At some point virtually every successful company has needed to raise money—and there are now more ways than ever to do it. Do you rely on your friends and family? Do you bring in outside investors? If so, who? Are you looking for an infusion of cash, or a long-term partner to help you grow and sustain your vision?
Kevin Fechtmeyer knows these tough situations and questions very well. With 25 years of experience in private equity both on Wall Street and at his own firm, Cave Creek Capital, he has helped fund over $1 billion in equity and made countless acquisitions, empowering a number of modern leaders in their respective industries, including Dell Computer, Qualcomm, and Hickory Farms.
Today, we spoke about his journey, the risks and rewards of entrepreneurship, and why company culture—and being able to cultivate great talent—is key to long-term success.
In this podcast interview, you’ll learn:
Hi. This is your host, Andrew Rafal, the founder and CEO of Bayntree Wealth Advisors, and I wanted to personally welcome you to Your Wealth & Beyond, a podcast that will empower you, the entrepreneur and business owner, with the insight and information you need to effectively manage and control your personal and professional finances. My goal is to help each of you get your fiscal house in order so that you could take your business to the next level. I’m going to help you focus on growing your business, building your wealth, and most importantly, finding purpose in what matters most.
[00:00:45] Andrew: Welcome, everybody, to another episode of Your Wealth & Beyond, the podcast built to help you, the entrepreneur, build your business and find purpose. Today, we are very excited to have on Kevin Fechtmeyer who is not only a friend but somebody I respect greatly in the financial and private equity business. Kevin is the founder and managing partner of Cave Creek Capital. He’s got well over 25 years’ experience in the private equity business and him and his firm has helped fund more than 30 platforms company with more than 1 billion of equity and has completed hundreds of acquisitions during his career. So, it is great to have you on board today, Kevin. How are you this fine day?
[00:01:36] Kevin: Great. Thank you, Andrew.
[00:01:38] Andrew: And as you guys, listeners out there know, Your Wealth & Beyond is about helping to shape and build your business, and one of the questions that we all get is, how do I fund my business from the initial startup into the different phases of the growth of the company? And today, we’re going to learn quite a bit from Kevin, his experiences, his background, and it’s going to help you, the business owner, kind of gauge out where you are and we’re going to have a lot of good tips and strategies and how to take it to the next level. So, Kevin, before we jump in, can you give us a little background on who you are and how you got started years ago on this side of the business, and some of your passions of helping these businesses grow from a maybe medium to your large, large companies?
[00:02:25] Kevin: Sure. I would be happy to. We’ve got, I guess, about 15 minutes left. I’ll try to not to consume too much of that time because obviously, I want to go through some of the questions you had mentioned in earlier discussion about different kinds of entrepreneurs and how they got to be successful, but I’ll try to minimize the time on myself, but my initial grounding was in public accounting. I started as a CPA at Touche Ross way back in the 1980s and went to business school for about two years until 1989 in Columbia Business School then went to Wall Street. At that point, I worked for some big firms, first Boston, Merrill Lynch and kind of made the decision at that point to just focus on smaller companies. I didn’t want my tombstone to read, gee, I saved General Motors 35 basis points. That wasn’t going to be my life goal. These guys were very smart, very successful, a lot of fun to talk to, but they were clearly doing bigger deals, a billion-dollar kind of deals, and there were 20 people in the deal team and your impact as a person in the financial world was pretty limited.
Venture capital and private equity were just getting going back then and at that time, I teamed up with a partner of mine who ran Goldman Sachs Private Equity Placement Group and then brought on another partner from Drexel. He and I, and really the three of us, started at that point what became the leading private equity placement group on Wall Street. Over the next seven years, we completed about $1 billion of placements. He had a lot of interesting background and deals that people have never heard of until now. Back then nobody had ever heard of Dell Computer. Nobody had ever heard of QUALCOMM. These are companies that then went on to become major companies in their own right. So, I knew that to be a lot more exciting in my career to focus on growing companies and became really kind of a 25-year passion to begin my own business and help companies like that raise capital and grow and develop their infrastructure which is no small task.
[00:04:28] Kevin: As you may know, only about 10% of the companies make it from $10 million in revenue to $100 million of revenue so there’s very high mortality rate and the quality of your capital partner and the quality management and a lot of things going to making that a success was not. So, going back to my background in 1996, we began a boutique that was focused on raising capital and also making investments and we were quite successful there as well, did companies like Hickory Farms and HQ Office Suites and here locally in Arizona, Peter Piper Pizza. And in 2003, I decided to move my family back to Arizona where we could base our business and 12 of our CEOs backed me and what became Cave Creek Capital which is really an extension of our co-investment activities in Wall Street. And in that time, we have been out in the last, gosh, since 2005 when we closed our first deal of Cave Creek Capital. We closed over $1 billion of transactions and 14 different transactions and nine different platform companies. So, it’s been quite successful since then.
[00:05:36] Andrew: Incredible. That’s an incredible success story. And when you look back to working on Wall Street, the late 80s and 90s, were you then in the midst of with the junk bonds and the financing there obviously working for with Drexel? Was that something for you on that tail end of some of the collapses there? Did that help to shape your vision of where you want the private equity and venture capital to be?
[00:06:01] Kevin: Now, that particular time actually was not the seminal moment of change for private equity. It was really 2001. The bubble burst and the Internet came in. It actually had the effect of commoditizing the agency role which everyone could then go on the internet and find out who is handing money out or not. And in addition, it began to mushroom in growth of the capital available in markets. So, we went in terms of total capital allocated to the industry over 20 times growth from the 1990s to today. So, it became a very different business after the 2001 stock market crash and Internet bubble collapse. And it’s really that’s affected, frankly, all the way through today.
