February 24, 2015
Interviewed by: David Snow
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PPM Smackdown: PebbleOak Capital

Privcap’s game show-style program PPM Smackdown, where private equity experts apply real analysis to fictitious funds. Our experts pick apart the track record of PebbleOak Capital Partners, a Chicago buyout firm trying to raise a Fund II with one big exit win and one big bankruptcy in its portfolio. Plus: Three due diligence findings thicken the plot. Will the experts give a thumbs up or thumbs down to backing this $500M (fictitious) fundraise?

Privcap’s game show-style program PPM Smackdown, where private equity experts apply real analysis to fictitious funds. Our experts pick apart the track record of PebbleOak Capital Partners, a Chicago buyout firm trying to raise a Fund II with one big exit win and one big bankruptcy in its portfolio. Plus: Three due diligence findings thicken the plot. Will the experts give a thumbs up or thumbs down to backing this $500M (fictitious) fundraise?

PPM Smackdown: Pebble Oak Capital
Real PE Analysis, Fake PE Funds

David Snow, Privcap: Hello and welcome to Privcap’s PPM Smackdown, where real private equity experts apply real analysis to fictitious private equity funds. I’m David Snow, CEO and co-founder of Privcap. Joining us today are Tim Kelly, an independent consultant and former long-time Managing Director with Adams Street Partners; Andrea Auerbach, Managing Director and Head of U.S. Private Equity Research at Cambridge Associates; and Steven Costabile, Managing Director and Global Head of the Private Funds Group at PineBridge Investments. Welcome to PPM Smackdown. Thanks for being here.

All right, we are going to be talking about a fictitious fund from a firm called Pebble Oak Capital Partners. Everybody has the PPM, and I can’t wait to hear your analysis of their story and their track record. Also, later, you’re each going to be revealing a duediligence finding from your fictitious due diligence into this fictitious fund that will influence whether you ultimately give this group a thumbs up or thumbs down and whether or not you would actually commit to such a group.

Again, your expertise and analysis are real, but this fund doesn’t exist. However, parts of its story might remind you of situations you’ve encountered in your long careers of deciding whether or not to commit to private equity funds. Why don’t we start with the basics of Pebble Oak Fund II?

Pebble Oak Fund II is the second fund offering from Chicago-based Pebble Oak Capital Partners. The fund is seeking to raise $500 million, whereas Fund I raised $250 million in 2009.

Pebble Oak Fund II will continue an investment focus on lower middle-market, consumer-facing businesses where the firm sees the ability to improve operations and aggressively grow profitability.

Before we move on to learning a bit more about the team of Pebble Oak Capital Partners, what are your initial reactions to the size of the fund, the timing of Fund II and anything related to the basics? Let’s start with Steve.

Steven Costabile, PineBridge Investments: I have to look at the size that they put on the cover; going from 250 to five would cause me to take a look and see if they can actually make that type of step-wise progression, understanding if they have the deal flow and the throughput.

Andrea Auerbach, Cambridge Associates: Not knowing the providence of the team at this point and where they might hail from, is the intention here by doubling the fund size to achieve an escape velocity from the lower middle-market? We often see a lot of managers raising smaller funds as their maiden voyage of their sophomore turn, but then is their real goal to get to where they want to be, which might in the upper middle-market instead?

Tim Kelly, Adams Street Partners: The 250 to 500 is kind of a red flag off the page, but that doesn’t necessarily scare me, as Steve and Andrea. What’s the reason? Why are they going from 250 to 500? Is it justified? Can you get comfortable with that? The overlying concern to me, though, is that they’ve been out of the market for six years, which goes against the 250 to 500 justifiable kind of growth. If it’s taken them five or six years since their last fundraise to come back to market, I need a little more understanding of why it’s taken so long to invest 250 and why they believe they can invest 500 now.

Snow: Pebble Oak was spun out of a much larger Chicago buyout firm. Its partners say they have deep backgrounds in developing sophisticated plans for operational improvement at lower middle-market, consumer-facing businesses.

Of Pebble Oak’s five original partners, one departed last year. He is described in the PPM as the partner who led the one deal that went bankrupt.

The firm has added one partner to replenish its ranks of deal talent. After the successful close of fund two, the firm will add one more partner.

They say they’ve replaced the one partner and they will add more talent if they raise the capital. Is that acceptable, Tim? What do you think?

Kelly: I’ll tell you, the natural inclination is to say, “Well, at least they’ve rid the firm now of the one person that made a bad investment.” I tend to be a bit of a contrary in that regard because, first, you have to question the attribution. Are they really attributing the right loss characteristic to the right person? If it’s a team, you like to believe that they’re all sitting around the table sharing the information and making a common decision. So, I always find it hard unless somebody’s willing to accept and stand up and say, “I’m the one that screwed up, and here’s how I did it.” It’s always hard to see some justification in a PPM to get comfort around without knowing more.

