Private Equity Pulse: Steering Through Economic Uncertainty

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of best, but never final. Hi, I'm Lloyd Metz, joined by Doug McCormick and Sean Mooney. Together, we'll navigate the quarters of private equity, revealing the uncommon knowledge, challenges, successes, and challenges. and lessons that drive the world of private equity and business forward.

Let's go.

[00:00:37] Sean Mooney: It is great to be back with Lloyd and Doug. Gentlemen, how are you?

[00:00:41] Lloyd Metz: Hey, Sean. Hey, Doug.

[00:00:42] Doug McCormick: Very good. Thanks. Good to see you guys.

[00:00:45] Sean Mooney: Absolutely. It's always good. So today we've got, I think, another really interesting topic to spin here and discuss. What we're going to go through today is going to be one of the more kind of timely episodes that we have and so we're going to talk about the economy that exists today and we've kind of persisted in over a period of time.

We're going to talk about how this is being reflected or isn't being reflected within your own portfolio companies, Doug and Lloyd, and then we're going to talk about how you use the private equity playbook as a business builder to navigate. What appears to be coming forward. Does that sound like a good plan?

[00:01:27] Lloyd Metz: Sounds great. It's in all the headlines. We might as well tackle it, right?

[00:01:31] Sean Mooney: All right, let's hit it. Maybe before we jump in, I'm just going to set the stage with everyone's favorite topic, statistics. So we'll just like set the stage. We'll go through it quickly. It'll be a relatively rapid prattle here in terms of what everyone's seeing, but I think that'll set the stage in terms of the rest of the conversation.

And so first, what everyone I think is seeing right now is we have growing GDP that is good, not great. So you've got seven positive quarters of GDP growth after two negative ones in 2022. Recently it's been tapering, largely and probably as a result of some of the Fed policy with raising rates, which is trying to tackle inflation.

And so what we have is also moderate inflation. So it's three and a half percent in March, which was down from 9. 1 percent in June, 2022. So down a lot. But the last leg of inflation has been quite sticky. But then if you look at that same time, you've got really strong consumer sentiment. So if you look at the University of Michigan Consumer Sentiment Index, it's at 77.

2 right now versus 63. 5 a year ago. So it's getting better, not worse. And then the business sector also pretty good lately. You've got the services producers manufacturing index, which measures kind of productivity and output. It's been greater than 50, which signals either flat to up since January of 2023, a year ago.

And then more recently, the manufacturing sector is also showing growth. So the producers manufacturing index has been up for four months in a row, at least 50 or greater. Now, on the flip side of this, you have a lot of change and anxiety and risk. You've got huge geopolitical risk. You've got a major election cycle, not only in the U.

S., but globally. There's huge amounts of technological innovation undergoing right now, which is, you know, one of the biggest periods of change, arguably, in modern commercial history with the rise of AI and chat GPT and all those similar type tools. So that's kind of as it exists today. Anything to add to that, Doug or Lloyd, or is that a good kind of survey?

[00:03:35] Lloyd Metz: Don't you think that's enough? That's a lot. Holy moly.

[00:03:38] Sean Mooney: Half our listeners have turned out by now, but I promise you it's going to help.

[00:03:44] Doug McCormick: Hey, Sean, I guess I'd just maybe ask a question for you guys. The one stat there that just jumps out at me, it's super surprising, is the strong consumer sentiment. And I say that in the context of just affordability and wage growth versus overall inflation and how that is hitting Main Street America in the pocketbook in terms of purchasing power.

I'm not sure how to reconcile that observation, but I'm surprised at how resilient the consumer's been. And I guess I can only point to, I think, coming into this change in interest rate environment, Consumer balance sheets were actually pretty good, and I think we may see, as consumers continue to tap into the balance sheet for consumption, that that sediment tapers off.

[00:04:26] Lloyd Metz: That's a good point that you raised, Doug. Some of this commentary, Sean, about the stats and the like, I think sometimes miss some basic facts, right? So, yes, inflation at 3. 5 percent is still an increase. Yes, it's a lower increase, but it's on top of all of your historical 9 percent 7s and 8s, right? So that absolute price level continues to get higher, although at a slower rate.

That's the definition of inflation. If you starting from a place where things were expensive relative to someone's income and they got even more expensive and your real income hasn't caught up, then what Doug's bring up in terms of affordability still has gotten worse and continues to be bad, right? So I think you probably need to do a little bit of digging and parsing between different pockets, different regions.

Different areas socioeconomically to figure out where people are feeling the pain or the discomfort from the current economy. That's my reaction on that point. And then John, you asked, is there anything else? I don't know. The treasury balance sheet's pretty big. Deficit spending is kind of near. Levels as a percent of GDP that we haven't seen since the forties and we kind of know what happened during the forties and with higher interest rates, how's that going to work?

Right? So depending on who you follow and what you read, the interest expense on the national debt is going to surpass the defense budget. Right? So how's that going to work out? I don't know. There's a lot. So where do you want to go with that, Sean?

[00:06:11] Sean Mooney: I'm going to go have a drink. I'll see you guys after the episode.

It's enough to, you know, with all of this noise,

[00:06:20] Lloyd Metz: I've been calling you to drink on the podcast.

[00:06:25] Sean Mooney: It's one of those things I've been calling it a washing machine economy that we live in where it's like, good news, bad news, good news, bad news. But net net, as I pull some of the signal from the noise, it seems like there's two good news is for one bad news, but there's still a lot of scary things out there.

And it certainly just doesn't feel like, at least in the retrospect, some of the other kind of cyclical upswings that at least I've been through, through, I guess what, late nineties. Mid 2000s, you know, and then everything in between in terms of recessions. I don't know if there's a good comp, at least during my kind of adult life.

