Introduction

Patrick: [00:00:49] For the 100th episode I've brought back my good friend Brent Beshore. Brent was the 10th guest on the podcast after we met because of a mutual interest in capital allocation. I quickly learned that Brent was one of the most unique and thoughtful investors around. He was an entrepreneur from the moment he left school, trying many different things before finding a fit buying smaller businesses with the intention of owning them forever. What amazes me about Brent is his encyclopedic understanding of business and the nuances of different business models and deal structures. This comes from reps. He and his team have looked at about 12,000 deals over the years at every kind of business that you can imagine. I've been with him when he goes through this process and it's fun to hear what makes certain businesses stand out from others, which is largely the topic of this conversation.

You all know transparency is key for me, so it's important to know that my family and I are investors in a fund called Permanent Equity Fund One run by Brent and his firm AdVentures. To commemorate this milestone episode I can think of no one better than Brent because he exemplifies what has made this podcast so fun for me: learning from other people who are willing to share what they themselves have learned through fun, blood, sweat, and tears. Please enjoy our conversation and thank you so much for coming along on this journey. I can't tell you how much it means to me.

Optimizing Risk in the Capital Stack

We're going to come back to the story of the Permanent Equity Fund, but given the funding source that you're working with... Looking at this part of the market, you mentioned this idea of how to work with a capital stack depending on the deal. Maybe you could talk about the way you think through that for each individual company. So if your primary sources of financing are committed equity capital, seller leverage, and bank debt, how do you think about that mix both from a risk perspective and from a recurrent perspective when you're optimizing each deal?

Brent: [00:02:31] When you're thinking about structuring a deal you got to look at what is the company. I think that too often your mind first goes to how much leverage can you put on a company and how can you make the equity look as good as you possibly can. I think that game's a dangerous one because it always leads you down to just stacking debt on debt on debt and trying to put in as little equity as you possibly can, which can work. Leverage is merely an amplification of the underlying value of the business, so if the business goes well it's going to great with leverage. The challenge is even if the business goes okay, like good... a family that owned it that had no debt would be perfectly happy with the performance... you stack enough debt on it and it quickly becomes a really dire situation. Then you start making really dumb decisions that don't make any sense in the grand scheme of things but you have no choice. You have to meet covenants. You have to meet your repayment schedule.

The first thing we think about is what is the company, what is the industry, what is the cyclicality. A lot of people, you sort of take the last two or three years and you extrapolate out in the future. Trees are growing to the sky: that whole business. It doesn't make any sense. Cycles happen. We're in a current long dated upcycle. No one has any idea how long it's going to last and I certainly have no predictions about how long it's going to last. We could enter a down cycle soon or we could go another five, seven, 10 years. I have no idea.

Patrick: [00:03:52] I saw a funny trailer showing Australia hasn't had a recession in 26 years or something, so weird stuff happens.

Brent: [00:03:57] And I think that's the key, though, is many more things can happen than do happen and will happen. You just got to look at the entire spectrum and say how are you going to take a business and continue it to be durable? For our model, since we buy with no intention of ever seller, it's real in the sense we want to own this business through up cycles and down cycles and multiple up cycles and down cycles.

The way we think about it first is almost all equity we almost default to no senior debt, which makes us the oddest of ducks in private equity. Then we focus on using seller debt to serve two purposes. One, it does provide some financial leverage, but more importantly it just really aligns interest. We do a lot of things around how do we provide a win-win situation where a seller who believes strongly in the business... We're not putting senior debt. It's usually flexible seller debt. Even if this business stumbled or had an issue, you're talking to the person that loves this business, that cares about the people. They're going to help figure it out. And we're putting such a modest amount of even seller debt... I mean, maybe two turns at most of seller debt... on the business that we really like to do that as the primary point of leverage.

We will, though, from time to time put senior debt on a company. I think that in some situations if there's a really big need at cash close, we won't do it to win deals but we'll do it if we need to put more cash at close to help exit certain people that are sort of older, that don't have the stomach to take a seller note for an extended period of time, something like that. There's nothing wrong with that.

Patrick: [00:05:28] What about further down the line? Let's say you do a deal that's majority equity at close, some seller leverage, and no senior debt, and you're four years down. What are the conditions down the line that you would then put debt on the company? Perhaps to provide to investors or because you feel the risk is way lower. What are those conditions?

Brent: [00:05:48] I think the way we think about it is since we want to own this business for a long time, when you're doing a dividend recap, which is basically what you're talking about, you lever up the business and then distribute out the cash. I mean, you're really just accelerating future earnings into the present and distributing them out now, which is fine, you're just trading the future for the present. Most people do that because they get into a heads I win, tails you lose-type situation where if you put a bunch of... you did a dividend recap and you put a bunch of senior debt on the company and it's non-recourse and you pull the cash out and you get your investors made whole or a good return and then you're playing with house money. That's the way they look at it.

That only works if you're willing to walk away from a company. If you're not willing to walk away it absolutely does nothing other than just accelerate the payments. And, I mean, you're going to look at what are interest rates: I mean, what is the opportunity cost on that money? And again, if you're not going to walk away it's pretty dumb to try to even put a moderate amount of leverage on the company. We may do it but it's going to be few and far between and I think that we would never do it to where we would endanger the future of the company.

