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Rule Breaker: TSG's Investment in Smashbox


When TSG Consumer Partners invested in the commercially popular Smashbox Cosmetics last year, it looked to be a primer on how not to handle a private-equity deal.

December 11, 2007 – When TSG Consumer Partners LLC ("TSG") invested in the commercially popular Smashbox Cosmetics last year, it looked, by all appearances, to be a primer on how not to handle a private-equity deal.

The usual private equity plan--get a deal book, focus intensively and then move on after a few weeks--went out the window. TSG, a San Francisco firm that specializes in middle-market consumer businesses, took almost a year, even walking away from the deal at one point, before getting comfortable with the makeup company.

While most firms focus on well-known investment banks or finders to locate promising portfolio companies, TSG partner Hadley Mullin first got wind of Smashbox while sipping a latte at a Costa Mesa, California, Starbucks alongside an acquaintance, who mentioned offhandedly that his wife’s friend’s husband ran an interesting business Mullin ought to look at.

Once the firm decided to move forward, it chose to execute the reverse of an LBO (call it an equity buy-in) by investing $20 million for just a 33 percent minority stake, rather than a control position. TSG then seemed to compound its mistakes: Instead of cutting budgets to enhance cash flow, it prodded Smashbox to spend more on advertising and an employee bonus program.

One other detail: With TSG’s help, Smashbox’s earnings, and margins, have skyrocketed, and it’s currently fending off approaches from major cosmetics companies. That makes Smashbox the latest in a remarkable 20-year string of success stories for this relatively small, low-key private equity firm, which has excelled by hewing to its own distinctive style, no matter what the standard private equity playbook would suggest.

"A lot of what they do is the exact opposite of what most people in this business say you’re supposed to do," says Brent Knudsen, who runs an advisory boutique, Partnership Capital Growth that focuses on the consumer and lifestyle sectors. "But if you look at results, they do everything right. It sounds like a cliché, but they really do focus on what’s right to build the businesses."

Dean Factor, Smashbox’s founder and chief executive, puts it more bluntly: "We talked to other funds, but that’s why we went with [TSG]. We went for smart capital. They taught me a lot about my own business."

TSG has no hesitation about trumpeting its unusual principles, no matter what the rest of the Street may think. The firm was founded as the Shansby Group in 1987 by J. Gary Shansby, the former CEO of personal-care-products marketer Shaklee, and Charles Esserman, an alumnus of Bain & Co. The duo leveraged their combined expertise by buying underperforming consumer-products companies, turning them around and selling them at attractive multiples.

The name was changed to TSG Consumer Partners in 2005, and Shansby has largely retired. But TSG, a pioneer in employing private equity in high-growth, middle-market branded businesses, has held to the same principles on which it was founded: maintaining a narrow focus, conducting proprietary market research and adhering to its commitment to long-term growth.

The close-knit firm, which has just five partners and seven associates, makes no horizontal hires, home-growing its talent to instill the company’s shirtsleeves philosophy. Unlike many of its peers, TSG generally eschews highly leveraged deals and touts its investing flexibility by taking a minority stake, rather than full control, in one-third of its transactions. The firm proudly says it can take as long as five years to court a target, all the while offering free marketing advice.

To put it mildly, doing everything wrong has worked out quite well. TSG has averaged nearly 60 percent returns over its 20-year history; according to Thomson Financial, the industry-wide return over that period was 13.2 percent. The firm’s fourth fund, nearly completely invested, has so far generated a 68 percent internal rate of return, according to TSG partner James O’Hara.

Those numbers have been boosted by a string of striking successes in the past year, including the sale of Glaceau vitaminwater, Smart Balance Foods and PureOlogy hair-care products. The combined enterprise value of the three rocketed from $230 million at the time of TSG’s investment to $3.1 billion once each was sold.

