Rob Small is a Managing Director at Berkshire Partners and has led Stockbridge, Berkshire’s public equities business, since its inception in 2007. Rob conducted diligence on TransDigm in its 2003 auction before investing personally following the IPO, building an anchor position with Stockbridge in 2007, and joining the Board of Directors in 2010. In this discussion, we cover the core elements composing TransDigm’s business quality, Berkshire’s and Stockbridge’s initial investments, and the trajectory of Rob’s conviction.
Explore the materials we used to prepare this podcast episode, including our proprietary research, original investment memos, and more.
July 10, 2022
Internal case study on TransDigm’s value creation playbook, historical performance, approach to capital allocation, notable crises, and peer group.
Private Placement Memorandum
Memorandum prepared for TransDigm’s original acquisition of Imo Industries’ Aerospace Components Group in partnership with Kelso & Company.
Private Investor Presentation
Investor presentation prepared for Warburg Pincus following the 2003 auction process.
2003 Investment Memo
May 23, 2003
Berkshire Partners’ investment memorandum from their unsuccessful bid with Greenbriar Equity Group and Western Presidio to acquire TransDigm in 2003.
2003 Exit Valuation
May 23, 2003
Diligence on exit valuation expectations leveraging comparable companies, historical trading multiples, and relevant private transactions.
2008 Investment Memo
May 19, 2008
Berkshire Partners’ investment memorandum from their open-market acquisition of public shares in 2008 following Stockbridge’s investment in 2007.
2008 Investment Presentation
May 19, 2008
Research and data behind key investment considerations supporting Berkshire Partners’ 2008 investment memo.
Esterline Initial Assessment
Long Path Partners
Initial evaluation of TransDigm’s $4 billion acquisition of Esterline, leveraging public filings and management commentary.
Mental Model Framework for TDG
Long Path Partners
Overview of Long Path’s framework to assess a business’ value accretion, initially informed by TransDigm’s example.
Systems view of Constellation Software and TransDigm, investigating the game selection, strategies, and execution responsible for their success.
Could TransDigm be the Valeant of the Aerospace Industry?
January 20, 2017
Short report speculating on price gauging, an unstable capital structure, and other headwinds that preceded a spike in short interest.
Bull Thesis in Response to Short Report
Value Investors Club
March 21, 2017
Anonymous investment case for TransDigm in response to Citron’s short report, addressing pricing, acquisitions, and leverage.
Interview with Yen Liow, Aravt Global
Graham & Doddsville, Issue 36
Interview in which Yen Liow highlights Nick Howley and TransDigm as an excellent manager and business.
Interview with Alex Captain, Cat Rock
Graham & Doddsville, Issue 39
Interview in which Alex Captain shares his perspective on TransDigm following COVID-19’s influence on aerospace.
Capital Cities: Briefing
The Outsiders, John Gilligan
January 27, 2005
Investigation into Capital Cities’ superior performance from 1966 through 1995, detailing industry-leading operational execution and its unparalleled acquisition activity.
Capital Cities: Interviews
The Outsiders, John Gilligan
May 11, 2005
Interview highlights from key operators, including Tom Murphy and Dan Burke, and investors featuring Capital Cities’ decentralized structure and disciplined operating practices.
[00:07:19] Will: I’m delighted to be here today with Rob Small. Rob is a Managing Director at Berkshire Partners, one of the leading private equity firms in the country, based here in Boston. And Rob is also the founder of Stockbridge, a public investment partnership originally formed to invest partners’ capital in the public markets. Rob has a unique longitudinal perspective on TransDigm. He was first involved in diligence on TransDigm as a potential private equity investment when Odyssey Partners sold the company in 2003. Though that opportunity did not materialize, Rob invested personally at around $24 per share shortly after the IPO and then led a large investment by Stockbridge in 2008. He ultimately joined TransDigm’s board in 2010. Rob continues to hold those original shares and with dividends reinvested, the multiple uninvested capital is in the vicinity of 60 times. So, Rob, welcome and thanks for joining us.
[00:08:12] Rob: Thanks, Will, happy to be here.
[00:08:14] Will: So why don’t we start, if you don’t mind, with a minute on your background pre-Berkshire, the Pleistocene era, pre-Berkshire.
[00:08:21] Rob: In the era when I still had hair on my head. I’ve been at Berkshire for almost 30 years now. So basically my full adult life has been at Berkshire and Stockbridge, but prior to that, I grew up as one of four boys in Connecticut, outside of Hartford. And went to college in New Haven at Yale, worked at Bain Consulting for a couple years between Yale, and then going on to Harvard Business School. And then was lucky enough to join Berkshire in 1992, right after that.
