Rollover Equity and the Power of True Alignment

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

Let's go.

Sean Mooney: It is great to be back with Lloyd and Doug. Doug and Lloyd, how are you?

Lloyd Metz: Good man.

Doug McCormick: Good man. How are you?

Sean Mooney: Doing great.

It's always a good time. We get to pull ourselves out of the craze of the days and then talk about fund subjects like rolling over equity into transactions. What do you think about that?

Doug McCormick: Nothing [00:01:00] more exciting here on a Friday afternoon.

Sean Mooney: That's what Lloyd lives for, is talking about rollover equity on a Friday.

Lloyd Metz: What else would you want to talk about? This is exciting stuff like this is actually super exciting.

Sean Mooney: It is as exciting as it sounds because it really actually is. It's something that makes the world go round and round in lower middle market, private equity in particular, and it's a way that multiple people win and who doesn't like the 'more' button?

We've all seen that commercial again, "Let's just all get more."

Why don't we jump into that, if that sounds good to you guys?

Lloyd Metz: Absolutely.

Doug McCormick: Let's do it.

Sean Mooney: Alright, Doug, kick us off. When we say rollover equity for people who aren't in the PE world, what is that? First of all. And why should owners want to do this?

Doug McCormick: Why not? Let's start there. So first of all, what is rollover equity? So essentially, if you're thinking about selling your business, it's simply keeping a stake in the business on a go forward basis. So oftentimes Lloyd and I are dealing in a lower middle market where we're buying founder and family owned businesses in many [00:02:00] cases.

And so as part of that transaction, we would often buy a majority, and the family may keep partial ownership interest. So why is that interesting? First of all, private equity is generally a high return asset class, and so you're always asking yourself, what am I going to do with the money once I sell the business?

And so here's a good alternative in general, but I think there's a bunch of other reasons, right? You know this asset super well, you've lived with it, you've owned it, so you have a very good perspective on the risks and the opportunities, probably more than any other asset or investment that you could choose to make.

Now if you're rolling over it presumes you think your partner's competent and you believe in the strategy. But in many cases, when guys like Lloyd and I are getting involved, there's, because there's a specific strategy about how you're going to create outsize value. And so whether it's a growth strategy around a new product or a new geography, or it's a consolidation strategy, you have the opportunity to avail yourself to that.

And in many cases, as [00:03:00] you think about when people take our investment, they're looking to realize a significant value creation opportunity, or they're looking to diversify their assets and rolling over allows you to do that. You've sold a majority, you can deploy that money in a variety of different assets, and this is the portion that you remain concentrated.

And I think the last financial benefit is it's super tax efficient. And what I mean by that is if you sell the entire asset, you're going to take all that money, you're going to pay tax, and then you're going to invest in, it's going to compound on that reduced number. Whenever I roll over, you can generally structure it in a way that's tax free and that allows me to compound that bigger number.

So it's like staying in the game with maximum dollars at work. One more point I'd make is there's a soft benefit, and that is, I think it gives the owners a chance to be a heads up partner. And I think there is a different feeling when you've got skin in the game and the ability to speak as an equity holder.

And I think a lot of entrepreneurs who are used to being in charge [00:04:00] like that. So there are lots of different reasons on why this is very prevalent in our part of the market.

Lloyd Metz: And Doug, can you say a little more, what is it maybe that guys like you and me, what, why do we like rollover? Why do we offer rollover?

Why do we like to see leaders of businesses rollover equity?

Doug McCormick: Yeah. Two big reasons. One is I do think there's a valuable signaling element here, right? Like it says, I've agreed to purchase your business at a fair value. It's a fair value that the seller still believes the prospects for the business are really good.

And I think the other thing is in many cases, listen we are relying on these management teams to drive the value creation playbook. And we want them to be aligned in a way that they're willing to work hard and be committed and stay involved and stay invested emotionally as well as financially to go make those things happen that we all think are possible.

So that alignment is super important and powerful.

Lloyd Metz: The alignment part, you can't [00:05:00] emphasize more how important that is, right? Because you definitely don't want, as we've talked about in other episodes, you don't want any gap between what we think is possible. What the founder, the CEO family member, leader thinks is possible.

