In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Ben Claremon discuss:
- Why Unsexy Industrial Businesses Are Ideal for Microcap Buyouts
- Beyond the Knockout Punch: Why Microcaps Struggle with Business Diversification
- Microcap Investing: Finding Diamonds in the Rough
- Skin in the Game: Why Microcap Buyout Investors Should Own Alongside Management
- Microcap Investing: Levered Companies Are Going To Be Zombies
- Institutional Exodus Creates Microcap Investing Advantage
- Unlocking Microcap Growth: Public-to-Private Strategies for Value
- Taking Microcap CEOs from B+ to A: The Value of Supportive Investors
- Microcap Investing: The Activism Approach vs. The Buyout Opportunity
- Building vs. Buying: A New Approach to Microcap Private Equity
- Microcap Buyouts: Why SPVs Can Offer More Flexibility Than Traditional Funds
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: This meeting is being livestreamed. This is Value: After Hours. I am Tobias Carlisle, joined as always by my cohost, Jake Taylor. Our special guest today is an old friend of mine, Ben Claremon. How are you, Ben?
Ben: I’m good. I’m excited to be on this world-famous Value: After Hours show.
Tobias: Ben and I have been wrestling small and microcap value equities. We’ve been wrangling them for what, 10 or 15 years now? 15 years, maybe longer than that.
Ben: Yeah.
Jake: This is winning.
Tobias: Micro cap equities. [chuckles]
Jake: Yeah. [laughs]
Ben: Somebody else large cap, S&P 500 burning. [crosstalk]
Tobias: I didn’t hear no bell. We’re still going.
Ben: Still fighting. Bloodied, beaten, underwater, but still fighting.
Tobias: So, let’s kick off with, what are you up to now? You got a new venture. Let’s talk about the new venture.
Ben: Yeah. So, maybe it’d be helpful if I just for people who don’t know anything about my illustrious career as a public equity investor, maybe I’ll give some background. I started my career in 2007. I was basically in public equity markets from 2007 until pretty recently. Well, where now I’m still in public equities, but just with a slightly different tone. So, most of that career was spent at a firm here in Los Angeles called Cove Street Capital, long only value suggestivist/activist. And so, it was really there where the strategy that I am running now was formed. Some of the experiences there have really led me down the path I’m on now.
So, what did I see at Cove Street? So, really the main takeaway that I have from being in a firm that focused a lot on small and microcap was that there’s just a structural lack of growth capital and capital in general, but growth capital available to these companies. There are very few large check writes in this space. So, I’ll give you an example.
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Institutional Exodus Creates Microcap Investing Advantage
At Cove Street, we owned probably 8% or 10% of a $700 million market cap company. We had a really close relationship with the CEO. He was on my podcast, Compounders, anybody who follows that show. We got a call from the CEO one day and said, “Our founder of this firm is sick.” He owned whatever, 25% or 30% of the company. The CEO said, “I don’t want these shares going to private equity. I would like you to buy them as Cove Street.”
And then we said, “Okay.” We went off on an experiment to try to raise $200 million for an SPV.
And so, what I saw was that we would have been able to buy these shares at basically a negotiated transaction significantly below the intrinsic value if we had been able to raise a $200 million SPV check.
Now what you find is that is a very challenging thing to do as a long only investor, like your LP base isn’t the right structure. We had mostly long only investors who worked with long only allocators who worked with us. Even if their firms invested in privates and other things, that was the other side of the house, that’s the old side of the house. I watched myself and the team run around for months trying to get raised this check, and it was just impossible to do it, given our structure.
And so, what that said to me was that, why isn’t there somebody who’s running a hybrid public private structure where you could own 20% of a public company or in the right situations execute on private? And so, I think if you just think about the structure of the small cap and microcap universe, there has been a secular problem which has been exacerbated by the underperformance of small and micro versus the S&P 500 and everything larger. So, what is that problem that I think creates the opportunity for us as microcap focused investors today, and I’ll talk about the firm I’m working for and what that actually means.
Small cap still is to some extent. But small and microcap used to be institutional strategies. I listened to Brian Bares, who runs Bares Capital Management, and he was on my partner Bobby Kraft’s podcast and he talked about, when he started, his micro-cap strategy in 1999 or 2000, institutions were interested in it. It was different. There were no $30 billion endowments back then that I know of, right?
And so, what’s happened is that when those guys have gotten so large, those big foundations and endowments have gotten so large that like micro-cap is no longer a strategy that they’ll fund, because it’s capacity constraint. If you need to write a $100 million or $250 million equity check, you are not going into microcap, because it can’t scale. And so, what happens is that there’s just very little capital flowing into the space. The good investors graduate out of microcap, because unless you’re willing to close at $100 or $250 million at the very most I think and still want to buy small companies, unless you want to close your strategy, you’re going to graduate into small cap. You’re going to graduate into SMID.
