Invest Like the Best with Patrick O'Shaughnessy - Will Thorndike - The Power of Long Holding Periods - [Invest Like the Best, EP.288]

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Starting point is 00:01:00 for instant impact with high limit corporate cards, payments, venture debt, and spend management software all in one place. Ready to accelerate your business, learn more at brex.com slash best. That's bR-e-x.com slash 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, stories, and strategies that will help you better invest both your time and your money. Invest like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at join colossus.com.

Starting point is 00:01:44 Patrick O'Shaughnessy is the CEO of O'Shaunacy 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'Shaunicee Asset Management. may maintain positions and the securities discussed in this podcast. My guest today is Will Thorndyke.

Starting point is 00:02:11 I first spoke to Will in 2017 about his excellent book, The Outsiders, and his career in private equity. I titled that conversation, how skilled capital allocators compound capital. In many ways, this conversation continues where that one left off. Through the lens of his new project, a podcast called 50X, we explore the power of multi-decade holding periods and the shared characteristics of businesses that are able to compound returns at high rates for abnormally long periods of time. Please enjoy this discussion with my friend Will Thorndyke.

Starting point is 00:02:42 And if you haven't subscribed to 50X, I highly recommend doing so. So, Will, we have a benefit of being able to talk about probably five or six different things today in your life of investing in business building. But I want to begin with a project that you and I have worked a bit on together, a new podcast that you've released called 50X and a firm in support of that effort called compounding labs. I think people that know you really well have certainly read the outsiders and may know a little bit about your investing career as well in private equity as one of the primary investors in search funds. They could certainly listen to our first episode together to get a deep dive on those two things. But maybe take the idea of the outsiders and describe to me how that work, what that work did to your mind, to your investing mind, and why and how you're continuing that concept with 50X. The Outsiders project was just enormously energizing for me. And it was a combination of a chance to work with a really talented group of young

Starting point is 00:03:40 sort of research partners, these Harvard Business School students who I worked with in their second years at HBS. And the process there involved. The key to those chapters was the depth of the research, the depth of the analytical work. And sort of the model that we evolved there was we had a full year, full academic year of research. in the first semester, we did a very deep analytical dive on each of the outsider companies and their peer groups. And then in the second semester, we used that research as the door opener to get in and have conversations with all of the living CEOs, many of whom were famously reclusive. And everyone alive who'd had anything to do with those companies, board members, former management

Starting point is 00:04:26 team members, key advisors, key employees of different business units, competitors, et cetera. It was a very rich experience. Rules we use for inclusion in the outsiders centered on performance relative to the S&P and relative to the peer group over very long periods of time. So the test was the average tenure of those eight CEOs was 20 years. And the idea was to see their performance across two full business cycles. And what it really drove home to me was just the power. of really long holding periods and the impact that has on how you think about kind of every aspect of the business, both as an investor and as a CEO and management team member. I really enjoyed

Starting point is 00:05:10 that process. And my own investing has evolved in such a way that I'm now, I retired from Usatonic, the firm I was involved founding about eight years ago. I'm now investing personally. And the common threat across the investing I'm doing is a focus on companies, and projects that can be built over much longer time horizons, holding periods, measured in decades, plural, the ongoing curiosity in understanding companies and CEOs and investors who've been successful in doing that. And so I've been fortunate enough to partner with a group of people at compounding labs, three people, Kent Weaver, Jason Pananos, and Jay Davis, whom I've known for a very long time. We've invested and worked together over a dozen years now. We all share.

Starting point is 00:05:56 of voracious curiosity around this topic. And 50X was sort of a natural outgrowth of that. The idea was to look at what Atul Gawande calls positive deviants in this area and to really study in detail the most successful long. And the idea for 50X is it's a 50X MOIC on your investment. That took 20 plus percent IRA over 20 years. It's a high bar. So to look for examples of companies that had passed that test, we thought about 100x, but that was already taken. So he settled on 50X. Still a reasonably high bar. 50 is pretty good.

Starting point is 00:06:29 I'd love to dig into this interest that you have in long-term holding periods in as many ways as we can. The Transdime episode and the conversation you had with Nick and some of the investors there really brings it to life where this is not a simple story, right? Like there's a lot going on over a very long period of time. Obviously, periods that long are fundamentally unpredictable. Like you don't know what's going to happen in the world. You don't know what's going to happen on the team. There's a crazy amount of unpredictable.

Starting point is 00:06:55 predictability that gets injected if you're talking a 20, 30 year time horizon. So how do you deal with that amount of uncertainty? And what are the benefits of having that sort of orientation? Is there a litmus test that you apply to the company to say, like this definitely won't work over five years, but it could over 30? Is that a positive thing? I would just love to start to understand the reason that you're so interested in this, given that as you get longer, it just seems harder to predict things. In the original Hussetonic Fund, we still own three. three of the eight companies that we invested in. And the holding period for each of those companies is over 25 years now. And those companies have been very good outcomes, but they've also just

Starting point is 00:07:35 been incredibly fun and satisfying to work on. You asked that question about how does the book influence my investing? Part of it is I've spent a lot of time thinking about those eight companies in the book, those three companies from the earlier Hucentonic funds, and then a whole range of other companies I've been involved in over a long period of time with the idea that in what correlates most highly with persistence in return profile over time. This is really translated into a lot of the work that we're doing at compounding lines, but we've really become zeroed in on revenue quality. So the purest form of that is, is it a recurring revenue business? And if so, what's the churn profile? And what we've found is there's disproportionate power in truly

Starting point is 00:08:19 low churn businesses. And when I say churn, I mean logo churn. gross churn. Net revenue retention is, you know, there are other metrics that are important as well, but really at the core of it is you start the year with 100 customers, how many do you end the year with? And why are there structural reasons for that? And so if you look across those companies, they tend to have this element of revenue persistence. It's absolutely the case for Transdime, transdime, which I'm sure we'll get into in some detail. Their business is very specialized aviation components, airplane parts. And they get engineered into these core airplanes. plane platforms, frames, whether it's the 737 commercial aircraft or the B-52 and defense aircraft.