[00:06:46] Andrew: So, let’s look at things for the listener because we’ve got business owners that are in the infancy of their companies and then business owners that have been building it and growing the revenues and building a business that down the road is going to be scalable and potentially sellable. So, walk through the listener what is some of the value in potentially partnering with the private equity firm or venture capital. And is that something that every firm should have the goal to eventually bring into the equation?
[00:07:16] Kevin: No, not necessarily. A lot of companies are just fine, staying their own size and growing at a modest rate and some of them are owned by business owners that are very happy to have a lifestyle business. They’ve got a good business that is providing a good income for their family and their partners. And so, I would argue that, in fact, only a minority of companies should really feel like they need private equity. And frankly, a very small percentage of them would be able to raise private equity. It’s actually something for companies that really want to think about growing to the next level and reaching 50 million, 100 million or 200 million of revenue. At that point, then I think it becomes very important to have an institutional background and the board and everything that comes along with private equity.
[00:08:04] Andrew: So, in the beginning stages then with a lot of small businesses that may have, like you said, lifestyle practice, they have good margins, they may be bringing less than 5 million of revenue, as they’re getting started with the infancy of a company and trying to build it out, what would you say is the best way for that type of business owner to try to achieve their growth and how would they raise capital? Would it be looking at things then more on the debt side versus an equity side?
[00:08:31] Kevin: Well, everyone’s different and every business is different but the pattern that we typically see in our businesses and our businesses are middle of the road consumer companies, manufacturers, business services but the patterns, they’re pretty consistent. They start with their own capital. They occasionally bring in a partner or two. It could be family, it could be friends, and they grow and validate their concept and that usually can be 2 million or it can be 5 million. It can be 10 million of revenue at some point the customer speaks. And at that point, the company may grow beyond the pocketbook of the owner. So, then what do you do? You end up looking around and oftentimes a bank comes in. And we don’t have to tell you that the banks are quite conservative relative to what an entrepreneurial capital need would be.
So, the bank only gets you so far as well. So, we typically see a company that’s getting to 10 million or 20 million of revenue and profits are growing but they’re not enough to fund a growing business. And the bank is limited based on their accredited and growing guideline. So, you have to look outside. Oftentimes, these guys are on the hook for personal guarantees. Their home is on the line. A whole host of different things can tie you up and actually make you more conservative as a business person. So, what happens is you end up with – actually you grow slower because you don’t want to lose your house. It’s much easier not to add another few people than to add another few people and risk growing payroll.
[00:10:06] Andrew: Do you see that then in most of the infancy that the beginning stages of the businesses that most of it is tied to for the entrepreneur, the personal guarantee? You’re going to have some collateral whether it be personal or on the business assets.
[00:10:18] Kevin: That’s a big part of it but not the only part of it. It can be just your bandwidth. You can only manage so many people. You can only develop talents and manage so many customer relationships. So, a lot of it is about having the courage to delegate. A lot of companies plateau and sometimes they plateau with just the founders, the driving forces. Sometimes they plateau with a small team, but they plateau, and you’ll see that in the numbers so that the growth will level off and they’ll have to create new engines for growth and that’s hard to do within a small company with limited resources. So, that’s also where private equity gets called in and can provide additional capital and human capital as well at the board level to help get new customers and grow to new markets and expand to an acquisition. There’s a whole host of things that you need to grow.
[00:11:10] Andrew: I think with entrepreneurs, a lot of us are really good in the beginning stages of a business when we’re running. It’s visionary. It’s getting what we fully believe in and getting that out to market. And then as you start having the success, what I’ve seen working with business owners as they get bigger and bigger is that the entrepreneur either has to make a conscious effort that they can’t do it all and they’re going to have to bring in people that they trust that maybe can run the business better and let them focus more on the grand door vision, but have you seen that the entrepreneur that doesn’t let go, is that where some of that stunting the growth happens because they’re still micromanaging and they’re not letting the right people come in and take it to the next level?
[00:11:55] Kevin: Yeah. Those are pretty common problems, and not always intentional by the way. A lot of people try to hire and try to grow and even in the best of circumstances, you’ll get a 50% success rate. It’s really, really hard to get the right people, the right talent, the right culture, the right fit. So, that’s another way that a good board and a good private equity sponsor can help minimize or maximize the chance of a good hire and minimize the chance of a bad hire. But you’re right, there are cultures of which the founder then sort of becomes the sole decision-maker. And it’s very, very hard to attract talent then and it’s very hard to create an environment for growth because they’re literally controlling every decision. That’s a tough situation then because as one of my entrepreneurs called it, “That’s when you created a cult, not a culture.” And you have to be real careful with that.
[00:12:46] Andrew: When we look at the term “angel investors” that a lot of the listeners out there maybe have gone down that path, some have just heard of the term, but what does that actually mean for a business owner? What type of investor is that in it? What stage of the game would we look at bringing on maybe an angel investor?