They have ambitions and aspirations to double or triple the size of the business. We're there to help them achieve that, right? You've got to remember the starting point. And so they need to benefit and gain from getting that growth dream realized as much as we do, like you can't have an us versus them dynamic.

You can't have a leader of a business thinking that they work for quote unquote the private equity firm. So you absolutely want them to benefit as much and in some cases you can set up, they can benefit even more than we do if we hit the plans, if we grow as dramatically as we all think [00:06:00] we can. That last point, Doug, I think is super critical.

Sean Mooney: Let's plan on digging into that a little bit more, because I think it's important. That's the name of the game, right? It creates alignment. And for our listeners, like one of the things that you'll hear probably from the private equity professionals or friends who are done, they'll talk about this being the second bite of the apple.

As the person on this podcast who is the jargon person, I'll let you know that's what you're going to hear. But before we go about my metaphors and cliches, let's maybe drill down first a little bit just about the mechanics. So when we say rolling over, does that mean the owner has to sell their stock or the assets of their company, pay their taxes, and then buy it back in after taxes?

Or are there ways around that so that they can get favorable treatment? Defer that day till later?

Lloyd Metz: You pay taxes on the part that you sell and get cash for at a very high level, simple way that's hard to avoid. The part of [00:07:00] rollover is the part that you're not selling, and so you're exchanging equity in your business that you currently own for equity in the new entity that the private equity firm sets up.

And so that exchange of equity for equity is tax free, just at a very high level, simple explanation. And so there's opportunity for that leadership team, that leader, their family members, whoever is in the current business, who wants to continue on in the new private equity backed journey to own 25%, 30% 40%, close to 50% depending on how you cut the deal with your private equity partner.

You own that much of the go forward equity of the new business. So to Doug's earlier point, it gives that leadership team an opportunity to benefit from the growth plans as much as the private equity firm. And given that they're going [00:08:00] to be running the business, Doug, I think you said it very well, like we are relying on that leadership team to execute and drive the business.

Those hour to hour, day-to-day, week to week, month to month decisions, they're going to think about it differently. If they own a material amount of equity, there's the idea that there's our expectation that they're going to make decisions that benefit the equity value and the equity shareholders and all of those little decisions that add up to the bigger decisions and add up to the ultimate results, they're going to keep that in mind.

Sean Mooney: As we drill further down on structure, so the good news is you'll sell your business. You get to A) monetize the majority of your ownership in a company and get real money to take that stress off your shoulders. You will have to pay taxes on the part that you sell. Now, if we drill down further on that, true or false, is it better to live in Tennessee or New York, Maryland, [00:09:00] Virginia?

Lloyd Metz: Hey. I'm not going to touch that one.

Sean Mooney: Wait a minute. Where do I live? Oh, wait, I live in Tennessee.

Lloyd Metz: Yeah. Or Nevada. Or Texas. Yeah. Yeah.

Sean Mooney: Now the ultimate is puerto Rico, which I haven't gone that far yet.

Doug McCormick: Sean, I appreciate you really rubbing that in.

Lloyd Metz: Just for our listeners, it's interesting where some of this applies, and Doug, you've probably seen it sometimes it's a family owned business.

So Sean, you are the leader of this business and you have siblings and maybe you have an aunt or uncle, they want a hundred percent liquidity. You don't, right? So in total, we're talking about the family needs to roll over. But it's best if it's the active participants in the business who are leaving money into the company who have continuing equity interest in the company.

If it's your older brother and older sister who aren't involved in the business and it's your uncle, your dad, who's the founder's brother, well we can cash them [00:10:00] out because they're not important to the business or they're not active in the business. And oftentimes rollover is helping to bridge those kind of dynamics.

Doug McCormick: And just to like do some real quick math because I think like the power of this tax efficiency is really interesting. So let's just do a real quick scenario. You say you had $10 that you're going to reinvest in the business or roll over. And if you just roll over $10, and let's say we do four times our money, so $10 turns into $40.

If you sold that and invested it somewhere else, your $10 turns into $7. So your four times is $28, right? So the difference between $40 and $28, 40%, so that the tax deferral and then the incremental compounding that you get in a good outcome, it really is powerful. And people often say if these situations perform well through a combination of leverage and growth, you can make more on your rollover than you did on the initial sale.

And that model I've seen manifest itself [00:11:00] a number of times. And so it's the gift that keeps on giving.

