Personality Profile: Past Downturns Inform Carl Thoma’s Strategy

Carl Thoma has lost millions on bad deals made during bubbles over the course of his 30-year career in private equity. He got burned in the crash of the high-yield debt market in the early 1990s, then took it on the chin a decade later after investing in companies pursuing unproven business models.

Nevertheless, Thoma’s funds have generally done well, generating IRRs as high as 57.9 percent (see chart), and averaging 28 percent across eight funds. And given past lessons learned, Thoma is confident that his latest firm, Thoma Bravo, can earn good returns on a ninth fund, expected to close at $800 million by the end of the year. “At my age you finally say, ‘These [cycles] do reoccur, so why not anticipate them?” Thoma, 60, told Buyouts.

Thoma joined the late Stanley Golder in 1980 to create Chicago buyout shop Golder Thoma & Co., which in 1984, with the addition of Bryan Cressey, became Golder Thoma & Cressey, and eventually, with the elevation of Bruce Rauner to partner, Golder Thoma Cressey Rauner. In 1998, the partners split, with Thoma and Cressey starting Thoma Cressey Equity Partners, and Golder and Rauner starting GTCR Golder Rauner. Since then, Cressey has moved on to raise his own $500 million fund for investing in health care, under the name Cressey & Co., while Thoma and Partner Orlando Bravo set out to raise their own fund for investing in financial services, education, consumer and distribution.

Like many buyout firms in the late 1980s, Golder Thoma & Cressey commonly financed its buyouts of companies in the business services sector with as much as 80 percent high-yield debt. After high-yield bond pioneer Drexel Burnham Lambert Inc. went bankrupt in 1990, the high-yield market collapsed, and many portfolio companies ran into trouble from the combination of a weak economy and their inability to refinance their high-yield debt.

Case in point was Sullivan Graphics, a commercial printer that Golder Thoma & Cressey created in August 1988 with James Sullivan, a former executive at R.R. Donnelley; Sullivan Graphics went on to buy printing company GBP Industries for $350 million, financing the deal with $100 million of 15 percent high-yield debt. When the economy slipped into a recession in 1990, many businesses cut back on newspaper advertising, which was a core revenue source for Sullivan Graphics. Cash flow fell by a third, and in February 1993 the company defaulted on its debt payments. Two months later, Morgan Stanley Capital Partners bought the company for $250 million. Golder Thoma & Cressey retained a small minority position, but lost its original $25 million equity investment

Golder Thoma Cressey & Rauner Fund III LP went on to turn in an exemplary 57.9 percent IRR, according to the California Public Employees’ Retirement System, but the deal inspired Thoma and his colleagues to re-evaluate their use of debt. “We stepped back and said, ‘There’s got to be a way to make money without excessive leverage,’” he said. Since then, Thoma has typically financed his deals with 50 percent debt and 50 percent equity, and companies his firms own typically have less than 4x leverage—far more modest than that employed by many rival shops up until the second half of 2007.

In place of leverage, Thoma said his firm achieves its returns through a combination of operational improvements and add-on deals. Thoma Cressey Equity was an early champion of the “buy-and-build” strategy in the early-1990s. The idea is to buy a company in a fragmented sector; do a series of tuck-in acquisitions at low multiples, and then sell a few years later at the higher multiples commanded by large, stable companies. “These guys were one of the first on the scene that made [buy-and-build] an integral part of their business,” said a limited partner whose firm has been investing in Thoma’s funds since the 1980s.

Tech Bubble

But Thoma still had some difficult lessons to learn. Thoma Cressey Equity Partners lost 80 percent of its $50 million investment, made in 1999, in start-up NerveWire Inc., which set up e-commerce portals for companies.

