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Scott MacLaren | The Keys to Longevity in Private Equity
POSTED 5.4.21 M&A Masters Podcast

Our guest for this week’s episode of M&A Masters is Scott MacLaren, Partner of The Sterling Group in Houston. The Sterling Group is a private equity firm, one of the oldest in the country, and currently has $4 billion of assets under management. 

Scott did not start off in private equity – he studied at the United States Military Academy at West Point, started business school after serving in the Army, and then finally found his private equity calling after working as a consultant. He started recruiting heavily for the middle market, and has now been with Sterling for seven years making investments in the industrial sector. 

We chat with Scott about his path to The Sterling Group, as well as: 

  • The competition of the private equity market
  • Establishing longevity in a growing industry
  • Finding excitement in investing in “unsexy” markets
  • Simplifying life-changing events
  • The predictions for industrial markets and partners after the pandemic
  • And more

Listen Now…

MENTIONED IN THIS EPISODE:

TRANSCRIPT:

Patrick Stroth: Hello there I’m Patrick Stroth, President of Rubicon M&A Insurance Services. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisitions and we’re all about one thing here. That’s a clean exit for owners, founders and their investors. Today, I’m joined by Scott MacLaren, Partner of The Sterling Group. Based in Houston, Texas, The Sterling Group is a middle market private equity firm that builds winning businesses for customers, employees and investors, and Scott it’s just a real great pleasure to have you here. Welcome to the show.

Scott MacLaren: Thanks, Patrick. Appreciate you having me on.

Patrick: Now I’m looking for I’m looking forward to talking about Sterling and your approach to a lot of things, but before we get into that let’s set the table. Why don’t you talk about yourself. Tell us what got you to this point in your career.

Scott: Yeah, no absolutely. And you know my path to private equity was fairly non traditional. So I did my undergrad at the United States Military Academy at West Point. I went there because I wanted to get a good a good education but also wanted to serve my country. And I entered before nine 911 so that definition of serving the country certainly evolved over time. I graduated went to US Army Ranger School and met my platoon. Served as a platoon leader, spent 15 months deployed to Iraq during the now famous Troop Surge. And while I enjoyed leading soldiers and I liked the Army, it wasn’t what I wanted to do forever. 

So after completing company commander in the army I applied to business school and went to Wharton and you know to be honest entering business school, I didn’t really know exactly what private equity was. I went into business school with the intention of being a management consultant or an investment banker or one of those you know traditional jobs you would think about in business school. It was probably my second year before I fully grasped what private equity was and that’s when I really started to focus and shift my efforts that way. The tough part was getting hired in private equity straight out of business school when you have a military background and no banking or consulting experience, it was really difficult. 

So I decided to go to BCG and do consulting immediately after business school and get some of those hard skills that I felt like I needed to make a transition into private equity. And you know I enjoyed working at BCG and I enjoyed the projects that I worked on. Most of my clients were Fortune 500 companies and I thought about staying but you know what I didn’t like was it there was no ownership. You know you you work a lot of clients that are Fortune 500 companies. You run into middle managers there who are very risk averse and a lot of them you know we’re just trying to continue their career, so they could get to that retirement point. Collect that pension or you know maybe they weren’t risk averse and they liked your proposal and you liked your ideas but as a consultant you’re just too expensive to keep off from implementation. 

So you never get to see a finished product or even if you do get to see the finished product, you personally don’t have upside in that. And so as I was thinking through where I wanted my career to go I really focused back on private equity and started recruiting heavily for PE in the middle market where I felt that my skill set that I had developed both those soft skills that I learned leading in the military which I think are directly applicable to leading and driving improvement in the company. And then those hard skills that I picked up and consulting. And so after two years you know I started applying and started to talk to firms and fortunately for me Sterling Group took a bet on me and I’ve been here for over seven years now. Have closed almost 30 transactions, which a handful of which has been platform investments. And then the vast majority or a large portion have been add on acquisitions of various sizes.

