Talking Top Quartile with Kent Wallace, Partner, Sterling Group

Sterling Group Partners III LP, the vintage 2010 buyout fund from Houston-based The Sterling Group, logged a net IRR of 23.5 percent as of December 31, 2014, for Sacramento Private Equity Partners. That’s ahead of the top-quartile threshold of 21.4 percent in an annual analysis of pension fund data by Buyouts.

Partner Kent Wallace, who joined Sterling Group in 2001, spoke with Buyouts by phone from his firm’s headquarters in Houston.

How difficult was it to raise Sterling Group Partners III in the wake of the financial crisis?

Our second fund, which we raised in 2005, was $470 million. For the third fund, we started in mid-2009 and it was a difficult time period to be raising money. A lot of LPs simply couldn’t commit to new funds or to private equity because their allocations to PE as a percentage of their total portfolio had risen above their target. That was primarily a result of the significant decline in their total portfolios from the stock market crash.

Because of these and other issues, it was a difficult time generally, but we were quite successful. Our target was $600 million and we were able to close at our hard cap at $820 million in May 2010. The fund was oversubscribed. We were pleased with how it worked out, since we were a little anxious to get into that market. We established a number of new partnerships with LPs that we expected would support us for a long time.

Did your past performance help you raise the fund in 10 months?

Both Fund I and Fund II were very good performers and that’s obviously key for investors. At the time, people were concerned about how GPs would create value given the weak economy. For us, the value creation and returns we were generating were solely attributed to strategic and operational improvements we made in businesses and that resonated with investors. They liked that we had a sustainable strategy rather than achieving our gains by picking a certain sector or through financial engineering. We also had a very stable team. When you have that, plus a consistent strategy and good returns, you’ll be able to raise money.

Did you use a placement agent?

We used Lazard for our second and third funds.

What was the first deal from the fund?

Saxco, a distributor of glass bottles to wineries, craft beer and spirits producers. Saxco had been owned by two brothers for a number of years. They were at the point in their career where they wanted to transition out of the management of their business over a period of a couple of years. We worked with them to buy their business while they retained a minority position. The business has done well. We still own it. Family-owned businesses like Saxco are a key focus for us. They account for about 25 percent of our deals over time.

What exits drove performance?

We’ve had two pretty significant exits. Our second Fund III investment was Stackpole, an automotive supplier we acquired from Tomkins Industries Inc. The fund acquired three divisions from Tomkins. We’ve had a very successful relationship with them in terms of the opportunity to buy divisions from them. We bought Stackpole in 2011. We sold it just over two years later to Crestview Partners. The business did extremely well, with EBITDA up by more than 80 percent on an organic basis. A portion of that was due to rebounding car builds. We also had some market share gains and we significantly improved the performance of our European operations. We also put some innovative cost savings plans in place that significantly increased EBITDA.

The other exit was Liqui-Box, a corporate carve-out we bought from DuPont. It was the fourth division we had bought from DuPont over the history of our firm. Carve-outs generally are a significant focus for us. About half our deals are corporate carve-outs. Liqui-Box is a manufacturer of bag-in-the-box packaging and it was really just a business line for DuPont at the time of our acquisition. We had to invest heavily in people, systems and processes to get the company to function as a standalone entity. During our ownership, the business gained market share and expanded into other packaging applications. We were able to sell it to Olympus Partners last year. Both Liqui-Box and Stackpole generated 3x to 4x over our investments. They were very successful investments for Fund III.

What companies remain in Fund III and how are they doing?

There are six companies left in the fund. We’re very excited about their trajectory and we expect a number of them will be quite successful investments for us. Another Tomkins carve-out is Dexko Global, a manufacturer of trailer axles. We bought it in 2012 and its EBITDA had grown by more than 50 percent. In December, we acquired a major European axle maker as an add-on. Now Dexko is three times the size of when we bought it. We’re excited about where that’s headed. American Bath Group, the third division we bought from Tomkins for Fund III, was the only company we bought that was losing money. We don’t typically buy companies that are not generating positive cash flow. The team there has done a great job of putting into place significant operational changes. The business had $40 million in EBTIDA in 2015. Overall, we’re still very optimistic about the fund and where it’ll ultimately shake out.

Are you worried about the big selloff in public equities impacting your fund performance since many private companies held in private equity funds are marked to publicly traded companies?

Obviously the most important thing is the value of each company at exit. We don’t expect public markets to impact that materially. Our companies are smaller than most public companies. Often there’s no clear comps in the public equities market. It is part of our valuation methodology, but it’s a small part. The most important is similar transaction multiples of companies that are actually sold. It’s not a major impact on us from quarter to quarter, but it’s a small impact.

Have you been impacted by the carnage in the energy sector?

It’s unusual that we’re in Houston and we’re not really affected by that. We focus on manufacturing, distribution and industrial service businesses. Most of our businesses are located outside of Texas and aren’t focused on energy. A lot of our companies have seen their raw material prices come down substantially. It’s helping our companies’ margins.

How did the fund contribute to the evolution of the firm?

It wasn’t a major change. It was another step in our growth. Our investment strategy has been the same: to focus primarily on family-owned businesses and corporate carve-outs and partner with management teams to put in place operational and strategic initiatives to allow businesses to grow faster than their competitors. We continued our focus on manufacturing, distribution and industrial service businesses. The team has been very stable. We’ve had no partners leave other than through retirement. We’ve added a lot of team members on the investment side, as well as folks focused on investor relations, deal sourcing, operations and regulation.

Our deal size has been about $220 million to $250 million in enterprise value throughout the history of the firm. Before the third fund, we had to bring in equity partners for deals. We’ve gradually grown into deals of that size with the ability to write equity checks out of our own fund. That’s where we are now.

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Photo of Kent Wallace courtesy of The Sterling Group