Invest Like the Best with Patrick O'Shaughnessy - [REPLAY] What You Learn About Business Deals After: 12,000 Deals Reviewed, 1,500 Deep Dives, 125 Site Visits, and 7 Portfolio Companies with Brent Beshore - [Invest Like the Best, EP.100]

Episode Date: February 4, 2020

For the 100th episode, I’ve brought back my good friend Brent Beshore. Brent was the 10th guest on the podcast, after we met because of a mutual interest in capital allocation. I quickly learned that Brent was one of the most unique and thoughtful investors around. He was an entrepreneur from the moment he left school, trying many different things before finding a fit buying smaller business with the intention of owning them forever. What amazes me about Brent is his encyclopedic understanding of business and the nuances of different business models and deal structures. This comes from reps. He and his team have looked at about 12,000 deals over the years, at every kind of business that you could imagine. I’ve been with him when he goes through this process and it’s fun to hear what makes certain businesses stand out from others, which is largely the topic of this conversation. You all know transparency is key for me, so it’s important to know that my family and I are investors in a fund called permanent equity, run by Brent and his firm Adventure.es. To commemorate this milestone episode, I can think of no one better than Brent, because he exemplifies what has made this podcast so fun for me: learning from other people who are willing to share what they themselves have learned through fun, blood, sweat, and tears. Please enjoy our conversation, and thank you so much for coming along on this journey. I can’t tell you how much it means to me. For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag Show Notes 2:02 - (First Question) – How does he think about optimizing risk in terms of the capital stack when looking at deals 5:27 – What conditions would they add debt down the road after investing in a company 6:52 – What business sectors are most intriguing for Morgan to invest in right now             6:57 – Trent Griffin Podcast 9:34 – Why no HVAC businesses if it’s such an attractive sector 13:56 – thoughts on rolling up similar businesses and horizontal scale 16:04 – Another industry Brent would focus on 18:02 – Difference between property management in larger cities vs smaller metro areas 18:51 – What role does profit margin play when Brent is evaluating a business 22:46 – The appeal of a hyper cyclical business             22:52 – Brent Beshore Podcast Episode 27:27 – Favorite counter cyclical business 28:14 – How they judge assets, tangible vs intangible assets 33:58 – How does he think about wage inflation when considering the cost of a business 37:21 – His fascination with pet crematoriums 38:57 – History of the permanent equity fund and the changes by having a larger pool of capital 43:48 – Pitching investors on a new structure for the business 46:14 – How will this business model scale Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

This week got away from me, so instead of a new episode, I'm replaying one of my favorites with my close friend, Brent B. Shore. The time is good as Brent's firm changed its name this week. It had been called Adventures, but is now called permanent equity, a convenient name as it's also the topic of our conversation. We'll be back next week with a new episode of Invest Like the Best. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time, and your money. You can learn more and stay up to date at investorfield guide.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion

of O'Shaunacy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaunosie Asset Management may maintain positions and the securities discussed in this podcast. For the one, 100th episode I brought back my good friend Brent Bishore. Brent was the 10th guest on the podcast after we met because of a mutual interest in capital allocation. I quickly learned that Brent was one of the most unique and thoughtful investors around. He was an entrepreneur from the moment he left school, trying many different things before finding a fit, buying smaller businesses with the intention of owning them forever. What amazes me about Brent is his encyclopedic understanding of business

and the nuances of different business models and deal structures. This comes from reps. He and his team have looked at about 12,000 deals over the years at every kind of business that you could imagine. I've been with him when he goes through this process and it's fun to hear what makes certain businesses stand out from others, which is largely the topic of this conversation. You all know transparency is key for me, so it's important to know that my family and I are investors in a fund called Permanent Equity Fund One run by Brent and his firm Adventures. To commemorate this milestone episode, I can think of no one better than Brent because he exemplifies what has made this podcast so fun for me. Learning from him. Learning from

from other people who are willing to share what they themselves have learned through fun, blood, sweat, and tears. Please enjoy our conversation and thank you so much for coming along on this journey. I can't tell you how much it means to me. We're going to come back to the story of the permanent equity fund, but given the kind of funding source that you're working with, looking at this part of the market, you mentioned this idea of how to work with the capital stack depending on the deal. Maybe you could talk about the way you think through that for each individual company.

So if your primary sources of financing are committed equity capital, seller leverage and bank debt, how do you think about that mix, both from a risk perspective and from a return perspective, when you're sort of optimizing each deal? When you're thinking about structuring a deal, you've got to look at what is the company. I think that too often your mind first goes to sort of how much leverage can you put on a company and how can you make the equity look as good as you possibly can. And I think that that game's a dangerous one because it always leads you down to just stacking debt on debt. on debt and trying to put in as little equity as you possibly can, which can work.

Leverage is merely an amplification of the underlying value of the business. So if the business goes well, it's going to go great with leverage. The challenge is even if the business goes okay, like good, a family that owned it that had no debt on it would be perfectly happy with the performance. You stack enough debt on it and it quickly becomes a really dire situation. And then you start making just really dumb decisions that don't make any sense in the grand scheme of things, but you have no choice. You have to meet covenants. You have to meet your repayment schedule. And so the first thing we think about is what is the company, what is the

industry, what is the cyclicality? And a lot of people, you know, you sort of take the last two or three years and you extrapolate out in the future. Trees are growing to the sky, you know, that whole business. And it doesn't make any sense. So cycles happen. We're in a current long dated up cycle. No one has any idea how long it's going to last. And I certainly have no predictions about how long it's going to last. We could enter a down cycle soon or we could go another five, seven, ten years. I have no idea. It's all funny. Charlie that's showing Australia hasn't had a recession in, you know, 26 years or something. So weird stuff happens. Yeah, weird stuff. And I think that's the key, though, is many more things can't happen than do happen and will happen. You've just got