The investment failed in part because the company’s customers—Fortune 100 companies—stopped buying the company’s products and services when the technology bubble burst, Thoma said. And the firm lost 80 percent of its $40 million investment in Eclipse Networks, which advised telecom companies on the design of their fiber-optic networks. That investment suffered amid the telecom meltdown of 2000-2002. The two investments helped pull down the performance of Thoma Cressey Equity Partners Fund VI, a $450 million fund invested in the late 1990s and early 2000s that has turned in a -2.89 percent internal rate of return as of March 31, according to the California State Teachers’ Retirement System. A survey of performance available to the public from CalSTRS and other pension funds suggests Fund VI was the worst fund Thoma has been associated with.

Thoma and his colleagues again stepped back and examined where they’d gone wrong. For its seventh fund, Thoma Cressey for the first time hired operating partners to sustain a more hands-on approach with its companies, and it only targeted companies with proven business models that provided steady revenue. It also renewed concentration on its buy-and-build strategy. “We’ve got to buy solid companies with maturity, a diversified customer base, and ‘high-quality revenue,’” Thoma recalled saying at the time. Today, explained Thoma in an e-mail, “we estimate our returns come 25 percent from operational improvements, 50 percent from synergies of tuck-in acquisitions and 25 percent from leverage.”

Thoma and his colleagues put their revamped strategy to work with success with an investment in VECTORsgi Inc., a company that provides check imaging software for banks. Thoma Cressey bought the company via its seventh fund in September 2003 from Sterling Commerce for an undisclosed amount. In keeping with its modest approach to leverage, the firm financed the deal with about 50 percent equity. The company enjoyed EBITDA margins above 30 percent when Thoma Cressey acquired it, and it had produced steady revenue growth since its inception in 1976.

Sydney Smith-Hicks, the former CEO of the company, said that Thoma and his colleagues had more resources and displayed a deeper knowledge of the software industry when courting the company compared with other potential buyers. “Carl and his team had done their homework and were asking penetrating questions, and they listened to our answers,” Smith-Hicks said. “The [competing buyers] would ask good questions but they wouldn’t listen to the answers, because they thought they knew the answers.”

With the help of Jim Lines, an operating partner with prior experience as a CFO, VECTORsgi created its own accounting system, which was necessary after being carved out of Sterling Commerce. A main goal of the company under Thoma Cressey’s ownership was to land 12 additional banks as customers, and it counted 10 as customers in the first year. The company was starting to look at a list of add-on targets when Metavante Corp., impressed with the company’s success, offered to buy it. “We could work for another five years and triple our money, or triple our money right now,” Smith-Hicks recalled thinking. Thoma Cressey sold VECTORsgi in November 2004 for $135 million, tripling its money. That and other big wins lifted Thoma Cressey Equity Partners Fund VII LP to an IRR of 28.52 percent as of March 31, according to CalSTRS, putting the firm back in the top tier of private equity returns.

Looking ahead, Thoma Bravo aims to make 3x its money on deals with its ninth fund, which enjoys backing from funds-of-funds managers Accolade Partners, J.P. Morgan Investment Management Inc. and HarbourVest Partners. Altogether the firm expects to make 10 to 12 platform deals, about 40 percent to 50 percent of which will come in software, 20 percent in financial services, 10 percent to 15 percent in education, and 10 percent in distribution.

The firm has so far made one platform deal with Fund IX: In April it bought the software business unit, now called Acresso Software, of Macrovision Corporation, for $200 million. The company’s products help software vendors manage entitlements, software licensing, compliance, installation, and electronic software delivery. In keeping with its modest use of leverage, the firm financed the deal with 50 percent debt and 50 percent equity. And in what would be its first add-on, Acresso last month agreed to pay $27 million to buy Intraware Inc., a company that makes licensing software.

Now 60, Thoma is grooming Bravo and Scott Crabill, managing partner, to take over the firm once he retires, which he said wouldn’t happen for another 10 years. He’s confident the lessons he’s learned over thirty years, and the returns he’s earned, have established a reputable institution in the buyout market that will continue after he steps aside. “When I think across this industry and individuals who’ve been around, no one has seen it all, but Carl has seen a lot, both the good and the bad,” said our LP source.