GP Profile: ACI Capital Cuts Its Losses

ACI Capital, once a promising mid-market buyout shop, has stopped investing in new platform companies. Executives at the New York-based firm told investors in September that they would wind down the portfolio after making only two investments from its second fund, one of which was a write-off.

After successfully deploying a $150 million SBIC fund, closed in 2000, ACI Capital raised $335 million for its second fund in 2006 after only a few months of fundraising. Support came from about 100 investors including the State of Wisconsin Investment Board and WP Global Partners. The aim was to invest between $10 million and $50 million in capital into companies across a variety of industries generating sales of between $50 million and $500 million, according to a Buyouts story at the time.

But according to a source close to the firm, ACI Capital’s nine investment professionals have decided to cut their losses primarily because the fund is underinvested: Only about 20 percent of Fund II has been deployed in two investments. The fund’s fees were so high relative to the value of the portfolio it would have made it extremely difficult to produce the kinds of returns promised to investors, the source told Buyouts. The investment period would have ended in less than two years.

A limited partner told Buyouts that the fees have been reduced to a bare minimum to keep the lights on at the firm as it manages out the remaining two investments. “It’s a disappointing outcome to be sure, but they acted very responsibly,” this LP said. “They could have dragged this into a zombie fund situation, but they decided to do the right thing.”

The firm’s demise illustrates the dangers emerging fund managers (and their backers) face as they try to follow up on a strong debut fund. Many firms take advantage of their intitial success to raise a far larger second fund from a more diverse pool of investors. But fortunes can change fast, and many firms in the last few years have struggled to build on their early momentum.

Promising Early Days

ACI Capital is led by Kevin Penn, a 25-year veteran of private equity on both the LP and GP side, including a stint as principal with Adler & Shaykin. Ironically, that firm stopped investing in the early 1990s after LPs, concerned the firm wasn’t putting enough money to work, demanded their money back from its $178 million fund, raised in 1989. Penn intends to eventually transition to work full-time at American Securities, a New York-based investment firm that is affiliated with ACI and where Penn is a managing director, according to a source close to the firm. Penn declined to comment for this story.

ACI Capital, which traces its roots back to the 1950s as an alternative investment manager for a wealthy New York family, began to invest for third parties in a fund format with its SBIC fund in 1999 and 2000. ACI Capital does not specialize in any particular industries, although Penn told Buyouts in 2006 that he preferred to “go into industries people don’t like or invest in them at moments that are less understood.” Prior to closing Fund II, the firm had made investments in wireless communications, restaurants, weight loss management, insurance, catalog retail, publishing and chemicals.

The firm had about 10 investment professionals at the time the second fund closed, according to an LBO Wire report at the time. They included Penn, Ezra Field, a managing director who joined ACI Capital in 2001, and who previously was an entrepreneur and venture capitalist who co-founded Teachscape, a provider of teacher training to public schools; Matthew Bronfman, a managing director with numerous business interests in Israel who, prior to joining ACI Capital in 2001, was CEO of Candle Acquisitions Company, a private-label specialty candle manufacturer; and Hunter Reisner, a managing director who joined the firm in 2005 after being a founder and managing partner of Citigroup Investments Private Equity Group, which eventually became Citigroup Private Equity.

Fund I produced some blockbuster returns, especially in the food industry. Most notably, in 2006, ACI Capital and co-investor MidOcean Partners sold the diet company Jenny Craig Inc. for $600 million, generating 11.5x its invested capital, according to a Buyouts story at the time. In 2003, ACI Capital realized a return of “north of 50 percent” when it and Western Growth Capital LLC sold Mexican casual dining chain Qdoba Restaurant Corp. to Jack in the Box Inc. for $45 million, also according to Buyouts. By September 2006, Fund I had already generated 2.5x invested capital, and a source close to the firm said the fund could ultimately post a 4x to 5x investment multiple. “Fund I continues to do great,” the LP said.

Indeed, 2006 was an especially promising year for ACI Capital. Riding the success of Fund I, its second fund was oversubscribed. Firm executives even had to cut back commitments from some LPs and deny others a slice. One investor whose organization ultimately did not commit to the fund but followed its development recalled a meeting in which Penn basically said the fund probably wouldn’t be able to take any more commitments. “They were feeling pretty good about themselves,” this investor said.

