Michael Carmen – Late-Stage Private Investing at Wellington (EP.332)

26:48we're starting to see a pickup in the amount of volume for deals in the late-day space. This is in a backdrop that valuations are better and competition's a lot less. So as this is settled out and you're looking in the market today, where have we shaken out in terms of deal volume compared to a more normalized environment? Say you go back four or five years. We're massively below where we were at the peak, but I'd say we're probably modestly below where we were four or five years ago. So we're getting back to the old normal. We're probably a little bit, but not massively below that. If anything, the market's becoming more and more global.

27:28The number of deals that we're seeing in Europe, Asia Pacific, Latin America, that there's been a little bit of a pickup on a relative basis. Because what's happened is a lot of the models that have worked, particularly in the US, have gotten exported to many other places around the world. And a lot of those companies that were early stage companies two, three, four years ago are now making their way to the later stage space. The other thing that I point out is that despite everything that's happened, particularly on evaluation basis, the level of innovation has not dissipated. It's still really, really strong.

27:59As I was alluding to earlier, the whole AI space is maybe the mother of all opportunities. This could be bigger than anything that I have seen in my career. You look at the number of people that have downloaded or started using ChatGPT and these other systems, It's some of the fastest ramp up rates that we've ever seen on any technology in our lifetime. And the use cases are piling up really, really fast. And so the level of innovation, whether it's in technology or in consumer and healthcare and financial services, that has not really changed. That to me is what's really exciting about the next stage and the opportunities that we're going to see.

28:39Even the tech bubble right back in 2000, it wasn't like the internet was a fake out. The internet actually did happen. I believe it's been a pretty successful thing. It just needed some better catalysts. We needed higher speed internet volumes. We needed the iPhone to be invented. So it took some additional development, but it wasn't a fake out from that perspective. It was just a little bubblish. And similarly, what we're seeing, whether it's in software and these other sectors, these are real companies and they're still growing. And there's more and more opportunities out there as we really look over the next 10 years.

29:11I am as excited today as I was back in 2011, which was really the beginning of that 10-year cycle that led to the bubble in 2021. When you have this combination of less supply of capital in the late stage and more and more opportunities, how are you sifting through all of it and deciding where you're going to make your investments? I don't think anything has really changed. It's less frenetic than it was in 2021, but it's not that different than it was back in say 2016, 17 and 18. And so that having been working at such a fast speed that working at this more normalized speed feels slow to us, but we have this ability to dig down and we have more time on every deal.

29:58It's amazing the number of deals that we had to pass on in 2021 because we'd get into the data room and the company would say like, hey, listen, we want term sheets by Thursday. And it was Monday. Well, we don't work that way. And so we're just going to have to miss that deal. That is no longer the case. It's now a case of basically you have almost all the time that you want. You could do things in the way that you want to do them without that level of pressure. So we're able to go at a really reasonable pace and do the level of work that we want to do. I love that. And it's very advantageous for the way that we like to work.

30:30And as we were talking about being able to bring our global industry analysts from the public side to the table on the deals that we're doing, if there's anything that I've learned in my career is you can't adjust your philosophy and process for what's happening at that moment in time. And I think because we were so consistent prior to 2021 and today that we really haven't changed a whole lot because we've been very, very consistent. And so the consistency has been a hallmark of the way that we run this strategy. As you turn from doing deals to your support of the companies, how's that changed given the changes in the market environment?

31:11It's changed a lot in terms of what we've been talking about, because in 2020, 21, everybody was sitting around the table wanting every one of their companies to grow as fast as they could. That was the mantra, right? You're going to get rewarded for growing really, really fast and nobody cared about your burn rates. Obviously, that is no longer the case. Number one, capital is not plentiful. And number two, capital is no longer free. So the biggest conversation we've been having around the table is really telling our companies, we now understand the roadmap to the future. You need to have a balance between top line growth and profitability, which is basically the way the world works, maybe 95 % of the time.

31:53And so we've been telling our companies is you need to be showing that balance. You need to show that every incremental dollar that comes to the top line is starting to show some incremental profitability to the bottom line. And that's what you're going to get rewarded for is your ability to do that. So that's the biggest part of our conversation right now. They're getting that message. And of course, it helps us out in making incremental investments because we understand the playbook going forward that you need to have this balance. And so that's really helpful in coloring the types of companies that we want to look at.