Interesting Business Sectors

Patrick: [00:06:53] Really interesting. I'd like to get into some of the... In my conversation with Tren Griffin, one of the popular areas was just picking apart elemental business ideas. I'd love to riff on a few of these with you and how you think about these concepts as you're looking through the thousands of businesses that you see every year. Before we do that I thought it would be fun to ask if you had to right now narrow your focus and you could only be looking to businesses in, let's say, two to three specific industries, what those two to three industries be? And then after we get through that we'll go into these operational business levers and how you think about them.

Brent: [00:07:28] The business sectors we really like tend to be more blue collar, tend to be more direct to consumer. When you think about the direct to consumer blue collar immediately your mind goes to home services. We think that there's a massive tailwind... If you look at bifurcation of wealth moving forward as a tailwind, you look at what happens when people obtain a level of financial security. What do they spend their money on? Almost immediately people start buying time. That's the almost immediate thing that people do, and they buy time in ways that not only saves them time but also saves them headache and pain. When you think about most people... There's freaks out there that love to mow their lawn but most people don't. Some people love gardening but most people don't. Most people just want house as a service, your office as a service.

When we think about the enduring need for the home, the enduring need for the office, for spaces, if you look at the growing footprint of square footage, it's kind of a common thing that houses are getting bigger and people don't want to take care of them. This leads into everything from pest control to HVAC, plumbing, and there's lots of nuances in these. These are very broad categories: lawn care, landscaping. Obviously, we're in the pool building business. We think that's an area that... We joke until people stop dipping their bodies in water for pleasure we'll be fine. Been doing it for a couple thousand years. I think we'll be probably good in the future to do it.

When we think about industries we always want to have a thesis behind why people will want that in the future and what could happen that would cause somebody to not need that in the future. A great example: this is air condition. I would probably rather air conditioning than the internet, personally. It's an amazing thing. If you think about being comfortable, like low humidity, especially where I live in the summer, it's a utility in a way that very few other things are. What you get is when you get larger square footage and you get aging infrastructure of that square footage you get the need to service this equipment frequently and accelerating. That's the sort of interesting non-linear result of that.

Why HVAC Businesses Are Not Compelling

Patrick: [00:09:35] Question on HVAC. You don't own an HVAC business and you've looked at a million, so on the one hand it's attractive as a subset of home services. What has stopped you from owning an HVAC business if it's so attractive?

Brent: [00:09:47] Great question. We've looked at hundreds and hundreds of HVAC companies and we love the space. We think that it's a really promising area that can also have a lot of innovation hit from a consumer of the product standpoint. I think there's a lot of things you can do to make the purchase of that service and equipment a lot more seamless and a lot more available.

Patrick: [00:10:03] What do you mean by that?

Brent: [00:10:04] So the standard is... I was joking... I think I tweeted this out the other day. I would love to have some small business callback index. I joked about that because if you just randomly in a city pick, let's say, five HVAC service companies and you give them a call and you say, "My air conditioning went out. When can you be here?" The odds are that maybe one or two of them even call you back and of the one or two the odds they show up on time are virtually none, virtually zero. You're coming into it... Anybody who's had work done on their home, home services of any time or office services, knows this. The joke's always like you get these windows from even the cable company that's like, "We'll be there between 11:00 and 3:00," and they show up at 6:00 at night and they're irritated that you're not ready for them to come hang out with you.

I think there's a lot of using technology, using basic business practices, and frankly having a culture of caring that I think you can out-compete in this area. Now, why haven't we gotten involved? That's a great question. We would love to get involved with a plumbing services... any type of home services. We love that. The issue is finding a team that you can scale. These are all small businesses, so there's a reason why these businesses are small. It's usually because they're not built to scale and we're not in a position, at least not right now, to come in and do all the work to professional as an organization. We've got to find an organization that we want to partner that is at least halfway to professionalization. We like to find teams that are trying to run harder and go further but maybe have hit the ceiling of brute force but are trying. There are a lot of ways to scale. It's just really hard to find that.

We find a lot of companies that are making a million dollars out there that when you talk to them they're really happy with making a million dollars. And look, for a business owner, making a million dollars a year is a lot of money, especially a lot of money in Des Moines. Again, these the chairmen of the country club. It's not like that's not a great business and we're not being judgmental in any way, it's just it doesn't fit with where we are now. We can't take a million dollar business that's built around one person's personality and do the work necessary to build out the systems and scale and recruit the talent and do all the things you need to do to scale.

We've really got to find a team that's already kind of pre-built or at least being on the way to being built and most of the time in home services the issue is those teams get formed around construction. This is the really big divide in home and office services versus construction. Most of the time you think about the construction leads into the service, so whoever builds your house you say, "Okay, well I need the whatever service." Well, who's going to service is the person who installed it, so the install leads to the service. But then the problem becomes you've got a construction organization and you got a service organization that are kind of lightly bolted together and it's so much easier in up markets to make money in the construction side, the install side, and the service side looks puny compared to it. It gets starved of all the resources. It doesn't get the attention. There's no innovation there.