And so, what’s happened is that, and it’s been unfortunate, but we’ve seen a hollowing out of the institutional investor base in this space. And so, what that’s meant to me is that there’s basically a lot of the space has been orphaned. Just look at the returns. The Russell Microcap Index has the worst performing relative returns over every long period you can look at. 10, 15, whatever it is, look at the numbers. S&P and obviously the larger has just crushed it. But it doesn’t matter. It’s been the worst performing space. And so, people think that its broken. People think that the companies are broken, that they’re small for a reason.
Our hypothesis at Devonshire is that the reason these companies are small, one of the reasons is that there’s a structural lack of growth capital available to them. Even if they could be larger, could graduate from microcap to small could compound, there’s the inability to raise capital, whether from the debt markets or the equity markets, hinders that ability to compound.
And so, at Devonshire, I joined a guy I’ve known for a long time named Shahzad Khan who’s a lower middle market private equity guy. We own a couple of portfolio companies at Devonshire, both private companies. And so, what we’re doing is we are just layering on a public market strategy to the lower middle market private equity strategy that he’s running and we’re just opening up the world to all the publics involved.
I think we’ve been running full speed at this basically, I, personally for six months and then my partner Shazad for a few months. I think the differentiation of what we’re trying to do, trying to develop a premium brand in microcap, be the shareholder of choice, the buyer of choice for some of these companies, it’s really resonated. So, that’s what I’m doing. I’ll stop there. That was a long story, but I’ll stop there because my guess is you have plenty of holes to poke in the story.
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Microcap Investing: Levered Companies Are Going To Be Zombies
Tobias: [chuckles] Well, obviously, I’m sympathetic to this view, because I run a small and micro strategy and I see many of the things that– We’ve obviously discussed this offline pretty extensively. Playing devil’s advocate, one of the things that I have observed, if you break out the universe into S&P 500, S&P 400, S&P 600 which is 500 large cap, 400 mid cap, 600 small cap, and I realize that there’s a big universe underneath that that we’re not talking about that. Just for illustrating the purposes, you can see the earnings in the S&P 500 have been very strong over the last few years. The earnings in the S&P 400 and the S&P 600 have been much weaker.
I think when I look at the compression in the multiples, it follows that weakness in the earnings. We can talk about the reasons why. But to what extent do you think that the underperformance is deserved?
Ben: I think we’ve been through a weird period of time, COVID, and the supply chain issues and the inflation and all of those things that happened, I think, disproportionately affected small companies. If you didn’t have excellent systems, excellent processes, excellent sourcing, excellent pricing abilities, you just got run over. Then when you combine that with rising rates, where whatever so for plus five used to be a reasonable number, and now so for plus five is a really high number for most companies. So, what you have is you’ve had a compression in margins in a lot of cases, where gross margins have been impacted because companies have not been able to maintain, have pricing offset the gross, the cogs headwinds they faced.
Especially, when that’s happening and you have labor inflation on top of that, you have SG&A rising, and then you have rates rising and so interest costs, I could see the compression. That to me is a fact, but it’s a very static fact. So, the dynamic way to look at that is to say, these are companies that– now because of all of those things we talked about are not generating as much free cash flow as they were. I’m not even talking about the non-earners, whatever. There’s 25% to 30% of the microcap universe that doesn’t earn anything. So, let’s just take that those companies out and say, all right, so these companies, a good company, for example, who, that has secular tailwinds, that has a potentially growing TAM that’s operating well, just got disproportionately impacted by all of the things that have happened over the last, whatever four to five years now.
They don’t have free cash flow to reinvest aggressively into the business, which that means that they’re not making acquisitions. Even if they were creative, how in the world would they raise the money? Because you’ve got this self-perpetuating negative cycle where if your stock price is low, you don’t have a currency, so you’re not going to use that to do a deal.
I’m not going to name any of the investment banks who play in this space, but they’re going to charge you 15% to raise capital, and you’re probably going to have to do it at a discount to the stock price. So, its massively dilutive and the cost of equity given where cost of debt is really high. And so, how in the world do you fund inorganic or organic growth if all of a sudden you are A, beholden to sell side analyst world and investors expecting you to continue to beat and raise, how do you think about investing in your business for the long run and taking that hit to earnings that you need if you can’t generate free cash flow?
And so, on the extreme end of the spectrum, what this creates is, anybody who’s levered is now really, I would say just broadly in a lot of trouble because rates are higher– Even if you have a credit agreement that’s going to expire in 2025, probably– Again, so for plus five is now a meaningful number or if you’re going to go floating rate and if you had fixed debt, it’s expiring obviously you’re going to have a much higher rate.
And so, the levered companies I think are going to be zombies in this space. No ability to raise capital. They’re just going to just putter along. Some of them will survive and some of them won’t. But the opportunity we see because where we are– Anybody who’s listening to anything I’ve said over the last number of years, I’m a quality-oriented investor. I’m looking for a good business that is getting more valuable, that has a good management team that just doesn’t have the capital to really grow and can compound much faster if they can.
