Strategic Exits and Sustained Growth: Year-End Insights from Doug McCormick and Lloyd Metz

[00:00:00] Sean Mooney: Welcome to the Karma School of Business podcast about the private equity industry, business best practices, and real time trends. I'm Sean Mooney, BluWave's founder and CEO. As we approach the end of the year and anticipate a big deal market coming in the near future, we thought it would be great to introduce you to our sister podcast, Best But Never Final.

[00:00:30] Best But Never Final is co hosted by two top private equity investors, including Doug McCormick from HCI Equity Partners and Lloyd Metz from ICV Partners. In this particular best but never final episode, we delve into the art of planning for deciding when to and how to successfully sell a company. I think it's particularly relevant for the very now when a lot of companies are thinking about, is this the time to test the market?

[00:00:57] If you like karma school business, I think you'll really also appreciate best but never final. Where three PE pros do deeper dives into demystifying the private equity, why, how, and what. Enjoy this special crossover episode.

[00:01:18] Great to be back together, Lloyd an[d Doug. How's everything going today? Good. Hey, Sean. Good,

[00:01:23] Doug McCormick: Sean. It's Friday.

[00:01:24] Sean Mooney: Happy Friday. We are almost sliding down the dinosaur tail and yawn yabba dabba doo. I'm old enough to know what you're talking about, Sean. Not just vitamins that we're talking about. It's my Saturday mornings.

[00:01:37] Today we're going to talk about how private equity firms think about after they've theoretically built these great businesses, having this idea, going into it that they think there's going to be some great buyers at the end of the day. Does that sound like a good plan? Sure. Great. Great. Let's jump into it.

[00:01:57] So Doug and Lloyd, I'd be really curious. How do you think about this? You're sitting there, you're at the investment committee, you've done all the work. You're at the last section of your investment memo. Is there going to be an exit? So how do you think about that once you have this otherwise

[00:02:12] Doug McCormick: great plan?

[00:02:13] I think a lot of people think that the decision around the time to sell. can actually be way more impactful in the total return profile than all of the upfront work about the right time to buy. So huge value creation opportunity related to picking the optimal market and then giving the thesis or the value creation playbook enough time to mature and compound.

[00:02:33] That would be the first point. The second is from my perspective, I feel like business models are durable. Strategies and teams are durable. If you execute well, markets can be very fickle. And so it's really hard to time the exact perfect time to exit. And so that biases us to try to focus on the long term value creation, focus on what you can control.

[00:02:58] And then if you build a good business, it gives you the luxury. of playing through volatile markets until you get to the right next environment.

[00:03:06] Sean Mooney: I think that makes a ton of sense. It's like first principles, build a great company, and there'll be plenty of buyers.

[00:03:11] Doug McCormick: And a great company gives you the luxury and confidence to hold it through choppy waters if you have to.

[00:03:16] Sean Mooney: Yeah, which odds are, right, during the course of an investment fund, Which is a five to 10 year life. You're going to have a cycle through there. We're

[00:03:24] Doug McCormick: in one

[00:03:24] Sean Mooney: now.

[00:03:25] Lloyd Metz: I agree with most of what Doug said. The other pieces, everybody thinks growth is just straight up into the right and have smooth. Continuous function straight line, but that's not really how execution works like independent of cycles, right?

[00:03:43] So a lot of the companies that we invest in, you're going to have a burst of progress from some execution, some initiative or some new strategy, and then may plateau and may dip. You may have to sort of pedal a little bit one year so you can advance a couple of years from now. So. You know, growth won't be a straight line and you layer onto that with Doug was talking about with market fickleness.

[00:04:08] You do have to build a better business, but what it does inform you is we got to make those changes and put those new strategies in up front early and get them going as soon as possible. So you can have some of that luxury of time down the road.

[00:04:23] Sean Mooney: It's never a straight up into the right now. That's right.

[00:04:25] When you're building these things, it's a plateau and a sprint and a plateau and a sprint. Lloyd, I'd be curious also, as you think about your building to something where you're having different gears and it's kind of going faster and a little slower and faster. What do you think about in terms of this idea that overall though, what are you looking for in your businesses that you think are going to create a buyer universe?

[00:04:46] Lloyd Metz: We try to start with businesses that are already market leaders. And our philosophy is if you start with the market leader and make it better and you get the growth tailwinds of that market niche, right. Then you'll have lots of buyers, right? So if you find a business, eight, nine, 10, 12, whatever, of EBITDA, which is where we tend to like to start, and you get it to 20, over the course of three, four, five years, that should be a pretty attractive asset to wide range of people.

[00:05:22] But the big ifs are, did you get the market growth trend, right? If you get that wrong, you'll have a problem. Okay. And make sure you got the market leadership, right. And that you can sustain it. If you can do that, we've had some pretty good experience. We've seen other firms have good experience. It tends to work.

