December 23, 2013
Credit: Zodiac Aerospace
The worlds of finance and industry do not often mesh well. This disconnect is especially true in the aerospace and defense (A&D) industry, which is dominated by engineers who believe in the value of “making things” as opposed to just “making money.” The root of the problem is that the two sides simply do not know or understand each other well. A&D companies have historically relied on their customers more than bankers for funding. To some of them, customer-funded R&D is a more familiar term than financial debt. Many smaller businesses do not even have a proper CFO.
I recently worked on a transaction where a long-time entrepreneur had finally agreed to sell his company provided it would be bought by a wealthy fellow entrepreneur, worthy of his trust and status. I suppose he expected to be handed a big personal check. But when he realized that there would be some debt and financial leverage involved, he became uncomfortable and backed out of the sale.
This case may be extreme, but the reality is a lot of A&D companies remain suspicious of financial investors such as private-equity or hedge funds. Unfortunately, such suspicion is not completely unfounded.
Private equity is like cholesterol: There is a good type and a bad type. The latter will have a purely financial engineering approach to a deal: Leverage the purchase, milk the company to repay the debt quickly and flip it to the next buyer, with complete disregard for the business's long-term sustainability. The only strategic dimension of the deal is the investor's exit strategy. This approach was particularly prevalent in the easy-credit times before the global financial crisis, leading some A&D companies through three or four leveraged buyouts in a row, each time with substantial profits for the financiers.
Hedge funds' poor reputation is not completely undeserved, either. They tend to come and go opportunistically, based on their assessment of earnings multiples, “stock momentum” and “upside potential.” Last year, TCI—one the largest hedge funds in the U.K.—wrote to Safran's CEO and CFO lambasting their management track record. The letter had the merit of bluntness: “The Sagem merger was disastrous . . . management's track record of investment . . . is one of failure.”
But the letter also was judgmental: “Bad decision-making. . . . A true owner of the business would never have acted in such reckless manner and of dubious veracity in some instances . . . . Zodiac is a company of lower overall quality than Safran . . . the defense industry is in structural decline.”
Even if there were some truth in the overall assessment—never mind that Safran's stock price has increased by 500% in the last five years—this type of letter, coming from an outsider with no long-term involvement in A&D, obviously does not generate warm feelings toward the financial community.
At the other end of the spectrum, though, a good private-equity investor will offer a proper wealth preservation strategy for the original owners, boost investment and encourage ambitious growth plans, with a potentially transformative impact on the company and on the sector as a whole. Many A&D suppliers clearly would benefit from opening up, at least partially, to such investors or, more generally, to financial markets. Both are a source of valuable capital. This is particularly important at a time when many subcontractors are undercapitalized and unable to make the large capital expenditures necessary to keep pace with surging commercial aerospace demand.