Growing returns

Once upon a time, two cousins in arms, Palamon and Arcite, fought over a woman. A timeless plot, as was the outcome: Arcite wounded Palamon but did not kill him. Having won the final battle, Arcite rode off victoriously, but fell off his stead onto his sword and killed himself, leaving Palamon to inherit his worldly goods as well as the woman.

This anecdote may prove more than amusing - it may portend the future of the private equity industry, as large and mega-buyout titans fall victim to their own exuberance, leaving the mid-market, formerly overshadowed by such largesse, to survive the crunch.

We are already seeing the beginnings of this, with dozens of CVs from large buyout houses now in the hands of mid-market players. In fact, even mid-market competitors are trying their hand at new things, namely re-focusing on growing sectors and equity-only (or "debt-light") deals. Ten years ago, an outfit was set up to do just that: Palamon Capital Partners.

Palamon was founded by Louis G Elson and A Michael Hoffman in 1999. Both were students of classics during university days and named their firm after the survivor of the Palamon tale they both liked. The firm now boasts EUR1.1bn of funds under management, but this could double as the firm will likely hit the fundraising trail next year for a fund in the EUR1.0bn range. Admirably, this will mark a "reasonable" increase on Palamon's second fund, which closed on EUR670m in 2006, according to an LP who became disenchanted with GPs constantly doubling fund size. Even that fund was only 50% larger than Palamon's debut EUR440m vehicle, despite the frenzy at the time to more than double fund size.

Maybe this is because Hoffman and Elson have been there, done that: after setting up a London office for Warburg Pincus in 1987, Hoffman was joined by Elson in 1990 and the two worked together for 10 years before leaving to set up Palamon, following Warburg's announcement that its latest fund would be a staggering $5bn. The strategy shift that this new level of funding implied sent the two off to pursue what they'd cut their teeth on: growing businesses.

And so they have: the founders built a pan-European investment team of 17 individuals from nine different European countries able to operate across Europe. In fact, the Palamon team works from a single office in central London, though among its investment team members, almost all speak three or more languages and operate across the Continent. The team seeks diversification within services businesses, as well as diversification across both stage-of-company maturity and geographic markets. It also aims for 15-30% annualised top-line revenue growth in companies it backs and tranches its investments to coincide with target company growth prospects and needs.

Slow but steady

Growth capital is neither for the impatient nor financial-engineering orientated investor. "It is not about a two and a half-year holding period. You have to be in it for the long haul. You also cannot leverage too highly because then you risk having a shortage of working capital for the business," Hoffman says, indicating that that can stymie growth, the essential underpinning of any growth capital investment strategy.

But rather than carry on with the gravy train of increasingly larger and highly leveraged transactions, Hoffman joined up with Elson to back smaller businesses, often pursuing a buy-and-build strategy. In fact, many of the companies acquired by Palamon are financed entirely with equity at the outset, as they are young and growing rapidly. But as they turn profitable and "prove themselves", moderate leverage is often brought on, resulting in average debt levels across Palamon's portfolio of just under 3x. The equity tickets have, unsurprisingly, increased: in Fund 1, the average equity cheque was approximately EUR26m, with a range of EUR10-40m. In Fund 2, as it is larger, the range may extend from EUR20-60m, with the average ticket in the low EUR40ms. A select number of larger deals can be completed through LP co-investment, so as to ensure Palamon never writes a cheque equivalent to more than 10% of any fund.

Impressively, the team didn't complete a single deal between the high-priced days of November 2007 and November 2008. Instead, Palamon focused on working its existing portfolio companies and developing its team, making no less than six appointments in that period and just this month, Owen Wilson joined Palamon from Candover.

The firm has completed two deals since last November. Most recently, Palamon beat off competition from financial and trade bidders for Spanish elderly care services provider Grupo SAR. Palamon had contacted the company over a year prior to winning the EUR200m deal, and spent five months in due diligence and negotiations before closing it at the end of May. Palamon brought in a dedicated healthcare investor, G Square, to participate and encouraged the original majority shareholder, Confide, to remain on board. Together, the investors plan to consolidate the fragmented Spanish elderly care market.

At the end of last year, Palamon backed German consumer products supplier DS Produkte (Dieter Schwarz GmbH), along with Commerzbank and Deutsche Bank who provided "substantial" debt, but at a "moderate" earnings-to-debt ratio. Currently, Palamon is in advanced talks to acquire British chain Associated Dental Practices from defunct backer Kaupthing.

Dealing with growth

An example of a classic Palamon thesis-led, growth investment strategy is that of its 2000 Fund I investment in Team System, an Italian family-owned provider of payroll services and tax software. "Our original thesis was one of outsourcing payroll management. We focused on the Italian market because there are so many small to mid-size businesses within highly fragmented service provider industries. It suited our buy-and-build approach nicely," Hoffman explains. When Palamon "cold-called the company with a local adviser, the CEO was not looking to sell". Hoffman explained that Team System was a strong regional player, but that it did not have national reach and management was unlikely to take the business to the next level on their own. But eventually, the CEO got comfortable with Palamon and agreed to team up. Initially, Palamon took a controlling 51% stake but this eventually grew to exceed 70% by the spring of 2003.