[00:05:43] Doug McCormick: We have a different strategy and I think it just highlights how different firms have different approaches and lots of different ways to make money in the business. And so because we're very focused on consolidation strategies, it's almost by definition we're starting with a very small entry point that's not a market leader.

[00:06:00] And so one of the big things for us is we want to convince ourselves, Hey, we're a couple percent of a market, but there are lots of acquisition opportunities and we're going to triple or quadruple or 10 X the business. And hopefully still have a relatively small market share so that the next buyer can continue to execute that growth strategy through M& A.

[00:06:19] Lloyd Metz: That's super interesting, Doug. Curious, how do you figure out how much consolidation that particular market can take? Right? Because most markets don't get to be 80, 90, 95 percent consolidated, right? Some level of consolidation where things sort of level out. So you need to figure out how much consolidation you take advantage of, right?

[00:06:41] And then you have to figure out how much consolidation you need to leave for the next person. I would imagine. Yeah.

[00:06:47] Doug McCormick: Yeah. And I think some of these markets in North America are so big and so fragmented and candidly were small enough. Yeah. That the math is almost totally unconstrained. We have a business called tech 24, which is a consolidation platform.

[00:06:59] It's food service, equipment repair. We've done 20 acquisitions and we're a whopping 3 percent of the market. We could triple the business and be 9 percent and you still got a ton of runway. And I think there are like 3000 competitors in that marketplace. The great news is there's tremendous kind of growth opportunity.

[00:07:18] I think the bad news is by definition, there are no market leaders defined as 30, 40 percent of the market. And that implies there are not huge barriers to entry. We think there are competitive differentiators, but not barriers to entry in the way you may think about it.

[00:07:34] Lloyd Metz: Got it. Interesting.

[00:07:37] Sean Mooney: Those are great examples of two different approaches in PE where you can have a very large market that's not consolidated.

[00:07:44] There's a lot of inefficiency. We can see. a lot of examples of that. And then Lloyd, I think what you're saying is like, let's start with a niche market leader and take it from good to great. That was probably the closer to the approach that I took when I was in P where it was, let's get a cornerstone asset that was successful in spite of itself.

[00:08:03] And I think one of the things that particularly, as you think about a business leader of these companies, no matter which approach you're taking, That I think is maybe a good thing that we can double tap on here is, I think a lot of people have this idea that you're building a company over a five year plan because it's a five year model.

[00:08:20] We would always start with a 10 year plan because you always have to leave something for the next buyer. And so we would always think, okay, we're going to take it this far, but there's got to be a road even further beyond that. And so Doug and Lloyd, I'd be curious about how you think about that.

[00:08:34] Lloyd Metz: Yeah, no, that's a great point, Sean.

[00:08:37] And I think in one of the previous episodes, I was talking about understanding the aspirations and the mindset of that leader, that entrepreneur, that founder, that CEO, and trying to figure out how far do they want to take the business. And then can we bring some of our insights and learnings to push that thinking, push that aspiration.

[00:09:01] If you get that right. Then laying out a plan in stages that says, okay, in years one, two, three, this is what we're going to do with you, get it done, and then let it compound as Doug said, and blossom into nice results in years three, four, five. Then the next. Private equity sponsor comes in and they will do phase two or whatever.

[00:09:28] But all of it starts with where does that leader, where's that entrepreneur, where's that founder dream and aspire to go.

[00:09:35] Doug McCormick: For me, I think what this really boils down to is I think the market has gotten very good at underwriting opportunities. In a way that I think the optimal strategy is manage the business like you're going to own it forever, and you can separate that framework from when you decide to sell a business, right?

[00:09:52] But basically, what my point would be, if sophisticated buyers will tell if you've made decisions that shortchange the long term opportunity to pretty up the business in the short term, The right strategy is always make long term decisions as if you're going to own the business forever. And good, sophisticated buyers will pay for that when you deliver those capabilities.

[00:10:12] Lloyd Metz: Doug, you're raising an interesting point and I'll raise this with you guys and see what you think. I actually try not to use the word exit with my portfolio company leadership teams. Because in most cases, they're not going anywhere. They're continuing on, as Doug is describing. They're intending to stick around for another 10 years, or 7 years, or whatever the heck it is.

[00:10:37] We're the ones who need to exit. And find them another capital partner. And so that's how I like to frame it, that we're finding you a new capital partner to help take you into phase next of growth.

[00:10:52] Sean Mooney: Hey, as a quick interlude, this is Sean here. Why don't you address one quick question that we regularly get?

