REALLY Private Equity: How to Buy and Run Small Businesses

“Castronics performs a very humble function, which is they carve into the end of the pipe the threads so that you can bolt together, you can wind together two lengths of pipe and put it down in oil or gas well. That threading needs to have two characteristics. It needs to be highly accurate so when you're at this remote site with a lot of expensive labor around and you're on the clock, those fit together beautifully.”— Royce Yudkoff

The Castronics Case Study · p. 15

Strategy & Decision Making · Economics & Markets

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$45 service on $3000 total: ratio creates moat

“When you buy an enduringly profitable, mature small business at four times EBITDA, you are pulling off a 25% yield on your total purchase price. If you financed about two-thirds of it with debt, senior and seller debt, and that debt is typically at some single-digit interest rate, your return on equity before any growth is somewhere like 60% or 65%. If you actually grow the business, even at a moderate rate, 5%, 6% a year, that's even higher.”— Royce Yudkoff

Perspective on Growth in Small Businesses · p. 19

Economics & Markets · Strategy & Decision Making

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Leverage converts 25% yield to 60% ROE

“We encourage our students to buy businesses that have recurring customer bases. That means customers where they are automatically going to repurchase the service or the product from year to year because it's in their financial interest to do so. That to not do that almost requires a whole new round of work in re-evaluating and selecting. When a local ambulance service contracts with System Design West, they link together their electronic information systems.”— Royce Yudkoff

Desirable Characteristics in Small Businesses · p. 8

Strategy & Decision Making · Economics & Markets · Psychology & Behavior

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Value delivered exceeds price paid by orders of magnitude

“If you're the manager of a 40-story building, that cost is infinitesimal to you. In fact, it's passed through as a common area maintenance charge, you don't even pay it. But you are concerned that on your class-A building, your window washers are on and off the building quick and not disturbing the tenants. More than anything else, that a bucket is not dropped on a convention of trial lawyers. In other words, safety is paramount.”— Royce Yudkoff

Desirable Characteristics in Small Businesses · p. 9

Psychology & Behavior · Economics & Markets · Strategy & Decision Making

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Downside from switching exceeds upside savings

“Growth just creates risk. If you think about looking for businesses that have high recurring revenues, the faster growth, the lower your recurring revenues, almost by definition. New customers, new problems. It's not just new customers, new problems, it's new customers, probably different problems. It may be that with growth, you're adding more high-value add customers but that's not the way it usually works. It's usually you end up like mining.”— Rick Ruback

Perspective on Growth in Small Businesses · p. 19

Strategy & Decision Making · Economics & Markets

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Growth dilutes recurring revenue and margins

“In big businesses, you're pretty almost always looking for what is a pre-insurmountable barrier. The barrier tends to be something real, like a patent, an idea, low-cost position, brand something, license, whatever. In small firms, the barrier is often excellent execution. So people don't switch because you as a small business person do what you do really well. You never give them a reason to get mad at you. That is itself a barrier in the same way a license might be for a larger company.”— Rick Ruback

Desirable Characteristics in Small Businesses · p. 9

Strategy & Decision Making · Operations & Execution

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Execution quality IS the moat in small firms

“I always approach it by asking a different question. I think the question you want to ask is why is this business small? Some businesses are small because they're lousy businesses. But some businesses are small because they're serving a local market in kind of a special way. That's the one you want to buy. Their market is small, they're the best, and everybody wants to use them. But you can only ship bread 50 miles. So you can be the best bakery and have huge profits.”— Rick Ruback

Desirable Characteristics in Small Businesses · p. 11

Strategy & Decision Making · Economics & Markets

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Small from constraint or incompetence?