Starting point is 00:09:00 And those platforms tend to stay in active service for 70 or 75 years. So if you're providing a small critical component part into those airframes, in order to be switched out, it requires FAA approval. It absolutely never happens. And so you have great visibility, predictability on your revenue stream, around which you can then do a whole range of other things in terms of how you organize the company, whether you choose a decentralized organizational form, how you think about financing the company. It has a dramatic impact on your capital allocation menu of alternatives. So we've intentionally been trying to select for a very specific type of business model at compounding labs and also in the work we're doing at 50X. Maybe we could just keep digging in until we find a

Starting point is 00:09:44 bottom on this concept of revenue quality. What are the most common things that you start to see early in the investigation of a business that indicate that this revenue quality that you're after may be there. And what is the process like early on as you're doing one of these deep dives? What kinds of questions are you asking of the business or the inverse? Like what kind of things are you looking to actively avoid even if there's, let's say, low turn? It's one of these things, you know, the mathematicians talk about the simplicity on the other side of complexity. And so we've spent a lot of time on this over a very long period of time across a lot of companies. At the end of the day, however, industries that are characterized by very low churn are just interesting places to be

Starting point is 00:10:25 looking for these sorts of long-holding period platforms. You know, the Porter framework is incredibly powerful. There are a lot of frameworks you can use to evaluate businesses, but I would argue at the end of the day, if a company has 2% customer churn, that's a very powerful indicator. So then you have to look at, okay, so what are the reasons for that and what potential dislocation risk is there that the reasons for that stickiness will change over time. It's a very rich hunting ground we've found, and you tend to get with that profile a lot of other good things. You tend to get relatively simple operations. You tend to get pricing power. You tend to get a high degree of capital efficiency, which is another thing we really focused on. We can talk a little bit about that. But a lot of

Starting point is 00:11:12 positive economic attributes tend to correlate with those sorts of revenue profiles. it's not in and of itself the only criterion, but it's a very powerful leading indicator, at least for the work we're doing. Say a bit more about capital efficiency. So what do you mean by that specifically? We don't have to use Transdine, but maybe with an example to nail home the point. So basically everything I was saying, Transdine would be a pretty good exemplar of. It's a really great business.

Starting point is 00:11:35 Capital efficiency, the way we think about that is the metric we use is something called return on tangible capital, which is a measure of the cash generated by a business relative to the tangible assets deployed in that business over time. So the math on that, just not to bore your listeners, is we look at EBITA. We assume that depreciation equals CAP-X, which is usually a pretty conservative assumption. So we take EBITA, we tax-affect it. So we multiply it by one minus the tax rate. Historically, that's been 0.6 at the moment.

Starting point is 00:12:04 It's more like 0.7. And you divide that by networking capital plus net P, P&E. So you're removing intangible assets, goodwill from the equation. you're basically looking for 20% or better. So that's the detailed math, but really at a more simplistic level, you're looking for businesses that have low maintenance CAPEX requirements.

Starting point is 00:12:26 In other words, they don't need to spend a lot of capital to maintain the current volume of business, and then they aren't working capital intensive. They don't have a long receivable cycle and they don't have to carry a lot of inventory. So it really comes down to those basic things. And what it rewards is things like businesses

Starting point is 00:12:41 that get paid in advance. One of the things that I think I've learned is I've gotten older is the incredible power of negative working capital. I know you know that, Patrick, because some of your businesses benefit from that, but it's a really powerful thing. And this ROTC, return intangible capital, we call it ROTC, really highlights that. So our businesses tend to be very capital efficient, which is code also for asset life. Say a bit about an example maybe of what looks like an attractive business, but requires a lot of maintenance, CAPEX, a sort of counter example. Something popped to mind there.

Starting point is 00:13:12 A really good business that we've invested in over time and actually done okay. And it is a bit of a counter example. So it's the data center business. So the data center business has excellent recurring revenues. But if you actually look at the mechanics of operating a data center, you're continually having to change the racking and the equipment and the power supply. There's just a lot of to maintain your volume of business. You actually end up having to spend a high single digit percentage of your revenue every year. to stay in place. It's a stark contrast with, say, the records management business, which is the

Starting point is 00:13:47 business Iron Mountain Dominates, where you store paper and electronic records, mostly paper records, but those records sit on racks in warehouse, zero capax required to maintain them. That's actually a wonderful business on these dimensions. It's a 2% customer churned business with very low maintenance capax. And they're very similar businesses. The business model is similar to one would have higher maintenance capax, one lower. And over long periods of time, again, this is a compounding game. Those seemingly small differences in capital intensity have a significant impact on equity returns for investors. The other notable thing you said is tangible capital when the world has gone the direction of intangible assets, beginning to ever more dominate

Starting point is 00:14:29 the total assets, let's say, of the SMB 500 companies or something. Say a bit about that. What do you think about the measurement of intangibles and whether or not you would be avoiding great businesses that are very intangible heavy? by having this calculation? The way I would think about intangible assets is in the balance sheet sense of goodwill. So you want to basically eliminate goodwill, which is really an accounting convention.