[00:10:58] We often get people to show up at our website, call our account executives and say, Hey, I'm not private equity. Can I still use BluWave to get connected with resources? And the short answer is yes, even though we're mostly and largely used by hundreds of private equity firms, thousands of their portfolio company leaders, every day we get calls from every day top proactive business leaders at public companies, independent companies, family companies.

[00:11:22] So absolutely you can use this as well. If you want to use the exact same resources that are trusted and being deployed and perfectly calibrated for your business needs, give us a call, visit our website at BluWave. net. Thanks. Back to the episode.

[00:11:40] And I think that is exactly right. And I think that's consistent with what we're talking about in that there's a right party for a right size and scale of a business. And then ultimately there's going to be a next party who's going to be just as good for that next phase of their life. They've got a longer hold period where they can do it.

[00:11:58] I'd be curious. One of the things that we would also think about is we are building a business and this is kind of the pre great Bernanke and mega cycle that we're coming out of. Where you had normal kind of debt levels and the fed wasn't pumping free money forever. And we would really say, okay, do we think there's financial investors?

[00:12:18] That are going to want to own this business. That's going to be a very good business, but also we would think, is there potentially a strategic that could come in and have to own the business that couldn't be your own exit. But if you could get a strategic that could come in in a normal market, in a normal cycle, you would always say, wow, they're going to be able to beat everyone because of the synergies they would have.

[00:12:42] But also. Because they were going to be able to take this business and take their products and services and give resources to these teams in ways that they never had before through the scale of a larger platform. So I'm still stuck on

[00:12:53] Lloyd Metz: Bernanke. And I have not heard that word before. I,

[00:12:56] Doug McCormick: that's

[00:12:56] Sean Mooney: one of my

[00:12:57] Lloyd Metz: coins.

[00:12:58] That's kind of cool. Never heard that.

[00:13:01] Doug McCormick: The way we think about it is the sponsor community has become so deep and so liquid. That I think we always feel like there's a pretty likely exit at a really good outcome within the sponsor community. If you do your job well, and then you don't plan for it, but you hope to get strategic interest and strategic interest, I think is less predictable, but when it happens, it can happen in a really big, positive way, because They see immediate synergies, whether they be growth oriented or cost takeout oriented.

[00:13:30] And if you create the right competitive tension, they'll capitalize some of that opportunity in a way that endures benefit to the owner or the seller. And what I would say, though, is I think the lines between strategics and sponsors are blurring. And I have a number of businesses in markets that are consolidating.

[00:13:49] Where there are more than five sponsor backed strategic buyers. So are they sponsors? Are they strategic? So are they strategic sponsors? I don't know, but I think those are the kind of buyers are very compelling because they see the strategic aspects of it, but they are super sophisticated and used to competing in processes from a financing and speed and underwriting perspective.

[00:14:11] Sean Mooney: I think that is a great point. And that's something that if you think about how the world has evolved, so many of the strategics are now sponsors. And so we had a very highly sought after data business. And we had all sorts of strategics that were constantly knocking on the door. It was just a really interesting business with a strong corner of this attractive end market and every strategic, we probably had five of them that said they needed to own this thing.

[00:14:38] And so we took it to market and we were convinced that it was going to be a strategic and ultimately though, it was a private equity backed sponsor owned business that owned it Because they have the benefit of the scale of a strategic, but they can move with speed and there's these big public companies.

[00:14:57] If you think about any transaction, you're thinking about a business on your exit. There's three components. There's valuation, speed, and certainty. The big public companies, they really have a hard time with speed and certainty, then get the valuation. And so this private equity backed strategic kind of brought the best of both worlds.

[00:15:14] And so it's an interesting that you've got this fusion in ways that may be in the earlier innings of private equity didn't exist as much.

[00:15:21] Doug McCormick: One more point on that, Sean, I think is interesting. Think about it from the private equity owner's perspective. We look at consolidation strategies and we often say, we think the riskiest capital we allocate is the first dollar in the platform because we know the industry less well, we know the team less well, we're less strategic and more financially oriented in terms of how we're underwriting.

[00:15:42] But boy, by the time we've done three, four or five acquisitions, We've got a team, we know the industry and the business much better. And so we look at those capital allocation decisions with a lot more conviction. And I think probably a better risk adjusted return profile, which I think in turn allows you to be more aggressive.

[00:16:01] Lloyd Metz: I don't disagree with Doug's view on how to approach things, right? You should have a pretty favorable outcome. If you just go to a regular way, private equity sponsor, and then you can oftentimes find outlier type of outcomes with a regular way corporate buyer or sponsor back corporate buyer. We try not to overthink it, but I will say, depending on the space, let's just take food and beverage.

