Invest Like the Best with Patrick O'Shaughnessy - Trish and James Higgins of Chenmark Capital - Permanent Equity - [Invest Like the Best, EP.28]

Episode Date: March 14, 2017

My guests this week are Trish and James Higgins, who run Chenmark Capital Management.  In this episode we continue to explore a style of investing I call Permanent Equity.  Returns in permanent equity come first from the ongoing cash flows of portfolio companies, not from reselling businesses down the line.  The partners are Chenmark are pioneering this style of small business investing and share their experience with us thus far.   For comprehensive show notes on this episode go to http://investorfieldguide.com/chenmark 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 podcast is sponsored by CFA Institute, the Global Association of Investment Professionals whose mission is to lead the investment profession by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society. CFA Institute serves a global community of investment professionals working to build an investment industry where investors' interests come first, financial markets function at their best, and economies grow. The chartered financial analyst credential is the most respected and recognized investment management designation in the world.

The views expressed in this podcast do not necessarily represent the views of CFA Institute. 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 a principal and portfolio manager at O'Shaunacy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of Oshamacy Asset Management.

This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Oshonnessy Asset Management may maintain positions in the securities discussed in this podcast. My guests this week are Trish and James Higgins, who along with James's brother Palmer, run Chenmark Capital. If you've enjoyed episodes with Brent B. Shore, you will love this episode because we continue to explore the style of investing that I call permanent equity. Returns and permanent equity come first from the ongoing cash flows from portfolio companies, not from reselling businesses three to five years down the line. The partners at Chenmark are pioneering this style of small business investing and share their experience with us thus far. These are exactly the kind of people I am lucky to

meet as a result of this podcast. They live and operate in Portland, Maine, not New York City. They are grinders who publish their lessons weekly in a newsletter that you should subscribe to. They describe an investing landscape that is very different than the one I am used to. This style of investing continues to have a romantic sort of appeal, but like Brent, Trish and James are quick to tell us that this life is anything but glamorous. It is hard, often stressful work, but work that is ultimately rewarding at both the personal and portfolio level. I doubt this investing trend is going away.

In fact, it is probably just getting started, and we should all take notice. I will continue to find people who can help us all understand the category. of permanent equity. You can find show notes for this episode at investorfieldguide.com forward slash Chenmark, C-H-E-N-M-A-R-K, and one last note. The name Chenmark itself is a play on question mark and is meant to serve as a reminder to plunge into the unknown. A great name and a great conversation. Please enjoy my talk with Trish and James Higgins. I thought a fun place to start would be to maybe pick one of the three businesses, assuming there are still three. walk through the process sort of soup to nuts because what's fascinating to me about this.

So this category now keeps coming up. And I'm calling it permanent equity for lack of a better, for lack of a better term, just to be able to use a term consistently. And I think what people appreciate the least, because they've never had to do it, is how difficult the actual process can be. So I'll leave it to you to pick one and kind of walk through the process. I'll pick the first one because that's the one we were the worst at and had the most learning. associated with it. But when we decided that we wanted to find a small business to buy, we didn't really know what we were doing. So we just went on to Google and we're like, how do I buy a small business? And a bunch of websites come up that are most like pizza realistings

and bars and things like that. And it took us a little while of like sifting through those things and different websites to figure out which ones made sense, which ones didn't. And when we first started, we were very informal. So we were like using our Gmail addresses to reach out to people. But then as we kind of got our sea legs under us, we started to realize, you know, there are more reputable brokers. Generally, the first prospectus or company you sort of see a listing for is generally not a good one. But if after a little bit of time, if you develop relationships with different brokers and tell them what you're looking for and that you're actually serious, that eventually they start calling you and saying, hey, I just got this. It fits your criteria. Do you want to take a look?

And so that's how we found our first company, which was Seabree's. We had looked at a company with the great branding of, I think it was like, Mark's lawn care and snow removal company in a different part of the country. That one didn't work out at all. But the broker for that business, who's based in Texas, called us and said, hey, I've got this company in Maine. Do you want to take a look? So that's how we first found out about the company. Did you move to Maine as a result of that find, or were you already? there. So a little bit of both, to be honest with you. There was definitely a part of us that

sort of valued being close to wherever the first investment happened to be. We thought that it was important for a variety of reasons. So certainly that played in Norr thinking, and we can get into a little bit later on in the conversation about how that plays with sort of your emotions when you're looking at which target to acquire. So there were definitely moments there when we thought we were moving to Reno, we were moving to Charleston when, you know, and so that's definitely a factor that needs to be managed. But, you know, ultimately it was a personal decision. We actually did move there and sort of completed buying a condo, sort of moving everything before the deal even closed. And largely that was due to the fact that we were living in Connecticut at the time. And

we were in Portland sort of every other week for six months, thankfully in the summertime. And it just got harder and harder to get back on 95 and head south. So we felt like home, so made the move. So walk me through the process of kind of first seeing what the business looked like very specifically. So what are you looking at it? Is it a brief? Is it a information memorandum? Is it a spreadsheet with projections and trailing numbers? What is the first raw material that you're dealing with to start to evaluate this business in particular? But I also want to talk more broadly about businesses of this size for people that are kind of in this permanent equity category. To be very tangible, the first thing we got was just a one page teaser that's

like commercial property company and like some very brief stats. And basically that's it. You sign an NDA with the broker and then they'll send you a prospectus or SIM or whatever you want to call it. Those range in quality from upside down PDFs of the QuickBooks reports for the past couple years to 50 page more sort of professional outlines of the industry and the company and what you're looking for. So the one for CBRES came and if I recall it was one of the sort of nicer ones. It had maybe like 40 pages of information about the space. And that's what we had to go off of. And the things that caught our eye were an industry that we thought would be around for a long time. So landscaping and snow removal will probably continue to be a thing. High percent of revenue was contracted. So

