Eric Berke shared his thoughts with Global M&A Network on the drivers of Canadian M&A and PE deals, the advantage of having strong relationships in sourcing quality deals, the importance of developing value creation theses during the due diligence process, the potential to unlock value in “carve-out” situations, as well as on what Limited Partners are looking from their General Partners in 2011.
Eric Berke, Managing Partner, Torquest Partners
Q. Increased middle market deal making and rebounding equity markets is expected to further fuel and strengthen the Canadian private equity market. Do you agree with this assessment, and why?
Mr. Berke: We have certainly seen strong mid-market deal flow in Canada in 2011. From a short-term perspective, we see the drivers as being strong debt and equity markets as well as vendors who were unable to sell their businesses on attractive terms during the recession. These vendors – including private equity owners – are creating a small wave of deals that otherwise might have taken place in the 2008–2010 period.
From a long-term perspective, large numbers of middle-aged Canadian entrepreneurs continue to come into the market in search of a transition plan for their mid-market businesses. This has been going on for a few years, and we see no sign of it stopping in the next 10 years as the baby boom generation enters retirement.
Q. In light of a robust rebound in PE deal volumes, where do you think valuations are headed, and at what point does the increase in valuations become a deterrent to executing deals?
Mr. Berke: Through the second half of 2010 and in 2011, we’ve seen valuations increase significantly. This appears to be driven by the large overhang of private equity capital in North America as well as the return of robust debt markets. In some cases, we’ve seen valuations return to 2007–2008 boom-time levels – which frankly makes us uncomfortable.
We executed four major transactions in 2010 at relatively attractive prices, but we’ve been less active in 2011, partly as a result of the froth we’ve seen in the market. We’re typically uncomfortable participating in highly competitive, top-dollar auctions unless we believe we have a differentiated and proprietary angle that gives us a good reason to win.
Q. How do these valuation cycles affect your deployment of capital?
Mr. Berke: Over the years, we’ve been successful at navigating the market cycles and knowing when to be buyers and when to be sellers. Our current fund is a 2006 vintage, but is heavily weighted to transactions closed in 2010 as a result of the discomfort we felt putting money to work in the 2006–2008 period.
Q. How is the investment climate in Canada and what are its attractive attributes?
Mr. Berke: Canada remains an excellent place to invest generally. It continues to lead the G7 in GDP growth, as it has done for over 10 years. Canada’s public finances are in excellent shape, the currency is strong, the banking system is sound, and the cost of doing business is low. All of these factors provide tailwind to investment activity in our market.
Q. Can you elaborate on TorQuest Partners’ experiences in certain Canadian industry sectors including financial services, business services, chemicals, branded consumer products, and manufacturing?
Mr. Berke: Over time, we’ve had very successful investments across all of those sectors. Through those investments we’ve also built good in-house domain expertise as well as strong relationships with industry experts and executives. This gives us an edge when we’re evaluating new opportunities in those sectors.
At the same time, while we have sectors in which we’re most comfortable, we remain a generalist firm. In the relatively small Canadian private equity market, a very sector-specific investment strategy is difficult to employ and the leading private equity firms in Canada tend to be generalists.
Q. What deals exemplified strong performance among the aforementioned sectors?
Mr. Berke: Within the sectors mentioned, some particularly strong performers in our current portfolio include Pinova Holdings, our specialty chemicals platform, and SCM Insurance Services, which operates in the property and casualty insurance sector. Both have great industry tailwinds behind them and are very well positioned within their industries.
Q. What is an ideal company for TorQuest to invest in and how do you spot them?
Mr. Berke: Generally speaking, an ideal investment for TorQuest is (a) in a Canadian mid-market company in an industry with attractive fundamentals, and (b) in a situation where the company can clearly benefit from external expertise and significant change to accelerate its performance.
