Invest Like the Best with Patrick O'Shaughnessy
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: Yeah. And so, because you rarely lose money, does that mean you also almost never hit some giant grand slam? [00:00:00] S1: Correct. We're like Cal Ripken – doubles and triples. We're not Sammy Sosa or Mark McGwire. It's all about hitting doubles and triples. And if you do that with very little leverage in the portfolio – 90% of our companies or 85% of our companies are recurring revenue. So if you invest today and know what revenues are in July, I think it's a pretty good way to invest. 56% of our companies are profitable businesses. You may get it wrong, you may back the wrong team, you may overestimate the size of the market – but I think 70% of the time we own the pref, your downside's 1x. Now sometimes you need to recut the deal with the entrepreneur or the managing team, so you're making slightly less than that. But if you can avoid zeros and turn those zeros into like 0.8x or 0.1x, it massively helps returns. We'll sell. Probably a third of our exits have been secondaries. We will buy secondaries. We will also sell. We constantly underwrite. We've been referred to as traders or corporate hedge fund guys, and we're like no, no – we're just trying to actually make money. Because this company's about to be a living dead and you're going to be in this thing for the next decade. [00:00:00] S0: Maybe spend a minute before we go through the buy criteria talking about selling more. What is the process that you run to be able to sell well?
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: Maybe spend a minute before we go through the buy criteria talking about selling more. What is the process that you run to be able to sell well? [00:00:00] S1: We have a divestment committee. There's 3 of us, myself, Brian, and Nimay. Been here all since fund one. We have a disposition committee, same thing. We think a lot of firms do a really, really good job on the buy. Very, very few firms do a very good job on the sell – like knowing when to sell, pressuring to sell. And I would tell you that the private equity funds tend to do a much better job on the sell than most venture growth guys. Hedge funds, if you do in invest public equities or long-only funds, you constantly can buy and sell. The 3 of us meet once or twice a month and just walk through the portfolio and just talk about it. Like "Hey, there's a round going down in this company, should we sell? How can we try to position this company for a sale over the next 12 months?" The fastest way to get fired at Lead Edge is to have a company and not tell us when there's a liquidity opportunity or just something's about to happen before it happens. [00:00:00] S0: What does the holding period end up being on average then?
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: What does the holding period end up being on average then? [00:00:00] S1: I bet our average holds are 3.5 to 4 years probably. Everybody gets all excited by these 2015, 2016, 2017, 2018 returns. Our '15 to '18 returns look very good, but it's just multiple expansion and we sold. That's it. If you think you're going to make a 2x in 4 years and you make a 4x in 2 years, it's amazing what it does to net IRR. People forget the reverse happened in '20 and '21. Nobody's '20 and '21 funds – I think the venture growth ecosystem gets a bad rap, but it's going to be every alternative asset. Their '20 and '21 funds are going to be awful relative to earlier funds because people thought they were going to make a 4x in 2 years and are instead making a 1.6x in 8 years. And so that's going to drive, that's going to have a huge impact on the industry. [00:00:00] S0: What is the most interesting thing about the skill of selling and making the transaction happen? Like presumably it's easiest to sell in private markets when a lot of other people are really excited about buying. You can't just hit sell like in public markets. [00:00:00] S1: Correct. [00:00:00] S0: Maybe in like a bad, medium, good – there's different kinds of outcomes that you'd be selling into. Are most of your sales into everyone else is excited and you're less excited? [00:00:00] S1: It can be everything in between. Like if a company goes public, it's just hit a 2 to 5x in 3 to 7 years. [00:00:00] S0: And then sell.
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: And then sell. [00:00:00] S1: So you're like, the company goes public. You're at a 3.3x in 18 months or 24 months. That annihilates a 12% or 20% net IRR. It's a great company, but we constantly are underwriting what's a forward net return from here. We made a 3x in 18 months. That's like an IPO. In a secondary sale, it's about underwriting the forward IRR. In Toast, which is one of our biggest investments, which we put like 12% of our Fund 3 into. And we'd always get crap. Our Fund 3 was a $290 million fund, and we put $36 million into it. And before the IPO we had sold $180 million. I think we made $350 to $400 in it total. People were like, why are you selling? You don't believe in us? We're like, no, no. All these other knuckleheads that invested alongside us – none of them put 12% of their fund in it. And by the way, somebody is paying us a price in the secondary markets that we think is just lunacy. We sold like in the secondary markets, like $40 or $50 in Toast. The stock today is $30, we think it's cheap, but it's just – by the way, we sold like 6 years ago. And so it's constantly underwriting forward IRR. [00:00:00] S0: Okay, now I get to talk about the 8 buying criteria. I don't know if you want to tick them off or give us some highlights or…
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: Okay, now I get to talk about the 8 buying criteria. I don't know if you want to tick them off or give us some highlights or… [00:00:00] S1: I’ll give you some highlights. So there's eight criteria. $10 million plus in revenue. Why? Do you have product market fit? Are you growing? Because we don't invest in startups. Are you growing like 25% a year? Returns to growth. We don't use leverage. Do you have 70% plus gross margins? Why? Because at the end of the day, you trade on multiples of earnings. Revenue multiples are just shorthand math for what will be EBITDA multiples or earnings multiples when you don't grow that fast. There's a reason that Facebook gives away electronics in the vending machines and Dell charges for Cokes. It's just one has 80% gross margins and one has 15% gross margins. And we think that just drives, at the end of the day, earnings. Are you recurring? It's a heck of a lot easier to invest knowing what revenues will be in July than they are today. Are you capital efficient? This metric has probably kept us out of the most trouble. It's like our version of return on equity. I mean, I think it's Warren Buffett with the ingredients, but are your revenues today greater than your historical cash burn? So what do I mean by that? Here's 20 of revenue. Have you burned 80 like every other tech company? [00:00:00] S0: Cumulatively?
· Patrick O'Shaughnessy, Mitchell Green
[00:00:00] S0: Cumulatively? [00:00:00] S1: Cumulatively, yeah. Have you burned 80 since inception or have you burned 10 since inception? We're looking for this 1-to-1 ratio. In a world where capital is a commodity and capital is everywhere, if you can build a business that's growing nicely while burning less than your revenues, you've got a pretty good business. Now, we don't invest in startups. If you invest in startups or $2 million revenue companies, then obviously it's harder. Are you profitable at the bottom line? Do you have any customer concentration? I just don't want to wake up and find out 40% of my revenue disappeared because some customer decided they don't want to work with you. [00:00:00] S0: I want to talk about the price you're willing to pay for companies and how you would plot yourself on the – so much of this sounds like a private equity strategy, but you mentioned Toast and it's not like the high growth rate.