Chit Chat Stocks - Clearwater Analytics (CWAN) with Conor Mac

Episode Date: November 11, 2021

Clearwater Analytics offers cloud-native reporting solutions for companies that manage assets. Clearwater's solutions include automated investment accounting, data management, and reporting. Conor brings his expert knowledge of Clearwater Analytics for a great discussion regarding the history and future of the company. Enjoy the show! Our Thursday Deep Dives are sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128  Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android  Special promotion through the end of 2021: Subscribe to 7investing with the code "chitchat" and get $50 off your annual subscription: https://7investing.com/subscribe/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested in more of Conor's work? Follow him on Twitter: https://twitter.com/InvestmentTalkk?s=20 Rather watch us on video? Subscribe to our YouTube channel: https://www.youtube.com/channel/UCG5Ni-SI-jyrEsoNUhqftNQ  Contact us: [e-mail]  Timestamps Clearwater Analytics | (4:41) Excitement & more | (23:57) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. Today, we have Connor McNeil on the show and we talk Clearwater Analytics. It's a company that I had not heard of until he kind of put it on our radar and he's got experience there. You'll hear why. But it was a lot of fun. Connor's been on the show twice and he's probably one of the best young investors that I know. His research into the company was super thorough. He also makes a joke at the start, which I didn't understand at first. He got Ryan very, very good. I think if you're on Twitter, you'll laugh when you hear it. Or a CNBC watcher.

The big, well, when you're listening to this, it would have been like a month or six weeks ago. Don't want to spoil it, but the funniest thing that maybe happened in a long time on financial news. Any highlights of the interview for you? Yeah, so he goes over the expense structure of the business. The business itself from a high level is not too hard to understand. So I think anyone that will get it, the intricacies are a little bit difficult, but he went over, I think, explained something you might not get from the S1 is how the gross margins stay a bit lower than a typical SaaS company. And a few other things like that, you know, they have all the reconciliation things. So I thought that was interesting, kind of his outline of, and especially this is very easy.

It's a lot easier for him to tell his next employee of how, you know, the operating expenses will scale, how the cost of revenue will scale. I thought that was very, very insightful. And I learned a lot from that. I might preface this as well by saying, once you hear about what Clearwater does, we run a smaller fund. Tiny. And the resources or the solutions in the industry are pretty fragmented. It's like a lot of different individual providers. So what Clearwater is doing is really interesting and it does provide a ton of value. Yeah. You really have no idea what to even do. So a scaled player like this, there's an opportunity for it. Now they're not really

targeting tiny places like us, but I mean, the value proposition seems fine. We don't need to pitch the stock though. Don't even belabor this point. We'll talk about our sponsors real quick before we get to the show. Quarter, it's earning season. Earning season is totally upon us. I guess it will have been upon us by the time you guys are listening to this. Yeah, it'll still be the heart of it when someone's listening to this, I think. And I don't know how you'd get through the earning season without our friends at Quarter. It is basically an all-in-one investor relations app. You can listen to conference calls from any companies that you like. You can read investor presentations, transcripts. They have pretty much everything you might want. And now

you use the emoji feature. Well, I didn't use it. I saw the tweet. I haven't used it yet. I hope they expand it to comments and stuff because emojis while exciting, you know, whatever. I mean, I've used emojis, but it's not like, I don't know, comments I think would be improvement but again again this is like a six-month-old company so i assume that's coming down the line and the new products they're releasing seems awesome but either way you can time stamp a part in the conference call and leave a reaction which is great because you can kind of see what parts of the call people were either interested in excited in drop a fire emoji yeah see yeah it's it's pretty funny i saw i was looking at some of the popular calls and it was

great and that just shows that they are expanding the products here really really quickly um it's fun to watch it evolve yeah i expect it to you know continue it's 100 free you can download it download it on ios or android it's quarter q u a r t r no e you can also follow them on twitter at quarter underscore app without further ado let's get to the interview Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast.

Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Okay, today we are welcomed by Connor McNeil. He has been on the show before. You may know him as Investment Talk on Twitter. You may read his sub stack. I believe it's called Investment Talk. But today we're talking Clearwater Analytics. And I think I know the answer to this question but how did you come across the company so first of all thanks for having me on again uh great to chat to you guys again i came across the company many years ago because i worked there full disclosure yeah okay well that's yeah that makes it pretty easy but um can you describe i

guess what they do and uh who their target customers are sorry what do they do you're breaking up sorry yes yeah what do they do sorry you're breaking up oh okay that was a joke sorry sorry oh yeah like you know from last week that was just a joke oh yeah yeah yeah um yeah so clearwater in a nutshell are kind of like a typical sass business they're offering cloud native reporting solutions for bodies that manage assets that's typically right now asset managers insurance clients and a little bit of corporate cash there as well for treasuries and right now they've got about 5.6 trillion in aum going through the system and so i'll kind of paint a few different pictures um because it's a pretty simple

business to understand like the underlying software might not be but overall it's pretty simple so if you imagine for a moment that you are an asset management firm in the kind of the daily order of business, you're going to be managing several client accounts, you're going to be dealing with a multitude of different custodians, and you're going to be responsible for kind of reporting the accurate AUM on a monthly or quarterly basis, typically for each of your clients. And typically, this is not done daily. So this work kind of includes reporting requirements, you know, most of which is done manually or at the end of the month, and is kind includes but not limited to compliance, accounting standards, financial statements,

