Services and Industrials: Resilience, strong fundamentals, and growth potential
Paolo Notarnicola, Partner, NA, Stefano Ferraresi, Partner, EUR
In our new four-part sector series, we shine a spotlight on each of the key sectors in which we invest: Services & Industrials, Healthcare, TMT, and Consumer. In each piece, our sector leaders in North America and Europe come together to discuss the themes, trends, and opportunities for their sector in their respective market, detailing the factors shaping our portfolio and investment approach into 2023 and beyond.
The first part of this series focuses on Services and Industrials (S&I), with Stefano Ferraresi, Partner co-leading our European S&I practice and coverage in Italy, and Paolo Notarnicola, Partner leading our North American S&I practice and coverage in Canada.
What underscores your long-term conviction in this sector?
PN: Services and industrials are the backbone of any developed economy. They represent a very large portion of GDP, and these services will always be in demand throughout economic cycles.
We focus on investing in good companies that we can make even better through our hands-on operationally intensive approach. These firms generally provide “mission critical” services, have demonstrated financial resilience throughout several cycles, and are led by experienced and effective management teams. Our North America portfolio companies Green for Life (GFL), an environmental services and waste management firm – the largest investment in Fund X - and global security services firm GardaWorld, are perfect examples.
The sector is broad, so we need to be disciplined in our approach; we have identified a number of sector themes that benefit from long term structural growth, which helps us form conviction and focus on a select few sub-sectors to more effectively invest and support growth. In North America, for example, we’re very confident in the long-term outlook for companies providing environmental and tech-enabled services, and the knowledge economy sub-sectors.
SF: In Europe, we’ve also narrowed our focus on three industrial sub-sectors: packaging, automation, and speciality materials. Here we believe we can find companies with strong underlying fundamentals and exposure to stable and growing end markets. For example, IMA Group, a crown jewel of the Italian engineering sector, has over half of its business exposed to the pharmaceutical sector. The insights we have developed in the paper and packaging sector and our experience through IMA led to the early identification of Fedrigoni, as an asset we wanted to own, and helped us build conviction on the investment thesis. Fedrigoni, a leading global producer of packaging and self-adhesive labelling products, that we signed earlier this year, is a major supplier to the luxury goods sector. Both end markets are resilient while retaining high margins.
Across all the sub-sectors we look at, we see some strong tailwinds in automation and digitalisation. These fundamentally allow for modernisation and drive operational efficiencies for which we believe demand will continue to be strong. The automation trend reflects a broader demand for tech-enabled services. Any company that can effectively provide these will benefit from widespread consumer demand.
PN: Another key theme for us sustainability. GFL is a great example of how we can work together with our portfolio companies to deliver dynamic, sustainable expansion and change. GFL has, from its inception, had ESG baked into its DNA, even down to its name: Green for Life. From the outset we knew we were partnering with a management team that had a deep understanding of sustainability challenges and opportunities. From our initial investment in 2018 we’ve supported GFL’s evolution from a waste management services firm to an environmental services firm offering a broader suite of services, including recycling and soil remediation. This is a continuous process, and we aim to position ourselves to capitalise on market demand opportunities - for example, we’re currently examining ways to leverage energy generation from our landfills, harnessing methane gas emissions to meet the record demand in the energy market.
SF: ESG tailwinds are also benefitting Fedrigoni, which has similarly embedded sustainability into its strategy and demonstrates strong leadership in this space. It is now effectively supporting its clients in their transition to sustainable packaging solutions, moving away from single use plastics to paper and reusable alternatives. The same is true for IMA, which supports its customers with the design of innovative machines supporting the switch to sustainable packaging materials.
How is the sector riding the wave of disruptive global events?
SF: The volatility we’ve been experiencing has required significant flexibility across our portfolio as the business landscape continues to shift dramatically.
The war in Ukraine introduced significant new challenges into the market with high and persistent inflation and rising interest rate raises providing a macro backdrop which is complicated to navigate. This has driven rising costs across almost all business areas, with manufacturing naturally being exposed to increasing energy prices. In this environment, our investment approach of seeking defensive growth becomes more relevant than ever; the businesses we invest in benefit from long term structural growth, have leadership in their individual markets, and organic and strategic value creation optionality, which has so far allowed us to weather this storm and limit any downside risks.
If you look at our realised investments over the last decade, on average 70% of the value creation has been achieved to EBITDA growth as opposed to multiple expansion. It is this owner-operator ethos that enables us to proactively address downside and upside risks in our businesses and positions us well for this environment.
PN: Our investment rationale has served to protect us from some of the worst impacts of recent years, having deliberately selected companies with demonstrated track record of financial resilience.
For me, three key takeaways stand out: one, is the mission critical nature of the services the sector provides as despite drops in consumer demand, there will always be a need for certain services; second, is the importance of a variable cost structure and multiple value creation levers to afford downside protection to the cash-intensive nature of the industrials sector; and, the third is the ability of well managed companies to maintain flexibility in their capital structure and a balance sheet strong enough to isolate against negative shocks without widespread impacts or intensive cash bleeds.
SF: In terms of outlook, finding financing arrangements has become more difficult in the current macro context - however, it’s still possible to find and finance attractive investments where others are struggling. For example, in July this year, despite the market dislocation in financing, we managed to secure a fully committed €1,150m financing package for Fedrigoni from relationship banks, which subsequently got syndicated on terms better than was underwritten.
Where are you seeing the challenges and opportunities across your portfolio and the wider sector?
SF: Inflationary cost pressures are impacting all sectors. Given the companies we invest in occupy leading market positions with strong ability to defend their profitability, we’ve been able to avoid margin compression and mitigate the worst effects of the inflation seen across markets.
In this market context and given the unstable outlook into 2023, we’re really focusing on our investment fundamentals: resilience, mission critical essential services, robust cash flows, and opportunities to partner effectively with best-in-class management teams, as well as focusing on where our expertise can make a real difference.
PN: Looking forward, these market conditions tend to be cyclical, and dislocations create opportunities, however it is important to remain disciplined and patient whilst the backdrop continues to evolve.
Prospects for a recession certainly invite prudence when it comes to near term projections but will offer opportunities to invest in attractive subsectors at lower valuations. Lower valuations currently seen across markets can unlock further buy-and-build opportunities to expand market presence and realise synergies, alongside organic growth. Supporting our portfolio companies with M&A has been a cornerstone of our value creation tool kit – GFL is a great example, the company has executed over 140 acquisitions under our ownership.
In relative terms over the last decade, we benefited less than others from the significant growth in valuations in technology fuelled by the low interest rate environment. We feel we have entered a new business cycle where the pursuit of growth at almost any cost is behind us and our investment strategy of seeking defensive growth is more relevant than ever.