GP Profile: Charlesbank Bets On Housing Rebound

Many buyout shops pride themselves on sniffing out deals where others are afraid to invest and closing their purses when industries get too hot.

Charlesbank Capital Partners, a Boston-based shop that has generated around 2.5x its invested capital since spinning out of Harvard Management Co. in 1998, has repeatedly generated good returns by doing just that. It is trying to do so once again with one of its latest investments.

In May, the firm joined other buyout shops inching back into the building products sector, which was hammered by the housing downturn. The firm paid $75 million, including debt, to buy Cedar Creek Inc., a Tulsa, Okla.-based company that distributes cedar used in home construction to lumber dealers and big-box retailers like The Home Depot Inc. and Lowe’s Companies Inc. Charlesbank Capital has also set aside as much as $50 million more for add-on acquisitions and other growth initiatives.

The Cedar Creek deal promises to show whether the firm, which has 21 investment professionals and is investing its largest fund yet, a $1.5 billion vehicle closed last year, still has a knack for picking diamonds from the rubble of battered industries. It could also offer a reminder of how prudent contrarianism can separate top performers from the pack and earn the loyalty of limited partners. “They’re not pure contrarians, but they tend to not follow trends,” said Elliot Royce, a partner with AlpInvest Partners, which invested $30 million in Charlesbank Capital’s sixth fund, a $900 million vehicle closed in 2005, and $110 million in Fund VII.

Charlesbank Capital began researching the building products sector in late 2008. At the time, the number of new homes being built, as well as repair and remodel activity, were rapidly declining.

Buyout firms were retreating from the sector. In the fourth quarter of 2008, 18 U.S.-based private equity firms took majority stakes in building products companies, way down from 37 in the third quarter of 2007, the peak for private equity activity in the sector during the then-current housing boom, according to Thomson Reuters. “You really did have an industry that was absolutely flat on its back,” said Jon Biotti, a managing director at Charlesbank Capital.

In the second quarter, Charlesbank Capital was one of 14 firms that made control-stake investments in the building products sector, up from nine in the first quarter. The number decreased slightly to 11 in the third quarter, but since the second quarter of 2009, when there were only six control-stake acquisitions in building products, there has been more sponsor-backed acquisitions in the sector.

The Strategy

Charlesbank Capital’s goals are to see Cedar Creek generate $1 billion of revenue in five years, and to make 2.5x to 3x its invested capital. To get there, Cedar Creek plans to create new distribution centers, buy competitors, introduce new product lines and expand its business with big-box retailers. Charlesbank Capital is also counting on at least a modest rebound in the housing industry.

This latter point is the key to the firm’s investment. In Cedar Creek, Biotti and Managing Director Kim Davis believe they’ve found a company that will thrive when the housing market eventually rebounds. Established in 1977, the company provides cedar boards, siding, trusses and logs used for home construction, as well as door and window moulding and trim products. About 40 percent to 45 percent of the company’s business serves new housing, 30 to 35 percent serves the repair and remodeling market, and 20 percent serves industrial customers that use wood as a raw material to build cabinetry, furniture, desks and other wood products.

According to Biotti and Davis, the downturn challenged Cedar Creek, but it remained profitable and had actually picked up market share thanks to its scale. The company, which operates distribution centers in Arkansas, Kansas, Louisiana, Missouri, Oklahoma and Texas, generated close to $500 million in revenue in 2009.

Deepening the challenge was the fact that Charlesbank Capital had never invested in a building products company, although Davis helped lead an investment in a building products company called ABTCO in 1992 when he was with another firm, Kohlberg & Co. To help in the effort, Davis recruited William Adams, an industry veteran whom Kohlberg & Co. hired as an executive for ABTCO, to look for deals and to eventually become CEO of Cedar Creek.