P&L reports, tax loss data, risk and performance reporting. You've got compliance in there as well, maybe composite management, file delivery, billing, and a portion of time spent on the front of house dealing with those clients and communicating there. So if you take all of that and then imagine that you're doing this across multiple jurisdictions or countries with different tax and accounting standards, different currencies, and also different reporting requirements as well. Clearwater basically gives the client a single kind of pane of glass to view all of that through, you know, taking all of the data and kind of giving them one place that they can go to get all of those things that I just mentioned before. It's kind of basically like

outsourcing all of that legwork to one company. Okay. And so I'm guessing this is more catered towards big funds or big asset management firms? So part of the appeal of using Clearwater is that you could be a $100 billion AUM insurance provider, or you could be like a $15 million dollar asset manager and you'd get the same product. So I would, I'd probably say the biggest value add is to a bigger client, but you can certainly use it if you're smaller. Right. And the clear use case is as a, you know, asset manager, but they do list different types of customers like treasury and insurance. How does that work for them? And are they going for that big opportunity with, you know, corporate treasury accounts, like say Apple or someone big

like that? Yeah. So Apple is a client, part of the corporate treasury. Right now they have about 1,000 clients and about half of that, or in terms of AUM on the system, about half of that is insurance. And then the other two quarters are kind of split over asset managers and corporate treasury. So they started back in the early 2000s, kind of focusing on corporate treasury because it's relatively simpler and then as they kind of grew they they leaned into asset management and then eventually insurance and it kind of went from there the tam is like to use that word the tam is a lot smaller in corporate treasury i believe they identify kind of a 3.5 trillion aum targeted base of which about 34 percent of that is already on the system in north america

But overall, the revenue opportunity for that, excuse me, based on the fee they charge is about $300 million. Whereas if you look at asset management in North America, they view kind of $68 trillion in AUM as their targeted AUM base. Currently, about 2% of that in North America is on the system. And that's closer to a $3.1 billion opportunity. And insurance is kind of about one third of that in terms of targeted AUM. and they currently have 12% of it on the system. And it's about a $1.4 billion revenue opportunity. Okay. That's a great overview. And I think a key question, especially for someone that's an investor that's listening to this, that may be using a legacy solution within a fund

or an asset manager or a financial advisor or whatever. So if a fund or asset manager already has an administrator or a legacy solution, why would they want to add Clearwater on top or replace i don't know if it's or are they always replacing it or is this something that kind of goes on top of whatever they already have so for context they previously used to always replace it but they i think in the last couple of years launched a product called prism which is essentially like a master copy so that funds or insurance providers or whoever it is can utilize both clear waters data and their platform as well as like legacy providers and it kind of plugs it all into one master copy and they can you know use Clearwater's front portal for that but typically

the reason why you would you would use it and to give context on the industry as a whole like this is a very fragmented kind of industry there's lots of very small niche providers and you know for clients that are dealing in multiple jurisdictions with different currencies and all that jazz they might use anywhere from two three up to tens of different providers so clear water is like a way to consolidate all of that and in a sense you know reduce a lot of the legwork that goes into managing all those relationships with those smaller parties and you can just do it all through clear water and how do they generate revenue is it just a percentage of the aum yeah so revenue what they disclose is like revenue is a fee based

on AUM over a kind of an average period so that can fluctuate but there are there are additional things as well like when they onboard a client there's it can depending on the size of the client it can take anywhere from you know a couple of months up to a year and there's a kind of a specialized implementation team that handles that and there's a one-off charge for implementation services and then they also charge for Clearwater Prism which is a lot smaller it has about 100 billion in AUM on the system, but the vast majority of their money just comes from, or revenue, I should say, just comes from a very small fee on the AUM that they have on the system.

Now, do they disclose what percent they usually have or does it range or take, excuse me, that they take, their take rate? They don't disclose. And from my experience, it differs. It depends on kind of what leverage, clear what I have, what leverage the client might have negotiations and again this is like one of the kind of riskier aspects of investing in the stock as well there's some areas where they might have contingencies for liability so if clear water this this is typically applicable on the whole but there are some clients that ask for it in

a contract as well you know if clear water reports something inaccurately and the client then makes a trade based off that inaccurate information clear water could be liable to kind of recouping those costs to some extent right right and what you mentioned the prism product and you may have described that briefly but can you uh explain what that is versus the core product yeah so the like if you think about implementation core product say i'm an asset manager i want to remove all my legacy kind of solutions and i want to just go and use clearwater as my sole source of kind of data aggregation you'd come to some kind of contractual agreement you'd agree on a fee And then you'd go into the implementation phase.

And at that point, they're kind of making all the correct data connections. So if I had 10 different custodians managing cash and holding my securities, we'd get the data connections from them set up. We would also set up connections from third-party data vendors to kind of verify the data we're getting from the custodian. And then we'd also hook up data from the client itself, whether they use their own tool or whether you use something like Bloomberg to execute trades. and on the back end that's going to be pulling in all that data into the kind of clearwater software

and then yeah so that would be how you'd kind of use it in that sense um i forgot what the original question was oh was it's uh the difference between prism what what does that add on yeah so so what i just described as like how a typical person would be kind of acquired as a client and then Prism. So if you have maybe two or three legacy solutions that you really don't want to replace, and you don't want to transfer everything over to the Clearwater platform, there is a way that you can kind of benefit from using Clearwater's front kind of portal, which is like that single pane of glass I described earlier, where you can see like a global portfolio in one view. There's a way that you can kind of get the benefit from that whilst

also using your existing solutions. And in that case, Clearwater will take the data from your existing solutions as kind of like an ancillary data source, and they'll pull all the data from that and feed it into the Clearwater system as well so that you have the benefit of using both and you don't have to fully subscribe to Clearwater.

