The Fine Line Between Being Different and Crazy (Part 3)

What’s the Unlock?

For more background on how Devonshire is approaching the microcap/nanocap universe, please see Part 1 and Part 2 of this series.

It has been a while since I last sat down to share my thoughts on the progress we are making with Devonshire’s public markets strategy that is squarely focused on what I would call nanocap: sub-$100mm market companies. Candidly, that is by design. I put a lot of thoughts out there in Parts 1 and 2, some of which were hypotheses. I wanted to let those ideas marinate for a while and live out in the wild to see if they could survive the cold winter. The feedback we have received on our approach and the structural reasons why opportunities exist in the netherworld of the public markets has been almost universally positive, so much so that the contrarian in me has started to worry that I am only interfacing with like-minded people. I probably have two to three conversations a week with people who have not heard my spiel, and the general response is that what we are doing is different (not crazy) and interesting.

Now, there remain a ton of legitimate concerns about our—or anyone’s—ability to execute consistently, get deals done, get Boards and shareholders to play ball, etc. But the philosophy has remained somewhat bulletproof, and while we continue to see lots of take privates of Canadian microcaps and see MBOs of larger companies (SKX, for example), there continues to be mostly apathy and disdain as it relates to microcap public equities here in the US. To wit, when I go to microcap conferences, I hear that I am the only PE guy there. Whether that is true or not, it is kind of beside the point. Even if there were a handful of other people attending, CapIQ still shows 2500 companies that trade on the major US exchanges, TSX or TSXV that have market caps between $10mm and $100mm. That is a lot of companies out there, most of whom get no love and attention from private equity or the broader institutional investment community. It is why I wasn’t worried about putting our microcap manifesto out there for everyone to see. There is plenty of room for more people to develop relationships with the companies and management teams in this space. I was not concerned about there being a mad rush—and we certainly haven’t seen it yet.

What is definitively not true is that all of these companies are deserving of our investment. The vast majority are not. Many are priced quasi-efficiently. Most of them will never be able to satisfy our financial criteria. Others don’t have viable business models or are so complicated or hairy that they are simply uninvestable. That’s fine. We continue to scour the universe for the 5% to 10% of the companies that have the characteristics we lean towards. We are in the “fortunate” position that we don’t have a fund that requires us to do 8-10 deals in five years. There is no clock ticking and there are no management fees sitting out there as a Siren’s song to put money to work. If we could do one or two deals per year, that would be just fine. We can be selective, patient, and focused on long-term relationships.

Who’s Got the Key?

Even if it doesn’t necessarily serve our purposes to reduce the TAM, which in this case the total number of public companies we could potentially target, to be intellectually honest, I have to do it. If someone reading this piece is interested in partnering with us on a deal, I want that person to believe that we are only going to act when we see an opportunity that checks all of our boxes. And since I wrote the first two pieces, there has emerged an Empire State Building size box to check that was always kind of there but has now become much more salient and critical. That is an unalienable requirement that our investment, especially in the case of a take private, has to unlock something that was not achievable or attainable without our capital, operating partners, capital allocation prowess or help in shepherding the company into the private markets. But isn’t that always true? Even for private deals?

The answer to that is an unequivocal “yes”, but there are major differences between public and private transactions. Public processes are harder, more expensive, and riskier for the sponsor in a lot of ways. There is also a huge opportunity cost of time if you go down the path of trying to buy a public company and the Board or management decides not to sell. Of course that can happen with a private business, but in most of our private deals, there are only a handful of decision makers and when someone has decided to sell, there is a pretty good chance that person is going to transact. With public companies, there are far more cooks in the kitchen, including shareholders who have to approve private transactions. There is also status quo bias that sets in with public companies. An owner of a private business who sells a stake in the business still owns a private business. However, a management team and Board contemplating privatization has to proactively change the company’s structure—and that can be a non-trivial barrier to a transaction. It is simply easier to stay public and hope that something good happens. Plus, the Board members are likely to lose their cushy Board roles after a transaction, thus creating yet another potential obstacle.

To put a finer point on it, what I am suggesting is that merely cutting public company costs, giving management more time to focus on the business, and potentially lowering the cost of capital for a company are not by themselves sufficient to warrant taking them private. I would argue that most companies below $100mm in market do not benefit from being public. In fact, being so is often somewhat of a limiter and thus companies of that size are probably better suited as private businesses. But that doesn’t mean they are great take private candidates for Devonshire. In our humble opinion, to seriously consider a take private transaction, there must be a path to juicy IRRs and MOICs that justify all the risks. To get that, you need to have some kind of low hanging unlock whereby a company is literally transformed when it is relieved of the burden of being traded on an exchange. With most of the companies we look at, it is hard to figure out what that is. I have started to ask management teams the question of “what would you do differently if this were a private company?” If they don’t have a great answer, there is probably not a compelling unlock. And there probably isn’t a substantial unlock in most cases. I would argue that Mr. Market is not that efficient in the lower end of the market cap spectrum and stocks can be undervalued or overvalued for longer than one would think. But I don’t think he is totally crazy in most cases. Even with the diminished interest in microcap, there is too much smart capital out there for five-cent dollars to be lying all over the sidewalk. (We’d be fine with a 30-cent dollar.) So yes, our TAM is not as big as it would seem at first. But we are starting to see more examples of what a true unlock looks like.

