On this episode of Deal-by-Deal, host Greg Hawver is joined by John Huhn, Managing Partner at the Compass Group. Tune in as Greg and John discuss lessons learned during the Compass Group’s successful independent sponsor investing phase.  John also provides key insights for those PE investors seeking to raise a committed fund in the current environment.

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Name: John Huhn

Company: Compass Group

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

You're listening to Deal By Deal, a McGuireWoods podcast. Deal By Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods partners Greg Hawver and Jeff Brooker, as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hello, and welcome to Deal By Deal, a podcast for independent sponsors and other private equity investors. My name is Greg Hawver. I'm a partner in the private equity group at McGuireWoods. I'm excited to be hosting this episode live from the Emerging Managers Conference in Dallas, put on by McGuireWoods. If you were to step outside the door here where we're recording, you would see about 1000 emerging managers who are raising their first or second fund together, with LPs, and a great speed networking session that we're having on the first day.

I'm even more excited to be joined by John Huhn of the Compass Group, who is actually a recurring guest now on the Deal By Deal Podcast. The general theme of today's podcast episode is the origin story of Compass Group, but also independent sponsors and emerging managers generally, and hearing about the evolution of Compass Group from an independent sponsor to raising multiple successful funds.

With that, John, welcome. Do you want to tell us a little bit about yourself and the Compass Group?

Sure. Thanks, Greg. Thanks for having me. If my voice sounds a little bit rough, it's only because I've been doing speed dating all day long. It's been a great day here at the conference, as usual. If anyone's been at the Independent Sponsor Conference, that blew up to be a huge success and still is. When this started, I guess just a year ago, is this just the second one?

Yeah.

It was a success right out of the gate so we're happy to be back.

Compass Group is based in St. Louis. We started as an independent sponsor back in 2015. We did eight transactions as an independent sponsor. Four of those have been exited so far, and we have obviously four more that we're working on. Over a period of time, we can talk more about the pros and cons of being an independent sponsor, but we did decide to cross that bridge and become a private equity firm and raise our first co-mingled fund. In fact, we call our portfolio of independent sponsor deals fund one. To keep everyone confused, our first co-mingled fund is called fund two.

Fund two was raised just two years ago today. Not today, but this month. So raised two years ago and we have deployed that in seven platforms. That was a $255 million fund. With a great team and great effort, and as a result of that great success, we were able to raise fund three, closing on an 408 million fund just last week.

Wow.

No rest for the weary. We came right down here and we decided we'd keep talking to LPs to be prepared for fund four someday.

That's great. You're a busy man. We appreciate your time. I would be interested in even zooming back a little bit further, the origin of the Compass Group as an independent sponsor firm. Where did you cut your teeth as a private equity investor? Then what are the deals that you focused on then and now?

Yeah.

I'm really good at asking four part questions, by the way. Sorry about that.

I might get one or two of those parts. If you go way back, I'm an engineer by training so I'm surround both at my office and here at this conference by a whole lot of finance and economics majors. I feel like an odd duck sometimes, as an engineer. But my background was engineering and entrepreneurialship. I had a variety of businesses, right out of school, which was back in the '90s. It makes me feel old to say around the turn of the century, I did consulting work in strategy and organizational consulting, primarily for large corporations.

What was interesting to me is when the organization was changing and when the strategy was changing, it was because of M&A. It was driven by acquiring a new business and what's the strategy to put this together, what does the organization look like. Or vice versa, they had divested a portion of the business and they had to reorganize and effectuate a new strategy based on those changes. That was my first involvement in M&A, that's what intrigued me. I probably have ADD a little bit, so I was always looking for a new activity, a new business, something new. I realized that this consulting side allowed me to be involved in different businesses and help different businesses over time.

Did consulting for a while. I then became the chief strategy officer and corporate development officer for a publicly traded company in St. Louis. Did that for a period of time. I had great experience, did about 14 transactions around the world to grow that business into the billions. Then, got tired of all that travel and accepted a role to lead a family office in St. Louis, where I'm from. I went from running 100 miles an hour in a publicly traded company to moving very cautiously in a family office environment. 115 year old family, looking to diversify the income stream to the family trust. While it was great experience, it just wasn't the pace that I was interested in.