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Unlocking Microcap Growth: Public-to-Private Strategies for Value
So, to me, the opportunity is to whether it’s through a very friendly private investment in a public company, or through a full take private give these companies the ability to access that growth, whether that’s inorganic or organic. So, the valuation that these things trade at is going to be, I don’t know if permanent is the right word, but for a long time impaired from the public market standpoint because of that inability to grow through the headwinds. And so, to me, for a patient long-term investor who sees volatility as his friend, I just think that is the opportunity we’re trying to tackle.
Tobias: It’s extraordinary to see the amount to which the small and micro has been beaten up through this period. I was looking at some charts the other day. It looks like, if you didn’t know that the rest of the market was up, you would think that there was a pretty significant stock market crash in small and micro. It looks like it’s getting close to 2020, 2009 kind of difference in performance. Some of its deserved because the earnings haven’t bounced and they’re down from 2021. The multiples of way down too. It’s all pretty crushed. So, I don’t think it’s permanent. I don’t think it’s going to go on forever. Like you, I think it’s cyclical. I think these are the things that sow the seeds of the growth comes out of this. But you must receive that objection like other objections. What do you say to that, and why do people think it’s so broken?
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Microcap Investing: Finding Diamonds in the Rough
Ben: Yeah. The first thing I hear from people is that this is just pure adverse selection, that anything that was good enough to grow out of microcap has, that it’s compounded its way into small caps, mid whatever, even bigger in certain circumstances. And so, what’s left are the dregs. Businesses that have some reason to exist but don’t have, that aren’t getting more valuable over time, that are often run by people who are not that sophisticated when it comes to either operations or things like capital allocation and corporate governance. So, what you’re looking at is that just a bunch of broken businesses that are public because of some historical accident or historical reason and can remain public, but you’re never going to make any money there. And so, that is the first criticism I hear.
I think the way I would frame it, and I’m not going to talk about any individual companies, but that may be true 85% of the time. That’s a totally arbitrary number. But let’s just say it’s true 85% of the time. That still leaves 15% of the time where it’s not true. If those 15% of companies that don’t fit that characteristics but are tainted by the microcap taint, then you’ve got the opportunity for undervaluation.
So, I think the point is, if you just paint the microcap universe, which is very diverse in terms of earners versus non earners versus industries– You’re looking at, there’s a lot of companies in this space and it’s very diverse. So, to paint them all with the same brush, I think misses a big opportunity to seek out the best companies in this space.
We can talk about why, but we’re starting in the nanocap space, which is we defined as $100 million in enterprise value, because we’re private equity guys now, so that’s more important than [chuckles] market cap. So, we’re are now $100 million in enterprise value and lower. We’re starting with that universe and distilling it down to the handful of the best companies in this space where there’s a significant reinvestment runway which the companies are unable to access in the public markets.
So, if it were true that these companies were broken, then they wouldn’t have a high return reinvestment runway. I think the idea is is to find those ones that are the exceptions to those rules, which I think broadly can be true in the space. But the cool thing about what we’re doing is that we don’t need 200 companies. We just need to be able to find a couple new interesting ideas per year. I think that is an evergreen space for us to make money.
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Taking Microcap CEOs from B+ to A: The Value of Supportive Investors
The other objection that we hear is a cousin of that, which is that these companies are small for a reason. It’s not even necessarily that it’s broken, but that there’s a limited town, there’s a limited end market. You’ve got customer concentration. You just have small company problems that are going to forever keep these companies small.
Again, that’s going to be true X% of the time that you find business that can continue to exist and be moderately successful, but you’re never going to make money there. And so, something that didn’t have the reinvestment runway, we’re going to shy away from.
And then I guess the last thing is that people have a huge amount of skepticism for the management teams in this space. Look, microcap is filled with some characters. Go to a microcap conference and you will meet some interesting, interesting people. Without any question, there are some promoters and borderline fraudsters and some creepy people who you’d clearly would not want to partner with. There’s something about the wild wild west nature of microcap that attracts unscrupulous people.
[chuckles] I’ve been doing this a pretty long time. I’ve met hundreds of different CEOs. I think I’m pretty good at figuring out who’s just totally promoting something that doesn’t exist. Look, you can look at the business model and say, “Does this make sense? Is it proven? Has this company generated free cash flow?” You can screen out a lot of things that you might not want to invest in as a private equity investor very quickly.And so, I guess my contrarian perception regarding the management teams in this space is that there are plenty of B and B plus management teams who just need more bandwidth to become better. Where does that come from? Well, in a situation where there was a take private, you would basically give them, what, one of their arms back. They won’t have to be talking to investors a third of their time, they won’t have to be filing case and queues and doing transcripts and talking to bankers, and all the things that these managers do that take away from running the business.
