Alex Abell - Lower Middle Market Buyout Investing at RCP (EP.383)

26:01That might seem expensive, but everybody else was buying companies at 12 times EBITDA. You might say, well, buying cheap is better. But when you look at the actual data, you do a regression analysis. And so maybe you would expect to see it in the cheaper you bought, the return would be up and to the right. And what we really see is that one, there's almost no relationship and the R squared is close to zero, usually de minimis. And there's a reason for that. One is that sometimes cheap deals are cheap for a very good reason. There's a lot of risk in those deals. Main learning from our data is that you have to put the data that we have in the context of what you're seeing in the rest of your due diligence.

26:39And so there isn't a magic button you can push that says, if you do X and we see X in the data, then there's a very good chance You're going to have good returns in this next fund. But what the data does do is help us provide context and validation, I would say. So, for example, there was a manager that we were looking to invest in that was an industrial manager, one that we had invested in over a long period of time. Their valuations that they were paying for deals were starting to go up pretty significantly over time compared to the market. So they were going up in an absolute way, but they're also going up compared to what their peers were paying for deals.

27:12And what they told us, which I think was a very valid reason, which was they've been in industrials for a long time. They've seen cycles. They know that if they don't buy the best assets in the market at any given time, there's increased risk. And they believe they could generate better returns by buying higher quality companies, which again, generally will have a higher valuation. And we asked them, what are the characteristics of these higher quality companies? And of course, there were qualitative ones like better management team, et cetera. But one of the key metrics they focused on was EBITDA margin.

27:43And they said, look, we're buying companies with better EBITDA margin. And we said, okay, let's go back to our data and see that. Because if we look at their data, what we should see is that for every company that they are buying, those companies have higher EBITDA margins than all the other companies that are being bought in the market in the same time period. And what we found was that, yes, the average EBITDA margin increase for these industrial companies like 900 basis points above the market. Now, 900 basis points is not that much if you're looking at software, but for these industrial companies, that's a big difference.

28:16And so what's important is that our data was able to validate that what the GP was telling us about what their strategy was, was true. But this is the most important distinction I want to make is it wasn't telling us whether that was a good strategy or not. All we learned was that they believe by higher EBITDA margin companies, as well as other characteristics at higher prices, was a great way to reduce risk and ultimately generate better returns. But that's only half the question. So we were able to validate that's true. And then the question is, is that actually something we want to do? Do we believe that's true?

28:51And then we can sometimes use data to sort of validate or invalidate those ideas as well, which you actually did in this case. One of the questions that's coming up in my head as you're talking about this is about market efficiency. So you mentioned, for example, smaller funds that do well get bigger. Well, that implies that even people that don't have your data have recognized those are good returns. I'm curious what you've seen about your ability to invest in, let's say, inefficient parts of the market or things where your data is telling you something that other people who don't have access to the data aren't getting because the market's just correct in assessing both quality of deals and managers?

29:29I would say that comes into play the most with smaller funds in smaller parts of the market where the number of observations they have in their track record that they have of realized deals where they can say, I actually generated this return, tends to be smaller. So if we're looking at a fund and we're evaluating a manager, the most relevant deals that that manager has ever done is the last fund they invested. And when we're looking at that fundraise, they generally have 80 % to 90 % of that fund still unrealized. That creates a really difficult problem because even if you're doing vintage -year benchmarking, the vintage -year benchmarking on the fund that's two years old doesn't tell you anything.

30:10So where I think we have advantages in that kind of situation is the operational data that we collect. So we can also say the manager is touting the fact that this particular company is growing at a 14 % revenue CAGR and EBITDA has increased at a 8 % EBITDA CAGR. I don't know, 14 %? That sounds good, I guess. I don't know. Is that good or not? I have no idea. Let's say it's a healthcare services company and he's telling at 14%. He's saying that's amazing. Without the data that we have, it's hard to understand if that is actually good or not. Have they actually been doing a good job of creating value?

