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Intro: Hello, and welcome to Dealmaker Insights, a podcast brought to you by Reed Smith's corporate and finance lawyers from around the globe. In this podcast series, we explore the various legal and financial issues impacting your deals. Should you have any questions on any of the content, please contact our speakers.

Nick: Welcome back to Dealmaker Insights, the Reed Smith podcast series spotlighting the private equity industry. I'm Nick Gibson, a private equity M&A partner in the Chicago office of Reed Smith, and I'm excited to welcome Matt Carlos of New Water Capital as our guest today. I've really enjoyed getting to know Matt and his team who have focused and thrived in the lower middle market. Matt wears a lot of hats at New Water Capital, and that's one of the topics we'll dig into a bit today. But first, I'll turn it over to Matt and let him introduce himself and New Water Capital. Great to have you here, Matt.

Matt: Thanks, Nick. Appreciate you having me and happy to chat through the latest and greatest of New Water here. So I can dive right into a quick background on myself and on New Water. So I'm a principal here at New Water Capital. Been with the guys now for over seven years. Joined back in January of 2017. The fund officially started in 2016 and was originally a spin out of Sun Capital Partners. So Jason and Brian spent around a decade together at Sun. Saw Sun grow from a few hundred million under management, multiples of billions. I'm sure as as you know. And the rationale or the reason to spin out and do their own thing, create New Water, was to refocus on the lower middle market. And we've incrementally refined that for us to be really focused on what we call blue-collar industries. So manufacturing, industrial services, packaging, distribution. That really covers the majority of what we're focused on. From an end market perspective, we're a bit more agnostic. So if you look at in our portfolio. It's food and beverage, it's industrial technology, auto, packaging, you name it. And so we do tend to be more operationally focused and much more opportunistic. So we've got an in-house ops team, ex-CEO, CFO, COO type folks who work exclusively for New Water, so not consultants on hired guns. And so they are invaluable in dropping into our portfolio companies and help them think through next steps. So there's just creating KPIs, budgeting, walking the shop floor, look at efficiencies, and or just being a shoulder to cry on, quite frankly, as we go through growing pains or integration. And so really a valuable part of the team, but it helps kind of differentiate what New Water does in the market, which is really focused on where we can help portcos grow, improve, and. Get to the next level.

Nick: That's great. Can you talk about the various hats that you wear in your role particularly, and maybe how that differs in approach from other private equity firms?

Matt: Sure. Yeah, we are a lean team. And so because of that, like you mentioned earlier, we do wear a lot of hats. First and foremost, I think other private equity funds that are our size and focus in our industries, I think it's very typical for those firms or a lot of our brethren these days to have a designated business development arm. We at New Water do not at the moment. I think at some point in the future, hopefully we will be large enough to where it's needed. But at the moment, we don't. And so what that means is that myself and the other folks on the deal team here, we will kind of pass the hat or pull straws to just do the best we can to attend as many events and conferences, to be doing city visits visits, and meeting with intermediaries and bankers and lenders as much as we can. And of course, that takes away from, I guess, what you can say is our day job or what we are focused on most actively, which is portfolio management and getting deals done. The flip side is that I think if you were to poll the audience here in the deal team, we really do like being out in the market. I think it gives us a flavor, some firsthand experience of what people are saying, what other private equity funds are experiencing in real time, what bankers are seeing in real. And another angle to that is that a lot of our investment banker and intermediary friends, they feel like they have access directly into the deal team when they see us out on the road as well. So I think it works both ways. But additionally, what really makes us different and what we really focus on is on that ops part of the business. And so not just the operations team, do they focus a ton on portfolio management and portfolio improvement. Really, the deal team does as well. We oftentimes are just an extra set of hands for our leadership teams that are portfolio companies. And so when you get down with diligence and the ink dries on the purchase agreement, the folks who know that investment best right out of the gate is the deal team. And so we're really helping to help them think through forecasting and building out weekly flash reports and budgeting and all that good stuff. And then skew rationalization analysis, ad hoc analysis, we're oftentimes just extra arms and legs for the DLT or for the leadership team at our portfolio companies, just get stuff done out of the gate. And then over time, our ops team plays a much more active role with those portfolio companies, but it transitions that way over time.

