It took me most of my investment banking career (1986-1998) to realize that the best private investors were those who had a margin of safety baked into their investment thesis. For example the leaders were able to mitigate risk by uncovering balance sheet benefits like mispriced real estate, deferred tax upside or poorly managed working capital. In some cases margin of safety came from liquidation value of the property, plant and equipment exceeding the purchase price. There were also circumstances where a company had pricing power but lacked the courage to capture it. Value investors often found significant earnings improvements from replacing people with productivity tools. Even growth investors who were buying a future stream of cash flow and earnings at high valuations often saw a margin of safety in barriers to entry, protected markets, patent protections, trade secrets, intangible assets or undocumented know how. These guys saw sustainable advantage and margin of safety that allowed them to pay a market price and still buy the business for a bargain.
It certainly feels like the margin of safety in any investment in almost any asset class in 2015 is hard to find. For most of us the cost of entry for good businesses in the lower middle market has risen dramatically over the last 10 years. This is especially true for value investors like CapitalWorks who have typically viewed visibility on management teams and entry price as the greatest determinants of investment performance.
So how can you build a portfolio and safely put money to work when the asking prices are rising and access to management is limited?
In two recent acquisitions we employed different strategies to pay a winning price without sacrificing the bedrock margin of safety.
In the first we looked at a holding company that had three unrelated businesses and saw the opportunity to combine them in a way that would create two businesses each of which could be a platform for tuck in investments. In the second we saw a services business at an inflection point in a changing industry with opportunities to carve out market share from dominant competitors for whom certain niche markets were increasingly unattractive. The investment thesis in each case meant meaningful business model and cultural change and in both cases the execution risk was extremely high. Our pre-closing exposure to management was constrained by the highly choreographed and controlled investment banking process so we were not sure what our inherited management group could really do.
In both of these portfolios company acquisitions that margin of safety came from an interesting intangible advantage we have over some other lower middle market private equity buyers. We have a bench of proven wealth creators with relevant industry experience who give us the courage to overcome the uncertainty of limited access to management in the investment due diligence process. Without knowing whether or not your inherited management can execute your investment thesis, you better have a backup plan in case they can’t.
That plan first involves coaching. Our LPs are comfortable with what they have accomplished in their own careers and are eager to share it with our management teams. Beyond coaching, these LPs bring their networks of industry relationships to help us replace retiring executives. Beyond networks, these LPs bring their peers and colleagues who are interested in investing and lending their wealth creation reputations to ours. Finally, the profile of these LPs changes the profile and market perception of the acquired company. Employees, suppliers, customers and even competitors often look at the new team differently when industry legends begin to play a more visible role.
Even more interesting is the reaction of tuck in sellers to a group of industry veterans playing a visible governance role. The selling patriarch often wants to leave his company legacy in their hands and often is more willing to rollover equity to better align our post-closing objectives. The patriarch’s ongoing involvement in the “second bite of the apple” helps us mitigate key man and customer relationship risks. We often observe a dramatic transformation of the tuck in company from a market participant that struggles with recruiting, pricing, strategy and execution into a more important market leader.
Company building also is enhanced by management teams’ willingness to trust industry legends and we have seen a remarkable receptivity to coaching when the “PE GUYS” are in the background. All of this is a way of saying that CapitalWorks’ business model has evolved from being a value investor who makes his money on the buy to a value investor who perceives a sustainable advantage- a margin of safety- in its ability to improve portfolio companies by executing change strategies. Our talented LPs are at the heart of it all.
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