Creative Destruction: How Private Equity BD May Change Forever

Read time: 3-4 minutes

“Every act of creation is first an act of destruction.” (Pablo Picasso)

 

Introduction

The pandemic is stress testing everything, and COVID-19 may finally kill several BD strategies already in decline.  This isn’t great news because finding good deals at reasonable prices is still challenging, and the menu of remaining strategies to stay ahead of the competition has become pretty limited.  Just ask anyone who has submitted an indication of interest in a traditional auction process recently.  It is not pretty.  

As it pertains to deal sourcing, investors that want to survive will essentially have two options.  First, they can go back to the well of the old reliable origination channels (i.e. intermediaries, executives, independent sponsors, direct sourcing, etc.) and commit to becoming truly excellent at the strategy or strategies where they think they have a shot at doing so.  That’s one option.  The other would be to invest in and treat deal sourcing like an innovation hub.  A laboratory, if you will, to crack the code on the next wave of technology- and marketing-driven strategies that will entice the fish to jump in the boat, so to speak.  I believe that the best originators in the lower middle market will start to approach the private equity game through the lens of a lead generator with the content and lead capture techniques to match.  More on this later – first, we have to pay our respects to the deceased. 

RIP Old BD Strategies

Not everyone is going to like or agree with what I’m about to say here, but it’s high time that we pour one out1 for a few strategies that just don’t move the needle anymore. For starters, the game of staffing up one or more business development professionals to focus their energies on literally the exact same strategy every other private equity fund is employing is simply dead. The famous investor Sir John Templeton once said, “It is impossible to produce superior performance unless you do something different.” This is sage advice as we usher in business development 3.0 and say farewell to the following activities that are sort of like rocking chairs – they give you something to do but don’t really get you anywhere.

  • Conference circuit.  With apologies to the ACG, it’s sort of an open secret that these events are generally not a great use of time for tenured business development professionals. And, conferences will have ever diminishing value as investment banks increasingly adopt CRMs and automatically include buyers that have expressed an interest in seeing their deal flow. Yes, there are exceptions to every rule, but the primary remaining benefits to conference attendance from my perspective are (i) allowing new business development professionals to get critically important in-person time with intermediaries that they have not yet met, and (ii) giving tenured business development professionals an opportunity to be seen and market themselves to the industry for whatever career opportunities that may produce. Outside of that, I would advise staying home, spending more time with your family and focusing on strategies that produce deal sourcing alpha.

  • High volume / low value city visits. Another travel-based strategy with diminishing value is the approach of picking a city with a critical mass of intermediaries and setting up as many meetings as possible to remind investment bankers that you have a fund and want to do deals. While investment banks may be more inclined to take the meeting since you are going to be in town, the net result of most of these meetings is the same. In most cases, buyers leave with information that could have been gleaned from a phone call and investment bankers go back to doing something more productive with their time. The key here is quality over quantity and activities that produce real relationship development. Go see people in person, but be intentional about it, and go long form when you can, particularly if you can do so somewhere outside of the conference room.

  • Book collecting. Many (of course, not all) business development professionals are tasked with hunting down as many CIMs as possible. Their firms judge the success of their BD efforts by the percentage of the addressable market of teasers / books that they capture. While an understandable initial approach, as firms evolve their deal sourcing capabilities, they ultimately realize that a robust top of the funnel is worthless if you can’t advance those leads through the later stages of the funnel. This is where leveled up2 BD professionals earn their paycheck. Good business development pros will analyze every deal that comes in the door through what I’ll call an “angle matrix” and elevate those deals with relatively higher probabilities of closing. In other words, before any deal is analyzed on the basis of its investment merits, a firm needs to first determine if they have an angle that will allow them to prevail. As a reminder, eligible angles include process dynamics (e.g. more intimate auction), executive resources to bring to the table, prior experience / investments in a related space, a previously developed investment thesis and geographic proximity. In the end, a thousand opportunities are simply academic if the firm cannot close on one of them.


Celebrating the Birth of New Strategies

All is not lost. Like a phoenix, or odyssey3 of phoenixes, the following strategies are emerging from the ashes of deal sourcing strategies past. Some have been around for a while with varying adoption, but with necessity being the mother of invention, get ready to welcome the following approaches to the world in a much bigger way.

  • Specialization.  This one goes out to all the generalists. Enough is enough. Pick a small handful of sectors on which to focus and become excellent at them. When a firm focuses, the brand becomes synonymous with the industries you care about and relevant deal flow will start to find you. The classic rebuttal to specialization is that a secular decline in one or more of the industries on which you’ve decided to focus could blow up your strategy if the timing doesn’t work in your favor. Solution: pick sectors that are specific enough to be memorable, but that are broad enough to offer room for pivots if need be.