anywhere from one to five-year contracts with commercial property owners throughout the area. So we felt that there was a pretty solid base to the company that would continue on. At the time, since it was our first acquisition, we really wanted owners to stay on through the transition. And this had two brothers who were looking to stay on sort of for an extended retirement transition plan. And that made us feel more comfortable because we didn't want to be the people operating the company on a day-to-day basis. So as you're acquiring the business and thinking about, one, the right price to pay, but two, the potential for growth. And those really being the two key drivers of how successful this is going to be. to be. For that first one, how did you balance those two things? So having, whether it being your first

experience paying price, you know, multiple X, Y, or Z, how did you think about that? And that could be related to your career prior to that, or I'd love to hear kind of what the lens was. And then how did you balance that with the potential for growth? With respect to the multiple, when we first got involved in this, the, the, we really got involved in it primarily from an investment perspective, really sort of top down. And that's largely due to our backgrounds in hedge fund investing, but on sort of a macro side, where you're looking at sort of broad trends

and trying to capitalize on them. So, and we all sort of tumbled onto the concept of small business investing from slightly different perspectives, but in general we all sort of triangulated on this core sort of back of the envelope thesis that, hey, you know, multiples in this space are much lower than comps associated with larger LBOs, larger public equities, that sort of a thing. So, you know, and you're waking up and saying, hey, I can buy this company for four times. You know, that means if I can make sure the ship stays more or less straight, I'm earning 25% on my money.

Now, theory is very different than practice, and we can get into sort of all the hurdles along the way to realizing that return. But conceptually, that's really what hooked us to begin with. And then the process from there was really a progressive, attempt on our part to try to break the thesis. And I think what happened was, in some respects, the idea became more compelling because the things we thought were going to be wrong weren't, and the things that were wrong were things that we actually enjoyed working on. So it ended up being kind of the work associated with earning that excess return was something that we found very exciting. Can you flesh those two categories out a bit more? So maybe starting

with the things that you thought would be the hiccups that turned out to be things you enjoyed? Yeah, so the, I mean, primarily, the businesses are small and everything you read about and anything you can kind of hypothesize about what it's like being involved in a small business, it's hard. And people wear lots of different hats and it takes a lot of energy and perseverance to sort of continually put one foot in front of the other. And sometimes the progress is substantial and sometimes it's very fleeting. And the other thing I think is that you are volunteering to have a very direct impact on a lot of people's lives in a way that I think, we found very different than our time in sort of more traditional investing where you're sort of looking at numbers tick up and down on the screen. Pursion buttons.

More less. Which isn't to say that that isn't extremely intellectually rewarding and fulfilling. It's just different. And I think that we went in sort of knowing that that was going, there was going to be a huge interpersonal element to what we were doing. And I think the reality was just sort of to a greater extent or a larger extreme than we we even conceived of initially. But I think the other, on the flip side, we've all found that.

that extraordinarily personally fulfilling. And so, you know, I think when we, I think when we first spoke, and we talk all the time about, you kind of break down, all right, why are sort of the back of the envelope returns at the level that they're at relative to a risk-free rate, an inflation premium, a credit premium, you know, whatever you want to layer on top? And our contention would be that, you know, if you go upmarket, you're sort of harnessing an illiquidity premium, you know, if associated with sort of larger private equity type folks. But when you go down market, I think there's a, there's a premium associated with rolling up your sleeves and getting in the weeds and sort of making something happen. And I think that process is something that we

really enjoyed. What were the things that you expected to be the difficulties that weren't actually there? Well, I'd say, I'd take that in two parts. One are, you know, we came in with these grand sort of strategies and I had a really good PowerPoint presentation of all of the things we were going to do in the first like six months. And part of that was like really streamlining the technology and creating our own or implementing an ERP system. And it was going to be amazing. And then we showed up in the first day and like the internet doesn't even work. And it turns out that like people barely use email like at all to communicate. So at first, you know, we had to come back and say, okay, like the actually like what we actually need to do now is not this like high

level sort of operational improvements across the board what we actually do is go back to basics and say you know do we actually have a server and do we actually have you know like on the technology side do we actually have an org chart which surprisingly is not a concept that a lot of people really grasp or sufficient space in the email client so what we were finding was that we were signed up with an email client that didn't have capacity for each individual account So we were getting emails from clients that were getting lost in the host server and weren't downloading onto the biz dev people's phones or computers or whatever.

So similarly, our contract with Time Warner had been on auto-renew for several years. So as a result, we were signed up for a bandwidth that was below their lowest tier currently. And people were wondering why periodically the Internet would just stop working. We had to lower our expectations for what we actually had to do. in the companies. And then I'd say, so that was surprise, one, there's a long list of examples in that realm. And then I'd say, at least for me, a big round was sort of the HR side. I think that when, as soon as you're involved in a small business and you actually start to like interact with everybody, you realize that, you know, managing people becomes incredibly important. So, you know, a lot of the

