Case Study in Operations: Eldorado Stone

Suppose you receive an investment memorandum proposing the rollup of a franchisor and two of its franchises in the building products industry. The combined company will not have a management team, infrastructure or information systems, and you have no previous experience in the niche. Upon further research, you learn that analysts are forecasting a near-term peak in the housing cycle and interest rates are expected to rise further. Sound like a good deal? While it’s not for the faint of heart, this is just the kind of situation in which operationally-oriented private equity firms thrive. One such firm, Graham Partners, received a memorandum in the fall of 2000 that described this very scenario, and it jumped at the opportunity.



Founded in 1988, Graham Partners originated as the corporate development arm of The Graham Group, a York, Pa.-based manufacturing conglomerate and investment concern. It has operated as a separate entity managing third party capital since 1998 and seeks to invest in industrial companies that participate in manufacturing niches benefiting from product substitution or raw materials conversion trends in their industries.  When the firm received an investment memorandum for Eldorado Stone, a maker of molded artificial stone products, it recognized a potential buyout opportunity. Graham viewed Eldorado as a chance to invest in a high-margin, high-growth firm that could significantly benefit from the additional operational and transactional expertise it could bring to the table.



Diamond in the Rough



Founded in 1969, Eldorado was a pioneer in its field. The company’s initial focus was to develop a national base of stone-making franchises that would buy the molds that it made. Many of its franchises grew rapidly during the latter half of the 1990s because they were able to produce an increasingly realistic cement-based stone veneer product using Eldorado’s proprietary molds at one-third the installed cost of natural stone. Eldorado’s flagship franchise in Southern California, StoneCraft Industries, grew at a rate of more than 50% a year for several years, far surpassing the revenue Eldorado generated from its mold manufacturing business.



In 2000, the founders of StoneCraft and Eldorado, under the leadership of StoneCraft founder Mike Lewis, proposed a new strategy for the Eldorado Stone brand that would require a dramatic change in each of its businesses. “Based on the tremendous success we experienced with the StoneCraft franchise, I understood the potential opportunities for the product on a much larger scale,” Lewis says. However, he adds, “it was apparent that we needed not only additional capital, but a partner with operational expertise to help in the growth and development of our business.”



The proposed transaction entailed merging StoneCraft with Eldorado to form a platform business with enough critical mass, influence and capital to consolidate up to 27 remaining independent Eldorado franchises. Ultimately, this plan would enable Eldorado to improve its market position by launching StoneCraft’s product line with consolidated marketing materials, consistent pricing, a national advertising campaign and customer service on a nationwide basis under the Eldorado Stone brand. To effect this plan, the founders of StoneCraft and Eldorado, along with the founders of Northwest Stone and Brick (another Eldorado franchise), worked with the investment banking firm Houlihan Lokey Howard & Zukin to structure a three-way merger between the stone-making operations of the two franchises and the mold operations of the Eldorado franchisor. The founders recognized that the success of this strategy would require more capital, a disciplined integration effort and a team of investment professionals with strong operations and transaction skills. As a result, they were seeking an operations-oriented financial partner to help with the consolidation plan. After a thorough search, Graham Partners emerged as the leading candidate and was selected by the founders based on those criteria.



The Devil Is in the Details



Once they were granted exclusivity, Graham Partners turned to confirming its belief about the growth prospects for artificial stone, which was the key underlying component of its investment thesis. The firm hired consultants to research the market, and initial reports indicated a market growth rate of 17% per year for the artificial stone market as compared to the 3% annual growth expected for the overall $7 billion U.S. siding market. Companies within the niche were able to achieve this rapid market share expansion due to both advances in product aesthetics that made artificial stone nearly indistinguishable from natural stone, and reductions in price that made artificial stone competitive with brick and stucco siding. These advantages allowed Eldorado to convert consumers from more expensive natural stone, as well as from the larger stucco and brick siding markets.