Things Turn Ugly

But after ACI closed Fund II in September 2006, things took a turn for the worse. The firm didn’t make an investment until June 2007, when it bought Hollywood Tans, a Sewell-N.J. based tanning salon chain. “The overall criticism was they couldn’t find deals and were slow to pull the trigger,” the second LP said. “They didn’t put the money to work, period.”

In fact, executives at the firm thought the market was overpriced and had trouble finding deals that made sense, a source close to the firm said. Deal flow was not the problem; it was the prices of deals that Penn, whom sources stressed has an excellent overall track record, and his colleagues couldn’t reconcile with. This is similar to what happened to Adler & Shaykin after the go-go days of the 1980s. “Quality transactions aren’t available anymore,” Leonard Shaykin, the founder of the firm, told the The Wall Street Journal in December 1991, in a quote that mirrors ACI Capital’s rationale for not investing. “We would rather back away from some deals, rather than put money at risk.”

To make matters worse, Hollywood Tans was a disaster almost from the outset, according to all sources interviewed. “Kevin is a very smart, selective, contrarian guy, who does not like to overpay and who has a great track record,” the first LP said. “And the one thing he does move on is this, and it’s a nightmare.”

Details of what exactly went wrong with this deal, and how much ACI Capital lost, are murky. A source close to ACI Capital said the firm, through a corporate entity, eventually sued the sellers of the company for fraud and other infractions, and that the parties are working on a settlement. A number of franchisees have also sued the company, alleging fraud. “It was akin to buying a car and finding there’s no engine in it,” the source close to the firm said of the company.

ACI Capital has effectively written off the investment, although our source close to the firm said the company still has some value. The same source said that even if Hollywood Tans was a good deal, the fund still would have had to call it quits. The fund’s net asset value would have improved, this source said, but not enough to justify the fees LPs were paying. Other sources were skeptical of this argument, however. “I think investors would have been a little more kind and lenient if it had been good deal,” the second LP said. “But the reality is the deal pace was incredibly slow.”

Not long after the close of the deal, Field, who helped lead the Hollywood Tans deal, left ACI Capital: Buyouts reported in September 2007 that he had joined Roark Capital Group. Field had also helped lead some of the firm’s most successful deals, including Jenny Craig and Qdoba, according to his profile on Roark Capital’s Web site. Why Field left is not clear, and he did not return calls for comment. But his departure, so soon after closing Hollywood Tans, roiled Penn and LPs, according to sources. “Most LPs viewed him as a pretty critical member of the team,” one source said.

By the summer of 2009, some LPs were restless. Since Hollywood Tans, the firm had made one more investment: in August 2008, it formed Unified Logistics Holdings LLC, a company focused on the delivery of extraordinarily large freight items, through the acquisition of two transportation logistics companies. (That investment is “more or less on track,” according to our source close to the firm). Meanwhile, LPs continued to pay fees on the $335 million fund. “We were frustrated, and we talked to others that were frustrated,” one LP said. “We knew something needed to be done and it took a while to get something done.”

Penn and his colleagues assessed the fund’s prospects. They were not good. They realized that to deploy the fund within its investment period, they would have to invest faster than any of them had invested previously, a risk that could induce more shaky deals. And even if they did deploy the capital, they felt that the odds that each deal would be successful enough to turn the fund around were against them. Around August 2009, Penn began speaking with LPs about halting new platform investments, a decision which became effective a month later, according to sources. “It was an unusual move and frankly, I think most of the LPs admired him for doing it,” the first LP said.

ACI Capital found itself in a difficult situation soon after it raised Fund II. It was the height of an unprecedented boom in leveraged buyouts, with cheap credit pushing valuations beyond reason. Investors throughout the private equity industry told GPs to hold off on investing at what felt like the top of the market. At the same time, however, LPs were paying fees and facing liquidity shortfalls. Many firms with more scale and resources than ACI Capital were able to ride it out. Leonard Green & Partners, for example, avoided control-stake buyouts from September 2007 until January 2010, but was still able to put $800 million to work through minority debt and equity investments. Others dove in and got burned. Penn, for one, was unwilling to invest in companies at prices he and his colleagues thought were too risky. Each source interviewed for this story said the firm’s story also had a lot to do with bad luck, a few strokes of which can cripple a small fund. “It could happen to anybody,” one source said.