Patrick: Well I hope you never get tired of hearing this but first of all and from the bottom of my heart thank you very much for your service and good for you to see how you managed to progress through this from zero background into creating opportunities for yourself. And I completely understand if you get to a point where you want to have passion and you want to make a change or make a difference or at least have some kind of impact that you could feel. You just kept looking you didn’t just settle down on it so that brings you over to The Sterling Group and as you, let’s talk about Sterling Group from from what you and I gathered in our first conversation, it’s among, if not the oldest, private equity firm in the country so tell us about Sterling

Scott: Sure so The Sterling Group we are a Houston, Texas based operationally focused middle market private equity firm. We make control investments in the industrial sector. We define industrial is manufacturing, distribution or services companies. We’re investing out of our fifth fund which is a $2 billion fund that we raised last year. A typical target for us is 100 million to 750 million total enterprise value company, and we primarily invest in founder or family owned businesses or corporate carve outs. We also occasionally buy assets from other institutional investors, but that is less prevalent compared to the other two types of companies. And we currently have 10 portfolio companies. Sterling was started in 1982, as you pointed out, one of the oldest private equity firms in the country. And the gentleman that started his name is Gordon Cain. 

Gordon was an operator and he had run chemical plants for many years. And in his 70s, he decided he wanted to be an entrepreneur. So there’s there’s hope for all of us to be an entrepreneur eventually. So he started buying businesses in in spaces that he knew well. And, you know, this was the 1980s. So it was sort of a wild west era of leveraged buyouts. And it was a newer concept, the LBO was, you know, very new to a lot of folks. And there were certainly a lot less firms doing it versus today. And in 1987, Gordon acquired several chemical plants and grouped them together and called them Cain Chemical. He paid about a billion dollars at the time, got 97.5% leverage from bank on the deal. Something you could never do in today’s LBO market as things have progressed, but again, sort of the wild west era, and he put 25 million of equity on top of that, for the for the total purchase price. 

They bought the companies. Gordon, obviously being an operator knew how to operate the companies. He implemented an esop an employee stock ownership program, so that the employees, 1300 of them, could participate in the upside of the investment and really got the employees together and on board with driving improvement in the company and increasing the profitability. Less than a year later, they sold the business for 2 billion to Occidental. So they made 44 times their original investment. More than 1000 employees made $100,000. 57 became millionaires. And keep in mind, that’s a 1988 dolllars, when when those amounts were were fairly significant. Not that they are not significant now, but but that’s big money, for sure. 

Patrick: Yeah, that’s real money. Yes.

Scott: Yep. You know, the employees, it’s funny employees took out a full page ad in the Wall Street Journal thanking him a Harvard Business School case was written about his team. But that was really the most notable point beginning of Sterling Group. And they continue to operate and do deals all the way up until 2001, in sort of what I would call past the hat fashion. So you know, they would go talk to a company about buying them doing an LBO. And, you know, to get the equity, they would pass the hat around to friends, collect it up and get the deal done. And that worked for them. And they were quite successful with it for a number of years, until a point where the number of private equity firms had increased in the space. Competition was more significant. 

And other private equity firms had raised institutional dollars in committed funds. And so then that pitch changed a little bit in the sense of, if you’re a seller, are you going to sell to the person says, don’t worry about it, I’m gonna pass the hat around and get the money or some of that has committed institutional dollars, saying no, my investors are contractually obligated, and we have this money. And so that is when Sterling started raising committed funds. Raised the first one in 2001. I joined in fund three, and it was an 825 million fund, we did fund four, which was a billion and a quarter, and now we’re on fund five, a $2 billion fund.

Patrick: Clearly, you’ve got a track record of success, and you’ve got the longevity. You’re flexible, flexible enough to make a change as the market and, you know, keep keep a step ahead of the competition. So well done for you and Sterling. But Scott, as you know, there are over 4000 private equity firms out there today. You know, what does the Sterling Group bring other, you know, in addition to its legacy, what do they bring to the table that the others may not be doing?

