Terry Mullen, partner at Arsenal Capital Partners, recently spoke with Buyouts about the New York firm’s vintage 2006 fund, Arsenal Capital Partners II, which rang up a net IRR of 19.3 percent for Regents of the University of California as of March 31, including co-investment returns. That’s ahead of the top-quartile threshold of 11.2 percent, according to a 2016 analysis of public-pension-fund data to be published in Buyouts.
When we spoke about Fund II in 2013, you cited a 4x return on battery-materials maker Novolyte on its sale to BASF, as well as growth at Royal Adhesives & Sealants as drivers. What’s been boosting performance since then?
What’s driving success is we’ve been doing this for 16 years. We are very specialized in executing high-growth buy-and-builds. That’s been a terrific formula and we’ve honed it and refined it. …
We’ve set out from the inception of the firm to focus on specialty industrials: technology rich industrials such as specialty chemicals and materials; also in healthcare business services. That focus has remained consistent. In these two areas, we’ve been building market-leading franchises — very specialized and very deep.
Let’s take a look at your approach in the industrial sector.
We’ve become the dominant player in specialty chemicals and materials. Over the last 15 years, we’ve done two times the number of platform acquisitions, add-ons and exits than anyone in private equity in the chemicals and materials space. These are middle-market deals, so there are lots of opportunities, though the key is to do them with focus and depth of expertise.
What about healthcare?
We have had consistent focus on business services; however, we have gotten deeper and more technical. We understand deeply the specific medical and scientific aspects of companies. We’re focused on business services to the pharmaceutical industry, helping them bring drugs to market better, faster and cheaper. We’re also concentrating on helping hospitals transform their workflow management to provide better care and more cost-efficient services.
The healthcare business services and healthcare information technology [segments] have been rich, attractive market spaces with high needs and demand.
We’ve had great depth in domain and technical expertise, which has become more important in the world of healthcare. It’s been a major differentiator. We’re deeper, more specialized, more focused and more prolific. These factors have contributed to increased consistency and magnitude of success in our strategic buy-and-builds.
Any other deals in the firm’s history you’d like to mention?
In Fund I, we had some terrific winners. More than half the exits in Fund I generated 3x multiple on invested capital or more. We also had an 8x and 13x in there. But we did that by taking on certain market and execution risks. We had a really big slugging percentage, but two big losses.
In Fund II, we made nice strides to maintain the high slugging percentage while reducing our loss ratio. Today, across Funds I, II and III, 55 percent of the deals we’ve exited in the industrials and healthcare sectors have generated a 3x MOI or greater and, over time, our loss ratio has gone down significantly.
Also in Fund II, we had Royal Adhesives & Sealants. We grew that company from $90 million in value in late 2010 and through eight add-ons, we grew it to $1 billion in enterprise value. We sold it to American Securities last summer and generated a 6.5x MOI.
In healthcare, another Fund II company, WCG (WIRB-Copernicus Group), a clinical-services organization, was also a very successful buy-and-build. We started out with a platform we acquired for less than $100 million and grew it — also through 10 add-ons —to nearly $1 billion in market value. We completed a major recapitalization of that business in August.
From Fund II, we sold a significant portion of WCG to an investor group led by Arsenal Fund IV, MSD Capital, the University of California Regents, and Goldman Sachs. The recap generated a 6.7x MOI to Fund II investors, with further upside on its rollover investment.
Why the recap?
WCG’s growth trajectory in coming years will be driven by continued growth of its core business, as well as the opportunity to expand into a full-service clinical-services organization. To take this step, WCG needed an owner who had the appropriate time frame and willingness to commit the capital and resources for this next phase of growth. WCG was best able to fulfill these needs through a recapitalization.
Your Fund III is generating a net IRR of about 20 percent, according to sources. Update us on that?
We found this combination — strong platforms, with multiple acquisitions lined up and executed in the first year or two — has been a huge hallmark of our success.
With the real successful platforms, we may do six or eight add-ons. So far, eight add-ons is the high-water mark, with Accella Performance Materials. That’s been a real high performer in Fund III.
Have you had any exits from Fund III?
The only business we’ve exited is Kel-Tech, which we sold to Clariant this year. We’ve got three or four others that we plan to exit in the next 12 months. In Fund III, we’ve done 10 platform deals and 30 add-on acquisitions. We would expect to do at least 10 more add-ons over time.
You closed Arsenal Capital Fund IV at its hard cap of $1.3 billion in October. How did the fundraising market in 2015 and 2016 compare with past efforts?
We raised our first fund in 2001 and 2002. It was a difficult time. We raised Fund II in 2006, which was very active and healthy. In 2012 when we were raising Fund III, the market was still a bit tight. Each fund has been different.
With Fund IV, the market was very robust, very active, with lots of funds in the market. Also, many LPs were getting a lot of returned capital, so they were looking to deploy money. So it was deeply active on the GP and the LP side. Out of our top 15 investors in Fund III, 13 of them re-upped. On average, they increased their commitments by more than 35 percent and helped us move up to $1.3 billion in Fund IV from $875 million in Fund III.
For Fund IV, your firm noted that 85 percent of existing top institutional LPs re-upped with the firm. How did you decide which new LPs to let in?
We were seeking a handful of new LPs who are long-term investors and committed to the lower middle market. It’s always a long-tail process to get to know LPs, usually years in advance of them making a commitment. There were several that got close on Fund III and we kept in touch and we were fortunate to convert on several of them.
The fund has approximately 60 percent U.S. LPs and 40 percent international. California State Teachers’ Retirement System is a wonderful new name in Fund IV.
In Denmark, we’ve had PKA Ltd and also Sampension, and we were delighted to add PensionDanmark as a major new investor. We’ve also had strong support from Pictet Private Investors and Unigestion based in Geneva. They’re all great institutions and provide us nice diversity for our LP base.
How is your portfolio doing this year?
Across the funds, this year we are experiencing revenue growth of 38 percent and EBITDA growth of 45 percent. A lot of the growth is driven by add-ons; however, organic growth is high as well. We already have two platform investments in Fund IV: BioReclamationIVT, a great pharmaceutical-services company, along with the recap of WCG, which we talked about. We’ve already put about 20 percent of our new fund to work this year.
Photo of Terry Mullen courtesy of Arsenal Capital Partners