The team has concluded that any housing rebound will be very slow, and they say that’s OK. They don’t need the market to rebound to historic 2005 levels, when 1.7 million new single-family homes were built. Rather, the firm needs it to get more in line with the 20-year average of around 1.2 million. “If you’re at 400,000 housing starts,” Davis said, referring to 2009 levels, “but you return to 1 million or 1.3 million, that’s still a huge uptick of volume.”

Two other factors favoring Charlesbank Capital are that it paid a fairly small price, and Biotti and Davis said the firm has capitalized Cedar Creek in such a way that gives it time should the rebound be exceptionally sluggish.

The firm provided 50 percent of the $75 million purchase price in equity. That puts Cedar Creek toward the bottom of Charlesbank Capital’s typical investment range of $50 million to $150 million. The rest was financed with a revolver from Bank of America and U.S. Bancorp. In addition, Charlesbank Capital has as much as $50 million in reserve for acquisitions and other growth initiatives. Cedar Creek, in the end, will be one of 12 to 15 bets the firm makes with Fund VII.

Biotti and Davis said they will be careful about expanding Cedar Creek into totally new geographic markets. Instead the company will try to gain share in contiguous markets with acquisitions and new distribution centers.

On that front, Cedar Creek has already been active. In early June, two weeks after Charlesbank Capital bought Cedar Creek, the company acquired three wholesale distribution centers in San Antonio, Houston and Harlingen, Texas, from Alamo Forest Products. The deal gives Cedar Creek more business in the Lone Star State, including with big-box retailers. In total, over the next two years, Biotti expects the company to be able to double its revenue from the big-box retailers like Home Depot and Lowe’s.

Davis also said the company might introduce more moulding and trim products, as well as products in different types of wood, such as cherry, oak and pine.

It’s Done It Before

Charlesbank Capital has developed a reputation as a firm that, while not necessarily a turnaround specialist, dives into toxic industries. “They tend to play in industries that can fall in and out of favor because they’re cyclical,” said Tom Danis, co-founder of RCP Advisors, which invested $5 million in the firm’s sixth fund and $20 million in Fund VII.

Back in 2003, Biotti and Davis helped lead the firm’s investment in Regency Gas Services, a company it formed to buy assets in the midstream natural gas industry. At the time, the industry was recovering from the Enron scandal and deeply unpopular. It was also during a recession, following both the Internet bubble and the attacks of Sept. 11, 2001.

The firm partnered with an industry executive and paid $130 million, including $56 million of equity, for several gas processing and pipeline assets from El Paso Corp. The company completed two add-on acquisitions in 2004, which resulted in a more than doubling of pro-forma EBITDA. In December 2004, Charlesbank Capital sold the company to Hicks Muse Tate & Furst for $239 million, generating a return of 3.6x. “They understood the industry and knew it would become more profitable,” Danis said.

Even after just a few months, it appears Charlesbank Capital had good timing on its Cedar Creek investment. In August, U.S. housing starts improved to a seasonally adjusted annual rate of 598,000, 10.5 percent more than the July estimate of 541,000, according to the U.S. Census Bureau and the Department of Housing and Urban Development. Single-family housing starts also improved more than expected.

Other firms seem to be catching on as well. In September, Hellman & Friedman LLC bought Associated Materials LLC, a Cuyahoga Falls, Ohio-based manufacturer and distributor of residential building products, for $1.3 billion.

There are still plenty of risks for Charlesbank Capital. The housing rebound could turn tepid, or slow altogether. Lumber prices, which can be volatile, have already forced Cedar Creek management to slightly adjust their forecast of $500 million in sales this year. “Any time you buy in an industry that has gone through what the building products industry has gone through, you’re certainly going to suffer some unexpected events,” said Danis, of RCP Advisors.

But the firm doesn’t need to be perfectly accurate, and between the relatively bargain price Charlesbank Capital paid and the modest leverage it used, there should be plenty of wiggle room to make the deal at least a success, if not a huge winner. “We don’t need to get back to 2006 new housing starts for this to be a fine, successful transaction,” said Biotti, referring to another robust year, when about 1.5 million new single-family units were built.