The Rise of Long-Term Holding Companies in ETA

You're listening to Think Big Buy Small, an official podcast from the Harvard Business School. Welcome to Think Big Buy Small, a podcast from Harvard Business School of that entrepreneurship through acquisition. We're your hosts, Royce Yudkov, and Rick Rubach. Today, Rick and I are welcoming back a season two guest to his Kent Weaver, one of the most experienced and active investors in search and a former searcher himself. But today's focus is new. We're Rick and I are going to be talking with Kent Tibet, Long Term Hold Coase, which have become part of the ETA landscape. For those of you who are not familiar with Long Term Hold Coase, they're really search vehicles set up to acquire, not one, but multiple targets, almost always in the same industry, sometimes into a single roll-up, but more often side-by-side companies which the searcher oversees through individual company CEOs. And because this takes longer than a single search to assemble a series of acquisitions, the time frame is usually extended. The method of compensation is tweaked to accommodate a longer time frame. The capitalization is different to allow multiple draw-downs. And Royce, I'm really looking forward to this conversation because I've always been dubious. As you and I have always talked about, one of the things we find so special about search is this concept of not only providing a seller with capital, but a seller with a bright eyed bushy-teal energetic heavily incented, incented because it impacts their own wealth. New CEO that's going to supercharge the business. And that's really what we think about as part of the magic in search. For sure, really we're left wondering, is this really taking a searcher and turning them into essentially a first-time PE fund where they're very involved in acquisitions and somewhat more remote from the actual operations? Just acknowledging Royce and I are both investors in Kent's fund that accumulates these search fund investments that we're talking about today. So let's hear what Kent has to say. It should be really interesting. I think a great place to start Kent is if you just tell us a little bit about your personal background and then how you came to be an active investor and board member in many searches. Thank you first just excited and very grateful to be here and appreciate all you guys do. In terms of background, I grew up in a small town, loving household, great parents, humble beginnings. So I worked early. I was a carbon installer in high school and paid my way through college. But I had the sage advice for my favorite undergrad teacher and my dad to please go get a real job. So I did an internship, ended up in a management consulting role for about the first three years out of undergrad and it was great for me. I learned a ton but really also validated that I wanted to be a business builder, a CEO. I didn't know what that looked like. I had heard a bit about the search fund from my bunkmate in consulting, Rick Gustafson. I ended up in the Pepsi system. My first rotation was in Pizza Hut and I was a regional CFO early and all kinds of scars and fun learnings and right about that time that that friend Rick was thinking about a search fund and I knew in two minutes that I wanted to do it. We talked about it deeply. We ended up not pursuing it and I went off and got an MBA and then came back to the ETA world a couple of years later and my path then was to do a self-funded search. I took about two years. I bought a healthcare company in Sacramento and my wife and I moved out there and raised four kids and in very owner operator style leaned into the business deeply, had a fantastic experience. It was all the kinds of highs and lows you expect. At about the 10-year mark, I stole on the company but we had a team that really wanted to run it. I was ready to take a pause and I transitioned out and thought I go back into another one but I made my first couple of search fund investments and it was super fun and probably a little bit more portable on where we could live and being a more present father and long story short that became the last 15 years and here we are. You've become known as one of the wise men in search who's been around for a long time and been very active. I guess the place that Rick and I would like to go in this conversation is, "For the audience, could you describe what a long-term holding company is and give us a little history on their emergence into the world of search?" Because this isn't something that really existed maybe five, seven years ago so talk to us about what it is. It's really just another variation to search. It's a way to buy and build a company. The ones that I've been involved in there's usually a permanent pool of equity committed right up front to the entrepreneur and it usually ranges from 15 to 25 million dollars and the expectation is they have four to six years to deploy it. That's pretty different. I think most of these have a developed theme when they start. There's a holding period that's talked about. There's an intent to build value over 10 to 20 years and why searchers might be attracted to this. One thing I've seen, it does trigger their competitive and challenge-seeking juices. It does take time to build something really valuable. I think there's a recognition, even an energy to that. I also think it triggers their intense curiosities or love of learning. A lot of these entrepreneurs, they want to be a great CEO across three or four stages of a build. It's not just buying and integrating a company early on. Then they want to build a platform. Then they want to scale and grow it. Then they want to create value at high velocity. I think the really ambitious ones, they love the learning. They want to have domain mastery and I think it's really fun to be around just in a practical sense. I think to give entrepreneurs the flexibility