Private Equity: Better Times Ahead

July 22, 2009 · 1 Comment

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By Neil A. Martin (Barron’s)

John K. Castle knows a good deal when he sees one. In 1995, the chairman and chief executive of Castle Harlan, a New York private-equity firm, spied an advertisement for a beach house in Palm Beach, Fla., that had served for six decades as the vacation home of the Kennedy clan and once was President John F. Kennedy’s winter White House. Castle paid $4.9 million for the aging, walled Mediterranean estate, which had been listed for $7.9 million, and poured in another $6 million renovating it. Even in today’s stressed real-estate market, it’s conservatively worth perhaps five times what Castle has invested in it. Not a bad return.

“It was basically a distressed asset when I bought it, but its history and setting, including 200-foot ocean frontage, makes it very valuable — and we are value investors,” says the 68-year-old Castle, who had been CEO of Donaldson Lufkin & Jenrette before establishing Castle Harlan in late 1987.

Over his firm’s 22-year history, it has raised more than $3.9 billion in equity capital and completed more than $9.6 billion in acquisitions. The 10 companies in the private-equity outfit’s current portfolio employ more than 39,000 employees and last year had a combined $5.3 billion in sales and $440 million in cash flow (as measured by EBITDA — earnings before interest, taxes, depreciation and amortization).

Among those holdings: Morton’s steakhouses, Perkins & Marie Callender’s restaurants and bakeries, malt producer United Malt Holdings and book distributor Baker & Taylor. Since its establishment, Castle Harlan Funds have generated a 20.5% annual return on realized investments.

With markets in turmoil, Castle was on the sidelines over the past two years, but he now sees opportunities. To learn where’s he’s prospecting, read on.

Barron’s: Why would anyone want to invest in a private-equity deal in the current economic environment?

Castle: Because things are cheaper, for one thing. Prices for private companies are down substantially, perhaps 30% or more, versus two years ago. Furthermore, sellers are frequently being forced to sell premium assets because they may be overleveraged. And they might not be able to deal with it by selling second-tier businesses. So a private acquirer can frequently buy better companies at much lower prices than in normal times. Certainly, this was what I experienced in the difficult economies of the mid-1970s, 1987, early 1990s and 2001 through 2002. Deals may be fewer than they were two or three years ago because today’s sellers are generally limited to parties that have some level of distress, but it is a time of opportunity.

Where do your funds get their investment money from?

Our investment funds are limited partnerships that include public and corporate pension funds, endowments and other institutional investors and affiliated individuals as participants. The minimum investment is $5 million. There is definitely less money around today — less for equity investment, less money for financing. This financial crisis has wiped out a quarter of the world’s wealth. It has been more ubiquitous than at any other time in my career. Back in the 1970s, there were huge losses in securities markets, but there were princes and sheiks in the Middle East selling oil which was doing better than ever. But this crisis has affected everyone.

What about the cost of capital?

In this current environment, the cost and availability of debt capital for leveraged buyouts is much more challenging than they were two or three years ago. In part, this is the reason purchase prices are down so materially.

What are investors demanding now?

Investors are expecting much better investment performance for money that they commit in times like these. My own experience is that they will get it. Whether in the mid-1970s, 1987, the early 1990s or 2001-2002, investments made in difficult times have resulted in outstanding returns to investors.

With this tough economic backdrop, how has your business been doing?

Things have been tough, but our funds have performed well. Castle Harlan Partners IV, currently our most active fund with assets of about $1 billion, was up 3% last year, which compared to most investment classes is very good. So, on a relative basis, we’ve done well, but that isn’t to say that this has been a real easy year for money that is already invested. The opportunity here is for investing in new assets. This is going to be an extremely attractive time, going forward, to make new commitments.

How many partnerships do you have at present?

We have five domestic partnerships, and we also have three offshore partnerships, mostly in Australia. We have joined forces with one of Australia’s leading private-investment concerns to create Champ — which stands for Castle Harlan Australian Mezzanine Partners. Together, the two firms employ nearly four dozen investment professionals.

