Introduction

Patrick: [00:01:21] My guests this week are Trish and James Higgins, who along with James' brother Palmer run Chenmark Capital. If you've enjoyed episodes with Brent Beshore, you will love this episode because we continue to explore the style of investing that I call permanent equity. Returns in permanent equity come first from the ongoing cash flows from portfolio companies, not from reselling businesses, 3 to 5 years down the line. The partners at Chenmark are pioneering this style of small business investing and share their experience with us thus far. These are exactly the kind of people I am lucky to meet as a result of this podcast, they live and operate in Portland, Maine, not in New York City. They are grinders who publish their lessons weekly in a newsletter that you should subscribe to. They describe an investing landscape that is very different than the one I am used to this style of investing continues to have a romantic sort of appeal, but like Brent, Trish and James are quick to tell us that this life is anything but glamorous. It is hard, often stressful work, but work that is ultimately rewarding at both the personal and portfolio level. I doubt this investing trend is going away. In fact, it is probably just getting started and we should all take notice. I will continue to find people who can help us all understand the category of permanent equity. You can find show notes for this episode at investorfieldguide.com/Chenmark, C-H-E-N-M-A-R-K. And one last note, the name Chenmark itself is a play on question mark and is meant to serve as a reminder to plunge into the unknown. A great name and a great conversation. Please enjoy my talk with Trish and James Higgins.

Acquiring Small Businesses

Patrick: [00:03:00] I thought a fun place to start would be to maybe pick 1 of the 3 businesses, assuming there are still 3, and walk through the process sort of soup to nuts. Because what's fascinated me about this... So this category now keeps coming up and I'm calling it permanent equity for lack of a better term, just to be able to use a term consistently. I think what people appreciate the least because they've never had to do it, is how difficult the actual process can be. So I'll leave it to you to pick one and kind of walk through the process.

Trish: [00:03:31] The first one, because that's the one we were the worst at and had the most learning associated with it. But when we decided that we wanted to find a small business to buy, we didn't really know what we were doing. So we just went onto Google and we're like, how do I buy a small business? And a bunch of websites come up that are mostly pizzeria listings and bars and things like that. And it took us a little while, like sifting through those things and different websites to figure out like which ones made sense, which ones didn't. And when we first started, we were very informal. So we were like using our Gmail addresses to reach out to people. But then as we kind of got our sea legs under us, we started to realize there are more reputable brokers that generally the first prospectus or company you sort of see a listing for is generally not a good one. But after a little bit of time, if you develop relationships with different brokers and tell them what you're looking for, and that you're actually serious, that eventually, they start calling you and saying, "Hey, I just got this. It fits your criteria. Do you want to take a look?" And so that's how we found our first company, which was Seabreeze. We had looked at a company with the great branding of, I think it was like Mark's Lawn Care and Snow Removal Company in a different part of the country. That one didn't work out at all. But the broker for that business who is based in Texas called us and said, "Hey, I've got this company in Maine. Do you want to take a look?" So that's how we first found out about the company.

Patrick: [00:04:58] Did you move to Maine as a result of that find, or were you already there?

James: [00:05:02] So a little bit of both, to be honest with you. There was definitely a part of us that sort of valued being close to wherever the first investment happened to be. We thought that it was important for a variety of reasons. So certainly that played into our thinking. And we can get into a little bit later on in the conversation about how that plays with sort of your emotions when you're looking at which target to acquire. So there were definitely moments there when we thought we were moving to Reno, we thought we were moving to Charleston. So that's definitely a factor that needs to be managed. But ultimately it was a personal decision. We actually did move there and sort of completed buying a condo, sort of moving everything before the deal even closed. Largely that was due to the fact that we were living in Connecticut at the time, and we were in Portland sort of every other week for six months, thankfully in the summertime. It just got harder and harder to get back on 95 and head south. So we, it felt like home, so made the move.

Patrick: [00:05:57] So walk me through the process of kind of first seeing what the business looked like very specifically. So what are you looking at it? Is it a brief, is it a information memorandum? Is it a spreadsheet with projections and trailing numbers? What is the first raw material that you're dealing with to start to evaluate this business in particular, but I also want to talk more broadly about businesses of this size for people that are kind of in this permanent equity category.

Trish: [00:06:24] To be very tangible, the first thing we got was just a one-page teaser that's like commercial property company, and like some very brief stats. Basically, that's it. You sign an NDA with the broker and then they'll send you a prospectus or SIM or whatever you want to call it. Those range in quality from upside down PDFs of the QuickBooks reports for the past couple of years to 50-page more sort of professional outlines of the industry and the company, and what you're looking for.

So the one for Seabreeze came, and if I recall it was one of the sort of nicer ones, it had maybe like 40 pages of information about the space. That's what we had to go off of. The things that caught our eye were an industry that we thought would be around for a long time. So landscaping and snow removal will probably continue to be a thing. A high percent of revenue was contracted. So anywhere from 1 to 5 year contracts with commercial property owners throughout the area. So we felt that there was a pretty solid base to the company that would continue on. At the time, since it was our first acquisition, we really wanted owners to stay on through the transition. And this had 2 brothers who were looking to stay on sort of for an extended retirement transition plan. That made us feel more comfortable because we didn't want to be the people operating the company on a day-to-day basis.

Purchase Price & Growth Potential

Patrick: [00:07:47] So as you're acquiring the business and thinking about one, the right price to pay, but two the potential for growth, and those really being the two key drivers of how successful this is going to be. For that first one, how did you balance those two things? So with it being your first experience paying price multiple X, Y, or Z, how did you think about that? And that could be related to your career prior to that, or I'd love to hear kind of what the lens was. Then how did you balance that with the potential for growth?