[00:13:04] Kevin: Well, it’s interesting. It’s always an interesting name, angel groups, angel investor, and I think they’ve acquired their own legitimate definition, but I think what started because they wanted to make rich people feel good because it’s like, “Oh, I’m an angel.” I would argue that it’s just any high net worth individual that whether it’s you loaning $100,000 to your nephew to start a Denny’s or a McDonald’s or it’s something else, it can be $5,000 for your college graduate to start a side business because this whole thing about putting something online that resonates with you, but it’s almost like pre-venture capital. It’s before even an institution can get comfortable. An Angelist is taking a much larger risk. Oftentimes, they’re successful in the [inaudible] and yet they don’t want to sell. And a lot of people think, “Oh gee, I have to sell,” but that’s not the case. There’s a lot of structures. Particularly, we’ve begun to specialize in structures where the owner can take half their money off the table and then keep earning the company and double, triple, quadruple, or more the other half.
So, they kind of have their cake and eat it too and a lot of them drives them to that decision as the desire to save for their kids’ education or buy a house or help their sons start a new business or help their daughter start a new business, and it can be anything in life that causes them to take a deep breath and reconsider. It could be health issues. It could be family issues. They’re saying, “Boy, I don’t want to sell but I need some chips off the table that help me sleep at night and take my personal guarantee off, and know that I’ve got someone to talk to but how do I do that if I don’t want to sell?” And then that’s really where we come in. That’s where a process usually starts, a small process where they begin talking to us or maybe a couple of people like us to see if there’s a way they can structure a tailored solution to meet all of those needs.
[00:15:02] Kevin: And because we’re structured as a family office, more so than an institution, we can do that. We can tailor part debt, part equity. We can stretch it out 5 or 10 years. There’s a lot of different things you can do as a private equity investor when you’re focused on the entrepreneur and you’re not hamstrung by traditional 10-year blind pool fund structures.
[00:15:23] Andrew: Right. And I think there’s an emotional side to this too where the business owner or the entrepreneur, they’ve been running, they’ve been going, they’ve been building, they own 100%, and letting go of that is an emotional side that you have to deal with. But in anything when we’re properly planning to have that diversification, to have not only the ability to take some chips off the table but now I have a partnership of being able to have outside counsel to help grow, it’s one of those areas that I think any entrepreneur should strive for. And your business is as good as it is today, but we just don’t know where it will be in three years, in five years, in ten years. What if the industry changes at your end, if there’s tax loss that change, if there’s another recession, if there are things that are out of your control, if you have the opportunity to diversify and take some risk off of your shoulders? I think it’s definitely something that you should look at and make that conscious decision that you’re okay with only a little bit less. Sleep well at night we call it. Right, Kevin?
[00:16:25] Kevin: Yeah. And a partnership is a good thing in many respects in ways that entrepreneur can’t even envision. A lot of our founders breathe a big sigh of relief after closing when they find out they have a board to talk to. They’ve got millions of dollars in the bank. They’ve got even more upside in front of them. And then when something complicated, an issue arises that they used to have to deal on their own, now they’ve got two or three smart people on their side to talk about it with and to solve. It’s a big relief for most entrepreneurs.
[00:16:55] Andrew: Yep. I definitely agree.
[00:16:57] Kevin: The angel investor is really pre-venture capital. It’s one of those categories which is ill-defined. It can be your rich uncle. It can be a friend. It can be anyone who is willing to take a far greater risk than a traditional institution. And some angel networks are pretty well formed. In certain cities, they’ve got seasoned executives that are helping little companies grow, helping them get started. It’s a very undefined area but it’s actually pretty valuable for certain companies particularly in the technology field. I generally see angel capital as really friends and relatives in the kind of businesses that I see, but if it’s a formal angel network, you can get a lot more than just money in those networks.
[00:17:41] Andrew: When you think about an angel investor then, I wouldn’t call it necessarily all dumb money, right? But is it usually where you, guys, is private equity or venture capital take a hands-on approach, what kind of approach does an angel investor take with helping to shape the business if anything?
[00:17:57] Kevin: They can take anything from an executive in residence role when they actually sit in the company’s headquarters and actually perform part-time executive duties which I’ve seen before to just literally be available for a phone call once a month, and the angels generally size their involvement to the needs of the company, ideally.
[00:18:16] Andrew: And so, when we look at the percentage of success on the initial stage in angel investors, percentage-wise, what would you say if I’m an angel investor, what’s the percentage of me actually getting a return on my money with the business in its infancy?
[00:18:32] Kevin: Yeah. Very hard to say and then oftentimes it takes five or ten years to find out. But I’ve heard one angel group locally has made 24 investments and one or two might work out. And those are pretty well vetted. Those are out of probably hundreds that they review.
[00:18:51] Andrew: And so, on the angel investor side, you’re looking at businesses that are, they’re not mature, the revenues are probably – is it more like a startup then in the case of where an angel investor would come into play?
[00:19:05] Kevin: Oh yeah, the startup or less than a million in revenue.
[00:19:07] Andrew: Okay. So, if I’m a business and I’m out there and I look at, “Okay, I’ve got this idea. I need capital,” I really have two routes to go. The debt side which is try to go deal with the banks whether it be the large banks or the local banks and/or the private investor, the family, and their friends. Would you say that’s really the two main outlets for a business that’s starting up that doesn’t maybe have their track record, etcetera?
[00:19:30] Kevin: Yes, based on what I’ve seen but I would argue that the most important capital component is the labor of the founder, the labor of the entrepreneur who’s generally working for free. It’s their passion, their vision that really drives the first year or two of the business and determines whether they’re going to be able to attract outside capital.
