March 21, 2012
Interviewed by: David Snow
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Global Portfolio, Global IR

It is becoming more and more complex to be a middle-market GP. Two examples of this trend: today, private equity firms must help their small- and medium-sized portfolio companies compete on a global stage and GPs increasingly must manage a perpetual investor-relations effort around the world and throughout the life of the fund.

These and other points are detailed in the Privcap program “Global Portfolio, Global IR” by TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris.

It is becoming more and more complex to be a middle-market GP. Two examples of this trend: today, private equity firms must help their small- and medium-sized portfolio companies compete on a global stage and GPs increasingly must manage a perpetual investor-relations effort around the world and throughout the life of the fund.

These and other points are detailed in the Privcap program “Global Portfolio, Global IR” by TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris.

David Snow, Privcap: Hello, and welcome to Privcap, my name is David Snow, co-founder of Privcap. Privcap brings you smart conversations about private capital. Our topic today is all about the U.S. middle market, and specifically we will be focusing on the globalization of the U.S. middle market. Luckily, we are joined today by three experts and veterans of the middle market. We have with us today, TJ Maloney, of Lincolnshire Management, Terrance Mullen of Arsenal Capital Partners, and Jay Coogan of Duane Morris.  Why don’t we get started?

Definitely ten years ago, but probably even five years ago if you approached a smallish, medium sized private business and said, “You should really be thinking of global strategy,” they would have laughed.  I think that has changed and I would love to hear from all of you, the extent to which you think some of your own portfolio companies and your potential portfolio companies really need to benefit from a more of a global outlook and maybe how a private equity firm, such as yours, might be help. Terry, I know that despite the size of the companies that you target, you definitely have global strategies in mind when you buy them, I am wondering if you can talk a bit about the pressures that are coming to bear on even the smallish end of the middle market.

Terrance Mullen, Arsenal Capital Partners: Absolutely, this globalization trend is a massive one for our generation, certainly our generation of investing, this world is flat phenomenon that we all know about is playing out and it is playing out fairly quickly. Even small- ended markets are not immune from these opportunities. They are competing globally whether they know it or not, and many businesses have key assets and capabilities whether it is certainly technology, certain service offerings, that could be applied globally, however, the issue is that most of these small businesses don’t know how to even approach global markets. They don’t have access, they don’t have resources or expertise, so it’s a huge issue and it is also a huge opportunity for us, this is one of the founding principals of Arsenal when we formed it back in 2000, and we built a team that a significant majority, eighty percent of the people have international investing industry and operating experience collectively. So, we’ve got a lot of experience operating different regions of the world, we focus primarily on Asia. U.S. is our headquarters. We got an office in Shanghai, and we spend a lot of time in Asia, specifically focusing on long-term industry trends, where growth is, seeking out cross-border partners and that is a huge selling point for us when we engage in conversations with lower middle market companies.

Snow: TJ, how has the game changed as far as the need to be international in the kinds of deals that your firm does?

TJ Maloney, Lincolnshire Management: Well, I think that the game has changed in that fifteen, sixteen years ago, you were sort of made in the United States, you sold in the United States, and your suppliers are in the United States, looking at international markets was just an imitation for margin compression. Today you can’t survive if that is your strategy. You have to be aware of what it going on in the globe, and you have to be in a position to sell your products internationally, to be able to open plants in different locations in order to serve different markets, and you have to be looking at a range of suppliers that come from all different geographies, so, there has been a very radical change, I think that Terry is right about that. I think that is one of the things that we’ve seen in our generation that has changed quite a bit.

Snow: Do the managers of these companies, or the owners of these companies understand, do they get it, or does it take some charts and some arguments to get them to understand that you need to be more outwardly focused or you won’t be able to compete as well?

Mullen: I think that your point about five years ago, I think that there were many people doing well, so it didn’t matter, and so in that growth period. When people are seeking growth, which we are seeking all the time, I think that most business owners understand global growth.  It is interesting, it is a major trend, when they see China growing at ten percent a year for the last five years, they see India growing at six, eight, nine percent, these are exciting numbers when they look at U.S. growth in the one to two percent, maybe three percent range, depending upon, you know these are averages.

