Middle Market Growth - November/December 2018

NOV/DEC 2018

// THE OFFICIAL PUBLICATION OF ACG

DNS Capital’s

Family Values How relationships, humor and country music inform the family office’s approach

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FROM THE EDITOR

Direct Investing: The Next Big Thing?

I

KATHRYN MULLIGAN Editor in Chief, Middle Market Growth

nterest in purchasing operating businesses and co-investing alongside private equity firms is undeniably on the rise among groups that have traditionally invested as limited partners. The allure of longer investment time horizons, more control and fewer fees is strong, but it remains to be seen how this trend will play out over the long term.

Pension plans in Canada have employed a direct approach to investing for years, and some U.S. pension funds such as CalPERS are starting to adopt it, too. Sovereign wealth funds are also showing an interest in going direct, and they appear to have a growing appetite for growth-equity investments in disruptive companies.

Family offices are similarly attracted to buying companies directly, and it’s this group that stands to have the biggest impact on the middle market.

There are more than 3,000 family offices in the United States, and each one is different. But a growing number are investing directly in operating companies, a departure from traditional means of managing wealth. That’s good news for the middle market. Unlike pension systems and sovereign wealth funds, for which middle-market deals may be too small, midsize operating businesses often fall within a family office’s sweet spot. That has generated a fresh pool of capital to fuel middle-market growth, and as we explore in our trend story, there’s a cottage industry of advisers emerging to provide families with deal flow.

But is direct investing here to stay?

Sources tell Middle Market Growth that many family offices have embarked on direct investing strategies in the last decade as the U.S. economy performed well. And while most families generated their wealth through successfully running their own companies, an economic downturn could hamper the growth of their newly acquired businesses. The question remains whether families have the risk appetite and operational resources to steer a portfolio through tough economic times.

While working on this issue, I came across variations of the phrase: “When you’ve met one family office, you’ve met one family office.”

That distinctiveness surely applies to their long-term approach to direct investments—some will continue down this path while others will take a different direction after testing the waters. //

MIDDLE MARKET GROWTH // NOV/DEC 2018

1

EXECUTIVE SUMMARY

We Are Family

T

PAT MORRIS President & CEO, ACG Global

2

middlemarketgrowth.org

he fast-approaching holiday season is a time devoted to loved ones. And like the 1979 pop superhit by Sister Sledge, “We Are Family,” our final issue of Middle Market Growth for 2018 takes a look at families—specifically, family offices that are making investments directly into midsize companies.

ACG has recognized the growing role of family investment offices in the middle market. Chapters like ACG New York and ACG Los Angeles have launched initiatives that bring together members of this community and address the opportunities and challenges they face. As middle-market businesses continue to seek resources to expand, family offices present another source of capital to support their growth.

A thriving economy requires ample capital, but it also depends on pro-business laws and regulations. ACG has been at the forefront of advocating in this arena, meeting regularly with decision-makers to share with them the powerful story of the middle market and the jobs created by midsize businesses with support from private capital. In 2019 and beyond, engaging in dialogue with lawmakers and regulators in Washington, D.C., will continue to be a high priority for ACG. We look forward to working with new and returning members of Congress and telling them about the powerful economic contributions of the middle market.

As ACG members know, midsize companies are sources of job creation and innovation across industries, and our 2019 editorial calendar reflects that range. Our January/February issue will look at sports and recreation, and later in the year we’ll explore health care, fintech and software, and logistics and distribution. We’ll also delve into the broader themes of human capital, talent management and diversity.

Many members of the ACG family are involved in this publication—from sharing tips about innovative companies and insight into industry trends, to contributing content. We welcome your feedback and encourage you to reach out to share your tips, insight and suggestions as we plan future issues of MMG. //

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NOV/DEC 2018

DON’T MISS QUICK TAKES Sustainability at CalPERS 17

A QUALIFIED OPINION Perspective from the Family Office Exchange 18

POLICY POINTS Compliance Issues Facing PE Firms 32

IN THIS ISSUE From the Editor 1 Cover and above photo by Matthew Gilson

Executive

GROWTH STORY

DNS Capital’s Family Values Chicago-based family investment office DNS Capital invests directly in operating businesses, a growing trend among family offices. But in many ways, DNS is one of a kind. It prioritizes relationships and culture in its long-term partnerships, and its approach is tinged with humor, a reflection of the family behind the investment office. 20

Summary 2 Executive Suite 8 The Round 10 Vertical View 12 Midpoints by John Gabbert 14 Growth

TREND

Fostering Deal Flow for Families A new generation of advisers is emerging to

Economy 34 The Portfolio 37 ACG@Work 42 The Ladder 46

meet the growing demand for direct investments.

Rather than going to market with a traditional

It’s the Small

fund, these would-be middle-market GPs are

Things 48

instead launching family office advisory services and bringing individual deals to families. 28

4

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EXECUTIVE SUITE

Family Offices Embrace Direct Investing F What’s driving family offices

CLAUDINE COHEN Title: Principal, Transactional Advisory Services Practice Company: CohnReznick Location: New York Expertise: Drawing on over 20 years of business experience, Cohen advises public and private companies both domestically and internationally. Her clients include private equity investors, alternative investment funds, lenders and strategic investors.

8

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to embrace direct investment strategies and what changes are you seeing in the market?

A growing number of family offices that once invested as limited partners now are pursuing direct investment strategies to increase returns.

Reduced fees and expenses are a primary driver. Increased transparency, greater decision-making authority and control over the underlying investments are other drivers.

We have seen several family offices implement successful direct investing strategies and more are following suit.

Some operate their offices using a traditional private equity model, while others are far less sophisticated.

We have also started to see greater collaboration between family offices and independent sponsors. Additionally, family offices are increasingly working on “club deals” with other family offices. Unless a family office is prepared to build out a team and infrastructure, developing relationships with seasoned independent sponsors and other family offices is a good way to transition from limited partner to direct investor.

F What are the challenges

associated with direct investing?

Many family offices are conservative and risk-averse, especially when investing in industries they are not comfortable with. Understanding a target’s business model and putting the right team in place to complete a comprehensive due diligence process will help.

Another challenge is the time it takes to close a deal, in part because of families’ cautious nature. In a competitive market, this can be problematic.

The biggest question for families to ask is, “Are we prepared?”

The prudent thing to do is invest in resources and infrastructure needed to go direct. The need for a business development person, investment professionals and operational resources is often overlooked and families are unable to complete a transaction.

F What insight would you offer a

family office considering this strategy?

Families shouldn’t underestimate the resources required. They should have their eyes wide open and recognize that getting deals done takes significant time and effort. Ongoing monitoring of each investment is essential, and managing the portfolio also takes a lot of work. Embrace the due diligence process and don’t be scared to utilize outside consultants to navigate this process.

If a formal direct investing strategy is adopted, consider recruiting someone from private equity to help, as opposed to going it alone. If your family office has certain industry expertise, speak with representatives from that industry. Remember above all else: The direct investment on-ramp is a bit more involved than you may think. //

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THE ROUND

Co-CEOs: Are Two Heads Better Than One?

O Corinne Mason Principal Consultant, Summit Leadership Partners

ne day in the early ’90s, when I worked at a large telecommunications c­ ompany, I arrived at the office to major news. Two industry giants planned to merge, and for the first year, the two CEOs would lead the new company. I was skeptical it could work.

My instincts were correct. The leadership styles and company cultures were so different that the CEO partnership lasted only a few short weeks before one of the leaders left for an “early retirement.” It raised the question of whether co-leadership can ever work well in an organization, especially at the top.

In recent years, however, we’ve seen a co-leader model work extremely well at companies like Oracle, Whole Foods, Samsung and Chipotle. Whether pairing two CEOs, CEO and president, CEO and chairman, or CEO and founder, organizations are looking for ways to maximize capacity at the top.

CO-LEADERSHIP CAN BE A POWERFUL CONCEPT FOR COMPANIES L ­ OOKING TO TRANSFER POWER AND THOSE WANTING TO SCALE.

The need is clearly defined. In organizations

where the co-leader model works, there is clarity around why both leaders are necessary and how they contribute. The founder’s role may be to carry the torch of the corporate culture, history and brand, while the professional CEO leads strategy creation, and systems and leadership development. Chipotle is one example of this model. Shortly after its founder, Steve Ells, promoted then-COO and President Monty Moran to co-CEO, Chipotle’s annual earnings jumped 67 percent as the two combined their talents to develop a better operational system.

The leaders have differentiated roles. In most

cases, there are lines of demarcation between the co-leaders based on their skills and interests.

For example, one leader may be more operationally focused and manage the delivery functions of the organization; meanwhile, the other might be more commercially oriented and oversee marketing and sales. The organization should be structured so that staff reports to the appropriate leader based on the functions aligned with these skill sets. The co-leaders also must spend time together and jointly draw conclusions on strategy and direction for the organization.

What may be lost in efficiency is often gained back in broader problem-solving, strategic options and innovative thinking.

Decision-making powers have been negotiated.

