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Are You Being Chased by a Bear?
Something I do now is walk over to Stankowski Field in the middle of Mizzou’s campus early in the morning before the students are out and take the old man VO2 max test that I read about in The Wall Street Journal on the track there (which they say is one-third of mile in circumference, but is definitely shorter than that). That test consists of running as fast as you can for 12 minutes and then seeing how far you got.
I like it because I like benchmarking, the test is not too long, but not too short, and it’s been fun to see progress. And sometimes, to stay motivated, I imagine that I’m being chased by a bear.
Wait, what?
Well, after I wrote about creating a sense of urgency at work in order to drive accomplishment, I received a note back from Joe R. He said that one of his first bosses believed “that you never run faster than when you are being chased by a bear.” I thought that was a funny mental image, so I adopted it during my next old man VO2 max test.
As a practical aside, if you are being attacked by a bear, don’t run away. If it’s a black bear, fight back, but if a grizzly, play dead – and hopefully you have enough wits about you right as you’re about to be attacked by a large predator to know the difference. I digress…
While imagining a bear chasing me has helped me run faster and farther, it wasn’t a good management strategy for Joe R.’s first boss. Because in actualizing it he “motivated people with fear...in an environment of low communication…[and] remains the worst boss I’ve ever had.” Because, in Joe’s words, while “you run fast when being chased by a bear…you can’t run a marathon that way” (leaving aside the fact that it might go viral if somebody tried).
Of course, Joe is no longer in his first job and has moved up the organizational chain of command to lead others, so I wanted to know what he does differently as a result of that terrible experience. Here’s what he said:
I’ve found that you should recognize that everyone has an extra gear to up their productivity, innovation, etc. As a leader, I try to engage that gear regularly, but not frequently, and to do it by giving goals to people and teams that are hard but not impossible. I deliver these goals with the message that “I am confident you will figure out how to reach it, and I will help you to do so. I believe in you.”
And I liked that advice. After all, you can accomplish a lot during sprints, but if and only if you recognize that you need to rest in between them.
-Tim
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Return of CIMple Truths
If you’re a more recent Unqualified Opinions reader (and most of you are), CIMple Truths was a gag I pulled out on Fridays back during season one to highlight ridiculous things seen in deal teasers called Confidential Information Memorandums (abbreviated CIMs sounds like “sims”). I stopped doing it because as interest rates rose and deal flow slowed, people stopped making so many ridiculous claims (just not the Trump SPAC). But sufficient ridiculousness has accumulated since then that I thought I would run CIMple Truths out for a curtain call ahead of the weekend.
So without further ado, here are some things that recently made us scratch our heads.
Tech-forward organizations…
That is some cutting edge stuff.
Very humble brags…
Wait, is that a good thing?
Creative addbacks…
There’s probably a story there.
Non-core business…
Well, that was unexpected, but aren’t they all? Have a great weekend.
-Tim
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Becoming Predictable
I was talking to someone the other day about measuring investment performance and we got on the topic of volatility. I mentioned, with some frustration, how volatile and unpredictable the performance at some of our businesses can be and my interlocutor said, “I didn’t think you would have cared about that.”
“What do you mean?” I asked.
“In my view,” he went on, “measuring and worrying about volatility only matters when it captures the risk of being a forced seller at a bad time. At a firm like yours, with your horizon and mandate, it doesn’t seem like that would be a problem.”
And he’s absolutely right. The fact that unpredictable volatility exists together with our ability to tolerate it is what creates one of our biggest competitive advantages as an investment enterprise. After all, you can’t leverage and flip unpredictable volatility (or you can try, but you shouldn’t, unless you want to risk blowing up spectacularly), so we’re able to make investments others simply can’t.
Yet despite it being what puts food on my table, unpredictable volatility is still frustrating because staying prepared to weather it is an impediment to performance. Every dollar we reserve for liquidity, for example, is one that’s not generating return, and everything that happens for a reason we can’t explain is something we can’t reliably repeat in the future.
And it’s that last bit that’s so frustrating and that also raises important existential questions such as “What are we doing here?” Because if you, as a business, lack agency, do you really have a business at all?
It’s in recognition of the fact that an answer to that question is “No, that’s more of a hustle than a business” that one of our strategic priorities with our businesses is to help them become more predictable. This can mean taking on lower margin, higher volume business or signing longer-term agreements. But you also have to be careful here because becoming more predictable is a slippery slope. Certainty is expensive and if you fill up all of your capacity with guaranteed low-margin work, you’re not going to do very well either.
Where does that leave us?
One widely used investing metric to analyze risk and volatility is the Sharpe ratio, which basically says that something is good if it has positive returns with low volatility with volatility here measured using standard deviation. In other words, something is considered volatile in the Sharpe ratio if it goes down or up a lot and going up or down a lot is bad. But then Sortino came along and said “Wait a second.” Because if something goes up a lot in investing, that’s good! So Sortino put forth his own ratio that only cares about how volatile something is when it’s going down with the goal of finding investments that go up a lot when they go up and only do down a little when they go down.
I didn’t bring up Sharpe and Sortino here to wonk out on risk management metrics, but rather to draw a parallel to what it ideally means for a business to become more predictable. This is to take steps and do things that gradually make bad months less bad without also limiting what makes good months good. Because while bad months frustrate me like they would anyone else, if not for them, there might not be any good ones.
-Tim
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The White Paper is Almost Done
If you remember our joke about being in the business of shaving hair, then you probably remember the business we reached out to that had botched an acquisition and gone through some rough years as a result. The reason we did that was because what was oddly impressive about this situation was that despite years of losing money trying to integrate a botched acquisition, the core business had been able to fund those losses for so long. Ergo, the core business might actually be a good one.