32:25I'm curious over these last two, three years, you mentioned the investment process, wanting it to be consistent in the types of companies you're looking at, but then also on the support, the market environment changing from growth to cashflow, as we know. What was that like for you having lived through the last bubble and you're saying you kind of knew it was going to end, you didn't know how, you didn't know when, but when you're talking to companies a couple of years ago, there's a certain vibe and then that vibe changes? And there's really two sides to that question because there's the buy side of that question and the sell side of that question.

33:00We were seeing a tremendous amount of IPOs in the second half of 2020 into the first half of 21. In my portfolio, we had 15 liquidity events in about a seven month period. So we had the biggest portfolio I had had since I'd been a public portfolio manager. At one point, like a dozen companies that were in our portfolios that were now public that were in our private portfolios. So job one was really making sure that we got the sell side right. Because if there's anything I learned from that bubble was not to drink the Kool-Aid. I had my face ripped off during the tech bubble. I was a young portfolio manager.

33:36I'd never been through a bubble before. I was a growth manager and I was doing what I thought a growth manager should do. And I stayed a little too long. I would have liked to have been leaning the other direction before we hit the peak. So this time, I was very intent on making sure I didn't ride these off the cliff. And so we were re-underwriting everything to normalize multiples. So we were selling everything. We ended up selling in 21 close to 90 % of everything that came up. And that included selling some secondary stock in companies that weren't even public. And that's all from my experience from the tech bubble.

34:11The other side was the fact that we had capital to deploy. Our clients gave us capital because they want us to deploy it. And I always think about Don Valentine, the legendary investor from Sequoia, used to say in his meetings that our clients gave us money so that we would say yes, not say no to every company. And so we were trying to balance that also. I think we did a reasonably good job of balancing the fact that we were in a very frenetic environment, very high valuations, by dialing down the companies that were burning a lot and staying away from those. We only did one software investment in 2021, invested in these other areas of the market that we're involved with.

34:50But I also remember when we had Gary Cohn from Goldman Sachs came in to see us right after the great financial crisis. We asked him, I said, Gary, what did you learn from the great financial crisis? He said, the last of everything we did was horrible. The last investment, the last bet that we made, we made mistakes because we were still in the game and we got out faster than others. And I look back at that 21 portfolio, I give myself a reasonably good grade in terms of how we handle the things that we bought. But there's no doubt a couple of things that I look at today, like we paid a little too high a multiple for that.

35:22Now, hopefully they'll grow into that. Maybe it takes a little bit longer for us to get the gains we're looking for. But it was a very hard environment. The number of times that we said no and sat in our weekly meeting and we're discussing valuation was almost nauseating because as a growth investor, I don't like to talk talk about valuation until the very end. I like to focus on fundamentals. And then we self-evaluation on the back end. That's how I always did it on the public side. In the private side, where you're setting what you think the price should be, you want that to be in the back end.

35:53But we were literally getting bid away 100 % more than we were willing to pay. Some cases, even more than that, by the nature of that, passing on a lot. But even we probably expanded a little bit. We would say, like, okay, maybe it shouldn't be 10 times forward sales. We're going to go to 12 or 13 or 14. Fortunately, we didn't go to 40 and 50 and 60 times. But I think that that's always the really, really hard decisions that you're making. It's hard to just sit on the sidelines and do nothing. And so we tried to strike that balance between not doing anything that was obscene versus not doing anything at all.

36:30But as I noted, there were definitely a couple of companies you look back and say, all right, if we're doing that deal today, we could have paid a much better valuation than we did then. Curious today with almost the flip side of the IPO market from two years ago, very little action happening on the exit. How are you thinking about that flow of capital through your portfolio to the exit strategy? The age-old question of what happens if the IPO market never reopens again. So we've done a lot of work on thinking about that and reviewing what's happened with the IPO market? And the short answer I always give to clients or prospects that ask that question is that on the list of things that I worry about, the reason for that is that ultimately it's going to open.

37:17When I look back over 40 years of data, the market generally doesn't close for more than a year. And when it does close for more than a year, maybe it closes for two or so years. And I look at where we are today, we're now in year two of this. And we're now seeing an improvement in the public markets. I obviously don't have a crystal ball, so I don't know if it's going to sustain or not. But definitely, it feels like we're through the worst of it. So I think that we're seeing this improving environment. And ultimately, when the public markets improve, the IPO markets improve. And the reason for that is I go back to my time as a public portfolio manager.

