Private Equity's Key Decision: Knowing When to Exit

[00:00:00] Lloyd: 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 lessons that drive the world of private equity and business forward.

Let's go.

[00:00:37] Sean: It's great to be back. For another episode with my friends, Lloyd and Doug, how are you doing gentlemen? Hey, Sean.

[00:00:45] Lloyd: Hey, Doug.

[00:00:46] Doug: How's everybody doing today?

[00:00:47] Lloyd: Good.

[00:00:48] Sean: Absolutely. Today. I'm really excited. We have another topic that I think is very keen on the M& A markets in general right now, and it's really digging in and getting to this whole idea of.

the life cycle of a deal and when a private equity firm knows when it's time to sell. It's the Kenny Rogers gambler song. It's like, how do you know when to hold them, when to fold them, when to walk away, when to run, and when to more importantly, exit and send capital back to your investors? Does that make for a good conversation here?

Sounds great. So per usual, I'll kind of just set the stage here for our listeners, particularly for those who aren't in private equity. Those who are maybe less exposed to it, maybe don't know the inner workings or aspire to be in private equity, just to set the stage a little bit, and then we'll go to the informed people on this podcast who can actually talk about the why, so IEU, Doug, and Lloyd.

Let's get into it. So maybe to set the stage, there's usually kind of three phases in every private equity deal. Um, and then we'll go to the informed people on this podcast who can actually talk about the why, so maybe to set the stage, there's usually kind of three phases in every private equity deal.

And the first phase is kind of from time zero, almost inevitably to like three years out. And this is the core value creation phase where the PE firms come in sprinting out of the gates. They're making large transformational investments in people, processes, systems, M& A, add ons. They're doing things. that are kind of the big lifts and we'll dig into this a little more, but things are going to take multiple years to get an ROI on this investment.

It's really important to get out of the gates fast. And do these big things early and I think every pretty firm pretty much does this because it makes sense and we'll dig into that a little bit more. Then you get to phase 2 and this is where you're going to like a rolling phase 2 of check ins and so at around starting year 3, the P firm is going to check in and they're going to say, okay, is this the right time to think about an exit X days, months.

ahead, but really get to the point like we're going to make a decision whether or not it's the right time to sell. And this is a series of decision points that can go on for another one to four years, depending on how the P firm comes out on that. Is it time to sell? Yes or no. And then ultimately you get to the third phase.

And this is once a decision is made, the private equity firm is going to start diligently preparing the company for sale. And once again, run for an exit with as much speed and certainty as possible. So Lloyd and Doug, does that kind of encapsulate the phases in a general way?

[00:03:24] Lloyd: It does, Sean. And we'll step back a step further.

Again, for folks who may or may not be super familiar with private equity, generally speaking, I think it should be said, like we have to sell, generally speaking, as private equity investors. We have to return capital with gains to our investors. So with the exception of a few firms that have a evergreen strategy where they have an open ended fund or a continuation vehicle, which buys you some more time, generally speaking, you always have to sell.

So it's never personal. It's just something we have to do as part of private equity. And so there always has to be a decision about exit.

[00:04:09] Doug: I think fund structure just Real quick is it's generally a 10 year fund life and you've got five years to deploy capital and 10 years total to return capital. And so as you think about that math in the context of this five year planning horizon, right, I'm putting portfolio companies into the fund in the first five years and then roughly every five years exiting.

So I think it is kind of fund structure driven. Sean, I think the one caveat I would share about how you're talking about these phases. These are the phases that we think about in terms of things we can control. And I think we got to acknowledge, I'm not sure what the percentage is, but there's 50 percent of the opportunity we can control and there's 50 percent that is exogenous factors.

So for me, all those exogenous factors are things like, what's the market that I'm playing in? What's going on in that end market? What's happening with cap rates? You look at all the businesses that were sold in 2020, A lot of that was cap rate driven because interest rates were darn near zero. What's happening in the financing markets in terms of leverage, micro issues with your business, those are all things are happening around this decision making process.

And if all that is status quo, I think this five year model kind of makes sense. And that's really focused on what am I doing that I can control in that five year period.

[00:05:32] Sean: I think it's a great point. And so for listeners, as you listen to this, this is kind of the template, but there's going to be like everything in life, variability to the left, to the right, up and down, that's going to impact timing, structure, framework, progress, navigating the ABs of life and business.

So, but that's a very, very good. Thing for our listeners to keep in mind as we're going through kind of a template discussion, if you will. And Sean,

[00:05:57] Doug: maybe just one more comment on that. As you think about uncertainty on top of uncertainty, you lay out this template. I would actually argue in phase one, where you talk about these transformational investments, I also find that that phase, there's a ton of learning, a ton of experimentation and R& D, and a ton of iteration, right?

Because We're trying to lay in the plumbing, if you will, so that we can drive this transformational growth. But we have general ideas and a thesis about how to do that, but then you actually got to experiment and get the right resources and team in place to make it happen. And there's a lot of failure along the way there in that first couple of years.