[00:06:58] Lloyd Metz: Yeah. I don't know about you, Doug, but it's one of the things that I like most about being in the lower middle market. You have all of these companies all over this country and they only know one way and that's to go forward. Right. So they figure it out. They grind it out. They work it out. Right. Right.

And oftentimes the experience at the lower middle market company level can be very different than what you read in the papers or what you see on CNBC. During the great financial crisis, we had a consumer discretionary business. That did not have a decline in EBITDA through the entire recession. It was so bad.

And, you know, the CEO's like worried and spinning himself up emotionally about all the stuff he's listening to on the news and reading. And I was like, but look at your business. And what you can control and he and this team grew that business through the GFR or GFC, whatever you call it these days. And so I think that's one of the beauties of being in the lower middle market.

Doug, I don't know what you think.

[00:08:02] Doug McCormick: I totally agree and I think it dovetails into your comment about It's easy to talk about the macro economy with all the statistics that we described, but I think to really derive insights that are actionable, you got to get pretty granular, whether it be region or whether it be type of industry.

And so we've talked about some of the different industries like commercial real estate and where it sits in its cycle. But I think the real discussion is an interesting one around, Interest rate sensitive businesses or industries and how they're faring in this environment. And for me, as I hear the aggregate discussion, I think, Sean, you would say feels like the economy is doing pretty well.

I think I would say the same thing. And for me, the key insight for investors. It may be less about, is the economy going into recession? Is it growing? And more about, to Lloyd's point, with deficit spending where it is, with the Fed balance sheet where it is, I think we have less tools to be accommodating.

And at these kind of interest rates, I think one of the big questions for investors is, what's the right cap rate, right? And so it may be less about, what am I going to grow here in the next several years? And is cost of capital 12 percent or 16%? And it's not clear to me the markets fully. Digested. What long term rates are going to be in there for what the appropriate cap rate is.

[00:09:21] Sean Mooney: I think that's going to be an interesting part of our conversation when we get to kind of, how do you play the hand that's dealt here? And we get into kind of, what do you do? But maybe before we get into that part of the conversation, let's talk a little bit about how you're seeing this kind of washing machine economy play out in your own portfolios.

Kind of bring some examples to it. Can both of you give some examples around what you're seeing right now?

[00:09:47] Doug McCormick: There's an interesting article in the journal this morning or yesterday about green shoots on Wall Street. All the financial intermediaries are seeing green shoots and things that lead them to be optimistic about transaction volume.

I think I see that too. I would say all deals are hard these days, and they're always kind of hard. But they're harder than normal, just given all these exogenous factors we talked about. I thought it'd be helpful maybe just to give you guys a snapshot. And I'm going to talk about 2023. We're just into 2024.

2023 is pretty representative, I think, of what's happening in 24. But if you looked at our most recent fund, so we're actively investing out of this fund. In 2023, we did two platforms and we did 12 add ons. So we've got nine platforms total with the addition of those last two. And if you look across those different platforms, seven grew organically in 2023, two contracted in 2023.

And I would tell you roughly the weighted average growth rate across the portfolio organically was in excess of 10%. We're acquisitive and so you add on acquisitions and it's a fair bit more than that, just given the benefit of incremental scale through acquisition. And I would generally say EBITDA is growing faster than revenue.

I think some of that's operating leverage, you know, it should. And I think some of it is 22 was a pretty easy comp. We were seeing compression of a lot of margin in 22, just given how prices were playing through the supply chain. But, you know, those stats are pretty positive. I mean, I think if you say that's a microcosm of the broad economy, I think we'd say we feel pretty good about the world.

Maybe just offer one more insight. So I talked about two that contracted, and I would tell you if you looked at the reasons for that, one is interest rate sensitive end markets. It's a business that serves residential housing, renovation, and construction. So that slowed way down in the context of cost of capital and new starts and disposable income.

And then the second one, it's actually in an industrial market where the demand profile is pretty solid. And I think we executed poorly. We lost some sales. We executed poorly on supply chain management in a way that we weren't able to take advantage of demand that was in our marketplace. So I would really say eight out of the nine had markets that were accommodating to pretty good growth prospects.

I think 24 is a continuation of 23 and I would say 24 feels so far a lot more like the second half of 23. And the second half of 23 was a lot better than the first half of 23 for us.

[00:12:24] Sean Mooney: That makes a ton of sense. And certainly something that feels familiar to what we're seeing. And maybe I can go into that a little bit, but before we do that, how about you Lloyd, what are you seeing within your portfolios?

[00:12:33] Lloyd Metz: So we have a slightly larger portfolio than yours, Doug. We've got 15 companies in the portfolio. A fair number of them are B2B businesses. We have four healthcare companies. And when you look over the portfolio and we do this every quarter, most of them are growing EBITDA year over year as of the first quarter, the four of the 15 that had difficulties and EBITDA compressed, two were what I'll call execution related, right?

Just internal specific issues to that particular company and their approach to the marketplace. Two of them were marketing driven businesses. Their customers are other corporations, but those corporations, their clients, their customers are selling through to individuals, to consumers. And last year and continuing into this quarter, there was a bit of a pullback as it relates to marketing spend.

And perhaps it was driven by a lot of the talk about imminent recession or something to that effect maybe. Maybe it was driven or exacerbated by an increase in some of the costs to digital marketing as it relates to physical marketing. Postage rates have increased 40 some odd percent, so that doesn't help the cause.

So, we saw material rollback in some marketing services investments that we have. But on the other hand, we have another one that has been growing at double digits, right? But they're a pretty niche marketing services company. So it varies a little bit, but we did pay attention when we started to see marketing dollars and marketing budgets start to get reined in.

That can often be a leading indicator. But so far it hasn't heralded anything significant. This episode is brought to you by HCI equity partners, a lower middle market, private equity firm focused on partnering with family and founder owned manufacturing service and distribution companies, ICV partners.