Sean Mooney: I think that's a great point and that's that whole second bite of the apple thing where, how many times have each of you seen that, where the owner or the person who rolled in made more than the original transaction in many cases by significant numbers.

And maybe we'll talk about next, like maybe how that alignment supports that case, but it gives you this opportunity to really get some of that risk off their shoulders, maybe align, we'll talk about aligning the shareholders within a large family business. The operators are solely involved in the next ownership.

What about for those who roll over if it's a family business or whomever, if there's one big holder, if you will, what do they also get if they've rolled over a substantial amount in terms of governance versus maybe a family seller, whether the CEO may continue, but they've sold every dollar of their equity?

Doug McCormick: If a management team or a seller is meaningfully reinvesting, we would treat them like any other meaningful investors. [00:12:00] So they often get board representation, they get minority shareholder rights, and that includes things like participation on new investments. And so they get to maintain their ownership percentage, which can be important.

You're investing along the way. And so in good deals, we're actively trying to get more exposure, and so this gives you a chance to preserve your equity along the course. I think those are the two biggies. Minority rights board representation, and I think the big one on minority rights is just the ability to participate along the way.

Lloyd Metz: I think you got that a hundred percent right, Doug. Part of the other benefit is, and again, it depends on the circumstance and how much people decide to roll over and how much people decide to liquidate, but I've seen situations where taking that very concentrated personal or family net worth tension off the table,

so they've literally put enough money in cash and liquid investments somewhere in the bank or an investment firm for their family, [00:13:00] whether it's college aspirations or whatever their family objectives are. They've got enough that they're now comfortable taking more risk. Actually, they literally, personally, at the job working at the company,

are more comfortable opening up the playbook and taking more risk. It's actually pretty cool to see. And so when you find the right person and they roll over the right amount, you kind of see that dynamic play out and it's really cool to see.

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, [00:14:00] and on time due diligence and value creation needs.

Now back to the episode.

I think that's so spot on. I always thought about, we'll do sessions with new team members who join and I'll share kind of like the history of the private equity industry. In large part, they created a segment that didn't exist. But one of the things that I think business owners feel and if you can talk about this more, is that once something becomes worth a lot of money, you start playing defense.

And then what happens, Doug, you can maybe talk about when you watch like the Army football team start playing defense and not offense, what happens to the score?

Doug McCormick: It stays low!

Sean Mooney: But like any sports team that we all like now I'm a Cleveland Browns fan, so I don't know what it's like to have a lead and so, so, but I've seen other teams when they have leads, but inevitably psychologically losses way more than gains. And then the companies start playing defense, and [00:15:00] then if you're able to take some off the table, then suddenly you can go to sleep at night.

But then you keep an amount in your plan for the future as well. So talk about that, like some more about like how that defense versus offense and how you almost reinvigorate yourself.

Doug McCormick: I think there are two aspects of what you're getting at. The first is fundamentally I think private equity is solving one of two things.

It's solving the succession planning, like the need to help finance generational transfer, or it's bringing growth capital to the table where they can execute on a strategy, right? And to your point, if this asset is the majority of the family's net worth, you've got to manage that asset in a way that's pretty low risk or risk adjusted relatively secure.

And so you're also consuming. The family's spending the money to live a normal life, and so this allows you to take the money off the table. And to your point, this becomes, quote, your 'equity portion' of your broad portfolio. You can really make some meaningful [00:16:00] moves and take some risk, but prudent risk in the context of a diversified portfolio now.

Lloyd Metz: That dynamic is a hundred percent true, and I don't know what you, Doug, but for us, we often are trying to figure that out in our diligence or in our pre diligence, getting to know a leadership team, an entrepreneur, trying to get in between their ears to figure out how are they thinking about things.

Because, rarely, at least in my experience, maybe folks are more forthcoming with you, Doug. Rarely do people share what they're thinking and feeling as it relates to what this transaction means, how they're thinking about it, what are the other factors that are affecting their decision to transact?

Doug McCormick: For sure, and that's why I think actions often speak louder than words.

And we circle back to this whole concept of there's a big signaling aspect of what reinvestment means from our seat. Where we get to evaluate the business and do all the diligence and do our work, and then we get to also say, these guys are [00:17:00] acting in a way that's consistent with the underwriting,

right? So I think that's super, super powerful.

