Seeking a Few Good Companies

July 20, 2012

Southlake-based private equity firm Prophet Equity LP has made its reputation turning around companies that have underperformed.

The turnaround shop specializes in buying distressed middle market companies (up to $500 million in revenues) and improving operations to boost cash flow.

Using an evaluation process called “Holistic Value Creation,” the firm has made its way by partnering with owners and management teams to improve performance and drive up a business’ value.

“We’re not just doing financial engineering; our success is based on understanding the strategic strength of a company before we make any decision to invest in it,” said Ross Gatlin, Prophet Equity’s CEO and managing partner. “If the strategic model doesn’t blink green, then we don’t proceed with anything.”

All of which is to say that a great deal of emphasis is placed on the quality of the companies Prophet chooses to acquire.

This is a persnickety due diligence model that, by design, may only be applied to a select few middle market businesses that present certain winning characteristics, including market attractiveness, supplier power, buyer power, competitive rivalry and substitution risk, according to the firm.

“Are you in a business that’s the emerging substitute to a large, addressable attractive market? Or are you going into a business that’s actually being substituted away from?” Gatlin said. “That’s a question we have to ask in a strategic screen.”

For a while there were no businesses that fit the process. From 2007 to 2009 Prophet made no deals at all, choosing instead to continue raising capital and wait for the right opportunity.

Those opportunities finally began popping up in 2009, when Prophet closed the year with three acquisitions. The firm closed seven deals in 2010 and one deal in 2011.

Most recently, Prophet Equity announced May 15 that it had acquired Louisiana-based Francis Drilling Fluids, a fracturing materials logistics company.

Gatlin said the company fit right into the firm’s strike zone: a strategically viable, asset rich business poised to benefit from the continued growth in demand for oil, natural gas, and other energy resources.

“At this point we have a set of characteristics that allows us to find Prophet-type deals pretty consistently,” Gatlin said. “The system we use allows us to highlight those companies that are the strongest strategically that are underperforming the most at the best possible value.”

The rhythm of a recession

Prior to establishing Prophet Equity, Gatlin was a founding partner and principal of a Southlake-based private equity firm and a founding principal of Carlyle Management Group in Dallas. Prior to Carlyle, Gatlin worked as a senior manager at Bain & 
Company.

“Fate put me in and around restructurings and bankruptcies and troubled situations,” Gatlin said, adding that he’s been through about five recessions in his career.

“You get to a point where you can really understand the rhythm of a recession, and really the human nature that drives it,” he said. “That’s really what we’re dealing with in the end is human nature, and that’s why our business model works and will keep working, because human beings won’t change.

“They tend to repeat behavior patterns.”

Being able to understand the rhythm of recessions allowed Gatlin to position his firm with a fresh pool of capital at the beginning of the last great recession. The firm’s first fund, Prophet Equity LP, was launched in early 2008 with a $250 million target and hard cap. Prophet closed the fund in 2010 after raising $300 million.

“We were in a really good position to do the right thing for strategically strong companies that were having major balance sheet issues because of decisions they had made prior to the tectonic shifts in the economic plates,” he said.

Gatlin says what his firm does is really a form of “business therapy”: where his team is tasked with finding good businesses at the proper time where there is a desire for change.

“Difficult circumstances often put them in a frame of mind that they may never have been in before to be open to doing things in new way,” he said. “We look for that in a company; it should be willing to try a new approach.”

Clear incentives

Portfolio company management teams at Prophet are motivated by clear, uncapped incentives based on a business’ performance. Every team is stacked with role players – financial gurus, operational experts and managers – and principals whose job is to lead the process.

“No matter what the management team is like, we’re still going to have at least one principal from Prophet Equity go live and breathe the value-creation plan that we built before we did the deal,” Gatlin said. “So before we do a deal, we have to be as near to certain as possible that company is strategically strong, and about 80 percent of all small companies are not.

“We’re looking for diamonds in the rough.”

Gatlin said he has heard from investors interested in establishing a new fund, Prophet Equity II, and he is considering it. Such a fund would likely launch in the next 12-18 months with a higher target and cap than the original fund, he said.

Featured in FW Business Press on July 20, 2012