E277:Why the Best GPs Refuse to Raise More Capital

0:00Deepak, I've been very excited to chat. Welcome to the How to Invest podcast. Thanks so much, David, for having me. Great to be here. So last year, you raised your third fund,$450 million, and you did it in four months. Given that it was a relatively easy raise, why not raise more capital? So from our standpoint, we really believe in a consistent approach to investing. And we started the firm actually having come from larger firms, Bank Capital and Vista Equity Partners, intentionally to come down market. We used to be in the mid-market. We used to invest kind of$50 to$150 million equity checks per deal.

0:35And so part of creating WaveCrest was being in the lower middle market, the sub -$50 million equity check market. And so when you think about our overall strategy, which we'll get into, we want to maintain that discipline, which means your fund size is limited. Otherwise, either your check size grows or you end up in a different strategy. So from our standpoint, obviously, we're grateful for the interest from our existing investors and new investors that enabled us to get it done quickly, as you mentioned. But the focus on the name of the game was always stay on strategy. And the reason for that is we believe that our end of the market, in growth equity at least, is kind of the sweet spot, is where the superior risk adjusted returns are.

1:19I know you'll probably reflexively say no, but wasn't there a temptation to make the fund bigger? you get essentially 20 % of those management fees guaranteed. Look, there's always a temptation. And we'll give you the exact number, but there was a multiple on the amount we closed of interest even towards the end, even the existing investors and the new investors who came in wanted to do more. And so again, grateful for that interest. I had the opportunity to upsize the fund. I think a couple of things. One, we're very focused on do what you say, say what you do. That's the approach we take with entrepreneurs.

1:52us. That's the approach we take with our investors as well. And we started with a$400 million target and$450 million cap. I think what happens oftentimes with PE is people start with a target of X and they end up with a target of 2X or a cap of 2X. And from our standpoint, that would have been disingenuous with the strategy. So again, always a temptation. As we've seen in PE, successful lower middle market funds can be in the middle market if they want to be and move up and be the billion dollar fund size. Again, we have a little bit of a unique history because we came from those billion dollar funds.

2:25You know, obviously we're trying to balance what makes sense for the long term strategy. We do want to grow. I think that's important for our internal team, our next generation who we're mentoring up. But at the same time, we don't want to get out of the strategies. Our word is our bond. So we wanted to stay at 450. Casual observers might say, what the hell are you talking about? $450 million fund. We could do the math. It's a lot of money. What they fail to realize is when you have a 450 million dollar fund every person's aspirations is to look for funds that are slightly more successful just like human beings they they get this big bonus they put a down payment to a new neighborhood and now their peers are all twice that are three times as rich they do that again they keep on so they think people it's very sneaky and people think that they're always going to be comparing themselves to their original peer group but this kind of sneakily edges up to you know to your point, some folks have a keeping up with the Joneses approach.

3:16And there's a, let me chase the next milestone, the next milestone. And certainly we're growing. So again, it's something that we're appreciative of, and it's part of our strategy, and it's part of hopefully taking care of our team in the right way. But I think there's limits to growth. I mean, the big challenge is there's a break point in our view in growth equity where above$50 million equity check, the market gets somewhere between five and 10X more competitive. We just don't want to be past that break point. And so you do the math. If you only want 10 to 12 positions in a fund, your fund size kind of caps out at five or 600 million.

3:50And so we don't want to have a venture spread of portfolio companies with 25 companies. We don't want to have a$5 million investment and a$75 million investment. We're pretty focused on, on average, say a$25,$30 million investment with some range on it. And we're pretty focused on a relatively concentrated portfolio construction. So, you know, what falls out of that is, you know, the team that we need to build and the size of the fund. And, you know, again, the goal here is, you know, with a straight face, you know, consistent, you know, three to four X, you know, gross fund level returns, which is something, you know, we're doing with fund one and two.