James: [00:08:15] With respect to the multiple, when we first got involved in this, we really got involved in it primarily from an investment perspective, really sort of top-down. And that's largely due to our backgrounds in sort of hedge fund investing, but on sort of a macro side. Where you're looking at sort of broad trends and trying to capitalize on them. We all sort of tumbled onto the concept of small business investing from slightly different perspectives. But in general, we all sort of triangulated on this core sort of back of the envelope thesis that multiples in this space are much lower than comps associated with larger LBOs, larger public equities, that sort of a thing. You're waking up and saying, "Hey, I can buy this company for four times." That means if I can make sure the ship stays more or less straight, I'm earning 25% of my money. Now, theory is very different than practice. And we can get into sort of all the hurdles along the way to realizing that return. But conceptually that's really what hooked us to begin with. Then the process from there was really a progressive attempt on our part to try to break the thesis. I think what happened was in some respects, the idea became more compelling because the things we thought were going to be wrong weren't, and the things that were wrong were things that we actually enjoyed working on. So it ended up being kind of the work associated with earning that excess return was something that we found very exciting.

Patrick: [00:09:42] Can you flesh those two categories out a bit more? So maybe starting with the things that you thought would be the hiccups that turned out to be things you enjoyed?

James: [00:09:50] So I mean, primarily the businesses are small and then everything you read about and anything you can kind of can sort of hypothesize about what it's like being involved in a small business, it's hard. People wear lots of different hats and it takes a lot of energy and perseverance to sort of continually put one foot in front of the other. Sometimes the progress is substantial and sometimes it's very fleeting. The other thing I think is that you are volunteering to have a very direct impact on a lot of people's lives in a way that I think we found very different than our time in more traditional investing. Where you're sort of looking at numbers tick up and down on the screen.

Patrick: [00:10:28] Pushing buttons.

James: [00:10:29] More or less. Which isn't to say that that isn't extremely intellectually rewarding and fulfilling, it's just different. And I think that we went in sort of knowing that there was going to be a huge interpersonal element to what we were doing. I think the reality was just sort of to a greater extent or a larger extreme than we even conceived of initially. But I think on the flip side, we've all found that extraordinarily personally fulfilling. So I think when we first spoke, and we talk all the time about, you kind of break down, why are sort of the back of the envelope returns at the level that they're at, relative to a risk-free rate and inflation premium, a credit premium, whatever you want to layer on top? Our contention would be that if you go upmarket, you're sort of harnessing an illiquidity premium if associated with sort of larger private equity-type folks. But when you go down market, I think there's a premium associated with rolling up your sleeves and getting in the weeds and making something happen. And I think that process is something that we really enjoyed.

Patrick: [00:11:31] What were the things that you expected to be the difficulties that weren't actually there?

Trish: [00:11:36] Well, I'd say I take that in two parts. One is, we came in with these grand strategies and like, I had a really good PowerPoint presentation of all of the things we were going to do in the first like 6 months. Part of that was like really streamlining the technology and creating our own or implementing an ERP system, and it was going to be amazing. Then we showed up in the first day and the internet doesn't even work. It turns out that people barely use email at all to communicate. So at first, we had to come back and say what we actually need to do now is not this like high-level sort of operational improvements across the board. What we actually do is go back to basics and say, do we actually have a server? On the technology side, do we actually have an org chart? Which surprisingly is not a concept that a lot of people really grasp.

One is, we came in with these grand strategies and like, I had a really good PowerPoint presentation of all of the things we were going to do in the first like 6 months. Part of that was like really streamlining the technology and creating our own or implementing an ERP system, and it was going to be amazing. Then we showed up in the first day and the internet doesn't even work. It turns out that people barely use email at all to communicate.

James: [00:12:38] Or sufficient space in the email client. So what we were finding was that we were signed up with an email client that didn't have capacity for each individual account. So we were getting emails from clients that were getting lost in the host server and weren't downloading onto the biz dev people's phones or computers or whatever. So similarly our contract with Time Warner had been on auto-renew for several years. So as a result, we were signed up for a bandwidth that was below their lowest tier currently. People were wondering why periodically the internet would just stop working.

Trish: [00:13:14] We had to like lower our expectations for what we actually had to do in the companies. So that was surprise one, there's a long list of examples in that realm. Then I'd say, at least for me, a big round was sort of the HR side. I think that as soon as you're involved in a small business, and you actually start to interact with everybody, you realize that managing people becomes incredibly important. So a lot of the people running the companies, even though sometimes they can have perhaps gruff exteriors, I think are sometimes potentially even more emotional than they let on. I think there ended up being, or there is a lot more attention to detail that has to go into sort of managing the relationship with the people in the small business than we probably thought there would,

Chenmark's Edge

Patrick: [00:14:06] You guys both have a career prior to Chenmark in the more institutional traditional asset management space. So you know that the first question every manager gets asked is what's your edge, and how is that sustainable? How might that persist, and can it persist with any sort of scalability? I am increasingly struck by the fact that it's these little things that don't scale that maybe provide the most permanent edge, but of course, also limit the scalability of the strategy. So as you think about Chenmark as a business, now with 3 portfolio companies and constantly looking at more, how do you think about that balance between how big you might want this to be? If you even, I don't want to assume you do want it to be big. And how far removed from your current universe or size companies could you get and have what you're doing thus far, still be an edge where you can earn outsized returns.