Nick: Where is New Water at in its fundraising cycle? And what are you hearing from LPs this year that may differ from previous years?

Matt: Yeah, great question. Fundraising, obviously, a hot topic across the private equity universe. So for New Water, we are winding down fund one. We've got three assets left in fund one. Two of those three are pretty mature. And so hopefully in the next handful of months here, those will be officially in market via sell side. And fund two is ramping up we probably got enough room and fun too to do a couple more investments platform investments and so I put two and two together we're we're kind of knocking the door for for raising funds that's that's super exciting for us. The market so what what we're hearing is that the current state of the fundraising market is not too different this year from where it was last year. So I'm sure you're well-tuned to just general deal flow. It has been slow for the past couple of years. That means capital is not being recycled very quickly, which means LPs don't have a lot of room for allocations. And so the dam kind of has to break at some point. I think everyone knows it's going to happen. It's a matter of when. And so if you are listening to what LPs are saying, it feels like 2025 is the year in which more allocations are expected. And so we certainly hope that that's the case. We know that the fundraising environment has been tough over the past couple of years. And so once the wheels start turning in a more normal fashion in the market, assets are trading hands, there's more deal activity, we think that that domino effect will lead to more fundraising opportunities for the property equity universe.

Nick: Reflecting back on 2023, what were some of the market observations you had, maybe challenges you face, and then opportunities within 2023 that you found?

Matt: So 2023, I just mentioned it a little bit. It definitely was slower deal activity. I think 2022 was slow. And the numbers will tell you that 2023 is even slower than 2022. So definitely not a flurry of deal activity. The deals that we did get done were interesting. A lot of assets had what we were calling noisy EBITDA. So in this kind of post-COVID world we're living in, a lot has happened. Think about labor shortages, shipping crises, semiconductor shortages, commodity prices ripping. And so you add all that together and that just creates, again, kind of a noisy environment to look at an asset super clean and to really understand what's a normal margin profile or a normal growth rate you can expect out of the business. Again, given all those noisy dynamics over the past couple of years. And so it just took a lot more work and a lot more negotiating with sellers to come to a compromise on what's practical, what's transactable, what can two sides agree upon. So noisiness on what did get done was definitely an overarching theme for us. That's tighter leverage, of course. I think everyone's been well aware of what the debt markets have done over the past couple of years. Obviously, higher spreads, higher rates on that debt leads to just lower valuations and tighter leverage overall. Not a lot of platform opportunities for us. Specifically, we were being much more stringent, maybe a bit of a tighter filter on what we wanted to transact on from a platform perspective. But we got a ton of that on top. So I think eight transactions we completed over the past 15 months or so, all strategic add-ons for our current portfolio. So definitely active, definitely a lot of work getting done. You know, quite frankly, not a ton on the new platform front.

Nick: Got it. And now that we're into Q2, what are some of the trends you're seeing in 2024? Has anything carried over, at least in what you're seeing in your end of the market? Has anything surprised you yet?

