November 1, 2012
Interviewed by: David Snow
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Internet or Die

The internet is revolutionizing consumer and retail sectors; private equity investors that can bring the capital required to internet-enable their consumer-facing portfolio companies will win big.

In the last in a four-part Privcap series on private equity success in the consumer sector, Michael J. Grossman of RSM; Joan McCabe of Brynwood Partners; and Timothy Mayhew of Fenway Partners explain the importance of an internet strategy in the consumer sector and why, as Mayhew says, “If you’re not focused on it, you’re dead.”

The internet is revolutionizing consumer and retail sectors; private equity investors that can bring the capital required to internet-enable their consumer-facing portfolio companies will win big.

In the last in a four-part Privcap series on private equity success in the consumer sector, Michael J. Grossman of RSM; Joan McCabe of Brynwood Partners; and Timothy Mayhew of Fenway Partners explain the importance of an internet strategy in the consumer sector and why, as Mayhew says, “If you’re not focused on it, you’re dead.”

Internet or Die

David Snow, Privcap: We’re joined today by Michael Grossman of RSM, Joan McCabe of Brynwood Partners, and Tim Mayhew of Fenway Partners. Welcome all to Privcap today. Thank you for joining us. We are talking about the consumer sector, very popular in the private equity industry today, very popular. strategy. Not always easy to make money in it, but. Of course, we all have a lot of experience on this panel, so I’m fascinated to hear your perspectives.

There’s one huge looming issue, at least for me, the non-consumer expert, is aware that there’s a huge looming issue over the consumer sector that’s the internet. I’m sure the internet affects all aspects of the businesses that you invest in and the businesses that you advise on. But I’m interested to learn a bit more about maybe some ways that the internet is influencing consumer businesses that, perhaps, the average person is less aware of and that absolutely impacts the ability of private equity firms to make money.

So maybe are starting with Michael. You have a good view across the market and have worked with a lot of private equity clients. What are some interesting ways that the internet is really affecting the decision that they make and affecting the ways that they build out these businesses?

Michael Grossman, RSM: Well I think first and foremost is social media. I think it’s obvious. You see what’s going on with what Google originally did, then, obviously, what Facebook did. We were talking at the break and we talked about liking something on any kind of product out there. It obviously goes right straight to Facebook.

So I think from a marketing perspective in the consumer space it’s huge, absolutely huge. And then transitioning from social media to the actual internet, of actually the saleability of products online, I think it’s vital for companies to have an internet-based ability to sell products. It could be their own, they could manage it themselves, or they could outsource it nowadays. The businesses that we look at– it’s interesting because I do believe that there’s a higher multiple that goes with a business that already has that in play.

Obviously, if it doesn’t have that in play yet, there’s an opportunity for an investor, like you guys, to go in to create that. I think one risk area that you have to really think about is the systems that are in place because a lot of people try to develop it themselves, don’t really do it successfully. And if you don’t have those systems in play already, you need to invest. And, obviously, there’s going to be a little bit more cash that you may have to put into the business.

Snow: And quick follow-up question to that. Are many private equity firms themselves aware of the importance of these social media marketing platforms? A lot of these firms are not run by 22-year-olds. So do they get the challenge that is in store for them?

Grossman: Well, you’re right. They’re not run by 22-year-olds, but it does seem like there are a lot of MBA 25- year-olds that are at these private equity firms. So I do think it’s becoming much more of a trend over the last few years. I don’t know if you guys see it in your funds, if you guys are aware of the social media and how it affects your investments and your–

Joan McCabe, Brynwood Partners: Well, it’s interesting. I’ll take it and then let Tim try. We own now mostly brands. And those are the brands that aren’t going to be generally shipped through Amazon, think about VO5 shampoo, $0.99 price point and heavy liquid. So it most likely will stay in the bricks and mortar environment. Balance Bar, Turtles, 70% of food goods are bought at impulse at the store. So we may not transition those sales to the internet, but we have to be very aware of the fact that, if somebody doesn’t like our product, they are for sure going to advertise it on social media.