to deploy, to buy something smaller, to know what your pathway to equity ownership is, to have a deep-tight investor route that's aligned. I think a lot of them are really craving that. There's an expectation that the growth levers are primarily going to be programmatic M&A in addition to organic growth right from the get-go. There's a border director that's usually formed right at the start and they have to approve of all the drawdowns in capital to fund the search, the M&A team that you build out. Then maybe one of the bigger differences is just the way the entrepreneurs incentive. These are almost all performance-based equity. There's almost nothing up front. There's almost no time-vesting and they're built on MOIC hurdles. That part's really different than what I see a lot in traditional search. Multiple of invested capital hurdles. If 10 million is put in and 30 million comes out, that forms the basis of the share of the entrepreneur yet. Got it. Yes. In terms of like the emergence of this, for me, there were really like four inflection points. It started and I was in high school installing the carpet for a pretty prominent money manager at the time and as a way of saying thank you, he offered me a stock tip. He said whatever money you're saving, I'm going to encourage you to go put it in Berkshire Hathaway or Lucadia National and these were like the two publicly traded long-term holding companies that just compounded like crazy over decades. I went to my local stock broker, talked to my dad, did a lot of research and I bought shares of both and I left that untouched for about 15 years. That money ended up funding my self-funded search. The power of compounding all the learnings that went underneath that were fascinating to me. It's almost like it's the eighth wonder of the world. I was imprinted early then later when I came to ETA, again, this is back in the dinosaur ages, late 90s, 2000, 2001, you know at the time I talked to investors like Will Thorndike. I lifted some of the people in the ETA world and Peter Kelly was building a business in Jim Sutheran and honestly, I don't think I ever even heard the term IRR come up and any of these conversations. It was about building a great business, building a valuable business, we talked about compounding, we talked about how to drive it and there was kind of a recognition that it just took time to do this. So that was kind of proof point two and inflection point three around 2015. There was an ETA entrepreneur I was just super impressed with. He wanted to launch a vertically focused, consolidator software companies. And again, this around 10 years ago, it was a super crisp plan. He almost wanted you to take a blood oath that you were going to ask for liquidity for 10 or 15 years. And it just kind of rekindled, reenergized me, refocused me about like the power of that. And so he launched it. It got off to a good start. I started to get more and more excited in the maybe inflection point four, you know around 2018, 2019. They're just started to be an uptick of intense curiosity and questions about like what some of these builds look like. These guys are building $100 million, $500 million, even $1 billion businesses. What's going on there? And there was a fascination around the playbooks, the flywheels, the evolving CEO role over time in the learnings. And it did start to seem like, well if you get past that fourth or fifth year, why would you sell it? It's like, what a ride to be on. And I think there was an appreciation and a recognition that to hit your full CEO potential, it probably takes eight to 10,000 hours if you're on a fast track. Why jump off early? I think we were all starting to recognize we sell some of these companies way too early than the private equity gets a lot of the value that I think we would have, we would have liked to have kept. It just takes time to build. I mean, some of these real legends we love to talk to and have speak in our classes and all of that. I mean, they're 8, 10, 12 years or longer into building their businesses. So there was excitement. There were data points. I'm not sure we even had a name for it. If I had said anything, I would have said, well, this is what early ETA looked like. I wasn't calling it long term anything. This is the way we've always done it. Those are my reflections. First of all, let's try to sing what's special if we can. So the horizon is interesting, but I know that there are lots of search investors who are very happy in a more traditional or even a self-funded world to hold their assets for a long time, particularly when they're working out. Even if there's bumps in the road, if you get the census being well managed through those bumps, there's no need to sell. And I think there's lots of searches where the CEOs hold for a long time. So that's not really special, right? I think the part that I was most intrigued by is this notion that the carry is computed differently. I've heard tell from really successful funded searches that they get to year five. They're fully vested. They meet their IR hurdle. So now they're really fully vested. And they feel like their annual compensation is going down every year because they're not contributing anymore to their carry. Every dollar, they're now getting 30% of that dollar. When I put on my investor hat, I say, what do you mean you're not contributing? You're getting that. But they say no. And our first few years, that percentage was growing, and now that percentage is no longer growing. Tell us how it's different if I structure that with MOIC instead of IRR. What a great question. And I'm going to give some credit to some of these earlier pioneering CEOs. Sometimes they would start with what happens after the fifth year? I don't see a path unless we sell to private equity and get a refresh. It looks a little unclear. And those kind of conversations would evolve into, can we