Palamon didn't own the business as long as their normal five to seven-year hold: "We had a good number of industry players and financial buyers interested in the business," Hoffman says. It's not surprising, given the stellar growth of the company. During the holding period, revenue grew three-fold, with EBITDA growth even higher. The company was not leveraged during these years, though modest debt was introduced toward the end of Palamon's ownership in conjunction with Palamon's second tranche of equity. An IPO was also considered; however, the conditions in the Italian market were not conducive at the time.

In the end, the business was sold to Bain Capital in December 2004 for a "very full" price corresponding to a double-digit earnings multiple which generated a money multiple of 4.2x and an impressive IRR of over 50%. "We do not normally focus on IRR - in growth capital investing it's really about multiples of money invested," says Hoffman, adding that Palamon seeks to achieve a consistent multiple of 2-3x money invested in a portfolio of deals.

Though lower than some LBO houses achieved in the heyday, those were deals relying on graft rather than real loans. The highest leveraged deal in Palamon's portfolio was Retail Decisions, which Palamon took private off the London Stock Exchange in the latter part of 2006. "We needed leverage at the outset to be able to get the deal done. However, the company was already modestly profitable so securing the loan and being comfortable with our ability to pay it back was essential," Hoffman explains. The business was initially leveraged at around 5.5x EBITDA, but a month ago Palamon sold the lowest growth and least-core part of the business to a trade buyer at an "attractive price". This allowed the company to pay back a significant chunk of bank debt and pump additional money into the business, thereby improving its cash position and funding a joint venture with a pioneering Chinese payment systems company. "They were attracted by Retail Decisions' technology and experience of payment systems globally, and Retail Decisions was naturally attracted by getting into the world's fastest-growing payment systems market," according to Hoffman. Not surprising, given the number of cards being issued in the world's most populous and high-growth country.

Loyalty Partner may be Palamon's next big winner. The German multi-partner loyalty scheme, by far the largest in the country, was backed by both of Palamon's funds in September 2005 and has doubled its EBITDA over the past four years through organic growth and the start up of new businesses. The company now boasts 30 million loyalty cards in circulation, though this will grow further as Loyalty Partner is now expanding into Poland. A number of interested parties have already approached the backers, though Palamon believes a bit more loyalty will pay off later.

Indeed, such patience and hard work have served Palamon well for the last decade, even though growth capital went largely unnoticed as it was overshadowed by the buyout bonanza. That is changing, with credit-crunch afflicted investors suddenly taking in the model's merits. It may not win them women, but many will hope it is a new way to win returns.

Fundraising

With its second fund roughly 60% invested and with another deal or two on the cards by year end, Palamon is set to hit the fundraising trail in 2010. While many GPs are hesitant about looming fundraising needs given the volatile marketplace, Palamon's niche makes their proposition quite unique in a world in which traditional, more mature buyouts may be on the wane.

There will probably be a half dozen or more keymen in the PPM, in contrast to the first six years, which saw just the two co-founders listed. The second fund included five partners at that time, just as the third fund will likely reflect the additional partners.

The team will likely target a fund around EUR1bn or more, depending on actual conditions, and has yet to settle on the placement agent question, though today's challenging fundraising environment may see one appointed for the first time in Palamon's history.

What concerns others

- Strategy drift

Some LPs indicated that strategy drift may have affected the firm. This is a perennial concern of sophisticated investors, yet a real one nevertheless. According to the team, Fund II investments are mostly in the same sectors as Fund I, but with specialty engineering replaced by healthcare services in the second, as the former had fallen from favour and more interesting opportunities were arising in healthcare across Europe. From a geographic point of view, the first fund covered eight geographies, and the second fund already has six at 60% invested.

- Succession

Hoffman and Elson have co-managed the firm since inception and there are 17 team members. The number is a lot for a fund of under EUR700m, but serves as an indication that next year's fund raise should be larger than the previous vehicle.

The co-founders owned all of the equity at the outset, but have been distributing ownership each year, with the co-founders now holding less than 50% themselves. This is primarily split among a core group of experienced partners who have each been with Palamon for between six and nine years.

With respect to firm governance, a re-structuring was announced in mid 2007 to ensure a smooth transition from the founder-led routes to a more institutionalised partnership structure. At this time, Hoffman formally became chairman and Elson became managing partner with more of a deal focus. Both have reduced the number of portfolio company boards they sit on, with other partners taking on a larger role. In addition, an operating committee was formed in mid 2007 in order to oversee day-to-day firm management matters. Two other senior partners, Daan Knottenbelt and Erik Ferm, were appointed to this committee and currently take a major role in firm recruitment and development, as well as oversight of financial and certain administrative matters. This allows Hoffman to focus more time on continuing to raise the profile of the firm externally, investment-thesis development and fundraising planning, while Elson focuses more on deal structuring, the monitoring of larger Palamon portfolio companies and deal exit strategy. While they will both still lead actual fundraising, this time round they will have many more experienced partners to assist in this process.

The team has hired seven new people since November 2007, with the newest recruit being Owen Wilson, from Candover, who joined on 12 October. The majority have come in at the vice president level, allowing them to develop their skills within the Palamon team with a view to advancement. There may be scope for further hiring in 2010.

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