So we reached out and floated a valuation and structure to suss out interest and receptivity. The valuation, we thought, was competitive and down the middle, but the structure was admittedly conservative since the valuation baked in righting the botched acquisition and then also refocusing on the core business to grow it.
As for what made the structure conservative, our offer was to pay half of the consideration at close and the other half a few years later contingent on those things (righting the botched acquisition and growing the core business) coming true. Our rationale was that the business was worth one amount if the obvious problems were fixable and a different, lesser amount if they weren’t.
Of course, 50% is a pretty big haircut and the upfront consideration probably undervalued the core business on a standalone basis. But the reason we weren’t comfortable offering a consideration equal to the standalone fair value of the core business upfront is because the core business wasn’t standing alone. Its management was distracted, its cash flow wasn’t 100% distributable, there was the potential for conflict in deciding what to do next, and taking steps to help the core business stand alone would be expensive (severance and lawyers and liquidation processes add up).
All of these things are risks and if you are going to take them, our view is that you need to be compensated for doing so. How do you do that?
In our line of work we see a lot of what academics would call “idiosyncratic risk.” These are risks that are unique to a situation and so therefore aren’t captured in the risk premia assigned to more widespread factors such as illiquidity, small-size, or equity risk. Examples include:
Inaccurate information risk: We’ve seen businesses that track their inventory in a spiral notebook and also lost track of inventory “back in the 90s.”
Slow feedback loop risk: We’ve seen businesses that don’t close their books until six to eight weeks after the end of the month and others that only do reconciliations quarterly.
Whim risk: We once saw a business whose sole supplier was wholly-owned by a hostile foreign government and another whose sole customer was a big box retailer. In either case, the reversal of course by the counterparty would cause the business to disappear overnight.
Rural risk: It’s really hard to relocate talent to small towns.
Relationship risk: Are customer relationships with the business or with an individual?
The list goes on…
Now, some of these, like whim risk, could metastasize overnight, while others, like rural risk, manifest themselves as more incremental long-term headwinds. But you can take any of them (and we have taken some, but not all of these) provided you are compensated for taking them. Now, if you asked a firm to do an independent valuation, they might look at these idiosyncratic risks and bucket them into an “Additional Risk Premium” that they add to the discount rate when valuing a projected stream of cash flows. And that’s one way to do it, and we do increase our required rate of return as we identify more and more idiosyncratic risks.
But structure is another useful tool in making sure investors are compensated for taking odd risks because thoughtful structures can more effectively account for the potential timing and magnitude of the impact of a specific risk materializing.
For example, in the case of whim risk, the business might disappear overnight. To be compensated for that might mean negotiating a deal structure with a shorter payback period and perhaps attaching a put option as well.
For something longer-term like rural risk, you might ask for some kind of hurdle or preferred return that bakes in the expected growth rate in the event it doesn’t materialize.
To return to our offer of 50% guaranteed at close and 50% contingent and deferred to invest in a turnaround project, we felt that our offer was fair because it compensated the seller appropriately for what had been achieved to date, but also recognized that they were offloading significant risk to us. But offers aren’t made in a vacuum, and in this case we got blown out of the water by someone who offered more than us all guaranteed at close.
Now, that’s a great offer if you want to get a deal done, and in terms of immediate feedback loops, mission accomplished. But is that buyer being compensated for the longer-term risks they are taking or is it the case that we wrongly perceived more risk than was real? Only time can tell on that.
-Tim
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You’re Different
I usually take everything that’s written in the Harvard Business Review with a grain of salt, but this piece about “When Your Colleagues Have an Outdated Perception of You” resonated. That’s not only because I think people have had an outdated perception of me in the past, but also because I’ve been guilty more than once of having an outdated perception of someone else and seen people I respect and admire have their career paths impeded due to others having an outdated perception of them.
For example, I recorded a podcast recently with some guys who work with some guys I used to work with. In order to make that happen, we exchanged emails with the customary pleasantries. One of those jokingly closed with “We’re looking forward to having you on. A lot of folks think very highly of you…[but Person A] warned me to avoid you on the basketball court.” As Shakespeare wrote, there is truth in every jest.
Because was I once a competitive monster on the basketball court? I will cop to that.
Am I still? Not as much!
But the perception persists.
As for how this works in the working world, that HBR article relates the story of an entry level employee at a company who grew to manage a team responsible for $22M of revenue, but was still considered unqualified for the role of chief sales officer when it opened up. I had a similar experience in a previous job when I was trying to hire for a role whose primary responsibility would be measuring, reporting, and providing feedback on the performance of others – which therefore required a lot of collaboration and conversation. I identified someone I thought would be perfect for the job, but was warned by his manager that he was too stubborn and single-minded to do well in such a role, citing, when I pressed for information, an experience he’d had 24 months prior (the guy ended up doing great).
A recurring theme this season has been that either you or the world is always moving on. My hope for you is that you’re always moving on and in more interesting and productive directions. A funny thing about that, however, is that even if you are, others may not see or understand the change. To combat that, the article makes two recommendations:
Have a “conversation strategy” with your coworkers that enables you to receive immediate feedback.
Delegate tasks that may make you feel productive, but that you have outgrown.
Now, even if you do that, perceptions of you may linger, but if you’re getting transparent feedback and always seeking out your highest and best use, my experience is that you’ll achieve tremendous personal growth and that the world will catch up to reality eventually. That’s because, as I wrote when I was talking about high-performers, the world is more merit-based, and more people want it to be so, despite injustices, than it appears.
-Tim
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Growth and Feedback Loops
One of our portfolio companies recently completed our second tack-on acquisition, and we are hunting for more. That hunting, however, is not broadly across our entire portfolio, but only at companies for which tack-ons make sense. The reason that’s so is because growth is risk and if we try to do a tack-on at a company that is not prepared for it, then the complexities associated with finding, evaluating, closing, and then integrating an entirely new, different, and potentially messier operation might derail the core business.
