Rising Sun

When Marc Leder and Rodger Krouse first set out to raise a third-party fund in 2000, they were brimming with ambition, but lacked the investor relations smoothness that general partners generally acquire through repeat fundraisings. A limited partner who eventually signed on to the first Sun Capital Partners fund remembers his initial meeting with Leder and Krouse. “They were wandering around the Street; they'd never raised a fund before. These two guys with bright eyes wandered into our door and said they wanted to be the KKR of the distressed world.”

Just six years later, it's hard to judge whether Sun Capital is the Kohlberg Kravis Roberts of distressed, or the Bain Capital of turnarounds, or the Clayton Dubilier & Rice of underperforming companies. More importantly, Leder and Krouse don't need to point to a major private equity franchise to explain what they do – Sun Capital has already established itself as a major and permanent new private equity franchise, and one that is set to continue expanding. In the meantime, mainstream buyout firms are scrambling to retool themselves to better resemble Sun Capital's operations-intensive model.

Even by the standards of today's frenzied fundraising environment, Sun Capital's rapid expansion, in terms of capital under management, strategy and geography, has especially impressed market observers. The result of Leder's and Krause's initial “wanderings” around Wall Street was a $200 million fund called Sun Capital Partners II, closed in 2001. Two years later, the firm raised a $500 million fund. Last year, the firm raised a $1.5 billion fund, having set out with a $1 billion target (the fund drew $3.6 billion in LP interest). So far that fund has completed 18 platform and add-on deals.

The firm also manages a $1.3 billion fund – Sun Capital Securities – that makes non-control debt and equity investments.

The Boca Raton, Florida-based firm has begun investing across Western Europe from a London office, and last March it opened a sourcing office in Shenzhen, China. The firm is also planning to announce an office in Tokyo from which it will pursue investments in underperforming companies across Japan.

In all, the firm has nearly 110 professionals among transactions, operations and back-office staff. And the firm continues to hire.

In a recent interview at the firm's New York office, Krouse, by his own account the more “reserved” of the two Sun Capital founders, chuckles modestly when asked what the firm's further expansions plans are. “We take it one day at a time,” he says, adding, “we have grown very quickly taking it one day at a time.”

FAILED STRATEGY'
The success of Sun Capital Partners began when Leder and Krouse met as 18-year-old students at the University of Pennsylvania's prestigious Whart on undergraduate programme in business. The two ended up at Lehman Brothers, where a friendship and “mutual respect” grew, says Krouse, who worked in corporate while Leder concentrated on retail investment banking.

An associate describes Leder and Krouse of having an “unusual partnership” because of their “opposite personalities”, with Leder being more upbeat and outspoken, while Krouse is more measured and often deep in a book. Krouse admits that in a certain light, he might be viewed as the more pessimistic of the two. “Of course, I would say that Marc's the optimist and I'm the realist,” he deadpans.

At Lehman, the two developed a desire to do something entrepreneurial, and in 1995 set their sights on the rapidly growing private equity market. They were both senior vice presidents at the time.

After two years of getting no deals done, we realised we had to change course

Rodger Krouse

Setting aside the attraction of Florida's warm weather, Leder and Krouse say they become intrigued by this state as a base because, while it was host to financial services firms of many stripes, Florida and the US Southeast in general had comparatively few private equity firms. (The firm started out in West Palm Beach and later relocated to Boca Raton, a sort of Greenwich-of-the-South because of its many securities firms and hedge funds).

“Originally we wanted to be a regional private equity firm,” says Krouse. “We knew even in 1995 that it was important to have a niche because the field was getting crowded. We thought that a Southeastern specialty would be a good niche and that we'd find interesting opportunities on the radar screen there.”

The founders of Sun Capital now refer to that initial step as “our failed strategy”. Leder and Krouse found opportunities to invest in the Southeast, but so did the many private equity firms based in New York and elsewhere who would swoop down to bid on companies. “We thought we would find things at what we felt were reasonable prices,” remembers Krouse. “I think we underestimated how many people were going to come in and pay what we felt were big prices for little companies. After two years of getting no deals done, we realised we had to change course.”

Sun Capital's first acquisition was of a small, troubled company called Atlas Papers. Similar deals followed. After four years, Leder and Krouse had acquired 9 companies. The portfolio did not have a Southeastern bias, but all of the companies had been bought out of varying degrees of trouble.

One of the early deals completed by Sun Capital was the acquisition of Labtec, a Washington-state maker of speakers for personal computers. At the time, the company was the number-one maker of PC audio products, but its sales were flat due in part to what Leder and Krouse saw as a stale line of products. The private equity firm bought a majority of Labtec for approximately $40 million, after which it replaced the entire senior management team (a spokesperson for Sun Capital estimates that today the firm replaces management in about one-third of its transactions, most often among the sales and marketing executives).

