May 12, 2012
Interviewed by: David Snow
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In Search of a Few Good Deals

Middle-market stalwart Castle Harlan sees about 1,000 deal opportunities per year but whittles these down to as few as a two transactions, according to Co-President Howard Morgan.

Which deals make the cut? In an exclusive interview with Privcap, Morgan discusses the importance of price discipline and dedicated management. He profiles his firm’s investment in automotive air-conditioning company IDQ as an example of “growing a market” by introducing new concepts to customers. Also discussed is the concept of “exiting too early” and Castle Harlan’s Australian affiliate, CHAMP Private Equity.

Middle-market stalwart Castle Harlan sees about 1,000 deal opportunities per year but whittles these down to as few as a two transactions, according to Co-President Howard Morgan.

Which deals make the cut? In an exclusive interview with Privcap, Morgan discusses the importance of price discipline and dedicated management. He profiles his firm’s investment in automotive air-conditioning company IDQ as an example of “growing a market” by introducing new concepts to customers. Also discussed is the concept of “exiting too early” and Castle Harlan’s Australian affiliate, CHAMP Private Equity.

Privcap: How do you sort through the many investment opportunities that come through Castle Harlan?

Howard Morgan, Castle Harlan: The big issue is finding 1,000 ideas and that’s about what we see every year. Some are just ideas. Some are actual businesses for sale.

We see that many in part because of a lot of momentum. We have been in business for 25 years. We’re now investing our fifth fund. We have a very good reputation, I think, of closing on transactions once we latch onto good opportunities.

We’ll relatively quickly work that 1,000 down into about 300 where we will sign paperwork and engage in a real study. We’ll form a project team around them. That will lead to visiting about 50 businesses every year and further making offers on 10 to 15 opportunities. Generally we’ll do only about two.

We’re very, very disciplined on price, so we are happy to not do a deal if the price is inappropriate. Matter of fact, in 2007, we were net sellers. We did not buy a single platform company. We did some add-on acquisitions, but we try to show a lot of discipline.

We do know that the deals have a way of coming back to you, that if we’re patient– in some cases we’ve looked at opportunities for 18 months. We’re looking at something right now where the theme has been resonating for over three years. And hopefully we’re maybe on the verge of transacting something.

Privcap: What are some top reasons to move forward with a deal?

Morgan: Our top criteria are size, value, market shares. We are firmly in the middle market, which we define as enterprise values of $100 to $500 million, occasionally a little less, occasionally a little more. But very large transactions, particularly without an angle or a partner, is not the space that we play in.

We are looking for market-leading businesses with high market shares, competitive advantages, barriers to entry, usually evidenced by good margins. We’re usually looking for companies that have a lot of potential, but in many cases are somewhat boring and mundane in everybody else’s eyes, that we feel with a little tender loving care and some capital and management attention, the level of growth can be improved. If we have an opportunity to meet with management, the caliber of the management is very, very important, the chemistry with management, their willingness to roll some of their personal capital into the transaction.

Those are the kind of criteria that we apply. Now, we review every transaction every week as a firm for several hours. And by the time we get to a transaction, we’ve probably discussed it 50 or 60 times.

Privcap: How can you expect good returns with the prices of strong businesses so high these days?

Morgan: Well, I think again you have to pick your opportunities well. Our view of the market last year is that it was somewhat bifurcated, that averages are tricky. I’ve said you can’t drown in an inch of water, on average. We’re seeing pristine companies with no issues sometimes go at eight to nine times, or at least that seems to be what the bankers are saying, whereas there are companies, if there’s an issue or a hiccup or a complexity– and we do like complexities– sometimes the companies go for more reasonable prices, five to six times.

So I think the generality of the averages still being high covers up the fact that there are still some very good opportunities. In many instances, we might pay a slightly higher multiple of EBITDA, but in the long run, that’s only a surrogate for free cash flow. So if we have a nice business that is generating a lot of cash flow, does not need a lot of capital expenditures to support the business or working capital, certainly the multiple can be a little bit higher.

Privcap: You’ve said that you’d rather grow a market than take a market share. Can you elaborate?