So this whole idea of keeping up with the blogging and Twitter and tweets and Facebook is critical because a good example is our Balance Bar business. It’s a good-for-you product. You’ve got to have the consumer saying on the internet that they think it is good for them and it’s working for them. And if you don’t have that awareness, you’ll be in big trouble. Your sales will suffer. So even if it’s not the front end, you’re not selling through the internet, you do have to have, I call it the back end, the social media awareness.

Timothy Mayhew, Fenway Partners: I tend to think about it in a very similar way. I think that there’s building the brand and then there is selling products. And the social media piece is hugely important to building the brands. I went on the board of a social media marketing business that is a start up out in San Francisco just to have an experience. It’s called Thismoment, and Sierra Ventures and Trident have now invested in it, and it’s got about $25 million of run rate revenue.

And it’s been fascinating for me to look at how brands are thinking about social media and developing themselves. And how they try to monetize likes or how they try to have a direct interaction with a potential customer. And that is very fast moving. And if you’re not focused on it, you’re dead.

I think, however, there’s a much larger and deeper and longer opportunity, which is actually selling directly to your customer. And that is one that certain businesses lend themselves to more than others. And for me, it’s a whole question of using the power of the internet, and the data storage capability that the internet has, that allows you to reduce friction from your customers life.

So how can you do that? For example, Open Table. Here’s a business where, on a Friday night, if you were sitting there with your wife and your sitting there thinking about where you’re going to go to dinner, that was a big kind of deal. Now actually you can go to Open Table, and it will give you all the information you need to have.

It’s all this data that’s in the cloud. It has all of your prior history. It has lots of likes, what have you. And it’s reduced friction. It’s made the whole choice of actually where you’re going to have dinner make a difference. We had an investment in a company called 1-800-CONTACTS. And, in that business, where we are moving is managing a family’s entire optical needs in the cloud.

So most families, it’s one of the parents that is actually managing everybody’s appointments with their eye doctor, when contact lenses have to be reordered, when glasses break, when you get a new pair. Imagine if I were that person in our family and all of the data were stored. And it didn’t really matter where I was. I could be on vacation, and my son could break his glasses, which happens.

And I could just pick up the phone and call, and I have those glasses come. Or I could be in Europe on business and realize that I’ve forgotten contact lenses, and I could have them overnighted or what have you. These types of situations are the ones that lend themselves for a long commerce experience. And that tends to be a higher gross margin

So if you take a look at Under Armour. Under Armour’s earnings just came out. They announced that 30% of their sales are direct-to-consumer at this point. Think about that. Think about the margin difference between that and going through Dick’s.

So first you build the brand, and that’s through the social media piece. And then you build the business. And there’s a whole question of how you’re managing the lifestyle and the data that you get from your customer to actually create repeat business.

Grossman: Yeah, it’s very interesting he says data. And I think that’s kind of where I was going with it because companies, in the middle market, especially, companies that are not that sophisticated don’t have that data. And I think the data is very important. But, I guess I’m curious, your perspective on– I agree with you, it’s first building that brand.

And then you’re saying it may not be necessary to sell on the internet, but are you concerned with the non- convenience factor that a company of yours may have? I can’t buy a certain product, so I’m going to go out look on the internet, buy a similar product. Maybe not as good of a brand, but at least it’s not going to take me time. I’m just going to go buy this online.

McCabe: What we find is, in an area we’ve been looking, is in OTC and nutritional supplements. And that has turned the whole brand building on its head because they are small, sometimes you take them on a daily basis, so you can automatically reorder. We’ve been looking at a lot of businesses that have been going like gangbusters only through the internet, building their brand on the internet, and, as you say, creating less friction.

And then, moving backwards into bricks and mortar. We looked at a company that had gone from zero to $50 million in three years, and only recently have they gone into the drug channel of trade. So the bricks and mortar market is now following the internet because, as you said, Tim, that’s where you’ve got your real loyalty. When you have, absolutely– your mobile app, boom, click it. I need my new lutein multivitamin.

