The Fine Line Between Being Different and Crazy [Part 1]

Launching a new investment strategy into a crowded field

Photo by Samuel Holt on Unsplash

[Note: This is part 1 of a 2 part discussion.]

After I left Cove Street Capital last year, I went on what turned out to be an eight month listening tour of the investment management industry. After spending twelve years at a long-only value shop focused on smaller companies, I wanted to be extremely thoughtful about my next landing spot. The reason for that is that I had watched Cove Street’s AUM, which peaked at about $1.1 billion, fall continuously during my last few years there. As it turned out, we were in all the wrong places: active instead of passive, public instead of private, and smallcap instead of large/megacap. My goal was to develop a better picture of the landscape associated with potential roles in investment management, with the added hope of avoiding prior mistakes and pitfalls.

On my tour of the investment world, I talked to public equity and private equity investors, people who worked at family offices, and buy-siders who had gone from public equities to working for corporations. What I heard was a reflection of my lived experience: the public equity business in the US was under a lot of pressure—on fees, on AUM, on the business model. And it was doubly hard for small firms. Scale had become the name of the game in public equities and smaller firms that ran capacity constrained strategies—and thus could not run the billions of dollars required to be perceived as having sufficient scale—had gone from being cool boutiques to being seen as risky by their institutional partners. Further, the conversations with existing and potential investors had gone from being about when a fund was going to close the strategy to what the firm’s breakeven AUM was. Even people who were in seats at public managers that I thought seemed pretty safe and stable had this existential dread regarding the likely fate of public-focused, especially long-only, strategies.

Another major takeaway from these conversations was that there is unfortunately very limited strategy differentiation available within US public equities. It really hit me as I was talking to people at the Berkshire meeting last year. I met so many talented, credible people who ran a similar quality SMID strategy to the one I had run at Cove Street. How was I going to stand out from that crowd? Sure, I had a podcast and had established a “brand.” But the world certainly didn’t need another compounder bro focused on mid-sized US stocks. It dawned on me then that while differentiation is not sufficient to be successful, it is probably necessary to grow and maintain AUM.

I also got some great advice from a contact at a family office who said “just join a growing firm.” I took that to heart but where were these mythical growing firms within public equities? Almost nobody I was talking to was building their AUM. In fact, the conversations I was having were indicative of a shrinking number of seats, a diminishing number of firms, and AUMs that at best were stagnant, even in a rising market. People who know me know that I like to think in base rates. In a tough fundraising environment, what is the base rate of achieving something special as a 40-something-year-old guy joining a public equity firm as a senior analyst? Not sure. And even if I went that route, would there ever be a PM role in my future? Hard to know. So, I decided to swim in parallel lanes and search for both public equity and private equity roles, with the hope that the activist/suggestivist skillset, especially within smaller companies, that I had developed at Cove Street would give me a shot at the latter opportunities.

A brief stint working for someone else in private equity

In 2021, I met a guy named Jeremy Tarica after I did a podcast on the investment opportunity surrounding Lionsgate (ticker: LGF.B). Jeremy and I hit it off over our fascination with the soap opera that is Lionsgate and became friends. Jeremy worked for a firm called Forest Road, which had been co-founded by his brother Zach. Forest Road is bit hard to describe. It is a merchant bank that buys businesses on balance sheet. It also is building an asset management arm. The general approach is that of private equity versus the typical public equity mindset. I was intrigued by what they were building and I reached out to Jeremy while I was looking for my next role. Jeremy was kind enough to bring me into the firm and introduce me to his brother. They both liked the podcast and my ability to generate content. But the major question was: if they hired me as an investment person, what else would I do to help build AUM and find investment opportunities? They weren’t looking for a SMID cap PM. That is when I told them about this microcap opportunities fund that we had been working on at Cove Street. I will give credit to my ex-colleague, Eugene Robin, for laying the groundwork for the strategy that I am in the process of building on. [Part 2 of this piece will cover the strategy and the opportunity in great detail.] After a few weeks of dating, the Forest Road guys became excited about my well-rounded investing experience, my ability to help build the brand, and the differentiation imbedded in the microcap strategy.

So, starting last October, I embarked on yet another tour of the investment business—this time focused on vetting the microcap strategy. I recognized pretty quickly that being successful would require cultivating and building a three-sided market of sorts: public company investors, companies that reside in microcap land, and allocators who would be interested in putting money to work where there exists a structural lack of capital. Those efforts validated a lot of what I was thinking and yielded some very positive feedback that has allowed the initial vision to evolve and become more refined. The external excitement and interest in the strategy was unfortunately juxtaposed with struggles internally at Forest Road. Specifically, the firm was trying to raise $1 billion for both private credit and distressed real estate, and I was having trouble getting people jazzed about a $25 million equity check.