An innovative private equity firm supporting management teams of leading companies at the lower end of the middle market and BluWave, the business builders network, connecting the most proactive business builders in the world with the best of the best service providers for critical variable on point and on time due diligence and value creation needs.

Now, back to the episode.

[00:15:19] Sean Mooney: That's another kind of consistent read and as I look at kind of our own data, which in some ways reflects what you all are doing, I usually will get kind of a conversation with it's almost like a, how you doing? They all look at the news from last year and the deal market was like down and nothing was good.

And they're like, almost want to put their hand on my shoulder and like, how you, how you doing? I'm like, I'm doing okay.

[00:15:42] Lloyd Metz: I will say we have investments in a couple of consultancies. They're doing really well, right? So I would imagine your business is doing better than just okay, right?

[00:15:52] Sean Mooney: As I looked at it, and we don't publish our internal statistics, but it was last year was a meaningful, meaningful double digit growth number.

And the first half was relatively slower. The second half of the year was much faster. The first five months of this year are much faster than that. And so everything that we look in our own data, which is a reflection of yours, even though there isn't really a deal market yet to speak of, there's a ton of value creation going on.

And so what we do is kind of what I just take homage and guidance from you all. So we increased our headcount 40 percent last year. And as I look into right now, what's happening. There's a whole host of interesting measures that go beyond even kind of the statistics of the economy. And so what was really curious in the first quarter of 2024 is that we saw diligence activity related to manufacturing up 62 percent, and that's staggering.

And we saw healthcare up 50 percent. Both of those parts of the economy have been kind of out of favor and in kind of cyclical decline over at least the prior couple years. And so we're seeing PE kind of say, Hey, we're coming through this. They're measuring their sentiment with their dollars, putting their money where their mouths are, if you will.

And then the other thing that we saw that was really interesting was We saw a 40 percent surge in technology related projects in the first quarter of this year, and these are the large tech projects, and these are the things that almost always get put on the shelf. Think about your ERP system. Every time there was a down cycle in my career in PE, you would tell the CFO, yeah, sorry, ERP's next year, and you take it out of the budget and put it in the next one, or the CRM system, or large marketing automation systems.

All of those are coming back on. And so it's not like clear, every light is green along the road, but you're certainly seeing people kind of hit the gas a little more and go a little bit faster, a little bit faster as we head into the new now. I still do think, really, to the points of some of our earlier conversation, we might be hitting the gas, but people are definitely keeping both hands on the wheel and have one eye where the brake is.

Is that maybe a fair way to describe where we are?

[00:18:05] Doug McCormick: Yeah, I think so. Still lots of risks that I think people either perceive or are experiencing, and a lot of variables that I think you just are unknowable.

[00:18:14] Sean Mooney: So it's a, particularly as you think about the lower and the middle market of private equity, these are kind of Raceboats.

You can go left and right really quickly, and you can go faster and slower. And so maybe our perspective here that we're, I think, collectively talking about are probably more shaded in the raceboat idea than the big tanker ships that maybe can displace water and get through the big storms with a little more certainty, but they can't go left or right nearly as easily either.

[00:18:41] Lloyd Metz: I'm not sure about the choice of metaphors, but I guess I will go back to at least this point. And I'd love to get your point of view on it, Doug. We're thinking about our investments over a three, four or five year horizon, right? And I'm not an economist, didn't really study it in college or anything, but last time I checked, most recessions, downturns in the United States don't last very long.

Two quarters, three quarters, and maybe there's a hangover of an additional quarter of a malaise or something. You want to be mindful of it, right? Like you don't want to do anything flagrantly, blatantly not smart heading into a recession. But to the extent you are investing in a business that you think is resilient, has a reason to be, has a compelling value proposition, et cetera, you capitalize it the right way.

So Doug already raised that. So we'll circle back to that. But the bottom line is you got to invest in making that business better. And then at least in my view, that's an all weather strategy. So whether a recession is coming or not, it's a good time to do an ERP. If you need one. To get you the data, to get you the capabilities, the responsiveness, the market timeliness, control over your processes, all that stuff, to help you be a more effective competitor in your business.

Like, yes, you should do that, right? Upgrading talent, upgrading leadership, finding out how to get closer to your customers and understanding what needs they have so you can develop new and more innovative products. Like those are things that you should generally do no matter what you think the outlook is.

That's kind of the mindset we have.

[00:20:23] Sean Mooney: How about you, Doug? What's your kind of level of conviction? And then maybe after this, let's talk about that playbook for each kind of facet of a company. Both of you are thinking about kind of playing this hand.

[00:20:33] Doug McCormick: I generally agree with Lloyd in the context of if you're playing the five year game, you're going to play through cycles.

And so part of our job is to put a field and a strategy and a capital structure together that can accommodate some volatility. And let's acknowledge the lower middle market, there's often valuation discounts associated with that, but that's partly because We're playing with volatility on volatility, right?

So if the overall economy has a certain volatility profile, these small businesses have an even greater profile of volatility and volatility is not always bad, right? We can dramatically grow, or you can be one customer away from a significant loss of revenue, just given size of the business, customer concentration, those kinds of things.

And so I do think the all weather strategy makes a ton of sense because The things that we're doing with our business, we think we can execute in good economies and bad economies, especially if you've set your strategy up in a way where you have multiple chances to dollar cost average, if you will. So if we're doing a consolidation strategy, I may be deploying my first capital today, but my average.

Dollar deployed is going to be two and a half years out. So today's economy is relevant, but it's really hard to predict what the environment is going to be deploying capital in those follow on investments.

[00:21:52] Sean Mooney: Let's turn the page here and talk about how do you kind of activate this understanding and head through these storms as they pass through with kind of an all weather perspective and a longer term mindset on building companies.