Starting point is 00:14:53 The intangible assets in the sense of intellectual property actually correlate very highly with this type of capital intensity. If you sort of look at the Fang companies, there's never been a precedent for the capital efficiency of those businesses. Look at the primary equity required to create Google and Facebook versus the free cash flow they generate now, it's just unbelievable. There's never really been anything like it. They're incredibly capital-efficient business models benefiting from intellectual property,

Starting point is 00:15:21 which is itself an intangible asset, but not one that shows up systematically on the balance sheet. And if you think about this being a compounding game and these small differences, adding up to massive numbers over time, you mentioned some other things that this high return on tangible capital, capital-efficient type businesses can do that maybe a regular company couldn't How does that show up most? Is it just more flexibility because there's more free cash being generated? What are the tangible ways that capital efficiency rolls into more capacity for compounding? If you have a low churn business that's highly capital efficient, you've got predictable cash generation, which is business a very, very powerful thing. Going back to compounding labs, we are partnering

Starting point is 00:16:05 with talented young CEOs to build very long-term holding companies, usually, focused in vertical industry niches where they will be acquiring a number of companies over time through serial acquisition. And our approach there centers on equity efficiency as a core principle. We're trying to build those companies very substantially over a long period of time, but to do it in an equity efficient way, much more equity efficiently than, say, a private equity would firm would do with the same vertical industry focus. If you have those two things, that predictability from the low churn and the capital efficiency, the high rotsie, it allows you to very efficiently use leverage to build those companies via acquisition,

Starting point is 00:16:48 particularly if you're thoughtful about the pacing in the early years. One of the lessons in TransDime, TransDime required $25 million of primary equity. That's it. Wow. Today, the business has $35 million roughly of equity market cap. It never required another dollar. And it's for this reason. The early first episode touches on this, the early chapters, basically in the first four or five years, they focused on optimizing the initial four businesses they bought in the Kelso transaction.

Starting point is 00:17:19 And they didn't do their next acquisition for four or five years until Odyssey came in. And at that point, they built the base of EBITDA very substantially, which they could then tap to the next acquisition that they did, which was also highly accretive. They did with debt, no additional equity. And then they were, we call that flywheel. the point after which you can do incremental acquisitions all with debt. And TransDimes is an excellent example that Nick built the flywheel really early on and it's still humming. If you think about the, I guess the power of that patience early on and you're doing these very deep dive looks at companies for the outsiders and now for 50X, what are the kinds of things that you're uncovering about,

Starting point is 00:17:58 let's say, TransDimes, since it's the most recent example, that you think would just be overlooked or underappreciated if you spend, I don't know, five hours researching the company or some shorter period of time that probably a more traditional like analysts new to the company would get familiar in 5, 10, 15, 20 hours, something like that. What kinds of things would they miss maybe specifically for TransDime? But what is the value of this like crazy deep dive year long type research that you do? It's the peeling back the layers of the onion analogy. So examples of things you learn from diving deeper pacing is one of them. You need to look really hard to get at that. But they're Approach to pacing is, it was very different, very differentiated.

Starting point is 00:18:36 Another item that's important to them is they've retained the ability to do really small acquisitions as they've gotten bigger. And that turns out to be a common threat across really long-term serial acquirers. Really small acquisitions tend to be very, very accretive for these companies over time. And so the trap that some serial acquirers fall into is to just focus on larger deals. Transtime has retained the ability to do a steady diet. of these smaller, highly accretive transactions, again, all done with debt. Game selection, so to speak, was really good here.

Starting point is 00:19:09 Nick and his team chose an excellent industry. But within that, it's sort of optimized along every single dimension. You can look at the decision they made around organizational structure. They chose an extreme, what I would call, hard form of decentralization. And they've been able to maintain that as they've grown. And the details of that, which are in the podcast, are all things you would miss on first study, but they're very important to understanding how sustainable that approach is going forward. The approach to compensation is unique among public companies,

Starting point is 00:19:39 and it's tied directly into the decentralized organizational form, and it's just unique in ways that are sort of provocative. It's entirely performance-based, no time-based vesting whatsoever, and it's tied to minimum thresholds of compounding for shareholders using a very sensible formula. there are lessons that come out about how to instill imprint a culture widely in an organization, the sort of idea of the simplicity of the value creation triad at Transign, which is repeated ad infinitum. It's repeated ad infinitum across our podcast, but even more so within the company, this idea that's productivity, pricing, and profitable new business, those are the only possible

Starting point is 00:20:25 sources of value creation and every GM is evaluated on those and every review of every business unit quarterly is centered on those. There's two things you bring up there coming back to my original question of like, why bother with super, super long holding periods where there's so much uncertainty. It seems as though game selection and then culture are like two really critical things to focus on early on and things that are sustainable. Choose the right game. You can play it for a long time, have the right simple, repeatable culture. It can last for a long time. Maybe we'll touch on both of those because they seem critical here, starting with game selection. And I'm just curious for everything that you've learned across your career now, looking at God knows how many

Starting point is 00:21:04 businesses, everyone's got to choose the game they're in. And I'm sure you've seen people that have done this great and those that haven't. What have you learned? What would be the career retrospective on good game selection for companies? As I've gotten older, it really does come down to predictable growth in free cash flow. So really great businesses are characterized by predictable growth in free cash flow, I think generally. At least that's been the case in my investing. If I look back on the best investments I was involved with, and the predictability comes from that dynamic we talked about earlier, the tightness of the customer relationship and stickiness around retention rates. And the profitability really does come from how efficiently does the business

Starting point is 00:21:44 translate EBTA into free cash flow. And that ROTC metric is central to that. Third element is growth. And growth is just really, really powerful. And organic growth, And inorganic growth are two different things. At CL, we're really focused on companies where the primary engine of value creation is inorganic growth, serial acquisition over time. And that leads to a slightly different set of criteria for game selection. In core search fund investing, which I remain very active in as do my partners at CL, the core engine there is organic cash flow growth. So it's a slightly different set of criteria that you use in evaluating the perfect business there.