[00:08:52] Will: So literally coming up on 30 years.
[00:08:55] Rob: Literally, yes, will be in August.
Berkshire Partners’ Initial Exposure to TransDigm
[00:08:57] Will: I thought it might be useful, as we’re starting to talk a little bit about Berkshire’s history with TransDigm pre-IPO, and maybe interweaving that with your career arc at Berkshire, because I think they dovetail nicely.
[00:09:11] Rob: Well, it’s interesting. The first time that Berkshire heard about TransDigm, I was at the firm, but I did not hear about it. One of the founders of our firm was a section mate with Nick Howley in business school. So when Nick was looking for equity sponsors at the time he was buying the original businesses with his co-founder Doug Peacock, he approached for advice, and I’m guessing potentially to invest, his section mate, Brad Bloom. And Brad, and I think Nick, had no idea what they were buying at the time. They thought they were buying a few manufacturing businesses from Imo Industries that they could make a little bit better and it would be fun to work for themselves. Brad passed. It wasn’t the type of deals Berkshire was doing at the time. But I think was an advisor to Nick along the way. We did not… Or at least I did not know of seeing the deal when it traded from Kelso, who funded that original one, to Odyssey, but when Odyssey went to sell it, we got involved in the auction and that was my real first exposure to TransDigm.
[00:10:15] Will: And at that juncture, were you a partner at Berkshire? What kinds of things had you been working on prior to that?
[00:10:21] Rob: Yes, I had been at Berkshire. That was end of ’02 and beginning of ’03, I believe, when that was being sold. And I had become a partner a couple years before that. Had spent a lot of time in a variety of industries. The most applicable to TransDigm was that I led our investment in Hexcel, which made carbon fiber for airplanes, but was much more dependent on the OEM cycle. It’s not something you replace very often as the carbon fiber on a plane. So it was an OEM play, but it was still aerospace and getting to understand the aerospace market. It was a good first step as we then had to learn a lot more as we got into the TransDigm auction.
Auction in 2003 by Odyssey Investment Partners
[00:10:57] Will: So this is the auction when Odyssey decides to sell.
[00:11:01] Rob: Yes.
[00:11:02] Will: Do you remember who the banker was and how the auction unfolded?
[00:11:07] Rob: I believe the banker was Credit Suisse and we came down to three people at the end. We actually were in a consortium with Greenbriar Equity Group. It was Berkshire Partners, Greenbriar Equity, and Western Presidio. The three of us were bidding as a group, since it was a large deal for us at the time, against Thomas H. Lee or THL Partners at the time and Warburg. And it came down to the three of us. We were leading the group, but working very closely hand in hand with the other two firms. And it was a fascinating experience because there were five main operating businesses. It was much smaller at the time. We got to visit each one of them. We really dug deeply into each one and started to get an appreciation for the power of the model and what the company built. And it was a fascinating business.
When we were projecting the business, we kept having margins go up over time, which is something that you wonder in an industrial business, how the margins can keep going up in a business. And every time you followed the math, it was the right way to look at it, but there were a lot of questions on our investment committee on whether that was a reasonable assumption and we kept working through it and kept working through it. It was the magic of the model coming through right then and you started to get a picture of what could be done. And then there was a question of how many acquisitions you wanted to assume the company could do over time. And back then, I think everyone was very conservative on additional acquisitions. There wasn’t a huge track record of them.
It was a heated auction among the three of us. And there was multiple final rounds of bidding where the banker kept coming back and saying, “It’s indistinguishable. Are you sure you can’t get there? Are you sure you don’t have more in your pocket?” It was one of the first ones where the market became the modern market, where it just kept going round and round and round. I remember we flew out to Cleveland, Brad and I, to visit with Nick and present our bid to him. He was encouraging. We never knew whether the fact that we were a three-headed bidder versus two single bidders had any impact on it. But I do remember one key moment where we had used all the gas we thought we had in our tank and they came back and said, “Are you sure that the tax savings from the option proceeds are on top of your bid and not included in your bid?” And I’ve always wondered if we had said yes, whether we would’ve won that deal or not, but we didn’t. Warburg won. Warburg, reportedly at the time, had been the runner up in a couple of deals with their new industrials group. And they did not want to lose another deal with their new industrials group. So I have a feeling we would’ve just made them pay more potentially if we had included those option proceeds on top, but we hadn’t.