Why would a customer be reluctant to fully subscribe? Like, why would they want to stay with their legacy providers? I guess in some instances that are kind of bald spots for Clearwater, whether it be a particular jurisdiction or, you know, if you have a big multinational asset manager and, you know, say that primarily in North America, but they also have some stuff in Africa and maybe Southeast Asia. And if there's maybe asset types that Clearwater don't support, that they're currently relying on a different solution to kind of get compliance and reporting and performance data from, they might want to kind of, you know, they don't want to just lose, they obviously can't just lose all the kind of reporting analytics for that. So they would use a mesh of Clearwater and their legacy as well. Okay. And we've been talking about legacy competitors a lot. um this seems like at its core this is uh however much aom you can get under management because the

take rate is just going to expand with that it's a very simple model at its core what who are the main competitors that clearwater is trying to take or steal aom from yeah so so like earlier i said it's like a very highly fragmented industry from my understanding and clearwater from my understanding the kind of like the only cloud native solution offers this fully extensive you know back office to front office offering and the target markets that they offer it to you know you have some competitors that do take components of their offering to the cloud but most of these core platforms are still reliant on some kind of underpinning underpinned legacy technology stack so i would kind of bucket it into three different solutions and they're serviced by

three different or categories of businesses so you've got large-scale incumbents with broad offerings across multiple asset classes and customer types, asset managers. You've got healthcare, insurance. It goes outside of that. And then you've got smaller vendors that are often more niche in the solutions that they offer for, typically for a single point solution within maybe a local market or a specific client type or an asset class or a function. And then you've got a third bucket, which is cloud native solutions providers like Clearwater, of which I believe there is only one, and that is Clearwater. So some of the world's largest asset managers as well, both clients that Clearwater do not have and ones that are actually on the system,

they also create internal tools that they can use to facilitate a lot of the things they have Clearwater as a client for. So that's something to consider. BlackRock, for instance, they have the Aladdin product, which means they can do all that stuff in-house bony melon also have a product where they can reconcile and aggregate data in-house they are a client of clearwaters but then you've got people like jp morgan another huge client for clearwater they definitely have the kind of capital to build something like that and use it so that's always that should always kind of be on your mind that they could just bring this in-house but i guess it's you know it depends whether they want to or not right that's only kind of maybe for

the huge big banks or something like that and i guess that brings up a quick question do they have any customer concentration risks here so off the top of my head i don't have it on me but off the top of my head i think no client no single client represents more than 10 percent and then the top 10 clients represent less than 30 percent there is there is a bit of concentration there just from my own understanding so you know the top 10 representing less than 30 percent you know it's not like super concentrated like you might get with a smaller cap company but there's definitely some really important clients on the system that have you know a really significant kind of portion of aum um in terms of you know back to your question i forgot to kind of note

some comps in terms of like companies that you should look at if you want to gain a better understanding directly i would say ss and c are one of the more interesting companies public they target probably all of Clearwater's markets but they also have other avenues in healthcare and stuff like that their margin is considerably lower it's less automated and then you have companies like State Street who have a product called PAM you have Boney Mellon they have a product called Eagle you have FIS iWorks you have BlackRock you have Aladdin and you also have northern trust as well um and then black line they're more on the accounting side they're not really um reconciling for asset managers but you know it's still a market that clearwater kind of

operates in so yeah it's hard to find like a direct competitor but they're probably some of the ones that i've identified as being you know interesting to go have a look at so if anyone's confused and they know black line this is kind of like black line but for asset managers more niche is that a good way to put it in a sense yeah like if you want if you want to just kind of yeah you could you could say that i haven't looked like too deeply into black line like i've chipped through a 10k or two and looked at the financials but from my understanding it's really just kind of the more not corporate treasury but it's more on the kind of inventory and you know financial reconciliation but yeah it's not going to be for kind of you know jpms and insurance

companies okay so two questions first one that comes to mind is that they have it sounds like they have a lot of big customers and my worry would be sort of customer saturation like are they kind of at a point where they're very mature business um have they reached that point yet or do you think there's enough fish out there to go get more customers i definitely say they're not mature just yet so they've been they grow at like 20 a year even even before they started kind of like disclosing that that's typically what the growth rate was and then if you look at management's incentives they're kind of incentivized to grow at 20 23 percent a year and then just kind of back to what i spoke to maybe five minutes ago they outlined a quote

unquote you know 10 billion revenue opportunity across north america and the rest of the world and this comes from you know the current markets they serve which is about a 4.3 or 4.5 billion opportunity and then the rest of that comes from adjacent markets and you know new geographies which they're not currently in so of their biggest tam kind of client servicing bucket that would be asset managers in north america and they currently quote that they have two percent of that kind of targeted aum on the system for insurance it's kind of in the mid-teens and then for corporate treasury, it's in the mid thirties. So I think in terms of asset managers, it's definitely still a long runway there for insurers as well, both in North America, in Europe