Starting point is 00:22:22 And the search community has just gotten better and better and better at refining those. and the results are showing that. But growth is central. So it's game selection, I think, centers on those three pillars, that sort of triad. And there's detail around it, but again, it's one of these things. If you get those three things together, you get all sorts of good things along the way. They're cross-correlations with a lot of other very, you know, for instance, very few businesses that have those three characteristics don't have high EBDA margins. What about the customers being served or the types of customers being served? So FAA change, you know, serving the government for a B-52, part or something is a visceral example because of how crazy the switching cost or the switching

Starting point is 00:23:01 story seems. But is there a common feature of the kind of customers that tend to be served by these businesses that we've talked about that you're so focused on? They tend to be business customers and to be B2B businesses, the vast majority of the time. And then they tend to be providing a service in the case you're transdiamer product that's absolutely critical, but a very low percentage of total end cost. The beauty of the records management business is it's a minute, monthly charge. No, I've never been able to talk to anyone who can tell me what they pay monthly, but they never move the boxes because if they move the boxes, they may lose the one box they need in litigation or regulatory agency exam. The culture piece is the other side of this coin that I think is so interesting

Starting point is 00:23:46 those three P's that you mentioned for Transdom. I think of Danaher business systems. Like, there's lots of interesting examples of this in the public equity community. How do you think about evaluating culture and its potential to propagate forward, whether it's customer obsession at Amazon or then her business system or something like that? Tell me about culture and the role that it plays in your interest in a company early on in one of these stories. I think you can evaluate, you can't perfectly evaluate culture quantitatively, but I think you can look at retention rate over time in the top executive ranks. And I think increasingly you can look at things like internal NPS scores,

Starting point is 00:24:23 and glass door ratings. You can get a sense for these things. I think Silicon Valley stereotype of culture, which implies sort of beanbag chairs and ping pong tables, I think culture is, at least in these companies, it tends to be something that is inextricably linked to the organizational design decision. And not to oversimplify it,

Starting point is 00:24:44 but the vast majority of these companies, and this is true for the companies we're working with at CL, are highly decentralized. They're choosing a decentralized organizational, form. And with that comes a very powerful sort of related culture, sort of an ethos of entrepreneurship, the idea that the status in the organization belongs to the business unit GMs, not the people who work at corporate. You've mentioned this kind of decentralized structure a few times. An example would be helpful of people might think of Berkshire or something where there's a lot of

Starting point is 00:25:16 trust and responsibility and ownership that's pushed down, maybe IAC. There's other interesting modern examples of a slim home office, not a lot of G&A at the home office, and a lot of responsibility at the business unit. Why does this work so well? How does culture permeate across very independent business units? It seems like that would be almost contradictory that, you know, unique cultures at the business level if it was fully decentralized. So I'm just curious to understand a bit more about why you think this works. First of all, it's not a universal panacea at all. So there are lots of companies that have been very successful with cultures and organizational structures that aren't decentralized. I would argue that Danaher has been wildly successful as a serial acquirer with a culture that is not highly decentralized.

Starting point is 00:26:01 It has elements of decentralization, but also importantly, elements of centralization. It's not a universal solution at all. I think it's very industry dependent. The characteristics of successful decentralized cultures, again, you can kind of super-executive. roughly get at it quantitatively by looking at the ratio of people at corporate to total employees relative to the peer group. And so a lot of the companies in the outsiders in the book and Transdime as examples were just off the charts. They had 10x, 5 to 10x as many employees, total employees per employee at corporate. And with that is this idea that, again, that you're trying

Starting point is 00:26:44 to retain entrepreneurial ethos. That's an essential. priority. So that's one of the objectives of a decentralized culture. The other is it's, you know, you are lowering your cost. And in these cultures, there tends to be an element of frugality, scrappiness in the culture. And it persists long past the early days. Another company that fits this model very well is Constellation Software, which famously has 500 plus, maybe 600 now business units under Mark Leonard. If you're the CEO of a company, you're constantly faced with decisions about what to centralize versus keep independent. And the tricky thing is, in almost every case,

Starting point is 00:27:20 the decision to centralize leads to a near-term economy, like a quantifiable near-term cost savings. But the reality is that if you do it every time, if you follow that path to its logical conclusion, you tend to end up with a bureaucratic, ossified organizational structure and culture. We talk about this with our CEOs all the time. You know, what messes are you willing to step around? what things do you think are important to have reside at corporate and what should remain with the

Starting point is 00:27:49 general managers? I'm curious for an example of a mess that's worth sidestepping. It would seem counterintuitive that a great business would actively avoid getting involved in a mess. So what's a good example of that in your experience? It's sort of what do you want to mandate? Do you want to mandate a certain type of Salesforce compensation program at all of your companies? And it's this idea, do you want to mandate it or do you want to suggest it? You know, the other thing that happens in these successful decentralized companies is they tend to regularly assemble the general managers and compare their results and share ideas in a way that naturally promotes positive peer pressure, a little element of competition, but also shares good ideas. That would be an example.

Starting point is 00:28:32 You know, you have health care insurance. You're going to make everyone on the same health care insurance program or let them choose their own, even if you get purchasing economies, what's the flip side? It's sort of looking at that. non-intuitive costs of efficiency sometimes. What have you learned if you apply a lot of these ideas to the world of software? It seems just face value that some great software businesses, maybe especially vertical market-focused ones, would have some of these features, you know, really key part of other people's business processes, very sticky, low churn, fairly asset light, and so on, low marginal cost.

Starting point is 00:29:07 What do you think about software? Like, it seems uncontroversial to say software is a good business model. And we haven't talked at all about price, how much the market prices in, all these great features. But what have you learned about software specifically and has your interest in that industry or business style grown? Software fits this model really closely. It's become in the last 10 years and make that specific, it's become a single most popular industry for search funds, for search fund managers. That's interesting. For that reason, it just fits the profile really, really well.

Starting point is 00:29:37 In addition, there are lots of targets. I do think it lends itself well. And if you were looking for current exemplars of this extreme approach to decentralization, as I mentioned before, Mark Leonard at Constellation would be very near the head of the list for that. And he's buying super nichey, super vertical market software companies and then keeping their P&Ls separate and running them very independently. What do you think the key is then to this art of long-term serial acquisition? You mentioned that it's a different set of considerations from a company that might be focused on organic growth. you've invested in some of these companies through compounding labs, I think, already.