4:28And we want to continue to do and not kind of revert to the me. So it's not necessarily that you don't want a bigger fund size is that you don't want it at the expense of returns and your integrity. strategy. I mean, look, the other big thing above 50 million is most of the deals become banked. 90 % of our deal flow today is direct sourced. So, you know, again, we came from Bain and Vista. We came from places where we were used to more bank deals, frankly, you know, and maybe it's a little bit selfish. It's just not that fun. You know, you participate in an auction, you don't get access to management.

5:00It's hard to differentiate and really, you know, have that intimate relationship, which we would love to have with our founders. So it's just a different thing. What are the second order effects of having a$450 million fund? It just cleared a billion of AUM. And so for whatever reason, that round number helps in terms of marketing. So certainly the second order effect as it relates to marketing to entrepreneurs and marketing to talent for us is improved. We also obviously have more resources to do that now. And so I think those are very important. I think the other second order effect, which is T-door strategy, is our growth operations team.

5:35Our approach to investing, I know we haven't gotten there, is to be a very collaborative partner with these, you know, bootstrapped underlayed companies. And that means helping them think through investments they want to make after we invest in sales, marketing, customer success, thinking about their pricing, bringing more analytics and a financial, strategic financial lens into the company. And so that's what we try to do in a collaborative way, also bringing more talent into the company. So having more fees, having the ability to have a dedicated team of four, soon to be five in growth operations is a definite important impact of size.

6:12And you look for treasure hunters and you yourself consider yourself a treasure hunter. What does that mean? It's very interesting. I view in the continuum of private markets investing, on the one hand, on the early stage side, you have venture capital, great strategy, higher loss ratio, higher risk, but much higher alpha. And, you know, I actually came from that area, and my partner did two earlier in our careers. On the other end of the spectrum, you have buyout, where you're buying, you know, companies typically at an EBITDA multiple with leverage, with debt. And, you know, there's probably less alpha, right, but probably less downside as well, given, you know, these are businesses that have been profitable, hopefully, for many years.

6:57In the middle, you have growth equity, and that's where we sit, and we're kind of a hybrid between the two. Growthy companies, maybe not as growthful as venture, but usually more growthy than buyout companies. But in addition, profitable, like buyout companies. So if you think about it, we're really looking for the best of both worlds. But companies that are growing really nicely, in our case, 20 % to 100 % a year, typically average about 50 % a year, and they're profitable. So these founders, basically every year, they're compounding the value of their company at some rate, 30, 50 percent. And what we have to do is try to find them, which is which is kind of the game, if I might say it, of growth equity is to get in front of these founders to find them wherever they are.

7:47and and you know in many cases they don't want to be found or maybe they haven't invested in marketing or their website isn't the greatest uh or there isn't a lot of you know publicly available information on them and so that's what i mean by treasure hunting going back to your question is we are looking for in some ways the diamonds in the rough or the diamonds that are kind of underneath the leaf and they're not in your typical tech cities they're not new york and San Francisco, you know, we have companies in Syracuse, New York, and in Montreal, in San Antonio, Texas, in Bethesda, Maryland, you know, Amsterdam.

8:24So we've got businesses across the North America, as well as, you know, Western Europe that have kind of taken what I'd say is the road less traveled. And, you know, we're intersecting with them at a point where they're growing nicely. And And that's really the whole, you know, that's really the sourcing motion in growth equity. In college, my junior year in 2007, I got to shadow Jay Jordan, who I think at the time, if I'm remembering correctly, had a$3 billion buyout firm. This was in 2000. This was a large one. And I was at his corner office and I was this kind of googly eyed undergrad business student.

9:04I love business. I love the whole concept. And I was sitting while he was signing documents. And I asked him a question like, are you passionate about what you do? And he was just signing. He's like, look at how passionate I am signing these documents. And although I'm not sure if he intended it or not, it was actually a really interesting lesson in that even the people that are most successful, most passionate aren't necessarily literally passionate about every little thing that they do, which at the point I maybe thought. But at the same time, I still have a hard time grasping how growth equity investors, buyout investors, investing in quote unquote regular companies can be so motivated about that career choice and about that type of investing.

