September 8, 2013
Interviewed by: David Snow
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Seeing As Many Deals As Possible

Buyout veteran Howard Morgan discusses the state of the market through the lens of his firm’s portfolio, which includes a do-it-yourself air-conditioner fixit kit and a new technology for oil drilling. Morgan also discusses the leadership transition that his firm has successfully structured.

Buyout veteran Howard Morgan discusses the state of the market through the lens of his firm’s portfolio, which includes a do-it-yourself air-conditioner fixit kit and a new technology for oil drilling. Morgan also discusses the leadership transition that his firm has successfully structured.

Seeing As Many Deals As Possible

A Privcap Conversation With Howard Morgan of Castle Harlan

David Snow, Privcap: We’re joined today by Howard Morgan of Castle Harlan. Howard, welcome to Privcap today.  Thanks for being here.

Howard Morgan, Castle Harlan: Thank you, Dave.  It’s great to be back.

Snow: Let’s talk first about what your portfolio is telling you about the economy. You have a large and diverse portfolio of companies that you’ve invested in and you monitor them very carefully.  How are they doing and what does that tell us about the direction of the economy?

Morgan: Our portfolio can be broken down to a number of pieces.  We have our U.S.-only.  We are very active internationally, both directly as Castle Harlan and through our affiliate, Champ Private Equity in Australia. As to the U.S., I think broadly the economy remains quite slow, although we are seeing positive growth across most companies.  Now within that, I think we’re able to find some niches that have above average growth and really that’s our objective, to key in on those companies that can perform irrespective of the macro-economy.

Snow: What are those bright spots if you could detail them?

Morgan: Well, you know, for example, a somewhat countercyclical business that we invested in several years ago and sold at Christmas was called IDQ. They manufacture a do it yourself product to repair your own car air conditioner.  It’s a great product if you haven’t used it. Matter of fact, the investment thesis is most people have not used it or don’t even know you can do it.

Snow: I can confirm that, yeah.

Morgan: Well, for $35.00 at retail – as opposed to hundreds and hundreds of dollars – if you take it into a service station, you can add a refrigerant gas to your engine. It’s not much more complicated than adding wiper fluid. Now, in a soft market people are holding their cars longer and they’re far more sensitive to saving money and doing things themselves.  So that was a business that in two years of basic recession we more than doubled the EBITDA.

Snow: Well, you say you sold that company in December.  Can you talk about the state of the exit market and the kinds of opportunities that your firm has to monetize your investments and, you know, maybe you can use IDQ as an example?

Morgan: Yeah. I think it’s a very interesting case example, certainly of the last few years. Our exit from IDQ was actually a four-stage process initialized with a cap of the existing debt facilities.  That was then augmented by a high yield bond that took out the bank debt and provided a dividend to us.  We then executed a holdco high yield bond. At that point we basically had committed to owning the business for about three years, but the bonds traded up into a significant premium.  The bondholders loved the company and we were approached by a private equity company who proposed that they step into our equity position keeping the entire capital structure in place.  And literally, on December 31st that’s exactly what we did.

Snow: How important do you see the debt markets continuing to be going forward as far as, you know, providing private equity firms an ability to monetize their investments?  Is this sustainable or is it going to go back to IPOs and M&As being these all or nothing exit events?

Morgan: In terms of dividend recaps, I suspect the bulk of dividend recaps have been done.  Now, that’s not say that there won’t continue to be a steady flow of dividend recaps.  Debt is important to execute transactions.  We’ve tried to be very disciplined about using a prudent level of debt, not letting debt set the price of the business for example.  We are seeing some indications of very high levels of debt and some very high prices.  Those tend to be situations we’re not going to pursue.  But I think there is overall a healthy amount of leverage in the business.  You know, there’s been a hiccup, for example, with the Bernanke’s announcement of easing of QE2 where the markets pulled back a bit in May and June.  They seem to have rebounded.  So what we’re looking for is a healthy, steady, reliable level of debt and I think we have that now.

Snow: Maybe this is an opportunity to talk about what I believe was your most recent acquisition.  It was in the energy space.

Morgan: A company that is now called Shelf Drilling and we bought basically the jack-up rig fleet of Transocean.  A jack-up rig is basically a drilling platform working in relatively shallow water, so call it 300 feet, that floats into position and is jacked up on legs.  I think you can probably visualize them.  So this is a fleet of some 38 vessels working around the world.  In our case, from West Africa to Singapore.  It was a carve-out of a business from Transocean, a business without audits or a senior management team per se. We built the management team now up to a group of over 100 in Dubai which is geographically the center of our business. And there is significant international demand for energy, for hydrocarbons, principally oil, and deep water is what you read about for the most part. Shallow water is a very steady producer. Most offshore hydrocarbons still come from shallow water.  Now, there may not be massive new discoveries in shallow water – that’s what they’re looking for in the deep water – but the cash cow and demand remains very strong in shallow water and we think we are now a market leader in that sector.

Snow: Can you talk a bit about the way your firm sources deals and how that is unique and how perhaps it’s evolved over the years?

Morgan: Well, we believe in seeing as many deals as possible and that’s been a constant.  With a 25-year brand we do see a lot of transactions.  See about 1,000 ideas a year, sign three to 400 confidentiality agreements, visit 50 companies, get very serious on ten and do two.  In some years it’s zero and some years it’s four.  I’m oversimplifying but we try to see as much as possible.  We try to generate proprietary deal flow by meeting management teams, by speaking at conferences, by basically being out in the field.  The Shelf Drilling was a bottom up concept focusing on shallow water opportunities when basically that was very contrarian.  Most investors and companies were focusing on deep water.  So it’s just a sampling of how we try to generate flow.

Snow: So you had the idea for shallow water and then an opportunity presented itself –

Morgan: Well, in this case there were four or five opportunities and this was the one that actually closed.

Snow: A final question that has to do with the evolution of Castle Harlan.  You are co-president.  How has your role evolved and how is the firm sort of situating itself for a next generation of leadership?

Morgan: I have a co-president, Bill Pruellage, and we’ve, you know, forged a very close bond.  We’ve worked together for 17 years and he and I are providing the next generation of leadership.  We have a great young team that is evolving which we’re working very closely with.  The founders of the firm remain very active.  I think they’d like to stay active and we’d like to see them stay active.  They are taking a more advisory role.  They like to be very involved in the building of our companies.  They both have great rolodexes and great credentials that are wonderful tools in terms of convincing management teams to work with us and also providing additional leadership for the growth of our portfolio companies.

Snow: Would you give any advice to private equity firms that are perhaps as old as yours and trying to figure out sort of how to make that transition?

Morgan: Well, I think the key advice is that it’s a journey, not a destination and, we have learned that an evolution is a good process.  Investors are looking for tangible signs and evidence, so you have to be able to provide that.  And I think doing so in between fund raises is the most effective.  I think it’s a mistake to try to have a dramatic change just on the eve of a fund raise and expect investors to buy into it as if it had been an evolution between fund raises.

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