look at the entire spectrum and say, you know, how are you going to take a business and continue it to be durable? And for our model, since we, you know, we have buy with no intention of ever selling, it's real. And since we want to own this business through up cycles and downs and multiple up cycles and down cycles. So the way we think about it first is almost all equity. We almost default to no senior debt, which makes us the oddest of ducks in private equity. And then we focus on using seller debt to sort of serve two purposes. One, it does provide some financial leverage. But more importantly, it just really aligns interest. So we do a lot of things around how do we provide a win-win situation where a seller who believes strongly in the business,

we're not putting senior debt. It's usually flexible seller debt. And even if this business stumbled or had an issue, you're talking to the person that loves this business that cares about the people, they're going to help figure it out. And we're putting such a modest amount of even seller debt. I mean, maybe two turns at most of seller debt on the business that we really like to do that as the primary point of leverage. We will, though, from time to time, put senior debt on a company. I think that in some situations, if there's a really big need at cash close, You know, we won't do it to win deals, but we'll do it if we need to put more cash in clothes to help exit certain people out that, you know, sort of older, that don't have the stomach to take a seller note for, you know, extended period of time, something like that. There's nothing wrong with that.

What about further down the line? So let's say you do a deal that's majority equity at close, some seller leverage and no senior debt. And you're four years down. Like, what are the conditions down the line that you would then put debt on the company, perhaps to provide return to investors or because you feel. the risk is way lower. What are those conditions? Well, I think the way we think about it is, since we want to own this business for a long time, when you're doing a dividend recap,

which is basically what you're talking about, you know, you lever up the business and then distribute out the cash. I mean, you're really just, you're accelerating future earnings into the present and distributing them out now, which is fine. You're just trading the future for the present. Most people do that because they get into a heads-i-win-tails-you-lose-type situation, where if you put a bunch of, you know, you did a dividend recap and you put a bunch of senior debt on the company and it's non-recourse and you pull the cash out and you get your investors sort of made whole or a good return and then it's sort of you're playing with house money. That's the way they look at it. Well, that only works if you're willing to walk away from a company. So if you're not willing to walk

away, it absolutely does nothing other than just accelerate the payments. And I mean, you're going to look at what are interest rates. I mean, what is the opportunity cost on that money? And again, like if you're not going to walk away, it's pretty dumb to try to even put a moderate amount of leverage on the company. So we may do it, but it's going to be few and far between. And I think that we would never do it to where we would endanger the future of the company. Yeah, really interesting. So I'd like to get into some of the, in my conversation with Trent Griffin, one of the popular areas was just kind of picking apart elemental business ideas. And so I'd love to riff on a few of these with you and how you think about these concepts as you're looking

through the thousands of businesses that you see every year. Before we do that, I thought it'd be fun to ask, if you had to right now narrow your focus and you could only be looking to buy businesses in, let's say, two to three specific industries. What would those two to three industries be? And then after we get through that, we'll go into these operational business levers and how you think about them. The business sectors we really like tend to be more blue collar, tend to be more direct to consumer. So when you think about the direct to consumer blue collar, immediately your mind goes to home services. We think that there's a massive tailwind. If you look at bifurcation of wealth moving forward as sort of a tailwind, you look at what happens when people sort of attain a level

of financial security. What do they spend their money on? And almost immediately, people start buying time. That's the almost immediate thing that people do. And they buy time in ways that not only saves them time, but also saves them headache and pain. So when you think about most people, I'm not, you know, there's freaks out there that love to mow their lawn, but most people don't. Some people love gardening, but most people don't. Most people just want house as a service, your office as a service. And so when we think about the enduring need for the home, the enduring need for the office for spaces, if you look at the growing footprint of square footage, it's kind of a common thing that houses are getting bigger.

And people don't want to take care of them. And so this leads into everything from pest control to, HVAC, plumbing. I mean, and there's lots of nuances in these. These are very broad categories. Lawn care, landscaping. Obviously, we're in the pool business, pool building business. We think that's an area that, you know, we joke and told people stop dipping their bodies in

water for pleasure. We'll be fine. I've been doing it for a couple thousand years. I think we'll be probably good in the future to do it. So when we think about industries, we always want to have a thesis behind why people will want that in the future and what could happen that would cause some. somebody to not need that in the future. So a great example, this is air conditioning. I would probably rather have air conditioning than the internet personally. It's an amazing thing. If you think about

being comfortable and like low humidity, especially where I live in the summer, it's a utility in a way that very few other things are. And so what you get is when you get larger square footage and you get aging infrastructure of that square footage, you get the need to service this equipment frequently and accelerating. And that's the sort of interesting nonlinear result of that. So a question on HVAC. So you don't own an HVAC business now. And you've looked at a million.

So on the one hand, it's attractive as a subset of home services. So what has stopped you from owning an HVAC business if it's so attractive? Great question. Yeah, we've looked at hundreds and hundreds of HVAC companies. And we love the space. And we think that it's a really promising area that can also have a lot of innovation hit from a consumer of the product standpoint. I think there's a lot of things you can do to make the

purchase of that service and equipment a lot more seamless than it is now and a lot more available. What do you mean by that? Well, so the standard is, I was joking. I think I tweeted this out the other day. I would love to have some sort of like small business callback index. When I joked about that is because if you just randomly in a city pick, let's say five HVAC service companies and you give them a call and you say, my air conditioning went out, when can you be here? The odds are that maybe one or two of them even call you back. And of the one or two, the odds, the odds, they show up on time are like virtually none. You're virtually zero.

So you like are coming into it. Anybody who's who's had work done on their home, home services of any type or office services knows this. The joke's always like you get these windows from even like the cable company that's like, we'll be there between 11 and 3 and they show up at 6 o'clock at night. They're like irritated that you're not ready for them to come hang out with you. And so I think there's there's a lot of using technology, using basic business practices.