James: [00:15:00] We may have all different answers to this, but my answer would be, I think our edge is involves at least a willingness to listen on a number of different levels. So one thing we didn't quite get into when we were talking about sort of the deal process and sort of getting going from that initial teaser to a letter of intent, or a transaction or closing, or what have you. There's a lot of trust that needs to get built up there between ourselves as a buyer, and any potential seller. The nature of the deal process is going to naturally stress that trust at periodic intervals, along the way.

Also, different sellers want different things. Different people who have essentially built their life's work into some business from potentially even their teenage years to when they're seeking an exit strategy, when they're 50, 60, 70s, what have you have a very wide range of motivations when they get there. There can be folks who really don't, as long as they feel like they're getting a fair shake from a valuation perspective, they care much more about their brand or their people, or sort of the standing of how their customers perceive the transition. On the other hand, you can get people who care very much about valuation and care a little bit less about some of those other factors.

So I think when you are trained in a sort of traditional financial way, and there's a lot more clarity of information, a lot of times that negotiation ends up skewing toward the financial and the transactional in a way that's different than what we see in our space. So as a result, I think one of the biggest things that we can do is take some of that training, but then be willing to spend 2 or 3 hours in someone's living room, talking to them about their hopes and their dreams and what they care about, and sort of how they got to that point. We've heard from sellers that differentiates us. Now, to your point about scalability, you're right, I think that you end up in a spot where you're willing to do that for a variety of reasons that are probably unique to each individual person. I do think though that that's a cultural thing and it can be built if you're stressing the right things internally.

Patrick: [00:17:11] Do you have a, let's call it a vision for the future of the firm? Or are you more oriented towards, let's continue to be immersed in this stream, not only of deal flow that sounds like it improves, compounds on itself, and the source of that deal flow. But also the hands-on, very rewarding experience. So are you more focused on that or do you also kind of step back sometimes and say, "Well, wait a minute, this could be a much bigger firm, a much more widespread trend." Which is what I'm seeing.

James: [00:17:42] To answer your question directly, I think we're more than... Even though we came at it from an investing side, I think what's evolved over the last call it 2 or 3 years is a much more sort of mission-driven firm. The reason I say that is I think we sort of see ourselves as sitting or ideally sitting at the intersection of kind of three different groups. So one is a provider of investment capital, and that could be ourselves, but it could be others as well. The other is the sellers we just talked about who are looking for an exit, but on sort of their terms, and terms meaning the broad scope of that word, not their valuation terms necessarily. And then the third would be executives/entrepreneurial talent. And some of that's us, some of that our folks were able to identify in the companies themselves. And I think some of it our people that we're able to source externally who we think there's actually this nascent preference shift away from a large corporate environment to a smaller environment, where there's a tangible, authentic opportunity to have a direct impact on people. Be they internal as employees, external as customers, or on a community at large. So when we think about scaling the firm, we think about it in those terms and we think our success is ultimately our ability to continue to create opportunity for those three networks to intersect with one another.

Trish: [00:19:10] I'd say that I think that we've been very fortunate to have observed the actual people who build large firms. So for us, there's something tangible and real to the notion that one person could build a large firm. That's just from personal experience being able to see some of those people and how they do it. So for that, I think the idea of making Chenmark big doesn't sound crazy to us. So from the very beginning, we've said we think there's a big opportunity here. We don't think a lot of other people are doing much about it. And we have always thought that there could be great value to a diversified portfolio of small businesses that is focused on long-term operational improvement. So from day one, that has been our goal. Of course, that started off with us buying a landscape, snow removal company in Maine. Everybody was like, you're quitting AQR to run a snowplow. And so I'd say that we understand that it comes one step at a time, and that it's one acquisition at a time. But we're pretty disciplined about valuation and disciplined about looking at companies that fit with what we perceive to be long-term and enduring in nature. Until we stop seeing those opportunities, we're going to continue to try to take advantage of them, because if we don't do it, someone else will, and why not us?

Patrick: [00:20:45] You probably know them if they exist, but there are probably not many people that have the traditional formal training in finance and investing that then go the direction that you have. So I'm curious what talents or skill sets or lessons from your prior careers, and maybe you could, we didn't do this at the beginning, because I should have, sorry. But maybe you could just give a 30 second kind of summary of your careers prior to Chenmark. But then more interestingly, what aspects or lessons from those careers have you seen most applicable or useful in approaching much smaller businesses?

Trish: [00:21:22] Yeah, so it's a little different for all of us, and James's brother Palmer works with us as well, and his experience is a bit different. But I started off directly in the hedge fund business. I worked at a firm called Protege Partners and was fortunate to have Ted as one of my first bosses, as well as a great guy named Scott Besson, who is a global macro investor. Went from there to business school and then went to work at AQR. I'd say that James worked also for Scott for a period of time at Protege. And I'd say that from that perspective, one of his big things when it came to portfolio management, was that you earned the right to take risk.

James: [00:21:58] You took my comment.

Trish: [00:21:59] Sorry, we are married. That manifests itself in different ways when you're managing an actual liquid portfolio. But when we think about building Chenmark, that's something that we really took to heart because we see a lot of different opportunities, but we have a very long-term vision when it comes to building Chenmark. We all expect that it's the last job we'll ever have. As a result, if we are spending the next 10 years building a portfolio of really solid small businesses, then maybe in 10 years we can afford to take more risk. Once we've built up the base and maybe get into things that are maybe a bit more cyclical in nature or earlier stage or things like that. But we decided that for basically the first 10 years of Chenmark, we are earning the right to take risk. So we're trying to prove ourselves. So that's lesson one.