And so, one of our pitches to the management teams that we’re discussing this with is that– By the way, I should say, our premise is that this is a management led buyout. In addition to some governance, capital allocation, incentives and maybe some operational expertise that we’re going to layer in, our value add is being a bridge between the public market and the private market through our capital base. And so, this is a management led buyout.
So, our goal is to take a B plus management team and parachute three seasoned financial people with an operating partner and help, A, give them their bandwidth back and then help them turn to an A minus or an A management team with our support. I just don’t see a lot of shareholders who are that active and helpful in this space. I’m not denigrating anyone who’s a public markets investor.
It’s just like when you’re running a 30-stock or 40 stock, 50 stock portfolio sometimes in microcap, how much time can you devote to one company? This is going to be our first deal, our first take private, our first big investment company. This is going to be our baby and we’re going to parachute four people in there to give management extra bandwidth to help on strategy, help on operations, make sure that corporate governance is tight, make sure that compensation is aligned with what the company is trying to achieve and make sure that they have a capital allocation north star. To me, that’s a lot of low hanging fruit in these companies comes from just checking those boxes and making sure those things are properly organized.
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Tobias: So, folks, JT has had to run. He was in the airport. You might have seen he had a flight he had to catch. So, there’s not going to be any veggies today, but we’ll get an extra helping next week maybe. Just before we move on, I’m going to give a quick shoutout to everybody. I know we didn’t do it last week, because were a little bit crushed, but Mendocino, California. What’s up? Punta Cana? Norwich, UK. Santo Domingo, Dominican Republic. Valparaiso. What’s up? Dubai. Malmo. Bangalore. Chapel Hill. Verona, Italy. Verona, Italy. Nice.
Ben: Wow.
Tobias: Prince George. Tallahassee. Nashville. New Delhi. Milton Keynes. San Diego. Hong Kong. Nafplio, Greece. Antwerp. London Town. Petah Tikva, Israel. Nice.
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Microcap Investing: The Need for Experienced Guidance in Capital Allocation
Where do you see the existing management teams in microcap falling down? When you’re reviewing all of these deals as they– all of these public companies, because they’re all publishing, when you see them, what do you see as the most sort of common error or the most glaring hole in what they’re doing?
Ben: Yeah. I think in terms of permanent capital impairment, where do you see that happen? It’s mostly in capital allocation, whether you make a deal that doesn’t work out or you bring on leverage for something or you build a plan [chuckles] where you can’t make it work. But I think when you see non-secularly declining business, a business that has a reason to exist and can grow and stuff like that, the way that you really see these companies permanently impair capital is through capital allocation.
And so, I’m a governance guy. I’m a capital allocation guy. Those are like my filters. So, I’m always looking for that. I think companies don’t get good advice. I don’t know that the lawyers and bankers that give these companies advice. I think there’s a conflict of interest in a lot of those situations. I think it’s explicit when you have an investment banker in the room. Nothing against my banker friends, but there’s a transaction-oriented nature to that job and I get it. I get why it exists and I get why they can be helpful, but that doesn’t mean they’re always helpful.
So, I think that, to me, situations in which you just see small companies do things where you read the press release and you’re scratching your head like, “Who told you this was a good idea? Who suggested to you that this was a good use of capital or this was a right way to raise capital or this pipe or this convert, which is going to crush this company? Why was it done this way?”
And so, I think it’s because– Being a CEO is a 24/7 role. I recognize that. I just think a small company, you wear a lot more hats. It’s hard to have the bandwidth to really exceed in investor relations, and strategy, and operations and capital allocation. Not everybody has a north star in capital allocation. I’ll say, like, return on invested capital is the north star. Free cash flow is the other north star. If there are two north stars for any firm that I’m looking at, those are the things that we care about.
That’s not always deeply embedded. In a company word and management team, if you came through sales, if you came through marketing, if you came through operations, it’s not always just like, whatever, the things that you learn as a public company investor and the way to think about businesses. You’re going to go to Berkshire this week. Like, how many of these microcap CEO’s have ever been to a Berkshire meeting?
I think that is where we can be the most helpful. Not even just like helping make good decisions. Avoiding making bad decisions can be really helpful. And so, I think that’s one place where we’re going to be– Given my experience in the public markets and my governance and capital allocation focus, I think that’s going to be low hanging fruit for us.
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Beyond the Knockout Punch: Why Microcaps Struggle with Business Diversification
The other place where companies struggle is what I would call small company problems. What really hurts these companies is things that like single product, like lack of diversity of products, lack of diversity of customers. A lot of these companies have customer concentration. Lack of diversity of end markets or regions. They’re selling regionally or they’re not selling globally.
I always talk about this. small companies have trouble taking punches. So, you’re a public company, things are going to happen to you. Either it’s going to be a COVID, it’s going to be a March of 2009, its somethings going to happen. The problem with small companies, when you have small company problems and customer concentration and market concentration, all of those things, is that a punch can knock you out. A big company like Honeywell, they can take plenty of punches. Honeywell is still going to be around, because it’s got breadth and depth and diversification. Small companies don’t have that. If you have a management team who doesn’t deeply understand capital allocation and has that, like, whatever they take a punch, sometimes it can be the knockout.