[00:16:27] For example, the private equity industry through acquisition through building smaller companies is almost like outsourced R and D for those companies. Thank you. They don't want to do the work of assembling all the businesses or identifying the new trend. We do that. We grow the business, and they're ready to take it on because it'll still be small by their standards.

[00:16:49] And that's how they get new product. That's how they get new market presence or what have you, and then they can leverage distribution and whatnot. To a certain extent, pharma does a variation of that, but on a larger scale with drugs and, Certain industries look at M& A as part of their R& D and product innovation strategy, and depending on the space you plan, that's another way you can think of your exit, if you will.

[00:17:16] Doug McCormick: We can talk about all the likely outcomes and how it's going to play out, and I am perpetually surprised by the outcome relative to the expectation going in. If you said to me, in the last 10 things you've exited, how many times did you predict the buyer? I would say it's less than 10 percent probably, right?

[00:17:33] So, you know, that's the beauty of run a process, build a good business, and then see who shows up.

[00:17:39] Sean Mooney: It's actually dovetails really nicely with some of the earlier episodes where we talk about in all of our experiences, we've never built a company and built it into the thing that we exactly thought it would be from day one.

[00:17:50] And so you need multiple avenues of growth and development. And this whole concept of optionality that's pervasive in some PE firms is like, you also have to have multiple options to exit. If you're only counting on one way, you're in a lot of trouble. And I think Doug, similarly, I can only name one company in 20 years that we exited to the company who we thought would buy it.

[00:18:10] Lloyd Metz: Yeah. Certain corporate buyers have a way of getting in their own way and snatching defeat from the jaws of victory, right? When they should be able to buy the business, but for whatever reason, they can't. Get out of their own way. That happens a lot.

[00:18:26] Sean Mooney: Yeah. And you never really even know what's on the mind of the CEO on the board when you come to them.

[00:18:32] And so there's always been just thinking about the actual exits we've been through and you go to them and you talk to your investment bankers and they're convinced that this is the key priority for the CEO of this large public company. And then in a C change, there was a quarterly earnings call that went wrong.

[00:18:48] And then their whole plan changed and no longer interested. So you just can never predict these things.

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[00:19:13] Sean Mooney: With this concept of optionality in mind, you've got to have multiple avenues to exit. First principles, build a great company, but there's a lot that you can do in between making your investment and finally selling the business to another custodian.

[00:19:29] And so I'd be curious, what are some other ways that private equity firms think about returning capital or Or giving kind of additional length and optionality to these companies in between kind of investment in sale.

[00:19:45] Lloyd Metz: I think we could do a better job of helping owner entrepreneurs, CEOs, the leaders of the companies we invest in, understand us as private equity firms better.

[00:19:58] And what do I mean by that? We can talk about our approach. We can talk about our strategy. We can talk about what we do for our portfolio company and the leadership teams that we are investing behind. But I think we could do a better job helping them understand our business. So who are our customers, our clients, and those are the LPs and what do they care about?

[00:20:20] Because the things they care about and want from us, that's what we're trying to deliver by explaining that and the importance of IRR and the importance of a multiple on investment. It can help them understand some of the things that we may propose or we may be pushing for. So like a dividend recap, right?

[00:20:41] Business has grown nicely. It's paid down that nicely. You're inside your recycle period, explaining to a founder that we have a recycle period. And so if we return money to our investors, we get to reuse that money. They want that. We want that. So in year two, when we're saying, Hey, how about we borrow more money and pay all shareholders a dividend.

[00:21:04] It's coming from a place of addressing our clients needs, right? Because our clients actually like IRR making two times your money over four years is great. It's better if you make one and a half times your money in two years and the rest of it over the balance, right? That has a higher IRR helping the leaders of the companies that you invest in understand that.

[00:21:30] And that's a motivating factor. That's, I think, something we probably need to talk more about.

[00:21:37] Doug McCormick: I love where you're going with this. So let's just back up at a very high level, talk about our customers broadly.

[00:21:42] Lloyd Metz: Yeah.

[00:21:42] Doug McCormick: So, you think about private equity, arguably the reason that we've been able to generate returns that are in excess of like public markets is because we have the luxury of more duration, right?

[00:21:52] We're thinking about things in five and 10 years and a portfolio manager for a public equities may be thinking about things on a quarterly or annual basis. That's first and foremost. And then you say, okay, so what kind of customers want that product that we have? It's often endowments, foundation, pens and funds, insurance companies who are trying to manage long term liabilities with investments that will pay out in that long term time horizon.

[00:22:15] As you think about that, to your point, I think there are really three things our investors ultimately look at. They look at MOIC, multiple invested capital. If I gave you a dollar, what did I get back? Two or three. I generally think that's the most important for most of our investors. As people evaluate our performance, it's not only MOIC, it's DPI, Disposition to Paid in Capital, and that I think is the true metric of what have you accomplished as opposed to how do you market your assets, and then they overlay that with an IRR discussion of how long did it take you to compound, and to your point, I think that's a byproduct of how quickly you could execute against the strategy and how much risk did you take in the context of leverage.