And frankly, having a culture of caring that I think you can you can just outcompete in this area. Now, why haven't we gotten involved? That's a great question. We would love to get involved with a plumbing services, any type of home services. We, you know, we'd love that. The issue is finding a team that you can scale. These are all small businesses. So there's a reason why these businesses are small. And it's usually because they're not built to scale. And we're not in position, at least not right now, to come in and do all the work to professionalize an organization. So we've got to find an organization that we want to partner with that is at least kind of halfway to

professionalization. We like to find teams that are trying to run harder and go further, but maybe have hit the ceiling of brute force, but are trying. They're trying to have a lot of ways to scale. It's just really hard to find that. I mean, we find a lot of companies that are making a million dollars out there that when you talk to them, they're really happy with making a million dollars and look for a business owner making a million dollars a year it's a lot of money especially a lot of money in Des Moines I mean again these are the these are the chairman of the country club so it's not like that's not a great business and we're not saying it from it you know being judgmental in any way it's just it doesn't fit with where we are now we can't take a million

dollar business that's built around sort of one person's personality and do the work necessary to build out the systems and scale and recruit the talent and do all the things you need to do to scale so we've really got to find a team that's already kind of pre-built, or at least being on the way to being built. And most of the time in home services, the issue is those teams get formed around construction. So this is the really big divide in home and office services versus construction. And most of the time you think about it, the construction leads into the service. So whoever builds your house, you say, okay, well, I need the whatever service. Well, who's going to service is the person who installed it. So the install leads to

the service. But then the problem becomes you've got a construction organization, you've got a service organization that are kind of lightly bolted together. And it's so much easier in up markets to make money in the construction side, the install side, and the service side looks puny compared to it. So it gets starved of all the resources. It doesn't get the attention. There's no innovation there. And so what you have is oftentimes all the focus being on the highly cyclical, very, very large construction side. And we don't want that. We don't want that side because I think full cycle, they don't make much money. They look like they make a bunch of money. when the times are really great, and then they lose a bunch of money and you have dire times when

things go down. It's incredibly cyclical. We like those service organizations, but you can almost never find a pure service organization or a service dominant organization. And so, yeah, we've got to find a team. We've got to find a service dominant organization. And then we've got to have all the normal factors line up. And even if you find, I mean, we've found probably 50 legitimate candidates over the last maybe two or three years that are somehow in home services that have the right fit, right match, but you just can't get the deal done. You know, you got to agree on price. You got to go through all the normal stuff to do diligence. You got to, I mean, it's got to work, right? And so it's just incredibly low odds. A popular idea that I know just having talked about this space now with so many

different people, the gut instinct would be like, okay, well, why not just not just not worry about scale and just roll up a collection of one part of this stack. So roll up the million dollar earning H-FAC businesses. Don't worry about growth and scale, scale horizontally versus vertically. What do you think about that idea, that strategy of creating a roll up and sort of centralized expertise, getting really good at just one thing? I mean, it sounds great. It just doesn't work. So that's the problem. Why not?

Yeah. So what's a bigger disaster than one million dollar earning company that's built around one dominant personality, which all businesses of that type, I mean, all business internally is a disaster. It's just like a functional disaster. Almost every operator I know is just trying to go as hard as they can and just you're putting your finger in the leaks and just working your tail off all day long. And so how in the world, if you're putting your head down and you're a founder-domin an organization with very little scale, with very little structure.

How in the heck do you slam together two, three, four, five of these things and somehow standardize everything? I mean, it is like the most mind-bogglingly difficult thing. And it's been done before. There's a couple people that I know that have done it successfully. It's never actually, though, done well in the long term. So you can temporarily build an organization that looks like sort of at the 30,000 foot view that it's successful, right?

You can produce a lot of ebada. for a short period of time and then the wheels come off. I mean, you don't have the infrastructure in place. You don't have the systems. And you have a lot of people who want to do it their own way. And everyone's doing it a different way. And everyone's been doing it a different way. Trying to get everyone to do it a different way than they've been doing it.

And trying to convince them that inherently the way they've been doing it's been wrong. And, but they've been successful. It's just like just very weird psychology that gets involved. So I've never, I've never seen that done successfully for very long. And when I get into the nitty gritty, I mean, it would be wonderful. magical to take five, seven of these in, you know, big cities that are each making a million dollars and each take them to making five million dollars and slam them all together. Like, that's a home run. I don't see how functionally it actually, you could actually make it work.

So outside, we'll do one more and then go to the levers. Outside of home services, so you're excluded from that part of the world, what would be the next industry that you would focus on? So I think another area that's interesting, it's kind of along the same lines of these big macro trends. So if you look at where people are congregating, especially in sort of net population migration areas. So Florida, Arizona, this kind of sunbelt, property management companies are a pretty interesting space as a thesis. And this is something that we've looked at quite a few of these very sticky relationships. So when you have a homeowners association, you know, who runs that? You get into weird neighbor conflicts. You get into like

whose kid can go to the pool at what time and, you know, they were there afterwards and there were beer bottles left. I mean, there's a lot of like maintenance of common space in neighborhoods. And so I think that, you know, if you look at these trends, more people are congregating in neighborhoods, more people are trying to kind of form almost like little communities by themselves. And so I think HOAs and property management's a pretty interesting space. And again, it's kind of a tangent to kind of the other one. I just think that that is a macro trend. Those are such big forces that are sort of underlying everything.

