Private Equity's Game Plan: Executing Optimal Buy and Sell Strategies

[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 corridors of private equity, revealing the uncommon knowledge and Challenges, successes, and lessons that drive the world of private equity and business forward.

Let's go.

[00:00:37] Sean Mooney: I'm excited to be back with the guys here. So Doug and Lloyd, great to be with you again.

[00:00:43] Lloyd Metz: Hey, Sean. Hey, Doug.

[00:00:44] Doug McCormick: Good to see you, Sean. Good to see you Lloyd.

[00:00:46] Sean Mooney: So we have another really good foundational episode regarding the basics and the pillars of private equity. And it's this whole concept of how does the industry think about maximizing outcomes throughout good and bad cycles on both the buy side and the sell side as a feature of these processes.

I've actually executing the underlying transaction is one of the kind of preambles, like every cycle, there are topsy turvy periods of time. There are periods of higher risk and lower risk. The one thing that everyone can count on is like a black swan flying right across your nose, every time you're in market, something can go wrong at will.

I can see basically both of you kind of shuddered a little bit, but that's not true. Let me know

[00:01:35] Doug McCormick: Murphy's alive and well, Murphy's alive.

[00:01:38] Lloyd Metz: I don't think it matters who controls Congress, who the speaker is, who's in the White House. I think Murphy law is going to stay on the books for sure.

[00:01:45] Sean Mooney: Murphy was a wise person for sure.

And so you think about periods. That is in this era, there's high cost of capital and inflation and tight labor markets and geopolitics and the election cycles and yada yada. But for you two, that's just kind of just another day at work. We're going to delve into here, how you approach those on both the sell side and the buy side to maximize outcomes.

But maybe before we get there, let's take a moment to pause and actually discuss what each of you are thinking about. So. With today being what it is, Doug and Lloyd, how do you think about this market? Are you net buyers or unit sellers? Are you both?

[00:02:26] Lloyd Metz: That's an interesting question, Sean. And at least for our firm, our very first investment, we closed on September 13th, 2001, because things were a little hectic a couple of days prior in New York city.

And so that's how we came into this industry, closing into the teeth. of a catastrophe. And you've been buyers in 2008, 2009. We were buyers in 2010, 2011 going in and out of the great financial crisis. So this is actually an intriguing time in our view. So we would like to be net buyers. I think that's going to be a challenge and maybe that's a part of what we're going to talk in more detail about today.

But we would think this is a good time to buy the right assets in the right spaces. That's our point of view. How about you, Doug?

[00:03:19] Doug McCormick: Yeah. Listen, I think I'm probably aligned with Lloyd a fair amount there. So I think I tend to be a little bit contrarian and I think all of the things that you highlighted, high cost capital, high inflation, tight labor markets, geopolitical, I think for investors that have a longterm bias and view that can create opportunity is an interesting entry point.

In general, I consider myself long term positive, short term cautious. And so I think if you have a duration where you can say, I'm expecting to hold the asset five years, I feel pretty good about my entry point. If you've got an asset that you don't have the duration to kind of see it through, that I think gives me pause for concern because I think there are so many unknowns out there.

And I just would comment, Lloyd and I are in the business of, we're always buyers and we're always sellers, right? And so in some ways, it's kind of like, are you putting the gas down or the brake on? Because we're always going to be exiting something and getting into something else. And so one of the things I would highlight is, it's very dangerous to generalize here amongst all assets versus select markets.

Because I think in volatile times, the subsectors behave very differently than the overall macro.

[00:04:31] Sean Mooney: Those are great points, and if I kind of reflect on what we're seeing, and so one of the great kind of benefits we have is working with a relatively large swath of PE firms across the country is you're kind of seeing how the industry is behaving in a relatively statistically significant way.

And one of the things that we're seeing is the private equity industry kind of jumping into out of favor industries right now. One, maybe even before we get there, there's this great Hamilton Lane study that I've referenced in other kind of things that we've done that shows that private equity firms hands down do best during periods like now.

They are statistically going to outperform the market every time we're coming out of a cycle. And these are always, at least historically through the Hamilton Lane house, the best vintage years for private equity at times, just like it's like buy on fear, sell on greed. I think. People like you, Doug Lloyd, are really good at that because of the discipline that you have.

And so, As interesting as we're looking at our first quarter 2024 data, some very kind of telling and foreshadowing things came up and it was one, the level of due diligence activity for new deals related to manufacturing is up 62%. I think most of the world right now is thinking that manufacturing is in a recession.

Because it has been, but we're seeing P E kind of leap into those markets right now. The other area that they're jumping into is healthcare, which is a 49%. Healthcare has been tremendously under pressure because of the confluence of capped revenue with reimbursement rates and inflationary pressures that kind of go up unchecked and their labor market.

And so we're seeing a lot of activity in these areas that would suggest they're taking action because they're seeing us at the bottom and a new cycle is renewing ahead. I just think that's a great kind of thing that you all kind of jump ahead of most.

