TOP 50 PE, 2017 | Written By Susan Tyson and Kerry Grady
In early 2017, we spoke with leaders from Top 50 PE firms representing 5 regions across the US to get a summery take on the current situation for Private Equity: opportunities, challenges, the impact of the new administration and tactics for increased visibility and improved deal flow.
Included in the interview:
Partner, AGI Partners
Founder and Senior Managing Director, Pfingsten Partners
Founder and Managing Partner, Blue Sage Capital
Derek A. McDowell
Founder and Managing Partner, Boyne Capital
Heather Smith Thorne
Managing Director, Swander Pace Capital
Here’s what they had to say:
Where are the opportunities for PE today?
Peter: I think that the best opportunities are at the small end of the middle market. Companies with under $10 million of free cash flow that have the ability to serve as a platform suitable for add-on acquisitions that have a free cash flow of $3 million to $5 million. Small companies cannot access the debt markets as readily as large companies and, therefore, the amount of debt on those transactions is less than the amount of total enterprise value as a multiple free cash flow tends to be less on those deals because they support less leverage. Those deals provide very good tuck-in candidates.
At Blue Sage, we’re strong believers in the small end of the middle market. Our strategy is focused on being the first institutional partner of families that have built strong businesses over a period of multiple decades but are looking for a partner to allow them to take some chips off the table and risk growing the company with somebody else’s money. They all very much want to grow their businesses but because their family’s livelihood depends almost exclusively on this single asset, they’re often hesitant to take risks or make changes to the business. Even with those changes, there will potentially require large operational improvements. However, they won’t take them because they don’t want to upset the apple cart. When it’s at least 70% our money and only 30% their money, we found that they’re much more willing to work with us to take some of these risks that ultimately end up growing the business.
Derek: Within the current environment for the private equity investor, we see the best opportunities coming from sector specialization within industry verticals and from targeting the lower end of the market spectrum. People have the most success when they’ve invested and developed core competencies, such as sourcing, managerial support, operational expertise, regulatory management within verticals such as healthcare services, IT, government contracting, specialty agriculture, and industrial services, to name a few. We then focus on a specific thematic investment thesis within these broader verticals, which will help us build a targeted and, ultimately, more valuable company. It’s a level of specialization that is different from the past where people might globally be driven to say, “we’re healthcare investors” or “we do general industrial”.
At Boyne, since our founding, we have focused on investing in smaller companies, businesses with less than $100 million of revenue, often less than $50 million, that generate from $2 million to $10 million of free cash flow. We have a team and toolkit that is built to work with these smaller companies to drive operational improvement and equity value creation in these businesses. This skillset is critically important and very attractive to our operating and ownership partners. Rather than considering ourselves to be a “buyer” of a business, we look for opportunities in which we can help an operator buy more of a business that they currently lead. We find these opportunities for greater alignment in a generational change of control situations and corporate divestitures.
Heather: I think in general, the opportunity for private equity, especially in the middle market, is to become more involved in helping businesses reach their full potential. So, here at SPC, one of the ways we do that is our playbook, and that’s what we use to expand the equity value of a business. And that can range from everything from operational improvements, but also revenue drivers like expanding distribution into new geographies or new channels. You know, things that help margin expansion like plant efficiencies or improving procurement. And then finally, product innovation and improvement; bringing new product launches to companies and developing things creatively. We feel that we need to work together with management to forge a new path for companies and help them have a lot more control over what they can be, and what the ultimate mission is. I think this is a departure from private equity in the past, which was more about buying a company at a great value and selling it for a higher value as multiples expanded over time. So, I think being active in the future of middle-market private equity managers.
So, your firm is actively involved then, in your portfolio companies?
Heather: Right. We don’t run them, but we do stay very involved. We are active board numbers, and we offer companies a lot of resources, and a lot of learnings and experiences, including the good, the bad, and the ugly, from prior experience with other portfolio companies, and we think that helps differentiate us as a partner.
Tom: We’re in the business of buying operating companies from entrepreneurs and building better businesses. Those opportunities were available twenty-nine years ago when our firm, Pfingsten Partners, was founded. Over time, as markets have become more competitive, it’s increasingly challenging to be successful. However, we have found that those opportunities still exist.
“I think in general, the opportunity for private equity especially in the middle market is to become more involved in helping businesses reach their full potential.”