It is critical, therefore, to understand what is going on global markets. Many of them went through their transformation on their supply chain side over the last two decades of thinking about sourcing parts and components, maybe it was assembling, and then it was definitely manufacturing in different parts of the world as playing out the globalization trend, and what many of them have been slower to accept, or really understand, is how to access growth. How do you develop a view on these different end markets, what strategies I can employ to win, who can help me form partnerships with companies in these regions that can be distribution partners, and be eyes and ears on the ground? This is a critically important trend that very few of the lower mid-market businesses and some of the mid-market businesses, only a handful or two have really understood, I think, and embrace, particularly in Asia. There are very few competitors that we have in China who do these things, and therefore on the front end for us, the track record of having done these things and sold businesses successfully that had significant international, particularly Asian operations.  A lot of our businesses, twenty or thirty percent of the incremental value, we ascribe to those international growth goals, and it is a major reason why strategists wanted to buy these businesses.

Snow: What do you think across your clients as far as a need to be more internationally focused?

Jay Coogan, Duane Morris: A bunch of interesting things have developed. One is that the further down you go is down and down, and down, the lower end of the lower middle market, even there, companies are either making something overseas, if they are selling to say they are selling parts to a larger OAM, they’ve got to set up little companies and put people, support people in foreign countries, where the larger OAM’s have their international.  There is no escaping the international component, and in fact we are seeing, even in smaller, smaller deal points, arriving at target companies where even very small companies already have some kind of international connection. They’ve figured out they need to manufacture something overseas, or how to sell something overseas, or at least get it into Canada. Further and further down the food chain they are already global.  It’s interesting culturally I think that some of our clients, as you hire up and develop your staff, you are finding more and more foreign MBA students in the U.S. want to stay here and bring tremendous value. There is almost a culture change where you used to have to think, gee, we have to think about overseas, now it’s become such second nature that I think that it is easier for the younger generation to adapt more quickly because they are more used to it, but you aren’t thinking globally anymore, you are doing it without thinking that you are doing it. It is just a reflex at this point that everybody is looking at the global component, whether it’s a sell into, or makes it there, it’s there.

Snow: Does it seem like private equity firms, I guess defined broadly are recognized by some of these business owners, some of these entrepreneurs as a channel, as an avenue to get to a more international operation?

Coogan: I think that the companies that you want to buy are the ones where at least some of the management team in place already gets it. They’ve at least put a toe in the water.  They want more help and that the operational expertise you bring, you are already kind of speaking the same language a little bit, and it’s another indicator, is this kind of company your PE firm wants to buy?  Or, are you starting from scratch with this management team, and that may be a differentiator in identifying an opportunity.

Snow: I would imagine that many private equity firms today will say, well, of course we are very internationally focused, we help our portfolio companies go abroad, but actually having the tools and the infrastructure in place to make that happen is a different thing.  If you were an LP scrutinizing a private equity firm, what would you look at as far as again the tools and the infrastructure necessary to get a portfolio company more internationally established? TJ what do you think?

Maloney: Well, I think that you have to look at the expertise that is imbedded in the firm and it is very difficult for the firms to have the expertise because all companies are different, you might have an executive who has experience with consumer goods, and there may be some foreign products that someone wants to roll out in the U.S., but, you know, then you have a B to B type businesses, you’ve got all different things, so, it’s really difficult to have the full complement of executives that have expertise in all these different industries that you look at. So, what we’ve found is that we have core group that understands the basic sort of business and we lever off that expertise and then reach outside for help to augment the in-house expertise.

Snow: Terry, what have you discovered as you’ve built your firm?  What makes the international component work, is it just the right people in the actual geographies that you are targeting?

