Investing Billions - E114: Brockenbrough $4.3 Billion Investment Edge

Episode Date: November 22, 2024

Chris Dion, Co-Chief Investment Officer and Managing Partner at Brockenbrough sits down with David Weisburd to discuss what makes small buyout funds resilient, how small buyouts outperform big private equity deals, and why the deal leader matters more than the firm.

There are basically three ways to make money in buyout that we see. One is you grow the business, you grow revenues, you grow even though you grow cash flow. The second one is you expand the multiple of that business. And there are kind of two ways that happens. The first one is completely beyond the control of us and the GP. And that's interest rates go down. Usually, as interest rates go down, multiples go up. The other area of multiple expansion is something that's really in control of our GP,

which is professionalizing that business, creating a business that has a sustained higher level of growth rate, expanding the addressable market, reducing customer concentration. There's a number of things and levers that people can pull to improve the value and the worth of that business to the next buyer. And then the third way to make money and buy out is debt and leverage. Why has the endowment model outperformed nearly every other institution over the last 40 years? The empirical data of greater than one billion dollar endowments over time is pretty compelling. If you look over the last 10, 20, 30 years, that greater than billion dollar group has really outperformed almost every other kind of institutional endowment foundation group

of smaller sizes. I think there are two primary reasons for that. So Broke and Bro manages $4 billion. Break that down for me. The firm manages about $4 billion, plus or minus, depending on the day. Assets under management are about 60% private wealth, which is individuals and families, usually taxable capital. And about 40% is our OCIO practice, which is typically endowments and foundations, typically

non-taxable capital. Given the differences in planning and taxes and a number of other things, we have teams that specialize and manage each of these practices at the firm. I am on the OCIO. And you mentioned that you always put clients first. What are some practical trade-offs that that creates for the firm? From a trade-off perspective, I think

it's just the way that we've always been built at the firm. I mean, Austin and Jim, who founded the business in 1970, they were working at larger firms and really felt like they were not incentivized to put the client first. And I just think that whether that was morally, whether that was morally, whether that was business-wise,

a number of different things in terms of longevity of relationships, I just felt like they thought that the better business practice was really to put that client first to really extend the life of that relationship for a very long period of time rather than to use that relationship for short-term gain and then have to turn that client because they felt like they weren't being taken care of the way that they ought to be. And so if you really think about, you know, call it the discounted cash flow analysis of a client or the churn of a client that they're, you know, they were

thinking about probably the long-term value add or long-term compounding of that client over that period of time and felt like having a client that was with you that maybe you didn't need as much revenue off of immediately, but were able to have for a much, much longer period of time was really just a better business practice. And I think they felt better about it as well. Taking away the moral aspect is putting your clients first, a smart long-term strategy. In other words, does it have compounding factors? Uh, we think so.

I mean, you know, our, on the private well side of our business, our, our retention rates are in excess of 95%. It's probably more like 98 or 99%. So we rarely lose clients. And it's a function of the fact that we believe that we take care of them and produce returns that are certainly helping to compound their capital and so that they have to worry as little as possible.

They can certainly be involved if they want to, but if they don't wanna have to pay attention to their financial management, they know and they can trust that we're doing that for them. So you started at Broken Row in the OCIO part of the business in 2012. You joined one week after the OCIO business started. Tell me about the portfolio you inherited and how that's evolved over 13 years.

