What auto suppliers can learn from PE to drive their EV transition

Auto parts suppliers that have hesitated to adopt an EV strategy can learn from the bold decision-making culture of private equity firms.

In brief

• The $1.9 trillion global auto supply sector will experience a shakeout in the changeover to EVs, and the slowest movers risk losing opportunities or bankruptcy.
• Companies that have hesitated to initiate change can benefit by assessing future options using the relentless, enterprise-value based approach of PE firms.
• Lessons from early movers highlight the value of planning the funding, rigorous execution and governance, and workforce transformation. 

The global automotive industry is undergoing existential disruption as the world market tightens its embrace of electric vehicles over internal combustion vehicles and hybrids. At this point—in the early stages of the transition and with a long way still to go—some challenges facing the diverse auto parts supplier industry are becoming clearer; however, many companies are still figuring out how quickly to embrace those changes.

The market transition to EVs is gathering momentum due to advances in technologies such as batteries and charging stations and growing buyer interest stemming from the success of Tesla and other electric models. The US and other governments are doubling down on commitments to transition to electric vehicles. Recently proposed emissions limits in the US would effectively require two-thirds of cars sold in the country to be electric by 2032, and California will require that all new vehicles sold in the state after 2035 be zero-emission Vehicles1.

Suppliers of parts—from gas tanks to fuel injectors—that run traditional cars are already seeing their market shrink, and the decline will only get worse from here. This $1.9 trillion industry will see a painful slowing of growth in coming years as internal combustion engine (ICE)-based product lines are phased out. About a quarter of profits are currently generated from legacy ICE components that will be the most adversely affected, resulting in a 50% decline from current levels by 2030. For some suppliers, the market will eventually resemble a game of musical chairs, with fewer and fewer safe economic places to land—and the slowest movers losing the game.

To be sure, segments of the ICE market will remain, such as parts for existing vehicles, and suppliers can continue to earn some revenue in this area long after production of new ICE models is phased out. Also, commercial vehicles have lagged passenger cars in the EV transition, so far, and are likely to offer another “long tail” of continuing opportunity for makers.

The impacts are hitting auto suppliers in different ways and at different velocities, depending on the parts they make and the size of the company. Many larger makers of powertrains and other ICE components, for example, whose production lines require long development lead times to transition, have embraced the need to change and have been developing transformation strategies and making operational changes, announcing new manufacturing strategies, new partnerships and new product lines. Public companies also benefit from the involvement of boards of directors and stockholders that push them to adopt transformation strategies earlier while balancing risks.

Small, medium and privately held companies, with traditional, risk-averse management styles and fewer resources tend to lag, however. Some that continue to delay adoption of an operational transition strategy may soon find themselves at risk quickly.

Julie Fream, President and CEO of the Motor & Equipment Manufacturers Association – Original Equipment Suppliers (MEMA), says that one of the biggest challenges companies face is estimating when the growing market for EV products will overtake the ICE components they are replacing This uncertainty is causing many executives to hesitate as they plan their company’s operational transition from ICE to EV.

“Suppliers know they need to be able to do both, but they are asking, ‘How do I know the volumes?’” Fream says. “How do they manage the crossover point, knowing that you can’t accurately predict at this point where the two lines will cross — where EV becomes dominant, and ICE becomes a secondary product line. That’s the question they are all asking.”

Companies that invest too early could end up financially overextended, with excess capacity and a market that is not ready for the new product. Late arrivals could lose opportunities completely if faster competitors beat them to the punch.

Companies seeking ways to exit ICE businesses also face challenges as certain, carved-out assets will become steadily less attractive to buyers. Without successful consolidation or divestiture, many will be forced to shut down, particularly if cost cuts and efficiency improvements are unable to keep pace with commercial declines. At the same time, suppliers wishing to embrace new technologies must invest heavily in new product and service innovations targeted at EVs. Often, these competing priorities absorb cash while also preventing the bold action that is needed in today’s market.

The PE mindset as transformation catalyst

Many auto suppliers, especially those that are small or mid-sized and often privately owned, have relied successfully on a traditional management approach of incremental improvement and risk management. This approach, however, is ill-suited for the current market upheaval. Tomorrow’s winners will be those that adopt a strong will to innovate and reinvent their whole business, embracing the entrepreneurial spirit that once helped them start.

Fortunately, a ready model for bold decision-making exists which can provide a model for the kind of aggressive approach they require—that of the private equity investor.
Two aspects of the PE mindset stand out as the essential, outside-investor viewpoints that many ICE suppliers urgently need: 

• The ability to make bold decisions, without attachment to unprofitable “sacred cows”
• A relentless focus on enterprise value.

For companies that are saddled with habits of incremental change and need to become unstuck, the PE lens can be a catalyst for the swift cultural makeover that is needed to get moving.

“The PE mindset is something many suppliers should consider,” says Fream. “There’s a lot of money on the sidelines right now that could eventually come in. This would create some opportunities if you accurately analyze your business and understand what needs to be done.”

This is not easy, she notes. “Suppliers need the skill set to assess what’s happening in the marketplace. The PE firm is ultimately trying to drive the company to be more focused on the marketplace. Generally, they don’t tolerate anything outside of that. But this can be very difficult for some suppliers, especially smaller, privately -  held companies.”

