Tuesday, June 11, 2013

Allowing Private Equity to Fail: The Case of National Envelope

Allowing Private Equity to Fail:  The Case of National Envelope

National Envelope filed for Chapter 11 bankruptcy for the second time in three years.  Gores Capital, a private equity firm that purchased the company in 2010, owns the company.  We don’t need to consult a Wall Street analyst to figure out that National Envelope is in a very tough business.  As snail mail declines, the size of the envelope market is declining, and there’s fierce competition for the remaining business.  National Envelope fell victim to the rapid decline of the market, as well as a long-term contract it signed with International Paper.  Apparently, the contract with IP locked in National Envelope’s paper price, and they were unable to drive down their costs as the market deteriorated.

Line Up (1996)

I don’t know much about Gores Capital.  According to its website, it has raised three funds, the latest of which is $2.1 billion.  Thus, it has the financial wherewithal to compete across a wide spectrum of private equity deals.  Its strategy is focused on businesses facing fundamental challenges and requiring operational change.  National Envelope would seem to fit squarely within the firm’s objectives.

In all likelihood, Gores Capital will lose its entire investment of $150 million in National Envelope, much as Ripplewood Holdings lost its investment in Hostess Brands (see, “Twinkies Sink a Private Equity Investment [November 17, 2012]”).   As an investor, your first reaction might be to strike Gores from your list of potential investments.  After all, it lost all its investors money in a deal.  Anyone should have seen that the envelope business was a losing proposition and stayed away from National Envelope.

I think this reaction is completely wrong.  There may be a variety of reasons why you might not want to invest with Gores.  Obviously, you’d have to dig into the details and interview the partners.  The data’s not publicly available, so we can’t make any decisive judgments about the firm.  However, the National Envelope investment demonstrates that Gores appears to practice what it preaches, and this is a big positive when it comes to investing.  Hundreds of private equity managers claim that they focus on operational change and take on large business challenges.  In fact, they engage in financial engineering and tinker at the edges of the businesses that they acquire. 

Turning around businesses is a risky proposition.  However, it can, and deserves to be, financially rewarding when it happens.  Obviously, when the turn-around fails, as in the case of National Envelope, the consequences can be dire.  However, bankruptcy is precisely the sort of risk that can be expected to transpire from time to time when a private equity money manager takes on a real operational challenge.

In order to generate exceptional returns and overcome the extremely high fees associated with the industry, private equity has to take risk.  If we unjustly penalize managers for taking risk and failing, we are guaranteeing that our future returns will be mediocre at best.

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