E348: Why “Boring” Businesses Beat Venture Capital

0:00One of the theories that I've been coming up with is this asymmetry in finance, specifically in private equity and venture capital. And venture capital is a little bit more pronounced, you know, about this power lock, where if you get enough shots on goal, one of them will be the next Uber, the next SpaceX, the next Anthropic. But I also think that that happens in private equity, perhaps not with 100x returns, where if you stay in business, you do the right blocking and tackling, you get the shots on goal, and you'll have one of these packs where it might go 20x. Have you found that to be the case?

0:29I do believe in private equity and venture capital are very different. Our goal is to have a loss ratio of zero. And the way we set up that opportunity is by being consistent in the types of investments that we make, that proactive sourcing strategy, identifying sectors that have the appropriate characteristics, partnering with the right leadership. Those are critical building blocks to what we're going to execute on. And then executing on that strategy. We've now done 33 different platform investments at GenX, over 100 add-on acquisitions. Our loss ratio is very low because of the consistency.

0:56Now it's evolved over time. We've gotten much better at what we do. So if you think about our more recent funds are performing better than our more historical funds, because we've just gotten better and better at it. And I think private equity enables you to do that. You enhance the strategy, you evolve your processes, and you continue to execute with a great team. Double-click on proactive sourcing. What does that mean, and how do you implement that on day-to-day basis? If you step back in time for us as an organization, we had some rough learnings early on around selecting sectors that didn't have the right characteristics.

1:20So we learned from those. This is really going back to our first fund in the Great Recession. We learned that we weren't targeting the right area. And specifically, we were in industrial manufacturing. lumpy businesses, cyclical businesses. We stayed focused on industrial service, industrial in particular, but we shifted to industrial services. Industrial services are generally larger industries, high fragmentation, attractive growth dynamics, recurring revenue streams. Those are the critical components. So in essence, that was a core part of the thesis. Okay, so those are the sectors we want to invest in.

1:46So instead of just sitting and waiting for opportunities to come to us through investment banks, we developed a proactive process. And that proactive process, in essence, entails identifying those subsectors within industrial services that have those characteristics, oftentimes going and finding sector executives that have been there and done it in the space. Databasing the industry, developing intelligence, getting a broad-based perspective, identified opportunities, proactively reaching out to opportunities, and then ultimately finding the right opportunity and closing on that opportunity. You go back to PAG.

2:13PAG, we identified the sector in 2015. We didn't close on the investment until 2018 because it took us that long to find the right investment opportunity in the space. That discipline is really important because it then enables us to drive the successful investments over time. So perhaps this is a dumb question, but what are second-order effects of proactive sourcing? What does that help you do, and what does that help you avoid? You focus on sectors that you know have the attributes that you're looking for that increases the likelihood of success of the investment. If we do this properly, we're databasing an industry.

2:40We're getting really smart. We're confirming that it's a fragmented industry with lots of add-on acquisition opportunities. So that's important. So that buy-and-build strategy is critical. So you fragment an industry, confirming that it is through your proactive sourcing. Oftentimes, we're even identifying specific add-on acquisitions that we're going to close on once we find the platform. But we find the platform. On occasion, we identify it and proactively identify it and proprietarily acquire it. So you can even get a more attractive valuation. But even in the cases where you don't, we get really smart about the space.

3:07Oftentimes, I have a sector executive we've partnered with that knows the space well. So we have greater conviction on the assets that we ultimately acquire. Then we're able to move quickly because we've already databased the industry for the add-on acquisitions. Oftentimes, we're closing on our first add-on within the first three months of when we close on the platform. acquisition. Today, you have AI seemingly improving every single day, maybe every single hour. How are you using AI in order to improve your sourcing? And what have been some of your latest developments? We think about AI in really two different ways, really three different ways.

3:34One, we think about AI on the investments that we make. It's critical to understand, you know, is AI a risk for the investments that we're going to consider? Secondly, on the investments that we make, how can we utilize AI to support these businesses, whether it's on the commercial side, operational side, back office side? But from the sourcing perspective, same situation. We're using AI to identify and really dig into the sectors that have the characteristics that we're looking for. So we use AI to help us source the sectors of interest. We use AI to then help us diligence those sectors of interest.

