Boom, Bust, the fed’s continuous “sugar high”, Pandemic and now?
Global markets have experienced unprecedented cycles over the last two decades. The Tech Crash of 2001 was just the beginning. After melting down 54% in the 2008 financial crisis, the Dow grew 328% to a peak in February 2020. When the pandemic hit, it was down 35% in one month, before recovering most of the losses in the next three months. The volatility of the public markets is driving Investors to seek superior returns through alternative assets. Hence, Private Equity commitments ballooned to become the leading source of capital for middle market companies, growing from $400 billion to over $2.8 trillion. There is now far more supply than demand for capital in the Private Equity market.
Looking backwards, overall returns in Private Equity have been superior to public stocks over the last 20 years by a wide margin. According to a recent study of Pension funds conducted by Cliffwater LLC, public stocks returned 5.6% annualized return over that period (or about 2.8X money invested). Private Equity funds produced net annualized returns of 9.6% over that same period (or about 5.7X money invested). This shows the power of compounding (note: pre-tax returns do not take into account the fact that most Private Equity is taxed at the lower long-term capital gains rate). Risk averse investors did not do too badly if they were willing to creep out on the yield curve; the return from Treasury bonds has averaged 4.6% per year. Although this occurred during an historic decline in interest rates and is unlikely to recur. Ten year T-Bonds now yield less than 1%, which tells us something about expectations of future growth in the U.S. economy. The challenge is that most investors have been conditioned to believe that higher returns are inevitable over time. Pension Funds continue to project 7-8% average annual rates of return from a blended investment portfolio while most investment managers believe that 5-6% is more realistic. What does a large institutional investor do? They over-allocate into Alternative Investments to try and make up the difference. This has created a bubble in Private Equity valuations, further depressing future potential returns.
Investors’ success in Alternative Investments depended on whether they had access to top quartile PE funds. One study conducted five years ago by Harvard Business School (“Private Equity is not an Asset Class”) showed that the difference between top and bottom quartile performers was much wider than any other asset class. Over the ten years analyzed, the upper quartile returned over 15% and the lower quartile returns were zero. FYI; getting into top quartile funds is difficult for new investors. A disturbing conclusion about “blind pool” funds; you have a 25% chance of meeting or beating your goal and a 75% chance of missing it.
There is considerable debate over whether superior Private Equity performance will continue. Returns have been shrinking in line with the decline in interest rates over the last 20 years, so most investors are planning for lower returns as the market has grown. Furthermore, as public and private equity returns converge, access to the best funds becomes vitally important. Since a small number of deals drive the returns at these top funds, deal selection becomes even more important. Hence, the best approach is to target investments in selected deals rather than funds.
Central Bank policies have lowered the overall returns of all Investments
How can you invest when you don’t know the real price? In response to several crises, Central Banks have reduced interest rates close to zero and, in some cases, even negative. Fed funds and ECB rates have become a political hostage. Governments worldwide may never cycle back to “normal” fiscal and monetary policies after years of conditioning investors to expect negative real interest rates. Negative interest rates started as a short-term incentive to encourage spending by consumers and lending by banks. They have now become addictive; permanently imbedded in the bond markets. Long term negative bond yields in several countries imply low to negative growth and encourage defensive investment postures. They are infecting the entire yield curve and all asset classes, including Private Equity. As I predicted four years ago in my blog “Is Private Equity Losing its Taste For Risk?”, target returns for Private Equity have dropped from the mid-20’s to the mid-teens; comparable to mezzanine investments a decade ago (before the advent of credit funds and BDC’s). With no room for error, GP’s are forced to focus on return of capital vs. growth, which diminishes their value as an entrepreneurial partner. That has changed the character of a vast majority of Private Equity funding groups from capital gains-driven principals seeking to multiply money to fee-driven asset managers seeking to grow assets.
Cave Creek Capital Management enables investors to maximize returns through deal by deal selection
What can CCCM control to improve its investors’ returns? Timing/patience and proprietary origination and deal selection. The trends reducing IRR’s also encourage longer holding periods to achieve the same dollar multiple returns and better control over deal selection. CCCM proactively solicits hundreds of deals from over 8000 contacts to proactively select those with the most favorable risk/return profiles. As highlighted in my blog “Transparent Capitalism”, deal by deal funding benefits both investors and companies. Each Member can target a particular investment and amount according to their current needs, goals and liquidity position. This provides much more flexibility than “blind pool” PE funds. As our Members shift lifetime goals from career driven earnings to investment driven earnings, the ability to identify and select the best private investments becomes critical to their long-term portfolio appreciation and income. Public stock and bond markets are likely to yield much lower returns in the future, so access to private investments on an a la carte basis is much better than locking up money for 10 years plus.
CCCM investments target individually selected, private equity and mezzanine investments which are designed to mature in 3-7 years but will also include a component of current return through debt investments alongside the equity investments in the same companies. These structures are designed to reduce duration, risk and overall exposure to equity market cycles. Historically, CCCM has achieved mezzanine returns in the mid to high teens and equity returns close to 30%. These IRR’s were generated in a different era and I expect that future returns will be lower. Today, we target equity returns of approximately 25% and mezzanine returns in the 12-15% range, generating a total blended return of 2.5-3.0X return, including a current return of about 4-5%.
