The Right to Win in Equity Investing
Do you have it? How do you know if you do?
Since I published what has become the treatise for the Devonshire microcap strategy, I have continued to talk to people and get feedback on what we are doing. As a result of that process, we have begun to develop a more nuanced understanding of the artificial silos and reasons why there are very few firms trying to do what we are—at least in microcap. Those typically arise from either for structural reasons having to do with a mandate and size ("we are only allowed to look at private deals" or "this deal is too small for us.") or due to self-imposed institutional constraints ("my first boss told me take-privates are too hard”). But does the lack of competition inherently give us the right to win? In reality, those are separate variables. We could have no competition for deals and still not be well-suited to be successful in those investments.
So, I started to think more deeply about the holistic elements that differentiate the Devonshire approach, with the underlying assumption that you need to be different and think differently to be able to outperform. First off, for any investment, we need to be able to look in the mirror and make a credible case for why our collective talents, experiences, knowledge, and EQ make us a good partner for the company. But we also need a structure, approach and philosophy that is consistent and repeatable, regardless of the specific investment. After the diligence we have done, I believe our chances of being successful will be amplified by our willingness to:
1. Stay small in terms of AUM and deal size
2. Focus exclusively on small companies, public or private
3. Go to all the way up to Canada to look for compelling, undervalued companies
4. Look at microcaps to consider what are considered treacherous take-privates
5. Get involved in a public company via the stock (via friendly PIPEs or buying out of shareholders)
6. Stay away from the hottest areas (i.e. software) and invest in “boring” businesses
7. Share the deal and the associated economics to get a deal done
8. Adopt a true partnership approach when interacting with management
9. Allow—and basically desire for—management to stay at the company post a control deal
10. Avoid the 3-to-5 year buy and flip game that many PE funds play
11. Flex our contrarian muscles by painstakingly sifting through an almost universally hated asset class (microcaps)
12. Stay away from situations where we clearly don't have the right expertise internally or in our network
13. Admit when we are not the best buyer of an asset and walk away
Be creative with the deal structure, including regarding the way we compensate management
By being consistent, thorough and very approachable, develop deep and meaningful relationships with the bankers and brokers who represent small companies
Some of what I hope will turn into competitive advantages are based on being able to cross through silos. Others stem from a willingness to be long-term greedy versus short-term greedy. Still others are based on the Devonshire approach, which my Memphis, Tennessee born partner Shahzad has honed to be an authentic pitch to why Devonshire is a better home for a company than is a traditional PE fund or a strategic buyer. On that last point, as a friend of mine who is in lower middle market PE said recently, “there are a lot a**holes in private equity.” We are currently testing the hypothesis that even if we offer a lower valuation range, if we are polite, complimentary, consistent, thoughtful and willing to get on a plane to travel to Wurtland, Kentucky, we might be able to win deals. (Check back with me in a few years and I will tell you how that is going.)
But I digress. For this piece, I want to dive deeper into the mentality that informs items #12 and #13 above, especially as it relates to the topic of having a right to win. As I have discussed at length, I didn’t feel like I had the right to win as a one-man-band running a quality SMID public stock portfolio. There were far too many smart people who had incredible resources and much larger teams looking at the same universe of stocks. And no matter how much I believed in the merits of the approach and strategy, there were tons of people just like me with a very similar philosophy—all competing within the shrinking pie (at least in recent times) of actively managed, smaller cap public equities. There was a seminal moment for me when I was walking around the Berkshire meeting in 2023 and met a bunch of smart, qualified people with a good pedigree who were running essentially the same SMID strategy. I realized then I didn’t have the right to win, at least in what were my current circumstances.
If you haven’t gotten it yet from my writings, I am not afraid to admit when I don’t know things or ask the questions other people won’t ask. I have been pretty upfront that I am still in the process of learning about a new industry—private equity—and have much to learn still. So I don’t have any issue with peppering experienced people from the industry with what are somewhat rudimentary but also fundamental questions about how to be successful. Sure, maybe the long list from above of what I perceive to be the positive attributes about Devonshire gives us a good shot at being successful over the long run. But what about on a specific deal? Why are we going to make this deal a success when there are so many potential suitors out there?
