Capital Allocators – Inside the Institutional Investment Industry

Episode Summary: Michael Che - Atomization of Private Equity Decisions at Charlesbank (EP.432)
Release Date: February 17, 2025
Host: Ted Seides
Guest: Michael Che, CEO and Co-Head of Flagship Private Equity Strategy at Charlesbank Capital Partners

1. Introduction

In Episode 432 of Capital Allocators, host Ted Seides welcomes Michael Che, the CEO and Co-Head of Flagship Private Equity Strategy at Charlesbank Capital Partners, a prominent $22 billion manager specializing in middle market private equity, credit, and technology opportunities. The discussion delves into Michael’s unique career trajectory, the evolution of decision-making processes at Charlesbank, and the firm's strategic approaches to private equity investments.

2. Early Life and Cultural Influences

[06:14 - 07:48]

Michael Che shares his uncommon background as a Korean American who spent a significant portion of his childhood in Seoul after his family was deported from the United States when he was eight years old. This experience profoundly shaped his perspective on cultural frameworks and decision-making.

Michael Che [07:54]: "Frameworks are something that I consider to be relative... understanding that the way an entire society does things doesn't necessarily mean it's the only way to do things."

Living in a different educational and cultural system instilled in him a sense of relativism, recognizing that multiple approaches can be valid in systematic problem-solving.

3. Career Path: From Science to Finance

[08:52 - 12:36]

Despite initially studying science in college, Michael found himself drawn to decision-making processes rather than traditional scientific inquiries. His first seminar on decision-making exposed him to peers interested in economics and finance, setting the stage for his unexpected shift into the financial sector.

Michael Che [09:01]: "My dad was an incredibly logical person... my mom, on the other hand, is an incredibly decisive person, but sometimes not the most logical."

This blend of logical and decisive influences inspired him to improve his decision-making skills. Accidental events, such as following a lab partner to a job in strategy consulting at McKinsey & Company, further steered him towards a career in finance. Eventually, he transitioned to Charlesbank Capital Partners, where he has remained for over 27 years alongside his partner, Brendan White.

4. The Evolution of Charlesbank Capital Partners

[12:42 - 14:32]

Michael provides an overview of Charlesbank’s origins within the Harvard Management Company, emphasizing its role as the private equity investment arm of Harvard's endowment. Under the leadership of Jack Meyer, the firm experienced significant growth and specialization, offering Michael a front-row seat to Harvard’s transition towards independent private investment operations.

Michael Che [14:32]: "Harvard was a deep believer in finding value in investments through superior research... not about having a better sourcing model or a better operating toolkit."

This focus on superior research over sourcing or operational advantages laid the foundation for Charlesbank’s distinctive investment philosophy.

5. Manufacturing High-Quality Investment Decisions

[14:32 - 16:46]

Charlesbank conceptualizes its investment process as a manufacturing operation, where each decision—from industry selection to talent research—is meticulously produced to ensure high quality and efficiency. This systematic approach aims to define and maintain competitive advantages through nuanced and dynamic value assessment.

Michael Che [16:46]: "We tend to think about our firm as a manufacturing process where the atomic unit of production is a decision."

This philosophy underscores the firm’s commitment to creating a robust decision-making framework that continuously adapts to the evolving private equity landscape.

6. Transition from Heuristic to Advanced Modeling

[16:52 - 23:42]

Addressing the limitations of traditional investment metrics like the five-year LBO model, Michael explains how Charlesbank developed a proprietary tool called the "Fan of Outcomes" (FANF). This tool employs a simplified Monte Carlo analysis to simulate 10,000 potential future scenarios over a two-year horizon, providing a more accurate probability distribution of investment outcomes.

Michael Che [23:46]: "The model is just a tool for us to think better and work better together... It makes the process more efficient."

Key benefits of the FANF include heightened accountability, specific key performance indicators (KPIs), and the ability to identify asymmetric distributions favoring upside potential with limited downside risk.

