May 2013


DVPYesterday, Del Monte Foods announced that they had entered into a merger agreement with Dick Van Patten’s Natural Balance Pet Foods.  The deal is expected to close in June, no financial information was disclosed. The fact that a transaction involving Natural Balance occurred is no surprise, the form of the transaction, well that is another story.

Some five years ago San Francisco consumer growth equity fund VMG Partners made an investment in Natural Balance, taking a minority position for an undisclosed amount at an undisclosed valuation (you might see a trend here).  The investment made a lot of sense for both sides at the time.  VMG had recently closed their first fund and was quickly able to get their brand associated with one of the leading independent players in the pet industry, a fact that would help them win the the Waggin’ Train deal later that same year.  Natural Balance was seeking to fuel growth and was able to attract the money at a valuation based on future financial performance. On paper, it was a win-win.

Generally speaking, minority investments from institutional equity funds come with a redemption right often set five years from the date of the investment (we see them range from five to seven years, but more heavily weighted towards the lower end of that range).  These rights require the company to repurchase the shares of the investor for the greater of a floor valuation (usually a multiple of invested capital) or fair market value. As a result, a minority investment often is the precursor to a larger financing or sale transaction.

With VMG’s mandatory redemption right looming, Natural Balance began to evaluate the potential for a transaction early in 2013.  While the company had grown nicely during VMG’s tenure as in investor, the San Francisco firm was a small player and had limited influence over strategy and operations.  Since 2007, revenue seemed to move up and to the right (exceeding $200 million), but profitability was elusive.  In contrast to Blue Buffalo, which is twice the size of Natural Balance, and boasts “high teens” operating income margins, Natural Balance was not thought to be highly profitable.  This would become a problem when the company went to market.   To raise sufficient capital to take out VMG (which generally invests +/- $20 million per deal) the company would need to raise a significant chunk of change. Assuming a redemption right at three times invested capital, Natural Balance would have had to raise in excess of $60 million, and likely much more. Equity funds do not write checks of that size in to companies with low levels of profitability at attractive valuations; enter Del Monte.

Del Monte was responsible for establishing the modern valuation paradigm for leading pet food and consumable companies through its acquisitions of Meow Mix and Milk Bone in 2006.  Today, when pet companies talk about being valued at 2.0x – 3.0x revenue, these are the transactions that set that precedent.  However, since that time Del Monte had undergone a transaction of its own, having been purchased by buyout giant KKR in 2010.  Notably, KKR would go on to purchase Pets-At-Home later that same year. While I have no insider knowledge of the purchase price, the acquisition of Natural Balance was unlikely to have taken place at those levels given the lack of profitability and limited competition for the transaction.  Natural Balance did not hire an agent or run an auction.  One of the driving factors for the deal was likely that Del Monte could rapidly expand Natural Balance’s distribution footprint through its Pets-At-Home franchise.

Net net, this appears to be a good pick-up for Del Monte making them an instant player in the natural category and in super premium.   It was able to achieve those objectives without shelling out the $1.5 billion Blue Buffalo has reportedly sought from strategic acquirors.  Opportunity knocked and Del Monte answered.  Expect them to keep the product in the pet specialty channel, as opposed to migrating it to mass a la Natura. VMG wins as well, likely making more than their mandatory redemption due to the valuation that would be associated with Natural Balance in a 100% sale transaction as opposed to another minority financing.

/bryan

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arrowAs most of you are well aware, the pet industry is in fact quite large.  Depending on how you measure industry size, the pet industry is the fourth largest consumer segment of the U.S. economy (excluding health care).  And where there are large market opportunities, logically, they are capital inflows from investors, both public and private, seeking to create wealth from changing dynamics in those markets.   As an example, if you were an investor in PetSmart’s public shares over the past five years, you have enjoyed a handsome return from the specialty retail chains’ ascendency, as consumers spent more on their pets as part of the broader humanization trend.

Pet companies have also received a considerable amount of interest from private equity funds seeking to capitalize on the growth trends inherent in the industry.  While I do not have purview into every equity funds predilections, I have yet to come across a consumer oriented growth equity or buyout fund that does not have an interest in the pet space.  Many of them long to replicate the success of Eagle Pack Pet Food, Old Mother Hubbard and Banfield Pet Hospitals.  This “professionalization” of the industry has been a thematic I have waxed on about at length in my prior reports.

However, despite the size of the opportunity and the amount of available capital seeking that very opportunity, private equity transaction volume in the pet industry has in fact been quite limited.  To put this in perspective, according to the Pitchbook platform, there were 364 private equity transactions completed in 2012 that involved consumer facing companies.  Of that deal volume, the pet industry made up just over five percent of private equity deal volume with 19 reported transactions.  The is a decline from the past three years, where pet industry transaction volume made up just over seven percent of total consumer transaction volume.  The chart below tracks the trend over time (source: Pitchbook).

GraphThrough April 2013, there have been six reported private equity investments in the pet industry, putting the industry trend at risk for a second consecutive deceleration.  So what gives?  A few thoughts based on my experience.  First, the interest of private equity in the industry does not align well with the size of its participants.  As a general rule, private equity firms target companies with at least $5 million in Operating Income, with a strong preference for more.  That is not to say that growth equity and buyout deals don’t get done involving pet businesses of every size, but the core interest from these investors is in companies with a strong track record of profitability.  The pet industry has a limited number of companies that fit this mold, with most businesses being bigger or well below that threshold.  Second, there is an active consolidator market in the industry which is a headwind for private equity firms to get a deal done.  If a seller can get a better valuation from a strategic, they will often bypass the private equity market all together and wait to do a strategic sale. Finally, the interest of private equity in the space tends to be disproportionately oriented around pet food and veterinary clinics. A lack of opportunities in these segments has increased focus on retailers, distributors and, more recently treat companies, but a historical sector bias has certainly limited deal volume.

I remain long term bullish on private equity and the pet industry, but, as evidenced by the above, the relationship between the two has some inherent complexity.  However, as private equity gets a track record of success in a broader segment of industry sectors look for the industry to embrace outside equity more fully.  Deals beget deals.

/bryan