EP269: The $350M 30-Year Fund Model

0:00Brent, let's start with your scale. Permanent equity today manages roughly$350 million across two long-duration funds, which we'll get into. $50 million in 2017 and$300 million in 2019 raised. Can you walk us through your fund structure and what makes your fund structure so different? In many ways, we're sort of the opposite of private equity. So if you look at the traditional private equity firm, they know who they want to sell to before they buy. Typically, they use quite a bit of debt, really as much debt as they possibly can employ to make the equity look as good as they can. And they're going to have a short period of time to do the work they're doing.

0:33So we just have taken a completely different approach. We look kind of first principles at how did people become wealthy? I mean, every big business started as a small business. We're not aware of big businesses. They got started because they got flipped to somebody else and new leadership every two, three, four years. You know, businesses take time to compound. And if you can catch that compounding well, it's an absolutely incredible curve that you can hit and wealth you can generate and life you can live. And so, yeah, we're fortunate. I think we have the best LPs in the world. They give us their capital for 30 years.

1:01And so that allows us to buy with no intention of selling the business. We typically use no transaction debt in our deals. So we will use debt post-close and line of credit or maybe a real estate transaction that helps support the underlying business. Typically no debt in our transactions. And we're able to hold these things in a way that allows us to create really meaningful long-term relationships and infuse them with talent, take a long-term approach to how we're going to reinvest back in the business. And I'm really fortunate to see some really great outcomes as a result of that. So it's a completely different approach.

1:32Definitely, we'll have to double click on a 30 year fund timeline, which is insane. But before we do that, you mentioned compounding. They use the term compounding two different ways. One is a literal 12 % compounding every six years is a 2x. The other one is exponential compounding, meaning every year is a higher growth rate than the previous year. Which one is it and which one shows up in your portfolio? From a numbers perspective, we're talking about the ability to sort of not interrupt that pretty consistent growth rate. You know, when we buy a company, we're typically seeing a growth rate, you know, pre-buy of, oh, probably call it 5 % to 12%.

2:07And then post-close, you know, we're able to, like I said, infuse talent. You know, we call it the table stakes of business hygiene, kind of all the standard things that every small company should be doing well. And I've never seen a small company do everything well. In fact, there's a reason they're small, right? Small businesses don't stay small on purpose. So if they're in a good industry, if we did our job right, we picked well, they're in a good industry. And they've been at it for a long time and they're still relatively small. Then there's something that's, you know, these lids that are keeping the business down.

2:33So as we're able to release those lids, the growth rate then starts to accelerate. We've certainly seen that in our aerospace business that we bought in the fall of 2019. Really great time, by the way, to get into the aerospace business. I don't know if you know this, but aerospace never goes down. It's always either flat or up, except for that little COVID problem that we hit. And, you know, that business is about 7x larger now than it was then because we were able to look at the business and say, OK, everyone else is negotiating with their banks. We don't have any debt on the business. What are we going to do?

2:59We're going to reinvest in talent. We're going to put the pedal down on new ERP system, make all the changes and sort of release all those lids that we saw in the business all at once. And then the results since then have been exponential. So it's fun. I mean, be able to take a longer time horizon is an absolute blast because you're able to do things that no one else can do if they've got short term capital. 30-year timeline. 30-year fun life. That's pretty crazy. 50 % of your investors are institutions. How do you get institutional investors comfortable around a 30-year fun timeline? Well, I mean, institutions should have the longest time horizon of anybody, right?

3:31I mean, they're able to set up a structure where they don't have to get capital back immediately. And the nice thing about our model is we're pretty cash flow heavy. So we're making regular distributions every six months. So 30 years sounds crazy, right? Initially, when you hear it, you're like, wait, I don't get anything for 30 years. That seems insane. The reality is that you can see the value of the business compounding over time, as well as the increase in checks that you're getting every six months. So we're very cash heavy since we're not buying these businesses with debt, and the businesses we're buying are very cash flow positive.

