Brentwood Plans to Stay Picky With LBO Funds
When Brentwood Associates collected $140 million for a new leveraged buyout fund in late 1988, the investment firm’s high-powered clients probably didn’t expect to wait 18 months for their first deal.
But wait they did. Brentwood felt that the prices companies were fetching in LBOs in 1988 and 1989 were absurdly high. So the firm said no thanks.
Today, Brentwood’s partners look like heroes for avoiding the LBO market’s peak.
The firm also is in a potentially powerful position to finance a new wave of friendly LBOs and venture investments in the 1990s--deals that Brentwood hopes will include many promising young Southland companies and entrepreneurs.
Still, any deal will have to fit the firm’s basically conservative--and painstakingly detailed--investing discipline. Says partner William Barnum: “To us, it’s better to do nothing than to lose money.”
Brentwood is perhaps the most respected of L.A.’s boutique investment banking and venture capital houses. It was one of the original venture backers of Apple Computer; it financed Teradata Corp. and FileNet Corp., two of the Southland’s most successful high-tech firms, and it invested money in A. J. Industries in 1977, the first LBO arranged by Kohlberg Kravis Roberts & Co., the New York firm whose initials became synonymous with LBO investing in the 1980s.
Brentwood’s success in LBOs and in basic venture capital investing made the firm’s partners, and their long list of institutional investors, very rich in the ‘80s. Brentwood says its compounded annual return on its LBO investments has topped 50% since 1972. The firm doesn’t disclose its venture capital returns, but within the industry Brentwood’s results are considered above-average.
Founded by investment bankers Timothy Pennington III, Fred Warren and Kip Hagopian in 1972, Brentwood has since invested $370 million in about 200 companies: 20 that the firm helped purchase in management LBOs, the rest via venture capital investments.
Now, the firm has $120 million in new money waiting to be invested in new LBOs and about $55 million available for new venture capital deals.
That’s a lot of money. And Brentwood’s nine partners pride themselves on being exceptionally choosy about where they plunk their dollars.
Some of their peers in the venture business say Brentwood may be too choosy, resulting in lost opportunities. The partners, mostly decorated Stanford University alumni, rely heavily on their analytical talents--poring over a prospect’s finances and fitting the numbers into various economic models, rather than leaning much on gut instincts about a new business’s chances.
“They spend a long time with the numbers, trying to decide if the entrepreneur is telling them the truth,” one rival L.A. venture capitalist says. “Sometimes you have to just look the guy in the eye . . . and make a bet.”
Still, Brentwood’s thoroughness is one reason for its high stature in the venture business. And none of its rivals argue with the firm’s results.
In venture investing, Brentwood’s score card is about 40% winners, 40% losers and 20% break even. In this business, a 40% batting average is major-league, because each big hit makes up for many losers.
Meanwhile, on the LBO side, “we’ve never had a (deal) go bust, and we never plan to,” Pennington says. Brentwood’s LBO formula has long differed from that of other investment bankers. The firm won’t do hostile takeovers or bust-up LBOs designed for fast profits, Pennington said. Instead, Brentwood buys companies to grow them.
An LBO is still an LBO, of course, in that the “L” word is the same: a steel-jaw trap waiting for those who stumble. Using mostly borrowed money to buy a company leaves relatively little margin for error. If the company doesn’t make its sales and earnings targets, and interest on the debt isn’t paid, the deal ends in disaster. The list of bankrupt or crippled LBOs has become an ever-lengthening one since last autumn--from retailer Southland Corp. to shoe giant Interco to publisher Harcourt Brace Jovanovich.
Those disasters have led many venture firms to exit the LBO business permanently this year, according to the Venture Capital Journal.
Brentwood, however, figures that it has no reason to change its LBO focus. The simplest strategy for avoiding LBO bombs has been to pick medium-size companies with great promise and excellent management teams, Pennington said. Generally, the firms Brentwood has financed in LBO deals have been divisions of larger companies. By helping managers of those enterprises set up on their own, Brentwood brings the capital and the management oversight that the firms often need to expand their markets.
The crash of the LBO market last year and the exit of many LBO financiers means that prices for many potential LBO candidates have finally come back to earth, Pennington said. So Brentwood is ready to deal again.
The firm’s latest LBO--the first since May, 1988--was completed in April. Brentwood bought L.A.-based Mobile Technology Inc. for $143 million from an investor group that wanted to cash out of the 7-year-old medical technology firm.
The MTI deal clearly is a new-era LBO--much more cash upfront, much less debt:
* Brentwood put up about 16% in equity, or $23 million. In 1987, LBOs typically required only 8% equity, and some were done with less than 5% down.
* The $120 million in borrowed money for the MTI deal, meanwhile, didn’t come from banks. Skittish bankers, terrified of lending for any takeover deal these days, offered Brentwood lousy terms. So the firm went to its long list of client investors and borrowed direct from them.