Mullen: Most of the firms have done it, and probably many people have read you know, Mr. China, or have seen emerging markets come and go in different cycles whether it is South America or they’ve seen the Asian flu. One, it starts with the understanding, a deep understanding of those end markets in which you are planning to play. So, if you are going to be in China, you really need to have local people who grew up in China, that have relationships in China, understand the government in China, that understand how to get business done in China, so, local presence, networks and relationships, resources that you can draw upon and we were saying just a moment ago, really a track record or a history of having done these things before. So, many people in our firm have grown up in different regions of the world, have operated businesses in different regions of the world and everyone makes mistakes in business, we are taking risks.  And so that collective learning curve we have is a critical starting point.

The second starting point is why many private equity firms in the U.S. aren’t expanding internationally. It’s hard. You have to do different things, you have to appreciate the issues and challenges, be flexible, I think that culturally that might mean that you know with China, you will be getting up and doing calls really early in the morning, we are doing them in the evening and this part of our culture many people from our firm have worked for multi-nationals, and that’s what you do. In private equity most people haven’t had to do that. Most people at private equity firms are used to setting the calendar, let’s do our call at nine a.m., whether that is convenient for other people or not. So, I think that there is a range of skills, experience, local market knowledge, and cultural, but the last one is, TJ’s point, which is you can’t be everything to all people.  You’ve got to choose whether you are going to be broad or deep. And so, for us, that is meant in very specific areas with industrials. Chemicals, materials we understand what those global markets are, who the players are, we network with them, and so, whether it is industrial side, the health care, financial services, we have to be very narrow in our focus in our best ideas and really understand those businesses deeply and so we can’t be broad.

Snow: One thing for sure is the next wave of fundraising from anywhere in the private equity market is going to involve a lot of plane flights and what I am hearing from just about every GP that the breadth of the footprint that they need to establish is getting bigger. I am wondering if I can hear from all of you about thinking about your next fundraising, or where you think you are going to find your next investor, to what extent are you going to have to go abroad to find sources of capital, since we are talking about the globalization of the middle market?  TJ?

Maloney: Well, we’ve had four funds to date and we already have a fairly international base of investors, and so I would expect that we would have to continue on that and you know over the years fundraising was difficult for us. It has become a little less difficult. We know the market is different today. We know that investors are demanding what they view is better terms. There is an old adage, which is, “Be careful what you wish for.”  A lot of investors are becoming term investors and I don’t think that makes you get good returns necessarily. I think that it is going to push a lot of private equity houses to because of their reduced funding to go outside and I think that when they go outside they are not going to get quite the quality that they would if they built up good expertise in their shops.  So, I think that this trend of reducing what GP’s are making is going to end up being sort of against the interest of the LP’s ultimately.

Mullen: That’s true. There have clearly been, this is a high fee and expense industry, a long-term investing industry, and certainly some of the abuses on the large end of the market, the mega-funds and the large funds and level of fees are able to garner and the expenses they’ve charged, have really caused a repercussion in the market.  What unfortunately does happen, that backlash has meant that smaller mid-market funds that TJ is pointing out, it makes it more challenging.  If you go to the one size fits all just based upon percentages, it makes it more difficult for us just to attract best in class talent, and have the operating and strategic impact that everyone wants us to have.

We find that most of the LP’s are kind of stuff.  They are saying we like all the things that you have, the industry folks and the operating team, but we don’t really want to pay for it. And so for us, it does put a pressure on us. We have found, when we formed the firm, back in 2000, we actually spent a time developing relationships with international LPs in our first fund knowing that many of them wouldn’t come in. A couple did, fortunately, which was great, and building long-term relationships that really paid off on the second fund.  So, our first fund, less than twenty percent of the investors were non-U.S., the second fund forty percent of the investors have been non-U.S. and that largely included Europe, but also Australia funds, and we would expect that in a third fund that would probably be fifty-fifty. There are different regions of the world which are very active, many of the Canadian pension fund systems, the Australians of course, Asia has become an important source of capital, Europe either in the sovereign wealth funds, broadly globally, but in Europe, many of these nationalized pension funds have been active investors and so the world, it’s important to have diversification in an LP base, both geography, as well as fund type. So, we do spend time in a pretty concentrated way visiting different regions of the world and meeting with investors a couple of times a year.