talk about a path to higher equity? What could that look like? What if I'm willing to take some of that risk and put it into all performance and into MOIC's compounding? What could it look like if I do well or very well? I really want to fill deep ownership. I like to have a path. So I think that's where the conversations have evolved. I think that's where maybe this model started to be a little bit distinctive and a little bit different. And IRR hurdle translates one to one into an MOIC hurdle, right? If you give me a particular internal rate of return, that's going to result in some particular MOIC. So does the MOIC hurdle grow through time? How does that go? I think the underlying modeling of it would be for the first five years, it probably doesn't look much different than what we're doing in traditional. But from years five to 10, if you can move those MOIC hurdles, then I think the entrepreneur started to ask, moving that from years five to 10 at the same IRR rate, that feels pretty hard. Would you acknowledge that? What if we were able to move it at 20% a year? Will you reward me for that? If I can get a 4.5 MOIC to 8 to 10 to 20, am I going to be rewarded for building much more value over a long period of time? And then we started to put some definition on what that could look like. I resonate with the point you're making, Kent, because I think if you were to put your investor hat on and you earn 30% IRR a year for the first five years, and now you have a much larger investment, you're going to be thinking, okay, I have a business that has been fully diligent. I have a CEO who's performed and been great. And so my risks are a lot lower than they were five years earlier when we made this investment. And logically, I would be willing to target a lower rate of return on this now larger investment, which I frankly rather not sell and pay taxes on, I'd take a lower return over the next five years to hold onto this talented CEO and this high quality business. So that part of the calculation where the IRR comes down and they're now rewarded on money multiple, I can see why an investor would find that appealing. I understand that if I keep applying the 35%, the longer the CEO is there, it's like moving the MOIC goal post, if you will. I'm moving the goal post because as Royce just said, if I have a bigger pool of value and I have to grow that pool of value at 35%, it's a harder thing to do. But if I would just say, okay, we acknowledge you now have 30% carry, I don't see where the incentives are different, but maybe I'm missing something. I think there's two kind of investors I'm oversimplifying, but I think that there's one type of investor that treasures higher MOICs with an eye on underlying IRRs. I think there's another type of investor that is more focused on IRRs with a shorter time horizon. This doesn't resonate the same for both types, for the MOIC focused investor. I think there was almost a frustration that so many of these great companies, not all of them, but a great many of them were sold prematurely to private equity or to a strategic and they got to continue on the compounding trail, whereas I think some of us investors would have liked to continue to hold. And to be even more pointed, I think some of these entrepreneurs, you know, when they're talking about their path to owning equity, one way they could frame it is, I see a path to own some percentage of equity based on an IRR hurdle, then it feels like I'm incentive to sell to private equity, get a refresh, keep running the company. Is there a way we can just simplify and eliminate all that? Why don't I just run it for the same investor group? Let's streamline all the paperwork. Let's get my full carry all defined up front. Let's not put me in a position where I have to keep fundraising over and over again. I want to work with the same investor group, but can we bake in these refreshes that happen with private equity maybe every three or five years? I'm willing to even put it in to MOIC hurdles. What happens if I hit an eight times, a 10 times, a 20 times, can we structure pathways to higher equity? But let's also recognize to build an IRR at 30 or 35% for the first five years of some things probably easier just because of scale than what years five through seven look like five through 10. So maybe underlying some of those MOIC hurdles is logic or modeling where it's 30 something percent for the first five years. And if you can just continue increasing that moving those goal posts at 15 to 20% year over time, what do you think of that? If you're an MOIC investor, I think you can get pretty excited, but it's not for everybody. But I still don't understand why isn't it the same of just acknowledging that the performance carry VAS after a particular moment and then the firm moves forward. What am I missing here? I think if I'm following this is because additional carry points are being given to the entrepreneur, but going forward, it's based on MOIC achievements and underlying that is lower IRR than that ties to those moics. Does the carry percentage increase through time if their MOIC hurdles are met? Does the entrepreneur have an ability to increase their carry percentage beyond that 30% in years five through 10, for example? So in these long term duration vehicles, I've seen, I've underwritten, I've been a part of, rupturing equity incentives where the MOIC hurdles are evolving and being calculated over long periods of time. The IRR underlying the maybe the first five year MOIC hurdle might be higher than the underlying IRR in years five through 10 years 10 through 15. There's an appreciation that it's harder to drive the same kind of inverted value at the same IRRs. So in these vehicles, the entrepreneur can have a pathway to up to 40% of equity, which is different. Yeah, that is different. They might realize the first 30% by hitting an MOIC hurdle that probably