A special situation

Clearlake Capital Group’s headquarters in Santa Monica are bright, white and modern, with views of sun-drenched rooftops, palm trees and the Pacific Ocean. José Feliciano, one of the firm’s three co-founders, pulls up a chair at the conference table.

His firm has just shot the lights out with its latest fundraise. The $789.3 million Fund III was raised in just six months and had to turn numerous investors away, pushing the seven-year-old US special situations firm squarely into the limelight.

SPECIAL SAUCE 

Founded in 2006 by Feliciano, Steve Chang and Behdad Eghbali (the first two were previously at Tennenbaum Capital Partners, the latter was ex-TPG) – with backing from hedge fund Reservoir Capital Group, Clearlake raised $180 million for Fund I from the GP, Reservoir and its affiliates.

“We felt there was a void in the lower end of the middle market [and] there was room for a smaller firm to capture that opportunity,” Feliciano says. “We were more excited by the returns – or felt the more interesting opportunity set would be – [at that end of the market].”

Since then, an increasing number of LPs have become interested in Clearlake’s hybrid strategy, which is designed to adjust alongside market cycles and target different parts of the capital structure.

Ask Feliciano to define what ‘special situations’ means to Clearlake, and he’ll tell you what it doesn’t signify:

“We are not going to do specialty lending; we are not going to be trading bonds, we are not going to do things like offer a risk arb[itrage] fund.” Clearlake is focused on special situations debt and equity investments in the lower mid-market and in industry verticals where it thinks it has an edge, he says. That hasn’t changed from fund to fund, though thanks to the success of its latest fundraise its average deal size will increase to somewhere between $50-$60 million, up from $40 million previously.

“In a nutshell, most of our deals involve special situations, small companies, certain sectors that we know very well, low valuations or attractive valuations and where we can do quite a bit,” Feliciano says. “But how we do it does differ quite significantly depending on where we are in the cycle.”

PROVING IT 

Investing its 2010-vintage Fund II, which raised $415 million after (a more average) 18 months in the market, gave Clearlake plenty of opportunity to demonstrate that approach.

For most of 2009, as credit markets and the economy suffered, Clearlake bought a lot of debt in the secondary market, often at significant discount to par value. It would then “work with the company and other stakeholders to try to affect some type of reorganisation that could be inside or outside of bankruptcy court”. Shrugging off the term ‘loan to own’, Feliciano says the idea was to de-lever the balance sheet, gain control or significant influence over governance, and provide “kind of a second chance” to restructure troubled companies.

“Up until the beginning of 2010, a lot of transactions that we did in Fund II had that flavour, where part of the investment was trying to fix the balance sheet and often times the entry point was debt that we were buying in the secondary market,” he says. “Sometime in 2010, the credit markets came back very, very rapidly and opportunities diminished quite a bit.”

He estimates that in 2009, roughly 80 percent of the firm’s deal pipeline comprised debt-related distressed opportunities. But by 2011, that trend had reversed, with 80 percent of the firm’s opportunities having shifted to special situations private equity deals.

In those cases, Clearlake typically injects equity in companies in conjunction with a turnaround, or perhaps a reorganisation outside bankruptcy court. “It could be a complex carve-out of the business, it could be a business that for some reason doesn’t have access to traditional private equity markets or traditional capital markets where we think we can be helpful,” Feliciano says.

Feliciano stresses that regardless of which type of deal Clearlake chose to pursue, it went about things exactly the same way. “The only thing that may change is the entry point.”

He says the other common denominator remains the firm’s focus on minimising losses, rather than focusing on outsized wins. “If you can do that in your portfolio … that creates a good mix of investments where you can generate two, two-and-a-half, three times your money for your LPs. And you can do that consistently, and show to your investors that you have conviction and a repeatable strategy. I think ultimately, unless you have really, really bad luck, you should be successful.”

Like other distressed investment specialists, Clearlake’s fund has the ability to recycle some of its proceeds for reinvestment, the rationale being that some of its secondary debt investments will naturally leave the firm with ‘toe-holds’. Those may include scenarios where the GP has “bought some of a company’s debt, and maybe that was not enough to acquire the company or maybe the debt traded up or maybe the company turned around quickly, but you end up with a very small position,” says Feliciano.

“Often times, those positions you can sell or get refinanced and get very high IRRs. If you look at our ‘toe-hold’ investments, they’ve got very high IRRs to multiples because they’re shorter duration and tend to be a little smaller – and because if you buy at 60 cents on the dollar and get refinanced at par, you made a 1.7x, 1.8x multiple. That’s okay, but it’s not fantastic. We have argued it is in the best interest of the fund to maximise the multiple by being able to reinvest that capital again.”

The fund typically reinvests the principal and distributes all the gains. In Feliciano’s view, this “better aligns our incentives with the LP, because we have to do maybe double the work for those dollars, but it maximises fund multiple and hence maximises carry. So I think most investors are pretty supportive of that type of approach.”

SEEKING DISLOCATION 

There’s been much talk about a high yield bubble. Has that meant Clearlake sitting on the sidelines? “There’s very little distress in the credit markets right now,” confirms Feliciano. “We’re doing very little in that part of our business.”

But he points out that in any market environment, there will still be companies that stumble or experience change. “Last year, even though the economy was still generally healthy in the energy markets, you saw a dramatic decrease in the price of natural gas. It went from over $4 to less than $2 in a matter of literally weeks. Those type of dislocations typically result in complexity, and that is the genesis [of deal origination] for Clearlake. There’s always something like that going on in the economy.”

“We spend a lot of our time thinking of longer term trends – how different changes in the market may create medium or even short term dislocations and how to take advantage of that,” he says. Investors evidently value that cerebral approach.