Podcast Summary
Understanding the 50x Podcast Series and Primary Research in Investing: The 50x podcast series examines successful investments with a fiftyfold increase, focusing on long-term value creation and the importance of primary research in the investing process, particularly in the B2B software industry.
The new podcast series, 50x, hosted by Will Thorndike, aims to analyze investments that have appreciated at least fiftyfold. The series will delve into each investment's origins, evolution, and eventual outcome, focusing on themes around long-term value creation. Primary research plays a crucial role in the investing process for firms like The Investment Group of Santa Barbara, where partners own 100% of the capital and focus on owning a small number of the best businesses for the long term. They believe that every business will be software-enabled in the future, making the B2B software industry a key focus. Primary research is where they find value-add, as access to instant financial and quantitative information was not available in the past.
The importance of qualitative information in fundamental investing: Qualitative insights from industry experts and company insiders complement quantitative analysis in creating shareholder value over the long term.
While technology has made accessing financial data easier than ever before, the value of fundamental investing lies in gathering qualitative information through direct interactions with industry experts and company insiders. This was a tedious but effective strategy 30-40 years ago, and it remains crucial for high-quality fundamental investors today. The example of TransDigm's extraordinary success story highlights the importance of both strong quantitative analysis and qualitative insights in creating shareholder value over a long period. Nick Howley's background in niche manufacturing and experience in mergers and acquisitions provided him with the skills and knowledge to transform TransDigm into a highly successful company. The company's impressive 37% compound annual growth rate over 28 years, evenly distributed between its private equity and public periods, underscores the importance of both strategic ownership and public market performance.
From high school to successful business owner: Education, experience, determination, and resilience are key to starting and growing a business. Overcome challenges with strong partnerships and strategic investments.
Experience and education, coupled with determination and resilience, can lead to successful business ventures. The speaker shares his journey from working in his family's business during high school and college to obtaining an engineering degree and an MBA. He then recounts his experience in buying a business from IMO, facing challenges such as conflict with management and competition from other buyers. Despite these obstacles, he and his partner managed to secure investment from Kelso and ultimately bought the business. Through these experiences, the speaker learned valuable lessons about the realities of cost management, value creation, and the challenges of buying a business while competing against management. He also emphasized the importance of having a strong education and practical experience to navigate the complexities of business deals.
A group of investors bought a struggling manufacturing business in the 1990s and turned it around: Investors bought a struggling business, optimized it, and saw significant growth through cost savings, market recovery, and new business concepts
During the 1990s, a group of investors, including the speaker, made a bold bet by investing $55 million to buy a struggling manufacturing business in a challenging economic climate. The business was composed of four small businesses and seven manufacturing facilities, with an EBITDA of around $9-10 million. The investors, led by Kelso & Co., focused on optimizing the initial businesses by getting the cost structure in line, shutting down excess facilities, and improving management. The market downturn in both the commercial and defense sectors presented an opportunity for cost savings and margin improvement. After a few years, the business saw significant growth, with EBITDA increasing fivefold to around $45 million. This success was due to the cost takeout, market recovery, and the development of value pricing and new business concepts. The investors' strategy of buying, optimizing, and selling businesses became the foundation for their successful 28-year investment approach.
Focusing on value drivers in business: To create intrinsic value, focus on getting the price up, reducing costs, and generating new business. Hire young, energetic, and smart individuals who understand value creation and are driven to make money.
In business, the only way to create intrinsic value is by focusing on getting the price up, reducing costs, and generating new business. These value drivers are essential and self-regulating, forcing a balance between delivering high-quality products and services on time and keeping costs low. The market and valuation multiples are beyond control, but focusing on these value drivers can lead to success in both small and large organizations. The importance of talent cannot be overstated, especially in the early stages. Hiring young, energetic, and smart individuals who understand value creation and are driven to make money can lead to long-term success. The experience level of employees should not be overemphasized at the expense of their potential. In the early days of the company, the focus was on collapsing businesses down to the essentials, having a CFO, and hiring young, ambitious individuals who bought into the value creation philosophy.
Focusing on value drivers in the early years of a business: Pricing based on perceived value and switching costs, controlling costs to offset inflation, and detailed tracking of new business opportunities are crucial for growth in the early years of a business.