9:45What is it that motivates you or is it just that you have to go in and do the job and it's not about motivation? No, it's 100 % about motivation. It's 100 % about passion. I mean, Wavecrest started as a passion project for myself and my co-founder. comes down to we really love helping build, you know, growth software companies, growth B2B tech companies. That's the fundamental thing. We think it's really fun to help companies go from$5 to$50 million of revenue. And when you think about that, it's why do we like it? One, we're curious about new technologies. Two, we invest in a lot of vertical areas that you would not necessarily consider innovation hotbeds, real estate, automotive, maritime, these kind of large multi -billion and trillion dollar industries that maybe haven't had as much innovation.

10:39So seeing that innovation is number two. Number three, maybe the most important is we love helping founders who've kind of put their blood, sweat and tears into something to kind of take it to the next level. And at the end of the day, this is their dream. You know, we're the coach. We're the capital partner. We named the firm Growth Partners instead of Equity Capital because we really want to be their partner. We want to collaborate with them. And, you know, it's really about what makes it fun is seeing their success and seeing them, you know, kind of change their status in life and kind of achieve their goals.

11:16Because at the end of the day, most of these founders that haven't taken the Silicon Valley venture route have been, you know, they're usually subject matter experts in their verticals. They've built their business over a five, 10 year period. Typically, it wasn't a, you know, overnight sensation. They've stared over the ravine. They've had their moment of doubt and they've gotten to a place they have and they're growing and they're profitable now. And now we intersect with them and they say, I built this business on my back to five or 10 or 15 million. And I'm really excited about it. And I want to go to 50 million or 30 million or 100 million, whatever their goal is.

11:50And we align on that and we say, let's both bring skill sets to the table. You and your subject matter area, us hopefully in growth software and B2B. us more on the go-to-market side. And let's put those things together and hopefully we can help you get there and we can hopefully help you de-risk that next five years. That's the whole really value prop for the entrepreneur. And the key distinction there is you're not buying a company with 10 million revenue, 5 million costs, and you're trying to decrease their cost 50 basis points a year. You're actually helping them grow. You're having a real catalyst event for the company, which is exciting.

12:29And also you seem to be filtering around the people. So if it was just a business, if it was a business run by AI, would you have the same passion for it? Or is it the people that bring most of the passion? You go back to your first point. Yeah. I mean, the goal is growth. The whole strategy is around optimizing growth and growing the business in a responsible way, not a, hey, let's burn 25 five million a year way, a responsible way to get the business to multiples of its size. And it can be, by the way, organic growth and organic. We do do add-on acquisitions. We've done over 30 as a firm since we started across the portfolio.

13:03We're not a roll-up shop, but we think there are synergistic add-ons you can do. But yeah, I mean, look, AI, we view as a productivity enhancer for these companies, as well as a productivity enhancer for their customers. We don't view it as a either or. We think it's a transformational technology across many, many industries that's going to really help the construction contractor or the transportation manager to really just do their job more efficiently. And so the way we view it is if this further enables those entrepreneurs to accelerate their vision and to serve their customers, then that's great.

13:40And that's kind of how we think about it. How important is for you to like the team versus the business when it comes to this motivation? I'm really trying to understand how people in growth equity and buyouts really get motivated. Is it about you don't necessarily want to help assholes become successful? We all have our day jobs. We all have to do the 20 % of stuff we don't want to do. I'm sure you have deals like that. But on the average, are you really looking for the people that you just intrinsically like to help? A hundred percent. Yeah, I mean, look, part of the reason you start any company is one, you're passionate about it, but two, part of the passion for us was to build a culture that we were excited and proud about.

14:17And part of that culture is the no asshole policy, both in terms of the people at WaveCrest, but also the people we work with. So, look, we all can pick and choose who we work with. At WaveCrest, our view is I'd rather make money with people and have fun with them together versus the and or or. I mean, sorry, the and over the or. So from our standpoint, I think it's possible. Maybe it means that there are certain companies, certain founders we want back or people who don't want to work with us because they want a different style of investor or different, you know, that's okay. I mean, from our standpoint, life's too short.