And so. For each of you, as you think about your portfolio companies and really for anyone who's building a company and leading a company or in a company, how do you think about revenue and growth? What are some of the things that you can do to keep that heading in the right direction during times like

[00:22:24] Doug McCormick: now?

I guess the first thing I'd say, I think the clarity of strategy becomes increasingly important in these volatile times. When it's up and to the right, it's easy and everybody's full steam ahead. And I think really having clarity and conviction and alignment across your partners and your management teams about, okay, what are we trying to build and where are we headed?

I think allows you to kind of navigate some of these choppy waters. And you know, you mentioned a series of areas of engagement, revenue, costs, HR, technology acquisitions, and like, how do we think about prioritizing those? I think Lloyd nailed this one. I think it's. All of the above. And to me, all are valuable levers.

It's more about the company's maturity and capacity to deploy them than it is about one versus the other. Because the ROI on all of them has a chance to be, in most businesses, really compelling, especially where Lloyd and I play, right? Because there are things you can do with the business to improve the capabilities that avail yourself to whole new opportunities.

And maybe just to start off with one, which I'll talk about is revenue or to me, biggest activity today is the pricing discussion. So revenue related, and we play in a lot of businesses that have some commodity aspect to it, like distribution. And I think price discovery is just such an important part of that market right now, because we've had such a run up in input prices and freight that everybody had to increase price.

Now, I think the market's normalizing, customers are shopping, and we're trying to figure out do we use this period of decreasing prices to go gain share, or do we use this period of prices to recoup margin? So I think there's a lot of action in the market generally in pricing and how to think about go to market strategy today.

[00:24:11] Sean Mooney: I think that's a great point. It's one of the most active reasons that we get called from P firms, like your firms, is exactly for pricing strategy. If you get that right, it's one of the best ways to A, enhance productivity or B, grab market share. If you're thoughtful about how to use this in an intelligent, thoughtful way to create value.

So I think that's something that every business builder should be using, but it takes conviction and it takes intestinal fortitude because nine times out of 10, when you're about to use it, the head of sales is going to fight it. And not only for the reasons they should.

[00:24:46] Doug McCormick: And I can't think of a time in my 20 year career where I've seen less clarity about what the market is commanding for price, because it's just all over the place.

And so I think, you know, you got to have conviction in competitive position, your cost position, you know, the right to be.

[00:25:02] Lloyd Metz: Doug, you bring up some good points. I think Sean, if you really want to go down the rabbit hole on pricing, there's just so many interesting, sophisticated ways. To set up your pricing structure that matches up with your business, right?

So having understanding of your processes, your costs, your operations allows you to be creative on the pricing side in a way where you don't have to fight your salespeople as often or as hard as you might think. What am I saying? Hey, if I'm your customer, Sean, and you bid me a price because I think I'm going to buy 10, 000 to 20, 000 widgets from you.

Great. But if I buy 30, 000 widgets from you or 5, 000 widgets from you, you can actually charge me different prices, right? Because the price you gave me was kind of assuming a certain range of volume, for example, if your business model is like that. And oftentimes companies aren't always thinking that way.

They're just thinking straight sticker price. Price increase, right? But do you have to know enough about your business to know, is it the little customers that are driving my costs the wrong way or are costing me more to service or is it the big ones or is it the jobs on Friday that we're producing versus the rest of the week or whatever it is, right?

But you need to have a good understanding of your business in order to start introducing these things that help you get price back.

[00:26:31] Doug McCormick: A little bit off topic here, but totally agree with what you're saying. And I can't help smiling because the intellectual debate around what to do once you have good information is pretty simple.

But man, is it hard to isolate? Like it's Friday, my bad production day. Is this customer really that profitable or that unprofitable? And so one of the key challenges that we all face in the lower middle market kind of relates to technology is quality information upon which to make quality decisions.

One of my partners has a saying that Smart people, equally informed, generally come to the same conclusion, right? But the problem is, in many cases, we're often dealing with different information or different assumptions about accuracy of the info.

[00:27:12] Lloyd Metz: Yeah, that's right.

[00:27:13] Sean Mooney: The pricing topic is interesting because it's always a bit of a provocative topic.

Because the pundits will say, how dare you raise prices? It's something that's salacious, it's not fair. But the reality is, particularly in an inflationary environment, if you don't do that, you're risking existential threats. That's right. that will impact not only your ability to grow, but your ability to reinvest in your companies.

And so I was having a conversation with another friend of mine who's a partner at another P firm, and he was talking about, no one likes to raise prices. Your customers don't always like it. Your salespeople certainly don't like doing it, but ultimately what that's going to enable you to do is to make more income.

That's going to allow you to reinvest in your products and services that are going to create greater utility for these companies and these customers. Two, three, four, five years down the road. And so maybe move one, you kind of say, how dare you do this, but move to in the reality of the way business in the world works, it's letting you do things that will ultimately benefit your customer multiple steps down the chess board in ways that they don't always even perceive.

It's not a topic that I think anyone really likes to talk about, but it's something that I think is so essential, particularly in an inflationary environment that we live in today.

[00:28:23] Doug McCormick: The one thing I would offer up on that one is I don't think these changes in price, are forever, right? And so in many cases, my advice is I'm asking people, I'm encouraging them to test.

Let's make changes and evaluate what happens. And I think the other thing that helps with this pushback, when you talk about pricing, people want to resist it. I always say, listen, I'm as open to decreasing price as I am increasing price. And what I really want to do is maximize GP dollars in most cases.

And if you can make an argument to me that if you price this 10 percent lower, you could triple the volumes, I'd be doing that deal all day. So it's more about let's objectively have some data to make decisions about what the market will bear, both positively and negatively. And some parts of our portfolio, we should be increasing price.

