E299: Why Institutional LPs Are Moving Into Lower Middle Market PE

0:00Peter Elliot Rothschild:Peter, you built RF Investment Partners from an SBIC fund back in 2016 to a powerhouse today. When you think about going back to the origins of RF Investment Partners, what problem were you looking to solve in the marketplace?

0:14David Weisburd:The problem that we were looking to solve when we entered the marketplace was to be able to listen to what lower middle market companies needed. So most investment firms that are out there come with a solution. we come with a mindset of looking to listen to management teams, looking to listen to what the company's needs are, and then trying to customize a solution around those needs.

0:34Peter Elliot Rothschild:And you like to be the first institutional capital into a lower middle market company. Why is that such an optimal time to invest into a company?

0:42David Weisburd:But when we're entering, we're not taking on a playbook that's already been established by another traditional institution that's been involved with the company for the past number of years. We're coming on board typically with family-run businesses that have been successful in what they've done, but it's really been one way of doing business as opposed to bringing different perspectives to the table, different traditional institutional management teams where there hasn't been that professionalization that's taken place yet. And one of the things that we can do, again, if we're doing our jobs correctly, is bringing different voices to bear, bringing best practices.

1:16David Weisburd:Having seen this across numerous companies and numerous industries, we always tell our management teams, you may have done things a certain way for the last 10, 20 years. That doesn't mean that that's the only way of doing business.

1:28Peter Elliot Rothschild:You really focus on bespoke capital solutions versus having one capital solution for every company. How does that give you an advantage over other funds?

1:40David Weisburd:The opportunity to go in to listen to what a management team and what ownership and what a company's needs are is really crucial for us. As opposed to where most private equity firms go in and tell a company, this is the solution that fits for your company. And they use that solution for 90, 95 % of the investments that they make. We can go in and listen to the needs of the company. We then take what we hear from the company and from management teams, and then we create a capital solution that best fits those situations. Often we're investing both debt and equity in every transaction that we do, but it can be more debt-heavy and it can be more equity-heavy.

2:18David Weisburd:And we're looking for the optimal risk-adjusted returns for us while also looking to put in place the best capital structure for the company. It's something that most investment firms don't have the ability to do. And for us to be able to customize solutions is something that we offer that we believe is pretty differentiated.

2:34Peter Elliot Rothschild:Do you not worry that LPs aren't able to place you in a specific bucket when you go out and fundraise?

2:40David Weisburd:We absolutely worry about that, and we absolutely deal with that all the time. For the larger institutions that are limited partners, they have an equity bucket for buyouts. They have growth equity. They have a credit bucket. And we're going to be a different solution. So University of Michigan happens to be one of our largest limited partners, and they have a separate bucket that's more opportunistic for the type of investments we make. But for many of the larger institutions, they don't have a bucket that they're looking to fill that's allocated for what we do. And then it's upon us to convince them how the risk-adjusted returns still make sense.

3:12David Weisburd:But it certainly is an uphill battle for certain larger institutions. institutions.

3:15Peter Elliot Rothschild:It's interesting because right now there's a philosophical divide between the traditional endowment, Yale Star type model with the TPA, which is all about finding the best risk-adjusted return. So in many ways, you're really aligning with what some consider the future of investing in a future of asset management.

3:32David Weisburd:We believe that we are, but you still have a lot of traditional institutional limited partners who have the mindset of having very defined buckets that they want to invest in. They also want to have scale. And so we're managing today a little under$700 million. We're not the type of platform that's going to be able to allocate billions and billions of dollars to this strategy. And so if you're an endowment that's managing$10,$20,$30 billion, it's difficult because you want to have a strategy within your basket where you can say we're going to allocate $3 billion,$5 billion,$2 billion to a certain strategy.

4:06David Weisburd:And again, we're much more opportunistic for those groups.

4:11Peter Elliot Rothschild:you're oftentimes minority investors in these companies. So you own less than 50%. What are some misconceptions about what it means to be a successful minority investor?

4:22David Weisburd:One of the hardest things of investing is seeing what's shifting before everyone else does.

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5:47David Weisburd:A few of the misconceptions are that all minority investors are the same. And so we have fairly significant controls and guardrails in place, not just on our equity, but we get those guardrails through our debt investment where there's not insignificant level of control and influence. As opposed to a traditional growth equity investor that may be to some degree more along for the ride, we've got these guardrails through our debt and through the ability to effectuate change with our equity docs.

6:15Peter Elliot Rothschild:Last time we chatted, you said that being a minority investor requires you to play therapist. What did you mean by that?

6:22David Weisburd:Yeah, so a couple of different things. Again, these are traditionally family-owned businesses that we're investing in. We're the first institutional capital. Therefore, often family members are involved with the business, and often the employee base is very loyal to the company, and the company's ownership is loyal to that employee base. What does that mean? Employees who have helped a business get from 10 million in revenues to 25 million in revenues may not be the right individuals who can then help a company go from 25 to 75 million in revenues. So dealing with companies and the personalities of both management, as well as with the owners of the business, helping them understand, bringing different people to the table at different points in the life cycle of a company can be incredibly helpful.

7:03David Weisburd:And then honestly, working with a company and the management team on a company that needs to be institutionalized, how decisions need to be made. It needs to be based on return on investment, not just on loyalty and on customers that have been around for 10, 20 years. It's got to be in the business's best interest to continue with those decisions or effectuate change.

7:23Peter Elliot Rothschild:How do you underwrite that risk when you make an investment and you can't actually replace the CEO?