[00:06:30] Doug McCormick: Just on that point, two observations as I kind of hear and process what you're saying.

First of all, this whole concept of we perform best in down markets. I'd like to claim that boy, the private equity industry is smart, but I think in some ways you could argue a lot of that is forced dollar cost averaging. You raise private equity vehicle and in aggregate, you know, we know what the market did, and then you're going to deploy that consistently over a four year period.

And so by definition, you're kind of net positive in terms of deployment, no matter what. And then the second thing is, I think this whole question of challenge industries, it gets back to duration. You know, if you have a five year time horizon, manufacturing looks like a good place to be. Certainly would think it's better than it is today.

A couple of years out, same with healthcare. They're exploiting the luxury of being able to deploy capital and challenging markets and the luxury to be able to take a long term view.

[00:07:23] Lloyd Metz: I think that's right, Doug, because ultimately, Sean, you remember this private equity, a lot of times because of the duration that we have the benefit of the luxury, the privilege of having, you can see.

Or think about where is the industry, a market going, right? Kind of like Gretzky said, go to where the puck is going to be, not where it is. I think that's the majority of how private equity functions. And so this is probably what explains that phenomenon, right? And it's not to say that healthcare or manufacturing are absolutely going to be The places to be with private equity, you got to do the work up front to figure out which sectors of manufacturing are going to be the good ones to get into, which sectors of healthcare, because some of them may be impaired.

Some of them may not be right, but you need to do the work now to develop informed points of views and investment plans.

[00:08:17] Sean Mooney: I think those are spot on points. And the only other thing I would add to what you are saying is We've talked a lot about on this podcast about the incentives that drive behaviors and outcomes.

And as I compare the private equity industry and venture capital industry, they both serve very important purposes for not only the U. S. economy, but the global economy. But if you think about the different incentive structures, The venture capital industry on average, they're going to say, we're going to be really right on two out of 10 deals and make a ton and then have various degrees as a breakeven or loss on the rest.

But those two are going to be through the roof. Private equity is more in kind of like the analogy I always use is the movie Moneyball. It's like, let's get on first base. Let's get in second. We're going to return two to three times our money. Sometimes more, sometimes less, but really like we have to make money on every single deal.

And so what we see during tough times also is not only that you all are practitioners of knowing when to maybe move into a sector or not, but also there's this confidence in creating value because you have to create value. And so we've had two cycles in BluWave history. Both times, what we see when deal markets go down is value creation goes through the roof.

So more than 80 percent of projects in the first quarter is value creation. And we'll talk a little bit about this, how that impacts your ability to work through when the best time to buy and sell is and your confidence in selling. But I think it also gives you all this confidence that like we can buy into this company.

We know how to make it thrive while others are maybe worrying about surviving. Does that resonate as well?

[00:09:52] Lloyd Metz: Sure does. And ultimately, Sean probably explains what you're seeing at your firm. Sure. Is at some point we private equity folks have to be practical and you got to focus on what you can control and what's within your control and that's where the value creation efforts are right can't necessarily control the mood of the external marketplace and what valuations may or may not be or what the Fed does or doesn't do.

You can have definitely more control over what happens inside the companies that you have invested in.

[00:10:23] Sean Mooney: It makes sense. In some ways, you are playing like multi dimensional speed chess at the park. And if you've ever seen those folks, they can think in ways I can't. They got like three boards and they're moving around and the conditions are changing and the players are different for each portfolio company, but you're making these decisions three to four moves ahead across a range of chess boards.

And so maybe with that in mind, let's talk about like how you think about on the sell side. Across ranging conditions. But for purposes of this, we might as well talk about a topsy turvy condition, like we're arguably in now, where it's just not clear. And so one of the things that I think P also, as you both pointed out, you have the luxury of time.

So what are some of the ways that you can stay in a deal longer? Lloyd.

[00:11:09] Lloyd Metz: The first way, obviously, is you just hold it right. If the business and the market conditions aren't ready. And you need both the company and the market conditions to be ready, honestly, to have a traditional M& A exit that works. If one of those is not ready, then you don't go and you hold it and continue to push on the value creation.

And then it becomes a question of how dramatic of an approach do you want to take? How material of an approach do you want to take? That's where you start, but you can get creative financially. And with some financial engineering, get creative, right? You can bring in additional equity partners, depending on how much value you have built into the business and how valuable your investment is.

You can bring in partners that take a portion of your position, get some liquidity that way, get a harder evaluation mark is what they would be called in the industry because a third party is validated. Continuation vehicles are out there, which is another conversation we can have. Later in this episode, if you like, you can also extend your fund life.

You can go to your investors, your LPs, and ask them to extend the fund life, an additional year or two, sometimes three with a plan to how you're going to improve that business and ultimately exit, but those are some of the basic tools that you have in your toolbox, there's a few others.

[00:12:35] Sean Mooney: I think those are spot on, maybe for our listeners who are newer to private equity.

