You’ve shed blood, sweat and tears formulating an investment thesis. So what’s next? You can’t just sit at your desk and wait for an opportunity to knock on your firm’s door. You have to search for companies that fit your thesis. And yet it’s rare you’ll track down a deal that matches your requirements to the letter.
In this captivating conversation, leading private equity pros explain how they proactively seek deals that match their agreed-upon sector plays. These GPs freely admit that their investments almost never start out as a perfect match. “The deal that’s finally actionable is unlikely to be the exact one you’re looking for, but it’s the thesis that dictates where you look,” says Doug Londal, of New Mountain Capital. Joining the discussion are Dan Galante, National Managing Partner of Transaction Advisory Services at Grant Thornton, and Richard Lawson, Managing Partner at Huntsman Gay Global Capital.
This is a must-see program for PE professionals interested in the best practices of deal origination and deal execution.
David Snow, Privcap: Today we're joined by Rich Lawson of Huntsman Gay Global Capital, Doug Londal of New Mountain Capital, and Dan Galante of Grant Thornton. Gentlemen, welcome to Privcap today.
We are talking about something very important, and that is how private equity firms form a thesis about which direction the world is going to go, and then go and find appropriate investments that will match those theses. And so I'm fascinated to hear what all of you practice, and also see in the market.
Maybe starting with Rich. Once your firm has gone through a tremendous amount of research and thinking to come up with a thesis about which direction a certain sector is going to go, what is the next step? How do you then go out and look for deals? Do you just sort of sit there and wait for the opportunities to come your way, or do you have to be much more proactive and knock on a lot of doors, and dig a lot of dry wells, I guess.
Rich Lawson, Huntsman Gay Global Capital: I think you first start with your in-house resources. So you have teams that are focused in certain areas, and in this case, commerce software, we believed there was an enormous opportunity more broadly in commerce software. And so outside of the team itself, we have a dedicated in-house group of professionals-- we call them transaction origination professionals-- that are, in many ways, reverse sponsor coverage folks within our organization, that spend an inordinate amount of time with the bulge bracket investment banks, the boutiques, and in many cases, most of the trade shows, and working with these companies.
So that's typically how we tend to-- once we act on something, we'll find an investment, a toehold investment. We'll begin the work that theme. And ultimately, at the end of the day, it's about getting smarter as you get into investment.
Usually, that's typically what's allowed us to move ahead, in many cases. We had a business in Montreal, Canada, a decidedly domestic North American business, that had aspirations to go global. And so for our opportunity to grow, we actually were able to identify, through our investment themes, the research we had done, tremendous opportunity, a tremendous management team in Munich, Germany, a company there.
That's typically how we'll tend to act on our investment thesis, is once we've created an actionable theme.
Snow: Is it the case that if a transaction-sourcing professional finds a great-looking deal and feels good about it, and it brings it back to the team, and it is not what the idea was-- is that pushed back, or are people willing to throw the thesis out the window, and say, actually, no, let's consider this?
Lawson: Happens all the time. I'm sure Doug has probably seen this movie many times before. I think we're only as good as our deal flow, and on our ability to actually wade through hundreds, if not thousands, of deal opportunities every year.
So I think folks come back with actual ideas, and then it really gets to the nature of the partnership, and how we tend to make decisions together.
Doug Londal, New Mountain Capital: It's actually quite rare that you come up with a thesis, and then go out and find a company that is identical to that thesis. Really, what it does is the thesis, I think, dictates where you spend time, and it dictates how you best treat others. So when you come up with that thesis, you're saying, this is what we like about a particular industry, whether it's the growth, whether it's the defensive nature, the barriers to entry. And this is what we don't like about some of the adjacent industries, which is why we focused.
Then you go out and you find whether it's the intermediaries, the consultants, oftentimes you get executives involved. So if we've got a particular thesis-- another example we had was distribution. We were looking at distribution in the health and wellness space. So we went out and found an executive who had spend his career as a CEO in several health and wellness distribution companies, and his network is also very helpful to actually finding opportunities, but also just confirming our thesis.
That thesis, from its embryonic stage, will change, but also, it's just the thesis itself that's dictating where you're going to look. Then the opportunity has got to come up where there's actually something that's actionable. So you may look at 20, 30, 40 companies, and the business idea that's actually actionable will have some of the elements in the thesis, but it's not likely to be the exact company or business model you're looking for, but you're educated about many of those aspects of the thesis, because you've spent so much time thinking about it.
Then you just sit back and do your normal underwriting practice, which is, let's understand the business, let's match it against our overall investing criteria. And if you can get something done, and it's within the same theme, then it's a success.
Snow: Dan, speaking of understanding the business, how often is it that a private equity client will bring a potential investment to your team and say, we like this business, we think it has certain characteristics, and you are forced to challenge them on their understanding of key aspects of that business? And then, if you do challenge it, upon what are you basing that challenge?
