Talking Top Quartile with Thomas Lynch of Mill Road Capital

Mill Road Capital, the vintage 2006 debut fund from the Greenwich, Connecticut, private equity firm, logged an IRR of 15.7 percent as of March 31, 2015, for Indiana Public Retirement System, according to data from the LP.

The performance is ahead of the top quartile threshold of 14.4 percent for that year, according to an annual analysis by Buyouts. The median IRR for that year is 8.7 percent. In December 2013 the firm announced the closing of Mill Road Capital II with $420 million in commitments.

Thomas Lynch, senior managing director, who founded the firm in 2004, spoke about the fund with Buyouts by phone. He previously was founder and senior managing director of Lazard Capital Partners, as well as managing director at Blackstone Group.

Could you provide some background on Mill Road’s focus on public micro-cap companies?

We source private equity transactions from public micro-cap companies, with a market cap of $50 million to $200 million, often traded on the Nasdaq and sometimes the New York Stock Exchange. We take small positions in these companies. What that allows us to do is to build relationships with management over a number of years. When it’s time for a company to go private, we have a voting advantage and we have an equity cost advantage because we bought the stock at a lower price. (Typically take-private offers are made at a premium to a stock’s trading price.) Usually we end up with zero or one competitors.

Could you talk about the origins of Mill Road’s first fund?

When I looked at the private equity world [during] the 2001-2002 period, I saw that for about the prior 20 years, two things happened. One, inflation went down and (exit) multiples went up. And the second thing, debt was increasingly available and it was excessively cheap. Together, that’s the sun, the moon and the stars for private equity. We thought those phenomena weren’t going to go on forever. So what we looked at was: What’s the essence of a successful private equity transaction in any environment? It’s buying undervalued securities and improving operations more intensely than anyone else can.

So how are you able to create value by buying public stock that any mutual fund or ETF can get?

When you look at micro-caps, you see companies that are structurally undervalued partly because there aren’t very many institutional investors for them since they lack (trading) liquidity. You see a universe of companies that for a variety of reasons can be improved quite extensively as private companies.

There are three ways to improve operational performance. One, eliminate public-company costs; two, focus on return on invested capital rather than revenue maximization; and the third is to put in a private equity board of directors that replaces a less sophisticated micro-cap company board.

So you had this model that seems to make sense, but how did fundraising go?

It was a good and bad fundraising environment. It was good because private equity had a very good five- or six-year run and there was a lot of capital available. But there wasn’t a lot of demand for a differentiated product. We needed to identify forward-thinkers in the private equity arena – investors that knew the environment wasn’t going to be sustainable. We ended up with a very sophisticated universe of investors. We targeted $225 million and we exceeded that by 10 percent to total $247 million for the fund.

What did you do once you raised capital?

We used the public market as a sourcing mechanism for private equity. Through the early and middle life of the fund, we averaged 15 to 20 public positions using only about 20 percent of the fund’s capital in total. From that universe, we completed seven structured and going-private transactions to invest the balance of the fund’s capital.

One advantage of using public equities is that capital gains from the public portfolio tend to reduce or eliminate the J-curve.

How did you navigate the early years of the fund and the financial crisis that took place at around the same time?

In the early years of the fund in 2007 and 2008, we believed the markets were overvalued. We created value through patience and discipline and we invested very little in the first 18 months of the fund, between late 2006 and the middle of 2008. Then, the market declined precipitously. During the downturn, we built a portfolio totaling 20 percent of our committed capital in public companies at multiples of about 5x Ebitda. When debt became available, we had very-low-cost positions in a big set of companies. We had established strong relationships with the companies because we bought their stock when no one else would. That, in turn, gave us the opportunity to take companies private.

Could you talk about a specific deal that drove performance of the fund?

When we bought a public position in Rubio’s by acquiring 2.5 percent of the company, we paid about 2.5x Ebitda. When it came time to take the company private, we had a very substantial cost advantage. Rubio’s is a quick-service fried fish taco chain. They were opening anywhere from eight to 12 restaurants a year even though they were generating almost no return. When we acquired them, we stopped all restaurant growth. We shrunk the base of restaurants by 5 percent and we redirected their entire strategy, such as changing the menu to a healthier selection with upgraded ingredients, and we redesigned the restaurants. That’s not something you can do as a public company — you can’t stop growth and redo the company on the fly.

We took it private in 2010 and Ebitda is 2x what it was in our first year of ownership.

Where does the fund sit now with exits?

Of the seven companies we invested [in,] we have had three exits, one substantial exit, Vision7 International and three unrealized deals still in the fund (including Rubio’s).

And what about the team that started with the firm – any updates there?

It’s the same core team. Three out of four of us came from Blackstone. When it comes to recruiting people, there are no firms that focus on publicly traded small caps. So, our basic focus is to train our people and promote them from within. We don’t do mid-level hires. The opportunity we give young MBAs is to work both in public and private markets, not to specialize in one or the other area. We give them a richer learning environment than most firms. That allows us to recruit on par with the largest private equity firms in the U.S.

How did this fund contribute to the evolution of the firm?

It gave investors a powerful understanding of how investing in public securities and a long lockup structure (where LPs can’t trade out of the public securities right away) can create substantial value.

If you look at our public and structured investments, on a gross IRR basis, we’ve outperformed both the S&P 500 and the Russell Microcap Index by more than 20 percent annualized for nearly a full decade.

We have the flexibility to invest capital even at times when you see mutual funds and hedge funds facing very strong redemptions. We’re able to invest counter cyclically with liquidity cycles. That’s the best time to invest.

Action Item: Mill Road Capital,

Photo courtesy of Mill Road Capital