Guerilla Warfare: RCP Stalks The Small Market

You can spot them in a New York skyscraper or maybe a West Coast pension fund office, but also in far less well-trod offices in Paris, Texas and Algoma, Wisconsin. Where other discretionary advisors are too big or too slow to go, they are knocking on the door.

These are the guerilla investors, roving in small, mobile troupes in places larger firms can’t find. Under the radar, in the jungle of the micro-markets—that’s where RCP Advisors operates.

RCP is a Chicago-based fund-of-funds manager focused on the small and middle markets. Those markets, in the view of managing principal Tom Danis, are the jungle, and he and his fellow managing principals are the guerillas, hunting where others fear to tread. This year RCP is raising its fourth fund, and already has much of the targeted $225 million raised. The hard cap is $300 million. The idea for the firm’s evergreen fundraising style—a model also used by fund-of-funds giant Adams Street Partners—came from limited partners. The structure lets LPs, including Indiana University, make a three to four year commitment, and tweak their allocations each year. Over the course of its history, RCP’s own investment base has shifted from 70% wealthy investors and 30% institutional to exactly the opposite. About 20% of its money comes from Europe.

Down on the jungle floor, “information and relationships are the currency with which we trade,” says Danis. “A small group of guerillas fights and forages in places too small for other people. RCP has no institutional impediments to us doing everything right for our clients.” RCP Managing Principal Jeff Gehl adds, “In this business you have to make a decision whether you’re an asset gatherer or an investment manager. We’ve made a decision we’re investment managers.”

So for the time being, they’re staying guerillas, not moving up market. Danis credits the image of the “investment guerilla” to David Swensen’s 2000 book, Pioneering Portfolio Management. While a big brand and size work for other advisors, the principals of RCP believe they can be more nimble.

RCP, short for Reserve Capital Partners, a name which came from a California resort at which the partners drew up their original business plan, has unusual beginnings. Most executives at fund-of-funds managers have roots in private equity, investment banking, or at least fundraising. The two founders of RCP—Danis and his uncle—had none of these experiences when they started their own firm in 2001. They were in insurance.

But they had a unique view of the private equity industry. Danis and his uncle, RCP Senior Managing Principal Timothy Danis, had worked at Aon Risk Services with buyout shops, bankers, and lawyers; their job was to help sellers clean up their liabilities and transfer them to a third party in the run-up to an auction. Moreover, Timothy Danis had invested alongside the buyouts he worked on, and noticed that returns trailed off once deal sizes hit $1 billion or more.

Seeing the opportunity and knowing the players in the smaller markets, Danis and his uncle then recruited Fritz Souder, a rival with insurance provider Marsh & McLennan, where he directed their private equity and M&A group in the Midwest. Next they locked down some LP experience by getting Charles Huebner from Heller Capital Management, where he was a senior managing director overseeing the $500 million portfolio of middle market buyout LP interests. The team lastly secured fundraising experience and a West Coast presence by hiring the entrepreneuring Gehl, who had co-founded sports marketing company Big Ballot Inc. and obtained venture money for it. With Gehl in Newport Beach, every private equity investment firm was only a day roundtrip away.

The younger Danis says the team has relationships with “people who have been on the playing field. If you want to know who a good player is, you ask someone who’s played, not a fan or someone in the press box.” Gehl adds, “We have a unique peek under the sheets into who worked on deals, who didn’t, and who has disciplined due diligence. It’s a very different perspective [from that of] an institutional investor who’s invested in Funds I and II and gets the quarterly report.”

RCP’s strategy of sticking to the middle market is supported by data that shows returns by smaller private equity firms far outstripping those of larger funds, though in the last few years larger funds have outperformed. Danis says that big funds are benefiting from a perfect storm in the sector. “You can’t just recap these companies forever and generate a superior cash on cash return. You have to sell them. I don’t know how long those sexy IRRs [posted by larger buyout funds] can stay there. It’s pretty interesting how IRRs can stumble without effective full exits.”

Sticking to the smalll and middle market has actually become contractual for RCP. The firm raises an annual fund of between $200 million and $300 million, which it believes is just the right amount to back quality buyouts shops investing in companies with enterprise values of between $25 million and $250 million.

