Private Equity's New Entrepreneurs

They run their own firms, seek out smaller deals that don't generate headlinesand make returns that are on par with the big boys

Steven Klinsky arrived on Wall Street in the early 1980s, just as a pioneering group of leveraged buyout firms was launching deals that would define an era. Klinsky, the scion of a Detroit-based retailing family, was armed with an MBA and a law degree from Harvard. He started off at Goldman Sachs (GS) (see, 12/13/06, "All That Glitters Is Goldman") and moved to Forstmann Little, where he worked on the firm's epic battle for control of RJR Nabisco.

While Kohlberg Kravis Roberts won that fight, Klinsky helped lead Forstmann through a highly successful period in the '90s. He oversaw the $1.75 billion acquisition of General Instrument in 1990 and then took it public in 1992 for three times the purchase price. General Instrument was eventually bought by Motorola (MOT) for $17 billion in 2000.

Now, Klinsky is part of a new generation of private equity entrepreneurs who have left established firms to run their own shops. Klinsky launched New Mountain Capital in 2000, with support from major investors such as California Public Employees' Retirement System (CalPERS), the largest U.S. pension fund. He leads a group of nearly 30 professionals who manage $3.3 billion in assets. The New York firm has hit some home runs, including a fivefold return on Strayer Education (STRA). The returns for its 2000 fund hit 28% over the first five years. That's on par with the large, first-tier private equity funds, which often generate returns of 30% and in some cases even more (see, 12/28/06, "Private Equity's Big Winners").

Some of the private equity entrepreneurs are well known. Glenn Hutchins, co-founder of Silver Lake Partners, came from private equity leader The Blackstone Group. Silver Lake led the $11.3 billion acquisition of SunGard Data Systems in 2005, a deal that generated a lot of attention.

Smaller Deals

But other profitable firms operate far from the spotlight, because they tend to focus on deals that don't generate headlines. The current trend in private equity is for large funds to team up on monster-sized deals (see, 12/8/06, "Private Equity: What's the Limit?"). But the returns on smaller deals that don't capture public attention can be just as high, if not higher. In 2000, New Mountain took control of Strayer, a publicly owned operator of colleges, for $115 million; it later sold its stake for five times its money. New Mountain also created Surgis Inc., an outpatient surgery company in Nashville, entirely from scratch.

"We don't want to just play in the auction market where there are high prices and low returns and high levels of leverage," Klinsky says. "We want to find sectors we really want to be in, invest in good companies, and spend time working with management to make them even better."

Klinsky won't discuss the firm's results from its latest fund, but he has won the loyalty of substantial investors. After its initial investment, CalPERS put another $150 million into a New Mountain fund in 2005. Brad Pacheco, a spokesman for CalPERS, says that about a third of that money has been invested. "So far with a return of 20.3%," he says, as of Sept. 30, 2006. Returns in such funds tend to increase over time.

Different Markets

Private equity entrepreneurs often work well beyond public view, making innovative deals and creating new markets. At Liquid Realty Partners, co-managing principals Scott Landress and Jeffrey Giller say they are the global leader in the real estate "secondaries" market, in which they buy limited partners' interests in other managers' real estate funds.

While the "secondaries" approach has been used in other markets, such "secondaries hadn't been used in real estate," says Landress, a veteran of Bank of America (BAC), Merrill Lynch (MER) and other firms. Liquid accounts for the bulk of transactions in the real estate secondaries market, said Giller, a veteran of Somera Capital Management.

JH Partners and Catterton Partners both have carved out niches in the consumer market. JH has focused on the "aspirational" luxury market, for mainstream consumers who stretch to buy special products once geared mostly toward the rich. JH, a San Francisco-based firm with $550 million under management, is known for deals such as its acquisition of premium skin-care company Bare Escentuals Beauty. JH is run by founder and President John Hansen. Its other investments include the coffee chain Peet's Coffee & Tea (PEET), high-end kitchen appliance provider CHEFS, and Design Within Reach, which has tapped into a growing mass-market appreciation for furniture design.

The newer breed of private equity firms often invests the bulk of their time doing broad research into business and finance. "We conduct our own trend research to support the diversity of our consumer focus," says Catterton founder and managing partner J. Michael Chu. The firm's diverse consumer holdings have included the Odwalla juice company and Breyers Yogurt, timely investments that caught the growing wave of interest in healthier foods.

Searching for Winners

At New Mountain, Klinsky's staff operates like a brain trust. Each investment professional is required to nominate three or four sectors a year for scrutiny. After an annual review of the nominees, Klinsky and his staff break up into small teams to focus on the seven or eight sectors that get the nod. They spend months scouring their sectors for companies that meet four criteria. They are looking for companies that perform well even when economic conditions are difficult. They like companies that have what Klinsky describes as "true free cash flow." He defines that as earnings before interest, taxes, depreciation, and amortization (EBITDA) minus the cost of capital spending and the cost of capital itself.

Klinsky, whose family owned the Albert's retail chain, also looks for acquisitions with high barriers to entry. And he looks for companies in a fragmented market, with more than just one or two big players that are for sale. He said the Strayer deal met all of the requirements. Strayer is licensed by the same groups that license Ivy League colleges, and the long approval process is a high barrier to entry. And the fact that students pay tuition at the beginning of a semester, instead of at the end, after the educational product is delivered, creates a strong flow of cash.

Klinsky, like many private equity entrepreneurs, has learned a lot from his years at bulge bracket firms. "The culture here is based on what I was exposed to at Goldman and Forstmann," he says. He prefers an organization of high achievers, but one that works as a team. "At this point, it's not about being the best dealmaker. It's about the growth of the team and the firm," he says.

Perhaps the final sign of success will arrive one day soon, when a younger partner leaves to hang out his own shingle.

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