And in many ways, you know, here, you know, we're recording this in New York. This is just a different world than what I swim in most of the time. And I think that a lot of times people in big cities really just don't understand how the world works outside of big cities. True story. And by the way, and the reverse is also true. I mean, I think that most people who don't live in big cities kind of look at it as like, why in the world would anybody live there? I think there's really great reasons to live in big cities and really great reasons not to. But they function like life is very different in big cities versus small towns or even outside of the major metros.

And so a lot of these trends that you'll see, am I bullish on property management services in big cities? No, but for different reasons. And I think that's where you get into the sort of the nuances of these different things, depending on what your investment style is and where you want to spend your time, I think a lot of that also dictates. So what is that difference? So why the negative relative view on management in the city versus? Yeah. Well, so it's a density issue. So when you think about property management and like how hard it is to manage a property, if it's easy to walk to, you can have one. person managing a lot more. So when you get into the logistics of property management, let's say in like a area like Phoenix, you'll have these communities that are 20 miles out into the middle of nowhere and you'll have like 1,500 homes in the middle of nowhere. And that's an incredible HOA to run. You're not going to put a full-time person there, but you're going to have like a part-time person, a lot of different people going there versus in Manhattan. You could take two city blocks and probably have a, it's completely different dynamics going on in those. So from a kind of

logistics, from a complication, from a personnel, staffing, availability of labor. It just functions very, very differently. Let's go to some of these levers. So I'm intentionally going to choose a few things that in our public market quantitative work are not all that relevant, meaning these variables are not nearly as predictive of future results or returns to investors. And obviously, this price gets tangled up in this mix and is really important. But we tend to ignore them. There's sort of blind spots for most quants because there's just not good evidence that. they matter when selecting stocks. But my guess is that they do matter to you. So the first one would be profit margins. So we can talk about gross operating net. How do you think about profit margins when

looking at a business? Is it relative to industry peers? Is it some overall picture? Does that matter in your evaluation process? It matters. I think that each one of these that we'll probably talk about is a factor that you have to consider that you want to paint a picture with that factor. So you can't look at each individual factor and say, I'm going to draw a conclusion in every situation from higher profit margins or lower profit margins, how those factors interact with one another helps tell the story of how defensible is the business and why is it defensible. And a lot of times, by the way, when you look at these, they're not defensible. The defense is basically the goodwill of the owner, the relationships of the owner. And so when we look at profit margins,

higher profit margins obviously connotes some things going on that allows for more money to be made on each transaction than you would expect on the higher. And sometimes I can just signal cyclicality. So if you think about it, a lot of these blue collar construction related building products type companies, I mean, they'll have almost no margin in downtimes when everyone's just hungry and willing to do whatever, just to keep people busy. And then in uptimes, I mean, they will just have enormous margins. Well, you can't look at top of cycle margins and say, well, that's normal.

So we're going to be able to maintain 30%. There's no way. Because then you look at the bottom and you say, wait a minute, what happened to your margins when things dip a little bit. It's like, well, we really need to keep our guys busy. We need to the work. So we're willing to do anything. So I think that you've got to look at margin compression and expansion over the life cycle of the business. You also mean even non-cyclicality trends. You'll see some businesses that the margins are just naturally compressing. When I think about this, I think of like the printing industry. So the printing business, we've looked at a ton of different

printing operations. And on the surface, they look incredibly profitable and attractive. Other than the facts, you have to constantly be dumping money back in to keep up with your competitors. And people are just getting more and more savvy about how much things cost to print and printing overseas and how you, you know, all those dynamics. So if you look at an industry, you've got continual heavy reinvestment for the latest technology, new techniques, kind of the red queen effect, if you want to call it that amongst competitors. And you have decreasing margins and decreasing margins in up times. So it's a really dangerous. I mean, I think that's an industry where we'd be happy to get into it if the right opportunity presented itself,

but we're very cautious whenever we see those types of trends. When you see a business that has quite low margins, so I would say under 10%, so let's kind of like put numbers around it. So under 10 percent being gross margins, under 10 percent gross margins, and sort of above 30 percent or above 40 percent, depending on the industry, would be very high, high margins. If you see something that has very low margins, the question you have to ask yourself is, is there a scale advantage that they have and is that there are a consistency of the work that allows that business to still earn really good returns on invested capital, but just happens to be at massive scale with low margins. So typically you get high volume, lower margin, lower volume, higher margin. It's very hard to get high volume, high margin businesses. So there's nothing wrong from our perspective with buying a business that is lower margin at high volume. There is usually some defensibility around that for some reason. Again, that doesn't tell you anything. So you can't independently, it's just one piece of information. that you kind of have to work.

How does it interact with the other co-factors? You mentioned cyclicality, and this is something that I always enjoy when we talk and you give me surprising answers. And this was one of the early surprises, you know, a year ago or a year and a half ago when we were talking about business, specifically around the pool construction business, which obviously is a hypercyclical business. And you had some interesting points about how you think about cyclicality. Most people, their neidric reaction, I think, would be to avoid hypercyclical businesses

because they're difficult. And, you know, you need to manage a cycle better. but I think you have a bit of a different viewpoint on this. So can you talk about how you think about the relative attractiveness of a hypercyclical versus a very steady business? Well, so I think cyclicality is really, really dangerous if you apply a traditional private equity model to it. So I think that's the reason why in a vacuum cyclicality is not a bad thing. Soicality is like a normal completely, it really makes sense, right? I mean, if you think about like the whole world has cyclicality in it, people's life cycles. We have seasons of weather.