And one of the things we're trying to do is demystify is why does private equity sometimes feel the compulsion that they have to even sell? And one thing just as real briefly I would share is most private equity vehicles are built with time limits in place. So the standard is you have five years to deploy the capital that you've raised and you have 10 years to return it.

And so where many private equity firms, you ultimately end up like kind of racing the clock. If you go longer and longer, eventually you have to sell, unless you do some of the things that Lloyd shared that are more creative, that lets you kind of live out the asset longer and create value. Because that's one of the huge advantages, private equity is time.

They're not managing quarter to quarter like public companies. So if you're going to go longer and hold the business, Doug, what are you going to do to make sure that time is well spent?

[00:13:31] Doug McCormick: I think the first thing I would highlight is if the only reason you're not selling the business is because it's not an optimal time and so your primary source of like value creation during the hold is that you think you're going to get a higher multiple later.

My sense is that that's probably not adequate reward for elongating the whole period. So I find that these kind of situations are most common where you can say, Okay, not only do I think it's not an optimal time to exit, but there are things in the business that will change dramatically between today and when I expect to exit.

Could be the earnings profile, could be continued growth, could be a follow on M& A. And so I think it's the combination of I want to weather a challenging market and I want to accomplish some very tangible things that are going to deliver real value. And I do think in this environment with so much volatility, the alignment that comes about through partnerships is super valuable and I think you get It doesn't fundamentally change the deal, but I think buyers react differently when they realize that the seller is also willing to be a buyer.

The person that knows the asset the best, that sees all the goods and the bads, is willing to put their money where their mouth is in terms of side by side capital exposure. It can accomplish some important things for the PE firm that has the asset. Not only, to Lloyd's point, do you get a third party mark, you also deliver some capital back to your investors, which is important.

And I think you get a partner with fresh eyes, maybe a different set of capabilities that are relevant to where you are in your journey. And also we do a lot of consolidation. You lay off some of the capital required to continue to do those consolidations. So yeah, I buy myself not only more runway from a time perspective, but more runway from a capital availability perspective.

[00:15:14] Lloyd Metz: Those are great points. I'm glad you brought it up because you brought it up earlier. We're always buying and selling as private equity firms, right? It's not. All buy or all sell. It's a mix. Some markets like the one we're in today, arguably, if you can strike a deal that you're describing where you're buying and selling at the same time in the same investment, even that's doable, right?

[00:15:38] Sean Mooney: Those are really spot on points. And so you can hold longer, but if you're going to hold longer, have a plan. Time isn't in itself. A good thing.

[00:15:46] Lloyd Metz: Yeah. Definitely have to have a plan.

[00:15:50] Sean Mooney: This episode is brought to you today 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. Before we kind of move, you can hold longer. What are some of the other structural mechanisms private equity firms We'll use beyond even maybe just selling a single asset may choose to use so that they can as thoughtfully as possible, not only build value, but return capital.

[00:16:47] Lloyd Metz: What's been talked about a lot these days and over the last couple of years is the real growth of. Continuation vehicles, secondaries, technically is what they are, where a private equity firm will sell two assets, three assets, four, five, six, whatever it is in the same fund or across funds, bundle them up and sell it to a set of investors, different investors than they have in their private equity partnership.

And so that's growing increasingly. Great popularity largely because for the new investors buying those assets, the assets are understood, you can diligence them, they're seasoned, and so when they invest their money, there's lower fees, lower carry, but the investment sort of starts immediately, right?

There's virtually no J curve. They would experience as if they were to invest in a new fund that Doug or I would have in the marketplace where you have to wait until you have new investments and there's fees that go against it and the like with secondaries, there's virtually no J curve. So those are pretty popular.

So that is a way to get liquidity back to your investors outside of the M and a approach.

[00:18:01] Doug McCormick: Yeah. Sean, and I would just say, as you think about like where the private equity markets I've been innovating in the last several years. This area is probably pretty fertile ground. I think people have started thinking about not how to exit individual assets, but how to exit collections of assets and you tap into a different source of capital, as Lloyd mentioned.

So I think that's secondaries, it's continuation vehicles. The other thing I would highlight is a related source of incremental duration is NAV loans. Where essentially the fund is borrowing money at the fund level to get liquidity to support additional growth or additional duration. So pretty active part of the market over the last several years.

[00:18:42] Sean Mooney: Yeah. If you think about the private equity industry becoming an industry, there's a couple of things that are striking is one that it's one of the only industries where the primary market is much bigger than the secondary market. So these secondary tools that are evolving are, I think, amazing. For the future of the private equity industry, but also kind of bringing it into a maturation space that's consistent with other kind of markets.

And then to your point is like the mechanization of private equity. These companies are coming in some ways like Dan are Dan and hers, a lot of have used that to be thoughtful at their operating company, private equity firms are kind of maybe taking a page out of that. And so if we move down the options list here.

Let's say you've explored secondaries. That doesn't make sense. You do want to get some liquidity out there. What are some additional options that you can play in terms of not only getting some capital return, but also having some optionality on what's yet to come, because you know, there's another bite of the apple on this porco.

