Buyers and Builders
00:37:33 · Mikk, Greg Geronemus
[00:37:33] S0: I found a... I'm quoting you in here what you've said previously on one of the podcast and again, you, traditional search is a win win for both investors and entrepreneurs. I think this sums up. Let's sum up this part. [00:37:49] S1: Yeah. I mean, look, I think, you know, there are a lot of advocates of self funded search describe or create this construct where traditional search is this sort of predatory concept... Predatory model where investors are taking too much of the equity or... And not giving enough equity to traditional searchers. I I think that the data speaks for itself that that's not true. There are people who... The many people who have made, in some cases, tremendous fortune, and in a lot of cases, a small fortune on traditional search as entrepreneurs. There's a lot of rest that traditional search investors are taking and a lot of work that they put in to support search entrepreneurs. And they're deserving of the rewards that they get. And certainly traditional search entrepreneurs are deserving of the rewards that they get. And I think the model has been around for many years. I think it's beyond fair and I really do believe it's a win win. There's plenty of upside to go around. [00:39:08] S0: We covered one side. We covered the self funded search side when it comes to the ownership, which could be like 60 to 80% of the business. But can you elaborate the ownership structure for traditional search?
00:39:08 · Mikk, Greg Geronemus
[00:39:08] S0: We covered one side. We covered the self funded search side when it comes to the ownership, which could be like 60 to 80% of the business. But can you elaborate the ownership structure for traditional search? [00:39:22] S1: So it's 25 to 30% depending on whether it's a solo searcher or a partner search. And it's broken down into tranches that vest for different reasons. So let's just go with a partner search for a second where you can get up to 30% of the economic upside. A third of that 10% vests at close as a reward for closing the transaction. 10% vests over time, typically a four year time vest. And then the remaining 10% vests subject to performance IRR hurdles. You begin to invest into that... The the third tranche at a 20% net IRR, and you max out on that third tranche through a... With a 35 net or higher internal rate of return. [00:40:22] S0: Okay. And now the last topic, the rise of committed capital vehicles and holdcos. Over the last two years, we've seen an explosion of committed capital vehicles and permanent holdcos. What do you believe is driving that trend? [00:40:39] S1: Let me take a step back and just explain how the... What the model is and how it how it differs from traditional search, and then I'll I'll get into sort of [00:40:46] S0: the Okay.
00:40:46 · Greg Geronemus
[00:40:46] S1: The drivers as I see them. So I'll lump I'll lump committed capital vehicles and holdcos together because I think they're more similarities than differences. But instead of in a traditional search where, as I mentioned earlier, searchers will raise search capital, giving them two, two and a half years of window to hunt for a business to buy. Committed capital vehicle holdco entrepreneurs will approach investors, typically the same investors where we participate equally and happily in both traditional search and committed capital vehicles. So entrepreneurs will approach us and say, I wanna raise $15.20, $25,000,000 to go out and buy... For the most part, do a consolidation of buy and build in a specific industry. So it could be a specific subspecialty of health care or a vertical within software. You know, could be... You know, you you name it. It it runs runs the gamut across across industries. And so, you know, unlike traditional search where a searcher might have a few ideas for the industries that they're gonna go after, This is a hyper focused entrepreneur or entrepreneurs. More often than not, it's it's a a team. Sometimes you'll see... You're... More and more, you're seeing three three person teams as well. So they'll they'll they'll get commitments from a group of investors to fund whether it's 15 or 20 or 25,000,000 to go after that strategy. It is referred to as a committed capital vehicle, but there's some nuance there around the committed piece. Investors have... There will typically be two or three investors that are on the board of that committed capital vehicle. And those investor board members need to approve any deal that's done or any capital that's called. So there's still, you know, a healthy governance dynamic, and it's it's certainly not the case that a searcher or entrepreneur can just call capital whenever they want to pursue anything. So in some ways, it's committed, but there are... There's governance and accountability embedded in the model as well. But fundamentally, these are for people that that wanna do a a roll up or consolidation play. That that is the strategy. So inorganic growth has to be a significant driver and component of the thesis.