Sun Capital added on two complementary businesses to Labtec, which increased the revenues of the new company and also helped it go from introducing ten new products per year to rolling out more than 50 per year, with new products spending less than six months in development time. The company's EBITDA went from $5.4 million in 1997 to $14.3 million in 2000. The next year Sun Capital sold Labtec to Logitech International for $125 million.

OPERATING MODEL
In focusing their attentions on underperforming companies, Leder and Krouse gradually developed the resources-intensive platform that today separates Sun Capital from other private equity firms.

The firm has on staff 18 operating professionals. Many of these staff members worked at a Sun Capital portfolio company prior to joining the firm full time.

Not counting back-office legal, accounting and corporate staff, Sun Capital has 76 investment professionals on transactions and operations teams. Pooling together the firm's most recent control and non-control funds, this places the 76 professionals in charge of roughly $2.8 billion in investor commitments, or roughly $37 million per professional. A study based on the same methodology conducted last year by sister publication Private Equity Manager found that the average private equity firm has on staff one investment professional per $95.75 million. Bain Capital, known for a resource-intensive approach to large buyouts, had one professional per every $55 million, according to the study.

What this means is that Sun Capital deals get swarmed by Sun Capital people. This doesn't come cheap. An LP in all of the Sun Capital funds says the firm charges a “slightly higher management fee, but you'd expect that” given the head-count at the firm. In addition, the firm charges a quarterly management fee to its portfolio companies.

If a company has been lethargic, how do you get management to feel like winners, not losers?

Marc Leder

Leder says his firm's approach to helping portfolio companies is “so far from cookie cutter – not much is atypical for Sun Capital.” But when it comes to monitoring the performance of portfolio companies, the firm has instituted an intensive regime that begins before the acquisition has even been finalised.

“There tends to be an inverse relationship between the space of time a company takes to report results and the results themselves,” notes Leder. “Troubled companies tend to hold numbers when they are bad.”

To counter this foible of management behavior, Sun Capital requires that all of its companies submit a “flash report” to the private equity owners each week, and a monthly profit and loss report within five days after the end of each month.

More often than not, Sun Capital will “coach” incumbent management team members out of whatever rut they find themselves in. Managers must travel to Boca Raton every four to six weeks for an executive meeting to review the company's operating plan.

Leder and Krouse rely heavily on their stable of seasoned operating executives, who tailor rejuvenation plans to the individual companies. “The crucial task is, how do you change the culture of the company?” says Leder. “If a company has been lethargic, how do you get management to feel like winners, not losers?”

Having acquired more than 125 companies since 1995, the founders of Sun Capital do see recurring themes as to why the companies are in trouble, but stress that each case is different. “There are many different reasons for problems at a company,” says Krouse. “It could be the wrong ownership and the management team otherwise is doing the right job. It could be the current management team made a mistake, but they've learned from it and we continue to work with them. Often we come to a business after there's been a management change, and the new group is doing well but is running out of liquidity. Sometimes we are faced with businesses that have no management team.”

Krouse says his firm has found that the most difficult problem to fix is declining revenues, while cutting excess costs is “the most straightforward thing to do”.

Only nine of the firm's deals have been purchased out of bankruptcy, says a spokesperson. Roughly double that number were bankrupt within a year prior to Sun Capital's acquisition.

Sun Capital will buy companies in almost any industry with as little as $50 million in revenue and as much as $5 billion (for now). “What speaks to our niche is the condition the company is in,” says Krouse. “We still focus on smaller transactions, but we've expanded on the upper side. We've found that we've been able to do more transactions in a controlled manner so that we don't have to abandon the smaller ones.”

Sun Capital sees far more opportunities than it acts on, although the firm promises in its marketing material to respond in a timely, discreet and professional manner to all inquiries. The answer is usually “no thank you”. As Krouse puts it: “Most of the companies that are dying should be dying. What is important to us is to recognize the five out of 100 that can and should be saved and that will allow us to make our returns.”

One capability that Sun Capital is not shy of broadcasting to the market is its ability to close deals quickly – in under 30 days. This is partly the result of the many resources it brings to bear in vetting and negotiating a transaction, and to its ability to bridge the entire purchase price of a deal at closing and arrange for external financing later.

For example, in the case of Sun Capital's acquisition last year of New Jersey drug store chain Drug Fair, Sun Capital initially met with management on November 10 and closed the deal 15 business days later on December 1.

Most of Sun Capital's deals have been successes, but when dealing with troubled companies, any firm is bound to occasionally buy into a business that is more troubled than expected. A spokesperson for the firm estimates that roughly nine percent of the firm's capital has been “wiped out” in unfortunate cases like these. This is, he adds, consistent with other distressed-focused firms as well as most LBO firms that focus on healthy companies. “We're buying high-beta deals,” he says.

