extreme cases, the enterprise simply dies outright.
Fortunately for us we were able to prevent Stage 5 by promoting CFO Joe Seladi to CEO. Joe understood there are no quick fixes and embarked on a more pedestrian, arduous process of rebuilding long-term momentum by getting the right people in the right place, building on existing strengths, and working with massive amounts of quantitative analysis. Seladi addressed several debilitating issues inclusive of:
- Improving operational execution by recruiting an outstanding operations executive skilled in Lean Manufacturing techniques and Six Sigma.
- Addressing crippling complexity by eliminating unprofitable customers and SKUs.
- Personally meeting every important customer and presenting the Amrep’s corrective action plans (i.e., begging for forgiveness and time).
Within two years Joe led a tremendous turnaround leading to our divestiture to Zep (NYSE: ZEP”) in December 2009. Ultimately, the sale yielded approximately a 2x gain on our investment over 10 years. Not a great IRR, 6+%, and clearly a missed opportunity. However, we learned many valuable lessons during our association with Amrep not the least of which were getting management to address the organization’s flat sides, reacting faster to under-performance and the added and often hidden cost of complexity.
Great companies can stumble, badly, and recover (See Apple). While, according to Collins, they cannot come back from Stage 5, they can tumble into the depths of Stage 4 and climb out. Most companies eventually fall, yet organizational decline is largely self-inflicted, and recovery largely within their own control. So the question remains: will you rise after you fall?
MCM Capital Partners is a Cleveland based MicroCap private equity fund investing in niche manufacturers, value added distributors and specialty service businesses. For more information on our private equity firm and investment principles, contact us today.