Invest Like the Best with Patrick O'Shaughnessy
· Mitchell Green
[00:00:00] S1: Our belief, for right or wrong, is that the competitive advantage of a software company has never been about R&D. We're not building semiconductor chips. We're not building biotech and pharma companies. This isn't that. It's to build like Chamber of Commerce software. You too could build this. My mother couldn't, but my brother could. No problem. He's an engineer. So could Microsoft. Any of our companies in our portfolio, if Microsoft took 500 people and gave them a month, each one of our companies could be out of business, but they just don't care about the Chamber of Commerce market. They don't care about the price optimization market for manufacturing companies. They don't care about the tax software market for a very specific niche product. So the software companies are really about distribution, sales and marketing, customer success, client services. We believe that it is the incumbent's game to lose in software today. I'll give you a couple examples. Workday has like 98 or 99% gross dollar retention. It grows 10 to 15% a year. Oh, it only grows 10% a year. I'm sorry, it's like $10 billion of revenue. It only took like 20 years to get there and it does like $3 billion of free cash flow. Exxon or your hospital system or Warburg Pincus or KKR or Procter & Gamble probably spent 3 to 5 years implementing the software. If you think they're going to like start building their own HR software, you're outta your mind. Now the GUI and how you access it is gonna be far different, but actually, they already have the customer relationships. And the only reason they built it is because Dave Duffield and Aneel realized 20 years ago that Oracle and SAP had really crappy products. They have thousands of engineers that are trying to build the product much better and are gonna use Workday versus Mitchell Green's cousin vibe coding his way to build Workday. The flip side, why did Coupa get built? And the reason it was able to be built is SAP bought Ariba and they just left it for debt. So they built this big business, they took it public, and now it's been sold to Thoma Bravo. So what I actually worry about Thoma Bravo or any of these big private equity funds, if they're putting a bunch of debt on it – it's not growing that fast anymore if they're putting a bunch of debt on it, and then what they do is they bribe.
· Mitchell Green, Patrick O'Shaughnessy
They're like, oh yeah, we drive all our companies to rule of 50 businesses. Now, do they end up cutting a bunch of people in R&D and sales and marketing and product, that if you were being run by an entrepreneur with no leverage, you would've kept. And now, I worry that a bunch of these private equity owned assets that are overleveraged are ripe for disruption, versus independent software companies that are focused on growth, that are trying to innovate. And I like to remind people that if you look at e-commerce in '99 and 2000, everybody thought every big box retailer was going out business. But if you look at the top 50 largest e-commerce companies in the United States, Amazon is number one. 2 through 10 are Walmart, Home Depot, Lowe's, Macy's, Target. I mean, Saks is a crappy company. Their online business is actually pretty good. Neiman Marcus, same thing. A lot of the incumbents will win. Now again, Montgomery Ward, Kmart, Sears went bust, they were either overlevered, didn't innovate. So for us, that's what we're constantly thinking about. [00:00:00] S0: Does that mean that right now feels like an especially opportune time for your style because entry multiples are lower? [00:00:00] S1: I think the best risk-adjusted returns right now are in public software names. By the way, Warren Buffett says buy when everybody is fearful and sell when everybody's super excited. [00:00:00] S0: Blood in the streets, yeah.
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: Blood in the streets, yeah. [00:00:00] S1: People hate software. When we bought a bunch of our ByteDance stock 2 years ago when everybody hated China. I mean, Alibaba's doubled off its lows and doesn't grow and trades at 15 times earnings. [00:00:00] S0: If you think about the CV, very specialist type buys that you'll do, can you explain an example of one of those?
