The Wall Street Journal today gently, oh so gently, prods the likes of Sun Capital Partners. Because it annoyed me, the takeover of Dow Jones easily becomes the focus in my causal searches for very real declines in Wall Street Journal quality, and my sense that they "go easy" on their subjects (even when the topic really calls for a good impaling) is just as strong now as it was last week. Why they have elected to spare Sun Capital- floundering, as it is, in an emulsion of ennui and leverage- some much needed scorn is somewhat beyond me.
The Journal does hit some of the key flaws that have plagued Sun (and many other buyout firms) but where they touch the wound and issue soft, almost cooing "tut tut tut"'s, I would call for the retractor. To wit:
Sun remains active in the deal market. Last month it made its biggest investment ever, paying $542 million for apparel maker Kellwood Co.
The wilting economy hurts Sun's companies, but also offers more bargains on ailing businesses. "This is a phenomenal environment in which to invest," says Mr. Leder, but it "requires a strong stomach."
Someone must own stock in a pig lipstick company. The reality is that firms like Sun have been victims of their own overreaching and the nature of the incentive structures and fund raising cycles in private equity. Given my views on the nature of human nature...
Man is basically lazy. Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior). Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.
...even the novice Going Private reader will understand my focus on incentive structures (both designed and resulting from unintended consequence) and the behaviors that they, well, incentivize. As such, it should be easy to see why the only prompting I need to start shaking my head is the "management fee" section in Sun Capital Partner's Private Placement Memorandum.
I have pointed out before that the purpose of a management fee is supposed to be infrastructure support, not a profit center, and that, one would think, infrastructure costs for a fund like Sun Capital would not scale linearly with capital under management.
We can hardly blame the likes of Sun Capital for endeavoring to raise ever larger and larger funds. But we might look skeptically at any firm that jumps its assets under management 400% from one fund to the next. Perhaps it was a sign of excessive growth, that a firm that made its best returns, even recently, investing in slices under $25 million, was raising $6 billion last year.
I remember this period. It is right about when teasers for three or four companies that had barely been owned by a certain brightly glowing parent (who shall remain nameless) for 12-18 months, landed on the desks of our Business Development folk. Too small now. They wanted out fast to concentrate on larger things. No time to manage these anymore.
More than half of the revenue from Sun's 75 companies comes from retailers, restaurants or auto businesses -- all cyclical industries that depend on ever-fragile consumer-spending levels.
Serious over-concentration in cyclicals...
Sun attracted wider notice when it closed a $6 billion fund last spring, four times the size of its previous one.
...with a necessary reduction in quality filters and increase in investment size to accommodate a much larger swath of money...
While private-equity firms protest they are not into "financial engineering," Sun embraces the concept.
...returns highly correlated to financial engineering...
Because Sun often puts little money into its deals, a single successful investment can generate huge upside.
Like other buyout shops, Sun has departed from its core buyout strategy. It launched a stock-picking vehicle in 2004. Sun Capital Securities Fund applies its turnaround expertise to the stock market, buying stakes in ailing public companies.
...with a shift from core strategy of turnaround and control investments, results in...
Private equity firms should be turn around shops. But there are limits. And those sit below $6 billion funds, and the skills required to succeed seem to contraindicate PIPE transactions and long-short equity strategies. Why should this surprise us? Looking at small underperformers and identifying problems that invite control investment and an active parent simply doesn't prepare you for value investing in public equities.
"We were on the board but were not operationally involved," Mr. Leder says. "It was just a bad stock pick."
I think it was more than that, Mr. Leder.