[00:19:48] Andrew: Working for free, I like that. I mean, it’s like if you think about the hours that an entrepreneur puts in, even if they’re showing some net income, at the end of the day they’re probably working for less than minimum wage, if not making anything. So, I thought that’s an interesting point there of working for free. And sometimes you look at your employees and they don’t realize how much work goes in and the risk that an entrepreneur is taking and it’s one of those that until they’re in that position, I don’t think an actual employee is going to know the type of pressure and the hats in all of the different fundamentals that the entrepreneur has. And that’s something that I don’t think any book or anything you can find that from that. It’s actually the experience itself.
[00:20:29] Kevin: Well, yeah, it depends on the employee but certainly, they all have an awareness when it comes to a young company that they’re taking a risk and some people that have vibrant careers elsewhere could probably go anywhere but they take that risk because they think there’s value in the equity that there’s some potential equity participation going forward. And if you join a little company called Facebook or Google, it can pay off great but if you picked the wrong one, you can end up with nothing. So, the employee is taking a risk often as well and oftentimes they’re taking cuts in salary to go there.
[00:21:03] Andrew: Right. With the potential of that home run or that lottery type of award.
[00:21:08] Kevin: Correct.
[00:21:08] Andrew: So, we’re not going to give tax advice here at all but when you think of the formation of a company, a lot of times it’s the initial entrepreneur. He started either as a sole proprietorship or is incorporating as an LLC. But if you were to talk to the business owner that had the growth mindset, the grand door vision to build this thing to get to the point of the 10 million in revenue then the 20 and up to 50 and 100, do you see companies building the structure differently than those that are more of a lifestyle practice in how they form the company?
[00:21:41] Kevin: It all depends. Most of the companies we see are sub-S or LLC and there are some real restrictions on sub-Ss but the LLC is a very flexible structure. We invest through LLCs, C-Corps and, obviously, for profitable companies, that’s the most efficient way to go. So, I think that you have to look at each company individually and we’ve actually invested companies that had subsidiaries that were all three, LLC, sub-S and C-Corp and we’ve combined them in a creative way to maximize or optimize the tax situation for the founders.
[00:22:17] Andrew: And where your value also comes in is S. We don’t know where tax reform is going at this point, obviously. It’s going to be a battle and until the end of the day, until it’s figured out, we, on our financial planning side and our tax side, we’re telling clients, “Hey, let’s not even focus on anything right now. Let’s let things shake out.” But if and when they do make some changes, will you go into the companies that you invest in, that you’ve partnered in, do you guys come in and take a high-level view? And will you change some structuring based on if Congress is able to get some things pushed through?
[00:22:50] Kevin: I don’t think we’re going to be doing a lot of changes. There may be one or two small changes we would make but LLC pass-through entities are pretty flexible and will accommodate any tax regime that comes down the road. A lot of the drivers for our company’s success is the growth and the human capital that we can attract, and a tax law change generally doesn’t change the prospects of the business. It may change some things that we do in the future but right now there’s very little we’re going to do retroactively because we’ve got a pretty flexible structure, to begin with.
[00:23:28] Andrew: So, you would say when you look at the success of a company, the human capital, because you hit on that a couple of times, that is the human capital of the company is something that really helps separate companies that make it and those that don’t?
[00:23:41] Kevin: Oh, that’s no question. The common phrase you’ll hear from private equity investors is rather have a B company with an A management team than an A company with a B management team. So, investors focus on people and they are the drivers of value and the culture that they develop and the culture they attract, and we’ve had a lot of experience over 25 years, and we’ve been fortunate enough in most cases to pick industry leaders and they become what we call the talent magnets. So, they can attract tremendous talent that even the larger companies couldn’t attract. That’s been a differentiator for us in almost every investment.
[00:24:21] Andrew: So, when you look at the deals that you’ve done over the years, what are some of the things that Cave Creek Capital management looks for when you’re kicking the tires and deciding if you want to go on this venture with this firm whether it be short-term or longer-term? Talk us through some of the key points in what you and other private equity firms look for as an investment strategy.
[00:24:43] Kevin: Boy, that’s an hour-long discussion right there but let me boil it down to maybe some of the handful of key points. I think we look at, obviously, the talent management which we’ve talked about before, the quality, and their ability to grow the company and attract other similarly talented people. We look at the overall market and what is the competitive environment. You want to pick areas that have a competitive advantage or the company that you’re investing in or at least some barriers to entry. And generally, when we’ve looked around, people in the past have said, “Boy, how do you invest in an executive office suite? How do you invest in candy distribution? There are no barriers to entry.” Well, if you look hard enough and you really dive into businesses like that, you find that they do a hundred little things right. So, the barriers, the things that we look at is a market where for a middle-market investor like us, the $20 million to $100 million company can be a leader. Those are generally pretty fragmented markets. They’re smaller, markets in the US that are not attracting huge competitors that have significant cost advantages.
So, we found that, for instance, companies like the candy distributor, they do a hundred little things right and then they become a cost leader. Nobody could do things more efficiently in that market than we did that we saw in Liberty Distribution which was one of our investments about eight years ago. Similarly, in the culture that was formed in HQ Office Suites, we found that they were attracting the very best managers. This is going back 15 years ago where the industry began to consolidate, and better centers were attracting the better managers and they were keeping clients longer and servicing them better and getting better margins. So, the reputation of somebody in the market as a talent magnet becomes a critical competitive advantage and we’ve done that in many cases.
[00:26:36] Andrew: When you look at HQ and they were able to attract the talent and keep it, what do you think they did differently than other firms in other industries to keep that talent?