And we moved on. From then on, I’ve always referred to that as the most painful loss in my private equity career. That was the one that got away. That was the company I always thought was the best company that I looked at during my time in private equity. And I was very excited to partner with Nick and Doug. Doug was retiring at that time, so I was really partnering with Nick in following the business, but it was not to be, so we had to move on.
[00:14:17] Will: Do you remember what the final bid was as a multiple of EBITDA or how you guys were thinking about that?
[00:14:24] Rob: It’s stretching the memory, I think it was in the 12 times, or even less than 12 times, if I remember. It was in the 10 to 12 times range. It was a very different world back then.
Contrast TransDigm with Hexcel
[00:14:35] Will: That experience with Hexcel, did that allow you to see the business quality at TransDigm? The contrast, selling the OEM versus aftermarket business quality contrast?
[00:14:46] Rob: It was fascinating. I remember talking to the very talented CEO of Hexcel about the business and he did some digging around and he came back and… This is a classic line, he said, “People don’t think that TransDigm’s really well positioned for the future because they don’t play in the higher technology areas of planes, which is where aerospace is heading. They just sell some of the older parts and some of the less complex parts. And they’re not leading the R&D of the industry.” And you realize that was the point.
They were not worried about being the glamorous company. They were worried about where they could drive value and where they could make money. And it became very clear right away the aftermarket was different than the OEM where we spent… Our Hexcel analysis was how few planes could aerospace and Boeing actually go to? How low could it go? And could the model survive with that? This was much, much more, what was the sales per ship set? And then how did that play out in the aftermarket? So it was a very different analysis and you got a much better appreciation of the steadiness of the aftermarket.
Reengaging with TransDigm post-IPO
[00:15:55] Will: Okay. So you guys lose the auction and then over the next several years, what was the pattern, if any, of communication?
[00:16:02] Rob: We would chat once in a while. If we had an investment idea in aerospace, we would often, in our diligence, talk to Nick to see if he had an opinion on it, but it was on again and off again, it wasn’t a regular conversation. They went public in 2006 and, at that point, we didn’t have a Stockbridge. We were just a private equity firm. So we still had the ability to have our own personal accounts. So TransDigm, one of my partners and I, who often did little investments together, we almost immediately bought TransDigm remembering it, as I mentioned, my favorite private equity company ever. So when public, we bought some stock on our own. Those shares I still own, which has been a wonderful investment.
[00:16:47] Will: What was the price, Rob, do you remember? That initial purchase.
[00:16:51] Rob: My memory is that the price was about $24 a share. The teasing part I have with my partner is I think I bought a little bit more and I got it a little cheaper. So I’ve always been able to hold that over his head. Although, I think both of us are pretty happy with the result.
[00:17:08] Will: Okay. So you go along and maybe talk a little bit about how Berkshire reengaged with the company and got involved again.
[00:17:17] Rob: In 2007, we launched Stockbridge. And the idea was that we were looking in private equity for good companies to invest in. And there were plenty of good companies in the public market to invest in. We were unsure about whether we could get to conviction with public only data. One of the nice things about private equity, and I would argue one of the dangers of private equity, is you get a treasure trove of internal data and you get to learn a lot about the business. So we didn’t know if we could get to conviction. So we started with our own capital, always with the hope that we would be good enough to attract partners, but we started. And since we were looking for good businesses and even though four years had passed since our diligence, we decided that TransDigm would be the first place we would look.
So we set out to get to know the business and reengaged with the company as a public investor. And it became in April of that year, the first investment Stockbridge ever made with our… I believe we had $30 million of internal commitments and we had drawn down a quarter of that, so it was quite a small investment, but it was the first one we made. And we used that to start our investing vehicle, Stockbridge, and so it was a great first investment and it has been our largest investment for the vast majority of our history and still is our largest investment.
Origins of Stockbridge
[00:18:33] Will: So Stockbridge, as you guys start that, there’s a commitment of $30 million from partners, you’re drawing it down as you find opportunities. How did Stockbridge arise? As I recall, you guys had made some investments in the core private equity funds, occasionally in public companies. I remember maybe Crown Castle, or maybe there are other examples. Was that a precursor to Stockbridge?
[00:18:55] Rob: Our expertise at the firm is trying to evaluate companies and then working to make them better. And didn’t really matter the form. We did some minority investments, we did some growth investments. We did some control buyouts, and we did some investments in public companies, both through PIPEs or just regular way stock investments. And none of that mattered to us. We were trying to figure out, did we think there was a great opportunity for appreciation and, typically, could we add some value?
[00:19:25] Will: Okay. So Stockbridge was somewhat of a natural extension of what you had already been doing at Berkshire. Was there a specific catalyst for launching when you did?