And so, I think that ability to grow and diversify your customer base, diversify your revenue base, make sure that you are not too dependent on single lines of businesses, that is where companies often fall down, because the management teams are so consumed with trying to grow what’s there and trying to maintain what’s there, that they don’t have the bandwidth and the time to really think strategically and operationally about how to become more resilient.
Look, bigger companies, when there’s a downturn, guess what they do? They buy up all the little competitors. Small companies that don’t have access to capital when there’s a downturn, even if they’re operating well, they don’t get to go on offense. They always are playing defense. And so, putting one of those companies in the hands of a private equity firm, any private equity firm who has access to capital and who have LPs that want to continue funding this business, just gives you so many more options.
One, the punch you take is probably not a knockout, because you have the capital base to support you. But secondly, when you take that punch, and everyone’s taking a punch in the industry, you might have access to capital to go on offense, whatever. Anything can go right or wrong for companies. But the capital allocation and then just the structural issue of being a small company is really where you, I think, often seek permanent capital impairment in these companies.
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Tobias: One of the reasons that I got into small and microcap was this document that I read, Darwin’s darling’s or the Endangered Species report, which was put out by Piper Jaffray and the three guys who made that went on to found a firm which was very successful for a long time and is now gone. That was written about 1999. They identified that there were all of these companies’ similar problem to the one that exists today. They were talking about the Russell 2000. There are companies that don’t qualify for the Russell 2000 list. They’re too small for the 2000. And despite the fact that they’ve got very good growing earnings, good business, probably still an owner operator in control, they’ve just got these very depressed valuations, because they don’t get into any of the indexes. All of the indexes see all the flows.
Their solution to it, I think they ended up calling themselves discovery or navigator or something like that. Their solution was to become activist, but I don’t know how– They were a little bit before that golden age of activism where you saw Bob Chapman and Dan Lobb writing a 13-D letter that was really nasty and that got all of the attention. Then there was the pop in the share price because they had, “Here’s the problem. We’ve identified it now that there’s going to be some energy devoted to solving it or kicking out the management team.”
Why go from public markets to taking these things private? Why not just take that intermediate step where you take a private investment in a public equity, get a board seat, take some control and try and right size them from that perspective? Would that be an easier proposition than a take private, do you think?
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Microcap Investing: The Activism Approach vs. The Buyout Opportunity
Ben: Oh, there’s a lot of directions– Let’s start with, yes, the answer is it could be, and our structure allows us to do that. Let’s think about what microcap activism traditionally is. Having been at a firm that had an activist tilt, and we were definitively not looking for problems to try to fix. We became activists when there was a problem and when we thought that things were not going well. Aggressive microcap activism is often looking for things that are broken to fix.
Tobias: Yeah.
Ben: I think that is a very difficult strategy in microcap to be successful at. So what? You get on the board, and you have two board seats– And so, you’re the dog that caught the car. Guess what kind of car you caught? You caught a broken car. And so, it’s not like they have a great– [crosstalk]
Tobias: Until it breaks down and goes into the ditch and then you catch it.
Ben: Yeah, that’s right.
Tobias: [crosstalk]
Ben: That’s one way to do it. Look, that’s the bankruptcy way of playing this space or I don’t know, like distressed. I think there will be getting to the zombification of some of the levered companies. I think there will be some really interesting distress plays in this space. I don’t think that’s going to be our focus, but I think anyone who’s in this distressed world should be looking at these over levered microcaps to see if there’s opportunities there. You got me off track with the–
Tobias: Sorry. I didn’t mean to.
Ben: No, all right. No. So, the microcap activism is often looking for problems to fix. We want to be the antithesis of that, in the sense that like, I want a business that has a growing town, that is getting more valuable over time, that has operational momentum, meaning, that they’re executing well on that, that has a good management team, and it’s just undervalued and underappreciated by the market.
Now, I think those opportunities are very, very few and far between as you go up market cap. I was this SMID cap PM– Whatever you say about large cap and how competitive that is, even SMID, I found that when I saw value, whatever, in a good business that was for some reason had clouds over it, the market would close that gap so quickly that there was so little time to do the research process that I wanted to go through to be able to invest. The companies would run before I even got there. I think it’s because that space is so competitive. You can even multiply that as you go larger and larger. There is so much capital and so many smart people available who focus on whatever, SMID to large cap and to mega cap that you just don’t have a long window to find opportunities and act on them.
In microcap, because of the structure of the market that we talked about, the hollowing out of the investor base, because of the lack of flows into the space, because of the illiquidity of some of these companies, you just have a longer timeframe in order to be able to diligence these companies.