[00:06:36] Sean: Absolutely. I think as people familiar with the industry, every PE firm or most operate with, we have a hypothesis. We think this is what's going to happen. We're going to test it. And if it looks true, then we're going to do it. Otherwise we're going to go left and right and look for our avenues of optionality.

And maybe with that in mind, why don't we jump in? And say, as you think about this first phase, we're doing the big lift right out of the gates value creation. What are some of the major categories that PE firms will invest in their portfolio companies in value creation? And why do they often put these kind of large categories towards the beginning of the investment phase versus maybe later?

We've talked

[00:07:15] Lloyd: about this in a few previous episodes and more specificity. But. You definitely want to get your people and your leadership figured out early. You definitely want to make any pricing process changes early to the extent you can figure out operational matters, whether it's production, capacity, balancing, Anything like that, you want to get that in the ground early for the reasons that Doug brought up, right?

You may have to tinker with it sometimes to get it right. But even if you don't, leadership, operational matters, market presence, whether it's with pricing or with products, you want to give those benefits of those changes as much time to compound as possible, so you want to get that done early.

[00:08:07] Doug: I think I'm pretty consistent with Lloyd here.

In this phase. I characterize it as it's the offensive phase. It's we're laying in all these investments, and I think the choice of those investments is often driven by like, what's the Gantt chart? What takes longest to get in, make right, working efficiently to derive the benefit that you thought? I think Lloyd was spot on in the context of.

Offensive investments, growth investments have the opportunity to compound. So if I can get them in place early, the magnitude of the benefit is even better. I also think growth investments are the ones that are the least tangible sometimes or the most opaque in terms of how to go make it happen. So you need to allow yourself the time to iterate and experiment to kind of get it right.

Alloyed hit a couple functions, but I would also add in addition to team. You talked about pricing, I think IT takes a while to get right because A, it takes a while to get it implemented and B, I think there's a real change management aspect to using IT effectively to make good decisions. And I think the M& A capability broadly is an offensive move that takes time to mature.

So how to mature a pipeline, how to have your team learn how to execute the M& A and internalize that capability. And then the integration playbook is kind of a subset of the value creation playbook, but I think that takes a while to get good at. So all of those things, they kind of take time to mature.

And then the one thing I would say, in the context of this offensive stage, Lloyd's mentioned this before, one of the things you're going to live with, for most of the term of your investment is a credit facility. And so in many cases, we can underwrite a lot of these investments. We can bake it into our capital structure and we have the flexibility to make investments and not be right all the time.

So I think it's also another reason why we kind of pull that forward when you've got the front end capital structure flexibility.

[00:10:09] Sean: I think those are all really spot on points and one of the terms for people kind of getting into private equity or junior people or management teams, you'll often hear something called the J curve.

Can someone explain what that J curve is? What does that mean?

[00:10:23] Doug: It's The part of the return profile where you got to screw it up before you get good. So it basically is saying that you get money invested into the ground. It's kind of dead money for a short period of time because you're doing all this work, but that work hasn't manifested itself into tangible value that somebody else will pay for.

And therefore over time you get the compounding of the investment. Simplistically. Investments today don't generate impact today. They generate impact in year one, two, three, and four. And so that's kind of the nature of what the return profile looks like in the J curve.

[00:10:57] Lloyd: I don't know if you're intending to do this, Sean, but part of what you're also opening the door for discussion is J curve also applies to the economics of the fund.

So not just the individual deals, but the actual fund, right? Where The returns and the cash flows are negative as you're investing and you're drawing fees. And then, as Doug said, your 10, whatever it is, portfolio companies that you've put into the portfolio over that first five year investment period, they don't start showing positive markups or returns.

For a year or two or three, and so net of fees and everything else, the return on your fund starts off negative, and then it turns positive. And that's why it's called J, right? Goes down before it goes back up. And so as a fund management matter. Cause that is our job. A good friend of mine told me many years ago, our job is to manage funds, not necessarily just do deals.

You have to pay attention to that J curb dynamic. And I guess we can talk about that a little later.

[00:12:05] Sean: That's a great expansion of the concept from an individual deal to a portfolio. And I think it speaks to the reality of private equity today in that it's really competitive. You're in a vacuum with so many P firms showing up at an auction to buy the same company.

The surplus has kind of been skimmed. So the only way to make an above market alpha inducing return is to create all this value. And so we get the privilege of seeing you all run towards your portfolio companies. And it used to be in the early two thousands, late nineties, it was about optimizing a company.

Now you're transforming it and each of the categories that both of you shared is totally in line also with what we see, you know, hundreds of P firms coming in and right out of the gates they jump in and it's holistic, it's people, it's optimizing costs of tons of procurement going on right now. Like how do you deal with inflation?