people running the companies, even though sometimes they can have, you know, perhaps gruff exterior, I think are sometimes potentially even more emotional than they let on. And I think there ended up being, or there is a lot more attention to detail that has to go into sort of managing the relationship with the people in the small business, then we probably thought there would have to be. You guys both have a career prior to Chenmark in the more institutional traditional asset management space. So you know that the first question every manager gets asked is, what's your edge? And how is that sustained? How might that persist? And can it persist with any sort of scalability? I am increasingly struck by the fact that it's these little things that don't scale that maybe provide the most permanent edge, but of course also limit the scalability of the strategy. So as you think about Chenmark as a business, now with three portfolio companies and constantly looking at more, how do you think about that balance between how big you might want this to be, if you even, I don't want to assume you do want it to be big. And how far removed from your current universe or size companies could you get and have what you're doing thus far still be an edge where you can earn, you know, outsize returns? We may have all different answers to this. But my answer would be, I think our edge is it involves at least a willingness to listen on a number of different levels. So, you know, one thing we didn't quite get into when we were talking about sort of the deal process and sort of going from that initial teaser to,

a letter of intent or a transaction or closing or what have you, there's a lot of trust that needs to get built up there between ourselves as a buyer and any potential seller. And just the nature of the deal process is going to naturally stress that trust at periodic intervals along the way. Also, different sellers want different things and different people who have essentially built their life's work into some business from potentially even their teenage years to when they're seeking an exit strategy, when they're 50s, 60, 70s, what have you, have a very wide range of motivations when they get there. There can be folks who really don't, as long as they feel like they're getting a fair shake

from a valuation perspective, they care much more about their brand or their people or sort of the standing of how their customers perceive the transition. On the other hand, you can get people who care very much about valuation and care a bit less about some of those other factors. So I think when you are trained in a sort of traditional financial way and there's a lot more clarity of information, a lot of times that negotiation ends up skewing toward the financial and the transactional in a way that's very different in a way that's different than what we see in our space. So as a result, I think one of the biggest things that we can do is take some of that training, but then be willing to spend two or three hours and someone's living room talking to them about their hopes and their dreams and what they care about and sort of how they got to that point. And we've heard from sellers that that differentiates us.

Now, to your point about scalability, you're right. I think that like you end up in a spot where you're willing to do that for a variety of reasons that are probably unique to each individual person. I do think though that that's a cultural thing and can be built if you're stressing the right things internally. Do you have a, let's call it a vision for the future of the firm or are you more oriented towards let's continue to be immersed in this stream, not only of deal flow that sounds like it improves kind of compounds on itself and the sources of that deal flow, but also the hands-on very rewarding experience. So are you more focused on that or do you also kind of step back sometimes and say, well, wait a minute, this could be a much more, a much bigger firm,

a much more widespread trend, which is what I'm seeing. To answer your question directly, I think we're more than, even though we came at it from an investing side, I think what's evolved over the last, call it two or three years, is a much more sort of mission-driven firm. And the reason I say that is I think we sort of see ourselves as sitting or ideally sitting at the intersection of kind of three different groups. So one is sort of providers of investment capital, and that could be ourselves, but it could be others as well. The other are sort of the sellers we just talked about who are looking for an exit but on sort of their terms and sort of terms meaning sort of the broad scope of that word, not sort of their valuation terms necessarily. And then the third would be sort of executive slash entrepreneurial talent. And some of that's us. Some of that are folks who are able to identify in the companies themselves. And I think some of it are people that were able to source externally who, at least we think there's actually sort of this nascent,

sort of preference shift away from sort of a large corporate environment to a sort of smaller environment where there's a sort of tangible, authentic opportunity to have a direct impact on people, be they internal as employees, external, as customers, or sort of on a community at large. And so when we think about scaling the firm, we think about it in those terms, and we think sort of our success is ultimately our ability to continue to create opportunity for those three networks to intercept with one another? I'd say that I think that we've been very fortunate to have observed the actual people who build large firms.

And so for us, there's something tangible and sort of real to the notion that one person could build a large firm. And that's just from personal experience being sort of able to see some of those people and how they do it. And so for that, I think the idea of making Chenmark big isn't, doesn't sound crazy to us. So from the very beginning, we've said, hey, we think there's a

big opportunity here. We don't think a lot of other people are doing much about it. And we have always thought that there could be great value to a diversified portfolio of small businesses. That is focused on long-term operational improvement. And so from, you know, day one, that has been our goal. Of course, that started off with us buying a landscape snow removal. company in Maine and everybody was like you're quitting a QR to run a snowplow you know and so our we I'd say that we understand that it comes sort of one step at a time and that it's one acquisition at a time but until we don't we're we're pretty disciplined about valuation and disciplined about looking at companies that fit with our what we perceive to be long term in sort of enduring in nature and

And until we stop seeing those opportunities, we're going to continue to try to take advantage of them. Because if we don't do it, someone else will and why not us? There are probably, you probably know them if they exist, but there are probably not many people that have the sort of traditional formal training in finance and investing that then go to the direction that you have. So I'm curious what talents or skill sets or lessons from your prior careers. And maybe you could, we didn't do this at the beginning, because I should have, sorry. But maybe you could just give a 30 second kind of summary of your careers prior to Chenmark. But then more interestingly, what aspects or lessons from those careers have you seen most applicable or useful in approaching much smaller businesses? Yeah.

So it's a little different for all of us. And James's brother Palmer works with us as well. And his experience is a bit different. But I started off directly in the hedge fund business. I worked at a firm called Protege Partners. I was fortunate enough to have Ted as one of my first bosses, as well as a great guy named Scott Bessent, who is sort of a global macro investor.

And went from there to business school and then went to work at AQR. And I'd say that James worked also for Scott for a period of time at protege. And I'd say that from that perspective, one of his big things when it came to portfolio management was that you earn the right to take risk. And...