What you have is often times all the focus being on the highly cyclical, very large construction side. We don't want that side because I think, full cycle, they don't make much money. They look like they make a bunch of money when the times are really great and then they lose a bunch of money in dire times when things go down. It's incredibly cyclical. We like the service organizations but you can almost never find a pure service organization or a service-dominant organization. Yeah. We got to find a team. We got to find a service dominant organization. Then we got to have all the normal factors line up. Even if you find... I mean, we've found probably 50 legitimate candidates over the last two or three years that are somehow in home services, that have the right fit, the right match, but you just can't get the deal done. You got to agree on price. You got to go through all the normal stuff, do due diligence. You got to... I mean, it's got to work. It's just incredibly low odds.

Horizontal vs. Vertical Roll Up Strategy

Patrick: [00:13:56] A popular idea that I know just having talked about this space now with so many different people... The gut instinct would be like, okay, why not just not worry about scale and just roll up a collection of one part of the stack? So roll up the million dollar earning HVAC businesses. Don't worry about growth and scale: scale horizontally versus vertically. What do you think about that idea? That strategy of creating a roll up and sort of centralized expertize: getting really good at just one thing.

Brent: [00:14:22] It sounds great, it just doesn't work.

Patrick: [00:14:24] What's the problem? Why not?

Brent: [00:14:27] What's a bigger disaster than one million dollar earning company that's built around dominant personality, which all businesses of that type... I mean, all business internally is a disaster. It's just like a functional disaster. Almost every operator I know is just trying to go as hard as they can and you're putting your finger in the leaks and just working your tail off all day long. So how in the world... If you're putting your head down and you're a founder dominant organization with very little scale, with very little structure, how in the heck do you slam together two, three, four, five of these things and somehow standardize... I mean, it is like the most mindbogglingly difficult thing.

It's been done before. There's a couple people that I know that have done it successfully. It's never actually, though, done well in the long term. You can temporarily build an organization that looks, at the 30,000 foot view, that it's successful. You can produce a lot of EBITDA for a short period of time and then the wheels come off. You don't have the infrastructure in place. You don't have the systems. And you have a lot of people who want to do it their own way and everyone's doing it a different way and everyone's been doing it a different way. Trying to get everyone to do it a different way than they've been doing it and trying to convince them that inherently the way they've been doing it has been wrong but they've been successful... It's a very weird psychology that gets involved.

I've never seen that done successfully very long and when I get into the nitty-gritty... I mean, it would be wonderful, magical, to take five, seven of these in big cities that are each making a million dollars and each take them to making five million dollars and slam them all together. That's a home run. I don't see how, functionally, you could actually make it work.

Next Interesting Industry

Patrick: [00:16:04] So outside... We'll do one more and then go to the leverage. Outside of home services... you're excluded from that part of the world... what would be the next industry that you would focus on?

Brent: [00:16:12] I think another area that's interesting... it's kind of along the same lines of these big macro trends. If you look at where people are congregating, especially in net population migration areas... so Florida, Arizona, kind of the Sun Belt... property management companies are a pretty interesting space as a thesis. This is something that... We've looked at quite a few of these. Very sticky relationship. When you have a home owner's association, who runs that? You get into weird neighbor conflicts. You get into whose kid can go to the pool at what time and they were there afterwards and there were beer bottles left. There's a lot of maintenance of common space in neighborhoods. So I think if you look at these trends, more people are congregating in neighborhoods. More people are trying to form little communities by themselves. I think HOAs and property management's a pretty interesting space. Again, it's kind of a tangent to the other one. I just think that is a macro trend. Those are such big forces. They're sort of underlying everything.

In many ways... We're recording this in New York. This is just a different world than what I swim in most of the time and I think that a lot of times people in big cities just don't understand how the world works outside of big cities. And by the way the reverse is also true. I think that most people who don't live in big cities look at it as, "Why in the world would anybody live there?" I think there's really great reasons to live in big cities and really great reasons not to, but they function. Like, life is very different in big cities versus small towns or even outside of the major metros. A lot of these trends that you'll see... Am I bullish on property management services in big cities? No, but for different reasons, and I think that's where you get into sort of the nuance of these different things depending on what your investment style is and where you want to spend your time. I think a lot of that also dictates...

Patrick: [00:18:02] So what is that difference? Why the negative relative view on management in the city versus...

Brent: [00:18:08] It's a density issue. When you think about property management and how hard it is to manage a property, if it's easy to walk to you can have one person managing a lot more. When you get into the logistics of property management, let's say, in an area like Phoenix you'll have these communities that are 20 miles out into the middle of nowhere and you'll have 1,500 homes in the middle of nowhere. That's an incredible HOA to run. You're not going to put a full time person there but you're going to have a part-time person, a lot of different people going there, versus in Manhattan you could take two city blocks and probably have... It is completely different dynamics going on in those. From a logistics, from a complication, from personnel, staffing, availability of labor, it just functions very differently.

Patrick: [00:18:52] Let's go to some of these levers. I'm intentionally going to choose a few things that in our public market quantitative work are not all that relevant, meaning these variables are not nearly as predictive of future results or returns to investors. Obviously this price gets tangled up in this mix and is really important but we tend to ignore them. They're sort of blind spots for most quants because there's just not good evidence that they matter when selecting stocks, but my guess is that they do matter to you.