MTI, says Brentwood partner William Barnum, had the key attributes that Brentwood hunts for in LBO candidates: first-rate management and a product whose sales aren’t affected by economic swings. MTI is the nation’s leading provider of mobile medical units for magnetic resonance imaging--expensive machines that allow doctors to see inside the body without surgery.
By making the machines mobile, MTI allows hospitals in 33 states to share the technology instead of buying it themselves. Says Barnum: “We’re pretty convinced that this will be one of the ways that health-care costs are lowered in this country in the future.” And MTI should make good money for Brentwood in the process, if the firm’s forecast of 20% annual earnings growth is on target.
Medical services is one of the chief industries in which Brentwood is hunting for LBO candidates in the 1990s. The environmental-services field and the broad spectrum of communications also are targets, although the partners publicly won’t be more specific than that for competitive reasons.
Likewise, Brentwood’s venture capital side--cash for entrepreneurs with new ideas--is also hunting for new investment opportunities in medical products and services, Brentwood partner Roger Davisson said.
Brentwood, like many other big venture investors, sees the venture market in a transition phase. A lot of the excitement of the 1980s is gone. “There haven’t been new technologies in the last few years--like semiconductors and biotech in the early-1980s--that have spawned whole new industries,” Davisson says. “I think we’re all kind of hungry for some kind of breakthrough.”
Davisson and partner David Chonette spend a lot of time looking for those breakthroughs among Orange County’s young medical-technology firms. “On the medical products side, Orange County’s strength is rivaled only by the Minneapolis area” in terms of firms with new ideas, Chonette says.
In recent years, Brentwood has funded such Orange County companies as InterTherapy of Santa Ana, which makes angioplasty instruments, and Advanced Surgical Intervention of San Clemente, a maker of urology and prostate-treatment instruments.
Eventually, Brentwood hopes either to sell those companies to other firms or to sell them to the public via stock offerings. Either way, the goal is a huge payoff--perhaps 10-to-1 or better--on Brentwood’s initial investment.
Yet venture capitalists admit that as more big investors jumped in to provide venture financing to entrepreneurs in the ‘80s, large payoffs have been tougher to come by. Venture investors have long figured that they’d have enough successes to provide overall 30% to 40% annualized returns on their money, even with their bombs. “But now, you hear rumors that several venture funds are going to lose money,” Davisson says.
Brentwood still expects to be a winner in venture in the 1990s. But Davisson admits that the firm has lowered its payoff expectations to reflect a different venture world. “I think (annual) returns in the high-teens to mid-20% range are reasonable for the kind of things that we do,” he says.
LBO investing will also be less lucrative than in the 1980s, Brentwood’s partners admit. By definition, tiny equity down payments in the deals of the ‘80s meant that you earned gigantic returns when the deals worked. Now, the down payment is higher, so the returns are lower.
Even so, Brentwood hopes to earn 1 1/2 to 2 times the average LBO industry return, Barnum said. And the firm at least expects to do better than if it merely invested the money in the stock market--or there wouldn’t be much point to all of the work involved in LBO deals.
As for the fall of other LBO investment giants--such as Coniston Partners’ recent decision to exit the business--Brentwood figures that its patient, growth-company strategy is merely being proved the correct route all along.
Says Pennington of Coniston and other hostile-LBO deal makers: “Our game plan hasn’t changed. But theirs was just blown out of the water.”
* MARKET BEAT
Tips for entrepreneurs. Page 5 INSIDE BRENTWOOD’S PORTFOLIO Since 1972, Brentwood Associates has invested $370 million in about 200 companies, via both leveraged buyouts and venture capital funding. Here are a few of the companies the firm currently is financing, and a list of the institutions that have invested the most with Brentwood.
LBO DEALS
Company/location Business Acme Rents Industrial and homeowners Los Angeles equipment rental Educational Publishing School supplies Oaklawn, Ill. Graphic Controls Supplies for recording Buffalo instruments and plotters Prince Manufacturing Tennis racquets, apparel, Lawrenceville, N.Y. other equipment
VENTURE CAPITAL DEALS
Company/location Business Actel Corp. Semiconductors Sunnyvale CellPro Inc. Cell selection and Bothell, Wash. separation systems Glycomed Inc. Complex carbohydrate- Alameda based drugs Interpore International Implantable artificial bone Irvine InterFlo Medical Catheter and computer Plano, Tex. systems for measurement of heart output
BRENTWOOD’S LARGEST INVESTORS Amoco Corp. Citicorp Equitable Life Harvard University Mellon Bank New York Life Northwestern Mutual Life Pennsylvania State Employees Retirement Prudential Venture Capital Sentry Insurance Washington State Investment Board Wells Fargo Yale University Source: Brentwood Associates