  • Thesis development. Investors that put in the work to get off of their heels and proactively call their shots by developing investment theses have advantages over more reactive investors. I’m always amazed by how much incremental deal flow arrives when I market very specific sectors of interest to intermediaries and other deal referral sources. What’s also amazing is how long people remember that you’ve stated interest in a specific sector. I’ve had people call me years after I’ve ceased a search for deals in a given industry to ask if we are still looking. Thesis development also offers a sort of synthetic specialization to generalist investors to create advantages in sourcing and closing deals. The missing piece for a lot of firms, though, is knowing how to market their theses effectively.

  • Digital marketing for lead generation. If I could hold up one new deal sourcing strategy like a newborn Simba in the Lion King, it would be this one. The vast majority of private equity professionals could not articulate their firm’s digital marketing strategy despite an insistence that their portfolio companies have one. This creates a real opportunity for early movers to differentiate themselves with high quality content written for business owners that facilitates engagement. Despite an improving philosophy around PE website design that offers a more welcoming feel to business owners, funds still have a long way to go to make contacting them easier and less daunting. Hint #1: make it easier, not harder, for business owners to contact you. You don’t gain anything by being elusive. Post your e-mail address and telephone number on your website. My personal goal is to close a deal based on a lead that came in through a website form submission4. Hint #2: If you’re looking for a nudge in the right direction, look at management consulting websites for inspiration around content and website design – they are lightyears ahead of most private equity funds.

  • Own your local market.  Yes, Virginia, private equity funds can still do proprietary deals. The way to do so is by leveraging geographic proximity to your firm, particularly in the era of COVID. All else equal, doing a deal with a local entity feels inherently more friendly, safer. Whether or not this is true is certainly debatable, but it does create an opportunity to avoid an auction process. In all likelihood, the buyer will not get a screaming bargain, because the valuation has to be sufficiently high to forestall an auction. However, the certainty of close improves dramatically. The hardest part about this approach is figuring out how to allocate the time / resources to best market yourself locally. Here are some ideas for consideration: membership in YPO or Vistage, providing regular content / interviews for the local business journal, sending personalized invitations to business owners to luncheons / events5, and partnering with law / accounting firms to deliver value-added in-person content (they have marketing departments after all).

Conclusion

Think like Gretzky: skate to where the puck is going to be. Indeed, there will be deals that get done through the old ways of doing things, but it doesn’t mean that this will last forever. If this stimulates any ideas or feedback, please call, email or comment on LinkedIn. Stay healthy my friends.

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1The act of pouring an alcoholic beverage on the ground as a sign of reverence for friends or relatives that have passed away.

2”Leveled up” is video game speak for having attained sufficient strength and abilities with your character to take on more formidable adversaries.

3While I had initially used the word “flock” here, it turns out that the collective noun for multiple phoenixes is “odyssey”. As an aside, my personal favorite collective noun for a group of birds is a murder of crows. But what, you ask, shall we call a group of private equity business development professionals? How about a blazer of BDs (nod to Brendan Burke at Capstone Headwaters for this one)?

4For anyone who scoffs at this aspiration, remember the words of Arthur Schopenhauer, who said, “All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.”

5One last tip, if you are nearby a racetrack that offers an exotic car driving experience, your conversion rate on invitations for such an event will be exceptionally high.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Never Let a Good Crisis Go to Waste: Themes & Sectors to Watch During and After COVID-19

Read time: 3-4 minutes

“When written in Chinese, the word ‘crisis’ is composed of two characters.  One represents danger, and the other represents opportunity.” (John F. Kennedy)

 

Introduction

I just read (and re-read) an article that suggests a third of Americans are now showing signs of clinical anxiety or depression according to Census Bureau data from May of 2020.  In response to one question about depressed mood, the percentage reporting such symptoms showed a twofold increase from when a similar survey was taken in 2014.  That means we now have just over 109 million people pacing around their homes in suboptimal mental states – a sobering barometer of the psychological burden levied by the Coronavirus pandemic and other factors.

So, I’m going to propose a new rule.  From here on out, let’s only see the glass as half full.  Let’s look for the silver lining.  No more dour clickbait headlines.  Only good news.  Per Winston Churchill’s advice, let’s figure out how to not let this crisis go to waste.  With that in mind, I wanted to share some reflections on sectors and investment themes that I think will be well situated for recovery and growth both during and after COVID-19.

 

Investment Themes & Sectors to Watch During and After COVID-19

As a disclaimer, I would expect that most sectors will experience revivals, to greater and lesser degrees, coming out of the pandemic.  The investment themes and industries profiled below are those that I feel show particular promise and could produce opportunity for investors ready to deploy capital with conviction.  Also, COVID has acted as an accelerant to many themes that have been underway for a while now, and several of the topics I mention below are simply calling out trends that have picked up and/or attracted more attention in the recent months.