Dan Galante, Grant Thornton: I think that happens all the time, really. I mean, from a standpoint of including external advisers to help understand the market and the commercial aspects, but also the specific performance of the company, and what is truly sustainable, and where the growth aspects are. And I think what we are able to do is really take an unbiased view of the company's performance, and you challenge the management team on what's been presented, challenge other advisers on what's been presented, then lay out the facts. The facts that are interpreted by both the private equity firm and the partners that are working on it, as well as the entire partnership within the firm.
I think one of the things I've seen in working with a lot of private equity firms over the years, especially in the last several years, is the level of open debate and candor that happens within the partnership. And also the movement towards almost complete consensus amongst the partners, and sometimes amongst the entire firm, that an investment is the right investment to be able to move forward on.
To be able to support that there's a series of meetings, and I've seen best practices where literally the objections and the concerns from a business standpoint, from a market standpoint, or from a post-transaction performance improvement standpoint, and the ability to achieve those, are documented, and the specific deal team needs to come back and really support their rationale and answer the questions before the partnership is willing to move on.
I think a lot of that's probably stemmed out of some investing that happened in the boom years of 2006 and 2007, and the private equity firms have actually stepped back and re-evaluated their process. And it's extremely collaborative. And I'm actually surprised as far as how open and how challenging the members in the equity firm are to each other.
Snow: I want to talk a bit about the wealth of personal experience often exists, or should exist, in a private equity firm, where the partners who are actually making decisions have actually made decisions before in similar sectors, and are able to draw on their own experiences. How often is it that a partner will have spent many years in a certain sector, or done deals in a certain sector, before? Who will step forward and say, actually, guys, this is not the right deal for us? Or alternatively, I'm so excited, because I've been waiting for this my entire career, now it's finally happening, or whatever? So Rich, can you talk about personal experience and the value of that in a firm?
Lawson: Sure. I think in the software space, we had a lot of discussion internally. And that goes back to this whole notion of consensus. As a GP, how do you think about governance?
But in the early 2000 period, we had a very strong view in what multichannel commerce was going to be for online e-commerce and technology. And because we had that experience and spent five years in the trenches working through that, and recognized that the market was ready, it gave us all quite a bit of confidence that we wanted to make a rather large investment-- a large directional, global investment-- that we could get the entire partnership behind us.
I think that's a great example. It's called Hybrid Software, and that's a situation where we were relying on our past experience-- not just one of us, but many of us-- having gone through that whole process 10 years prior.
Londal: Yeah, this is a business that is all about experience, and the more experience you can get around the table for the underwriting decision, the better. We are, I think, all focused on, how do we set up a process that gets the right thesis out, such that we can go look for interesting opportunities? But once you find the opportunity, it may be that there's somebody you haven't met yet, it may be there's somebody in your organization, who's going to have a lot of experience around that particular deal.
What’s important is getting somebody who's on your side of the table that's actually able to opine on that. So our particular model is, we try to find people who are experts in the industry, and have actually lived in the industry, who are on our payroll, and participate in our carry, that we don't have to worry about whether they're saying, sure, go do that deal for a fee, for example. You need an unbiased person to say, look, I've seen a bunch of deals, and that's not the one to do
The thesis on paper can be very different from how they play out. There was a company we owned-- it was a sporting goods company-- and on paper, it was a terrific business. And what you couldn't tell on paper, and through the thesis, was what happened in the trenches when it came to actually negotiating with your distribution. And If you've got somebody around the table that says, I've been in that interplay, and I know that your models don't work, because it's great on paper, but this is what's going to happen when you actually get down to your renewal cycle, it would have been a different decision around a particular investment.
So you have to have that industry expertise, and so you have to have it around the table when you decide.
Lawson: Doug raises a great point. That is, I think, historically for us, we've always underwritten at 25% IRR with 80% confidence. Three times return, that's exactly what our partnership is going to go do. And I can tell you, through 200 transactions, we've never generated 25% IRR. It's always some other number. And there's a variety of other factors that come into play, but you do your best, you make directional decisions, and quite frankly, you end up relying on the team. Not only the management team, but the investment team.
Londal: Even if you do get to 25%, you're going to get there a different way than you expected. No business is a straight line, and there's always business volatility, and really what you have to underwrite is understanding what the volatility is, understanding how you can mitigate it, and just trying to get directionally to the right spot.
The best deals that have worked out as close to thesis as possible have been, if you look back at the original business plan, it got there a very different way. It may be that one channel that you expected didn't come to fruition, but another one came up. So you've got to start with a thesis to have direction in your investing decision, but ultimately, it gets there a very different way than what you expect.
Lawson: And pull the trigger.