But all those experiences together allowed me to start Compass Group. The part that's probably most interesting is that when you're in a corporate development environment, you know all the competitors in your space. You know who is doing what and you're looking to make an acquisition for very tactical reasons. It could be a geographic footprint, it could be for talent, it could be for capabilities, or any of those things. You knew everyone and who was good, who was bad, et cetera. I translated that to what I called thesis based investing, to say we don't want to buy a deal just that's on the market being sold in a process, we want to buy the best business in a space that's interesting to us.

From the very get go, Compass Group was thesis based. We will research a sub-sector, sometimes ad nauseum, for an extended period of time. It could be years before we've now learned all the players, talked to all the executives and know literally dozens, maybe even 100 companies in the space. We've looked at their P&L so we know what they spend on marketing, and we know what typical margins are, and we can find the one that fits best not necessarily the ones that is for sale. Our goal is to understand a market, know what we're going to bring to that business, and then find a proprietary deal.

That's fantastic. How many theses do you have at any one time?

We're usually working on anywhere between 10 and 15 at one time, but they're at different stages. Everyone at Compass Group has a thesis that they're working on and maybe participate on a team on another thesis as well so that you get smarter over time. You become more sophisticated as you grow in the company, you become the expert in that sub-sector and know that market so deals get funneled to you that are in that space. We're working on maybe 10 to 15 at any one time, but I'd say there's maybe four are five that are further along, more mature.

At that point, we may have hired an expert advisor to help us navigate that space. We may have turned our business development, John and Stu, who do a great job of going out and finding opportunities in spaces that we're interested in. We put what I call extra effort on those that have grown to that level of maturity.

How has that playbook evolved as you moved from independent sponsor to fund? I assume you have more resources now, so there's more bandwidth. Have you moved up market in enterprise value as well? Any other kind of shifts in strategy?

Yeah. We certainly have gone upmarket a little bit, just because we have the ability now to close a larger deal. But the truth is, and I said this in a podcast not too many years ago, the value that we bring as an independent sponsor is the same value we bring today. The reason somebody can get a deal financed as an independent sponsor is that they know a space well, they can bring value to that transaction, they maybe found it in a proprietary way and they probably found it or got it under LOI at a low multiple. Therefore, your investors can afford to give you economics and help finance that business. That's why somebody would invest with us as an independent sponsor.

That's exactly what our LPs want in a private equity fund. What are you doing? Why are you investing in a space? What value are you bringing to it? As opposed to just taking books and bidding against others from bankers. We love the bankers, we use bankers as well, but our job is really to find those opportunities at below market multiples because we understand a business, we can add value to the business. You've heard it before, but capital's pretty fungible these days.

Even when we're selling ourselves to someone whose selling their business, we say, "Hey, you can get capital from anybody, but we can help you on that second bite at the apple. How are we going to grow this business?" You can imagine if we'd been swimming around in the space for years, we can then bring executives, we can bring bolt-ons. We have some strategy and knowledge of how to help grow that business. Sometimes in ways that the owner of that business hadn't even thought of, because they're so head down, focused on operating day-to-day.

From what I see out there, that's exactly the type of sponsors that capital partners are looking for, bringing that expertise and focus in specific sectors.

Switching to the equity raise side, when you had your independent sponsor hat on, were there certain types of investors you had particular success with or other lessons that you learned along the years investing in that space?

Yeah. It's a fair question. I had people often say, "Well, how have you successfully raised these funds?" Just like looking at a deal where you try to check all the boxes, you want a strong management team, you want a good business and a good market, with good margins and growth opportunities, you like to check as many boxes as possible. When you're in the fundraising environment, you feel the same way. You want to check as many boxes as possible.

We're fortunate that we had a good pipeline and we have a good team, and we had a track record. As I mentioned, we had done eight deals in the independent sponsor model. We had had multiple exits in the independent sponsor model. We've taken that full roundtrip and realized some of them. In raising our first fund, we actually had a business, first under LOI and by the time we closed the fund, we have bought in warehouse that first business for the fund. All those things, not everyone is going to have all those things, but if you can check those boxes, that's attractive to the LPs who say they know what they're getting.