37:53When the markets are bad, nobody wants to do an IPO because you got 50 fires in your portfolio, the last thing you want to do is sit across the table from a company you don't know with a management team you've never met and even think about making an investment in this company unless it's the greatest company ever. So it's really, really hard to go public. But once you get out of that and once you start to feel better about the performance of your portfolio, you've gotten rid of some of these fires and you redeployed, you ultimately know that the way you differentiate yourself is finding new companies that others are not as familiar you with.

38:27And so you're going to make your way into the IPO market. And so ultimately, this is why the IPO market will come back. But I always look at our companies and actually some of our better returns have been in companies that have taken longer to go public. So my view is that as long as our companies are compounding at 30, 40, 50%, if it takes a year or two years, or even three years, those companies are going to be two, three times larger. And unless valuations have just gone through the floor, we're probably going to be better off than we would have been if the company went public today. And so as long as our companies are executing, I feel that time is our friend.

39:08And if there's anything that I've learned about the private markets is that patience is a really, really good virtue relative to the public markets where you're being engaged on your quarterly performance. We have the luxury of time to work things out. I look at a company like DraftKings, which is probably one of the higher drama stocks that we've had in our portfolio, where literally every attorney general was investigating the legality of the Daily Fantasy Sports. And then ultimately, the law around sports betting was taken out by the Supreme Court. And now the company is one of the premier companies in the sports betting market.

39:43If I was on the public side, I probably would have sold that at a really bad time. And we held that company from late 2014, early 2015 through 2020. And so it was a six-year holding period, but it worked out incredibly well. And that, to me, the advantage of the time that you have on the private side that sometimes you feel you don't have when you're investing companies on the public side. I'd love to hear a recent favorite example of an investment you made that is somewhat emblematic of this newer normal environment that you might not have been able to make in the same way a couple of years ago?

40:17A good example of that is the company SeatGeek. Many people probably have used their site. So they're a secondary as well as primary also on the ticketing side for concerts, for sports and all events. And so one, the reason we got to invest in this company was because they announced they were gonna go public through a SPAC and that SPAC was announced, I'm guessing it probably was sometime in that 21 period. And then ultimately as the SPAC market fell apart, they decided that it's probably better to stay private than go public. And probably a great decision because we all know there's pretty much 80 % of the SPAC market is trading under$5 today.

40:55But they still need a capital. The company's still growing at a very high rate. They just won the ability to do secondary ticketing for Major League Baseball. And they're winning more and more primary deals and that requires capital. And so we'd known the company for a long period of time. We'd known than probably for five years. And so when they decided to raise capital, they reached out to us to look at that deal. We revisited it. And previously, the only reason we didn't invest in it, we just couldn't find the right valuation that we liked the asset a lot. We liked what they were doing. They're picking up share relative to all the other players in the secondary market, but we just couldn't come to the right price.

41:30But now we looked at it about a year ago at this point, and the price was really reasonable in terms of what we thought the company was worth and what we believed it would be worth several years out. It was a moment where there wasn't a lot of other capital around the table, but we really loved the property. And now we were able to match the fundamentals with the valuation. And we were able to write a very large check into that company without a lot of issues around allocation. And so far they've executed super well. They've met or beaten expectations. They're moving closer and closer to profitability.

42:06and the fundamentals are as good, if not better, than they've been over the time that we've been watching them. That's a great example of a company that would actually have been public today if it wasn't for the fact that the public market shut down and obviously the SPAC market has really shut down. And so that gave us a great shot to invest in a late stage company that has hundreds of millions of dollars of revenues and is on a really concrete path to the public markets. What concerns you about your portfolio and new investments going forward? When I look at all of the mistakes that we've made in the last eight, nine years and all the successes that we've had in that same period of time, 95 % of the time, if not more, it's idiosyncratic.

42:51Did we get the fundamentals right on the companies that we invested in? Did we value the companies appropriately for where they were and where they were going? And that's what it's mostly come down to. because our company's on average growing 50 % or more. And so whether we're in a 3 % GDP economy or a 1 % GDP economy or inflation's 6 % or 2%, it's not going to be the gating factor on whether we do well or do not. We're not really investing in cyclical companies. They're all secular. They're taking share. They're very large TAMs. And so it's going to come down to execution. When we've been wrong, the execution has been poor.

43:30When we've been right, the execution has been strong. And so the big stuff doesn't generally keep me up at night. It really comes down to the fundamentals of each one of the companies in our portfolio. And that's what we worry about. And that's what we talk about 90 % plus is what's going on with these companies and how are they doing and what can we do to help them do better. And if they're doing poorly, why? And the why is usually because the company is not doing a great job. Their sales force is not selling well, or their R &D is not bringing out innovative products, but it's really rarely because of something that we missed on a macro environment.