Like we talked about in previous episodes, it's bringing in new people with new skills, hiring like crazy technology, it's growth strategy, it's anything you can name, it's every room of the house. When we all start in our careers, probably more like we're going to do a kitchen or a bathroom to use like metaphor.

Now it's like, all right, we're stripping it down to the studs. And it's going to be a totally awesome new house at the end. So I think that that makes a lot of sense. You're going through this metamorphosis position. And maybe the last thing that we've kind of touched on, but just to put a fine point on it, like, why don't you do the big lifts and late in the hold or do a big add on late in the hold?

Why are private equity firms maybe in general less likely to do the big major investments when they think they're getting to the end of a hold period? First of all, I would say we're

[00:13:52] Doug: not opposed to doing those things that you just mentioned, but if we're doing those, it kind of means that there was.

mediocre execution or lost opportunity because we could have done it sooner. And had we done it sooner, we'd have had the benefit of this compounding. And in general, the math just doesn't work as well, right? So if you're going to do a big transformational acquisition, it's probably going to be priced in a way that to clear the market, you're going to pay a full price.

So you would have to believe I can very quickly articulate what the strategic rationale is that's going to drive premium value, or I can very quickly execute on the synergies. And I think There's a double edged sword around in acquisition plays in the context of integration. We ultimately get paid for delivering a business of scale that's fully integrated and has a perpetual skill set of integration.

And so I think if you slap two things together and try to take it to market, I think sophisticated buyers see that as more financial engineering than delivering a business of scale.

[00:14:51] Lloyd: Yeah, Doug, I think you're right on that. I think Sean, part of. The answer to your question and Doug kind of made an assumption and touched on it.

It depends on how the business has performed to date when this transformative acquisition presents itself and how have you done your job with respect to your investors, right? So have you returned any capital from that investment to your investors yet? If the answer is none, then you might think differently than if the answer were, yeah, I've returned one and a half times our initial investment to our investors and this transformative acquisition is presenting itself.

And maybe if we do hold it an extra year or two beyond our current plans, that actually might make sense to do, right? So it kind of depends on where you are when that acquisition shows up. This

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Now back to the episode. Those are both spot on and maybe adding to that one thing that I would always think through is Once again, here's another saying Lloyd. So be ready. Everyone in private equity, they're from Missouri. It's the show me state. And when we would start building companies. You're building them for the next 10 years really at time zero because you want the next buyer to have a very clear vision of what the next five years are.

And so as you get towards that year 3, 4, 5, you can show that those investments are making and paying off. The investor's like, yeah, show me that they're working. You can't just tell me it's going to happen. And so it's very natural for those big investments to take some years to mature, like, oh yeah, that's going to feed into my next five years.

The things that come later, it's just a little harder to show. Buyers that are often skeptical because there's large sums of money and that's both strategic buyers. It's private equity buyers. It's really anyone who's going to transact with large sums of money. It's harder to very clearly show that these large investments are going to pay off without some sort of maturation or kind of vintaging that goes along.

Does that resonate as well?

[00:17:32] Lloyd: No, absolutely. Again, getting back to your initial question here, which is how come private equity firms are reluctant to do a large acquisition late in their hold period? It's because they know on the other side of that, Table they're from Missouri, right? So you have these capabilities that's better than not having them, but I'm not going to pay you full value for having it and you haven't demonstrated the actual benefit.

So it's a helpful step. So sometimes that may be enough of a reason to do it, but you know, you're not going to get paid full value for it. Sellers will try and do the proforma exercise. And if you imagine this to be run rating and all this other sleight of hand. to convince you to pay full value for something that hasn't materialized yet.

Sometimes people will go for it, but oftentimes people won't.

[00:18:26] Sean: So it's more of the reality of the buyer's mentality than the builder of the private equity firm on the Porco side, not having full confidence in the ROI. It's just like, well, we won't necessarily get as full credit as we believe we should.

Yeah.

[00:18:39] Doug: And I guess I think I'd add one kind of nuanced point. As you think about consolidation strategies. Maybe this is not transformational deals, but a sizable deal. I think in consolidation strategies, you're trying to find a way to demonstrate compelling evidence to the next buyer that there are two predictable, reliable sources of growth.

One's organic growth and one is M& A growth. And so the same way you have a pipeline of new customers that you're growing with organically, you have a pipeline of M& A that You're going to execute against, and so in that case, like we find you better continue to be executed on the M& A plan as well, or people can underwrite it, even though you may have done five deals in the first three years, if you went dry for two years, they would question, are the targets available?

Why aren't you competitive? Can you not buy them at reasonable prices? And so in that case, Buyers expect that there's always going to be some level of integration that's yet to be done because the nature of the business is I'm going to continue to grow through acquisition.

[00:19:41] Sean: I think it's a very good point, particularly as it relates to add on.