The first one would be profit margins. We can talk about gross, operating, net. How do you think about profit margins when looking at a business? Is it relative to industry peers? Is it some overall picture? Does that matter in your evaluation process?

Brent: [00:19:33] It matters. I think that each one of these that we'll probably talk about is a factor that you have to consider: that you want to paint a picture with that factor. You can't look at each individual factor and say, "I'm going to draw a conclusion to every situation from higher profit margins or lower profit margins." How those factors interact with one another helps tell the story of how defensible is the business and why is it defensible. A lot of times, by the way, when you look at these they're not defensible. The defense is basically the goodwill of the owner: the relationship to the owner.

When we look at profit margins, higher profit margins obviously connote something's going on that allows for more money to be made on each transaction than you would expect on the higher end. Sometimes that can just cyclicality. If you think about it, a lot of these blue-collar construction related building products-type companies, they'll have almost no margin in down times when everyone's just hungry and willing to do whatever just to keep people busy, and then in up times they will just have enormous margins. Well, you can't look at top of cycle margins and say, "That's normal so we're going to be able to maintain 30%." There's no way because then you look at the bottom and you say, "Wait a minute, what happened to your margins when things dip a bit?" It's like, "We really needed to keep our guys busy. We needed the work so we're willing to do anything."

I think that you got to look at margin compression and expansion over the life cycle of the business. You also... I mean, even non-cyclicality trends. You'll some businesses that the margins are just naturally compressing. When I think about this I think about the printing industry. The printing business... We looked at a ton of different printing operations and on the surface they look incredibly profitable and attractive, other than the fact that you have to be constantly dumping money back in to keep up with your competitors and people are getting more and more savvy about how much things cost to print and printing overseas and how you... All those dynamics. If you look at industry you've got continual heavy reinvestment for the latest technology, new techniques... kind of the red queen, if you want to call it that, amongst competitors... and you have decreasing margins and decreasing margins in up times. It's a really dangerous... I think that's an industry where we would be happy to get into it if the right opportunity presented itself but we're very cautious whenever we see those types of trends.

When you see a business that has quite low margins, so I would say under 10%... let's kind of put numbers around it... under 10% being gross margins, under 10% gross margins, and sort of above 30% or above 40%, depending on the industry, would be very high margins. If you see something that has very low margins the question you have to ask yourself is, is there a scale advantage that they have and is there a consistency of the work that allows that business to still earn really good returns on invested capital but it just happens at massive scale with low margins? Typically you get high volume, lower margin, lower volume, higher margin. It's very hard to get high volume, high margin businesses. So there's nothing wrong, from our perspective, with buying a business that is lower margin at high volume. There is usually some defensibility around that for some reason. Again, that doesn't tell you anything, so independently it's just one piece of information that you kind of have to work at. How does it interact with the other co-factors?

Relative Attractiveness of a Hyper-Cyclical Business

Patrick: [00:22:47] You mentioned cyclicality. This is something I always when we talk and you give me surprising answers. This was one of the early surprises a year ago or a year and a half when we were talking about business, specifically around the pool construction business, which obviously is a hyper cyclical business. You had some interesting points about how you think about cyclicality. Most people, their knee-jerk reaction, I think, would be to avoid hyper cyclical businesses because they're difficult and you need to manage a cycle better, but I think you have a bit of a different viewpoint on this. Can you talk about how you think about the relative attractiveness of a hyper cyclical versus a very steady business?

Brent: [00:23:21] I think cyclicality is really dangerous if you apply a traditional private equity model to it. I think that's the reason why... In a vacuum, cyclicality is not a bad thing. Cyclicality is a normal completely... It makes sense, right? If you think about... The whole world had cyclicality in it. People's life cycles... We have seasons of weather. Cyclicality is a normal, ordinary part of life and a normal and ordinary part of the economy and businesses. You have micro cyclicality amongst a business: kind of the life cycle of a business. You can sometimes avoid that cyclicality through certain techniques, but there's sort of a normal arc of a business. Then you have the economic cycles, which by the way affect micro smaller businesses differently than they affect macro businesses, and then obviously the trading of the underlying equity of those is sort of an amplification of that cyclicality.

So there's a lot of meta layers on top of cyclicality but in and of itself cyclicality is not a bad thing. It just presents different opportunities. If you have a non-cyclical business, yes, it's incredibly... or even a counter-cyclical business... profitable all the time. You're just going to invite a ton a competitors and over time it's just going to be brutal to maintain that.

In low professionalism you've got... Another factor is professionalism amongst the businesses and what's the type of person that's naturally attracted to that type of industry. When you pair up low professionalism, which again tends to be more blue collar, more dirty jobs, that type of stuff, with high cyclicality you get an incredible wash out effect. If you look at most construction related or highly cyclical businesses the turnover rate over a full cycle is astounding. You basically get very few players that endure a full cycle. What happens is people go out of business, people join other firms, new firms are created. It's just this ongoing renewal effect that occurs.