4:00And then you can utilize AI to even go and identify the potential add-on acquisitions. So it's pretty robust. We're still in the early stages. We've got a team dedicated to how to utilize AI. But so far, it's proving out to be a great resource for us. Expert calls have always been one of the most powerful ways to build conviction. But today, investors are asked to cover more companies, move faster, and do it with leaner teams. With AlphaSense AI-led expert calls, their TGIS call service team sources experts based on your research criteria and lets the AI interviewer get to work. The magic is in the AI interviewer, purpose-built and knowledgeable-based information to conduct high-quality context-stretched conversations on your behalf, acting as a trusted extension of your team.

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5:53Learn more at alpha-sense.com slash how I invest. There's an AI researcher, Dr. Alexander Gross, and he says, in regards to AI, if you're not at the table, you're on the menu. Meaning, if you're not the one that's disrupting the industry, you will be disrupted. To what extent is that true in the industries that you're working with? And to what extent are you looking for managers that are proactively using AI? So we made an investment in a company by the name of IT Savvy. To get your point, IT Savvy had a tremendous CEO that understood the benefit of AI. And we invested in IT Savvy probably three years ago, sold it about a year ago.

6:24So this individual helped us to recognize that his view was, if you're not utilizing AI, your competitor is, and you're going to lose your competitor. So similar mindset. So he opened our eyes up to AI early on. We use it as a tool. When we invest in businesses, we invest in a lot of founder, family-owned businesses. So the reality is a lot of those executives, those family owners, family and founder-owned businesses don't have a full appreciation for AI. I think they're fearful of it. So they are looking for a partner that can grasp it, help them to understand it and leverage it. So it is a tool that we use.

6:53oftentimes we introduce it to the portfolio companies that we're working with. Taking a step back, talk to me about Gen X, talking about the firm's history, AUM, and how the firm has evolved since inception. Take a lot of pride in the organization that I've been a part of. It's really been a tremendous experience. The firm came together in 2006. Four individuals partnered. One individual, Ron Blalock, partner came from the investing side. Three individuals that came from the operating side, all XGE individuals, with the mindset of building a business focused on the lower middle market that had operational excellence, really bringing operational excellence to these lower-middle market companies.

7:23So that strategy has been the hallmark of the organization from day one and one of the three pillars of value creation. So how we've evolved over time, I mentioned early on we invested in manufacturing and had some challenges with the Great Recession. As we shifted to fund two, recognized we need to shift our focus, stay in industrial but focus on services. So that was the first evolution, was really focused on services. Next, we introduced the proactive sourcing, saying if we're going to target a sector that we know of, let's be thoughtful around how we identify opportunities and let's develop the proactive of sourcing.

7:50At the same time, we shifted our strategy in terms of value creation, bringing in with the operational excellence, bringing in a focus of growth versus just driving efficiencies in the business. And then the final point was the buy and build strategy. That's really the element that we brought in towards the end of fund two. So every transaction today now has a proactive sourcing strategy around it, a growth strategy around the operational influence, and then the growth strategy on the buy and build. So that's consistent across all our investments. As a result, we've gone from a firm that had some challenges at fund one to fund three, in essence, top quartile top-desk-sout performance.

8:21And you've consciously decided to keep the fund size consistent. Talking about the trade-offs and conversations with LPs, and how did that develop that stride? Our view was shifting our scope would not enable us to maintain that attractive returns that we've been able to drive. So our LPs are very supportive of us staying within that size range. What we have done is we've, in essence, grown the organization. We've evolved our capabilities. So our fund sizes are getting bigger and bigger, but all within a controlled situation so that we don't shift our scope and we don't get outside of really what our core expertise is.

8:53Having hundreds of these conversations with GPs, but also LPs, it's becoming obvious that capital markets are changing from purely a blind pool fund to a blind pool and co-invest and continuation vehicles and all these things. There's this interesting industry practice of taking a business, growing it three to five X, and then selling it to your competitor and flipping it to your competitor because of these fund lives and because some of these dynamics. have you talked to LPs or thought about doubling down on your assets and doing things such as co-invest continuation vehicles or growth vehicles?

