Secondary Deals Turn Sour for Castle Harlan

The constrained growth and debt difficulties facing Castle Harlan Partners’s Caribbean Restaurants business underscores the troubles that LBO firms can encounter after buying companies from other shops.

Buyout firms haven’t hesitated to recycle a used company. Secondary buyouts—when a business gets sold from one buyout firm’s portfolio to another—made up nearly 60 percent of all sponsor exits in 2007, according to Dealogic. Most firms don’t have a problem with these kinds of deals. In fact, a 2006 survey by research firm Mergermarket concluded that most buyout pros prefer to buy an LBO-backed company because dirty work like auditing and reorganization is out of the way.

But cracks have begun to show in some deals. In 2007, recycled buyouts missed earnings forecasts more often than did first-time LBOs, according to a recent European Standard & Poor’s report. The study reasoned that already-squeezed profits, typically constrained by high amounts of leverage, put the companies at higher risk. And the economy sinks, these companies—especially those dependent on discretionary consumer spending—are in even more danger.

Such is the case with Caribbean Restaurants. The Puerto Rican Burger King franchisee has been around the LBO block not once, but four times. By the time New York-based Castle Harlan bought it in 2004, all the traditional buyout firm levers like cutting costs and building new stores had been exhausted by previous owners. The firm declined to comment for this story.

Last month, S&P cut its rating on the company’s corporate credit from ‘B’ to ‘CCC+,’ predicting a potential covenant breech by April 30. Further, it warned that the company’s covenants will become more restrictive at the end of July.

Castle Harlan picked up Caribbean Restaurants from Oak Hill Capital Partners for $340 million. After Caribbean Restaurants bounced from Quad-C Management to American Securities Capital Partners to Oak Hill Capital, Castle Harlan investors wondered openly what value was left for the firm to extract. At the New York-based shop’s annual meeting that year, LPs questioned what the firm planned to do with Caribbean Restaurants. The company’s CEO, Luis Arenas, answered that the company did not plan any big moves, according to an LP source who attended the meeting. Our LP source is generally skeptical of secondary deals.

Arenas was right: Caribbean Restaurants’s previous owners left little for Castle Harlan to do. Together the prior owners packed roughly 80 more stores onto the island of Puerto Rico. The company now operates 171 Burger Kings in an area smaller than the state of Connecticut. The market is fully penetrated, according to our LP.

“There’s no growth left,” the LP said, “so you have to lever the crap out of it.”

As of March, Caribbean Restaurants’s debt-to-equity ratio is 6x, and S&P assigns a highly speculative rating to restaurant companies levered 6x EBITDA, according to Diana Shand, a director at the ratings agency. Caribbean Restaurants’s recent downgrade reflects S&P’s concern over the lack of a cushion in its debt covenants. Aside from constrained geographic growth, Caribbean Restaurants has also suffered because Puerto Rico has been in a recession since 2006.

Even if Caribbean Restaurants’s woes are particular to that company, our LP source remains worried that eight of the 12 companies in Castle Harlan’s fourth fund are secondary buyouts. Ames True Temper, which Castle Harlan bought from Wind Point Partners in 2004, has operated at a consistent loss, though recent results show signs of a turnaround. S&P revised the outlook on its CCC+ corporate credit rating from negative to stable after the firm’s latest quarterly report. Restaurant operator Perkins & Marie Callendar’s, formed after the firm bought Perkins Bakery and Restaurants from venture firm BancBoston Ventures and LBO shop Peachtree Equity Partners in 2005, saw its corporate debt rating lowered to CCC+ as well, thanks to tightening cash flows amid depressed consumer spending.

To be sure, Castle Harlan’s fourth fund scored a few wins with secondary deals: Horizon Lines, an ocean carrier company bought from The Carlyle Group, garnered a satisfying return through its 2006 IPO and secondary offerings. Likewise Castle Harlan’s exit of Rath Gibson, a tubing manufacturer picked up from Liberty Partners, returned 2.5x its money to Fund IV when Castle Harlan sold it to DLJ Merchant Banking Partners last year.—E.G.