As I mentioned, the firm in 1970 primarily managed private wealth capital from that period of time. And while we did manage some smaller endowments and foundations over that period of time, the firm really didn't utilize what I'll call the endowment model at that point, which was made popular by David Swenson and the Yale Investment Office. We had the opportunity in 2012 to begin our OCIO practice, and I was the first hire in that practice, as you mentioned. I came from the University of Richmond's endowment, which is called Spider Management Company,

and we were fortunate enough to begin that practice with a handful of clients at about $600 million on January 1st of 2012. Today, that practice manages 10 clients at about $1.7 billion. If we were a single endowment office, we'd be about the 75th largest endowment in the country. As you mentioned, we began in 2012 with a portfolio that had been managed by an investment committee that really met quarterly to make decisions. One of the selling points of outsourcing to Broken Bro was that the idea we'd give these long lab pools of capital kind of the daily attention that they deserved. And so while our initial clients had pinch funds in their portfolios, that exposure was generally through fond of funds and not direct relationships. And other than

a tiny bit of real estate, the clients had really nothing in private investment. So very, very light on the alternative side. We did a ton of work with each client's investment committees around strategic asset allocation. And we coalesced around the idea that the portfolio could and should be managed using the endowment model approach to better optimize returns. When we last chatted, we talked about the endowment model, as you mentioned, popularized by David Swenson from Yale. Why has the endowment model outperformed nearly every other institution over the last 40 years?

So yeah, the empirical data of greater than $1 billion endowments over time is pretty compelling. If you look over the last 10, 20, 30 years, that greater than billion dollar group has really outperformed almost every other kind of institutional endowment foundation group of smaller sizes. And I think there are two primary reasons for that. One is higher allocations to alternative investments generally like hedge funds and privates. The second area, as I mentioned, is having access or to capacity constrained or hard to find managers. And the hope is that those hard to access things

will generally be in the top half of that widespread that I mentioned or better over some period of time. And so, it's really those two things that are the majority of the difference over time. There is another third reason, and I mentioned it earlier, which is skill. And skill is obviously hard to measure on an ex ante basis, but what we've seen over time is if you have teams that are culturally aligned, that are philosophically aligned, that have

generally worked together for a statistically significant period of time, they've often tended to optimize their decision-making around each other. And they often will look at the team and understand what the core competencies of that team are. And they will optimize their decision-making and tend to concentrate in those particular areas. There's no one way. It really depends on the skills and experiences of the team to do that. But we've seen that that third part, the skill piece, is important because, look, I mean, if I say greater than billion-dollar endowments have had more alternatives, it's easier to allocate money to more alternatives if you're someone just sitting in a chair somewhere in an office. To some degree, there are plenty of groups that even can get access to what would be hard to

access or capacity constrained managers, but there are also plenty of capacity constrained managers that don't end up in the top half of those spreads. It's really that judgment or the execution layer of the team to choose among the available options that tends to be over time really, really important and separates even the good billion dollar endowments from the excellent ones. And that skill factor, do you attribute that to just better recruiting, more prestige? Why do large endowments have higher skill? One of the endowments that we've tended to model ourselves after over time is the Notre Dame endowment.

They've generally hired, this part we can't necessarily do, but most of Notre Dame's offices are Notre Dame graduates. They call themselves domers. Most of the Notre Dame offices is domers. They have that passion, that alignment from the mission perspective of having gone and graduated being an alumni from school that I think is super helpful in terms of feeling more like a vocation than a job. And then I think over time, just the alignment of learning from the people that hired you, we really look at it like a craft or an artisanal type of situation where you come in and you may have certainly skill sets and things like that, but you're kind of taught the way that the various endowments and foundations invest or the way our office invests.

Each person certainly then brings their own thing to the table that hopefully can be additive to that process and sometimes different as well, which is great. But the goal over time is to utilize those things to your advantage and to concentrate your portfolio in the areas where you believe those things give you a core competency to succeed. And I think the other thing that's been important over time is not to have too many people deciding. There's a ton of research around this, but there's a 1976 study that I often refer to that talks about decision making quality. And usually the optimum number of team size of the team in terms of optimizing overall decision quality is an odd number between three and seven.

And after seven, the decision quality actually tends to decline at a relatively modest rate, and then it actually increases as you add people. We oftentimes talk about succession or the apprenticeship model among top general partners. Is there a succession in apprenticeship that goes into being a top limited partner? But I do think it's very much an apprenticeship

or an artisanal, it's craft in many ways, I think. And again, it's not like you're trying to hire and create facsimiles of the people that are more experienced and more senior in the organization. I do think that each person brings their own perspective and their own tilt based on their own experiences that they can add to what they're learning.