cyclicality is a normal, ordinary part of life and a normal and ordinary part of the economy and businesses. So you have sort of micro cyclicality amongst a business, kind of the life cycle of a business. You can somehow sometimes avoid that cyclicality through certain techniques, but there's a sort of normal arc of a business. And then you have the economic cycles, which, by the way, affect micro-smaller businesses differently than they affect macro businesses. And then obviously the trading of the underlying equity of those is sort of an amplification of that cyclicality. So there's a lot of different sort of meta layers on top of cyclicality. But in and of itself, cyclicality is not a bad thing. It just presents different

opportunities. So if you have a non-cyclical business, yes, it's incredibly or even a counter-cyclical business, it's incredibly profitable all the time. You're just going to invite a ton of competitors. And over time, I mean, it's just going to be brutal to maintain that. In low professionalism, so you got sort of another factor is professionalism. Like what's the standard? level of professionalism amongst the businesses and what's the type of person that's naturally attracted to that type of industry. And when you pair up low professionalism, which again tends to be more blue collar, more dirty jobs, that type of stuff with high cyclicality, you get an incredible washout effect. So if you look at most construction related or highly cyclical businesses,

the turnover rate over a full cycle is astounding. You basically get very few places. You basically get very few players that endure a full cycle. And what happens is people go out of business, people join other firms, new firms are created. It's just this ongoing renewal effect that occurs. But as an owner of a business, if you plan for cyclicality, so how do you plan for cyclicality? Well, you just don't put a bunch of debt on the business. You keep a really healthy sort of under levered balance sheet. And it shouldn't surprise you when the business has a downturn. It shouldn't be like, oh, gosh, what are we going to do now? Well, we know this was coming. So what's the game plan now? So we have a game plan for when the economy down cycles. And we have an game plan for when the economy's going

great. And you've got to play the playbook on both directions. But on the down cycle, you entrench, you try to maintain, you build an organization that you try to have low operational leverage. This is an interesting from a business model perspective. You try to maintain, let me back up, in most highly cyclical businesses, there's a tendency to try to grab as much margins as you possibly can at every turn. So this means you try to vertically integrate when times are good all the way down the stack. And you can kind of get attractive multiples to do like tiny little acquisitions. You sort of buy teams to come on board. You're doing the work yourself. Now what happens when things reverse? Well, the operational leverage works against you and you go deeply into losses. And you

sort of nuke the entire organization has a sort of catastrophic effect. So we think a lot about business model in terms of how do we diversify risk, make less money in each individual year, but survive full cycles, and then be the buyer of choice in a down cycle. So you get aggressive when everyone else is getting passive or scared. And this isn't anything radical. I mean, this has been written about in sort of the public markets investing. It's just applying it to a very straightforward approach in the private market. So when we think about highly cyclical businesses, we think about under levering them. So not just not putting a lot of leverage on a actually maintaining really strong balance sheets, keeping a lot of working capital in these

businesses, which again, from an investor perspective, you're thinking to yourself, well, golly, that means I get less cash out. But no, you've got to think long term. You got to think about how these businesses are going to react when everyone else doesn't have any cash and you're sitting on cash. Well, now you can be the mosquito with the nudist colony. Sure. And go nuts. Yeah. What's your favorite example of a counter cyclical business that you've looked at? Well, like fast food is an interesting business in and of itself. Fast food has a, a, when people have less money, they tend to also be stressed out and have less time. So you have this interesting weird effect where it's like you have less time to make food. Obviously, everyone still

has to eat and you have less money to sort of eat out. So where you naturally, you get this big upending trend in the bottom end of the restaurant market. We've looked at a number of sort of fast food or fast casual chains in the past. We're not going to buy one. You know, we have a kind of a predisposition against restaurants or just brutally difficult industry. But in the lower end, in the fast food market, you can actually standardize to where it looks more like a manufacturing company than it does a food company. And I think that's where we have looked at those. We obviously haven't pulled the trigger on any of those. Yeah, fascinating. What about assets? So tangible versus intangible specifically, we've just written a lot about this. And the global trend is towards intangible assets,

more investment in intangible assets than in tangible in some cases, like in the United States, although some places like Italy still have the opposite. How do you think about that? Do you care about how asset rich or asset light the business is. My guess is that like your other answers, it all is interdependent. But any thoughts on asset light businesses or asset heavy as you think about evaluating one? Yeah, it's a great question. So the way we think about it is it tells you something about the business. So if it's very asset heavy, that means usually these assets are going to be in depletion mode and you're going to have to re-deploy capital back into the business to maintain it. It's interesting from a purchase standpoint, it does provide this weird dynamic,

though, where you have a backstop in liquidation value with a lot of these heavy asset businesses. So if I buy a business just for around numbers that has $7 million liquidation value of hard assets, and I buy it for $10 million, well, I now know that I'm really putting $3 million at risk. Now, the bad part is, let's say we're buying it for $10 million. It's doing $2 million of just roughly $2, $2.5 million of earnings, you know, maybe of EBITDA. But you're taking that $2.5 million of EBITDA and you're rolling it into a million dollars of reinvestment in the business. Well, now that looks like a pretty crappy return. So you've got this weird dynamic where you've got to look at the incremental return on invested

capital. How much is sort of just to even tread water, how much do you need to redeploy? And then you look at growth. I mean, growth in a business like that, assuming you have to maintain those type of expenditures, I mean, it's just really expensive and it drains cash to grow the business. We don't like to get into businesses like that. We'd like to get into businesses that throw off a lot of cash and have good uses, but really can't even come close to consuming all the cash that they're throwing off. And a lot of it depends on business model again. So going back to sort of the other factors, a lot of it, you know, this is where you get the interplay between profit margins, asset intensity, you know, all these different things that are sort of all the

covariance in them. And it, again, just paints a picture. So if you, if you paint a picture of a asset light, maybe sales and logistics organization in like a construction business. So this would be as an example, a contractor. So let's just take just a general contractor on, you know, multifamily housing, for instance, right, as an example. So really, if you look at the different functions of that and you sort of break it down, you've got the sales and marketing, you know, how do you work with developers? So let's say that, you know, the developers are coming to you and saying,

okay, we want to go and develop this piece of land that we have. So you've got to generate the lead. You've got to sell them on why you're the best choice. You've got to price it, all that stuff. And then your job is to functionally deliver. these housing units to them at a pre-agreed-upon price and a pre-agreed-upon time. Now, how do you do that is so much to do with the business model. So there's really two paths to take.