30:50So in our part of the market and the smaller part of the market, we don't use financial leverage to generate most of our returns. Most of the returns are generated through growth. They're generated through taking smaller, less sophisticated companies that have a lot of levers to pull operationally to improve them and making them grow and scaling them to a place that they can be sold in a much more efficient market. So the operational improvement that we see is a really critical part of most of our theses. So when a manager tells us they're growing their companies at certain rates and it's in their data room, what we can do is look and see, is that actually good or not?

31:28And that gives us an advantage, we think, in terms of our evaluation of trying to decide good versus bad and whether or not in situations where there's limited track record of realized deals, how do you get comfortable with those managers? As you mentioned, at some point, some of our managers get very big and it's because they've done really well and everybody recognizes that that's true. But the problem is that when you're investing, when they're fund two or fund three, and they're not at that stage yet, you need to figure out how to do an evaluation with more limited information that gets you to conviction.

32:02And that's what we spend a lot of time on. The only other area I'll say that we end up having advantages on emerging managers and somewhat for similar reasons. But what's different about emerging managers is that one thing for sure is that on the data side, you don't have vintage or benchmarking to use on an emerging manager. Even though the most basic tool that most LPs are using is not something that is applicable because in most cases, an emerging manager has a collection of attributed track record from their previous organization. So maybe there's 10 deals over 10 years that that person or team has done.

32:36And so again, like going back, our deal level data allows us to evaluate these types of managers in these types of ways in, we think, a much better way than if we were just taking big leaps of faith alone. So as you look at that whole middle market, you have to still pick your spots. What are the type of managers based on maybe the metrics and qualitative metrics that you've decided to add to your portfolios? For us, the best managers are ones that present a team, a strategy, a process that we believe has the ability to create repeatable returns. That seems like a very obvious statement. What we're dealing with, as with any investment team or professional of a manager, is there are oftentimes managers that have really good track records.

33:22And when you dig into how they were able to execute to develop those track records, you find out that it might be a track record based on one really amazing deal where there was no consistency or even a couple deals that were good, but that the reason that they ended up being good, there's no common thread and there's no way to sort of guarantee that those reasons will ever occur again. So for us, the way we think about it is we're obviously trying to back teams that are exceptional, but maybe the most important part of that is teams that are exceptional that based on their background experience have the ability and have a stated process and strategy for how they do deals that we think gives them the best probability of outproducing other managers on the return front.

34:10And I say probability because if anybody tells you they can pick the top decile manager of any given vintage year, they're completely wrong and lying. But what it does mean is that we can look for characteristics in each of those sort of big buckets and say, we think that there's something about this that puts them in a position for every deal they do to have and achieve outsized returns. So on the process side, that could be something like sourcing, something unique about their sourcing strategy. How do they find deals? How do they create proprietary deal situations where their valuations are, let's say, moderate and less than the market?

34:47How do they win deals when it's a very big competitive process and there's 10 other private equity firms? How do they win deals for less than the top bid, which we hear often from private equity firms. So that's one interesting idea, right? And some people have sourcing strategies that we would consider fine, but that's not their superpower. And there's some managers where that is their superpower. That's their magic fairy dust that makes them differentiated. Another example would be really value creation, right? And we mentioned this a little bit before. The ability to create value in these smaller companies is where you generate most of your returns.

35:21And most teams today have some form of operational capabilities that they have either as part of their existing team in -house or as a very close outsource resource. These operational teams are critical. We've seen a development over time of how private equity uses these operational folks. And the models have changed over the years. But no matter what the model is that you're using, we have to see something about the way they attack the issues within these companies that we have faith that they can do over and over again. How do you then construct your portfolios? At RCP, on the primary fund side, which is what we're mostly talking about right now, the way we think about it is a fund for all seasons, to use a phrase that my partner likes to use.

36:07And really the idea is when you're investing in private equity, it's an illiquid investment that is on at least the surface, a 10 -year marriage that you can get out of at least in the secondary market, but it's not something you're planning to do, right? So for us, we're looking for managers that have the experience to invest through cycles. And so as part of that, when we construct our portfolio, we're looking for managers that create a diversified portfolio across a little bit across size. Although again, for us, everything we're doing is under essentially a billion dollars in fund size with some very few exceptions.

