September 1, 2012
Interviewed by: David Snow
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Investing in Consumer Success

The consumer sector drives the U.S. economy and is a big private equity target. But how can GPs make money amid weak consumer spending?

In the first of a four-part Privcap series on private equity success in the consumer sector, experts Michael J. Grossman of RSM; Joan McCabe of Brynwood Partners; and Timothy Mayhew of Fenway Partners explain how to identify consumer niches that are growing faster than the broader economy. With consumer spending making up two-thirds of GDP, this video is essential viewing for any investor looking to grab a piece.

The consumer sector drives the U.S. economy and is a big private equity target. But how can GPs make money amid weak consumer spending?

In the first of a four-part Privcap series on private equity success in the consumer sector, experts Michael J. Grossman of RSM; Joan McCabe of Brynwood Partners; and Timothy Mayhew of Fenway Partners explain how to identify consumer niches that are growing faster than the broader economy. With consumer spending making up two-thirds of GDP, this video is essential viewing for any investor looking to grab a piece.

Investing in Consumer Success

David Snow, Privcap: We are joined today by Michael Grossman of RSM, Joan McCabe of Brynwood Partners, and Timothy Mayhew of Fenway Partners. Welcome to Privcap today. Thanks for joining us. So today we’re talking all about the consumer opportunity, huge part of the economy, huge part of the private equity market. And yet we find ourselves in a flat economy, not a lot of consumer spending going on.

So I guess my first question for all of you is, I’d really like to understand how you can make returns, how you can chase good opportunities, despite there being not being the tail winds of consumer spending to push you along? So maybe starting with Joan. How do you, as an investor, try to get good returns from a consumer-investment strategy, despite these economic challenges?

Joan McCabe, Brynwood Partners: Well, it’s interesting because the consumer is 2/3 of our economy. So, although, GDP is growing at 2% per annum, it is a vast segment of the market. And so there are many opportunities. The way that we at Brynwood really get our opportunities is two-fold. Either we find the niches that are growing at higher than GDP, and that would be areas like health and wellness. We own a business called Balance Bar.

Or, we like to say we make our own luck. We work very much in the value-oriented side of the business. And, although, that market may be growing at a flat rate, certain niches like private label and value-oriented products are growing higher than that.

So, if you look at the consumer in the great recession, they’ve really been trading down. So they’re buying more value products. They want something for $0.99 instead of $3.99. That’s where we find our opportunities.

Snow: Tim, as someone who also invests in the consumer sector, how are you finding opportunities to deliver outsized returns, despite, again, the challenges of weak consumer spending?

Timothy Mayhew, Fenway Partners: Well, I completely agree with what Joan was talking about. Jim Cramer always says that there’s a bull market someplace. OK? And in our economy, there is always some area within the consumer area that’s going faster. And, certainly, the macro trends have been that, either uber-high end has been growing, or the lower market has been growing.

We tend to skew a little bit higher in terms of premium brands. But, in this world, we owned Harry Winston for a while, for example, very high-end jewelry business. We own Easton Bell Sports. And we have baseball bats that are $500 a baseball bat or hockey sticks that are $200 a hockey stick. So it can be very high end.

But in this economy, what we’ve been looking for is somebody who is producing a great product at a fair price and maybe providing a little extra ounce of service associated with it. So if you look at some of the brands that are really doing well, it could be J. Crew or Lululemon or Under Armour. All of these brands are brands that have very, sort of a wonderful, product. And it’s a luxury that the consumer is spending against, as opposed to maybe the big vacation or something like that. And as a consequence, we are looking for something that emulates that little extra special bump up in terms of a performance area.

McCabe: Well I was going to add to that, although we buy value products, it is the case that the consumer looks for transparency and good products, regardless of the price point. You can’t hide things anymore. And you can’t just put things out on the shelf. It used to be that you’d go to the retailer, and they would put it out and you’d have to buy it.

And now the consumer is very educated. They want some value for that product. So we may sell a bottle of shampoo for $0.99, but it’ll have five vitamins in it or some value added that will make it different from the competitors.

Snow: So Michael, as someone who spends a lot of time with private equity firms in the consumer sector and in the consumer sector deal flow generally, how are you seeing investors sort of go after better-returning opportunities despite the weak economy?