Those are just the latest successes from the firm that in one of its first investments made Famous Amos famous or, at least, immensely profitable. At the time, everyone thought TSG was nuts, but the firm took the popular, if troubled, cookie maker from a loss on $6 million in sales in 1988 to operating income of more than $9 million on revenue of $70 million four years later; it was then sold for almost 20 times the initial investment.

There’s more to TSG than great returns, however. Every investor wants not just impressive profits, but success in good times and bad. From its Transamerica Pyramid offices commanding a postcard view of San Francisco Bay and its newly opened satellite operation on Fifth Avenue in Manhattan, TSG looks out on a deal world that has hardly changed despite the recent turmoil in the credit markets. Because of its focus on business strategy rather than simply financial engineering, TSG has been all but immune to private equity’s problems.

In fact, in the middle of August’s financial storms, TSG completed its 70 percent purchase of Yard House, a Southern California based restaurant chain, for nearly $200 million. The firm, in typical fashion, had been studying the restaurant sector for about 10 years and had been talking to Yard House for more than 18 months before consummating the transaction.

"What gives me an unusual amount of comfort as a lender on TSG’s deals is that you know when it’s over the company is going to perform well," says David Ligon, a managing director at Emporia Capital Management, which provided $13 million of mezzanine-style lending on the Yard House deal. "People who are focused, who know why they’re getting into an investment, are the ones who give you real confidence as a lender, no matter what’s happening in the market at the moment. TSG has always done that."

TSG is, in short, that rare firm that makes the counter play work. The company attributes its success to humility and consistency it sticks to what it knows, never loses sight of what it doesn’t know and emphasizes ideas and consensus over hierarchy. "The egalitarian philosophy is so ingrained in the corporate culture that if one of TSG’s five partners were to resist a particular investment, we wouldn’t do that deal," says Esserman, its 49-year-old cofounder and CEO. "We’re not into losing money. We’re sort of risk-averse. Life is too short."

One word sums up the secret to TSG’s returns: growth. It sounds deceptively simple, until you look at how few private-equity firms succeed in profiting from smart corporate expansion rather than cash flow and nimble debt management. TSG is able to forego the potential benefits of high leverage by using its in-house marketing expertise to push high-growth strategies.

It has shown a knack for buying businesses that often achieve explosive growth rates with the fresh capital and ideas TSG brings to the deals. Esserman stresses that when a company demonstrates its potential for high growth, it can also attract a much higher multiple when it comes time to sell the investment, boosting returns.

Smashbox, for instance, has gone from $32 million to $60 million in net sales since TSG invested early last year, and earnings have gone from zero to about $13 million, says Factor, the CEO. Factor, a great-grandson of legendary makeup impresario Max Factor, adds that TSG had played an integral role in producing that improved performance by offering superb advice. "They came to us not just with money but with a plan, and it definitely worked," he says. "They’re really consultants. It was exactly the help I was looking for."

TSG looked at Smashbox’s sales channels and determined that department stores, which demand that cosmetics firms pay for their own sales help, had unattractive margins. So the company has emphasized outlets like Sephora and the QVC cable network; both produced higher sales and margins. At TSG’s urging, Smashbox also altered its advertising strategy away from image messages and focused instead on explaining the benefits of a key product, Photo Finish Foundation Primer. TSG partner Mullin calls the primer a hero product, because it is perceived as the best in its class. Factor says primer sales immediately shot up by 33 percent.

Factor admits he resisted when TSG suggested he raise prices about 3 percent, fearing the risk to sales growth, but he ultimately conceded. Sales continued to rise. "They had to convince me to do it, but we’re so much more profitable now," he says. TSG also encouraged Factor to pay employee bonuses. "I never would have done that without them, honestly, but morale is way up."

The Smashbox scenario was not the first time TSG had proved that it brings much more than capital to its deals. Says Bob Harris, the founder of Smart Balance Foods, a company that makes trans-fat-free margarine and other products, in which TSG has invested, "The Wall Street guys have a very short-term perspective. But I had a shorter-term view than TSG did. The first thing I asked after we closed their investment was how much we should cut the advertising budget. They said, 'We want you to increase it.'"