With that in mind, here are the main questions I have for the sponsors who have done multiple deals and have been at it a long time:
How do you know if you are the right or even just a good buyer of a specific company?
If a company is willing to sell it to you for a really attractive price, doesn’t that mean there is something wrong with it?
How do you mitigate the risk that the company was dressed up for a sale and that the operating results are not likely to be anywhere near as attractive going forward?
If you are getting a deal from a banker, isn’t the base case that winning an auction will not lead to great outcomes?
If a banked process seems like it has been very lightly attended by sponsors, is that a good thing (limited competition, potential to establish an edge) or a bad thing (everyone else saw immediately that the company was not worth spending time on)?
The value I bring to my partner is that we can approach the topic of the right to win and these explicit questions with fresh eyes. I was never an i-banker. I am not a deal guy. Plus, I come from the US public equity markets, which is likely the most competitive and well-covered equity market—public or private—on the planet. I don’t having any baggage or pre-existing biases about the way things should be done. All I really care about is how to make good returns for our investors. The common thread here is being self-reflective and thinking deeply about why an investment is likely to achieve above average returns relative to all the other places we could put that money and to all of the other sophisticated investors who are competing for the same deals.
As I reflected on the responses I have gotten to these questions and thought about where Devonshire has the right to win, it occurred to me that a lot of what gives me confidence in our strategy is tied to what we are NOT going to do (see more below). In my opinion, all good investing goes back to the old Buffett quote about the first and second rules of investing: don’t lose money. Let’s be honest here, everyone in the private equity space has an incentive to put money to work. You don’t generate any fees or carry on deals you don’t do. No one is going to own an NFL team if he/she doesn’t take risk with other people’s money. But you also aren’t going to get a lot of swings if you lose investors’ money in deals. The way I look at it, irrespective of the short-term benefit of getting deals done, the only way to win long-term is to do the right deals. What the right deal means to Devonshire is aiming for singles and doubles but creating optionality that a deal could turn into a homerun or grand slam.
What constitutes a “wrong” deal? In equity investing, the most likely way to get knocked out of the game (aside from using excessive leverage) is to play when you don’t have a right to win. I guess it is often hard to affirmatively say “we have what it takes to win” without compromising the need for humility and intellectual honesty within an investment process. But it should be pretty darn easy to figure out when you unequivocally DON’T have the right to win. With all of that as context, here is what we are doing at Devonshire, especially on the private control deal side, to try to avoid playing a game we are destined to fail:
Avoiding turnarounds
No one at Devonshire it s turnaround expert. When we see the words turnaround or distress in a CIM (Confidential Information Memorandum for readers who are not in the PE game), we immediately pass. We are happy to let someone else buy a problem.
Requiring ongoing skin in the game from sellers
One way you protect yourself from buying a company that was made to look a lot prettier than it is in reality is to require the selling management team and/or owners to continue to be large shareholders. We won’t always shy away from situations in which management wants to sell 100% and retire but we will most often pass unless the owners are willing to roll and are excited to get another bite at the apple. Skin in the game creates alignment while the lack of it creates perverse incentives that we want to avoid.
Focusing only on situations where management wants to continue running the company
Maybe I am naïve but it feels arrogant to me to believe that the base case is that an outsider can run a business better than the people who have been managing it for 10, 20, or even 30 years. Maybe it is true that a lot of business owners do some sub-optimal things and could use some guidance on capital allocation, establishing operational excellence and compensating employees. I see our job as being to amplify whatever was working before as opposed to tearing the company down the studs and starting over with new management. It just seems to me like you lose a lot of intellectual capital, legacy relationships, and wisdom if you go into situations proactively looking to replace management ASAP. If it happens after a thoughtful, patient evaluation of the needs of the company, fine. But my sense is that if you start with the premise that you want to partner with great management who you can work with to accelerate compounding, my sense is that you are much more likely to win.