And in likely cases, some parts were probably overpriced and we need to be more competitive.

[00:29:12] Lloyd Metz: And you have to be careful, Sean, and Doug's touching on this as well, right? You want to be careful that the conversation about increasing price isn't a crutch to cover up cost increases that arise from just not being as efficient as you ought to be or not rethinking your processes like you ought to or rebidding your suppliers or whatever it is, right?

Right. You need to marry the two together, right? You can't sort of neglect taking care of your operations and your efficiency and your rethinking, how many parts does it take to make this widget? Can we do it in fewer parts? That's another way to address inflationary pressures too, but. Just got to make sure you're doing that too, in addition to just talking about increasing price.

[00:30:01] Sean Mooney: I think that's a great kind of segue to the next topic of operations and costs. And before we do that, maybe one other point I'll make for people, particularly building and growing companies and what we'll call the traditional economy companies. And so these are. Companies that make products, manufacturing, et cetera.

And so one of the things that you want to make sure that it's not lost on people is this whole notion that the sales funnel in many ways it flipped. Historically through a lot of the modern commercial era, it's been 80 percent sales, 20 percent marketing. Gradually slowly but surely marketing has been rising in prominence and sales has been going down in terms of impact on funnel.

Mostly that's been on like software companies and business services. What's happened really since COVID in the traditional economy, it was a huge accelerant. Everything went virtual, everyone put in systems, everyone embraced marketing. There are huge digital measures that now every company can use. And so what we've seen since 2020.

is a huge shift for every company embracing these digital signals and doing more and more marketing in a super targeted way that used to only be able to be done with someone doing a handshake in a conference. And then the world, the entire world saw the benefit of these tools. So don't sleep on the marketing tools.

Don't avoid embracing them because they can have a huge impact on incremental growth in your companies. It's not, or it's, and you're still going to do sales and you're going to do it better, but you're also going to embrace marketing ways you haven't before.

[00:31:33] Doug McCormick: I generally agree with the premise. I just would ask you, I sometimes struggle with translating cause and effect clearly in a way that I can justify good ROI.

And so if you're not careful, everything sounds like a really good ROI. How have you navigated that or how are you advising clients to navigate that?

[00:31:48] Sean Mooney: I think the old adage, I know 50 percent of my marketing works. I just don't know which half is probably still a little bit true. What I would say is, it should always be the way that we see it.

It should always be sales and marketing, they work together, and maybe if we go back to our Top Gun analogy from one of our most recent shows around the CFO, marketing is kind of air cover, sales are like troops on the ground. And so marketing raises awareness, you're going to find digital signals, the signals need to be acted upon by your sales team.

And so when done well, when you're tracking things through the funnel, it's going to vary, I think, excellently and effectively show intent signals that your sales team can activate and act on in ways they couldn't before when they were guessing, like, when is a buyer ready? You can very meaningfully and accurately track these signals now over time if you set up your tech stack correctly.

And that said, your conferences, you're still not going to quite know what part works unless you're really thoughtful about it. So even our company, when we travel and we go to conferences, we look at the efficacy of every type of conference we go to, every meeting, every dinner we host. Is there an ROI on that?

And if we can do it, any company can.

[00:33:02] Lloyd Metz: That definitely has been our experience and we actually own A couple of companies that participate in this marketing chain. Just think about it, just your own personal life experience, right? There's a lot of things when you're interested in buying something, you're like, you'll go online and you want to do research.

You're reluctant to have someone quote unquote, try to call you and talk to you and sell you when you're not ready. So I think that mindset is pretty much what you're describing, Sean, where you want to be able to allow prospective customers to check you out, figure you out. use cases, case studies, whatever it is digitally to figure out, yeah, I think BluWave is in the consideration set.

Now I'm ready to talk to someone from BluWave.

[00:33:46] Sean Mooney: 100%. It's just getting more information as we keep on talking about the clarity and quality of information that you have. It's an and, not an or thing. So maybe to turn the page here, Lloyd, let's go to the point that you brought up around, are you covering things up by price?

And, or are there other things that you can do within your operations of your business, within the cost structure? How do you think about some of that, given this kind of world that we live in today?

[00:34:11] Lloyd Metz: We're always nudging our leadership teams to look at their processes. Whether it's a manufacturing business or whether it's a professional services consultancy business, are there steps that we're doing in billing or collection or the production of our service offering or our widget that we're producing?

That may be legacy from 10, 15 years ago, but can we rethink it and say, you know what, we don't need to go through 17 steps to produce a bill for our client. Maybe we only need to do this in five. So making that time and space to rethink processes and use technology, right? You talked about ERP systems.

And a few of our portfolio companies were about to start going down that process, specking out ERP systems and putting them in place this year into early 2025. Because as you've described that tech stack is key to not just your internal operations, but it enables more effective sales and marketing.

It's key.

[00:35:21] Sean Mooney: That makes a hundred percent sense. How about you, Doug?

[00:35:23] Doug McCormick: Yeah, Sean, I'd offer three comments. The first is we're always, it's kind of like the Jack Welch model where like we feel like we should be able to take a couple percent of cost out every year, year in and out. And so there's a progression of getting better all the time in this area.

We do a lot in distribution and so a lot of our spend is external purchasing. And so you can be pretty methodical and disciplined about procurement processes that drive comfort that at least you're purchasing at market. I think two other really interesting opportunities that you can get a lot of traction for it, I feel like if you just tell your team, do more with less, that's a really hard conversation that doesn't go anywhere.

And so I like to think about it in the context of what investments can I make that allow you to fundamentally change the way you're offering your product or providing your service. And you can unlock that with capital, right? And that could be a capital for labor trade, or it could be a new capability that allows your team to be much more productive.