[00:19:34] Rob: If you remember, in 2005, six and seven, the private markets were extremely strong and debt fueled. There were very high amounts of leverage. And, for the first time in our history, we started to see comparable sheets when we were trying to value private companies where the private company would sell for more than the public company was trading for. So the control premium, in some ways, outweighed the liquidity premium. And we hadn’t seen that much, at least in my time working or the founders who even went farther back. So we said, “Was there an opportunity in the public space to do it?” And as I mentioned, the one thing we didn’t know was whether we could get to well-placed conviction in public companies. So we set out to try. And when we did that, we wanted to learn with our own money. So we put $30 million aside to try to see if we could prove it out to ourselves and start to build a team and a process.
I think we realized that it was important to stray as little as possible from what we did privately, at least to start. So that’s how we came to the belief that we should have a concentrated portfolio, believing that deep knowledge of our best investment would be better than trying to figure out a 25th investment, that we would look for better businesses and think very long-term. That’s how we had grown up in private equity. And as we built a team, most everyone had private equity roots, mostly at Berkshire, but we wanted to go in that way. We thought that was the smallest leap and if we wanted to grow into doing more things, we would. We have not really. We’ve basically stayed with that plan is to buy better businesses, have a concentrated portfolio where the top 10 are 80 plus percent of the portfolio. And we do all our analysis on a five year IRR, which takes understanding or having a view on the company for 10 years at least, so we understand what someone might pay for it in five years. So it is very long-term focused. And we think the only way you can be really long-term focused is to buy really high quality businesses, which is why TransDigm was a great place to start.
[00:21:40] Will: The decision to start Stockbridge, you were tapped to allocate some of your time to go figure that out and get it started. Was it at all contentious internally to take a key partner and allocate them to that? Curious how that internal process unfolded knowing how process-oriented you guys are at Berkshire and then a little bit about for you personally, that was a major career fork.
[00:22:01] Rob: Yes, it was a fascinating period. We had started it part-time in a sense. Stockbridge, in many ways, was the vision of one of our founders, Chris Clifford, who thought this was a great opportunity and recruited me to help him think through it. And the two of us started to build a team. And as we started to do this, created a part-time investment committee, which he, I, and one other partner were on and we were going to make the decisions while the team processed things. We quickly realized that that was a bit of hubris in the sense that we were competing in the public markets against super smart people who were doing it more than full-time. And so to think that our senior presence could be part-time that I could continue to do, or anyone leading it, could continue to do private equity deals at the same time was exactly that, hubris.
So we had, in our unique way… Remember, there’s no single leader of Berkshire Partners and there never has been. It’s always been run by the partners. So we had no one to go assign someone to go do something. So we had a partner meeting and we discussed that we needed to do this. People had spent a lot of time thinking about whether we could give up someone for a period of time. And the plan was that whoever would go do it, would go do it for two years to get it going. And we ended up having everyone write two names down on a piece of paper. We counted up the ballots, they kicked two of us out of the room and came back and asked if I would devote the next two years to get Stockbridge going.
It was a fascinating opportunity for me. Some theories are that I was the most expendable partner. But another theory is that I probably liked thinking about investment process and what made companies great and differentiated more than I loved the deal process. So I like thinking about businesses and thinking about investment decisions more than I liked deals. So I was probably the best fit for that. So I went off for two years with the goal. It was fun for me. I got to try something new. I was 15 years in, at that point, at Berkshire. I enjoyed private equity, it was fun, the firm was doing well, but it was fun to go do something entrepreneurial within a place that I loved and with the people that I loved. So it was a great opportunity and it seemed like I had, in some ways, an escape hatch, if it didn’t work out so well, to come back and do private equity since we needed more people. So my spot would seem to be open, but two years turned into… Right now, we’re going on 15 years. So it’ll soon be half and half, it’s amazing.
[00:24:38] Will: And just to flash forward, you guys are managing about a 100 times that original capital base now, is that about right?
[00:24:45] Rob: Closer to 200 times, I think. We’re around $6 billion of capital under management now.
Core Elements of TransDigm’s Business Quality
[00:24:53] Will: So let’s go back to early days at Stockbridge. The minute you’re tapped, you’ve focus on TransDigm. That comment you made earlier about TransDigm being the best business you’d seen across all the private equity companies you’d looked at… How would you crystallize that? What were the elements of the TransDigm model that stood out for you?