I took my comment. Sorry. Well, we are married. So, and that manifests itself in different ways when you're managing an actual liquid portfolio. But when we think about building Chenmark, that's something that we really took to heart because we see a lot of different opportunities. But we have a very long-term vision when it comes to building Chenmark, and we all expect that it's the last job we'll ever have. And as a result, if we are spending the next 10 years building a portfolio, of really sort of solid small businesses, then, you know, maybe in 10 years we can afford to take

more risk once we've built up the base and maybe get into things that are maybe a bit more cyclical in nature or earlier stage or things like that. But we decided that for basically the first 10 years of Chenmark, we are earning the right to take risk. And so we're trying to prove ourselves. So that's lesson one. The other big lesson, I'd say, comes from seeing AQR. And I worked for David Cabiller, who is one of the founders there, and seeing him and what he's done in terms of actually building the business of AQR had a huge impact on me because he's all about, and AQR is all about diversification, not just from a portfolio, sort of like liquid portfolio sense, but also just from like the business, which I'm sure you know. And for us, that's why we have a strong bias towards building a portfolio of these businesses, because anyone is in inherently risky. It is also, so building a portfolio of those sort of helps us sleep better at night, but also from a sort of correlation and portfolio theory perspective, we can see how like the return stream from, again, landscaping in Maine is very different from the return stream of like the S&P.

And so as part of a sort of broader asset allocation theory, we think that, you know, could it be $10 billion? No, but could it be big enough to have a meaningful sort of impact on providing sort of uncorrelated return stream to people, yes. So at least for me, those are the two big lessons from our sort of pre-chenmark days that we've been able to apply and are pretty core tenets to how we're thinking about it. I'd really echo that. And I think it's just, it's not, sort of talking about it in these terms is interesting because it's funny how applicable a lot of the kind of basic rules of risk and portfolio management that have, you know, applied to a completely different setting are actually very relevant.

And that can extend even into the companies themselves when you're thinking about how to allocate capital, you know, and it's not allocating capital to a certain publicly traded equity, but it's allocating capital to new mower technology or what the ROI necessarily is on an ERP system and that kind of a thing. So I think that's, that piece of it's very relevant. On the flip side, and I think this is worth talking about, again, very classically trained, I went and got a CFA and did all the sort of studious book stuff. And if you want to understand how the three financial statements flow together and work, spend two weeks trying to manage the cash flow position of a small business.

And you got it. In accounting class, I always was like the cash flow statement. Like, who looks at the cash flow statement? Like, whatever. And then, like, three weeks into actually owning a business, I was like, oh, like, that's why it matters. Yeah, so it works both ways. I think it's not just, you know, all this, you know, super sophisticated training that then you dump into the small business. I think, you know, getting back to an edge, I think a healthy respect for the entrepreneurial talent and really just the intestinal fortitude associated with building a business from nothing with limited resources and sort of all that kind of stuff is extremely, extremely impressive.

And I think we do ourselves a disservice to assume that our training is, better, it just is different. Yeah. Let's get back into the actual search process, which is, of course, the bread and butter of your success alongside how you manage the businesses after buying them. You mentioned a couple interesting things, very specifically the idea of the first landscaping business having contracts that were relatively long to provide sort of a de-risking of your investment, especially at something like a four times multiple. What are some of the variables that you, as you've looked at thousands, I'm assuming, of businesses now, or considered thousands of businesses, have started to stand out little things like that that provide you with comfort to go to the next

level. So go from the one-page memorandum to devote your time to do the next level of diligence. The biggest thing that we talk about, or that we think is important, is identifying and being very clear about the question you're trying to answer via your investment. And I think that when you think about more traditional private equity, the nature of that business and the time frame associated with, it means that when you're getting into an opportunity, a decent part of your calculus involves, sort of asking yourself the question, all right, so what are the growth prospects for this company over a three to five year time horizon? So how much can that valuation increase over in a short window? For us, we've been very clear from pretty much day one that

the question we are trying to answer is entirely related to the durability of the franchise. So how confident can we be that the business, the product that it produces, the service it provides, et cetera, will be around in 15 years, 20 years, what have you. And so that's really our, other than size, that's really our biggest filter. And, you know, that can manifest itself in a few different ways. But sort of contracted revenue for a service that's sort of a basic need for, for a number of companies is something that sort of easily passes that first test. What are the other two businesses in the portfolio today?

So the second acquisition we did was a frozen dough manufacturer up in Western Canada. You're from Canada, right? I am from Canada. Yep. So that company basically makes frozen dough that is sold into grocery chains across Western Canada. A lot of grocery stores that you go into about half of them, even though it says freshly baked, it's actually, well, it is technically freshly baked, but it's actually, it is technically freshly baked, but it's shipped there and then frozen and then baked.

So they make like hamburger buns and rolls and all, you know, jalapeno cheddar poppers or whatever. And so, and that company's been around for 15 plus years, sort of steadily grew over time, started by a local baker who just thought, you know, maybe I could make something more in this side of the business. And so that company doesn't have contracts, but it has a pretty defensible position because, one,

there aren't any other people providing their product in Western Canada that are not owned by competitors of grocery stores. So there are some that don't, unless they want to buy from a competitor, are going to buy from this company. Also, it happens to be, if I put my Canadian hat on, only a couple of kilometers away from... I spend like 20% of my time in Canada, so I appreciate it. Yeah, a couple kilometers away from the largest flour wheat producer as they're very. your supplier and they back on to their largest distributor. So just from a geographic standpoint, it makes a difference for margins. So they have far, far above industry norms for their margins because of that.

