November 18, 2012
Interviewed by: David Snow
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Thomas H. Lee’s Strategy

The investment professionals of Thomas H. Lee Partners no longer “latch ourselves on” to growth the way they did in the 1980s, but rather deploy operating talent to drive returns, according to the firm’s Co-President, Scott Sperling.

In a wide-ranging interview with Privcap, Sperling discusses the evolution of his firm’s operating strategy, how it is now able to turn around the fortunes companies like Warner Music, what it was like to get “beat badly” during mid-2000s buyout auctions, and how the firm models out success without the deal size and “quantum of leverage” available during the buyout boom. Sperling also describes a core investment thesis of THL today, which is looking for “companies that help companies.”

The investment professionals of Thomas H. Lee Partners no longer “latch ourselves on” to growth the way they did in the 1980s, but rather deploy operating talent to drive returns, according to the firm’s Co-President, Scott Sperling.

In a wide-ranging interview with Privcap, Sperling discusses the evolution of his firm’s operating strategy, how it is now able to turn around the fortunes companies like Warner Music, what it was like to get “beat badly” during mid-2000s buyout auctions, and how the firm models out success without the deal size and “quantum of leverage” available during the buyout boom. Sperling also describes a core investment thesis of THL today, which is looking for “companies that help companies.”

Privcap: Among the large PE firms, what distinguishes THL? 

Scott Sperling, Thomas H. Lee Partners: We have, for over 30 years, been focused on three distinct sectors. And that would be business and financial services, media and information services, and consumer health care.

And while over the course of that period there have been investments made that were outside of those three areas, about four or five years ago, Tony DiNovi and I came to the conclusion that we should focus only on the three key sectors that we have probably more experience in than almost anybody in our business, that we have a set of relationships that have been built over 30 years with management teams, with bankers, with strategics, that really help us drive better deal flow, both proprietary and advantage deal flow, which is very important in terms of being able to find the kinds of companies that we really want to invest in.

And secondly, in terms of understanding what you need to do with those companies in order to drive better operating performance that leads to better financial performance and therefore higher rates of return on our investment. And so, we believe focus is really important.

And that focus also extends to geography. So amongst the major firms, we’re probably also the most focused in that we try to buy companies that are headquartered or domiciled in North America. That’s the place where we have an advantage because of the relationships we have. If we go to Central Europe or even most parts of Western Europe, we are not the ones with the advantage. And oftentimes, playing fields are not level. In fact, most times they are not.

So if we aren’t looking down a slant, then we know that we’re probably really looking up a slant, even if we don’t know it. And so we try to put ourselves in a position where we have advantages over other players, in terms of sourcing, in terms of how we can manage a company. And in order to achieve those advantages, we find we really need to stay focused in areas where we have the experience, the knowledge and the relationships.

Privcap: How has your role with portfolio company leadership evolved?

Sperling: It’s been an interesting evolution over the course of the 30-plus years we’ve been doing this. If you look back into the 1980’s, I think what we were really good at is figuring out which companies had sustainable growth. And we just tried to latch ourselves onto that and get taken up by the companies.

And that was a pretty good period, I think, for the industry overall, when you look at the rates of returns. Obviously much less competitive. We were in a period where the underlying growth of the economy was much stronger. And so therefore, being able to find that kind of situation– and if you were able to be really good at understanding where sustainable growth is, then I think you were able to drive returns.

As we got into the ’90’s, particularly after the recession of ’90, ’91, ’92, we found that the ability to not just find good companies but to look for situations where we could become an active board member, partner with really strong management teams, but then help them drive the growth of their company even higher than they’ve had, through acquisitions, through geographic expansion and through product expansion, was a key way for us to sustain the very high rates of return that we were able to drive.

And then, if you went into the middle ’90’s and you look at companies like Fisher Scientific and Price Cellular, companies that were in good industries, where we had proprietary deals, where we worked with good management teams, we found that those companies were able to really drive very high returns for us by significantly improving the way that they did business.

And as we moved into the 2000’s, we found that we would now look for companies that may not be so good, that may be in a little bit of a challenged environment, and where we could now bring in key managers who can help us take that business to a very different level, and where we can work with those key managers to come up with plans where we can really reform the way that company does business, leading to much higher levels of cash flow generation, and over longer term, increase revenue growth.

And so when we bought Warner Music from– at that time, AOL Time Warner, it had been an industry that was challenged. It was a company that had lost its leading position, and we were able to buy it for a price that made quite good sense to us, based on those factors.

And we brought in an entirely new management team.  Edgar Bronfman as CEO, Lyor Cohen to head up recorded music. Lots of people underneath them changed. And we worked with that team to really change the way that whole company did business, whether it was the way they did A&R, the way that they find and attract and sell artists, or whether it was the way that they distributed the physical product, as well as pushing them into digital distribution.

And the net result was we were able to double the cash flow of the company in a reasonably quick period of time. Coming out of that– and we did this with a number of other companies– again, a Houghton Mifflin, a ProSiebenSat.1, able to really grow National Waterworks. These types of investment led us to conclude that having the ability to control the operating talent that can help drive these changes would be a really important element for our strategy going forward.