Lloyd Metz: Absolutely.

Sean Mooney: I'll even personalize it. My whole career, nearly 20 years in PE that was ingrained like the power of this alignment and rolling over it. And you could see family business after family business, like fighting the risk and playing it safe.

In the earlier days of their business as they're all gas, no brakes and just creating tons and tons of value, then it starts being worth something. Even though I knew that for the vast majority of my professional career, I started feeling that here at BluWave, where it's just like every day I am like, "Oh my God, this thing is worth something now."

Like, what if I screw it up? I would constantly have to hold myself accountable saying like, "Don't screw it up. Don't screw it up. Be safe." And I think every business owner feels it, but I never knew what it really felt like being on the other side. And then we brought in some capital and I took a modest amount off as far as the minority equity investor that came in, but really as much as anything, just for my wife, it [00:18:00] was great because she's like, "All right, dude, if you get hit by a bus, at least like college is paid for," and like.

Doug McCormick: Well, and good chances. She knew you were going to screw it up.

Sean Mooney: Yeah she's still giving me time too, this is very true. So she's like "One of two ways: you take a little bit off or you double your insurance." I think it was more of an "and" wait a minute. No, actually I've been like, somehow, amazingly, I've been able to double down on this thing for like nine years.

But to your point, it's like that's in everyone's mind. Like, "What if I screw this up? Like the vast majority of my net worth is in this thing and it's all on paper."

Lloyd Metz: So you've lived this, Sean, you've lived this.

Sean Mooney: Yeah.

Lloyd Metz: Yeah. You get it.

Sean Mooney: Yeah. The difference is on, this one versus maybe the next one is that I rolled north of 90% of what I had in this new one, and we'll talk a little bit about what that signals to the investors and what it does in other ways.

That does create a huge amount of alignment, because I'm still like the [00:19:00] vast majority of what I have is in this business. So every day I wake up like, "Oh God, I start at zero. Let's go

Doug McCormick: One comment on your specific situation. So we've all talked about how there's an important signaling aspect here, but in some cases it's not a perfect signaling aspect In many deals that Lloyd and I do, because we're still providing 80%, maybe even 85%, 90% liquidity.

In your situation, there is no way that you could do that deal without believing in it, right? Because there's no basis on bringing in capital and keeping 90% where you don't think it's a good outcome for your own investment, right? So you couldn't take enough off to make that make sense.

Sean Mooney: I think that's exactly right.

You have to really believe in it. And I also, to be candid I also have a pretty good vision of like how we're going to get to the next spot in large part. I think through the grace of having been in your industry for so many years that I just learned a lot about the next road ahead. But [00:20:00] so many people, I can imagine if I didn't go on that path, I would really want to partner where I'd say, I don't know how to get it there.

And don't take this as like, I really know how to get it there. I have strong hypothesis and I guarantee you, to your point, I'll screw it up like probably two times a day, but I'll go left and right really quickly.

But to your point, I think it also says like a lot of people, if you didn't get to see that movie over and over again, it really behooves you to also bring in a partner.

And so talk about now, you've got an owner who's rolled in and then maybe what are the benefits of now that the risk is off their shoulders, they've got fuel, they've got a partner to show them the way, and then maybe they've got less noise from the family.

And we all know family businesses can be amazing, but there's also tough elements of it.

Lloyd Metz: I just want to go back before we jump into this. I think the piece Doug was raising about your specific decision to roll over whatever 90% of your value and take a minority investor relative to [00:21:00] the control buyouts that Doug and I do and that many private equity firms do,

the nuances of signaling do differ. I just want to take a little time and talk about signaling though, because I'm consistently surprised at how many CEOs, business leaders of the companies we look at don't really think about the signaling effects when they say, we think this business is about to hit an inflection point and it's going to double in size in 3, 4, 5 years.

And with your help, we can triple it in size, but I want 80% of my value cashed out today, and I'm only going to roll over a little bit. Like those are super inconsistent. But that kind of presentation happens really often and it's super telling. And so for any business owners or entrepreneurs who might be listening to this episode, just be mindful of that.

You don't listen to your advisors if you've hired bankers or brokers or what have you, because they will try to get that rollover number [00:22:00] lower. But the signaling affects your capital partner. It gets you off on the wrong foot, I think.