Starting point is 00:30:13 And you're partnered with the people running these serial acquirers, I think, to help them with advice and whatever. So what is it about that style that makes it work? Like, what do you think the best serial acquires do or focus on? I mentioned pacing. If you have a decades-long time horizon, you don't have to worry so much about making a lot of acquisitions in the early years. And we tend to be backing really talented earlier career CEOs over the first three. years anyway, we tend to go substantially slower than a private equity firm would with the same sort of general serial acquisition mandate. So pacing is part of that. But the center of what we do, Patrick, is something we call the rule of 10. As we're thinking about industries going back to

Starting point is 00:30:54 game selection, we think a lot about the rule of 10. And the rule of 10, the way we define it is it's the sum of customer turn, gross churn, plus the enterprise value to EBITDA multiple paid. And it's like a golf handicap lower is better. You want to be under 10, the combination of those two things. And that's a rule we spent a lot of time thinking about as we're building out these CL companies, compounding lab companies. What's implicit in that is that for this type of project, serial acquires, the predictability of the revenues we think is more important than the organic growth. We would trade high organic growth for lower churn. These companies are all growing. We know, we want some growth, but again, the profile would be substantially less than the organic growth profile of a typical, say, search fund company. One of the things that's super intriguing is the use of debt for acquisitions because the obvious benefits of, if you go a little slower at the beginning, have really high quality EBITDA free cash flow against which you can borrow money to do the next acquisition versus a private equity fund. Like the advantage for a long-term holding period is, you know,

Starting point is 00:32:02 is eye-popping. Say a bit about debt financing and the role that maybe a new rates environment will play in that strategy because it's been great, really cheap way to do things for 20, 30 years, but maybe that's changing. We're active, prudent, but active users of debt. And we tend to be reasonably creative in how we use debt. We're open to new solutions. So we tend to have relationships with senior lenders, but also there's often some seller financing and some of our transactions. And sometimes we also work with mezzanine providers. So we use debt actively and we spend a lot of time thinking about the right capital structure for these companies. Generally, for us, the most important things are the amount of available leverage, how much is available as a multiple of EBITDA, how they define EBITDA.

Starting point is 00:32:49 A lot of our businesses are businesses where we think the trailing 12-month look at EBTA is not necessarily as accurate of you as the last quarter annualized. We're very fortunate to work with a group of very sophisticated lenders, but there's sort of a lot of detail around how we think about the right ratio of leverage. And then we spent a lot of time thinking about the covenants and how are they said and what are the different tests and so forth and so on it. And we think a lot about the amortization. And so we're willing to trade higher rates for the right answers in those other three buckets, the amount of debt, the pattern of amortization, and the covenant levels. We're generally not optimizing for rate alone. In the current environment, rates are moving at this juncture that has

Starting point is 00:33:32 yet to become a major factor in how we're thinking about capital structures for our companies. That could be a very different 24 months from now. If you think about the lessons learned from outsiders, trans dime, et cetera, and the way the great capital allocators operate, like one that stands out to me is just the flexibility of the allocator. I always think of Singleton. I think that was the first chapter in outsiders that he was just willing to completely change his strategy if the prevailing market conditions changed, you know, his own stock price, the price of whatever, price of debt, price of equity. How do you think that's going to affect young CEOs most today looking forward?

Starting point is 00:34:06 Like if you were a 25, 30, 35-year-old CEO with a capital allocator's mindset, do you think the future will be much different than the past that you've spent so much time studying? It's an interesting question. The pattern that we see in the search fund companies and so far in CL is that in early years, say the first three to five years, capital allocation is pretty straightforward. The excess cash generated by the business is usually paying down debt and funding. funding organic growth in the case of a search fund, or maybe beginning to get ready to fund inorganic growth in the case of a serial acquisition consolidation platform, as those companies

Starting point is 00:34:42 grow and evolve over time, the menu, the palette of capital allocation options tends to widen. And so by the time you get out to year 7 through 10, they often have a much wider array of options, which can include and have included a number of our company's stock repurchases, even in private companies, we've been able to do some of that over time, although it's much harder, obviously, in a private company than a public company. And then selectively, we have looked at a dividend re-you have a broader array of alternatives, both in terms of how you source the capital. As you get larger, you're continually lowering your cost of capital and generally increasing

Starting point is 00:35:20 the amount of flywheel you have available to grow the business. Hopefully, most of the compounding labs companies just have gigantic Tam runways. I would expect that default outlet of accretive acquisitions will remain the primary capital allocation outlet for a decade plus for most of those companies. Back on the concept of revenue quality and the recurring nature of that revenue, I didn't dig in on that word recurring, but I'd love to. One version of recurring is literal subscription. If you want access to the thing, you pay for it again every year, and that's a very common software model. but what other forms of recurring have you seen? And are the things that sort of are on the line between recurring and not? I'm trying to figure out exactly what that word means in your mind.

Starting point is 00:36:07 Purist form, of course, is contractual recurring revenues with long contract terms and a long history of renewal at the end of those terms. So that's the gold standard. But the reality is lots of companies have very strong recurring revenues that aren't contractual in nature. But the due diligence bar is higher for those companies. You really have to study cohort by cohort and understand what the pattern of repurchase has been over a long period of time. At the other extreme, you've got consistent businesses where there's a consistent pattern of repeat business. And those are sort of B plus on this dimension. And they can qualify. I mean, I would say for the compounding labs work, we wouldn't likely do a deal that fit that. We wouldn't back a platform.

Starting point is 00:36:49 were really focused. And I'd say just generally for me, as I've gotten older, I'm less open to high quality repeat revenue. It's sort of like Transdime itself. Actually, one of the learnings at TransDime, you asked that question earlier, but that was fascinating is if you watch Transdime over time, several times they've bought larger companies were 75%, 80% of what they bought was pure form, aftermarket, recurring business. And 20% was other aviation stuff that was pretty good. And in every case, they chose to immediately divest the pretty good stuff, even though they would have gotten the higher multiple on it. It would have added near-term enterprise value and equity value. In every case, they insisted on saying they were purists.