But as an owner of a business, if you plan for cyclicality... How do you plan for cyclicality? You just don't put a bunch of debt on the business. You keep a really healthy under-levered balance sheet. And it shouldn't surprise you when the business has a downturn. It shouldn't be like, "Oh gosh, what are we going to do now?" "Well, we knew this was coming, so what's the game plan now?" We have a game plan for when the economy down cycles and we have a game plan for the economy is going great. You got to play the playbook on both directions. But on the down cycle, you entrench. You try to maintain. You build an organization that you try to have low operational leverage. This is an interesting, from a business model, perspective. You try to maintain...

Let me back up. In most highly cyclical businesses there's a tendency to try to grab as much margin as you possibly can at every turn. This means you try to vertically integrate when times are good all the way down the stack and you can kind of get attractive multiples to do tiny acquisitions. You sort of buy teams to come on board. You're doing the work yourself. Now, what happens when things reverse? The operation leverage works against you and you go deeply into losses and you sort of nuke the entire organization. It has a catastrophic effect.

We think a lot about business model in terms of how do we diversify risk, make less money in each individual year but survive full cycles, and then be the buyer of choice in a down cycle? So you get aggressive when everyone else is getting passive or scared. And this isn't anything radical. This has been written about in the public markets investing. It's just applying it to a very straightforward approach in the private market. When we think about highly cyclical businesses we think about under-levering them, so not just not putting a lot of leverage on them but actually maintaining really strong balance sheets, keeping a lot of working capital in these businesses, which, again, from an investor perspective you're thinking to yourself, "Golly, that means I get less cash out," but no. You got to think long term. You got to think about how these businesses are going to react when everyone else doesn't have any cash and you're sitting on cash. Now you can be the mosquito at the nudist colony. You can go nuts.

Patrick: [00:27:27] Yeah. What's your favorite example of a counter-cyclical business that you've looked at?

Brent: [00:27:31] Fast food is an interesting business in and of itself. Fast food has a... When people have less money they tend to also be stressed out and have less time. You have this interesting weird effect where you have less time to make food. Obviously everyone still has to eat and you have less money to eat out, so where are you naturally... You get this big upending trending in the bottom end of the restaurant market. We've looked at a number of fast food or fast casual chains in the past. We're not going to buy... We have kind of a predisposition against restaurants. Just brutally difficult industry. But in the lower end, in the fast food market, you can actually standardize where it looks more like a manufacturing company than it does a food company. I think that's where we have looked at those. We obviously haven't pulled the trigger on any of those.

Asset-Light vs. Asset-Heavy Businesses

Patrick: [00:28:14] Fascinating. What about assets? So tangible versus intangible specifically. We've just written a lot about this. The global trend is towards intangible assets: more investment in intangible assets than in tangible in some cases, like in the United States, although some places like Italy still have the opposite. How do you think about that? Do you care about how asset rich or asset light the business is? My guess is that, like your other answer, it all is interdependent. But any thoughts on asset light businesses or asset heavy as you think about evaluating one?

Brent: [00:28:45] It's a great question. The way we think about it is it tells you something about the business. If it's very asset heavy that means usually these assets are going to be in depletion mode and you're going to have to redeploy capital back into the business to maintain it. It's interesting. From a purchase standpoint it does provide this weird dynamic, though, where you have a backstop in liquidation value with a lot of these heavy asset businesses. So if I buy a business, just for round numbers, that has seven million dollar liquidation value of hard assets and I buy it for 10 million dollars I now know that I'm really putting three million dollars at risk. The bad part is let's say we're buying it for 10 million and it's doing two million dollars of... just roughly, two, two and half million... earnings, maybe of EBITDA, but you're taking that two and a half million of EBITDA and you're rolling it into a million dollars of reinvestment in the business, now that looks like a pretty crappy return.

So you've got this weird dynamic where you've got to look at incremental return on invested capital, how much is... Just to even tread water, how much do you need to redeploy? Then you look at growth. I mean, growth in a business like that, assuming you have to maintain those type of expenditures, it's really expensive and it drains cash to grow the business. We don't like to get into businesses like that. We like to get into businesses that throw off a lot of cash and have good uses but really can't even come close to consuming all the cash that they're throwing off. A lot of it depends on business model, again.

So going back to the other factors, this is where you get the interplay between profit margins, asset intensity, all these different things, sort of all the co-variants in them. It, again, just paints a picture. If you paint a picture of an asset light sales and logistics organization in like a construction business. This would be, as an example, a contractor. Let's just take a general contractor on multifamily housing as an example. Really, if you look at the different functions of that and you break it down you've got the sales and marketing. How do you work with developers? Let's say that the developers are coming to you and saying, "We want to go and develop this piece of land that we have." You got to generate. You've got to sell them on why you're the best choice. You've got to price it. All that stuff. And then your job is to functionally deliver these housing units to them at a pre-agreed upon price and a pre-agreed upon time.

How do you that is so much to do with the business model. There's really two paths to take. And there's an in between you can take but really there's two dominant paths. One is the complete asset light path where you say, "We're going to generate that lead, we're going to sell the developer, and then we're going to sub out every bit of the work. We're just going to do the logistics." Well, then when it throws off cash what do you do with that cash? Because I mean literally...

Patrick: [00:31:27] You can't plow it back.

