Happy Labor Day weekend! It’s tough to believe two-thirds of 2019 is complete. I’m still writing “2018” on my homework.
Raise & Exit: The Food Capital Primer
I have launched a guide for entrepreneurs in consumer packaged goods (CPG) designed to provide useful knowledge about the capital markets before and during fundraising and considering exit. It probably applies to most industries, although CPG has distinct qualities that are acknowledged therein. Having been on the principal investing side of equity and debt and represented sellers as an investment banker, I designed this to give some “inside baseball” on terms, deal structure, and even firms to whom you can reach out. It will grow and evolve, so please reach out with feedback.
Check out Raise & Exit: The Food Capital Primer here.
Markets are Eating the World
In 2015, Taylor Pearson wrote End of Jobs, a book about the present and future of the “gig economy.” In 2019, he wrote Markets are Eating the World, an essay about the notion of the existence of “markets” in juxtaposition to “firms.” Pearson defines a firm as a single entity and a market as a group of distinct entities. His premise is that the world is shifting from firms (lots of big companies) to markets (lots of small entities functioning as individuals). Another way of looking at it is owning versus renting: firms “own” employees whereas they “rent” contractors; you “own” a car but you “rent” a ride on Uber. With the help of mid-20th century economist R.H. Coase’s 1937 work The Nature of the Firm, Pearson suggests that firms only exist when markets are inefficient.
Markets are inefficient when what he calls “transaction costs” are too high. Transaction costs can be put into three buckets:
Triangulation: How hard it is to measure the quality of a service;
Transfer: How hard it is to bargain and agree on a contract for the good or service; and
Trust: Whether the counterparty is trustworthy or you have recourse if they aren’t.
He applies these buckets to historical and contemporary business case studies, such as Henry Ford and AirBnB. Henry Ford vertically integrated all the way back to the iron ore foundries because he could not source reliable raw material suppliers who could deliver consistent supply at consistent prices (Triangulation and Transfer). AirBnB is similar. Before, you went on vacation to Hilton Head you either used a booking service to find you a hotel or you bought a beach house. If you bought a beach house, you and the family were going to Hilton Head at least once a year for the rest of your life. Now, AirBnB has made it easy for you to Triangulate and Transfer micro-rentals of properties all over the world. To summarize, the higher the transaction costs, the larger the firms. Or, the higher the transaction costs, the more likely a consumer is to buy versus rent.
The essay goes deeper into the historical drivers of transaction costs: advances in technology. He divides these advances into four eras and provides ample examples throughout. If you don’t read this entire essay, at least read the short section titled The Unreasonable Effectiveness of the Mechanical Clock, in which Pearson illustrates how the Feudal system may not have given way to capitalism without it.
The technological eras, in Pearson’s vernacular, are:
The Neolithic Era: Once Humans advanced from hunter-gatherers, in which everybody was responsible for hunting, gathering and fighting off predators and enemies, to farmers. Crude hunter-gatherer societies had one concern: survival, which meant that any attempt to specialize away from food and fighting likely jeopardized the tribe. Farming enabled specialization because our early ancestors could store food and use it to bargain, and thus could accumulate wealth. Farmers who owned land, servants, and livestock could, for example, pay warlords for protection. Ultimately, the concept of “Division of Labor,” or members of a group acquiring skill by doing discrete specialized tasks, began to emerge.
The Industrial Era: He points to the market as the key catalyst for this era. The centralization of buying and selling made it easy to Triangulate and coordinate customs related to Transfer costs. The fact that one’s repute as a merchant was staked to a permanent geographical location built in Trust. This enabled people to further specialize: if I was a master woodworker, I would always have a place to sell my wares. I would be properly motivated to be better than other woodworkers, which cast me deeper into my discipline. As the industrial era wore on, the emergence of giant firms like Ford made it such that a worker’s skills would be more highly valued in a firm than in a market. This is because the firm was built to reduce Triangulation, Transfer, and Trust costs, and hiring full-time employees did away with all three, thus making those worthy of full-time employment worth a premium.
The Computing Era: The age of bytes has made searching easy. The proliferation of smart phones has made services like Uber incredibly effective. Within Uber, I can triangulate and transfer easily (the trust piece is still a bit dubious for some). A taxicab driver is compensated far better by the market than by a firm, and it is easier to quickly book an Uber through your app than hail or call a cab company. Thus, thanks to computers, the market has eaten the firm.