4:02We're first looking for high probability, high quality reinvestments back into the portfolio. So if there's a place especially pre-tax where we can put dollars and generate a great return with high probability, We certainly want to do that first. Otherwise, we want to get that cash up and out. I mean, we've got opportunity costs. Our investors have opportunity costs. We want to make sure that we give them the option to be able to use the cash however they see fit. So the reality is 30 years sounds like a long time horizon, but there's a lot of cash in the interim. And historically, we've actually returned cash back to investors faster than traditional private equity.

4:31So sounds scary. It's less scary in practice. You guys don't charge a management fee. How does that work? And how does that influence your decision making? Yeah, this is probably the greatest innovation we made. First set up our fund structure, the person who we worked with told him, we said, hey, we don't need the cash. We've got investments that were more than covering the team that we had assembled. Fortunate to be able to have that. And so we said, we'd really like to just as closely align us with our investors as possible. And the best way to do that was if we don't eat unless they eat, you know, we joke that unless you can buy beer with it, we don't charge fees on it.

5:03And so the way that we do it is no fees of any kind, no reimbursements of any kind. I have to say it like five different ways because people are assuming that there's some cash coming from somewhere. There's no cash coming from the LPs. There's no cash coming from the portfolio companies. I'm going to say it one more time, zero, except for as we return cash back to investors, there's a split on that. And so we're able to align ourselves with the investors in the sense of, hey, as we do better, as they do better, we do better. And if we do not very well, we work for free and actually lose money in the process.

5:31It's extremely entrepreneurial. I just sort of am morally opposed to making money if our investors don't make more. I mean, I always want to be anything I sell to somebody. I want to be on the other side of it and be able to say, hey, I would buy that if I wasn't doing what I do now. And I would want the structure if I was on the other side of the transaction. That sounds philosophically easy, practically hard. How do you pay for your stuff? Yeah, we pay in rainbows and promises. It's incredible how you can scale an organization. No, we pay in cash. So everything, if you think about our organization, cash is the lifeblood of our organization.

5:58So down from our CEOs up to us and then to our investors, everyone's aligned. Again, there's a great place to put cash. We want to generate that high return, especially pre-tax. And then we get to share in that in every out year, right? All of us do. If there's not a great place to put cash, then our operators are incentivized to send that cash up. They get a percentage of that. And then we take it and send it out to our investors and we get a percentage of that as well. And so everyone is incentivized the exact same way, including my staff. The staff here at Permanent Equity all shares in the cash flow of the businesses as we're able to generate more.

6:29They have built-in pay raises. Does that not limit you in your ability to recruit? not everybody could get paid and essentially promissory upside. How does that affect your recruiting? And does that sometimes help too? Well, I was going to say it actually, I think it's a huge help. Traditional private equity, I mean, you're getting a salary and then you're getting a really long dated call option on the future success of the business, right? I mean, it's going to pay off in eight, 10, maybe even 12 years down the road. For us, we're paying out to our staff quarterly. And so as the cash hits us, we get it out to our staff.

6:57Everyone's sharing in that immediacy of it. So it's a really beautiful thing. I mean, people, especially their spouses, like it a lot more than having long-dated carry structure, I can tell you that. You've taken this philosophical stance against debt in your companies. Isn't there a right time and a right place to take debt? And why are you so opposed to that? I probably sound more hard-lined about debt than I am. I think there's an ability to use debt in a very responsible way. I just think in the types of companies that we're investing in, so we call it$5 to$15 million of free cash flow, these businesses are lightly professionalized or or to some degree, not professionalized organizations.

7:31There's usually a pretty decent amount of key man risk in the business. These are not businesses that I think are by, you know, as a whole qualified to use a lot of debt. And I think that it's sort of a lasting vesture of the upper market, right? How the KKRs of the world pioneered the buyout, that it's kind of moved down market. And look, if you're going to buy a multi-billion dollar, tons of assets, multinational corporation, I think you can use debt pretty well. If you're going to invest in software and you have a very consistent recurring revenue streams, I think you can use debt responsibly.