The other big lesson I'd say, comes from seeing AQR. I worked for David Kabiller, who was one of the founders there. Seeing him and what he's done in terms of actually building the business of AQR had a huge impact on me. He's all about, and AQR is all about diversification, not just from a portfolio, like liquid portfolio sense, but also just from like the business. Which I'm sure you know. For us, that's why we have a strong bias towards building a portfolio of these businesses because any one is inherently risky. So building a portfolio of those helps us sleep better at night. But also from a correlation and portfolio theory perspective, we can see how like the return stream from, again, landscaping in Maine, is very different from the return stream of the S&P. So as part of a broader asset allocation theory, we think that could it be $10 billion? No, but could it be big enough to have a meaningful impact on providing uncorrelated return stream to people? Yes. So at least for me, those are the two big lessons from our pre-Chenmark days that we've been able to apply, and are pretty core tenants to how we're thinking it.

James: [00:24:16] I'd really echo that. I think talking about it in these terms is interesting because it's funny how applicable a lot of the kind of basic rules of risk and portfolio management that have applied to a completely different setting, are actually very relevant. That can extend even into the companies themselves when you're thinking about how to allocate capital. It's not allocating capital to a certain publicly traded equity but it's allocating capital to new mower technology, or what the ROI necessarily is on an ERP system, and that kind of thing. So I think that's that piece of it's very relevant. On the flip side, and I think this is worth talking about, again, very classically trained, went and got a CFA, and did all the studious book stuff. If you want to understand how the three financial statements flow together and work, spend two weeks trying to manage the cash flow position of a small business, and you got it.

Trish: [00:25:12] It's like in accounting class, I always was like the cash flow statement? Who looks at the cash flow statement? Like whatever. Then three weeks into actually owning a business. I was like, "Oh, that's why it matters."

James: [00:25:26] Yeah, so it works both ways. I think it's not just all this super sophisticated training that then you dump into the small business. I think getting back to an edge, I think a healthy respect for the entrepreneurial talent, and really just the intestinal fortitude associated with building a business from nothing with limited resources and all that kind of stuff is extremely, extremely impressive. And I think we do ourselves a disservice to assume that our training is better, it just is different.

Riches in the Niches

Patrick: [00:26:00] Let's get back into the actual search process. Which is of course the bread and butter of your success, alongside how you manage the businesses after buying them. You mentioned a couple of interesting things, very specifically the idea of the first landscaping business having contracts that were relatively long to provide a de-risking of your investment, especially at something like a four times multiple. What are some of the variables that you, as you've looked at thousands, I'm assuming of businesses now, or considered thousands of businesses, have started to stand out? Little things like that, that provide you with comfort to go to the next level. So go from the one page memorandum to devote your time to do the next level of diligence.

James: [00:26:43] The biggest thing that we talk about, or that we think is important, is identifying and being very clear about the question you're trying to answer via your investment. I think that when you think about more traditional private equity, the nature of that business and the timeframe associated with it means that when you're getting into an opportunity, a decent part of your calculus involves sort of asking yourself the question, all right, so what are the growth prospects for this company over a 3 to 5 year time horizon? So how much can that valuation increase in a short window? For us, we've been very clear from pretty much day one that the question we were trying to answer is entirely related to the durability of the franchise. So how confident can we be that the business, the product that it produces, the service it provides, et cetera, will be around in 15 years, 20 years? That's really our, other than size, that's really our biggest filter. That can manifest itself in a few different ways, but contracted revenue for a service that's a basic need for a number of companies, is something that easily passes that first test.

Patrick: [00:27:56] What are the other two businesses in the portfolio today?

Trish: [00:28:00] The second acquisition we did was a frozen dough manufacturer up in Western Canada.

Patrick: [00:28:05] You're from Canada, right?

Trish: [00:28:06] I am from Canada. Yup. So that company basically makes frozen dough that is sold into grocery chains across Western Canada. A lot of grocery stores that you go into, about half of them, even though it says freshly baked it's, actually, it is technically freshly baked, but it's shipped there and then frozen and then baked. So they make like hamburger buns and rolls and jalapeno cheddar poppers or whatever. That company's been around for 15+ years. Sort of steadily grew over time. Started by a local baker who just thought maybe I could make something more on this side of the business. So that company doesn't have contracts, but it has a pretty defensible position because one, there aren't any other people providing their product in Western Canada that are not owned by competitors of grocery stores. So there are some that don't, unless they want to buy from a competitor, are going to buy from this company. Also, it happens to be, if I put my Canadian hat on only a couple of kilometers away from-

Patrick: [00:29:10] I spend like 20% of my time in Canada, so I get it.

Trish: [00:29:15] Yeah, a couple of kilometers away from the largest flour wheat producer as their biggest supplier. And they back onto their largest distributor. So just from a geographic standpoint, it makes a difference for margins. So they have far, far above industry norms for their margins, because of that.

Patrick: [00:29:34] That just reminds me of a great piece that you guys put out about bait shops, and the importance of location and geography. This is something that keeps coming up in the small business arena of moat or geography as a component of a moat. So I would love it if you could flesh out the bait shop example, and kind of the implications for it, and why you use as an example.