7. Implementing Mission Atomization in Decision-Making

[18:46 - 20:18]

Michael introduces the concept of "Mission Atomization," which involves breaking down workloads into explicit, mission-driven tasks to prevent workload creep and ensure focused objectives. This method includes conducting regular stage-gated reviews to assess progress and determine whether to continue investing resources in a particular project.

Michael Che [20:18]: "Within our origination and sourcing process, there's typically three stages... we want a certain number of checklist items to be reviewed."

This structured approach ensures that every decision is purposeful and aligned with the firm’s strategic goals.

8. Impact of the Fan of Outcomes on Investment Strategy

[23:42 - 34:52]

The FANF has significantly influenced Charlesbank’s investment strategy by shifting the focus from long-term, often uncertain forecasts to short-term, actionable insights. By prioritizing the first two years of investment performance, the firm enhances its ability to predict and influence outcomes effectively.

Michael Che [23:42]: "The model doesn't give us any answers that we can't generate as human beings, we just think it makes that process more efficient."

This shift has led to more disciplined sourcing, with an emphasis on identifying companies that exhibit attractive upside potential within a shorter timeframe. Michael cites the US CPA industry as an example of a sector with low private equity penetration but significant opportunities for value creation.

9. Key Success Factors and Historical Insights

[37:30 - 39:14]

Through regression analysis of historical investments, Charlesbank identified several key factors correlated with investment success:

1. Earnings Growth: Strong correlation between pre-tax earnings growth within the first two years and ultimate investment success.
2. Organic vs. Inorganic Growth: Both organic and disciplined inorganic (acquisitive) growth contribute significantly without diluting returns.
3. Management Stability: Surprisingly, changes in C-suite management showed minimal correlation with investment outcomes.
4. Entry Multiple: Lower entry multiples tended to correlate with weaker investment results, indicating the importance of favorable valuation metrics.

Michael Che [39:14]: "We've shifted all of our modeling to a homegrown proprietary tool that we call our two year fan of outcomes."

These insights have refined Charlesbank’s investment criteria, emphasizing metrics that provide a more accurate reflection of potential success.

10. Applying FANF to Portfolio Management and Operations

[39:14 - 44:15]

Charlesbank leverages the FANF model not only in investment selection but also in ongoing portfolio management. By using probabilistic thinking, the firm evaluates operational decisions—such as expanding branch offices or making key hires—through the lens of their impact on the probability distribution of outcomes.

Michael Che [41:39]: "Every decision that we're making we think of as part of that process."

This approach fosters a culture of high urgency and accountability, ensuring that every operational decision contributes positively to the investment’s trajectory.

11. Overcoming Challenges in Implementing FANF

[44:15 - 43:36]

Implementing the FANF model presented several challenges:

1. Tail Events Management: Differentiating between bad luck and flawed decision-making when unexpected outcomes occur.
2. Logistical Hurdles: Transitioning from traditional models to the FANF framework required significant time and resource investment.
3. Simplifying Complexity: Initially, overly complex models hindered intuitive understanding, necessitating a streamlined approach.

Michael Che [43:26]: "Curtailing our impulse to be overly nerdy and trying to really simplify the number of things that we put in to drive the 10,000 simulations."

Addressing these challenges has been crucial for successfully integrating the FANF model into the firm’s operations.

12. Strategic Industry Insights and Future Outlook

[48:15 - 52:44]

Michael discusses the evolving landscape of private equity, noting that the industry has transformed significantly over the past 25 years. He highlights the following:

• Underpenetrated Sectors: Industries like specialized human capital services present substantial opportunities due to their recurring revenue models and low private equity involvement.
• Valuation Dynamics: EBITDA multiples have become increasingly divorced from free cash flow yields, leading to a new focus on how successive private equity ownership can unlock value.
• Concerns: Excessive leverage and capital inflows into private credit pose risks of valuation bubbles, a legacy from the early 2021 market conditions.