Galante: I think that's really interesting, Doug. Maybe you could share a little bit about your experience, and when you make that transaction, the level of involvement of the private equity group post-transaction, and be able to provide guidance and counsel. Because it's not making the transaction and kind of stepping back. The management team needs the support, they sometimes need to be challenged a little bit, and be able to think prospectively, as far as what's happening.
Londal: So we tend to be very involved post-transaction, and I'll give an example. There was a company called MailSouth, which was a shared mail provider that when we did the deal, we had a thesis that said, we're going to go out and we're going to add frequency to this product, we're going to add geography to our market, and we're going to do acquisitions. And we worked with management very closely to say, let's go out and explore each of these different things, and it was a pretty even mix in our thesis as to how we were going to get to our returns.
Well, when we actually got our hands on the business and started working, we did one acquisition, but realized that we could almost go open geography and add frequency to this shared mail product at will. And so we changed. We sort of altered direction and said, instead of looking at acquisitions, let's focus all our attention here, and then we work with the management team to actually go execute that.
So again, if you look back at the original thesis letter-- and we try to lay out the theses ahead of time. When we call our capital, we'll write a letter to our LPs that says, this is the deal we're doing, this is how much we paid, here's how we found it.
Probably importantly, most importantly, this is what we intend to go do. It's a little bit like calling our shot in baseball. And it makes us hold ourselves accountable to actually doing whay we said we were going to do.
We’ll oftentimes go back and do that. We'll look at the thesis letter and we'll say, all right, we said we were going to do five things to grow the company. We were successful in doing three. We were unsuccessful in doing two. Ultimately that's OK, if it was a successful investment. But it's really a way for us to lay out, this is what we want to try to do. But that's going to change through the course of investment.
Snow: Further to topic of, in the underwriting process, attempting to really understand what the opportunities, the growth trajectories, and the risks are in a deal-- Dan, you have an interesting story about how you helped the client understand a certain very specific kind of health care-related risk. Can you talk about that, and how it was involved in the underwriting process?
Galante: Absolutely. And this goes in during the diligence phase, but we're not talking necessarily about company specifics, but a lot of the external dynamics that are working around the industry. And in health care, that's constantly changing, and we feel it's important that we have not only specific industry experience in health care around our firm, but even within our transaction advisory group, to be able to understand the dynamics that are moving around the deal aspect.
We looked recently at a physical therapy clinic that had, probably 80% of the revenues was workers' compensation. And there's constant changes based, at a state level around the country, of worker's compensation, the level of reimbursement. And really, based on the talent that we had, we were able to, within the firm, supplement a lot of the external research that the equity investor was doing, and help them think through what's going to happen from a reimbursement standpoint.
Within the context of the deal, the deal, which was probably a four-month period which had a slow start, the actual regulations within certain states changed, and they had a direct impact on the business model. But what's interesting is, it was a competitive process, and as you saw the different dynamics of the different equity funds, they took different views as far as what they thought was going to happen, and sustainability of what actually does happen.
So that's why it's really important, getting back to not only looking at the company, looking at the industry, and looking at all the other aspects that go around in bringing in the right level of expertise, to support and/or challenge initial thoughts.
Snow: Right. So there was an example of a private equity firm taking a view of the world, physical therapy, people are going to need more of it in the future. And yet this other influence became crucial to them smartly underwriting the deal. Did they end up doing the deal?
Galante: Actually, the firm that we represented did not do the deal.
Snow: Was it in part because of the changed reimbursement?
Expert Q&A With Dan Galante, National Managing Partner, Transaction Advisory Serives, Grant Thornton
Privcap: How does Grant Thornton help its private equity clients make better-informed investment decisions?
Galante: It starts in a number of different ways. First if we think about the identification of the investment thesis and the help that we could provide with our 800 partners and managing directors and 6,000 professionals and the knowledge that we have into not only industry sectors but deep into different sub-sectors of companies they may be looking at and areas they want to focus on, and bringing data points together to be able to help challenge their investment thesis and corroborate some of the things that they're looking to move forward.
And we take that into the valuation of a company from a diligent standpoint-- a blend of both commercial diligence-- how the company's positioned in the market-- financial and business diligence-- the actual performance that the company is doing today-- blend in operational diligence-- the capabilities of based on what they're doing today-- how sustainable is it, but more importantly, what opportunities are there to be able to grow at post acquisition, and then of course, including tax from a structuring as well as diligence standpoint.
Privcap: How does your firm help add value after the deal is done?
Galante: We're able to leverage that knowledge and those insights into helping co-develop with the management team and the private equity investor or the board post transaction, a 100-day plan. And that 100-day plan is going to be how do we then help transform the company, and augment management, and augment the capabilities from a functional standpoint that the private equity firm really has in-house to accelerate the value creation process.
Privcap: Talk about how you build relationships with GPs via a ‘single point of contact.’
Galante: A single point of contact is going to be able to provide access to all of Grant Thornton's solutions and ideas across the firm and across the country.