Interview – Ben Wallace with Azalea Capital (#2)
In recent years, there has been heightened interests from private equity firms in the lower middle market. In this market segment, companies are predominantly family/founder owned and privately held. With that, comes a variety of opportunities and challenges for a private equity owner.
Differences between lower mid-market and more mature businesses…
As you said, the lower middle market is largely comprised of smaller, family-owned businesses. We have a great deal of respect and admiration for the entrepreneurs who founded and built a company from scratch. A key difference in this segment of the market is that a business owner is often looking for a partner in the truest sense of that word – someone they can trust to bring into their business, someone who brings skills and perspectives they may not have, and someone who will carry on the legacy and reputation of their company. Larger middle market companies have often been owned one or more times by outside investors, and the “pride of ownership” may not be as present as when the company was smaller.
A common theme we see in smaller companies is that they are often managed to support a lifestyle, rather than to build long-term equity value. One approach isn’t necessarily better than the other, but the mentality and mode of operation can produce quite different results.
Companies that consistently generate $1 million+ in annual earnings can provide a nice lifestyle for an owner and their family, however, taking current income versus investing in future growth has consequences. As private equity investors we are tasked with providing a meaningful return on capital for our limited partners. Given the relatively short window of time we have to meet return expectations (typical hold period of 5 to 7 years), we usually must grow an investment two to three times its original revenues to accomplish our goals. This requires us to pro-actively manage risks while addressing the typical impediments to growth – the market, people, capital, and product/service offerings to successfully meet our investment objectives.
Each company is different, but many investments have similar issues centered around strategy and people – having the right person in place to properly execute mission critical activities. It’s less about the rate of change at the start and more about maintaining a steady cadence of continuous improvement throughout our involvement as investors.
What do you find missing from owner/founders that prevents them from scaling the business further (i.e. risk appetite, balance sheet, skills)?
Every situation is unique, but a few limiting characteristics of small, closely-held businesses include:
- Undeveloped long-term vision for the business or perhaps no clarity about the vision among key leaders
- Corporate governance or reporting disciplines tend to be inconsistent or inadequate
- Owners wearing too many “hats” – trying to lead sales, operations, and finance functions rather than investing in key management hires and delegating authority
- Information systems and operating processes and procedures usually need to be upgraded or improved
As an example, in 2003 we invested in a business called Power Equipment Maintenance (PEM) with entrepreneur Keith Ravan (owner/CEO). PEM was an industrial service business that maintained and repaired rotating equipment owned by major utilities to generate electricity. Keith grew PEM from a start-up to a profitable business with approximately $15 million in revenues. As is customary for a company that size, Keith was touching every aspect of the business on a regular basis – he was soliciting new business, quoting new projects, recruiting staff, overseeing the execution of work, and paying the bills and balancing the books in his spare time. Keith was limited by his own bandwidth and was too busy to properly develop a vision for what PEM could become with additional resources and capital.
PEM’s customers loved Keith and the company performed high quality work, but customers were concerned about what might happen if Keith was ever incapacitated. The constraints on PEM’s balance sheet also limited Keith’s ability to take on larger contracts. By recapitalizing the business, Azalea was able to provide Keith with immediate liquidity to help secure his personal financial plan and allow him to retain a significant equity stake in a properly funded growth vehicle. We were also able to build both breadth and depth with additional management talent and provide the working capital necessary to properly scale the business. As a result, the company grew to approximately $50 million in revenues in a period of 4 years and, competing against major international firms, was able to win a five-year, $50 million contract during our last year of ownership. The overall success of PEM enhanced their profile in the marketplace, which captured the attention of numerous strategic buyers that facilitated our exit.
By removing the constraints of people and capital, we empower small business owners to realize their full potential, while breaking as little glass as possible during the process.
What story do you tell LPs?
Our Limited Partners hear essentially the same story. Azalea’s role is to help unlock the potential value of small businesses, particularly those based in the Southeastern region of the U.S. We have been active in the lower middle market for over 20 years. Through our own direct outreach efforts and introductions from our network of advisors and intermediaries, we continue to uncover interesting and unique investment opportunities that form the base of our business.