In recognition of that, we developed a simple checklist to help us gauge when we might pursue tack-on acquisitions on behalf of one of our portfolio companies. For us, the company needs to have:
Demonstrated stable business performance;
While generating timely and accurate financial statements;
With trusted leadership in place that is likely to remain in place; and
Resources available to oversee integration.
Our view is that absent these characteristics, a business that makes a tack-on acquisition is:
Unlikely to know what to do with it;
Unable to manage it; and
Without any idea how it’s going (or, worse, liable to have hallucinations).
And that, for us, is a recipe for disaster.
Recently, we’ve started putting the many business models that exist in this world into two buckets: fast feedback loop and slow feedback loop, with a variety of factors determining the pace of the feedback loop of a business. In other words, if you make, sell, get paid for, and watch your customer consume your product all on the same day, that’s a fast feedback loop. If that happens over a period of years, on the other hand, that’s a slow feedback loop.
Our experience is that slow feedback loop business models are dangerous because you can’t have a precise idea of how you’re doing at any given point in time. You know how you’ve done and how you might expect to do in the future, but things could go off the rails at any time without you being aware that they have for quite a while.
To bring this back to tack-on investments, the point of our checklist is to make sure that any of our businesses that do one have the conditions in place to make sure that the feedback we get on the deal is fast. Because if it’s not working we want to know that as soon as possible in order to right the course and if it is, we want to know that too so we can try to do another one.
Because while organic growth is great, inorganic growth, done right, is a cheat code.
-Tim
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Be Kind, Not Nice
Maybe it’s semantics, but recently around the office we’ve been talking about the difference between being low-performance nice and high-performance kind. This came up the other day because a CEO we know reached out about one of her senior employees. This person, who has been struggling in his role for some time, expressed frustration about having not received a compensation increase for some time. What, he asked the CEO, did he need to be doing differently?
The CEO sought our advice because, while this was not a critical employee, it was an important one. Further, her assessment of the reason for his struggles was more fit than attitude or skill, but unfortunately the business did not have a role to offer that might be a better one. So if she told him the unvarnished truth, she was not only worried that he might leave, but that in this tight labor market, he would prove difficult to replace. Might it be better for everyone, she wondered, if she said she thought everything was fine and encouraged him to just keep working hard?
Given that context, what we’ve been talking about around the office is that the latter seems like the low-performance nice thing to do. It doesn’t rock the boat, it closes down the conversation, and it doesn’t make anyone uncomfortable. And the fact that it doesn’t make anyone uncomfortable – neither the CEO nor the employee – is a key point. It’s relatively easy to be nice, and being nice enables one to be done with a hard conversation. In other words, being nice is about protecting you to the disadvantage of the other.
If something is easy and conclusive, of course, it probably means it is also lazy and settling (except for no-brainers). Hence the low-performance part. Because those aren’t the characteristics of a good business or, more importantly, a good relationship.
So if that’s the low-performance nice thing to do, then what’s the high-performance kind thing to do?
Now, nice and kind are often used interchangeably and certainly what they have in common is that a person who is those things is polite, careful with words, and cares that the people they are interacting with have a positive experience. With that as a given, the high-performance kind thing to do here would seem to be to explain to the employee the situation he finds himself in that is in some ways through no fault of his own. And then to take time to figure out where the employee sees himself in the future and ideate paths forward that might help him get there. Another high-performance kind thing to do would be to offer support, but not subsidy.
This, of course, is harder than being low-performance nice. Not only does it take more time and thought, but if the conversation doesn’t go well it also potentially leaves the CEO in the lurch. Yet if it goes well (and why wouldn’t it if you truly have one’s best interests in mind?), everyone ends up better off. Put another way, kind is about helping the other, which should end up being better for both of you because it’s always the right thing to do to help people get where they want to go (just don’t ask me about the time some West Virginia fans asked me how to navigate the DC Metro after their team had defeated Georgetown in basketball).
So be kind, not nice, and have a great weekend (and sorry to those West Virginia fans who got on the wrong train).
-Tim
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Average Deals
Someone asked me about Permanent Equity’s average deal the other day, so I pulled the numbers. On average, I reported back, when we make an investment we buy 75% of a company, write a $20M check, and pay six times beer money.
But, I said, you may want to be careful with how you use this information because we don’t own 75% of any company and have never written a $20M check nor paid six times beer money. Instead, we own anywhere from 51% to 100% of our portfolio companies, have stroked checks ranging from $5M to $68M, and paid (leaving aside the nuance as to how some of these investments were structured) as little as two and as much as 12 times beer money.
Now, when I tell people about this deviant behavior, the reactions are not down the middle either. In fact, one potential investor declined to continue chatting with me, saying “your deals seem funky and capital deployed is too intermittent.”
Okay, then.
But this particular investor said, “That’s great. The fact that you all have done such a wide variety of deals shows that you’re taking advantage of the flexibility of your fund structure and lends credibility to your claim that you’re always trying to do things that make sense.”
Exactly.
See, no two deals are alike for us and there is no average deal. That’s because we view sellers of businesses as our customers and our product as capital. And since money can easily become a commodity where the only better is more, we try to offer our customers differentiated and personalized products that best achieve what they are trying to accomplish. In some cases, yes, that’s money, but in others it can be things like partnership, certainty, legacy, or peace of mind (or some combination of all of the above). That doesn’t mean we win every deal, of course, but we find that since our offers tend to stand out, they usually garner presentation and at least some consideration.
And since nothing gets done without first being considered, here’s to never being average.
-Tim
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I’m Gonna Finish this White Paper
Something I first read a long time ago, but that took a while to understand and appreciate was this special feature from the June 2000 Bank for International Settlements Quarterly Review. Called “Evaluating changes in correlations during periods of high market volatility,” it makes the case, using math, that when things become more volatile, they also become more correlated.