Heather Smith Thorne
David: Not so long ago, PE funds focused on larger deals. It’s hard to grow those companies organically, so, the focus was on financial engineering for generating returns. Unlike the lower end of the middle market, which does not benefit from financial engineering. Rather you focused on old-fashioned value-creation of building businesses, by adding on headcount, by expanding geographic coverage, as well as offering new products and services to your clients, etc. My focus as a private equity investor has always been on building business for returns. As an investor, we are active on the board but not day to day activities of the company. I work closely with our management teams in developing and executing the strategy while focusing on our investment thesis.
But if there’s a limited number of firms on the smaller end of the spectrum out there, doesn’t that mean you are going be competing that much more?
David: Several years ago, the lower end of the middle market was not as competitive as it is currently now. Companies and investors have much more funds looking at the lower end of the middle market. The challenges in investing in the lower middle market is to have an appropriate sized fund and the right mindset to look at these companies, among other things. So, yes, you’re going to get a lot of bigger guys looking down market given the valuations and supply of appropriate sized companies. But they’re not used to dealing with the fact that the CFO is still using Excel spreadsheets (and not an actual accounting software), limited IT systems, lack of infrastructure, etc. I think the larger funds coming down market will be disappointed because the opportunity cost is a lot greater for them.
“The challenges in investing in the lower middle market is to have an appropriate sized fund and the right mindset to look at these companies.”
At AGI, we’ve always been focused on the lower end of the middle market. It is in my mindset and DNA. The way we distinguish AGI in the midst of increasing competition is to share our track record of growing companies by classic value creation – investing in organic initiatives, hiring new people, and finding the right complementary add-ons to help expand the company base. We do not rely on financial engineering.
Peter, you mentioned that many members of your firm are on the operational side, so you go in and you acquire to hold and grow and bring in your people for operations.
Peter: A key part of our strategy is being very operationally involved. You know, my partner and I founded the firm. We’ve both operated businesses other than Blues Sage in the past, so we’ve got some experience sitting on the other side of the table. We can relate fairly well with these new people that are running businesses because we’ve had to make payroll and we’ve had to do a lot of things that they’re going through and will go through. We’ve seen that movie many times in the past, from their perspective, not just our perspective.
Looking to what might be ahead for private equity – What are the greatest challenges?
Heather: It’s a great question. I think in the short term, at least in the consumer products sector, especially in the middle market, it’s competitiveness with strategic buyers. So, at this time in the economic cycle, we feel that CPGs have a lot of cash on their balance sheets, and a lot of reasons to buy middle market businesses. And they’re buying businesses at earlier and earlier stages. So, it’s lessening the number of opportunities for middle market private equity firms to be the first round of institutional capital into entrepreneurial businesses like we have been in the past. That said, there are still a lot of businesses that would prefer a partner on their path of growth before they sell to a strategic buyer, and that’s where we are really focusing our time.
I think in the long term, increased competitiveness of the private equity industry overall is the greatest challenge. More and more capital is getting allocated to private equity, especially in middle market and lower middle market by limited partners and that’s allowing more private equity firms to launch and grow their fund sizes. And while that’s great for middle market companies, because it means more support for growth, for us, it makes it more competitive. That said, the better the competition, the better we are as a firm. It forces us to constantly raise the bar in the way that we partner with companies and to differentiate ourselves further, to add more resources to our rosters, to add more capabilities that can help our portfolio companies.
Tom: One of our biggest short-term challenges is that purchase prices in our market segment are at a historical high. The good news is, if we are looking to sell a company, high purchase prices at the time that we sell is a good thing. Conversely, we’re also in the business of buying companies and creating value. With extremely high purchase prices, it is very difficult to deploy capital at a good value.
We’ve experienced a very slow recovery from the recession and below average post-recovery growth rates in North America and Europe. It is very difficult to grow a business organically when you’re working against market headwinds. Over the past decade, it has become increasingly more difficult to do business in a highly-regulated environment. Additionally, long-term growth prospects for North America and Europe remain volatile.
Derek: I think in the last five to 10 years, it’s been a relatively challenging regulatory environment, with dramatic shifts and movement. For the most part, it has been unfriendly toward employers, if you look at DOL actions or other governmental changes, which is especially hard on private equity. Until we have more certainty about where things are going, it will make it more challenging for investors to plan.
David: For the industry, I think there’s a lot of money chasing fewer quality companies and the current valuations are not justified by the fundamentals of the underlying asset. We all seem to be chasing the same thing. Something must give. Whether some of that money goes away or more quality companies will come back into the market looking for capital remains to be seen. I think the longer-term challenge is that the barriers to entry for private equity are not as great as in was in the past. Hence, the number of new firms popping up has experienced tremendous growth, thus increasing competition. I also think that there will be increased challenges in managing private equity due to regulatory and compliance issues. All of this shows you what a great asset class private equity is to investors!