One of Sun Capital's highest-profile wipeouts has been Musicland, a chain of home entertainment retail shops that the firm bought from Best Buy in 2003. Musicland filed for bankruptcy earlier this year and subsequently agreed to sell its assets to Trans World Entertainment. Sun Capital no longer lists it as a portfolio company on its website.

SUN NEVER SETS
Sun Capital opened its New York office in 2002 and has since then opened offices in Los Angeles and London. “We hadn't expected initially to be international,” says Krouse. “We have just found that there are so few people in our specialty niche that we started seeing opportunities from abroad without soliciting them.”

From its London office, Sun Capital has closed platform deals in the UK, France and Germany, and has closed add-on acquisitions in many other European countries.

As few competitors as they have in the States, they'll run into even less competition overseas

Rodger Krouse

Earlier this year the firm opened its China office not to source underperforming companies, but rather to source products and services for its North American and European portfolio companies. Heading the Shenzhen location is David Stokoe, who formerly was president of JTECH Communications, a Sun Capital portfolio company, and prior to that was director of Asian operations for UK production control conglomerate Invensys Sensor Systems.

Interestingly, Krouse speaks fluent Mandarin Chinese, a skill sharpened during his Lehman days, when one of his clients was a shipping conglomerate run by the Hong Kong- and Taiwan-based Tung family.

Although the firm has not officially announced it yet, Sun Capital is planning to open an office in Tokyo to pursue its brand of turnaround investing throughout Japan. Six months ago the firm hired Shigeru Utsugi, who will officially launch the firm's Japan operations in December. Utsugi began his career in private equity through Whitney & Company, a Connecticut private equity firm that created what eventually became East Point Capital Management in Japan. Utsugi then worked for a private equity arm of Mizuho Banking Group before joining Sun Capital this year.

Leder and Krouse are circumspect about the cultural and legal differences outside of the US, but are confident that their model works across borders. “There is a certain amount of education that is required,” Krouse says serenely.

Sun Capital's LPs are crazy about the platform that Leder and Krouse have built. An endowment manager says Sun Capital stands out in a market that is flooded with capital because it directly competes with very few other groups. “They have an appetite and skill set to do difficult deals,” he says. “There's very few corporate buyers really interested in buying and turning around underperformers.”

On the firm's global expansion plans and increasing deal sizes, the endowment manager is as confident in the Sun Capital system as are Leder and Krouse. “Right from the beginning we were impressed at how defined their process was and how fast they move. They have a process that allows them to look at a lot of deals and work a lot of deals. And as few competitors as they have in the States, they'll run into even less competition overseas.”

A separate LP notes that Sun Capital has benefited from three trends among investors – an increased demand for distressed funds, an increased demand for operating expertise, and an increased demand for specialised managers.

Throughout the growth and success of the firm, Leder and Krouse have maintained an “encyclopedic” knowledge of the details of their business. An associate recalls an incident two months ago where an accounting detail was about to be reported to LPs, but Leder, from memory, questioned its accuracy. It took meetings with two separate accountants to determine that the number was, in fact, wrong and Leder right.

Leder and Krouse also remain crazy about each other personally and professionally. The two agree “90 percent of the time” says Krouse. He adds that in an investment strategy that is by its very nature contrarian, having a partner who often sees an opportunity in a different light is crucial. If that person is a good friend, he says, a consensus tends to be reached all the quicker.

SUN CAPITAL PARTNERS MILESTONES
1983: Marc Leder and Rodger Krouse graduate from the University of Pennsylvania's Wharton School. The two end up working at Lehman Brothers and rise to the level of senior vice presidents.

1995: Leder and Krouse found Sun Capital in South Florida.

1996: The two make their first investment in Atlas Companies, a troubled maker of carbon paper and dyes.

1997: In October, Sun Capital buys Labtec, a computer speaker maker; in December the firm buys Nailite International, a siding products maker. Both deals prove extremely profitable for the firm.

2001: Sun Capital closes Sun Capital Partners II on $200 million.

2002: The firm opens a New York office.

2003: Sun Capital Partners III closes on $300 million in commitments.

2004: Sun Capital joins Cerberus, Lubert-Adler and Klaff Partners to buy Mervyn's department store from Target for $1.6 billion; the London office is launched.

2005: Sun European Partners buys UK van-maker LDV; the firm buys US retailer ShopKo for $877 million; Sun Capital Partners IV closes on $1.5 billion; the firm completes 30 acquisitions and 12 exits for the year.

January 2006: Fund I completed with a gross IRR of 71 percent, or 7 times cash invested.

March 2006: Sun Capital Securities fund reaches $1.3 billion; the firm opens a sourcing office in Shenzhen, China

August 2006: Sun Capital buys Real Mex Restaurants, its 12th platform acquisition of the year.