Now, if you’re among the legions of people more intuitively numerate than I am, you might be saying, “No duh.” But for me this was not intuitive. That’s because it seems like one way to think about volatility would be as difference. For example, if lots of things are zigging and zagging all the time, it seems like it should be the case that all of that zigging and zagging would be more random and therefore less correlated.
But another (and the right) way to think about volatility is as magnitude. In other words, something that’s volatile isn’t necessarily zigging and zagging a lot, but rather has the potential for explosive zigs and catastrophic zags. And as the math in that paper shows, while there can be a lot of relative difference between a lot of events in a clustered distribution, extreme events are fewer and a lot more alike relatively speaking precisely because they’re extreme and so they are much more highly correlated.
This is a problem for business and investing because Modern Portfolio Theory posits that you can earn better returns with less risk by doing things that are uncorrelated. But if it’s true that things become more correlated when they start going really badly, then the benefits of being diversified are reduced at precisely the time you need them the most.
And this is a reality that has proved to be true during significant market dislocations.
This National Bureau of Economic Research working paper, “Long-Term Global Market Correlations,” was published in November 2001, just as the bursting of the tech bubble and 9/11 terrorist attacks were wreaking havoc on global markets. It remarked that “the diversification benefits to global investing are not constant,” that “diversification potential today is very low compared to the rest of capital market history,” and that “periods of poor market performance, most notably the Great Depression, were associated with high correlations, rather than low correlations.” Global correlations increased again with the 2009 financial crisis, and during Covid everything went way down then way up together.
In other words, it’s clear that when people panic, they’re likely to panic about everything all at once.
And while there is less academic research into how this propensity manifests itself in small operating businesses, I can tell you from experience that when something starts to go poorly at a small operating business, a lot more is likely to go poorly alongside it. A business that loses a bunch of money on a project, for example, might see performance suffer at other projects as it repurposes its best people to deal with the crisis. Then its controller, stressed out by the situation, might decide to retire a year earlier than expected, leaving a massive hole on the leadership team right when accurate numbers are most important. And seeing deteriorating prospects and a lack of appetite for growth, a star salesperson might then leave for a competitor. Heck, it’s when morale is low that office supplies even start to disappear.
When it rains, as they say, it pours.
So if the lesson is that the world is more correlated than we think, an implication is that we can’t engineer our way to stability when constructing an investment portfolio or building a business. Instead, we have to accept that there will be instability and that when it happens, there will be a lot of this at once. The two ways to handle this are (1) temperament, i.e., know ahead of time what you’ll need to do to keep your cool and (2) structure, i.e., your agreements with others and liquidity requirements can never turn you into a forced actor.
-Tim
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Skateboarding Non-Competes
AThe thing I miss most about living in the city is skateboarding to work. See, because if you live one mile or so from your office (and not on a gravel driveway in rural Missouri), a skateboard is the ideal form of transportation. That’s because:
You get where you’re going faster that if you were running or walking; but
You don’t sweat through your work clothes; and
You can keep that mode of transportation under your desk; so
You can commute home quickly in the evening even if traffic is backed up into the parking garage (true story).
But the problem with skateboarding to work back when I lived in Alexandria, VA, was that it was illegal. Skateboards were not allowed on the roads, nor in the bike lanes, nor on the sidewalks, which made for a bit of a kerfuffle about where they were allowed. And while very few police officers enforced those limitations, few is not zero, and so therefore I had a number of awkward encounters with badged men with strong opinions.
Thankfully, nothing ever escalated to the level of prison. But I mention this all here in reference to the recent FTC decision to nullify and ban non-compete agreements.
Bear with me…
I wrote that one way I’m inspired to write these missives is by talking through things with my son on the way to school in the morning. And so this came up the other day when we were listening to NPR and Morning Edition reported on this story in between reporting on how abortion restrictions are contributing to global warming (I kid, I kid). He was interested in the issue (non-competes) and knew that it had relevance to me and asked what I thought about it. I said something like, “Most non-competes are unenforceable anyway, but that said I’m all for free markets, but that also said, I’m also for contracts.”
I get, of course, that the idea here is that some number of these so-called non-competes have been thrust on people who don’t understand what they agreed to and also may not have the firepower to litigate them (and therefore are already unenforceable!). But provided there is thoughtful negotiation between informed parties, what about leaving us negotiators alone? Because I didn’t see anything in the FTC’s ruling about reducing compensation or severance for eliminating the non-compete even though those things would have been agreed to right around the same time. And if that’s true, this would be a long-term drag on wages and business valuations (particularly for those whose main asset is intellectual property) even as it might be a near-term election year talking point win.
Imagine that.
-Tim
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You’re Not Obsolete
Emily texted me the other day and said “Your next Unqualified Opinion should be about how just because you say something doesn’t make it true.” Her beef was with an email we had received from someone who was clearly integral to the success of her business saying that she wasn’t integral to the success of her business because all she did was drive strategy (which only happened a few times a year), review the financials and set goals (which only happened monthly), and collect overdue AR (which only happened weekly).
So not integral!
The statement is absurd on its face, but the reasoning was that none of these activities happened daily and therefore were not critical to day-to-day operations. And while it’s true that none of these things happened daily, that reasoning ignored the fact that these more intermittent activities are what enabled critical daily activities to occur.
When we pointed that out, we were met with frustration. This was not only because we were disagreeing (on the merits!), but also because I think us pointing that out forced this person to come to terms with the fact that she had not achieved an important goal of hers, which was to have made herself obsolete.
Look, we should all be endeavoring to make ourselves obsolete. Our jobs, our families, and the world will one day have to move on without us and we should do what we can while we are present to make sure that that inevitable transition is as seamless as possible.
