Finding a Needle in a Haystack w/ TA’s Hythem El-Nazer

One of the hallmarks of TA is it is a true meritocracy. It's a place where if you show your competent and your work hard, you're given tremendous latitude. That's Heitham Elnauser, co-managing partner of TA Associates and co-head of their North America Technology Group. TA is one of the oldest private equity firms in the world, and yet their approach to due diligence is surprisingly entrepreneurial. Each year, they'll reach out to some 40,000 companies, then meet face to face with 4,000 management teams, and that's just the prelude to a firm-wide debate about where to invest. Our strategy really is a needle in a Haystack strategy where we're looking for growing profitable businesses across our core sectors. Today on Dry Powder, I'll ask Heitham to take us inside the proverbial Haystack. We'll see how they delegate decisions across the firm and run a strikingly decentralized investment committee. At the heart of this strategy, Heitham says, "There's a culture of merit, transparency, and radical accountability." Because if a company misses its plan in the first two years, there's a clawback. You know, we pay current year based on quality of productivity that that's made, and so if a company misses its numbers, the executive committee has the ability to claw back deal-teams bonuses. I'm Hewmac Arthur, chairman of Baines Global Private Equity Practice, and this is Dry Powder. Heitham, I'm really excited about our conversation today. Welcome to the show and thanks for being on. Thank you for having me, Hew. TA's actually been around for a long time, as far as private equity firms are concerned. I think you guys were founded in 1968. That's a really long time ago, even among all of the most time-tested firms. So tell me a little bit, Heitham, about what you see from your time at TA that's been kind of the same in terms of how you go about your business and what's changed? I would describe our firm in three various aspects. One is an entrepreneurial sense of culture and nature. A good example might be in terms of how we find our companies. So every year we're contacting around 40,000 unique businesses. The partners are jumping on planes to visit 4,000 of them. Last year we took 45 of those 4,000 visits to investment committee and we made 17 investments and invested about $4 billion. So our strategy really is a needle and a haystack strategy where we're looking for growing profitable businesses across our core sectors. Two, because we've been around for six decades, we have been fortunate to invest with phenomenal companies, phenomenal entrepreneurs. Those are great calling cards when we're calling into a business. And three, we understand that these businesses have been successful before we've gotten involved and many of them will be successful regardless of our involvement. So I think that sense of humility is hopefully endearing to the founders and the entrepreneurs with whom we partner. Now 40,000 companies identified and 4,000 visits, that sounds like an incredible amount of manpower. First of all, how do you even go about identifying 40,000 companies and how do you decide which 4,000 you're going to go visit? So across our sectors, technology, business services, financial services, and healthcare, every individual is a sector expert. When you show up at TA, you get your building pass and you get a sector that you're focused on. So I joined the technology group in 2004. And within technology, my assigned area were telecommunications and Fintech. And your job as an associate is to get to know all of those companies. And you do that by reaching out to them, going to trade shows and conferences. Over time, as you can imagine, we've developed a lot of IP around these businesses. And so we have a database that we've built, which logs every single phone call, every single meeting we've had for these companies. Today, the database numbers over 600,000 companies. And so that institutional knowledge and history on how those companies have evolved and performed over time, really is helpful to staying close to these businesses. And so when a new associate joins, he or she inherits a callback list of companies that we've been tracking over time. And you know, 80% of the investments that we make are proprietary, where it's TA and the founder or TA and the owner having a bilateral conversation. And we talk about being invited into our companies, you know, founders and owners are choosing to partner with TA. Our founder, Kevin Landry, like to say, that our biggest competitor was do nothing. These are profitable growing businesses. These are businesses that have track records of organic growth. You know, our average new investment is growing 20% per year. Our average company has approaching 30% profit margins. And so they are deciding to bring TA in because they want to go faster. And that's really what we try to sell to our companies is choose TA and we'll help you take your five, six year business plan and we'll get there in half the time by really turbocharging the growth of your business. It must be a really powerful message because you hear the word proprietary a lot, but in practice I never really see it. So what is it about TA and your approach that actually encourages these entrepreneurs or family businesses to simply choose to partner with you instead of going for the highest dollar figure that might be able to get? I think it starts with the kinds of people that we attract to TA. We're looking for people who are commercial people who enjoy getting to know companies and really like spending time with people intellectually curious people are a team of associates are really the backbone of our firm. In fact, 85% of our partners started out as associates and we spend a lot of time looking for these people. And so oftentimes you'll see partners at TA involved in the first round interviews of these associates because in some ways we're looking to hire future partners at our firm. Where exactly do you look for these associates? Where are you sourcing them from? We are looking at the investment banks. We're looking at the consulting firms, but one of the hallmarks of TA is it is a true meritocracy. It's a place where if you show your competent and your work hard, you're given a tremendous latitude. And I think that sense of meritocracy attracts a certain individual, a certain drive and energy that's really hard to articulate. But when you see it, you know it, and I think we've done