Just like businesses have a J-curve, I think private equity firms have a J-curve. They have to learn. If someone's spinning out and starting their own private equity firm, they may have a track record with attribution, but they still got to hire a team, they got to start the pipeline, they got to get an office. They have to get things set up and that takes some time. Where, as an independent sponsor, if you morph from an independent sponsor into a co-mingled fund, you already have momentum on the deals you're looking at and the knowledge you have of the marketplace, the team that you might be working with, et cetera.

That was very helpful for us. We raised our first fund, over subscribed, we had to allocate back. Then just like I'm here today, we kept in touch with those individuals that weren't able to move as fast as maybe that fund closed, and therefore we had people waiting in line for fund three, if you call it that. Fund three was raised fairly quickly as well, just over a four or five month period of time.

Got it. Tell me a little bit more about those timeframes because I get that question a lot.

Yeah.

How long does it take? The last one, fund three, was very quick, four to five months. How was the first fund, from a timing? Maybe just when did you make the decision to raise a fund, and then what was that timeframe like?

Yeah. The first fund was raised fairly quickly as well, about six months period of time. I can tell you from having hundreds of discussions with potential LPs and repeat discussions, you have the first discussion and then you repeat it, and then you repeat it again. Then you have diligence calls. Lots and lots of conversation. Six months feels like a really long time if you're doing that every day. I know for a lot of folks, it takes a lot longer so I'm sympathetic to that.

But what we tried to do is plan first, and then jump in raring to go. As you asked, we probably spent at least six months planning the fund. Who are we going talk to? Are our materials together? Do we have a data room ready? Are we going to use a placement agent? What's our target list? Who of our current investors would invest in the fund as well? You might imagine, we had family offices and fund-to-fund that were institutional investors that supported us as an independent sponsor, but we also had investors who only invested in direct investments and could not invest in a fund environment. We had to identify which ones would come along or not. After all that planning and getting all ready, we launched it in October '21 and closed the fund in April '22.

As you were planning to make the move to raise a fund, what in hindsight, looking back, was one of the most important decisions that you made as far as hiring or not hiring a placement agent? What are you glad that you did in those initial steps, if anything comes to mind?

I'm glad we planned ahead. We really had a pretty good plan and pretty good track record. Probably the two most fundamental success pieces were having a deal under LOI and subsequently having a deal warehoused prior to the close of the fund. That really accelerated the interest level. People will often say, "Sure, I'll talk to you and learn your story," but there's no sense of urgency. Having a deal created a sense of urgency.

Then we did in fact hire a placement agent. We decided, hemmed and hawed about that. We were able to bring about half the equity to the fund from our own relationships, but we wanted to just make sure we were 100%. That's a hard decision because, if you're raising a fund and you're going to pay your team and live off of that management fee, it's hard then to pay a placement agent. Placement agents usually will work with you on a payment plan or whatever. We were very fortunate that we had income from the portfolio of independent sponsor deals, and with that income, we weren't really needing that management fee right out of the gate. We were able to get comfortable that fee was worth assurance that we could get this fund raised. It worked very, very well.

Great, great. Remind me, what was your track record profile when you went out to the market? You had been several years as Compass Group, you had X deals closed, X exits.

Yeah.

What was that general profile like?

Yeah. We started in 2015 and we started raising this fund in 2021. We had been six years as an independent sponsor and we had done eight transactions during those six years. Eight what I call platform transactions. We're pretty prolific in the bolt-on, so we had done a fair number of bolt-ons as well. But eight platforms.

As I reflect back, we had three exits. We had a fourth right after the fund closed. But three exits, one of which occurred during the fundraising process. That's always helpful, too. It was a wild success, so that's helpful. Then we had one, again under LOI and subsequently warehoused for the fund. Enough where I think you can make the case that, if you've bought a company and you've had an exit, okay you can maybe do that once. We can now make the case that look, the team we had assembled, and the process and the strategy we used, we've done eight successful transactions, we've had multiple exits so you can't consider that an anomaly.

Yeah. That's a super impressive track record.

Well, we really started Compass Group and behaved like a private equity firm. We didn't ever want to just do a deal by deal, and act like we're buying ourselves a job. Managed a portfolio like a portfolio, we reported to our boards and our investors on a quarterly basis. I think that helped them realize we had a certain amount of sophistication or a certain amount of comfort making that migration to a funded environment.

I think you just touched on it, but the intent, was the intent always to raise a fund?

It was not.

Okay, got it.