In general, I think going back to our caveat in the beginning, what we're talking about through all these are general kind of concepts, but there are going to be things absolutely where you're going to make a big systems investment in the end, a major hire, all those types of things can happen and will happen based upon the business case for each company.

But particularly as it relates to consolidation strategies, I think that's a really good point. You got to, that's part of the demonstration of the engine of the show me that, yo, this engine just spins. So maybe along the path, before we kind of move on in terms of like when you decide to sell. These are major investments that you're enabling and fueling in your portfolio companies that have big repercussions on the upside for paying off and on the downside for not being executed properly.

Okay. So how do your firms or just P firms in general hold their deal teams or ops teams or portfolio company leadership teams accountable for the progress, pace, value creation plan versus what you intended to do versus actually what happened?

[00:20:48] Lloyd: That's a great question because it varies across firm by investment strategy, firm size, but ultimately what you're trying to.

Manage and deal with as a private equity investor. You are living with this company for years, the CEO, the entire C suite. You may have hired them all. You certainly work with them on a day to day basis. You're personally invested dollar wise, intellectually and emotionally in that investment. You came up with the investment thesis.

It's in the investment committee memo. It can get very personal. And when things get personal, emotions get involved and that can cloud judgment. You get attached, right? And so regardless of the size of firm, that's what you have to manage against because if I get too emotionally attached to this investment.

But it's time to go for fund reasons or the exogenous reasons that Doug alluded to. There's a storm coming macroeconomically and we got to go return capital to our investors and I'm clinging to it. It's like, no, it's not ready. It's not done. I'm just, give me more time, right? That emotional attachment I think is the root of a lot of tension in private equity firms and different firms deal with that differently.

[00:22:12] Doug: How about you, Doug? We talked about all these. Transformational investments that we're trying to front and load. And I think it's really important to differentiate the progress that we are making on the value creation playbook and getting to the end state. Versus a discussion around the financial performance, right?

Cause they are distinctly different and you can sometimes have disconnects, right? Where financial performance is not as what we had hoped it to be, but I actually feel better about what the end state opportunity is and what we can do with this asset. And so that's an important distinction, but I think it also comes with a real challenge around accountability because.

If you always can say, well, my financial performance isn't what I thought, but boy, I love the end state here. It's hard to hold people accountable in a timely fashion. We're always trying to say, let's understand the business we underwrote, and how is it performing relative to that underwriting. And then let's evaluate ourselves on the quality of our management in executing that playbook.

So I think there's a balancing act there. I try to force myself to evaluate teams based on what's controllable versus what may be outside of their control. And I think in some cases, I don't want to say that the underwriting case gets stale, but if you missed on the first couple quarters, Are you really going to hold that team accountable for the next five years and beat them up in year five because they still missed their underwriting case budget?

It's not practical. And so, like, we try to level set on what is the forecast in the context of what we know, and how should we compare ourselves to other competitors in the space that are dealing with the same market dynamics, because then at least I can evaluate. What's good in this environment or this market and I think this is where we talk about the difference between being good at the math of the business versus being good at the art.

I think creating the culture where organizations can have these really like intellectually honest conversations about here's what we missed in the underwriting. Here's what's going great, here's what's not going great, here's where we were wrong. That kind of discussion and then holding people accountable for the performance they signed up for.

That's a real balancing act. And I don't know that anybody ever gets it right all the time, but it's worthy of note.

[00:24:29] Lloyd: So Doug is touching on an approach to answer your original question, Sean, on how to deal with that emotion. Right. So one, hopefully you got to hire folks who can be dispassionate and fact based.

Right. Absolutely. Absolutely. But that's what memos are for. That's why you write it down when you're presenting to the rest of your firm. It's not something you do solo, by yourself. You have to put it on paper, state your assumptions, identify risks and opportunities, and share it with the firm. So just that simple act.

Builds in the beginnings of the accountability, right? You ultimately wind up talking about your investments in some firms every quarter. How's it doing relative to the underwriting case? If it's not performing, what's changed? Is it execution and internally driven or is it something external? What did you say about the risk in the investment committee meeting?

What did you say in terms of. Approaches we could take to mitigate those risks, are those risks still present? Are they still as severe as we thought they were? Are the mitigants effective? Are they in place? Right? You start to have those conversations generally at a firm wide level to some degree, depending on how large the firm is.

But if you do that every quarter, you again, start to reinforce that accountability and then you can have the conversations as Doug also pointed out, having a culture where you can have. The open, honest conversations is critical, right, because you have to be self critical in private equity, I think, to ultimately be effective.

What did we miss and what did we think was true that we got wrong? Is something changing that we didn't think was going to change, but turns out it's changing, right? You need to set a form and most firms have some sort of portfolio review quarterly or semi annually or however, which way they want to handle it.

That's often where these things come up.