But yeah, I think there's definitely a craft to it. And I think that it's something that can make its way through an organization that can improve decision making over time. You mentioned when we were chatting about the endowments that 40-year track record of success may be coming to an end. Why don't you believe that the large endowments will continue to outperform to the same level over the next 20 years? If David Swenson were alive today and you asked him if he thought he'd generate better returns at the current scale of the Yale Investment Office

or when he was in the 1980s when I think the Yale Investment Office was maybe two billion dollars, a billion and a half when he started with them, I think he felt like he could probably make more money when he was small. And that statement again isn't to take anything away from the Yale Endowment today, where I think the Yale Endowment does a wonderful job at their current size, but they do have a lot of resources. But can they do it in the same size that they were doing it 10 or 20 or 30 or 40 years ago? And both those to say yes to is harder because at Yale's size today, a $50 million investment 20 years ago might be a $200 million investment today. Let's talk about asset allocation.

Broken Bro really focuses on small buyouts. Why do you focus on small buyouts? We don't do only small buyouts. I just wanted to state that upfront. I mean, we have a fully diversified portfolio across all asset classes, but we definitely have chosen to have more of our capital in small buyout. And so it's an area that we really like. If you look at the last 10, 20, 30 years, small buyout has actually had the best risk adjusted

performance of any private asset class. So I will say caveat, full disclosure venture has had a higher absolute returns over that period of time, but small buyout was still able to produce what I believe to be very strong absolute returns, but they did with substantially less observed volatility. So knowing that data, we believe that SmallBio helps our portfolio produce better risk-adjusted returns, which is why we've allocated more to it. But interestingly, while we talked about the quantitative measure of volatility, it's really more than that piece of it. It's really what underlies the strategy that

we believe makes it less risky. And there's a couple of points to note here. I mean, one, prices paid matter. Our typical bio GP, they're buying an industrial or services business that roughly has 5 million cash flow, David. And they tend to buy that business for 6 to 7 times cash flow. If you look at the data so far in 2024, the average price paid for M&A transactions is about 11 times. You could argue and say, look, that four multiple point discount could be our group's sourcing proprietary deals. And it might very well be the case. But the reality is, is they're buying a smaller business too. They should pay less, but they are paying less. And so that's one. The second one is lower financial

leverage. When you buy something for six or seven times, the bank is not going to give you more than probably three turns of leverage on that business, just because it is a small business, because they view it as being somewhat risky. And so you're just going to have it be less geared than a larger private equity M&A transaction. Three, these businesses are kind of boring. They're stable. They usually are business to business, kind of providing a valuable product or service that got usually that goes into some larger product or service that's also being offered. It's a part within the whole.

It's not terribly exciting to talk about, but they tend to have a pretty recurring business as a result of that. They tend to have a diversified customer base, usually by sector and geography. The threat of disruption, most of these businesses have been around 30, 40, 50 years. And so like that, you know, usually provide some stability to the cash flows, even if they're not growing massively. The fourth point I mentioned is that there's usually

a lot of low hanging fruit with these smaller businesses. There's lots of things that can be improved at some of these smaller businesses that might not be able to be improved as much upon if the business were bigger and more professional. And then the last one is really just lack of correlation. You know, one of our GPs noted to us like last week, said that below $20 million in revenues,

there are over 4 million businesses in the United States alone, which is just a staggering number. We chatted last time about the attribution of small buyout managers, and you mentioned that the attribution is four times more about the individual manager than about the brand. Unpack that for me.

I was actually alerted to this research by a person in a firm that I really highly respect in this business. And that's a guy named Adam Shapiro at East Rock Capital. Adam has a group of think pieces on LinkedIn that he calls from start a founder. And I'd highly recommend any or all of those to your listeners.