Also part of the RCP strategy is its advisory board, which includes executives from JPMorgan, GTCR Golder Rauner, and ProLogis Trust. RCP routinely circulates faxes to its advisors when meeting with GPs to get dirt on a firm and its habits. The real value of the advisory board, says Gehl, is the off-reference-sheet information. “We have a voracious appetite for market intelligence,” says Danis.

It Helps To Specialize

Looking for the right GP, RCP gets its share of frequent flier miles. The firm keeps a proprietary data base of roughly 700 mid-market managers and last year visited with more than 160 that were fundraising.

When trying to decide where to invest, Danis used to believe in the importance of proprietary deal flow. He doesn’t bother with that metric anymore. Now, intermediation is an inescapable part of the landscape and LPs have to be careful about sorting out who can make money in an auction-saturated market and who can’t, he says.

“If someone made all their money on proprietary deals but the last seven have been with intermediaries and they haven’t done as well, that might be a light bulb that says, ‘Maybe these guys don’t do as well with intermediation.’” He adds, “Proprietary deals tend to be more luck than anything else these days.” Gehl says the only kind of proprietary deal is a limited auction where an industry specialist doesn’t have to be the winner on price.

To get RCP’s money, being nichey and experienced helps. Among RCP’s 45 GPs, only eight are generalist funds, among them Brockway Moran & Partners. If you are a first-time fund, know that RCP devotes 20% of its capital to emerging managers, but the definition of “emerging” remains elusive. For RCP it often means spin-outs from other firms or guys that already have a track record. But in this market, even roman-numeral-II funds can be considered emerging because they’ve only had one third or one quarter of their portfolio realized, says Gehl.

Among the funds RCP has invested in is—no surprise here—Riverside Co.’s $250 million Micro-Cap Fund I, raised earlier this year, which falls perfectly into its sweet spot. Other GP relationships include The Sterling Group, a Houston-based buyout shop investing in manufacturing, industrial services and distribution, where Danis is now a member of the second fund’s advisory committee. Among RCP’s best performers are two New York-based funds, distressed player KPS Special Situations Fund II, a $404 million 2004 fund, and mid-market specialist Harvest Partners IV, a $558 million 2002 fund.

RCP has a few peeves with GPs—among them terms, which the firm believes are changing in favor of GPs. The most egregious? GPs taking carry so early on, says Danis. He adds, “The clawback provisions that exist out there are entirely too weak.” With many funds, when LPs need to clawback money from the GP, they’re only going to get net after taxes–in other words, for a $10 million clawback, LPs may only get $5 million. LPs occasionally can gang up on GPs as a collective bargainer. But that isn’t always an option, says Gehl, as relationships with GPs are sensitive.

RCP also complains that many partners don’t have enough skin in the game. Danis says he is endlessly surprised at how GPs will only put a few hundred thousand into a fund because, they say, “that’s what I needed to.” Danis would like to shoot back, “’Wait a second, if you think this is a great place to put our money, why won’t you put in as much as possible of yours?’” Gehl’s biggest gripe with GPs is “strategy drift.” Following hot sectors betrays the original deal that the firm made with investors, he says.


Once invested, RCP stays out of the way of its GPs. “A lot of people get an ego boost for taking three hours of a GP’s time so they can say they are monitoring the fund,” says Danis. RCP leaves its money alone.

RCP has ramped up its business well so far, but the firm has hit something of a glass ceiling. Its ideal fund size is around $300 million. If RCP grew any larger, they would either have to become larger LPs in middle market funds, or move upstream to GPs that are looking to buy larger companies. With $700 million under management, the firm invests about $20 million per fund, which makes it a 5% to 10% investor in the size funds its likes, which are between $200 million to $400 million. Neither Gehl nor Danis had firm ideas about where the group goes from here—but the priority is to “keep the guerilla mentality” says Danis.

Overall, Danis is bullish on buyouts, an industry he believes is revolutionizing the way people look at ownership and how the structure of ownership creates value for the owners. Companies are not managed best on a quarter-to-quarter basis to please the public equity markets, he says. Also, private companies don’t have to let customers or competitors know what their strategy is. The bottom line, says Danis, is “There’s a better way to own than via the public stock market.”