And there's an in-between you can take. But really, there's two dominant paths. One is the complete asset light path where you say, okay, we're going to generate that lead. We're going to sell the developer. And then we're going to sub out every bit of the work. So we're just going to do the logistics. Well, then when it throws off cash, what do you do with that cash?

Because, I mean, literally, you can't plow it back into the business. There's nowhere to put it. I mean, maybe you can open up other sales offices, but that's not going to take up most of your cash flow. So you just have all this free cash flow, which is a great problem to have. But here's the other path, which gets sexy in an up cycle. So the other path is we're going to do all the work ourselves. So we're going to have construction crews. We're going to buy concrete mixers.

We're going to do, I mean, we're doing the full deal. We'll do the rebar. We'll do the framing. We'll hire the painters. I mean, you can vertically integrate up and down the stack in 10,000 different ways. And the great part is in an up market, you make a crap ton of money. I mean, it makes, it is eye-popping. We looked at a business recently that three years ago lost $4 million in a year.

And this year will clear about $22 million in free cash flow with this business model. Very interesting. And when you think about it, it makes sense at the time because you're like, well, we want to grab more margin. We want to be able to do better. You know, we want to grow the company. But the issue is then you start getting into, well, now you've got to buy a fleet of trucks. Well, now you've got to buy all this equipment. Now you've got to buy all the special.

So what happens when the work dries up? I mean, you've got this big downside risk. But then you've also got the capital intensity dramatically increases. So maybe on that $22 million of free cash flow, you've got to take six or seven of that and plow it back into buying more stuff. Well, now you've completely altered your balance sheet. You completely altered your return on invested capital. So it's a very, it's like all these different things all interact with one another. And it's not like a straight line like you should do this or do that.

I mean, if you think the economy is going to go up for the next 10 years and you can build an empire, bring all these captives in house, yeah, it makes complete sense. If you think the economy's maybe going to cycle in the next two or three years, it's basically suicide to do that. So it's just it's all a bet on the future. And, you know, everything that comes with opportunity cost. It's really hard to look at somebody's earning stream today in a snapshot in time and understand the risk they're tolerating for that income stream. So we always try to look at it as over a full cycle, what do we anticipate? to make and at what risk tolerance are we making that. And we just frankly, the way we kind of operate is we'd rather have, if we're going to have a highly cyclical type industry, we'd rather have very low capital intensity business.

And we'd rather under lever it and not put debt on it. And sort of over time, you're just, it's really hard to harm a good entrenched, great reputation, good relationship business that's highly cyclical. If you don't put a bunch of debt on it and you don't have a highly levered balance sheet, it's just, I mean, it's just almost impossible. Another really interesting input that I don't think you and I have ever talked about, but it's an interesting one in the context of kind of where we are in the cycle and what's gone on in the country, which is labor costs and wage inflation. So everyone knows that's kind of read the history that for a very long time, adjusted for inflation, wages really haven't gone anywhere.

And I think there are early indications that that is changing, that there is wage inflation, labor is more expensive, unemployment at, you know, extreme lows in like every category that you look at. How do you think about that as an input? on the cost side of a business and is something you think about when kind of underwriting the future of some of the companies that you're looking at. The first thing we think about is transfer pricing power. So we always want to understand things are going to change. Inputs are always going to change.

So the price of commodities are always going to change, whatever the inputs are in that business. And obviously labor and the availability of skilled labor is an input into the business. The first question we want to ask is, how immune are we to changes and fluctuations in that? So when it goes down, do our customers, demand that we pass that savings along to them. And when it goes up, are we able easily to pass that along to them? Or do we have to eat it both ways? Meaning sometimes it's great. If we think that the input costs are going to dramatically go down over time and our customers are not going to know

the difference, of course, like, that's a beautiful scenario. Your margins are just dramatically expanding and sort of natural tailwind. That doesn't usually happen. So like usually where you get it is on the other end of things, which is, you know, you get a lot of demand for labor. I think that especially in unattractive, like sort of surface level unattractive, things that don't make you impressive at a bar. We see these, we see those trades really trending older and there's just not a lot of new entrance into, you know, commercial painting business as an example. If you hire a commercial painting company, the person who's going to show up or the team that's going to show up to actually do the painting is going to be older. There's just not a lot of young talent flooding into and saying,

you know, I could go do X, Y, or Z, and I'm going to choose to be a commercial painter. Usually people back into it through sort of a family trade or a relationship or, frankly, because they have no other choice. And then they fall into this and they say, well, holy cow, I can make a lot more money being a commercial painter than I could being a social media manager, right? I mean, you know, as an example, right? But being a social media manager is more impressive. Maybe it's more impressive, I don't know, at a bar.

I haven't been to a bar in probably a long time. But you know what I'm saying, like when you tell somebody at a bar that you're, you know, I'm a painter. It just kind of ends there. Yeah, you kind of connotes like, okay, well, it's not somebody who's going to be somebody I'm super excited about talking to. There's a lot of signaling going on. We do see the single biggest challenge that we see every single business in anything in the trades is just labor. Availability of skilled labor, skilled labor, trained skilled labor.