[00:26:33] Doug: I have the same, which is I always reserve the right to change my mind with new information and I value people's ability to change their mind quickly. One story comes to mind, one of my very senior partners. We were at a portfolio company, day with the business, and then we were back at the hotel and we were kind of sitting around having drinks and another portfolio company came up, he's lead on that deal, and I asked him how the new CFO was, who had been there like a couple weeks, and he said, I think we hired the wrong guy, and I said, how could you have that opinion so quickly, and we walked through all these things, and my response to him was, this is why we're going to be good, because like, you're a willing able to like change your mind with new information and you're also willing to own it and then fix it and we got to be able to trust each other enough to be able to say we made mistakes because this is baseball, right?

Like, You're going to make mistakes all the time. And the key thing is how quickly can you course correct and can you avoid the fatal one?

[00:27:33] Sean: Those are such important points about business building that are so essential and spot on. You know, if I were to turn the lens on myself, like I think I was pretty good at like getting the main thing, like this is what we can do with this.

But in that investment memo, rarely did I spell out how we get there. But where I think like your firms and others industry is so good is getting that new information and acting on it, not just blindly plowing ahead because this was your strategy. It's the left, the right, hit the gas, hit the brakes. And that cadence of navigating the A's and B's as new information comes in is so critically important to getting to that end state.

Sean, this is a little bit off

[00:28:11] Doug: topic, but we have a set of like values and things that we prioritize. And one is intellectual curiosity. Because like in this business, there's so much data in every business. And if you just have the time and the curiosity to noodle through it, the insights that you can derive are often pretty powerful.

100%.

[00:28:30] Sean: Let's go to kind of the next chapter here. You've made these investments. You've gone your, maybe some lefts and rights along the way, you've learned, you've reacted, you've taken action. What are your internal processes for making the sell decision? And maybe talk about who's in the room, how often do you have these conversations and what do you consider in terms of signals?

[00:28:53] Lloyd: We meet quarterly to discuss the portfolio and we have some colleagues that are more operationally focused, so they also give input on how the portfolio companies are performing. So, that's it. Another step to kind of get a informed, but perhaps not as emotionally tied point of view as the investment lead or the investment deal team.

And then we also have the deal team make a call. Like when is this going to be exited? Which quarter of which year? And what do you think it goes for? And so now this is all presented to the entire firm. So you can have a conversation. Based on the recent financial history and the trend, are we still tracking to hit this level of performance that you're basing your exit assessment on?

Is the timing still what you expect? Is that reasonable or is that not reasonable? And then the flip side can be, well, given how the company's performing, should we think about exiting earlier? So you can have those conversations and people who are not on the investment can chime in, of course, and sometimes that's the most helpful input where you're.

Again, really focused on that particular investment and you're tracking at. 3 times your money, and maybe you're trying to get it to 3 and a half times your money, and maybe 1 of your colleagues says. I appreciate that, but if we can get a solid 3 times our money. And not wait the extra year to get the half turn.

Maybe we should just exit sooner rather than later, and then you can have a different kind of conversation.

[00:30:35] Doug: I think that's spot on. How about you, Doug? I think in this business, everything is for sale always, but we try to make decisions as if we're going to own it forever. Right? And so that's like the ultimate contrast, right?

At the right price, everything's for sale day one. My management teams know that and they understand that we're economic animals and that's like what we're in the business to do. But I think if you own the business as if you're gonna own it forever, I think it gives you the conviction to pick your point on when's the optimal time to sell and hold when you need to hold.

Our process is kind of like Lloyd's. We basically do this throughout the year, but every portfolio company has a conversation amongst the firm on where we are tracking on this value creation playbook, which is the the context for, well, then how are we doing and how close are we to being ready to sell?

Our deal teams will come in and they'll say, here's the financial performance. Here's where we're tracking on the value creation playbook. And we kind of like assess ourselves on a whole bunch of different metrics. And then we say, based on that, here's the conversations we've had with various bankers.

And therefore our view is those things all roll up to this kind of exit timing or profile. To me, it's a little less precise. I think that conversation sets us up to say, it's this year, it's next year, or it's unknowable, and so we're a little bit like, I got really good visibility in the next 12 to 18 months, given what's happening, and you can kind of say it's clearly not, or clearly is.

And the other stuff may take time.

[00:32:12] Sean: How do you think about timing the market with a portfolio on the ups and downs? Because I'm sure there's a lot of people that say, Oh, I wish I sold everything in 2022. And there's probably a lot of people that said, Oh, I wish I bought everything in 2024. So do you think about timing the market?

Can you weigh that in? Or is that just something that good luck, right?

[00:32:38] Lloyd: Well, it's a little bit of both. I think Doug please chime in, but the fact of the matter, it takes the better part of a year, sometimes 18 months to get a company ready to be sold. So, yeah, you do need to kind of look ahead and to a crystal ball as best you can engage what may or may not be around the corner 12 months in terms of market conditions.

But like Doug said, there's only, but so much you can control. One of our first exits ever at our firm closed in the fourth quarter of 2008 when the world was pitching into the great financial recession, right, but we got it done and had a pretty good outcome. So, yeah. You can't always get the timing right, but you do the best that you can with the information at hand.