During the first few years of running a business, focusing on value drivers such as pricing, cost, and new business is crucial. The speakers, who were the CEO and president of a niche engineered product company, moved to Cleveland to be closer to the manufacturing facility and ran the business with an assistant. They emphasized the importance of pricing based on perceived value and switching costs, rather than just cost. They found that most niche businesses underprice their products and overlook the value of their aftermarket franchises. In terms of cost control, their goal was to offset inflation every year with savings, and they were strict about counting all costs. Lastly, they emphasized the importance of detailed tracking and gating of new business opportunities to ensure profitability. The speakers' approach was to pick a subset of projects that could be affordably lost if they didn't work, rather than worrying excessively before trying. Overall, their focus on these value drivers helped them grow the business.
Preparing a business for sale in private equity ownership: During the first phase, PE firms focus on debt repayment and business preparation for sale, while in the second phase, they pursue acquisition strategies to scale the business.
During the first phase of private equity ownership before the IPO, the focus was on paying down debt and preparing the business for sale. The balance sheet was leveraged, but no dividend distributions were made. When it came time to sell, Goldman Sachs facilitated the process, and the bidders were primarily private equity firms. One challenge during this period was a delay due to the 1998 bond market freeze. The sale resulted in a significant increase in valuation. In the next phase under Odysee's ownership, the focus shifted to more acquisition activity. The Odysee team was supportive of this strategy and encouraged its implementation. Several acquisitions were made, confirming the thesis and the ability to scale the business. The acquisitions were in line with the criteria of proprietary aerospace businesses with significant aftermarket content. Overall, the experiences during both phases demonstrated the success of the private equity model in the aerospace industry.
Focusing on cost reduction and price increases for successful investments: Implement a playbook of price, cost out, and new business strategies to increase margins in acquisitions, and be prepared for unforeseen events.
Successful investments require a hands-on approach and a focus on cost reduction and price increases. The speaker shares his experience with two acquisitions, Adams Wright and Champion, where they significantly increased margins by cutting costs, particularly in labor and people, and raising prices in the aftermarket. They also took a harder line with long-term agreements with OEMs, demanding price increases to catch up for inflation. The playbook they developed included price, cost out, and new business, which they repeated in subsequent acquisitions. The speaker's willingness to live on-site and lead the turnaround efforts personally was crucial to their success. However, even with careful planning, unforeseen events like 9/11 could impact the investments. Despite these challenges, the speaker's approach proved successful, and they were able to increase margins substantially in both cases.
Assessing and moving on from unprofitable deals: Focus on profitable deals and restructure unprofitable ones, respond quickly to external shocks, and maintain cost management philosophy.
In business, not every investment opportunity is worth pursuing. Some deals may have a low probability of success or have already given away much of their potential upside. It's crucial to assess the situation and determine if there's a chance of restructuring the contract to make a win possible. The company discussed in this conversation has found success by moving on from deals that don't meet their criteria and focusing on increasing the rate of arrival of new, profitable business. The company has faced external shocks before, such as the 96 plane crash incident and the 9/11 attacks, which caused significant disruptions in their industry. During these crises, they responded quickly by ramping up legal activity, reducing costs, and focusing on new business opportunities. For instance, after 9/11, they introduced cockpit security systems and saw a pop of revenue in a badly needed time. Although these crises were scary and uncertain, the company managed to push through and eventually recover. Throughout these challenges, the company held firm to their cost management philosophy: costs are revenue minus three. They refused to engage in a fixed variable argument and emphasized the importance of someone in the industry reducing costs. The company's compensation during these periods remained relatively stable. The lessons learned from these experiences served as a template for handling future crises.
Champion's first two ownership phases saw 4x growth, lean corporate structure, and deep entrepreneurial culture: Champion's first two ownership phases resulted in 4x growth, a lean corporate structure, and an entrepreneurial culture that fostered success through self-regulation and decentralization
During the first two private equity ownership phases of Champion, the company's growth was organic and significant, with approximately 4x growth from an estimated initial purchase price of 15-20 million to a sale price of around 120 million. The equity and options played a role in self-regulation, and the company was run with a lean corporate structure, prioritizing decentralization and autonomy for its businesses to function like owners. This approach, rooted in the belief that corporate structure and staff contribute little value to niche engineering businesses, was instrumental in attracting the right talent and fostering a strong entrepreneurial culture. Despite some challenges, such as the economic impact of 9/11, the company maintained a consistent leverage ratio of 4 to 6 times. Through this period, Champion's decentralized culture was deeply embedded, leading to a successful and profitable business model.