and elsewhere for corporate treasury in North America. You know, it's probably a little bit more saturated. I wouldn't go so far as to say mature, but it's certainly very competitive, but the relative time there is a lot smaller. So, you know, does it warrant as much reinvestment? you know probably not well once you get apple that's basically the entire market right but no you'd be surprised um if yeah you'd be surprised like in in respect of like what they do for companies in corporate treasury it's like like it's a big win in terms of oh we have apple as a client but in terms of like how much revenue does this company bring in you know it's it's not insignificant but it's not as big as signing someone like you know a jp morgan or a

huge european insurance yeah all right so so another thing that would come to mind then is if you're charging as a percentage of aum and a lot of these are asset managers does revenue tend to ebb and flow with the market so we don't have data from pre-gfc which clearwater did survive um so i don't really have a great deal of context on how how that went or how revenue looked then But, you know, from that point, they have grown revenue fairly well. But we've also been in this period of the market where it's kind of low interest rate. And, well, the interest rates have been going down and about 80% or more of the AUM that Clearwater has on the system that they're billing for is fixed income. So that's certainly something to consider, you know, whilst they've been landing clients and growing revenue that way, which is definitely probably one of the primary drivers of their growth.

you know the environment for the kind of aum that they have on the system has been positive to allow kind of aum on the system to grow organically as well so yeah that's definitely something to consider there okay that's interesting it's not all equities so it's it's mostly or mostly in fixed income here yeah like what like if you're if you're when you're working there like you get exposure to so many different types of things like you know vanilla equities are not really what you see is typically like direct derivatives and complex assets and fixed income and you know yeah but it's mostly fixed income all right let's uh we got more questions on the second half we're going to hit a quick ad break this episode is brought to you by lakinta by

windham here you are miles from home and ready to start your vacation good thing you're staying at lakinta by windham they have free high-speed wi-fi to stream all your favorite movies and in the morning get fresh waffles with their free bright side breakfast or squeeze in a workout at their fitness center either way you're ready to conquer the day tonight la quinta tomorrow you triumph book your stay at lq.com this episode is brought to you by kpmg as a business leader how can you innovate build trust and move forward in a digital era kpmg can help by bringing together the right talent and technologies, generating insights that spark opportunities. To explore their thinking, visit reed.kpmg.us slash opportunities. Okay, welcome back in. One

question that was coming to my mind during the first half is, what exactly excites you about this investment? Because it seems like a relatively unexciting business in that their business model is pretty simple so i'm curious what kind of attracted it to attracted you to it in the first place so initially and you know this is public disclosure reuters had an issue like they disclosed someone from the company leaking news that an ipo had been discussed as early as 2019 so um you know i i knew about it internally as well i don't think it's a crime to say that So I was always kind of waiting for it to come so that I could get more insight into the company. Just having worked there as well, I understood that this is, in my opinion, a best in class product offering.

And, you know, clients really do value it. Like in the last question, you asked me, you know, how durable is this revenue? Does it grow over time in a way that's kind of related to the market performance? You know, I was still there in 2020 when COVID happened and the expletive hit the fan. And, you know, it was a very volatile period and clients really valued having kind of daily, up-to-date data on everything that they have across their global portfolio. It allows them to be a lot more nimble and make accurate decisions. So the product itself excited me. elsewhere i felt like and it was one of the rare occasions i maybe had an informational advantage

over the broader market because it's such a boring industry and probably not a well-covered company you know and having the experience of actually being on the back end as well as the front end understanding how the software works i just felt like i had an informational advantage my time there was pleasant i didn't really enjoy all aspects of it so i was you know trying to guard for biases there as well um which i think i did because there are still aspects of the business and i'm sure we will discuss that that i don't really like but as disclosure i am i'm long the position right now but yeah i would say overall it's a mixture of like the product the informational advantage that i perceived that i might have um you know and it's just not a sexy space and most

people will look at a SaaS business and say, oh, it's growing 20% per year. There's a lot of other stuff you can buy that's growing a lot faster and there's a lot more exciting. But I view the reporting analytics and risk analytics to be as important as cybersecurity. It's not a cost that you throw out of the window during a crisis. It's one that you rely on and are thankful that you have. It seems like they've proven that they're a durable grower, at least if you mentioned And they've grown at 20% at least for a decade here. What are your thoughts on the IPO valuation? I guess also, when did they end up going public?

So they went public. They filed their S1 late August, and then they went public maybe two weeks after that. Felt very rushed, in my opinion. I feel like I only just finished their S1, and then they were suddenly going public. So that was interesting. the IPO valuation it went for a lot more than what I thought it was would go for considering

the valuations it had in the private space for years before that I wasn't overly bowled away I did buy a small chunk of it but that's more so for my own style I wouldn't buy a lot of it the revenue growth

when you're thinking 20% on a 75% margin and you're paying 20 times sales, I think, when it IPO'd. It's not that impressive. I would say that the durability of the revenue growth is something to look at. Whilst other companies are growing a lot faster and they might decelerate within 2 or 3 years, I think Clearwater has a good chance of growing top line in that kind of 20s range for the next 3 or 5 years, at least, given that they are not fully saturated in North America yet, which is where they have the biggest brand power.

And then also when they're going into APAC in the EU, there's going to be a whole bed of new clients in there as well. And when they're already well-established in North America and they've got huge clients like JP Morgan, I think the returns on investment in Europe and APAC are going to be lower than they are in North America anyway. But certainly being a public company helps with that. And I think that's partly one of the reasons why they decided to go public, just for more legitimacy in terms of landing clients as they now look to be expanding internationally. But yeah, overall, didn't love the IPO valuation.