“One of the big risks you face is you buy a great business for seven, eight, 10 times EBITDA and then there's multiple compression. The whole space re-rates and suddenly, these businesses trade for seven times, not nine times. It's really hard for re-rating to take place when a business is bought at four times EBITDA. It's just there's an almost irreducible minimum here.”— Royce Yudkoff

The Risk from the Investor's Standpoint · p. 7

Economics & Markets · Strategy & Decision Making

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Floor valuation plus low leverage equals resilience

“Across North America there are hundreds of thousands of small businesses with anywhere from $750,000 to $2 million of EBITDA. These businesses often have founders who need to retire. The businesses are enduringly profitable, successful small firms but there's no natural successor. That population is much smaller than the population of people reaching the end of their careers in these small firms.”— Royce Yudkoff

An Overview of Search Funds · p. 1

Economics & Markets · Strategy & Decision Making · Business & Entrepreneurship

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Valuation inefficiency from succession gap

“Because these markets are relatively small markets, the idea of building a new pipe threading facility to split that market in half it's just not that appealing as a proposition. It could happen if you're totally undisciplined and raising the price. But if you're reasonably thoughtful about it, you're not going to invite in competition. Castronics was in Kimball, Nebraska. I think there was not another pipe threader for 500 miles. So what are you going to do?”

The Castronics Case Study · p. 15

Strategy & Decision Making · Economics & Markets

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Small market plus geography equals natural moat

“I don't like technology companies. Anything that has this stroke of pen risk. For example, there was a time when autism clinics were like the best investment ever. I guess it was the time before that, MRIs were the best investment ever. The problem with all of those is that they have all this reimbursement risk. Somebody can just change the reimbursement rates and what are you going to do then? If reimbursement rates dropped by 20%, it doesn't change your cost of providing the service at 20%.”— Rick Ruback

Red Flags when Searching for a Small Business · p. 17

Economics & Markets · Strategy & Decision Making

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Revenue changes hit margins disproportionately

“If the business is priced at four times there's one business not growing priced at four times and there's a similar business that's growing at 25% a year, you're not going to buy that business at four times, that might be six times. So you're paying for it upfront as if you've been able to realize it and then you have to go realize it. That said, I think every business does better if it can grow a little. But I really like growing a little, as opposed to growing a lot.”— Rick Ruback

Perspective on Growth in Small Businesses · p. 20

Economics & Markets · Strategy & Decision Making

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Paying for growth upfront eliminates advantage

“The biggest challenge of being an investor in the private equity world is that an enormous amount of capital has flowed into private equity. Private equity, like any inefficient space, there's just a huge dispersion between the results good managers get from what bad managers get. It's sort of the opposite of the bond universe where there might be a half-point difference between best and worst. There's a 15-point difference, 15 points IRR between the best managers and the worst managers.”— Royce Yudkoff

Challenges in the Private Equity World · p. 23

Economics & Markets · Strategy & Decision Making

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15-point IRR spread in PE vs. 0.5 in bonds

“These businesses are hard to find because it's a very inefficient mechanism by which these businesses are traded. So what search fund LPs do is they will form a group and each pitch in a little bit of money to fund a searcher going out to look for a business to buy, vet it, negotiate it. If they like the business, they have a right to put in a piece of the capital like a private equity investment.”— Royce Yudkoff

An Overview of Search Funds · p. 2

Business & Entrepreneurship · Strategy & Decision Making · Economics & Markets

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Staged capital deployment reduces risk

“We pull into these small towns. There are these absolutely nondescript, unknown businesses where the owners are pulling out $1, $2, $3, $4 million a year and no one has a sense of that. But the margins in these businesses that we've been describing to you typically run 20% to 30% of sales. Would be kind of at the normal range we expect to see. Some higher, rarely lower.”— Royce Yudkoff

The Best Example of a Student Acquisition · p. 27

Economics & Markets · Business & Entrepreneurship

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Hidden prosperity in nondescript locations

“The soldiers particularly go on and explain when we're in combat, we're in combat for just a little bit of time. We'll spend years training for those few minutes of combat. When we do this, the kind of stress is permanent. We're responsible for other employees all the time and we don't really train for it. Except in the courses that Royce and I teach. So it's sort of this really interesting juxtaposition of rules that I find really fascinating.”— Rick Ruback

Most Memorable Day · p. 28

Psychology & Behavior · Leadership & Management

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Permanent vs. acute stress: different courage