[00:25:12] Rob: This is a little bit of a longer answer, but first of all, TransDigm plays in a unique industry. Planes are extremely complex, especially large commercial aircraft, and everything is centered around safety. Having planes take off and land and fly successfully time after time after time is incredibly important for obvious reasons. But an airplane is also an incredibly complex product. I’ve seen numbers that sell you the 737 now has about 600,000 parts. So the engineering complexity to get all those parts designed and built so they come together to not only fly, but fly incredibly reliably is amazing. So you have an incredibly complex piece of equipment with an incredible part diversification, yet Boeing, in their latest forecasts, hopes to ramp to only about making a few less than 400 737s a year. So there’s not a huge amount of volume, but yet, a very complex product. So Boeing uses their volume in the OEM market to negotiate pretty good rates with suppliers, but they also need suppliers who can help design the plane and deliver the components reliably. Remember, the production line depends on all the parts being available. So people have an opportunity to really add value to the process and therefore get paid some for it.
The aftermarket then is even lower volume. There’s some parts that never get replaced or get replaced extremely rarely in the 30-year life of an airplane. But there are parts that get replaced every once in a while and there are rotable parts that get replaced a lot. But the aftermarket for the core of TransDigm is very low volume and really distributed among the end customers. So the math for creating a second source for such a small market where perfection… You remember the product has to be perfect, is really tough to make the numbers work. Fortunately, for people who get on airplanes, the regulatory regime works to ensure that new parts will be safe or safer than the parts already approved.
So the combination of low volumes, large barriers to entry, the need to be responsive on a very diverse set of products, and the intellectual property that was built up from the original design allow for very strong margins in the aftermarket. So that’s just the business and almost everyone who plays in the aftermarket makes pretty solid margins on those aftermarket businesses. I’ll be fascinated when we really get a good view, if we ever get a good view, of General Electric spinning out their engine business on what they make in the aftermarket. I think incredibly high margins.
[00:27:51] Will: Do you think of that in terms of gross margin, as starting point, Rob?
[00:27:56] Rob: I bet for General Electric… I can say that because I have no knowledge. I bet for some other parts, they’re in the 90s in gross margin. It has to be on things they sell. They’re the only supplier for their engines. And it’s very high barrier on an important engine part to trust a PMA supplier.
[00:28:14] Will: SaaS software-like gross margins?
[00:28:16] Rob: Yes, very high. And you’re getting paid for the intellectual property and the switching costs. The interesting thing is margins are basically defined as the markup on the metal and the labor to shape the metal, but it’s really the intellectual property and the switching costs that you’re getting paid for. So margin is a weird concept because that’s not the value, is not the piece of steel or the piece of aluminum or the piece of titanium that went into the part. It’s how you make it and how you make it so reliably.
And then you add on the unique attributes of TransDigm to all this. One is their discipline on acquisitions. They focus on companies with proprietary technology, a sole source position and some product diversity. They don’t want too much concentration, any single product type, because that’s what allows them to then deserve pretty high margins.
Then when operating them, they focus very clearly on their value drivers and they try to get as much as their activity focused on these value drivers, which are to secure profitable new business, to have productivity in their operations, and to provide great product and service to their customers so they can price to that value that they provide.
And then finally, they have had a history of superior capital allocation. So their first choice is to invest in the business. Anything they can do to create productivity that has a strong payback, they’d love to do. Next is buying those additive businesses that fit. And then finally, returning capital while maintaining a carefully leveraged balance sheet. It all adds up to an incredible business.
Investment Trajectory for Stockbridge and Berkshire Partners
[00:29:52] Will: So let’s go back and maybe trace two threads, the trajectory of investment for the core PE fund and for Stockbridge.
[00:30:00] Rob: When Stockbridge started, as we mentioned, we were totally internal capital. We believe that every opportunity first belonged to the private equity fund. So when we had made a small public investment, as we were learning… We bought in it around, I think at that time, $35 a share. We were looking for immediate gratification and proof of our investing prowess. The stock went up into the low 50s very quickly, and we then patted ourselves on the back and said, “Boy, we must be good at this public market investing.” And then 2008 happened. And the stock was very quickly back to where we had bought it and at times dipped significantly below. And we got an initial learning that you don’t count too quickly.
But at that point, we thought it was crazily cheap. The OEM part of the business had slowed down, that number of orders for new aircraft slowed down significantly, but flying is pretty steady and the rate of growth can slow. And, other than when there’s global pandemics, it rarely shrinks. I think it’s gone down very small amounts in very big shocks. So we understood that the aftermarket was still going to be strong. And ironically, even though their total sales would shrink, certainly their gross margin would mix up as it would become more aftermarket weighted. So we thought, with our models that we had built, that it was remarkably cheap that time.