The Blockchain Era: Blockchain is essentially a giant ledger that is fully transparent to every user in a market. Pearson’s argument for the case of blockchain’s emergence applies to finance and politics. Until 1973, the U.S. Dollar was backed by gold, meaning that the money supply was always trustworthy in that its holders always had security that if the currency lost its practical value, it could be exchanged for gold. Thus, in many ways, inflation (growth in the money supply) was limited by growth in the supply of gold. Post-1973, no currencies are really backed by physical goods, which puts the power of the money supply back in the hands of a small cadre of humans. Pearson sites NYU political scientist Bruce Bueno de Mesquita’s model of Selectorate Theory, where a small “selectorate” ultimately controls outcomes. In theory, in a republic, the selectorate includes the entire population, and it is difficult to get things done, but it is also difficult to make mistakes. In a dictatorship, the selectorate is small, and it is easy to get things done and make lots of mistakes. The theory of blockchain is that through the democratization of information via a giant ledger, the selectorate becomes very large, but because of technology, the ability to transact and get things done is easy. He argues that the future could be governed by a series of distributed ledgers.
Regardless of how we feel about the death of the firm, it seems plausible that our value, especially as knowledge or skill workers, is greater through market participation than in the firm.
The Decline of American Investment
My favorite newsletter of late has been from the guys over at Verdad Capital Management. Their interns are smarter than me, as evidenced by their brilliant research in The Decline of American Investment.
As a private equity investor, this one hits close to home. The article references Elizabeth Warren’s Stop Wall Street Looting Act designed to limit some of private equity’s toolkit related to maximize investor returns (specifically internal rate of return or “IRR”) through dividend recaps using debt. Why? She feels as though companies owned by private equity have stopped investing capital in their companies, and thus public good, because they are too weighed down by returning capital to shareholders and paying back lenders.
Former AT&T CEO and current private equity tech, media, and telecom investor Leo Hindery wrote an op-ed piece in Fortune on the subject calling for change. In the July 24th issue of Fortune’s Term Sheet after some PE professionals were surveyed, one anonymous writer-in named “Jeff” had this to say:
“Mr. Hindrey’s op-ed is so loaded with factual errors and logical fallacies that it’s hard to know where to begin critiquing it. At the core, he rejects the American Way—the free enterprise system. If he has a better model for private equity, he should do the hard work of convincing LPs, of buying companies, and building a team that can repeat that over and over. He could use his success as a shining example and urge all to emulate. Instead, he wants to use government force to have central planners—without any capital of their own at risk—to force others to conform to Sen. Warren’s views of what is best. This type of busybody regulation has always reduced capital formation, which would in turn harm most of the very people he claims to champion. This is pure demagoguery.”
Personally, I do think Mr. Hindrey’s take is too vague to be taken seriously. Private equity firms do not usually “bleed companies dry,” though I am sure they do sometimes. The view that they “strap companies with debt and suck out the cash flow like vampires” is antiquated. They usually can only borrow up to 50% to 60% of the value of the company. If you paid $100 million for a company and could only borrow $60 million before running it into the ground, you would return $0.60 for every $1.00 you invested. In other words, you would suck too bad to stay in business as a professional investor. You would have to grow the Company at least somewhat for this to even start making sense. Take a look at my primer on how private equity firms structure their transactions for a better idea of how this works.
Most of the time, however, companies are done in by competitors and change. Toys R’ Us, for example, never stood a chance in the era of Amazon and WalMart without iteration into a more experiential model. That is hard to do with huge stores all over the country, but that isn’t Cerebrus’ fault. The demise due to an over-levered balance sheet is more of a symptom than a cause.
As with most things, the cure for demagoguery is nuance. Yes, part of a nuanced view includes acknowledging that there are idiots in private equity doing stupid, 2006-like things. It is also worth looking at the data to see if more nuance is available for extraction.
Our friends at Verdad cut to the quick with analysis of capital expenditures and R&D in U.S. companies pointing out four things:
Yes, capital expenditures have declined from 10% of annual company in 1980 sales to 6% in 2015, a 40% drop; *but*
Due to technological innovation, the average price of capital goods has decreased by… you guessed it… 40% since 1980; and
The US equity market cap was 18% healthcare and technology in 1980, compared to 34% in 2015, while industrials, energy, and materials have falled from 50% to 19% over that same period;
Corporations in America have more than doubled R&D investment as a percentage of annual sales from 1.3% to 2.7% since 1980.
Furthermore, unemployment is at an all-time low. People have jobs, companies have equipment, and they are investing in innovation. Thus, it is possible that corporate investment has actually been on the rise. Verdad fairly points out that concerned politicians aptly point out that shareholders would rather receive capital than invest it, and this may be due to the fear that historically, management teams are poor capital allocators.
I cannot comment here, but I can say that there is a culture of “cocktail napkin” numbers in private equity. This is a common cocktail hour storyline: “we bought this business for X, did a levered recap 1 year later and sold it in year 3 and got a 5x in 3 years.” There is little heed given to the company’s long-term competitive position and ability to thrive for its community and workforce, though it is often implied.
Even though I do not think private equity is the rapacious group of capitalists made out in the media and in politics, perhaps a positive change of culture is on its way in the investment world.
Failure
(Editor’s note: Click on Kevin’s to see the full 7-Tweet story).
Thanks
Thanks for reading my stuff. Since I am not a man compensated by the Firm, but rather the Market, please feel free to send it around to anyone who might like it.