Private equity has a significant appetite for the food and beverage sector, and a number of private equity firms have made the food and beverage industry their primary focus. What's driving their interest? What are the favoured segments within this space? What are the critical risks to be aware of when making these investments? We canvassed these issues and more with two leading private equity firms in the food and beverage sector: Investeco and Swander Pace Capital. Andrew Heintzman, President and C.E.O. of Investeco, says they have a primary focus on fast-growing food companies that promote health and sustainability. Andrew Richards, Managing Director and Valerie Scott, Principal of Swander Pace, say their firm specializes in buyouts of growth-oriented consumer products companies and within that sector, half to two-thirds of the investments are in the food and beverage space.

Fuller Landau: What is driving private equity interest in the food and beverage industry?

Heintzman: There are many attractive elements within the food and beverage sector. These businesses are reasonably recession-proof. It is a large sector with innovation and the potential for growth in various niches, which makes it a sector that will, over time, continue to attract private capital. What attracts us in particular are the high growth niches focused on health and sustainability. The market for conventional foods has not been growing quickly, but organic foods and health food trends such as gluten-free, anti-oxidants, omega enriched, GMO-free, heritage farming (e.g. grass fed), probiotics, etc., have seen double-digit growth. If you look at other places in the world, like Europe, there are more advanced levels of adoption. This leads investors here to believe that these food areas can become even more significant markets in North America.

Richards/Scott: We've invested in food and beverage businesses for a very long time. From an investment standpoint, you have macro characteristics of an enormous market, customer awareness and customer loyalty, all of which says you have a large opportunity of scale to go after. And then you have pockets of fantastic growth as consumers become more educated and more thoughtful about what they're eating, how they're eating, and when they're eating. We like to find small to medium-sized companies that have entrepreneurial spirit and are poised for growth, and we help them accelerate that growth to create a successful business, and for us, create successful returns on our investments.

Fuller Landau: What risks do you face when making investments in this sector?

Heintzman: We actually judge this sector as less risky than other industries, such as technology. It has real revenue, customers and products. There is always going to be execution risk depending on the abilities of the management team, risks around health and safety issues (e.g. recall issues), and capital risks of building out a supply chain and associated gross margin risk if products are not sold. There are barriers to entry, once you get a decent moat around the business. However, the more you grow, large companies become interested in the segment and will enter the market and compete on price and shelf space. It is a dynamic, competitive environment that can change quite quickly and you have to be prepared for larger competitors to enter the market at any time. The key is to focus on your brand and continue to build it out.

Richards/Scott: The key characteristics for us are: has the company in the consumer space become large enough, or achieved a strong enough market position in its niche, to be able to say it's 'established'? It has some barriers to entry, consumer loyalty, growth with accounts and with consumers, so the risk is evaluating that correctly and making sure that they've been able to get over that initial hump of the business being successful and established. Once that happens, then it's a question of execution. Is the company selling in the right places to the right customers? Are they reaching consumers and do they know how to manage a business as it's going through a growth trajectory? This is really where we come in. We've invested in over forty different companies in the consumer space. Our expertise is having seen these companies go through these growth trajectories and helped them figure out how to manage that growth. Sometimes it's a question of finding growth and sometimes it's a question of: when you find the growth, can you actually execute on it from a sales perspective, a manufacturing perspective, and a marketing perspective?

Fuller Landau: What is your view on branded products vs. private label or non-branded products?

Heintzman: Our group has a bias towards brands. We want our companies to have branded offerings because if you don't, you are exposed to strong retailers. If you are a private label, there are greater risks. In the smaller niches, you have the opportunity to be the best brand.

Richards/Scott: We will invest with branded companies as well as with private label companies or contract manufacturers, and what we really like is to analyze a category and look at it and decide on the better investment opportunity for us: the branded play or the business with the contract manufacturing? I'll give you a couple of examples: We are investors in a company called Kicking Horse Coffee in British Columbia. Kicking Horse is the largest organic and free trade coffee player in Canada. It's a fantastic business, not just in the coffee category, but also the natural and organic category. That's a space where the consumer is very brand-loyal and there's an element of trust between the branded players and the consumer, because they're buying the product a) because of taste, so you get loyalty that way, but then also b) for what the company does and what the brand stands for. As a contrasting example, we had a business called Santa Cruz Nutritionals that makes nutritional gummy bears, as a vehicle to provide vitamins and nutritional supplements. That's a category where the manufacturing of that product is actually quite difficult. And so there the choice that we made early on was to focus on being a best-in-class manufacturer and then we could supply all of the branded players in the category. This category happens to be not as brand-focused, because the consumer tends not to differentiate quite as much between the whole spectrum of brands that they'll find on the shelf. They just want a vitamin that's in a gummy form, and they don't really view the products as particularly different.