Doug McCormick: I agree with you, and I'll even be a little more explicit. I think people actually will lean in on value more if you are putting skin in the game with you in a way that your 20% didn't cost 20%, I think people will stretch in a way to say, "I was going to pay X. This guy's going to be a partner with me, and I'm willing to lean into that because I value that alignment of incentives in the signaling."

Sean Mooney: What does it tell each of you?

Maybe we'll do like the binaries and you've got in the extremes of what's possible in a buyout. You have an owner that says, "Hey, I want to bring in a partner. I want to get some liquidity, but I want to roll 49% or have 49% as much as I can roll to get 49% of the ownership afterwards." Versus the person who says, "I don't want to roll anything.

Maybe I'll roll like one to 2% over."

What goes through your mind when you see that and the banker tells you about that for the first time?

Lloyd Metz: So in the first case, [00:23:00] I want to hug that leadership team and I walk away from the second one. Why? You just don't believe, you couldn't send a more clear signal that you don't believe in the future prospects of this business.

Doug McCormick: So in the first one where there's this meaningful reinvest, you don't have to underwrite whether they believe you're underwriting what they believe to be true. And in the second one, you're underwriting do they believe, and you're underwriting whatever the base case is. So obviously that's a slightly more difficult underwriting, I will say.

I've had situations where like we bought a hundred percent of the business and there were reasons that made total sense. Sometimes it's an estate issue, sometimes it's a really significant older founder who has said, "I need to be fully retired." We have done deals where we've cashed people out a hundred percent, but I think the circumstances have to be reasonable in the context of like why they're doing it.

Lloyd Metz: And in the case, Doug, with the older founder who wants to [00:24:00] be cashed out entirely, how do you set it up such that the go forward team can benefit from equity other than the incentive equity grant? Have you ever cut a deal with the founder to say, "Hey, gift or grant some portion of your current equity to the leadership team for them to roll over?"

Doug McCormick: The situation where I find this coming up the most is when we're doing a consolidation platform. I've already got my platform and I'm working with entrepreneurs where they're a small piece of a bigger business now, and they're not maybe a senior part of the new team and they want a hundred percent liquidity.

And at that point I say, "I've got a business to scale with competent managers and I know the business well enough and I can act like strategic in a way that I can buy them out a hundred percent and feel pretty confident about being able to manage the outcome and underwrite effectively." So I'd say that's the most common scenario where I found that.

Sean Mooney: Got it. Let's drill down further because I think this is a really important, like what are the red [00:25:00] flags for business owners and IT signals that they may not even know they're sending and they say, "I don't want to roll anything over. I want to be a CEO who just has options in the business. Just like if you had hired me outside of it."

And so what goes through your fear? You buy this business and it's a part of a multi-location platform. We'll say it's pool cleaning, something like, oh, you're doing a new platform in pool cleaning. And this person says, "I want to sell everything." And they are the company. What goes through your mind about what are the bad things that could happen?

Are they signaling immediately one day after close?

Lloyd Metz: Well, a big part of it is, and again, this is also part of what you try to suss out as you get to know a company's leadership team, the CEO and diligence, you're trying to figure out is this transaction going to result in enough money in terms of proceeds net of rollover.

Where that person, if things don't go to plan, if things go south actually and get bad where they can walk away and they're perfectly happy with their [00:26:00] proceeds in the bank and their lifestyle won't be impaired. They can literally just walk away and go do whatever they want to do next. You're trying to figure that out.

Sean Mooney: Yeah. That was always my fear is like, okay, they're going to move to Florida. They got all the sales relationships, they're like the fabric of the business. They were so fundamental to the story of the business, and then one day later they're out and then you're left without all of this historic knowledge, the leadership and all of that's risk, right?

And if risk goes up, you mentioned earlier, price goes down. And so these sellers are signaling things to buyers of companies that they might not even appreciate that they're doing. But professional buyers all have scars and wounds from, countless like cycles of these things. At least I did.

Lloyd Metz: Now, Doug, you do raise an interesting distinction between this dynamic with a platform company versus an add-on. I agree with you. An add-on the dynamic changes, [00:27:00] if you need that leadership team to drive the new product line that you're acquiring or the new geography or service line that you're acquiring, that's different than necessarily I need a platform, I need a partner. I need you to stick with me to get this investment thesis off the ground into completion like you would with a platform. So I appreciate you raising that distinction.