That push for long-term growth over quick profit is evident in the other rules TSG typically breaks: It takes few if any fees or dividends from its portfolio companies; it generally leaves the management alone to run the companies; and, perhaps most important, it pays top dollar, rarely bargain-hunting. The firm has never bought a business in an auction, Esserman says, preferring to sniff out superior targets and pursue them for years if necessary even if it means having to pay a high price to persuade the seller to bypass open competition.

That was the case with Smashbox, Smart Balance, Glaceau vitaminwater and several other investments. Alexander Panos, a TSG partner who opened the firm’s New York office earlier this year, stresses that money is not the only concern. "For the right businesses, yes, we’ll pay," he says. "The difference is we’ll pay only for the unique ones."

Of course, TSG is not the only mid-market firm to focus more on growth than on leverage. "With these smaller companies, you tend to create equity value through growth, so you can’t overleverage the company," says Charles F. Baird Jr., founder of the Greenwich, Connecticut, investment firm North Castle Partners, which specializes in the healthy-living and aging sectors."Typically, you put in new capital and new strategies, new structures, maybe new systems and controls to help them expand. That has to be your focus."

There is a difference, though: North Castle, like most private equity firms, will do only those deals in which it can acquire majority control. TSG feels it can achieve its objectives at times as a minority investor because of its confidence in the company’s strategy rather than the financial structure. In 2003, TSG plunked down about $40 million to buy a 30 percent stake in Glaceau vitaminwater, a health drink often sold in free-standing cold cases at pharmacies.

TSG liked the business because it promoted a healthful alternative to soda and appealed to all age groups. TSG also believed in the company’s management. The firm pushed the company to focus on sales growth over immediate profits, and business boomed. TSG sold its interest in 2006 to the Tata Group, the Indian conglomerate that owns Tetley Tea, for more than 12 times its initial investment. In short order, Tata sold the company to Coca-Cola at a huge markup. Did TSG sell too quickly? O’Hara shrugs. "We achieved all our objectives", he says, adding that the sale to Tata is what piqued the interest of both Pepsi and Coca-Cola, triggering the second acquisition.

"Most people in this business get very nervous about leaving an extra dollar on the table, or an extra million dollars", Knudsen says. "[TSG does] not. It’s because they have more confidence than anyone else that they understand what they’re doing and know where they’re going."

TSG’s returns have certainly attracted notice from investors. With its fourth fund dwindling, the firm raised its fifth last year. It turned away $1 billion, choosing to close its fund at about $900 million. Turn away money? That hardly sounds like Wall Street, which is exactly what TSG’s fans say is so attractive about the firm. "We’re very concerned about the amount of money coming into the private-equity business, and we never want to be in a position where we have to invest," Esserman says. "Also, we can always raise more."

"I think that Wall Street guys ruin more businesses than they help, honestly," says Smart Balance’s Harris. But he readily credits TSG with helping propel his company’s growth: "They turned us on to the idea that we wanted to grow even faster. They wanted us to spend more on the business, not less. That was the difference. That’s what’s special about TSG."


TSG Consumer Partners, LLC is a leading investment firm with
approximately $5 billion of assets under management, focused
exclusively on the branded consumer sector. Since its founding
in 1987, TSG has been an active investor in the food, beverage,
restaurant, beauty, personal care, household and apparel & accessories,
and e-commerce sectors. Representative past and present partner
companies include Duckhorn Wine Company, vitaminwater, thinkThin,
popchips, Muscle Milk, Yard House, Stumptown, Pabst, Planet Fitness,
REVOLVE, PAIGE, Smashbox Cosmetics, Pureology, Sexy Hair, e.l.f. Cosmetics
and IT Cosmetics.


Meghan Gavigan / Dan Goldstein
Sard Verbinnen & Co

Meghan Gavigan - 212.687.8080

Dan Goldstein - 310.201.2040