August 28, 2013
Interviewed by: David Snow

Total Alignment: The Fundless Approach Advantage

The Watermill Group does not invest in the fund format, and founder Steven E. Karol details why this model has worked for the firm for over 30 years. He also discusses Watermill’s emphasis on strategy and operations over financial engineering.

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Total Alignment: The Fundless Approach Advantage
A Privcap conversation with Steven E. Karol of The Watermill Group

David Snow, Privcap: Today, we are joined by Steven Karol of Watermill Group. Steven, welcome to Privcap today. Thanks for being here.

Steven Karol, Watermill Group: Thanks for having me.

Snow: I’d like to learn more about your firm, Watermill. You’ve been doing deals and creating value with the private equity approach for a long time. But why don’t we just start out kind of at the thousand-foot level and tell me what is unique about your firm and your approach to investing.

Karol: Okay, well we started doing buyouts. They weren’t called leveraged buyouts. They were called bootstraps over 30 years ago. And in those days, the companies that would sell, they were numerous and for the most part needed to be changed in some way. They needed to be fixed. So that’s how it started and then we’ve been doing the same thing ever since. And over the years, what we’ve learned is that the way you fix a company is not by slashing and burning or cutting and chopping, but by putting it in the correct direction and then making sure that it can go in that direction.

And that really takes two skill sets. One is understanding strategy and the other is implementing strategy. So it’s a kind of a different approach then how the private equity industry had evolved in the past. So if you look at our team, every one of them were operating people, either CEO’s or CFO’s or strategy people and what we kind of say, it’s a little glib, but it’s not that far from the mark, is that the finance stuff you can learn. So when we screen for our people, it’s can you add value to an operation and then we’ll go to school on what the current financing trends are and then hopefully we’ll stay with those.

Snow: Well, I mean I think you mentioned bootstrapping. I think when people think about the early days of private equity or buyouts or whatever it used to be called, people saw very much a balance sheet or a financial engineering activity. So you’re saying that that was not the origins of your firm, that you always had sort of a more strategic approach to investing?

Karol: No, “always” is a big word. We started with that approach. In those days, you didn’t need a lot of equity. You just needed to know how to do a revolver and get the seller to take back a little paper and that was a financial engineering kind of a basic sort. But what you learn after you do that and you arrive at your new company on day one is now you have to do something and you now have a highly leveraged company in an environment in those days where that wasn’t normal. And if you didn’t quickly figure out the operations and improvement of the EBITA improvement, you could get in trouble. So we learned on the job but it was right away we learned that we had to make sure that what we bought got better. It wasn’t oh boy, we own a company, let’s go party.

Snow: One way that the private equity market has evolved significantly is the use of funds, limited partnerships to gather equity and of course, the rise of private equity can almost be characterized by the rise of the proliferation and the growth of these huge funds. Your firm does not invest in a fund format and so I’m wondering why and maybe what some of the benefits are of the fundless approach.

Karol: Well, we looked at it and what we discovered is that our way is better for us. And I’ll take a little time with this ‘cause there’s a few components to this as to why it’s better. The first one I’ll say from the limited partner’s standpoint it’s better for them ‘cause we’re totally aligned and from an incentive standpoint. Without a fund, we don’t take any management fee on money. So nobody has to pay us to go look for deals. That’s all done internally.

We fund our own overhead. So what we do is we get a reward at the end that always has been higher than norm. We get 25% rather than 20% and that extra five is kind of our payment for not having taken the 2% up front. And our investors really like that because they’re getting a win and we’re getting a win and if they don’t get a win, we don’t get a win. But more importantly than that, what we’ve been doing for these 30 some odd years is raising investors rather than investments. So we’ve got, I don’t like the word, a bunch, we’ve got 50 or so very high net worth in the family offices or investors, many of whom, the great majority have made their own money and have done so in various fields.

And as a result, we have committed capital and we have committed talent. And so when we go out and look at a deal, we can call our network of investors and say who knows about this and it’s much better due diligence because we have firsthand experience. We don’t have to pay an MBA to learn about an industry. We know about the industry because someone’s made a lot of money in it. And also we have his or her capital and potentially board or advisory participation at the end. So we end up with a very large pool of resources that’s much more valuable than money to us. Over these years we have not had any difficulty raising whatever was required to do our deals so it’s not a question of lack of capital. And so we end up with the capital we need but with much, much more. It’s a better model for us.