And it is so hard to compete. There's just not enough people out there. And so you have firms doing all kinds of crazy, like signing bonuses. you have like trying to do basically aqua hires in in that area of the market some really like nutty stuff that's going on and some of it being able to be passed along to the customers. I mean, if you're building a building and everyone's telling you it's going to be X, like you have just have no choice. Your choices did not build the building, right? And so you see this as it is trickling through. But I think from an owner of a business standpoint, we always just want to know what are the

inputs and how much can we pass that along in terms of price increases through to the customers. Why do you like pet crematorium so much? This is coming from our Omaha hangout. I think somebody asked me, they were like, what's the single best business you've ever seen? And I said, I don't know, pet crematoriums are really up there. I mean, the short version is you need a storefront in an oven. And the longer answer is you have some major psychology that comes with it where

anytime you deal with a wedding or a funeral, like the price of anything, like a flowers, like flower arrangement, it basically like triples. And you're running a pet crematorium, the whole pit crematorium. the whole pitch is this pet's been a part of your life for 10, 12 years and your kids grew up with the pet, are you really just going to bury fluffy out back? You're not going to have any closure. Your kids are going to be screwed up for life. You're going to be paying for it in psychology, your psychiatry. No, I mean, you can get people and then obviously the upsell and then you get into these strange dynamics where if you, do you care that your lifelong pet gets put in the oven

with five other pets or do you want the oven to only fire your pet? Do you want mixed ashes or not mixed ashes. Do you, I mean, do you know the alternative is? One of these places that we talked to at one point said, you know, what happens to at veterinarians? Like it varies. But like a 110 pound dog, like you have to do something with that. And so, you know, there's only so many things you can do with that dog and none of them are pretty. And so, you know, there's a lot of like closure, cleanliness. So margins are enormous. And the startup costs are a storefront and oven. Pretty amazing how many ways there are to make money. I love it. I love it. Yeah. Yeah. Yeah. That's my favorite part of my job is we get to see the most interesting business models and just really interesting people that we get to work with.

So let's talk a little bit about briefly the history of the permanent equity fund itself and sort of the early advantages that you're seeing changing from really just doing what you do with your own capital to having a significantly larger committed pool of equity capital. I'm always interested by how that affects everything else that you do. And it's something that's obviously relevant for anyone out there that's beginning something on their own and potentially scaling that up. So maybe from your perspective, tell kind of the story and your thinking around moving from one to the other and sort of the early observations or returns on that decision. So I think to maybe start at the end first, the big difference we've seen is access to people.

We have some incredible investors. I mean, obviously you and your family are one of them in full disclosure. We brought on just an all-star cast of investors that are just like I was terrified to be completely honest. I mean, maybe I shouldn't be telling you this at this point. But I mean, I think even at one point you talked me off the ledge. I remember more than one point. Yeah, probably more than once. I was like, I can't do this. I don't want to do this. I'm terrified that I'm going to be dealing with, you know, sort of a pool of investors that are hassling me all the time and second guessing and all the stuff. And honestly, I have found it so far. I mean, it's only, we closed in December, right?

It hasn't been that long. But it's been a wonderful value. to be able to call incredibly smart, thoughtful people who have a vested interest in my success and say, hey, I want to run something by you. This may sound a little nutty. I think you probably get one of those calls for me about, you know, a week, probably one a week or at least once every two weeks. And you're always like, sure, let's hop on the phone and chat about it. And having that has been unexpectedly positive, I would say. But that all depends on who you can get to invest. I mean, I think we had a selection bias. You know, when you're starting pitches, plan on never getting your capital back. You're going to attract a.

an unusual type of person who thinks in a different way than the norm. But that's been great. I think the other really big advantage that we didn't anticipate is what it means to be able to write a very large equity check for a relatively small-sized business. So we are one of the only, I mean, when I say one of the only, we might be the only person operating in our area, group in our area of the market that can write a $20 million equity check on a smaller business. We have just so much more flexibility in how we can structure deals.

And it's just all about what is the seller need and what's optimal for them. I mean, when we think about adventures, we think about it as we have a client. And no offense, Patrick, you're not the client, right? Our LPs, our investors are not the client, right? The investors will benefit from this. But the client is the seller. We think about everything from the seller's eyes. How do we optimize for them contacting us?

because almost all of our deal flow, virtually all of our deal flows inbound at this point. So we want to optimize for getting a selection bias on that side. We want to repel the wrong people and attract the right people. We optimize the negotiation process for the sellers. We do a lot of things that inconvenience us that is great for the seller. We do a lot of things in due diligence very differently than how a traditional private equity firm does due diligence. And a lot to wrap back to the fund, a lot of the fund documents express that. And when we talk about the flexibility that we have to be able to do what we do.

And so we optimize everything from a seller's perspective. And so when we look at a seller who I'm on a site visit in New York right now, that's why we're getting together. I'm flying to D.C. later today doing another site visit and then flying to Louisville, Kentucky and doing another site visit after that. I mean, we are always looking at it as how do we make things work really, really well for the sellers? And money it closes and structures a big part of that. These are businesses that by definition if they've survived 20, 30, 40 years, or maybe one of the deals we're working on now has been around for 110 years. These are companies that don't carry leverage. They just don't, like functionally, they just don't carry debt.

Everything's paid for in cash. And so you take a company that has that in their DNA and everyone else is telling them, well, we're going to buy you. We're going to lever you up. We're going to go through this like almost immediate sale process, all that. That's what everyone else is doing. Or we come to them, we say, we're not going to do preferred equity. we're not going to put senior debt and mezz debt and we're not going to go and flip you. We're going to create one asset class or one equity class.

We're going to pay you all cash in equity. We're going to have a seller note for part of it, but you carry, keep things incredibly simple. And they're like, oh, well, this feels like a family is buying the business, not a fund. And it's like, yes. Like we are functionally able to provide capital that is family capital. And then all of our capital providers, all of our LPs are families, right? I mean, there's no institutional investors. that's probably a whole separate reason why both selected on our side and on their side.