[00:33:28] Doug: I totally agree. I think it's a dangerous strategy to try to time the market if that's your Requirement to be successful, right? Like I don't want to have to make the bet that I'm gonna call the market correctly to generate a decent return But I think like if I'm self critical of our firm, we're so Into the business building and we're so focused on like what we can control that I think sometimes it's really important to step back and pick your spots in the market, right?

Because the value creation opportunity can be huge. The insight to see that 2021 was a great time to sell anything that was sellable is super valuable in driving kind of that fun portfolio construction. We try to remind ourselves, okay, we're business builders, but we're also investors and you got to be looking at both of those drivers of value.

[00:34:20] Lloyd: Doug, you got me thinking about a mentor of mine from a previous firm. Who said when the ducks are quacking feed them and it took me the longest time to figure out what the heck does that mean? Right? But that's what you're talking about, right? You talk to your bankers, you talk to your lenders, you get a sense for the animal spirits in the marketplace.

And if folks are. Feeling frisky like in 2021, if you have something that's saleable, sell it. Don't overthink it, , just give it to 'em because that's what they want, right?

[00:34:52] Doug: If you think about it in a leveraged business where half your enterprise values equity, half is debt, a multiple turn can represent a 20% equity value appreciation.

So that's a lot of growth where obvious. Very price sensitive to where the market is.

[00:35:08] Sean: And the only thing I would add to the ducks are quacking kind of point is sometimes you get someone who comes in with an offer that's this preemptive offer just out of nowhere. And when the universe calls, you got to listen.

And sometimes that's enough to say, all right, let's go. And then you call your friend at the investment bank that you prefer most, or probably multiple friends and say, let's go. Well, let's bring it because we have something that's too good to pass up because you can always take something off the market.

You never want to, but sometimes just some sort of manna from heaven just kind of flies down and you got to respond to it. So one other question that I'd love to get both of your perspectives on is, The idea of how much are you thinking about constructing a portfolio and optimizing a portfolio return versus maybe looking at each portfolio company in a vacuum and optimizing for that individual company.

How do you think about this? Like now we're really generating a collective outcome versus a series of single outcomes.

[00:36:09] Doug: Ultimately, our investors. I don't believe they care that much in the context of how the return has been generated. They're going to measure us mostly on aggregate returns, net IRR, DPI, net MOIC.

And so that would imply like they care less about the individual contributors. And the one caveat to that is I think if you got a lot of zeros, they see volatility in the portfolio, which implies I think that's harder to replicate. But I think our customers want a product that generates kind of consistent.

NetMOIC and NetIRR targets, and so It implies we should be managing the portfolio. I think the best way to do that is to look at each individual asset on a risk adjusted basis. And so you're looking at the contribution to the portfolio up and down, but also the volatility around that outcomes as you think about what you're managing.

[00:37:02] Lloyd: Yeah, I think that's right, Doug. And again, MOIC, multiple uninvested capital. So how many times your money have you made an IRR? We talked about that in a previous episode. I personally think IRR. Is the more impactful measure in the minds of most investors. And so returning capital, DPI, distributed investment.

Is important, right? So returning capital sooner helps with your DPI metric. So how much of the invested capital has already been returned to your investors, the closer that is to one or exceeds one, the better. And then you get that done sooner, that increases the IRR, flattens out your J curve, particularly if you can invest the money faster versus slower, that's less fees.

And less time, which hurts IRR and stretches out hook part of the J in the J curve, right? So you got to keep those things in mind because you're managing a fund, not necessarily individual deals. And there may come periods of time where that conversation that I mentioned before, where the deal team is like, I think we can get this to three and a half times or maybe a little more.

But from the fund's perspective, if I just got three times, it's a good result, but it's also good enough. You should go get the three times and exit sooner. That's where that conversation about the fund performance management kicks in. Some firms separate the two, right? There's a separate group of people who make that exit decision from the investment team for that reason, right?

So you don't have to get into that debate.

[00:38:52] Sean: That's an interesting way to do it. That will definitely remove the emotion. And kind of the connectedness to an individual deal, particularly on deal teams, if you have someone else make the call.

[00:39:03] Lloyd: But you also have to think about it. I was just listening and you might call a party foul on this comment, but I was listening to another podcast about private equity and they were interviewing.

The guys from 3G Capital who made 28 times their money on Burger King, right? And they took you through the different steps and stages where they decided to double down again and again and again. And so, that's also part of the tension, right? If you have a real strong winner, doubling down a company that's sitting on a three or three and a half X can get you to seven X, right?

Double down again, that gets you to 14 X and those kind of returns don't happen every day, right? So. If you're too dogmatic about it, you might miss some really strong opportunities.