correlates to a 30 or 35% IRR by the fifth year. So something I'm going on with five times, but they can earn increasing equity levels maybe every time that MOIC doubles. So when four or five goes to eight to 10, they can be granted more equity based on performance. When the eight or 10 goes to 15 or 20 times, they can earn more equity based on that achievement. Everybody has a hot take on the economy. And whether you're curious about inflation, trade wars, or the markets, what you need is reporting you can trust. Hi, I'm Kai, Rizdal, the host of Marketplace. Our award-winning reporters talk to everybody from CEOs to farmers to help you understand how the economy takes shape in the real world. You'll be smarter every time you listen. And these days, that's priceless. Listen to Marketplace on your favorite podcast app. Let's return to our conversation. I think it's hugely logical because when you acquire a $2 million EBITDA business and five years later, it's a $6 million EBITDA business and you've grown it at a very high rate of return, a very high IRR. It is just probably harder to triple that to an $18 million business a few years later. There's some reasons why it's easier, you're more experienced, you have more resources, but just the number of customers you have to get and the number of sales you have to make is harder and so I think you need to recognize that keeping the same, say, 35% IRR threshold is increasingly difficult and maybe it should be a 20% IRR threshold. And also to the investor, the risk they're taking half a decade later looks extremely different from the risk they took on day zero and so there's a logic to this deal structure to me. But the part I don't get is the increasing carry. That was the part that I thought you might take Umbridge with because we've had this discussion before and if we acknowledge that when they reach their 35% hurdle, we just say fine, you're fully vested at 30% is that increasing carry for just continuing to do the work they've already signed up to do. And so argument is different because at the very outset, you've signed a different contract. And I think that's the difference. There are plenty of search deals where the agreement is, hey, you're going to get 30% of this company if you perform and you're our partner and if we go forward, that's the deal. You're a 30% owner. And then as you said and Kent said, this is very different from the outset because you have this path, the higher equity at the beginning of the funding and the mission is different tracks different plans different. So I think that's the difference because there are plenty of search deals where everyone's happy and someone feels like they're almost a one third owner in the business and they're get paid at market salary and they do very well, of course, as as the value of that business increases, no matter how long it's held because they're getting a third of it. That's right. I'd like to turn to another difference here, which is in most search deals, all the equity the searchers going to draw down is drawn down at the initial acquisition. And then they run this as an operator. There might be an ancillary M&A component to it, but most of these searchers are primarily operators doing some opportunistic acquisitions along the way. Here there's a big reserve of capital they can draw down because there's a real intention to have a muscular M&A program side by side with running the businesses you buy. And it's capitalized on day zero that way. So you don't have to renegotiate for capital down the road. This is the question I'd like to ask you can't do this anything different about the profile of the searchers. A lot of the searchers who buy one business just want to be an operator and of course they'll do an opportunistic acquisition every now and then. But here someone is signing up for a programmatic acquisition program or the people who do this different or are they the same as the regular way searchers. I think this is a very ambitious path to entrepreneurship. There's an attraction, a gravitational pull to knowing you're going to have to drive growth through programmatic M&A and organic growth. M&A is not for everybody. I think for some it can be pretty exciting. When I ran myself funded business, it was hands on, on site, I had that business probably way too tight. I thought that's the way you do it. Now having been in dozens of these, I've seen a couple different permutations. I think there can be different variations. I would say that the commonalities I do see. I think there's an expectation to be heavily involved in the first one to two years. But after that, I think you transitioned back to your whole co the CEOs are deeply engaged in M&A and there's a focus on the inorganic plus organic growth rate and usually these are like 30 to 50% a year. You got to watch the M&A part in the integration part. I think there's an expectation on these long-term CEOs to lead leaders earlier. These are very like decentralized models. There's a lot of ownership placed on the op-cos. It's really the way we've seen it scale best. That's a big ask for a young early CEO. I think there's a lot more time allocated to resource and capital allocation earlier. And then there's whole co build out activities. A lot of these CEOs are centralizing back office accounting, messy, gritty work. They're worrying about integrations, they're optimizing pricing, they're standing up centers of excellence, maybe they do offshoring or outsourcing. They're building out their core teams, their M&A teams, their HR teams, maybe they have internal general counsel. So those type of things tend to keep them very busy. I think that's where a lot of their hands on work comes, but it's not always on-site. Are they related businesses or not generally? I think there's two themes. I'll use examples. Banistern is a long term duration CEO, she was focused on an HOA