Michael Grossman, RSM: Well, I think there’s some funds that are focused on consumer products, like you guys, consumer brands. And so I think that helps when the seller is looking for a partner and an investor. A lot of folks that are looking to sell, they don’t want to necessarily sell to a strategic. So they’re going to sell to a partner kind of like a couple different turns on their investment and kind of hold some.

I think one of the ways that we’ve seen it is a lot of our clients have been looking at minority interest-type deals. I don’t know if you guys do these kind of deals, but growth equity-type deals, as opposed to just taking control like the traditional private equity LBO of market. I think that one thing that Joan hit on earlier was the brand. Obviously, the brand is very important and the value-added product.

But I think, also, in this economy, when GDP is somewhat flat, I think there is certain distribution markets, like the Target, the Walmart, those are obviously getting bigger, internet channels. So I’m seeing where it doesn’t necessarily have to be high brands. Obviously, the higher the brand, probably, the better your investment would be.

Mayhew: For us, there’s the sector, there’s the channel, and then there’s the region. OK. So we’ll look, I think, just like Joan is for that sector of the economy where there’s some sort of demographic push. So the population is aging at this point. People are living more healthily. They care a little bit more about what’s inside their product.

That’s an area where, if you have a better-for-you product that is actually priced fairly, with a brand that represents that lifestyle, that sector’s growing double digit. So we would like that. Or, you could take something that’s a little bit more mature– baseball bats, for example, baseball is not a growing sport per se– and try to think about the channel or the region.

So, in this instance, we think an awful lot about the direct-to-consumer area, the internet channel. Or the region, how can we grow in China? And so, either way, you’ve got to figure out how you’re going to grow double digit. And you have to– it’s either got to be the sector, it’s got to be the channel, it’s got to be the region. It’s got to be something along the lines.

Grossman: It’s interesting you mention that because right now we’re working on a health and wellness deal, where it is in a certain region of the country. So you’re right. I think there is the appetite for consumers to get that health and awareness, to kind of feel better, it’s a food-type deal. It’s in a very small part of the country. And so there’s that opportunity to really brand out, not necessarily in China. Although, maybe that would go global, but, really, to at least distribute across the country.

McCabe: Well, a couple of points I’d make. We only do majority deals. We don’t do minority deals because we like to control our own destiny. And, for better or for worse, we make the decisions. We don’t want to be in a position where we’re fighting at the board level. So we will only do control.

And we don’t buy growth businesses. We look back instead of forward. So where you stand depends on where you sit. We buy businesses that are declining. And many of the brands that we buy are declining double digit. So to us, to get to zero is a success. So it’s a whole different perspective.

Snow: So, the secret to your success is to buy declining businesses?

McCabe: And to know how to turn them around. And they’re not declining because, necessarily, they’re bad businesses– just because there hasn’t been marketing and effort put against them. We like to call them corporate orphans.

Mayhew: Do you often change out management?

McCabe: We mostly don’t buy management. We buy brands from companies and then we put in place a team. So we create a culture. I would say that sometimes that’s a lot easier than changing out the culture

Mayhew: Right.

McCabe: We have difficulty when we have to change the culture and change people and knowing who to change. So it’s a lot easier when you have a team. We tend to have serial entrepreneurs that we work with. That’s an important part of our thesis. We always work very hard to have our entrepreneurs work with us and then keep coming back. So when we buy a business, we want to know we have somebody that knows the, quote unquote, Brynwood style who can go in there and quickly create a business.

Mayhew: You know, it’s funny. We tend to do a little different. We have historically done control as well. And that is not as quite a hard and fast rule for us as it is for you, but certainly that has been our standard. We tend to like to work with founders.

So, I would say eight of our last 10 deals, the founder has actually rolled over. And so that founder can remain as a consistent presence. Sometimes we work on developing the team underneath them. And it is only a failure for us, I think, if we have actually completely swept the culture.

And we have done that occasionally. There’s no question about it. And sometimes to a positive effect, but it’s not our norm. So we try to pick up on some existing momentum, and then maybe there’s going to be a little extra tweak or a little extra push or a little extra change that’s going to take it from a single digit to maybe a double digit. But we don’t start with a complete clean canvas like you. That’s interesting.

Grossman: I’m curious, from both your perspectives, how important the distribution network is, especially in a business that may be declining, doesn’t have that proper distribution. Is that important or is it really just the brand?

McCabe: No, it’s critical. We actually– that’s the key differentiator for us as well. We keep the distribution network at the Brynwood level. So five of our general partners, our operators, have been COOs, CEOs, CFOs of companies. So we actually have an office in Bentonville, Arkansas for Walmart, and it’s for the Brynwood companies.

It’sa Brynwood office. And one of our senior managing partners has a Walmart relationship. So, it’s a key driver to success. Can we get one or two more SKUs into Walmart or Sam’s? So that, candidly, is more important to us than the brand. Not that the brand’s unimportant, but we’ve had great success in private label.

Store brands are an increasing part of the landscape today. If you think about it, retailers are trying to cement their brand. So they want more products that are their brand. So you want the Costco Kirkland brand. They have a lot of brands in Kirkland. You can really make a good business out of being their trade partner.

So we don’t make an investment if they don’t think we can help those distribution– we can augment the distribution to the channels. The other thing I’d say is that we focused a lot, in the great recession, on the dollar store channel. Family Dollar, Dollar General, a decade ago those were really kind of 2000-foot, small stores, mostly in rural areas.

And they have really grown as a percentage of the retail landscape. They’re now pretty sophisticated stores. And you can do a lot of volume in them. So we’ve, for the past decade, we’ve really focused on them, and we’ve ridden that growth trend.

Mayhew: Yeah, that has been– the dollar stores have been the bane of Walmart’s existence.

That has absolutely hurt them. Answering your question, we also care a lot about distribution. And we absolutely want to be able to bring some kind of incremental level of distribution to the business than existed when we invested in it. So that’s a big key. We also have, I think, our own relationships with Walmart or with Dick’s Sporting Goods   or with any particular large retailer in the space.

We tend to focus in certain areas. We do a lot in sporting goods, a lot in luxury, a lot in optical. So we know a lot of the players in that area. We do a lot of in health and wellness, in general, so we know an awful lot of the people at Walgreens or the big drugstore chains. And that is a huge key, that the owner actually has their own independent relationship with the key customers.

Thisis not a situation in which you’re making a public market investment and sitting back and wondering where the business is going to go. I think one commonality that Joan and I are talking about here is actually actively forming the clay. So for us, we’re going to work with a founder that wants to evolve. And we’ve talked a little bit about what kinds of deals are we looking for, we’re looking for a very specific kind of founder.

Andthe seller that we’re looking for is a founder that knows that they actually want to stay in. And they want to double or triple their business, and they need help to do it. And that might mean taking them into the internet, or that might mean taking them into Walmart. And we’ll talk about that.

Ihave an instance where we did that for somebody. But where it might mean taking them into China, but it’s taking them someplace. And it’s coming from us not just sitting back waiting and saying, hey, where are you going?

Grossman: It’s interesting from the due diligence side because we obviously see it on the pre-acquisition side. And there’s multiple companies that I can think of that weren’t in Target. And then once the deal happened, obviously, the private equity, our client, got them into Target, the company just exploded.

Same thing with Duane Reade, who is a west coast company, never in Duane Reade, never on the east coast. And, of course, New York presence with Duane Reade is pretty– has a lot of volume in it. So, of course, it just exploded as well. And so, I see distribution as being pretty key.

McCabe: We like to say we take businesses from kindergarten to high school. So, they’re beyond venture capital. But a lot of the tools we give them– it sounds like that’s what you do too, Tim– or MIS, and just sophisticated financial control.

So that when we sell, they’re at high school. And they can go to a buyer that maybe is a little less hands on, but they have confidence that the business will continue to survive. We always say they go to college or get their baccalaureate degree when we sell them.

Mayhew: You have a kinship. That’s so funny. We sit there and say that we invest in businesses that generally have around $100 million of revenue and we get them to a billion. And there are a lot of companies that can get to a $100 million in revenue in this country. A lot of founders can get them there, and then they stop.

And you can get to $100 million by being good at one thing. If you want to get to a billion dollars revenue, you’ve got to be good at four or five things. To your point, you’ve got– they’ve got to be able to go to college. And I don’t really care what the business is, those things are the same. And the growing pains of going from being good at one thing to being good at four or five things is very consistent.

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.

Privcap: 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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