The Secret to Making Money in ETA

Daniel Lazier of Skyline Crest Partners teamed up with Jacob Thomas and A.J. Wasserstein to produce an extraordinary paper seeking to shed light on the drivers of value creation in successfully exited search fund investments. Their data set is big — $4 billion in exited enterprise value, equaling 35% of all exited traditional search deals — and their math is deep and rigorous. My goal here is not to question or even comment on the analysis they have done, only to supplement it with my own personal observations and thoughts, for whatever that is worth. The punchline of their work is that multiple expansion drives 80% of the value creation, with revenue growth (and subsequent growth in absolute EBITDA) a mild positive, and EBITDA margin going down, a drag on returns. There are some non-obvious reasons for this data not covered in the study. I also have some further thoughts on what makes for extraordinary outcomes, way above the averages being discussed in this massive data set, since to make real money as searchers and search investors, my argument is that we all should increasingly focus on best practices rather than the mean data points as competition increases and dilutes average returns. Size matters For sure, as the authors point out, multiple expansions can be driven by a good exit auction with a banker and by an asset large enough to attract PE and strategic buyers. But in my opinion, multiple expansion is also an expression of the other factors, so it isn't possible to state that they are independent and ascribe separate attribution. Revenue growth, improved margin, and increased EBITDA all contribute directly to achieving a bigger multiple on exit. The scale of the business and the CEO and her team's ability to paint a pretty picture of future revenue, EBITDA, and margin improvements all also contribute to achieving maximum exit multiple. The exit multiple captures everything the search CEO has done right and is not some sleight-of-hand magic trick. "ETA CEOs shine as buyers and sellers and make less impact as operators," the most recent Yale study states flatly. I understand where this conclusion is coming from. Still, I bristle at it, as it greatly truncates the whole point of the exercise here, which, in my mind, is done by creating actual value: mentoring and developing great operators capable of compounding gains through strong leadership over long periods of time. "All of this makes sense because many ETA stars are former investment bankers and private equity alumni whose core skills are deal making rather than operations," feels like a slap in the face, reducing the effort here to day trading, which it most definitely is not. For sure, size matters, and a wider pool of buyers in a well-executed auction drives value, but, in my opinion, there is more to the raw data here than meets the eye. Some of that may be wishful thinking on my part. Still, below, I will expand anecdotally on what in my direct experience separates the truly successful search CEOs from the average. Eighty percent of the value of great ETA investments has nothing to do with the CEO being just a day trader flipping ETA assets, hoping for the best. The process is way deeper than that. Centrality of the strength of the relationship between the searcher and the seller. When discussing the cause of multiple expansion, the study focuses on the exit multiple but does not address the entry multiple, which is obviously equally important. In my experience, how well the searcher buys the asset plays a significant role in the ultimate return. Finding some way to buy a quality company at a discount to its market price creates embedded return day 1 before the ETA CEO has done anything, which will ultimately be realized on exit, no matter what else happens. As I have emphasized elsewhere, I believe that ETA is a people business, and nowhere is this truer than in the depth of the relationship between searcher and seller. The ideal scenario is that the search finds a bootstrapped asset whose seller has no succession plan, hasn't made a final decision to sell, but falls in love with the searcher. The best situations take months, and sometimes even years of painstaking work by the searcher to build trust until the seller views the searcher as the son or daughter they never had, and one they will entrust their baby, their company. The terms become secondary to the trust. And in a real way, the search is doing something meaningful and good for the owner in giving them an answer to a problem they knew in the back of their mind they had but couldn't face. I have seen this scenario play out most vividly in my work in Latin America, where deals take forever to close because the less developed capital market and M&A landscape requires increased education on the process. There is almost no competition and such deals have rarely been done. All of which is good for the searcher if you have the patience to get to the finish line, as the entry multiples are astonishingly low. But it takes a tremendous amount of blood, sweat, and tears. As well as true love, compassion, and patience for a seller making the most important financial decision of their lives. Why the margin goes down (and should go up) In almost every search deal, EBITDA margin goes down after acquisition. The whole point is buying an undermanaged asset with no professional team or infrastructure. These are companies run on a shoestring with no ability to scale and few, if any, modern systems in place. So, search CEOs bring their business school expertise, and hopefully a great mentor and even their experienced board, to build a team, build product and marketing, and scale the organization, all of which costs money. If done well, these investments pay off in terms of top-line growth and repeatable business processes to generate a scaling operation where even if margin isn't improving, greater revenue means greater absolute EBITDA and more shareholder value on exit because of the size of the business and the reward in some amount of multiple expansion for all the reasons mentioned above. My argument is that the sign of the great ETA CEO, and returns far above the mean, is those who complete the task and achieve the most challenging part: translate increased scale into increased margin. It's a different skill set, a different mindset, and often comes several years into the tenure as CEO. But it's where a good deal becomes a great deal. Because buyers will pay a dramatically higher multiple for a business with higher margins this piece of value creation is on top of all the other factors listed above. In fact, one of the biggest factors in the negative data on margin and search in general is a growing lack of patience. Lack of patience in building a deep relationship with the right buyer, and in fact, lack of patience in building CEO skills and holding onto the asset for long enough to maximize value. One large institutional investor, whose data is in the study, told me that they have seen average hold period drop from 7 years to 4, and that has had a dramatic impact on the ability of search CEOs to drive margin up in the out years and capture the resulting value creation. One situation I was involved in is a great example of what happens when everyone involved shows patience. We had significantly grown the business's revenue six years into the investment, but the company's margins were still in the teens. I kept pounding the table about the need to ring out efficiencies, but the CEO felt it was impossible. We saw a technological challenge on the horizon for our industry and felt we had to hit the exit, but wanted to take the time to do so correctly. We brought in an ex-CEO-turned-coach to help our CEO with operational improvements and to guide him through the exit process itself, the story for bankers, banker selection, and all that followed. Just before bringing in the coach, we had a reservation process in mind that would have been a good but not great outcome. Our coach helped our CEO restructure costs and increase margins to 30% by the end of 12 months. We achieved 3x our reservation price on exit. Sure, we did all the banker, buyer, story elements right. But what really drove the excess return was not just the raw increase in EBITDA, but the doubling of margin, which made it a far more attractive asset going forward, dramatically increasing the multiple buyers were willing to pay. What is the point? If the point of ETA is buying and selling assets perfectly, I believe we are missing the whole point of the exercise, the heart and soul of what I think is special and great here. It is not about a great trade; it's about great people. It's about building deep trust with a seller and providing them with a solution to their problem. It's about deep and productive relationships with investors and board members. It's about learning how to lead, build a team, and fundamentally operate a great business at scale that can grow top-line revenue and convert that to increased margin. This note is my attempt to convey my intuition about all this, my direct experience, and my desperate hope that there are drivers hidden beneath the surface of the Yale data that offer a deeper explanation about what is truly important in ETA value creation.