If Its Customers Love a Business, This Equity Firm Does, Too

The bookshelves and coffee tables at the offices of the private equity firm Brentwood Associates offer a window into its consumer-focused portfolio: Sundance catalogs with artisan jewelry and designer jeans; menus for vegan cuisine at Veggie Grill; stationery and calendars from Paper Source; DVDs for The Great Courses lectures on topics as varied as astronomy and wine tasting.

These companies share a characteristic, and it is not customers with large disposable incomes, a surplus of free time or an interest in self-improvement. Rather, all of these brands have a fiercely loyal customer base.

“Over time, that’s really what drives market share,” said Bill Barnum, who co-founded Brentwood’s private equity practice in 1984. It has since invested in more than 40 companies with a total transaction value, or market value of equity at the time of the deal plus debt, of more than $5 billion.

The firm, which has more than $650 million under management and is raising its fifth consumer-focused fund, began honing its current investment strategy in the 1990s, when many brands were hitching their fates to the likes of Walmart and Target.

“We realized we didn’t want to buy companies that were at the mercy of these massive retailers,” Mr. Barnum, 59, said.

A better strategy for investing in the consumer space, the firm surmised, was to be the first active institutional investor in small- and medium-size companies that had a strong following but, with additional capital and outside expertise, could triple in size in five years.

Brentwood said it was the only private equity firm it knew of that consistently takes this approach. It said many other consumer-oriented firms focused on consumer-packaged goods sold to grocery stores and other retailers.

Over the last 20 years, Brentwood has bought and sold iconic brands like Prince Global Sports, the maker of tennis gear; Filson Holdings, the outdoor apparel company; and Ariat, the maker of equestrian and Western boots.

In 2002, the firm invested $25 million in the sports retailer Zumiez and took it public three years later, ultimately generating $141 million in gross proceeds. Similarly, it parlayed a $58 million investment in the Oriental Trading Company, which it bought in 2000, into $527 million in gross proceeds when it sold the company in 2006.

In its fourth fund, companies held for more than a year have averaged 127 percent revenue growth since Brentwood acquired them.

Mr. Barnum and his team of four other partners and nine investment professionals take an analytical approach when sizing up prospective holdings. “We don’t know what color is going to be popular next fall,” he said. “But we can look at data and know where customer loyalty has been and where it’s going.” The Internet, no doubt, has made it easier to track consumer spending patterns and to see how customers rate products and services. While social media have helped shine a light on the importance of customer opinion, Brentwood’s investment decisions do not hinge on where companies stand on any single platform, particularly Facebook.

“There are ways for companies to engineer ‘likes’ through competitions and other incentives,” said Anthony Choe, a partner who joined Brentwood in 1996. “We think there are better measures of customer enthusiasm.”

When sizing up prospective investments, Brentwood often starts by looking at customer loyalty and satisfaction metrics like the Net Promoter Score, This number, developed by Satmetrix with the loyalty specialist Fred Reichheld and Bain & Company, gauges whether customers are likely to promote a brand or, conversely, criticize it. A score above 50 on a scale of negative 100 to positive 100 suggests a company has a strong following. “Most of our companies have scores in the 80s and 90s,” Mr. Barnum said.

Many factors contribute to customer loyalty, including the quality of the product, pricing, marketing and customer service. Great brands, however, know how to connect with their customers on a deeper level, he said.

One holding that typifies this is The Teaching Company, which is best known for its Great Courses lectures. The founder, Thomas Rollins, started the company in 1990, having been inspired by a 10-hour video lecture he watched while at Harvard Law School. He recruited top professors and subject-area specialists, and gradually built a library of audio and video lectures based almost entirely on customer feedback.

“Every course in its library is there because customers voted on it,” Mr. Barnum said. As a result, the customers not only make repeat purchases, they are advocates of the brand.

In 2006, Mr. Rollins started looking for an investment partner with direct marketing expertise and found his way to Brentwood. The firm studied the company for three months and concluded that its growth prospects were even better than its own management had projected.

“That’s a pretty rare find,” said Eric Reiter, a partner who joined Brentwood in 1999.

Brentwood invested $50 million, a majority stake, and used its connections and capital to help The Teaching Company enhance the quality of its video production, expand its catalog circulation to nearly 70 million from 20 million, broaden its course offerings and digitize 6,000 hours of content. During Brentwood’s first year of ownership, sales increased more than 35 percent and have continued to grow at a double-digit annual pace. Revenue was about $150 million last year.

“All of this was built on a great starting point,” Mr. Reiter added. “Nothing was broken.”

Yet Brentwood contends the company still has plenty of room to grow, particularly with new partnerships and distribution channels. In early July, The Teaching Company announced it was teaming up with Audible, the Amazon subsidiary that distributes digital audio and entertainment.

Brentwood is looking for similar results with another recent investment, Veggie Grill. The chain, based in Santa Monica, Calif., specializes in plant-based comfort food. Brentwood made an initial investment in September 2011 and increased its position to become the largest investor late last year. During Brentwood’s ownership, Veggie Grill has improved its back-of-the-house operations, expanded to 19 restaurants from seven and increased same-store sales by 16 percent. Though the restaurant caters to vegetarians, it has broader appeal. “Roughly 70 percent of its customers say they eat some meat,” said Rahul Aggarwal, a managing director at Brentwood.

At first glance, vegetarian cuisine, sports equipment and enrichment courses seem like strange brethren in a private equity portfolio.

“We’ve had lots of meetings where we finish the presentation and people say, ‘So what’s the connection?’ ” Mr. Barnum said.

And not every investment has panned out. Notably, in 2000 Brentwood invested in Monarch Designs, a manufacturer and distributor of luggage and travel-related items. A decline in travel after the Sept. 11 terrorist attacks and increased pressures from retailers turned their investment thesis on its head. In 2008 the firm sold Monarch at a loss.

Still, the concept of investing in brands consumers love does not raise as many eyebrows as it once did, Mr. Barnum said.

As technology put more power in the hands of the consumer, the recession illustrated that the consumer sector is more nuanced than many investors realize. In fact, Brentwood’s investment thesis held up relatively well during the downturn; the fourth fund declined 3 percent in revenue on an ownership-weighted basis from the end of 2007 through the second quarter of 2009.

That higher customer loyalty translated to lower volatility in tough economic times was no surprise to Mr. Barnum.

“When customers have a connection with a brand,” he said, “they’ll make it one of the last places they cut back and one of the first places they start spending again.”