James: [00:29:56] Going all the way back to the beginning of conversation when you asked about growth and growth prospects. To be honest, that isn't necessarily a huge component of our analysis, at least in the beginning. The reason for that is largely due to this bait shop concept, and to be fair this is borrowed, this is something I read. But conceptually, the thesis is if there's a bait shop that's at the end of a dirt road in front of a very popular fishing spot, it's likely that that type of business, even though it's not particularly differentiated in the context of all businesses out there, can earn above market returns because it's kind of the only game in town. Now, it also means that there's not necessarily a lot of reinvestment opportunity. So if you own it, you're maybe earning a yield, but you're not necessarily compounding wealth over time because you're going to have to pull the money out and do something else with it. So a lot of our initial thought was, well, we can buy these things have interesting niches that they define for themselves. They earn high returns on investment. Can we then build a portfolio of them and then essentially use free cash to buy the next one, and on and on it goes. But your reinvestment opportunity is the fact that you're just a lot of these types of things out there if you're willing to turn over enough stones and look. We still very much believe in that, but I think what's interesting is that there's just a lot of room under the giant companies that you hear about. So I think what's happened over the last 2 years, rather, 2 or 3 years, is that the thesis has evolved somewhat where we're still looking for those bait shops, but we're finding is that those, those "bait shops" actually have some re-investment potential in them. And there's an opportunity maybe to move from local to regional, and that can represent an even higher return on capital if done prudently.

Trish: [00:31:48] The other thing that I'd add is that we're all about our network and bringing on people who are better than us at whatever it is their background is. I think we have realized that if we really truly want to surround ourselves by talent and particularly we're only going to be as good as our operators in the companies, that very difficult to find really awesome people who don't want to grow a company. So some of it is you bringing high charging, high powered people into these companies and seeing what they can do. That is, I think part of our thesis that has evolved that we didn't quite know when we first started.

So I think what's happened over the last 2 years, rather, 2 or 3 years, is that the thesis has evolved somewhat where we're still looking for those bait shops, but we're finding is that those, those "bait shops" actually have some re-investment potential in them. And there's an opportunity maybe to move from local to regional, and that can represent an even higher return on capital if done prudently.

Search Funds

Patrick: [00:32:26] Let's talk a bit about competition. I've heard from others, we both know Brent Beshore, who's kind of the guy who opened my eyes to this entire world. This permanent equity kind of small P/E world. Competition always comes when there are high returns to be earned. Of course there seems to be, I've been searching, and I found you guys and him for the most part so far, so it's a relatively small universe. But you were the first ones to turn me on to this idea of a Search Fund. So maybe you could talk a little bit about that as a jump off point to talk about the competitive landscape for buying businesses at the scale you're looking at.

Trish: [00:33:04] So the search fund is an increasingly popular thing to do coming out of business school these days. Started at, it depends who you ask, but it started somewhere either at Stanford Business School or Harvard Business School. Basically, it's this notion of typically people graduating saying, I don't want to go work for McKinsey or Goldman, but what I do want to do is I like the idea of being an operator of a business. So they'll go out to a group of people and say, "Hey fund my search." Which basically means cover my living and search costs for anywhere from generally it's about 2 years. And during that time, as I'm getting backing from this group of people, I will go and basically do what we do search around the country and try to find a business to buy.

The big difference between us and a search fund is that once that person finds a company, they take it back to the original investors, who have the option of participating in the purchase or not if they don't want to. Raising the capital and upon execution of the transaction, that person becomes the CEO of the company. They tend to then have the objective of growing the company and get equity in the company in return for hitting different growth targets. It has become incredibly popular. So about 10 years ago, there is a class actually 2 classes, taught by these 2 professors at Harvard Business School. One is on search funds and one is financial management of small businesses. I think about 10 years ago, I don't know the exact numbers, but there was a small handful of people who would take those firms because like who cares. Most recently, I've heard they have 3 sections of 90 people of grads who are looking to take this class. Not all of those people go on to actually do a search because as you can imagine, 2 years of uncertainty, it can be difficult for people to actually pull off for a whole host of reasons. Then a fewer number of those people actually find a company and execute it. It's become popular because Stanford puts out an annual review of search fund activity, and the returns associated with investing in search funds are very, very impressive. That has gained the attraction of investors who are supporting more searchers. The more people learn about search, the more young people are interested in doing that. It's seen as an actual career path, so now if it used to just be a Stanford and Harvard Business School thing, now Booth are super into it and Northwestern is getting into it, Yale School of Management. So it's starting to really spread as a credible thing for people to do.

Patrick: [00:35:55] What kind of returns are we talking in terms of, when you say impressive?

Trish: [00:36:00] So there's a wide distribution, but like I've heard mid-30s IRRs is kind of what's expected when people are going out and structuring their deals. What's interesting to us about the space, to answer your question about competition is that relative to the hedge fund space, where like my best friend could be working for a hedge fund, and I couldn't talk to her about our positions because they were all proprietary, even though we're all like long Apple. In the small business space, relative to that, is still so under competitive that people are still sharing information left, right, and center. So it is the type of thing where you have to find a business that fits what you're looking for. So a searcher could be out there and they could say like, what I'm really looking for is something that's in financial services in the Midwest and it might come across my desk and it might just not be a fit for what we're looking for so we can pass it along and share. So right now the industry is actually, I think, quite a friendly, happy community. It is possible that as more people get involved, it becomes less friendly. But my sense is that we still have a really long ways to go before that actually happens. I also think that for us, we have found that what's helpful is it takes 5 years to have a 5 year track record. For us having gone through the pain of searching for a company for the first year, I mean, it's like we already have a year of search experience. So the experience starts to compound and people also start to understand that we are real. So when we're talking to you, we're actually going to potentially close a transaction. So I think that it helps to have been doing this, but it still is an area that's pretty wide open from a competitive standpoint.