When we started Compass Group, we believed that the opportunity was there for us to assemble a stable of investors and do deal by deal. The economics and the process of deal by deal makes a lot of sense, so we were quite comfortable as an independent sponsor. But there was a couple of triggers that occurred.

It's horrible to say, and I think it's much less now, but independent sponsor, many years ago, we were called the fundless sponsors. This pejorative term that means you don't have any money. People wrongly thought that if you had a private equity firm, you were sitting on tens of millions of dollars in a bank account, when in fact you still have to go to those investors and call that capital. We tried to set up a scenario where we had this stable of investors and we could reach out to them and say, "We have a deal. Let's talk about what it looks like. You choose whether you want to invest in this one or not," but we weren't running around with our hair on fire, trying to finance a deal after we got the deal. We had built the stable of investors, many of whom invested multiple times with us, so a lot of overlap. But over time, a lot of different investment groups came together.

Maybe the second part of that question is why would we switch to a funded model? Really, we came to the conclusion, a couple things. The pejorative, independent sponsor. We had deals where we lost where we went in there, we won them over, they were interested in working with us, and then somebody whispered in their ear, "They're an independent sponsor or a fundless sponsor, God forbid, and they don't have capital so you're at risk that you go through this diligence and it doesn't happen." We've never had that happen in any of our transactions, but that moniker was out there, that tag was on us. That was one, we were trying to get through that.

Number two is that we now had eight businesses which meant eight audits and eight boards and eight reporting, we were spending more time on the administration of essentially eight small funds. As people know, when you do an independent sponsor deal, essentially you create a mini fund of investors to acquire this individual business. We had eight small funds that we were administering and we were missing out on spending more time with the businesses, which is what we love.

Then the final thing, as we grew as a firm, we were trying to attract and retain great talent. While we were confident we were going to continue that way, if you were a young stud or studess joining Compass Group, you wanted to make sure that there is that continuity there. The 10-year life or 12-year life of a fund gives a lot of people comfort and confidence that they can leave their investment banking job or wherever they might be and join Compass Group, and have a career there.

Those were the three triggers that we said, "It's time for us to raise a fund."

Yeah, yeah. That is very informative. I think that in working with the independent sponsor community, it's just so interesting to see the wide variety of independent sponsors. Thank you for your time on this one, giving us the perspective of going from independent sponsor to closing your third fund. Super, super informative and interesting.

Maybe just, as a parting thought or parting comments, any pitfalls or things to watch out for if you're an independent sponsor and you're working on closing deal one or deal two, and you're starting to think about, "Should I raise a fund or should I not?" Any just words of wisdom if you're having that thought in that stage?

We made mistakes along the way so certainly, learning from those mistakes. If I can help anyone, happy to.

One of the things we did is have this cadre of investors, many of whom were high net worth individuals, or friends and family, those types of things. We had a pretty unique mix of investors in different deals. Where I think today, the independent sponsor marketplace has matured. As your conferences have shown, I think you had 1600 or so people at the last Independent Sponsor Conference. Finding institutional capital that then can roll with you into the fund environment I think is a huge step. They get to do a deal with you, they get to know you, you get to know them, and then they can be an LP in the fund. Where many of our investors weren't fund investors, they were high net worth individuals who said, "You got a deal? I'd be interested in throwing in some cash." Those who could roll with us were in the later stages of our independent sponsor life were more institutional. The more you can do that early on, I think the better.

Then of course, some continuity and a track record is always important. Continuity, and as I mentioned earlier, some urgency always helps. Really getting the right mix early on I think is an important step.

That's fantastic advice. Well, John, I really appreciate your time. You're an active person. You just closed a fund a week ago and you're here in Dallas, meeting a bunch of people. Then on this busy day, I'm sure you have a jam packed schedule, and you took 25 minutes to record a podcast. I appreciate that. I think our listeners will appreciate it, too. Thanks for your time.

Yeah. Thanks for having me, Greg.

Awesome.

Appreciate it. Take care.

Thank you.

Thank you for joining us on this episode of Deal By Deal, a McGuireWoods podcast. To learn more about today's discussion and our commitment to the independent sponsor community, please visit our website at mcguirewoods.com. We look forward to hearing from you.

This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those at McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state, and should not be construed as an offer to make or consider any investment or course of action.