Auerbach: How a partnership stands up for its underperforming investments says a lot about the partnership, I think is what Tim was alluding to. To have it explicitly stated in the PPM that it was that guy—it’s like Mr. Brown in the den with the candlestick—is a bit aggressive to not own that loss, given it probably was a partnership decision. One question I had on that is, is this a “Lone Ranger” type of setup where each partner is doing deals away from rest of the partnership and has that consent with their partners to just do the deals they think are best? There’s much more referencing that would need to be done here.

Costabile: Just looking at this, the concept that they spun out from a larger firm is, for me, more of a due diligence item for Fund I.

Kelly: Right, yeah.

Costabile: Obviously, they’ve made the transition. There might be some lingering issues to make sure they’re institutionalized in all the ways they need to be for raising a fund that’s twice the size of the last one, but for the most part, I’m more comfortable with that.

Auerbach: Five original partners. One’s gone, added a new one, adding another new one; so, now you’re actually adding new elements into the partnership. Unclear how that’s going to bed down during a Fund II that’s going to be double the fund size. So, if there is a Lone Ranger philosophy on eat what you kill, do your own deal, then there are two new unknowns coming on to this firm that need to be met and assessed.

Kelly: To Andrea’s point, if I could add, when you think about the complexity of relationship-building, the intercommunication aspect of bringing two new partners on for a firm at this point—there’s a lot of team formation. A lot of team risk is built into that.

Snow: Pebble Oak Fund I has been fully invested in six portfolio platform companies. It currently shows a net IRR of 24%, putting it in the top quartile of 2009 vintage U.S. private equity funds.

However, the fund has had only two exits. The first exit, in 2012, was a massive win, generating a 4x net return on equity. The second exit, in 2013, generated a 1.4x return on equity.

The other portfolio companies are all valued above cost and are described as in good health and on track to generate attractive returns…except for one portfolio company, which went bankrupt in 2014, wiping out one-sixth of the fund’s equity.

Starting with Andrea, what is your reaction to the stated track record?

Auerbach: Six companies—that’s concentrated. I also have to call out Pebble Oak’s LPs. How could you let these guys blow through exposure limit—a typical portfolio exposure limit like that—to have 15% in every company? I was like, shame on those LPs. Clearly, they have some concentration. Their net IRR is really generated by the one strong exit.

The other thing we tend to dig in on to further get conviction around the value lurking in a track record is we ask for portfolio company operating metrics. So, if you’re marking something up, but its revenue and EBITA growth is actually declining, we’re going to have to have some discussion around that because—

Snow: “You’ve got some ‘splainin’ to do.” Right.

Auerbach: Exactly, “You got some ‘splainin’ to do.” There’s a matchup there, or a mismatch, that we would want to explore.

Costabile: I had the same reaction looking at the six portfolio companies. It could go either way. It is a concentrated portfolio. At the same time, we don’t know yet based on the information. I can assume maybe it’s a control strategy. But when you have a concentrated portfolio, batting average is extremely important. So, it’s great that they had the 4x. On the other end, you had the bankruptcy. That’s still a huge duediligence item. If you are in control of that company and you went bankrupt and you obviously had a board seat, what happened? What’s transpired? We still don’t know yet.

Snow: Tim, does it give you pause if a track record is not more consistent as far as the performance of individual portfolio companies? If you have big wins and big losses?

Kelly: Actually, I am intrigued by the concentration element. Not when you overlay, necessarily, the three particulars they’ve had on the realized side in terms of the volatility, but I like teams that have conviction about what they do best. And going after what they do best. If you can get comfortable that they are able to do that, and they have a real differentiated strategy on creation of value, I’m not as concerned about the statistical comfort that comes with the argument of diversification. Because I think that leads to some sense of false security, as well, for some GPs.

Snow: It’s time now for invasive due diligence, in which each of you reveals a duediligence finding from this group. Obviously, when deciding whether or not to invest or commit capital to a private equity fund, you don’t just rely on the information provided by the GP. You do your own due diligence. And you learn interesting things when you do that due diligence, which affects whether or not you decide to move forward. Why don’t we start with Andrea? You’ve performed due diligence. What did you discover?

Auerbach: I discovered that the partner who left the firm and to whom the losing deal was attributed says, “The decision to do the deal was unanimous and enthusiastic.” He says he is being unfairly blamed for the debacle.

Snow: Does that ever happen? Fingers of blame being pointed in unfair directions?

Auerbach: The “he said, he said?” Yes, unfortunately it usually is “he said, he said.” But it’s not so unusual when we have conflicting information. We often just dive back into the reference barrel and start talking to other individuals who are involved in that investment to get a better sense of how it really worked. Who was really at the board meetings? How were people legging in and from which corners?