The Illusive Unlock

I apologize if this is somewhat redundant for certain readers, but it is probably worthwhile to revisit the topic of why there could be hidden value trapped in microcap companies. The first one is that the price discovery mechanism as it relates to small, illiquid public companies does always function that well. If a $50mm market cap stock sees $50K worth of daily volume, it is hard to believe that volume and pricing represent true measures of the company’s intrinsic value. In other words, the stock price you see on your Yahoo Finance screen is simply a snapshot of what a very small buyer or seller of shares was thinking that day. What it means is that the last tick is simply a tiny vote on what the shares are worth today—and may have more to do with someone’s desire for liquidity than what the company is likely to be worth over the long run. If someone could buy that whole business or a much larger stake via a single check, that firm or individual might have a totally different willingness to pay. While it is true that these dynamics can lead a stock to be overvalued just as well as undervalued, our thesis is that the abandonment of microcap by the institutional investment community makes it more likely that the latter is the case.

The next reason I will highlight is that microcap is, for lack of a better word, a wacky place. When you spend time in this world, you come across all kinds of funky ownership structures, business models, reporting standards, and historical reasons that companies are public. I always say that you can never understand what is going on with a sub-$100mm market cap company by pulling it up on CapIQ. There is almost always a backstory. Most of the time, these companies screen terribly for any number of reasons. You have to dig to understand the financials and the underlying fundamentals. When you combine that with the distinct lack of sell-side coverage, financial media attention, quarterly conference calls, and investor relations efforts, it is not hard to imagine that the market could have a complete misperception of the company’s prospects.

I could probably come up with some other conceptual reasons that there is value to be unlocked, but I think the point is clear: we sincerely believe that through relationship building, digging where others are not, and being creative, we can unearth situations in which the intrinsic value of the company is far higher than the stock price reflects. But what does that look like in reality? This all sounds wonderful on paper, but out in the messy world of small companies, what does this look like? It would be self-defeating to give specific examples. (Plus, we are under NDA with a handful of companies.) But for people who think this could be a compelling place to search for value, here are some categories of situations, some of which may even exist simultaneously, where we are seeing interesting opportunities to put capital to work:

Good Co./Bad Co.

This can occur when a company has multiple operating segments or businesses, some of which are profitable and some of which are not. The whole company looks like it is not particularly profitable despite there being attractive segments or businesses. By separating the businesses and/or finding a better owner for the struggling ones—for example someone who has more scale and can generate synergies—a buyer of this company can extract a large amount of value. This is mainly because the stock price reflects a mediocre company that may look like it doesn’t generate much cash or have meaningful growth opportunities. The other benefit is that post the split, the company can focus on the solid businesses and not spend all management’s time trying to fix the bad ones. Never underestimate how exhilarating it can be, especially when combined with the right incentives, for people who lead an organization to focus on building as opposed to putting out fires.

Companies with legitimate growth opportunities but limited access to growth capital

The base case with most of these small public companies is that the cost of capital is high. When you combine the illiquidity of their stocks with the lack of providers of capital on friendly, non-usurious terms, it can be prohibitively expensive (in the form of dilution) for these companies to raise capital for M&A or organic growth investments. What this does is create zombie companies that can’t really grow and are weighed down by the time and financial cost associated with being public. In a private setting where that company had access to growth equity and follow-ons from its sponsor, it could create a positive fly wheel where more growth allows for more re-investment—and then more growth—that is not available as a public company.

Companies that have a large shareholder (10%+ owner) desperately looking for liquidity

As mentioned numerous times, there is not a lot of liquidity in nanocap land. With some of these stocks, owning 20%-plus of the company is not so different from owning 20% of a private company. Whether it is due to estate planning, the illness of an owner or executive, or a PE firm holding onto a position for 10 years in a fund with a 7-year life, there are periodic opportunities for Devonshire to be a liquidity provider for selling shareholders. In these situations, we can acquire a big block of stock that would give us significant influence and hopefully our steady hands would take some pressure off stock price, thus immediately creating value for us and all shareholders.

Situations in which a controlling shareholder or executive has unique economics

I am not sure how many more times I am going to see this in my career, but last year we had the opportunity to buy almost 40% of a company that trades in Canada where the largest shareholder enjoyed some very attractive economics. We may still have a chance to buy this owner’s stake at some point, but in the transaction we were negotiating, he would have given up his profit share rights and EBITDA for the company would have immediately increased by about one-third. In that case, our capital would have unlocked value for shareholders on day 1.

Stay Patient My Friend

The unlocks above are synonymous in my mind with fat pitches. If we take a big, public swing and miss, we might not get any more swings. As such, it only makes sense to swing if there is an unlock that puts us in a great position to exceed our hurdle rates, which are quite honestly higher for public investments, especially take privates. We are playing the long game here. Nothing has changed regarding our big, hairy audacious goal of developing a premium brand within the microcap space and becoming a partner of choice for companies who are in need of a capital provider. We certainly are not going to achieve those goals if we are not willing to wait for an opportunity that is so compelling that we almost feel stupid not pursuing it with vigor. We have a couple of those and a couple where we are hanging around the hoop, just in case there is a capital need in the near term. As I am writing this, we are going after a whale that fits in the Good Co./Bad Co. bucket above. I have no way of properly handicapping the probability that we end up as the acquirer of this business. But we have assembled a phenomenal team of capital providers and operating partners that certainly gives us a fighter’s chance. What I am generally happy with is the process we are employing to unearth these opportunities and even if this one doesn’t represent our first investment, I feel good about our chances on the next one.

Regardless, we will keep you posted. I am always happy to discuss our strategy and receive constructive feedback, so please don’t hesitate to reach out.

Thanks for following Devonshire on this journey,

Ben Claremon