7:27David Weisburd:We're looking at how deep we're going in the capital structure. We need greater downside protection when we're doing a minority investment. So when we do a minority investment, we need controls on the debt, the different covenants that we put in, and then we need a bigger equity cushion to underwrite the risk that we're taking by not being able to effectuate the same controls. So with our equity, we're typically coming in as senior equity, either convertible preferred or participating preferred equity. The participating preferred equity gets all of our initial investment back, plus a preferred return, and then equity on top of that.

7:58David Weisburd:But knowing that we don't have the ability to go in and effectuate changes quickly, we need a bigger buffer that It allows us the incremental time before our capital would be at risk to effectuate that change.

8:08Peter Elliot Rothschild:In many ways, it's just being compensated for a higher risk investment. The lack of control is a risk.

8:15David Weisburd:The lack of control absolutely is a risk. It means we need to have returns correspond with that incremental risk, but it also means taking less risk, not going as deep. So whether it's an eight times enterprise value business, our last dollar of equity in those situations may be going five turns deep. So we're not going through the entire capital structure. There's more of an equity buffer between our last dollar of risk and where we see the enterprise value of the business.

8:41Peter Elliot Rothschild:As I mentioned, you have this really flexible mandate where you sometimes own as little as 5 % of the business and you could end up owning 65, 70 % of the business. How does that change in terms of giving advice to the CEO when you have a small stake in the business versus a very large one?

8:56David Weisburd:We still have rights over certain decisions of being collaborative, but we have to prove ourselves as good partners to the management team. If we own 5%, 10 % of a company, the company doesn't have to listen to our advice. We hope that they do in certain situations. We think we bring a different perspective to bear, but the company doesn't have to listen. In those situations, developing the relationship, spending more time with the management team, showing them that we're aligned with them, looking to grow the shareholder value is absolutely critical. But to your point, it is different than when we control the board of directors and when we can make changes without having to convince someone that we want to make those changes.

9:34Peter Elliot Rothschild:They make an investment. It's a majority control. So you now have effective control of the business. You have this 180 day plan. What happens in the first month? And walk me through that 180 day plan.

9:45David Weisburd:Typically, we're trying to come up with that 180 day plan in our diligence process. So what we're now trying to do with all of our change of control transactions, which I think is different than most lower middle market companies, is bringing an executive chairman to the table in diligence and then have them in place after we execute the transaction. Why is it different? A lot of lower middle market firms are bringing board members to the table. We want to bring individuals who are former CEOs, not looking for their next CEO gig, but rather be coming into a situation where they can sit on two to four of our boards and spend 10 hours a week working with the management teams, working with the CEOs, helping recruit new managers, being on the intercompany management calls that are taking place.

10:27David Weisburd:But quite frankly, we don't have the time to spend 10 plus hours a week on each of these companies. We're going to be more involved talking to the CEO, the CFOs on acquisitions from a financing perspective, but on making sure we understand where the sales team is spending their time, putting a true go-to-market strategy in place. So we start the process in the diligence process of putting the 180-day plan together. We clearly then spend time refining that post-investment, but we want to be working with an executive chair person at that time.

10:57Peter Elliot Rothschild:I've never met a private equity fund that doesn't claim that they provide value-add. What does that look like at a smaller company, a sub -$50 million enterprise company?

11:07David Weisburd:I agree with you. I think every investment firm says that they're value-add. As I think you said to me the other day, there are more McDonald's, or there's more investment firms now in this country than there are McDonald's franchises. The reality is investing firms try to say that they're smarter than everyone else. When you're working with a lower middle market company, it's not financial engineering that's taking place. You're dealing with personalities. Personalities are critical for us being able to get in and help a company think through spending the money on the right management, interviewing, using recruiting firms from an interview process, making sure you've got the right go-to-market strategies in place, aligning your employee base with the financial goals of a company, having more employees have ownership outside of just three or four of the senior management team members, and drilling down so that employees at a different level can see how their financial wherewithal will be tied to hitting certain KPIs.

12:00David Weisburd:Often financial firms and investment firms are saying, if we hit certain EBITDA goals, there's going to be a bonus pool for mid-level managers. Mid-level managers don't understand what EBITDA is. They're looking at revenues, they're looking at gross profit, They're looking at customer retention and customer service, but drilling down into some of those KPIs, that if a company does well in those KPIs, it's clearly going to then lead to higher EBITDA margins, higher retention rates with customers, making sure turnover within the staff gets cut down. But you have to give the employee base the ability to see tangible KPIs that they know how they can hit to lead to good things and have bonus tied to those KPIs, not just tied to EBITDA figures that they don't know how their jobs really affect.

12:44Peter Elliot Rothschild:To really distill it down to each individual employee so they understand how his or her effort and his or her incentives are tied to the overall picture of the business.

12:53David Weisburd:I would say we're still in the third inning of this. I'm not going to tell you that we're the best out there by any means. We still have to constantly effectuate change. And I'll tell you, a former CEO of mine used to have the mentality of improve 1 % every week. And so constantly looking to get better at what they do. It's exactly what we're trying to do. we're trying to bring the operating aspect of it with these executive chair people who can help us effectuate that change. Because invariably, we get focused on transactions, and we'll go in and out working on a new investment, working with an M &A opportunity.

13:25David Weisburd:But having consistency and also having, we do something called a CEO summit, which I think is also somewhat unique for a lower middle market firm that does both control and non-change of control transactions, is critical. we're bringing the minds together of both our advisors as well as with a group of our CEOs, which we find very helpful.

13:44Peter Elliot Rothschild:Tell me about the CEO Summit.