Sky Island Capital recently closed an oversubscribed $300 million sophomore fund for lower middle-market manufacturers, overcoming a challenging inaugural fundraise and LPs’ current flight to megafunds and familiar PE brands. Firm founder Jack Waterstreet discusses how the Dallas shop retained all its original LPs while attracting new investors.
“Fund I wasn’t very successful,” Waterstreet says candidly, recalling Sky Island’s 2018 launch. “It was a painful and difficult experience.”
The firm had set a target of $225 million but had stalled at $116 million.
“I felt like I was selling black and white TVs,” Waterstreet says of competing with red-hot VC firms competing for the same investor check sizes in 2018 and 2019.
Then Covid hit.
Organic Growth
So he and the firm decided to concentrate on the five lower middle-market companies they managed to acquire with Fund I, a decision that led to Fund II easily and quickly surpassing its $225 million target.
- Material Science Corp., a maker of specialty coated metals.
- Polished Metals, the country’s largest supplier of architectural and ornamental metals.
- Valley Forge Flag, a maker of U.S. flags and other flags.
- Skymark Refuelers, a manufacturer of specialty aviation refueling trucks and tanks.
- USA Industries,a maker of specialty equipment for petrochemical companies.
“We improved Ebitda across the board,” Waterstreet says. “Neary 95 percent of the growth was organic.”
Sky Island managed to extract enough dividends to satisfy cash-hungry investors. He said the firm resisted the temptation to squeeze as much cash out of the portfolio companies as possible to boost LP distributions to impress potential investors.
“We lost a few potential investors because of that,” Waterstreet says. “But most were on board with it.”
Fund II
So when Fund II launched, all LPs re-upped at higher stakes, accounting for $150 million of the $300 million. New investors, convinced by Fund I’s IRR, accounted for the rest.
“We put some time and effort in building relationships with investors,” Waterstreet says.
Waterstreet also credited the hiring of Stifel’s placement agent Eaton Partners with helping with the successful fundraise.
Recent onshoring trends have caught investors’ attention and increased demand for PE firms investing in U.S.-based manufacturing. The lower end of the middle market’s track record in general, too, attracted LPs to the firm.
Sky Island, named after an individual mountain surrounded by lowlands, focuses narrowly on lower middle-market manufacturing companies generating revenue between $5 million and $15 million that are founder-owned.
“Typically it’s someone who wants to retire,” Waterstreet says. “They’re successful companies with room to grow.”
Sky Island’s portfolio has grown to seven platforms and 17 companies manufacturing everything from cheese curds to specialty aviation refueling trucks.
Blocking and Tackling
The firm applies the same investment strategy across the board, keeping most existing managers while significantly beefing up sales teams, installing modern IT systems and adding key performance indicators.
Before launching Sky Island, Waterstreet spent nine years at Southlake, Texas-based Insight Equity, where he served as a partner and chief investment officer.
Waterstreet launched Sky Island in 2018 to focus narrowly on lower middle-market manufacturing companies, which have lower multiples and require less leverage to acquire compared to bigger companies.
Waterstreet says he took that big leap because he saw few PE firms playing in a space rife with successful founder-owned businesses with tons of room to grow.
“There were few PE players in that space. Still are,” Waterstreet says. He says Sky Island’s biggest competitors are independent sponsors, who are more prevalent today than when the firm launched nearly seven years ago.
Waterstreet says 2025 will continue operating the firm’s playbook.
“It may not be the most exciting strategy,” Waterstreet says. “But we’re sticking with our blocking and tackling.”
Contact Waterstreet at [email protected].