Privcap: How has THL changed, organizationally, as a result of the increased focus on operational improvement?

Sperling: Starting in the 2005 period, we created what we called our Strategic Resource Group. And the Strategic Resource Group is now a dozen individuals, 20 to 30 years of experience each in consulting and operating, who are now integrated into our investment deal teams with investment professionals from the start of the diligence period. And if we make that investment, all way to the selling of that company.

And we now not only have investment professionals who work at the Board level and the C-suite level, which is traditionally where private equity is worked, but we now have our operating people working deep into the company, coordinated up with our investment professionals at the Board level.

And what they’re working on are specific projects that we think can really make a big difference in that company’s competitive position and really help that company dramatically improve its profit margins, and over, again, the longer term really increase its revenue growth rate by becoming a market leader, taking market share from others, and moving into areas that we think may have even higher growth than the core business. And we’ve had an enormous amount of success with this process, particularly over the course of the last half dozen years.

Privcap: What lessons did you and the company learn from the financial crisis?

Sperling: We thought we were being pretty cautious. And we did very few deals in that ’06, ’07 time frame. More in ’06, almost nothing in ’07. Some of it was we were just getting beat badly.

And it occurred in both deals that were proprietary, where we were the only ones talking to the Board, but the Board’s expectation for price was way above what we were willing to pay, or in auction situations where we found that we were just not even competitive in a number of things.

So we’d like to say we were smart by not rushing out and putting as much money to work as maybe some others in that period. But really, it was that we found it out because we just kept on losing.

But one of the things that we concluded as we look back is, even with that and with that discipline, it was a really hard time when you look back at those companies, given where the pricing was in the overall market.

So even if you were reasonably disciplined, when you get a recession that can really eviscerate the growth of a company for a two- or three-year period, then you’re working really hard to do the things I talked about doing to make this a better company, improve its competitive position, drive revenue through market share gains, but you’re still digging out of a bit of a hole.

And so as we look back at that period, we continue to look at the issue of how do you derive your returns not just in the model that you have, but how do you derive those returns in terms of how much you’re getting from leverage versus purely from the operating performance of the company, and also looking at what the intrinsic value of that asset actually is.

And what we do now is we look at unlevered returns as one of the key metrics when we make an investment. And we want the unlevered return to be in that low teens, mid teens area, which means that we’re not driving our returns, as sometimes happened in that ’06 period, because you were able to get a lot of very cheap leverage.

And that’s important, not just because you will have periods where you can’t get that leverage. Today, you may not be able to get the quantum of leverage, but debt is very attractively priced. So you’re again in a period where you can make a lot of models work. You can drive a 22%, 23% projected rate of return, because the debt is very attractive.

But what you really need to look at is, am I also driving that return because the underlying business can achieve superior unlevered rates of return? And so we really focus an enormous amount of our decision on how that works on an unlevered basis.

Privcap: In what sectors and industries do you find the most opportunity today?

Sperling: So each of our sectors has been reasonably active in terms of looking at transactions. We’ve still been at a pace that is slower than we would have thought, if we look back to 2006. And some of that is that transactions are smaller today, and I think will remain smaller.

We have found that if we take this operating capability we developed, which is married to what is one of the largest groups of investment professionals in the North American buyout market, maybe the largest, and we take that capability and we apply it to companies that are now a bit smaller.

So in that $250 million to $2.5 billion enterprise value range, we can really move the needle a lot. And what that means is that we’re buying companies that use less equity than we might have imagined in ’06, in terms of the annual investment pace that we are on.

And as we look at that, we see each of our sectors, each of our vertical groups, looking at lots and lots of transactions. But trying to find the right ones has been not all that easy. And the one area that has transcended all three of the sectors has been investing in companies that help other companies reduce their cost basis, move fixed cost to variable cost, and actually perform critical functions not just more cost effectively, but better than they can on their own.

And that has ranged from– in our consumer and health care business, that would be companies like an Inventive, where we are helping big pharma, small pharma and biotech in areas such as clinical research, contract selling, staffing, communications, general consulting. So being able to take a set of capabilities and use that in an industry where there’s a big trend towards taking fixed costs and turning them into variable cost. And so have had very strong growth.

It applies to companies that are relatively low tech, like an Aramark, which is one the world’s leading providers of food service and facilities management services. Very few companies really should be doing food service or facilities management on their own. Aramark does it better and cheaper. And so we’ve been playing a growth trend there.

It’s a company like Acosta, which manages the sell in to the sell through of consumer products, where they’ve had enormous success at being able to do that whole set of critical processes better than even the very large consumer product companies can. And therefore, they’ve seen an enormous growth in their business. And that growth is coming from some very large consumer product companies who maybe had never considered, 10 years ago, doing that kind of outsourcing.

And so, we can do a lot of things for– in terms of if you look at what these portfolio companies in this sector can do, they can do a lot of things for their customers that really help drive growth, even in an overall growth challenged environment. So we like that area because it’s not GDP growth dependent. And we’ve seen very strong growth, even as GDP has been very disappointing over the last few years.

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