Scott: Yeah, in 4000 is the first time I’ve heard that number, but that is a big number. So I’m gonna tell you just in the seven years that I’ve been in the industry, the number of new firms that come every single year, it clearly is an industry that continues to grow. But you know, what we do, we have been around for nearly four decades. In the big three differentiators, I always point folks to one, we are operationally focused, and I’ll talk about that in a minute. Two, we push incentives deep within an organization, and we are a true partner. I’ll talk about that a little bit more in a minute. And then lastly, we have 40 years, almost 40 years of experience. And through those 40 years, we’ve interacted with a variety of different companies on a variety of different initiatives. 

And we have a playbook that we can bring to the table that we know helps to generate and create value. Just on that first point operationally focused. I think a lot of private equity firms like to say they’re operationally focused. And you know, folks say, Well, what does that mean? In you know, the firm saying, are they actually truly operationally focused? And I’ll tell you what that means to us at Sterling. And look, we invest in industries that that are inherently not sexy. And we find that exciting. I mean, we we own companies that make trailer axles that that make bathtubs, I mean, things that you just don’t think about, but we all love it. We’re all operators at heart. We roll up our sleeves and we get to work right alongside our management team. You know, just an example of this, we have a program that we call The Year Away. And this is a little unique compared to all of our peers. I don’t know anybody else that does it. But every, every investment professional that joins us out of their MBA program, we send a portfolio company for a year, where they embed with a management team. And they work on the most important initiatives at the company, and report to that CEO at the management team. 

And we do this for a variety of reasons. But we think it’s a very invaluable experience, because allows our people to learn how to drive change, improve an organization and create value at a middle market industrial company, which is an environment, I can tell you, as I spent my year away, it is different than the Army, it is different than certainly working in investment bank in New York, it is different than being a consultant for a Fortune 500 company. And it’s an experience as an investor, if you’re out there looking and partnering with middle market, industrial companies, you ought to have that on your resume in order to be really a true partner, and understand the companies and the way they function. And what is feasible to get done with those companies, when you invest in partner with them.

Patrick: I think before you get to the next part I clearly operational is in your DNA just from the founder story, okay, and to incorporate and inculcate your investment executives in there, where you’re embedding them for a year, that only, you know, builds familiarity for the professionals in there that get familiarity from the management team that’s working with them. And it just shows you’re going to some additional loyalty and commitment that’s in there, both sides because of that year away. So I would picture you know, the the physician being sent off to Alaska, you know, once once he got his degree, and he stuck there for a year, but I think is a very, very positive and unique way, and you’re walking the walk with your own people. So I think that’s fantastic.

Scott: Agree. No, it’s everybody that’s done the year away comes back, I think with a completely different perspective about what is feasible, and you’ll never look at investment the same way. You’ll never look at a middle market company the same way. And we’ve never had a CEO turn down the opportunity to have a you know, post MBA quality investment professional join their team and report to him for a year. Could be because we pay for it. But it also could be because they know that person’s driving value. But it’s been a really successful program for us in developing our folks here at Sterling.

Patrick: Great. Now your next point, the second one.

Scott: Yeah. So we push incentives deep within the organization, because we want to be a true partner, you know, just like Gordon did in the 80s, with the esop. And of course, we don’t do esop’s now there’s some tax implications to that. But one of our big tenants is to push options and equity, deep in our portfolio company so the employees can participate in the upside. We think managers who are owners operate with a different mentality, and they’re able to embrace improvement initiatives, and incentivize to grow profitability. And option payouts at our companies can be, you know, quite large, how to deal that, that we exited recently that I was involved in, we had over 80 option holders, in those 80 option holders made more than $30 million in option proceeds. 

And so, you know, for some of these managers, it could be a life changing amount of money, it can pay off mortgages. And you see people understand that at the beginning of your investment, and they will work hard and drive toward that goal of an exit of growing the business of improving the business to get an exit in order to achieve that. And it’s a that is probably one of my favorite parts of the job, to be honest.