I think those are super powerful and really appealing. And whether it's an investment in a new piece of equipment, or it's an investment in M& A, Every time you make those investments, you have an opportunity to re engineer the organization to fit that new set of capabilities. And so I kind of feel like cost takeout is best evaluated in the context of investment.

[00:36:42] Sean Mooney: I think that's a really, really, really good point as well. And that you're not cutting costs so much as you're providing more fuel to support the growth, development, and value creation of your company. And just thinking about even from like the lens that I've gone through here is we've done what I call like the private equity version of venture capital.

So we raised a little bit of capital when we started in year one, but everything else we've done is just by figuring out clever ways to use our own cashflow to grow this company at a pretty meaningful clip. And what we're always challenging ourselves with is, can we use something to enhance productivity that will enable us to invest further in the business to grow faster?

And so whether it's tools, whether it's using productivity from AI, whether it's looking at our own costs, there's ways that you can do this that frees up free fuel. So you don't have to go to the gas tank, it's like a solar cell. And so it's in many ways, the best capital any company has is their own. If they're clever and thoughtful about how to use it with constraints in mind.

I'll double tap on a point that you raised Doug. This idea of particularly in a mindset of we're in this kind of like maybe slowing inflation, people are raising prices, but the flip side of the equation is people are also willing to lower prices to grab share as we're coming through this exhaustive kind of ramp.

You're seeing the pendulum swing the other way, and so we're seeing some really interesting things with portfolio companies of us coming to us saying we want to be thoughtful about is there free money on the table that we can find someone who's maybe willing to lower prices. And so one example is we had a consumer products type company.

They buy all sorts of resins and corrugated cardboard for shipping things. They're like, we think there's some savings here. We're not sure. It's like, well, we've got groups that are really, really good at that, and that's all they do. So they went to market second half of last year, and they found 20 million of savings.

And then you put a 10 times multiple on it. This is a middle market company. It's a 200 million value creation activity, and both sides of the equation were happy. The resin manufacturer and the corrugator they got to take share, and the company just created all this value that they had never even fathomed they could create that quickly.

And so you can create these win wins in a market, particularly in a time like now, that's kind of coming through this kind of like dipsity doo part of the economy.

[00:39:03] Lloyd Metz: And Sean, your client was the buyer or the seller?

[00:39:06] Sean Mooney: The buyer. So the portfolio company of a private equity firm that bought the resin and bought the corrugated.

[00:39:13] Lloyd Metz: It might be interesting for our listeners to hear, just what do you think the seller missed or what do you think kept the seller from realizing 20 million of savings or substantial portion of that savings? Is it some special know how from the buying company or what do you think it was?

[00:39:35] Sean Mooney: The portfolio company that bought those materials, the reason why they didn't see it is they're not experts at buying resin and corrugated.

billions of dollars of those things on behalf of large groups of companies. And so they know who is interested in being competitive and making moves in ways that no one in the world could see. In some ways, it's the flip side of the pricing strategy deal where the head of sales is always nervous about price increases.

Similarly, in almost all companies, it's the head of supply chain that's really nervous about procurement. It can be embarrassing to them. It can be something where you're like, Oh, I just took all the savings out. I was going to get over three years. That's the lesser case. But what we find is like the real reason is there's no way they could know that they're not buying billions of dollars like they should never be expected.

But if you have the audacity to go to a group that really gets it, they can create tremendous value because, you know, business as we all know is a three dimensional chess game. There may be someone that's raising prices, but there may be someone else that's willing to offer price in order to get share that nuance and that disconnects really hard to understand.

But if you're thoughtful in the and versus or game where you're going to intelligently raise prices where it's deserved and then thoughtfully lower your input costs where it's appropriate, you create value that ripples through the entire kind of supply chain and economy.

[00:40:54] Lloyd Metz: So they didn't know about BluWave and the team that you were able to supply to your client.

That's the answer, right?

[00:41:04] Sean Mooney: Well, the buyer knew about BluWave, and so they got 200 million of EV. Supplier didn't, I guess. Got it. But they'll probably be calling us next for growth strategy. So I think we've covered the bases on the operations costs. Let's talk about people. How are you all thinking about hiring the types of people, the quantities of people, where, the mindset, et cetera.

[00:41:29] Lloyd Metz: Yeah, when things get bad, that's usually when I get excited and I grab a pair of pom poms and start trying to cheer the leadership teams of the portfolio companies I work with to get on their offensive front foot, be aggressive. Upgrade talent, add talent. One company in particular that I'm thinking about cratered in March, April, May of 2020 cratered.

And once we figured out we weren't going to go to zero, the CEO had already come in with a plan to transform the company. And we said, might as well start now. Right. Can't get any worse. We know we're not gonna go out of business. So let's just start redoing everything. So hired new executive talent in 2020, 2021 and 2022, and started investing in different capabilities, both technical and marketing and sales, the whole thing.

So that's one example. Another example, uh, CEO did the same thing. Was aggressively pursuing new salespeople, sales team leadership in 2021 aggressively and into 2022 new COO, new CFO. So we were busy during quarantine, upgrading the leadership teams of many of our portfolio companies.

[00:43:00] Sean Mooney: I think it's a great observation.

It was pretty much almost a once in a generation hiring opportunity for those who could see past the fear, where just amazing people who would never be available were suddenly available. That makes a ton of sense. How about you, Doug?

[00:43:15] Doug McCormick: I think human capital is one of those all weather high creation plays for sure.

I kind of think about it as, Capability versus capacity and from a capability perspective, I think no matter what economy, no matter where you are in the life cycle of your investment, if you don't feel like you have the fundamental capabilities in like your C suite, call it so we can debate what those functions are, but finance CEO sales ops, let's say if you don't have the right nucleus there, I think you've always got to be pushing yourself to make sure you feel like you are skilled in those core competencies appropriately.