Before we get, it just reminds me of a great piece that you guys put out about bait shops and the importance of location and geography. This is something that keeps coming up in this small business arena of moat or geography as a component of a moat. So I would love if you could flesh out that bait shop example and kind of the implications for it and why you use that as an example. Going all the way back to the beginning of the conversation, when you asked about growth and growth prospects, to be honest, that isn't necessarily a huge component of our analysis, at least in the beginning. And the reason for that is largely due to this bait shop concept where, and to be fair, this is this is borrow. This is something I read.

But conceptually, the thesis is, look, if there's a bait shop that's at the end of a dirt road in front of a very popular fishing spot, it's likely that that type of a business, even though it's not particularly differentiated in the context of all businesses out there, can earn above-market returns because it's kind of the only game in town. Now, it also means that there's not necessarily a lot of reinvestment opportunity. So, you know, if you own it, you're maybe earning a yield, but you're not necessarily compounding wealth over time because you're going to have to pull the money out and do something else with it. So, you know, a lot of, so a lot of our initial thought was, well, we can buy,

these things have interesting sort of niches that they define for themselves. They earn high returns on investment. Can we then build a portfolio of them and then essentially use free cash to buy the next one and on and on it goes? But your, your reinvestment opportunity is the fact that there's just a lot of these types of things out there if you're willing to turn over enough stones and look. We still very much believe in that. But I think what's interesting, interesting is that there's just a lot of room under the giant companies that you hear about. And so I think what's happened over the last two years, two or three years, is that the thesis has evolved somewhat where we're still looking for those bait shops, but we're finding is that

those quote-unquote bait shops actually have some reinvestment potential in them. And there's an opportunity maybe to move from local to regional. And that can represent an even higher return on capital if done prudently. The other thing that I'd add is that we're all about our network and bringing on people who are better than us at whatever it is their background is. And I think we have realized that if we really truly want to surround ourselves by talent and particularly we're only going to be as good as our operators in the companies that very difficult to find really awesome people who don't want to grow a company. And so, you know, some of it is you bringing, you know, high, sort of charging, high-powered people into these companies and seeing what they can do. And that is, I think, part of our thesis that has evolved that we didn't quite know when we first started. Let's talk a bit about competition.

And I've heard from others, we both know Brent B. Shore, who's kind of the guy who opened my eyes to this entire world, this permanent equity, kind of small, PE world. and competition always comes when there are high returns to be earned. And, of course, there seems to be a very, I've been searching, and I've found you guys and him for the most part so far, so it's a relatively small universe. But you were the first ones to turn me on to this idea of a search fund. So maybe you could talk a little bit about that as a jump-off point to talk about the competitive landscape for buying businesses at the scale you're looking at.

Sure. So the search fund is a very big. very increasingly popular thing to do at coming out of business school these days. Started at, it depends who you ask, but it started some either at Stanford Business School or Harvard Business School. And basically it's this notion of typically people graduating saying, I don't want to go work for McKinsey or Goldman, but what I do want to do is I like the idea of being an operator of a business. So they'll go out to a group of people and say, hey, you know, fund my search, which basically means cover my living and search costs for anywhere from,

generally it's about two years. And during that time, as I'm getting backing from this group of people, I will go basically do what we do, search around the country and try to find a business to buy. The big difference between us and the search fund is that once that person finds a company, they take it back to the original investors who have the option of participating in the purchase or not, they don't want to, raising the capital, and upon execution of the transaction, that person becomes the CEO of the company. They tend to then have the objective of growing the company and get equity in the company in return for hitting different growth targets. It has become incredibly popular, so about 10 years ago, there's a class, actually two classes taught by these two professors

at Harvard Business School. One is on search funds and one is sort of financial management of small businesses. And I think about 10 years ago, I don't know the exact numbers, but there was a small handful of people who would take those firms because, like, who cares? And most recently, you know, I've heard they have three sections of 90 people of grads who are looking to take this class. Not all of those people go on to actually do a search because, you know, as you can imagine two years of uncertainty, it can be difficult for people to actually pull off for a whole

host of reasons. And then a fewer number of those people actually find a company and execute it. It's become popular because Stanford puts out an annual review of search fund activity, and the returns associated with investing in search funds are pretty, very, very impressive. And that has gained the attraction of investors who are supporting more searchers. The more people learn about search, the more young people are interested in doing that. It's seen as an actual career path. So now if it used to just be a Stanford and Harvard Business School thing, you know, now Booth is super into it. Northwestern is getting into it.

Yale School Management. So it's starting to really spread as a credible thing for people to do. What kind of returns are we talking in terms of when you say impressive? So I've heard, there's a wide distribution, but like I've heard sort of mid-30s IRAs is kind of what's expected when people are going out and structuring their deals. What's interesting to us about the space, to answer your question about sort of competition, is that, so relative to the hedge fund space where like my best friend could be working for a hedge fund and I like couldn't talk to her about our positions because they were all proprietary, even though we're all like, law. long Apple, like in the small business space is still, relative to that, is still so under competitive that people are still like sharing information left, right, so it is the type of thing where you have to find a business that fits what you're looking for. So a searcher could be

out there and they could say like what I'm really looking for is something that's in financial services in the Midwest. And, you know, it might come across my desk and it might just not be a fit for what we're looking for so we can pass along and share. So right now, the industry is actually, I think, quite a friendly, happy community. It is possible that as more people get involved, it becomes less friendly. But my sense is that we still have a really long ways to go before that actually happens. And I also think that for us, we have found that what's helpful is it's sort of like the, it takes five years to have a five year track record. For us, you know, having gone through the pain of searching for a company for the first year

means like we already have a year of search experience. And so like the experience starts to compound and people also start to get, understand that we are real. So when we're talking to you, we're actually going to potentially close a transaction. And so I think that it helps to have been doing this, but it still is, I think, an area. that's pretty wide open from a competitive standpoint. The numbers are a bit opaque, but sort of clear enough to be compelling. We've done a little bit of research on this just internally, and we admittedly are self-selecting a very small slice of the small business universe.