Yeah, I mean, these days, 20 times sales is, it's not the worst outcome, I guess. But one question that brings up though, what do you think, you're someone that's been inside the business, you kind of know how much operating expenses are going to be scalable or what's really a variable fixed cost.

what kind of net or free cash flow margins do you think this type of business could have at scale at scale honestly i think even though it's like 30 i think and if we if we ignore 2020 because there was a recapitalization in that year so you know numerically they look non-profitable but that's not the case um the business has always been profitable as long as i've known it and strangely enough whether you like that or not that's been something they've kind of prided themselves on you know being able being able to grow at 20 every year but whilst also kind of having a nice bottom line there and not reporting losses long term i'm still more than now i really don't know um where the kind of margins would be on the bottom end i think internally 75 was like

the north star and they've they've hit that it's an interesting one so if we talk about gross margin first. 75% is what it's sitting at. And then if you think, how do you expand that? It's not the same as a typical SaaS business. So to give you some context, if you land a new client, and they're really big, and you go through the implementation phase that I just brought up a few minutes ago, when they are, quote unquote, live, which means they are relying on our data every day to do whatever it is they want to do with it um they're a live client and every day that'll involve some element of manual reconciliation so end of day us they'll send all the data to clearwater and then so they have offices in the uk and india to benefit from that follow the sun

model so basically there's going to be analysts working on that in the morning uk time and by maybe 2.30 PM UK time, it's US market open and they have daily reconciled accounts from the day before and they're good to go for the market open. So say you have this big client, it takes maybe two or three reconciliation analysts to kind of get it done every day. And reconcile just means kind of to make calls. So they're just ensuring that all the data they get from all these different, whether it's a custodian or the trading data or third party data, they want to make sure that's all accurate before they put it up on the Clearwater system and allow the clients to use it. So say this big client has two or three analysts to use it over time. One of the goals of the

reconciliation analyst at Clearwater is to make those accounts more automated by using various kind of trinkets in the software. So you might get this client that's maybe 40% automated when it first comes in. And what I mean by that is 40% of the kind of transactions flowing through clear what are going to be automatically matched and verified, and they can go to the front office or the single pane of glass that they're viewing the data through. And the other 60% requires some kind of problem solving, whether it be the custodian has said that this trade is for five units, the trading partner has said it's for six units, you know, you have to decide which one's right. It could be the third party data provider Refinitiv has said that this share price was $115

dollars yesterday. It closed out, but the custodian thinks it's 117.50 cents. These are all issues that have to be manually reconciled. But over time, the analyst can work on that and create protocols. And say after 6 months, this client goes from a 40% automated client to an 80% automated client. It might only require 1 or 2 analysts to do it every day. It might even know only require one and at that point you know that's two analysts that you freed up so in a sense you're spreading you're reducing the labor cost per kind of client if that makes sense and that's a good way to scale the the gross margin in that sense because they include those costs and cost of good sales because that is the cost of delivering the service but right now at this

phase of clear what is kind of growth trajectory they're landing a lot of new clients every year so the benefits of spreading that labor cost around you don't really see them because you know every other month or every quarter they're adding a huge client that that extra labor has to go and then serve and so like yeah i'm trying to do things on my hands but if you just can't see it listeners can't see it but if you imagine like a chart that kind of goes right and it kind of skews up um really fast which is kind of on the on the bottom axis like how it's worked now on the left axis is like revenue that's what it should like look like for a SaaS business you know as more people come onto the platform you're leveraging one service across a greater number of people

so kind of yeah um but at Clearwater it's more like a kind of a horizontal line going up so it doesn't really break away at any point but I think as they mature that should be something that might you know become a bigger kind of effect across the the broader business but right now i'm unsure how they're going to get to like 85 margins like you see some other sass companies have i think there's definitely kind of expansion there but i wouldn't be surprised if it sits at like 75 maybe high seven uh 75 high 70s you know over the next three or five years um and then going down from that into the operating margin, I think pre-COVID, they were about 15%. And the bottom line was maybe anywhere from 5% to 7%. And this recent year, it was about a year to date, it was

17% operating and about 3% net. So I'd say mid to 20s operating margin over the next couple of years. But then you have to consider that this is going to be quite an aggressive push into Europe in APAC. So that might suppress the operating margin there as they look to kind of build out their network and land clients and customers. Because the biggest costs in this business are really the analysts themselves. 50% of the workforce is a reconciliation analyst or client serving analyst. And the difference is really a recon analyst is on the back end and a client servicing analyst is on the front end just dealing with the clients directly another 33 percent of the workforce are data engineers who are all on the back end working to ensure that everything

from you know the legitimacy of the data that we get the accuracy um the connections to custodians all works fine um all way above my pay grade but really interesting so you have like 83 percent of the the workforce just purely working on the the software itself and that's quite a big cost so when you're adding new clients you're adding new engineers and analysts and yeah okay yeah okay and then i guess that brings up a good point does that mean there is some sort of economies of scale here where some you know startup team of 10 people can't really repeat and replicate what clearwater is doing it's a good question i think it would definitely be it'd be a hard market to into like i've looked at barriers of entry i think there's a reason why there's not like

so much competition here because it's you know it's very hard to get right um ssc have been doing it for ages i think they made top of my head anywhere from 10 to 15 billion in acquisitions or maybe a lot more don't quote me on that in acquisitions so they've been doing a lot of bolt-ons to kind of add those services whereas clearwater up until now have been doing it all in-house and building that all out um they've not really landed any big m&a um which is something that might be in the pipeline might not it was discussed in in the prospectus but i don't know but i think yeah it would certainly be difficult to replicate in terms of economies of scale the more aum you have on the system and the better your analysts get reconciling these companies