9:25You're absolutely right. If you go back 10 years ago, it was a sin to sell or to purchase a business from a private equity firm. Today, it's pretty common practice. One of the things we've gotten very good at is this buy and build strategy. So we used to be able to build businesses from 5 to 15 million to 20 to 30 million at EBTA. But today we can take that same business, 5 to 15 million. If we're better at selecting the sector and the industry, greater fragmentation, greater scale, greater potential to really build that business and expand into different geographies, different products. So we've gotten great at building businesses that are not 15 million in EBITDA going to 20, but now we're going to 40 or 60, or in the case of PAG, 140 million in EBITDA.

9:59So that's requiring us to think a little bit differently about how we fund those transactions. So we are bringing in co-investors earlier, recognizing those co-investors will support our buy and build strategy. We're also doing continuation funds. So we've done two continuation funds to date, single asset. In all those cases, we're taking really good businesses with great teams and great sectors. And now we're able to support them. I'll give PAG as one example, right? We grew PAG from 12 million to 62 million in EBITDA. Did the continuation fund because it was our path to grow to 200 million. So now in the case of PAG, we've now grown it as we did the continuation fund.

10:30We took it to 140 million. Of course, Bergen Scott, similar situation. Whitson's another situation where we see this path to grow beyond what the fund enabled us to do because we ran out of capital in the fund. So we bring in this third-party capital, so to speak, continuation fund or co-investors. In that case, you're giving LPs the ability to cash out or roll into the new investor. Exactly, exactly. And I think that's critical. First of all, I don't think the continuation fund strategy works if you're just fixing a broken asset or a broken fund. For us, it's really driving accelerated growth in those companies that are performing and giving the opportunity to those investors.

11:03So PAG was out of fund too. Okay, so PAG grown it to$62 million. We went out and raised the continuation fund, brought in some great partners, but we had to go to our existing investors and give them the opportunity to invest. And the ones that chose to reinvest, I think have done exceptionally well, but those that didn't reinvest, they took over four times money off the table. So it was a win-win for everybody. And technically a secondary. So you get to print that DPI. So then when you go out and raise your next fund, you could show DPI. I love continuation vehicles. A lot of LPs are ambivalent about it, mostly because they don't have the team and the capacity internally to look at one-off deals.

11:33They also have this weird cognitive dissonance between having to ride along the GP that they've already underwritten. So you are the expert in the space and now we have to decide whether we agree or disagree with you. Again, it's almost like a second underwriting. But ultimately, I do think it's a better outcome than the other outcomes, which is just selling the asset early, which is probably the worst thing. And two is these elongated DPI cycles where it was supposed to be a 10-year fund. Now it's a 12, 13, 14-year fund venture capital. It could be even worse. It is really interesting because I've had this debate before with people about the benefits of the continuation fund.

12:03And listen, there's a lot of different types of continuation funds and vehicles, right, that people are doing. For us, it's very simple. It's simple, single asset. It's performing businesses, opportunity to continue to support that business. And here's the benefit for us. We are now taking businesses from$60 million to$140 million, as PAG is an example. Arguably, it's a little bit outside of our size range, what we're used to doing. But we know the management team well. We know the industry exceptionally well. We've database the industry. We know where the add-on opportunities are. We know the fragmentation.

12:28So the beta in our minds is lower because we figured out all those challenges. New investments for us are different. You know, we're getting to know the industry. We're getting to know the management team. We're still identifying the add-on opportunity. So there's lower risk in our minds and the continuation vehicles that we're pursuing because these are really good businesses with great trajectory. There's inherent trade-off, which I think should be made explicit, which on one side, you're getting to deploy the Stanley, Druckenmiller, invest, investigate. You know this team. You know their strengths.

12:54You also know their weaknesses. It's kind of like the devil you know. You de-risk a lot of the management team. You know the industry because you've done a deep dive. You've really consciously thought about it. The downside or the trade-off is you're operating lower middle market. This is maybe middle middle market. And do you know how to grow a$140 million EBITDA business into a$500 million EBITDA business? That's what an LPS to underwrite. Dell PCs with Intel inside are built for the moments that matter. For the moments you plan and the ones you don't. Built for the busy days that turn into all-night study sessions.