44:08It really comes down to just getting the fundamentals right across the portfolio. Outside of generative AI as a huge potential opportunity, what are you most excited about where you're seeing the fundamentals play through? So if you take it sector by sector, if you look at the consumer sector, there's still a number of really interesting direct-to-consumer slash omni-channel models that are developing. And I always look at the consumer that somebody's gaining share and somebody's losing share every day of the week. And there's still these models that we're seeing really ramp up super fast and resonating with their customers and addressing parts of the market that there's either very established companies that lost their way or haven't really moved with their customer base.

44:52And so we still see a lot there. We still see a lot in terms of marketplaces being able to really drive supply and demand. And so we still like those areas of the consumer space. And it's an area that we've been very active in and seeing some good opportunities. SeatGeek is a perfect example of that. That's basically a marketplace. You go to the healthcare area, there's always exciting med tech companies. There's still a lot of differentiation and exciting opportunities happening in the med tech space and also in the services space. What we're seeing is there's a lot of therapeutic areas where the managed care companies cannot get on top of the cost structure.

45:31And there's these companies that are able to optimize for various parts of the cost structure. So, for instance, we own a company called Somatis. That company is involved in kidney disease management. So that's all they do is optimizing kidney disease management, which is one of the highest cost areas for managed care companies. And so if they can do it better and reduce the cost to the managed care companies, that's worth a lot of money to them. And there's a lot of those types of categories that we still see really strong opportunities. And so that's some of the areas of healthcare in consumer that we love.

46:02The fintech area, there's still opportunities, there's still across the globe, a tremendously high number of people who are either unbanked or underbanked or better way to deliver financial services. And so we still see a lot of opportunities there. We've made several investments, ironically, I guess, in the buy now, pay later space. Originally invested in a firm. Then we invested in a company called PayD. We're now invested in Klarner. And we think that that's a great way to acquire customers for brands. It was probably one of the single best drivers for Peloton back in the day when they went to buy now, pay later and offering another option for their consumers.

46:39It seems to me that this millennial and Gen Z consumer doesn't want to have a tremendous amount of credit card debt. So they like the shorter term aspect of that. And so that's been an area that we've been involved in. And then in tech, you look at software. We love software. We didn't invest in a lot of it back in 21 because it was super expensive. But software as a service is still one of the best business models that you could think of in any environment. And so we're now starting to see a lot of those companies coming back to market across the board. And there's still a lot of areas that workloads can be moved into more of a SaaS-like environment.

47:15And then as you alluded to, the biggest opportunity and the biggest threat is going to be AI. And I think every one of our companies or new companies we're looking at, is AI going to be disruptive to them or are they going to be the disruptor? Because that question is going to be super, super important over the next five to 10 years. Well, Michael, I want to make sure you get some time to ask you a few closing questions. What is your favorite hobby or activity outside of work and family? Definitely fitness. I'm very, very focused on continuing to hack my way to a younger chronological age, which I'll never be able to do.

47:50But I'm very focused on weight training and cardio fitness. I was thinking about this the other night. I probably work out 350 out of 365 days a year. I just came back from a business trip that was 22 days long and took me to five countries. And I worked out 21 of the 22 days. And so hopefully I was successful with the clients, but I was very successful in not getting out of shape. And so that's the first one. And then the second thing is travel. I love to travel, even business travel. I just went on a trip that took me to Paris, Berlin, London, Singapore, Hong Kong. And as much as it sounds like a grind, I actually had a good time.

48:26Obviously, I do a lot of leisure travel too with my wife, Pam, but I just love meeting people. I love meeting other cultures. I love walking the streets and walking through alleys and really embedding ourselves in the culture and trying out the food and doing that on a global basis. It's just, it's so much fun to just meet new people along the way. What's your biggest investment pet peeve? One of my pet peeves on the investment side is being inflexible. I remember the old Keen's line, when the facts change, I change my mind, what do you do, sir? And I'm a big proponent of that. I probably was a little too flexible at times, but a CEO once said to me, having a flexible mind is a sign of strength, not weakness.