During its due diligence, Graham also focused on a review of Eldorado’s franchise agreements. Many of these agreements contained a strict right of first refusal clause, which gave Eldorado the right to buy the franchises out from under a potential acquirer’s nose, even just before closing. This clause gave Eldorado a significant amount of leverage in negotiating with its franchisee acquisition targets, as other potential buyers would shy away upon learning of this risk. In fact, the clause helped Graham Partners in significantly advancing discussion and delivering a letter of intent to another franchisee before the initial deal had even closed.



Filling out the management team was a critical aspect of closing the deal. After working with Mike Lewis for several months, Graham Partners realized that he seemed capable of running a much larger company than the Southern California Eldorado franchise he had co-founded. In addition, the firm began to actively recruit other management candidates and was able to find a CFO who started within two weeks of closing, as well as a VP of Operations who started soon thereafter.



The deal, however, also had its share of risks. One of the company’s biggest shortcomings was a lack of infrastructure and management team experience that would be necessary to implement its growth strategy. However, the broader Graham organization had experience in succession planning and in growing industrial middle-market, family-held companies through a combination of organic growth and acquisitions. In addition, the firm had already identified an operating partner who attended the management presentation and worked with Graham to assess the management team throughout the due diligence period. “Our goal was to support the Eldorado management team . . .  by expanding their business into new geographic areas where demand for manufactured stone was on the rise,” says Joe May, managing principal at Graham Partners and a member of the Eldorado team.


Challenges while Closing the Deal



Eldorado’s complex ownership structure and lenders’ misgivings about the prospects of the housing market made completing the deal a challenge. The three-way merger resulted in a complex corporate structure whereby the shareholders of the company, who collectively represented the six founders of the three different predecessor companies, owned stakes in the company through dissimilar interests in complicated stock ownership and partnership arrangements. Consequently, Graham Partners had to devise a complex, creative transaction structure that would lead to roughly equivalent after-tax treatment for the various shareholders. Otherwise, the firm’s offer would have run the risk of alienating one or more shareholders, who in turn could have foiled the entire deal.



In addition, the shareholders had disparate views on valuation and ownership retention. Shareholders who intended to roll over a portion of their equity and participate in the future earnings potential of the business were more interested in selecting the right partner and less interested in accepting the highest nominal offer for the company. In contrast, those who did not want to remain active with the business preferred to maximize the cash delivered at closing.



The initial stages of raising debt for the transaction were difficult because of concerns about the state of the housing market, the execution risk in acquiring and integrating the franchise network and the lack of infrastructure within Eldorado. Graham Partners went out to almost a dozen financing sources in order to find a partner who could see the potential in the deal and would be willing to take on the risk. In the end, CIBC World Markets, a firm with which Graham Partners had a long-standing relationship, signed on as lead underwriter and was able to syndicate the financing.



Summing up the major risks that Eldorado presented, Rob Newbold, managing principal at Graham Partners, notes: “The level of housing starts was an issue on everyone’s mind. We were creating a new company but it did not have any management. The CEO was the founder of the Southern California franchise, but there wasn’t a CFO or vice president of operations. In addition, the company lacked an integrated MIS system. One of the companies ran its business on QuickBooks.” Adds May: “To further complicate matters, the strategy was dependent on our consolidation of a number of independent franchisees who had the right to use the Eldorado name and to sell into our territory. This was perhaps the most important area to clean up with the greatest execution risk. Multiple operators competing with one another in the same territory can create damaging brand confusion, and it was impossible to tell if a franchisee would be willing to sell to us at this early stage.”



Despite these difficulties of structuring, financing and closing the deal, Graham Partners and Eldorado management won shareholder approval for the recapitalization and obtained ample leverage for the transaction. The transaction was structured as a hybrid asset/stock purchase, involving the purchase of a portion of the shares of StoneCraft Industries, a portion of the Class A units of Northwest Stone and Brick Co., 100% of the common stock of Eldorado Stone, and 100% of the Class B units held by Northwest Stone and Brick Co. CIBC led the senior financing, which was eventually oversubscribed at a multiple of 2.9x trailing 12-month EBITDA. Indosuez, National City Equity Partners and Argosy Capital provided the subordinated debt financing for the transaction, pushing total leverage to 3.7x trailing 12-month EBITDA. The equity component of the deal included a 27% rollover interest from certain of the company’s founders who planned to remain active in the business, in addition to the cash paid by Graham Partners for a controlling stake.