Yet even if you recognize that and work hard to achieve it, a true fact is that unless you are entirely absent, you are never as obsolete as you might tell others or lead yourself to believe. Case in point, we invested in a business where a clear succession plan was in place and there was universal agreement that the number two was ready to take over. Then the CEO was diagnosed with cancer. A few days later he went into the hospital and never came out.
While the business at that moment was the least of our concerns, when we and everyone else got back to focusing on the business, we believed it to be in good hands. Many moons later, and only after the numbers had worsened, we figured out that while the business was in caring hands, it wasn’t necessarily in adept hands. By losing that CEO, we had lost an important driver of quality control. In other words, even though the CEO wasn’t necessarily doing much, he was, by virtue of sitting in his seat and having the potential to do something, causing others to work smarter and make better decisions.
I told this story to the “not integral” woman we were talking to and also said “Hey, look, this may be my own problem that I have scar tissue.”
But!
Scars are scars for a reason, and you should never want to or do something again that gave you one. She looked like she agreed, but didn’t, but also did, but also didn’t want to admit it. The resolution is that we’d both think about it and revert.
The heartwarming side of this story is that as long as you’re around, you’re at least not obsolete and probably more likely incredibly important. The more frustrating flip side is that you and others, even if you’re being intellectually honest, probably don’t fully appreciate that.
-Tim
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What You Think is Worth Reading
After I made my recent book recommendations, I had more than a few people (since I asked you to) send in their own. Thank you! I’m always on the lookout for new tomes and now I have some things to take to the beach with me this summer. In case you’re also deciding what to read next, here’s what some others are recommending (with some reasons why)…
Jon: Thinking in Bets by Annie Duke
“Thinking of decisions in terms of bets and odds has been a very useful framework for me, and the book has a lot of overlap with concepts like Bayes and position sizing.”
Justin: Calculated Risks by Gerd Gigerenzer
“The book really helps with the logic (with great visuals) on how to think about Bayes’ theorem, base rates, and how to update. A good read for investing, but more importantly a great book to help you think about the numbers you see in life.”
Joe: Liar’s Poker by Michael Lewis
“Guys in suits often aren’t as knowledgeable and/or smart as they appear.”
Johnny: Boss Life by Paul Downs
“Nothing gave me a better appreciation of the daily battle that is SMB ownership.”
Matt: Great Mental Models by Shane Parrish
“Improving the way one thinks is likely the best compounding investment anyone could ever make.”
Emily: Glass House: The 1% Economy and the Shattering of the All-American Town
“The author draws some pretty extreme conclusions (basically blaming private equity transactions for the opioid epidemic in Ohio), but his research on the actual cycle of deals is thorough and well told. This book will probably never leave my mind.”
Michael: Capital Returns by Edward Chancellor
“The boom and bust told through the investor letters of Marathon Capital.”
Milo: Investing: The Last Liberal Art by Robert Hagstrom
“Big ideas in multidisciplinary domains with parallels to investing.”
Mark: The Psychology of Judgment and Decision Making by Scott Plous
“A highly concentrated walkthrough of the biases that drive our everyday decision-making and how we can fight against them.”
Oh, and a lot of people think you should read The Psychology of Money by some Morgan Housel guy. Whatever. Have a great weekend.
-Tim
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Mushrooms!
We’re in the midst of mushroom hunting season here in mid-Missouri, which means that the crazy guy with the knife wearing the Capital Camp hat (May 21!) walking slowly through the woods out by the river at six in the morning is me. Mushroom hunting wasn’t anything I’d done before we moved to mid-Missouri, but I picked it up as a hobby as part of the whole “if we were going to move to Missouri, we were going to move to Missouri” thing. Plus, one of our neighbors was pretty sure I could never find as many as he does and, well, I do still have a bit of a competitive streak in me.
Anyway, Holly, after stumbling across a cryptic post on my X nee Twitter page, asked me about hunting mushrooms the other day and how I did it. Suffice it to say that there isn’t a lot you can learn from others about hunting mushrooms. That’s because people are secretive about their spots and techniques since the season is short, supply is limited, and the little guys are both valuable and delicious. My aforementioned neighbor, for example, after challenging me, had no interest in showing me the ropes (and I don’t blame him).
So five years ago I googled the basics and then spent a lot of hours walking slowly through the woods near my house finding very few (14 to be exact…I have a spreadsheet).
Fast-forward to today and I found many more than that in my first hour of hunting this season. Why? Because now I know where to look!
See, morels have a tendency to spring up in the same areas as they have in the past. Not always, of course, but your probability of finding one is much higher if you are looking in a place where you found one before than if you’re looking in a place where you haven’t. And every year I’ve looked, I’ve found at least one new place to look, which means that five years into the hobby I now have more than a few “spots” (shoutout compounding).
Because every time I go out, I don’t just go to the spots I know will yield. Instead, I also set aside at least 30 minutes (depending on how much time I have) to look in spots I’ve never looked in before, in spots I’ve looked in before because they seem like they should be promising from a moisture/soil/sun/leaf cover perspective, but that haven’t previously yielded anything, and in spots where I may have once seen a crazy person slowly walking through the woods in April. The reason being “just in case” and also because I always want to be adding to my spots in case one of my spots goes away (which happened a few years ago when a particularly good one flooded over).
And when I explained this, someone who was listening in (I can’t remember who) said, “Aha! 20% time!”
If you don’t recall, 20% Time is Google’s (perhaps apocryphal) policy that full-time Googlers spend 20% of their day doing something that isn’t proven, but is instead high potential. To apply this to small business, I previously recommended to “Keep a list of everything your business might do to grow…but force rank them based on potential and only tackle one or two at a time” and to “watch competitors…like a hawk and be shameless about trying things they are doing that might be working.”