Patrick: I think it’s also real generous move. I mean, it’s it’s strategically brilliant. Because if you’ve got buy in from the rank and file, okay, and you’re all going in the same direction, you’ve got, you know, communists of purpose, what better way to do it, and then you get the the outcome. I think the other thing that you touch on this, and I sincerely believe this is that mergers and acquisitions represent the most exciting business event out there. Some people would argue it’s IPOs. I think nothing has a greater chance of being a life changing or even generational change than a M&A transaction. I’ll tell you, you know, Scott, if you and I are doing our jobs, these life changing events happen. They happen faster, they happen cheaper, they happen simpler, and they’re happier. And who wouldn’t want to be part of that?

Scott: Agreed. Couldn’t agree more, Patrick. Absolutely. And then just lastly, so 40 years of experience, here at Sterling in it’s certainly what we have what’s called our seven levers, which are the seven areas over the last 35 to 40 years where we’ve learned there are opportunities to drive value creation. And so we sit down with the companies that we partner with, and we go through an entire strategic plan and layout when we’re gonna pull each one of these seven levers throughout the lifecycle of that investment, and get the employees and the managers on board with doing that. And we have experience from other companies where we’ve done this and can leverage that experience from the past, to help the companies that we’re working with now, to increase the probability of success on pulling each one of those levers successfully and growing the business. And so for me, those are the three big areas where I think we differentiate ourselves. You talk to other people, they may have different opinions, but those are the three that we certainly focus on. 

Patrick: Well, tell me, you know, as we talk about mergers and acquisitions, usually, you know, the folks on the outside of M&A think they think of M&A as what they read in the newspaper, where you have Amazon buys Whole Foods. And in reality, it is a group of people choosing to work with another group of people. And the objective is one plus one equals five or six. However, these deals don’t happen in a vacuum, there’s risk. And when you got human beings involved, you got you know, fear, greed, worry, a lot of a lot of these elements out there that that the outside world doesn’t know about. And you know, quite frankly, a lot of the target owners and founders who don’t go through M&A day in and day out, they get surprised when they go through a due diligence process. And then at the end of that they get informed by their attorney. 

Well, here’s this indemnification provision we need to talk about. And then they learn, wait a minute, I’m personally liable financially to my buyer, if something I have no idea about, and they didn’t find in diligence, will cost them money post deal. Wait a minute. You know, and all of a sudden, you get that injection, that you’re not able to hide behind a corporate veil. Your future, your wealth is at risk. And that can create not only worry and fear, but some distrust. And the tragedy is, you know, these types of interruptions and so forth. You know, they’re they’re reasonable, but they’re avoidable. I mean, on the buyer side, look, they don’t want to be stuck holding a lemon. 

And on the seller side, they want to be, you know, on the hook indefinitely for things that are out of their control. And they’ll they’ll protest, but an experienced buyer is going to say, well, you know, you’re asking me to bet 10s of millions of dollars that your memory is perfect. And I just can’t do that. Well, what’s been nice is that the insurance industry came in a few years ago, and introduced a product called reps and warranties insurance. And what it does is it looks at the seller reps in the purchase sale agreement, polls the buyer to find out what diligence the buyer did to make sure those reps was accurate as possible. And then they say, hey, for a couple bucks. If something blows up, and buyer you suffer financially, don’t go to the seller come to us, we will give you a check. Just show us the loss. And we will go in. Buyer has certainty of recovery. 

So their downside is now been hedged. They also avoid the real uncomfortable situation of having to claw back funds from their their seller. On the sell side. Number one, they have more cash at closing because rather than having a large chunk of funds being set aside in an escrow account for cash on hand, the insurance policy covers 90% of that. So not only does the seller get 90, 90 plus percent cash at closing, they’ve got the peace of mind when they get to keep it because that risk of a clawback is now gone. It’s out with the insurance industry. And it’s it’s revolutionized mergers and acquisitions to the point where well your targets are in for your platforms are 100 million dollar transaction value and up, you’ve been very, very active in add ons, deals that are way under 100 million probably isn’t as low as 15 to 20 million. This product rep and warranty wasn’t available for those until now. 

That’s now been something that’s been coming along now, in the same benefits for the larger transactions are now being available to the smaller ones. Which is great because saving two or $3 million for an owner and founder on a small deal. That’s a huge, huge difference. You know, but you don’t have to take my word for it. You know, Scott, good, bad or indifferent, tell us about your experience with rep and warranty.