consolidation right from the get-go. That's homeowner associations, right? Correct. Everything she's done was geared toward building out in that industry. So I'm going to call these focus themes, it could have been child autism, but I've also seen some that are horizontal. There's a CEO named Miles Wood that he has a generalist theme. He's a big believer in revenue quality. So everything he buys has to meet an underwriting criteria of a rule of 10. So that the churn rate plus the EBITDA multiple has to be less than 10. And you can find it in software. You can find it in old economy service businesses, but it's sticky customers buying for cheap. Am I following method? The multiple is 5, and the churn rate is 5%. And so that's 10. He wants to do better, better, right? That's the expectation. That's a great combination there in a tough test. And I would say kind of high-define, super hard to find. He's bought two, he's 24 months in. Good for him. He has a hunting license, accumulate as many of these as he can. That's the charter from the board, but they're hard to find, really hard to find. You could have a generalist that's more like a high cash flow. We're going to buy high cash flow yielding companies, and we're never going to pay more than five or six times. That might be a theme. But point of fact, most of what I've seen is themed and vertically focused. Kent, one of the things that's interested us is that as funded search acquisition sizes have gone up, the average acquisition size for a funded search is currently somewhere in the $15, $16 million total enterprise value range. It could be argued that those deals have become more competitive. They might be bumping against smaller private equity firms as competitors. We think it's gotten tougher as they've gotten bigger, but there are reasons that searchers and investors have wanted to get bigger deals done, like it's more dollars of carry for the searcher. One of the intriguing things about these is even though a lot of capital is committed, which is great for the searcher and great for the investors, it's divided up between a number of companies, so that the searchers are actually buying smaller companies, which might be less sought after, less competed for cheaper for what you're buying. But in aggregate, everyone's putting more money to work. Is that part of the thought of what's going on here? Royce, I think that's right on. I'm not sure. There's always a definitive, we're going to buy small, but I think there's a design principle that gives latitude to the CEO if they can buy into a quality industry and start by buying smaller. They're support for that. And I think what's really interesting and energizing, if you looked at the first 50 of these long-term duration vehicles that have emerged since 2018, 90% of them that are in their first 15 months have found a deal. And the average purchase price is a ticker to smaller than what I'm seeing in search right now. That's a different kind of motion to build it. It's a different kind of integration, but there's a view, there's an excitement around small, can equal, very big over time. And that's really why we have found so many searchers abandoning the traditional funded search mode and going to self-funded search if they can because one, they get more carry, but two, we think and the evidence is clearly there that if you want to buy high quality firm at four times, you're going to have to buy a firm, probably with EBITDA, with cash flows less than a million dollars. And maybe less than $750,000, but that's okay. You're going to own 60 or 70 or 80% of it. So it makes up for a lot of size. I'm 100% aligned. I'm excited by that it's different kind of onboarding and integration once you close the deal. It asks the CEO to do a different kind of work. And there's risk, but I think a lot of us have had a lot of success in that space, yeah. So one question that I have is, and maybe this is an investor hat question, is that if you're looking at a business to buy or sell. And there are. four businesses all unrelated. And let's just say low-chirn in the underlying businesses. And they're each $500,000 of cash flow. And so you look at it and say, okay, so we have four businesses, we have two million dollars of cash flow, normally two million dollars of cash flow. And so we might say that business should sell for six times. If it was a single industry business that had low-chirn and two million dollars of cash flow. But here, it's really four separate businesses, each one which would sell for four times. Does the combination sell for six times or four times or something in between? Can I add a question to Rick's very good question, because it'll come in a pair, which is tell us a little bit about who the buyer would be. Would the buyer be someone who wants to buy a holding company or would the buyer be four buyers because you break it up at the end into four separate companies? I've been involved with these when the good ones have matured, whether they were vertically focused or more horizontal. The buyer universe has put a hot x-ray on how distinct and unique is your M&A machine. They are quite enamored with inorganic and organic growth that's 30 or 40, 50% or more that's consistent over time. And you can point to why and how. Even though these are disparate companies, when there's an underlying philosophy about decentralization, being extremely equity efficient, like knowing how to use debt, then I think the buyers, whether the private equity or even strategic, when they start to believe in the playbooks, the methods, the models, they start to fixate on the consolidated financials of the build up. And when it looks consistent, then I think they start to put a multiple expansion on it. Peter, your story is there has to be professionalization somewhere. Yeah, even when the businesses are a little bit different than each other, most of these