· Mitchell Green
[00:00:00] S1: We like to use the house analogy. You walk down the street, go into an apartment building. My apartment needs to have these 6 things. You can go in the front door and you can lead the primary round and put money on the balance sheet, or you can buy the whole business. You can go in the side door and buy an early investor or early employee out. But look, maybe that's not available. So we'll go through the basement window with a pickaxe and buy a derivative. Because if you run a business and this can of Pepsi owns 30% of your business and I go to the glass that is an investor in the can of Pepsi's fund, and that is nearly half the LPs, and I literally buy that out and you own 30% and I buy half the fund, I just bought 15% of your company. It's the same damn thing. It's just a derivative. Do you have as much control? No. Do you have as much insight? No. But you trade off price for access. We made a big investment in Zoom, so we couldn't go into the front door. The company didn't need money. We sure as heck weren't buying the entire business. You couldn't buy secondary. There was secondary to buy, you couldn't buy it because Sequoia would roll you for it. They're smart, they're not dumb. They're like, why would we let these knuckleheads in? We'll take the stock and make 2 to 3 times our money. And the company was one that took a long time to get funded and wasn't backed by Sequoia day one. It was backed by a bunch of random Chinese people and Chinese funds. It was actually a secondary buy, but you couldn't because they were over. So we're like, huh, why don't we go to this fund that has stock? Their LPs have been in this thing for 10 years. Maybe their LPs want to sell and we can do it one of two ways. We'll just buy your position in the fund and we'll know exactly how much, we'll know exactly how much Zoom we have through it. Or why don't you just create a new vehicle? Any LP that wants to sell, we'll step into their shoes. Well, if you own 2% of Zoom and half the LPs want to sell and I then step in those shoes, I now own 1% of Zoom. And if I say to you, listen, we get to vote 'em like we own 'em, but you still hold it. The company gets an M&A offer and you get to vote. You have to call us day 181 of the IPO after lockup. You gotta give us the stock. We just bought the position.
· Mitchell Green, Patrick O'Shaughnessy
In a world where LPs and GPs are desperate for liquidity, that part of our business is absolutely booming. And that part of our business is headed by Tim Bemer, who's one of my partners, who was actually a Notre Dame alum as well. [00:00:00] S0: If I think about the dollars deployed last year or over the next year, how much of it is direct capital on the balance sheet, secondaries, something creative like what you just described? [00:00:00] S1: 70% is creative on the balance sheet. 70% is special sits or secondaries. We will evaluate in an IC a public position, a control buyout, a minority deal, or a special sit. You could get 4 different things in one week and literally we underwrite to the same return. But today the opportunity is in – we are a market drawdown away from it exploding in value or exploding in stuff to do. [00:00:00] S0: The hard part, it seems like, is finding a company that has 6 of the 8 criteria that you can also buy at a multiple that you're excited about for the forward return. What percent of companies of the 9,000 or whatever meet all 8 criteria? [00:00:00] S1: By the way, no correlation how it performs either. If we do an 8-criteria deal versus like a 5-criteria deal, there's like actually no correlation to like, it was a better deal. [00:00:00] S0: What about like 4 or 3? [00:00:00] S1: We've never looked at it, because what we try to do is – if you say it must meet 8 criteria, 9,000 companies becomes 90. [00:00:00] S0: Okay.
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: Okay. [00:00:00] S1: To do 5 to 7 deals a year, it just doesn't work. And so for us, what we say is it just like must meet 5. That's about a 10% yield. We're trying to get to a set of companies that we can then actually do work on. So you have 900 companies that meet 5 or more criteria. You do diligence on about 150 to 175 to do 5 to 7 deals a year. And you're like, why not more? I'd love to, but like, we're cold calling entrepreneurs. They're like, "Oh, I'm sorry, I wanna sell my business tomorrow. You just happened to call me on this day." No, the sales cycles can be a decade and it's about staying in touch as an entrepreneur because we're not the only ones calling them. There's great firms like Summit or TA or Insight or Bessemer or Battery and they're great firms. And so it's like, well, ask the entrepreneur, how do they need help? Try to tease information out of them. Oh, you sell into the consumer space. You want to meet the former CEO of Colgate-Palmolive? And you're doing that to try to build a relationship with somebody. [00:00:00] S0: If 5 criteria companies don't outperform 8 criteria companies, doesn’t that imply the criteria aren't predictive? So then why have the criteria? [00:00:00] S1: Because you need to set a framework for what to focus on and what not to focus on. [00:00:00] S0: So they're not predictive necessarily.