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.