a really good job of identifying those talented driven individuals and we've done a really good job of retaining those people. You know, I like looking for individuals who have overcome adversity. Why is that important to me? Well, when you're calling companies and your biggest alternative is do nothing, you need to have a real sense of drive and motivation. And so I want people who aren't afraid to be told no, who can take that with humility, but their battery, if you will, stays fully charged. I'd like to go back to something we were talking about earlier, because I think this conversation we've had about culture kind of infuses not only how you do things, but what you do in order to generate results. And you were talking about a 600,000 company database and 40,000 companies that you reach out to per year and you go and jump on planes and you visit 4,000. Tell me about how you get from 4,000 down to something that you'd like to invest in. And then how does the investment committee pressure test in that process? Because you clearly go through a tremendous volume of businesses each year and it must be quite complicated to figure out, well, what are we really going to do here, guys? Where are we going to put our money to work? And how does that actually proceed? So our associates are our frontline in identifying those companies and hopefully we're able to convince that entrepreneur or that founder to do a deal with TA. We then write what's called a warm deal presentation. And at that point, most firms, the way they adjudicate the investments is a handful of wise old men, women sit across a table and they give a thumbs up or thumbs down. Our process is decidedly different than that. We have what's called a core investment committee. There's eight senior partners who review every single opportunity across the firm on a weekly basis, but that committee itself doesn't actually have investment approval authority. What happens is two managing directors from that committee are assigned to work with the deal team. There's always two partners leading every transaction. And so those four partners plus the vice president and associate will then travel to the company's offices, always in person and spend four to five hours really getting to know the business. And so we delegate investment approval authority to those individuals. And we think that delegation of authority really allows those individuals to go deep to really understand the business and the drivers of the business and spend time in a really rigorous manner. We're spending eight to ten weeks really getting to know these businesses unshapped around. And that really is helpful, particularly when we're driving value post-closing. We get a jump on the value creation plan before we even close the investment. But I'm coming away with just that it starts out as kind of a centralized process and that you've got this group of eight of very experienced individuals. But they're not the authority to approve deals and it becomes actually a decentralized process at that point, where some of them integrate with the deal team and spend a really fulsome amount of time with management and the company making sure that you understand all of the opportunities and all the risks of an investment. I think that's a fascinating that you start centralized. You go decentralized, which actually multiplies your investment evaluation and power, which I think is tremendous. And then where do you go from there? I have more fill in a piece that we missed. So after that investment committee meeting, the deal team and the IC members individually ride a seven to eight page reaction memo to the entire firm, the entire firm reading these memos and the deal team and the IC come back together and they'll align on a diligence plan coming out of that investment committee meeting. And they'll spend the next eight to ten weeks running down their own questions, the ICs questions, and it's an incredibly rigorous process. And at that point, the sponsors end out individually their own memos again to the entire firm. And that memo is really the summary of their investment thesis, the pros, the cons, they'll then commit in writing to what that company will do for the next two fiscal years, revenues and profits. And that's really important because if a company misses its plan in the first two years, there's a clawback. You know, we pay current year based on quality productivity that that's made. And so if a company misses its numbers, the executive committee has the ability to claw back deal teams bonuses. You don't want to have a clawback, less about the financial implication, but there's a lot of pride involved. Sure. And so those memos get distributed and the pro-con meeting happens. And we want collective enthusiasm at that meeting. And so the two sponsoring partners along with the two IC members vote on the transaction. There's a rating of one to five and you need 12 cumulative votes to pass. And you can't gain the system as a sponsor. You can't rate it a five if the IC members are a two. We want the IC members to also be enthusiastic about the investment. And the vote has to generally be in agreement because the last thing you want are the folks that are on the central investment committee disagreeing with the deal team. 100%. You know, in the past, you could have a very bullish sponsor of an investment who can sometimes wear down one of the investment committee members. And the investment committee member at some point says, gosh, you know, he or she has a ton of conviction. I'm lukewarm, but I'm going to be deferential. Right. And we look back at one of our funds and the common characteristic of some of our lackluster investments was when we had acquiescent or lukewarm IC members. And so we changed the rating system to where two acquiescent IC members effectively vetoed the transaction. And so if the investment passes, we attribute credit not only to the deal team members, but also the IC members. So the IC members have a vested interest in the outcome of that investment. It goes into their own personal track records. Personal accountability here for the first two years of investment. Incredible personal accountability. On the next episode of dry powder, we'll see what happens the day after the deal closes. Our business, I mean, private equity has really been a high nemphasis on what I describe as yards after the catch. What are you going to do when you catch the ball? I'm Hugh McArthur. Thank you for listening.