The Riverside Company`s Lessons From The Loo

YOUR SOURCE FOR LEVERAGED AND MANAGEMENT BUYOUTS
October 17, 2011 • Issue 4
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GP PROFILE:
GUEST
ARTICLE
KPS
CAPITAL
NOT
WORRIED
The
Riverside
Company's
ABOUT
BIG WAR CHEST
Lessons From The Loo
By Bernard Vaughan
E
Pr
xecutives
at KPSand
Capital
Partners
LP
By Stewart
Kohl
Béla
Szigethy,
Company
Firm:The
KPS Riverside
Capital Partners
LP
ed
executives thought the entire company was
worth. “I don’t understand how a limited
Senior Executives: Michael Psaros, man- partner can make an investment in a fund
aging partner; David Shapiro, managing
that does PIPEs,” Psaros said. “If I want to I
partner; Jay Bernstein, partner; Stephen
can call my broker at JPMorgan and buy
stock on the public market without paying
Hoey, partner and CFO; Raquel Palmer,
someone 20 percent carried interest.”
partner.
Many market analysts say the default rate
Strategy: Invests in turnarounds of
won’t be as expansive as once believed.
underperforming or distressed businessStandard & Poor’s, for example, recently
es, financial restructurings and businessslashed its September 2010 high-yield default
es in bankruptcy.
forecast for U.S. issuers to 6.9 percent from
13.0 percent.
Investment Professionals: 20
Three KPS Capital limited partners interHeadquarters: New York
viewed by Buyouts expressed cautious optimism over the firm’s ability to invest the
ing their wounds... I think being cautious capital effectively. “Whenever a GP has a
early in the recession makes sense,” said dramatic jump in fund size it’s certainly a
Barry Gonder, general partner at Grove risk factor—it’s worked for some GPs, it’s
Street Advisors, a longtime investor in KPS been a catastrophe for others,” said Charlie
Huebner, a managing principal at RCP
Capital funds.
Despite having invested between $200 Advisors, an investor in the firm’s second
million and $300 million of Fund III’s $2 bil- and third funds. “We’re hopeful that
lion, KPS Capital has its work cut out for it because of the strategy they have and the
when it comes to deploying the rest of the fact that they’ve been getting better and
better,
and given
the environment we’re in,
fund over the remaining
fourSzigethy
years of itsand
Béla
Stewart
Kohl
investment period. To do so, KPS Capital they’ll see enough opportunities to deploy
would have to invest roughly the amount it that and see the same types of returns they
saw financials
in smaller we
funds.”
raisedprevents
for its entire
2003To
fund
every
often
disaster.
save
you year.
a trip to The
saw during due diligence
Perhaps
the
firm’s
biggest
competition
is
our offices, we’ve summarized our six top were all lies. The company had overstated its
the rebound
in the capital markets. The abil- EBITDA
The KPS
Method
findings
here.
byCapital
$15 million
and its working capital
ity of companies to amend and extend loan by Not
many
firms
go due
where
KPS Capital
$14 million. During
diligence,
they
maturities,
secure
loan-to-own
deals
and
does.
The
firm
wades
into
turnaround
situabugged conference rooms, involved customers
1) Fraud Kills
attract
private
investments
in public
equities, and
tionsvendors
that are
so fraud,
thorny—from
troubled
in the
and manipulated
Nearly
a decade
ago, we found
a company
or PIPEs,
hashallmarks
let themRiverside
avoid limping
into
auto-part manufacturers
to makers
of adult
We and our auditors
missed
the
with
all the
seeks in
a documents.
bankruptcy
and,
potentially,
into
the
arms
of
diapers—that
most
firms
wouldn’t
even
deal. It was growing rapidly, had a strong warning signs, and we ended up losing
KPS Capital.
Earlier
this year, theCEO,
firm and
lost aa millions
consider of
them
viable deals.
dollars.
market
share,
a knowledgeable
deal
in
which
it
would
have
purchased
a
KPS
Capital’s
of turning
We found a lotmethod
of warning
lights ina
set of innovative products in a growing
company pursuant
to a structured
bankruptcompany The
around
starts
buying
CEO was
full ofwith
charisma,
but
industry.
It was growing
so fast,
it had retrospect.
cy;
instead,
a
buyout
shop
did
a
PIPE
that
conassets
at
or
below
liquidation
value,
often
of
liquidity issues and was seeking a buyer. the company had more than one example
verted
into aon
20the
percent
through and
bankruptcy
processes;
dramatisketchy ethics.