So, my thesis and hypothesis here is that, if you’re executing well, if you grow for 20 straight quarters, guess what? The markets going to recognize that eventually. But as an investor in the space, you have more time to get on that train before its completely left the station because of all those structural elements. So, to your point, Toby, it’s not that these things are permanently undervalued. It’s that you just have a longer timeframe versus the two weeks you have and it’s with a $7 billion company.
I’m just trying to dispel the idea that we’re going to be going in here in trying to fix broken things. Like, that is the opposite of what we’re trying to do. But our structure allows– Here’s what I been observing people who have tried to do this, either public market investors doing take privates or the private equity guys coming into this space and trying to do deals. What I’ve observed is that you need a flexible structure and a flexible mandate.
So, let me give you an example. Let’s just say there was a situation like the one I discussed where there’s an opportunity to buy 25% or 30% from a selling shareholder, near control, but not control, get a couple board members. A traditional private equity firm would have trouble executing on that strategy, because you buy 25% or 30% and then what? What if there is no take private opportunity? What if there is no other check? So, then you’re like, you own a lot but you don’t own enough to take it private, and so then you’re stuck. And so, I think a lot of people wouldn’t even want to write a check there, because their mandate prefers take privates.
And then the public investors, unfortunately, what we saw at Cove Street is that even if we wanted to own 20% of a public company, a $700 million public company, there’s no way to raise the money. So, I think there’s a structural lack of capital available for said situations, like the ones you brought up, whether it’s a pipe, whether it’s buying out a founder or a selling shareholder.
So, I think the way this could really work for us is to do a two-step buyout situation where we bought 20% today and then we bought the other 80%. 24 months later, we’re on the board. It’s more like an insider transaction. Not insider trading, but an insider transaction versus just coming from the outside trying to write a big check. Because I think in microcap, you just have to be more flexible. You have to be able to buy common stock. You might have to tender for shares. You might have to at times file 13Ds. We have no interest in going hostile, but like, yeah, maybe that’s something that has to happen at some point. But you have to have a lot of things in your toolkit to be successful here that I don’t necessarily think is as true as you go up market cap.
And then when you combine that with the fact that this strategy, even though a tick private strategy, microcaps can scale and way more than a public equity strategy can, you’re just not going to attract a lot of competition. I put out a white paper on the strategy. You can go to my Substack, compounder Substack and you can see the white paper and people are like, “Ben, why did you put that out there? You gave away your strategy.” I’m like, “You, please come and try to copy this thing because I’ve been spending six months at it and all I hear is how it’s going to be really hard and almost impossible to execute. So, please come try to copy it because we can learn from each other.”
I think the simple answer to your question is that, to be successful here, you have to be willing to do things that other public investors might not be able to do and then the private investors can’t do. And so, having a flexible mandate with a capital base, who understands that the things that make this strategy not work are too many constraints, too many silos, like, “Is this public or is it private?” If someone can’t see that it’s a hybrid and there’s no firm that can say, “Well, do you talk to the [unintelligible [00:37:05] guys or do you talk to the long only guys?” I don’t know. If there’s all these institutional constraints that stop investors from putting money in and those are your LPs, then I think you’re going to struggle.
So, our focus has been on family offices, because it’s just a much more entrepreneurial group in general. The very large family offices look just like an institution. But the people who have a few multi-billion-dollar deals, but not like $90 billion, those are much more likely to be run by an entrepreneur or a family of an entrepreneur or not an outsourced CIO. They can see that the lower end of the market cap spectrum is where the value still is. You can put meaningful amount of money to work here and not have to pay the multiples that now the [chuckles] private companies trade at which is–
I’ll stop, but I think you and I have talked about this and about how what used to be a private market discount in a lot of ways has turned into a private market premium for certain businesses and business models, where there’s so much lower middle market private equity chasing these deals. Its better covered by the little bankers and brokers who cover the space. And the private equity firms are chasing a good deal way more than are chasing good microcap deals.
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Building vs. Buying: A New Approach to Microcap Private Equity
Tobias: So, the objection of private equity firms is just that, it’s a hassle to try to take a public company private, because there’s so much more compliance, regulatory obligations on the board, so on and so on. How receptive are the management teams to your approach?
Ben: So, let me say right up front. I am not going to dismiss in the slightest that perception of the lower middle market and the middle market private equity firms that take privates are hard. If there’s anything that I have heard over and over and over again about when I’m talking about this strategy is just how hard take privates are. You have outside shareholders who can object. You have a board you have to convince. You have the possibility that even after signing an LOI, there’s a go shop where someone can outbid you. And so, then what do you want to do? Do you want to bid more? Do you basically get to the bottom of the ninth and someone takes a deal from you?
