October 28, 2013
Interviewed by: David Snow
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Food: Constantly Disrupted by Innovation

Think the food market can’t be disrupted? Think again. These private equity veterans have seen innovation spell new investment opportunities again and again. You’ll learn how changing consumer tastes drive deal flow, what the recession meant for food buying, and how pricing and convenience are big opportunities.

Think the food market can’t be disrupted? Think again. These private equity veterans have seen innovation spell new investment opportunities again and again. You’ll learn how changing consumer tastes drive deal flow, what the recession meant for food buying, and how pricing and convenience are big opportunities.

Trends in the Consumer Sector
Investing
in Food & Beverage Brands

David Snow, Privcap: Today, we are joined by Dan O’Connell of Vestar Capital Partners, Joan McCabe of Brynwood Partners, and Cristin Singer of RSM.WelcometoPrivcap.Thanksforbeinghere.

We’re talking about the food industry, a sector in which private-­‐equity firms have spent a lot of time and invested a lot of capital. All of you are deeply involved in that sector, so I’m fascinated to hear what trends you’re seeing with regard to the private-­‐equity opportunity in the food sector.

Dan, your firm Vestar is a veteran investor in a number of sectors, including food. Starting at a thousand-­‐foot level, what are some important trends by way of macroeconomics or demographic/lifestyle trends that are creating new opportunities to invest and make money in the food sector?

Dan O’Connell, Vestar Capital Partners: One of the biggest trends in recent years has been health and wellness, with consumers really wanting to move in that direction. A big movement towards ethnic-­‐type foods, new flavors, more a packing standpoint toward freshness and those kinds of things. But, this sector is constantly innovating, desiring to come out with new and better ways for consumers to experiment. It’s a dynamic space.

Snow: Do you agree, Joan? Is the food sector constantly in a state of flux, therefore creating opportunities for investors like you?

Joan McCabe, Brynwood Partners:  As Dan says, it’s a dynamic industry because two-­‐thirds of all purchases are made at the store, at impulse. It’s  not an industry where you have to spend years of research and necessarily have patents. You can do something a little different and have great success if you have a pulse on the consumer. The market is also changing because the economy is changing. With the great recession, we’ve had a bifurcation of the consumer who is more value-­‐oriented than they might have been in the past. And, the typical, large companies have historically focused on brand building. So, a niche has opened up in the market for private equity to get in and work with some of the retailers that are focused on either value brands or private label.

Snow: Let’s talk more about the economy and the fact that, hopefully, things are pointed in an up direction. How have the constraints on consumer spending affected the private-­‐equity opportunity to help a company grow or to identify companies that will grow with those headwinds from the consumers? Starting with Joan.

McCabe: The consumer will splurge but they have become much more sophisticated in how they’ll splurge. The internet has allowed people to look at product quality. If they don’t feel there’s a value, they’ll go to private label—that trend started in about 2007 when we had the great recession. You saw that not only is it private label, just opening price point, but also emulates the brands. We had a very successful investment in a business called Richelieu Foods, a private-­‐label frozen pizza business. That was a situation when we got involved, it was your plain old pepperoni-­‐and-­‐cheese pizza for ninety-­‐nine cents and we emulated restaurant quality. As a private-­‐equity investor, you can be a fast follower, you don’t have to research, you just go to California Pizza Kitchen and make that same pizza. If you can convince a retailer to try it, it’s easy to get distribution.

Singer: Yes, but private-­‐label brands have become more sophisticated. They are no longer your generic brand that people wouldn’t think twice about buying. They’ve really emulated the brands people want to buy.

O’ Connell:  Costco has really led the way there with Kirkland Signature by making it the top quality at an affordable price. You’ll see a number of other retailers now following in that regard.

McCabe: The other thing Costco does is give you a fourteen percent gross margin. So, not only do you get really good quality, but you get it at a good value.  It’s a treasure hunt. We’ve looked at businesses that have created their business on the backs of Costco. Twenty years ago, that really wasn’t possible.