[00:39:52] Sean: That's a good segue into a good topic to kind of wrap things up on is, there's clearly an art to selling. There's some science, but there's a lot of art, there's a lot of feel to it.

I think we can all think about opportunities where you had positive and after the fact regrets either way, because it's hard to be perfect, but we all strive to be that best but never final. Kind of mentality. So what are some of the pitfalls that you've kind of experienced or think about during that time to sell?

What are the some of the things that would give you that kind of like, oh, I wish I did it.

[00:40:27] Lloyd: Oh boy Hope is a pitfall. I would say things aren't performing the way you would like them to You are making some changes and you hope that things work out and you hope the leadership team Can get things going?

And the next thing you know, a year's gone by and you're kind of in the same place. Should you give it more time or should you make another change and those kind of decisions can get you, I don't want to say frozen, but it can kind of get you immobilized a little bit in terms of taking action. That is a pitfall.

[00:41:06] Doug: I'd offer up a couple of things. In this business, there's a tendency to fall in love with the asset. You're close to the team, you see all the opportunities, and so you get too close to it. The second is just this whole concept we talked about of balancing the exogenous factors and the market dynamic upon which you're competing versus the tangible things that you believe can create value.

And I think sometimes the tangible nature of those opportunities gets overweighted relative to evaluating where we are from a market context. We've talked about the different emotional dynamic between being a dispassionate buyer and a dispassionate seller. I think I've shared with you guys before, I'm super dispassionate on going into a business because like until I own it, I don't own it.

And so I'm very analytic about exactly what I think we've agreed to do. I try to put myself in that same position when I'm exiting, but because you're invested personally in the journey, you tend to like, Not be as dispassionate. And so I think just forcing yourself to be clinical about what that looks like on the back end.

I've never sold a business where I didn't think it was worth more than it sold for, right? Cause you see all the good. And then I think if you don't have conviction in owning, it's kind of like a management challenge. If you think you have a management problem, you do. I would say the counter argument on the portfolio is if you're not sure you want to own it, you shouldn't, right?

And so as soon as you lose conviction, you got to change something about the asset. Or you gotta figure out how to get outta it.

[00:42:34] Sean: That's a great way to think about, it's like, would you buy that company again at that point in time? Every time you're having the decision, but I wanna put more money at that price.

Yeah. Yeah. At that price. Yeah. Yeah, at that price.

[00:42:45] Lloyd: And that is being explicit in asking that question could be part of an effective accountability discussion, portfolio review discussion, and also helps you decide whether you wanna fold them or hold them or run away. To use your gambler analogy from the top of the show.

[00:43:03] Sean: It's so interesting that whole mentality and I love the idea of like, would you buy that company again at the market clearing price every time you think about buy or sell? The answer is yes, there's kind of your answer. And then the other thing that I would always kind of wrestle with is just the psychology of people, right?

It's just this idea. We know that loss is way heavier on people than gains and you're like, Oh, I'm going to lose it. You think through it like the Burger King example, I think a lot of PE firms would say, you know what? What if we just sell this thing at. We got a five bagger. Let's go. And turned into a 28 times return.

And so, what some of the Partners I had were really good. It's like when things are really good, don't stop pushing that flywheel and let it coast. That's when you push it really fast and you go, and you get everything you can out of that. A couple that kind of crystallized the way to think through that for me is that whole idea of like, would you buy it again and again and again, knowing that it's going to get better and better and better because who knows that asset better than you.

That was the thing that I wrestled with is like, Oh, let's take five and go, like, no, it could be 28. I don't know that I was ever great at that.

[00:44:08] Lloyd: Yeah, that's why that's a great question to ask explicitly because it gets you thinking about things the right way.

[00:44:14] Doug: That scenario I think is hard in the context of like, the upside downside are not proportionate in my mind.

The person who had a 14 bagger available to them and didn't take it. Think about the consequence of that outcome when it goes to two.

[00:44:30] Lloyd: Hey Doug, sorry to interrupt. Same timeframe as the mentor with the ducks quacking, there was an investment that was a 13 bagger, took no distributions, no cash, and wrote it down.

Not exactly to zero, but close enough into the single digit. And there was a conversation with some of my mentors, peers who were. Fonts of wisdom they struggle to understand how you could do that right because in their minds if you have a 13 bag or shouldn't you couldn't you wouldn't you have distributed three times your money and then let the rest ride but to distribute or to liquidate or return to investors.

Nothing. They really struggled with it. And it left an impression on me where I was like, you know what, that's actually a really good point.

[00:45:29] Doug: Just out of curiosity, did he tell you the ducks quacking story after he rode down to

[00:45:34] Lloyd: 13? There's a totally separate, totally separate person.

[00:45:38] Doug: Yeah. Okay. All right.

Just

[00:45:40] Sean: checking. Just checking. Didn't look and see that there are no ducks left in that pond.

[00:45:45] Doug: And that's a great segue into fund management versus. Individual company, right? From a fund perspective, locking in at least partially a really good outcome or turning capital. That's hard to say no to.