But it just allows us to have much greater flexibility and do whatever's in the best interest of the seller, which then in turn is in our best interest. One of the most interesting things I learned through the process and thinking through this with you is just the return on flexibility. So the same customization, I guess, that you're willing to do for your sellers to make their lives easier, that goes up the stack. And so if you were investing out of a two and 20, 10 year life, five year investment period, you know, X-year harvest, private equity fund, that neuters the advantage that you have

with the seller. And so just this importance, increasing importance, I think, in capital markets to think about structure differently as a huge advantage. But also, I mean, we could both tell long stories about the inertia is difficult to overcome. So when you bring a new structure to investors, like, it's an arduous process. Like that's probably the thing I learned most in that process. Yeah, the process, I don't know. I don't know what I expected because I'd never done it before. I think, you know, there's always a

bias that anything you haven't done before seems easier than it's, you know, going to be. Right. Even if you assume it's going to be harder than you think it initially will. It's always harder than you even think it could be hard. And I think one of the unexpected things about raising the capital was just that we were doing something different. And anytime you're doing something different, the only people that can participate are people that don't have career risk. Yep. So anytime you introduce the factor of career risk into the decision making process, you have to do the norm. Because it's a divergent system. So if you, if you invest in a divergent system or you participate, you know, sort of even outside of investing, and it goes wrong, you have massive downside risk for your career personally, separate from the organization. It could be the right,

right decision. So we're going to assume it was the right decision. It was probabilistically a great bet, but it goes wrong and it looks different. You could get fired. If it goes right, you sort of don't have enough upside career wise personally. And so this is, you know, principal agent problem. And I We experienced that, you know, when you and I went and talked to some of these, whether it's endowments or even even larger family offices where they're quote unquote professionalized. Sort of an intermediary layer, professional interior. Yeah. As soon as you add a professional layer, it really just became immediately unpalatable. Just the whole structure, they're like, well, I have so many like reasons why I can argue that you shouldn't do this. And if you come out of from that perspective, you're always going to find a reason not to do something. And so I think literally, I'm trying to, I'm trying to go through the. investor list, literally the only people that invested, the 50 million, is all from people who are the decision makers and hold the capital. So there's no career risk to them. How do you think looking forward that this will continue to scale? So you mentioned the advantages of having this pool of

capital kind of being the only one without the traditional PE structure, but this amount of capital to deploy into these family-owned businesses. Let's say we're five years down the road or two years down the road and that capital is depleted. Do you think, and this is something we've talked, a tremendous amount about that this continues to scale better horizontally or vertically. Have you given any future thought to that idea? Yeah. So the plan is to continue to scale horizontally. So when we say horizontally and vertically, we probably need to define it. Right. There's basically two ways to grow an investment firm. You either start doing bigger and bigger deals as you accumulate capital and hopefully generate great returns. And that's sort of what Berkshire did. I mean, if you want to look

at them as being the clearest example, they did smaller deals and they did bigger deals and then they do mega deals. And now, I mean, I think that Berkshire can't even probably do a deal. And under $2 billion now. It probably doesn't even like move the needle. I mean, they got with 100 billion or 110 billion in cash on hand. So it's that anchor that, that unfortunately, you got to drag behind you. And I think the only alternative to that is you go wide instead of go sort of deep or, you know, go tall, depending on what way you want to look at it. And that's to continue to scale out and buy lots of lots of companies as opposed to doing bigger deals. And so you deploy, instead of, you know, right now, Adventures is set up to maybe do two to three deals a year. In five years, hopefully we're

going to do 10 deals a year. That's arbitrary. Maybe it's six. Maybe it's 15. I have no idea. Obviously, it depends on everything starts with opportunities. So, you know, the way I think about building adventures and the way we talk about as a team is we want to have the highest opportunity costs in the world and continue to build the opportunity costs at every turn. So we, I don't think we're great investors from a like a like, like we're not great at slicing and dicing. We're not great at, you know, making really tough decisions. Like we just want no brainers. And, and we want to decide between really good opportunities and great opportunities. And if we, you know, the only way to get those types of opportunities is to have a ton of opportunities you look at and have good filtering

mechanisms and selection bias that are all positively set up in your direction. So continue to scale out means doing more deals of similar size. We will from time to time have deals. We have a deal right now that's a $17, $18 million earning company that's a private company, family owned, and we're just the right cultural fit for them. And so they're, you know, they're coming directly to us and saying, look, we want to talk about this. We know we're a little bit on the big end for you all. And, and, but, you know, could we figure out how to create a permanent equity structure around the sale of, of a portion of the company? They want to, you know, hold back. The family wants to hold back some of it and kind of continue on for the ride, but wants to take some chips off the table.

I mean, if you've got, I mean, that's a lot of money. It's a lot of cash flow, but it's also a lot of equity. If all your assets are tied up in that company, I mean, there's a real, a real fear, right, a concentration risk. And so, you know, the issue is right now, outside of us and maybe a handful of other investors, there's really just not a good mechanism to be able to liquidate part of a company and keep the same culture, keep the sort of family attitude. And so, yeah, we will go up market. You know, we probably, unless it's bolt-ons, won't go down market. We really like kind of moving forward in that kind of three to seven, three to eight million in pre-tax earnings. And then we'll go up from there opportunistically.

But we're not going to just move up into bigger and bigger deals as we, as we have more capital just to, because we got to deploy it. I mean, one of the things that we told our investors was, you know, we may do five deals in one year or one deal in five years. And you got to be okay with that. And most people aren't. But that's, I mean, we're just, if we have, if we have, have the right deals at the right time. We want to do them. If we don't have the right deals, and it's not the right time, we're not going to do them. It's just that simple. Hey, everyone. Patrick here again. To find more episodes of InvestorFieldguide.com, forward slash podcast. If you're a book lover, you can also sign up for my book club at

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