One of the posts that you mentioned highlights what I think is some pretty groundbreaking research, which the report contains data supporting the conclusion that the individual person that leads a given buyout transaction is four times more important than the firm that they work for in terms of the forward return of that deal. And so I'm going to warmly use a quote from Top Gun Maverick, which is basically that investment excellence really comes down to the palette in the box. And the data illustrates that there really are stars in this business that have demonstrable

skill and are likely to outperform going forward. And you can have lots of plans and playbooks and frameworks from some of these larger organizations, but the plans don't execute themselves, people do. And this research shows that a single person matters honestly even more than we thought. It also underpins why we actively invest in emerging funds of people that are leaving larger more established organizations to form their own funds. So I'm sharing here on the screen gross fund performance across fund size for private equity funds.

Walk me through that. Yeah. So this research was actually done by the same group that did the Forex research that we just talked about. And it's also really pretty compelling. I spoke to a group of investors and I told them that smaller fund sizes over time have led to the opportunity for higher returns versus larger funds, I think most people would nod their heads and agree. If I then said to the same group that not

only is there a reasonable chance for higher returns, but that the smaller funds are no riskier than the larger funds, I think I'd have a lot of people questioning me and saying, gosh, you can't really have the reasonable chance of higher return without higher risk. This chart empirically shows that those people would be wrong. David, the chart you noted, I'm going to describe it just a little bit more for those that are listening and not watching. The chart splits the biofund world in four fund size ranges. It illustrates the returns of the top decile, the best 10%,

the bottom decile, the worst 10%, as well as the mean and the median return of each of those things. And the data shows that the smaller the fund size, the better opportunity for outperformance, which is noted by a higher mean and median outcome, as well as a much better top decile, top 10% outcome versus the larger funds. What's really interesting about this chart, though, is not the upside, but it's the bottom 10% of historical outcomes. The chart illustrates that the performance of the worst decile of funds in each fund size cohort are essentially the same. So that basically means that the small fund has a lot of additional upside for basically a similar amount of downside versus larger funds. This obviously to us seems pretty asymmetrical and is one of the main reasons that we've tended to invest in smaller funds over

time. The average size buyout fund that we have invested in over the last 12 years is about a $200 million fund, David, and so somewhere between the smallest and the second quartile on the left side of this chart. It is interesting to compare to something like venture capital, this kind of chart where you would have these extreme tails on the upside. You would have funds returning 5, 10, 20X in extreme cases. And you would have, I imagine, the bottom 10%, maybe a 0.75 or below losing substantial capital. No, I think that's right.

I mean, the outcomes piece is actually what's really attractive to us. And we talked about how it is the kind of the best risk adjusted asset investment on the private side. And like what you said, I mean, we'll get into the anatomy of perhaps the returns of small buyout, but you're not going to have the same power law outcome as venture necessarily on an individual outcome or even a fund level, but you can still have some really, really good outcomes. The converse of that is that chart we just showed doesn't have that many zeros. And so in the average venture fund, you might have a portfolio of half your things that go to zero and you still end up with a five or 10 X fund because of that power loss aspect of it. The distribution and the attribution of returns is actually

quite a bit different, but you can see how it underlies a better risk adjusted return. When it comes to the alpha for small buyout managers, are they making it on the purchase, on the sale and how do you attribute that? Definitely there is some value that can be had on the purchase. I mentioned, when you're talking about a $3 to $5 million cash flow business, there is more opportunity. We mentioned there are over 4 million of those types of businesses in the country. There is a greater opportunity to source proprietary deals that are not banked, that are with their family owned still. And you go through a process over sometimes a period of years where you build trust with that entrepreneur and that founder. And you can buy