[00:26:47] Kevin: Well, they kind of redefined the business and this is a lot of the theme of our investing is we like businesses that did exist 20 years ago, and executive office suites essentially didn’t exist 20 years before we had done that deal. They were temporary office space and they sort of recruited somebody, an office administrator from somewhere to just keep track of the offices, and maybe do some of the administrative work. And what HQ did under their chairman, David Viel at the time was go out and over-hire. They would buy tremendous benefits by paying an extra 20% or 50% or creating a commission system for the manager to be rewarded by keeping clients longer and adding revenues and services. So, if you look at that, they changed the rules of the game. They were hiring out of the Marriott Management Training Program. They were hiring serious people with serious backgrounds and they were in some cases doubling the revenue of the centers after they bought them by filling them up and creating more services. That was just something people have never done before. They didn’t think about it. So, by being first and building that reputation, they became the leader.
[00:27:57] Andrew: And like a company like that, this is years ago when you, guys, put in the capital but is a company like that looking through you or are you looking for these companies to invest in?
[00:28:09] Kevin: It’s really both ways. And this, again, goes back to the two-way street. Today there are ten times more investors calling companies than there used to be, but I liken it to what Monster.com and LinkedIn have done to the job market. Employers, like companies, can get thousands of resumes and it’s harder than ever. Back when you had to mail it, lick the stamp and send it in, you got 10 or 20 resumes. It was easy to sort. How does a company sort through 100 or 500 options? That’s what the capital markets have become like in private equity. They’re almost impossible to really distinguish. And so, what’s happened is you got to have a much more sophisticated way of determining what the capital leads are on both sides, both the company and the provider.
In the case of HQ, they were initially coming to us through referral from Goldman Sachs that it was too small for the Goldman private equity effort and that they were looking for I think $3 million, and we convinced them they might need $5 million. And then it became $8 million and then we started talking about the opportunities to consolidate the industry and they had not thought about that before. And then turned out that as we were doing our due diligence, we found another company with 20 locations that needed to do something because one of the founders was looking to sell. So, we ended up going from 3 million to 5 million to 8 million to what ended up being about $32 million on the original closing and triple the size of the company from what they had even envisioned themselves. So, that dialogue traded a wider mindset that we call it our supercharged model and it turned out to be more than supercharged. They went on to complete over $150 million of acquisitions, closing one every month for 36 months and then ended up recapitalizing and selling in a transaction with the Blackstone base company about four years later.
[00:30:07] Andrew: And then with that, you guys exited out of it at that point?
[00:30:10] Kevin: We exited out of about 70% of our shares and left in about 25% to 30%. I don’t recall the exact split, but the majority of the dollars were returned, and it represented almost an eight-fold return in our capital.
[00:30:25] Andrew: You know, you look back at how they went from point A to Z. They were doing something right without you but the guidance that your firm and as a partner that came to the table, I would assume that that helped shape their vision and gave them the confidence and the wherewithal to say, “Okay, we can do this,” and then having that team approach really allowed everyone to set these goals and then to take it to the next level and bring the right people in. And that’s something that companies can’t do on their own. The banks aren’t going to do that for you, right? The banks are not going to be your partner. That’s where the private equity comes into play and getting into bed with both sides. I think one of the things that you probably have to look at is, beyond the numbers, it’s do we like this management team? Do we want to work with them?
[00:31:10] Kevin: And that’s exactly correct. It was a good chemistry, good board, terrific investment group, and things just worked well in that team, and it enabled them to become the leader in the industry quite rapidly. But before we pat ourselves on the back too much, they had to fight off a lot of competition. Within 18 months, there were a number of copycats and the industry consolidation accelerated. Valuations increased. So, you can become a victim of your own success particularly if you don’t move to clean up, to capitalize on it, and that capital partner can get you there a lot faster. And then that itself creates its own competitive advantages.
[00:31:48] Andrew: You know, when you look at businesses, you have lifestyle versus growth. I see on our side, a lot of businesses that the owner is not putting the profits or the income that they’re accruing. They’re not putting it back into the business. They’re filling their own pockets and right, wrong, or different, it may not be the wrong thing but by doing that, would you say that stunts their growth potential by taking too much out of the business too soon?
[00:32:15] Kevin: Sometimes. Not always. Depends on what the requirements of the business are. In the restaurant business, you’re constantly renovating and building new restaurants and that requires higher capital expenditures to grow. In some things like human processing, we’ve looked at that where it’s very limited capital expenditures or the capital reinvested back in the company goes to originating more customers. And so, it’s a different kind of capital expenditure and a different kind of need. So, I think you have to look at each business differently.
[00:32:44] Andrew: You guys don’t pigeonhole as one sector. You’re going to look at all businesses and if it fits in with your models and the numbers work, and you like working with the management team, is that something that – or let me rephrase that question. Does Cave Creek do what you guys do? Is it just focus on a certain number of industries or are you open to any business and any industry that you think has the aspects of what would make a successful company for the long-term?
[00:33:11] Kevin: Well, it has to tie to one of our partners or CEOs experience base. If you look at the 30-odd platform companies, they cover a gamut from consumer to business services to manufacturing. But there are certain areas we bring a lot of value because we don’t have a deep experience base or a bench of former executives in that area to serve on board or help us to do due diligence. So, we’ll tend to focus on those sectors where we have that experience base.