centralized back office accounting and IT. And they stand up centers of excellence that like even in a decentralized model, actually add value to the app companies, it's pricing, it's HR, it's chief people officers, so that the pressure testing is hard. The M&A machine has to be real. But when all the check boxes are there, I think these are rewarded with a lot of multiple expansion. And it's hard to build that asset. And let's just for our listeners, make sure we distinguish this strategy from what a lot of entrepreneurs do, which is they start the landscaping business and then they buy a nursery business and then they buy a business that services small engines because they have lots of small engines in their business. And they might have a half dozen separate businesses, but there's no professionalization. And this I think is fairly typical of the smaller entrepreneurs who are maybe less systematic about it, but they're opportunistically, they acquire a bunch of businesses that are in adjacencies, but they're really run as separate sub-scale businesses. Those aren't going to get you a reward for the combination. What's going to get you a reward to put a shopper and point on what you say is the professionalization, showing that this isn't just opportunistic, this is deliberate. This is part of a strategy and we've built a business to execute this strategy. And that's what you're getting the premium on, you're not getting the premium on the underlying businesses, you're getting the premium on the strategy, which accumulates these underlying businesses. I'm aligned with everything you said. I just put an extra punctuation on when it really intensified the most, not only that this M&A machine is consistent, it's distinctive, it's like robotic how systematic it is. And then it helps a lot when eight or nine out of every 10 things you buy are positively value creating. There's operational playbooks where what these whole codes buy, they double leave it up by the third, fifth year, 80, 90% of the time when the inorganic plus organic growth rates are consistently 30 to 50% year after year that speaks volume. Yeah, of course, of course. So these really do feel like small private equity firms. I take a little issue with that. I feel like these are small that grow to mid to large size. They're more operating company and stitched together. These are serial acquires that have distinct but crisp playbooks, including operational playbooks. They have proven M&A machines, they know how to use debt, they know how to be equity efficient, they have real cultures. And that's when I think the multiples get peaked. The value per share gets peaked. But I would say that those are the characteristics of a good private equity firm as well. Yeah, I think if you imagine a private equity firm which is say industry focused in the way, say a software focused long-term hold co is focused, I think from an operational perspective, they get very close. They come in with a muscular operating plan when they acquire that company. You'll raise prices, you'll do this customer survey. Here are three people that you should hire because they're terrific at this. So I see that as getting very close. Where the difference remains in my mind is duration that the private equity firm isn't going to want to hold something for 10 or 20 years because in the end, they're money managers and they know that if they can deliver greater than 20% IRR and a three times money multiple that they'll be a line outside their door to fund the next fund and that's the business they're in, not running software businesses. And so I think the duration remains different but the engagement in operations can get very close. That did trigger a thought. Like I think one difference might be too. Just the way the senior leadership teams and the CEOs are incented, I think you might find more longer term incentive designs with these whole co's and I think you'd see in private equity. I agree. I'd like to suggest another great HBS podcast to you. It's called Skydeck and it features really engaging conversations with HBS alumni, sharing lessons from their personal lives and leadership experiences, diving deep into big ideas and just making business more personal. You can hear the CEO of a Fortune 500 company talk about how anger management therapy transformed his family life and career or hear a tech veteran share how the worst moment of her career helped teach her what effective feedback really looks like and why she believes it will make you a better boss or you can learn about how one of America's youngest mayors leaned on his military background to help the city respond to violence. There are more than 125 episodes filled with engaging stories and actionable intelligence. The Skydeck team likes to think of the episodes as quick 15 minute hits of inspiration. Listen wherever you get your podcasts. Royce let's get back to the conversation. Look I think what is interesting about the structure of most of the incentive contracts we see is that they have in mind a particular transaction and that particular transaction doesn't have a 10 or 12 or 15 year hold to it. What we find is the CEOs become impatient. We think that it's the drive to liquidity not a complaint about compensation that causes most of these to sell but I accept the notion that after they've reached that hurdle if you don't do something even if something is to say yes we agree you've reached the 30% hurdle we're not going to hold your feet to the fire anymore on the 35% I agree that if we don't do that you're driven to the shorter term holds. I think that's a great point. Kent is the boardwork very different. A lot of the time investor spend is often surrounding the initial acquisition and then the amount of time that the board spends becomes more regularized if things are going well. Here it seems that there must be involved some selection of investors