Peter: The thing about the short term and long term, the biggest challenge for private equity is it’s just getting incredibly popular. The number of firms that are in business today is greater than the number of people that were in the business when I got into it about 20 years ago. It’s pretty amazing to think of the spectacular growth this industry has taken. The assets under management are many many many x times what they were when I first started in this industry. All that competition is really pushed up the amount of capital that’s in the market at all stages. Even the small end of the middle market. That in turn has pushed up competition and purchase prices on businesses that are sold through large investment bank-led auctions. We generally use investment banks to sell our businesses, but when we purchase businesses, they have a bank involved approximately half of the time. It’s a lot less on the ingoing. The fact that bankers have really gotten out there and done a good job is pushing returns down across the board. I think most pension funds would be happy with 12% net return. 20 years ago, you needed to be producing 20%.
In that market with so much capital and not enough deals, what do you do? What tactic do you use to overcome this challenge?
Peter: We like to network with our geographically focused lead sources. We’re geographically focused on the southeast and southwest, in particular, Texas and states that touch Texas. We lever our limited partner network pretty heavily. We’ve got dozens of limited partners that to us are much more than suppliers of capital. They’re really partners that help us source and diligence. Several of them are also operators. We have some family offices and some individuals who are running businesses in some of the areas that we focus on. We do try to focus on a couple key areas. One is waste management/environmental services, and the other is niche manufacturing. By focusing our efforts in a couple verticals, it really helps us to know the players in that vertical, more so than we would if we were just looking into any deal across the world. Industry focused networking with small business brokers, accountants, lawyers and these families, which is our primary source of the deals. That’s really helped us quite a bit, particularly within those two verticals.
“By focusing our efforts in a couple verticals, it really helps us to know the players in that vertical, more so than we would if we were just looking into any deal across the world.”
How does your firm see how the Trump administration is going to be impacting private equity?
Tom: Three months before the election, we were planning for a recession in 2017. Now we are seeing optimism and no one that we know is planning for a recession in 2017. You are seeing this reflected in the stock market gains which is an indication of how investors feel about the prospects for the underlying businesses. I would say the most immediate impact of the election result is that the economy seems to be improving in areas that we didn’t see improvement over the last 18 months. And, I think you’re seeing some of that reflected by what’s occurring in the stock market, which is really a harbinger of how people feel about the future. I would say the other things that look like they could be positive, but until they actually do something, we won’t know – de-regulations, an overhaul of the tax system, energy independence, and boosting the energy industry, reducing the cost of health care. If those come to pass, we would view those as positives for private equity, and US business as a whole.
“Three months before the election, we were planning for a recession in 2017. Now we are seeing optimism and no one that we know is planning for a recession in 2017.”
Do you think all four things need to happen all at the same time or each in a certain order?
Tom: I’d say all are important. And deregulation and health care expenses are probably the two. If they get those done, it’ll have a huge positive impact. Tax. You know, changing the tax structure would probably be next in line. And then energy independence would probably be number four. Any combination of those factors, I think, would be positive. Even if they did one of them, it would be better than what we have now.
Peter: I think there’ll be some changes. It’s still too early to tell exactly what’s going to make it through. Several of the things that have been talked about, if I had to handicap them, I would say a reduction of the corporate income tax is likely. You’ll probably see even more private equity portfolio companies structured as C corps, as opposed to past entities like LLCs or LPs. I think you’ll see evaluations increase because the after-tax cash generation of these businesses will be higher if they have a lower tax rate. I think you’ll see personal income taxes reduced as well. That will leave more money for investment.
Further down the spectrum of likelihood, you’ve got this border tax or some variant thereof. If that comes through, you’ll definitely see domestic manufacturers that do not use foreign influence and export a lot of their output do very well. On the other hand, retailers who import 100% of what they sell will suffer pretty dramatically profitability wise. I don’t see a pure border tax. 100% at that level to be coming through, but there might be some variance of that. Deductibility of interest paid by the companies is another item.
Peter: Of interest paid on leverage. Again, I think that’s less likely. There may be some variant, but you know, leveraged buyouts don’t work very well if you don’t have leverage. You’re going to have less leverage in an environment where interest paid is not deductible. The relative advantage of debt over equity will disappear in that case. You’ll see deals that have more equity in them, if that ever happens, with a limited deductibility or limited deductibility of interest. Then you’ve got the carried interest piece, which may or may not happen. People have been talking about it for a long time, but that would change the economics to the fund managers if that came to pass.