How we used to make money:
Our Track Record over 25 years
Our previous 25 co-investments ($500MM total cost basis) had a weighted average IRR of 27% and returned 2.4X capital invested. Co-investing alongside major PE funds created good returns from larger deals but we experienced a higher loss rate; six investments representing 15% of capital invested lost money (over half of that was a single case of fraud; our only such experience in 27 years). Over the last decade, CCCM has applied lessons learned from these investments alongside 65 major Private Equity funds. Since 2001, we have not lost money on a CCCM investment and CCCM investments have returned an average of 4.3X on the equity and 2.0X on mezzanine debt. We remain focused on established middle market companies in the consumer, services and manufacturing sectors while avoiding investments in the highly volatile, earlier stage, tech sectors.
- Traditional PE strategy; Buy right (ie “fair” valuation in non-auction process and a reasonable multiple of ebitda; 5-7X) Use modest leverage (3-4X ebitda max) then sell at expanded multiple in 3-7 years after paying down debt. PE markets are more efficient today than earlier years making this financial engineering strategy of limited value; auction premiums are higher today and bid win rates are lower.
- “Down and dirty” turnarounds; companies with suboptimal performance and/or limited infrastructure– profits are typically well below potential with a low valuation multiple provide enormous upside but higher risk. The less equity you risk, the better the returns. While they are highly labor intensive for us, they have been very lucrative; (10X+) returns
- Accelerate growth; Our average portfolio company grew revenues nearly 300% during our ownership (driven by equal parts organic and M&A). We focused on all avenues of growth and depending on management and their skill sets, we were able to buy companies add new customers, lines of business or products/pricing.
- Be the first in a rollup; Buy platforms and then add bolt-on businesses in the same industry before other investors pile into the industry. Even a good head start only buys 18 months before acquisition prices rise. Management needs to be able to build a template process where acquisitions can be integrated quickly and generate revenue and cost synergies when combined.
- Protect downside with structure; investments with preference rights, dividends and/or subordinated debt that provided current income and protections in the event of a “sideways” deal.
- Momentum investment; timing is everything; Invest early in technology, telecom, media prior to public market bubbles forming then sell into bubble.
- Transformational industries; (technology enhances an established business to the point of transforming an industry; (Airwaves’ scaleable digital image storage and printing enabled Mass Customization, Liberty utilized advance logistics with UPS for climate controlled Direct Store Delivery at highly competitive cost, Kenexa leveraged superior technology in online recruiting to build first SaaS software portfolio for Fortune 500.
What have lessons of the last 25 years taught us for future investments?
- Boring can be beautiful; success of our basic industrial businesses are driven by very predictable customer relationships and steady cash flows. For example, the average customer relationship is over 20 years at both VMC and Bastech. The key is to constantly innovate and invest in both people and technology (but not at the expense of lower margins). You don’t have to be first, just don’t be last.
- Timing can be everything; We cannot time our entry and exit perfectly but we should be aware of industry cycles and how to manage a process to take advantage of having the “wind at your back”. In most of our industries, valuation multiples can expand or contract by 2-3X over the course of the investment. Other segments of Technology and Telecom can be brutally swift – with wild valuation swings inside of one year.
- Don’t bet the ranch; invest a modest amount in several companies and be patient. Often, one of our companies can swing in value by 50% or more in a given year but the total CCCM portfolio average rarely moves more than 20% in the same period. While CCCM has not had a loss on any investment since 2001, we usually experience volatility in between entry and exit.
- Take money off the table when you can; CCCM has recapitalized several of its companies successfully. Typically, distributions can total 50% or more of the cost basis of the investment before a company is even sold. Eliminating the risk of total loss and generating current returns reduces duration and risk and improves IRR.
- One strategy never lasts forever; Several industries thrive by capitalizing on a set of finite trends so use prudent judgment to know when to sell. A radio investment thrived in the late 90’s. The PE firm invested at under $5/share in the original deal and gradually sold after the IPO all the way up to $45 (it peaked at $66 in 2000). Radio consolidation opportunities faded afterwards and additional satellite and streaming competition pushed the stock price down to $30 in five years and $1 in 8 years.
- Be ready for new, profitable paradigms to emerge quickly; we like businesses that didn’t exist 5-10 years earlier. Airwaves redesigned T-shirt production processes to meet the needs of emerging online apparel merchants. By being one of the first to utilize advanced digital image storage, DTG and warehouse logistics, they have been able to service that rapidly growing segment. Airwaves pioneered Mass Customization at the multi-million unit scale and has grown over 300%. Liberty Distribution was the first to work out a logistics solution to deliver candy directly to stores in temperature controlled boxes at competitive cost. Retail stores had never been able to offer chocolate, etc. at checkout until then. They grew from startup to over $40MM in sales at the time of our investment and an additional 400% by the time of the sale to a strategic acquiror. Executive offices suites were generally low margin, underutilized office space until HQ Offices revolutionized the industry by adding talented managers and additional high-end services to service mobile Fortune 500 executives. The company from $8MM in sales to over $360MM in sales in four years.