who are willing to do that work until the point or the company so proves it's good at this and as a template that these can be processed through the board very swiftly. Is there truth to that or am I misreading the type of board members who should be signing up for these? There's some real differences. These are deeply trust-based highly engaged boards and that part's not so different but where it might start to veer off having a longer term duration and staying authentic and deeply aligned on that holding accountable and driving CEOs to try to be extremely equity efficient. There's a more intense punctuation on that and when a lot of the growth levers serial acquisition M&A there's a different kind of risk to that that can go wrong. Integrations are tough. Putting in systems how you're measuring success on the acquisitions how discipline you are. I feel like that comes up and it shows itself in a different way than maybe some of the other boards that I've been involved with. Kent we always like to leave people with a chance to ask ask a question. Any questions for Royce and I? So much fun talking to you guys and you've seen a lot there's a ton of pattern [BLANK_AUDIO] Now I'm just curious your thoughts on this variation to ETA, any reflections or observations that you're seeing? On the long-term hold in specific. Correct. There are two things I like about this idea. One is the notion that an entrepreneur and his or her collection of investors can put a significant amount of money to work, which is good for both of them, bigger carry dollars for the entrepreneur, more money at work, and a single investment for the investors. But they're deploying it in smaller companies. You get the benefit of buying small and professionalizing small, which is often significantly under professionalized. That's one thing I really like about it. The second thing is, when you get a good company and a good manager, years in the saddle are really additive. On the year 10, it can be great because that entrepreneur is appearing on the cover of their industry magazines. They just have this so down as a skill that they wouldn't have been able to do in year 3, 4, and 5. So I think as long as you pick and choose the people in the acquisitions, nothing substitutes to that, you can really do much better in year 10 than you can in year 5. And those two things are a recipe about this. Rick, I'd be keen to hear your reactions either to those two items or other items that have caught your attention. Let me just start with an exclamation mark on your last point. I agree with that and what I really like is you make that decision, not in year 1 or year 0, but you make it in year 5 or 6. And it's instantaneously reversible. Everybody agrees we're going to keep on going. And then somebody offers you 15 times and you say, "Maybe it's time." But you're not deciding that before you know that there's a CEO that you want to work with that the CEO is very capable of running the company that the CEO is committed to long term success. So all that I fully agree with. The other thing that has always made me curious about five year holds is that it's really hard to find a good company. So if I put my investor hat on, I say my task is to deploy a bunch of capital. And yes, it's terrific to get the realization and the money and that's always a joyful moment for an investor to have a success, right? But the flip side of that is now you've got a bucket of money you have to reinvest and find another searcher to reinvest it in. And as failure to find rates are now pushing over 50%, if you want to be in this sector, it's really hard to do that and keep on recycling your money. Again, if we think about where this five year horizon came from, it came from the funds, the private equity funds, the venture capital funds. And particularly on the private equity funds, they have a professional sourcing vehicle. And you're attracted to a partnership who is a preferred acquireer, who people want to sell to or have a demonstrated machine to get people to sell them their businesses. That's not the case in search. The searchers don't have that dedicated machine. So if you want to invest in this space, I think getting rid of this five year hold is a great idea. And I don't really know that you need to make that radical a shift. You can just say, look, we have an indeterminate old period. This is our expectations or not have a performance based bonus at all. Just open up by saying you own 25%, we own 75% on a funded search and a unfunded search, maybe it's 60, 40 or something like that. But just agree on the percentages and not have this disincentive pop up in year five because the incentive is uniform all the way through. I love that. I'm energized even thinking about it. I guess where I get most excited to catch a super compound or early. And when it starts to work, to be able to defer your payments on capital gain taxes, to not have to spin up, researching a new industry, a new asset, deepening a relationship with the entrepreneur, it's just dreamy. And then maybe my favorite part when there's a CEO you just love working with. And now you get exclusivity for 10, 15, 20 years, that is just gold. And you don't have to worry about early due diligence failures. That's what keeps me up at night. That first six months of owning a business, right? That you're going to discover not just a skeleton or two in the closet, but that there is no closet. You hit on another point, too. I'm starting to see this with these longer term durations that are over five years old in their M&A pipelines, more than half the deals that are getting close as they mature are from relationships that started three, four, five years ago. The relationships in the brand and the right to win are compounding and inverting non-linear along the way, too, which is very value-creating. Yeah. That makes a lot of sense to me. We're delighted