Are the five domestic partnerships open to investors?

Three are. One is nearly fully invested, so practically speaking, it isn’t really open to new investors. And the fifth has no investments yet and is available for new deals. Investors are making commitments to the funds, and we are looking at a lot of transactions right now.

We have a substantial amount of investment capital on hand and are ready to commit it for the right deal. The equities monies that are immediately deployable are a little over $700 million. But that would probably translate into at least a couple of billion dollars worth of transactions.

What kind of companies are you interested in?

We take a very disciplined approach and focus almost exclusively on control positions in middle-market private companies. We believe that achieving above-average returns requires investing at sensible prices in companies that offer opportunities for solid, attainable growth. Our goal is to expand and improve the companies we acquire, sometimes modifying and enlarging their market presence through add-on acquisitions.

Why the middle market?

We’ve done studies that indicate that there are probably as many as 60,000 companies in the United States that are in our mid-market area. If you try to do megabillion-dollar deals, the number of transactions that can be done are far more limited. The Fortune 500 starts at about $3 billion or $4 billion of annual revenue. So you are talking about just 500 possibilities. Maybe there are a few more, but it’s not 60,000. We like a bigger pool. We think the mid-market is a less efficient area, and so there is far more likelihood that we can identify a property that has solid value there.

Can you give us an example of that philosophy in action?

Of course. In July 2004, our Castle Harlan Partners IV fund acquired Horizon Lines [ticker: HRZ] for $650 million. Originally Sea-Land, which pioneered the container-shipping industry and later CSX, Horizon is the leading Jones Act shipping line between mainland U.S. ports and Alaska, Puerto Rico, Hawaii and Guam.

What’s the Jones Act?

It was a law enacted in the 1920s requiring that maritime trade between U.S. ports be conducted by American-owned and incorporated companies that use ships built and registered in the U.S. Because Coast Guard and Jones Act regulations also set strict safety and service standards that most shipping companies can’t meet, only a few serve these Jones Act markets. That provided Horizon with a strong niche-market position.

We felt that this, coupled with the operational excellence and bottom-line orientation of management, offered solid growth opportunities. We sold it about a year and a half ago, and we were able to make 3.2 times our investment and achieved a 115% compound return by carefully executing our business plan.

What’s been your main focus?

We’ve always focused on doing buyouts, which means that you are buying companies that are established, have established cash flows and a business history. We’ve focused on companies that have had moderate growth.

Our plan is to make them grow a little more rapidly. Instead of growing 3% to 5%, we can make them grow 8% to 10%. We can do some strategic things. We can do some acquisitions. We can do some development of new products and so forth to make them grow a bit more rapidly. We have always focused on value in our activities.

How much are you willing to pay?

Generally, we want to buy companies at less than 6½ times EBITDA. Sometimes, we go a little bit above that, but we are pretty disciplined in our value approach.

Where are the opportunities now?

I am salivating at the opportunities that I see coming forth here, probably over the next couple of years. Among the businesses that we might look at would be manufacturers, perhaps certain kinds of specialty chemical companies. Historically, we have sometimes invested in restaurants. People have to eat and, in many cases, restaurants sell at a lower multiple than an equivalent company in some other area.

How many deals might you be involved in at any given time?

In a given year, we are likely to look at 1,000 deals. Out of that, we’re likely to end up doing, at most, a handful.

You were pretty much on the sidelines during 2007 and 2008. Do you see an uptick in activity this year?

If you look at last fall and early winter, there was so much chaos [in the markets and economy] that most people were kind of hiding in their bunkers. Now, as the explosions stop, they’ll come out and say: ‘OK, here is where I am. This is the mess I’m in, and how do I deal with this? And maybe if I can sell this, I can put together the money that will pull everything else together.’ Or, ‘having lived through this war, I don’t want to live through any more wars. Let me out of here.’ My guess is that things will kind of start to get sorted out, and that, over the next 12 months, a lot of things will start happening.

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Tagged: castle harlan, john castle, Value Investing

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