The co-CEO model is rare, but it can work effectively with proper planning and execution.

Given the growing use of private equity and venture capital by companies, more founders and investors are intent on scaling the business with someone from the outside. Companies that find a way to include the founder and new CEO in a co-leadership structure seem to manage the transition best—under the right circumstances.

Here are a few key principles to help this leadership model work successfully:

10

middlemarketgrowth.org

Even in the best cases of collaborative co-leadership, there is still a need for mutually agreed-upon rules of order so that both leaders understand which decisions they own and those they must agree upon together. In the case of a tie, one of the co-leaders must have the right to make a final decision with no renegotiation.

These decision rights can be formal and informal, but in all cases, it must be clear who has the final say. The co-CEOs of the accelerator TechStars have said that knowing who has the

decision-making authority is crucial so that employees don’t feel obliged to get sign-off from both of them. Co-leaders often employ “what’s said here, stays here” rules that allow them to debate one another privately, but they always present a united front to the organization.

The executive team is supportive. In successful

co-leadership situations, the surrounding team supports the arrangement. Less productive outcomes can emerge if there are challenges to— or subversion of—one or both leaders. When members of the management team try to play the co-leaders off one another, the co-leaders must remain united and resist the temptation to become competitive.

For companies contemplating co-leadership, considering these principles in the change management and communications planning will help.

In situations where the co-leadership situation has evolved over time, it would benefit the organization to evaluate itself based on these principles to ensure the challenges have been managed effectively. Boards can also provide support and consider metrics to determine whether the co-leadership relationships are effective or not.

Annual 360-degree feedback for the co-CEOs is recommended to ensure key stakeholders such as investors, employees and customers are not confused or stuck between the two leaders.

While co-leadership may not become the preferred strategy for all organizations, it can be a powerful concept for companies looking to transfer power and those wanting to scale.

For those that take this approach, planning, role clarity and investment in the interpersonal dynamics between the two leaders can make a positive impact on the structure’s success.

Corinne Mason, Ph.D., is a principal consultant at Summit Leadership Partners LLC. She brings over 25 years of executive leadership and management consulting experience in the fields of assessment, executive coaching, leadership development, talent strategy, analytics and capability building.

REPORT

Shifting Preferences Among Sovereign Wealth Funds SWFs trim real estate in favor of growth-stage direct investments

S

overeign wealth funds completed more direct investments in 2017 than a year earlier, according to a report published by the International Forum of Sovereign Wealth Funds. Yet the amount funds invest in private markets has slowed, likely because of a pullback from real estate in favor of growth-stage investments.

The “Dealing with Disruption” report found that SWFs— funds set up by governments to manage financial assets— completed 303 direct deals last year, up from 290 in 2016.

Deal value, however, was $52.6 billion in 2017, up only slightly from $51.4 billion the prior year.

Part of that drop came from real estate, which has been a popular investment target for SWFs in recent years. That trend appeared to slow in 2017 as the number of real estate and infrastructure investments declined. Despite the overall drop, funds continued to show an interest in mixed-use and residential properties as they seek to capitalize on aging populations looking to downsize and millennial buyers in need of affordable housing.

Meanwhile, direct investment in innovative sectors, such as new medical devices and artificial intelligence, seems likely to continue, according to the report. SWFs have demonstrated an appetite for investing in technologies with the potential for large-scale disruption.

The report found that median equity check size in 2017 was $50 million, down from $90 million in 2016, likely a reflection of less activity in real estate, where investment value is typically higher, and more early-stage investing, associated with lower check sizes.

Another emerging trend revealed the increased favor private equity firms are showing SWFs as co-investors. As limited partners in PE funds, sovereign wealth funds are increasingly purchasing minority stakes in deals. “This enables the PE firm to book some profit, while the SWF can take on some upside by investing in growth businesses they already know, limiting the downside risk,” according to the report. // —Kathryn Mulligan

MIDDLE MARKET GROWTH // NOV/DEC 2018

11

VERTICAL VIEW

LPs Take a Direct Approach The amount limited partners deployed 6,000

equity firms reached $110.7 billion in

5,000

2016, a sharp increase from the previous decade high of $98.2 billion in 2007.

The number of co-investment ­transactions has remained relatively steady since 2014, when there were 82 deals. The count dipped to 77 in 2015 but rose steadily thereafter,

DEAL VOLUME ($M)

as co-investments alongside private

4,000

H The number of direct investments # of deals 16

by limited partners peaked in 2017 with 21

18

3,000 9

2,000

21

transactions valued at $4.0 billion, though LPs invested more dollars

1,000

in 2015: $5.0 billion across 18 deals.

0 2014 2015 2016 2017

reaching 87 in 2017.

Canadian pension plans arrived earlier

The Ontario Teachers’ Pension Plan has

Exit activity for LP co-investments

to direct investing than their U.S. peers.

been an active investor, and it has also

rose dramatically from 2013 to 2014,

Collectively, the Ontario Municipal

made a number of recent exits. Its 2018

rising from 17 to 45 before slowing

Employees Retirement System, Canada

exits include the sale of Prumo Logistica

slightly. The average exit count from

Pension Plan Investment Board, Ontario

Global to PE firm EIG Global Energy

2014 to 2017 was 41.

Teachers’ Pension Plan and The Caisse

Partners; and the sale of Helly Hansen to

invested $6.9 billion in companies

publicly traded ­Canadian Tire.

from 2014 to 2017.

Data provided by PitchBook 12

MIDPOINTS by John Gabbert

An ‘Aha!’ Moment with Staying Power

A

JOHN GABBERT Founder and CEO, PitchBook

Content Sponsored by

14

middlemarketgrowth.org

s the private equity industry has grown, so has competition for deals. The number of active PE funds in the U.S. and Europe has risen to roughly 2,000 from around 600 at the turn of the century. But the number of PE firms is only part of the story. Limited partners have begun to recognize the benefits of investing directly in operating companies. Why not cut out the middlemen and reap even bigger rewards?

LPs had a collective “aha” moment around 2013. Direct LP investment volume more than doubled that year from 2012, and deal activity hasn’t come down since. Last year saw a record number of direct deals totaling more than $4 billion in value. Meanwhile, LP co-investments alongside PE firms reached a record 87 transactions last year with $35.7 billion invested—a drop-off from the $110.7 billion in LP co-investments in 2016.

The trend of going direct appears to have staying power, particularly among family offices, whose money operates under different rules than institutional fund capital. Family offices don’t need to worry (as much) about fund economics or return timeframes, since they are their own LPs. They often can move more quickly on deal opportunities than their institutional counterparts, where return assumptions dictate the kinds of offers PE firms can make.

Because family offices don’t need to return capital to outside investors, they can take a longer view of their investments. They often can afford to make higher offers for companies they might own for 10 years or more.

Family money can also appeal to sellers who don’t want to be part of a Wall Street portfolio. Family-owned businesses may be open to selling to family offices, which are less likely to demand big changes or cost cuts.

Companies aren’t the only ones warming to family offices—so are investment professionals. Working in private equity can be highly demanding. As family offices become established investment houses, more industry professionals are forwarding their resumes. The perks are tempting: no time on the road fundraising, no capital deployment timelines, no pressure to write big-enough checks, less turnover and less bureaucracy.

Family offices also have drawbacks.

Capital calls, and capital availability in general, may be an issue. Their private equity counterparts can produce money at a moment’s notice, and PE fund commitments are considered more secure because they come from a pool of capital raised solely to invest in businesses. PE firms also have demonstrated their ability to scale companies, though family offices may prove adept at that over time.

As family offices attract Wall Streetlevel talent, they also will grow in stature. In response, the PE industry is recognizing the need to provide long-term capital. A number of PE firms have raised funds with 10-plusyear time horizons. Private equity might lament the added competition from families—and the reduction in fee revenue—but there’s another benefit to be had: more potential buyers when it’s time to sell. //

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QUICK TAKES

CalPERS Strives for Sustainability with New Direct Platform

A

s pension plans across the country struggle to meet their distribution requirements, they are seeking creative approaches to strengthen their systems.

That reality led one of the largest U.S. pension funds, the California Public Employees’ Retirement System, to announce in May plans for a new initiative that will target direct investments in operating companies. CalPERS Direct is slated to launch in 2019.

“We’ve got a very simple but bold idea that we’ll have our own holdings in companies, but it’s not through someone’s investment fund,” says Anne Simpson, investment director, sustainability, at CalPERS. “It allows us to be permanent owners. That’s the kind of really long-term capital that companies need when they’re growing.”

CalPERS Direct will consist of two separate funds, according to a press release announcing the platform. One will focus on ­late-stage investments in technology, life sciences and health care. The other will target investments in established companies.

Simpson says CalPERS Direct is a means to address the financial sustainability of the pension system as well as environmental s­ ustainability, social responsibility and good governance.

“For us to have a sustainable financial system for CalPERS, we have to pay attention to managing physical and human capital,” she says.