14:50And that was part of why we started this around 10 years ago. And is the no-asshole policy a luxury that you've given yourself? Or does it also have a higher expected value in that you find yourself working incremental time, your team is more energized? Which one is it? I think it's the latter. I mean, look, I think that, you know, the folks we've brought into WaveCrest, you know, we have a, you know, 18, 19 kind of passionate WaveCresters. They all we think you can have it both ways. There are high, high degree of talent and performance and folks who are kind and collaborative and helpful and, you know, entrepreneurial and and, you know, don't have some ego and don't throw elbows.

15:29So that's part and parcel with what we wanted to build. I mean, there's many ways, many, you know, huge PE firms that have been built in other ways that we respect. But from a culture perspective, this is the culture we want. We think we can be as successful, you know, without having Sharkelbo. Last time we chatted, you characterize your business as selling capital to people who don't need it. How do you get businesses that don't need your capital to take your capital? It's a few key things. And this is the funny part of our business that when you talk to limited partners, they sometimes, you know, don't fully grasp because it's not just about valuations.

16:05For these folks, envision yourself as a founder. You own, say, 50, 60, 70 percent of your company. You've been building it for seven years. You've gotten it to 10 million of recurring revenue. You're at a good spot. You're growing 50 percent a year. You're profitable. Those are the companies we seek. Those are the companies who we meet with every single day. The founders we meet with every single day. They have choices. They have choices at investors. They have choices to not do anything. And, you know, in many cases, they don't do anything. They meet with different folks like us. They consider it.

16:41They think about it. So if you're in that really positive position where you're growing that fast, you're profitable, you're master of your own destiny. it, then the only reason that you should want to bring in a partner is for a few reasons. One, you are self-aware and as all human beings are, we all have blind spots and you realize that I don't know everything and that this is the largest company I've ever run. And I don't know what it looks like at 20 million. I don't know what it looks like at 50 million. Why don't I have a partner who's seen what it looks like at those sizes and it can help me get there and maybe what we like to say, de-risk that path from 10 to 50.

17:17And so that would be one reason. Another reason is, you know, maybe, you know, I've, you know, leveraged my life and put, you know, money on my credit card to fund this business. And I don't own my house and my kids are getting older and they're going to college. And, you know, it's the whole classic investment diversification issue. I've got 99 % of my net worth locked up in this illiquid stock that I don't know when, if ever, it's going to be liquid. And so I want to diversify personally. And that's an important thing. Now, our style of investing is we want to see the founders roll a majority of our equity.

17:52On average, they roll 75, 80 % with us. That's what we mean by true growth partnership together is we're building the business together. They clearly believe that the best years of the company are ahead of them. However, you can have your cake and eat it too. And so they, you know, they can take a few million out and, you know, put it aside and maybe breathe a little bit easier. Maybe their spouse will breathe a little bit easier. But we think that, you know, personal part of it is key. In other cases, there are maybe investors seven years ago who, angel investors, the doctor and the lawyer around the corner who gave them 50K to get off the ground.

18:30and those investors have done right by them and they feel like they want to provide a return to those investors or a partial return to those investors. So that's another reason. Another reason may be, you know, I want to buy another product company or a smaller competitor. That's an ankle biter. And I need capital that I couldn't get from the bank or do on my own. There's a number of reasons, you know, obviously going on the offense with more sales and marketing is another reason. There's a lot of reasons why founders who are profitable would say, hey, I'd love to do this. There's plenty to your point where we meet them in 2021 and we meet them again in 2022 and meet them again in 2023 and then we invest in 2025.

19:10That's actually happening right now with a company that we're closing a deal on is things didn't line up and it wasn't because we didn't like them and they didn't like us, but there were a lot of other things that were being contemplated. So our investment style, which is again very different than venture and buyout, is to build long-term relationships with lots of entrepreneurs that we really like and get to really build a relationship with them such that typically we've known them for six to 12 months on average before we invest. It's one of the biggest luxury of any business is when the deals are big enough that you could spend time with the customers or in this case, the portfolio companies that you're able to efficiently provide value and build a relationship.

