Will Thorndike, author of The Outsiders and Host of 50X, joins Patrick O’Shaughnessy to explore the power of multi-decade holding periods. From revenue quality to culture, Will digs into the characteristics that promote long-term compounding. Throughout the conversation, Will relates his philosophy to both an emerging investment partnership in Compounding Labs, as well as the 50X podcast and its inaugural series on TransDigm.
Explore resources related to Will's conversation with Patrick, including 50X's first series on TransDigm.
October 23, 2012
“An outstanding book about CEOs who excelled at capital allocation.” — Warren Buffett
Will Thorndike - How Skilled Capital Allocators Compound Capital
Invest Like the Best
May 9, 2017
Will's prior interview with Patrick covering how the Outsider CEOs were contrarians in business tactics, lessons for capital allocation, and Will's experience in private equity.
Trish Higgins and Will Thorndike - The State of Private Equity
Trish and Will join Brent Beshore to discuss investing in the lower middle market, the explosion in popularity of search funds, and where reality strays from expectations.
Letter that explores various flavors of serial acquirers, why they're often overlooked, and what successful companies share in common.
Studying Serial Acquirers
October 2, 2021
Building on Scott Management, this write up offers more thoughts on why (good) serial acquirers are special
Paying Entrepreneurs to Find the Right Business
New York Times
March 12, 2009
A peek into the most successful search fund and one of Will's earliest long-term investments.
TransDigm: Foundations with Nick Howley
July 14, 2022
Nick Howley explores TransDigm’s foundations under private ownership, digging into its core value drivers, decentralized culture, differentiated compensation program, and early M&A motion.
TransDigm: Redeeming the Most Painful Loss with Rob Small
July 21, 2022
Rob Small discusses the core elements composing TransDigm’s business quality, Berkshire’s and Stockbridge’s initial investments, and the trajectory of Rob’s conviction.
TransDigm: Operator to Capital Allocator with Nick Howley
July 28, 2022
Nick Howley on TransDigm’s approach to special dividends and leverage, meaningful acquisitions, the prior three decades, and the future beyond $50 billion of Enterprise Value.
Bridging The Outsiders to 50X
[00:02:09] Patrick: Our guest today is Will Thorndike. 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 Thorndike and if you haven’t subscribed to 50X, I highly recommend doing so.
So Will we have the benefit of being able to talk about probably five or six different things today in your life of investing and 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 what that work did to your mind, your investing mind, and why and how you’re continuing that concept with 50X.
[00:03:30] Will: 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 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 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 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 team members, key advisors, key employees of different business units, competitors, et cetera.
It was a very rich experience. Rules we used 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 that process and my own investing has evolved in such a way that… I’m now I retired from Housatonic, the firm I was involved founding about eight years ago. I’m now investing personally, and the common thread 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 have known for a very long time. We’ve invested and worked together over a dozen years now. We all share a voracious curiosity around this topic. And 50X was 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, and the idea for 50X is it’s a 50X MOIC on your investment. That’s a 20 plus percent IRR over 20 years. It’s a high bar. So to look for examples of companies that had passed that test. We thought about a 100X, but that was already taken. So we settled on 50X, still a reasonably high bar.
Ideal Businesses for Long-Term Holding Periods
[00:06:28] Patrick: 50’s pretty good. I’d love to dig into this interest that you have in long-term holding periods in as many ways as we can. The TransDigm 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? There’s a lot going on over a very long period of time. Obviously, periods that long are fundamentally unpredictable. 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 unpredictability 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, “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.
[00:07:22] Will: In the original Housatonic fund we still owned 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 been incredibly fun and satisfying to work on. You asked that question about how has the book influenced 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 Housatonic funds, and then a whole range of other companies I’ve been involved in over a long period of time with the idea that 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 Labs, but we’ve really become zeroed in on revenue quality. So the purest form of that 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 low churn businesses. And when I say churn, I mean, logo churn, gross churn, net revenue retention is, 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 TransDigm. TransDigm, which I’m sure we’ll get into in some detail, their business is very specialized aviation components, airplane parts. When they get engineered into these core airplane platforms, frames, whether it’s the 737 commercial aircraft or the B-52 and defense aircraft, 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.