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15:30For us, the greatest challenge with any one of our opportunities is leadership, getting the right leadership in place, because that leadership is going to drive the success of the business. And as I mentioned, we're investing in five to 15 million dollar EBIT businesses, founder, family owns over 60%. These individuals did a great job taking the company to where it is at that point in time. And the question is whether or not they are the right team to take it to the next level. Nine times out of 10, we are working with that existing team, identifying the gaps, trying to figure out where the opportunity is to really enhance leadership.

15:58So we'll add a COO. Oftentimes they don't have one. We'll add a CCO. Oftentimes they don't have one. These are businesses that rarely are focused on growth the way we are. Oftentimes we're assessing the CFO to make sure it's the right CFO that can bring the right information at the team. So all that's critical. And then continually over time, assessing the leadership to make sure it's the right team and they're in the right place. David Mass is a great example at PAG. Here's an individual who literally founded the business, grew it to 12 million with us in partnership, grew it to 62 million when we did the continuation fund, and now it's$140 million.

16:26Unique characteristics with an individual like that, that has the leadership skill, has the willingness to not micromanage, has the recognition of putting the right infrastructure in place in terms of information to be able to make the right decisions. Those are the types of things that an individual when he starts a business has to think about if he wants to grow to that scale. You used the word leadership twice because a lot of people couple management and leadership as one person or one function. The leadership is essentially the spiritual leader of the business. Management, sure, you could bring in a COO that's scaled from 140 to 500.

16:55Maybe they don't have that skill set, but you do need this leadership, which is extremely hard to find. It's very hard to in-source leadership, especially when it's not the founder. And two is the management is something that you could actually, it's a solvable problem. It's a predictable problem. How do you know somebody has scaled from 140 to 500? They've done it three other times. It reminds me of the Charlie Munger quote, which is somebody was asking how they choose managers. And he said, well, we find somebody that's done it a bunch of times and then we hire that person. They said, but what about somebody that's coming in that could develop in that scale?

17:23And he's like, we don't do that. We are actually investing in businesses, right? Where you've got an individual that's taken the company to where it is. And we have to make an assessment over time. Is that the right person to take it to the next level? And what we've learned is one of the best ways to, you know, to help him together is to surround him with the right people. Get that COO in place. Get that CCO in place. Upgrade, you know, the finance team to the extent you need to. Get in the FP &A analyst. Get all that right information and provide that CEO with guidance. Sometimes we'll even provide them with coaching to enable them to succeed because you're hitting on an important point, leadership and building a culture.

17:53And sometimes that founder, family, owner, they have built that culture to where it is today and you don't want to break, you know, the culture by building the business. So that's the balance is making sure you've got the right leadership that is supported by the right management. You have a really interesting vantage point in that you've done this probably dozens of times in this exercise of sitting with the CEO, essentially doing a SWOT analysis on them, figuring out where their strengths and their weaknesses are. Double-click on that. Let's stand the CEO of a company. It's grown. I founded it.

18:20It's now grown to 50 million EBITDA. You believe my leadership is there, but my hard skills are not there. A, how would you approach that conversation? B, what would the exercise be in order to upskill my team? There's an art involved in this. I mean, that's, I think, where private equity can succeed or fail is your ability to really interact, develop a relationship with that leadership team, that individual. Help them to understand the challenges of taking that business to the next level and hopefully get them to the point where he realizes we're partners. Our goal is to succeed as a partnership and for this company to win.

18:48That's really the ultimate goal. And getting them to recognize that sometimes they're stepping back is the better answer for the overall organization. And sometimes it's them stepping in in order for that business to succeed. And it is an art. there's no tool that you can specifically use that's going to enable you to do that. It's an art to understand the team and your testing and retesting. Probably the most important thing as an organization, though, is to recognize that you have to continue to test it. And when in your gut you feel that it's probably time to change, it's probably the right thing to do and not to wait.

19:15And that's one of the things we've evolved very well at is historically we believe the same leadership in place and kind of hope and pray that they're going to get there. We don't have the patience to do that. But then it's a process of how do you... And oftentimes the team around them, it's very obvious to them what needs to change. Sometimes it's hard to face your own limitations, but everybody around you, especially with 40, 60. Yeah, I totally agree with that. Continuing on with this idea of keeping your best assets and doubling down on them, I had Sam Zell's longtime partner, Mark Soter, they worked together for many decades.