to have you on the podcast, honestly, Kent. You say so many interesting things and the audience benefits from it. So a big thank you from Rick and me. Very much appreciate you guys and thank you. Hey, thank you. So Royce, one of the things that happens when you have in search for an investment, if you're close to it and have a close sense of where the market is, maybe you don't need any verification of the market price. But as soon as you start putting this layer between you and the businesses so that now you have a dozen businesses held by the holding company, I think the market test is really important to tell if values actually being created. I love this idea of being able to not have to reinvent and find new targets and incur additional search costs. I agree with that and love that. But offsetting that is these are very much paper profits and not as real as cash. What do you think about that? It's certainly true what you say. If you look at the private equity world, one of the reasons that limited partner investors want private equity firms to churn is they say, what you said, hey, these statements you give us are great. Now sell these things and show us that that's accurate. And the same is true here if you're not extremely close to these businesses and even if you are sometimes it can be tough to tell the value you're building. I think it requires a board and a CEO. To first of all do the basic tracking like is the EBITDA of each of the things I bought bigger than it was when I bought it and is it grown at a high enough rate that I'm happy and to be really tough on businesses that are underperforming and avoid that conglomerate discount that you talked about earlier. Yeah, you are deferring a market test for sure. My understanding is that in a private equity firm you go through a very detailed process annually to get a good sense of value and it's not just a perfunctory activity. People actually do some work to try to figure out what market multiples are and alike. It's hard work. Yeah, absolutely. And you have your outside out of there who's inspecting your work and then the SEC inspects the work that's been done, so there's a lot of eyes on that which is not the case in search, right? Right. It's just not the case in search at all. So you really do have this world where you could have these zombies that you just don't see for a long time. I think it puts a lot of responsibility on to the boards which don't typically a pine on the equity value of the company to their investors. So I think there's a lot of what is the value that we're building if the goal is to go out 10 or 15 or 20 years. Right. And I think if you have a terrific CEO that stays engaged and the industry doesn't shift and the world doesn't shift, you know, there isn't a big technological shift. I could see that, you know, you're backing the same CEO who's proven successful. I know you hate sports analogies, but you know, one of the things you see are these teams that do really well for a long period of time and then the underlying games change. And for whatever reason the general manager or the coach is slow to adapt to that change. Right. And of course, the same happens in business, talked to anyone who was in the newspaper industry or owned office buildings in central cities and they found that the game changed and everything they were good at is irrelevant now. So you do have to be very careful that the same business that was great can suddenly be not so great and you know, private equity people and traditional search investors will argue that is one of the great things about turning these businesses over is you're less likely to be caught by an industry change because you are turning these things over. You're not in level with any of them. Right. And there is a sense that selling too early is sad. I get that. But I would say selling too late is even sadder. Right. You know, maybe we can agree that what's fundamentally good here is this is yet another option that searchers and search investors can take. And like each of the options, it has to be right for you. You know, it has to be right for your idea. It has to be right for your skills, your aspirations. But it's an additional option, much like self-funded search and focusing on smaller, small companies, funded search and focusing on bigger, small companies, whole goes as an option. Right. is so intriguing about this, it's just more evidence of this space evolving as we sit and look at it. Every year, every month, it seems to be different than it was before. - Agreed. - And this is just part of that evolution and you know, it might be great. It might not be great. It's really hard to tell, but it sure is interesting. - I agree with that. This has been a great conversation with Kent Weaver. As Roy said at the outset, Kent really is a very influential and very knowledgeable search fund investor. So we're intrigued, a little dubious, but intrigued about how these long-term whole codes will evolve over time. This episode really begins season four and season four launches officially on September 14th. And we're really excited about the guests we have in season four and really excited about the conversations and we go a little further afield. Our very first conversation is with James Crowley and it's not about dollars and cents and finance, although James was really successful at all of those things. It is about how to manage people and how to think about corporate culture differently and is a fascinating conversation. I hope you join us on September 14th. - You've been listening to Think Big by Small. We're your hosts Royce Yudkov and Rick Rubach. Katie Zanberg in Produced Today's episode. - Craig McDonald is our audio engineer. If you have any questions, comments, thoughts, feel free to just email us. Rick and Royce, all one word at hbs.edu. We'll be back next week with another episode of Think Big by Small.