James: [00:38:00] The numbers are a bit opaque but clear enough to be compelling. You know, we've done a little bit of research on this just internally. and we admittedly are self-selecting a very small slice of the small business universe. We estimate that there are on the order of 200,000-ish businesses that are just in our... There're better stats on revenue than there are on cash flow. So just in our revenue range with owners who are in an age where they would be at least contemplating retirement. You comp 200,000 obviously some subsection of those are going to be the ones that are potentially available, but you comp that against even an exponentially growing search fund community of maybe 100 or 200 active searchers, and there's still just a very compelling mismatch there.

Taking on Outside Investors

Patrick: [00:38:54] It's such a fascinating space that, again, I'm just going to be curious to see the balance of scalability with returns, how much institutional money will be flowing this direction. So I'm then thinking about your business and the fact that you're going to be spitting off cash flow, free cash. You can either reinvest for higher returns, to go back to the bait shop example, in the existing businesses. Or you can obviously use that free cash to fund future acquisitions. But the timing is always interesting. So you might have a glut of cash and no opportunities or a ton of opportunities and no cash. So how do you think about outside investors? Have you taken on LP investors to this point? Do you plan to in the future? Then I want to get into a discussion on how, in the future where there are these permanent equity managers, such as yourselves that are taking on LPs, how they should charge those LPs? Which is, I think, the most important topic in investing today is how we're charging clients.

Trish: [00:39:58] So just in terms of how capital allocation into a sector can create mutations of strategy and scalability. You've seen that a little bit in the search fund space already, in the sense that as more quote/unquote institutional capital, which is still not really, it's not like Goldman institutional. But as more capital comes in, you do see people feel pressured into areas that have the ability to generate very high growth returns. So traditionally-

James: [00:40:32] And can accommodate larger checks.

Trish: [00:40:32] Correct. So traditionally search fund community was very $1 to $2 million contracts, enduring business grow for the long-term. That's where the industry started. Over the past couple of years, you've seen a lot of searchers gravitate more to the $2 to $3 million range and pay multiples that we would personally never even consider. So a lot of times we'll be like, oh, this company has it's like $2.5 million of EBITDA. It's like some sort of SaaS platform. That like they're going to pay nine times for and grow aggressively and sell in 5 years. So I think that part of the search fund community is becoming more just like mini private equity. You're seeing that pressure for people to go in that direction. So I think that for us, what's important is, to answer your question about external capital, at some point we will, if we want to continue to grow, we will need to find external partners to work with. That said, we don't really have any interest in working with people who are going to pressure us into taking on high debt loads and growing aggressively to generate super high IRRs.

James: [00:41:52] Especially over a short time horizon.

Trish: [00:41:53] So for us, it's really only interesting if somebody is like, "Hey, I get what you're doing, and I think that there's value in it, and I want to participate in that." So we haven't really aggressively gone out and done any capital raising. I think that we have surprisingly had more people come to us just saying, "Hey, is there any way for me to participate? If so, if you do think about it, let us know." But we haven't formalized our thinking about how exactly that would look because there's a lot of different ways for it to manifest. We did take one strategic small slice of outside capital of participation for our recent deal. That was also in the landscaping space. And it happened to be a prominent property owner in the local area who expressed interest in participating. We saw benefit in having him on board as somebody who could actually provide us with industry expertise in that deal. That worked out great so far.

Patrick: [00:43:03] What do you think about fees from two dimensions? One, how you would think about fees management and incentive charging potential LPs in the future? But also looking back, now having extricated yourself from the rat race of institutional asset management, at the fees and the trends in fees in my world, your former world, what do you think about those two things, I'd be really curious?

James: [00:43:31] Few different points. But the first would be when we have thought about it in general we have... Some of it depends on there's a certain element that has to do with how you choose to structure the scaling Chenmark. What I mean by that is we deliberately, and getting back to core filters, we deliberately target companies that are kind of between $1 and $3, really $1 and $2.5 million of cash flow or EBITDA, or however you want to define it. We do that very deliberately for a number of reasons. What that means is two things. First, companies at that size of cashflow tend to be very similar with respect to their stage of life, so to speak, regardless of what industry they happen to be in.

What we tend to observe is that they tend to be extraordinarily good at their core competency. So if you're in landscaping, you're very good at landscaping. You can build a wall, you can lay a beautiful patio. You can mow a lawn expertly. If you're in the baking industry, you're extremely good at making bread. Your new product development is extraordinary, et cetera, et cetera. Where most of those businesses tend to be underdeveloped is on what we talk about as the business of business. So probably a little less focused over time on finance, HR, technology, marketing, et cetera. So the challenge then becomes how can you deploy some of that into these businesses to allow them to continue to grow over time without breaking the bank? Because the cost of a subject matter expert in any of those disciplines is maybe you could source one of them, but then you'd be priced out of the market of the others. So one of the things that we think quite a lot about is, is there a way to centralize some of that core expertise and then deploy it across the portfolio so that each company is benefiting from exposure to that area in a more cost-effective way.

To bring it back to the management fee conversation, obviously, that takes funding. So that requires some ability on our part to chargeback each company, the cost of the high-powered head of HR, the quality CFO, what have you. So there's a whole component related to structuring. I think that kind of comes sort of tying it into fee creep or fee excess in more institutional investing. I think what we believe very strongly in is transparency with respect to that conversation. So I think we really wouldn't have much of a problem talking about how we're budgeting and what value we think is being delivered to the companies. But that's a conversation that needs to be had because if you are charging things like that to the companies, your management fee as a percent of EBITDA invested capital, whatever is going to be off market. So that's something of an issue that we talk about and need to work through. In terms of wealth generation for the manager, so for Chenmark as a business, we feel extremely strongly that we should be compensated almost entirely via some type of carry. We want to be as aligned as possible with any investor that we bring on. Then I think that's just a philosophical preference. I think that that keeps our focus on finding really good opportunities that can generate above market returns and keeps our focus off asset gathering.