it's going to be better for margins like as an example say you have a client that is brand new and you're onboarding all their securities and they have a very basic example but say they have the they have apple as an equity well we already have that on our master copy in the system so it doesn't require any legwork just immediately go on there and then if you have say they have a bunch of alternative investments that are maybe a bit more obscure and niche you know when we learn how to onboard them onto the system for the next client that comes along that has something simpler it'll be a lot easier um yeah okay and what are your thoughts on management i know i was reading your write-up uh and the founding story and what the founders are doing is a little bit interesting

there's a funny anecdote in there about idaho uh and then the national forest and stuff but yeah what are your thoughts on management currently and how's that going so there are no founders present in the company anymore and in my opinion that's a good thing as you referenced they're not they're not like the most um respectable characters they created the company and then took a back seat for a number of years um there's one of the brothers that was the ceo for a number of years but they're no longer part of the company and to my understanding they sold out a lot of their their shares in the recapitalization last year in 2020 um i'll quote something that i wrote I said that the management team looks like a mishmash of corporate bobbleheads that have

been stitched together in order to push through an IPO. There was a sprinkling of private equity and a delicious garnish of long-term Clearwater employees that have actually been with the company long enough to have witnessed their transition and understand the culture. So that's something that I wrote. And then if you look at the executive suite, about 80% of those have been brought in post-2019. And as I referenced earlier, this IPO was likely known about you know long before that at least at the start of 2019 according to what Reuters said from the employee that spoke out not a whistleblower but you know someone just kind of disclosed information that shouldn't have been disclosed and from my sense

on you know internally and you could go look at Glassdoor I would say the kind of feedback over the last two years on Glassdoor is strikingly accurate, both on the positive side and on the negative side. There was a feel that Clearwater was turning from this startup environment, despite having over a thousand employees, there was this startup environment that was built from Boise, Idaho, and that just didn't translate so well into the UK and India. I'll discuss India as well in a moment. That's an interesting one. But yeah, so there was definitely this transition from being a startup environment to being one that was more corporate.

And there was some frustrations around get to 75% gross margin at all costs. We have to grow revenue by 20%. The North Star was acquiring new clients. But that could just be the teething troubles of a growing business that's transitioning into more of a corporation as opposed to a fledgling startup.

There are definitely so many talented people that work there. I think that is the biggest net positive there. I wouldn't say the management team are incompetent. I wouldn't say they're not smart. They all have a lot of experience in the industry and in SaaS businesses as well. But I think the biggest importance here is the ability to keep and maintain the really switched on and intelligent employees because that's 8% of the employee base. And they're the ones that are dealing with all the clients every day and are managing the software. And effectively, if a client gets bad service, it's the recon analyst's fault or the client

servicing analyst's fault. So I think the ability for management to keep them on board and keep them happy is the biggest kind of thing there. And if you look at Glassdoor, a lot of them are not happy. there's a lot of attrition i think in 2018 to 19 attrition rates were about 30 percent which is strikingly high i don't have data on what that's like in 2020 but i wouldn't imagine much has changed um i live you know five minutes from the edinburgh office and i know that a lot of people leave leave there like a turnaround door but it's interesting because the the pay is not

terrible the work is a bit monotonous but you know it's engaging and it's fun the office environment is super fun and a lot of people that work there say it's the people that work there that you know make the job fun more so than the work so to cut a long story short i think management are okay they're not they're not overly exciting they're not you know they don't have a lot of their wealth riding on the success of clearwater they're not you know they don't have huge positions there's no founders all i really expect from management is to be able to trust them that they can execute on international expansion and keep clients clients of clearwater happy and you know fix the issue with the kind of employee culture because that's definitely one of the

biggest red flags there for me so then what are you tracking to determine whether or not that expansion and clearwater as an investment general is uh successful yeah so i think there's a few basic things that you can track obviously and we'll go over them but like i wanted to just first kind of touch on more on that revenue opportunity thing that i mentioned earlier and kind of where i see so the clearwater today is big in north america still slightly under penetrated but they're going you know into a back in eu so when you ask how do you track you know that the clearwater business is doing well you know one of the things that you look at is kind of revenue and arr but in order to track how that's going i think you need to understand

what builds that up over time. So in order of priority, this is the points that I would highlight to watch out for. So number one would be new client relationships in existing markets. So I mentioned before that the return on investment in terms of customer acquisition will be a lot better in North America than it will be internationally purely because Clearwater already have this strong presence in North America, despite management claiming that the revenue opportunity is larger in adjacent markets, Clearwater has already grown recognition across the core markets in insurance and corporate treasury and asset management in the US.

So this is where the largest opportunity is for expansion, in my opinion. I said that 2% of US asset managers have been penetrated in the US. without taking away how difficult it is to land new clients grabbing new clients in existing markets feels like the lowest hanging fruit in that sense um yeah so that would be number one number two would be extending existing relationships so an interesting thing about clearware is that you know existing clients have historically been one of the more potent avenues for ARR expansion, so annual recurring revenue, both from nurturing and retaining clients,

as well as incentivizing them to onboard more assets into the system. So if you grow with the client, the prospectus shares this kind of story about a number of different clients and how they grow. But one of them was Delphi Financial. Over a few years, they've grown their asset base from $35 to $50 billion. whilst on the platform, and that's just pure down to their own performance, and that's great.