If you don’t have the capacity to own shares, that’s just broken deal costs and a huge opportunity cost of your time. So, again, that gets the flexible strategy where you might need to buy a few million dollars of the common, so that you at least make money if someone takes a deal from you. So, it is 100% true that there is more, it is much harder to go from trying to do what we’re doing where we’re buying a public company than a lower middle market private equity firm calling the proprietor of the 12 location industrial distribution business who owns 100% and is in his or her 60s and their kids don’t want to be in the business and they’re going to sell. That’s a much easier transaction to close. Of course, there’s some uncertainty of not closing but it’s just much easier to close.
But the point is, at least the anecdotes and the stories I hear from the lower middle market private equity guys is that they don’t even start the process of looking at the publics, because they perceive it to be so hard. I just wanted to make sure that no one thinks that I am underplaying how difficult that is and how high a hurdle we’re going to have to jump through.
Okay. So, now to the management question. So, let’s just put ourselves in the shoes of a microcap CEO over recent times. Okay. So, the index that I am either part of or not part of depending on how big of my company is, has been the worst performing index. So, that means just the base rate– This company has been left behind by everything larger. I used to have some access to capital at least debt capital, because rates were low. Well, now, I don’t even have access to cheap capital there. Well, equity capital, if your cost of debt is now 10% to 15%, what’s your cost of equity? And so, now equity is really expensive.
If you combine that with the fact that the performance of these stocks hasn’t been particularly good, then you probably don’t have a currency. You can’t raise capital. You probably have to pay someone 15% if you wanted to. And if you want to do a deal and use stock, well, you’ve got to find something that trades at a lower multiple than you do to even make that make sense. So, being a microcap CEO, and I’m friendly with a lot of these people, has been a distinctly unglamorous job over the last number of years. Some of the small company issues that I highlighted and the issues with COVID in the post-COVID period have just exacerbated how hard it’s been to be a small company executive.
And then I said, you’re always dealing with some service providers and people who are, for lack of a better word, trying to make you spend money with them as opposed to doing other things with it. Very few people come to management teams and say, “We like your business. We like the way you’ve been running it. We would like to help you fund the next leg of this company’s growth.” In the microcap space that is not something people hear very often because of all the structural things we’ve talked about. I’m not saying they never hear it, but I think it is just more rare.
So, that pitch that a management led buyup of a company that has all the characteristics we’re looking for and can have access to capital in the private market that they can’t be accessed in the public market is without question resonating with people, because it’s just so rare that anyone comes to them with that opportunity. And so, we have this big, hairy, audacious goal of being a premium brand in this space and being a shareholder of choice, where we would walk into a room because of our track record of executing deals and helping companies grow, either as public companies through some non-crazy dilutive financing, or as a private company, our track record suggests that we are business builders.
I will say one thing about the changes in rates and how that’s going to impact private equity is that, obviously, a lot of private equity was successful due to a 40-year decline in interest rates. Rates going down from 18% to 0% was a really nice tailwind for a lot of private equity firms who focus more on some degree of financial engineer. I think with rates where they are today and multiples where they are today– Like, if you look at the pitchbook data on middle market deals in 2023, the average multiple was 11 times. So, if you’re paying 11 times and you’re paying 12% to 15% on your debt, how in the world are you going to hit a 25 IRR? The only way you’re going to do that is by growing the business really fast. So, business building is going to be the only way, I think that private equity generates returns. And so, we want to be known as business builders in this space. Our goal is to use–
This is not like traditional leverage buyouts. We want to add extra equity to these companies in private, so that they can continue to grow, so that they can continue to make acquisitions and compound. So, this is a light debt, very business building oriented framework, which I think distinguishes us from some of the perceptions of what private equity has stood for over recent times, especially since we’re also not coming and saying our first lever is to fire as many people as possible to rip and replace management, that kind of thing. This is a management led buyout. Frankly, when we get feedback on this, it’s very refreshing because the very few people come to them with ease, like a very solution-oriented approach.
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Microcap Buyouts: Why SPVs Can Offer More Flexibility Than Traditional Funds
Tobias: There’s some research out there, and I’ve covered this in some of the books that I’ve written, that the capital structure arbitrage or the capital structure activism seems to be easier and a shorter route to generating returns than the operational improvements. I guess you’re not really talking about operational improvements. You’re talking about things that are already doing well. Their real problem is that they’re just not getting enough attention from fund managers and so on. So, by taking them private, you free them up to concentrate on the core business while you and the other executives focus more on the capital allocation side of it.
At some point, I assume you’re raising, these are funds that have a finite life cycle to them. So, there must be some exit strategy at some point. And then on top of that, I guess the related question is that, how you’re incentivizing management?
Ben: Yeah, I don’t want to incentivize management just based on an exit. We want to incentivize them for operational improvement, margins improvements, and growth, obviously. So, some combination of growth and profitability is really the way that we would look at incentivizing people. But yeah, of course, traditionally, the way this has worked is that in a deal where we do a management led by management would get some promote and some percentage of the carry. That’s how we can pitch someone on come work with us versus being a $35 million market cap public company that no one cares about, you have an opportunity to make a lot more money with us. I think the incentives are actually much more aligned, if someone owns as much as we do. Sorry, the first part was–
Tobias: You’ve got a finite period of time if you’re raising for a fund. Yeah, I was just tacking the incentive question on top of that. I know that there are other models. So, there’s a good model– I can’t believe I’m blanking on his name. I’ll come back to it in a moment. You keep going.
