Money Talk

Episode 20

Private Equity Investments with Guest Thomas Bagley

Ed and Chuck interview the founder of Pfingsten Partners, Thomas Bagley.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Chuck LeFebvre: This is Chuck.

Ed Sutkowski: I’m Ed.

Chuck: Today we have a guest on the show.

Ed: We have Tom Bagley, founder of Pfingsten Partners. Tom, how are you?

Tom Bagley: Good morning. I’m great. Thank you.

Ed: Let’s hear a little bit about Tom Bagley, how this all began.

Tom: Okay. Tom Bagley grew up in Chicago. I went to undergraduate school at North Park University. I earned an undergraduate BA degree with a major in Economics. Then from there, I earned an MBA at DePaul University in Chicago where I picked up accounting and corporate finance disciplines. By way of professional background, the first portion of my career, I refer to as a 13-year apprenticeship with two large financial institutions. I spent nine years with what used to be Continental Bank in Chicago. I also worked for them for three years in Cleveland. After Continental, I spent four years with CitiCorp in Chicago where I ran a leveraged capital group that covered 12 states in the Midwest. After my 13-year apprenticeship, I actually wanted to own companies, not just finance them. I left CitiCorp to start what now has become Pfingsten Partners. I founded Pfingsten Partners in 1989. That’s what’s kept me busy over the last 30+ years.

Ed: Tom, going back to North Park, you graduated with honors, and you were also a three-sport captain. Wasn’t that true? Football, baseball, basketball?

Tom: I played four years of college football and started all four years. I also played basketball through college, but not on the college team. We had our own club team that we played. I played baseball in the city league throughout my college career as well.

Ed: Okay, now let’s get to the founding of Pfingsten. I understand why you wanted to do it, but remember, how did you raise the money? Let’s talk about the funds there. I understand there are five funds. Could you describe, first, what is a fund, and what does it do?

Tom: A fund is really a pool of capital. Really, what a private equity firm does, a private equity firm is really an asset manager that makes and manages investments for private company. In order to do that, you need access to capital, and you also need access to investment opportunities. The access to capital, you need to raise the capital, which is typically from a very high net worth individuals and families and institutions that invest in private equity. When you raise that capital from high net worth individuals and families and the institutions, we pull that capital into a fund, and that becomes the pool of capital that we use to acquire the operating companies that really make up our investment portfolio.

Chuck: It’s like a mutual fund except much more exclusive.

Tom: Yes, it’s an invitation only. We select the individuals and the families that invest with us, as well as the institutions. Then once we pull that capital, the fund is closed so we don’t accept new investments. It’s a little bit like a closed-end mutual fund. We use that capital to make the acquisitions. During the course for our ownership, we create value in those businesses. Eventually, monetize the investment by selling the company. The proceeds we get from the sale of the company return the capital and provide a return to the people that have actually entrusted us with their capital.

Chuck: One of the differences, I guess, was this the case in typically with all funds of this type? I know that sometimes that when you invest in one of these funds, that part of the deal is that you’ll put some initial capital in, but then you’re scheduled to have to make further contributions down the road. Is that normally the case? Is that just unusual, or does that happen based on what opportunities come up within that fund?

Tom: Normally, when you make a commitment to a private equity fund, it sets legally binding commitments. If I were to just pick a number, if somebody committed $10 million to our fund, they’re legally obligated to fund those capital calls up to $10 million. Not anything more than 10 million, and not anything less than 10 million, but they’re legally committed to invest $10 million in the fund when the capital is called. In addition to that, some of our limited partners or investment partners express interest in co-investment opportunities. If we have an opportunity that requires more capital than we’re comfortable putting in from the fund, we will open it up to our limited partners on a co-investment basis. That might be what you’re referring to, where they have an opportunity to invest more if they choose to.

Ed: Stepping back and concluding the history of things and to date, I understand you’ve raised about $1.3 billion?