The writing was on the wall pretty quickly that my strategy was going to struggle to get the attention and resources it needed to be successful. As I wrote in my piece on survivorship bias and evolution within investment firms, new strategies often suffer from a lack of resources and time. But, in my case, if this strategy never saw the light of day, it was unclear what I was going to do at Forest Road. So, I had a few options:

1. Start sending out my resume to potential employers

2. Stick it out at Forest Road in hopes that the winds would eventually shift in my direction

3. Spin off with some partners who could help me execute the strategy—with the blessing of Forest Road—as a bet on myself and the work I had done in vetting the opportunity

The universe weighs in

I am admittedly not a particularly religious or spiritual person and I am not sure I have a strong belief in concepts such as fate. I am more of a proponent of working hard and being generous with my time so that, at some point, I will benefit from some serendipity. I am not sure what forces have been at play as I have spent the last six months running 100 miles per hour trying to figure out how to make the microcap strategy work. However, I have gotten the distinct impression that the universe is pushing me to be an entrepreneur. Maybe this was inevitable in some ways. The dream of almost every young investment person (including me when I first started) is to run his or her own firm some day—or to be a founding partner. I have learned many lessons and thought deeply about culture, strategy, differentiation, building relationships with clients and portfolio construction. I have also made tons of mistakes that continue to inform my process and security selection. As a result, I feel confident in the ability to excel at what me and my team can control. But why would anyone else care?

Going back to the base rates mentioned above, I am keenly aware of the low probability of success of starting any new business. On top of that, keep in mind that my 2023 listening tour of the investment industry yielded the takeaway that virtually no one was raising money. Plus, many institutions were suffering from what is called the denominator effect, where the drop in public stock prices in 2022 combined with the limited drop in the value of private assets had made a lot of firms even more overweight private strategies. Not a good backdrop for what we are building.

So, how could I possibly be arrogant (or crazy?) enough to believe that my partners and I could raise funds, execute deals and build a business when so many established firms are struggling and there has been no money flowing into managers who focus on smaller public companies? Despite the very tough backdrop, there are a number of things in our favor that I believe give us a good chance (hard to know how high that is of course) of making this work:

1. The feedback we have gotten from allocators, investors and the companies we have talked to about our strategy has been universally positive. Everyone says that it is going to be hard to execute but that the idea and the structure have lots of merit. Plus, no one has come up with a smoking gun reason why this won’t work.

2. I am attracting people who want to be involved in this strategy. It turns out that a lot of the people I know have tried to do something like what we are embarking on—just not full time or with a full team that possesses complementary and overlapping skill sets. The job market for investment people is very rough right now and there are some excellent people on the sidelines who are willing to put in sweat equity to help us be successful.

3. Microcaps, despite their move off the bottom last fall, remain the worst performing Russell equity asset class over every long time period. To us, that means there is opportunity abound to find mispriced assets.

4. There remains very limited competition in this space, for reasons that will be discussed in depth in Part 2. What that means is that even if we do start to gain traction, it remains very unlikely that a bunch of firms are going to dive deep into microcap land to try to compete. And even if they did, there are 1600 companies in our potential universe.

5. The allocators I have talked to perceive this strategy to be differentiated and everyone understands that the fact that microcaps have become uninvestable for most institutional investors leads to an evergreen opportunity to write big checks in the space. I know a good investment pitch has to be simple and while the execution of our strategy is not going to be simple in slightest, people get the logic of what we are trying to do right off the bat.

6. I have a platform with the, podcast and the Inoculated Investor and Compounders brands that I hope will give us the ability to evangelize our ideas as well as attract both investment ideas and potential investors. Plus, I am excited to use this Substack as a way to generate feedback on our ideas.

7. Smart, diligent public company investors have been willing to share their ideas with us. It was unclear if people would be willing to share companies that they think will fit our criteria but I have had—to my surprise—no trouble convincing investors that there are win-wins available for both sides.

8. The CEOs we speak to are enthusiastic about what we are doing. I can’t tell you how many executives have said that this is the best time in their careers to be executing a strategy like ours. Being a microcap CEO is frankly not glamorous and many companies in the universe have no business being public anymore—given the time and financial costs associated with being listed. We don’t have a huge sample size yet but the receptivity to date suggests we have an audience who is willing to listen to our pitch.

9. The battlefield in microcap is littered with people and firms that have been wholly unsuccessful or have struggled to make something like what we are pursuing work. In crafting our strategy and structure, we can learn from their mistakes regarding security selection, the approach to management teams, the inflexibility of their mandates, the way they treat minority investors and the limitations of certain structures.

10. We have a team that has a diverse set of experiences in both private and public markets and that can cover all of the necessary bases, including equity and debt funding, closing deals, and assisting in the operations acquired companies. Plus, we have collectively navigated the tricky microcap waters for decades with experiences that include serving on public boards, running Proxy battles and figuring out ways to accumulate shares. It is the hybrid public-private skill set, with a sprinkling of partnership-style suggestivism, that I believe will give us a lot of credibility with companies and potential investors.

I think of building this business as similar to building a house. There is not one big brick that builds the structure. You have to layer on one brick at a time in order to complete the building. Similarly, I don’t see any of the above as individually being sufficient to ensure our success but all of them in conjunction—along with some others that I will discuss in the next article—give us a shot at defying the base rate odds.

Next week, I will dive more deeply into the strategy, the differentiation and why we don’t believe we are crazy to be incubating this strategy right now.

I hope you will follow along and be willing to share feedback with me on the ideas discussed in both pieces.

Starting to remember why investing is so much fun,

Ben Claremon