Additionally, it’s been proposed that habits are formed or dropped over the course of about a month, and we’ve been quarantined for going on five months now.  So, the key here is first recognizing that behaviors have changed. Then, the idea is to focus on the areas where people aren’t going to just go back to the old ways of doing things once we can all take our masks off.  So, without further ado…

 

Investment Themes:

Explanation
1. At-Home Convenience Services Pre-COVID, I had not once had groceries delivered to my door. Because I had always driven to the supermarket and walked up and down the aisles like everyone else, it hadn’t occurred to me that there could be a better way. Well, there is. Order your groceries online and let someone deliver them to you. It’s amazing. I’m never going back. Look for ways to disrupt old life patterns that suggested that you had to be physically present to transact when in reality you did not.
2. Recurring Revenue Yes, I realize that identifying recurring revenue as an attractive investment theme is tired and hackneyed at this point. But, boy are investors happy right now that have recurring revenue-driven businesses in their portfolio. Nothing like a once-in-a-lifetime, black swan pandemic to elevate the power of recurring monthly payments. Don’t take my word for it, talk to anyone, for instance, with a SaaS-focused investment strategy about how well they’re sleeping at night. SaaS isn’t the only way to participate in recurring revenue, though. What can be more interesting for investors is to identify de facto recurring revenue in sectors that have not yet thought about their business in that way.
3. Remote Monitoring Remote monitoring and other like processes that provide real-time data and analytics without requiring a human to be in the vicinity of what is being monitored are having their moment in the sun. Nothing like keeping tabs on something from the safety of whatever Coronavirus-free location you choose, and it’s an added bonus to eliminate the wasted time and monetary expense of air travel.
4. Small, Consummable Luxuries Times are hard right now, but a great way to boost morale is through small (i.e. inexpensive), consumable luxuries. For instance, we recently invested in an ice cream franchisor called Handel’s. For my money, nothing is going to pull me out of a funk faster than one of their extra thick strawberry milkshakes for around $6. It also gets the kids out of the house. As important, it gets me out of the house. Look for analogues to this in other areas where a relatively small monetary outlay produces an outsized happiness ROI on an ongoing basis.

 

Specific Industries:

Explanation
1. Outpatient Behavioral Health You saw the statistic I referenced earlier – we’ve got a third of our population dealing with anxiety or depression. This is a staggering number. The good news is that the behavioral health industry is here to listen to your problems one empathetic nod at a time. There are a lot of ways to do good / do well in behavioral health, but I’m personally attracted to outpatient behavioral therapy services. Feels like the stigma of seeking help for things like anxiety, depression, relationship issues, etc. is coming off. Further, the onset of an array of start-up teletherapy concepts could provide a sort of marketing halo effect that raises awareness of the broader behavioral therapy industry, benefitting all participants.
2. Express Car Washes It dawned on me recently that owning an express car wash is sort of like owning a toll road except you have to spray water at the cars as they drive by. It’s automated, high margin, and recurring revenue hiding in plain sight, and the only reason many investors turned their nose up at the sector, until recently, is because we all saw Breaking Bad1 and observed how Walter White and his wife used their car wash business2. The beauty of the express wash model during COVID is that you don’t have to get out of your car. In other words, getting your car washed requires no (or very limited) human interaction. Many express car washes also sell monthly memberships which is a great way to play the recurring revenue theme.
3. Fitness Perhaps part of the reason everyone is depressed is because they haven’t been able to exercise as much (or how they would prefer), and exercise has been proven in some cases to be as effective as taking antidepressants. Once the doors of our favorite fitness concepts fling back open and we are comfortable engaging in a regular exercise regimen, the industry is poised to resume its gangbusters performance. Having invested in both the Planet Fitness and Orangetheory systems as franchisees, we’ve voted with our dollars about our view of the industry, and we see no signs of long-term headwinds.
4. IT and Other Tech-Enabled Services IT Services is one of those great industries that, in many cases, has continued to post growth amidst COVID. MSPs and other IT services companies have quietly pulled this off because a lot of their revenue is recurring, and a lot of what they do can be done remotely which captures two of the investment themes above. Look also to other tech-enabled services companies where recurring revenue and remote capabilities are present. My money is on tech-enabled services being one of the most dominant sectors to emerge from the pandemic. Investors with prior expertise with such companies will be well situated to capitalize on this trend.

 

Conclusion

Hopefully this has provided some food for thought. The easy part is identifying the trends and areas on which to focus. The hard part is actually sourcing relevant investments and deploying capital.

If you are a business owner that stands to benefit from any of the topics mentioned above, please reach out early and often! We’re here to help, so give us a call to start a conversation.

