By Jessica Resnick-Ault
December 26, 2007 - Wall Street Journal

Upscale retailers that are leaders in niche markets are poised to weather a potential recession in 2008, according to Tom Stemberg, the founder of office-supply retailer Staples Inc.

Elevated gasoline prices and weakness in the housing market are less likely to change the spending habits of wealthy consumers, boosting retailers focused upon those consumers, Mr. Stemberg said.

Mr. Stemberg, who founded Staples in 1985 with Leo Kahn, is at the helm of Highland Capital Partners Consumer Fund I. That is a $300 million private-equity fund financing small retailers looking to expand upon a proven concept. Mr. Stemberg who is managing general partner of the Lexington, Mass.-based fund, quips that its investment philosophy is best summarized by his first-year marketing professor at Harvard Business School, Ben Shapiro. "His mantra was: 'It's all about the consumer, stupid,'" Mr. Stemberg said.

The fund, started in October, currently holds stakes in six companies specializing in products catering to the health-conscious, wealthy, outdoorsy and other demographics.

"We always try to look at every investment first and foremost from the perspective of the consumer," he said, adding that the fund tries to find products that consumers have been waiting for, rather than products looking for a new market. Because Highland's managers have experience running retailers, as Mr. Stemberg does, he says they are positioned to avoid some of the traditional pitfalls of the business.

Rather than financing untested concepts, the Consumer Fund will invest in those that have been proven at a small scale and need capital to expand.

"We look for something the consumer has looked at, kicked the tires of, and enjoys," Mr. Stemberg said. Highland Capital Partners Fund has made four investments into the sector since he joined the firm in 2005, and is geared toward taking advantage of "the significant volume of promising deals in the pipeline and to commit the capital required to become a leading investor in the consumer sector," according to the fund's prospectus.

Vancouver-based activewear manufacturer Lululemon Athletica Inc. was among those four early investments in the Highland Capital Partners Fund, which ordinarily invests in technology, health care and communications. The brand appeals to a strong and growing market of people who practice yoga, Mr. Stemberg said.

In the summer of 2005, he saw the concept at work. "I remember standing outside and inside a Lululemon store in Toronto, and [customers] uniformly perceived the product to work, feel and look better than anything else they had worn. To me, that's the greatest testimonial," he said.

For more than a decade, Mr. Stemberg said, big investors largely avoided the retail space, investing instead in high tech, particularly dot-com businesses. This focus on other industries made investments in retail less lucrative to venture firms that were rapidly growing in size, and thus required larger-scale investments. For instance, Bain Capital, which helped Mr. Stemberg start Staples, now manages $10 billion, which limits its ability to invest in small companies.

In addition to Staples, venture capital seeded now-household names such as Starbucks Corp., Whole Foods Market Inc. and Home Depot Inc. Injections of about $20 million could help the consumer fund's holdings, such as Pharmaca Integrative Pharmacy, Pacific Pathway and Blue Tulip, reach a larger consumer audience, he said.

Boulder, Colo.-based Pharmaca Integrative Pharmacy, which is also held in the Highland Capital Partners Fund, is a particular example of a company with opportunity for growth, Mr. Stemberg said. "It has the kind of large-growth potential to become a big company, maybe not as big as PetSmart or Staples, but a pretty big company," he said.

Investors who are interested in the Consumer Fund's holdings may buy into the fund for $1 million for an individual investor or $5 million for an institutional investor, Mr. Stemberg said. While the returns earned by the fund thus far weren't disclosed, he said the fund hopes to outperform publicly traded companies.