And then the rest of it, I think, is more around you can moderate with growth, right? So if I've got that key nucleus, that's job number one, and I've got to keep moving until I find that group that can perform well together. And then I can scale the rest of the business with leaders as the organization is scaling.

[00:44:07] Sean Mooney: And how do you think about your hiring, particularly when you're growing a company? Maybe something you think about in the beginning of a hire. Do you try to hire? Equally across all your spots, or do you go deeper in places maybe where you have more value creation opportunity? How do you think about equipping your teams, maybe holistically with talent?

[00:44:25] Doug McCormick: Sometimes I don't feel like we have enough fidelity on the opportunities to say, Hey, I think the value creation is all going to be in supply chain, so I really want to leverage into that. It's more of where is the company in its journey? What's the best talent I can attract for that sized opportunity, and then try to make sure I've got the team that's capable in all those functions.

[00:44:49] Sean Mooney: You know, you got a salary cap. There's only so much you can spend. You're going to be a value higher where you can get it. But then you also know some areas where you can really kind of upgrade on the kicker and kind of certain spots.

[00:44:59] Doug McCormick: Yeah. And I think in the lower middle market, I do think there's this dynamic where you've got to have a vision.

You've got to start building the vision and make enough progress that people from the outside can see. What the opportunity is in a way that it's worth their time, right? Because in many cases, we're hiring folks that have been successful at much bigger organizations, asking them to come down a level of complexity and manage a business that may be smaller than things they've done before, because the opportunity can be much bigger, right?

Both opportunity in terms of autonomy, fun, but economics.

[00:45:35] Sean Mooney: I love that point as well. It's like this whole idea of. You're often hiring, but at the same time you're hiring, you're selling talent and joining you for the opportunities that you can clearly portray. That's a big thing that I think is lost on many.

And something certainly took me a long time to learn. How about you, Lloyd? What are you seeing?

[00:45:53] Lloyd Metz: So generally, we want to upgrade the talent and the capabilities just broadly. And as it relates to the specific function or area, it depends on what the growth plan or the value creation plan is for that company.

So, for some companies, it's improve operations and upgrade the internal technology or the internal processes. So, then we might be adding FP& A people or we might want to upgrade the COO or the CFO or what have you in situations where we want to grow sales, grow marketing, be more sophisticated with pricing.

We'll focus on building or upgrading the commercial team, right? Sales leadership, marketing, et cetera. I'll be honest. The hard part is not when there's somebody who's clearly not getting the job done. That's a easy to make a decision. To upgrade kind of like the book. Good to great. The hard part is when you have someone who's okay.

You really would rather like better. You'd really rather someone who's good. And that's often where you lose some time in making change. Because someone who's okay that the existing leadership team, the CEO is comfortable with, and they know it's hard to make a compelling argument that you need to swap them out for someone who is by definition unknown to the CEO.

They've not seen them in action. Even though your pattern recognition is like, I've seen this movie 10 times to that CEO. This is the first time they've seen it. Maybe the second, I don't know. But you're trying to convince them that this person that they're comfortable with, that they've worked with.

Who's okay, not terrible, not bad, just okay, needs to be swapped out for someone who's better. That's a tricky position. I'm still working on how to articulate that in a compelling way. That can be a hard position.

[00:47:51] Doug McCormick: I'll make it one more complicated. You got all that and then you say, and so now we're gonna endure all that pain for the opportunity to pick someone who may end up being better or maybe not.

Exactly. . Exactly. So, so the human capital, this is the art, not the science. Right?

[00:48:07] Sean Mooney: What you guys are pinging on is a thousand percent the art and the challenge of business. 'cause you all are in a people business. We're all in a people business. And if you figure that out, let me know. immediately. And then, you know, the hard part is you kind of know somewhere in your, like your gut, what the right thing to do is, but we're dealing with people and you want them to do well, you want them to thrive.

And the challenge, I think a lot of business builders go through is, is it more just to be fair to the individual, or is it more just to be fair to the enterprise? And there's never a clear answer in between, I think when you're in these edge cases. So if you guys figure that out, let me know. Okay, a couple topics left here as we kind of round out this really interesting conversation here.

We're in this new now. The next thing I think that would be really interesting to address is, how do you think about acquisitions? What's a way that you can think about that, particularly in this topsy turvy washing machine?

[00:49:05] Doug McCormick: We started with, you got to look through the noise. And I think my general view is, if you are comfortable doing a platform acquisition in this volatile environment, you should be more comfortable in doing add on acquisitions.

I just think your ability to act like a strategic, your ability to effectively underwrite the quality of diligence you can do, and the ability to attract good partners, and I mean good acquisition candidates, is all better. And in a choppy market, I think the things you can do with that strategic asset in terms of integration, to drive synergies, to drive better value prop, to drive your growth, all become increasingly important.

So said differently, if the market's not cooperating, acquisitions allow you to achieve some of your growth objectives. That you couldn't accomplish through just organic growth.

[00:49:51] Sean Mooney: Very well said. How about you, Lloyd?

[00:49:54] Lloyd Metz: We are frequently investing in companies that are the leaders in their market niche. And so when things are uncertain and when they get choppy or just outright difficult in the marketplace, that tends to be when we go shopping.

Because if it's hard on us. And we're breaking a sweat, so to speak, expending a lot of energy and resources to make forward progress. Some of the smaller competitors must be in worse shape and therefore more vulnerable or open to having conversations about being acquired. We're starting to gear up and develop a pretty targeted list.

Affirms that some of our portfolio companies would like to own.

[00:50:37] Sean Mooney: I think that's another great point. And I'll go with my questionable analogy of kind of these race boats versus tanker ships. Forgive me. As you guys know, by now I'm from Texas. I only know how to speak through a mixed metaphors. And so as I think about kind of the times right now, particularly as you compare PE and VC, Your boats are larger, they carry more fuel, they have cash flow, they can create their own fuel.