So we went to the private equity fund and said, “We think you should look at this.” As we had had a history of investing in public companies from that fund as well. To make sure it was a good process, private equity put a second team on it and took our work and built on it as much as they could. We came to a similar conclusion and we approved a $150 million investment in the stock. We actually first called Warburg and tried to buy some of their stock as we had been looking at it and they weren’t ready to sell, so we just went into the market and ended up buying $150 million worth.
[00:32:03] Will: And Rob, how large was that PE fund? The 150 million would be what percentage of that PE fund for Berkshire?
[00:32:11] Rob: I’m trying to remember which fund it was out of, but it was probably about a 5% position if I had to guess. I’d have to go back and look.
[00:32:21] Will: It’s just worth noting that what Rob just described, that’s pretty rare. It’s unusual for a private equity firm to make a sizable investment in a public company, in an open market transaction like that. So the bar is high for that.
[00:32:39] Rob: I think it is a high bar because your investors often have you in a category where they’re trying to manage their exposure. So they often want their exposure to be in private deals. And so the fact that we would put some in a public company is, in some ways, a riskier transaction for us. But overall, our goal is to do the best we can and we thought this was a really good opportunity for ourselves and our partners. And so we maybe hold it to a slightly higher bar because of that, but we thought it was a great investment opportunity.
[00:33:04] Will: And riskier also because those same LPs can check the stock price every day. But anyways, you guys had that conviction. You make the investment and then does Stockbridge continue to add to its position? This is ’08-ish, Rob? Just before and continuing after the financial crisis.
[00:33:22] Rob: As we started to take an outside capital in 2009 and accelerated that in 2010. We continued to build our position in the company.
Rob’s Appointment to TransDigm’s Board of Directors
[00:33:31] Will: Out of all that, you eventually become a board member. Can you explain how that unfolded, what that process was like?
[00:33:38] Rob: We had continued our dialogue with Nick as shareholders. Warburg had started to sell down their exposure. They have a practice of not holding companies very much when they are public, or at least at that time. And so they had started to sell down what they could and one of their directors had left the board. And so they had an open spot.
Nick viewed very much the company as private equity in the public market. So to add an investor to his board who had a private equity background, but yet was a public investor, I think, fit exactly what he was looking for. So he put me up to the rest of the board as a potential board member in 2010. I was on the younger side at that point, not so young in many ways, but younger than most of the members on the board, so I had to get quite a bit of interviewing from Doug Peacock, who was the founder, along with Nick, who was still on the board. Definitely wanted to make sure that he didn’t want a young whipper snapper on the board.
[00:34:37] Will: What did the board look like at that point in time? How large was it? What was the general composition when you joined, Rob?
[00:34:42] Rob: It was a relatively small board. It’s grown some sense then, but there was another Warburg person, Mike Graff, who is still on the board. There was, at the time and now retired from there, the CFO of Sherwin-Williams, which is a great Cleveland company. And then a couple of outsiders that they had recruited along with Nick and Doug.
[00:35:06] Will: So by public company standards, not a gigantic board.
[00:35:09] Rob: It’s an interesting business. The board’s important, but because of the heavy decentralized approach, in some ways, the executive management team acts like a board for each of the individual businesses. And then we act like a board for the combined business. So there’s a lot of engagement as a supervisory level from the executive team to each of the individual businesses that run themselves.
[00:35:34] Will: So comparing it to other private equity boards you’d served on beforehand, what was the TransDigm board like?
[00:35:41] Rob: In many ways, the TransDigm board is very similar to a private equity board. People are engaged in the company. The conversation and the activity is designed around adding value. And people care. People are engaged and informed. Nick has always used the board as a valued input to the decision-making of the management team.
[00:36:06] Will: You joined in 2010. And at this point, the private equity fund has a full position. Stockbridge has a full position. It’s 20-ish percent of AUM.
[00:36:16] Rob: It was smaller at Stockbridge at that point. It took us a while to get as comfortable with concentration as we got over time. We didn’t sense we wanted to figure out whether we deserve to have that much concentration in something. We had a little more data behind how often we judged things correctly. So we built up to having the conviction and the courage to have larger positions. So it was probably closer to high single digits at that point, but it then built up over time.
Rob’s Trajectory of Conviction
[00:36:42] Will: So maybe if you don’t mind, Rob, talk a little bit about that, the trajectory of conviction. Go on the board and you get to know the team and the business better over time. How did that translate into further building an already large position for Stockbridge?
