Are Specialized Funds Still Special?

These days, specialized PE firms are all the rage. It’s a great way to distinguish oneself from the (still growing) pack. But what happens when you’ve put all your eggs in one basket, and that basket isn’t recession-proof? I’m asking myself that in light of the recent slew of LBO-backed consumer products companies filing Chapter 11. Look no further than Pierre Foods, Steve & Barry’s, Western NonWovens, and possibly Mervyns.

The consumer products, food and retail sector (which I’ll refer to simply as “consumer”), with its ties to the fluctuating demands of consumers, has a pile of PE firms dedicated specifically to it. Examples of consumer-focused firms include: TSG Consumer Partners, North Castle Partners, LNK Partners, Mistral Equity, VMG Equity Partners, and Catterton Partners.

I talked to a handful of the firms and a few outsiders to ask: If the entire sector begins to buckle under economic headwinds (which, to be fair, it hasn’t yet), will these consumer-concentrated firms be hit the hardest? And the question facing all PE firms now, but especially the ones I mentioned: are they going to be forced to invest in situations at a bad time just to deploy capital?

The short answer to both is probably not. The key for these firms’ survival is simple: While they may be concentrated in one sector (consumer products and retail), they are diverse within it. According to evidence I gathered, the argument in favor of sector specialization is that, because they’re experts, the sector-specific firms will pick better targets than, say, a generalist who decided to dabble in the sector when it was on an upswing. Furthermore, the sector is big enough that there are a few recession resistant coves in which to invest.

TSG President and CEO Chuck Esserman said sales and earnings on his firm’s investments are up more than 25% for the first half of this year. The firm’s approach is to use little or no leverage, so the companies have free cash flow to invest in the business, and returns generally come from growth, he explained.

John Poushine of Poushine Cooke Capital Management, which invests in retail but also manufacturing and health care services, said three of his firm’s eight portfolio companies are “feeling the pain.” Two of those companies are tied to the housing industry. His firm’s strategy is to work with the lenders to restructure the debt and avoid principle repayments during the recession. Meanwhile, his firm is avoiding store expansions and “cutting expenses to the bone” while these troubled businesses ride out the downturn.

David Landau, of LNK Partners, said “Any portfolio company in the consumer sector would be better off not in a recession. The positive is maybe your companies are less vulnerable because you’ve been intelligent and thoughtful.” Conservatively capitalized deals don’t hurt, either, he added.

The riskiest proposition for a consumer-focused firm is a growth-oriented firm that uses leverage. The second riskiest, according to those surveyed, is a value-driven firm that paid up for companies in the last cycle.

So what are some large, highly leveraged, “second tier,” consumer-facing companies that may be at risk? According to an informal survey, watch out for Outback Steakhouse, owned by Bain and Catterton and Claire’s Stores, owned by Apollo.

One last note: Landau pointed out the potential advantage of the recession for a firm like his. “Now that people who dabbled in consumer when it seemed easy have run for the hills, it may be a better time for us to invest with less competition,” he said.