In this episode, I continue to pull on one of the most interesting threads that I have uncovered in the course of producing this podcast: the world of permanent equity.
My guests today are Royce Yudkoff and Rick Ruback, two Harvard Business School professors who have partnered to create a popular class that teaches students how to search for, acquire, and run a small business directly after graduation. The course is aimed at students who want hands-on, management experience as soon as possible. After purchase, there is no timetable for selling the business. Indeed, if done well, there is never any reason to sell because the free cash flow yields to owners are higher than most alternatives.
I approach this conversation from an investors standpoint. LP investors usually partner with these searchers to form what is called a search fund. A search fund allows recent MBA grads to spend time looking for a business and ultimately acquire it. The result is a small-scale but often high return proposition for investors.
I loved our discussion of what to look for in a business and what to avoid. The principles we list are useful for investors of any kind, and will particularly appeal to those from the buy and hold, value investing, and quality investing camps.
One point of note which wasn’t captured during the recording. One of the reasons this style of investing isn’t more well known that it is extremely costly upfront. It can take years to find a company, and once found, the transaction costs can be 20% of the total purchase price. Rick calls this category “REALLY private equity”
If you enjoy this conversation, be sure to check our Royce and Rick’s book. HBR Guide to Buying a Small Business, which goes into many of the topics we cover in even greater detail.
3:11 – (first question) – Explain the idea of a search fund and why recent MBA grads and LP investors would be interested.
5:26 – A look at the folks that tend to be most active in this space
7:53 – What is the scale of people involved in this
9:55 – Why it tends to remain among smaller investors and not attract larger hedge funds
10:57 – Is there any collectivization happening that are trying to muscle in
12:31 – With a good example, they walk through the process of going through this
15:40 – Exploring the time horizon in these deals
17:41 – Getting into the idea of risk to these businesses
22:36 – The characteristics that people should screen for in these businesses
23:51 – Recurring customer bases
28:36 – Low cyclicality
30:04 – Low customer concentration (supplier concentration as well)
31:46 – Good free cash flow characteristics
32:05 – One that can be transferred away from the selling owner
34:04 – Recurring revenues vs repeating revenues
35:18 – What percentages of business hit these marks and qualify as good enough to be invested in
37:52 – The Castronics example and why you don’t want to be the most important provider to a large customer
42:15 – Looking at the entrepreneurs who get excited about this
44:15 – What are some red flags that you don’t like to see in these types of businesses
45:14 – Technology companies
45:55 – Companies that have stroke of pen risk
47:05 – Lifestyle businesses
48:23 – Why growth is not a massive priority in this arena
51:27 – What financing for these types of businesses is like
54:03 – SBA 7A financing
54:48 – How do you get involved in this if you have a check you want to write
58:58 – What is the incentive structure for someone running a searcher firm
1:01:22 – What was right and wrong about the traditional private equity world?
1:02:38 – What business would they want to own in perpetuity
1:09:05 – A quick look at margins in this space
1:09:34 – Looking at the most memorable individual day for each guest
1:12:36 – Kindest thing anyone has ever done for you
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