Matt: So if you would have asked me a month ago, I would have said no real change in 2023. But really over the past month, we've seen deal activity pick up a pretty good bit. Definitely not this watershed moment where all of a sudden, it's blow your doors off busy, but it's definitely busier. Pipeline's a little fuller. There's more opportunities out there. We're actually seeing a lot of carve-out opportunities. The reason for that, not quite sure, but a lot of larger public and private businesses are trying to shed assets, maybe to raise some capital, maybe just being opportunistic in the market. But we're seeing a lot of carve-out opportunities, which is great for new water. Like I mentioned before, we're very operationally focused. So the extent there's some value there to carve something out of a larger business and get standing up on its own, clean it up. Obviously, all great opportunity for us. Valuation expectations, there does seem to be still a little bit of a gap from what sellers expect their assets to clear for versus what the market is speaking for at the moment. I think that's going to work itself off, but we definitely still see a bit of spread there. And the other thing that we've seen in 2024 that's a little bit of a mystery for us in 2023 is there is this kind of destocking phenomenon that folks kept talking about in 2023. Volumes were down pretty consistently across the board in industrial and markets. And a lot of folks pointed their fingers to this destocking event that was a byproduct of COVID. So, supply chain issues and COVID in many different facets led to buyers of raw material or commodities or finished goods to buy as much as they could because they weren't too sure of the certainty for product to be available when they needed it. And so, they opted to be more safe and just to buy as much as they could when they could. And what that led to is kind of rampant growth in 2021 and in 2022. And as you look back in 2023 and part ‘24 now, you can see that those inventory levels are coming back down, folks are buying less, and they're telling people that we bought too much and we have to clear out what we purchased too much of in prior years. And so in 2023, that felt like an anecdote. We were hearing that a lot, but couldn't be really sure of it as the dust settled. And in ‘24, we get to evaluate across our portfolio companies and talk to other experts in the the field, we can kind of validate that that was indeed a phenomenon that we saw. We see things kind of being more normal now and a little bit closer to business as usual.

Nick: And maybe it's among the themes you just touched on, but what excites you the most about the rest of 2024 ahead of us?

Matt: Yeah. Deal activity picking back up. I mean, you said it. So I think we are excited to have more to do, more to look at. That's every deal guy's dream, of course. So we're excited to see the wheels turning a little bit on the industry. We can definitely see it in our pipeline. I think investment bankers are reporting pretty robust pipelines of pitch activity. And so we know it's coming, kind of feeling it getting up a little bit. We hope it's something sustainable, not a head fake. And so we'll keep our ear to the ground there. And we know it has to happen, right? There's $2.6 trillion of dry powder on the sidelines, just in private equity capital. It's a record amount. Money has to be put to work. And so we know it's coming. It's just a matter of when, not if. We're still busy. A lot of space for smaller assets, founders, entrepreneurs in the lower middle market to where we play. They're still motivated to sell. That's where we find the most activity. So we continue to get a lot of looks. And like I mentioned before, hopefully more platform opportunities for us in 2024.

Nick: Well, you just touched on and perhaps gave a great segue into my next couple of questions, which are really focused on what you're hearing from founders, closely held businesses. I know from my experience in the lower middle market, there's some nuances there that maybe aren't as applicable or that are more important in the lower middle market. Maybe talk to us a little bit about what are you hearing specifically from founders and closely held businesses, particularly as now we're a few years past the pandemic, now we're heading into another election cycle. They've been through a lot, right? The last couple of years. So what is it in specific you're hearing maybe this year as you're talking to new opportunities or your existing platforms?