So, in things like financial services or payment processing, we’ve got a very strong executive group in consumer and restaurant. We happen to have a very strong group of executives in things like distribution and logistics, route-based services. We have a really strong executive. So, we can usually find out of our 50 odd executives who can service our CEO network, somebody who’s got relevant experience in the majority of deals that come over the transit. But then you have to dive in and see how much that helps you and whether they think that that particular company is going to be a winner in that industry. So, we’ll probably end up looking at for every 100 deals, we might focus on five or ten that have high potential for success. And that’s where our background with our team and with our CEOs helps us.
[00:34:27] Andrew: When you look at the industry from your side over the last two decades, the evolution, and you had mentioned earlier that more and more companies are staying private, a lot of the rules, regulation, bureaucracy has shifted it from, “Hey, we’re going to go public so let’s keep it private.” And with that, the competition is there just, what, five, six years ago. We didn’t really have a secondary market for individuals that were credited to go out there and get into these companies at the initial stages. And that evolution itself, I’m sure, makes your job even harder because you’ve got a lot of people out there they’re just throwing money around that don’t really know what they’re doing and they’re not going to help guide the company. It’s more of utilizing the internal basics of keeping that public market out of it and allowing only a set number of people to get in and invest. Where do you see the evolution of things going over the next decade in regard to your business?
[00:35:24] Kevin: Well, it’s interesting because you’ve got two forces pulling at you. What you said is the huge increase in the number of investors has created a lot of investor groups or even individual investors that are trying to invest in areas they just don’t know. And as people reach for yield and reach for return and their capital greatly outstrips the supply of deals, we see a lot of what I would call illogical investments where the downside is huge and upside isn’t that great. But that’s the function of where we are in the capital markets today and in terms of the oversupply of capital. So, then that gets to what it takes to make a quality investment or quality company and a lot of institutions have developed a real strong background in the industry. So, the really, really strong private equity firms have industry verticals where they invest a great deal of time and energy with executive roundtables and partners with deep experience in those industries whether it be chemicals or whether it be restaurants.
All areas that require a good expertise, they’re actually burrowing deeper and deeper into that industry and focusing more and more and specializing more and more. And the only issue there is you can know an industry real well but very few have a breadth of an industry group that gives you diversity in your portfolio. So, it’s up to the individual investor or the pension fund that sort of pick their own sort of group of managers that can access a diversion of group of businesses. And this goes on to the whole economy with what’s happening is the growth segments are narrowing. So, there’s a lot of companies that you can invest in that won’t grow much. And there’s a really small number of companies that are really growing rapidly but you’re overpaying wildly for those if you get anything wrong. So, if you’re getting double-digit growth but they’re charging you double-digit multiples, you can’t be wrong. So, it’s creating a lot of pressure on the industry to do due diligence.
[00:37:22] Kevin: It’s actually increasing deal mortality, so you sign up for a deal and due diligence goes slightly wrong, the deal has collapsed. So, we’re seeing a very high percentage of deals that get started and that don’t get finished because it’s the pressure on companies to achieve perfection in their growth plan.
[00:37:42] Andrew: Right. You see this in the last eight, nine years since the great recession. I mean, we’re just awash with capital. There’s just money that is out there that needs to be put to work. So, you had talked earlier about you got this segment of people that are investing that really don’t know the industry and I guess I would liken it to the amateur coming into the poker table in Vegas with the professionals and those guys looking their chop saying, “We’re going to take advantage of this person.”
So, I’m sure that more of that probably happens on the angel investor side but even in your business as you’re getting a lot of people into the private equity to venture capital business that maybe doesn’t have the experience and the expertise but they’ve got the capital, they’re going to have a hard time making things work especially when things start shifting with the economy itself with this expansion as one of the longest we’ve had in our history and at some point it’s good to shift. And it’s who can pivot and who’s built the structure in place to be able to weather the storm. But when things are good, people forget that they actually they can go sour and that’s where probably people that know what they’re doing and firms that know what they’re doing, that’s where you guys can shine.
[00:38:51] Kevin: Well, we like to think so and we’ve slowed our investment pace the last few years as that occurred but obviously, you can work around that. If you have a proprietary introduction to a company that wants a highly structured transaction that doesn’t really want to sell, they just want to sell part of their company and get some liquidity so they’re not trying to auction the company and then go away to the beach. I think those are the kind of companies that may not be quite as frothy of evaluation. Everything’s going to be a full evaluation today but those are going to be less frothy and less prone to risk of loss in an auction. So, but I would agree that there’s a little bit of the poker table analogy as to where, “Oh gee, if I know who the sucker is, it’s me.” And that’s what everyone says in their auction. These investment bankers know that this over time doubles. They’re like, “Oh gee, you won this auction,” and then this private equity friend of mine goes, “Oh my God, I won. What did I do wrong?” Because I just outbid a lot of other smart people who bid less than I did.
So, there’s a real fear factor of screwing up and I can give you my 25-year perspective on evaluations and why people did what they do but the story you hear a lot is that these large funds have to put the money to work. They have three to five years so they’re just shoveling it out the door even if they know they’re going to make not such a great turn and they’re taking more risk than they would like because if they don’t use it, they lose it and that’s a real factor in our industry right now.
[00:40:22] Andrew: And where do you think where the industry is right now? Or just the economic factors both US and globally, where are you in that mindset of where we are in the stages of the cycle?