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1Breaking Bad initially aired in 2008. If you didn’t catch it during its heyday, I would need to hear a pretty good excuse as to why. If, now that we’ve been quarantined for nearly five months, you still have not seen it, then the only response is to look at you disapprovingly with arms crossed and silently shake my head. Watch it.

2To be clear, I am not advocating the use of a car wash in a manner similar to Walter White and his wife.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

What Investors Want to See in an MSP

Read time: 3-4 minutes

“Information technology and business are becoming inextricably woven.  I don’t think anybody can talk meaningfully about one without talking about the other.” (Bill Gates)

 

Introduction

Something is up in the world of IT services.  Investors are flocking to MSPs like the salmon of Capistrano1.  By my last count there are now approximately two dozen PE-backed MSP platforms in the U.S., and the majority of this deal activity has transpired within the last three or so years.  So, why now has a sector like IT Services, historically less of a focus for private equity investors, stimulated so many transactions?  Well, come along with me on a journey into the history of IT Services to find out where MSPs came from, where they are now, and the specific attributes that have compelled investors to place big bets on the sector.  To start, let’s define what an MSP is.

  • An MSP, or Managed Services Provider, is a business that, on an outsourced basis, provides the following primary services to businesses of all sizes and across industries:
    • Subscription-based management of cloud-based, on-premise & other IT assets;
    • Onsite project-based services (e.g. network design, deployment & repair); and
    • Hardware / software re-selling & implementation

In short, MSPs are delivering the same services your in-house IT guy2 used to offer onsite but now on an outsourced basis, and often remotely.  However, this wasn’t always the case.  In fact, MSPs weren’t even always referred to as MSPs.  The following section will explain how IT services companies have evolved into their current form.

 

A Brief History of the IT Services Industry

The need for IT support emerged alongside widespread adoption of technology, which in the earliest years simply meant a transition away from legacy communication and productivity methods to the use of computers.  And, with more computers came more opportunity for things to break.  Thus, the IT Services companies of the 80’s that initially focused primarily on hardware re-selling to participate in the rapid growth of business computing inevitably found their way to break/fix services when issues emerged that customers weren’t capable of or inclined to solve on their own.  So, if you’ve ever heard the term “VAR”, or value-added re-seller, this simply referred to an entity that provided hardware and/or software but also the ancillary services to assist with technology implementation, maintenance and repair.  What’s really interesting is that everyone saw the growth of IT Services coming.  In an article in the Washington Post from December of 1981, it was written, “Computer service technicians – the people who install, test and maintain the equipment – will experience the fastest job growth in the industry.” It just took a while for VARs to become MSPs.

The transition from VAR to MSP began in the 90’s, though this was well before any widespread awareness of what managed services was or would become.  This evolution was facilitated, in part, by the emergence of application service providers (ASPs) which allowed for the remote monitoring and management of IT infrastructure.  Initially, remote monitoring and support was focused on servers and networks, though the scope of service ultimately expanded to include mobile device management, managed security, remote firewall administration, security-as-a-service, and managed print services.

In 2005, the modern MSP business model began to take shape, and three individuals – Karl Palachuk, Amy Luby and Erick Simpson – are credited with having pioneered the new recurring revenue model.  In fact, both Paluchuk and Simpson published books on the topic of managed services in 2006, and the MSP model began to take hold with adoption led by enterprise-level clients.  Consequently, savvier VARs migrated their businesses to higher margin, recurring revenue models and tailored service offerings to the needs of the small-and-medium sized business (SMB) community.  Since then, SMBs have responded favorably to the MSP model.  The key drivers for outsourcing IT support in the current environment include a need for:

  • A more proactive and strategic approach to IT given that management of IT resources is non-core to most businesses
  • Maximizing “uptime” to mitigate the risk of disruption from technology malfunction
  • Enhanced risk management / compliance support in light of regulatory requirements that can put an outsized burden on SMBs
  • Cost savings / better forecasting – MSPs often provide for cheaper and more predictable costs (via fixed monthly fees) relative to in-house resources
  • Access to newer technologies to keep pace with change and cybersecurity needs

Today, the global managed services market is estimated to reach over $250 billion by 2022 with an expected growth rate in excess of 10%.

 

Why Private Equity Funds Like MSPs

PE funds are smitten with MSPs. One need only look at the large and growing volume of transaction activity in the industry to draw this conclusion.  The following graphic and supporting commentary will explain why.