[00:09:42] Patrick: Maybe we could just keep digging in until we find a 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? What kind of things are you looking to actively avoid? Even if there’s, let’s say, low churn?
[00:10:08] Will: It’s one of these things 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 looking for these sorts of long holding period platforms. 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 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 focus on. We can talk a little bit about that. But a lot of 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.
[00:11:23] Patrick: Say a bit more about capital efficiency. So what do you mean by that specifically? We don’t have to use TransDigm, but maybe with an example to nail home the point.
[00:11:30] Will: So, basically everything I was saying TransDigm would be a pretty good exemplar of, it’s a really great business. But 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 EBIT A, we assume that depreciation equals CapEx, which is usually a pretty conservative assumption. So we take EBIT A, we tax effect it, so we multiply it by one minus the tax rate.
Historically, that’s been 0.6, at the moment it’s more 0.7, and you divide that by networking capital plus net PP&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 of it, really at a more simplistic level you’re looking for businesses that have low maintenance CapEx requirements.
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 that get paid in advance. One of the things that I think I’ve learned as I’ve gotten older is the incredible power of negative working capital. And 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 on tangible capital, we call it ROTC, really highlights that. So our businesses tend to be very capital efficient, which is code also for asset light.
[00:13:02] Patrick: Say a bit about an example maybe of what looks like an attractive business, but requires a lot of maintenance CapEx as a sort of counterexample. Something pop to mind there?
[00:13:12] Will: 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 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 business Iron Mountain dominates, where you store paper and electronic records, mostly paper records. But those records sit on racks in a warehouse, zero CapEx required to maintain them. That’s actually a wonderful business on these dimensions. It’s a 2% customer churn business with very low maintenance CapEx, and they’re very similar businesses. The business model is similar. So one would have higher maintenance CapEx, 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.
[00:14:22] Patrick: The other notable thing you said is tangible capital, when the world has gone the direction of intangible assets, beginning to ever more dominate the total assets, let’s say, of the S&P 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?
[00:14:44] Will: 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. The intangible assets in the sense of intellectual property actually correlate very highly with this type of capital intensity. I mean, if you sort of look at the FAANG 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, which is itself an intangible asset, but not one that shows up systematically on the balance sheet.
[00:15:25] Patrick: 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?
[00:15:51] Will: If you have a low churn business that’s highly capital efficient, you’ve got predictable cash generation, which in business is a very, very powerful thing. Going back to Compounding Labs, we are partnering 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. 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 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 hierarchy, it allows you to very efficiently use leverage to build those companies via acquisition. Particularly if you’re thoughtful about the pacing in the early years. One of the lessons in TransDigm, TransDigm required $25 million of primary equity. That’s it.
[00:16:59] Patrick: Wow.
[00:17:00] Will: Today the business has $35 billion 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 and they didn’t do their next acquisition for four or five years till Odyssey came in. 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 TransDigm’s an excellent example of that. Nick built the flywheel really early on and it’s still humming.
Value of Deep Research
[00:17:45] Patrick: If you think about, I guess the power of that patience early on, and you’re doing these very deep dive looks at companies for The Outsiders now for 50X. What are the kinds of things that you’re uncovering about let’s say TransDigm, since it’s the most recent example. That you think would just be overlooked or underappreciated if you spent, I don’t know, five hours researching the company or some shorter period of time that probably a more traditional analyst new to the company would get familiar in five, 10, 15, 20 hours, something like that. What kinds of things would they miss maybe specifically for TransDigm, but what is the value of this like crazy deep dive, year long type research that you do?
[00:18:23] Will: It’s the peeling back the layers of the onion analogy. So examples of things you learned from diving deeper, pacing is one of them. You need to look really hard to get at that, but their approach to pacing was very different, very differentiated. Another item that’s important to them is they’ve retained the ability to do really small acquisitions as they’ve gotten bigger. That turns out to be a common thread 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. TransDigm 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. 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. 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 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.