Trish: [00:46:58] Well it's a philosophical preference, but also I think just smart business at the moment. We're just starting Chenmark, we intend to be around for a long time. I would rather be ahead of the curve on fee structures than trying to grasp to a model that's slowly dying. So I think actually Brent was the one who mentioned this because we were able to connect with him out in Arizona. And he made the comment that like living in a small town is a competitive advantage, which it is because living in Portland, Maine, the amount that the Chenmark partners have to compensate themselves is relatively low, to have what I think is incredible quality of life and pretty much do all that I really ever want to do.

So I think that we're able to think through, if we were to take on external capital, I think that we could figure out a way to pay Chenmark the amount to basically cover operating costs. Then sort of incent compensation towards carry, assuming that if everyone does well, we should do well. I think that that's important for us, but I think it's even more important for building the Chenmark team, building the operators who were in the companies. Bringing on these shared services experts, those types of things. Working in a small business is messy and hard and long hours and all that stuff. I think that if you can bring in people who say, like I'm going to build this company and I'm going to make it awesome, but I'm also participating in the upside. That's a really important component to being able to attract talent to this space.

Skin in the Game

Patrick: [00:48:37] One of my favorite writers, even though he's a controversial guy, is Nassim Taleb. He has a new book coming out called, I think he's calling it Skin in the Game, which is a key idea for him. The core idea being you should not listen to anyone unless they have an enormous amount of skin in whatever game you're talking about. And he even has a little aphorism that says "No opinions are allowed without skin in the game." So I want to ask about that almost as a feeling for you guys where your livelihood now depends on enormous skin in the game. I love that comment earlier that you need to earn the right to take risk, where risk is just another way of saying skin in the game. I came across this funny little book that someone recommended to me called the Zurich Axioms about a generation of Swiss risk-takers that runs very contrary to a lot of conventional wisdom about diversification and spreading your bets and being cautious. Basically preaches the opposite that you should bet really big and really smart when you find an interesting opportunity. There's a little quote in there that made me think of you guys, which is, "Worry, is not a sickness, but a sign of health. If you're not worried, you're not risking enough."

Trish: [00:49:46] You know what's really funny, I'm just going to pause you, but James... This was in your newsletter, right?

Patrick: [00:49:51] Yes.

Trish: [00:49:51] Yeah. James, like on the way here, read me that quote.

Patrick: [00:49:55] Awesome.

James: [00:49:55] Like stop everything, let's do this. So we identify with that.

Patrick: [00:50:02] Yeah. So what I want to hear about is kind of what that feels like relative to old, less skin, I'm assuming you had much less skin in the game in your prior career, even though I'm sure-

Trish: [00:50:14] I was not a majority owner of AQR Capital Management.

Patrick: [00:50:20] You weren't a big AQR owner. So the difference in feel, good and bad.

Trish: [00:50:23] Yeah, so I think it probably manifests itself differently in all three of us. I think that being a family in this endeavor makes all the difference because we're all in it together and you can rely on that family level of support when things are going well and things are stressful. So when we first started we had very little/no compensation. I think that just on a personal level, it's not as if James is out doing something and I'm like, why are you doing this? And we have to eat at home every night or something. We have felt very much from the beginning that we're all in it together. We're all building something. The sacrifices that come along with that don't bother us at all. It's just not a problem. I'd say that in this space you, personal guarantees are a thing. So at the end of the day, we have the philosophy that we're trying to build something and if things go wrong, we'll figure it out. Having that mentality off something doesn't work the way we expect it to, or things are bad, we'll figure it out and we'll be there for each other. And let's just move forward is how it manifests itself for us.

James: [00:51:46] I would draw a distinction when we got on this topic, I would draw a distinction between the perception of risk as it concerns the vision, and the overall overarching goal, and the perception of risk as it concerns the day-to-day. I think that there've been plenty of times when idiosyncratic events with respect to all sorts of different things at each individual company have created some sleepless nights and a lot of anxiety within the group. But I can't really think of a time when there's been any wavering with respect to the overall vision. I think that comes back to, and I'm failing to come up with a good example, maybe you have one. But a lot of times when you read about really successful people who've done something just slightly different, there's this perception they took a huge risk. When you actually interview them or talk to them, a lot of times, they'll say, "Yeah, I know it looked that way, but when I thought through it, it didn't seem that risky to me." And I think for us, for whatever reason, the overall overarching vision of creating this portfolio and thereby creating opportunity for others in addition to ourselves has been extremely motivating. To such an extent that I don't know that we ever really perceived it as risky, so to speak.

Trish: [00:53:04] Yeah, I'd say it's also, there's the perception of risk. So we started our careers pretty much right before the great recession. So to me, the risk has always been more that somebody else is going to terminate me for some exogenous reason. Especially in the hedge fund community would I ever get lucky enough to join the right fund at the right time, in the right position? Having seen so many do well, and so many close shop for a whole host of reasons, and they're all super smart, talented people. So I always saw it more as at least now we control our destiny. So it can take a lot of different shapes, but at least I don't have to worry about some other person deciding that we're going to close that division or close the shop, or that thing. So that's the type of risk that I have no interest in taking.

So I always saw it more as at least now we control our destiny. So it can take a lot of different shapes, but at least I don't have to worry about some other person deciding that we're going to close that division or close the shop, or that thing. So that's the type of risk that I have no interest in taking.

