Skin in the Game: Why Microcap Buyout Investors Should Own Alongside Management

During their recent episode, Taylor, Carlisle, and Claremon discussed Skin in the Game: Why Microcap Buyout Investors Should Own Alongside Management, here’s an excerpt from the episode:

Ben: I’ve got this thing, where I want to invest in companies that I would intellectually be happy owning 1% of 20% of or 100% of. And so, everything we do has an eye towards control. I don’t want to just own 1% of a company in perpetuity. I think a passive strategy in microcap where you just, whatever– 1% positions, that’s not for me and I don’t think that’s a good strategy. I think you have to be more active when you’re in microcap. A fund where we could establish the firm team and in a situation, where we got to the end of the line of a take private and someone else took it from us, at least we would own some stock and make some money.

So, I feel like I’m swimming in parallel lanes here with our primary go to market is going to be through via SPVs. I need to say this, because I’m an investor first. I’m not a transaction guy. I’ve never been an investment banker. And so, again, nothing against investment bankers, but I think if you come from that background, you might have a slightly more transactional nature here. The idea of getting a deal done versus the best deal could I think if you just used to that world could permeate your thinking, but I’m trying to do great deals, and so only things that we would put our own capital in.

So, the timing of such could be months. It could be hopefully not years, but it could be months. And so, we want to be really careful and judicious about what we take to people, because we want to have the reputation that we’ve done a lot of work on these companies and that we have an approach that can A, resonate with the management teams and LPs, but also sustainable and repeatable. So, we’re unapologetically not going to be jumping– just trying to jump in the pool as fast as possible to get deals done. But probably, if things work, knock on wood, we’re going to be in the position to have, as we distill the universe, a handful of things to take to our LPs in the coming months.

Tobias: Do you see anybody in this space who’s already doing what you’re doing? Is there any model competition?

Ben: Yes. So, I would say, we would love to be the little brother of P2, which is a group that has done– They bought Blackhawk Networks. If you want to know what we’re trying to do, we’re just trying to do what P2 is doing and in the microcap space, and they’re invested in much bigger companies, so they’re not even playing in the same world as we are. But that’s the model that they are running, where they invest in these companies. And then obviously, if there’s a situation where there’s a take private available, they raise an SPV to do the deal. That model where you have a public fund and that being a farm team for take privates or a venue for take privates, I think is the model.

There are other people who have been doing something like this. A lot of you may be familiar with Mill Road. Mill Road has a public strategy, and they have done a number of take privates. There’s a company called RG Barry that Cove Street actually owned when Mill Road bought it. They’ve got a good model. Their idea is like, you’re going to buy X% in the public markets, you’re going to agitate– It’s like an activist strategy in a lot of their holdings, and they’re going to agitate for change. If they agitate for change and it happens, the stock remains undervalued, they bought X% at hopefully a low price, and then they can buy the other Y% take private and their cost basis is lower, because they already owned, whatever, 15% or 20%. It’s a good model, but it’s taking those guys a really long time to do it. And so, what that is the evidence of how hard this to get right and having the right LPs and doing the right deals.

And so, there’s a couple other firms. I think [unintelligible 00:54:47] is a public microcap-oriented firm that did a deal. It’s just like here and there. One thing that I am concerned about and I’ve heard this from allocators is if your main role is to run a 50-stock microcap fund, that’s a full-time job. That’s a lot of securities, that’s a lot of management teams, that’s a lot of people to be watching over in terms of capital allocation. To execute to take private, in some ways, that’s a fulltime job. So, I think it’s a little hard to run a traditional microcap strategy and execute private. I think some of the players who have tried to do that, they have run into that situation.

So, the simple answer is the capacity constraints in this strategy, the perception that microcaps are broken, the lack of institutional capital available for such a strategy means that there’s unlikely to be a lot of competition going forward. But I don’t want to pretend that we’re not going to run into situations where a strategic or a financial sponsor could be a better owner of something. I think that’s one thing that I’m really focused on is, as we’re approaching these companies, like if it is really clear that we’re not the best owners of something. We have to have the humility to say, ” You know what? This is not for us.”

There’s a strategy, there’s a sponsor who already has a platform here. We can’t be the best owner, or we just don’t understand. We don’t have enough history with a business model. And so, we’re going to be highly selective in everything we do. We don’t need to do 20 deals over three years. If we did a deal a year and whatever, because this is going to be labor intensive, it’s going to be time intensive, that would be a great outcome for us.

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