Doug McCormick: Yeah, and I think there's one other aspect here, which is I think we're always trying to evaluate, not only is it a deal that we like, but is it worth our time to get there?

And I think when you have a partner two things happen. One, you get a pretty good sense of is there good chemistry and are you well positioned to win? Because they really like, they like you, they value you for your skillset or expertise in, in what you're about to do. And the second thing is this is not just a negotiation around price.

There's all kinds of terms and conditions and indemnities and things that we're going to have to navigate. [00:28:00] If you've got somebody that's got a significant reinvestment, I think it ends up being more of a, I'm negotiating a partnership document versus I'm doing a transaction that I'll never see the seller or the buyer again.

It's much easier to navigate and therefore higher probability close.

Sean Mooney: So someone one time taught me this great term, it is called 'selfish altruism', and it's that you're doing the right thing, hopefully because it's the right thing. But often like doing the right thing is selfishly good for you. And one of the things that I think about like rollover, it's the right thing to do.

It aligns incentives, it doesn't sell false signals. It gets people the opportunity to have liquidity, but then also the fuel and the reinvigoration to build something even better. And for both sides though, I think there's a lot of selfish altruism. And for the PE firm, you get to get good outcomes for your own investors.

B) you get to create, in some ways, super life-changing outcomes for the partner at the business [00:29:00] that you're creating. C) it's the CEO of that family business then gets to go and like realize their full self, not only generate income, but then build their own legend and their team's legend. Talk about these other side benefits that come, that serve the long-term benefit of not only the IRRs and OICs, but also just these more subjective benefits.

The things it does for your own firms when you have these stories again and again, and the investors themselves, what they're able to do and what the CEOs are able to do.

Doug McCormick: I totally agree. I feel like some of my best investors are people that I've partnered with historically, where we had a chance to work together.

We had a good outcome. They've created some wealth. They've seen the quality of the organization through an entire deal cycle. Because there's no better diligence, right? They understand how we're going to prosecute and how we're going to compete in the marketplace. We've had super good experience there and talk about great references.[00:30:00]

They can speak to the goods and the bads and the proof points on a great outcome.

Lloyd Metz: That reference, that halo effect of successful outcomes, and you can speak to the CEO or whatever member of the executive team as what is the private equity firm like to work with from an executive perspective, but you can also speak to them like Doug, you're mentioning you had money up with them.

How did it turn out and how do you feel about their commercial skill as investors, right? So those can be two separate conversations that these people can address. And I may be in the minority here, but I'll also say it feels good, at least for me to see an entrepreneur. Express their ambition where they want to take this business.

We come and help them get there and to see them achieve it and to have created wealth for themselves and the people that they have on their team who are having [00:31:00] six figure and seven figure outcomes. That actually feels good to me and maybe some other of my private equity colleagues feel good when you see that happen.

And so that is selfish altruism in many respects. We want them to do well and when they do well, we do well. And I'll even take it a step further. At our firm we often provide some structures that juice up the rolled over investment matching loans of and other structural elements that can double up. Or if you want, triple up the rolled over amount, so that you can have equity participation further down into the leadership ranks, down to the supervisor level if you want, where people are putting up five figures and have the chance to turn into six figures if things work out well. So we don't mind people making a larger multiple of their rollover or their money that they write a [00:32:00] check for than us.

We don't mind that at all, actually.

Sean Mooney: I think that's amazing and it's very well said. Have you all also, like once you realize the future that they can become, have you ever invited these business owners slash rolled over partners to participate in your own PE funds afterwards?

Lloyd Metz: Yes. Yeah. Yep. Yep.

The CEO of our firm's very first investment, he's an LP. He loves coming to the annual meetings and asking questions after all those years where we were asking him questions.

Sean Mooney: Then the shoe's on the other foot.

Lloyd Metz: Oh yeah, absolutely. And he's loving it.

Doug McCormick: Yeah. Be careful what you wish for, right?

Sean Mooney: Keeps on mentioning this thing called DPI or something. I don't know.