Tom: Yes, that’s correct.

Ed: Purchased almost 140 companies, and revenue currently is $3.4 billion.

Tom: We’ve bought 140 companies, and that’s over a 30-year period that we’ve been in existence. If you added up the revenue for all the companies that we’ve acquired over that 30-year period and consolidated the revenue, it would be $3.4 billion.

Ed: Then Fund One was $26 million. Two, $100 million. Three, $285 million. Four, $525 million. Five, $382 million, to date. In other words, $1.3 billion. Not too bad for a guy starting out with a chair in Deerfield, Illinois. Is that fair, Tom?

Tom:  It’s been a good run, and it’s been a bit of a labor of love. We’ve had some great limited partners that have entrusted us with their capital over a 30-year period. As I said, it’s been a labor of love and a lot of fun, and it has worked out.

Ed: Tom, I understand you’ve learned to sleep standing up. Is that fair?

Tom: I learned to sleep fast.

Ed: You guys have offices in India, as well as in China, is that right?

Tom: That’s correct. Our main office is in Chicago. I would consider that the main office and the holding company. Then we have three offices outside of the US. One in China, which is in Shanghai, China, which if you’re familiar with China, is just outside of Shenzhen. Then we have two offices in India, one in New Delhi, and a second office in Chennai.

Ed: Tom, what are the return expectations for a private equity investment?

Tom: The gold standard for private equity is it’s measured two ways. The first way it gets measured is a cash-on-cash return of what you’ve invested in the fund. We refer to that as a net cash multiple. The net portion of that would be net of all fees expenses that get paid to the fund. It’s really a net return to the investors. The standard there is a 2X net return. If someone were to invest $10 million that I mentioned before, the expectation is that they would get $20 million back, which would be a 2X net cash multiple. The other way we measure the return is a net IRR, or an internal rate of return. That range or our target range is about 15% to 20% net IRR, which again is after fees expenses and carried interest.

Chuck: Why would those two numbers not be the same?

Tom: Well, they’re just two entirely different numbers. One is a multiple of the cash you put in, and then the other one is a compounded return on that cash that you put in. For instance, if I doubled your money in a year, you would get 2X your money, but your IRR would be 100%.

Chuck: Right. Okay. I understand that part. Doubling the money and then an IRR of 15%, that just suggests that, that’s a characteristic of how long it takes to double the money, then I guess.

Tom: Yes. Typically, private equity funds are set up to be 10-year vehicle. When you make a commitment to a private equity fund, the expectation is those investments are going to be made, those companies are going to be managed, and then those investments will be monetized, or sold,  sometime within that 10-year period. The reason we measure the net IRR, is we want to make sure that we give you an appropriate cash multiple within a reasonable period of time. For instance, if I gave you a 2X net cash multiple but it took me 30 years to do it, you’d have a very low internal rate of return, which would be acceptable to the investor, it wouldn’t be acceptable to us.

Chuck: That net IRR is really the number that most directly would compare to the — what you’re typically looking at as your rate of return, and if you’re comparing this to other investments. For instance, you’re thinking, “Oh, my return on the stock market might be 7%. If I’m getting a 10% net IRR here, that’s better.” That’s apples to apples, or maybe apples to pears, they’re close.

Tom: No, that would be apples to apples. Because that IRR from private equity fund would be analogous to a rate of return like you get on your stock investment portfolio.

Ed: Tom, how does this fit into a typical asset allocation model? 80% should be in private equity, 20%, 10%. What’s your view?