[00:22:59] Sean Mooney: For those who are not up to speed on some of those acronyms, explain each of those as if they were a seventh grader kind of a thing.

[00:23:07] Doug McCormick: Yeah, so multiple invested capital, it's simply, you know, if I gave you a dollar to invest, when it's all said and done, how much did you give me back over the whole fund?

[00:23:16] Some people look at it on a deal by deal basis, but at the end of the day, they care about the body of work. The second is DPI. So this is a metric of return of capital relative to investment. So, how much have I actually given you back today based on actual realized results? And I think the challenge in our market is a lot of times you have private assets and how do you figure out what they're really worth?

[00:23:41] And there's some judgment associated with that, but no one can argue about the capital you've actually returned. And so it's kind of the realized record versus the unrealized record. And I think IRR is simply rate of return. Over the investments that you've made.

[00:23:57] Lloyd Metz: And we can probably have a whole nother episode, Sean, around the interplay of those three elements.

[00:24:04] I would make the case that many, most investors care about IRR first and the rest tied for second, perhaps DPI in second place, Mike third.

[00:24:18] Sean Mooney: And the reason for that is I understand, I'd love for you to dial me in on this, but if you think about the limited partners, these are large asset managers, whether it's an endowment or an insurance company, or a high net worth family office, they're looking at private equity firms, not only relative to other private equity firms for the allocation of these large portfolios that they dedicate.

[00:24:43] What are called alternatives, but they're also looking at that relative to other asset classes, like the S and P 500. There's been this benchmarkification and large asset management world where everyone's got to compare versus a benchmark. And the standard one that most people will benchmark, at least in the U S as I understand, is the S and P 500.

[00:25:03] And if you're constantly comparing to a percentage growth on an annualized basis, that means that IRR is going to be the most Comparable to that key benchmark. Is that a good way to think about it?

[00:25:17] Lloyd Metz: That's another way of thinking about it. Absolutely. And again, whether it's S& P 500 or the Russell 3000 or some other index that maps to slightly smaller elements of publicly traded companies, small cap indexes, some investors will comp you to.

[00:25:36] But that's part of the thinking. And again, you can have a whole nother episode on the pros and cons of that approach, but that is the case. So IRR helps you do comparisons across different types of assets. And again, there are pros and cons to that approach as well.

[00:25:52] Doug McCormick: Kind of going down the path of how people think about the tools to manage some of these competing dynamics.

[00:25:59] How long am I going to. allow the business to compound versus delivering DPI or IRR. I think there's a variety of tools. So you mentioned and Lloyd mentioned a dividend recap or a partial recap. So that returns capital along the way that can be helpful for DPI and IRR. I think you're seeing a couple other trends.

[00:26:19] One would be partnership deals where you're finding a buyer that sees the opportunity on a go forward basis. And the existing owners coming along for the ride in some follow on percentage as a way to demonstrate confidence in the future, drive premium value, but also participate in that continued growth.

[00:26:39] And I think another variation of that is a continuation vehicle, which is essentially a way to avail the companies to more access to capital and a longer time horizon and give investors that have been in the business for a period of time. The option to get a full or partial liquidity. And so one of the great things about, I think the private equity industry is a willingness and always a bias to innovating, to solve these kinds of problems.

[00:27:06] Sean Mooney: Those are great points and great vehicles. Cause you think about it at the end of the day, the private equity firm, I think one of the lines we would always say is you can't eat IRR. If you invest a hundred dollars and you return 140 in one year, you've now made 40 bucks, right? But you got a 40 percent IRR in the vehicles that you're talking about, whether it's a recap or it's a continuation vehicle or a partnership that you're bringing in, it allows the private equity firms to go longer while still getting IRR, but also generating multiples of invested capital, which is really what matters, right?

[00:27:45] Can you turn 1 into three versus 1 and a buck 40. Breach and I think those are some of the particular I'd be curious to understand a little bit about what's going on with these where you bring in a partner because that used to never happen in private equity. And then also these continuation vehicles, maybe explain what they are and why they add value.

[00:28:05] So not only the LPs for reasons that's important to them, but also to the management teams

[00:28:11] Lloyd Metz: and to the investors. And Doug, when you talked about bringing in a partner, you meant like another GP, another private equity firm coming in. Yeah.

[00:28:19] Doug McCormick: Yeah. And I think that's been prevalent here in the last, I would say two years because it's a choppy financing market.