Snow: I would imagine that it is a simply bigger and a longer process to go to places like Australia to see capital as opposed to just knocking on the local pension fund?

Mullen: For us it is more spread out, meaning, we do it over time, it is part of what we do, building relationships with investors. We know that the long-term relationship. They want to know us and track us over time and so we spend time going to conferences, meeting with people one-on-one years in advance of them committing to a fund and managing and really strengthening the relationship over time through co-investment and other situations.  So, yes, the fundraising activities, if you want to view it that way, we view it as investor relationship, building activity is an every year activity, it’s not just when you go to fundraise. Yes, of course when you do go to fundraise, there is more intensive time you need to spend there, but the significant majority of investors, we expect will come into our fund three, we’ve known most of these people already. We would be very surprised if we find too many new investors. For fund three, during this process, we may find them in fund four.

Snow: Jay, what are you hearing from your clients as far as fundraising and what will be different next time?

Coogan: As far as international, I think that it is a pretty strong correlation to size and sophistication of the PE firm and their opportunity and ability to attract international investors.  But some of the smaller funds, you’ve got three or four principles, three, four, five staffers, six or eight portfolio companies, you are trying to crank up fund two, or fund three.  Getting the Nina, the Pinta and the Santa Maria, and just heading across the ocean and think that I am going to go and get some overseas funds that would probably not be the highest investment use of time. So, they are going to go to their traditional target markets as the bigger, deeper funds, with longer track records.  They’ve had more chances over more time to meet more people. It is going to be more than incrementally easier for them to attract the international investor. So, I think that a lot of the smaller places are going to stay closer to home.

I think that it just, in the arc of what happened in 06’ through 08’ and 09’ up to today, it is one of my favorite sayings, know with whom you are having a pleasure. To Terry’s point, managing your current LPs and keeping them apprised of the progress of what you are doing right now, is probably the best fund marketing and fundraising activity you could possibly do, because it is really hard to get that next fundraise if the people in your earlier funds aren’t re-upping and they have money to re-up with. So, you can’t ever have that happen. So, I don’t think that has changed at all. I think that you are taking care of what’s close to home, and build up from there.

Snow: Final question, do most GPs get that point that it’s not about now we got to go fundraising and meet with all these investors that maybe we haven’t spent a lot of time talking to over the past four years, do they get that it is investor relations and it’s a constant job. I am referring to some studies, or surveys that have been circulated saying that LPs want more attention, they want more details, they want more servicing and of course as TJ pointed out, when you are asking for lower fees at the same time there can be that’s where the crunch time comes from, right?

Maloney: Yeah, absolutely, I think that a lot of it is sort of inaccurate in a sense.  I read the same reports that you are talking about, yet many times when you are trying to schedule things with LPs they are kind of unavailable to come to it, so, there is clearly a disconnect. I think that, you know, my experience has been that we give very detailed reports on all of our investments. Many times I think they go to different people than the people are looking at evaluating your fund for the next raise, and so I am not sure if the information is always getting to the right people, not because you don’t send it to the right people, you send it to who they tell you to send it to, but I don’t know if they pass it along.  So, there is a bit of a disconnect out there and I don’t know if it is anything that involves sort of blaming GP/LP, it’s just a disconnect that seems to exist.

Mullen: It’s the same thing as winning deals, you just have to go and see people and so, you have to schedule it.  It is part of the job, it’s critical, we have the privilege of getting a blank check and it’s locked up for ten years, or maybe thirteen years, and so it is a great privilege to be in the industry and engage in the type of strategic and long-term investing that we try to and so this is just part of the relationship. As TJ said, LPs want to know what we are going, where we are investing and how it is performing and they want to be able to ask us questions, which are of course always delighted to entertain. But, GPs also have to make the effort to reach out and as you said, investor relations are a year-round activity.