And we estimate that there are, on the order of 200,000-ish businesses that are just in our – they're better stats on revenue than there are. on cash flow. So just in our revenue range with owners who are in an age where they would be at least contemplating retirement. And you comp sort of 200,000. Now, obviously some subsection of those are going to be the ones that are potentially available, but you comp that against even a exponentially growing search fund community of maybe 100 or 200 active searchers. And there's still just a very compelling mismatch there. It's just a fascinating space that, again, I'm just going to be curious to see the balance

of scalability with returns, how much institutional money will be flowing this direction. So I'm then thinking about your business and the fact that you're going to be spitting off cash flow, free cash, and you can either reinvest for higher returns to go back to the Baychap example in the existing businesses. or you can obviously use that free cash to fund future acquisitions, but the timing is always interesting, right? So you might have a glut of cash and no opportunities or a ton of opportunities and no cash.

So how do you think about outside investors? And have you taken on LP investors to this point? Do you plan to in the future? And then I want to get into a discussion on how in the future where there are these permanent equity managers such as yourselves that are taking on LPs, how they should charge. those LPs, which is, I think, the most important topic in investing today is how we're charging clients. Yeah, so just in terms of how sort of capital allocation into a sector can create sort of

mutations of strategy and scalability, you've seen that a little bit in the search fund space already in the sense that as more, quote unquote, institutional capital, which it's still not really like, it's not like, you know, Goldman institutional. as more capital comes in, you do see people feel pressured into areas that have the ability to generate very high growth returns. So traditionally... And can accommodate larger checks. Correct. So traditionally, search fund community was very sort of one to two million contracts enduring business grow for the long term. And that's sort of where the industry started. Over the past couple of years, you've seen a lot of searchers gravitate sort of more to the two to three million dollars.

range and pay multiples that we would personally never even consider. So a lot of times, you know, we'll be like, oh, this company has, it's like two and a half million of EBIT dot. It's some sort of SaaS platform that like, you know, they're going to pay nine times for and grow aggressively and sell in five years. So I think that part of the search fund community is becoming more just like mini private equity. And you're seeing that sort of, that pressure for people to to go in that direction. So I think that for us, what's important is to answer your question about external capital, you know, at some point, you know, we will, if we want to continue to grow, we will, you know, need to find external partners to work with. That said,

we don't really have any interest in working with people who are going to pressure us into taking on sort of high debt loads and growing aggressively to generate super high our IRAs. Especially over a short time horizon. Right. So for us, it's really only interesting if somebody is like, hey, like, I get what you're doing, and I think that there's value in it, and I want to participate in that. And so we haven't really sort of aggressively gone out and done any capital raising. I think that we have sort of surprisingly had more people come to us just saying,

hey, is there any way for me to participate? And if so, if you do think about it, let us know. But we haven't sort of formalized our thinking about how exactly that would look because there's a lot of different ways for, I think, it to manifest. We did take one strategic sort of small slice of outside capital participation for our recent deal that was also in the landscaping space. And it happened to be sort of a prominent property owner. in the local area who expressed interest in participating.

And we saw benefit in having him on board as somebody who could actually provide us with industry expertise in that deal. So, and that's sort of worked out great so far. What do you think about fees from two dimensions? One, how you would think about fees management and incentive charging potential LPs in the future, but also looking back, now having extricated yourself. from the from the rat race of institutional asset management at the fees and the trends in fees in my world your former world what do you think about those those two things I'd be really

curious few different points but the first would be when we have thought about it in general we have some of it depends on there's a certain element that has to do with how you choose to structure the scaling of of of 10 mark and what I mean by that is we deliberately and sort of getting back to sort of core, core filters. We deliberately target companies that are kind of between one and three, really one and two and a half million dollars of cash flow or EBITDA or whatever, however you want to define it. And we do that very deliberately for a number of reasons.

What that means is that, two things. First, companies at that size of cash flow tend to be very similar with respect to their stage of life, so to speak, regardless of what industry they happen to be in. And what we tend to observe is that they tend to be extroarer. ordinarily good at their core competency. So if you're in landscaping, you're very good at landscaping. You can build a wall, you can lay a beautiful patio, you can sort of mow on expertly. If you're in the baking industry, you're extremely good at making bread. Your new product development is extraordinary, et cetera, et cetera. Where most of those businesses tend to be underdeveloped is on what we talk about as the business of business.

So probably a little less focus over time on finance, HR, technology, marketing. etc. So the challenge then becomes how can you deploy some of that into these businesses to allow them to continue to grow over time without breaking the bank because the cost of a subject matter expert in any of those disciplines is maybe you could source one of them but then you'd be sort of priced out of the market of the others. So one of the things that we think quite a lot about is is there a way to centralize some of that core expertise and then deploy it? across the portfolio so that each company is benefiting from exposure to that area in a more cost-effective way. So to bring it back to the management fee conversation, obviously that takes funding,

and sort of that requires some ability on our part to charge back each company, the cost of the high-powered head of HR, the quality CFO, what have you. So there's a whole component related to sort of structuring, and I think that kind of comes, sort of tying it into sort of fee creep or fee excess in sort of more institutional investing. I think what we believe very strongly in is transparency with respect to that conversation. So I think we really wouldn't have much of a problem talking about how we're budgeting and what value we think is being delivered to the companies, but that's a conversation that needs to be had because if you are charging things like that to the companies, your manager fee is a percent of

EBITDA, invested capital, whatever, is going to be off market. So that's just, that's something that, an issue that we talk about and need to work through. In terms of wealth generation for the manager, so for, for Chen Markers of business, we feel extremely strongly that we should, we should be compensated almost entirely via some type of carry. And we want to be as, as aligned as possible with any, investor that we bring on. So, and then that kind of, that's the, I think that's just sort of a philosophical preference. And I think that that keeps our focus on finding really good opportunities that can generate above market returns and keeps our focus off asset gathering.