Letting go of misaligned team members and growing the right ones: Maintain cultural fit by quickly releasing misaligned team members and investing in growth opportunities for those who align with company values. Embrace performance-based compensation in the public world, focusing on intrinsic value growth.
Building a successful decentralized business involves making tough decisions and maintaining a strong cultural fit. The speaker emphasizes the importance of quickly letting go of those who don't align with the company's values, while providing opportunities for growth and development to those who do. The discussion also touched upon the unique approach to compensation in the public world, which mirrors private equity compensation by underpaying in cash and over-equitizing, but with a focus on intrinsic value growth. This performance-based system has proven successful, although it was initially challenging to explain to public shareholders.
Aligning executive interests with company performance through equity plans: Equity plans can increase retention, reduce infighting, and foster a long-term focus for both employees and companies. However, implementation requires careful consideration of factors like company size and equity funds availability, and potential buyers may raise concerns about sustainability of high EBITDA margins.
Aligning the interests of key executives within a business unit with the overall company performance through an equity plan can lead to increased retention, reduced infighting, and a longer-term focus for both the employees and the company. This approach, as discussed, was adopted by the speaker in their business context, leading to positive outcomes such as increased job satisfaction, reduced turnover, and the ability to grow beyond the PE world. However, implementing such a plan can be complex and requires careful consideration of various factors, including the size of the company and the availability of large equity funds for potential buyouts. Additionally, potential buyers may raise concerns about the sustainability of high EBITDA margins, leading to a need for thorough diligence and communication.
Warburg Pincus shifted focus from operations to capital allocation: CEO became more involved in capital allocation, focusing on M&A as primary channel, established clear M&A function, and were successful in expanding business through acquisitions
During the Warburg Pincus ownership, the company shifted its focus from operations to capital allocation. The CEO became more involved in capital allocation as Warburg prepared for a public transition. The primary capital allocation channel was M&A, which the company began to approach like a sales activity. They established a clear M&A function and ramped up their efforts, looking at potential deals more systematically. The company's template for analyzing potential acquisitions was well-developed, and they were successful in expanding their business through acquisitions, meeting their criteria for margin expansion and strategic fit.
Evaluating Aerospace Acquisitions: A PE Approach: Assess businesses as standalone PE buys, focusing on proprietary nature, aerospace industry alignment, aftermarket potential, and cost savings opportunities.
The speakers discussed the importance of a professionally run and analytically sound process when evaluating potential acquisitions in the aerospace industry. They emphasized the need to identify proprietary, aerospace businesses with significant aftermarkets, and the potential for a clear path to a private equity-like return. The process involved assessing the business as a standalone PE buy, with no credit given for strategic fit or arbitrage opportunities. The team used a clear framework to evaluate each business, focusing on its proprietary nature, aerospace industry alignment, and aftermarket potential. They also estimated the shipset content of the business and forecasted revenue and EBITDA flows, assuming no increase in EBITDA margins unless active measures were taken. The cost structure was also thoroughly evaluated, with a focus on potential cost savings, particularly in headcount. Overall, the process was designed to be data-driven, predictable, and focused on maximizing value creation.
Identifying cost savings and efficiency improvements in acquired businesses: Our company acquires businesses, improves margins, and sells after 5 years, aiming for a 20% hurdle rate. We focus on cost savings, efficiency improvements, and integration planning post-acquisition.
Our company focuses on acquiring businesses and improving their margins to generate additional cash flow and EBITDA. We go through each department to identify areas for cost savings and efficiency improvements, adding these new streams to our existing organic growth. We aim to sell these businesses after five years, maintaining a 20% hurdle rate target, although we often exceed this timeline. Post-acquisition, we have a detailed plan in place for integration, including changes to pricing, cost takeout, and organizational structure. Our team, which is involved in the diligence process, becomes heavily involved in the integration process, and we track progress against our base case plan each quarter. We have a strong track record of successful acquisitions, with minimal losses and capital impairment. Despite some challenges, such as with the Summit acquisition, we remain committed to our value creation strategy through acquisitions.