36:41Sector. We don't have sectors that we feel like we have to have. We do want to make sure we're not over -concentrated in any sector. And even within sectors, the strategies themselves can be very different. So in one fund of ours, we might have a technology -oriented buyout manager that focuses on very high growth companies. And then in the same fund, we might have a technology -oriented manager that's focused on complex special situations, doing carve -outs of orphan software products from a larger company. And those are both technology, but they're very different technology. So for us, we look at that as well to make sure that we have not an over -concentration in any style, any sector, and certainly diversification by size.

37:22From a geography standpoint, we're pretty boring. So it's U .S. and Canada, with 90 % or more usually in any given fund being from the United States. but our main goal is to understand that different strategies will operate through cycles differently and to make sure we have managers within each of these types of funds that have experience and track record that can go through those cycles. How do you think about secondaries both as a mechanism for your primary funds and then as a separate vehicle where you're investing and buying? Yeah, so we have a separate secondary program. I'll actually touch on what you mentioned first, which is how do we think about our own funds?

37:58One of the things that fund -to -funds are notoriously, I think, bad at is they end up having really long, long fund lives where they can go well beyond the 10 years that a normal underlying GP commitment is. And part of that's just because oftentimes if you have a portfolio of 10 or 12 underlying managers, there might be one or two that have some leftover positions. There's escrows, they're still doing audits, which of course starts to degradate returns for everybody. And most investors don't want a 14 -year K -1. Well, you try to aggressively, really starting in years 8, 9, and 10, start to look at opportunities in the secondary market, just like we would as a buyer of secondaries.

38:37We look for places where we can package funds where we believe there's more value in selling than what we can get in the lift of the return in the remaining hold period that could be unknown. So we start evaluating them over time. We have someone internally here who that's part of their job to do on a regular basis. And when we find there's situations where we think it is in the best interest of our investors to exit an opportunity, we do so. We've been very successful at doing that and wrapping up older funds. In our secondary investing, that's in some ways a little bit of a reverse. We're obviously looking for great deals, but the market in secondaries has changed a lot over the years.

39:17Traditionally, when we talked about secondaries, we would talk about limited partner secondaries. That used to be 95 % of the market, and now it's probably more like 50 % of the market. The other 50 % has been GP -led secondaries, or CVs, continuation vehicles. Now, we see tons of these things, and many of them have significant conflict problems. They have significant issues around structure and alignments. But for the ones that don't, the ones that are structured correctly have good alignment with your underlying manager, they can be really good investment opportunities as part of the overall secondary world.

39:54And then the other way to think about secondaries is not just GP versus LP, but single asset versus multi -asset. So many of these GP leads can also be multiple companies in a portfolio that they're selling. And those behave much more similar to a traditional limited partner secondary than the single asset deals, which in many ways behave a little bit more like a traditional co -investment. There's a lot of noise in private equity about the challenging exit environment with rates going up. What are you seeing both in your portfolio and then across all the information you have of all these different funds?

40:29So last year was probably one of the worst years for proceeds and realizations that we've had in our data. And not surprising, anybody who's been touching either the bigger part of the market or the lower part of the market, we've seen overall activity decrease. Luckily, in the smaller part of the market, it hasn't been as extreme. There's a variety of reasons for that. Usually, our part of the market is more immune to whatever macro effects are going on. I think the biggest reason is that we just, one, use much less leverage in our part of the market. So where the credit markets at the top part of the market create huge difficulties, I think, for getting deals done.

41:05in our part of the market, we're using maybe three turns of leverage on EBITDA. That's probably less than half than most of the bigger part of the market is. And the other dynamic in our part of the market that's a little bit different on leverage is that vast majority of the leverage in our part of the market is not from traditional money banks. And it's certainly not syndicated loans. It's a lot of private debt. And the private debt funds have been raising capital very consistently for the last 10 years. And they have, in some cases, a higher risk appetite. So even through the uncertainty of the last 12 months, 18 months, they have been willing to lend.