Mayhew: The potential for stickiness to that customer, once they’ve loaded up your app on their mobile device, is huge. And the potential for reducing friction, improving the customer experience, and improving your gross margin, sort of virtuous upward cycle, is real. And that only inures to the benefit of the brand in the long haul and fits into the social aspect of what you’re doing, the lifestyle.

Now Joan, I think, actually gets to participate in the internet in a lot of different ways because she would take a brand that has been around for a long time and to get into channels that it hadn’t been in the past. And some of those might be– she might not have to sell– you own Zest, for example. You might not have to sell Zest directly, but you could get it on drugstore.com, which Walgreens now owns. And you might have a great relationship with Walgreens and get Zest into Walgreens and drugstore.com.

And that might fit with the social media strategy you have. That all comes together. So, you can do it a lot of different ways. You can do it directly, where, for example, we own Easton. Easton’s selling baseball bats directly at this point. Or Giro, you can buy Giro ski helmets and goggles or cycling helmets directly from us. And that might be something where there would be the emphasis of having a direct relationship. Or you can do it indirectly getting with the fast-growing online retailers.

McCabe: But it’s surrounding the consumer and allowing the consumer to get the product however he or she wants and make it as easy for them as possible.

Snow: I have a question about the due diligence that firms like yours and your clients would perform into a company you might invest in with regard to the internet. What are some things that might turn up in the due diligence process, specifically with regard to internet strategy, that might be cause for concern?

That would make you say, hmm, this doesn’t seem like it’s pointed in the right direction, and would either A, make you decide not to invest in the company, or B, tell you that there is a major opportunity to bring better internet strategy to a company. So I’m wondering if anything strikes you as being particularly, I guess, worrying or something that would stand out?

McCabe: I can take a stab at what we’ve looked at. And what has been the hardest for us is to know, particularly if it’s a high-growth product, is it a fad or is it sustainable? You can sort of show month over month changes that are really dramatic. And the question is, where does it sort of flatten out and how much is really consumer brand building? That’s where we spend most of our due diligence and have the most difficult time because then you get back to basic, old, brand-equity studies.

Mayhew: So it’s sort of like you’re saying the internet could actually amplify what is an age-old problem. So I think, if you look at like Atkins or Airborne, or some of these things it went whoom and then whoom. You’re saying, with the internet, they could even go more whoom and whoom and so you better–

McCabe: And they may be sustainable because it’s that whole sort of disintermediation. There are a lot of these bricks and mortar consumer brands that haven’t gotten over to the internet, and there’s an opportunity for a young brand to take their position. But it’s almost a competitive analysis too.

Is that major consumer business, somebody mentioned it, they don’t have a lot of 25-year-old social media guys. And they don’t want to cannibalize their bricks and mortar sales, so they haven’t moved over to the internet very quickly. Well, can you move quickly enough that you can take share from them? It’s fascinating. But it’s really hard to predict.

Grossman: I think from a due diligence perspective, a couple things. One is the data that you’re talking about. Just kind of see where that data is flowing, and, obviously, if the data doesn’t really match up with what your goals are, or if they have problems with giving data, then that’s concern number one. I think the big thing that we focus on are returns because, with the internet sales, you’re going to have an increase in returns.

And what that’s going to do is that’s going to end up telling you a little bit more about that product. It’s a little bit different if you go into the store and you actually buy a product, you’re likely maybe not to return that. Something on the internet, you’re not really feeling that product, it’s likely to return. So that’s one of the key areas we look at.

Mayhew: We tend to think about architecture, how robust is the actual architecture itself and then the design. And it doesn’t take a website to be down for very long for serious damage to be hurt. So the architecture is really important, and not all engineers are created equal.

From a design standpoint, we focus a lot on people because there a lot of people looking for SVPs in the internet and getting really high-quality people is hard. And we have to be honest with ourselves, do they exist and do we think we’ll be able to attract them if they’re not in the business right now. So we look at that.

Snow: Final question for all of you, and this maybe is challenging, somewhat, the idea that the internet is going to completely dominate retail. To what extent do brick and mortar strategies still win? To what extent is there money to be made in going back and maybe fine-tuning the stores, the locations, of brick and mortar strategies that some of these brands have. Maybe starting with Michael.