[00:28:27] There's lots of economic uncertainty. And so I think The alignment of incentives and deal structures that demonstrate that the existing owner has a lot of conviction in the future, I think are very appealing to both buyer and seller. I also think there's been this increased focus on consolidation strategies.

[00:28:44] Consolidation strategies require additional capital. And so if you've got a great consolidation strategy in the works and you have a time period, that's not optimal to sale. You also have a financing need. And so it's solving the business problem of making sure that that M& A strategy or that consolidation strategy can be funded along the way.

[00:29:06] It seems to me that these structures are solving real problems for the GP and the consolidator by elongating duration to sell at an optimal time, and ensuring access to capital to, Continue the consolidation strategy. I would characterize the CV or continuation vehicle as simply a nuance of that, which is rather than bring in a new GP partner.

[00:29:30] Another private equity firm, you're bringing in a new set of investors who have a new duration and new access to capital. So it accomplishes the same purpose. It's just a different financing process to get there.

[00:29:41] Lloyd Metz: As Doug said earlier at the top of the show, the private equity market is pretty broad, deep and liquid, and there are more information tools at GP.

[00:29:51] So you can track, you can identify and track companies that you want to invest in. And for example, if Doug bought a business in a process and HCI buys it, and let's say I was first runner up or second runner up and I still like the space and I still like the opportunity, I could very well just track it and every so often ping Doug or email Doug or take him out to lunch and say, Hey, how's it going?

[00:30:16] And as it sounds like it's tracking and they're executing on the strategy at some point, I may just say, Hey, Doug, Doug. Can I come in with you? Give you a win, give your LPs a win, I get to put money to work in something I've looked at and liked. And we hold hands and we go skip down the yellow brick road together.

[00:30:33] And that is often how those partnership opportunities come about.

[00:30:37] Doug McCormick: Hey, Sean, for the record, Lloyd has not pinged me, bugged me or asked me to lunch.

[00:30:46] Sean Mooney: All right, Lloyd, you're on the hook. It was just, it was just an illustration,

[00:30:49] Lloyd Metz: just a hypothetical.

[00:30:51] Sean Mooney: But I think your points are really good ones in that. The PE world used to be so much more binary. It's like one person, one and 99 lost. And then two, the thing that always struck me is if I were to kind of reflect what I wish I had before I became an operator and I was in the PE world, it was when you had a really good company and you're getting ready to raise another fund, you often had to make a choice about which one of your portfolio companies you needed to exit because there's this pressure to return capital.

[00:31:23] And it was often one of your better companies. And so it always just like hurt me in my inner core, because you knew that it was so much longer to take this company in terms of Doug, that duration concept you talked about in what this evolution of kind of these partnerships is the evolution of these continuation vehicles.

[00:31:41] It's letting kind of. People have their cake and eat it to a little bit where they can deliver IRR, which is important to the LPs, but while also getting multiple invested capital of being able to go longer and longer, is that a good way to think about it?

[00:31:54] Lloyd Metz: Absolutely. And again, this is back to the innovation that Doug referenced in the private equity industry.

[00:32:00] Like, we're always trying to solve problems. I love how you put it, Sean. We're always trying to figure out how to have our cake and eat it too. We're always trying to figure out how to retain as much optionality as we can.

[00:32:11] Doug McCormick: The one thing I'd say is, and I'm going to double speak here, but so I'm a huge believer in play the long game, take advantage of duration, build a business that you're willing to own forever.

[00:32:19] That's point one point two. I would say in our industry, it's easy to fall in love with your business. You fall in love with the teams and you think you want to ride that horse forever, right? So you got to be objective and dispassionate about when the right time to sell is. And then the last thing I would say is like, I feel like there's the emotional roller coaster of private equity ownership is more volatile than the objective performance of the businesses.

[00:32:46] And what I mean by that is when it's, when you think it's really good, it's never that good. And when you think it's really bad, it's unlikely that bad. And so some of the art here is. Separating the emotion from the objectivity of where you are in the cycle, where you are in the journey of the business, and really forcing yourself to be disciplined about when's the right time to part ways.

[00:33:05] Lloyd Metz: Yeah, and that's a great point, Doug. So whether you practice your own personal exercises to establish objectivity in your own thinking. Or perhaps at some firms, the decision to exit an investment is sometimes taken out of the hands of the actual investment partner, the investment team, for the reasons that Doug's highlighting.

[00:33:28] I

[00:33:29] Doug McCormick: had never heard of that. That's really interesting though, Lloyd.

[00:33:31] Lloyd Metz: Yeah. Somebody who has enough distance to make that call. And I bring that up because as we were talking about that founder, that CEO, you know, they May take it personally as if there's been some sort of shortcoming or failure in some aspect of the execution or the relationship and may say, Lloyd, Doug, what's going on?