We frequently encounter our best mid-market opportunities in entrepreneurial transition situations, in carve-outs of neglected divisions from corporate parents, and in businesses that have never had the access to capital required to reach their full growth potential. We mainly source our deals through our networks and relationships in Canada, and we’ve also been successful in building a brand over time in Canada as a good partner for management teams. This results in strong inbound deal flow for us.
Q. What is TorQuest’s due diligence process across its various buyout strategies?
Mr. Berke: A good and rigorous due diligence process has many elements. When I consider how we generally approach transactions, two key features stand out. First, we go to great lengths to learn the ins and outs of the industry environment we will be operating in, usually working hand-in-hand with an industry veteran. In particular, we aim to ensure that we have a crystal clear understanding of where and how the target fits into the industry environment.
Second, we spend a great deal of time developing our value creation thesis during the due diligence process. This goes far beyond the financing arrangements and the financial model and considers exactly how we can improve the business strategically and operationally to create value. This work leads directly into our post-closing plan and a strategy development process in cooperation with management.
Q. Can you elaborate on TorQuest’s investment focus on corporate “carve-out” situations?
Mr. Berke: We have completed a large number of corporate carve-outs in our history. These situations can make for excellent investment opportunities They can be very complex and difficult to execute, and we find that only a relatively small number of private investors have the skills, the experience, and the willingness to see them through. This reduces competition for the asset.
We’ve acquired businesses that were little more than product lines or a plant, and we’ve had to put in place the management teams, the sales teams, the back-office functions, IT systems, and more to create viable standalone businesses. Part of this process usually involves negotiating a very comprehensive transition services agreement with the parent company.
Q. How do you create value in “carve-out” situations post-acquisition?
Mr. Berke: Carve-outs typically involve corporate divisions that have been unloved by the parent company for a period of time, and as a result are frequently under-invested, under-managed, and often are suffering from a lack of clear strategy and focus. We find that enormous value can be unlocked by creating a standalone business, strengthening management and providing appropriate incentives, and clarifying the strategy.
Q. Congratulations on the add-on acquisition of LyondellBasell Flavors & Fragrances, LLC. How was this deal sourced and what was the process of acquiring the asset given Lyondell’s bankruptcy proceedings?
Mr. Berke: In January 2010, we acquired Pinova, Inc., a specialty chemicals platform that manufactures products from natural, renewable resources. During the acquisition process in 2009, we noted that the flavor and fragrance division of LyondellBasell would be an outstanding strategic fit with Pinova. The business was not available at that time due to Lyondell’s bankruptcy process, but we stayed very close to the asset and had the opportunity to build a relationship with management.
We approached Lyondell again immediately after it emerged from bankruptcy and encouraged them to put the division up for sale. We ultimately succeeded in that process by being seen as a highly credible bidder who not only had a strategic asset in the space but could also complete a corporate carve-out efficiently.
Q. Could you elaborate on the current state of credit markets effect on mid-market buyout deal structures? In your opinion, what is a “conservative capital structure”?
Mr. Berke: In the first half of 2011, we’ve seen leverage ratios go up and equity contributions go down significantly from where they were in the same period of 2010. When we talk about using conservative capital structures at TorQuest, it means we aim for leverage levels that give us flexibility to execute our growth strategies and it also means we aren’t relying too heavily on leverage to drive our returns.
Q. How important is leverage in delivering returns?
Mr. Berke: We believe that good mid-market private equity firms should be able to drive a large portion of their returns through strategic and operational change and execution. In comparison to the average North American mid-market PE firm, our average leverage multiples on acquisition are lower while our returns have outperformed significantly over a long time period.
Q. Could you elaborate how private equity firms create value without high levels of leverage?
Mr. Berke: We aim to create the majority of our value through growing earnings – both organically and through add-ons – and by improving our businesses such that they attract higher multiples on exit. Leverage is clearly a factor in enhancing returns, but it is not our primary focus.
Q. What are the pros of having low leverage?
Mr. Berke: We tend to look for businesses where maximizing value requires significant change, such as a rationalization of production facilities or a shift in strategic direction. In these situations, being heavily levered constrains our options and adds risk.