H Anne Simpson (left), investment director, sustainability, at CalPERS; Heather Stratman, ­former CEO of the ACC-OCC

Addressing long-term issues like climate change through its investments requires time horizons beyond a traditional private equity holding period, she adds.

In an effort to develop solutions for addressing pension challenges from a municipal perspective, the Association of California Cities-­Orange County began to build a ­relationship with CalPERS in 2016. According to Heather Stratman, who served as the association’s CEO from 20162018, that has allowed for productive dialogue between CalPERS staff and members of the association, which represents the cities of Orange County, local government special districts, ­businesses, nonprofits and higher education institutions.

“We have been exploring different options with CalPERs both administratively and legislatively in terms of fine-tuning existing laws and looking

at creating new tools and flexibility for municipalities,” she says.

Collaborating with key stakeholders is an important part of the strategy to strengthen the pension plan, whose revenue comes from three sources: CalPERS members, investment earnings and employers. Payments to members amount to about $20 billion a year, according to Simpson, who notes that those dollars ultimately stimulate small and medium-sized businesses in the local economy.

Simpson and Stratman agree that creating a sound pension system for the long term is the ultimate goal.

“I view it as a personal responsibility, paying pensions and keeping people out of poverty in retirement, and providing pensions to the first-line responders who are protecting us all,” Simpson says. “Sustainability is at the heart of everything we do.” // —Kathryn Mulligan

MIDDLE MARKET GROWTH // NOV/DEC 2018

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A QUALIFIED OPINION

Kristi Kuechler Managing Director, Investor Market, Family Office Exchange Kristi Kuechler is managing director of the investor market for the Family Office Exchange (FOX), a 29-year-old organization that provides education and networking for 380 single-family offices. FOX members oversee investable wealth of more than $500 million, on average. Kuechler opened FOX’s West Coast office in San Francisco, where she is based. She recently corresponded with MMG about family office investment trends.

“THE MAJORITY OF THE FOX MEMBERS THAT WE WORK WITH ARE SOURCING DIRECT INVESTMENTS THEMSELVES THROUGH THEIR PERSONAL NETWORKS, AND NOT THROUGH GPs.”

MORE ONLINE Find more interviews at middlemarketgrowth.org.

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Q A

What shifts are you seeing in how families approach investing?

An important distinction between family offices and institutional investors is that at some point in the history of most families, the family created a successful operating business. Given the entrepreneurial nature of business-owning families, it is logical that they may want to jumpstart the wealth-creation engine that helped them become wealthy.

We have seen significant growth of interest in—and execution of—direct investments in operating businesses, real estate and venture capital by FOX families. Families have always been operators in individual sectors—they knew their space better than anyone else. Ten or 15 years ago, families would more typically look at buying another operating business in the sector that they knew well, essentially the family’s “alpha.”

They rarely looked for deals outside of the sector in which their wealth was originally generated. Now there seems to be a reconsideration of the investment strategy that many families pursued in the past, which was more of a “manager of managers” approach. Families are reawakening their interest in directly investing in

operating businesses, whether as lead or co-investor.

While some family offices are co-investing alongside private equity general partners, the majority of the FOX members that we work with are sourcing direct investments themselves through their personal networks, and not through GPs.

Q A

What other drivers are leading family offices to invest directly in operating companies?

There are both financial and nonfinancial reasons that families take this approach. They’re of course looking for a strong return: FOX members expect their direct investments to generate a 14 percent return. In contrast with investing through a private equity fund, going direct allows families to take advantage of a longer time horizon. Some family investors are also looking to avoid paying the management fees and carried interest to private equity funds, and going direct allows them to disintermediate the general partner and avoid those fees.

Owning an operating company is viewed by some families as an investment from which they can draw more personal satisfaction, through hands-on involvement rather than a purely “paper portfolio.” It might also

be an opportunity to get a member of the family’s younger generation involved with running a business and encourage entrepreneurialism. And finally, some families, especially those driven by the younger generation, may be attracted to investing directly in a company with a mission of social or environmental impact.

Q A

What types of direct investments are family offices pursuing?

The majority of family office direct investments are in real estate, but 47 percent invest directly in operating companies. Of that group, family offices held an average of 15 direct investments and entered an average of two new deals in 2017.

There’s a pretty strong interest in early-stage and midmarket growth equity. Our data show family offices target $500,000 to $1.5 million for venture investments and larger sums for middle-market investments.

Q A

What are the top challenges associated with direct investing for family offices?

While appetite is strong, families face several important challenges in making direct investments. One truism among family offices is that most are fairly under-resourced: They are asked to do a great deal for the family, often with fairly small staffs. Family offices recognize that sourcing and due diligence are significant impediments to finding

strong direct investment opportunities, as are current high deal prices and valuations.

Another challenge is that many of the families that have been investing directly in operating businesses (outside of the sector where they sourced their wealth) have done so in the last decade and therefore have a fairly cycle-dependent perspective.

Lastly, the interest in direct investing is upending many of the more traditional ways that families have approached asset allocation. As direct investments do not fit well in a more conventional “top-down” portfolio approach, families appear to be less focused on developing a risk framework within their private portfolios. //

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(From left) DNS Capital Chairman and CEO Michael Pucker; Managing Director Charles Tollinche; and Vice President and Head of Business Development Elizabeth Hess

Photos by Matthew Gilson

DNS Capital’s

Family Values How relationships, humor and country music inform the family office’s approach

BY S.A. SWANSON

W

hen Michael Pucker meets someone for the first time, there’s a good chance he will upend preconceived notions about the ultra-rich, which probably don’t include “down to earth”—a description commonly used by people who work closely with him.

For 29 years, Pucker has been part of the Pritzker family, as the husband of Gigi Pritzker. Heirs to the Hyatt Hotels and Marmon Group fortunes, the Pritzker family has been on the short list of America’s wealthiest families for a very long time, so it’s understandable that people have certain expectations—ones that Pucker and Pritzker in many ways defy.

Take Pucker’s office attire. He typically wears a shirt, jeans and a pair of cowboy boots he’s owned for 15 years. (“They’re like slippers,” he says.) Pritzker, too, has a reputation for being relatable. “Think in terms of Tupperware as opposed to fine China,” Pucker says. “It’s a joke, but it’s true.”

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It’s also true that family offices reflect a family’s DNS CAPITAL culture. By all accounts that Family: DNS is the family is the case at DNS Capital, investment office for Gigi Pritzker, the Chicago-based family Michael Pucker and their three investment office for Pritzadult daughters ker, Pucker and their three adult daughters. It may Location: Chicago explain why all six of the Year Founded: 2014 investment values on the firm’s website link to videos Focus: Long-term direct investfrom country music group ments in a range of industries, the Zac Brown Band, which including health care, mining, IT, Pucker, the chairman and steel-mill services, and food CEO of DNS, has seen perand ag form more than 15 times.

“The most entertaining comments are from people who think [the videos] were inadvertent,” says Elizabeth Hess, the firm’s vice president and head of business development.

Another fit with Pucker and Pritzker’s values and experience is DNS Capital’s focus on direct investing. As a practicing lawyer for the past 30 years, Pucker has handled more than 150 transactions for the Pritzker family and hundreds more for non-family clients. Meanwhile, Pritzker founded an entertainment and media company, Madison Wells Media, that she’s run for more than 30 years, backing projects that include the movie “Drive,” the Emmy-winning TV series “Genius” and the Tony-award winning musical theater production of “Million Dollar Quartet.”

For the couple, direct investing represents more than a wealth-creation strategy (although

“IF SOMEBODY WANTS A THREE-TOFIVE-YEAR EXIT AND TO REPLACE THEIR MANAGEMENT TEAM OUTRIGHT, THEY PROBABLY WON’T LIKE US.” ELIZABETH HESS Vice President and Head of Business Development, DNS Capital

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it is that, too). It’s an extension of their ethos, and what they seek in relationships, business or otherwise. Their approach can be summed up by the DNS acronym, which stands for “Does Not Suck.” “It’s an expression of how we feel about everything we do, and the way in which we want to do it,” Pucker explains.

BEYOND BASEBALL TICKETS According to the Family Wealth Alliance, the United States has more than 3,000 family offices with over $1.2 trillion in assets collectively. An EY report suggests that of the 10,000 family offices worldwide, at least half were created during the past 15 years. The Pritzker family contributed to that growth. Prior to 2000, the vast majority of the family’s wealth was controlled centrally. From 2000 to 2012, the enterprise was restructured, prompting the formation of about 10 Pritzker family offices, including DNS Capital in 2014.

From the start, Gigi Pritzker and Pucker preferred a direct-investment focus. “We didn’t want to hire an investment adviser or an asset manager and give them the bucket of assets that we had, and ask them to keep us posted, and buy us tickets to baseball games,” Pucker says.

The financial and cultural advantages of longterm investing appealed to the couple. Instead of cashing out in five years, the money can stay invested for decades and compound over time.

But their rationale for direct investing extends beyond wealth management.