Tom: It really depends on either the individual, the family, or the institution as to what their investment goals are. If I gave you an example of an endowment fund for a university, typically an endowment fund for a university needs to draw approximately 5% of their endowment every year to support the operations of the university which would be a typical draw. If they have an endowment, they want to make sure that they cover the liquidity requirements of the endowment of 5% of the endowment every year. They have to earn enough to cover inflation, and then they need to be above inflation to earn enough of a return on the entire endowment to keep it in perpetuity. In that case, typically if you’ve got a 5% draw, if you factor in inflation, then a little bit above inflation, typically the targets for college endowment fund would be 8% or more that the entire portfolio has to return. Then what happens is, you need to calculate the asset allocation model that’s built in the expectation that you’re going to get an 8%+ compounded return. For instance, if you’re just going to invest 100% of that endowment fund in AAA corporate bonds over the last 10 years, and really over the last 50 years, corporate bonds have yield is about a 3% return. You couldn’t build a portfolio with 100% AAA corporate bond to achieve your objective for that endowment. Then you would layer in public equities into that endowment, but public equities, the expectation, I think over the next 10-year period, is that public equities might yield 7% to 8% return. Typically, you’re not going to from asset allocation on a risk perspective, but 100% of your endowment funds just in public equities. There’s going to be a blending between public equities, corporate bonds. Then the third asset class is referred to as alternatives, which really is everything that’s not a public equity or a bond. That would pick up private equity, it would pick up hedge funds, it would pick up commodities, real estate, debt funds, anything that’s not a classic public equity or a bond. I like to use the example that add a few– If you won the lottery tomorrow, and let’s just say you won $100 million lottery. Overnight, you would become what would be described in the industry as a high net worth individual. If you’ve got a pool of $100 million as an individual, and whether it’s $100 million or $10 million or some other number, you have to decide how you’re going to invest that pool of capital that you have either earned or that you won in the lottery or came into through inheritance or some other means. Anytime you’ve got a large pool of capital, you’re going to hire two people. The first person you’re going to hire is a tax expert to make sure that your either new found wealth or the wealth that you’ve accumulated, you want to minimize the taxes you’re going to pay, or minimize the amount of your wealth that gets confiscated by the government. That’s your first professional. Your second professional you’re going to hire is an investment manager. What that investment manager is going to tell you is really two things. The first thing they’re going to tell you is, you have to have a diversified investment portfolio to reduce the risk of losing a portion of your wealth. The way they structure that diversified portfolio is what most people refer to as an asset allocation model that’ll be spread across different asset categories and subcategories within those asset categories in order to reduce the risk and spread out the risk in your portfolio, but also meet your liquidity requirements and your return requirements.

Ed: What percentage of that $100 million would you allocate to Pfingsten?

Tom: In the example I gave you before, and you could use the same example for an individual, but in the example I gave you before where an endowment needs to draw 5% per year from the endowment, that’s their liquidity requirement each and every year. When you factor in for inflation, you want to be able to earn above inflation and then maybe a little more, so let’s just say that endowment wants to earn at least 8% or 9% every year to keep that endowment in perpetuity. They would set up an asset allocation model which would include public equities, corporate bonds or government bonds, and then some alternatives. Most endowments, in order to achieve annual compounded returns over a long period of time that are in that 8% or 9% range, will typically have 50% or less in public equities. They might have 10% in corporate bonds, which is the hedge which creates the diversification so that they’re not taking too much risk in the portfolio. Most endowments, or the best earning endowments that I’ve seen have anywhere from 30% to 40% or 45% in alternative investments. Then when you get into that alternative investment category, private equity is the largest component of that.

Chuck: I’m going to play a little bit of devil’s advocate here and lead in with a question which is, I’m assuming, correct me if I’m wrong, but I’m assuming that where a private equity fits into this picture that it still probably conforms with the golden rule of investing that being that your returns are related to the risk level. To the extent you’re able in private equity to achieve a greater return than, for instance, public equity markets, is it fair to assume that that also is attended with higher risk?

Tom: Yes, that’s correct. When you set up your asset allocation model, the two things you’re managing around how you set that asset allocation model is really what your risk profile is or what your appetite for risk is, and what return you need and what your liquidity requirements are. It’s really three factors. What that investment professional will do is work with either the individual or the institution to understand what their risk appetite is, what their liquidity requirements are, and what the overall return from the entire portfolio needs to be in order to satisfy their requirement.