  1. Investing behind technology growth.  Worldwide IT spending is expected to increase 4% annually through 2022, and a great way to invest alongside this growth without taking direct technology risk is to invest in MSPs.  This is because MSPs are not necessarily beholden to any specific technology and can nimbly adapt, and help their clients adapt, to inevitable technology change when it occurs.  Although the backdrop within the MSP industry is technology, the B2B nature of the service offering is comfortable for non-tech investors and will likely be a gateway for firms with less tech experience to get closer to technology plays.
  1. High fragmentation.  The most credible figure I’ve seen is that there are an estimated 3,700 MSPs in the U.S., the vast majority of which are owned / operated by individuals (i.e. rather than by VC or PE funds).  And, in most cases, the basis of competition is largely local or regional with no clear national leader serving SMBs.  Therefore, the sheer number of remaining independent MSPs bodes well for the ability to build regional leadership through a focused acquisition strategy.
  1. Meaningful “white space” remains.  Believe it or not, an estimated 30% or so of SMBs have not yet outsourced the management of their IT needs which suggests strong organic growth potential via new client acquisition.  Further, MSPs continue to offer a compelling value proposition for SMBs to outsource this service, so it’s likely that any slow adopters of the MSP model will ultimately see the light.
  1. Contracted, recurring revenue.  Contracts are customary in the MSP industry which provides good revenue visibility to investors and management teams alike.  Most MSPs will have some mix of recurring managed services revenue, project-based work and re-selling income, but the best MSPs will derive 50% or more of total revenue from MRR.
  1. Tangible benefits of scale.  Investors want to know that there are real benefits to scaling their MSP platforms aside from simply generating more profitability.  With MSPs, growth means the ability to better leverage fixed costs (e.g. Network Operations Centers (NOCs), internal software expense), achieve better pricing & mindshare from key product / software vendors, and access more resources to support customer acquisition which can be expensive when targeting SMBs (e.g. Sales force, digital marketing).
  1. Consolidating, but still early enough to grow via M&A.  To borrow a baseball analogy, we’re likely in the 3rd inning of the MSP industry’s consolidation.  Despite the fact that there are two dozen or so private equity-backed MSP platforms, many markets have little-to-no representation by consolidators.  In other words, secondary or tertiary markets continue to present opportunity for investors.

 

What a “Good” MSP Looks Like to a Private Equity Investor

With nearly 4,000 MSPs in the U.S. there are going to be good MSPs and not-so-good MSPs.  Fortunately, many MSP owners have readily embraced best practices and KPI benchmarking to maximize the valuation of their business.  Here are some general guidelines for what a private equity investor is going to look for in an MSP.

Explanation
1. Higher Value-Added Service Offering There’s no faster way to determine how commoditized (or not) an MSP’s service offering is than to look at their Gross Profit Margins.  Ideally, you will want to see Gross Profit margins in excess of 30%.  Higher margin services include managed services and cybersecurity whereas less value-added services include things like hardware re-selling and routine project-based work.
2. Strong Recurring Revenue Profile Across all industries, companies are doggedly chasing MRR in the interest of maximizing the value of their companies.  MSPs are no exception – in fact, the most tangible benefit of IT services companies evolving from VARs to MSPs has been their ability to capture more recurring revenue.  So, investors are generally going to want to see 40-50% or more of an MSP’s revenue tied to recurring maintenance and monitoring services.
3. High Client Retention One of the benefits of the MSP space is a tendency for service providers to retain clients.  I would argue that MSPs doing a satisfactory job or better should not be losing accounts with the exception of those clients that go out of business or get acquired.  Therefore, annual client retention should be in excess of 90% for a good MSP.  Below that level, and MSPs will need to have a pretty good explanation as to why.
4. Longer Contract Terms are Better For the same reason that investors like recurring revenue, they also like contracts – increased certainty of future revenue and profits.  Contracts are customary in the MSP space, so suitors will typically want to see a minimum of 1-year contracts (particularly for any larger accounts) to provide more comfort around stability of an MSP’s clients.
5. History of (Successful) Acquisitions Insofar as M&A growth is a compelling way to rapidly grow the scale of an MSP, an investor will take comfort in the fact that an MSP has lived through at least one acquisition and integration exercise.  Anybody can talk about doing add-on acquisitions, but until you’ve done them, you won’t have the benefit of knowing the pitfalls to watch out for.  Interestingly, investors may even like to see that one or more prior deals didn’t go well such that you won’t make the same mistakes again.
6. Sophisticated Client Acquisition Engine The double-edged sword of high client retention is that it can be hard to unseat the incumbent service provider of a prospective client.  Therefore, a material portion of organic growth for an MSP will be the acquisition of clients that may have not previously had a relationship with an MSP.  This means that MSPs seeking to ramp up organic growth will have to invest in things like sales personnel, SEO and digital marketing with the attendant processes behind them to produce good outcomes.  An MSP with organic growth of less than 5% may not yet have cracked the code on client acquisition.
7. Client and End Market Diversity Most private equity professionals learn in Investing 101 that customer concentration is bad.  And, as a general rule, investors will pause if any customer accounts for 20% or more of total Revenue.  The beauty of the MSP space is that many MSPs are serving the SMB community which often translates into a very appealing diversity of accounts with limited dependence on any one or more clients.  Similarly, end market exposure can create risks if, say, an MSP is serving a preponderance of clients in a cyclical space that may put a swath of those clients out of business every time a recession hits.  So, investors will want to see a healthy mix of industries served and may hesitate around a focus on clients within sectors like Energy or Construction, for example.
8. History of Adaptation to Technology and Industry Change  One thing is for sure, there will be technological change to which MSPs will have to adapt in the future.  A good present example is the migration to the cloud and the implications that’s having on on-premise maintenance and hardware sales.  So, a good MSP will have proven able to nimbly react to prior periods of technological disruption and help their clients respond accordingly.  After all, the beauty of the MSP industry is that most MSPs are not beholden to any one technology and should be able to successfully adapt during times of change.  A negative sign would be if an MSP holds firm to declining service offerings in spite of clear signs that the world is changing.