[00:40:33] Kevin: Well, we’re certainly late in the cycle, maybe later than late. I would say that it’s not quite 2007 housing market, but I often think so. If interest rates go up just one or two percentage points, you’re going to have a very difficult time for a number of these leveraged transactions that we’re doing in the double digits. So, the company’s growth rates will not rate in some cases. They were okay, and they had to grow out of their debt but if you suddenly layer on another couple hundred basis points on the interest front, you’re going to see a lot of trouble. And so, we try to keep our leverage down and evaluations down in the single digits and even then, it’s hard. Even then, you’ve got battles, customers, competitors but you layer on financial risk with operating risk, with competitive risk. I think that’s too much risk and I think we’re going to find out in the future, maybe sooner rather than later, where the problems were. And as Warren Buffet said, “Who is swimming without a bathing suit and the tide goes out, you find out.”
[00:41:40] Andrew: Right. I love it. I mean, you said you guys are not using leverage to that extent but are you seeing now more and more of the deals out there that are being done? Are they using more leverage than we’ve seen in the past to get to some of those levels there that if anything happens wrong that they’re just not going to be able to repay their debt?
[00:42:00] Kevin: Well, yes, but there’s a number of caveats to that. There’s a lot of leverage out there and what’s happened, essentially, the lenders at that high-end have become pretty sophisticated so they’re happy taking over a company if something goes wrong. So essentially, it’s just you have what I would call an uncertain ownership structure. If you get into a deal, you sell it 12 times, you leverage six times, put six times in which in private equity world we consider a reasonable leverage. But if anything goes wrong, the people that own the debt could easily step in and use their covenant structure to what they would do what they call loan to own and that’s become pretty popular. These aggressive lenders will lend aggressively but they’ll have triggers and structural benefits to make sure that they get their money back even if it means crushing the shareholders. I’m not making a value judgment but that’s the market. That’s the way. You’re going to take that risk, that’s the downside.
[00:43:04] Andrew: I’m sure a lot of business owners, sometimes maybe don’t even realize what they’re getting into in that scope especially if they’re working with some firms that are more aggressive and maybe don’t fully understand the realm of that deal and how it can come back to take everything that they’ve worked so hard for.
[00:43:22] Kevin: Yeah. I mean, I think you’re correct. There is a lot of downside to excessive leverage. I would stress though that the majority of what I call middle-market buy out groups in the smaller end where we occupy are really focusing on partnership, focusing on growth, and if they run the bumps they’re very, very good to work with. There’s not an issue of taking control or anything of that nature. There’s a group of what I would call hard-core distressed investors. They get a lot of the headlines like Cerberus, but the reality is most people don’t want to take over a company. Most people want to let the management team work it out and it’s hard. They know it’s hard and they want to support your team.
The only time in, gosh, 25 plus years in investing and working on these deals where I’ve seen an actual management replacement in our group is for those in fraud that you had to move some things around. But where there’s just real negligence or fraud that is unmistakable, that’s when you’ll see, that’s when they exercise their rights. But again, I like to focus on the growth because the majority of these companies are growing and it’s good enough to make the cut and they’re in the top 10% of companies in that category. You’re going to likely see them be successful. The majority of the companies are very strong and that’s why the private equity market exist. So, we know the winners from the losers in this market.
[00:44:57] Andrew: And when you go into a deal and you’re weighing things out, is there an optimal time that you want to be in that deal as the investor and capital and the guidance?
[00:45:07] Kevin: Those used to be an estimate of five years because that was very commonly embedded in the pension fund documents backing most of the private equity firms. But the reality is now that that period is stretching out and it’s one of the reasons that we believe that the traditional 10-year blind pool fund is breaking down as a structure that’s useful to entrepreneurs where you have to be in and out in five years. You have to raise your next fund in five to seven years. You’re constantly pushed to accelerate the velocity of money regardless of what the needs of the portfolio companies are.
So, we’re seeing more and more changes to private equity firms that I think are beneficial to the entrepreneur. They’re stretching out investment horizons. They’re lowering the fees. They’re creating more accountability, in most cases, in the private equity investor. So, the entrepreneurial environment I think is much more likely to thrive in an environment where you’re not forced to sell every five years. And that’s a big pitch for us. Because most of our capital is personal capital from ourselves and our CEOs, we don’t have to sell at a particular time and founders love the fact that we don’t have to flip, and we can hold one company for 10 years. We’re still holding. So, we’re not there to push out returns so we can raise a giant fund. We’re there to grow our capital while that capital is our personal capital.
[00:46:33] Andrew: And you think about private equity and I know it’s come a long way, but you think back to the 80s and 90s, the Liar’s Poker, and all the negative press and I’m sure that’s still something that you have to compete with of why we’re not like that and that transparency, and maybe the fee compression. It’s probably a good thing for you that it helps to shape the industry of what you guys really do versus the private equity that’s coming in like the vampire and just trying to get everything out of that company and then move on to the next one.
[00:47:05] Kevin: Oh yeah. We’ve got a long way to go to repair our public reputation as an industry. Some of that was justified and I think a lot of these issues really surface to when the industry mushroomed in size and hear stories about the $5 million birthday parties and the multimillion-dollar paydays despite no good returns. It’s obviously gotten a lot of negative press. Those are unjustified as well, but the structure of the industry is creating I think a better environment today for entrepreneurs as they’ve adapted to these changes. But, boy, ever since the Mitt Romney run in 2012 where they dredged up all these stories, a lot of which are actually fictitious, they were taking and misconstruing some issues that created in my view a very distorted picture.