But because they like Clearwater, all of that new AUM is then on the system, and any new clients they get as an insurance provider also goes in the system. Thus, Clearwater's fee runs higher as the client itself gets stronger. And then on the other side of that, there is an opportunity to attract more of the client's AUM. so in some instances you might have a client that on on board a portion of the aum on to clear water just to either test out experiment or maybe we don't cover some things they want us to cover just yet um so you might have them on on board five percent of the aum if they're a huge huge

client with hundreds of billions and then over time as the relationship grows they might on board 10 and then 15 and then you know 20 and if that's a huge client each time they're kind of unloading more AUM onto the system. That's like landing a new client, but with the benefit of already having a relationship there and understanding what their needs are. So I think new client relationships in existing markets and extending those ones they already have are going to be the two biggest drivers going forward. And number three, I would say simply new client relationships in adjacent markets. So adjacent markets is this secondary revenue opportunity that they're looking at in both geographic and then they highlight

clear what prayers in there as well but then it's also like new buckets of client types so whether it's sovereign wealth funds or pension funds um state and local governments which they've very kind of on a small scale entered into but they're going to lean into that a lot more so attracting new clients um in those adjacent markets is going to be really important it will be harder and the roi on spend will probably be a lot worse but that's definitely one to consider number four just generally international expansion is going to be big about 91 or 92 percent of the revenues right now come from north america so expanding that um across europe and apac is going to be big you know there's a lot of huge clients there number five i would say developing new

adjacent solutions so i i kind of highlighted some of the adjacent markets they're looking to tackle. And I'm pretty sure that when they kind of communicate with these new adjacent client targets, there'll be opportunities to kind of create solutions around those specific types of client. And eventually that's going to bring in more AUM because it can facilitate more complex or unique or niche different types of client on the system, expanding the user base there. I wouldn't say expanding the TAM because I think that's already pretty baked in. um but yeah um just depends on how that goes and then lastly i'd probably say partnerships in m&a so historically clearwater just haven't really done a lot of m&a none that i know of um but in

the prospectus interestingly and also just from my own experience um without going too much into that you know it feels like it feels like management might look to m&a at some point in time they in 2019 they hired a chap into their executive suite and i don't want to butcher his name i can't really remember it but he specialized in m&a previously in a similar industry so even when i was there that kind of kind of raised my eyebrows a bit so that could be something i look to do in the future i'm not entirely sure how that would work out and they don't really have the balance sheet to make huge acquisitions, but there might be small tuck-in ones there. So with that in mind, the things that I'm really focusing on right now is just revenue growth for

obvious reasons. It's an indication of the success of the growth efforts and management are incentivized to hit 20% plus revenue growth for the next three years. Annual recurring revenue as well. Revenue only tells us so much. So Clearwater's ARR has grown about 25% CAGR over the last five or six years. And it currently stands at about $245 million as of halfway through 2021. So as I said, over 80% of those assets in the platform are going to be low volatility, fixed income securities with respect to market value. So growth in ARR is less attributable to fluctuations in AUM on the platform. And it's going to be more so indicative of the increasing clients

as well as the onboarding of new assets onto the platform. So there is that. And then also you have gross retention, net retention, which is kind of showing you how those revenues play out over time and some churn there as well.

So gross rates, gross revenue retention is going to be kind of more indicative of existing and to be recognized recurring revenues. And I'll explain that in just a moment. for both new and existing clients.

So net revenues are going to be more indicative of the ability to retain AR from just existing clients over a period. So in order to get like a gross retention rate, you would take something called an annual contract value for the trailing 12 months, and then you would take away the amount of churn or attrition, and then you would just divide that

by your annual contract value again. so the ACV is just going to be your annualized recurring revenue plus revenues which are contracted but have not yet been billed giving you the kind of total contract revenue value for the new and existing clients for the year just to know you know subscription revenues that's how it's work you charge on a 30-day basis and you know there's a projected amount that you sign up for but the client you know um so traditional churn is basically just going to be the revenue loss from the point that a client hands in the termination notice for their contract with clear water that only requires yeah does does most of the churn come from asset managers failing or

switching to a competitor so for my i don't have data on this but from my experience like most of the churn is in very small clients that you know like for someone like uh jp morgan to kind of quote unquote churn from clearwater would take a lot they also have to find someone that can suit all of their needs as well and then they would have to onboard onto that new provider and and all that jazz so typically from my experience it's been smaller ones that maybe aren't doing so well in the markets or maybe they i think when you're cutting clear water the not incentive if i can find another word the like the switching costs don't feel they feel lower if you're smaller because you know if you're smaller you maybe are more sensitive to price perhaps um but yeah

typically from my experience it was smaller clients that would churn so clear water average like 98 gross retention rates and have done for the past two or three years and yeah when i was there like whenever we lost a client which was very rare it was just that they were either reducing the size of their aum or like maybe offloading certain portions of the business or they could have switched as well yeah or doing it in-house was a common one as well makes sense all right so did you have anything else on the net retention right there or yeah Basically, I wanted to say was like gross retention rate is something to watch. That's like going to be measuring, you know, how new and existing clients' revenues stay on the platform.