Typically, PE has a variety of strategic approaches to generate profits from companies in either fading industries or start-ups in new technology fields. PE investors can improve enterprise value and prepare an asset for profitable sale through organic upsides—topline growth and bottom-line improvements—as well as inorganically, through a potential portfolio play.

Leadership can use the PE agenda as the basis for conducting a data-based assessment of how their business creates value today and its potential future role in the developing EV ecosystem. Based on this deeper understanding, leaders can adopt and carry out a transformation strategy that aims to maximize enterprise value, as highlighted in the 2022 EY article How auto suppliers can navigate EV technology disruption in four steps.

The PE approach can help identify the appropriate operational strategy

Not all traditional product components are expected to decline in the near term. Many product lines can be suitable candidates to pivot to other markets, and some can be continued as sources for income that can be invested in new EV product development. Strategic approaches for how companies are managing their existing ICE businesses can be grouped in three broad categories:

• Exit (cash out and focus) – One clear option is for suppliers to wind down or sell their ICE products businesses to a buyer that can squeeze value from them, for longer, than the original owner can. The spin-off strategy can reduce exposure to the declining demand for ICE products and can raise capital for reinvestment in new market opportunities
• Consolidate (double down) – suppliers can prepare for the coming shakeout by consolidating existing ICE-only businesses to create synergies and scale so they can continue to milk value from the operations for as long as possible, with the option to continue to operate them alongside new EV businesses.
• Pivot (parallel pursuit) – Companies can wind down their ICE businesses according to a clear step-down plan, while pivoting product lines to new EV products. This may require massive investment in R&D, innovation and digitization to develop new EV products and services. It could include acquiring EV startups or niche players to expand product portfolios and acquire new skills or technologies. (For a full description of strategic options, see How auto suppliers can navigate EV technology disruption in four steps). The approaches cover a variety of tactics and entail different risks, and many companies are likely to adopt hybrid approaches, depending on their unique circumstances and what works best for different parts of their portfolio

The transformation journey so far: signs of success, and warnings

Quite a few OE suppliers have identified enterprise EV transformation strategies and begun to execute them. Based on this track record it is possible to understand the challenges of redesigning value chains or operating models with the perspectives gained by companies that are already undertaking these changes. Three examples of companies that have begun putting these into effect demonstrate the risks and success factors

A supplier divests ICE divisions while investing the proceeds in EV partnerships

A German powertrain company with ICE and EV products that was spun off in 2021 is following a two-part strategy of divesting its remaining internal combustion divisions to help fund its growing EV business, while focusing on EV innovation and growth through investments and partnerships.

The company is selling its catalyst and filters operation and intends to divest its internal combustion engine division, which has been profitable since 2021 after years of losses. Meanwhile, it is bolstering its EV business through partnerships with auto makers, to jointly develop power electronics, and electronics companies, for access to semiconductors. The company’s electronic mobility business has significant orders from the likes of Hyundai and is expected to break even in 2024.

A powertrain maker focuses on common ICE and EV products

A US-based powertrain supplier has combined some divestment measures with a more nuanced approach that is betting on continued viability of its ICE-based businesses. The company had plans to divest its ICE-based powertrain and clean air operations and use the proceeds to fund the EV transition in its aftermarket and ride performance businesses. It changed course after a PE firm took the company private in a $7 billion deal in 2022, highlighting a belief in an elongated sunset period for the company’s ICE operations. The company is continuing to build on its suspension and braking products, which can be used in EV as well as ICE vehicles, and is using its expertise in these technologies to launch other EV-agnostic products such as hybrid friction material composites. 

This strategy’s success depends on a slower decline of ICE-based businesses than markets are expecting, however, and therefore it entails a certain amount of risk. Companies could still aim for a profitable spin-out of a “leaner and meaner” version of the traditional ICE business.

A fuel system maker bets big on EV technology

A Tier 1 power drive systems maker based in the US is going all in on EVs with a three-pronged strategy of organic investment of up to $4 billion in EV technology, acquisition of EV charging and battery businesses and the divestment of non-core fuel system and aftermarket assets worth $3 billion to $4 billion. It has also invested in a company that makes flexible circuits for cars and entered into a licensing agreement to include capacitors in its range of inverters. 

The company expects its EV business to grow at least 72% in 2023, meeting or exceeding its target of 25% of its revenue coming from EVs. It expects its EV investments to reach the breakeven point by the end of 2023 or early 2024, driven by major new EV supply contracts.

The financial squeeze will come when negative price pressure begins to impact the profits of traditional parts suppliers, while at the same time, the new EV parts may be less profitable due to the cost of upfront investments and a still-developing market. By maintaining a PE attitude, companies can maintain a steady focus on profitability.

An entirely new set of products requires not only new production lines but also reconfigured technology, supply chains, R&D and new skills at every organizational level.

Enablers of transformation: risks and opportunities

Once organizations have determined the strategic way forward, however, they will face significant challenges in executing the agreed-upon roadmap. The experiences of companies that are already making progress, as well as recent EY work with automotive supplier clients, can help identify the strategic enablers companies will need to carry out the transition, while also providing useful observations and lessons.

Private equity value creation approach

A special thank you to Natalie Smith, Pravi Dubey, Matthieu Popesco, Jason Taylor, Jonathan Moore and Anselm Karitter who contributed to this article.