[00:45:57] Sean: That's

[00:45:57] Lloyd: right.

[00:45:58] Sean: To go to the gambler, take some of your chips off the table and play with the house's money.

[00:46:01] Lloyd: That's right.

[00:46:02] Sean: So maybe one last kind of topic. This is more of a nuanced one, but let's talk about, as you think about fund management versus individual management and individual people on your teams. There's this concept in private equity for those who are newer to it or they haven't been in it called track record, and it's specific to the deal team.

And if you're a deal team investor, you pretty much track every investment you've ever made since your first day in private equity. So you can demonstrate the complete. Work of investing that you've made over your career and demonstrated a continued change of success through cycles, through decades, through time, et cetera, that can create bias or impact like anything can in a decision making process.

So how do you think about kind of that concept of track record and how it could influence things specifically as it relates to private equity and the nuances of fund performance versus kind of individual performance?

[00:47:06] Lloyd: I'm sure it plays a role and I suspect it plays more of a role when things are not working well.

I think that's probably the more dangerous scenario where trying to do something to protect your track record, so to speak, kicks in, right? Because that's going to lead to asking for more time or asking for more resources or not cutting your losses, not focusing on return on time. On the other side, There's usually enough guardrails to protect against taking excessive risk on the upside.

You can have the conversation like we were just having, Hey, if you think this four bagger or five bagger can become an eight or 10, how do we de risk it? How do we return some capital to our investors and then play with the house's money? I think it's easier to have that conversation. It's probably rare that you get hurt by that individual incentive to.

Have a great track record on the upside. I think it hurts you on the downside. What's your experience been done?

[00:48:13] Doug: What's all acknowledged. There's oftentimes individual incentives can be misaligned with organizational incentives and every business deals with that in some form or fashion. We try to address it a couple of different ways.

First of all, in our investment committee, we have very broad participation. And so everybody that's an officer votes on every investment. And so my view is, hey, I don't care if you led the deal or you voted on it, you voted on it, you supported it, you kind of own part of that record. Now that's not perfect, but I think it does cause us to really challenge and figure out where you stand on the deal because you're going to have to be accountable for participating and approving it.

I think there's a cultural element to this, like do you trust people enough to have those hard honest conversations? There's an economic element for all of us, which is. Pissing away Kerry on a bad deal is a really expensive proposition, and so, like, we're all super motivated to get to the right answer regardless of the individual politics.

And I think you bring up a slightly different topic around, there's a balance between group decision making and hard one on one conversations. My analogy would be the following. Our entire deal firm sits in on investment committee meetings because I think it's tremendously important to have everybody see the topics being discussed.

It's really a great developmental opportunity for our young team members. And so I want everybody in the decision making, everybody should feel the opportunity and the right to participate and like give comments because some of the best questions come from our junior team members. But sometimes some of the real hard conversations have to be more one on one or smaller group.

If you're really going to take on a deal team with a hard issue, sometimes that's better a discussion in a small forum. And so that balance between like the whole firm discussion versus individual discussion. I

[00:50:04] Sean: think those are completely on point. And you think about there's the individual impacts that people in your own decision making I'll certainly profess to feeling that with investments I've made where I'm like, Oh, I'm a wee in team person, but there is a royal wee like, Oh my gosh, I need to do well, I'm going to be out of a job, right?

But then on the flip side, private equity is the ultimate team sport because the only way everyone does well at the P firm is if everyone does well. If you're not meeting that minimum preferred return of 8 percent and then some, and then some, The real economics and private equity are on the carried interest, the making and sharing of the profits that everyone generates.

And if you're as a team making bad decisions and one person goes off the reservation, then everyone suffers. And so I think the investment committee is the great kind of check and balance in that process, because everyone can have those open discussions. Now they're not without politics. They're not without kind of agenda in reality.

That's human nature in general in any team, but it usually gets to the right point because everyone is tied to everyone else's kind of success and failure. Is that a fair way to think about it? Totally agree.

[00:51:16] Lloyd: Absolutely. Well put Sean.

[00:51:18] Sean: And I think that's one of the big reasons why it is an industry. You are generating the most differential, consistent returns over time because of the way that you've, Kind of built the systems and structures and incentives.

So I think we've really, really had a great conversation. This is another kind of like private equity MBA class for those who are new to the industry. This will give you an inside lens into how you should think about selling a company well, and going through those processes. And I think it's going to be something that will really also tee up further conversations that we have as a podcast as we kind of demystify and pull the curtain back.

[00:51:57] Lloyd: Thanks a lot, Sean. Really enjoyed the conversation. Thanks, Doug.

[00:52:00] Sean: Good stuff, guys. Thank you. Doug and Lloyd, great talking. We'll see you next time.

[00:52:06] Doug: 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 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 builder's 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.

[00:53:07] Sean: 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.