This article is sponsored by L Catterton
For private equity firms, one of the most gratifying aspects of the PEI LP Perspectives Survey is just how supportive investors are of the way that GPs are investing their funds. Of the LPs surveyed, 69 percent say they think that GPs have allocated capital at an “appropriate rate” in the last 12 months, and when asked about “style drift”, more than one-third of LPs say GPs are remaining disciplined and sticking to their investment thesis, and, of the rest, 55 percent saw just occasional style drift. Either way, LPs are more focused than ever on how GPs can add real and measurable “alpha” to their portfolios, and as a result, are increasingly focused on how GPs drive operational success, say Scott Dahnke, global co-chief executive officer at L Catterton, and Karen Gordon, managing partner of portfolio operations at L Catterton.
What do LPs want to know about operational value creation and how do you address the topic with investors?
Scott Dahnke: In today’s environment, with record levels of dry powder and significant access to relatively inexpensive financial leverage, LPs are increasingly seeking to understand the drivers of performance that will be consistent over time, regardless of the prevailing economic conditions.
We’re seeing LPs engaging more with GPs and portfolio companies, and asking for more data to understand the sources of the returns. Increasingly, LPs are looking for specific drivers of operational value creation in addition to how much of that return is being driven by earnings growth vs. multiple expansion and/or debt paydown. As an operationally focused GP, we love it when LPs are asking more about value creation from an operational perspective.
We tend not to use as much financial leverage as most others in the space, which means that our equity has to work harder. Better operating performance is therefore key to our ability to drive high risk-adjusted returns. Historically, roughly 80 percent of our value creation has been of an operational nature.
Karen Gordon: Our operating approach is highly replicable deal after deal, fund after fund, and we’re very proud of what we have built. We do our research and assess the value with respect to the execution risk. Our operational team brings relevant expertise in specialised operating disciplines, such as digital marketing, procurement and Six Sigma. The fact that the economy has been strong means there is more pressure on operating returns and more focus by LPs on operating returns. That is all good from our perspective.
Could you describe your operational value creation process?
SD: We’re category-first investors. We identify categories to target for investment based on identifiable consumer trends and then develop an investment thesis in those categories based on how we see competitive dynamics, consumer trends, and other forces playing out. We then partner with management and deploy our own resources to help the company execute that plan.
KG: This helps us to identify specific companies, and once we build a relationship with them we can jointly develop a value-creation thesis that’s right for that business, in that sector, that reflects current and projected consumer behaviour.
SD: At L Catterton, our operating and deal teams work together seamlessly to identify categories, develop an investment thesis in these categories, and conduct diligence for targeted portfolio opportunities. It’s two halves of the same brain.
How do you approach management teams?
SD: Our first interaction is rarely about a potential transaction. Most of the time, our first interaction is with a founder or C-level executive and starts with a conversation about the dynamics within the category that the business operates. We share data from our research and insight from our experience which helps entrepreneurs understand that we have value to contribute that can supplement what they already have in the organisation. Our detailed category work and research is a key differentiator.
Can you describe the methodology you use once you’ve made an investment?
KG: We believe we have a particularly powerful framework. We have a consistent approach to collaboration, to issue identification, to prioritisation, and a philosophy for how and where we deploy resources to drive higher levels of value creation.
The first step is to develop a value creation thesis very early in the diligence process. This ensures our team is aligned with management from the outset. Immediately upon deal closing, and sometimes earlier, we work together to get very specific about the initiatives that we want to drive, how those initiatives translate into value creation, what resources are required, and what milestones we should measure our progress against. We have a disciplined approach to creating KPIs that gives us visibility into the performance of the business overall.
This also allows us to project performance so we can respond to what is happening, predict what will happen, and plan for it proactively. At times, we will also dedicate our own internal team resources to drive certain initiatives and support their delivery.
SD: We’re investing in growth businesses across the consumer sector. At a high level, the drivers of value creation are similar across many of these companies, however the approach required to achieve the value is always bespoke. From that perspective, metaphorically, we are not walking around with a hammer looking for a nail – we have developed a broad tool kit that enables us to deploy the right tools for the job, in partnership with portfolio company leadership.
How much does being a sector-focused fund help you with operational value add?
SD: CEOs, boards, and even investment bankers are increasingly aware of our operational success in the consumer arena, and that proprietary edge helps us source deals that fit our skills. Given the competitive dynamic in the private equity space, founders and CEOs are increasingly asking what an investor offers beyond capital. Having the ability to bring case studies and relevant value creation examples to bear is powerful in winning investment opportunities. Further, our sector-specific expertise has helped cultivate a well-developed global network of industry relationships. There are myriad benefits from being a sector-focused fund and from having been a sector-focused fund for 30 years. We can’t imagine it any other way.
What do you expect in 2019 for the economy and private equity and can you explain how that may impact your investment thesis?
SD: We’re now 10 years into a five- to seven-year economic cycle, so every investment we make today is one in which we forecast a recession within the hold period of that investment. That doesn’t mean that we necessarily think a recession will happen in 2019 or in any specific time frame, but we would forecast some sort of pullback in the next few years. This impacts our underwriting, our capital structures, and our value creation plans.
We really do our homework and that’s a differentiator for us. Many of us including Karen and me have backgrounds at places such as McKinsey, BCG and Bain and know the value of data and research. As it relates to our investment focus, we are targeting areas where consumers are likely to continue to spend and prioritise. These are driven by secular and demographic trends, technological trends, geographic trends and socio-economic trends. While we expect that there may be some slowdown, we’re confident that if we pick a well-positioned company in an attractive and on-trend category and apply our unique capabilities, the investment will still do well.
When L Catterton invested in fifth-generation family-owned pet food manufacturer Ainsworth Pet Nutrition in May 2014, the consumer growth firm already had a deep knowledge of the pet products and natural pet food space. L Catterton sold Ainsworth to JM Smucker for $1.9 billion in April 2018. Earnings increased by more than 10- fold and on an unlevered basis L Catterton realized an 8x multiple to invested capital during the four-year hold. Ainsworth organically tripled its market share during the period. For their success with Ainsworth, PEI awarded L Catterton the 2018 Operational Excellence Award for the Upper Mid-Market in the Americas. This marked the second-time that L Catterton has garnered the award, having won in 2014 for their successful exit of Restoration Hardware.
What did you see in Ainsworth?
SD: We have watched the dynamics and tracked consumer trends within the pet food category over multiple decades – again, we do our homework. With Ainsworth, one of the opportunities we saw was to bring super premium pet-store quality products to food, drug and mass retailers and grow that in partnership with these retailers. In short, “pet store quality, supermarket easy”.
What was your focus once the company was purchased?
SD: We wanted to build the Nutrish brand in the food, drug, and mass market area. That focus led us, in partnership with management, to refocus and align virtually all assets of the business on Nutrish, from marketing and brand building, to product innovation, distribution, and retail strategies, all the way through to operations and operational efficiency. We increased consumer advertising spending in the business almost 10-fold in a period of four years. We worked with the company to write the first TV ad, which was award-winning. By the time we exited the business, we had invested more than $50 million in television advertising and social and digital advertising in support of the Nutrish brand.
Do you see other opportunities in the pet food space?
SD: Absolutely. The pet food business is exceptionally large, and consumer drivers remain strong. We have other investments in the pet space, both domestically and internationally, including Lily’s Kitchen, Just Food For Dogs, Canidae, and others. All these investments capitalise on our knowledge of these trends but in slightly different ways. We are also targeting a number of new investments in the space.