Chuck: I guess this would be the devil’s advocate part of my question, which is, given that, I wonder why you would blend in some bonds which would reflect lower risk, and then make up for that by adding additional private equity which involves higher risk. Why not just do a mix of public equities and private equity?

Tom: You could, in fact, many institutions, the old formula used to be for institutions, 60% used to be in public equities, 30% used to be in bonds, and then 10% would be in alternatives private equity. The problem with that old model is that the returns on equities and the returns for the bonds have actually come down, particularly on the bond. So that if you really need to earn 8% to 9% every single year on a compounded basis, you can’t do that simply with stocks and bonds anymore. What’s happening is that 30% that used to be allocated in the asset allocation model the bonds, is either down to 10% or has disappeared altogether.

Ed: Let’s introduce a different concept. Let’s assume Peter here has this $100 million. He has enough pairs of shoes and cars, and he just wants to make more money. He comes to you and says, “Look, I have this $100 million, but really, I want to give you $150 million. I’m going to borrow $50 million.” Tom, here’s $150 million. How are you going to apply that $150 million? What’s the debt-equity ratio in each of the platform companies that you’re going to invest in?

Tom: We build a portfolio every time we raise a fund. When we raise a fund, we’re going to invest in at least 10 companies, and sometimes as high as 15 companies, which actually creates diversity within our portfolio. The way we reduce risk is we tend to be conservative with respect to financial leverage, and every private equity firm has a different strategy. Some strategies allow you to use more financial leverage, other strategies would require less financial leverage. Really it depends on what the strategy is of the individual private equity firm. We obtained diversity because we diversify our investments. We have certain limits on how much of the fund we’ll put in any single investment. Then we typically operate with fairly conservative capital structures, because ours is more of a growth play and an operational improvement play. When you’re taking a company through an operational transition, or you’re trying to grow the company, the last thing you want to do is use too much financial leverage. We tend to use more than 50% equity in all of our platforms, and our average over the last 10 to 15 years has been closer to 65% equity and 35% senior debt, no mezzanine, which is more analogous to a public company capital structure than it is to a traditional private equity firm capital structure.

Ed: Tom, you don’t ask the investor what sort of money that you’re putting in here. That is, is this equity you’re putting in or is it a debt-financed contribution, so whatever the investor does, and how to come up with the money, you really don’t care?

Tom: When they make a commitment to the fund, that’s an equity commitment. The money that they commit to the fund will be invested in the equity of the underlying operating companies that we invest in, and then each of those operating companies will put the equity in. Then we’ll use some debt in the capital structure as well.

Ed: Yes, let’s assume I put in a $1 million, you don’t really care if I borrow that million dollars or half of that or none of it. The investor’s own pocketbook doesn’t control the destiny of the investments in the funds. Is that correct?

Tom: That’s correct. We’re pretty clear as to the types of companies we invest in, we’re pretty clear on what our criteria is for the industry types of companies that we invest in, geographically, where we’re going to invest. We’re pretty clear with respects of what our typical capital structure is going to look like for those underlying investments so that the limited partner, which is either the individual or the family or the institution, can make their own judgment as to the risk appetite that they have for that type of investment, and the lack of liquidity that usually comes with that investment because they’re making a commitment for a 10-year period. How they choose to fund that commitment is really up to them, and ought to be built into their own asset allocation model that they have on either an individual basis or institutional basis.

Ed: What industries do you focus on, and why?

Tom: For 30 years, we’ve always focused on really three sectors. Manufacturing, not heavy manufacturing that requires heavy capital expenditures, more light manufacturing, light assembly type manufacturing companies that are for manufacturing niche products in their sectors that actually have very good gross margins. We also invest in the wholesale distribution or mostly business to business, company distribution, and then selectively we invest in business to business service companies, as well. Our portfolio tends to be more business to business as opposed to business to consumer. Our portfolio tends to be more industrial than consumer.