- Old Habits die hard; Businesses that are left for dead and available for low prices can often be sustained with little capital investment and generate tremendous free cash flow. Examples of this include POTS (Plain Old Telephone Service) and Pagers. The paging industry has slowly declined over the last 20 years but the technology has lasted far longer than anyone imagined. With minimal further investment, one investor in this segment bought remnant assets many years and has generated over 3X his original cash investment through free cash flow. There are still 2 million pagers in use in the U.S (frequently by doctors, first responders, etc.). Never underestimate customer inertia when they have a good, cheap no fuss solution that just continues to work.
- Don’t get stuck with a one trick pony. The skills to build a company are often different to grow and manage the company when the industry matures. We occasionally back charismatic Founders who know how to grow companies but their gifted salesmanship doesn’t help build the infrastructure required to support that growth. The primary role of a PE firm investing in founder led companies is to lay the groundwork for the next buyer; Board building, strategy, management succession, accounting, financial forecasting. Building these teams while maintaining the character and culture of what made the company successful is critical. Delegation is critical. Different times require different skills.
What Criteria will drive future CCCM investments?
- Defensible Niche– Our investments have been in fragmented markets where the company can achieve leadership and cost advantages with sales under $100MM (eg. Selected business services, regional waste management, specialty food distribution, specialty chemicals, etc).
- Management with Vision and Execution Capabilities (plus high ownership); Energy, focus, sophistication, willingness to delegate and pivot strategy when necessary. Founders should be strong leaders but also willing to delegate. Our five highest return deals had management with these traits (plus high- 15-50% –ownership).
- Fair Price and Modest Leverage; valuations of 5-7X runrate EBITDA is the range that we estimate generates equity rates of return with a margin of error, based on our 25 years of experience. CCCM has established a well-known “brand” in the Private Equity market and has originated all its investments via proprietary/ negotiated deal origination from over 8,000 deal sources.
- Structural Protections and Current Yield when available and/or necessary; generally investing in part debt, founder/seller equity stakes, and preference rates of return plus some additional equity and/or warrants can achieve this.
- Acquisition Expertise; ideal to have management expertise, but not necessarily internal; CCCM frequently supports its portfolio M&A programs
- Patience- investment returns will not be premised on market timing. Unlike CCCM, many firms are captive to a five year fundraising cycle and have to sell their winners too early.
- Customer/Supplier diversity (unless price and diligence can offset concentration risk)
- CCCM Chemistry and Potential Value-Add Much of our historical success has been from winning over Founders and management teams with our track record and approach which emphasizes flexibility and support when needed but not force fed (M&A experience, recruiting network, sales/customer relationship network, lender relationship advantages)
Target Vertical Investment Sectors
We are focusing our origination energies to develop proprietary deal flow in the following areas:
- Consumer, with proven omni-channel delivery mechanisms
- Health and Wellness (eg. fitness, nutrition, preventive/holistic medicine)
- Business Services; outsourced services, including SaaS subscriber-based platforms
- Industrial markets, focus on those leveraging tech enabled platforms and communication
- Online learning/communication
- Fintech to facilitate payments and lower price umbrella on transactions costs, enhance speed
- Rental Economy hospitality and transportation (eg. Uber, AirBnb, Destination Resorts, VRBO) will come back strong in 2021
- Leisure / Travel (very depressed now but the brands will survive and thrive; focused on asset light aggregators, strong brands and companies with good margins and variable cost structure
- Secondary Private Equity; A rapidly emerging segment of private equity provides enormous opportunity for CCCM to leverage its 27 year experience and hundreds of fund relationships. Very little capacity exists currently for individual stake purchases triggered by retirements, death, divorce or other reasons that don’t coincide with the timing of an exit transaction. Based on dozens of interviews, every PE firm I’ve spoken to has “stranded stakes” that could be available for purchase at a discount. CCCM can be the right buyer given our reputation for working constructively with partners and work within the existing rights and documentation. The investment horizon for these stakes will be shorter than primary investments since these will be well along their way in their investment cycle (likely 2-3 years instead of 5-7 years). CCCM plans to target such investments with companies in existing portfolios with PE firms with whom it has a relationship.
Investment Size and Return Criteria
- Size; $5-25 million per deal
- Total Enterprise Valuation (TEV) of under $100MM preferred –to avoid auction premiums driven by the bloat in Private Equity fundraising for firms raising more than $500MM. 93% of PE dollars now managed by $1 billion plus firms. Stay out of their way.
- Mezzanine IRR- 10-14% current; plus PIK or Warrant (1.5X cash on cash return or higher)
- Current Return and preference structures to reduce risk and duration
- Equity IRR -20-30% (2.0X or higher cash on cash return)