Morgan: When you go after market share, all too often you may have to go after on price. I think what we have found in many cases is that companies are under-pricing their product already, to take market share. We believe that there are opportunities in some of these niche markets that, again, don’t necessarily have obvious high-growth characteristics, to improve the growth by creating customers or by working internationally.

A lot of what we do is outside the United States. We are primarily North American in our focus, but we’re very active internationally. A great example would be a company we bought two years ago, called IDQ, that makes a do-it-yourself product to repair your own air conditioning in your car. The product costs $35 off the shelf. If you take your car into a service station, the gas alone will probably cost you $200.

Now, very simply, people don’t– customers, even salespeople in the stores, don’t know that this is a viable option. Most people know you can fill your own tire with air, or you can replace your windshield wiper fluid. But we are engaging in investing a lot of capital in simplifying the product, in educating consumers, and in educating people at the store level. We’re also looking to bring the product outside the United States, into Mexico, into Brazil, with the added benefit there that it would be counter-seasonal. But we’ve had a lot of success growing the market and changing the market.

Privcap: Your firm is very aggressive in seeking exits. Can’t you be accused of leaving money on the table by selling too early?

Morgan: Well, I think it’s been said that I’ve never lost money taking a profit. I think that’s a very solid discipline. Again, I think part of our brand is discipline, that if we have accomplished our goals– with every company, we established a five-year plan and return objectives, a strategic plan of things we want to accomplish. In many instances, we are in fact able to accomplish that plan far faster than we thought.

One of the benefits of private equity is a sense of urgency. In some corporations, people are sort of hiding away little nuggets of things to work on in subsequent years. They don’t want to over-perform just to see their budget increase the following year. I think in private equity, you have an opportunity to just keep running at issues as hard as you possibly can and generate your results as quickly as you can.

The other thing we do, which I think is a very important part of private equity, is monitoring the capital markets. It’s our job to find opportunities in the high-yield market, in refinancing, recapping, IPO-ing, not just in the United States, but in markets abroad. And when those windows open, if there’s a chance to fully or partially capitalize on our gains, I think it’s incumbent on us to do that.

It’s actually one of the hardest things that we do. If you spend a year working with management, getting to know a company, getting to know an industry and then you spend two or three years really understanding it and the players, and you have a lot of success, the easy thing to do is just to continue to ride that success. And oftentimes, you get lazy. And you may make mistakes.

So having the discipline to know when it’s time to move on– our objectives are generally a two to three times gross return. If we are in that ballpark, generally we will be looking to take a profit. We’re also a fund, obviously, but that means we have to do this 10 or 12 times. Ultimately with respect to the portfolio, having that discipline I think will reflect back on the entire portfolio.

Privcap: Please talk about your Australia affiliate, CHAMP, and how that has evolved over the years?

Morgan: In 1998, as you pointed out, many of our peers were looking at Europe. We’ve managed to do about one transaction in Europe per fund from our US fund. And we thought it was very contrarian to look at Asia. If you recall, there was quite a crisis in Asia in 1998. But as we started to look at parts of Asia, we were struggling with what makes our business of control private equity work.

In Australia, we found rule of law, established banking, a culture in which we could be very effective. Importantly, we found a great partner. The group that we teamed up with had also been in the business since 1987.

We changed the name to CHAMP Private Equity, the CH standing for Castle Harlan, and focused on middle market buyouts in Australia, an area that was very under-served. There are still only a handful of groups that focus on that sector in Australia.

We have expanded. Three years ago, we established a two-partner office in Singapore. So now we have a more broad Australasian focus. And that would pick up areas like Singapore itself, but Malaysia and Indonesia, Thailand, both for acquisitions and for growing our portfolio companies.

I think when CHAMP and Castle Harlan work together– and we have directly worked together between the two funds on several transactions– we can engage in what I would call global middle market, relatively small companies that have a footprint or an opportunity around the world that most middle market buyout firms will find way too complicated to deal with. Those are actually complicated situations that are ideal for the network we’ve established, and we think is a big differentiator both for Castle Harlan and for our affiliate at CHAMP.

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