Brent: [00:31:28] You can't plow it back into the business. There's nowhere to put it. I mean, maybe you can open up other sales offices but that's not going to take up most of your cash flow so you just have all this free cash flow, which is a great problem to have. But here's the other path, which gets sexy in an up cycle. The other path is, "We're going to do all the work ourselves, so we're going to have construction crews, we're going to buy concrete mixers, we're going to do... We're doing the full deal. We'll do the rebar. We'll do the framing. We'll hire the painters." You can vertically integrate up and down the stack in 10,000 different ways.

The great part is in an up market you make a crap ton of money. It is eye-popping. We looked at a business recently that three years ago lost four million dollars in a year and this year will clear about 22 million in free cash flow with this business model. Very interesting. When you think about it, it makes sense at the time because you're like, "We want to grab more margin. We want to be able to do better. We want to grow the company." But the issue is then you start getting into now you've got to buy a fleet of trucks, now you've got to buy all this equipment, now you've to buy all this... So what happens when the work dries up? You got this big downside risk, but then you've also got the capital intensity dramatically increases. Maybe on that 22 million in free cash flow you got to take six or seven of that and plow it back into buying more stuff. Now you've completely altered your balance. You completely altered your return on invested capital.

It's like all these different things all interact with one another and it's not like a straight line like, "You should do this or do that." I mean, if you think the economy's going to go up for the next 10 years and you can build an empire, bring all these captives in house, yeah, it makes complete sense. If you think the economy's maybe going to cycle in the next two or three years it's basically suicide to do that. It's all a bet on the future and everything comes with opportunity cost. It's really hard to look at somebody's earning stream today in a snapshot in time and understand the risk they're tolerating for that income stream, so we always try to look at it as, "Over a full cycle what do we anticipate to make and at what risk tolerance are we making that?" Frankly, the way we kind of operate is we'd rather have... if we're going to have a highly cyclical-type industry we'd rather have very low capital intensity business and we'd rather under lever it and not put debt on it and over time it's really hard to harm a good, entrenched, great reputation, good relationship business that's highly cyclical if you don't put a bunch of debt on it and you don't have a highly levered balance sheet. It's just almost impossible.

Patrick: [00:33:58] Another really interesting input I don't think you and I have ever talked about but it's an interesting one in the context of where we are in the cycle and what's going on in the country... which is labor costs and wage inflation. Everyone knows, that's kind of read the history, that for a very long time, adjusted for inflation, wages really haven't gone anywhere. I think there are early indications that that is changing: that there is wage inflation. Labor is more expensive. Unemployment's at extreme lows in every category that you look at. How do you think about that as an input on the cost side of a business and as something you think about when underwriting the future of some of the companies that you're looking at?

Brent: [00:34:35] The first thing we think about is transfer pricing power. We always want to understand things are going to change. Inputs are always going to change. The price of commodities are always going to change. Whatever the inputs are in that business... and obviously labor and the availability of skilled is an input into the business. The first question we want to ask is, "How immune are we to changes and fluctuations in that? When it goes down do our customers demand that we pass that savings along to them? And when it goes up are we able easily to pass that along to them? Or do we have to eat it both ways?" Meaning sometimes it's great. If we think that the input costs are going to dramatically go down over time and our customers are not going to know the difference, of course that's a beautiful scenario. Your margins are just dramatically expanding in sort of natural tailwind.

That doesn't usually happen. Usually where you get it is on the other end of things, which is you get a lot of demand for labor. I think that especially in surface-level unattractive things that don't make you impressive at a bar, we see those trades really trending older and there's just not a lot of new entrants into... Commercial painting business is an example. If you hire a commercial painting company the person who's going to show or the team that's going to show up to actually do the painting is going to be older. There's just not a lot of young talent flooding into and saying, "I could go do X, Y, or Z and I'm going to choose to be a commercial painter." Usually people back into it through a family trade or a relationship or, frankly, because they have no other choice and then they fall into this and they say, "Holy cow, I can make a lot more money being a commercial painter than I could being a social media manager," as an example. But being a social media manager is more impressive... maybe is more impressive, I don't know... at a bar. I haven't been to a bar in a long time. But you know what I'm saying. When you tell somebody at a bar that, "I'm a painter," it just kind of...

Patrick: [00:36:25] It ends there.

Brent: [00:36:28] It kind of connotes, "It's not somebody who's going to be somebody I'm super excited about talking to." There's a lot of signaling going on.

We do see... The single biggest challenge that we see every single business in anything in the trades is just labor: availability of skilled labor, trained skilled labor. It is so hard to compete. There's just not enough people out there. So you have firms doing all kinds of crazy signing bonuses. You have trying to do basically acqui-hires in that area of the market. Some really nutty stuff that's going on. Some of it's being able to be passed along to the customers. I mean, if you're building a building and everyone's telling you it's going to be X, you just have no choice. Your choice is to not build the building. It is trickling through, but I think from an owner of a business standpoint we always just want to know what are the inputs and how much can we pass that along, in terms of price increases, through to the customers.

Why Brent Loves Crematoriums

Patrick: [00:37:22] Why do you like crematoriums so much?