[00:19:47] Lloyd Metz: I don't know what your experience has been, Doug, and what you think about this, but part of what's going on in the M& A market now is there's a valuation perception gap between prospective buyers and sellers, where the sellers have a valuation that's higher than most prospective buyers, on average, for most assets.

It usually takes some time and some sort of external events to kind of change that psychology to get sellers to come down and buyers to move up so that there's a meeting of the minds. I think that's important. That to me seems to be a good description of where we are now, where there's a lot of sellers who would like to sell their companies or the equity stakes in their companies, but their expectations are higher than the market generally is willing to entertain.

But maybe I'm in the wrong aisle of the shopping mall.

[00:20:36] Doug McCormick: I would agree. I think there are two dynamics at play. First of all, I think there. Given the choppy capital markets and the choppy economy over the last kind of, I'll say 18 months, I think there is pent up supply of assets that are waiting to come to market versus in an overall demand.

And at the same time, I think there's a big question on what's long term interest rate. And if you have a view that it's going to go back to something that's closer to what it looked like in 2020, you have one view of valuation. And if you think. Inflation in two to 3 percent is here to stay for a long time.

You got a very different view. And I think the jury is still out on that question in some ways. And so I think over time, those cards will get turned over and there'll be more clarity. But in the interim, I think people are finding creative ways to close that gap. And it's, it's through either structure, like a preferred investment that gets you a minimum return, and then you convert into common at some price.

Or an earn out, which is. Essentially some bet on near term performance. Those accomplished two very different things, like the pref equity or structure that looks like a preferred is a bet on terminal value where the earn out is a bet on kind of near term performance. And so I think they're appropriate in different circumstances, depending on what the bid ask spread is about.

[00:21:55] Sean Mooney: There's some sort of like chart that I'm trying to channel when we all probably took this similar, but different class in business school with like the options where you can lock in your return and then get option value and the tail across valuations. And so I do think that's kind of what you're talking about.

The people are doing is like, you know what, why don't we sell the portfolio company? We'll sell the control to the next buyer. But what's really different that we're seeing that I had not seen in my career is like seeing the private equity firm roll into the next owner's deal. And or even potentially entertain and earn out so they can lock in some portion of the returns, but maintain optionality on the growth that they probably agree or believe in more so than anyone else.

And candidly, it also signals to the buyer that they have a lot of confidence in that projection that was shared. I'm curious if you all have seen more of that. We're hearing about it more on the episodic anecdotal stage, but it's something that really in my experience didn't even exist before that.

[00:22:55] Lloyd Metz: It's happening for sure. Both the rolling over some equity into the next owner, particularly if it's a private equity firm with experience that you have confidence that they know what they're doing and can take the business to the next level. And then as Doug said, for short term differences in performance, earnouts are absolutely on the table.

Again, you try to get it right when you time, when your business is coming to market, but inevitably there's going to be a moment where you're saying, Sometime in October or November or September, we're going to start producing for this new customer and you're trying to sell the business in April, May, June, right?

A lot of times that's the setup for an earn out where it's near term performance driven. Most private equity firms wouldn't necessarily give you full credit for that future business and the future profits from that future business. Some will, sometimes they won't. So to bridge that risk gap, you'll do an earn out.

[00:23:58] Doug McCormick: Yeah, I would say certainly seeing more of it. And I think in some ways, listen, we all would say we want full price and we want it non contingent, right? But I would argue that private equity owners are probably pretty well positioned to underwrite the risk. They know the business very well. They're pretty good at forecasting, at least on a near term basis, what they think the business is going to do.

And so I think most private equity sellers are well positioned to see value in that earn out or that pref equity instrument because they have a good view of where things are headed. I think that's in a challenging market, a creative way to kind of close that bid ask spread. The other thing I'd say. In my own experience with partnership deals, we have a core competency that's kind of like, let's just say five to 40 of EBITDA.

And when I've done partnership deals with bigger firms, it's a really interesting complement of skillset because we've got all the domain expertise around the business. We've spent a lot of time with it. We know what we know and they come in with a different skillset and it's pretty complimentary to the long term opportunity set for the business.

So I think you get more than simply capital, you get another smart partner that comes at it from a different perspective.

[00:25:10] Sean Mooney: I love that perspective of the industry kind of turning into an industry and there's this concept of win win. You can both succeed together in ways that maybe wasn't as commonplace before and it's not because it was bad or good, it's just the way it was.

To wrap up the sell side perspectives here, you've Decided you don't want to stay in longer. You maybe don't have a perspective on how to get it there. Some of these structural things probably aren't attractive either. What's the last option on the table?

[00:25:43] Doug McCormick: Yeah. At some point, I mean, I think you evaluate the business trajectory.

You got a couple of shots on goal to find the right exit alternative. And at some point you're in the business of moving on that asset and onto the next one.