00:43:39 · Greg Geronemus
I would say over the last six, nine, twelve months, we've seen a massive shift from people who would otherwise pursue traditional search, now moving into this committed capital vehicle holdco model. Nine months ago, I thought it was maybe just a, you know, a small adjustment. Now I'm convinced that committed capital vehicles are gonna take significant traditional search in the years to come, and that's that's happening real time. You asked what's driving that trend. I think there there are many things. One, there's... It's definitely an element that it's the new shiny object. So I think people... It... It's the it's the hot, sexy, exciting thing you do. So I I don't wanna I don't wanna I don't wanna overstate that too much, but I also don't wanna downplay it. You know, it's it's more elusive and and exclusive than than traditional search. The bar for the entrepreneur is higher, so the people who are able... Who self select in or are encouraged to go down that path, I think just feel special because they're doing something that not the entire ETA ecosystem would be able to pull off. So I think that's one. Two, there have been increased data points... Increasing number of data points in the... Over the last several years that inorganic growth can be a buy and build. Zero acquisition strategies can be significant drivers of outsized returns in the lower little... Lower middle market private equity investing. So there's a... This is a... In part a response to that trend. Three, you see... You know, part of this, I think, is a response to the increased difficulty in for searchers to acquire businesses. So if you have a if you have a traditional search where typically you're buying just one business and there isn't much of an understanding around buying additional businesses after that, you feel the pressure to go and buy a bigger business. So you wanna buy something 2.5, three, 3.5, 4 plus million of EBITDA. If you have a committed capital vehicle where you know that you're gonna be buying businesses, many businesses over a three to four year period, you feel more empowered and comfortable going further down market and maybe starting with a business that has $809,100,000 dollars of EBITDA that gets you in the game. It's not a you'd wrong to call it a platform, but it gets you it gets you in the action. And once you... And you can build EBITDA from there.
00:46:45 · Greg Geronemus, Mikk
So you're... It's... It it... For many people, they see it as a way to go further down market and avoid some of the competition that we were talking about earlier. And then last but not least, there's sort of a pure economic motivation for a lot of these entrepreneurs. I mentioned the equity that these committed capital vehicles are raising, $15.20, 25,000,000. We've seen few that are a little bit larger. It's just simple math. Putting more dollars to work gives you a greater opportunity to make to make more money. So, you know, a lot of traditional search deals, certainly bigger than self funded search, but a lot of them... You know, let's let's take a a $12,000,000 enterprise value deal. Maybe it's a fifty fifty split between debt and equity. You're putting $6,000,000 to work. You know, let's say you get a a four x return on that. You go from six to 24. They're $1,818,000,000 dollars of proceeds. That's what you're you're working with in terms of the percentage of of economic upside that you can that you can capture as an entrepreneur. If you deploy $25,000,000 through zero acquisition or CCV model, you get a four x on that. You have $75,000,000 worth of, you know, of economic upside from which to draw the incentive pool or carry interest or whatever you want to call it. There's a fundamentally different economic opportunity that searchers are availing themselves to when they go down this path. [00:48:38] S0: What do you prefer as an investor when a talented individual coming to you, everything prepared? What do you guys prefer?
00:48:38 · Mikk, Greg Geronemus
[00:48:38] S0: What do you prefer as an investor when a talented individual coming to you, everything prepared? What do you guys prefer? [00:48:46] S1: It's a great question. And I think we're still sorting through that real time because this trend has really taken off in the last nine, twelve months. I would say if if a if a searcher comes to us and says... And has a a really, really excellent thesis, They have prior experience in that industry. They have a pipeline that they've developed with, you know, ideally a target, maybe two, that are... With which they're in advanced conversations. Maybe they've got one of them under LOI already. And there's significant industrial logic to combining a bunch of businesses, and they have a thoughtful integration plan as to how to do that. Think on balance, we'd probably prefer a committed capital vehicle. Absent all of those factors, we would prefer traditional search. So the the bar the bar is higher. You... There's more... A lot more prework that needs to get done. For a lot of folks, they're highly pedigreed with their work experience or MBA program. You know, they can sort of roll out of bed and raise search capital. You cannot do that with a committed capital vehicle, at least not at the moment.