All of this is to say that I was subconsciously treating my hobby like it was one of our businesses, and when I realized that, I realized I might be a little sick.
-Tim
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The White Paper Work Continues
Diversification can get a bad rap in the investing community as “diworsification,” which is to say that if you are spreading your bets too thin, you’re not mathematically making any bets at all. Of course, a mitigating factor here when applying this framework to small, private companies is that these companies tend to be volatile and, as I’ve said before, can be at all times a few consecutive bad months away from a crisis. What that means is that if you are trying to build a compelling long-term return stream in our space, you need to be cognizant of aggregating highly disparate assets. Further, your odds of diworsifying among small, private companies is difficult because you can’t practically go out and acquire 100 or more all at once like you can in the public market, so the risk to be aware of is concentration, particularly if it’s inadvertent.
And that’s the twist re: diversification among small, private companies. Ones that look different can actually be quite similar and ones that look similar can actually behave very differently. So what makes a small, private company a disparate asset?
When it comes to public companies, for example, accepted vectors for diversity include size (even though almost all public companies in the overall scheme of things would be considered pretty big), industry, geography, and growth profile/valuation. Among small private companies, however, size doesn’t really apply, since none are big enough to not be fragile and nor, for the most part, does growth profile/valuation. That’s because valuations tend to cluster around the average and also because, as we like to stay around these parts, no business stays small on purpose, so the growth of any mature small business is definitionally being blocked by something.
That leaves industry and geography, which both apply and should often be considered in tandem, though on a more refined scale (e.g., it’s not US versus EMEA, but the Sun Belt versus the Northeast). For example, a pool company in Arizona makes a lot less margin on service than one in the Northeast because in geographies where it freezes and thaws, there is more price insensitive seasonal pool opening and closing revenue. And a fence company in a geography with soft soil will have better economics than one operating in rocky soil because of the throughput on putting up posts.
So if you’re building a portfolio of small, private business, here are some other vectors to consider:
Seasonality: A fireworks distributor will generate a much more reliable stream of cash flows when paired with a Christmas ornament manufacturer than it will with a pool toys manufacturer.
Business model: A service company that gets paid upfront will generate a much more reliable stream of cash flows than a construction business that has to try to collect 20% retainage.
Weather: We didn’t realize until it happened how much a rainy month in the Southwest would impact our pool, fence, and waterproofing businesses all at the same time.
Deal structure: If all of your deals have earnouts, it might be a long-time before you generate a reliable stream of cash flows, so if you do a deal with an earnout, you might complement it with a deal that includes a preferred return.
People: Your portfolio is significantly riskier if all of your operators want to retire within three years than if they don’t.
The point is that if you’re building a portfolio of small, private businesses then you’ll want to be as highly diversified as you can be, but also that what makes for diversification in this space can be incredibly idiosyncratic. So be aware of what your exposures are and aren’t with the goal of turning inevitable individual business volatility into a more reliable blended return stream.
-Tim
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Space Junk
One of the craziest stories I’ve been following recently awaiting resolution was that of the Florida man whose house got bombed by NASA. Because way back in March 2021 the International Space Station decided to throw out 5,800 pounds of old batteries, expecting them to burn up in Earth’s atmosphere and disappear forever. But 1.6 pounds sneaked through, blowing a hole in Alejandro Otero’s roof in March 2024 and crashing through two floors while almost decapitating his son.
Whoops.
Commenting on the fact that the rocket scientists didn’t quite get the math right on this one, NASA wrote:
The International Space Station will perform a detailed investigation of the jettison and re-entry analysis to determine the cause of the debris survival and to update modeling and analysis, as needed. NASA specialists use engineering models to estimate how objects heat up and break apart during atmospheric re-entry. These models require detailed input parameters and are regularly updated when debris is found to have survived atmospheric re-entry to the ground.
NASA remains committed to responsibly operating in low Earth orbit, and mitigating as much risk as possible to protect people of Earth when space hardware must be released.
Comforting, no?
I wrote a while back about the spreadsheet that presumably exists somewhere where if you change the value of one cell (the one that calculates estimated future viewing patterns of Netflix content and therefore the rate at which the cost of that content is amortized), you could double Netflix’s profit or cut it in half. Well, apparently there’s also a spreadsheet somewhere where if you change the value of one cell (the one that calculates how much various metals heat up and break apart during re-entry), it might get us all annihilated by falling space debris.
All things considered, Mr. Otero seems to have dealt with this manifestation of what I call “Are you effing kidding me?!” risk in a remarkably calm manner. He’s waited for NASA to confirm its findings and is asking them to “resolve the damages” (though I have no idea what court has jurisdiction over space releases and/or whether or not anyone could prove that NASA was negligent here). But if they don’t “resolve the damages,” well, are you effing kidding me?
Here are the takeaways:
Risky actions can take a long time to materialize into tangible consequences. While federal law may have a 5-year statute of limitations, the real world can punish you whenever it wants, so reserve accordingly.
Exogenous factors outside of our control are conspiring against us all the time, even up in low Earth orbit. You may not have time to worry about space junk, but you need to be prepared for space junk.
Oh, and your model is probably wrong.
-Tim
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Hair Is Opportunity
We have a joke around the office that we’re in the business of shaving hair. This is in recognition of the fact that small- and medium-sized businesses (SMBs) often come with lots of hair on them in many forms. That can include sloppy accounting, unresolved personnel matters, customer and/or supplier concentration, and even compliance with laws and regulations that is, shall we say, in the gray area. And of course this hair is what can make a business hard to transfer and even uninvestable.
But!
One way to create significant value is to remediate these issues over time i.e., shave the hair. That’s because in doing so, while you might or might not improve the performance of the business, you’re making it more investable. That increases the size of the pool of potential future buyers, making the business more valuable.
In other words, the less hair, the higher the multiple.
