The strength in industry fundamentals and end-user demand over the past 24 months — as we have previously written — has led to substantial outperformance, relative to market benchmarks, for publicly traded aftermarket equities, in turn drawing interest from hedge funds and traditional long-only shops alike. What is also interesting, however, has been the increased interest of private equity funds in potentially putting money to work within the automotive aftermarket.
In our opinion, the aftermarket offers investors a number of desirable characteristics including continued industry fragmentation, and thus opportunity for consolidation, as well as a long-term track record of consistent and steady growth. For private equity funds, we believe that the resiliency of aftermarket demand and relative predictability of cash flows make this segment particularly appealing. While no two deals are exactly the same, generally speaking, the typical private equity transaction involves the use of financial leverage to amplify returns. This typically entails raising somewhere in the range of 20 percent to 30 percent in equity capital, supplemented by a combination of high-yield bond issuance and reliance on bank debt.
Over time, the sponsor will look to drive operational improvements throughout the business and gradually utilize free cash flow generation to reduce the amount of transaction debt outstanding, eventually culminating in a sale of the company to another strategic/financial buyer, or perhaps in a stock offering. Critical to this model is the consistent generation of cash flow such that the private equity sponsor can be confident in its ability to effectively service its debt.
With steady long-term growth in the number of vehicles on the road and miles driven, aftermarket fundamentals are generally accommodative, in our opinion, to private equity investment. And with buyout fundraising exceeding equity deployments every year since 2004, according to Thomson Reuters Buyouts, there is currently more than $400 billion in outstanding equity capital that has been raised with sponsors looking for suitable opportunities in which to commit these funds. In addition, high-yield paper, as measured by the Credit Suisse Bond Fund High Yield Index, Yield to Worst, is now trading at yields below levels seen in 2006 and 2007, effectively lowering the hurdle for successful portfolio company acquisitions. While the majority of this article focuses on the potential for heightened merger and acquisition activity by financial buyers, we would also point out our expectation for continued transaction activity by strategic players as industry participants look to solidify and expand their businesses.
So, where do we see the most opportunity for industry consolidation? Over the past 10-15 years, we would characterize the majority of aftermarket consolidation as having occurred within the retail and distribution channel. Recall AutoZone’s 1998 acquisition of approximately 560 Chief Auto Parts stores; Advance’s 1998 purchase of Western Auto and the 2001 acquisition of Discount Auto Parts; and O’Reilly’s 1998 purchase of Hi/Lo, 2001 acquisition of Mid-State, Midwest Auto in 2005, and of course, most recently, its 2008 acquisition of CSK Auto.
Moving forward, we expect to see continued consolidation within the retailer and distributor base, although at a slower pace as that seen in recent years. In our opinion, over the coming years it should be the aftermarket supplier base and service shops that see the greatest amount of activity.