Starting point is 00:37:33 That's fascinating. I think as we've gotten older, we've gotten more focused on the purity of, you know, why settle? Why not focus on the truly elite recurring models? What have been the biggest changes for you moving from managing outside client capital to just, managing your own. You mentioned that was eight years ago that changed. So you've had some perspective in it now. What are the biggest felt changes? And is it impossible to translate maybe the benefits of doing with your own money into the client model? The number one thing, Patrick, honestly, has been that I stepped back from Housatonic about eight years ago. And that was coincident with

Starting point is 00:38:09 some of the renewed focus and work around that's led to this longer, even longer. Like Housatonic had extremely long holding periods relative to the world of private equity, as we talked about the last time. The number one thing for me has been intensified focus on extraordinarily long holding periods. Part of that is a reflection on what's worked for me and what's been fun for me in the past. Part of it is just the math of that as a taxable investor. And honestly, it's the most fun projects I've been involved with have been those where we've had an opportunity to build the companies over longer periods of time. And I've always had postpartum depression when we've sold our best.

Starting point is 00:38:46 businesses, you know, had to because of fun life reasons. And so I've also did some work on the IRAs to the next owners of businesses, really good businesses I was involved with that had to sell. And they're unfortunately really good, really consistent and really good. That further underscored, you know, the value of being able to own these things, setting things up from the outset in a way that structurally you can own them for longer periods of time. Can you say a bit about the three companies that you mentioned that Hussatonic has owned for more than 25 years and whether or not those fit into some of these themes that we've talked about today. I would just love to hear what they are. Two of them were early search fund companies, two of the first 10 search fund companies.

Starting point is 00:39:23 One is an amazing company called Pishurian, which it's possible might be a 50X candidate at some point, which we were fortunate enough to be invested in in the earliest days run by a business school classmate of mine named Kevin Twill and a very, very talented team, still going very strong. In that case, it's coming up on 27 years this month. Another one is a company, also a search fund company called Keralon, which is an assisted living business in North Carolina run by an extraordinarily talented CEO named Karen Moriarty, again, still going strong. And the other is a niche cooking information business called America's Test Kitchen that we've

Starting point is 00:39:58 been involved with also for a very long period of time. Those businesses would all score really well on the dimensions we were talking about. The Carolina assisted living, it's a little harder for that to be a pure form recurring revenue business because you have an actuarial component to your residence. but within the world of assisted living and has very high persistence, very high retention rates, and both the Shurian and the information business had extraordinarily low churn.

Starting point is 00:40:23 All those businesses had excellent returns on tangible capital, and they've all had great organic growth over a long period of time. What was Karen so good at? And this is a foray now into a set of questions on leaders. I know you've worked and are working with two public companies as well, where you're a chair, and have worked with just a crazy amount of CEOs hands-on in your career.

Starting point is 00:40:43 So let's start with Karen. What made her so good and for so long? So Karen is really unique in that she's, so the assisted living business is operationally intensive. The degree of difficulty to operate an assisted living facility well is very high, much higher than the norm in the search fund and the other companies that we typically invest in in the search fund universe or elsewhere. And she has evolved an excellent model for that. So she consistently operates her facilities at margins that, are the envy of the industry. And she evolved sort of a system for that over time. She's excellent at hiring. And she has a very systematic approach to hiring, which fits that business very well.

Starting point is 00:41:24 She is one of the world's leading experts on Myers-Briggs. She implements that in an incredibly rigorous way across all levels of that organization. And that's led to great consistency of results in it. So she's both an excellent operator in a difficult industry. And we've been in that company for 26 years. So she's evolved that approach over time. But then, on top of that, she's turned out to be an highly rational surgical capital allocator. She's used her balance sheet very effectively. So assisted living is actually on its face, not super capital efficient. Karen's approach at Caroline was a greenfield approach. We were building facilities. But the way she ran it was incredibly equity efficient. We were able to use debt in a

Starting point is 00:42:04 very creative way there to finance new facilities through the ownership of the land and using mortgage debt to do that. So she's generated a terrific equity return. earns over a long period of time. And then she's just been very savvy in the way she's used her balance sheet, both to build new facilities and to make occasional distributions and a tax-efficient way to shareholders, and then occasionally to sell facilities and sale lease back transactions and her timing around this. So she's got both sides, both country and rock and roll. She's proven to be a really effective operator and a terrific capital allocator. What about this crossover public and private? This has been a really popular topic of

Starting point is 00:42:40 conversation for, I guess, all CEOs. Everyone has to make this. if there should be lucky enough to have to make this choice, I guess at some point. What do you think are the primary virtues of one and the other? And what have you learned being as involved as you are with a couple public companies? There's some real costs to being public. One of the primary costs is the time you need to spend on investor relations, which for the typical public company CEO is around 20% of their time, sort of a day a week.

Starting point is 00:43:09 One of the commonalities across the outsider CEOs is they, made a conscious decision to allocate a lot less time than that to IR. And then there's some actual real financial costs to be in public. And a question around how you can in public form afford to run your company in a really long-term fashion. So I think a way to think about it is if you're public, what does it force you to do differently? The same company, the same set of revenues and cash flows, do you have to run the company any differently in public form than you would privately? And the outsider Their CEOs basically found a way to minimize the frictions of being public, so it was as close to being private as possible.

Starting point is 00:43:47 But that's not easy to do. That's non-trivial to do that. The companies I'm involved with, I'm involved with two public companies in a pretty intimate role. One is a company called CNX Resources, which is an energy company, a natural gas company. And CEO there, Nick Julius is excellent. And he's spent a lot of time, and we've spent a lot of time, freeing him up to spend less time on investor relations over time so that you can spend more time.

Starting point is 00:44:09 on the activities that really drive value in the business. And the other company I'm involved with is a company called Perimeter Solutions, which I'm actually involved with Nick, Nick Kelly and I are the co-chairs there. And we're early days there, but we're intentionally following a model, not surprisingly very similar to trans-dimes and how we're setting that up. I'm confident we'll be able to also have that run in a way very similar to how we'd run it privately.