To wit, we saw a business recently that had botched an acquisition a few years ago and in the course of trying to integrate it had lost and was still losing quite a bit of money. Further, it had been through several rounds of layoffs, revalued inventory, written off assets, and recategorized expenses. The numbers were a mess.
That’s hair.
And while it’s normally not a good thing to lose money with that much hair, what was oddly impressive about this situation was that the core business had been able to fund those losses for so long. What that meant is that the core business might actually be a good one. Or, at the very least, that it could afford to pay for its shave.
So I said to Holly, “Hey, let’s reach out and see what the story is here. While we’d normally not be interested in a business with so much hair, this hair seems shave-able. And if we can shave the hair, we should do okay.” And Holly, after giving me a funny look, agreed.
The key to shaving hair, though, is not just knowing what the hair is, but also figuring out ahead of time that you can shave it. And there are two keys to that:
The business is generating enough cash to self-finance its shave.
The people at the business won’t resist or sabotage being shaved.
But if either one of those things isn’t the case, well, you might as well just start calling the business Cousin Itt.
-Tim
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You All Do a Good Job
I should have seen it coming…
Prompted by me to tell me that I do a good job, you all responded with a whole lot of emails telling me I do just that. Thank you for making my day. It turns out there is no such thing as too many kind and thoughtful emails. After all, no one puts something out in the world without wanting a genuine response, so good job on that.
Of all of the responses I received, two stuck out for their clarity of thought and so I thought I would pass them along. One, from Casey, said this:
As a people-pleaser, I often catch myself writing “Sorry to clog your inbox” (I’ve maybe even said it to you). As with many things, I’ve settled on it coming down to scarcity versus abundance. If I feel like I’m clogging an inbox because I’m looking for attention or some other ulterior motive, that’s scarcity, and I rethink whether I want to send. If I’m sending because I appreciate what they said or it’s something else genuine, that’s from abundance and I send. Not a hard and fast rule, but it’s been helpful.
Lance, striking a similar tone, said:
I’ve contemplated this a lot and have arrived at erring on the side of over communicating. Email is one dimensional communication so acknowledgment of receipt or saying a quick “Thank you” is affirming and closes the loop.
That last bit in particular resonated with me because one of the most infuriating things that happens in my life these days is when I say something to my kids and they don’t respond. While I’d certainly prefer a positive response, I could handle a negative response, but what’s infuriating is the lack of response. It leaves me wondering if they heard me, care, and what they’re thinking.
C’mon guys!
Because maybe that’s what we’re all reliably looking for in this world: acknowledgment. Have a great weekend.
-Tim
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How to Test
One of the scarier and more difficult, though unfortunately necessary, parts of operating a business is testing the validity of new ideas. That’s because doing so risks time and capital and can be disruptive to your core business, but also if you don’t do it, your core business risks stultifying and being competed away.
Remember, either you or the world is always moving on.
To that end, we keep a prioritized list of new ideas for each of our businesses and try to be tackling at least one (and ideally the one with the most potential bang for the buck) at all times. The question is how best to do that?
Because I’m the one who keeps a very close eye on our capital stack, I’m generally a fan of incremental testing. This approach is born out of the lean startup/minimum viable product schools of thought, which is to say that if you have a hypothesis about a new initiative, the right way to go after it is to start small, iterate as you go, and feed it with more capital only as it proves itself out.
To that end, our COO Mark is constantly advising our businesses to test new things so long as those tests are (1) measurable and (2) above the water line. What above the water line means is that if the test fails, it’s not catastrophic to the business i.e., punching a hole in the side of a boat is not as bad as punching a hole in the bottom. And if you do find a win, then work on scaling it.
Of course, a catch-22 here is that if you have a big strategic idea and you’re only willing to start small and test incrementally, you may never get around to actually testing that entire big strategic idea. To wit, we have a retail business that is interested in assessing the opportunity of having a brick & mortar location. (And before you say that’s stupid the economics of selling online are way better, a true fact is that building a durable consumer brand requires selling through multiple channels.)
Now, they did the work and identified an ideal spot where we could open a store that would benefit from the right kind of foot traffic, and that could be staffed with people who already knew the brand well and stocked with inventory that could quickly be repurposed if we got indicators that the test wasn’t going well. It was a more significant initial capital outlay than I’d typically greenlight, but when we modeled it out, the returns from getting good data on how to open physical locations was very much worth it.
Unfortunately, the landlord came back and said we couldn’t have that space, but that we could have one that was not entirely dissimilar and also quite a bit cheaper. It wouldn’t benefit from the right kind of foot traffic, but would allow for the risk mitigation pieces on the staffing and inventory side.
As we thought about that, though it was less expensive, we decided that wasn’t a test we wanted to run. The reason was it wasn’t a good location, and if we ran the test and it failed, even if it didn’t cost us much in dollars, the cost of getting a false negative on a big strategic idea might in the long run turn out to be really expensive.
In other words, there is a fine line between the lean startup/minimum viable product/incremental approach and half-assing something. Further, it’s important to know the difference between the two when thinking about how best to test a hypothesis about your business. So in designing any kind of test, resource it sufficiently such that the conclusions you ultimately draw from it are meaningful. That may cost more upfront, but the cost of believing something to be true that isn’t is likely to be significant.
— Tim
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Still Working on that White Paper
When it comes to thinking about how much capital to put behind an individual investment, one universal truth and three considerations apply. The universal truth is that anything can go to zero, so never invest an amount that if that amount did go to zero, it would prevent you from making additional investments. That specific amount will be different for different actors, but one way to know that you haven’t sized your bets too big is if you always live to fight another day.