[00:36:55] Rob: In some ways, I had a misplaced view that the business strategy was so brilliant and so well constructed and so carefully done that that was the reason they had such great results. Therefore, that always left me with the fear that it could be copied, and that it would be harder to make acquisitions as the world got more exposure to how good a business it was and where the opportunity was in this.
Then we did a couple of transactions. One was buying a business called McKechnie from JLL, which was their attempt to do a TransDigm and they had bought a number of businesses. And I saw the incredible level of improvement that we were able to do and the discipline of selling off a few of their businesses that we didn’t think fit with the strategy at the time, even though they added EBITDA, and so probably would’ve been valued in with the rest. But we chose to sell them.
Then even closer to home, we had bought a business in private equity called AmSafe that makes most of the seat belts on airplanes. You think of the seatbelt that you’re accustomed to on almost every commercial plane, those are made by Amsafe, both the buckle and the actual webbing. And they have a number of other businesses. Berkshire had bought that along with Greenbriar Equity and had done a nice job of improving its productivity and improving its profitability and making good, solid pricing decisions. And had created quite a bit of value for our investors.
[00:38:35] Will: Do you mind going a bit deeper on how the Amsafe story played out following Berkshire’s ownership?
[00:38:41] Rob: Eventually TransDigm was the buyer. We had a very limited process. They acted incredibly quickly, incredibly diligently, did exactly what they said. It was great to see on the other side of a buyer why they’re a good person to sell a company to. They basically completed their diligence and did all the work in a couple of weeks because we had an offer on the table that was attractive, so they didn’t have time. And they acted very quickly and came in with a higher bid and delivered. There was no backtracking, so they were a great counterparty.
[00:39:13] Will: I remember around the time that happened, talking to one of your partners about AmSafe and him telling me how well he felt the company was run, how much improvement there had been in the margins, and so forth. So it was an example of a well run private equity asset falling into the hands of a strategic buyer.
[00:39:31] Rob: We thought it was, and it was well run, or it had been improving. And certainly, it improved a lot over the years. And we wondered about some of the one off acquisitions. We knew the game plan. We were following the playbook of TransDigm. We had been investors in TransDigm. We had done diligence on TransDigm. It’s what led us to be very interested in AmSafe. So we were implementing what we thought was a little bit their playbook at AmSafe. And the management team did do a good job. TransDigm, as I was saying, has… Their typical acquisition model calls, if you have to guess, I would say typically a doubling of EBITDA over five years, which then I believe they usually achieve quicker. This was no exception, which was a little humbling. We had this business. Now, part of it is they can have a little more courage in making moves because they’re diversified.
It’s not going to sink the company if they make a wrong move on any particular one, so that gives them a little more freedom. But the truth of the matter is the blocking and tackling and the detailed execution on the operating side. On the portfolio side, they stripped out some businesses that they didn’t think belonged in AmSafe and got rid of them, where most people would say, “Wait, that adds EBITDA, why be so careful?” They just got rid of them. And on pricing, they went through and very thoughtfully, almost on a SKU by SKU, customer by customer basis, thoughtful on pricing and in moving prices in both directions to maximize.
The big thing that it made me realize at that point was not only how great of executors they were and how much better it was, but it made me realize that they could always win an auction. They could, with confidence, ring more value out of an asset than anyone else in the industry, which means they could pay the highest price, which means they should be able to buy anything unless another bidder made a mistake, frankly, because no one else executes like they do. It’s really interesting, it all comes back to the execution. The execution drives the M&A because it makes them the logical bidder and the logical winner in all of these. And it’s because they run it better.
[00:41:39] Will: It’s actually very analogous to capital cities many years ago. In a similar way, their advantage was their ability to operate broadcast properties exceptionally efficiently, and to improve even really, really well run ones. So going back to McKechnie, that was a big bet. It was around a quarter of the company’s enterprise value at the time.
[00:42:01] Rob: McKechnie was the largest acquisition at the time. And the beauty of McKechnie was it showed the discipline in the portfolio. They immediately sold off some pieces. There’s always the temptation to grow larger, because if you can grow, it’s good for valuation. You can make money, but that temptation can lead you to want to buy things that don’t fit the portfolio or hold onto things that don’t fit the portfolio. And McKechnie had a couple of pieces like that, which we sold on immediately. And then they operated the rest and had the same type of results, again, from a sophisticated seller and a sophisticated corporate management team that was trying to recreate a TransDigm company. And TransDigm, again, took it over and created tremendous value from that acquisition.