8:02If you're buying a pool builder in a highly cyclical market that is beholden to the whims of all kinds of different economic policy, individual buying decisions, and it can even be as strange as the weather. You know, I think that being able to be very responsible, if not not using debt, I think is a very good strategy. The plus side of that is the more cyclicality you can either, you know, debt makes cyclicality to be a problem. Cyclicality can also be a huge boon. And again, I'll go back to our aerospace business. You know, we're the only ones of our competitors that didn't have debt. And when the airline market goes down 70%, it's terrifying.

8:35Everyone's scrambling. Everyone else is using all their time to negotiate with banks. We weren't doing that. What we were doing is trying to identify the best talent. We were able to buy parts packages for pennies on the dollar. We were highly focused on improving the business. Everyone else is stressed out. Everyone else is distracted. Everyone else is siphoning off all their cash to go and deal with the stress of it. And we were focused and we were able to, again, like make 10 years of progress in 18 months. And so I think that when we've seen, if you're going to be in these businesses for the long term, you're going to experience cycles.

9:02There's going to be cyclicality. There's no doubt. And by the way, there's almost no industries that don't experience some cyclicality. And so if you're going to experience that cyclicality, you have to really think about what are the consequences of using debt where you can't take advantage of the cyclicality? And how does that compare with the upside you would get by putting the debt on the business, especially over the long term? If your time horizon short, if you're two years, two and a half years, three years, maybe of owning these businesses and you try to catch it perfectly, you're saying, hey, okay, we're going to invest.

9:26Hopefully there's no cyclicality. Yeah. I mean, you can roll the dice and I guess, you know, heads you win, tails they lose type of thing. I think it's an incredibly stressful life. I don't think it sets up well for good relationships. And I don't think you can make good long-term decisions with that type of short-term capital, especially when so much of the cash flow of the business is going to deserve us a bet. The next black swan is unpredictable, but it is highly predictable that there will be one. How often do you see these industry buying opportunities? How often do these come along? Yeah, I've been at this thing.

9:55I bought my first business in February 1st, 2010. So I've been at it for 15 plus years now. I would say we see, you know, really kind of generational opportunities about once every seven to 10 years. Now, the interesting part about that. Is that across your entire portfolio or is that within every industry? Some industries will become disfavored here and then. You know, sort of it's like there's really no rhyme or reason. It's just sort of some things get, you know, get wind in the sails and other things fall out of favor. I would say there usually are some big macroeconomic shift. I mean, you use the term black swan.

10:25There's usually typically not a black swan event for an industry unless there's major, you know, technological disruption would be sort of a major black swan for a specific type thing. You know, we've seen more, you know, obviously COVID was a black swan event and there was a tremendous number of opportunities that rose out of it. But the challenge is that for somebody like us who, you know, we keep a lot of cash on hand, we're ready to move quickly. I remember in the depths of COVID, we said, hey, there's gonna be a lot of great businesses that for one reason or another are gonna be cash poor and can't get refinanced and are gonna, you know, are gonna go out of business.

10:54And it was so dramatic that obviously the government stepped in with a bunch of different programs. And, you know, we went from having, I remember one week we were engaged in a hundred conversations that week with different businesses to absolute crickets the next week once the government released it. I mean, they kind of, you get gone over the top from the government. There's not much you can do about it. And I think that's the, maybe the question in my mind that I would not have guessed 15 years ago is, you know, will the government ever allow there to truly be blood in the streets? I don't know.

11:20It looks like right now that our tolerance as a country for allowing businesses to go out of businesses is pretty low, which, again, I mean, you can make the argument that as a country, we don't want that to happen and for very good reason. And I was all in favor of the government stepping in with the original PPP program for the small business market. And I think it was extremely effective. But for us, I mean, I don't know what it would take for us to have sort of Warren Buffett-esque, Charlie Munger-esque, blood in the streets moment where we're able to do 10 years of investing in a year. I'm not sure if the government will ever allow that to happen again.