Focusing on proprietary aftermarket businesses: TransDigm creates value by acquiring sole-source businesses, unpacking holding companies, and divesting non-proprietary assets to focus on valuable assets. A decentralized organizational structure and culture that values value creation and equity generation are crucial.
TransDigm's approach to acquisitions involves identifying and focusing on proprietary, sole-source aftermarket businesses. However, not all acquisitions create value for shareholders, with some estimates suggesting that between half and three quarters destroy value. TransDigm's strategy involves unpacking holding companies and treating them as a collection of individual businesses. When necessary, they divest non-proprietary assets to focus on the crown jewel assets. This approach requires careful diligence to determine what's proprietary and what's not. TransDigm also emphasizes a decentralized organizational structure and culture that values value creation and equity generation. Hiring and retaining people who believe in this culture is crucial, and those who don't fit in are quickly let go. The presidents of each portfolio company serve as culture carriers, and the EVPs play a primary role in this regard. TransDigm has tried to avoid adding non-performing businesses to their portfolio to maintain the value of their good assets. Overall, TransDigm's approach to acquisitions involves a focus on proprietary businesses, careful diligence, and a strong company culture.
TransDigm's culture: Get Shit Done: TransDigm emphasizes efficiency through continuous training, just culture, autonomy, pricing, and cost reduction. The company values preparation, clear communication, and a no-nonsense attitude.
TransDigm's culture is centered around getting things done efficiently, and a significant part of achieving this involves continuous training and reinforcement of key values. The company places a strong emphasis on just culture, autonomy, pricing, and cost reduction. Training sessions are cycled through regularly, with employees attending multiple courses over several years. Product line reviews are held quarterly, allowing for the assessment of business performance and the identification of upwardly mobile product line managers. These reviews are attended by top executives, and the company places a high value on preparation and clear communication. The "3 Ps" approach of getting things done, being smooth (not duplicitous), and focusing on nuts and bolts business became the mantra within a few years of TransDigm's ownership. The culture is described as "GST" - Get Shit Done, and the company has a no-nonsense attitude towards sloppy thinking and incomplete information.
TransDigm's focus on KPIs and accountability drives growth and efficiency: TransDigm's culture of accountability and focus on KPIs like pricing, cost, and new business has led to impressive returns through primary capital investments
TransDigm's culture of accountability and focus on key performance indicators (KPIs) such as pricing, cost, and new business, drives growth and efficiency within the company. This culture is reinforced through regular reviews and comparisons to industry peers. The company's focus on primary capital returns, which come from the original equity investment, has resulted in impressive returns over the years. However, it's important to note that returns for individual private equity buyers, who rely heavily on leverage, may vary. Overall, TransDigm's approach to business has proven to be a powerful culture enforcer and illuminating in its results.
Successful private equity ownership phase of Odysea (TransDigm Group): 47x multiple of invested capital and 37% IRR for investors, impressive returns for management, enterprise value of $1.8B at IPO, 80 employees per person at corporate, significant success for all parties
The private equity ownership phase of Odysea (now TransDigm Group) was highly successful, delivering impressive returns to its investors. Odysee's returns during this phase were 5x with an IRR of 42% over a 4.5-year holding period, while Warburg's returns, including TransDigm's first dividend recap in 2005, were 3x with a 35% IRR. If held all the way through to the IPO, the returns to the original Kelso equity check resulted in a 47x multiple of invested capital and a 37% IRR. This success was not only beneficial for the investors but also for the management team. At the IPO, the enterprise value was $1.8 billion, slightly above 10 times the $170 million of trailing EBITDA. The leverage at the IPO was 4.5 times enterprise valued EBITDA, and the company had deleveraged in the last phase of private equity ownership to prepare for the IPO. The corporate headquarters had around 18 people managing a total of about 1,400 employees, resulting in a ratio of approximately 80 employees for every person at corporate. The headquarters were still cohabitating with one of the operating units but were no longer in the manufacturing facility. Overall, the private equity phase was a significant success for all parties involved, setting the stage for TransDigm's public chapter.