There was much of more good news that could’ve come out of that and the industry has done a poor job of describing how it adds value in the public press, but I can tell you that this has gotten bigger. It’s real hard to stay entrepreneurial. And that’s a choice every fund makes. We’ve made the choice to stay under $100 million transaction size for most of our deals but the industry’s gotten to a point at $2 trillion or $3 trillion that they are focusing on much larger deals. 93% of all private equity is now managed in billion-dollar funds and bigger. So, culturally, it’s changing just due to size.
[00:48:35] Andrew: And you know, trying to change that image and so forth is I look to, I wanted to talk to you a little bit about the show that you have coming out. So, you’ve got just like I do the podcast, we wanted to disseminate good information out there to listeners that are growth-focused and wanting to build the right practice. So, walk us through why you’re starting the radio show, Cracking the Private Equity Code, what it entails and how we, as the listeners, can tune into it?
[00:49:05] Kevin: Sure. I was approached by a network to start a show on private equity because, shockingly enough, there is no show on private equity. You look at the news media, there are tons of shows on everything from real estate to public stock investing and there’s nothing in private equity. So, I thought it be kind of intriguing to do that. And so, we started just beginning our recording last week. It’s every Wednesday at 10 AM on Voice of America. And what we do is interview entrepreneurs who want to raise capital or who did raise capital and hear their story, hear why they were successful. And I think one of the things that caused me to say yes when they approached me was just the amazing amount of misinformation that’s in the private equity market. People were given wildly different stories about what their company was worth or what they had to do to get capital or what their bank was going to force them to do.
And I was surprised that here we had multitrillion-dollar market globally and yet the owner of a $50 million or $100 million business was not getting any guidance, any objective sense of what structure in terms would be. Some of the investment bankers were very good and some of them were not so good. In fact, some of them weren’t even investment bankers but reported to be and were happy to deliver advice at the country club to these business owners. And so, they were coming in with just amazing amounts of misinformation about what you should do with your company or what was required to get a bank loan or things that in my view are vital if you’re going to succeed as a business. So, I thought this would be a good forum to begin a discussion of what is it that takes to be a successful company backed by private equity.
[00:50:58] Kevin: So, our first episode next week is our private equity do’s and don’ts and we’re hosting one of our mezzanine debt partners, C3 Capital, along with one of our collective investments. So, in their portfolio, they backed a very interesting fellow in the restaurant business in his new venture. His name was Jeff Mastro who founded the original Mastro’s chain here in Arizona. So, I’m excited to talk to people who have been successful and are doing it again and it’s a lot of fun to hear their story.
[00:51:30] Andrew: Yeah. I think hearing the stories of those that have made it and those that maybe had some struggles, same thing on our podcast here bringing people in that are great at what they do and learning from them and I think you’ll learn a lot as well bringing these people on. So, we can listen to it. It’s going to be on Voice of America. If I’m a listener, how will I get to tune into this? Is it only a live show or is it also going to be recorded and I can hear it after you have the interviews?
[00:51:57] Kevin: Oh, it’ll be both. It’s going to be live and recorded but it will air in the business channel, VoiceofAmerica.com, 10 a.m. every Wednesday, so starting next week.
[00:52:08] Andrew: Awesome. Yeah. I’m very eager to hear your interview with Jeff Mastro. I mean, those that are out here in Scottsdale in Phoenix, it’s been a staple out here of how they’ve grown that company, how they sold it, and then it sounds like reinventing after time to take what he did really well and to do it again.
[00:52:26] Kevin: Yeah. We’re excited. And each week it’ll feature a different entrepreneur, and some will be pretty, and some won’t be so pretty. So, we’ll see where it goes.
[00:52:36] Andrew: I like the non-pretty. Those are some of the best for us to learn why it failed. So, in the show notes, listeners, we’re going to have on there the way for you to be able to listen to Kevin’s show, Cracking The Private Equity Code, as well as a way to get a hold of Cave Creek Capital if you have questions in regards to the business structure, some of long-term goals, investment options, those type of things that Kevin and his team can definitely help with and see if it’s potentially a fit to guide you or at least through your network of relationships throughout the country to be able to position you to somebody that may be more beneficial in that relationship.
So, I think, Kevin, we could be a three-hour show here digging in. We can dig on what mezzanine debt is and get in really to the weeds in all kinds of stuff, but I think we covered a lot on the high-level today of what different businesses look like in the stages and how the funding works and really what a private equity firm and venture capital can do to not just raise the money but to take your business to the next level. So overall, businesses and some of you may be in that early stage and some on the late stage, the key is just to understand what your goals are. And as Kevin mentioned, align yourself and make sure that you have the right talent in-house and do everything you can as a culture to keep those individuals whether that be through the work culture or providing on top of that, awards, bonuses, compensation that’s going to allow you to keep those that are going to help you get to the next level. As business owners, you want 100% great but what if you owned a little less, and you had the right people to help take you to that next level? To me, I think that’s the way to go.
[00:54:20] Kevin: Well, great. Thank you, Andrew, and I appreciate the opportunity to talk to you.
[00:54:21] Andrew: Kevin, it’s been great. Looking forward to catching up soon. Have a wonderful day and tune in later this month for another episode of Your Wealth & Beyond. Have a great day, listeners.
Thank you for joining me for today’s episode of Your Wealth & Beyond. To get access to all the resources mentioned during today’s podcast, please visit Bayntree.com/Podcast, and be sure to tune in later this month for another episode of Your Wealth & Beyond.
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