The lessons that come out about how to instill, imprint a culture widely in an organization, sort of idea of the simplicity of the value creation triad at TransDigm, which is repeated add in for an item. It’s repeated add in for an item 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 sources of value creation and every GM is evaluated on those and every review of every business unit quarterly is centered on those.
[00:20:32] Patrick: There’s two things you bring up there, coming back to my original question of why bother with super, super long holding periods where there’s so much uncertainty. It seems as though game selection and then culture are two really critical things to focus on early on and things that are sustainable. Choose the right game, you can play 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. I’m just curious for everything that you’ve learned across your career now, looking at God knows how many 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?
[00:21:14] Will: 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 and 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, the stickiness around retention rates and the profitability really does come from how efficiently does the business translate EBITDA into free cash flow? That ROTC metric is essential 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. 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 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 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… For instance, very few businesses that have those three characteristics don’t have high EBITDA margins.
[00:22:47] Patrick: What about the customers being served or the types of customers being served? So FAA change, serving the government for a B-52 part or something is a visceral example because of how crazy the switching cost or the switching 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?
[00:23:11] Will: They tend to be business customer. B2B business, the vast majority of the time and then they tend to be providing a service, in the case of TransDigm, a 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… 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 the boxes they may lose the one box they need in litigation or when the regulatory agency examines-
Culture & Decentralization
[00:23:43] Patrick: The culture piece is the other side of this coin that I think is so interesting, those three Ps that you mentioned for TransDigm, 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 with Danaher 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.
[00:24:10] Will: 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. I think increasingly you can look at things like internal NPS scores Glassdoor ratings. You can get a sense of these things. I think Silicon Valley stereotype culture, which implies sort of bean bag 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, 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 that people who work at corporate.
[00:25:09] Patrick: 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 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 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 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.
[00:25:44] Will: 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. 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, I mean, again, you can kind of super, roughly get at it quantitatively by looking at the ratio of people at corporate to total employees, relative to the peer group. So a lot of the companies and the outsiders and the book and TransDigm as examples were just off the charts, they had 10 X, five to 10 X, as many employees, total employees per employee at corporate.
With that is this idea that again, that you’re trying to retain entrepreneurial ethos, that’s an essential priority. So that’s one of the objectives of a decentralized culture. The other is you are lowering your cost and in these cultures, there tends to be an element of frugality, scrappiness in the culture. 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. The tricky thing is in almost every case, 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. 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 general managers?
[00:27:50] Patrick: 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?
[00:28:01] Will: 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? The other thing that happens in those 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 or a little element of competition, but also shares good ideas. That would be an example. You have healthcare insurance, you’re going to make everyone on the same healthcare 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.
Applying Investment Criteria to Software
[00:28:46] Patrick: 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. Really key part of other people’s business processes, very sticky, low churn, fairly asset light, and so on, low marginal cost. What do you think about software? It seems uncontroversial to say software is a good business model and we haven’t talked at all about price, how much the market price is in all these great features, but what have you learned about software specifically and has your interest in that industry or business style grown?
[00:29:22] Will: Software fits this model really closely. It’s become in the last 10 years, you make that specific, it’s become a single most popular industry for search funds, for search fund managers…
[00:29:33] Patrick: That’s interesting.
[00:29:34] Will: …for that reason. It just fits the profile really, really well. 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. He’s buying super nichey, super vertical market software companies, and then keeping their PNLs separate and running them very independently.
The Art of Serial Acquisition
[00:30:00] Patrick: 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. 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? What do you think the best serial acquires do or focus on?
[00:30:26] Will: I mentioned pacing. And 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 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 churn, 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 in the combination of those two things. And that’s the rule we spend 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 acquirers, 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 want some growth, but again, the profile would be substantially less than the organic growth profile of a typical, say, search fund company.
[00:31:45] Patrick: 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, the advantage for a long-term holding period 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.
[00:32:17] Will: We’re active, prudent, but active users of debt. And we tend to be reasonably creative in how we used debt. We’re open to new solutions. So we tend to have relationships with senior lenders, but also there’s often some seller financing in 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. A lot of our businesses are businesses where we think the trailing 12 month look at EBITDA 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 spend a lot of time thinking about the covenants and how are they set and what are the different tests and so forth and so on. 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, it has yet to become a major factor in how we’re thinking about capital structures for our companies. That could be the very different 24 months from now.