Matt: Yeah. I think you just said it, which is they've been through a lot. And I think that's why we're still finding motivated sellers in the lower minimum market. They've been through a lot. So between COVID and labor shortages, supply chain issues, commodity and raw material costs us swinging wildly up and down. And then just getting those materials was difficult for long periods of time. I think they've been through a lot. And to get through the other side of that. Pandemic and all the issues that came after, I think they're looking at is you've got a clean business now. You've got a good sellable asset at the moment. You're still going, okay, maybe I can't maximize my proceeds like I thought I could maybe a year or two ago or pre-pandemic even, but it's still sellable. It's still a life-changing event for me. And a lot of those founders and entrepreneurs are still pushing forward the transaction. And so... We know that to be true in our segment of the market. We've also seen a return. And this has been reported on a bunch. I don't think this is anything novel, but we've definitely seen a return of structure to the segment of the market as well. When the market was really hot, I think the ball was in the court of these founders and entrepreneurs, right? The sellers. And they were able to get better terms, not just in terms of valuation, but in terms of rollover and seller notes and structuring and performance notes, things of that sort that helped bridge the gap between expectations and market valuations. And as we sit here today, I think that pendulum has swung very much so back into the court of the buyers. So we've been able to execute transactions with more structure. So depending on the transaction, obviously what that looks like, but it's definitely opened up a little chest for us. A lot of uncertainty still with the economy. Like I mentioned before, you're still having to kind of wade through some noisy EBITDA. You know, 2023 was just a few months ago. And so you're still having to digest what actually happened in 2023, what's normal, what's not normal, and try to adjust for that. We know inflation has been sticky. It feels like rates are going to stay higher for longer. At least that's our expectation. We know that will have to come back at some point, but just given how sick inflation has been, it's not something we're betting on at the moment. And also, like you said, and I mentioned it just a few moments ago, but we can definitely tell a return to maybe more normalized volume activity in our portfolio has returned. Some of these destocking phenomenons that we were dealing with last year, I think that's been worked through. And so we've seen some volumes returning way too early to say if it's here to stay. Again, we hope it's not just a dead cat bounce or a head fake here. But at the moment, it feels like it's a more stable, normal operating environment.

Nick: Before we close, I wanted to go back to something you hit on in your intro, your blue collar industry's focus. What is your approach and how have you found success in building trust with founders in these blue collar industries, particularly from origination through exit? What does that partnership look like from your perspective? What do you hope it to look like from their perspective? And maybe then talk about the role that emotions play in these types of deals.

Matt: Yeah, such a good question. And honestly, it's something that we take a lot of pride in is this exact topic, which is gaining the trust of these founders, these entrepreneurs, these, multi-decade, multi-generational family-owned businesses, and getting them to trust that we will be good stewards or custodians of these legacies. And so it's something we focus on all the time. And... What I can say, what I think we do well is we are very transparent communicators. And so I think what these founders and entrepreneurs can tell is that we are being very honest in what our expectations are for the business, the relationship, the time, the energy it takes to transform business. And I think they feel that authenticity in our message. You know, we all sort of hyper communicative in our feelings around what we expect out of the business and them. And so I think they always feel like they're getting kind of an open book approach from us. And we combine that with the fact that thankfully, we have been very successful in our recent past and transforming these family owned businesses in the lower middle market. And so we're an open book when it comes to, please do call former sellers, executives, CEOs that we either work with now or worked with successfully in the past to ask them directly, how was it working at New Water? And so, again, we try to be an open book. We try to be transparent. We try to be authentic. And the last thing that I'll say, which I think is definitely more tactical in our approach that resonates with these sellers is we truly walk into these organizations without a playbook beforehand. And trust me, we've made mistakes before going and thinking that we already had a plan for business and we were just going to kind of expedite our way to success. And you can't move too fast without having everybody on board with you. And so the point of saying that is every opportunity is different. Every business is different. And you really have to go in there and listen to the people who have run that business every day for decades and solicit their feedback before making your own mind up on what does the business actually need, first and foremost, in terms of building out infrastructure and investing in people, investing in systems, investing in processes, before you have the platform ready to grow in the direction you want it to grow. And so no preconceived notions, no predetermined playbook, but just open communication and dialogue to figure out how to move business forward. I think that tactically has been helpful for us.

Nick: Well, Matt, that's all the questions I had for today. I really appreciate you joining Dealmaker Insights. You've shared quite a lot and I found it extremely valuable. Look forward to following New Water Capital the rest of the year and I look forward to you becoming a recurring guest on the program.

Matt: Perfect. Thanks, guys. Really appreciate it.

Nick: Thanks, Matt.

Outro: Dealmaker Insights is a Reed Smith production. Our producers are Ali McCardell and Shannon Ryan. For more information about Reed Smith's corporate and financial industry practices, please email dealmakerinsights@reedsmith.com. You can find our podcast on Spotify, Apple Podcasts, Google Podcasts, reedsmith.com and our social media accounts.

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