Scott: Yeah, so over the past seven years, it was funny when I started in private equity, you know, rep and warranty insurance. It wasn’t it wasn’t that prevalent, you know, certainly it’s existed. It was used on select deals. But over the past, you know, five or so years, it’s really evolved. And I’ll tell you now, we’re at a point where I can’t think of the last deal I did where we didn’t have a rep and warranty policy. And as you mentioned, even on the smaller deals, it used to be you would have difficulty finding underwriters, to quote the smaller deals. People would say 20 million TV was kind of the mark, and now we’re at a point we quoted, we had, you know, put one out to market a bit ago and we have four different underwriters quote a deal that was under $20 million of TV, which is just really impressive and tells you how far this market has come. 

But to your point in terms of what it’s allowed us to do, it creates doing a deal, particularly with um, I wouldn’t say it’s sellers, who aren’t normal sellers. So, you know, founder and family of businesses, they may only do one transaction in their entire life. And that transaction they’re looking at, and they’re looking at that, you know, the the purchase agreement, which is 100, you know, 120 page document. And lawyers, and I love lawyers, and we can’t do our job without lawyers, but they’re very good about making you think about that 1% scenario. And so you’ll get founders and family owned businesses that think of that purchase agreement, talk to the lawyer, and just get so petrified of, well, okay, I’m gonna sell the business and you’re gonna give me money. 

But if there’s a clawback scenario, or a large portion of my money is going to get put in this escrow account, which earns, you know, very little to no interest and we don’t have access to it, it creates friction. In thinking back to before rep and warranty was as prevalent as it is, the conversations that we would have with sellers at that point in time. We’re fortunate to not have those conversations anymore, in the sense that we can have an insurance policy that backs them up on that it says, look, you were on define how much you were on the hook for you are on the hook for an ordinary rep amount of X. And anything beyond that the insurance company is going to pick up. And oh, by the way, your escrow is only going to be this many dollars versus in the past, you saw escrows that were 5%, maybe 10% total enterprise value. 

Patrick: Yeah. 10% we saw.

Scott: Yeah, really big numbers that you when you’re thinking about calculating your proceeds, in your mind as all sellers do. Especially if they’re rolling in the deal and putting equity in incremental deal go for that was a large portion of the proceeds that we’re going to take off the table, right. And so the progression of rep and warranty insurance has alleviated a lot of those burdens. And like I said, I don’t see it going away. If anything, I just see it becoming more and more prevalent, more and more underwriters out there. And it continuing to be a part of of every single M&A transaction. 

Patrick: Yeah, I mean, we’ve been really striving to get this on the checklist, if you got rep and warranty, at least is on the checklist. Now it’s something that you know, can get addressed on each deal. May not be a perfect fit for every particular deal. But the fact that it’s there is something to look up look at and and quite frankly, I mean, it is a tragedy if you’ve got avoidable situations where you’re taking wear and tear on people’s soul, because they get so fearful. It can be avoided. And here’s how it goes. And I would say on this on the on the buyer side, my goodness, the in a lot of cases, particularly where the buyer has leverage reps and warranties at no cost because 99 out of 100 sellers will pay the entire cost just to get the benefit of the of the indemnity indemnity transfer. They really really do appreciate it. Scott, now tell me because I had referenced this slightly, but we are talking about industrials, because you’re in Houston. So you’ve got the energy sector over there. 

Scott: Sure.

Patrick: Give me give me a profile of your ideal client. What is Sterling Group looking for now?

Scott: And be very clear. We don’t we don’t touch anything in energy. So it’s odd to be done here in Houston, and be one of the few private equity firms that that doesn’t touch the energy space, we touch the downstream a little bit but midstream, upstream, different types of investing different firms. It’s just, you know, Houston’s where the firm started. And we’ve stayed here, but the vast majority of our companies are outside of Houston, and certainly you know, most outside the state of Texas. But an ideal partner for us and ideal company, that would be a target is a good business. In a consistent industry. Typically, like I said earlier, usually not a sexy industry, usually an industry that folks don’t typically think about, that has a management team, whether it’s a founder or a family of corporate carve out management team that wants a partner that can help make a step change in their business and work with them to make that step change. 

