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Circle of Competence Issue #50

Quote of the week: 'Culture is religion externalized' - Henry Van Til


Troubled Vision

3 weeks ago in issue 47, I wrote about the magnitude of Masayoshi Son's Vision Fund and the difficulty which may arise in squeezing returns out of such a mountain of capital. This week a piece came out indicating that his investors were balking at some of the high valuations he is paying for equity in private companies, and one quote in particular caught my eye.

A trend has been on the rise in private equity of shifting equity in a single company owned by the same sponsor from one fund to another at a higher price, often to show paper gains that may or may not be illusory. Some of Masa's investors have noticed this behavior with their capital under SoftBank's management:

"PIF is also concerned about SoftBank’s practice of investing in companies first and later transferring the stakes to the Vision Fund—often at a higher price, according to a person familiar with the Middle East investors’ thinking."

It's a bit concerning for investors because it does cast a shadow of doubt around how or if their incentives are aligned with SoftBank's incentives if SoftBank is taking gains from investments at the expense of the fund's limited partners. Incentives and business valuation still matters folks.

Small Business Investing

I've been exploring and learning more about small business investing recently, and this week I was fortunate to have spoken with a friend, Neil O'Donnell, about his journey from the world of corporate law to becoming a search fund operator. Before I get started, I want to point your attention to the three main resources Neil sent me on thinking about investing in small businesses and search funds:

Before we dive into search fund investing and operations, let's define what a search fund is for those unfamiliar with the term. It is defined as an operator or group of operators who are funded by investors to 'search' for a company to acquire, operate, grow, and sell. Typically the investors put up the capital to employ the young manager (known as a 'searcher') over a period of 1-2 years to acquire an attractive company. Then, once a deal is identified and approved, more capital is put up to purchase the business. This is just the beginning - the hard work lays ahead. Once purchased, the operations of the company are studied, improved, and optimized. Ideally, the searcher will sell the company after growing it significantly over a 5-7 year period and will return a multiple of capital to the investors, sharing in the upside along the way.

I'd highly recommend listening to the two podcasts above and reading the Stanford Search Fund Study, as they contain some great nuggets on what it takes to be successful investing in small businesses. From listening to the interviews with Chenmark Capital's Trish and James Higgins and Housatonic Partners' Will Thorndike, I took away the following nuggets:

1. It is clear that there are many small businesses that may not have a lot of growth opportunities internally to reinvest in to grow (the example they talk about a lot is a bait shop or bakery), but that generate significant returns on capital employed that can then be used to buy other high return businesses ad infinitum (Chenmark Capital). A perfect, well-known example of this would be Buffett's See's Candy. It generated incredible returns on capital, but no matter how hard management tried, it would only require but so much reinvested in the business to grow. So, the excess cash would be sent to Berkshire headquarters to be invested in other ways.

2. Always optimize investments on an after-tax basis - this is what pays the bills and makes a big difference when compounded over many years! (Will Thorndike)

3. Invest in high-return, recurring-revenue businesses - these are the businesses that have the highest rate of success according to the Stanford search fund study (Will Thorndike). In fact, according to the study, 70% percent of the investments that produced a 2x to 10x ROI reported high recurring revenues.

Neil was a young lawyer at Davis Polk when he happened to be listening to the Thorndike/O'Shaughnessy interview in the gym. About an hour into the podcast, there is a great exchange where O’Shaughnessy asks Thorndike what industries he is currently interested in that meet his criteria of high returns on capital and recurring revenue. Thorndike responds by saying he would love to invest in a cell tower business predominately buying ground leases (fancy term for owning the land under a cell tower and leasing it out) outside of the United States because it is a higher return on capital business, you can use leverage to boost returns and minimize taxes, and it is a highly recurring revenue business because of the long-term cell tower leases. The light bulb went off in Neil's head that day - long story short, he wrote an executive summary and sent it cold to Thorndike about the cell tower idea that was mentioned in the podcast. Faraday Partners was born.

After studying the overall returns of the search fund industry, nascent as it may be, it seems that investors have been compensated amply, especially if you invested in solid young talent and recurring revenue businesses. The overall asset class has returned an overall IRR of over 35% based on the study's findings. Will Thorndike at Housatonic Partners has this exact model - back a portfolio of promising young talent in high return, recurring revenue businesses. On the flip side however, one fact that stuck out to me in the Stanford study was that 48% of all search fund efforts ended in either no acquisition, a partial loss, or total loss of capital. The best way by far to reduce the risk of this outcome is to simply seek businesses with recurring revenue according to the study. Ultimately, these types of businesses work out better for the investor and also for the searcher in the long run. If searchers continue to churn out returns like the study published and thousands of boomers continue retiring from their businesses, I would bet that the search fund movement will become a more viable, burgeoning industry for both institutional capital and young entrepreneurial talent.

To wrap up, for anyone investing in small businesses, whether you are a search fund operator or a small business owner or a fundless sponsor, I would recommend getting your hands on anything that Chenmark Capital, Will Thorndike, or Brent Beshore has written or spoken. You won't go wrong with any of these thinkers who labor daily in the small business investment business.

Have a great week!

- Benton



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