And so they tend to make it through these things versus maybe even unbacked companies. And smaller companies, there's safety in that. They run out of gas, they don't have a place to go, they need a life raft. And so it's one of those things that your companies can also offer is like, come join a bigger platform in choppy waters because it's safer, we displace more water, we'll make it through this a little easier.

Maybe let's talk to one last but very important topic about how companies can navigate the current world we're in. Let's talk about capital structure. How do each of you think about how much debt you're using within your companies, the multiples, the mix, the type of providers that you're going to, to provide additional capital as part of this fuel of building companies.

And so maybe Lloyd, I'll throw you this one first here.

[00:51:50] Lloyd Metz: You might regret having done that because you might not like the answer. We're pretty conservative when it comes to capital structure. So for the 20 plus years, we've been in business, we use senior debt and equity. You don't use. mezzanine or junior debt, if you will.

And as it relates to the levels of leverage, we probably get uncomfortable north of four times debt to EBITDA. We thought about five times debt to EBITDA, but generally we're not borrowing that much. And our most recent investments have generally been one to two and a half times debt to EBITDA. So very modestly levered.

One, so that the balance sheet could withstand whatever the number of federal reserve rate hikes wound up being. Two, the rate of growth that was expected and the rate of investment and hiring and all the things we've been talking about at the particular companies. We didn't want interest, expense, and debt service to crowd out the cash flows.

And cut into the cash flows that could be better used for CapEx and building plant or CapEx for software or hiring people, et cetera. So, for those reasons, we have very low levered businesses when I think about the investments that we've made in the last two years. So not very exciting.

[00:53:21] Sean Mooney: But it's a good point though, and I think it's one that's not always thought of in private equity, but reasonably common.

I started my career at a firm called Houlihan Loki's Financial Restructuring, which was really well known for that kind of practice. And they're seeing companies that were over levered. And I had a mentor of mine there who always said something that stuck me to this day. And he goes, Sean, debt is a great amplifier of results.

Both good and bad and it can be great when things are great it's really really good but if things don't go well it can crush you there's a goalie locks in there there's the right amount for the right types of companies and i was with kind of two different genres of private equity firms and one of which was more conservative.

Buying companies that made things that had more volatility. Another one that was more like subscription type companies that had huge market share and like they were steady as they went and we kind of had different perspectives, but I think both of them had this concept of expected value that we talk about so much of like probability of success, time, size of outcome, and both of them probably ended up at the same risk adjusted place with the specific use of debt.

How about you, Doug? What do you think about this?

[00:54:31] Doug McCormick: I think I'll just try to offer two comments that are building on what you guys said. As we talked about all the things that are going on in the economy, all the uncertainty. You can manage risk with amount of capital structure. I think you can also manage risk by the partners that you work with.

And so I think this kind of environment is when you figure out the value of a broad relationship where let's say I've got six portfolio companies that have loans with one or two banks and all of a sudden they're able to look at the portfolio and the relationship as you need accommodations and as you need them to stretch to get things done as opposed to taking the chief as capital.

At a point in time for each of the financings of your six businesses. So this whole just concept of relationships where people can find value in more than a one off transaction, I think becomes increasingly important. And then the second is, I think this discussion and this valuation should be of topic throughout the life cycle of the investment.

And in many of our situations, The leverage capacity of the business we bought is dramatically different than the leverage capacity of the business that we build. And so, like, we may be at two times leverage when we start, and it's a relatively small business with a relatively new management team. And by the time we exit, it's a big business that's relatively stable and can support five or six times leverage.

You've got to be willing to look at a business in its life cycle to determine the appropriate cap structure.

[00:55:54] Lloyd Metz: I agree with that 100%. Well said.

[00:55:57] Sean Mooney: Similarly, I think it's a great point, and I think it goes back to a lot of these common themes that we've been talking about in these episodes is, and I just call it expected values.

It's size of outcome times probability of success, like don't over optimize and go chasing that last nickel. If you work with really good people. Groups that you trust and know. You can grow into something bigger. You don't have to do it all day one. And it may take the outcome total potential down just a little bit.

But your probability success goes way up at the end of the day when you're hitting the exit. All right, gentlemen. I think we've covered a lot here. This has been another really, really good episode. I've personally taken a lot of notes. I'm not going to go to the mezzanine debt lender and take eight times the loans and I'm going to take seven.

I'm not going to do either of those to be clear.

[00:56:45] Lloyd Metz: Good conversation guys. Doug. Thanks, Sean. Thanks a lot.

[00:56:49] Sean Mooney: All right. Thanks Doug and Lloyd.

[00:56:51] Doug McCormick: Thank you guys. A special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies by partnering with family and founder owned manufacturing, services, and distribution companies.

Learn more at hciequity. com. ICV Partners, an innovative, lower middle market private equity firm supporting management teams of leading companies At the lower end of the middle market. Learn more about ICV at icvpartners. com. And finally, BluWave, the business builders network, connecting the most proactive business builders in the world with the best of the best service providers for critical variable on point and on time due diligence and value creation needs learn more about BluWave at BluWave.

net for further information on HCI, ICV and BluWave. And relevant topics discussed here in the episode, please see the episode notes or links.

[00:57:54] Sean Mooney: The views and opinions expressed in this program are those of the individuals presenting and do not necessarily reflect the views or positions of any other persons or entities, including those referenced herein.

Join Doug McCormick from Oridian Capital Partners, Lloyd Metz from ICV Partners, and Sean Mooney from BluWave as they explore timely private equity topics and offer their seasoned perspectives on crucial areas of focus within the industry. Gain valuable insights from these industry experts in this engaging podcast tailored for PE professionals.