41:40Now, sometimes at higher spreads, higher pricing, maybe less leverage than they traditionally have historically, especially on the entry of a deal. But that has maintained activity in our part of the market in a way that I think has been a little bit more robust than what we've seen in the bigger part of the market. Now, that said, it's still been lower. And so what we've been hearing over the last, I would say, three to six months has been a much more positive attitude by many of our managers about the potential for exits. And so many of our managers have a set of companies that they've been essentially waiting to take out to the market that they now feel some confidence that they can get the valuations that they hope and look for.

42:21Now, what I'll say is that anecdotally most recently, we have heard some amazing success stories related to that where people have brought those companies out and have gotten the valuation they want and have been very happy and good realizations. And we've heard some anecdotal stories where people have brought it out to market and not getting the bidding that they want and they're stopping the process. They're just figuring they're going to wait longer. So I think the jury is out as to whether or not the market has recovered. I certainly think activity -wise, we are seeing a little bit more pickup on the investing side for sure.

42:57It's the exit side that's from the GPs who, again, are going to be very picky about exiting their companies when their carried interest is relying on that cash -on -cash multiple that they're going to generate. They're okay waiting for another year if they need to, six months, a year. There's a variety of other tools that exist in the market today that didn't exist 10 years ago. They have the ability to do recaps and takes away maybe some of the uncertainty that the market still has on some of these sectors that are having trouble. As private credit has exploded, how have you thought about investment opportunities on the credit side?

43:30We have an affiliate of ours that does small market buyout credit called Five Points Capital. They are a fund that utilizes the SBA's SBIC program to invest in small businesses. They've done extremely well and believe there's a huge market for the leverage that exists in the smaller part of the market. And so what we've seen generally is that the private credit markets have become way more sophisticated. They've become larger. There's many more players. And that creates some competition, which helps the equity holders when they're going out and raising capital for these. As you look out over the next couple of years, what risks are you most concerned about in the strategy?

44:10One question I often get, which I think is certainly somewhat of a concern, is part of our thesis of what we do and what our managers are doing is they're taking these smaller companies that bigger private equity firms can't and don't want to invest in. They're buying them for two or three turns lower than what those folks want to buy companies or can buy companies for because they're in a much less efficient part of the market. And they're also companies that are worth two or three turns lower because of where they are in their own maturity and life cycle. The goal of our private equity firms is to grow them, to diversify their products and services, to make sure they have professionalized management teams, to make sure they have a diverse customer base.

44:49And all of a sudden they have a shiny asset that they can then sell up to the bigger private equity firms to the next layer of the market. So the big question I sometimes get is, well, what if people stop investing in the next layer of the market? There's two really real reasons that they can pay bigger valuation multiples for the companies on the sale from our managers. One is the companies are just better, higher quality. So that gives them the ability to do it. The other is they have the ability to finance them at much higher leverage levels. That helps drive higher valuations. And then really the final way is that they have a lot of capital.

45:22And frankly, their cost of capital is really different than the managers at the four or $500 million fund size. And so the question is, if that dynamic changes where capital becomes more scarce above us, does that crush our thesis? And the quick answer is yes, it certainly could. The other big buyer of companies from our portfolios are strategic companies, other companies that are buying add -ons either as a portfolio company of a bigger private equity firm or as an independent company. Most of those companies don't want to buy a $7 million EBITDA company. It just doesn't move the needle for them.

45:53But if a company can grow to 20 or 30 million or more, it all of a sudden can be an important add -on. And those folks have been active for more than 20 years. They've been active forever and we don't see any stopping of them. And frankly, don't see much stopping of the private equity markets at the level above us, mainly because I will certainly tout that the returns in our part of the market have historically been consistently better. The returns of all private equity have been generally very good and most institutional platforms recognize the need to have allocation to it. And while in times like this, everybody starts asking questions because LPs have slowed down on their commitments and fundraising has become more difficult, the pendulum will swing back because long -term returns that most private equity firms can generate tend to be better than the public equity and other alternatives.