[00:25:55] Lloyd Metz: You just got to remember at some point. Whether it's gone well or not gone well as an investment, you're obligated to return capital to your LPs and if the market speaks and you look at the rest of your portfolio and all the things that you said are true, Sean, in terms of alternatives or how things are shaken out, then you transact and take whatever it is, whether it's okay investment or not okay investment.

It's better to close that out, return capital to your investors, your LPs, and then focus your attentions on another good opportunity.

[00:26:33] Sean Mooney: And that's just so key. We've talked about people in a private equity really liking being investors. And that's the sober mindset you often have to have when sometimes.

You just have to Kenny Rogers it, right? Or it's like, you got to know and hold them, no one to fold them, no one to walk away and no one to run. And sometimes you got to just say, you know, we've done everything we can. And the next buyer will have a perspective that's probably different than yours. And they can help that business get to all the places it can and should

[00:27:03] Doug McCormick: be.

Sean, just on that point, I'd say it's important to remember the investors are looking at the fund performance, not the individual portfolio performance. And so the mandate is optimized fund performance. That makes sense.

[00:27:15] Sean Mooney: So let's turn the tables here to now you're on the buy side. How do you think about in a market where it's not as fully functioning?

It's Lloyd to use your analogy that I really love and go back to. It's like, it's not flowing like water, but it's a little muddier, but it's maybe picking up a little bit. You have the basics to do things. How do you think about structuring a deal to get to yes?

[00:27:42] Doug McCormick: So I think there's a lot of ways to put together an attractive deal.

And when I say an attractive deal, it's in the context of, it works for the buyer and it's compelling to the seller. And I think we all get myopically focused on valuation and that's an important part of every transaction, but I think there are a number of other tools that people can use to differentiate in the marketplace to get to the point where you can effectively deliver a compelling package.

So valuation is an important part. I think when you think about valuation, form of consideration. Is a key part of that. So is it all cash at close? Is it cash in a note? Is it cash in some contingency? I think in this kind of market, sellers so under appreciate the importance of speed and certainty and they go hand in hand, right?

Like how quickly can I get to yes and certainty so that I can close? And what are the contingencies or things that I've got to accomplish that quote, have to check out between when I gave you my offer and I wired the check. And then I think there's a whole lot of creativity around structure that can allow you to isolate specific concerns from a buyer's perspective or reward the seller for a value that you maybe can't pay for today, but that the seller believes is really there.

And that can be in the form of the earn out like we talked about. It could be. Warrants or some residual equity ownership. So lots of different tools. And I think good deal guys and girls, they focus on the whole tool kit and they're good at selling all of those components. So the seller really appreciates the importance of all the components.

[00:29:16] Sean Mooney: Yeah. I think those are spot on in terms of the way to think about it more comprehensively and in more of a nuanced way than I think is often kind of thought about. And so. Maybe let's break each one of those down.

[00:29:32] Lloyd Metz: But before we do that, I'll jump out there and add something. A mentor of mine told me this, and maybe you'll think it's off base a little bit, but I think in addition to valuation, speed, certainty, and structure, let's not forget just basic enthusiasm, right?

Act like you actually want to invest in this company. Act like you want to own it. And act like you're excited about it, right? Not every business is perfect, but focus on the opportunity, focus on what you do like about it, and communicate that to people who are across the table from you. That actually colors the valuation speed, certainty, and structure in my experience.

And that was also the guidance from a mentor of mine. So I'm a believer in that. I literally just had this conversation with a partner of mine. A couple of hours ago where I said, do you want to own this? If you do call this person and tell them, call that person and tell them, call this person and let them know, actually do the work that backs up the fact that you're excited about owning this business.

Right? So I would add that as an overlay to those four dynamics.

[00:30:38] Doug McCormick: You're onto a really important point of this whole business and this whole industry. We consider ourselves investors, right? And I think in many cases, the tools we use to get to answers are very consistent with the underwriting tools that investors in public markets use.

But at the end of the day, I think one of my primary jobs is being a salesperson, right? Because I've got to convince this entrepreneur that I've got a big vision for their business and that I'm going to be a good store of their legacy. And I think so many people under appreciate that part of the job.

And so it's. Not only convincing them that I want to own it and that I'm serious, but that I've got a plan that's going to make them proud. That's one. And then the second is this just ability to establish trust. And I find that the best way to establish trust is through real authenticity that doesn't hold back on the problems.

I think when people distrust it's when. You make your pitch and it's all perfect and I'm going to close and there's no work to be done and I'm not concerned about anything. And they know damn well there's still a fair amount of work to be done and everybody always has concerns. And as soon as you like lay that out, I feel like the person on the other side has a respect and can really begin to trust what can be counted on and then what the legitimacy of the offer is.

[00:31:51] Sean Mooney: I think those are really, really, really good points that are often not communicated because this is a musical episode. The sellers are playing that song in their head. Like, I want you to want me pretty good. Right. That's why I'm not allowed in anywhere near Nashville downtown, but it's not so true. Like, let them know that you want them because like half the time they're beat up by these parties that are in the party.