Michael Che [52:44]: "Because of our fundamental research driven model, we tend to look to find opportunity in that type of chaos."

Looking forward, Charlesbank aims to identify opportunities in emerging sectors and navigate potential market turbulences with their robust decision-making frameworks.

13. Excitements and Future Goals

[52:44 - 58:29]

Michael expresses excitement about integrating analytical rigor into talent management. By utilizing personality profile testing, Charlesbank seeks to enhance recruitment strategies and foster high-performance teams.

Michael Che [52:45]: "Recruiting higher caliber human capital into our companies and into our firm is obviously a major unlock for us."

Additionally, Michael emphasizes the firm’s goal to systematize investment excellence, ensuring consistent performance across varied market conditions without over-reliance on individual star performers.

Michael Che [57:06]: "Creating a system that we can look at and say, boy, that system has a reasonably high probability of generating great results across a wide range of uncertain environments."

14. Personal Insights and Closing Remarks

[53:23 - 58:36]

Michael shares personal anecdotes, highlighting his passion for cooking, his first job as an English tutor in Seoul, and his fascination with near-death experiences and quantum physics—areas that intrigue him with their unresolved mysteries.

Michael Che [55:48]: "The fabric of the physical universe as we understand it may actually contain some mysteries that are consistent with life after death."

In reflecting on his career, Michael expresses satisfaction with his path toward becoming a professional decision-maker, a skill he has diligently honed over his lifetime.

Michael Che [55:20]: "I've worked on this my entire life... and I find it somewhat surprising that I've become a professional decision maker."

As the conversation concludes, Ted and Michael reaffirm their mutual appreciation for the insights shared, encapsulating a rich dialogue on strategic decision-making in private equity.

Conclusion

Episode 432 of Capital Allocators offers an in-depth exploration of Charlesbank Capital Partners’ sophisticated approach to private equity investment. Through Michael Che’s experiences and strategic insights, listeners gain valuable perspectives on evolving decision-making frameworks, the importance of probabilistic modeling, and the nuances of navigating an ever-changing investment landscape. This episode serves as a compelling guide for institutional investors seeking to enhance their capital allocation processes through systematic and data-driven strategies.

Notable Quotes with Timestamps

• Michael Che [07:54]: "Frameworks are something that I consider to be relative... understanding that the way an entire society does things doesn't necessarily mean it's the only way to do things."

• Michael Che [09:01]: "My dad was an incredibly logical person... my mom, on the other hand, is an incredibly decisive person, but sometimes not the most logical."

• Michael Che [14:32]: "Harvard was a deep believer in finding value in investments through superior research... not about having a better sourcing model or a better operating toolkit."

• Michael Che [16:46]: "We tend to think about our firm as a manufacturing process where the atomic unit of production is a decision."

• Michael Che [23:46]: "The model is just a tool for us to think better and work better together... It makes the process more efficient."

• Michael Che [20:18]: "Within our origination and sourcing process, there's typically three stages... we want a certain number of checklist items to be reviewed."

• Michael Che [27:52]: "Another one would be customer concentration... That's a very counterintuitive result relative to a five year base case model."

• Michael Che [41:39]: "Every decision that we're making we think of as part of that process."

• Michael Che [43:26]: "Curtailing our impulse to be overly nerdy and trying to really simplify the number of things that we put in to drive the 10,000 simulations."

• Michael Che [52:44]: "Because of our fundamental research driven model, we tend to look to find opportunity in that type of chaos."

• Michael Che [54:08]: "Simplifying complicated things to teach little kids English, I think I learned a lot from that."

• Michael Che [55:48]: "The fabric of the physical universe as we understand it may actually contain some mysteries that are consistent with life after death."

• Michael Che [57:06]: "Creating a system that we can look at and say, boy, that system has a reasonably high probability of generating great results across a wide range of uncertain environments."