And while that advice can help one avoid catastrophic blow-ups (which is something we should all strive to avoid), a bigger challenge when it comes to generating above-average long-term return streams is betting too small. That’s because the more bets you make, the more likely you are to achieve average results, which are then likely to become below average over time due to the increasing frictional costs of trying to keep up with so many bets at once. Ergo the three considerations:
1. How big can this bet get if it goes well?
2. If this bet goes well, what is the net impact on returns if everything else in the portfolio doesn’t go well?
3. If this bet goes poorly, what is the net impact on returns if everything else in the portfolio does fine?
Asking and answering these three questions can help size the opportunity and scope the influence on the rest of the portfolio. The reason that’s important is because you want to be thoughtful about not making investments that are too small to matter, but also avoid making investments that are so big nothing else matters.
For example, one of the smallest investments in our Permanent Equity portfolio is a 3% position. Now, it’s expected to punch above its weight this year and contribute 4% of our total return, but run the numbers and that’s only 73 basis points of that return. So a fair question to ask is: Was it worth it to make and now maintain an investment that contributes less than 1% to our returns and that would still be relatively inconsequential in the scheme of things if it only doubles or triples?
Indeed, we asked that very question at the time we made this investment and our answer was yes because the total addressable market for this business is significant and the operating leverage inherent in the model meaningful, so we thought it had multiples more potential. This doesn’t mean it will achieve that potential, but by virtue of having it, this is a small position size that’s worth it. To put it the context of the considerations:
1. If this bet goes well, it could grow into a 10% to 20% position.
2.As a 10% to 20% position, this bet could be a meaningful positive contributor and make up for one or two bad bets.
3.If this bet goes poorly, it will be a 1% to 2% annual drag on returns.
Now contrast that profile with one of our larger positions, which is 20% of the portfolio and will contribute 30% of this year’s return. We’re happy with that, but don’t necessarily expect the company’s return contribution to grow significantly over time. To put it in the context of the considerations:
1.If this bet goes well, it should remain approximately 20% of the portfolio.
2.As a 20% position, this bet will immediately be a significant contributor to our returns if it goes well.
3.If this bet goes poorly, it will be an 8% to 10% annual drag on returns.
Given that profile, we wanted to take a big enough position now so that the investment would be a material contributor to the portfolio both now and in the future when other companies had grown at higher rates. But in order to take that upfront risk in light of consideration 3, we needed to be compensated for doing so, which we believe we were and are by the valuation we paid and also by being invested via a preferential share class that gives us favorable economics if the business significantly retrenches. So while there is concentration risk, it is mitigated in the near-term by the terms of our investment and in the long-term as our other investing decisions play out.
Having said that, I recognize that none of our investing decisions will play out according to plan. But that’s exactly why we should all try to build a thoughtful portfolio of some number of them sized accordingly.
-Tim
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Tremendous Upside Potential
Prompted on X nee Twitter to share an insult he’d never forget, our founder and CEO Brent told of the time (and he wasn’t making this up) a Deputy CIO at an Ivy League endowment told us they weren’t interested in investing with Permanent Equity because they were “only interested in opportunities with upside.” Having, at that time, recently moved my family to mid-Missouri to take a job at Permanent Equity precisely because I was interested in upside, the comment caught me a little flat-footed.
I think this Deputy CIO’s perspective was that because Permanent Equity invests in companies that do rudimentary things like build fences and then does uncreative things with the profits from those enterprises like distributing them to owners (hello, beer money), our returns were necessarily constrained. And while our approach was and is pretty exciting to me, I guess that is another way of looking at it.
But I was thinking about this whole idea of upside the other day as I watched the machinations in the stock of the newly public Trump Media & Technology Group (Nasdaq: DJT). What a curious situation that is…
In case you haven’t looked under the hood, this is a “business” that former (and perhaps future) President Donald J. Trump (clever ticker!) conceived of to compete with Twitter now X because they kept kicking him off the platform due to things he said that others thought he shouldn’t. But I put “business” in quotes because it’s not much of a business at all. Based on what was filed with the SEC (and let’s go out on a limb and say we can trust that), Trump Media & Technology Group lost $58M last year (though some of that was not beer money) on revenue of just $4M. Further, this “business” believes that “adhering to traditional key performance indicators, such as signups…might not align with the best interests of TMTG or its shareholders.”
Yikes!
Yet a recent market valuation of this “business” was more than $6B. To put that in context, Trump Media & Technology would be by many, many orders of magnitude the worst-performing business in the Permanent Equity portfolio, but by many, many, many, many, many orders of magnitude the most valuable. How does that work?
People are crazy is one answer, and it's not an unreasonable one. Trump Media & Technology is currently a terrible “business.” Not only is it incinerating cash, but its highly-respected audit firm issued a going concern notice (i.e., warning that the company could go bankrupt) at the same time it went public. But another answer is upside. Trump (the former maybe future President) has a lot of supporters and were they to all become loyal, paying sources of recurring revenue for Trump Media & Technology Group in some shape or fashion in the future, that terrible “business” could become a profitable one that delivers unconstrained returns.
But I dunno. $6B seems like an expensive call option on the counterfactual I just described (and people are catching onto this fact with the stock down some 50% since it was at that level).
At this point I’m reminded about the time (and this is dating me like most of my pop culture remembrances do) that ESPN blogger and now Spotify host Bill Simmons called out NBA commentator Hubie Brooks for assigning every unknown basketball prospect in the annual NBA draft with Tremendous Upside Potential. These were players who were not statistically elite, but had characteristics like height or the ability to shoot the lights out when guarded by a chair to maybe one day be. But very few ever panned out.
The point is that upside is not so different from imagination and that imagination is not so different from deception. And that’s the reason why we’re all conned so easily and/or pay up for the prospect of unconstrained returns, because believing something to be true that isn’t yet but could be is exhilarating.
In other words, Trump Media & Technology has Tremendous Upside Potential and probably more than Permanent Equity. But I’m good with Permanent Equity.
-Tim