And they're just like, do you even like this company?

[00:32:19] Doug McCormick: So, you know, we all have lots of successes and lots of failures and anybody that doesn't have the failures, they're lying. You met Scott Milberg from Amercare on one of our previous podcasts. So we were bidding on that business. It was in an auction.

This is the base business, a 40 million top line business. And we bid something like 32 million bucks and we got beat. And this was right before Christmas holiday, the bids were submitted. I called the founder of Amercare on Christmas Eve at about like 2 p. m. So afternoon. And I basically said, Hey, I think this is the wrong answer.

I want to figure out a way to buy your business and I'm willing to pay more. And he basically said, if I had lost a piece of business in my business, I would have done the same exact thing. I would have called the customer and I would have told him that I wanted another shot. And so. I'm interested in doing your deal and it's that human connection that being willing to kind of find that person where they are that I think is an important part of the business.

[00:33:21] Sean Mooney: That's a really, really good point, Lloyd, that you brought up that is so important to the success, not only from just the basics, but also the humanity part of the business. Now that we talked about the human element. We'll go back to some of these pillars that we also talked about here in terms of just valuation itself.

How do you think about that in terms of deciding where you want to pay up, where you don't and where you feel comfortable and what the trade offs are?

[00:33:48] Lloyd Metz: Doug, how do you decide what the right price to pay, what the right valuation ought to be?

[00:33:54] Doug McCormick: I think that's a great question. I think it's some combination of fundamentally what do we think the asset is worth?

And then there's some assessment of What do you think the market is? If the market is like it is today, we may say, you know, we think the fundamentals would suggest it's worth X. Nobody's doing deals right now. It's a challenging financing market. And so we think we can get compensated for working through this environment.

And I think there's some kind of Kentucky windage on that overall valuation. So fundamental value, competitive dynamic kind of leads you to an answer there.

[00:34:29] Lloyd Metz: I think that's right. And also I think Sean and. It's influenced by your insights. If you have any particular insights on the market that this company is in, or the business or the customer or client base of that business, I'm thinking about a business that we pursued where we had developed a point of view probably three months before we had to submit our final bids that their primary input costs were going to be declining.

They had started declining in June. We were engaging in October, we submitted our final bid in December, so we had this point of view that the input costs were declining already, so when we did our quick diligence before our final bid, that's one of the things we checked. And sure enough, their input costs were coming down, so the valuation we bid and the multiple we bid, we knew would actually come down each and every month subsequent to submitting our LOI once we got it signed up.

We knew our multiple would come down all the way to close. So sometimes it's the insights that you have on the space or the market that can also inform what you're willing to pay valuation wise.

[00:35:40] Sean Mooney: Those are all spot on. And as I kind of reflect back in my career, there's almost like three types of key firms that are building their strategies and their perspectives around this landscape and continuum where you have some that are kind of like, we're going to buy good enough.

We'll make it gooder. We're going to then take gooder to great and then great to greater. And they've built their tactics, their strategies, their operational capabilities around that kind of transformation continuum. And so one of the P firms I was with, it was kind of like good enough to gooder or maybe gooder to great, but they had structural elements to the way they invested that could protect them on the downside and operational capabilities, and then.

The firm after that was more about gooder to great or great to greater, and it was the same kind of approach, but different skill sets that enabled success throughout the segments of that continuum that they chose to compete.

[00:36:39] Doug McCormick: It's interesting. I think what we're talking about here is how comfortable with various types of risk are we?

And as we think about these deals, there's There's business model risk, there's earnings volatility risk, and there's kind of terminal value risk. How much do I have to sell the business for to justify what I'm paying today? From our perspective, I think we lean in a lot to, we want to buy quality business models, but we're generally willing to overlook deficiencies in the end state team, and we're willing to do a lot of the work on building a business of scale.

And so that also implies we don't need fast, fast growing markets. And I think that where it could be challenging in my mind is you pay up for an a business model and you also pay up for an a market. And I think those markets can be fickle sometimes. So getting that right all the time, I think is challenging.

[00:37:30] Sean Mooney: That makes a ton of sense. And maybe another thing that Doug, I'd love to hear your perspective on that you all do is. There's this concept of maybe being a little bit more ambitious on valuation with the platform, but then you can do things to the all end valuation over time through add on. So can you talk a little bit about how people think

[00:37:49] Doug McCormick: about

[00:37:49] Sean Mooney: that?

[00:37:50] Doug McCormick: If we start with the premise of, okay, how do we get to valuation? We talked about fundamentals. What does the business look like today? What are the fundamental support? Then you say there's the second element of what do you have to pay to clear the market? And then the third element is what can I afford to pay?

And that is with my thesis and with my expectation of what I want to do in terms of creating the end state, how much can I afford to pay if I have to? And I think in many cases, We start relatively small with our platforms. And so in some cases, paying up to buy the platform and the optionality to execute that strategy, that's justifiable.