Chuck: Can you comment for a second about the tax characterizations of the gains that you’re generating? For the investor, is this appreciably different than other types of investment? Do they ultimately get out a capital gain or a qualified dividend, or are they incurring ordinary income, or how does that typically work?

Tom: Almost always, they’re going to end up with capital gain, because we make these investments in the underlying operating companies. We typically hold those investments anywhere from a 4 to 7-year time horizon. When you do that, when we actually monetize or see that investment, the gain is going to be treated as capital gain. Sometimes when the companies are performing extremely well, and they’ve completely deleveraged during our ownership, we may recapitalize the company and declare a dividend. In those cases, the underlying investors might receive dividend income. It’s either going to be dividend income or capital gain.

Chuck: That’s typically going to be a qualified dividend, or is that sometimes not a qualified dividend?

Ed: I think, mostly qualified. I would think so.

Tom: Yes, it’s all qualified.

Ed:  Pfingsten buys shares of a regular or a C corporation. The hope is that when you sell it, you’re selling the shares that’s generates capital gain.

Tom: That’s correct.

Chuck: It sounds from your comments you made before about the use by endowment funds and so on, that really people don’t have to worry about unrelated business taxable income. Someone were to make an investment, either as part of the investments of a charitable foundation, or if they did this. Do you ever see people using their IRAs for this type of thing? Or is that something you try to avoid?

Tom: Yes. Occasionally people do. Some of our limited partners will use an IRA, and then when we offer co-investment at the individual company level to the managers of the companies, occasionally they will use an IRA.

Ed: I’m thinking about this is actually the most preferred method of investing. You’re generating capital gain or qualified dividends. There’s no ordinary characteristic to this, and no debt outside the organization. It is you’re buying stock, as for example you buy a stock CAT. Whatever happens inside Caterpillar is not impacting at all on the ownership of the shares.

Chuck: Yes, that’s what it sounds to me.

Tom: Right.

Ed: Tom, is this unusual or not?

Tom: No, it’s very typical in private equity. In fact, most private equity firms will set up the investment vehicle. It might be a partnership. It might be a limited liability company. Or, it could be a corporation taxed under Subchapter C of the Internal Revenue Code, i.e., a “C corporation”, but no matter what they set up, they’ll typically have a blocker or C corporation  between the business corporation and the Fund which then means that when the investment is sold, the sale will generate as a qualified dividends or a capital gain.

Chuck: Can you talk a little bit about inside the fund? How do you identify your targets and the mechanics of how you go about making those purchases?

Tom: If you think about how a private equity firm works, it’s really a five-step process. The first thing that has to happen is — The two things you have to have if you’re going to be in this business, is you have to have access to capital, and you have to have access to investment opportunities, but you can’t have one or the other, you have to have both, otherwise you can’t be in this business. If you’re going to run a private equity firm, it’s really a five-step process. Step number One is, you actually have to raise the capital or raise those capital commitments so that you have the capital available to make the investment. That’s step one. Step Two is, you’ve got to generate the investment opportunities. Step Three is, once you generate the investment opportunity, you actually have to buy the company, which means you’ve got to process that acquisition transaction. That’s step three. Step Four is, you’ve got to, once you own the company, you actually have to manage that investment actively, and you’ve got to create value during the course of your ownership.Step number Five is the sell point. You’re going to sell the business at the end of your investment time horizon. Almost every private equity firm that exists in the United States or world-wide, goes through that five-step process. Raise the capital, generate the opportunity, buy the company, manage the company, and then ultimately sell the business or monetize the investment.

Chuck: We’ve heard a lot of public discourse in the last several years offering criticism about the things that happen in steps number Four and Five, that there’s this perception that involves maybe doing things that are socially not desirable, or bad for workers, or etc. Can you comment at all about what you, in your own experiences, is typical in those phases?