Costabile: We don’t know if the remaining partners have actually said, “We weren’t enthusiastic.” Maybe they’re saying, “Look, we were enthusiastic. Yes, we did vote for it, but we still blame the guy who brought us the deal and sold us on the deal and we want him to go.” So, in fact, you could still have a balanced position here where the remaining partners say, “Yeah, we admit it. We voted for the deal and we were enthusiastic, otherwise we wouldn’t have voted for it. But this departing partner convinced us and that is something we’re going to hold against him.”

Auerbach: Partners can become very attached to the investments they’re affiliated with and maybe they don’t see it with eyes as clear as a less-involved partner who’s equally focused on generating returns for LPs.

Costabile: What I’d like to see these partners [do], if in fact this is the case, is admit that, “We were enthusiastic, but we should have did more early intervention with the—“

Auerbach: Early intervention. We’re having an intervention.

Costabile: As opposed to just letting the partner work in isolation for four months and bringing the deal. And then they said, “Oh, it sounds great. Let’s do it.” I’d like to see them say, “Even though we blame that partner, we did need to tweak our internal process to be more involved in the early stages.”

Snow: Tim its time for you to reveal your due diligence finding, what have you discovered about Pebble Oak Capital Partners?

Kelly: Discovered one of the founding partners is in the middle of a highly acrimonious. It starts becoming an issue where the partners view themselves as sharing carry equally, but one or more of them are highly distracted because of personal problems or issues, [like] family issues of a variety of natures, whether it’s divorce or children or the like. Or it’s that the divorce has been achieved and now, all of a sudden, the partner is dating somebody else at a distant geographic point and is not necessarily in the office all that much.

Auerbach: I much prefer the conscious uncoupling rather than the acrimonious divorce. But I think—

Snow: Far preferable.

Auerbach: I think what Tim mentioned is [that] this, of course, happens. I mean, we’re investing in high-performing teams and their people and things happen to people. So, when we learn of personal situations that may impact an individual’s ability to execute on their strategy, we often just dive back into the pit and start looking at partner attribution trying to get a sense of who’s been more active in terms of putting deals on the books.

Costabile: It could mean nothing or it could actually cause one of the partners to have to delink from the firm. We have seen that in the past, where this has been meaningful enough where that partner going through this unfortunate situation was unable to continue with the fund.

Snow: Steve its time for your due-diligence finding what have you learned about Pebble Oak Capital Partners?

Costabile: So through my factious due-diligence we found that all six portfolio company CEOs interviewed, including the CEO from the bankrupt company, attest to the expertise and professionalism of the firms partners and said the Pebble Oak team gave valuable hands on strategic guidance throughout the lifecycle of the investment.

Snow: So, a good duediligence finding, and—

Costabile: Yes, that’s very meaningful across the board. Obviously, we don’t just call the references that are given. Any duediligence construct has to go off the reference list.

Auerbach: One of my questions when I learned of your fictitious findings was, are any of these six replacement CEOs? Have any of them been rotated into a position [where] maybe the less well-performing or the under-performing executive is no longer on the reference list? That’s one of my quick questions.

Snow: All six fired CEOs said that they had a poor experience with the firm. Right, yeah.

Auerbach: Three out of five dentists prefer this team, right? Yes.

Kelly: How broadly were the comments in terms of off-reference list? Were they supported? Because if it’s just the six CEOs, then to Steven and Andrea’s point, I need to know more because they might simply be provided positively for fear of reactions on the part of the partners. These CEOs might be more long-term CEOfocused, private equityintentioned kind of CEOs. They don’t want to ruin their next opportunity to be running another potentially successful portfolio company because of speaking negatively about a GP that’s in fundraising.

Snow: It’s now time for the moment of truth. I’d like to get a thumbs up or thumbs down to whether or not you would commit to the fictitious Pebble Oak Fund II. With all the caveats that, in real life, things are much more complicated, let’s start with Steve. Would you give a thumbs up or thumbs down to committing to this fund?

Costabile: Well I think assuming that we can mitigate some of these concerns, the fact from what we can see at least, to imply that it looks like they structure these things very conservatively. Assuming that the track record holds up as far as the unrealized, references superficially look good. So based on what I’m seeing here and the space they’re operating, the fact that they focus on operations, I would be positively inclined to look at this, absolutely.

Auerbach: I’m going to give it a slight thumbs up. Steve articulated it well. There’s enough here to really compel a deeper dive and to keep moving this forward through a process with an intention of, if we get comfortable with all the issues we’re busy discussing in this fictitious realm, there could be some real interest to commit later with full knowledge of what’s really happening at this firm.

Snow: Tim, thumbs up or thumbs down?

Kelly: I think it would be a thumbs up for me to do more work at it. It’s not a thumbs up in the sense of, “OK, let’s write the check.” But there’s definitely enough here to get excited about in the sense that the volatility in the returns are quite broad. But if there’s reason to believe they can generate more of those 4-timers than they do the bankruptcies, there might be justification for doing it.

Snow: Great, well three out of three thumbs up for the partners of Pebble Oak Capital Partners. It’s great news for them and thank you all for being here today.

Unison: Thank you. Thanks.

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