Starting point is 00:44:32 And there's some real benefits to being public. You have at least one and maybe two capital allocation alternatives that you don't as easily have privately. The first, sort of indisputably, is it's much easier to repurchase your shares. And on top of that, your shares trade in a more volatile fashion. You have more of an opportunity to add value by select occasional market dislocations through that capital allocation alternative than you do privately. The second thing is you also have the ability to sell stock at high multiples in an easier, more seamless fashion. So every now and then you can create a lot of value by selling shares at really high

Starting point is 00:45:13 values. That's something that's lost on people who read the book, but Buffett at General Re and General Dynamics, when they purchased Gulfstream, created enormous value because they did those acquisitions all with stock that was priced at an all-time high multiple. It was very accretive as well, and it's a bit easier to do that. And then the other thing about public company form is it's truly permanent capital. As you think about the function of compounding labs itself and what that thing can grow into or should grow into, how do you think about that?

Starting point is 00:45:44 I'm tempted to apply some of the same concepts of you want the home office to be pretty slim. But yeah, like if you think about compounding labs, the thing, the company, the entity, what does great look like? What do you want it to become? Obviously, you want to make great investments, but what's behind that? What we hope that looks like is we hope that we're partnered with a group of exceptionally high talent CEOs, which is true so far for us, building companies over multi-decade time horizons

Starting point is 00:46:10 in a highly equity-efficient manner. And just conducting ourselves, one of the benefits of those really long time horizons is you can have a different lens on every aspect of the business, how you think about talent, how you think about building your team, the pacing, as we talked about, the long-term investments you can afford to make in the business, you know, how you conduct yourself with service providers and how you conduct yourself with sellers are very different than the way you might think about each of those one-off decisions in a different setting, like a typical five-year private equity time horizon investment. So we hope that we're conducting ourselves in a ways that this activity could go on for many decades. The other partners are

Starting point is 00:46:53 substantially younger than I am. So I hope that I've got two, two, two, and a half decades left. I'm 58. But the other partners are in their early 40s and early 50s. So I hope we've got at least four decades of building and hopefully longer than that. Hopefully it'll persist much longer than that. But that's sort of the visible horizon. As you think about targets for these same sorts of 50X outsider deep dive explorations, what is at the top of the wish list, whether it started or not? Because it seems like each of these things, I guess nine now, if you count transdime, has led to these incredibly rich lessons, which then factor over into your investing activity. And you have to believe there's a lot more than that that

Starting point is 00:47:32 that you can still learn. What sorts of things do you want to learn? What sorts of companies are you craving to explore? It's a good question, Patrick. We have a long list of candidates across a range of asset classes, actually. I think an important thing to mention about 50X is the primary difference between it and the outsiders and the Transdime series is a good example of this, is we're hoping to pair the CEO perspective, which was predominant in the book with the long-term investor perspective. We think there's power in those two things. We paired Nick Howley with Rob Small, founding managing partner at Stockbridge, long time private equity investor and really talented and thoughtful investor and company builder. But the twin perspectives we're hoping to have across most of the companies that we'll dive in on.

Starting point is 00:48:19 And so I think we'll probably stay, this is as you know, very much in discussion at the moment, but I think we'll have an organic story and another inorganic story. So company specific, multi-decade, deep dives before we move into ranging more widely than that. Full disclosure, the depth of work that we hope to do and that we were able to do it. Transdime means that our frequency will not be high. Frequency will be low and sporadic and unpredictable. So our very clear analog is, you know, outstanding investor digests, which you may be too young to remember, but I only know it because of you, having told me about it. Yeah, this wonderful publication that published deep in-depth interviews with investors, but came out very sporadically and had sort of a cult following.

Starting point is 00:49:06 So we're likely at least to have that sort of unpredictable frequency because we're going to try to do deep dives and then make the materials available in the show notes and in the links. If you had to do one or two of these on companies that really don't fit the criteria that we've laid out in terms of revenue quality or B2B or the several things you've mentioned, what companies pop to mind that you would still be fascinated despite it maybe not meeting your. personal investing criteria to still spend a crazy amount of time understanding and learning about. We may unpack investments that are even substantially shorter term trades that meet that bar. So it's not necessarily just going to be unpacking long-term company building.

Starting point is 00:49:51 That will be the majority of what we do. But we're excited to range more widely than that. So you may find us popping up in entirely different assets. interviewing John Paulson or something. Different asset classes. The key is going to be access, you know, we feel like it's important that we can talk to principles. I think in some cases, we hope this is maybe the case of Transign. We want to be kind of content of record on some of these amazing stories and that hopefully

Starting point is 00:50:14 that will appeal to a certain sort of CEO who maybe hasn't told their story in depth before, CEO or investor. But, you know, the clay is still very wet at 50X. If you think about the other side of this coin, obviously the focus of the outside is like you said, was on the CEOs, the people running the businesses and their partners, more share this time given to the investors. One of the things that you and Rob talked about that I find fascinating is the development of investor conviction over time and how important that is to great investing stories. We've really talked about great business stories today. And usually a great

Starting point is 00:50:49 business story can be a great investing story too. But the investor, by definition, has less information. They have less time to spend on something. Conviction is very different than it is for a CEO. What have you learned about, obviously, you've had to develop conviction yourself, too. Like, this seems like a topic no one really talks about. What have you learned about the development of conviction long term for investors? It's a super interesting question. And I think really it's at the center of 50X. I think we really want to dive in. You can look at Transnon. In simple retrospect, it looks like an amazing company that was super straightforward to just buy it and hold it forever. but there were three, maybe four existential crises along the line.

Starting point is 00:51:30 9-11, what that did to the aviation industry. They had a company-specific 60-minute investigation they had to go through. COVID, this is an aviation company. COVID. I mean, you could never have anticipated COVID. Stock got cut in half in two weeks. And so how did Nick behave as the CEO of the company? And then what did Rob do?