Tom: Yes. I think we as an industry have done a horrible job of communicating what we do and how we do it and how it affects the companies that we own, how it affects the people that work with us to help create value. We’ve done a horrible job, and for some reason, we have chosen to cede, the dialogue on private equity to professors and politicians and the press. Whenever you’re hearing from a professor or a politician or the press, it’s typically negative. That’s our own fault for not controlling the narrative as well as we should. The reality is, private equity is here to stay because any entity, individual family entity that has a large pool of capital is going to have an asset allocation model, and almost every asset allocation model will include alternative investments, and the largest sector within the alternatives is private equity. It’s an industry that has grown quite rapidly over the years. It’s going to continue to grow because of the underlying fundamentals with an asset allocation model. I’ve seen statistics that 10% of all companies in the US are owned by private equity at this point, which most people don’t really realize.

Tom: We also have an obligation as an industry to be responsible owners so that when we make an investment in a company, we’ve got to make that company better. We’ve actually got to build a better business during the course of our ownership, which typically means you want to see some growth in the business, operational improvements. At the end of your ownership, you really want to have a company that is bigger, more profitable, more competitive than it was from the day you bought it. If you could do that successfully, which we’ve been able to do over the years, it’s a win-win. It’s a win for the investors, which are really the underlying shareholders of the business. It’s a win for the employees because they’re working for a bigger more competitive and better run organization. If it’s a win for the customers in that business, the suppliers of that business, the employees of the business and the shareholders of the business, that’s really the objective.

Chuck: I can comment based on our experience. We’re dealing on the other side of that, which is that there’s an awful lot of these smaller family owned businesses that the family reaches the end of its life cycle with respect to being able to continue to closely own that business and manage that business, and then the exit strategy, it’s either the private equity market or it’s the public equity market. The public equity market is not available for companies unless they’re quite large. What I can say is that, what we’ve witnessed with our own clients is that this is really the only exit strategy that allows a business to continue operating, but I’m going to challenge you a little bit if you can expand a little bit. Let’s say we’ve got a company that’s locally owned, it’s been run by a family for a generation, and they’re manufacturing widgets. That ends up being something that the family is exiting, and so a private equity firm comes in and buys that. What happens with that company when it’s owned by the private equity firm, and then where does it ultimately end up when you monetize that so you’re no longer owning it? Then who does?

Tom: That’s a typical scenario for us because 95% of what we buy are companies from the original entrepreneur or entrepreneurs, that started the business. We are almost always the first institutional capital that goes into these businesses in that sale process. There’s really that entrepreneur really has three options. One option which you mentioned which is to take the company public, but unless they have a sufficient size and the specific sector that would lend itself to an IPO, it’s rare that that’s really a viable option for a small family held business. The second option is they could sell to a strategic buyer, a publicly held company or a much larger privately held company that would view that as an add on investment for what they already owned. That’s the second option. Then the third option is to sell to a private equity firm that will take the company forward. In the case of selling it to the private equity firm, there’s really two ways to do it, and we offer both. The first way to do it is they could sell 100% of the company to the private equity firm. Completely sell their investments, and then really manage the proceeds they get from the sale any way that they see fit, whether they’re going to distribute that among family members, free to family partnership or a family investment vehicle, and then they would have their own asset allocation, and then they would manage that pool of capital anyway they chose to. The other alternative, which most private owners of businesses don’t understand, is that almost always we offer the underlying family, individual entrepreneur, or entrepreneurs, the ability to roll equity or add a portion of their management to into our transaction, where they can monetize majority of their investments so that when we ultimately sell that investment, they get a second payday. Since we’ve been doing this for over a 30-year period, we have enough empirical data that points to the fact that when the entrepreneurs choose to do that, or the families choose to do that, the combination of their first payday when they take off the table, the majority of their investments, and the second payday when we monetize the investment, is typically greater than have they sold 100% of the company on day one.