Enhancing the Organization



“Immediately after closing the deal, we worked to focus company management and our investment team on the development of a strategic plan, the creation of financial and operational reporting templates, and the assessment and identification of executive management capabilities and needs,” Newbold says. “This plan set accountability for all efforts and ensured that new management hires had a clear vision of responsibilities.”



Generally speaking, small, entrepreneurial businesses tend to be run a bit more loosely than larger organizations. When Graham first asked about indicators used to gauge productivity, management replied (a bit facetiously) that the “smudge test” was crucial. “We just go over to that window, wipe a smudge off the pane, and count how many trucks are leaving the plant.” In fact, prior to the rollup, each of the businesses had been run more or less by the gut instinct of management, which may have been adequate for an entrepreneurial concern, but needed to be supplemented and professionalized as the company grew into a larger, fast-growing organization. This was certainly an area where Graham intended to focus.



Vinay B. Nair, a professor of finance at Wharton, points out that Graham Partners’ approach to Eldorado differed considerably from that of private equity firms that make large cap investments. “Large cap firms don’t usually get involved in operational issues,” he says. “They make their money from leverage and financial engineering. If they want to bring about operational changes, they do that through hiring appropriate executives. Graham Partners was significantly more hands-on in its approach.”



Moreover, Nair adds, “Buyout firms trying to add value in small entrepreneurial businesses often play some of the roles that VCs do. VCs are known to play an important role in the professionalization of start-ups through actions in information technology, human resource policies, adoption of performance-based compensation plans, and the hiring of senior managers. Buyout firms dealing with smaller firms have a similar role.”



Although Eldorado’s management had already identified several of the key metrics that were driving sales and productivity, “Our team and our operating partners worked with the company to institute additional measures to more formally and proactively monitor plant productivity and implement best practices across locations,” Newbold explains. “While we initially experienced some resistance from management on this front, who perceived the measures as ‘overkill,’ these concerns were put to rest once the company began to realize productivity gains across plants.”



In addition to adding more professional management practices and infrastructure, Graham set out to implement its strategy of acquiring additional franchises and unifying the company’s product and marketing efforts under a single nationwide banner. Prior to the acquisition, each of the franchises maintained its own name brand, packaging and marketing plan. As franchises were acquired, names were changed to Eldorado Stone and consistent packaging was adopted throughout the system. “In keeping with our initial investment thesis, the franchise acquisition strategy was very effective. Over the course of our ownership, we completed five additional acquisitions, all at very attractive multiples,” says May.



One of the major difficulties that arose while implementing the acquisition strategy hinged on the fact that current Eldorado management had formerly been a competitor of many of the other franchisees, who had to overcome their sense of competitiveness to work on the same team. Because of the company’s outstanding growth and performance, these acquisitions were executed with no additional equity from Graham Partners. More importantly, most of the acquired franchisees also stayed on as general managers, making the transition much easier. Within three years from the original transaction, Eldorado represented approximately 90% of the total North American franchise network volume.



Moving to a consistent, nationwide product line also proved challenging as a result of the inefficiencies caused by changing the well-established production methodologies at various plants. One plant had developed a coloring and production system that was superior to systems at other plants, but rolling this out nationwide during a period of rapid growth proved to be difficult. While it resulted in significant non-recurring expenses, the company managed the issue by employing large numbers of temporary employees while permanent workers were trained in the new production methods.