Snow: Have you ever found that not withstanding your history of being able to call together the capital needed to get a deal done, that sometimes the sellers or the representatives of the sellers might see you in a weaker light than a committed fund?

Karol: Yeah, we have that problem all the time. And normally what we’ll do is well now, because we’ve been around for so long, we can just say look at our track record and there’s enough intermediaries out there and successful deals that it doesn’t really last very long. Before we got to that point, we would get one of our investors to call up and vouch for us or get an investment bank to write a highly confident letter or whatever was required. It’s never stopped us from doing a deal. It did give, in a couple of instances, a seller or an intermediary pause and took an extra week or so for them to get through that. Now it’s okay. You know, we’re known and it takes a phone call.

Snow: So how do you find that ultimately the sellers gain confidence in your ability to close a deal?

Karol: Well, we’ve been around for a long time. There’s a network of intermediaries, sellers, and investors who know us. And so, it really only takes a phone call now for us to get through that.

Snow: So you’re saying that in many cases, the investors that you network with might even discover and bring a deal to the group?

Karol: Yeah, that happens all the time. In particular, industry experts that know of something that’s going on, they’ll bring it to us. Not all the time is one we can do. It’s maybe an idea. So, “Hey, you know, have you looked at this? The industry is consolidating. This might be for sale.” And then of course, we have to go try to dig it out and see if it really is. But yeah, we do get proprietary deal flow from our investor network.

Snow: It seems like there is a growing community, maybe it’s always been there and I’ve just simply noticed it lately, but a growing community of people who might be called club deal firms or fundless sponsors. Have you seen that grow and is it sort of-, what are the commonalities among all these sponsors?

Karol: Yeah, so we don’t like the term “fundless sponsor” because it’s a derisive term used by people with funds who take fees to make fun of people who don’t and try and get an edge up on a deal. And we’re not fundless. We have tons of money. We just don’t have a fund. But we are seeing, to answer your question, an increase in the amount of people who are trying to do deals without funds. And this may be a subject we want to talk about later if you want, but we’re seeing a significant change in the dynamics of the private equity industry.

Like any other industry, since the beginning of industries, there’s always a peak of the industry and then there’s a period of age and decline and consolidation. And our belief is that we’re in that period now with funds. So funds that are at the end of the barbell, the main funds, are raising less money and having a harder time doing it. Funds in our category who are kind of more boutique, they seem to be okay but are being more specific. And the ones in the middle of the barbell are having a great deal of difficulty. They’re spinning our partners or they’re spinning out managers and those people are out trying to do what they learned how to do without funds. And they’re a lot different than we are ‘cause we’ve been doing this for over 30 years our way.

Snow: Well, I agree. Let’s dwell on that. It is interesting that the demand for capital to get into private situations, private deals remains very strong and looks like it could continue to grow. But the format by which the capital gets into those situations is changing or at least there’s pressure on the traditional format. Why do you think that is? Is it just that these larger pools of capital or private families would simply prefer to bypass the fund structure and go directly into situations?

Karol: I think there’s a variety of reasons for that and it all revolves around an increase in value to the customer and a lower price for the provider, which is kind of the strategy 101 way of describing a consolidating industry. In this case, limited partners and investors are getting much more sophisticated. They’ve paid a lot of fees over the years for not necessarily consistent results. And there have been even brand name funds have had mediocre…vintages, they call them. And the LP’s are realizing they don’t need to pay the fees.

Snow: Do you have among your network of investors, institutions or people who, for the most part, invest through funds and decide to take a flyer with your or allocate part of their capital to the deal-by-deal approach that your firm pursues?

Karol: Yes, so because our investors are high network people, they have significant diversification in their portfolios. We’re only a very small part of them. I mean it’s not hard for us to get whatever the check is necessary but we would never want to be the only thing on of our investors did. We never would be anyway but that’s not our strategy. So yeah, these guys they’ll invest in Watermill and Bing and the smart ones and most of them are investing in every Watermill deal so it’s not a deal-by-deal thing. It’s really Watermill’s call – how can I help?