“For our family investment office it’s good, mostly because I’d be bored doing anything else,” says Pucker, who is currently a partner at Latham & Watkins in Chicago. Prior to forming DNS Capital, he worked with clients to build new businesses and acquire companies and helped them as a partner and adviser. “It’s basically a continuation of what I’ve been doing professionally for a long time,” he adds.

LONG-TERM PARTNERS DNS currently has about 30 active investments, with control (or shared control with The Pritzker Organization, the family investment office

for Gigi’s oldest brother, Tom, and his immediate family) in five mature operating businesses, three fund platforms that DNS has co-founded or sponsored, and a variety of other businesses.

Its portfolio companies run the gamut in terms of industry and maturity. On the cash flow continuum, DNS has companies that are pre-revenue, others that generate some cash, and still others that generate “a tremendous amount,” says Charles Tollinche, managing director at DNS. “That breadth, just from an equity investment perspective, is a function of the fact that we don’t have a fund or limited partners,” he says, adding that most family offices of comparable size specialize in particular industries.

Of the 450 potential deals DNS assessed last year, it ended up making 15 investments, which include both brand-new investments and incremental investments in existing holdings. Hospitality is the only industry DNS is unlikely to consider, in an effort to diversify given the amount of Hyatt stock the family

owns. Industries represented in its portfolio range from health care to mining to IT to steel-mill services. DNS’s food and agriculture investments would make a satisfying meal: They include vegan burger-maker Beyond Meat and salad kiosk company Farmer’s Fridge. To wash it all down, the firm provided funding for Atlanta-based New Realm Brewing Co. The brewery’s leaders conducted a comprehensive market study and determined that the southeastern United States had room for additional high-quality craft beer brands. DNS met with New Realm’s co-founders in late 2015 and

by January 2018, the company opened its first brew pub, in Atlanta, with a 650-seat restaurant and 20,000-barrel brewing facility. In August, New Realm opened its second location, in Virginia Beach, with seating for 450 and an expandable 40,000-barrel brewing facility. Across its two locations, New Realm has about 225 employees. They include one of the most prominent brewmasters in the industry, Mitch Steele, who

E Elizabeth Hess, VP and head of business development, and Michael Pucker, chairman and CEO

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previously worked at Stone Brewing Co. in Escondido, California.

“They really wanted to find a long-term capital partner they could work with for the next 10 or 20 years,” says Hess of New Realm’s co-founders.

Bud Shear, CEO of Industrial Magnetics Inc., had a similar long-term vision for his company, which makes powerful magnets used in automotive assembly lines, recycling facilities and food processing. When he “IF YOU DON’T SHARE started working at IMI in 1999, its revenue was about HUMOR, THEN YOU’RE $9 million. This year it will PROBABLY NOT GOING exceed $30 million. Shear TO GET ALONG VERY became the sole proprietor WELL AS LONG-TERM in 2001, and since then the company has been under PARTNERS.” private equity ownership twice. Shear says that MICHAEL PUCKER although both private Chairman and CEO, equity experiences were DNS Capital positive, the sale process was unavoidably disruptive.

“It just took away eight months to a year out of every four years, putting together a proposal so that the investment bankers could have the data they needed,” he says.

When the company’s last private equity owner put IMI up for sale, Shear was told he could choose the winning bid (above an agreed floor return). “They had five offers, and DNS wasn’t the highest bidder,” he says. “And the beautiful thing is, they could have walked away with a few more million.” Instead, the PE firm stayed true to its word and gave Shear final say on IMI’s buyer.

Shear appreciated Pucker and Pritzker’s entrepreneurial backgrounds and felt DNS shared his values about workplace culture. “I refer to everyone who works here [at IMI] as my family. And it’s extraordinarily important to me,” he says. Whenever the company has a record month, Shear’s wife prepares a meal for all 83 employees. “We draw a name out of a hat to see who gets to pick what in the world we’re going to have for lunch,” Shear says.

He also appreciates that DNS encourages

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investment by its portfolio companies, which allowed IMI to triple the size of its previous R&D space, to 2,400 square feet, and to continue to innovate. “You just show them why you need it and what you’re going to need and why you’re going to buy it. We’ve never had anybody from DNS say no,” Shear says.

Not all portfolio companies are used to that approach. Some management teams are accustomed to owners who value acquisitions over creating new products or services in house, according to Pucker.

He recalls discussing innovation with members of another company’s management team.

They assumed that meant a bolt-on acquisition.

“We said, ‘No, no, no. No acquisition. You don’t have to go buy anything. We want you to tell us what you’d like to spend money on to go do something different to improve the business, to help satisfy the needs of your customers,’” Pucker says. “We do encourage our companies to do bolt-on acquisitions at the appropriate times, but not as a substitute for innovation.”

LIFE’S TOO SHORT While innovation is emphasized by DNS, there’s a larger priority for the firm: people and relationships. DNS is not the only organization to make such a claim, but Pucker is determined to put it into practice.

Unlike many investors, DNS rarely views “alignment” through the lens of financial metrics. Instead, that term refers to culture, values and relationships. Pucker recognizes that the firm’s philosophy might mean the next blockbuster investment gets away. “I don’t really care if we end up missing the next Google or Facebook. Life’s too short, at least in my case, to buy into a relationship where you know there’s going to be misalignment,” he says.

After an investment, companies become part of the DNS extended family, which can include support both in and outside of the business context. “In a number of different situations, we’ve provided medical help, we’ve provided personal loans, we’ve helped with educational opportunities,” Pucker says.

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“YOU GO ALL OF A SUDDEN FROM BEING A BUSINESS TEAM TO BEING KIND OF A FAMILY. [THAT] IS UNCHARACTERISTIC IN THE INVESTMENT COMMUNITY.” CHARLES TOLLINCHE Managing Director, DNS Capital

E Michael Pucker (center) looks for cultural fit and a strong financial background when building his team

That family ethos, longstanding in both the Pritzker and Pucker families, also applies to the firm’s 11 employees, who attend social events together throughout the year, along with their spouses, and often their children. “You go all of a sudden from being a business team to being kind of a family,” Tollinche says. “[That] is uncharacteristic in the investment community.”

DIVING DEEP About three times a year, Hess attends various family office conferences—typically a gathering of about a dozen families. She says there’s a running joke at these events: “No matter what the intended topic is, all everybody talks about is direct investing.”

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This doesn’t surprise Christopher Deveny, chairman of JPMorgan Private Bank in the Midwest. Over the last five years, he’s seen interest in direct investing pick up significantly.

He recalls a conversation three years ago that reflects one of the drivers behind that trend. An executive from a large family office told him that after looking at all of their private equity investments as a limited partner during the past two decades, they realized they had indirectly owned the same company three times.

Although family offices want to avoid unnecessary fees and paying tax on ordinary income, Deveny says direct investment isn’t always a good fit. It’s time-consuming to own multiple companies, and he’s seen families struggle with

hiring the right staff. “The ones that really make a huge investment up front to build a team of people are the ones that probably stand the best chance of really succeeding because you’ve got to generate deal flow,” he says.

Pucker agrees that hiring the right team is essential. In addition to cultural fit, he looks for a strong financial background when building his staff, noting that the firm enlists the help of subject matter experts when needed. To bolster industry knowledge, every year each of the firm’s investment professionals chooses an area to research in-depth—fragrances and flavors is one recent example—and to expand the firm’s network of experts.

This deep-dive approach has important benefits. “It forces us, in a positive way, to be proactive in the market,” Hess says. “We won’t sit in the office and just wait for the phone to ring.”

“Star Wars,” added a wise Yoda-ism, and emailed it to the CEO and his employees. “They needed a release,” Pucker says. “They needed to laugh at themselves.”

At DNS, that’s among the screens for identifying the right investments. “If you don’t share humor, then you’re probably not going to get along very well as long-term partners.” // S.A Swanson is a business writer based in the Chicago area.

BONDING THROUGH HUMOR Because long-term investing diverges from the traditional private equity model, DNS doesn’t view PE firms as direct competition. Many investment opportunities aren’t a good fit for family offices’ preferred time horizon, which can extend well beyond the 10-year mark. “If somebody wants a three-to-five-year exit and to replace their management team outright, they probably won’t like us,” Hess says.

There’s another dimension to DNS’s approach, hinted at in the firm’s goal to “create lasting value with a sense of purpose and a sense of humor.” The latter quality reflects the lighthearted spirit of the family behind the family office, a trait that’s also on display on Pucker’s LinkedIn profile, where his photo is a modified version of Edvard Munch’s “The Scream,” featuring Homer Simpson.

Pucker views humor as a way to maintain perspective. He uses it as a rapport-builder and stress-buster, useful in any context and particularly handy for keeping business problems in perspective. When a CEO at one of DNS’s companies became uncharacteristically anxious earlier this year, Pucker superimposed the executive’s headshot on a picture of Yoda from

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Fostering

Deal Flow

for Families How a new generation of advisers is meeting the growing demand for direct deals

BY BAILEY McCANN

F Illustration by Mitch Blunt

amily offices have long been a source of capital for midmarket private equity funds as limited partners, but in recent years their influence in the middle market has increased in another important way.