But that was the other thing that, but I think is a good thing, is they do well. That was one of the most powerful things we would do is we would invite them into the fund really, at [00:33:00] frankly, pretty advantageous terms.

And then to your point is then they become almost like this sage council that you can bring in for the next deals and talk to them about it. because they've seen it, they've done it. Not only are they an advocate in reference calls, but then they become part of like, almost like a peer or a limited partner who's backing you.

And that whole kind of circle of trust, the karma wheel kind of spins and spins.

Lloyd Metz: Yeah. Now I have a question for Sean and Doug. We've talked in other episodes about value creation. We've talked about portfolio operations colleagues, and what does value creation mean and the different aspects of it.

How do you think rollover equity and making sure the team has enough equity, like how does that actually come into play when you are talking about a value creation plan and the execution of it? How does that make a difference?

Doug McCormick: Candidly, I think it's really tough to operationalize the difference, but I fundamentally believe that it [00:34:00] results in a positive impact simply because you have direct line alignment of incentives and not only risk of gain, but risk of loss, which I think is more appropriately balanced.

And listen, equity is the one instrument where we're absolutely a hundred percent aligned and a lot of incentive programs are not perfectly aligned as much as you try, right? If you have KPIs for the guy who's on the shop floor that's related to throughput on a weekly basis, that may not translate into profitability or equity value.

And annual budgets based on profitability for the year have nothing to do with end state equity value. It's simply an interim measurement period. So to me, it is the ultimate everybody on equal footing, we're paying directly for the outcome, we're most desirous of incenting.

Sean Mooney: That's spot on.

And when I think about it personally, one, my own rollover into this transaction, one, I'm highly incented [00:35:00] or incentivized, whatever the incorrect term is, to work really hard, right? And like the vast majority of my net worth is tied to the success and failure of our team. And so I have high incentives, and frankly, I'm fortunate because we brought in great investors who are great partners, and I frankly,

probably didn't do it soon enough in that I really am benefiting from their partnership and having another ear and another set of perspectives to help us make better decisions faster. And so we really are benefiting from that and they bring a lot in that regard. So we're fortunate with that. And then I think the second part of it, and this is something we've done from day one, just from the private equity way, is push equity down into our organization

to inspire our team members to think and act like owners. And what I'd say is it's a mixed bag. The leadership team people, and ultimately people who either became on the leadership team or were recruited in were people who truly demonstrated their ability to think and act as owners and [00:36:00] truly value that equity.

And I'll tell you, there are people who are not in an organization who are in the seat, who didn't value that, and they're no longer with us. And so for me, that's a huge signal of like, can they be here on this run, not only where we are today, but tomorrow because they can think and worry and get as excited about the multiplying effect of equity as much as I can?

And then where it's been more mixed, I think is on the junior level, people where they don't really understand it. And maybe that goes to us for not explaining it as much. I am always shocked when there is natural either unplanned or as much as often not the not planned turnover, how seldom the options get exercised.

And that's just extremely candid and probably more candid than most people want to hear. I am surprised by that part of it in ways that I didn't think would be the way it happened.

Does that resonate with you all?

Lloyd Metz: It does, and we're starting to talk about incentive equity versus the bought equity or rollover equity.

We're still trying to [00:37:00] fine tune how to make that incentive equity, whether it's profits, interests, or stock options, to make it easier to understand and therefore perceived as valuable with lower middle market companies. We haven't gotten it perfect yet, but we're still working at it.

Doug McCormick: So, Lloyd, for what it's worth, I think it's a really interesting point and it's less about structure and more about education, right?

Because we all are pretty familiar with it and have seen the power of it, and I think in many cases the challenge with these equity incentive programs is, it's really powerful once somebody's experienced it once, right? And I've seen this scenario where we have a great outcome and at the end these people get paid and the light goes on at the end and they didn't see the power of the program until the very end, which is totally inconsistent with the intent.

So I think education's key, here.

Lloyd Metz: It is. And you remind me of [00:38:00] occasions where when we've gotten to a successful exit, you hear people say, "I wish I had bought more. I wish I had rolled over more." To exactly your point, it seems theoretical to them when you're talking to them and inviting them and I think you can sketch out what it might look like, but when it actually happens, people are like, "Doggone it,

Like what? I messed that one up."