Snow: So, sticking with the private-­‐label example, is that the kind of business a larger entity would seek to acquire or couldn’t they do that for themselves? What is the secret sauce of success in something like a private-­‐label strategy?

McCabe:    Good question there. It’s this issue of buy versus build. ConAgra has just made a big initiative in private label—having historically been a branded business—and they see the need to have opening price points. They purchased one company called [Raw Corp], which was publicly traded, but they’ve been buying a lot of private equity-­‐based private-­‐label food companies. It’s definitely a strategy the big guys have started to look at.

Snow: Let’s talk more about something that’s less easy to measure: consumer tastes and changing tastes. How can a private-­‐equity investor get ahead of that?  What tea leaves are you reading, what

studies tell you that younger people want fresher, more ethnic foods? What kinds of studies do you follow, Dan, to stay ahead of those?

O’ Connell: I’m not a food expert, but we are constantly in touch with consulting firms and firms specializing in the food business to try to get ahead or be up to speed on the cutting-­‐edge things.

Singer: Social media is great, too. Just looking out there, you can see what people are blogging and talking about, what the latest trends are, what people are interested in. It’s become quite a phenomenon.

McCabe:       We go to trade shows—there are ‘Expo West Tradeshows,’ which tend to be natural and organic, tend to be smaller firms, tend to be that entrepreneur sitting behind one table with maybe five million of sales. But, if you spend a day walking those aisles, you’ll get a synthesis of what’s hot. One year it was soy, then, it was whey protein. Then, out of those small companies, you’ll see companies emerge that have the staying power and the clout to take a great idea and transform it into a real product. At the early stages, generally venture capital, but the time we get involved, there has to be some distribution and some hook that the consumer is buying.

Snow: It’s one thing to say ‘Tofu is big this year,’ but it’s another thing to actually have a business with solid growth characteristics that looks like it will be able to turn that into a real business, as opposed to just a short-­‐term buzz.

McCabe: And that’s key—it’s hard to measure. When is it not just a fad, but a trend? There is a secret sauce to that.

Singer: Do you also look at the evolution of how the product could branch out and have different segments, while you’re looking at companies? Not just the one product they have today, but what potential do they have in the future?

McCabe: You look at a couple of examples: one would be Earthbound. Who would have thought produce would be branded? Earthbound is owned by a private-­‐equity firm, HM Capital. It started out as lettuce and they’ve taken that brand and expanded it into many categories.

You almost have to be private equity and be singularly focused on that as opposed to doing a lot of studies. Same with Annie’s Mac and Cheese, now a publicly traded company. They are very successful and trading at a high multiple, but they went from being entrepreneurial-­‐ owned to private-­‐equity owned. And, they went from their original product of macaroni and cheese to pizza and all sorts of products in the middle of the store that are not only good, but good for you.

Snow: Let’s get back to something more macro-­‐related: the cost of making food, the commodity inputs. How has that affected the ability of private-­‐equity firms to smartly buy, grow, or exit at a good value,

these food-­‐related portfolio companies?

O’ Connell: A key part of the analysis there is just how powerful your brand or pricing power might be, ultimately, to be able to pass along the fluctuations in the raw material costs. That’s the key element in analyzing whether it’s something you want to pay a real, full value for.

Singer: With the big relators controlling a large share of the market, it puts a lot of pressure on the suppliers and distributors of food. If they can’t pass those price increases on to their customers, they’ll be pressured to have lower margins as a result. Our clients are looking to strategize different ways they can manage the rise in commodity prices, whether it’s hedging, derivative contracts, or different arrangements like that to try to manage that process.

