January 19, 2009

by Bernard Vaughan
Buyouts

Chuck Esserman, co-founder of TSG Consumer,has spearheaded some of the most successful private equitybacked investments inthe consumer productsmarket.Canhe sustainhis remarkable record in a crippling recession?

Esserman's 21-year-old firm (counting its predecessor) has delivered the kind of returns limited partners adore, including an amazing 46 percent net IRR on a vintage 2002 fund; the firmhasn't lostmoney on a single realized deal. But now TSG is clawing through perhaps the thorniest market it’s faced. The consumer products sector has been among the hardest hit during this recession as cash-strapped shoppers curtail unnecessary spending. A firm whose portfolio includes a company that make $40 bottles of juice should be feeling the pinch.

And yes, San Francisco-based TSG isn't immune to the recession. While combined sales at TSG’s 11 portfolio companies rose in 2008, the firm expects soft sales in 2009 as a result of the retail slowdown. Among the challenges, TSG expects weakness in some sales channels this year for Perricone MC Cosmeceuticals, a Meriden, Conn.-based beauty products maker acquired in 2006, although the firm expects the company's sales to climb overall. TSG also expects challenges growing sales at already-opened restaurants managed by Yard House Restaurants LLC, an Irvine, Calif.-based restaurant chain that TSG bought in 2007.

Still, other TSG companies continue to thrive, according to Esserman. Sales at TSG’s two beverage companies, CytoSport Inc. and MonaVie LLC—which sells healthy juice in dark wine bottles—rose 50 percent and 100 percent year over year, respectively, in 2008, and the future looks bright as well. (Esserman believesMonaViemay capture the record for being fastest to $1 billion in sales of any company.) To help support growth, MonaVie is opening international distribution channels this year, while CytoSport recently struck a distribution deal with Pepsi.

Indeed, the portfolio is performing sowell that TSG has no immediate plans to shift from its strategy of investing $15 million to $100 million in highly specialized consumer goods companies with $20 million to $300 million in sales. “I couldn't conceive why we would,” Esserman told Buyouts.

‘Essentialness’
Esserman started his career at Bain & Co. before co-founding the predecessor firm in 1987 with Gary Shansby, the former CEO of Shaklee Corp. The partners did business as TheShansbyGroup until 2005, earning a reputation as expert investors in consumer brands with deals such as Famous Amos Chocolate Chip Cookie Co. LLC, a struggling cookie maker Shansby bought in 1988 and sold four years later for a 20x return. Today the firm, which has raised $1.7 billion across five funds, has 12 investment professionals investing from TSG’s $900 million fifth fund, closed in 2007. Last year TSG made two investments and secured one exit, selling Meguiar’s Inc., an Irvine-Calif.-based company that makes cleaning products, to 3M Co.

TSG4 LP has generated a net IRR of 46 percent on the $40 million the Colorado Public Employees’ Retirement Association committed to the 2002 fund, as of Dec. 31, 2007. “From my perspective they have been doing a significant job for their investors in two ways: generating top-tier returns, but doing it with an extremely low loss rate,” said TomGaluhn, senior managing director at advisory shop Mesirow Financial Private Equity, which committed a total of $50 million to the two most recent funds.

Even in the face of a major recession, TSG continues to look at opportunities in cosmetic products and health products— goods, Esserman said, that improve people’s lives—the same way it did when he and Shansby founded the firm. It also employs a three-pronged strategy consisting of deep research to determine a product’s “essentialness,” patience and growth.

To Esserman and TSG, a product’s success— its essentialness to the customer— depends on how important it is to the customer rather than on howmuchmoney that customer has. Esserman acknowledges that consumers are choosier in a recession, but he contends they’ll continue to spend more on a product they see as essential to their health or physical appearance. By this logic, a person who might weigh the price of two different types of apples won’t think twice about spending $40 on a bottle of MonaVie if they think it’s that important to their health.