More and more family offices today are investing directly in operating companies, either on their own or alongside other family offices. In response to this trend, a growing number of would-be general partners have changed their business models. Rather than going to market with a commingled fund with capital commitments from LPs, they are launching family office advisory services and bringing individual deals to families.

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Florida-based Bonaventure Equity is among the firms taking this approach. Its founder and CEO, Ross O’Brien, had over a decade of experience in investment banking and private equity before starting Bonaventure. He says for small and medium-sized family offices, going deal by deal can provide a better return profile than joining a large mega-cap fund or trying to research hundreds of middle-market GPs. “We work with families to help them diligence companies, create the investment thesis and manage the investment,” O’Brien says.

“The model works well for both sides. Investors feel like they have more control and entrepreneurs often choose us over a traditional sponsor-backed deal because they prefer our terms.”

O’Brien adds that working this way allows him to be more collaborative with investors.

“We are regularly in meetings with families to understand what kinds of opportunities they are looking for. And when we can go to them and say we have a deal that fits, you stand out. You’re not just another first-time fund.”

Austin-based CrowdOut has taken a similar approach to differentiate itself in a packed field of lenders. It specializes in loans to midsize companies and provides financing to middle-market private equity firms and fundless sponsors. The firm also works with families and other investors, bringing them individual financing deals with unique terms.

“Being based in Texas, we work with a lot of investors that are already heavily exposed to energy, for example, so when we talk to them about opportunities, they’ll say ‘We’re up for anything but energy, we want to diversify,’” says J. Sulester, CrowdOut’s senior vice ­president.

“We’re able to provide that for them with

“I THINK WE ARE JUST STARTING TO SEE INNOVATION IN DEAL TERMS AND STRUCTURES.” ERIC BECKER Founder and Co-Chairman, Cresset Capital Management

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options that are fully exited in a few months to a few years.”

Unlike banks or credit funds that ask founders to pay only interest for several months, companies working with CrowdOut begin paying back the principal right away. That lowers risk from Day One and shortens the repayment window, giving both investors and founders a clear timeline for exit. Individual deals also mean that family office investors can tailor their exposure to a greater degree than through a traditional private equity fund.

PRODUCT INNOVATION Family offices have approximately $1.2 trillion in collective assets, according to a recent report from Capgemini. The increased allocation of those dollars toward bespoke direct investments has served as an anchor for a growing ecosystem of investment product innovation in the middle market. Investors and founders say there is a freedom to experiment when it comes to working with midsize companies because of the dynamism and growth opportunities in this segment of the market. Family offices are positioned to support this creativity because they aren’t under the stringent mandates—such as provisions for minimum deal sizes, meant to curb risk—that often restrict how large institutions can invest.

“I think we are just starting to see innovation in deal terms and structures,” says Eric Becker, founder and co-chairman of Chicago-based private wealth management firm Cresset Capital Management. The firm recently launched a family office in San Francisco to advise families on deals, governance and leadership development. Cresset is in the process of evaluating several new structures specifically geared toward matching family office investors with middle-market companies. Becker says he’s seen investors and founders come together on terms that might lead to a long-term equity interest in a portfolio company, rather than a traditional five- or 10-year investment.

In addition to funding, family office investors often bring operating expertise from running the businesses where their wealth originated.

Cresset is working with some families to help them partner with other family-owned businesses, enabling them to share firsthand experience and take a more hands-on approach than they could as part of a commingled fund.

Special purpose vehicles, a legal structure that lets founders and investors define specific and narrow financial terms, are also becoming more popular as a way to structure direct investments.

They still allow for deal-by-deal evaluation, but they look similar to a traditional private equity fund and can be attractive to family offices that want more external management. Multiple transactions can be included in an SPV, but investors retain control over the investment selections and terms.

MANAGING EXPECTATIONS It remains to be seen how this experimentation will play out. Investment terms—including the length of the investment, milestones for when new capital is available, or lower fees—may be more favorable to families outside traditional private equity fund structures, but this style of investing requires close monitoring and could potentially warrant operational coaching for businesses. Both require resources and deep expertise, and there may be more hands-on work than some families realize. Meanwhile, the current environment of high prices and intense competition creates the challenge of finding reasonably priced deals that haven’t been picked over.

“The issue is how many quality deals are available at reasonable valuations,” says Jolyne Caruso, CEO of The Alberleen Group, a family office advisory firm in New York. “Families have to determine what are the best ‘unshopped’ investments, then they have to diligence them, negotiate deal terms, and ultimately monitor them until they exit. With a diversified portfolio of 10-15 direct deals, it becomes a full-time job to manage a portfolio of direct investments.”

Caruso doesn’t expect direct investing to slow down anytime soon, but she notes there isn’t much data on direct investment performance in aggregate nor in a recessionary environment.

“As this cycle matures, it will be interesting to

“WITH A DIVERSIFIED PORTFOLIO OF 10-15 DIRECT DEALS, IT BECOMES A FULL-TIME JOB TO MANAGE A PORTFOLIO OF DIRECT INVESTMENTS.” JOLYNE CARUSO CEO, The Alberleen Group

see if many smaller family offices just decide that paying a 1 to 2 percent management fee and 15 to 20 percent [carried interest] is ultimately a more efficient way to generate alpha in their alternative portfolios,” she says.

O’Brien and Sulester say that finding quality deals is easier without a fund because they can identify opportunities for families without the pressure to invest against the life cycle of a 10-year vehicle. “This is an old story at the mega-fund level,” O’Brien says. “Many of those firms can’t find enough high-quality deals at the size that they need, on the timeline they need, so they just do any deal. We see it happening more now in the middle market as well, as valuations have come up and more capital is waiting to be deployed.”

O’Brien says investors should be concerned about GPs who are under pressure to invest.

In that case, it is less clear where the value will come from and the level of return they’ll be able to achieve. To adapt in the current environment, a number of private equity firms have opted to lengthen their investment time horizon or build more flexibility into their deal terms. But many remain beholden to a five- to seven-year investment period, which doesn’t fit the long-term needs of some companies.

“I don’t have to invest that way,” O’Brien says.

“We won’t do a deal unless we think there is a clear path for value creation.” // Bailey McCann is a business writer and author in New York.

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POLICY POINTS

What Keeps Compliance Officers up at Night?

Two ACG PERT steering committee members weigh in

A

CG formed its Private Equity Regulatory Task Force four years ago to bring together CFOs, CCOs and in-house legal counsel of middle-­ market private equity firms. PERT’s goal is to share best practices for navigating the current regulatory environment, as well as to engage with federal decision-makers as they craft policy.

Middle Market Growth recently spoke with two members of the PERT steering committee, Randy Guttman, CFO and general partner of JMI Equity; and Joshua Cherry-Seto, CFO and CCO of Blue Wolf Capital Partners LLC, to hear their take on the compliance issues facing middle-market PE firms today and the value they see in PERT. E Randy Guttman, CFO and general partner of JMI Equity

E Joshua Cherry-Seto, CFO and CCO of Blue Wolf Capital Partners LLC

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What regulatory and compliance issues are impacting middlemarket private equity firms?

Randy Guttman: A lot of middle-market private equity and growth equity firms don’t have a dedicated chief compliance officer. In some cases, it’s the chief financial officer who is also acting as the CCO, so it becomes a resource question as reporting and compliance demands increase.

Limited partner reporting requests are growing, and some of the quarterly requests and capital call and distribution requests can be difficult for a smaller firm that doesn’t have the same back-office resources as a larger firm. Breaking out partnership expenses based on varying LP requests can also be challenging. It requires breaking out certain types of expenses that a private equity firm wouldn’t typically break out on its financial statements.

Another area impacting PE firms is some of the SEC filings, particularly

Form ADV and Form PF. You have to read between the lines and ask lawyers to interpret what the forms are asking. And it’s hard to answer because the forms often are not applicable to middle-market firms—they were designed with mutual funds or hedge funds in mind.

Joshua Cherry-Seto: There are also

important issues around co-investment, which over the last five or 10 years has become a normal part of doing business for commingled funds.

One important issue is the allocation of co-investment opportunities and how GPs offer them to their limited partners. There’s also the question of allocation of expense. If there’s a situation where there are dead deal expenses, it creates an interesting question from a regulatory standpoint in terms of who should pay for the expenses.

“YOU HAVE TO READ BETWEEN THE LINES AND ASK LAWYERS TO INTERPRET WHAT THE FORMS ARE ASKING.” How has technology impacted the compliance demands for middle-market PE firms?

RG: Cybersecurity is one area. It has become less of an IT issue and more of a compliance issue. Institutional limited partners are increasingly interested in speaking with the back-office employees involved with cybersecurity to learn more about the firm’s approach.

JCS: Marketing and advertising rules

for GPs remain very outdated as technology evolves. They were designed in a pre-internet era and fit poorly into today’s world. For GPs that want to use websites or online means to reach potential partners—companies looking to sell, or investment banks we might work with—the existing rules perceive this as an advertisement to retail investors, which is prohibited.