David: I wrote an article about this for Private Equity Professional Digest. I happen to be very bullish for the Trump administration on PE. I think that as somebody who has run businesses, albeit a larger global branding businesses, he understands what the day-to-day business individual goes through. I’ve spent a lot of time doing public policy work in middle market PE, and I recently came back from Washington DC, where you spend a lot of time educating members of Congress and their staff on what PE is about. Trump understands this. I think he realizes that the two biggest killers of economic growth are lack of incentives and excessive regulations. I think he’s going to change the tax code to be much more palatable.
The amount of regulations that we have just keeps getting greater and greater. Now, I do believe that if people misbehave they should be punished. But if you do some kind of compliance activity because we need to follow a law but there’s no economic benefit, that’s actually a big loss for us. If you take an altruistic view of economics, what is it? It’s about limited resources, and trying to combine with unlimited wants. If you are spending time filling out forms and spending time and money on compliance that doesn’t provide an economic benefit to the investors that it’s supposed to protect, it becomes a waste of time. I think that overall, the expectation of the Trump administration is for a positive impact on private equity. I think in the long term there’s a lot more optimism now among my fellow GPs.
Heather: I think there’s a lot of ways you could look at it in terms of impacting private equity, and not to be too myopic, but I think about it often in terms of how does it impact middle market consumer companies based in North America. I think the biggest thing that we think about from our companies’ perspectives is what effects his policy will have on global trade.
There’s a bit of a contradiction in the sense that he has said the dollar is too strong and he’s actually looking for a weaker dollar, but his policies all point toward strengthening the dollar, which obviously can have an impact on US companies. There has been quite a bit of strengthening in the dollar in the past few years before Trump took office and we’ve seen what impact that’s had on our businesses, so we have a precedent of what that does to our companies, both good and bad, and we’re thinking through how further strengthening will impact us. If the dollar increases further, international revenues will certainly contract for middle market businesses. As we’ve seen in the past few years, that can have dual impacts of hurting financial performance but also driving companies to improve operations or other revenue expansion efforts to make up the gap.
Derek: The short answer is “I don’t know”, and that’s probably the same for a lot of investors. I think there’s been a general sense of optimism reflected in the stock market around the concept of less regulation and a pro-growth administration. That said, there’s a level of uncertainty as it gets to some of the foundational issues that underpin the administration. Tax reform is an example. People are generally excited for increased clarity in the system and less complexity; whether it’s repatriation of offshore dollars, reduction of rates or code simplification, reform should help the corporate environment and the individual.
At the same time, if you have the concept of the border tax adjustment, it will create really significant winners and really significant losers. Think about a host of companies that are primarily import-driven, whether it’s consumer products or apparel or other businesses that source a majority of their product offshore. Many would become insolvent the day the border tax, as currently described, goes into effect. There are a lot of private equity firms that have invested in firms like that and I think that will be fairly troubling for them.
The same thing for private equity firms who have been healthcare investors. The lack of clarity around what an actual ACA restructuring or repeal and replace entails has pretty significant ramifications for companies operating in that space. Medicaid, Medicare, private pay, understanding how it fits together. Not to say that there won’t be a net positive outcome from either tax reform or Affordable Care Act restructuring. It’s just for the time being, there’s also significant amount of uncertainty which makes it tough to plan around that.
I was reading the Chicago Tribune this morning – there was a story about manufacturers that are concerned about import tax. Hart Schaffner and Marx, which is a well-known custom and volume tailor here in Chicago, do all piece good manufacturing in the US, but their fabrics are all imported. It’s interesting that you bring up that point, unless you read the same article today.
Derek: A lot of the classic “middle market” companies in the US would be significantly affected by this policy. These are companies that tend to serve the domestic market, could be significant importers of goods, but don’t serve a corresponding export market. Take the classic example of a consumer products; it could be importing toys, other household goods, or apparel products. Let’s say it’s generating $100 million in revenue and that, for the sake of argument, it’s importing, most of its goods, which is probably typical if it’s plastic toy, electronics or a household fixture, where most production has moved offshore.
Let’s assume that that’s a business that generates 30% in gross margins and, for the sake of this argument, it generates 10% pre-tax margins, or $10 million on its $100 million of revenue. If we assume, 80% of its $70 million of cost of goods was imported goods, that is $56 million of “expense” that is no longer deductible for tax purposes.