Brent: [00:37:26] This is going to be from our Omaha hangout. Somebody asked me, "What's the single best business you've ever seen?" I said, "I don't know, pet crematoriums are really up there." I mean, the short version is you need a store front and an oven and the longer answer is you have some major psychology that comes with it where any time you deal with a wedding or a funeral the price of anything... like flower arrangement... it basically triples. You're running a pet crematorium. The whole pitch is, "This pet's been a part of life for 10, 12 years and your kids grew up with the pet. Are you really just going to bury Fluffy out back? You're not going to have any closure? Your kids are going to be screwed up for life. You're going to be paying for it in psychiatry." You can get people... and then obviously the upsell. And then you get into these strange dynamics where do you care that your lifelong pet gets put in the oven with five other pets? Or do you want the oven to only fire your pet? Do you want mixed ashes or not mixed ashes? Do you know the alternative is...

One of these places that we talked to at one point said what happens at veterinarians, it varies. Like, a 110 pound dog, you have to do something with that, so there's only so many things you can do with that dog and none of them are pretty. There's a lot of closure, cleanliness, so margins are enormous and the startup costs are a storefront and an oven.

Patrick: [00:38:46] Pretty amazing how many ways there are to make money.

Brent: [00:38:48] I love it, yeah. That's my favorite part of my job, is we get to the see the most interesting business models and just really interesting people that we get to work with.

Permanent Equity Fund

Patrick: [00:38:58] Let's talk a bit about, briefly, the history of the Permanent Equity Fund itself and sort of the early advantages that you're seeing changing from really just doing what you do with your own capital to having a significantly larger committed pool of equity capital. I'm always interested by how that affects everything else that you do and it's something that's, obviously, relevant for anyone out there that's beginning something on their own and potentially scaling that up. Maybe from your perspective tell the story and your thinking around moving from one to the other and sort of the early observations or returns on that decision.

Brent: [00:39:35] I think that, to maybe start at the end first, the big difference we've seen is access to people. We have some incredible investors. I mean, obviously, you and your family are one of them, in full disclosure. We've brought on just an all-star cast of investors that are just... I was terrified, to be completely honest. Maybe I shouldn't be telling you this at this point but I think even at one point you talked me off the ledge.

Patrick: [00:39:54] More than one point.

Brent: [00:39:56] Yeah, probably more than once. I was like, "I can't do this. I don't want to do this. I'm terrified that I'm going to be dealing with a pool of investors that are hassling me all the time and second-guessing and all this stuff." Honestly, I have found it, so far... I mean, we closed in December so it hasn't been that long, but it's been a wonderful value add to be able to call incredibly smart, thoughtful people who have a vested interest in my success and say, "I want to run something by you. This may sound a little nutty." I think you probably get one of those calls from me about a week... probably one a week or at least once every two weeks and you're always like, "Sure. Let's hop on the phone and chat about it." Having that has been unexpectedly positive, I would say. But that all depends on who can get to invest. I mean, I think we had a selection bias. When your starting pitch is, "Plan on never getting your capital back," you're going to attract an unusual type of person who thinks in a different way than the norm. But that's been great.

I think the other really big advantage that we didn't anticipate is what it means to be able to write a very large equity check for a relatively small-sized business. We are one of the only... I mean, when I say one of the only, we might be the only person operating in our area... group in our area of the market that can write a 20 million dollar equity check on a smaller business. We have just so much more flexibility in how we can structure deals and it's just all about what does the seller need and what's optimal for them.

When we think about AdVentures we think about it as we have a client, and no offense Patrick, you're not the client. Our investors are not the client. The investors will benefit from this, but the client is the seller. We think about everything from the seller's eyes. How do we optimize for them contacting us? Because I mean almost all of our deal flow, virtually all of our deal flow, is inbound at this point. We want to optimize for getting a selection bias on that side. We want to repel the wrong people and attract the right people. We optimize the negotiation process for the sellers. We do a lot of things that inconvenience us that is great for the seller. We do a lot of things in due diligence very differently than how a traditional private equity firm does due diligence. And to rev back to the fund, a lot of the fund documents express that when we talk about the flexibility that we have to be able to do what we do.

We optimize everything from a seller's perspective, so when we look at a seller who... I'm on a site visit in New York right now. That's why we're getting together. I'm flying to DC later today doing another site visit and then flying to Louisville, Kentucky, and doing another site visit after that. We are always looking at it as, "How do we make things work really well for the sellers?" And money, it closes, and structure's a big part of that. These are business that, by definition, if they've survived 20, 30, 40 years...

I mean, one of the deals we're working on now has been around for 110 years. These are companies that don't carry leverage. They just don't. Functionally, they just don't carry debt. Everything's paid for in cash. You take a company that has that in their DNA and everyone else is telling them, "We're going to buy you. We're going to lever you up. We're going to go through this almost immediate sale process," all that. That's what everyone else is doing. We come to them and we say, "We're not going to do preferred equity. We're not going to put senior debt and Mezz debt and we're not going to go and flip you. We're going to create one asset class or one equity class. We're going to pay you all cash and equity. We're going to have a seller note for part of it but you carry..." Keep things incredibly simple. They're like, "This feels like a family is buying the business, not a fund." It's like, yes.

We are functionally able to provide capital that is family capital, and all of our capital providers, all of our LPs, are families. There's no institutional investors. That's probably a whole separate reason why... both selected on our side and on their side but it just allows us to have much greater flexibility and do whatever's in the best interest of the seller, which then, in turn, is in our best interest.