Doug McCormick: I think it's interesting Lloyd. I think we need to do a better job of, when we're upfront in investment of talking about what it means to my partnership. So we're in there going, "Okay, so we're buying your business. By the way, we're 3% or 5% of the capital of the fund, and so that means we personally have this kind of investment in your business.

We believe in it. We expect it to do this, and this is how it translates for you."

Because I think not only is it an education issue, but it's a credibility issue because you're coming in on the front end. They don't know you from Adam. And you're saying, "This is going to be a [00:39:00] great deal. We're going to do three times our money." But like they don't necessarily believe you or they don't have reason to have trust in you yet.

And so I think some of this is where the commitment comes at a stage in the in relationship that's relatively immature.

Lloyd Metz: And to that point, and you articulate it beautifully, we have generally kept the door open for the leadership team to buy equity. We usually keep that door open after close. Because to your point, oftentimes after the first year, they get to know us as private equity investors and as people.

So they're like not as scared as they might have been pre and shortly after close they start to see that some of these quote unquote crazy ideas actually are working. And so oftentimes a year in people will come knocking on the door, like, "Can we buy more?" And a group of employees, or a group of the C-Suite or whatever it is, [00:40:00] have six figure dollars that they've cobbled together to put into the company.

And we're always accepting that. Like we never turn that away because of the positive signaling effects that we talked about earlier, right?

Doug McCormick: Lloyd i'm with you a hundred percent, except it's now 1.2 times your money.

Lloyd Metz: Yes. Then you have to have that conversation. You have to have that conversation. But that's okay.

That's okay.

Doug McCormick: No I'm totally with it. One more point that I do think it gets back to an earlier point we made, many of these deals, there will be multiple investments during the life of the investment. And so it gives people the chance to say, "I see it, I believe in it more now with a little bit of time of working together."

And so on. The next deal when they have their chance to participate pro rata, you see really good uptake on that.

Sean Mooney: That's right. As I'm thinking through exactly what you're sharing, it's a kind of a call to action to me. It's like I've got to do a better job explaining what this stuff is. The people who get it, those who've seen it before, and they're usually this more senior level people and they don't get, it's like everyone's from Missouri.

It's the "show [00:41:00] me" state. And so like if you haven't seen it and you haven't spent the time teaching and teaching, it's hard to appreciate. That's something that we're going to do better at. And I think a large part is just inspired by this conversation here. Just don't hold me to it. If our team members are listening to us, I'm just kidding.

We're going to do a better job.

Lloyd Metz: A continuous process to figure this out and get it right because we had an episode a little bit a while ago, where we talked about the American economy being very dynamic and at the lower middle market. Private equity firms are trying to spur innovation, trying to spur growth, trying to spur evolution in family owned businesses, of which this country has millions of them.

This is an important key to unlocking all of that talent, energy, and creativity. When you find the right people, find the right partner, incent them the right way with rollover plus bought equity, broadened out the leadership team, some pretty amazing companies can get built and some pretty [00:42:00] amazing outcomes and wealth can be created and that's a worthy pursuit.

Doug McCormick: Totally agree 100%.

Sean Mooney: All right, gentlemen, this has been another awesome conversation about really one of the core concepts and flywheels of business and value creation and wealth creation in private equity, and candidly probably the entire US economy now. I really appreciate you all pulling back the curtain and candidly sharing like, here's how it works, here's why it works, what should be done and here's some of the considerations that need to be made when doing it.

So thank you once again, Lloyd and Doug for sharing.

Lloyd Metz: Thank you, Sean.

Doug McCormick: Good discussion guys.

A special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies by partnering with family and founder owned manufacturing services and distribution companies.

Learn more at [00:43:00] HCIEquity.com. ICV Partners, an innovative lower middle market private equity firm, supporting management teams of leading companies at the lower end of the middle market. Learn more about ICV at ICVPartners.com. And finally, BluWave, the business builders' network, connecting the most proactive business builders in the world with the best of the best service providers for critical, variable, on point, and on time due diligence and value creation needs.

Learn more about BluWave at BluWave.net. For further information on HCI, ICV, and BluWave, and relevant topics discussed here in the episode, please see the episode notes for links.

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.

No representations, warranties, financial, legal, tax, or other advice are made herein. Consult your [00:44:00] advisors regarding any topics discussed during this episode.

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.