Passing on deals where we don’t have an operating partner in our network who immediately makes us a credible owner
We are all generalists at Devonshire. That means we know a little bit about just about any business or business model you can imagine, but we are only experts in a handful of industries. And even the expertise that comes from following an industry and its constituent firms for a long time pales in comparison to the knowledge and experience base of someone who is or was an operator. A friend of mine who has done a few take-privates said to me recently that he will never do another deal where he doesn’t have an operating partner he can put into the C-suite of the acquired company. That is our guiding light as well. As such, for every deal we dive into our network of close contacts to see if there is an operating partner who wants to work with us. If not, we determine that we don’t have the right to win and pass.
Walking away from deals when we recognize we cannot be a best-in-class buyer
When you are public equity investor, it can be totally fine to establish a small position in a company that plays in an industry you are not that familiar with. Sometimes a starter position is a good way to learn about a new company and industry. And if you size it right, it probably won’t impact performance much. But if you are buying control of a company, you can’t just put the capital to work and then hope that you are going to be able to figure things out. Sure, you will learn a ton once you own the company and can get inside. But you better know whether or not you are in a position of strength before you close the deal.
What does it mean for Devonshire to be a best-in-class buyer? It can’t just be money. There is plenty of capital chasing private deals. To me, it has a lot of elements to it, some of which include: a deep familiarity with the business and industry (ideally which results from having invested in a similar company before), physical proximity to the company’s HQ, an immediate connection with management, operating partners who can help supercharge aspects of the business, a credible plan for how your involvement is going to make THIS business better over time, a proposed compensation structure that creates highly aligned incentives, and a structure or approach that aligns with the seller’s goals for the business. As an example, we have already been in a number of situations where it has become abundantly clear that a strategic acquirer or a PE firm with a platform would be a much better owner of a company. That means the most likely outcome of a process is that we would be outbid by a wide margin, mainly based on the acquirer’s ability to extract synergies . In that case, there is no reason to compete. The opportunity cost of out time is simply too high. And that’s fine. We will find another opportunity where there isn’t an obvious strategic buyer or where our structure or time horizon or history with an industry make us a better a buyer.
Coming up with creative structures that produce alignments, protect our downside and give management upside if the team executes
I am working on a deal right now that I initially passed on because of some concerns about our ability to underwrite the rapid growth the company has experienced in recent years. Why do I bring this up? Well, I like this deal because it sort of encapsulates all of the items above. The story goes that my contrarian juices started flowing when the bankers came back to us and sort of begged us to take a look. My guess is that most people passed for the same reason I initially was not interested. As I have have dug in, I have been really impressed with the brand and team but my concerns about the sustainability of the current revenue base remain. Thankfully, in this case we have an exceptional operating partner to help us perform the diligence and assess the team. And yes, it helps that management is willing to stay on and roll a lot of equity. Plus, after having invested in the industry and directly in some of the company’s partners back in my Cove Street days, I feel very comfortable with my ability to understand the business.
But what can we do about the gap between the EBITDA they have put up in prior years and the current run rate? I don’t know how creative or unique earn-outs are. I am sure they happen all the time, but in this case it is the only way we feel comfortable moving forward. We are likely going to submit an IOI (Indication of Interest) that protects our downside by offering a low multiple of TTM EBITDA but also offer another turn of EBITDA if the company hits specific milestones over the next two years. I love the alignment that creates and the fact that a management team that accepts this structure is making a big bet on themselves. Will they go for it? Who knows? But I think this is a perfect example of using all of the elements above to put ourselves in position to win, while being 100% willing to walk away if even one item is not in place.
There is no way to guarantee that I am going to be in this new adventure I am on. And drawing any firm conclusions after what is essentially just the first inning (or maybe even the first pitch) of a 9-inning game is likely foolhardy. But it sure feels like there is a clear negative art in investing in small private companies where you win based on not losing. With that in mind, I am trying to create a foundation that we can build upon over time and that new people can pick up quickly as we begin to grow the team. We have three fantastic interns this summer and I am working hard to ingrain the right to win mentality into their heads. A lot of time has to pass and capital has to be put to work to know whether or not the elements I have discussed in this piece are necessary or sufficient for this to be both a financial and personal success for me and my partner. However, I hope to continue to use this platform to update readers on our progress, solicit feedback, and hopefully offer a window into the lower middle market PE world to those who are interested in it.
As always, if you agree or disagree with any of the above, I would love to hear about it.
Learning so many new acronyms,
Ben Claremon