Though certainly one of the more exciting aspects of the company, the 25% organic growth rate achieved in the first few years also resulted in capacity constraints much sooner than expected. After less than two years of ownership, the company needed to build a plant in Southern California to keep up with demand. As this was by far the largest plant ever built by Eldorado or its predecessors — adding roughly 33% to the production capacity of the company — inefficiencies were expected and did materialize. However, Graham and the company’s focus on a key metric used in managing plant efficiency (square footage of stone produced per man hour) turned out to be critical. Once plant managers began consistently tracking and monitoring this metric, it became clear which plants were producing efficiently, and adjustments could be made to incorporate best practices across facilities. Another difficulty arose in recruiting plant employees. While the company had hoped to use some production managers from its existing plant nearby, these employees proved difficult to recruit. After a few months of working out the kinks, however, the company had all of its plants running efficiently and the capacity issue was resolved.



Commenting on Graham Partners’ strategy, Wharton’s Nair explains that it had pros as well as cons. “Any time a private equity firm gets involved with a small firm, franchise or family owned firm, it pushes through operational changes that make its finances more transparent and efficient,” he says. “These changes are made — as Graham Partners did in the Eldorado case — among other reasons, to prepare the firm for future sale. The downside is that these changes can de-motivate managers who have been used to running the firm in a certain way. They now have to run the firm according to the new rules. You can compensate managers by giving them equity but they don’t realize these rewards until the sale goes through. In the meanwhile, you can antagonize your managers.”



Reaping the Rewards



Just a couple years after investing in Eldorado, Graham Partners found itself having completed its initial objectives and decided that the time was right to find a buyer to implement the next stage of the company’s expansion. After interviewing a number of investment banks, Graham Partners settled on Citigroup Global Markets to run an auction. However, the company’s difficulties with its new Southern California plant persisted after the auction process began, and potential acquirers were unwilling to fully adjust for the one-time, non-recurring plant start-up charges. As a result, Graham Partners decided to suspend the auction until its new plant was running efficiently.



Soon after the auction was put on hold, another investment bank contacted Graham Partners regarding a client, Headwaters, that was interested in Eldorado. While Headwaters had not been on the original list of potential acquirers, the company was looking to expand into a higher growth, higher margin business segment that would also create synergies with its current business units. Headwaters was attracted to Eldorado as a result of its strong historical growth and high margins.



Nair believes that, “The timing of the exit was questionable. With problems in a major plant, an unsuccessful auction was a possibility and an important risk. If this happened, Graham would carry the stigma of a failed sale attempt and possibly lower exit multiples in the future. In a perfect world, Graham should have waited. Fundraising pressures, however, could have affected the timing. Private equity firms are keen to exit on good investments such as Eldorado when they are in the process of raising follow-on funds, making them more willing to take on such risks. In hindsight, Graham Partners could have received a higher valuation if it had waited.”



“In our case, as it related to Eldorado Stone, there were a number of factors we had to consider in determining the timing of our exit,” says Christina Morin, a managing principal from Graham Partners who also worked on the Eldorado Stone transaction. ”In particular, the long overdue end of the housing boom continued to loom in front of us, we had achieved all of our initial objectives for Eldorado that comprised our investment thesis, and we had the opportunity to sell the company into a strong M&A market at a very full multiple, generating a return that exceeded our overall objectives for our investments. Had we held onto Eldorado, which was just one of several building products holdings in our portfolio, and if the housing market had softened, as was projected, our investors would have really questioned our decision, as fiduciaries of their capital, to leave all of our ‘chips on the table,’ rather than put some cash back into their pockets.” 


As such, the sale of Eldorado to Headwaters worked out well for Graham Partners and its investors, who had invested some $18 million out of a total $30 million of equity to complete the Eldorado transaction. (Most of the remaining equity was from management, with a portion from debt financing sources.) The sale closed in June 2004 and was an all-cash transaction representing an enterprise value of approximately $210 million (including a working capital adjustment of $8 million). As a result of the sale, Graham Partners distributed to its investors roughly half of the capital invested from its vintage 1999 fund. The sale yielded a 4.3x gross return on invested equity and a gross IRR of 57%. Who says you can’t squeeze gold from stone — even if it’s artificial stone?

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