19:53It's the most fun part of what I do, working with these entrepreneurs, talking to them, you know, every day is a puzzle. Every day is a different growth challenge. You know, whether it's hiring, whether it's upgrading, whether it's a customer issue. Look, we're not as deep as these founders. They're the experts in their fields. We're not operators like them. We've all had some operating experience in the past, but we're not in the day-to-day trenches. So there's a lot of humility that goes into that. But we've seen, you know, our advantage compared to a single entrepreneur as we've seen the movie 30 or 35 times.

20:25So hopefully there's some pattern recognition. Hopefully there's some framework. Hopefully there's some, you know, value we can add as it relates to not reinventing the wheel and providing some, you know, strategic guidance or, you know, even tactical guidance on, you know. And that's why we build relationships. The foundation of everything, it's, you know, from back to human relationships 101 is trusting relationships. I'm going to trust you if I'm going to listen to your advice. And our goal, whether we own a majority or minority, is to have a trusting relationship where there's mutual respect and influence.

21:00Ben Horowitz has this concept of earned secrets, the secrets you get within a business for hustling and grinding for a long time. And I think you can actually apply that on an industry basis. So you could have an earned secrets of scaling businesses from five to 50 million. It doesn't mean that you know every single portfolio company and their widget are better than the founder, but you see the pattern matching itself becomes an earned secret. Let's be honest. subscriptions out of fast streaming services, apps, memberships you forgot you even signed up for, and canceling them is usually a pain.

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22:06Paid memberships with a connected payment account required. See Experian.com for details. Yeah, we built these things called WaveCrest growth levers because we see consistent what I call problems of growth as companies go from five or 10 to 25 or 50 million. How do I scale my sales team from three reps to 15 reps? You know, what are the right comp plans? How do I think about customer health scores? How should I think about demand gen practices that maybe I didn't use? How should I think about executive, you know, comp issues? How should I think about, you know, the overall, you know, org design?

22:43You know, there's a number of areas. We We have 25 what we call frameworks, our growth levers that are effectively best practices. And to your point, the goal is to provide that knowledge base in a transferable way to the next set of entrepreneurs. And it's been very, very effective. They're not one size fits all. That's very different from how we view the world versus, say, certain buyout firms. We don't jam it down their throat. we say, here's a framework for marketing, or here's a framework for, you know, customer success org design. Should we have account managers or not? And so then it becomes a dialogue and a whiteboard session on how do we, you know, create the right system for this specific company.

23:25And our GrowthOps team, in addition to the deal folks, are looking at that with the CEO or the founder. Because that's what's the fun part of your job. You get to whiteboard, they go out and execute, and you get to do this all day long with different founders. Yeah, it's a super fun job. I mean, look, I get to satisfy my ADHD every single day because I get to meet two or three companies a day that I know nothing about, you know, fluid mechanics, software, you know, something that esoteric. In addition, I get to work with, you know, a number of entrepreneurs who I respect and enjoy and participate, to your point, at 20 ,000 feet.

23:59We're also helping these companies prepare to exit and hopefully getting some of these entrepreneurs to, you know, the pot of gold that they envisioned, you know, 5, 10, 15 years ago. It's like the dream MBA job. Every MBA wants to graduate and be the head of strategy. I'm like, that's not a thing at a startup. Just whiteboarding. You got to find another way to find that role. you get to meet these founders six to 12 months oftentimes i'm guessing years as well is there a golden ratio to how much value add you want to give or do you just open up the komodo thinking that the most the most value add the more value add you give the more likely they are to to partner with you in the future you're talking about before we invest yeah it's a great question we don't open the full kitten caboodle right i mean it's part of sales uh salesmanship and i think any industry We, what I'd say, we get to know them.

24:52We introduce them to our growth ops team, our talent team. We talk about two or three things that we think might make sense for them. Look, we don't want to be presumptuous as well. That's a key part. I mean, again, humility is a key part of our culture. And so we don't go in and say, we know what would be great for your business and we know exactly what you should do. We don't. And so through an iterative process of meeting with the founder and asking them, what are your key issues and what are your friction points? And if you know, why do you how do you think you could grow faster? And I would have you thought about this.