It’s this confidence in the perceived value of their products that led TSG to back companies such as MonaVie, a company in which TSG took a minority stake in March that makes antioxidant-rich juices sold by “independent distributors”—i.e. regular folks who pay a $39 initiation fee to sell it themselves; and in Smashbox Beauty Cosmetics Inc., a cosmetics company into which TSG pumped $20million for a 33 percent stake in 2006. “A consumer is not going to trade away from a Smashbox product for a product they see in a drug store because they perceive a value relation in paying more for a product that is vastly superior,” Esserman said.

Determining a product’s essentialness is where the research comes in. About half of TSG’s 12-person investment team, including Esserman, comes from research powerhouse Bain & Co. TSG does not play in auctions, and when a product piques TSG’s interest—Partner Hadley Mullin first heard of Smashbox over coffee with a friend—TSG will make 60 to 80 calls to its network of store managers to gauge the product’s performance while scouring market data from The Nielson Company. Then TSG pros conduct “customer intercepts”: Basically, they stop customers in store aisles and ask them questions about the product. “We don’t get too far in the evaluation without talking to customers,” Esserman said.

Another key to TSG’s philosophy is patience. The firm took an undisclosed stake in Smart Balance Foods, the Cresskill, N.J.-based maker of trans-fat free margarines, in 2004 after courting the company’s management for five years while offering them free marketing advice.

So what about the financials? How does TSG make these deals work? First off, about half of the firm’s deals are minority slots. This gives TSG flexibility, as the management at many targets will only accept minority investments, Esserman said. TSG also sees minority investments as a vote of confidence in management's vision, as opposed to a majority position in which the firm has total control. But the fundamental ingredient is growth: TSG drives its returns by increasing sales at its companies, instead of using debt. TSG financesmany of its companies with no debt, and when it does employ financing, it is typically with senior debt at about 2x to 3x EBITDA. Union Bank of California and Wells Fargo are frequent supporters of TSG deals.

To drive sales, TSG helps companies expand product lines and distribution channels. TSG helped Smart Balance Foods increase the sizes and types of margarine it offered, invested in its sales and marketing force, expanded its product line to include peanut butter and popcorn, and got the products more shelf space in more supermarkets. The firm ultimately earned 7x its investment, Esserman said, when it sold the company in 2007.

For exits, TSG typically sells its stakes to corporations and conglomerates. In 2003, for example, TSG invested $40 million for a 30 percent stake in health drink maker Glaceau Vitaminwater, and ultimately sold its stake in 2006 to the Indian conglomerate Tata Group, earning 13x its invested capital.

Esserman himself is an expert deal negotiator, according to Peter Mann, former CEO of Medtech Holdings, a beauty care products company that The Shansby Group launched in 1996 and sold to GTCR Golder Rauner in 2004. To create Medtech, the firm bought brands such as Cutex, the nail polish remover, Denorex, the dandruff shampoo, and Spic and Span, the household cleaner, from Carson Inc., Wyeth, and Procter & Gamble, respectively. In each deal Esserman negotiated transitional service agreements in which the sellers continued to take ship orders and handle other administrative services for 18 months post-deal. These agreements saved significant costs and freed up the firm to concentrate on marketing and sales, Mann said. Under TSG ownership, Medtech’s EBITDA grew from $18 million to $30 million before selling to GTCR, earning more than 3x invested capital. “He’s the smartest private equity guy I worked with,” said Mann, now an operating director at West Hill Partners, a Boston-based mid-market shop.

Brent Knudsen, a co-founder of San Francisco-based advisory shop Partnership Capital Growth Advisors, who introduced TSG to the MonaVie deal, said he believes the quality of TSG’s companies will enable it to hold on to its “no bad deal” record. “With consumer weakness, a consumer fund could be challenged,” he said. “But I would suggest— and Chuck would prove—that investing in the very best companies, even in a downturn economy, is still a strong strategy.”

Even a downturn as severe as this one? “Did I anticipate this level of downturn?” Esserman said. “No. Would I have done anything differently? No. Am I glad I made the investments I did? Yes.”