 

In the Land of the MSP, the MSSP is King

Wait, what is that extra “S” doing in there?  If you’re like me, it actually took me a while to admit that I wasn’t quite sure how an MSP differed from an MSSP.  To eliminate any doubt, an MSSP is essentially an MSP that specializes in providing security-as-a-service offerings for their customers.  In other words, MSP + strong cybersecurity capabilities = MSSP, and the acronym stands for Managed Security Service Provider.  While MSPs have been around for nearly 20 years, MSSPs have only recently started to emerge as a more sophisticated variant on the traditional MSP model.  This is important because there will likely be an ongoing and increasing need for companies to embrace best practices in thwarting the cybervillain community lest they be subjected to ransomware or some other crippling attack on their business.  So, the mission critical and esoteric nature of cybersecurity is likely to create a high growth, high margin opportunity for MSSPs for the foreseeable future, and investors will react accordingly by demonstrating strong interest in both acquiring MSSPs and helping their existing MSPs get their extra “S”.  The challenge is going to be when MSPs simply start referring to themselves as MSSPs in an effort to elevate their valuations.  Investors will need to respond in kind by asking more granular questions about service offerings, creating an interesting cat and mouse game while it unfolds.

Conclusion

We hope this sheds some light on why private equity funds like investing in MSPs and what they’re looking for in an MSP.  As always, we’re here to help, so give us a call to start a conversation.

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1Yes, I realize that the proper saying would have been, “…swallows of Capistrano,” but I couldn’t help myself3.

 2I must admit that one of the things I miss most about having an in-house IT guy at a prior firm were the colorful stories about niches of daily life not often frequented by members of the non-tech community.  My all-time favorite involved a lengthy diatribe about the alleged dangers of using ammonia to clean out a ferret cage given the potential to lose consciousness – an unfortunate experience endured by our IT guy on more than one occasion.

 3If you somehow don’t know that this is an homage to Dumb and Dumber, then you are likely terribly confused by the reference and should watch the movie immediately to enhance your awareness of an essential film in the canon of American comedy.

4The same article from 1981 also addresses the notion of technology-driven job displacement when one economist is quoted as saying, “What we’ll see is a large displacement of many people as more computers and computerized robots are brought into the workplace.”  If this sentiment sounds familiar, it’s because the idea of AI’s potential to eliminate jobs is presently top of mind for workers across most, if not all, sectors.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

This Too Shall Pass: A Message of Hope to Business Owners from Private Equity

Read time: 3-4 minutes

 

Hope is the only thing stronger than fear.” (Robert Ludlum)

 

Introduction

 

To date, Coronavirus has claimed over 95,000 lives globally across 210 countries, the Dow Jones has lost approximately 20% of its value from a peak in February1, businesses across all sectors have been forced to furlough and/or lay off employees and, in some cases, close, and most states have ordered residents to remain at home to slow the rate of infection. And, these are not just lifeless facts and statistics – everyone’s lives have been personally upended to some degree by the current outbreak including many with connectivity to a loved one that has been infected.  That’s the bad news. However, this article is not intended to further contribute to the daily assault on our collective consciousness by ever worsening news headlines. To the contrary, this message is one of inspiration to business owners from investors that have persevered through adversity over a 20-year period since our firm’s founding. We are here to say that the lasting consequences of surviving a great trial include resilience, strength and depth of character.  This too shall pass.

 

Prior U.S. Epidemics and the Results

 

One way to foster optimism is to better understand what those before you have overcome.  As you might expect, the U.S. has encountered its fair share of disease over the past couple hundred years.  In some cases, diseases occurred in waves and spanned decades.  What may be comforting is observe the conclusion – in every case, medical and/or hygienic innovations resulted in the particular disease’s ultimate containment or outright end.  This is not to diminish the tragedy of each outbreak, rather to simply illuminate where we currently are amidst the Coronavirus saga as compared to other instances of disease.

