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December 21, 2007

PrivateEquityCentral.Net- Friday, December 21

When Ross Gatlin says he and his team are just opening their new private equity firm Prophet Equity, he means that literally. While describing Prophet during a phone conversation, he is interrupted by the landlord of the building in which Prophet is setting up shop to discuss getting him the keys to the front door.

Gatlin’s new firm will look to make control investments in companies with revenues below $500 million. The firm began operations earlier this month and currently has four employees. Gatlin says the plan is for the team to be built out to as many as 20 members.

Prophet will focus on special situations, turnarounds, acquisitions, bankruptcies and reorganizations. The firm will invest in smaller and mid-sized businesses, an area Gatling says is underserved by the investment community, which gravitates toward larger deals. Prophet’s investment strategy will more or less be a generalist approach, looking at everything from aerospace, energy and healthcare, to distribution, manufacturing and telecom. Gatlin says the only sectors in which the firm will not invest are retail, restaurants and real estate.

At the moment, the firm has access to $100 million. Gatlin says $50 million of that is from firm partner capital and the remaining $50 million is from outside investors that match the money dollar for dollar. Gatlin says this structure, where he and others have invested their own money into the firm, has attracted other partners to co-invest with the firm due to the “extreme caretaking” of capital by the firm.

“When it is your own money, you are really careful,” says Gatlin.

Considering the state of the economy due to the subprime meltdown, one has to wonder if this is the right time to start a new private equity firm. Still, listen to Gatlin discuss his new firm and it is hard not to feel his excitement. The state of the credit market does not scare him. In fact, he says current conditions work well for Prophet since he and the Prophet team know how to make money in difficult environments. The firm will employ a number of screens before making an investment.

Gatlin has worked at The Carlyle Group, where he started in 2000, getting caught in the middle of the tech bust, and was a founding partner in Insight Equity.

The Prophet team is not alone in thinking the time is right to enter the market with a new private equity fund. Rory Jones, a principal and cofounder of management consultancy firm Business Intelligence Associates, says this is easily the best time to start a private equity firm. He says firms today are stuck in the old way of doing business – buy an underperforming company on the cheap, install new leadership and then sell in a few years. Jones says this model, however, is outdated because prices have gone up while growth and exit values have remained the same.

“Private equity firms need to have a secret sauce – a systematic approach to driving value in their portfolio companies,” Jones says. “They need to start to behave like real businesses themselves and take their own medicine; they need to differentiate to attract acquiree management teams and capital.”

Jones offers a few suggested ways to do this. One is to manage market strategy by finding untapped pools of profit in the existing business and by targeting long-range market profit pools. He says that nearly 75% of business value is within the 15-year horizon; business leaders tend to focus on the short-term of the next one to three years.

“Old private equity firms appear unable to adapt to the new environment,” says Jones. “If you do start a new firm and focus on a systematic approach to portfolio company operating value growth, you’ll clean up when the portfolio starts maturing in five years.”

If one is to open a private equity fund, the place to be is in the lower end of the middle market, according to Bryan Hursh, a managing director of private equity for Republic Financial. Despite the turmoil in the credit markets seen in the upper stratosphere of deal-making, the smaller end of the spectrum has been relatively unaffected due to lower valuations and smaller leverage multiples. Hursh says there is a massive pipeline of deals in this part of the asset class with more than 275,000 companies with revenues between $5 million and $100 million. Most are family-owned and will be looking for exit strategies.

It is hard to imagine any private equity fund other than one that invests in distressed markets would be excited right now about the future. Still, funds have raised billions of dollars in the last few years and are prepared to deploy that cash shortly. That means capital will be flowing through the asset class, but more of it will be coming from the funds themselves rather than through debt financing. As we enter the New Year, it is unlikely private equity will tumble as an asset class. However, it probably won’t be surprising to see fewer new funds this time next year.

By Marc Raybin, Editor in Chief

Edited by webmaster

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