[00:33:53] Right and they need to understand back to the point about understanding more about private equity. It's not personal. We have to go at some point and whether I made the decision or whether. Our investment committee or partnership of our firm made that decision. Now you have to seek liquidity for our investors and find you a new partner.

[00:34:13] And so they need to understand those nuances.

[00:34:17] Sean Mooney: I think it's a great subtlety of it. And kind of the personal element of it is that it's not personal. It's just part of the business. And I think if everyone has their druthers, you keep on going, but everyone marches to the beat of someone else's drum and the GPs have to return capital over time, that's part of their business and what their bosses want.

[00:34:36] Lloyd Metz: That's right.

[00:34:37] Sean Mooney: So, let's talk about one more element that, at least to me, is a bit provocative, but also gives you kind of an intermittent option, and it's the concept of what's called an ESOP, which is an Employee Stock Ownership Plan. So, do you have any perspectives on that? Is it a tool that can be valuable?

[00:34:57] Why is it valuable, etc.?

[00:34:58] Doug McCormick: I would say it is one of many tools that I think is valuable, not just for private equity, but across the ecosystem of financing, generational wealth transfer, et cetera. And so, in my mind, some of the most compelling attributes of the ESOP program are actually A way to facilitate transition and liquidity for entrepreneurs, given the way that there are tax benefits associated with ESOP and given the way those tax benefits are structured, they really benefit the seller who happens to be an individual or a family most.

[00:35:29] But I think some private equity firms use ESOPs or some variant of them as a way to get alignment of incentives across a broad employee base. And in some ways, the ESOP structure can be used and the, the private equity firm can be a financing source more so than an outright owner. So lots of complexity, but also lots of flexibility associated with ESOPs that can be pretty appealing.

[00:35:53] Lloyd Metz: It can be bought from an ESOP. And that has its set of complexities. We've never used an ESOP to buy a business, but I think the real point that you're touching on and something we try to accomplish as much as possible when you take ownership, economic ownership, equity ownership. And broaden it out in an organization.

[00:36:14] Our experience has been, you get better results. You get more people at the firm beyond the CEO and CFO and the C suite even thinking like owners. The more you do that, you'll get better ideas, better execution, better consensus building and decision making. And the results can be pretty spectacular. So we try to encourage ownership more broadly in our portfolio companies and the companies we invest in, and we try to find vehicles to transfer more ownership.

[00:36:50] So even after the initial investment, we try to find ways to allow people to buy more equity during our investment hold period. And ESOP is writ large, a way to do that on turbocharged steroids, but it's complicated, but the spirit is something that we actually subscribe to.

[00:37:10] Doug McCormick: I like where you're going there.

[00:37:11] Forget about. A specific format. The concept is whether it be the entrepreneur that you're partnering with, or whether it be the management team, alignment of incentives, skin in the game. Right.

[00:37:24] Lloyd Metz: Yeah, absolutely.

[00:37:25] Sean Mooney: And I think that'll be another really good topic. How do you provide the incentives and align incentives to drive outcomes?

[00:37:31] And Lloyd, I loved your point too, as well, about the. Empowering your employees to think like owners and act like owners. And one of the best ways to do that is equity upside. And certainly I think one of the reasons that the private equity industry pretty much outperforms all because they give ownership stakes to those that can make impacts.

[00:37:51] Lloyd Metz: We try to encourage equity ownership, not just equity upside, right? Cause if you just get equity upside, the implication is you don't get the downside. Part of that dynamic is what drives. An equity investors mindset, approach to execution, sense of urgency, the downside fear motivates, but that's another episode.

[00:38:12] We'll get to that some other time. Absolutely.

[00:38:15] Sean Mooney: So let's talk about is we kind of bring it to a head here. You've got an idea of you're going to build this great company. You're comfortable that there's optionality on the exit. What are some of the pitfalls that business builders should be aware of as you're going into this plan and you want to kind of protect against, there's a great line from Oscar Wilde that I live by in many ways, or try to not live by actually, but it's like, he said, I can resist everything except for temptation.

[00:38:42] And so there's a lot that you can do as you're doing this. And what are some of the pitfalls that you can get in trouble with

[00:38:48] Lloyd Metz: before you even get started? Given the nature of our business. We do keep. Liquidity events exits, if you will, always in mind, it's always running in the foreground in our conscious mind.

[00:39:02] I don't know if it's as pressing and ever present in the minds of the leadership teams at the portfolio companies. And where I'm going with this is if you, let's say, don't necessarily get to everything with finance or technology or what have you in year one. And you don't necessarily get to everything.

[00:39:24] In year 2, and you don't necessarily get to everything in year 3, well, that all accumulates and compounds and shows up in the outcome when it actually is time to exit. And so when the leadership team start thinking about the liquidity event, the recapitalization, the private equity sponsors exit, and a new private equity sponsor coming in, oftentimes they will start thinking about it as if it's another one of this year's projects.