Prior U.S. Epidemics

Year

Disease

Geography

Outcome

1793 Yellow Fever from the Caribbean Philadelphia

§  5k people died, 17k fled the city

§  Vaccine developed

1832-1866 Cholera (3 Waves) New York City

§  2-6 Americans died per day during the outbreak

§  Vaccine developed

1858 Scarlet Fever New England

§ 95% of the people who caught the virus were children

§  Improved hygienic standards ended the epidemic

1906-1907 “Typhoid Mary” New York

§  Over 10k people passed away annually

§  Vaccine developed

1918 “Spanish Flu” U.S.

§  Estimated 675k Americans died

§  Vaccine developed

1921-1925 Diphtheria U.S.

§  Over 15k people died

§  Vaccine developed

1916-1955 Polio U.S.

§  Over 3k people died from Polio during its peak in 1952

§  Vaccine developed

1981-1991 Measles Outbreak U.S.

§  Annual death rate fluctuated between 2-10k people

§  Vaccine developed

Source: Healthline.com

 

The closest historical parallel to what we’re currently experiencing is the influenza pandemic of 1918, often referred to as the “Spanish Flu”2.  In total, approximately one third of the world’s population caught the Spanish Flu which caused a severe respiratory tract infection.  Estimates of the global death toll exceed 50 million with 675,000 casualties in the U.S. alone.  The immediate economic consequences of the outbreak included the shutdown of major U.S. cities such as New York and Philadelphia as much of their population became bedridden.  As we’re experiencing now, businesses were closed, sporting events were cancelled, and private gatherings were prohibited to flatten the curve of transmission. Additional economic consequences included labor shortages, wage increases, deterioration in GDP, and increased strain on the social security system as a safety net. The losses were substantial and not at all to be taken lightly, but we pulled through.  What’s amazing is that despite the Spanish Flu’s ferocity many in the present era had not even heard of it until it became an oft cited analogue to Coronavirus.  It seems we can always count on the passing of time to bring healing.

 

Prior U.S. Recessions & Economic Crises

 

The Coronavirus-driven disruption to economic activity in the U.S.  and abroad is now expected to result in negative GDP growth for 2020 in the low- to mid-single digits.  This is on the heels of the longest period of economic expansion in our country’s history, the era following the Great Recession.  At nearly 11 years of GDP growth, many of us find it hard to remember what a recession even feels like, but we’re going to be powerfully reminded.  However, as was the case with prior downturns, we’re going to get through this.  The following chart highlights 12 recessions in the U.S. since the Great Depression.  Note that none of them exceeded 1.5 years in length and a couple posted declines well in excess of what we’re expecting for 2020.  That’s something about which we can be optimistic if history is any predictor of future events.

Prior U.S. Recessions Since the Great Depression
Name Period Range Duration GDP Decline (Peak to Trough)
Great Depression August 1929 – March 1933 3 years, 7 months -26.7%
Recession of 1937-1938 May 1937 – June 1938 1 year, 1 month -18.2%
Recession of 1945 February 1945 – October 1945 8 months -12.7%
Recession of 1949 November 1948 – October 1949 11 months -1.7%
Recession of 1953 July 1953 – May 1954 10 months -2.6%
Recession of 1958 August 1957 – April 1958 8 months -3.7%
Recession of 1960-1961 April 1960 – February 1961 10 months -1.6%
Recession of 1969 – 1970 December 1969 – November 1970 11 months -0.6%
Recession of 1973 – 1975 November 1973 – March 1975 1 year, 4 months -3.2%
Recession of 1980 January 1980 – July 1980 6 months -2.2%
Recession of 1981 – 1982 July 1981 – November 1982 1 year, 4 months -2.7%
Early 1990’s Recession July 1990 – March 1991 8 months -0.3%
Great Recession December 2007 – June 2009 1 year, 6 months -5.1%

 Source: Wikipedia

 

We’re Living This Alongside You, and We’re Optimistic

 

As current majority investors in eight U.S. businesses operating in diverse sectors across the economy, we are living these challenges in real time alongside you.  Coronavirus’ effects to our portfolio companies range from slightly positive to materially negative. Challenges across the portfolio have involved managing liquidity, compliance with bank covenants, revenue declines, supply chain disruption, staffing discontinuity and some extremely hard decisions around cost reductions.  However, the current pain we are feeling will subside, and business will resume as normal before long.  One way to view the glass as half full is to remember the sentiment shared by Winston Churchill when he said, “Never waste a good crisis.”  In other words, while times are hard right now, the key is to look for ways to emerge stronger and to grasp new business opportunities in the post-Coronavirus era.