[00:33:39] Patrick: If you think about the lessons learned from The Outsiders, TransDigm, et cetera, and the way that great capital allocators operate, the 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 The Outsiders, that he was just willing to completely change his strategy if the prevailing market conditions changed, 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? 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?
[00:34:16] Will: It’s an interesting question. The pattern that we see in search fund companies, and so far in CL is that in the 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 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 grow and evolve over time, the menu, the pallet of capital allocation options tends to widen.
And so, by the time you get out to year seven 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 dividend recap… 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 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.
Defining Recurring Revenue
[00:35:40] Patrick: 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 there 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.
[00:36:06] Will: Purest 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. 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 TransDigm itself. Actually, one of the learnings that TransDigm, you asked that question earlier, but that was fascinating is if you watch TransDigm over time, several times they bought larger companies where 75%, 80% of what they bought was pure form after market 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’ve gotten the higher multiple on it, it would’ve added near term enterprise value and equity value, in every case, they insisted on staying. They were purists.
[00:37:33] Patrick: That’s fascinating.
[00:37:34] Will: I think as we’ve gotten older, we’ve gotten more focused on the purity of, “Why settle? Why not focus on the truly elite recurring models?”
[00:37:42] Patrick: 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 change. 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?
[00:38:02] Will: The number one thing, Patrick, honestly has been that I stepped back from Housatonic about eight years ago. And that was coincident with some of the renewed focus and work around that’s led to this even longer term… Housatonic had extremely long holding periods relative to the world of private equity, as we talked about last time. The number one thing for me has been intensified focus on extraordinarily long holding periods. Part of that is 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 sold our best businesses, had to because of fund life reasons. And so I also did some work on the IRRs to the next owners of businesses, really good businesses I was involved with but had to sell. And they’re unfortunately really good, really consistent and really good. That further underscored 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.
[00:39:09] Patrick: Can you say a bit about the three companies that you mentioned that Housatonic 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.
[00:39:19] Will: Two of them were early search fund companies, two of the first 10 search fund companies. One is an amazing company called Asurion, which is 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 Taweel 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 Carillon, 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 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 Carillon 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 residents, but within the world of assisted living, it has very high persistence, very high retention rates and both Asurion and the information business had extraordinarily low churn. All those businesses had excellent returns on tangible capital and they’ve all had great organic growth over a long period of time.
[00:40:29] Patrick: 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 are a chair and have worked with just a crazy amount of CEOs hands on in your career. So let’s start with Karen. What made her so good and for so long?
[00:40:47] Will: 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 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. 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 a 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 to it, Carillon 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 very creative way there to finance new facilities, the ownership of the land, and using mortgage debt to do that. So she’s generated terrific equity returns 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 in a tax efficient way to shareholders and then occasionally to sell facilities and sell the spec transactions and her timing around those. 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.
Operating under Public Ownership
[00:42:35] Patrick: What about this crossover, public and private? This has been a really popular topic of conversation for, I guess, all CEOs. Everyone has to make this choice, if they 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?
[00:42:56] Will: 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 the day a week. One of the commonalities across the Outsiders 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 cost to being 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 CEOs basically found a way to minimize the frictions of being public. So it was as close to being private as possible, 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 DeIuliis 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 he can spend more time on the activities that really drive value in the business. And the other company I’m involved with is company called Perimeter Solutions, which I’m actually involved with with Nick. Nick 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 TransDigm 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.
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 values. That’s something that’s lost on people who read the book, but Buffet 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.
Function of Compounding Labs
[00:45:35] Patrick: If 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? I’m tempted to apply some of the same concepts of you want the home office to be pretty slim. But 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?
[00:45:58] Will: 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, in a highly equity efficient manner, and just conducting ourselves. One of the benefits of those really long time horizons is that 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, 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 ways that this activity could go on for many decades.
The other partners are substantially younger than I am, so I hope that I’ve got 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.