Now, what it forces you to do though, it forces you to have conviction in the ability to execute the strategy and therefore conviction in buying other assets at reasonable valuations on a go forward basis. Cause if you get stuck in. You did one deal and that's your platform. And then there's nothing else that happens.

That's a pretty challenging environment. I actually think that's a healthier way to underwrite though, because it forces you to underwrite on what you're going to do as opposed to what the business is going to do.

[00:38:54] Lloyd Metz: The going in underwriting process, I think is really the part that you got to focus on, whether it's acquisition driven or not as acquisition driven, whether you're building a new plant or brownfielding launching a new product or.

Doubling the sales force, whatever it is, you really have to have some rigor in your underwriting, have your base going in valuation makes sense on that basis. So I agree.

[00:39:22] Sean Mooney: I really like that point as well. I think a number of times P firms can get a little bit of a trap where they say, we're going to play the scale arbitrage, we're going to pay more for the bigger platform, and then the smaller ones, we're going to be able to get a lower multiple because they're that step down on the scale function than has Lower economic multiples associated with that.

But if a sector gets hot, that arbitrage can evaporate really quickly. And so Doug, I really appreciate what you shared is the business needs to stand on its own merit and be really good. And then each one is kind of a separate analysis into itself versus just saying that I would have loved to freeze both my kids at age.

five and eight that grew up on me. And so now I love him for different reasons. I just don't get any hugs from either of them anymore, but that's a whole different conversation.

[00:40:14] Lloyd Metz: That's another episode, Sean.

[00:40:18] Sean Mooney: So, we've talked about valuation, let's talk about the next one, speed. What is your ability to move

[00:40:23] Doug McCormick: quickly in a transaction matter?

Any seller of a business that's got any kind of advisor will advise that time is your enemy as a seller, because generally with time, you've agreed on the price, so the price isn't going up, and only bad things can happen then, whether it be some event happens with a customer, some events happens with the economy.

And so generally sellers are incented to compress the timeline from LOI or the marketing when it commences to consummating. And for buyers who know the industry, know the asset well, that's a competitive advantage because we can move much quicker. I don't have to do my work on the market. I may know the customers.

I understand the business model. And so I can be very precise about I have these five diligence streams. I'm going to do those in four weeks. I'm willing to backstop financing because I know how these businesses finance, and that'll be my risk. And by taking all that risk off of the seller, arguably, you should get compensated for that in a different way, which is you win the deal when you wouldn't have otherwise, maybe you pay a little bit less because you've delivered certainty.

[00:41:29] Lloyd Metz: I agree with what Doug said, they tend to go together and speed and certainty, the advisors to that company. That CEO, that family or whomever, all the things that Doug said are true, right? And so to the extent as a buyer, you can do that work up front and, or signal to the advisor that the work you have to do, those five work streams that Doug mentioned are confirmatory, right?

So we haven't seen any red flags or yellow flags, but we need to kind of check these five things out and confirm that whatever, whatever, whatever You said, or whatever we believe to be true is actually true. And that is not going to affect value. Those are messages that help with your speed and certainty, your perceived speed and certainty of your bid.

[00:42:16] Sean Mooney: I think those are spot on. And I think so much of the way that private equity views the world, and certainly I do, is through this concept of expected value. So it's the size of the outcome times the probability of that thing happening. And the size of the value on that term sheet, or the LOI. Happening times, the probability of happening, they can be very differently weighted.

And I think you all are so good at doing that math at the same time. It made me recall one of my portfolio companies. It was an A. It was an information data and analytics business. It kind of owned a sector. It had this huge opening of an end market that we kind of opened up for it. We had A whole host of private equity buyers, and then large strategics from all over the world, interested in this thing.

And a well known technology focused investment firm came in and they said, you know what, here's our valuation. And they were near the top of, they certainly weren't at the top by a noteworthy measure, but they said, we're going to close. We've done all our diligence. We're going to have no contingencies.

We're going to have no reps and warranty surviving close, which is more of a moot point now with. rep and warranty insurance that has developed since, but then it wasn't. And they go, we're going to close in 15 days and here's a fully marked purchase agreement. We're ready to go. Are you? And we said, here are the keys.

[00:43:39] Doug McCormick: It's interesting in that scenario. I think the one thing that would highlight is that there's a carrot and a stick there because not only are they saying here, I'm ready to close in 15 days and here it is. There's also a little bit of a veiled threat, which is, and if you don't pick me, I'm run ahead in a way that I've advantaged myself, but I can also.

I have my offer expire for the kinds of deals we do. I don't think that strategy is effective, but I think it's important to acknowledge it is a strategy.

[00:44:07] Sean Mooney: Yeah. I mean, it's right time, right place. And you have to have domain knowledge to do that or just a lot of guts, which is a generous way of describing.

And I think in this case, they had a really good perspective. They had the executive and it kind of serendipitously lined up. Maybe that's an extreme example of how speed and certainty can play into the equation in ways that are thoughtful as a private equity investor, that it doesn't just have to be the highest price that wins.