Patrick: [00:43:48] One of the most interesting things that I learned through the process and thinking through this with you is just the return on flexibility, so the same customization, I guess, that you're willing to for your sellers to make their lives easier, that goes up the stack. So if you were investing out of a two and 20 tenure life, five year investment period, extra harvest private equity fund, that neuters the advantage that you have with the seller. Just this increasing importance, I think, in capital markets to think about structure differently as a huge advantage but also... We could tell long stories about the inertia is difficult to overcome. When you bring a new structure to investors it's an arduous process. That's probably the thing I learned most in that process.

Brent: [00:44:34] Yeah, the process... I don't know what I expected, because I had never done it before. I think there's always a bias that anything you haven't done before seems easier than it's going to be. Even if you assume it's going to be harder than you think it is.

Patrick: [00:44:46] It's always harder.

Brent: [00:44:46] It's always harder than you even think it could be hard. I think one of the unexpected things about raising the capital was just that we were doing something different and any time you're doing something different the only people that can participate are people that don't have career risk. Any time you introduce the factor of career risk into the decision-making process you have to do the norm because it's a divergent system. If you invest in a divergent system, or you participate even outside of investing, and it goes wrong you have massive downside risk for your career personally, separate from the organization. Could be the right decision. We're going to assume it was the right decision. It was probabilistically a great bet but it goes wrong and it looks different. You could get fired. It goes right you don't have enough upside career-wise personally.

This is principle agent problem and I think we experienced that when you and I went and talked to some of these whether its endowments or even larger family offices where they're, quote unquote, professionalized.

Patrick: [00:45:45] Sort of an intermediary layer: a professional intermediary layer.

Brent: [00:45:48] As soon as you add a professional layer it really just became immediately unpalatable. The whole structure... They're like, "I have so many reasons why I can argue that you shouldn't do this." If you come at it from that perspective you're always going to find a reason not to do something. I think literally... I'm trying to go through the investor list... the only people that invested... The 50 million is all from people who are the decision-makers and hold the capital. There's no career risk to them.

Patrick: [00:46:15] How do you think, looking forward, that this will continue to scale? You mentioned the advantages of having this pool of capital being the only one without the traditional PE structure but this amount of capital to deploy to these family-owned businesses. Let's say we're five years down the road or two years down the road and that capital is depleted. Do you think... and this is something we've talked a tremendous amount about... that this continues to scale better horizontally or vertically? Have you given any future thought to that idea?

Brent: [00:46:43] The plan is to continue to scale horizontally. When we say horizontally and vertically we probably need to define it. There's basically two ways to grow an investment firm. You either start doing bigger and bigger deals as you accumulate capital and hopefully generate great returns... and that's sort of what Berkshire did. I mean, if you want to look at them as the clearest example they did smaller deals and they bigger deals and then they do mega-deals. Now I think that Berkshire can't even probably do a deal under two billion dollars now. It probably doesn't even move the needle. I mean, they got, what, 100 billion or 110 billion in cash on hand? It's that anchor that unfortunately you got to drag behind you.

I think the only alternative to that is you go wide instead go deep or go tall, depending on the way you want to look at it, and that's to continue to scale out and buy lots of companies as opposed to doing bigger deals. Instead of... Right now AdVentures is set up to maybe do two to three deals a year. In five years, hopefully, we're going to do 10 deals a year. That's arbitrary. Maybe it's six. Maybe it's 15. I have no idea. Obviously it depends on... Everything starts with opportunity. The way I think about building AdVentures and the way we talk about it as a team is we want to have the highest opportunity cost in the world and continue to build the opportunity cost at every turn. I don't think we're great investors. We're not great at slicing and dicing. We're not great at making really tough decisions. We just want no-brainers and we want to decide between really good opportunities and great opportunities. The only way to get those types of opportunities is to have a ton of opportunities you look at and have good filtering mechanisms and selection bias that are all positively set up in your direction.

Continuing to scale-out means doing more deals of similar size. We will, from time to time, have deals. We have a deal right now that's a 17 million, 18 million dollar earning company that's a private company, family-owned, and we're just the right cultural fit for them. They're coming directly to us and saying, "We want to talk about this. We know we're a bit on the big end for you all but could we figure out how to create a permanent equity structure around the sale of a portion of the company?" The family wants to hold back some of it and continue on for the ride but wants to take some chips off the table. I mean, that's a lot of money, that's a lot of cash flow, but it's also a lot of equity. If all your assets are tied up in that company there's a real fear: a concentration risk. The issue is right now outside of us and maybe a handful of other investors there's really just not a good mechanism to be able to liquidate part of a company and keep the same culture, keep the family attitude.

We will go upmarket. We probably... unless it's bolt-ons ... won't go down market. We really like moving forward in that three to seven million, three to eight million in pre-tax earnings and then we'll go up from there opportunistically, but we're not going to just move up into bigger and bigger deals as we have more capital just to... because we got to deploy it. One of the things that we told our investors was, "We may do five deals in one year or one deal in five years and you got to be okay with that," and most people aren't, but that's... If we have the right deals at the right time we want to do them. If we don't have the right deals and it's not the right time we're not going to do them. It's just that simple.

Transcript by @ScarrottKalani