46:43So people want them as part of their portfolio. If we circle back to so much of how you spent your time on the analytics of these funds, what are the things that you're working on today or hoping to work on in the near future that's the next wave of innovation and understanding performance? One of the things that I talked about earlier on is that private equity investors, we haven't done a really good job of figuring out how to quantify risk as part of this equation. So I can tell you whether private equity managers outperformed and outperformed against their peers on a variety of different metrics.

47:16One of the things that I'm spending a lot of time on is trying to think about ways to both analyze the deals and the managers themselves, but also things like sectors and sort of areas of investment. Yes, technology investing has done extremely well in the buyout space over the last 10 years. How do we judge how much risk is associated with that as well? Because we're only thinking about this generate great returns. And the question is, is there a distribution of outcome across a histogram that looks very different? So places we have seen this very explicitly is things like consumer. So consumer investing It's been a rocky number of years depending on your strategy.

47:52Some strategies during COVID did really well. Some had companies that did poorly. Some had companies that did both depending on what they were doing. But even beyond that, what we've seen in consumer is that there are some managers that have been able to do really amazing returns doing things like consumer branded product goods and things like that. And then we've seen some managers have huge volatility in those portfolios where even though maybe the overall returns are going to look good, there is certainly a lot of risk on a variety of levels in getting to those returns. Most of us in the LP world use a variety of measures like loss ratio, but I think there's some better ways that we can start thinking about how to measure inter -portfolio risk that is not being taken into account today.

48:36So I'll give you an example of something. One of the things that we recognize is that not every deal in a portfolio, even the ones that do well, are straight up into the right. When we're evaluating a manager, we're seeing the outcome of a deal that might've happened, say, three, five years ago. And let's say they got a 3X. But if you look at the underlying company and the historical marks and their historical operating performance, there was two years it went through, which was horrible. And there was a lot of risk in that company that the manager was able to save and get to a great return. Well, the problem is if we have a way of measuring that kind of risk systematically through their portfolios, then the end number itself is not the only thing we need to look at.

49:18We need to look at the journey because there's going to be lots of examples of that where they aren't able to save it. And just because they were able to save that company does not mean that if they're buying companies that inherently have certain types of binary risk, and we've just been lucky that they haven't come to play in a negative way yet, well, that could lead us to bad decisions. What I would say is all this analytics that we're talking about, the way we think about evaluating managers is certainly important in finding the best investment opportunities. That's our goal, right? But maybe as important or more important is avoiding the mistakes.

49:53Because any portfolio we do, whether it be co -investing that we do or secondaries or primary fund investing, if you can avoid the mistakes, you can give yourself the highest probability of having the best high performing managers, knowing that not everyone will be there and create an asymmetrical return profile where you have a greater probability of outsized returns, very low probability of what I'll call bad returns, or even mediocre returns. All right, Alex, I want to make sure I get a chance to ask you a couple of closing questions. Yeah, sure. What is your favorite hobby or activity outside of work and family?

50:28My favorite hobby or activity is actually sailboat racing, sailing. So I grew up in sailing on Lake Michigan here in Chicago. I started racing when I was 12 or 13. I raced in high school, went to high school nationals, raced in college, raced on tons of other people's boats. Just recently, I bought my own. So I have a small 29 -foot racing sailboat called a J88. I race here in Chicago. And whenever I can during the very short summer we have here, I'm trying to be on that boat in regattas racing it and have a lot of fun doing it. What's one fact that you find interesting that most people don't know about you?