We believe leadership is the key value driver within every company. That is the reason we are committed to partnering with proven industry executives whenever we are looking to make a new investment. This approach seems to be more common at the upper end of the middle market, but less so with lower middle market investors. We bring capital, strategic experience, and a sense of urgency to the table. When these are paired with a proven executive, the scope of opportunities for an investment is enhanced, while providing better overall risk management. These leaders usually co-invest with Azalea and either become an active Board member or the CEO leading the business.
Azalea’s operating executives bring:
- Deep industry experience
- A track record of success
- Industry relationships to immediately impact growth
- Experience building scalable operations and reporting processes
- Many have private equity experience (sense of urgency, accountability, etc.)
This is what we communicate to our investors – Azalea brings the disciplines of private equity to the lower middle market along with the value-added perspective of our operating executives. Our approach, from our LPs to the family companies we partner with, is anchored by the core values and culture of our firm, which emphasizes doing things the right way the first time and treating others the way we wish to be treated.
Presently, our investment focus is centered in the industries of Aerospace, Industrial Services, and Consumer Products. These sectors have strong overlap with our Southeastern U.S. footprint, and we believe they offer less cyclicality and provide sustainability from a macroeconomic standpoint.
How much involvement does Azalea have in its portfolio companies in addition to the operating partner?
This will vary based on the operating partner and the needs of the business, but it’s always collaborative. We prefer the operating partner and the management team to develop and articulate the strategy to us in a clear, coherent manner. Azalea can then focus on accountability and providing the capital resources necessary to achieve the plan. On occasion, the operating partner may have tremendous industry experience, but may have been running a much larger company. We try to ensure the strategy being pursued is aligned with the resources (people and processes) of a smaller but growth-oriented enterprise.
In the first 6-12 months, Azalea’s portfolio management lead is in regular contact with the CEO, usually weekly. After the strategy and team are in place, most of the interaction occurs at the monthly operating meetings and quarterly Board meetings, unless the CEO needs our perspective on a pending decision.
Can you think of a hurdle that Azalea can get comfortable with that might be an obstacle for other PE firms?
I think one of our best assets as a team is our willingness to listen to the whole story before rendering an investment decision. Some of our best investments came from a willingness to take our time to fully understand the opportunity or potential hidden value rather than just walking away at the sight of the first red flag.
For example, a few years ago we invested in a pizza crust company that had experienced flat revenues and minimal profitability for several years. The owner and founder had cobbled together a small group of shareholders, mostly friends and family, who had provided sufficient capital over several years to build capacity, but not enough capital to fill the capacity. Ultimately, deal fatigue and shareholders aging out led to a request for us to recapitalize the business. In assessing the opportunity, there was a significant disconnect between the value required to pay shareholders the amount of their investment versus the actual value of the company relative to its ability to generate cash. As a result, the effective investment multiple we were facing was in the mid-teens, which well exceeded the actual market multiple for comparable companies. The historical performance and the entry price would have turned away most traditional equity investors. However, the founder of this company had invested a tremendous amount of capital in manufacturing equipment and had enormous untapped capacity. In fact, there was enough capacity to triple the volume of production with minimal future capital expenditures. The company simply lacked the capital needed to fill their capacity as consumer product firms need to promote, market, and oftentimes pay slotting dollars to gain access to retail distribution.
If you were doing the typical private equity fly-by on the business, you would probably have passed over it. In recognizing the opportunity, we were able to bring an industry executive alongside us who could not only verify the available capacity, but more importantly provide the leadership necessary to develop and execute the strategy to rapidly grow the business. As a result, revenues more than tripled, while EBITDA grew more than ten-fold over a 5-year period, allowing us to realize a 7X multiple on our original investment.
It was an example of how we approach the lower middle market – patiently listening to the whole story, being sensitive to the objectives of owners, and partnering with experienced operators to help realize the untapped potential of the underlying business. We have made mistakes, but we have been very fortunate in developing and utilizing a broad network of executives who make us look far better than we would relying on our skillset alone.