Chuck: They’re trading essentially their stock in this closely held company for an interest in your fund.

Tom: No, they would sell a majority of the shares to us, and then they would keep a portion of the shares for themselves. They’re not investing in the fund, but what they are investing, as the minority investor going forward, is they’re going to own a portion of the underlying company on a go-forward basis.

Chuck: They have a non-controlling interest after that, what you refer to as the first payday.

Tom: Yes.

Ed: Thinking, or from what I understand, Tom, Pfingsten must have the power to control the exit.

Tom: Yes, we’re majority investors. We always have to own 51% or more of the shares. Almost always, we’re offering the selling shareholders of that company, the ability to own a portion of that company going forward. That portion could range anywhere from 5%, 20%. We’ve had them as high as 45% ownership going forward. That’s typically an individual’s decision as to what their appetite is for owning shares on a go-forward basis. I would say about 80% of our transactions are a form of that where we buy the majority and the underlying selling shareholders will roll equity into our transactions and own a portion of that business on a go-forward basis.

Ed: Yes, and the idea of rolling forward, I just want to make sure that I understand, let’s use the typical 80/20 rule. I own 100% of the stock of Newco that makes widgets, the margins are 60%. I sell the fund, 80% of my C corporation shares, and I retain 20%. I have hopefully a long-term capital gain on the 80% and no tax on the 20% until the underlying business is sold. Is that fair, Tom?

Tom: Yes, there’s almost always we’re able to treat the rollover equity. It’s not a taxable event when they roll it over and they get taxed as a capital gain when we sell the investments 4 to 7 years into the future.

Ed: Ideally, I died, and so my 20% I get a new tax basis and my heirs get that tax free. I’m not planning to do that. I’m speaking of a client. Having said that, Tom, I would like to address the issue of compensation.

Tom: Ed, before we do that, I want to answer Chuck’s other question, which is the selling shareholders when they sell us their business, and if they choose to roll equity into our transactions really for that second payday. When we sell the investment, at least historically, 60% of the time, we’re selling our underlying company to a large strategic buyer. About 40% of the time, we’re selling those underlying businesses to much larger private equity firms. Our whole investing strategy is really based on buying the companies when they’re smaller, owned by the entrepreneur, or a family business. We offer them an opportunity to roll equity in our transactions. Then during the course of that four to seven-year period, we’re trying to literally build a better business by growing the business, improving it operationally, improving the management practices and processes, and improving the internal controls to make that business attractive to a large strategic buyer or a much larger private equity firm. Neither one of those firms typically wants to do what I would call the heavy operative lifting to help that business through its transition from an entrepreneurially managed business to a more professionally managed business.

Ed: You’re running these businesses, so you’re not only finding them, financing, giving the money and all that sort of, you’re actually putting management in to run the business or assisting existing management.

Tom: Sometimes they have a great management team, and we can leave the entire management team in place. Typically, what we find, though, is they typically have some very good managers, but they may have holes in the organization that haven’t been filled. They might have an accounting manager, but if we’re going to grow the business and double or triple it in size, we’re eventually going to need a CFO as opposed to an accounting manager. They typically have sales but not sales marketing together. They typically don’t have a fully developed human resource function, job descriptions, salary grades and the like. There are a lot of things from what I would call an infrastructure standpoint that we have to the businesses, to put the company in a position where we can grow the business. Our typical objective when we make that initial investment, is we’re looking to double or triple the size of the business within a five-year period.

Chuck: When you, let’s say, in the 40% of the cases where that ends up, you end up selling them to a larger private equity firm. Now they’ve got an obligation to their investors to somehow create some further growth or efficiencies. I imagine that that’s their goal, to essentially exceed the types of returns, just like your goal is to exceed the types of returns that investors could get in the public equity market. Now, you’ve already done this heavy lifting in terms of, I guess we’ll call it shoring up the management structure. Then what’s that larger fund doing once they get it from you?