Starting point is 00:51:51 And the fascinating thing about Rob is he's super thoughtful, and he runs. runs a concentrated portfolio, and TransDime has been a large, generally the largest position for him over time, but he's meaningfully added to it at different junctures over time, usually in combination with these crises. That part of the story really interesting. We'll be looking for similar cases like that where people, in order to earn the very high MOIC, they had to make decisions to hold that weren't obvious at the moment. You've obviously not, I don't think, set out in your career to be a big producer of media. You've written one of the most popular books on investing and now you're entering a foray into the more modern media podcasting. What have you learned

Starting point is 00:52:32 about producing what for you is great media? And obviously I recognize that there's lots of different ways of exploring topics. Your preferred way is extremely deep dives and then synthesis of that data and information. What would you say you've learned even if you're a reluctant media creator, you've nonetheless created some really great content about company building and investing. What have you learned through doing that a few times now? Well, honestly, Patrick, I think I'm sort of following your example to a degree. I mean, a lot of this is, and this is true for all of us at compounding labs, we're trying to first satisfy our own curiosity.

Starting point is 00:53:04 And we're following that curiosity. We're going to embrace tangents if we find them interesting. And we realize that may limit our audience to about eight people, but we're going to track these things down. We're going to track these things down. And the authenticity of following legit, honest curiosity is that's generally what has driven the project so far. Also, the super low frequency slow pace of things are related. It's surprising to me how undertapped people's curiosity is as an energy source.

Starting point is 00:53:34 Like, it's such a good one. It never burns out. Definitely highly recommend figuring out what does that for everyone listening and find some way to capture it and something like this. As you think about the process itself of these deep dive research projects, and working with, I guess I'll call them lead analysts, I think about the HBS students that helped you do each of the outsider companies, the people that will help you, Miles and others do research on the 50X companies. What could you teach us there? Because this process seems really valuable. Someone who has lots of experience in business and investing, coaching, mentoring, working with younger researchers to create one of these event studies.

Starting point is 00:54:12 What has worked and what hasn't worked in those interactions? I know that's a kind of a random, strange, nuanced question, but it seems like sure it would be great if somehow we had a pairing, doing a research like this on every company in the world. There'd be a lot to learn. So what have you learned about that process? Miles Wood has been working very actively on 50X for TransDiam and the next episodes we're working on. It has been unbelievably great with Kent Weaver and I on this project. And Miles is following. I was fortunate enough, as I mentioned before, to have these eight HPS students, second year students, so I work with them on the chapters in the book.

Starting point is 00:54:45 You know, honestly, I think it's a function of finding young people who share the zest for curiosity or the zest for these topics, the voracious, omnivorous characteristic. And so in talking to potential researchers to work with on these projects, I always ask them what they read and what they're listening to. And there's a very high correlation with the way they answer that question and the probability that we have good fit for this work. For my last question, I just want to ask about the world writ large and how what seems to be a very higher variance, I guess, world today than maybe existed 10 or 20 years ago affects all of what we've talked about. So it seems as though we've had the luxury, especially in the U.S., of being really able to focus on individual companies and not worry too much about inflation and rates and wars and all of these other bigger exogenous things that could really directly affect companies, COVID. And now we seem to be in a different situation and a different kind of world. One, do you think that's right? And two, if so, how do you adjust your thinking and you're investing for a more complicated

Starting point is 00:55:50 world? Yeah, I think the world is, it's more unpredictable than it's ever been. I mean, my general approach, Patrick on this is I just fundamentally don't believe I have any edge in thinking about macro topics whatsoever. It's just too complicated. And I'm almost always bearish. And I've actually never been more bearish than I am right now. But honestly, I don't let that affect my investing behavior, fortunately. It's a daunting list of secular problems that we face at the moment. That being said, I think if you just focus on the

Starting point is 00:56:23 quantitative outputs of all that uncertainty, inflation and interest rates that are most likely to hit us as investors, there are other things. But it'll evidence itself to a degree in those things. So thinking then about it that way, it's sort of like, what businesses do you want to to be in if bad things happen in those two areas, high inflation, high interest rates. But you want to be in businesses that have pricing power that are not capital intensive. I don't mean to diminish it by saying that, but really, no kidding, those are the two most important attributes in a business if you're heading into an environment like that. And I think the businesses we're talking about are relatively well set up for those contingencies,

Starting point is 00:56:59 not that they won't suffer in an economic downturn, but I think they'll be relatively well positioned and relative to other businesses for those. those sorts of environments. But it's scary. Why do you think you're always bearish? What is it that for a long time has made you bearish? It's really hard to make the bullish case, at least it is for me. They're always daunting. In the background there, it's the warming of the climate. There's sort of secular trends that are sort of inarguable. I really just sort of tune it out and don't let it affect my investing behavior. I'm as busy now as I've ever been looking at new investments. And if I did, looking back in hindsight, thank goodness, I haven't let it influence my investing

Starting point is 00:57:37 behavior. Collectively, I put it in the too hard bucket, so it worries me. It worries me, but I have no ability to control it or impact it. I try to put it to the side and focus on the company's company by company. Well, Will, I have learned just an absolutely tremendous amount from you over the years, both talking and reading and consuming the things that you've created. I'm so glad that you're doing more of it and exploring some of these interesting companies. There's plenty of people exploring Apple and Microsoft and, you know, the fan companies, et cetera. And to do it in some of these, long stories, it's just so valuable and so interesting. So I so appreciate the chance to work with you and speak with you today. And thank you so much for the lessons you taught us all over the years.

Starting point is 00:58:18 Thanks for having me on Patrick. It's a complete delight to work with you on 50X. So I'm enjoying that very much. Thanks for having me out. If you enjoy this episode, check out join colossus.com. There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

Invest Like the Best with Patrick O'Shaughnessy - Will Thorndike - The Power of Long Holding Periods - [Invest Like the Best, EP.288]

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