Small Is Beautiful

Last September, Minnetonka-based Tonka Bay Equity Partners scored another triumph just as securities markets around the world were plunging. The private equity firm secured debt financing for a “dividend recapitalization” at one of its showcase companies, All-Flex, a flexible circuit manufacturer in Northfield.

The recap brought dividends to the company’s owners—Tonka Bay, Granite Equity Partners in St. Cloud, and three All-Flex executives—and provided capital to sustain growth at All-Flex. This happened even as “the credit markets were crashing all around us,” says Tonka Bay founder Cary Musech.

All-Flex is in Tonka Bay’s second private equity fund, which still has $60 million of its original $125 million remaining to invest. That means Tonka Bay won’t need to seek more capital, an unusually tough task today, until the end of 2010. The firm raised $75 million for its first fund, which closed in 1999. Musech says the initial fund generated an internal rate of return “in the low 20” percents—robust enough to be in the top quartile for U.S. private equity funds.

Tonka Bay’s odyssey underscores the sharp differences among private equity players. It’s a small, mostly regional firm, which focuses on buying established, profitable companies in Minnesota, Wisconsin, and Iowa with annual revenue of less than $50 million. Tonka Bay has avoided companies in interest rate–sensitive, housing, and consumer products sectors—all niches now under stress.

The success and now the troubles of the private equity giants—Blackstone, KKR, Carlyle Group, and others—tend to define the industry. But to compare those firms with the smaller ones is like comparing Mars and Venus.

Early in 2007, Blackstone CEO Stephen Schwarzman became the poster boy for the golden age of private equity. He predicted that by year’s end, the industry would do a $100 billion buyout deal.

That never happened. The buzz at the industry’s annual “Super Return International” fete in Berlin this February was all about not-so-super returns, falling valuations, financial engineering gone bad, and over-leveraged deals.

That’s not the case at Tonka Bay.

Small Versus Big

“We have not looked to financial-engineer our way to success,” says Tonka Bay principal Steve Soderling. “That’s why we don’t think the credit crunch will affect us as much as the large private equity funds.” Musech and Soderling cite research from Standard & Poor’s Leveraged Commentary and Data to make their point: