← How I Invest with David Weisburd
How I Invest with David Weisburd
E179: How UCLA's Endowment Wins in Private Equity w/Deputy CIO Michael Marvelli
01:04:41
Loading summary
Transcript65 lines
- [00:00]
David
So tell me about how you came to be the Deputy CIO at UCLA Investment Company.
- [00:06]
Michael
It took all of 20 years or so. I've been at UCLA 22 years. When I joined, we were a 400 to 500 million dollars pool of capital. We've grown about 10x over the course of my time here. And that's after distributing to the campus an amount that would equal three to four times the capital base, which when I joined. So it's been a rewarding experience. Today I spend most of my time in the private markets and outside of my investment duties, I get involved in asset allocation as well as working on our annual spending policy.
- [00:55]
David
So you were at the endowment when you launched in 2011 and it became its own entity. Tell me about how that launch happened.
- [01:03]
Michael
In the wake of the great financial crisis, we had sort of resurrected AUM just above a billion dollars. We were more than twice the size of when I joined. The portfolio was also a lot more complex because we had pushed into alternatives. And we wanted to pause at that point and ask ourselves what structure would serve us best long term as we thought about growing the endowment from there. And that's when we decided to set up a proper management company in 2011.
- [01:47]
David
It's now been an independent management company for 14 years. How has the strategy evolved across those 14 years?
- [01:54]
Michael
There were three of us at launch and now there are 15 professionals. So you can, as you can imagine, you can do quite a bit more with that level of resource. We can just take a much more nuanced view of asset class strategy. And frankly, that's where I'd like to focus. A lot of our time today is on formulation of asset class strategy because I don't think enough time is spent on that topic.
- [02:29]
David
A famous pension fund study showed that 90% 90 of the returns were due to the portfolio construction and only 10% to manager selection. Do you think that still holds today?
- [02:41]
Michael
I don't know about the percentages, but asset allocation absolutely drives the returns, particularly in endowment land, where the less liquid pools of capital have outperformed over long periods of time. So here we're talking about asset allocation, and then what I would say is the asset class strategy is, is the. The next determinant of performance, followed by manager selection.
- [03:16]
David
There's three layers. There's portfolio construction, asset class strategy, and manager selection. So let's talk about that middle layer. What is asset class strategy?
- [03:27]
Michael
We might use the. The lower middle market in private equity to illustrate that. But I would say that a lot of endowments, they'll arrive at some asset allocation target and then they'll just hunt for the best managers. In my view, unless you're focused on the right segments within the asset class, you can be the best manager selector in the world and your performance might be good, but it's going to be suboptimal. So the pieces that's missing is the strategy.
- [04:12]
David
You said something that I want to double click on. So what does it mean to have good manager selection and bad asset allocation strategy? Give me an example of that.
- [04:24]
Michael
Well, if, if you don't have a specific strategy and you're not targeting particular segments within an asset class, then you're just left with finding the best managers available. And so if you're hunting in the most prevalent segments of the private equity market, say the middle market and the, in the, in the upper market, there's a lot of really bright people and great teams that can talk a good story. They can walk you through a very rational model of how they invest. And you're left thinking that this is a high quality group, they would be great stewards of our capital. And then you select on that basis. And my point is that you could end up with a bunch of high quality firms of competent people, but you're going to be exposed to the segments of the market that they're investing in. And those might offer good returns, but they may not offer the best returns.
- [05:51]
David
You mentioned private equity. You have upper middle market, core middle market, lower middle market. In venture you might have growth or pre ipo, traditional venture, and then pre seed and seed. And it's before you even pick which manager, picking what part of that market makes most sense as an overall portfolio strategy.
- [06:10]
Michael
In my opinion, it's very important to do that.
- [06:14]
David
And it's not just that there's a right or wrong answer, although you probably argue in private equity there is one. There's also a portfolio construction question which is what is your overall diversification of your portfolio? Perhaps there's tax strategy. If you're just a regular high net worth investor, not an endowment investor. There's other factors beyond just picking the right answer.
- [06:37]
Michael
You're certainly, you know, wanting to consider how the strategy is going to fit within the overall context of your portfolio. And you know, as an endowment, it's a multi asset, globally diversified portfolio. And so you're really looking for private equity and venture, you know, to drive returns, you're shooting for high returns, whereas in other asset classes you might be seeking diversifiers or strategies that might hedge against inflation, or in the case of cash and fixed income to provide liquidity to a fairly illiquid pool of capital. So, yeah, all these asset classes have a role to play. And the role for private equity and venture is to help increase returns.
- [07:31]
David
So you love the lower middle market of pe. Before we go into why, how do you define lower middle market? What does that exactly mean?
- [07:40]
Michael
This is a great question. And there is no consensus. So you'll find people talking about sub billion dollar funds or sub 300 million dollar funds, or you'll hear people talk in terms of EBITDA levels. To be a little bit provocative. It doesn't really matter in the end. I guess it matters from the sense that a label helps one talk about what's important about the market. But what I would say is it's much more important to think about it philosophically and what it means in terms of strategic value and, you know, allow me to kind of expand on that point. And so the easiest way for me to talk about it is in terms of EBITDA level. So let's say I go out and I buy a $6 million EBITDA company for seven times. So that's $42 million of enterprise value. And let's say I put two turns of leverage on it. So two times six million is 12. So 42 minus 12 is $30 million of equity. And let's say I make eight of those investments in the fund. So now we're talking about 240 million. So this is very typical of what we do now. If I have one 8x outcome on 30 million of equity, I have now just returned the fund with one investment. And it just so happens that the preponderance of those types of outcomes of that quantum happen in smaller funds rather than larger funds. And the way you get into the top quartile in private equity is not by printing these steady 3x returns on all eight of your investments. You have one or two large outcomes that drive those returns. And so the question is, how are returns generated? And it's very important for us as investors to understand how returns are generated. And so if you look at a value bridge and that value bridge, the drivers are cash flow, accretion, debt repayment, and multiple R. And so now if you really study each of these three variables that drive value, drive performance, you begin to understand the difference of the opportunity offered in the lower middle market versus upper markets. And of course, job number one is to drive cash flow. We're all doing that. We're all trying to do that. And that's a big determinant of performance. Debt's a bit different in the upper versus the lower market. In the upper market, debt is very available. A lot of these investments resemble leverage buyouts. So you start with a lot of debt and then you pay the debt down. And as you pay the debt down, that's value accretive. So it's a value driver. In the lower middle market, you can't get much debt. And if you're doing a buy and build and you're acquiring small businesses and adding them to your platform, you're typically increasing your debt over the whole. So it's actually value destructive in the lower market. But the single largest determinant of value, or the most distinguishing one when looking at the upper versus the lower market is the third characteristic, which is multiple arbitrage. Valuation arbitrage. And I would argue, based upon my own experience, that there is materially more value arb opportunity offered in the lower middle market than the upper market. We've been at this 10 years, our own experience across our realizations, more than two dozen realizations out of 100, 110 small businesses in the portfolio. We've been able to increase the multiple from entry to exit by seven and a half turns. And that surprised us. And we certainly don't forecast that we'll be able to generate that when we go from a couple of dozen realizations to 100 realizations. But it does illustrate the quantum of value accretion you can add in the lower middle market by buying at a lower valuation, growing the company and then serving it up to that next rung of capital that has a massive amount of dry powder unfunded commitments where it's far more competitive and they're willing to pay higher prices?
- [13:14]
David
Unpack that seven and a half. How much of that is due to increased cash flow or increased profits and how much of that is due to multiple arbitrage?
- [13:25]
Michael
Yeah, so I want to be clear. So when I, when I talk about a seven and a half turn uplift from the entry valuation to the exit valuation, we're only talking about multiple R. So not to be confused with like a multiple on invested capital. Right, which we can talk about. But those three variables, cash flow accretion, you're hoping to add one or two turns of MOIC through that activity and you're hoping not to destroy too much of that with the use of debt. As I mentioned, the debt is typically going up. For us, we've averaged about 2.09 times EBITDA of leverage at entry. And that will tend to go up a bit. But it's rare that it would exceed four turns of EBITDA at exit. But that third component is pure valuation multiple arb. For us, when we look across all the sectors that we invest in and we're single sector investors, for the most part, we blend in at buying these companies at eight times and we have sold them at 15 and a half times. That's the seven and a half turn up with that I spoke about.
- [14:58]
David
So in that example, with 8x, you're doubling the multiple of which you're selling them at almost you also. And then you also have the increase, the 1-2x increase from the cash flow. And then you're paying some of that is being paid back in debt and the leverage that you put on the deal.
- [15:19]
Michael
That's exactly right. And so to frame this in terms of moic, because I think people are interested, I mean ultimately people are going to select a strategy that hopefully delivers better outcomes. If you look at the private equity market historically, and I should qualify that, I am talking about for the most part control equity and growth equity transactions. I personally don't invest in venture. We have another colleague that's far better at that than I am. So when I refer to private equity, it's really control equity and growth equity. The broad market has historically delivered a two and a half times gross MOIC at the deal level. So that's kind of the private equity market. And we've been doing this for 10 years. And across the realizations I spoke of, we've been able to generate a return that is two turns higher than the market. So it's been a pretty compelling segment of the market for us to focus on.
- [16:43]
David
Basically going from a two and a half average to four and a half for UCLA is great performance. Why are there not more endowments like UCLA going into the lower middle market?
- [16:57]
Michael
I think there are a lot of reasons. At the end of the day, the stars have to align in terms of the AUM you're managing because that dictates what kind of team you can support. And you need a large enough team so that you can devote sufficient time to develop a specialization to a particular strategy, this being one that we pursue. And then on the other hand, if you write $50 million checks and if you're worried about, you know, being too large a percentage of the fund you're entering, then it becomes very difficult to invest in small funds. And if you reduce your fund check size, then it really is not moving the needle for very large endowments. Then you, you know, you're not, you're not putting money behind partners and managers that have a very strong brand recognition. In many cases you're meeting managers for the first time as, as you get to know them. And therefore you need the right governance framework. And so it's extremely helpful if the team is making the decision on manager hires as opposed to say, a board that you're reporting to. And I have, I'm very fortunate to have very strong support from my CIO who appreciates the performance potential that this strategy represents and believes we can manage the loss. And that also holds true for our board. And I would also add that we have a strong capability in operational due diligence, which is important when you are diligencing, you know, managers that really don't have a brand name. And you know, probably 12 of the 15 managers on our roster we entered at Fund 1. So there's very, very little in the way of track record. So for all these reasons, you know, size, you know, governance model and then, you know, capability in terms of specialization and odd, all this kind of factors in to what kind of firm can focus on this end of the market. And I think that's why you see less in the way of, you know, institutions investing in this part of the market. And back to my earlier point, if you don't formulate a strategy and you're just left with, you know, quote, selecting the like world class managers, you're not likely to focus on this end of the market. I believe that you always have to invest in highly competent people and teams. But I don't like to use words like world class or rock stars or golden boys or girls, or any of this nomenclature that you hear frequently talked about when people are talking up a manager.
- [20:55]
David
So there's this paradox where you need somebody highly technical, very experienced in the space, but also you can't be this mega endowment that has to invest billions and billions of dollars in every strategy. So you need almost this like Goldilocks endowment with precision asset allocation. Also a board and governance that supports this precision like strategy.
- [21:23]
Michael
That's fair. At least that's how I approach it. And you mentioned something that triggered another thought just as important as pursuing these specific segments because you think they offer higher potential. It does another very important thing for the team, and that is it allows you to completely ignore large swaths of the market. And that's not only important to help us find the better managers in the small market, but we also have to manage a few other asset classes. And so we have also developed pretty Nuanced strategies and those nuance, I'm sorry, those asset classes which help us ignore large swaths of those markets because time is the most precious resource that NLP has just given that most of the time these are fairly small teams managing large pools of capital.
- [22:30]
David
Presumably you're becoming more skilled in whatever you spend time, effort and turns on. So you're building your competency within the lower middle market versus if you were to dilute it across all of private equity, you would become a generalist across those verticals.
- [22:47]
Michael
Absolutely, that's true in spades. I mean we take it further and we invest in two strategies within private equity. If we're buying performing companies, high quality companies through our partners, we're doing that through a single sector format. And you know, the other strategy we pursue is special situations and we sort of relax that single sector orientation because we want them to cast a really broad net because it's more of a bottoms up hunting exercise. But you know, it's the lower middle market, then it's single sector or specialist sit. So it gets very specific. And that level of specialization allows you to have a degree of pattern recognition whereby one, you're taking far fewer meetings and then the meetings you're taking are highly productive and you're using that pattern recognition to diligence different aspects of their activities in business. And it just helps you. It's a much more efficient exercise than having a group come in that says, hey, by the way, you know, we invest in these, you know, these four or five private equity sectors, you know, consumer, you know, tech, industrial, financial services. It's very sort of discombobulating for me to take that kind of meeting today and spend 15 minutes on each of those sectors. I don't find it very productive.
- [24:33]
David
I would even further strengthen that in that your value as an LP to the GP is also your focus and that you're able to see. Because you could only invest in so many funds and managers, so many managers, you have much more valuable insights across your GPS that you could share with your gps versus if you were spread thin, it'd be more difficult to bring value as an lp.
- [24:57]
Michael
It's very important, like, you know, it's, it's important that an endowment team be the partner of choice with the, you know, the GPS that you're targeting. And I think in their view, you know, the more knowledgeable the LP is about their business, the more likely that LP is going to be able to ride through the rough patches that are invariably going to occur because we're all Equity investors, we're just taking lots of risk and so it's never sort of a straight line to a, you know, a 3 or 4 or 5x outcome. And, and so that, that intimacy with their business I think makes us a better partner.
- [25:51]
David
You mentioned you do a lot of fund one investments. I've had TIFF and in a TIE foundation on the podcast talking about they even go earlier they do independent sponsor deals. Do you look at independent sponsored deals and what are your thoughts on.
- [26:06]
Michael
Yeah, let me even back up further and help flesh out this, this market and where it sits sort of like downstream and upstream. So we talked about what is downstream in terms of the middle market, the upper middle market, the large market. And we can get into it, but effectively there's so much dry powder in those segments that we're trying to play underneath that wave of dry powder. And we're taking, yeah, we're taking the execution risk of doubling or tripling the size of a small business and graduating it up over a certain EBITDA threshold. Where the buyer universe opens up, the debt, capacity opens up. Debt pushes value, competition of capital pushes value. And that's where you get that multiple arp, whether it's two times, three times or seven and a half times, you can count on some level of multiple are now upstream from the market that I've been talking about is, I would not define it. I think you have to separate size versus capitalization. You know, so we talked about the independent sponsor market. That's really a capitalization lens, you know, to look through. So you have to. A lot of times those, those folks are buying middle market, upper middle market or, or small market companies. So you can't just say that independent sponsors are buying smaller companies. They're not. Okay. And then of course upstream from them is the search fund market and those break down into funded search or unfunded search and the funded search, committed capital vehicles. Those folks are typically going after larger companies than the unfunded search and we can run into those folks and I prefer the risk in the lower middle market to funded search because the team is just far more resourceful and has a lot more value creation levers to pull because the portfolio tends to be more concentrated, whereas funded search they're doing, they could be doing, you know, two dozen deals. It's, it's hard for them to really add a lot of value as a, as say a gp. The unfunded search. We can't touch it. It's, it's more just one off. It's just some Person that has found a company and then they're passing the hat, looking for capital. We're not set up to, you know, to invest in that opportunity set. So back to your question on the, on the independent sponsors. You know, of course there's always one off co investments to be made there. We have not done that. And then of course now you see funds being raised that would invest in independent sponsor transactions, either one off, you know, sort of, you know, partner by partner, or programmatically where they're funding maybe three or four deals for the partner, preparing them to launch a fund, you know, at a later time. And you know, we haven't had to consider that because our performance has, has been sufficient. I don't see any performance advantage right now in pivoting our, our, our focus to that end of the market.
- [29:59]
David
So you've chosen not to be in the middle market and upper middle market private equity funds. But as an endowment, you do have to be diversified. How do you think about it from a portfolio construction side, not having exposure to that part of the market.
- [30:13]
Michael
Back in the old days when we first launched, we were much more opportunistic than methodical in deploying our private equity. And so there might have been years where we made one investment or two investments in private equity. I personally don't think that's enough. I think private equity is probably the best beta out of any asset class. If I'm defining beta as just the market return. And so through cycle, you know, rolling five year periods, rolling ten year periods, private equity is the best performing asset class in our portfolio. And I think it's probably the best in, in most. And so I, I like to think that you want to, when you have a great beta like that, this is getting into portfolio construction which you ask about. You want to make sure that you're harvesting that beta. And so if you're making one or two investments, the return dispersion within private equity and venture is so wide that you might be lucky enough to have participated in a first quartile fund or you know, you might have participated in a fourth quartile fund. So in my view, 4 is kind of like the ideal 4 per year. And I think a good range to think about is three to six commitments per year. And that's going to diversify you sufficiently so that you're harvesting that return. But through manager selection, you stand a chance of outperforming the market. So you're adding the alpha.
- [31:59]
David
So three to six months per year, which may have how many positions under.
- [32:04]
Michael
My preference is for five to nine positions. You know, in the old days you'd see a lot of these groups. Again they were, a lot of them were multisector and so they had, you know, teams working in consumer and fin services and software and you know, industrials and, and they were all expected to populate the portfolio. So you'd see 12 to 15 positions. I think the other thing that's changed is the commitment period. You know, in the, in the legal docs it's still five years. In the old days people were using five years. Today they're not. I think it's shortsighted not to think in terms of like the value of the optionality that you're given with the five year commitment window. But you rarely see that today.
- [32:54]
David
So it's what's a typical deployment? What's the typical deployment in the lower middle market?
- [33:01]
Michael
I don't think it's, I don't think it's too different across a lot of other asset classes. I think it's probably gravitated to closer to three years and that, you know, that creates its own vagaries. Because if you're a serial investor and you're trying to invest, we like to say arbitrarily, we'd love to get three funds out of a relationship. I've been here 22 years and we still have a group that's in the portfolio that we put in the year in which I joined. So there's three serial funds is arbitrary. But you can imagine that if you're on a three year cycle by the time you get to fund two, more likely than not there's been no realizations in fund one. And by the time you get to fund three, maybe you've seen a few. And so it puts a lot of pressure on the lp. And so you have to start looking at the fundamentals at the portfolio company level and you have to start to, you know, evaluate what the company has done in actuality along the lines of revenue, EBITDA margins versus what they underwrote for a company that might be, you know, three, four, five years into its hold period if it hasn't, you know, been sold. So you have to start looking at the fundamental performance.
- [34:37]
David
And the investment period may be similar across lower middle market, middle market and upper middle market. What about where the value is from the GP side? So we talked about you do less leverage and you have more multiple arbitrage. But are the top GPS the top quartile gps, are they top quartile pickers, negotiation, all that, or are they top quartile value add and operational people.
- [35:07]
Michael
I think most investors, we were very focused on operational value add. And I mean really the quantitative metric is growth of cash flow. And I'd throw in margin there. So revenue growth and margin. And so that's the ballast of the return. And I think everybody is focused on that. But back to the value bridge, I think what a lot of people downplay. And you'll hear general partners make comments like, well, we don't underwrite multiple expansion. And I think that's fine. That expresses a view of conservatism, which I think is healthy. But I think on the other side of that coin, they, it's also a illustration that they believe that multiple arb is fleeting, meaning that it comes and goes over the course of a multiple, a market cycle. And I'd like to make a comment about that. So when you look at the price at which the middle market and the upper market are buying companies, you know, it's a high. It not only is it a higher, you know, sort of relative sort of multiple than the lower. So if the lower middle market is down here, the upper middle market's up here. But the other fascinating thing that you find about that market characteristic is that through time, the amplitude of the purchase multiple in the upper markets, that amplitude swings more than the lower middle market. The lower middle market is pretty steady. You don't take a lot of market risk buying small companies. You know, the multiple might flex, you know, one turn over or under its historical trend line. But you can see really massive fluctuation in the middle and the upper market. And the reason you see that is that there's a lot more capital washing around that market as represented by unfunded commitments. And there's a lot more debt capacity. You can put on a lot more leverage. And as the interest rates fluctuate, you know, we came out of a really low interest rate environment up until a few years ago that really pushed those multiples quite a bit higher. And then when those rates go up, you see the multiples, you know, come down because those, those partners, they know they can't get as much debt and the debt isn't as accretive. So they got to make their return from a higher amount of equity. And so they recognize they have to pay less for that in order to get their return. So that's another really interesting dynamic about the lower versus the middle and upper market.
- [38:45]
David
Upstream you have the interest rate, the interest rate goes down. Private equity managers are able to either raise, probably raise bigger funds and also pay more because now less of that is equity and more of it is debt. So now that drives up pricing. Is that a lagging indicator? In other words, if interest rates go down in 2026, will it take a couple years for that to flush out in the market? Or is it more like an efficient market where it basically the prices go up almost immediately?
- [39:20]
Michael
The way that we get impacted in the smaller end of the market, it's not on the buy, it's on the sell. So if our manager's done their job and they've tripled the size of a company and they've graduated up into this, you know, this higher rung of, you know, higher valuation segment where all these middle market firms are, you know, they're trying to find the best new platform, right? Or they might even be trying to find an add on to a larger platform and our platform becomes their add on, right? The way we get impacted is they might come back, you know, if rates go up as they did. This did happen to us, you know, rates shot up and that buyer came back to our partner and said, hey, you know, I can't get the debt I used to get. I can't pay as much, you know, I have to retrade you and I want to offer a smaller amount. And you know, our partner just pulled the deal and decided just to kind of wait it out to see if things would improve. And I think it happens pretty fast. So if, I don't know, I'm not going to be a prognosticator of where rates go, but if they do go down, then I think you'll find people just putting on more leverage because the.
- [40:50]
David
Leverage essentially is on a deal by deal basis, not on the fund basis.
- [40:53]
Michael
That's right, yeah.
- [40:56]
David
Double clicking on that GP on the ideal gp, the ideal GP avatar. If you had to choose between somebody that was really good at picking and negotiating versus somebody that was very good at operations, which one would you pick and why?
- [41:17]
Michael
The way we've evolved, David, is, you know, I mentioned when buying performing high quality companies, we come at it through a single sector orientation. So we're, we're big believers in this. In other words, they may do nothing but consumer or fin services or gov services or industrial or business services or healthcare services. So we have exposure to all those managers and we're probably one to three deep in each of the sectors, you know, so the question is, why do we do that? We want the manager to have the, the best odds at buying the highest quality companies at the lowest possible price. So we want their value proposition to the prospective portfolio company to be overwhelming. We want the portfolio company to meet with the manager and reflect on that meeting and come to the conclusion that they don't even want to go on it. A lot of times these sellers are wanting to roll equity and stay involved, but you know, take some chips off the table. But they do want to roll equity and they want to stay involved. And so they want to find the right partner to go on this journey with. And so, you know, if we're talking about the industrial sector, generally speaking, we want our managing partners to come from not only investment backgrounds, but it's very common that there is a former PE back CEO involved. And you know, why is that important? Well, it gets to exactly what you're talking about. I'll come to value creation, but just staying on the purchase opportunity for a moment. The way you get to really strong returns is you buy a company at a lower price than is prevailing in the market right now. Okay, so if that sector is trading here, you're buying at a turn low or whatever, then once you purchase it, you embark on your value creation initiative and you grow cash flow and then you graduate it up into this higher rung of capital that's willing to pay a higher multiple. So all those things come into play in producing your return. And I would just add one more thing. You're professionalizing the company and you're improving the quality of the earnings and although that may not show up quantitatively in growing cash flow, it will in the margin and it will absolutely result in a higher multiple. So all those things are important. But you know, back to, you know, single sector, you know, wanting operating executives and investors on the team. And just sticking on that topic for a moment, you can just imagine if you're going to a meeting with a potential seller who wants to rule some equity in a sector like industrial and your partner is a former PE backed CEO that had three successful outcomes in industrial. You know, he or she can sit across from, from that owner and you know, sort of reminisce about their shared experience. And ultimately what you hope happens is, you know, you have several factors that the seller's considering when selling that company. Price being one, but you know, potential partnership is another. Terms might be another. You know, I think about this as key buying criteria. It's a marketing term where, you know, if you're pitching your product to a customer that that customer has, you know, four or five criteria that they're considering when deciding to buy your product or service over Another. So, you know, hopefully, hopefully through that kind of dynamic, you're able to persuade that seller to deprioritize price amongst their criteria of selling the company to the right partner. And so that's why it's important on the buy. And that's the value that a single sector fund that has operating capabilities sitting inside the partnership brings to the table.
- [46:33]
David
I gave you a false binary. I said, do you want the lowest price or do you want the most value add? And your response was the most value add will lead to the lowest price and also lead to multiple.
- [46:45]
Michael
So you want the lowest priced and you want the highest value add. And you know, there's a circular aspect.
- [46:52]
David
To it in that the lowest price will also get you the highest, the highest return on, highest absolute return on it as well. So you might buy a $20 million company for 15 million because you have the value add. And because of the value add, you could now increase the value by three times versus by two times. So you get this multiplicator.
- [47:10]
Michael
A very excellent formula to think about is to buy a company a half a turn or a turn under the comp set that's prevailing in the market, double the cash flow and sell it for three turns higher and use modest leverage. That's going to lead to a very attractive outcome that every private equity investor is going to be happy with. And so that, that is, I think it's extremely important for people to understand the value drivers and how you generate a return and how much each of those value drivers can flex and therefore how much they're contributing to the return. And then you can start, you know, putting together your diligence sort of process based upon trying to answer those questions.
- [48:09]
David
So let me try to break this model. So let's say you have three operating partners, best in class operators, and you have either no investment people or maybe some junior partner that has been at one of the top PE firms for 10 years. Could that work only operating GP, PE fund work? Or does it also break if you don't have enough investment acumen?
- [48:32]
Michael
I think it's helpful to have both. I think both backgrounds bring an immense amount of value to the table. And I'm trying to think. So we have a partnership where there's three operators and one investor and the investor's the junior partner. We have another one with two operators and one investor. And then you see an awful lot where there's one investor and one operator. The investment acumen is important for a couple of reasons. I would just say, generally speaking, fund management portfolio Construction, governance. You know, I think another really important value they bring is capital allocation of making. You know, because the operators, they can dream up all kinds of value creation initiatives to embark upon once you own the company. But the, the best teams know that their time is limited and they need to prioritize those value creation initiatives. And there's no better way to do that than in terms of thinking about return on time and return on capital. So that gets to capital allocation. And generally speaking, the folks with the investment background are better at that, have more experience at that.
- [50:12]
David
Thank you for listening. To join our community and to make sure you do not miss any future episodes, please please click the follow button above to subscribe. Do you find that in the lower middle market, since a lot of those companies are owned by the original founder, the family operator, they tend to have more rapport with the operators versus maybe if a private equity fund bought the company, that more rapport with investor types. Is there something to that?
- [50:36]
Michael
Absolutely. Like there's no question. I had a really interesting diligence call a couple of weeks ago with a seller and he was rolling equity. So this was the founder of a small business in the industrial space. And you could tell this gentleman was extremely reticent to sell or to take on an equity investment. It was a control transaction. But he, he was rolling a very substantial amount of equity and you could tell that he had so much pride in his business, it was so important to him, and he had kind of a chip on his shoulder and he was a little wary of how much value the private equity firm could offer him. And he said repeatedly throughout the call whether or not he thought they would add any value. But you, of course, you know that he hoped they would add a lot of value. But I think it gets back to the idea that he had a lot of pride. It dawned on me during that call that that company would never sell to the vast majority of private equity firms, even though, you know, that company was for sale and it was represented by a broker and anybody, you know, you know, could have thrown in a bid. Anybody could have potentially meted with the management team. It dawned on me that the vast majority of them would have no chance at any price to sell to that gentleman.
- [52:21]
David
So double click on that because I want to put numbers on that. So let's take it to the extreme. Let's say it's 100% sale of the company when founders found the company. Have you ever seen a founder take leave less money because they thought the company would be in better hands?
- [52:37]
Michael
Oh, Yeah, I mean, that's almost the formula.
- [52:42]
David
That's an emotional belief in what you've built and wanting it to be in good hands, not a quote, unquote, rational decision.
- [52:49]
Michael
So you're bringing up a very important point to managing risk. You are very hopeful that your manager isn't buying 100% of the equity. You know, you're. These are small. We haven't talked about the risks of small businesses, but, you know, the, there's. There are risks. And you know, of course, the founder of a small business is, is potentially very important, particularly through a transition. And so one way to manage your risk is not to buy all the equity, but to make the transaction very meaningful for the founder so they can take some chips off the table and they have a nice pool of capital that they can diversify their lifestyle with. But they're rolling equity. And if the manager has done their job correctly, they have shown to the, you know, to the founder what the potential is for them on that amount of equity rolled. And many times the potential at the ultimate sale five years later can result in, you know, a higher amount of capital flowing into the pocket of the founder than the initial transaction amount that they take off the table. And so if that's the dynamic, then you can understand, you can appreciate the importance of selecting the right partner to go on that journey with, right? That that individual has to really trust the people involved and they have to buy into the, the business plan, the value creation plan, and if they don't, they're never going to sell to that partner.
- [54:55]
David
What advice would you give to younger professionals that are looking to get into private equity and maybe this part of the private equity market, the lower middle market, what's the best approach to land in that part of the industry?
- [55:08]
Michael
My answer is the same across all asset classes. I think it's really important to, you know, just, you know, bring a lot of independent thinking. You know, the term gets overused. But first principles, take a fresh look at the, the asset class. And I think there's, I think there's immense value for investors and young people in particular to, to really get familiar with the variables that are driving the returns in the asset class. So what are the components that are driving the returns? There's no better way to do that than to build a model, an Excel model from scratch. So build a, I call it a J curve model. It's really a fun model that you'd build it quarterly, you'd deploy it over five years, you'd define some hold period, you would add A variable that grows cash flow from entry over the course of the quarters and the hold period, you would make some assumption about where you're going to sell that at. On some EBITDA multiple versus entry, you'd add leverage to the model, you'd add a waterfall. And once you have all this, you can start to play with these variables and you can understand the relative importance to each of each on the total return. And then once you're comfortable with that, you can look at the dynamics of the, of the asset class and in private equity, you know, I think, I personally think one of the most interesting things is just where all the dry powder sits. And so if you look at this mountain of dry powder and you start stratifying it by fund size, you'll find that it all sits above funds that are $500 million and larger. So that was the, the original basis for our strategy in the lower middle market is hey, once you strip out all that dry powder above 500 million, you're basically left with this like if you were to take like a, a fat tip black felty and just draw it on the zero line, that's the dry powder in the lower middle market. And then of course there's far more targets in the lower middle market than the large market in terms of the number of portfolio companies to buy. So that was the basis of our original thesis is hey, like if we buy these small companies that are trading at lower multiples multiples and they're trading at lower multiple because there's less capital splashing around and we can take the execution risk of double or tripling the size and then selling them into this next tier of capital where all this capital is washing around and where this debt capacity is higher, then you know, that's a good formula.
- [58:14]
David
You mentioned first principles. I agree, that's, that's something that's overused. One other way to say the same thing is top down thinking versus bottom up thinking. Usually top down thinking, you look at what everyone's doing and you start asking why? And 90, 95% of the time it makes sense. It's an efficient market. They're doing them, they're doing things the way that they should be done. But sometimes 5 to 10% of the time and it could be asymmetric. That could be a really big opportunity. They should, they're just following what everyone else has always done and that's the wrong strategy. And that's where you could really generate alpha, which is just risk free return or additional return. That does not commensurate with the risk, the definition of alpha. So I think as an investor you could use, you could just keep on asking the question why and why. You could get some interesting answers. And a lot, there's, there's a lot of sacred cows and in our industry that nobody dares question why they're done. Because you know, most of the time you're, you have a question, you have an answer and you look like an idiot. But sometimes you uncover something special.
- [59:25]
Michael
This is absolutely true and you're spot on. And it, it makes me think of, I think something else that's important for me to, to say, particularly to younger professionals. You know, my team didn't wake up and just have this epiphany moment and you know, and just sort of like envision this grand scrat strategy that, that we just hypothesized overnight. It just doesn't work that way. Right. Like all, you know that this whole conversation is kind of capstone. It's a capstone of 10 years of effort. Right. And so hopefully you have some market insight into one of the, like the very important basic elements of market structure that is occurring in an asset class. You know, for us, that epiphany moment in private equity was where the dry powder sits. In natural resources, it was, hey, you know, you're facing a real steep cost curve, so you better be very low. And then you just start pulling these threads and you know, you're surrounded by really smart people that are contributing to these conversations and you're just iterating and you're pulling on these threads and you're developing, your strategy evolves and you just put one step in front of the other, you know, and in some cases it's two steps forward and one step back, right? Where you make a mistake, you make a mistake, right? And then you course correct and then you take another step forward and then you ultimately end up with a really robust strategy. That, and I should say, I'll say another thing, I'm not very tactical. I used to think that it would be smart to get really cute and make one or two tactical investments per year. Maybe I'll do that, but I'm not trying to do that. And that's very hard to do. And so my point is that you want to think more strategically. And so you're hoping that whatever element of the market structure that you're focused on is going to have some legs, right? It's going to, it's not going to be this fleeting six month or one year sort of trade. Right. I honestly believe that we could be executing. I mean, we've been executing this lower middle market strategy for 10 years and if we don't get too big, you know, it's kind of damned if you do, damned if you don't. You know, we want the endowment to be as large as possible so we can have the biggest impact to ucla. But on the other hand, at some point we're going to grow out of our ability to invest in the most attractive segment of the market. But I believe that we have some Runway still back to young people and young professionals. I would also say know, really think about your personality and your strengths and weaknesses. And you know, I, I happen to be a, a big believer in Myers Briggs and in, in my, in my younger years, I was never really that focused on, okay, what are my strengths and weaknesses? Today I'm very attuned to what my strengths and weaknesses are. And I function better in private markets than I spent my first 10 years as a generalist. So across the entire portfolio, public markets, hedge funds, et cetera, I am, as a personality type, much more better equipped to work in private markets. And I would encourage people to know, put one foot in front of the other, get familiar with what drives returns, and then develop, you know, an approach. And, and what comes with that development is confidence. And, and then with confidence, you're willing to kind of, you know, stretch the boundaries of your strategy and your approach and you're, you're able to take on a little bit more and then you're going to find yourself, I think, in a spot where you can bring all that to bear on behalf of your organization and really drive performance.
- [64:20]
David
Well, Michael, this has been an absolute masterclass in the lower middle market. Thanks for taking the time and look forward to continuing this conversation in person.
- [64:28]
Michael
Thanks, David. It's been my pleasure being with you.
- [64:31]
David
Thanks for listening to my conversation. If you enjoyed this episode, please share with a friend. This Helps Us Grow also provides the very best feedback when we review the episode's analytics. Thank you for your support.