Ben: Yeah. So, there are two paths here. I think traditionally, the lower middle market private equity guys started off as independent sponsors where they raised specific SPVs per deal. And then once you’ve done two or three deals, you raise a fund, a blind pool and then you have the discretion.
The family offices that we talk to, because we think they’re the right base of investors here given their forever time horizon, they don’t necessarily have the need and desire for company to be bought. And then three years later, you start dressing it up for a sale in hope that you can flip it, because there’s tax consequences there. So, the family offices we’re looking at and talking to appreciate the ability to not have a blind pool that has a set time horizon but want to be more opportunistic. And the SPV structure gives you that ability.
So, you create an SPV, you do the take private and then your LPs have the choice of what to do. If this thing is compounding really well in the private markets and the acquisitions being growing organically, to me, that’s something that you could own forever. And in a traditional fund structure, you wouldn’t have that ability. And so, as we’re discussing this strategy with people, I think our primary route to getting deals done would be through an SPV structure.
Look, I’ve talked to some people, some private equity guys, who have been independent sponsors and raised deal by deal SPV forever. They have 10 or 12 port codes, and that’s what they focus on. Because they think the fund structure is actually the worst way of going about it.
One thing that’s been highlighted to me is that if you have a home run in the fund, but then a bunch of dogs in addition to that, your fund returns are going to be mediocre or terrible because of what’s happened. And so, you may not make any carry. But in the situation where you’d go deal by deal, a couple of deals go south. And obviously, you never want that. But in some ways, it gives you the ability to benefit if you really create a lot of value in a deal.
So, I’m a public markets investor, kind of in my history. And so, the traditional way to go about it there is that you raise a fund or you raise an SMA. We would be open to working with a family offices or group of family offices who wanted to see the strategy with a certain amount of money that could create a firm team where we could own some stock in these companies, the ones that we’d want to own–
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Skin in the Game: Why Microcap Buyout Investors Should Own Alongside Management
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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Why Unsexy Industrial Businesses Are Ideal for Microcap Buyouts
Tobias: We’ve got about three minutes left, Ben. If you had to look into your crystal ball, what do you think will be the industry that you do your deal in?
Ben: Yeah. I think the odds are that it’s going to be an industrial or focus company, some kind of manufacturing business or somebody who provides a small component that goes into a larger piece of hardware or that an OEM assembles. Because I like businesses like that because they have often provide mission critical systems and structures that if the device fails without them, so they can often be specked in. These companies have pricing power, because if you’re a mission critical part of a larger system and you’re only like, whatever, less than 5% of the cost, there’s some price and elasticity there. So, I love businesses like that.
So, I think we need to be really clear about where we can best in class. I do not think we can best in class in software. If Constellation is willing to write a $20 million check, we’re not going to be competitive there. And that’s fine. We don’t need to compete with Constellation. Banks, we’re not going to do banks. I think there’s a long roll up for microcap banks. I just don’t think we’re going to best in class there. Biotech, there’s no PhD’s here. We’re not going to do biotech. So, part of this is just understanding where you’re not going to go.
I’ve been a generalist my whole career, but I think in the industrial space is where you can find a real business that has all of the characteristics that we want, but it’s just unsexy. Boring and unsexy. I think for private equity are the best businesses, because you pay a low to fair multiple for a business like that. You can layer on all kinds of improvements operationally and from capital allocation basis and you can own the business forever. So, I think I’d be surprised if it wasn’t industrial, but you could also say business services would be a close second.
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Tobias: Yeah, I like that. If folks want to follow along with what you’re doing or get in contact with you, how do they go about doing that?
Ben: Yeah. Thanks, Toby. Thanks so much. So, you can look me up at Devonshire Partners. bclaremon@devonshirepartners.co is email address. You can follow me on Twitter @benclaremon. You can follow my Substack, Compounders Substack or you can follow the Compounders podcast. There’s a lot of different ways to get me.
I like to hear from people. I’d love to hear– If anyone listens to this and thinks this guy’s totally full of crap and this will never work, please reach out to me and tell me why, because I’m looking to– The old quote from an investor who just passed who said, “All I want to know is where I’m going to die, so that I don’t go there.” [Tobias laughs] I want to know where this strategy goes to die. So, please reach out. Whether you like it or you don’t like it, I want feedback because I’m a learning machine and I’m a continuous improvement, and I hope that the next time we talk about this, my approach is even more refined.
Tobias: Well, Charlie– Yeah, thanks, Ben Claremon. Folks, we’ll be back same bat channel, same bat time next week. See everybody then, post-Omaha.
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