I think under SEC Chairman Jay Clayton there’s a constructive view on working together and improving the dialogue to bring more clarity to these regulations.

What role does PERT play in helping PE firms navigate the regulatory and compliance environment?

RG: A CFO, COO or CCO often can feel like they’re on an island within their own firm. It can be a challenge to talk with colleagues in your firm about these issues because there aren’t many who understand the point of view of what you do. PERT provides a network of peers who are

engaged in these issues and available to exchange ideas. The group also gives its members the opportunity to meet directly with SEC staffers and congressional representatives to talk about the issues we’re facing and to hear policymakers’ perspectives.

JCS: In the past, CFOs and others in

the middle office could focus on managing the books, cash management, and other core accounting functions.

In today’s heightened regulatory environment, one way to avoid having to add multiple people to our back-office staff is to talk with other middle-market GPs about best practices and new reporting demands. That’s a role that PERT serves.

Another is giving us a voice outward. If there’s an issue related to an LP request, for example, one firm has a single voice. But if 60 firms have come together and talked about the topic, it gives the response to the LP more weight. PERT also allows us to have a united front in Washington, D.C., to tell the story of Main Street private equity and the role of private capital in job creation. //

JUST CHECK THE BOX AUTO-RENEWAL IS NOW LIVE! U P D AT E Y O U R PROFILE TO O P T- I N T O D AY. W W W. A C G . O R G

GET INVOLVED To learn more about PERT and how to become a member, visit acgpert.org or contact ACG VP and Senior Counsel, Public Policy, Maria Wolvin, at mwolvin@acg.org.

MIDDLE MARKET GROWTH // NOV/DEC 2018

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GROWTH ECONOMY

GEORGIA // 1998–2017 Over the past two decades, private equity-backed businesses in Georgia grew jobs at more than three times the rate of the broader business community. In 2017, there were 159 private equity transactions in the state, a level consistent with the past several years. Deal flow is spread across a diverse range of sectors: IT accounted for 18 percent of activity in the past decade, followed by the business-to-consumer sector, which made up 17.5 percent.

JOB GROWTH % BY SEGMENT

SALES

0.2% 17.1%

ACG ATLANTA

28.9% 53.9% 0%

SALES GROWTH % BY SEGMENT 3.5% 46.9% 36.5% 13.2% 0%

288.5%

SALES GROWTH IN PE-BACKED BUSINESSES

56.5% SALES GROWTH IN ALL BUSINESSES

Small: Less than $10M in sales MM Seg 1: $10-50M in sales MM Seg 2: $50-100M in sales MM Seg 3: $100M-1B in sales Large: More than $1B in sales

JOBS

GROWTH IN PE-BACKED BUSINESSES

GROWTH IN ALL BUSINESSES

100.9% 31.5%

JOBS CREATED

BY PE-BACKED BUSINESSES

32,067

MORE ONLINE See the impact of middlemarket private equity on your state at GrowthEconomy.org.

All stats are from PitchBook and the Business Dynamics Research Consortium at the University of Wisconsin-Extension.

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I found the right investor to grow my client’s business through ACG. S E E T H E P O W E R T H AT MEMBERSHIP BRINGS. J O I N T O D AY AT W W W. A C G . O R G

THE POWER OF

© 2018 Association for Corporate Growth. All Rights Reserved.

THE PORTFOLIO

CRACK THE COMPLIANCE CODE A C G P E R T g a t h e r s t o g e t h e r CFOs, CCOs and in-house legal counsel of middle-market private equity firms nationwide. As a member of PERT, your firm will join a national network focused on shaping compliance best practices alongside federal regulators.

FOR MORE INFORMATION, CONTACT MARIA WOLVIN, AT MWOLVIN@ACG.ORG 36

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Content Provided by ACG Partners and Featured Firms

© 2018 Association for Corporate Growth. All Rights Reserved.

E

THE PORTFOLIO

Tax Considerations for Direct Investments SOUND DECISIONS // Tax Structuring Can Impact Rate of Return

T Janice Kong Tax Director, DHG Private Equity

o minimize fees levied by third-party asset managers, certain investors, including tax-exempt organizations and sovereign wealth funds (SWFs), have significantly increased their investment allocation to direct investments. Both types of investors have specific tax structuring considerations that may often affect the rate of return on their investments. Thus, it is important to consider the tax entity classification of both the investor and the investment entity.

Considerations for U.S. Tax-Exempt Organizations Internal Revenue Code Sec. 511 may tax otherwise tax-exempt organizations on their ­unrelated business taxable income. UBTI is income from a trade or business regularly carried on by a tax-exempt organization that is not substantially related to the organization’s exempt purpose. Additionally, although loan origination may be treated as a business, capital gains, interest and dividends are excluded from UBTI unless the underlying property is debt-­ financed property.

Furthermore, the unrelated trade or business activities of a partnership are imputed to its tax-exempt members. Accordingly, if a tax-exempt organization wants to invest directly in an entity that is taxed as a partnership for federal income tax purposes, a so-called blocker is often implemented to mitigate the UBTI. A blocker is a corporation that is placed between the tax-exempt investor and the source of UBTI. The blocker incurs and pays tax on the operating income that is allocated to it from the partnership, and thus blocks the unrelated business income from reaching the tax-exempt investor. Any net after-tax proceeds distributed by the blocker to the tax-exempt and foreign investors should be non-UBTI distributions.

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Considerations for Non-U.S. Sovereign Wealth Funds IRC Sec. 892 grants an exemption from U.S. federal income tax for certain U.S. source investment income earned by foreign governments unless derived from the conduct of a commercial activity or received from or by a controlled commercial entity. An entity is a controlled commercial entity if it is controlled by the foreign government and is engaged in commercial activities anywhere in the world. Thus, while IRC Sec. 892 encourages foreign investment in the U.S., it is not intended to provide a tax exemption for active commercial activities.

Because the application of IRC Sec. 892 and the definition of controlled commercial entity are often unclear, sovereign wealth funds and other non-U.S. investors may consider the use of blocker corporations. Foreign investors may be subject to U.S. federal income tax on income effectively connected with the conduct of a trade or business within the U.S. With a blocker structure, the U.S.-sourced effectively connected income, or ECI, remains at the blocker, and the foreign investor will not be deemed to be engaged in a trade or business that is subject to U.S. federal income taxes.

The structure of any direct investment by a tax-exempt organization or SWF in the United States must be made after a case-by-case analysis. Tax-exempt organizations and SWFs should consult their tax advisers prior to any proposed U.S. direct investment. // Janice Kong is a tax director in DHG’s Private Equity practice. She leads cross-functional teams that execute tax due diligence and tax strategies for private equity groups and portfolio companies.

She provides tax structuring services for M&A clients, successor liability transaction analysis and tax classification analysis of target companies.

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THE PORTFOLIO

How Outsourced HR Can Bolster Bolt-ons SOUND DECISIONS // Scalable HR Infrastructure Streamlines M&A Due Diligence

M Nate Olsen Managing Director of Business Development, Insperity

any private equity firms today find that employing a bolt-on strategy delivers a competitive advantage when bidding against other buyout firms and companies for assets, and they continue to solicit bolt-on opportunities for their platform companies.

In years past, a single bolt-on acquisition was the standard. However, the current market has witnessed increasing frequency of PE firms acquiring two, three and four bolt-ons to bulk up their platform portfolio companies in hopes of eventually achieving the best exit price possible. Many PE firms are adopting the bolt-on approach as they realize how much of the more robust middle market has already been rolled up.

When considering a bolt-on strategy, the capability to carry out that strategy efficiently is essential. Human resources service providers can help PE firms standardize HR across their portfolio companies, as well as within their own organizations. This can help firms reduce costs and risk, while freeing management to focus on business strategy and execution.

Advantages of HR Outsourcing and Scalable Infrastructure Outsourcing HR functions makes a great deal of sense in the M&A arena, as it allows PE firms to enjoy economies of scale in terms of HR systems and functions. Whether a PE firm is buying or selling, working with an HR company that can implement a scalable HR infrastructure can: ɋɋ Facilitate selling at a higher multiple ɋɋ Deliver value to a buyer with HR infrastructure already in place ɋɋ Yield value to a buyer by helping to mitigate risk associated with HR-related compliance ɋɋ Provide readiness for a buyer’s due diligence

be modeled, executed, repeated and systematically improved over time, especially as the platform company becomes more adept at navigating the challenges of bolt-ons. This approach allows the platform company’s management team to concentrate on running the company while exercising oversight and making key decisions related to the evaluation and integration of each bolt-on acquisition.

Jason Brown, a partner with Victory Park Capital, has experienced the advantages of HR outsourcing with M&A, including the benefits for management. “We actually made a decision to outsource our entire accounting, entire HR function and our entire IT functions, which I think to a lot of people might sound rather extreme,” Brown says. “But it has allowed us to flex up and down when we need to. We found that outsourcing these functions has allowed us to expand up and down and focus on things that drive revenue for us.”