I think, well, it's also, it's a philosophical preference, but also I think just smart business at the moment, like we're just starting Chenmark. We intend to be around for a long time. I would rather be ahead of the curve on fee structures than sort of trying to grasp to a model that's slowly dying. And so I think actually Brent was the one who mentioned this because we were able to connect with him out in Arizona. And he made the comment that like living in a small town is a competitive advantage, which it is because living in Portland, Maine, the amount that the Chenmark partners have to compensate themselves is like relatively low to have what I think incredible quality of life and pretty much do all that I really ever want to do.

So I think that we're able to think through, if we were to take on external capital, I think that we could figure out a way to sort of pay Chenmark the amount to basically cover operating costs and then sort of incent compensation towards Kerry, assuming that if everyone does well, we should do well. And I think that that's important for us, but I think it's even more important for kind of building the Chenmark team, building the operators who are in the companies, you know, bringing on these sort of shared services, experts, those types of things because, you know, working in a small business is messy and hard and long hours and all that stuff. And I think that if you can bring in people who say, like, I'm going to build this company and I'm going to make it awesome, but I'm also

participating in the upside, that's a really important component to being able to attract talent to this space. One of my favorite writers, even though he's a controversial guy, has not seen to Leb and he is a new book coming out called, I think he's calling it skin in the game, which is a key idea for him. And the core idea being, you should not listen to anyone unless they have an enormous amount of skin in whatever game you're talking about. And he even has a a little aphorism that says, no opinions are allowed without skin in the game. And so I want to ask about that almost as a feeling for you guys where your livelihood now depends on, you know, enormous skin in the game. And I love that comment earlier that you need to earn the right to take

risk, where risk is just another way of saying skin in the game. I came across this funny little book that someone recommended to me called the Zurich axioms about a generation of Swiss risk takers that runs very contrary to a lot of conventional wisdom about diversification and spreading your bets and being cautious. Basically preaches the opposite that you should bet really big and really smart when you find an interesting opportunity. There's a little quote in there that made me think of you guys, which is worry is not a sickness but a sign of health. If you're not worried, you're not risking enough.

You know what's really funny? I'm just going to pause you. That James, this was in your newsletter. Yes. Yeah, James, like on the way here read me that quote. Like, stop everything. Let's leave this. Yeah.

Yeah, so I was. So we identify with that. Yeah. So what I want to hear about is kind of, what that feels like relative to an old, less skin in the, I'm assuming you had much less skin in the game in your prior career, even though. I was not a majority owner of a capital management.

You weren't a big AQR owner. Yeah, yeah. Shocking. So the difference in feel, good and bad. Yeah. So I think it probably manifests itself differently in all three of us. I think that being a family in this endeavor makes all the difference because we're all in it together and you can rely

on sort of that family level of support when things are going well and things are stressful. And so, you know, when we first started, you know, we had very little to slash no compensation. And I think that just on a personal level, it's not as if James is out doing something and I'm like, why are you doing this and we have to like, you know, eat at home every night or something. Like we have felt very much from the beginning that we're all in it together. We're all building something. And the sort of sacrifices that come along with that don't bother us at all. Like it's just not a problem.

I'd say that in this space, you know, personal guarantees are a thing. So you kind of, at the end of day, like we sort of have the philosophy that, you know, we're trying to build something. And if things go wrong, we'll figure it out. and having that mentality of just sort of, if something doesn't work the way we expect it to or things are bad, we'll figure it out and we'll be there for each other, is pretty much, you know, and let's just move forward, is how it manifests itself for us. You know, it's...

I would draw a distinction, sort of when we get, on this topic, I would draw a distinction between the perception of risk as it concerns the vision and the overall overarching goal and the perception of risk as it concerns the day to day. and I think that there have been plenty of times when idiosyncratic events with respect to all sorts of different things at each individual company have created some sleepless nights and a lot of anxiety within the group. But I can't really think of a time when there's been any sort of wavering with respect to the overall vision. And I think that comes back to, you sort of, and I'm failing to come up with a good example, maybe you, maybe you have one, but a lot of times you read about really successful people who have done something just slightly different, there's this perception they took a huge risk.

And when you actually interview them or talk to them, a lot of times they'll say, yeah, I know it looked that way, but like when I thought through it, it didn't seem that risky to me. And I think for us, for whatever reason, sort of the overarching vision of creating this portfolio and thereby creating opportunity for others in addition to ourselves has been, extremely motivating to such an extent that we, I don't know that we ever really perceived it as risky, so to speak. Yeah, I'd say it's also, there's, there's kind of the perception of risk. So, you know, we started our careers pretty much right before the sort of great recession. And so to me, the risk has always been more that somebody else is going to terminate me for some

sort of exogenous reason. And having, and especially in the hedge fund community, you know, I ever get lucky enough to join the right fund at the right time in the right position. Having seen so many do well and so many, you know, close shop for a whole host of reasons, and they're all super smart, talented people. So I always saw it more as at least now we control our destiny. So it could take a lot of different shapes, but at least I don't have to worry about some other person, you know, deciding that we're going to close that division or close the shop or that sort of thing. So that's the type of risk that I have no interest in taking.