Potential Candidates for 50X Deep Dives
[00:47:10] Patrick: 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’s started or not? Because it seems like each of these things, I guess nine now, if you count TransDigm, 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 you can still learn. What sorts of things do you want to learn? What sorts of companies are you craving to explore?
[00:47:39] Will: 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 TransDigm 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, longtime 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 will dive in on. And so, 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 at TransDigm, means that our frequency will not be high, frequency will be low, and sporadic, and unpredictable. So, our very clear analog is Outstanding Investor Digest, which you may be too young to remember.
[00:48:54] Patrick: I only know it because of you having told me about it.
[00:48:56] Will: Yeah. This wonderful publication that published deep in depth interviews with investors, but came out very sporadically and had sort of a cult following. So, we’re likely to at least have that unpredictable frequency because we’re going try to do deep dives and then make the materials available in the show notes and in the links.
[00:49:15] Patrick: 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?
[00:49:36] Will: 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, 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 asset-
[00:49:59] Patrick: Interviewing John Paulson or something.
[00:50:01] Will: Yeah, different asset classes. The key is going to be access. We feel like it’s important that we can talk to principals. I think in some cases, we hope this is maybe the case of TransDigm, we want to be content of record on some of these amazing stories. And that hopefully that will appeal to a certain sort of CEO who maybe hasn’t told their story in depth before, CEO or investor. But the clay is still very wet in 50X.
Developing Conviction as an Investor
[00:50:25] Patrick: If you think about the other side of this coin, obviously the focus of The Outsiders, 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 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. This seems like a topic no one really talks about. What have you learned about the development of conviction long term for investors?
[00:51:09] Will: It’s super interesting question and really it’s at the center of 50X. I think we really want to dive in. And if you look at TransDigm, 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 way, 9/11, and what that did to the aviation industry. They had a company specific 60 minutes 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? And the fascinating thing about Rob is he’s super thoughtful and he runs a concentrated portfolio and TransDigm 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 is 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.
Producing Great Media
[00:52:19] Patrick: 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 of podcasting. What have you learned 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?
[00:52:53] Will: Well, honestly, Patrick, I think 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 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.
[00:53:15] Patrick: Not so far.
[00:53:15] Will: We’re going to track these things down. And the authenticity of following legit, honest curiosity, that’s generally what has driven the project so far. Also, the super low frequency, slow pace, those things are related.
50X Research Process
[00:53:29] Patrick: It’s surprising to me how under-tapped people’s curiosity is as an energy source, 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, what has worked and what hasn’t worked in those interactions? I know that’s a random, strange nuance question, but it seems like, sure it would be great if somehow we had a pairing doing research like this on every company in the world, there’d be a lot to learn. So, what have you learned about that process?
[00:54:26] Will: Miles Wood has been working very actively on 50X, TransDigm and the next episode we’re working on and has been unbelievably great with Kent Weaver and I on this project. And Miles is following, I was fortunate enough, as I mentioned, to have these eights HBS students, second year students who I work with on the chapters in the book. Honestly, I think it’s a function of finding young people who share 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 probability that they’ll be a good fit for this work.
Evaluating Macro Conditions
[00:55:10] Patrick: For my last question, I just want to ask about the world for at 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 US 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 in a different kind of world. One, do you think that’s right? And two, if so, how do you adjust your thinking and your investing for a more complicated world?
[00:55:52] Will: Yeah. I think the world, 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 quantitative outputs of all that uncertainty, it’s inflation and interest rates that are most likely to hit us as investors, and there are other things. But it’ll evidence itself to a degree and those things.
So, thinking then about it that way, it’s sort of like, what businesses do you want 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. 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 sorts of environments. But it’s scary.
[00:57:09] Patrick: Why do you think you’re always bearish? What is it that for a long time has made you bearish?
[00:57:13] Will: It’s really hard to make the bullish case, at least it is for me. They’re always daunting… In the background, there is the warming of the climate, and there’s secular trends that are inarguable. I really just tune it out and don’t let it affect my investing behavior. I mean, 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 behavior. Collectively, I put it in the two hard buckets, 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.
[00:57:50] Patrick: 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 the fan companies, et cetera, and to do it, and 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.
[00:58:18] Will: 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 on.