Without a doubt, the execution of mergers and acquisitions presents complex challenges. Timing is critical, with small windows to conduct due diligence and communicate any changes to employees, shareholders and customers. Then there’s the actual work of merging two organizations, which comes with each bolt-on.

Incorporating a scalable HR infrastructure streamlines the complexities that are inherent to the business and helps PE firms and their portfolio companies better manage costs and risks to facilitate the best exit price. // Nate Olsen has nearly 20 years of experience in the professional employer organization industry.

He provides leadership, guidance and alignment of Insperity’s business development function in the United States. For more information, please call

As a result, the evaluation and integration of bolt-ons becomes a structured process that can

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866-814-6817 or visit insperity.com/acg.

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THE PORTFOLIO

Family Firm Fit: Evaluating Cultural Synergy SOUND DECISIONS // Culture Audit Helps Preserve a Family’s Legacy in M&A

A Tiffany Yates Senior Manager, Organizational Strategy, Grant Thornton

Sharon Whittle Principal, Human Capital Services, Grant Thornton

s M&A deal activity continues to accelerate, it’s critical for would-be buyers and sellers to apply a cultural lens to test interorganizational fit. This is especially true of family-owned businesses.

When considering a sale, it’s important for family businesses to remember that due diligence is a two-way street when it comes to considering the culture fit. They should focus on five critical success factors to ensure a fit with a potential buyer: decision-making style; leadership focus; appetite for risk and change management; talent development and team effectiveness; and shared values and beliefs.

Considering cultural synergies will help ensure success and determine whether a blended organization makes sense. And while a family business’s cultural distinctiveness does not typically appear on the books as an asset, preserving its valuable aspects should be considered a top priority in an M&A deal.

Daseke Inc., a flatbed trucking company that began as a family-owned business, took this approach as it grew from $30 million to $1.5 billion and added 17 companies to its portfolio.

When seeking acquisitions, Daseke focuses on family-first companies that align with its own values and culture. Don Daseke, the company’s CEO, noted in a recent National Center for the Middle Market podcast that his business respects the legacy of families behind its acquisition targets, typically businesses that have been managed by the same family for more than 50 years. Daseke makes a concerted effort to maintain the culture—and retain the leadership— that’s made the business successful.

Ed Kleinguetl Partner, Transaction Services, Grant Thornton

a cultural assessment that addresses a range of topics, including the buyer’s talent management approach. How will it handle talent management in the new blended organization? Is it a performance-management culture? What is the average tenure of an employee?

An assessment should also explore the buyer’s operational model. How are key decisions made? How does work get done and where can ­efficiencies be gained? How are budgets developed and managed?

And finally, the assessment should explore the buyer’s brand values. How closely aligned are its values to those of the family business?

What presence does the company have in its local community?

In addition to evaluating the potential buyer through discussions with company leaders and employees and through observation, it is beneficial to review key documents and collateral, such as the company’s vision and mission statements; employee communications, such as newsletters and memos; policy handbooks; and organizational charts. Understanding the cultural dynamics of the acquiring organization can help with integration and ensure the culture will enhance value creation.

Selling a family-owned business is a major decision that will impact not only family ­members but also long-term employees and customers. Performing comprehensive cultural due diligence will help ensure it’s the right decision and one that will help preserve the family’s legacy, culture and values for the long term. // Tiffany Yates, Ph.D., is senior manager of organizational strategy at Grant Thornton, Sharon Whittle

Assessing Cultural Fit Family businesses should perform due diligence on a potential buyer to help protect their legacy and culture. They should consider performing

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is the firm’s principal of human capital services, and Ed Kleinguetl is partner, transaction services.

MIDDLE MARKET GROWTH // NOV/DEC 2018

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THE PORTFOLIO

Innovation Is Transforming M&A MIDMARKET TRENDS // Four Technology Trends Impacting Dealmaking

N Mark Williams Chief Revenue Officer, Americas, Merrill Corporation

othing is changing the lives of people around the world more rapidly than technology, and it is clear that technology’s explosive growth will continue for decades.

Disruptive technology is also transforming dealmaking for M&A professionals, allowing forward-thinking deal-makers to thrive by utilizing the best elements of innovation to complete deals securely, quickly and successfully.

Four key technology trends have changed how we live our lives while also disrupting M&A across the globe. These trends have become powerful tools for M&A professionals who understand and utilize them.

Insight Through Analytics More than ever, analytics are providing deal-makers with accurate, reliable and fast information that is vital during due diligence.

Strong analytics provide deal-makers with high quality data that can drive actionable insights.

Effective analytics services should also shorten the decision-making process by using strong visualizations that provide all the necessary information. In fact, current analytics services provide deal-makers with an image that points to needed action before they even get to the office.

21st Century Gold Rush Organizations that have vast amounts of data and use it strategically are able to realize substantial revenues. However, a data breach can cause immediate damage and long-term distrust. We are all generating vast amounts of data whenever we connect our devices to the internet. Knowing how to securely manage this data is crucial and should be of paramount importance for any technology provider.

Artificial Intelligence Is No Longer the Stuff of Science Fiction Whether driverless cars or warehouse robotics, artificial intelligence has been a buzzword for the last several years as the technology advances rapidly. But by itself, AI is not an effective tool— it needs to be applied to real problems. Natural language processing and heuristics are forms of AI that can be applied in cutting-edge ways to solve different problems across industries, including M&A. Robust Due Diligence Deal-makers across the globe face a variety of challenges that come with M&A, especially in due diligence, which may include thousands— and sometimes millions—of documents written in various languages and located in multiple countries. In this complex professional environment, collaboration and secure document sharing is essential so that colleagues and advisers can work together securely and efficiently.

The security and speed provided by emerging technology has transformed how M&A professionals handle due diligence, and technology continues to evolve to meet the needs of sensitive capital transactions.

Though technology has provided a tremendous leap forward for M&A, there is no doubt more developments are on the near horizon, thanks to constant innovation. This innovation will make due diligence more secure and easier than it has ever been, allowing corporations and their advisory teams to concentrate on the more important, high-value work associated with capital transactions. // Mark Williams is the chief revenue officer, Americas, at Merrill Corporation, a global leader providing SaaS collaborative software and full-service solutions for corporations and their advisers.

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THE PORTFOLIO

Building a Successful Health Care Portfolio

BY THE NUMBERS // Investments Require Specialized Treatment

T Duane J. Fitch Partner, Plante Moran

he booming health care market offers lucrative investment opportunities. In 2017, private equity investment in the U.S. health care market totaled $83 billion, up from $72 billion in 2016, according to the American Investment Council. And the surge is continuing. The first few months of 2018 saw the busiest start to a year in health care mergers and acquisitions in more than a decade, with approximately $156 billion worth of M&A deals (of all types, not just private equity) already agreed upon, the strongest start in over a decade, according to Bloomberg Markets.

It’s a complicated market in the midst of major structural changes. The business model is changing from fee-for-service—in which providers are paid for each service performed— to value-based, in which they are paid based on the overall outcome in terms of a patient’s health. Payers reimburse at a lower rate, or in some cases not at all, for ancillary services like lab work. Instead, payers are focused on services that improve outcomes in demonstrative and quantifiable ways. Their move to bundled payments and capitation (paying a set amount per patient) is squeezing margins. Meanwhile, patients accustomed to better service in other sectors of the economy are becoming more demanding consumers of health care.

These new realities create new challenges.

They require that a private equity firm and its accounting partner have in-depth knowledge of its intricacies. Plante Moran, which has more than 2,000 health care and 400 private equity clients, works closely with its clients to help them profit from the new age of health care.

Plante Moran’s work with Frazier Healthcare Partners is a good example. The firm, which has raised $4.2 billion from 11 institutional funds, specializes in both growth buyout and venture investments. On the growth buyout side, Frazier

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leverages its knowledge and long-term relationships in the health care industry to identify possible acquisitions.

Technology is one of the most important factors. Health care has underinvested in technology compared with other industries like finance. Providers who have not changed their cost structures will suffer. Traditional hospitals, for example, are fixed-cost machines and many struggle to retool. But those that use technology to streamline and automate processes and lower costs can thrive. New free-standing emergency clinics, for instance, can deliver cost-effective care that is customer-friendly and appropriate.

Pre-acquisition due diligence is especially important and requires specialized actuarial and legal skills to evaluate risks and ­revenue streams.

A buyer needs to understand a ­target’s care model and associated risks, as well as whether its revenue streams and payer sources are well-diversified. It should also take professional liability and other exposures into consideration.

After an acquisition, Frazier usually focuses initially on evaluating and then upgrading or replacing technology, including building the company’s data reporting and analysis capabilities. An early win can be automation of paperbased processes that either prevent clinicians from focusing on patient care or that drive up administrative costs in the back office.

Even in this age of high valuations in general and increased complexity in health care specifically, private equity firms that are equipped with the right expertise and experience can find and profit from health care investments. // Duane J. Fitch, CPA, MBA, FACHE, is a partner with Plante Moran and has more than 25 years of experience specializing in helping health care organizations develop and exceed their strategic, financial and operational objectives.