Tom: Typically, what the larger fund is doing is, they have their own growth strategy. Sometimes, when we’re buying these companies when they’re small, we’re making heavy investments in infrastructure. It’s not just management, its management, its facility, its operating systems within the companies, its business processes in those companies. It might be getting them in an e-commerce channel that they’ve never been into before. It might be taking them global or offshore, either for sourcing products or entering new markets. There’s a number of things that we do during the course of that ownership to effectively build a better business. When we built that better business, with the help of the management team, and typically with the help of the prior owners, and we monetize that investment, and, of course, selling it to a much larger private equity firm, they’re going to have their own growth strategy. Our business might be combined with a business that they already own in the sector, to make it larger and even more profitable. They may buy that because they have a desire to be in the sector that we’re in. Because they have more capital, they can provide more capital to the company to take it to the next level of growth and profitability. There’s a lot of different reasons they would buy it, but they’re typically plugging it into their own growth strategy with respect to the opportunities they see for the business. The same would be true for a strategic buyer. They’re going to be desirous of the company to either combine it with something that they have, or this might represent a new market that they haven’t been in that they want to be in that they think has growth potential.

Ed: Tom, before we end this interesting discussion, I’d like to just briefly talk about compensation to Pfingsten, that is the general partner specifically, my hobbyhorse happens to be a percentage of the assets under management, irrespective of the success or failure, I would say 1% or 2%, whatever. It seems to me that your situation, from what I can discern, is one which forces an investment return, that is, you’re not going to make money unless the business organization makes money. Could you briefly describe your compensation arrangement?

Tom: The compensation arrangement we have, which should be typical of private equity firms, is you get a 2% management fee for capital under management, and that typically will last during the investment period, which is typically a five-year period. Then after the fifth year, you’re going to get a 2% management fee on the amount of that capital that you actually deployed for investment purposes. It typically ratchets down after the fifth year to only be applied to the amount of capital you’ve actually deployed. Then on top of that, there’s a 20% carried interest in the gains that we create that get paid to the general partner, or, in this case, the Pfingsten Partners, that the way we structure the gain is we guarantee the people that entrust us with their capital that they’re going to get a minimum 8% compounded return before we start sharing in the gain. If they don’t get an 8% return, we don’t get anything, but we have to exceed that 8% return and then we get to share in it.

Ed: It sounds like that model would be a good thing for many of these investment advisers to get 2% in respect with the performance. It sounds to me, Tom, that you’ve devoted a career to this. Of course, the academic question is, why would you try to do this learning how to sleep standing up given the hours you devote to this? The bottom line is, Tom, looking back, would you do it again if you had another choice?

Tom: Absolutely. I’d do it all over again because I can’t think of anything else, I’d rather be doing. Because we get the benefit of we buy a lot of great company that are started by entrepreneurs and are taken to a certain level, and then we get the joy of taking those companies and building a better business from there, and creating value that really accrues to the selling shareholders that are partners, it accrues to the management teams who also invest with us in these transactions, it accrues to the employees through compensation systems. It basically takes these businesses to another level, and then even when we monetize our investments, typically taken over either by a larger company or a larger private equity firm that plans to take it to another level. It’s all part of our capitalist system where its corporate renewal on a constant basis. It sucks.

Ed: Tom, your passion is obvious. On behalf of Chuck and yours truly, thanks for your time and effort and generosity conveying all this information, which is going to make it easy for folks to at least understand how this works. I’m not saying a lot of people are going to stand up and asked to be hired by Pfingsten, but on the other side of it, it’s a great opportunity. This learning opportunity is fantastic.

Chuck: I really appreciate your time, and I do think ultimately what we’re trying to accomplish here is to just let people know what sorts of investments are available out there and how they work. This has been fascinating.

Tom: Thank you.

Ed: Again, Tom, thanks for your time. Talk to you later.

Tom: My pleasure. Thank you.

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