Snow: Well, it sounds like the middle market still has far to go as far as having more global and also as far as facilitating a greater communication between the managers and the investors. Certainly the three of you are on the forefront of those trends. There is a lot more that we could talk about. We could talk about deal flow in the middle market, we could talk about middle market finance, but as far as the sort of globalization, for now, why don’t we pause. Thank you very much, gentlemen, for joining Privcap today.

Expert Q&A with Gary Levy, Partner, J.H. Cohn

Privcap: How do your clients understand the private equity opportunity?

Gary Levy, J.H. Cohn: I would say that we have a growth concept companies as clients or what I call ‘emerging concept companies, ‘and those are really ideal for middle market private equity funds because they want growth concepts. Our clients, they are unbelievably curious about the whole private equity arena. Who wouldn’t be? You hear all these stories about people getting piles of cash and what they do with that and the capital gain benefit of doing it. But do they know a lot about it? I don’t think so. I think that’s part of our job is to educate them on that opportunity and introduce them to the right private equity funds that would be a good fit.

When you’re talking about what that right fit would be, those are funds that financial capital, I think, is all equal. All these funds have lots of money. But what you really want is intellectual capital that you don’t have to grow your company. Intellectual comes with guys who have done it before. They get you the right team. They can show you, “This is where we go with the business. These are the right hires. This is how we structure this type of stuff.” I like to say that people have already made those mistakes.

Privcap: What do you mean by ‘growth concepts?’

Levy: One of the areas of expertise we have is in the hospitality in the consumer arena, so growth concepts in the hospitality arena are restaurant companies that are easily replicated, that the math works in terms of the investment to build the units and how quickly they pay back on that investment. You could take a company that has five, ten, fifteen, twenty units, and with the right financial and intellectual capital, very quickly turn that into 50, 80, 200, 300 and get to some point of an exit where obviously private equity funds really like that.

What’s that 5-year time horizon? When I’m introducing my clients to private equity guys, I say, “Yes, you’re going to like them. They’re very smart. But as they’re talking to you, they’re thinking down the road of who they’re going to be selling you to in five years.”

Privcap: Has capital become a commodity, and if so, what can private equity firms do to distinguish themselves in the eyes of business owners?

Levy: That’s a great question, and I don’t want to pigeonhole that all the – is the financial commoditized? There’s going to be differentiators, just staying on that topic, about how a private equity fund is going to present a deal. They’ll more or less be pretty close on valuation of the company, but how they structure that investment could be remarkably different. Some will let you take money off the table, some won’t. Others will want control of the board. Others will be the minority and let you do whatever you want.

To answer your other question about how can a private equity fund differentiate themselves? Again, they have to demonstrate intellectual capital in that industry that they can bring value added to the table. In the end, if they’re all the same from a math point of view, then it’s going to come down to, “Is this the guy I believe is going to quarterback me and get me into the end zone in the long run?” I tell my clients a lot, when they’re looking doing a deal with a private equity fund – and we have several that talk to lots – don’t look at the valuation of the first offer. Look at the guy and say, “Who is going to be the one that’s going to really maximize the value of this company in the long run?”

That’s the bite of the apple you really want. The first bite is nice, but that second bite, that could be generational wealth changing events, certainly something that could be a legacy for the right type of company.

Privcap: How do investor introductions fit into the J.H. Cohn business model?

Levy: I think that’s a very unique differentiator between us and so many of the other firms out there. We work very hard to provide proprietary deal flow introductions to private equity funds that we know we work well with and we know that are the right match for our clients. That works pretty well because our clients are curious. They want to learn more about it. They want to meet these people. They don’t know much about the arena, and then we’re finding them funds that are really going to help them protect their business.

Getting someone to sell a business or take a new partner on, that’s like a child to these people, so it becomes a very emotional event for them. You’ve got to find them the right partners, people that are really going to have the same values and help you build something that’s great.

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