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ACG@WORK

H ACG MINNESOTA ACG Minnesota hosted its 14th Annual Upper Midwest ACG Capital Connection at the Renaissance Minneapolis Hotel, The Depot. The event brought together 500 deal-makers from across the country. Jeff Kiesel of Restaurant Technologies was the keynote speaker.

ACG ORANGE COUNTY F ACG Orange County recognized the region’s highest-performing companies at the organization’s 23rd Annual Awards Gala at the Hotel Irvine. Nearly 500 executives attended the event.

H ACG KANSAS CITY ACG Kansas City hosted its annual ACG Capital Connection and Wine Tasting with more than 250 attendees.

The event brought together senior leaders and business executives in the dealmaking community for an afternoon of networking.

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H ACG NEW YORK ACG New York held its 2018 SummerBash at the Central Park Boathouse, where 150 attendees came together to network. Pictured (left to right) are David Hellier, Bertram Capital; Heidi Deiner, Citizens Bank; David Acharya, AGI Partners LLC; and Marcia Nelson, Alberleen Family Office Solutions.

ACG NEW YORK F ACG New York hosted its 8th Annual Champion’s Awards to honor the leading middle-market transactions, firms and deal-makers who are driving middle-market growth and helping to create deal flow within the ACG New York community.

H ACG CLEVELAND ACG Cleveland hosted a fireside chat with Lee Banks, president and COO of Parker Hannifin. The event drew 190 attendees who gathered to learn more about the successes of Parker Hannifin, a 100-year-old Fortune 250 company. Banks has won the chapter’s Deal Maker Award three times over the past 22 years.

MIDDLE MARKET GROWTH // NOV/DEC 2018

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ACG@WORK

H ACG NATIONAL CAPITAL ACG National Capital held its 16th Annual Corporate Growth Awards gala, where 450 attendees gathered to honor 11 winners representing successful growing companies, deals and deal teams. The Regional Impact Award was presented to Nestle USA, which moved its headquarters to northern Virginia last year. Nestle has generated numerous jobs, increased the area’s economic base, and contributed to multiple community social services.

ACG BOSTON F ACG Boston hosted Providence Networking Night, which brought together the M&A community from Boston and Rhode Island to hear a panel of local experts discuss when a business should consider growth equity as a funding option. ACG Boston began holding events in Providence in 2017 to broaden and strengthen New England’s M&A community and tap into the active deal network in Rhode Island.

H ACG BARCELONA ACG Barcelona hosted its 6th Annual Summer Party with 90 attendees. During the event, the chapter’s current president, Javier Perez Farguell of Clearwater International, recognized the achievements of Sergio Sanchez Sole, past president of ACG Barcelona.

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E ACG SEATTLE ACG Seattle’s young professionals group, Y20, hosted its annual Summer Social with Dan Price, founder and CEO of Gravity Payments. Price weighed in on the benefits of his credit card processing company’s $70,000 salary minimum for all employees.

H ACG NEW JERSEY ACG New Jersey hosted its 7th Annual Corporate Dinner event, which brought together more than 160 corporate executives for an upscale evening of networking. Don Katz (center), founder and CEO of Audible, was this year's featured speaker.

CONTACT Want to share photos from your recent chapter event? Email us at editor@acg.org.

MIDDLE MARKET GROWTH // NOV/DEC 2018

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THE LADDER

MEGAN KNEIPP joined Blue Point Capital Partners as head of business development. She will be responsible for overseeing new deal origination, strengthening investment banking relationships, and supporting acquisition sourcing. Prior to joining Blue Point, Kneipp was vice president of business development at CenterOak Partners.

MARIE BURZO has been appointed partner in BDO’s New York and New Jersey office. She has more than 13 years of experience in the technology, franchise, pharmaceuticals, and manufacturing and distribution industries. Burzo is part of BDO’s Retail and Consumer Products group and previously was a director in BDO’s New Jersey office.

PETER JAFFE was appointed managing director of Gordon Brothers Finance Company, where he will lead the U.K. and European financing platform from London. Jaffe brings over 20 years of experience from previous roles, including managing director at JPMorgan and, most recently, founding partner of Grovepoint Credit.

CRISTINA RUBBO joined Watermill Group as director of finance. She will be responsible for managing the corporate accounting and finance function and supporting Watermill’s investors. Previously, Rubbo served as manager of corporate finance at Bain Capital LP.

SEAN WINDSOR has been appointed partner at BDO in the firm’s New York and New Jersey office. Windsor has more than 30 years of experience in investment banking, auditing and private industry. He was previously managing director of BDO’s New York office.

TIM SMITH has joined Dixon Hughes Goodman as valuation ­services principal. Smith has over 20 years of experience in both the United States and Europe. Previously, he was managing partner and founder of QueensGate Corporate Finance.

SCOTT OUDHEUSDEN joined Watermill Group as senior associate.

He will be responsible for evaluation, due diligence and execution of possible transactions. Oudheusden joins Watermill from Stadium Capital Management.

SUZANNE BURKE has joined Ravinia Capital as senior director.

Burke brings over 30 years of experience in public and corporate accounting, credit management and turnaround consulting. She spent the past several years at Cole Taylor Bank as special assets portfolio manager and as commercial and asset-based lending credit officer.

MORE CAREER INFO Watch for more career information in The Ladder monthly e-newsletter.

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$200 SAVINGS BEGIN SOON R E G I S T R A T I O N

O P E N S

D E C E M B E R

2 0 1 8

W W W . I N T E R G R O W T H . O R G

# I N T E R G R O W T H © 2018 Association for Corporate Growth. All Rights Reserved.

MIDDLE MARKET GROWTH // NOV/DEC 2018

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IT’S THE SMALL THINGS

DIRECT INVESTING // Give it to me straight

1

Family Values U.S. family offices employ an average of three

5

More than Middling Returns A 2018 survey conducted by Intralinks and Global

investment professionals per office, two of whom

Fund Media revealed that 64% of limited partners

focus on private equity, according to a survey from

will focus their direct investments on middle-

the Family Office Exchange published in 2017.

market deals. —Intralinks

—Institutional Investor

2

Investors See Real Potential in Property

6

The value of co-investment deals more than

Real estate remains the third-largest asset class

doubled from 2012 to 2017, when it reached $104

for family office direct investments, representing

billion, but direct investment by limited partners

about 10% of family office portfolios in North Amer-

has stayed relatively stable at around $10 billion.

ica, despite declining by 0.7% from 2016 to 2017,

—McKinsey

according to a UBS-Campden report.

—National Real Estate Investor

3

In It Together

7

Power of the Purse Canadian pension plans are compensating their

Next-Gen Priorities

staff involved with direct investing at levels com-

Single-family offices that have transitioned lead-

parable to those of middle-market private equity

ership to the second generation are more likely to

firms—in the $1 million to $2 million range, sources

make direct investments than those led by the first

say—in an effort to attract qualified talent.

generation, according to an iCapital report.

—Pensions & Investments

—iCapital Network

4

Penchant for Partnerships

8

The (Flat) State of SWF Direct Investment Value

Investing directly without private equity firms is

Last year, sovereign wealth funds completed 303

far from the norm for limited partners like pension

direct equity investments, up from 290 in 2016.

funds and sovereign wealth funds. Only 62 of more

But the value of these has largely stayed flat:

than 300 direct deals done by LPs in 2017 were

$52.6 billion in 2017, compared with $51.4 billion

solo endeavors, according to the Boston Consulting

the prior year. —International Forum of Sovereign

Group. The majority were co-investments. —Reuters

Wealth Funds

Š 2018 Wipfli LLP

It’s a Muddy MIddle Market,

thInk of us as your all-terraIn VehIcle.

Great deals and legendary stories are made in the trenches.

Risk is high. Reward is higher. You often take the road less traveled and value a guide who knows the terrain.

Wipfli is your Private Equity Guide, your all-terrain vehicle, powering through with accounting, tax, technology, and advisory services. From fund and transaction advisory services, to portfolio performance and management, you get powerful direction to plow forward, achieving growth while balancing compliance.

Gear up. Gain More Traction with Wipfli.

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RUSTED

REVIVED

Abandoned Bethlehem Steel complex

New Tradepoint Atlantic project

Innovative Real Estate Redevelopment Solutions for the 21st Century Hilco Global’s vision of transforming obsolete industrial and manufacturing facilities was realized by transforming a closed steel mill into a powerful economic engine in the Baltimore/Washington DC area.

Today, Hilco-owned Tradepoint Atlantic is a growing trimodal logistics facility attracting new tenants such as Amazon ®, FedEx ®, Fiat Chrysler ®, Harley-Davidson ® and others. Hilco Redevelopment Partners provides: • Capital to guarantee completion of all project phases.

• Redevelopment of the sites in a socially responsible manner.

• Monetization of assets, including receivables, inventory and PP&E.

• All remediation to regulatory standards.

Gary Epstein at 847.418.2712 or gepstein@hilcoglobal.com

VA L U A T I O N

I

MONETIZATION

I

ADVISORY