Or that has a you know, an industry that they know well that wants to partner with someone and go out. And can you continue to acquire competitors continue to grow through acquisition, we do many buy and builds. And oftentimes we’ll bump into founders in industries that think that they’ve created the best mousetrap. And oftentimes they have, and that allows them to go out there and swallow up competitors, or get the competitors to join the team. And then continue to grow and get the benefits of scale. And we’d like that playbook just as well. And we’ve partnered with with many folks in doing that.

Patrick: So they the partners, you’re looking for our management teams where they’re looking to, you know, they’ve reached perhaps an inflection point. And they want to stay on and see this through or do you have other situations where owner, founder, they just want out?

Scott: Yeah, we have we see both, probably equally as much. There are certain situations where you have bounders that have run the business for forever, and we’re looking for retirement. And and that’s fine. And oftentimes we’ll have those individuals sit on a board of directors and continue to help and advise and find a CEO that we all trust can run and grow business. But equally as much we see folks out there management teams that have gotten their business and grown it to a point where they know that that next level is a complexity that they’re uncomfortable with, and they want some help navigating that and growing the business. Or that next level requires capital that they may not have access to. Like I gave the example of out there doing a buy and build in an industry and that’s something that we can help them with and put in place a program that helps them do those add on acquisitions in an efficient manner. You know we’ll have portfolio companies that have made 12 13 14 acquisitions in their lifecycle with us.

Patrick: It’s just I can imagine the inflection point for them is they’re they’re too big to be small but they’re too small to be enterprise.

Scott: That’s a good way to put it. Agreed. Agreed. In looking at enterprise it can be daunting sometimes.

Patrick: And that’s the resource the private equity provides on that so that that’s fantastic not to mention the second bite of the apple for owners and founders. So there’s a real great value proposition which is why you’ve got the big growth in these PE firms by numbers so forth. Scott we’re well into 2021 right now we can see only the beginning of the end of the pandemic. Give me your thoughts or what trends do you see for manufacturers or for the industrials for Sterling Group as we go through into the next year or two. What do you see down the road?

Scott: Yeah, no it’s a good question. Yeah we’ll see I can make some predictions who knows if we’ll be right. I would say in the deal making environment first, I think we see a return to in person meetings. You know we have been doing deals throughout the pandemic, closed a couple last year, we’ve closed a couple of the beginning of this year. And started off a lot of Zoom meetings and folks but it’s really hard to get to know management team over zoom and it’s there’s not a replacement for an in person meeting when you’re getting to know a management team and getting to know a partner that’s going to be a significant partner for the next 5, 6, 7 years of your company’s of your company’s life. 

So I see us returning back to these in person management meetings and we’ll see how that goes. I think there are other folks who disagree, but we’ll see. And I think the pace of deals right now it’s already back to I think pre pandemic levels. The number of deals out in the market right now it’s been surprising. From a more macro perspective um I can tell you what I’d really like to see. I really like to see us get an infrastructure bill done investment in infrastructure would be very beneficial to some our companies that we own in the space and I think much needed for us. So we’ll see how that turns out but it would be a nice tailwind to the the current environment we’re seeing with our businesses.

Patrick: For any of you out there that are in the industrial sector and you’re looking for some way to partner up and get past that inflection point really should look at The Sterling Group. Scott MacLaren how can our audience members reach you? How can they find you?

Scott: Yeah so our web pages www.sterling-group.com and I’m on there. My email’s on there. Feel free to reach out. Happy to talk to anybody and certainly always happy to talk to any potential companies out there thinking of partnership.

Patrick: Yeah let me highlight that also with the website because there’s more than one Sterling out there in the financial sector so it is sterling-group.com. And Scott absolute pleasure meeting you. Great to hear about the story. Again thanks for your service, and we wish you all the best going forward okay. Thank you.

Scott: Thank you. You, too, Patrick. Take care.