The second
tier
We
jumped
deal. stake in the compa- litigation
nyAlmost
at a value
that
what
KPS Capital
cally
reducingwas
theinexperienced
debt and liabilities;
management
yet highly
from
theexceeded
start, it was
apparent
that of
py
co
na
so
er
rp
ng
di
ea
lr
ly
on
or
tf
no
n!
tio
bu
i
str
di
We’ve found that simply avoiding a handful
of mistakes and heeding a few red flags
fo
P
t
in
sold a slew of companies at the top of
the market, closed a new fund while
investors still had cash, and avoided
catching falling knives in 2008 even as many
firms got burned
after diving
into theabout
turneople don’t
make movies
around market
too sails
early.across
Now that
for
smooth
the knack
Atlantic,
timing is going
to
get
a
serious
test,
with
KPS
peace negotiations or sleepy SunCapital sitting
onDisaster
more dry and
powder
than sell,
ever
days.
drama
before despite
an
ostensibly
improving
econso we thought we’d share some
omy
and a rebound in the credit markets.
of
ours.
Limited
Newequity
York-based
When
all partners
goes well,give
ourthe
private
work
turnaround
shop
the
benefit
of
the
doubt,
in
does not capture headlines. We
make
part
because
of
its
previous
foresight.
KPS
companies bigger and better. We create jobs.
Capital
took superior
advantage
of what
out to
We
generate
returns
for turned
our investors.
be
a
bubble
in
valuations,
selling
eight
of 11
All that’s been true for The Riverside Company
portfolio
companies
by
August
2007.
“We
are
since 1988, and we remain a leader in the
selling
everything
that
isn’t
nailed
to
the
floor
smaller end of the middle market. Through 23
at
prices
that business,
are between
stunning
years
in this
we’ve
exitedand
64
inconceivable,”
Michael
Psaros,
a
managing
platforms and their corresponding
67 addpartner
at theafirm,
told The
WallIRR
Streetand
Journal
in
ons,
realizing
53 percent
gross
a 3.5x
May
2007.
Partly
as
a
result,
the
firm’s
vintage
gross cash-on-cash return.
2003
$404 million
KPS had
Special
Nonetheless,
we’ve
our Situations
share of
Fund
II
LP
has
generated
a
morecapital
than
reminders that we’re in the risk
respectable
1.9x
investment
multiple
as
of
business. These deals are a form of costly
March
31
for
the
California
Public
Employees’
tuition during our decades of schooling in
Retirement
System.
private equity,
and their lessons are invaluable.
Indeed,
Capital’s limited
partner
To make sureKPS
our employees
all see how
some
meeting
in
November
2007
marked
a
heady
of our worst deals went south, we came
up
time
for the firm
and
investors.
The firm
with “Lessons
From
theits
Loo”
for our crappiest
had just
raised,
in less than process
four months,
$1.2
deals.
This
introspective
involves
billion
for
its
third
fund,
which
has
since
dissecting our losers, analyzing them
been upsized
by an
additional
$800
million.
internally,
talking
about
them with
each
other
The
economy
was
sliding
into
a
recession,
and our investors—all in an effort to learn and
andtransparent.
the firm’s investors were giddy with deal
be
prospects
forproudly
the firm.
Butprofiles
what they
then
While we
post
of more
heard
from
Psaros
wasn’t
at
all
what
than 55 solid exits throughout ourthey
20
expected:
offices,
weKPS
alsoCapital
had todidn’t
find aexpect
home to
fordo
thea
single we’d
deal in
2008,forget.
believing
the weakdeals
rather
So that
we put
them
est
companies
would
be
the
ones
to
fail
where they belong—in the restroom,
onfirst.
the
“Had
they
puta deal
money
work for
before
wall.
Each
time
hastosoured
us,
the bottom
fell examined
out, they’dwhat
probably
lickwe’ve
carefully
went be
wrong.
something was wrong but the fraud was so sophisticated that it took us a year to uncover it!
compensated. The company would have faced
serious challenges if the transaction failed to
www.buyoutsnews.com
October 17, 2011 | BUYOUTS
GUEST ARTICLE
masked the company’s non-cyclical reasons for
underperformance. Hence, what we thought
was a relatively low multiple price became a
clear lesson: Low multiples don’t guarantee
success, but may guarantee failure. Our biggest
takeaway from this deal, however, was to
avoid companies with declining sales. Such
deals have rarely been kind to us.
3) Change Managers When Necessary
Pr
close. The company saw a lot of turnover in
senior personnel and lenders—they obviously
smelled something. The company had
increasing supplier and customer concentration, and its fast growth allowed problems to
be hidden. Perhaps most telling, they placed
restrictions on talking to individuals
throughout the organization during the due
diligence.
On the accounting side, the company engaged
in complex transactions and had complicated
organizational structures. They created
financials “offline” or delivered them in PDF
format with excessive adjusting entries. And it
always took a long time to get them to us.
This deal solidified our belief that values
matter. We strive to do business as ethically
as possible, and we look for the same in
prospective sellers. While we’ve never seen
fraud perpetrated on such a scale since,
we’ve avoided plenty of fishy deals thanks to
a much stronger fundamental approach.
And we created a checklist called the “Profile
for Indicators of Fraud” which we now use
during every due diligence process. Our own
systems, people, and processes are improving
every day. We require that all prospective acquisitions allow us to spend at least three
days on site with unfettered access to
systems, files, employees, and facilities.