McCabe: To follow up on that, the commodity cycles have gotten much more volatile in the last decade than they were historically. I read that it’s six times more volatile than it used to be. In some situations, private-­‐ equity firms and smaller firms have gotten very hurt when a key input went up. With our firms, we have taken businesses and made sure we have understood purchasing and have been able to hedge. Or, in some cases, we have had commodities like nuts, where there’s no hedging mechanism, so you have to buy physical inventory. It requires a purchasing department—it’s not enough to say ‘I’m going to buy for my inventory.’ As prices go up, they come down, too, so when commodities go down, the retailer frequently will ask for either monies on terms of promotions or pullback in prices.

When we do our due diligence, we always look at a ten-­‐ or twenty-­‐ year history on that commodity, then we tend to price it in for the average. Because you can tell when it’s spiking up—usually, you’re not smart enough to know when it’s trending down.

Snow: Quick follow-­‐up for Dan: you mentioned the importance of brand in having some flexibility with the prices that you present to the customers. Is that something you look at very carefully when acquiring a company? Is that relationship the brand has with the customers and is that a key aspect that informs whether or not you decide to proceed?

O’ Connell: Yeah. The deals we tend to do over the years—companies like Celestial Seasonings, Birds Eye, Del Monte, Michael Foods—have tended toward brands that have lost their way a bit, have been neglected but have real brand equity. Then, with the right tender loving care and resources behind it, you can develop an innovation pipeline so you can be constantly innovating. That can keep you ahead from a competitive and pricing standpoint.

That’s what we look at, in terms of ‘How defensible is this brand, what is the brand equity, can we extend it, grow it with ideas and good

research?’ That protects you to the different raw material cycles, the economy, whatever.

Snow: Speaking of innovation, are there any recent breakthroughs—by way of technology or method of marketing—that are creating an interesting new set of opportunities in the food space? Maybe smaller packaging? What particularly food-­‐facing innovations have changed the game?

McCabe: Let’s talk about the nutrition bar industry. We owned a business called Balance Bar that we sold about six months ago. Conventionally, the nutrition bar was just that—a bar. Then, TSG, a private-­‐equity firm, got involved with a business called Muscle Milk, taking the idea of a bar, but drinking it. And that’s huge industry now.

Whey-­‐protein, Kind bars are also in the same industry, but their innovation was ‘Do good for the world.’ They gave proceeds to the Arab-­‐Palestinian conflict. Then, they did something very simple: a clear package, which no one had done before, and a clean label—those have really driven growth of both of those sub-­‐segments. We call it ‘the barbell strategy,’ where the bar business is in the middle and a fairly flat business. But, the growth in the liquids and clean labels has been very high.

O’ Connell: Cristin hit on it earlier, when she talked about snacking, but convenience is a key driver. For us, when we invested in Birds Eye, coming up with Birds Eye steam-­‐fresh and microwavable steam package, which were innovated in Europe, we were lucky enough to bring it to the United States. When we first launched that product, we thought freshness and soft packaging was going to be the real driver. But, what we found over time was that convenience—that someone could pop this in the microwave and within five minutes have fresh vegetables or fresh vegetables with a starch, ultimately, with a meal— was the key driver, so they could do it in a short period of time.

Expert Q&A with Bill Spizman, RSM Bill Spizman, RSM:

We have dedicated people within our transaction practice who work with public-­‐equity firms in buying metal-­‐market companies, as well as helping them sell their middle-­‐market companies. We also have dedicated people working on the audit and tax side of the portfolio company audits. We also have specialists in our consulting business who work with IT and performance improvement. So, we’re well rounded with respect to the services we can provide private-­‐equity firms and we’re dedicated and committed to owning food and beverage companies.

I am approached regularly by private-­‐equity firms that specialize in food and beverage or want to specialize in food and beverage about our expertise in [by-­‐side?] due diligence, both on the IT financial tax and performance improvement. With our expertise, we can help them identify various issues through the process. It’s a distinct advantage for us because we can help a private-­‐equity firm buy the company. Then, through its ownership period, to perform audit, tax, and consulting business. Then, upon exit, we can help them through the exit process, whether it’s focusing on the quality of earnings, tax planning, or working capital considerations that must be considered upon exit.

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