James: [00:53:57] One more point on that. So we write this weekly newsletter and at the beginning of every year, we kind of recycle an article that outlines our core values. So the cliff notes version is the first one is being willing to be different in order to do something great. Cribbed from Howard Marks and his Dare to be Great essay. But we really latched onto that conceptually. So I think probably the biggest risk that third parties perceive on our behalf is a pretty significant career/opportunity risk associated with, "Wait, so are you shoveling the snow, or are you driving the Bobcat?"

Trish: [00:54:38] I'm more of a mulcher, myself.

James: [00:54:40] So I think from day one, really, we had comfort with that and with the understanding that we were doing something different and that, that had value. The other two pieces are an unwavering belief in our own potential and a commitment to the slight edge concept. Where if you can just be incrementally better tomorrow than you are today, you can make real progress over time. I think the sum total of all three of those means that even if we're in an environment that's highly differentiated, with a lot of uncertainty around it, we feel very comfortable in that space for those reasons.

Most Memorable Day of Career

Patrick: [00:55:18] So I can talk to you guys for hours, but since we both have other commitments tonight, this is the late, late, late night edition of the show. I'll go to my two favorite and always my two closing questions. So the first is to hear about, and you're married, so it can't be your wedding, to hear about the most memorable day, let's say of your career.

Trish: [00:55:38] Do you have any that comes to mind? I'm trying to buy time. So something comes to mind, but it's not flattering, but it was extraordinarily humbling. I think that in one of my first, early on in my career, I had a performance review that I did not think through properly how to give feedback up the chain. And that's something that comes up to me as the most memorable day because I think that it actually, it had a huge impact on me in understanding both my place, but also how to communicate properly. My place I say because it's like, I felt like until that point, I was like flying high maybe a little bit, maybe I had a bit too much of an ego. I think in that moment I realized that I'm really just an analyst. I really need to earn my stripes, and if I want something or want to improve it, I have to think a lot more about how to properly communicate that to whomever it is I'm talking to. And how to think about positioning things to get what I want. Does that make sense? So that was like a big one of those like professional slaps in the face, but definitely, I think had a huge impact on me.

James: [00:56:58] So I've got one. When we were in the initial search phase, looking for our first company, we were trying to be quite frugal with respect to our overhead. We found a company in Louisville. We were living in Connecticut, and we found a company in Louisville, and there was a bit of time sensitivity to the owner making a decision about who he wanted to partner with to go to the next stage. So it was like a Monday, and we had to be in Louisville on Thursday. So we pull up Kayak or Google Flights or whatever, and the flights actually weren't prohibitively expensive, but they seemed very expensive at the time, $500 or whatever. We just collectively all decided that it made no sense whatsoever. So we rented a minivan and bought an air mattress, and we drove to Louisville and took shifts, sleeping and copilot and driver and rotating. Made it to Louisville, had a great meeting, really interesting guy, and then drove back. I don't know what that says, but I think it's something that we all talk about all the time is something that was really fun. I think sort of some people are like, "Oh my God, I'd never do that." And some people are really energized when it's kind of all three of us making it work somehow. I think that was a really cool thing.

Patrick: [00:58:14] My reaction to that, which is an awesome story, I just see this over and over again with people I talk to who are founders. That by being a founder, all of a sudden, all the things that seem bad take on this kind of special air to them in a way that's kind of magical.

Trish: [00:58:34] I feel like it's like being a new parent. You know, it seems terrible that your child's up all the time but also, you cherish it. Right?

Patrick: [00:58:42] Yeah, I remember a moment with my son, who's 3 now, but was up at 6 months old or 7 months old or something. And just up the whole night for like 3 nights in a row, sick. We were exhausted, and just holding him in the middle of the night, it's exactly that. Like this sucks, I really wish I was sleeping, but somehow this is also the best moment ever. I just hear little stories like that so many times, very specifically from founders. Founders is all about that skin in the game idea.

Trish: [00:59:11] I can tell that if Ted was like, "Hey Trish, I want you to rent a minivan and drive to Kentucky for this meeting and then drive back." I probably wouldn't have felt so good about it.

Patrick: [00:59:19] You'd say, "Go screw yourself."

Trish: [00:59:20] Yeah.

Kindest Act

Patrick: [00:59:20] So last question, and then I know we got to go is, and you've probably heard me ask other people this, to hear the kindest thing that anyone's ever done for you.

James: [00:59:28] Probably too many examples, but volunteering time would be the biggest thing. I think both of us feel as though we've been extraordinarily lucky to benefit from people who are smarter, more experienced, tougher than us. Taking the time to educate us, be patient with us, teach us how to invest, to think about risk, to think about life. To me, that's the kindest thing anyone can do with anyone is to allocate your time.

Trish: [00:59:59] I'd say that, and this is a very small example, but we recently had our first daughter she's 7 months old. But I remember the guy that we bought the dough business from after he retired, and he was off doing his travels in Spain. He went out of his way to send us like a little baby present. I just remember, like it was such a small thing, but I know that selling his business was so hard for him, and he was very emotional about it. With this little note about taking care, you know, taking care of his company and how much that meant. For me, his thinking through taking the time to send us a present, and to also let us know that even though he had been quite emotional at the closing that he felt good about who he'd sold to was like something I feel like we'll definitely cherish that for a long time.

Patrick: [01:00:52] Very humanizing and a great point to end. So thank you guys very much for your time. Hopefully this is the first of many similar conversations. I appreciate it.

James: [01:01:00] Sure. Thank you.

Trish: [01:01:01] Absolutely.

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