49:07And I always believed in that. As we're getting the facts, we need to make different decisions. Whenever we had an investment meeting, when we were on the public side, if it was a really bad meeting, I would come out and think, if it was a company we owned, they'd say, well, how do we think about the meeting? And everyone would be like, oh, that was a horrible meeting. I said, so what are we going to do? Are we going to sell? Because if we didn't own the stock, we wouldn't buy it. So if we own the stock and we just had a really bad meeting, shouldn't we be selling? And so I always believed that maintaining your flexibility was really, really important because the facts are going to change all the time and you should be somewhat reflective of that.

49:39The other pet peeve I have, I always think this is kind of a funny one, is that I don't like when people remind me of my mistakes. Now, that doesn't mean that I don't own my mistakes because I own them. I never try to obfuscate. I'm never defensive about that. But I have felt that my strength as investor is I have short-term memory loss. I can make a mistake and I could take away what did I learn from it, which is super important. It's a big proponent of embracing failure and understanding it and embedding it in what I'm doing on a go forward basis. But I don't like to be reminded of it because once I forget it, I've moved on.

50:15And so we don't need to remind me that I made a big mistake because I've owned it. I've absorbed it. And now I've moved on. Which two people have had the biggest impact on your professional life? So the first one I would say would be John Gooch. John Gooch, who's now 82 years old. And I always tell him that on an age-adjusted basis, he's the most aggressive investor in the country. He's still emailing me all the time. He's like, hey, what do you think about Snowflake? What do you think about MindGoldDB? And he's amazing. He hired me at Wellington in 1999. He was the guy who took a chance on me coming from a hedge fund, but he saw something in me and he hired me 24 plus years ago.

50:53And not only was he an amazing boss and an amazing mentor, but he is also a really great investor. And I've learned a lot from him on all aspects. He now splits his time between Florida and Maine and will basically seek him out and see him in all those places just to continue to get his pearls of wisdom. And then the second person is going to definitely be my wife, Pam. I don't think that whatever level of success I had in this business would be possible without her. She's just been that rock, the person that absorbs all of my stress over the years. And also, I would say, is one of the best consumer discretionary investors that I know.

51:32She does nothing on the investment side, but her gut in terms of understanding what's going to work and not work has always been great for me over the years. And she is always the person to remind me when things are not going well that I need to go with my gut. And that's been probably one of the best investment lessons for me is that you can have all of these numbers and you can always make things work and you could model everything. But at some point, you got to use your gut in terms of making good investment decisions. And she always is the one to remind me, go with your gut and that will push you in the right direction.

52:03What teaching from your parents has most stayed with you? Two things. So for my father, was really just quietly working hard. You know, my dad owned a liquor store when we were growing up. He worked six days a week and never complained. He just did the job. And I think that was the same lesson that I tried to instill on my kids. and they're both super, super hard workers. You can't guarantee a lot in life, but if you can get that done, it's super important. And then when my mom, who passed away a year ago, I don't think I ever really exceeded her expectations. I always felt like I had to do a little bit more.

52:39It was nothing ever that she was over the moon excited about. So as much as I would like a little bit more accolades, I think that was just super important. My wife keeps me super grounded. My mom kept me super grounded. Raintaining that humility is a great, great reminder. And so I think those would be the two key lessons for my parents. Michael, last one. What life lesson have you learned that you wish you knew a lot earlier in life? I always love when you ask that question, because on the one hand, I do believe that all of these life lessons you needed to learn in order to achieve success. When I talk to younger people, I always say to them, embrace failure.

53:16You're going to have failure. You're not going to get everything right, but you need to embrace it. So you need to make all of those mistakes. Within the context of that, there's probably things that it would have been nice to know a little bit earlier that might have made things a little bit easier. The one thing that I remember that was probably from 15 years ago, we had Robert Kraft, the owner of the Patriots, came in to talk to us. And the thing that he said that he learned when he was old that he wished he knew sooner, which I totally agree with, is that eliminate drama in your life as quickly as possible, whether it's people or events or other things, that's the stuff that brings you down and makes it harder for you to be successful.

53:57And so I think that there are times where I and probably everybody endure a little bit more drama in their life than they really need. I've tried to do a better job of eliminating it, whether it's relationships that are just not as good for me as I think they should be or other things in my life in order to make things easier. Because I think when you have more focus, you can have more success and when you have less headwinds, when you have more tailwinds, that's great. And so I love that advice. And so I'd say if I had to pick something that I wish I knew about 30 years ago, that would be at the top of my list.

54:29Michael, thanks so much for sharing your perspectives on this great update on late stage private markets. Awesome. Well, thank you. I really appreciate it and really enjoyed the conversation. 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.