that business at a better price than the market would generally allow for if it was a fully banked process. So there's definitely the ability for that. It is certainly not a given. And it takes a lot of hard work to do that. But yes, you can make money on the buy. Outside of that, there are basically three ways to make money in buyout that we see. One is you grow the business. You grow revenues. You grow even, you grow cash flow. The second one is you expand the multiple of that business. And there are two ways that that happens. The first one is completely beyond the control of us and the GP and that's interest rates go down. Usually, as interest rates go down, multiples go up. And there was a period of time over really a 30-year period of time where we had

a bull market and bonds and as interest rates went down, the multiples of private equity transactions and the overall stock market improved. Whether it's controllable or not, certainly private equity funds can benefit from that piece of it, from multiple expansion. The other area of multiple expansion where we're probably more interested than the first is, and it's something that's really in control of our GPs, which is professionalizing that business, creating a business that has a sustained higher level of growth rate, expanding the addressable market, reducing customer concentration. There's a number of things and levers that people can pull to improve the value and the

worth of that business to the next buyer. And then the third way to make money and buy out is debt and leverage. And while it's definitely true that when used properly, leverage and debt amplifies equity returns for sure. And we're not opposed to attributing some of our GPs returns to debt pay down, but we tend to focus on the growth part of the business, growing revenues, cash flows and EBITDA. And then, multiple expansion,

while we'll certainly take multiple expansion from interest rates just going down, we really focus more on that growth and professionalization of the business over time to improve the overall multiple of that business where you're demonstrably improving it to the point that it is a more valuable business. And we believe those things are much more repeatable than kind of the change in interest rates and the availability and price of leverage.

Given the trackness of the asset class, why aren't more LPs focused on small buyout? So I do think that small buyout is becoming more popular. There's a research report that we can put in the show notes that it's publicly available from RCP that they just did part one of a three part study on the case for small buyout where they're really kind of highlighting the durable nature of business building and risk mitigation that we've kind of already mentioned in this discussion of small buyout. But we are hearing of other groups that are kind of meandering down the fund size spectrum, you know, into where we've been for roughly a decade, I would say. But I do think there's also a reason why it's happening now versus some other time.

And the reality is, is that over the last, call it 10 to 15 years, the return difference between large biote and small biote actually hasn't been that dramatic, not that different. And both have actually been pretty good in absolute terms. But if you start looking at the anatomy of how those returns were produced, that is where I think the forward returns of small biote are more attractive than larger biote. So if you look at the anatomy of returns of large buyout over the last 10 or 15 years, most of that has come from multiple expansion of

interest rates going down, of bull market and bonds, and then from the availability and the price of leverage and debt. Those two things were a fair amount of the return. Well, you know, I would argue that the growth and professionalization of the business, there's certainly some of that I don't think it was the majority like we tend to look for in our small buyout managers where it's much more kind of operationally Well, I would argue that the growth and professionalization of the business, there's certainly some of that. I don't think it was the majority like we tend to look for in our small buyout managers, where it's much more operationally focused.

At the same time, too, to be fair to those larger buyout businesses, the businesses they're buying are already a larger and more professional business. So there is less to do functionally with some of those businesses as well. But we're in the ZERP environment. And when interest rates were low and debt was freely available, those larger firms took advantage of that the most. And they produced really good returns and business was good. But if you look from this point forward, and you look at where the absolute level of interest rates are, where the relative level of lending, the capacity of lending is on a go

forward basis, you would argue that some of those sources of attribution of return from larger buy out might be more challenged going forward than they were in the past. At the same time, you know, we believe that our GPs, you know, are kind of control their own destiny because we are more focused on kind of what we believe are these repeatable and durable, you know, processes of growing and improving these businesses and making them, you know, functionally better, better operating and better functioning businesses. That piece is repeatable over time and doesn't really depend on so many things that are really kind of out of our GPs control. Well, Chris, thanks for jumping on the podcast. Thanks, David. Really appreciate the time. Thanks so much.

Thank you for listening. The 10xCapital podcast now receives more than 170,000 downloads per month. If you are interested in sponsoring, please email me at david at 10xcapital.com.