We often say that our businesses need “runway” to make changes and improve performance, and excessive leverage can shorten that runway. After we’ve implemented change and seen that the strategy is working, we’ll frequently look at refinancing a business, for example in conjunction with an add-on acquisition.
Q. How does TorQuest Partners engage with the management team of its portfolio company?
Mr. Berke: We prefer to be a strong partner to our management teams and to work very closely alongside them. At any given time, our Partners have responsibility for no more than two portfolio companies, allowing us to commit a great deal of time and attention to each investment.
As we seek to accelerate the performance of a business, we want to ensure that the management team has as much support from us as they need and also that the needs of the controlling shareholder are taken into account when major decisions are being made. It’s not uncommon for one of our CEOs to call us multiple times per day when a major initiative is underway. At the same time, we are also very clear about where our role as investors should begin and end.
Q. What are the responsibilities of the management team of a portfolio company?
Mr. Berke: Management must have ultimate responsibility and accountability for operating decisions, and we try to be aware of our limitations when it comes to providing input on day-to-day matters. Our fundamental responsibility it to make sure we have the best possible management teams, to hold them accountable for business performance, and to augment their skills by delivering insights and opportunities from outside the business.
Q. What are the emerging trends in Canadian mid-market PE exits?
Mr. Berke: Over the past 18–24 months in Canada, we’ve seen a mixture of exits to both strategic players and PE players (after a period when not many exits of any kind took place during the downturn). By contrast, IPOs of mid-market portfolio companies have remained relatively scarce in Canada. Prior to the regulatory change in 2006, the public income trust markets in Canada provided a rich source of mid-market private equity exists including for TorQuest. However, the public market exits haven’t yet recovered to those levels.
Q. What is TorQuest Partners’ preferred exit strategy?
Mr. Berke: At TorQuest, we have exited our investments in a variety of ways. If we have a preferred strategy, it is growing a business into the “sweet spot” for a strategic acquirer who begins to see it as a must-have asset. This isn’t always possible and we’ve realized great wins through PE exits and the public markets as well.
Q. TorQuest has managed more than $700 million of equity capital and has completed 12 platform investments (34 total acquisitions). Is Fund II fund fully deployed, and are there any near term plans for fund raising?
Mr. Berke: Fund II is largely deployed. We still have capital remaining to complete another platform acquisition as well as to support our existing investments in making add-on acquisitions. Later this year we will be launching a fundraising process for our third TorQuest fund.
Q. What in your opinion are Limited Partners looking for from their GPs post the 2008–2009 crisis?
Mr. Berke: Our experience is that since the financial crisis, LPs are increasing scrutiny of GPs and some are reducing the number of GP relationships they have. The successful GPs will not only have good track records, but will also have shown that they can add operational value to their portfolios.
Having a good, deep team is also critical, as is the general level of comfort an LP has with how a GP operates and how they manage the relationship. Finally, GPs that show they can consistently invest successfully in attractive niches such as the Canadian mid-market in which we operate will have an advantage.
Q. What makes TorQuest unique in the universe of other mid-market Canadian private equity firms?
Mr. Berke: The universe of mid-market Canadian private equity firms is relatively small in comparison to the US. We have some key differences from the other Canada-based players in the market. We’re more focused on Canada and our team has very deep and long-standing relationships in the Canadian market. This is enormously valuable in driving deal flow, obtaining financing, and sourcing executives.
We tend to focus more than others on driving returns through strategic and operational change as opposed to through leverage and market trends. We’re attracted to situations where there is significant work to do to help a company realize its potential. Finally, we also have a very deep and strong team that we’ve assembled over the years.
Q. On a personal note, what book are you currently reading?
Mr. Berke: I’m reading The Wave by Susan Casey. It’s a great summer read about science, nature and the constant human quest to understand and conquer. It has a great story about surfing intertwined within it – I’ve always wanted to surf, but can’t quite seem to get the hang of it!