[00:39:53] And unfortunately, a lot of what you can do, it's too late. That's what year one and year two and year three was about right now that we're trying to find a new, a new private equity sponsor in year four. A lot of the cake has been baked and there's only, but so much he can do. We're talking about frosting.

[00:40:11] We're talking about sprinkles, right? The cake's been baked. And sometimes I don't know if all the leaders fully grasp that. I don't know what you think, Doug.

[00:40:22] Doug McCormick: Yeah, totally aligned with what you're saying here. So, For me, I think the first mistake is the converse of what I said earlier about building a business you'll own forever.

[00:40:32] If you get forced into trying to hit an exit timing and you start cutting corners because you're trying to rush to get out, I think that's a very dangerous scenario because if you end up holding longer than you expected, you got to live with those bad decisions. So that would be point one. Point two, Thank you.

[00:40:49] is these M& A processes are very, what I would characterize as information or data intensive. And I find that that manifests itself in two dynamics. One is in a consolidation strategy, when you're buying other businesses, the value of having good clarity of information, how did the businesses perform on a pro forma basis?

[00:41:08] What's my customer concentration? What's my margin profile? All those kinds of things become really increasingly important. So making sure that you are. M& A strategy doesn't get ahead of your integration strategy, I think is critical. And then the last is a joke, but there's sincerity to this, which is, I always feel like I learn a lot about the business when I go to sell it that I should have learned three years before, because you have the process of somebody else coming in and trying to learn the business, which forces introspection.

[00:41:37] And so I'm a big believer in, before you go to market, have another team internally or somebody else, like, Try to do diligence on the business and ask all the questions that they would have asked that you're likely to get in your process because a lot of times the answers aren't readily available and If you don't have them prepared you haven't been through the process.

[00:41:58] I think it really slows down good competitive process

[00:42:01] Lloyd Metz: Absolutely agree a hundred percent with that and again just even that last point that you made Doug I don't know if all management teams if they've never done it before if they've not gone through recap process You Don't appreciate how the ease of which you deliver answers to their questions and they're going to bombard you with a lot of questions and to the extent you can effortlessly answer them, provide them with schedules or whatever it is actually builds confidence in them that you know what you're talking about, you know what you're doing and you have control over your business.

[00:42:35] That's a nuance, but it's big. And so that's a whole nother conversation, Sean, you know, a lot about, but just the preparation for this kind of process is not trivial.

[00:42:45] Sean Mooney: A thousand percent. And I think the best companies, they start preparing for sale the day they're invested in by a private equity firm, meaning like keeping their data clean, being prepared, knowing where they make the money, their market size, their five year outlook.

[00:42:57] But also if you're going to sell a company, if you do it well, The best. People at selling their company spend just as much time selling their company as they do buying one. I think that's another topic that we will absolutely dig deeper into in the days ahead here.

[00:43:15] Doug McCormick: The only thing I'd say about the way you characterize that, you're saying the best companies are the ones that prepare for sale day one.

[00:43:20] I think the skill sets that make you exceptional owners are also the skill sets that make you an exceptional seller. And they're not like two different things, like knowing where you make your money, knowing what your value proposition is, having good clean data is a fundamental part of being a good owner.

[00:43:38] Lloyd Metz: That's great advice there. Well put, Doug. Well put.

[00:43:42] Sean Mooney: That's all we have for today. Special thanks to Doug and Lloyd for letting us post this special crossover episode. If you'd like to learn more about the Best But Never Final podcast, please see the episode notes for links. Please continue to look for both the Karma School of Business and Best But Never Final anywhere you find your favorite podcasts.

[00:44:04] We all truly appreciate your support. If you like both of these, either of them, etc., please follow 5 Star Rate, review, and share them. This is a free way to support these shows, and it really helps us when you do this, so thank you in advance. In the meantime, if you want to be connected with the world's best in class, private equity grade, professional service providers, independent consultants, interim executives that are deployed and trusted by the best business builders in the world, and you can do the same, give us a call or visit our website at BluWave.net. That's B L U W A V E, and we'll support your success. Onward.

Private equity insights for and with top business builders, including investors, operators, executives and industry thought leaders. The Karma School of Business Podcast goes behind the scenes of PE, talking about business best practices and real-time industry trends. You'll learn from leading professionals and visionary business executives who will help you take action and enhance your life, whether you’re at a PE firm, a portco or a private or public company.

BluWave Founder & CEO Sean Mooney hosts the Private Equity Karma School of Business Podcast. BluWave is the business builders’ network for private equity grade due diligence and value creation needs.