One more point on that. So we write this weekly newsletter, and at the beginning of every year, we kind of recycle an article that sort of outlines our core values. And so the Cliff Nose version is, sort of the first one is being willing to be different in order to do something great, sort of cribbed from Howard Marks and his Dare to Be Great essay. But we really latched on with that conceptually. So I think probably the biggest risk that third parties perceive sort of on our behalf. is a pretty significant sort of career slash opportunity risk associated with sort of wait, so you're like do you, are you shoveling the snow or are you driving the bobcat? I'm more of a mulcher myself. And so I think from day one really we had a comfort with that and with the understanding that we were doing something different and that that had value. The other two pieces are sort of an unwavering belief in our own potential and a commitment to sort of this slight edge concept where if you can just be incrementally better tomorrow than you are

today, you can make real progress over time. And I think sort of the sum total of all three of those means that even if we're in an environment that's highly differentiated with a lot of uncertainty around it, we feel very comfortable sort of in that space for those reasons. So I can talk to you guys for hours, but since we both have other commitments tonight, this is a late night edition of the show. I'll go to my two favorite and always my two closing questions. So the first is to hear about, and you're married so it can't be your wedding, to hear about the most memorable day, we'll say of your career. Do you have something that comes to mind?

I'm trying to buy time. My career, so something comes to mind, but it's not flattering, but it was extraordinarily humbling. I think that in one of my first, early on in my career, I had. a performance review that I did not think through properly how to give feedback up the chain. You remember that. Yeah. And that's something that comes up to me as the most memorable day because I think that it actually had a huge impact on me and understanding both my place but also how to communicate

properly to sort of be able to, my place, I say, because it's like I felt like until that point, I was like flying high maybe a little bit, maybe I had a bit too much of an ego. And I think that in that moment, I realized that like I'm really just an analyst. I really sort of need to earn my stripes. And if I want something or want to improve it, I have to think a lot more about how to properly communicate to that sort of to whomever it is I'm talking to and how to think about sort of positioning things to get what I want. Does that make sense? So that was a like a big, one of those sort of like professional slaps in the face, but definitely I think had a huge impact on me. So I've got one. When we, when we were in the, the initial search

phase, looking for our first company, we were trying to be quite frugal with respect to our overhead. And we found a company in Louisville. We were living in Connecticut and we found a company in Louisville and there was a bit of a time sensitivity to the owner making a decision about who we wanted to sort of partner with to go to the next stage. So we had, it was like a Monday and we had to be in Louisville on Thursday. So we pull up kayak or Google flights or whatever. And the flights actually weren't prohibitively expensive, but they seemed very expensive at the time, you know, $500 or whatever. And we just collectively all decided that made no sense whatsoever. So we rented a minivan and bought an air mattress and we drove to Louisville.

and took shifts sort of sleeping and co-pilot and driver and rotating. And sort of made it to Louisville, had a great meeting, really interesting guy, and then drove back. And, you know, I don't know what that says, but I think it's something that we all talk about all the time is something that was really fun. And I think sort of your energy, sort of some people are like, oh my God, I never do that. And some people are really energized when it's, you know, kind of all three of us making it work somehow. And I think that was a really cool thing. My reaction to that, which is an awesome story, is this idea, I just see this over and over again with people I talk to who are founders. That by being a founder, all the sudden, all the things that seem bad take on this kind of special air to them in a way that's kind of magical.

I feel like it's like being a new parent. You know, it seems terrible that your child's up all the time, but it's also, you cherish it, right? Yeah, I remember a moment with my son. who's three now, but was up, you know, at six months old or seven months old or something and just up the whole night for like three nights in a row sick. And we were exhausted and just holding him in the middle of the night. It's exactly that. Like this sucks. I really wish I was sleeping, but somehow this is also the best moment ever. And I just hear little stories like that so many times, very specifically from founders. And founders is all about that skin in the game idea.

I can tell you that if Ted was like, hey, Trish, I want you to rent a minivan and drive to Kentucky for this meeting and then drive back, I probably wouldn't have felt so good about it. So the last question, and then I know we've got to go, is, and you probably heard me ask other people this, to hear the kindest thing that anyone's ever done for you. Probably too many examples, but sort of volunteering time would be the biggest thing. I think both of us feels that we've been extraordinarily lucky to sort of benefit from people who are smarter, more experienced, sort of offer than us, taking the time to educate us, be patient with us, teach us how to invest, to think about risk, to think about life. And, you know, to me, that's sort of the kindness

thing anyone can do with anyone is to allocate your time. I'd say that, and this is a very small example, but we recently had our first daughter. She's seven months old. But I remember the guy that we bought the dough business from after he retired and he was off doing his like travels in Spain and he went out of his way to send us like a little baby present and I just remember like it was such a small thing but I know that selling his business was like so hard for him and he was very emotional about it and with this little note about like taking care you know taking care of his company and how much that meant you know for me his sort of thinking through sort of taking the time to send us a present and to also sort of let us know that even though he

he had been quite emotional at the closing that, you know, he felt good about who he'd sold to was like something I feel like, well, we'll definitely cherish that for a long time. Very, very humanizing and a great point to end. So thank you guys very much for your time. Hopefully this is the first of many similar conversations. I appreciate it. Sure. Thank you.

Absolutely. Hey, everyone. Patrick here again. To find more episodes of Invest like the Best, go to investorfield guide.com forward slash podcast. If you're a book lover, you can also sign up for my book club. at investorfieldguide.com forward slash book club. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month.

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