[00:42:49] Will: And same sort of profile where EBITDA at least doubled within five years or less performance post TransDigm ownership.
[00:42:56] Rob: It was not different than the pattern.
Translating Conviction to Position Size
[00:42:59] Will: So you see the improvements at McKechnie, you see the improvements at AmSafe, and you build conviction. Does that translate into position sizing for Stockbridge?
[00:43:09] Rob: Yes, that led to more conviction over time. Its outperformance compared to our portfolio throughout a lot of its history also led to just natural growth in our position size. And, in some ways for us, the remarkable thing about TransDigm is that, at least to our projections, which the unique thing about projecting the future is you know that they’re wrong, but it’s the best you have, so you rely on them to a degree. And TransDigm has always traded in an attractive range. In the 15% range at the low and it’s traded significantly above that at certain different shock periods, in our mind, where we could get much higher returns.
Persistent Undervaluation: Acquisition Pace and Exit Multiples
[00:43:50] Will: Just to frame that. So when you say that, you mean that five year IRR math, that you guys run systematically, as I recall, weekly, you’re looking forward at the next five years based on your projections and from the then current market price, the five year IRR is 15% to higher than that?
[00:44:07] Rob: Yes, that’s exactly the way to explain it is that we keep it updated with the current price. We don’t update our models weekly. When you’re looking at five year increments, we hope the world doesn’t change that quickly. So we try to update our models as we get new information, but we update daily with the price and run that through the model, so we know where our five year projected internal rates of return are. And TransDigm has always been attractive and that’s unusual.
Most companies that we’ve invested in, we’ve been lucky enough to have some others that have done extremely well, but those we’ve been tempted and sometimes fallen prey to that temptation to sell those great businesses because our current models didn’t look as good. So the unique thing for TransDigm is that never happened.
[00:44:50] Will: That’s interesting. What’s behind the persistent undervaluation?
[00:44:54] Rob: It’s because our prediction of the future understated what was going to happen. And it understated, in this case, in a couple of areas.
Most notably, the pace of acquisition, which I think is a very common thing in companies that are serial acquirers for people to underestimate. And that may be an opportunity in the public markets, but we started assuming that TransDigm was going to acquire at $30 million of EBITDA per year. And we ended up raising that after a couple years to $50 million of EBITDA per year. And that still is in our base case model. We show sensitivities on everything, but they’ve obviously way, way, way outperformed that.
And then we underestimated the exit multiple. And part of that’s just market. The market has gotten more expensive than it used to be. Which one’s right, which one’s wrong, it’s very hard to know. But also, the company has proven itself over the years to be spectacular and have spectacular performance. And so it should trade for a higher multiple. So if you put that high multiple in before, then you’re just doubling your risk on getting that performance. So we’ve adjusted that, we started with a 12 times EBITDA multiple. Keep in mind, this is a company with very little capex.
[00:46:11] Will: 2% of revenue.
[00:46:12] Rob: Yes, it’s relatively small, which means unfortunately, 2% of revenues means 4% of profits since they have such a high margin. Between exit multiple being higher, we went from 12, then we ultimately went to 14. We’ve tried to improve how we think about exit multiple generally across the firm. And the little bit is what should this company return to the next buyer? If we sell the company in five years, we typically have a model that goes at least to year 10. And what’s the IRR that the next buyer should earn? And we try and come up with a judgment on that based on long-term returns on capital and the risk and the leverage here and different things, which has led us to a little bit of a higher multiple. And especially now, we think it should trade at a higher multiple today, certainly, because we have a brighter view for aerospace ahead after people decide they want to get back on planes. And so we think we’re on a depressed earnings level now. So today’s multiple we think is not very important.
[00:47:12] Will: Did you guys raise exit from 14 times as part of that process, in the current environment?
[00:47:16] Rob: It’s gone up, it moves around a little bit, depending on what we think the long-term returns are, but it’s gone up a little bit, probably closer to the 16 or 17 times multiple over time.
[00:47:27] Will: You mentioned acquisitions also, which is obviously a significant driver. Did you say, Rob, you guys are assuming 50 million a year in acquired EBITDA going forward? That’s still the assumption?
[00:47:35] Rob: The problem is 50 million of EBITDA has been a pretty good average excluding the big whales. So, question is how many more big whales are out there and how much do you want to bet that they do it? So when we think about our base case, we don’t put that in, but then we realize that there’s potentially option value on top of that.
[00:47:57] Will: Great. All right. Well, this is a nice place to pause. Next time, we’ll dig a bit more into your experience on the board and Stockbridge’s management of the TransDigm position.