Well, if $56 million of imported goods suddenly becomes a non-tax deductible, this is a business that goes from paying tax on $10 million of pre-tax profit (let’s say $4 million of tax) to owing tax on $66 million of pre-tax loss (the $10 mm plus $56 mm), which could be $26 million of tax owed. So, there are a bunch of businesses like this company that will be rendered effectively insolvent the day the currently configured border adjustment tax is implemented. Now, the argument is that you’re going to have a change in the dollar exchange rate which will effectively make it much cheaper to buy the product and it’ll compensate for it, is pretty academic or theoretical and it’s a pretty big “if.” There are a whole host of businesses that don’t have productive capacity in the United States to accommodate bringing back sourcing or production onshore within the first five years of a change like that, so we’ll see what happens.
What tactics do you use at your firm for increased visibility and improved deal flow?
Heather: I think our number one goal is to build our capabilities and make ourselves a better, more differentiated partner, period. And, that goal, when it’s executed, creates more deal flow and visibility. It’s first and foremost the way we do business and the kind of partner we are. But, I think it also helps us see more deals and put ourselves at the center of more activity.
Our view is the playbook helps us generate success, as we feel like it has helped us grow a lot of businesses in the past, and successfully sell them to strategic buyers. This then creates a great cycle through which great outcomes help us see more inbound deal flow. Our playbook has another benefit around deal sourcing, which is that the more we build it and the more capabilities we have, the more it allows us to look at a broader range of opportunities. We are no longer tied to just a few historical consumer categories; instead, we can look at a number of different areas within the consumer sector because we feel more confident in our ability to add value in many different situations.
Derek: We focus on very proactive outreach to our deal sources and network with a narrow message of specific industries and types of companies that we’re looking for. We have a very focused commitment to finding companies that fit within our investment criteria and parameters. That’s it. I think in the 25 years I’ve been doing this, it’s felt like there’s been more money than opportunity 22 of those 25 years and our job is just to find good opportunities, regardless of how competitive it is.
David: At AGI, we pursue aggressive outbound marketing (emails, calls, visits, etc.). I am also very active speaking at conferences and events such as ACG NY and iGlobal Forum to increase visibility. I have a targeted focus with respect to deal intermediaries – not just large banks but also small boutique banks and service providers that are transaction oriented. Because of these strategies, our deal flow has increased every year since we started the firm.
Tom: I would say increased visibility; we predominately use our website for visibility. We also attend a lot of industry events. So, we’re visible at those. But I would say those would be the two tactics we use for visibility and deal flow. We have spent a lot of time, money, and effort in the last decade plus generating direct deal flow, where we go to companies we’re interested in acquiring rather than go through intermediaries. So, we are generating probably 25% of our transaction opportunities on a direct basis. But, if you look at the platform investments we’ve closed, really, in our last three funds, about 50% of our new platforms, our new investments, are done on a direct basis.
When you say attending events for increased visibility, is that just attending? Or is it speaking or both? How do you use those events?
Tom: It would be things like an ACG event, you know, would give us visibility. Where we would have a booth, a table, at a capital connection. Something like that. We do a fair amount of speaking and sitting on panels. at these events. We probably do more of that than attending the events. A lot of speaking engagements, panel discussions would be, predominately, how we go after the industry events.
How do the event planners know to find you to get you to speak? Or do you just hear of an event and apply?
Tom: They usually approach us. And, we’ve been around enough, we’re a known name and we occupy a certain segment in the market, so certain events would apply more to the market we serve. Or they would want the voice of a low-end middle market private equity firm to round out a panel for a panel discussion. We also do a lot overseas. And that seems to be popular for speaking events and for panel discussions.
Peter: I think that goes back to a lot of the stuff I was talking about earlier. We try to network with families in our industries and in our geography extensively. We’ve got a very nice limited partner group that is concentrated in the southeast/southwest with a smattering of limited partners in the northeast and on the west coast that we get a lot of strategic relationships in our geography. We try to get the companies before they hire an investment banker. Get exposed. We try to get them small and work with them for a long period of time. We’re not as obsessed on growth as some private equity firms are. It doesn’t have to be packaged up nice and clean. We’re willing to work hard and clean up a situation. That’s how we feel like we’re going to best optimize our value add. Not by finding something that’s clean and nice that’s something that we can work alongside the family to jointly improve the overall value of the business.