Net retention rates is really just, you know, existing clients. And for Clearwater, it's about 98% gross retention rate, which is kind of in line with maybe someone like CrowdStrike, which has a similar retention rate. If you look at SS&C, it's about 96%. in terms of net retention rate clear waters you know typically in the high hundreds and then if you look at crowd strike and snowflake they're in like the 125 170 range um they're just growing a lot faster and that's really what that's kind of showing there clear what is net retention rate is a lot more similar to kind of black line for instance um but yeah i just say top line ar are retention rates margin as well just things that i'm looking at margin gross margin in

particular operating and net margin not so much given that they're going to be reinvesting quite aggressively over the next few years right that's a that was a fantastic overview last question here what is the what are the biggest risks to an investment in clearwater what could go wrong with this investment so besides all of the obvious things that are kind of inherently risky in this industry because your fee is a derivative of AUM, and most of that is fixed income. So if interest rates were to hypothetically increase by X percent, the value of fixed income securities is in relative relay, so that might go down, therefore your fee goes down. So that's something you just have to consider. I would highly advise flicking through the risk

and the risk section of the 10k for someone like ssnc someone like blackline and then the prospectus for clearwater but you know kind of higher level one of the first things i noticed when looking at it was the big pile of debt they had on the balance sheet i knew about that from working there as well you know big private e private equity ownership over 90 which is also something you have to consider in terms of alignment of shareholder interests there's there's um welsh and carson the majority shareholder and then you've got a bunch of minority ones in there as well but you know a lot of the voting power is concentrated to private equity still um but back to the debt there was there was about 420 million in debt via a term

loan that was in the balance sheet um which one if i saw it was quite you know relative to the size of the business was quite big um but they raised about 500 maybe more million from their IPO. That plus the refinancing of that term loan, management's commentary suggested that they would be paying down the entirety of that old term loan. And then they would have one revolving credit facility and one term loan in total adds up to about $160 million there. So I'm not super concerned about that. Another one is cyclicality. So we touched on this as well. There's not really been a huge period of market disturbance for Clearwater whilst they've been at this size so great financial crisis maybe they were small enough to kind of you know withstand it I don't

really have any context for what happened there um they were private equity backed as well so maybe I don't know um but you know if you think about 2020 that would have been a great time to study this but you know revenue and ARR actually went up because they were still signing clients during that time. And the market retraced, I think S&P went down 30, 35. It retraced that within two or three months. So when you're thinking the fee is charged on average AUM, it wasn't a big hit. So we've never really seen a period that could really demonstrate how cyclical this business is. But I do think there is certainly a cyclical element to it. Employee culture, we've already kind of spoke about that that's a big one um i recommend looking at glass door um for sure to

get some more insight on that but that is a big problem something they're going to have to sort out the employees now get rsus restricted stock units so that that might help and they're kind of leveraged over four years paying out you know once every year um so that definitely might help they're quite they're quite generous with those um private equity already kind of covered there's the liability element as well so i mentioned this briefly briefly earlier but you know clue are liable if they misreport something and the client acts on that data and you know makes a terrible loss because the the power at the hands of a reconciliation analyst is pretty big you know in effect if you wanted to misreport something um it should it should ultimately get flagged

before it ever goes in the front office but you know it's manual and humans are not perfect the failed india office is something that's not reported very widely i you know i didn't expect it to be but it's something that you should certainly check out if you're interested in this company so in 2019 clearwater vowed to kind of build a an india office in noida in india and very quickly filled it with like 250 employees so for context us is maybe a thousand uk is maybe 125. India's double that. And the plan was to shift a lot of the quote-unquote easier work from the UK, where they're dealing with US clients, over to India so that the UK can onboard a lot more complex clients because the workforce there are a lot more established and

experienced. But within maybe 6 months, they put a halt on that plan because the employee culture in the india office and also just the level of kind of quality of the work was not as good as was first perceived and the training as well didn't really go so well so they kind of put a halt on that um and yeah the employee culture there is just really terrible lastly i'd probably say pricing power as well so i don't have like reams of data for this um but you have to consider the pricing power of clearwater is to continue to grow like ultimately a big client like jp morgan has ultimately more leverage over Clearwater than they have over JP. So last year, average AUM on the platform that were billed to clients

increased, I think, about 24% from 2019 to 2020. But the average basis point rate billed to customers declined about 3% over that same period. So AUM is going up, but the average percentage point that they're billing on that AUM is going down at the same time. so it's not like a damning sign of a lack of pricing power but it does make you wonder how much they'll be squeezed as they continue to land larger clients in the future um that's kind of and then management as well but it really depends on your view there if you want to found a led

company management it's definitely not going to be for you if you want someone that can really just act as a trust trusted steward of capital and you know it's quite boring then you might like this kind of bunch of managers, but it's definitely something to consider that the perception of management is not highly kind of regarded from employees. Okay. All right.

I think that's all the questions we have. You got any more? Nope, I'm good. Okay. Where can our listeners find you? What's the Twitter handle? Twitter handle is at Investment Talk with two Ks. All right.

And you have a write-up on if anyone's more interested in Clearwater Analytics, where can they find that on your sub stack right yeah so i don't have the web address to my sub stack memorized sadly um but if you go on my twitter account you'll find it there in the link all right perfect and we'll link that we'll we'll link to that in the show notes yeah all right that's gonna do it we want to thank our listeners we want to remind them that we are not financial advisors brett and i are not financial advisors anything we say or discuss on the show is not formal advice or recommendation we are however general partners arch capital so clients

may have positions in the securities discussed in this podcast. Thank you all for listening. We'll see you next time.