Fuller Landau: What is the difference between Canadian and American food company investments?

Heintzman: There is huge growth potential is the U.S., both in terms of the market and how quickly a company can grow. You also don't have the same customer concentration risk in the U.S. Another difference is in the exit strategy. In Canada, it is basically strategic buyers first. In the U.S., there is a whole kind of category that you don't have in Canada which is family offices. There are some family offices in the U.S. that are large enough that they will buy companies. Then there is private equity. If you can build the company large enough, then you can go IPO. You can also refinance, where some investors stay and others leave.

Richards/Scott: There are just as many opportunities in Canada because in many instances the companies are smaller but have better upside potential than some more established companies. If you go back a bit, Canada has been well ahead of the United States in terms of private label penetration, so private label makes it an interesting market. Whether it's a business in the U.S. or in Canada, the key attribute is you've got to have a product that is unique. Or if you have a product that's not unique, you've got to have service levels and manufacturing capabilities to execute better than your competition. On the branded side, similar trends are going on in both countries. We see opportunities in natural and organic, ethnic food, and in more traditional categories like bakery and dairy. The organic and ethnic categories have experienced a lot of innovation because they are relatively new. Similar trends exist in the two countries, and both are very positive. In general the consumer, whether Canadian or American, is getting much more intelligent about what they're purchasing, where the products are coming from, what are the health benefits, and price points. There's a lot more label reading than there was ten years ago, even five years ago, and that's all an opportunity, particularly for smaller companies to take market share from some of the larger brands and players. Clearly the Canadian marketplace is experiencing consolidation. That being said, that point always gets made about mainstream grocery, and the reality is there are other alternatives out there. From a consumer product manufacturer standpoint, there are multiple other channels that you can sell through from club stores to some of the more boutique and niche channels. When we invest in Canada, we're looking for ways to expand in the different distribution channels and into different geographies. And so specifically in Canada, that's moving east to west usually, or north to south. And both have been great opportunities. With Kicking Horse, that's a Western-Canadian business, we're moving west to east. When we owned Liberté, the organic yogurt company that was based in Québec, that was about taking a fantastic business and moving that east to west. For both businesses, we were also looking to distribute north to south. These are good brands with good market positions. Both the American consumer and the Canadian consumer like trying new products and the retailers in both markets like showing a diversity of products on their shelves. So there's always an opportunity to bring in new products, and then hopefully if it's a good enough product that catches consumer attention. Then you're often running on a growth strategy.

Fuller Landau: How do you time your exit from your investment?

Heintzman: It is case-specific. You come to gates along the way where key decisions have to be made involving investment. For example, you may have to decide whether you are going to do your own manufacturing or not. The answer to this question may lead you to deciding that you are better off selling to a larger group. Strategic purchasers are coming downstream in the market. It used to be that they were not interested in making acquisitions unless a company's sales were at least $50 million. Now, they are coming in at just $20 million. It generally comes down to whether you have a leading brand or not. If you have a leading brand, you can hold off competition.

Richards/Scott: We look to typically have a five year hold for our investments and that can be longer or shorter, depending on our goal of taking a business through the next chapter. Sometimes that next chapter is geographic growth, and sometimes that next chapter is the transition of an entrepreneur who wants to retire. Sometimes it is bringing on new capabilities, moving into new products, moving into new markets. And if you think about all those things, we should be able to get through that chapter within a five year time horizon. Most of what we do is working with families and entrepreneurs who are going through that transition. They either want to retire, bring in professional management, or they want to keep running the business and to bring in a partner who has some perspective that they don't have. For example, in the Liberté transaction, no strategic buyer would have invested when we bought it. There was a lot of heavy lifting to do, professionalising the management group and upgrading the plants. We did all that heavy lifting and only then were strategic purchasers interested when the time came to exit.

Fuller Landau: What advice would you give to entrepreneurs selling their business to maximize price?

Heintzman: Ultimately, you want to build a great business that has significant competitive advantages, high margins, a strong brand and high calibre management team. You want to invest in what makes you different. It is the brand, customer growth and the sticky connection with consumers that gets you that special price.

Richards/Scott: I have two pieces of advice. The most important one, is choose your partner well. There are many possible food and beverage private equity players and other investors out there. You need to find someone who is compatible with what you're trying to do with your business, and that's compatible both in terms of understanding the space, but maybe more importantly, just compatible in terms of your business ethics and how you want to operate your business, and how you want to be perceived in the marketplace. And make sure that your partner shares the same sense of how you want to treat your employees and your customers. Beyond that, does your partner provide a value-add? Are they bringing something to the table, have they done it before? Do they understand the different distribution channels that you're selling into and do they understand what drives the successful growth of a company in your industry?

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