51:03All three of my children are named after professional sports stars. So my wife is from Pittsburgh. I'm from Chicago. The first names are all Chicago famous sports stars, Jordan, Payton with an A, P -A -Y -T -O -N, and Maddox for Greg Maddox, who I grew up watching on the Cubs. And then their middle names are all Pittsburgh Steelers for my wife's love of the Pittsburgh Steelers. She grew up going to games, even as a little kid. So my first son's name is Jordan Bradshaw. My second is Peyton Harris. And my third is Maddox Green for Mean Joe Green. That's awesome. What's your biggest pet peeve? My biggest pet peeve, which happened to us pretty recently, is renting a car, especially for a family trip where I have three kids, need a big car, showing up and having them tell me that they don't have the car I reserved six months ago and having to figure out how to deal with that problem in the beginning usually of a family trip of some sort.

52:05That drives me nuts. Which two people have had the biggest impact on your professional life? The first, Sally Shipping Russell, who was one of our partner heads at Quellis Group. She was just really influential for me in a time period where I was just getting started doing this type of work. She had a wealth of knowledge herself and experience. I was at the beginning stages of my career trying to move from being what I'll call a task executor to someone who's actually taking a lead role and doing due diligence and things like that. And she just had a significant impact on, I think, my career development, both from a technical perspective, but also relationship -wise.

52:45Meaning one of the most important things in private equity investing as a limited partner are relationships, relationships with the GPs, but also with other limited partners. We share information. We talk to each other. We learn a ton of stuff from each other. And I think she was a huge proponent of that and was very good at it herself and taught me, I think, how to be good at it in this profession. How about a second? I would give credit to a guy named Andy Berman. My first job before business school was actually not doing this at all. It was a highly technical and quantitative consulting firm called Cornerstone Research.

53:16And I was a history major. So I came out of Penn. I was always a very quantitative person, but never really interested in being like a math major engineer. And all my roommates were Wharton undergrads who always made fun of me for being a history major. But he took a chance on me. I interviewed for that job and they described it as really highly quantitative. And he saw past my major and hopefully what my skill set was. And I think it gave me a lot of conviction. And that job itself before business school, I think, led to, in some ways, a lot of the quantitative thinking that we've been talking about and really being focused on thinking through things in that manner.

53:51And I think a lot of that was based in that first job I had out of college. And I'm very grateful that I was able to get it, even though I probably didn't fit the profile what they normally hired. What's the best advice you've ever received? It was done by a manager of mine long, long ago when I was young. And I think it was stolen actually from a line in Pulp Fiction. So I'll give some credit to Pulp Fiction. But the idea was that he said, was that when someone else is talking in a conversation, he told me to stop simply waiting to talk and actually focus on listening to what they're saying. For me, it was important because that's what I do.

54:22And even today, it's something I try to fight. I like to talk and I like to give my opinion. And I've tried to learn to do a better job of listening before I just start speaking. All right, Alex, last one. What life lesson have you learned that you wish you knew a lot earlier in life? I think that early impressions that you give people of yourself, and not just first impressions, not meaning like when you first meet people, but let's say the first three months you're working with a new job is of outsized importance to anything you'll do after that three, six months. And what I mean by that is that if you create an impression of competence and high quality work, then every mistake you make after that is seen as an exception.

55:02If you begin your career in a company or a job and you don't take it seriously, you're not responsive to people, you're making mistakes, you're sloppy work, it takes years for people to unwind that from their mind and their impression of who you are. So no matter what you do that's good after that first three or six months, it's always put in the context of, yeah, it's good, but like in general, Alex isn't very good at X. Luckily, I didn't have any significant extreme examples of that, but there's certainly been times in my career where I have given people the impression of in certain ways of things that I should be doing better.

55:40And it's taken a long time to convince them that that wasn't really me. I think that's a really good learning lesson. I teach my kids that all the time. Alex, thanks so much for sharing this very data -driven exploration of the middle markets and private capital. Thank you. Really appreciate the conversation. Really enjoyed it. Thanks for listening to this Sponsored Insight. Sponsored episodes are paid opportunities for another 12 managers a year to appear on the podcast. If you're interested in telling your story in front of the largest audience of investors in the industry, please email us at team at capital allocators .com to apply for one of the slots.