11:51Speaking to people on the political aisle, incumbent rate, win rates are over 90%. There's a theory out there, which I subscribe to that will never have more than two years of downturn on S &P because incumbents need to win their next election. And although they don't directly control the Federal Reserve, there's other levers they could push that can make the stock market go up. And every president, too, has that incentive on a four-year basis. But even on a two-year basis, it seems like it's unlikely that we're going to have many of those cycles. This is a bit of a contrarian take, but it at least makes sense to me.

12:28I don't disagree with you. I mean, I think that, again, if you look back to really post 2008 to 2010, government's not allowed any serious downturn to happen for, I mean, really longer than about six months. So, I mean, we'll see when it happens. I'm sure it'll happen at some point. I hope we've got enough levers to pull that it won't happen anytime soon. And I hope that we're not building up a bunch of risk in the system that we don't realize is there that releases in a way that we can't control. But I don't disagree with you at all, David. You oftentimes are negotiating against private equity firms with portfolio companies, trying to buy them.

12:58How do you get those portfolio companies to take lower bids from you versus ABC private equity firms? When we enter a competitive process, there's usually us and call it three to four more traditional private equity firms in the mix. And the nice thing is for us, everyone else is kind of battling against each other. And really, there's very little differentiation between those groups. I mean, it's just going to be whoever bids the highest, maybe personality matters a little bit, but it's mostly just it goes to the highest bidder. You know, what we're offering is so different and unusual and really aligns with if you care what happens next to the business.

13:28I mean, if you kind of go down the two paths of traditional private equity, you sell into traditional private equity, they're going to hold for maybe at most five years and then you're going to be resold to another private equity form or you're going to be sold to strategic and subsumed up. And so you know that this thing that you've spent, you know, 20, 30, 40 years of your life or maybe even generations in your family will never be the same once you sell the traditional private equity. And that's okay. And by the way, most people frankly don't care. Most people, what they care about is to realize the value that is maximum to them and their family.

13:57I don't blame them. I don't judge them. But there's just a real cost to that. The higher the expectations, the higher the price that's paid, the more changes have to be made. The money has to come from somewhere. And so the knowledge that most people have is when they sell the traditional private equity, the world will never be the same for them. For us, what we're able to do is to offer people, especially if you're going to stay in the business or if you have family members who can stay in the business, if you're a community employer, if you want to maintain a large amount of continuity, we're able to offer a product to them that's just wholly differentiated.

14:24So whereas in traditional private equity, you're going to be levered up, new leadership team is going to be brought in. You're going to be injected with a steroid needle, like let's go to the moon. And by the way, you're going to be resold in three to five years, which by the way, no shade on that. It works. Us, we're coming in. We're not putting debt on the business. We're able to have no intention of selling it. We're able to keep you as a community employer. We want to keep the leadership team in place as tact as we possibly can. We want to generate great long-term relationships with the leadership teams we have.

14:50We all want to go win over the long-term, making good long-term decisions. So we're just much more continuity for businesses who want that and that care what happens next. A lot of these sellers, so they might sell a company for$200 million, and a lot of these people are in the Midwest or in other areas. they can never really spend that$200 million. So they end up sometimes dying with more money than they ended up selling for. And at the late stages of their life, they want to build a legacy. So they put their name on a building. Smart owners will realize that the business is their legacy. That if you spend three generations of your family building this organization, that is your legacy.

15:27So what you could do and the impact you could have on the world is actually the business. They just think of it actually as a lot of people think of it as sequentially versus this is their life's work. Couldn't agree more, David. That's exactly what we talk to people about. And look, everyone's got to make a choice and feel good about it. No worries at all if you choose to sell the highest bidder. And by the way, it's not like we're paying dramatically less than other people. We're just probably going to be the very highest bidder. So maybe there's a 5%, 10%, 12 % difference in what we're paying, depending on the situation.