Grossman: Well, I think, like I said earlier, it’s still a lot of consumers do want to touch and feel their product. And I think Best Buy is what, 40% of their sales are still brick and mortar sales. And so I still think there is going to be a component, that it’s not just going to transition 100% to the internet.

That said, I also, personally, we do a lot of software technology deals. And that space also has increased tremendously as well. So that could be a foreshadow of what’s to come. But I still think brick and mortar is still going to be around, in some fashion.

McCabe: We have a chain of pet hotels. And so we look for opportunities where we don’t think that can move easily to the internet. You’re not going to send your dog on Amazon. You still have to have a location. But we have changed our whole marketing, our marketing budget, away from conventional marketing towards internet-based marketing.

So back to this idea of the consumer wants a friction-less experience. They want to be able to book online. I think that if you have a bricks and mortar strategy that’s not internet-enabled, you’ll have a difficult time. I wouldn’t want to invest in a situation like that.

Mayhew: And I echo that. You have to be where the consumer wants to be. So I’m a huge believer in multi-channel strategies. You got to be on the phone, you got to be on the web, you got to be in the bricks and mortar. And it’s got to be seamless. And I’m still amazed at the infancy in which we are all in in this stage.

I don’t know why, when I go into J.Crew- J.Crew has 15 different types of t-shirts. I buy a specific kind of t-shirt online. So when I go into J.Crew it’s unclear to me why, when I go up to the salesperson and say, where are the t- shirts, they don’t say, what’s your name.

And then they take me over, specifically, to the t-shirt that I have bought. I don’t know why they don’t know me, equally, in all these channels. And I think that is where we’re going. It’s a level of good, old-fashioned service. It doesn’t matter what channel you’re in.

McCabe: But that’s the opportunity for private equity. That is the opportunity. It is taking what you’ve done in the past and just what seems logical and actually spending money. There is capital there are two things, there’s human capital and money capital.

It costs a lot of money to become internet-enabled, but it also takes a cultural shift. And we find that’s always the most difficult thing, training people, educating people, to think differently. And I think a lot of companies are just too big to really kind of be at the cutting edge of that.

Grossman: And that’s one of the reasons, too, that our clients are getting into deals where maybe it’s a growth equity type deal. Where maybe it’s a seller that doesn’t want to sell, but they need some working capital to get to this next level because they know that they’re going to end up getting somewhat crushed in the market if they don’t get to that level.

McCabe: But, on the other hand, if you can do that, if you can put that internet component, as you did in 1-800- CONTACTS, you’ll be able to sell to a strategic party who can’t build it. It’s just impossible, as a large company, to build it. So they’ll buy it and then they’ll take that knowledge to other parts of their business.

What is a major deal-flow trend you are seeing in the consumer sector?

Grossman: We see a little bit more minority interest deals. I guess this kind of started back in ’09 when there weren’t really a lot of deals going on that you had some consumer focus, private equity groups looking at minority interest deals. You had companies that didn’t necessarily want to sell 100% or 80% of their business, but yet they needed some working capital, growth equity. And so they were able to get those deals done.

What services does RSM offer to private equity firms?

Grossman: Well, in private equity, we’ve got a lot of experience. And so, not only me personally, I’m on the transaction advisory. So we do buy-side due diligence and sell-side due diligence. But we also do tax structuring, M&A tax advice. Technology is a big piece of our business, and so we have a whole consulting practice built around technology and other areas of performance improvement. And, of course, there’s also the portfolio audits, as well as the audits of the fund.

In performing due diligence on a consumer-facing business, what numbers are of particular importance?

Grossman: Margins are very important to our private equity clients. And it’s amazing, in the middle market, you really need to understand what you’re doing, what you’re looking at, to make sure that those margins are appropriate.

Do you mostly perform buy-side due diligence?

Grossman: We see a little bit more in the sell-side. We primarily did buy-side due diligence. We still do, but we are trending towards sell-side. We used to probably do 80% buy-side, 20% sell-side, and now it’s more like 60/40.

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