These safeguards have strengthened our
entire diligence process and made us better
buyers. Because it can be so hard to detect,
though, fraud is still the biggest issue that
keeps us up at night.
ed
t
in
py
co
If management is bad or mediocre, change
it. Now! When you do change managers, pay
up for the best talent possible. On more than
140 platform deals, we have changed CEOs approximately two-thirds of the time, and CFOs
75 percent of the time. We’ve never felt that
we moved too quickly, but we’ve often
lamented that we should have moved sooner.
In one case, an outstanding CEO declined to
remain on board and co-invest in the deal. This
should have been a message. Instead, we
started with a weak management team led by
an internal sales manager who was unfit for
a CEO role. At the end of Riverside’s long and
fruitless ownership, there had been three
CEOs, three CFOs, and two law firms. We
could never build a coherent and successful
strategy due to all the movement at the top.
As a result, a promising investment consumed
years of staff time and resources while
producing a small loss.
If you know you have to replace an
executive, do it right away. We now use
interim CEOs and CFOs when necessary,
relying heavily on our internal operating
partners and outside directors, and we search
for the best people possible, paying top dollar
whenever required. Choosing and incentivizing the right management is still the single
most important thing we do.
na
so
er
rp
ng
di
ea
lr
ly
on
or
tf
no
5) Sell When You Can
We’re in the business of maximizing investor
returns. It’s risky, and our investors can earn
small returns on plenty of safer investments.
You always think you can squeeze a bit more
value out of a deal, even if it might be a lemon.
We’ve found that if a deal is underperforming
after two or three years of ownership and a
buyer comes along offering a reasonable price,
it’s often best to get out right then and there.
We have finite resources, so hanging on to
middling performers is a waste of time and
money. Several of our deals that have lost
money could have been exited for a gain at one
time, but we were greedy and in retrospect not
as smart as we could have been.
We’ve taken steps to boost our exit process,
most notably with the Riverside Realization
Review. We developed this recently, after we
underexited during the last bubble. The
process forces us to justify not selling, rather
than waiting for the “right time” or the perfect
buyer. It’s already helped us to kick start exit
processes several times this year.
n!
We’re not suggesting that you can wish away
market fluctuations or avoid every pitfall. This
is about controlling the things you can, like:
• Avoiding businesses where you have no
control over key third parties. We once
acquired a company that received 75 percent
of its inventory from one source. Whenever
that supplier had quality problems, they
became ours. When they dumped inventory
or raised prices, it wrought havoc on our
company. In the end, the supplier situation
contributed to a poor performance with
the investment.
Changing IT systems. One of our
•
companies went through an IT implementation shortly after acquisition and just got it all
wrong. For awhile the company was
completely unable to track performance
tio
4) Never Lose Control
bu
i
str
di
The investment world attracts confident and
competitive people. There’s a fine line between
those attributes and hubris. Many a general
partner has lost money thinking they could fix
fundamental problems at a company. We’re no
different. We once bought a leading company
with strong market share in an industry with
high barriers to entry. Better still, the company’s
strong management team had grown EBITDA
despite a cyclical industry downturn—all while
integrating four add-ons. We paid what we
thought was a favorable price, knowing that
there was a lot of room for operational improvements, industry consolidation and other trends
favorable to the investment.
Then sales continued to decline. There were
issues with management. In the end, we had
to make more space on the bathroom wall. So
what went wrong?
Well, we learned the hard way that market
leadership is not worth much when the
industry is unpredictable and low-margin. In
this case, the down cycle in the industry
fo
2) Down Cycles Are No Excuse
indicators and was flying blind! The system had
problems that directly affected customers
and the bottom line, including inaccurate
inventory management, tardy product
shipment, and billing errors.
Costs. Especially at the start of a
•
downturn it’s crucial to cut expenses
sooner rather than later. Often the
management team that did well during
the good times is reluctant to cut when
sales start to head south. Over the years,
we’ve built a large operating team to help
management teams address these issues. At
the same time, we’ve built the Riverside
Toolkit, a group of more than 20 vetted
resources that helps our portfolio become
more effective in crucial areas like sales,
manufacturing, and pricing.
6) Be Committed To Making Mistakes
These painful lessons do not represent our
biggest mistake—we’re saving that for its
very own guest article in 2012—but they do
represent mistakes from which we’ve learned
and improved. As we said, we’re in the risk
capital business, and we would not have been
able to produce 23 years worth of superior
returns while helping so many companies
thrive if we never made a mistake. In a sense,
we’re committed to making new and different
mistakes in the future, continuing to learn, and
becoming even better investors. ❖
Stewart Kohl and Béla Szigethy are co-CEOs
of The Riverside Company.
(#70794) Reprinted with permission from the October 17, 2011 issue of Thomson Reuters Buyouts. Copyright 2011 Thomson Reuters.
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