15:54If you care deeply about the business and the legacy and what happens next, that seems like a reasonable trade. But for most people, most people don't care. And that's okay. You describe your portfolio as an island of misfit toys. Where do you get that? Yeah, I joke because you look at our business and we've got aerospace, we've got manufacturing, we've got construction. We own a Heisen matchmaking firm, so executive search but for love. We've got military recruitment. We're all over the board. We're all over the country. So we have 16 businesses literally from coast to coast across different industries.

16:22And I think when most people look at our portfolio, they're like, what in the world is the common theme there? Like, why do you own all these disparate assets? And our answer is that there's a combination of the people side, which is the most important for us. We really just get to know people and we really love the people that we got to get involved in. And we find that every industry has some sort of niche that's detected. And when we're looking at what we want to buy in a business, we're looking at typically what's their margin, how quickly do they get paid, and can we work with the people?

16:49Do we enjoy picking up the phone? We always use the cell phone test as if the CEO or the seller calls us, are we cringing before we pick up the phone or are we excited to pick up the phone? What is that? And how do you unpack that? Yeah. I mean, it's just the idea that like life's too short to work with people that you don't want to work with. And I mean, look, we're all messy. We all can be difficult. No one's perfect. But certainly there's people who you enjoy chatting with and you enjoy the relationship. And there's other people that, you know, you cringe when they call. Characteristics of people just taken to the extreme, people you really like talking to and dealing with and people that you really do not like.

17:24The commonalities of people who we really enjoy working with are earnest and sincere in what they do. They have fun. We have fun. We love what we do. I think I have the best job in the world. We want people who are playful and lighthearted and don't take themselves too seriously. I mean, we deal with serious things, right? There are real consequences, decisions we make. There's a lot of people's livelihoods on the line. And there's a way of taking things seriously without taking yourself seriously. And so we want to work with people who we can enjoy. Like when we go visit them, we go out to eat.

17:51We have fun. We're maybe even go to a ball game. We have a really enjoyable time. We enjoy the business itself. We enjoy chatting about it. It's not like drudgery. It's not a stressful, difficult thing to talk about, even hard things. We're able to deal with them in a way that's respectful and enjoyable and people are self-aware and humble about what they're doing. So I say that's what we're looking for. Where we get into trouble with people is when it is just a transactional zero-sum game where life is not meant to be enjoyed, is meant to be grinded through. Look, we have a job to do. This is serious business.

18:21I'm a serious person. Big ego. I need to get my way. I'm the smartest guy in the room. There's nothing you can tell me that I don't already know. I don't need any help, especially from you. It's that sort of closed off, shut down, highly protective, prideful mentality that we just don't have a lot of tolerance for. I mean, look, we all have our moments, right? Like, I don't know about you, but for me, I get feedback sometimes. It makes me bristle. I'm like, oh, I don't want that. Right. And I can maybe react negatively. I'm going to come back and say sorry. Right. And I mean, at the end of the day, that's what we want is we want to find people who, even at their worst, come back, say sorry, let bygones be bygones.

18:54We move on and actually let it strengthen the relationship. You don't want people that you're walking on eggshells, that you have to be a different version of yourself. You can't be a real version because A, that's not a great way to live. and B, that actually constrains the opportunity side of the business because you want to be focused on the business, not on the operator's ego around the business. So it really takes away the degree of possible outcomes for the business. Amen. I mean, it's extremely stressful to have to remember who you need to be. Man, I don't want to live life like that. I can't keep things straight.

19:23I'm not that smart. Like if I'm, I just want to be me and I want them to be them and not have to hide and shade the truth and try to pretend to be somebody they're not. I mean, And the amount of intellectual overhead and emotional overhead that that puts onto the relationship is awful. And I'm curious because I'm an immigrant, so I've had to deal with a lot of different personalities. And I've always seen that as a luxury getting to choose who you pick with. But now I'm starting to see some inkling where the people that you could be yourself around and the people that you could be a true partner with, you end up getting these power law outcomes and these great outcomes with those type of people.