It also can be speed and certainty and rapport. Lloyd, to your point, where they say, you know, I want to be your partner because a lot of times the sellers, particularly in lower middle market family owned businesses, they're rolling into the transaction. So we've talked about valuation, speed, certainty, rapport.

There's kind of one other area we talked about that can make incremental differences in getting a deal done and that's kind of structure. Can you talk about the way that private equity firms think about deal structure and capital structure to say we're going to give us an ability to get to yes

[00:45:07] Doug McCormick: here?

I'll give three very common examples. One is just this rollover concept. I think, especially when it's a management team or a family that wants to roll, I think that alignment of incentives is really important for a lot of buyers. So that's an important component. The second is we talked about this earn out concept, especially if there's a hockey stick growth trajectory that the owner really believes in and is trying to get value for, I think that can be an elegant solution.

Candidly, like, To be intellectually honest, I think that also can result in some challenges. Uh, how do you define the earn out? Does it create some short term behavior problems? All those are legitimate concerns. The third one is debt financing. In this high interest rate environment where debt is less available, the seller can provide debt financing as part of the overall package, and I think that can certainly help relative to today's environment.

[00:46:00] Lloyd Metz: And again, Sean, back to the speed, certainty, and rapport. At least for our firm, we try to keep our capital structure simple and resilient because it allows a whole bunch of bad things to happen externally in the marketplace, in the world, the geopolitics and all that, because it is a resilient balance sheet.

When I say resilient balance sheet, it's a simpler debt credit agreement and a lower level of leverage than you might otherwise get from the marketplace. It is not an optimized maximum leverage kind of philosophy and approach that we take. So even when interest rates went up 550 basis points, it was more of an annoyance to our companies as opposed to a critical, threatening incident.

So yes, a black swan did land on our desk, but it wasn't a problem.

[00:46:52] Sean Mooney: I really like that perspective, particularly considering my first job out of college was in Hoola and Loki's financial restructuring group, and seeing this intimate appreciation right in a front row seat, how debt can be a great amplifier of results, both on the good and the bad.

And so that idea that we're going to be prudent with the capital structure, and if you think about the yesteryear in private equity. Sometimes they would finance purchase prices, 80, 90, sometimes a hundred percent with debt, and those days are long gone. I think really in the upper bounds, you're talking about 50, maybe 60%, but a lot of times 20, 30, 40 percent compared to someone buying a house today or a car can still often finance 80 to a hundred percent as an individual.

So I think the private equity industry has come a long way to bring that back to this kind of like middle risk profile where they can manage, you know, Like I said, the black swan flying across your forehead. And the only thing I will add that some private equity firms will do is they will take educated bets on capital structure, where they'll say, you know what, I can lever the deal at four times today EBITDA and at 10 or 11 percent cost of debt, but I'm looking at the yield curve.

I'm looking at what the Fed is saying. I think I'll be able to refinance this for cheaper. I think that the debt markets will be greater or we're going to have, we have all this cash flow. We're going to pay down debt because they still want to play. Like we talked about in the earlier episode, they feel compelled to play the IRR world that's compelled upon them.

Just because that's the way the industry is and how the incentives flow down from the upstream investors into private equity firms. And so that's part of it. But I think as we talked earlier, that's not without risk.

[00:48:38] Lloyd Metz: Yeah, that's a lot of risk. And now

[00:48:42] Doug McCormick: the one that we haven't talked about that I think is interesting and often can be a win win.

I think there can be a lot of creativity around tax efficient structuring. Right. So we always encourage our entrepreneurs to think about what's your after tax take home, not just your take home. And can we ensure that if you're going to reinvest, can we do that on a tax deferred basis? And when we structure the transaction, can we ensure that we get the maximum step up in a way that the going concern has the benefit of a tax asset that had purchased?

[00:49:14] Sean Mooney: It's a great point in terms of like, Hey, how do you let them to roll into that optionality that you're providing that second by the apple that we've talked about.

[00:49:21] Doug McCormick: And a competitive market is never going to be a good deal or a bad deal based on tax attributes. But if you're competing for a couple hundred basis points in IRR, it all adds up.

[00:49:32] Sean Mooney: I think we've covered a lot here. And once again, this is a real foundational episode for people who are Either not familiar with the industry or even those who are familiar and want to know some of the more masterclass nuances, Lloyd and Doug, what you shared here are absolutely in the category of the things that I wish I knew.

I'd say all the way back to even like when I was a VP trying to figure things out. So this has been really, really helpful. And I appreciate you all pulling back the curtain on some of these topics.

[00:50:02] Lloyd Metz: Thanks a lot, Sean. Thanks Doug. Thank you, Sean. Thanks for leading

[00:50:07] Doug McCormick: 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 own 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. com. For further information on HCI, ICV, and BluWave, and relevant topics discussed here in the episode, please see the episode notes or links.

[00:51:08] 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.