 

In the Meantime, We Can Help You Solve Problems

 

If you are a business owner and are going through tough times right now, we would encourage you to reach out to us to share your story.  It’s likely that we have dealt with or are currently wrestling with similar challenges based on having invested in over 20 companies since our inception.  Please use us as a resource if you are looking for anyone to talk to about ways you might address any current business hardships.  Common areas where we see business owners presently needing help include:

Common Coronavirus-Related Business Challenges

Issue

Commentary

 

1. Managing
Liquidity / Cash

Insofar as cash is king, this is a critical area to which businesses need to be attuned.  Many companies have chosen to draw on their revolving lines of credit to make sure they have sufficient cash on hand to weather the next several months.  There are other tactics that can be employed to preserve cash reserves until the Coronavirus runs its course that we’d be happy to discuss.

2. Compliance with Bank Covenants

Many businesses that were previously comfortably compliant with bank covenants are now having some difficult conversations with their lenders.  Having lived through the Great Recession, we are familiar with the nature of these discussions and can help you navigate those conversations to minimize the disruption to your business.  A proactive and transparent communication strategy with your lenders will allow you to spend more time focusing on restoring stability in the business.

3. Staffing
Continuity / Managing a Remote Workforce

Some businesses, such as those that continue to operate in more consumer facing arenas are experiencing a challenging labor environment due to a workforce that has either contracted Coronavirus or is fearful of doing so and have decided to not work.  This can be a challenging issue to solve for.  The same goes for managing a workforce that has historically come into the office and is now working remotely.  These are issues with which we are currently contending and would be happy to share our perspectives.

4. Revenue Declines

Most sectors are experiencing material revenue declines in the current environment.  While not permanent, it can be painful in the short-term, so it’s important to determine if there are quick pivots that can be made to generate incremental revenue while your traditional lines of businesses are taking a hit.

5. Supply Chain

Disruption

Whether your supply chain has been significantly disrupted or is simply moving more slowly, the movement of goods is essential to product- oriented businesses.  We’re presently investors in several companies with complex supply chains that have been affected by Coronavirus and have had to respond accordingly.

6.  Cost Reduction

Perhaps the hardest decisions to make are surrounding if, when and where to make cuts to make sure the business remains on stable financial footing.  We’ve had to examine each of our portfolio companies through this lens and would be happy to share some reflections on best practices across the industries in which we are operating.

 

Conclusion

 

We hope this review of prior U.S. epidemics and challenging economic periods has given you some hope as to the impermanent nature of what we’re currently experiencing.  Rest assured that there will be good days ahead, and we will be able to share the war stories of surviving Coronavirus.  Please know that we are genuinely here to help anyone wrestling with current business challenges and would be happy to lend our expertise or just a sympathetic ear.  Please call us any time.  In the meantime, please stay safe, healthy and optimistic.

 

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1Also, during Q1 2020, the Dow Jones posted its worst ever first quarter

2The Spanish Flu is referred to as such because it was first reported in Spanish newspapers

 

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects.  Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value.  For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Back to School: The Current Opportunity to Invest in Private Preschools

Read time: 3-4 minutes

“The child is both a hope and a promise for mankind.” (Maria Montessori)

Introduction

The basic definition of a “do well by doing good” industry is one where you can achieve financial success as a result of owning or operating a business that benefits society. Perhaps the most readily acknowledged sector that embodies this concept is education. For decades now, investors have flocked to for-profit educational products and services, and in many cases strong returns have ensued alongside the enrichment of students of all ages.

Presently, a growing recognition of the benefits of early childhood education (ECE) is stimulating entrepreneurship and investment alike in facilities focused on serving children up to around eight years of age. To start, children who attend preschool are more likely to have eventually attended and completed college. Further, preschool educated children are less likely to be arrested, more likely to graduate high school and less likely to struggle with substance abuse as adults. For these reasons and others, the evidence overwhelmingly points to the conclusion that preschool is a good idea, and parents are voting with their dollars. Another powerful driver of the industry’s growth has been the increased labor force participation rate of women which now sits at around 58% of the female population. This trend has elevated both the need for childcare as well as disposable incomes. Today, the U.S. ECE industry is around $28 billion and growing at a rate of 5% annually.

Back to School: The Current Opportunity to Invest in Private Preschools

The Different Types of Private Preschools

In this context, preschool generally refers to childcare centers with an educational focus. Preschools are typically more expensive than traditional daycare and charge tuition that is paid directly by families (i.e. not subsidized). When referring to the different types of preschools, more often than not, you’ll identify them by their pedagogy. If you weren’t previously familiar with the term pedagogy, it stems from Greek word paidagōgia which essentially means “to lead a child”, and the dictionary1 defines pedagogy as follows:

  • Pedagogy (pe-dә-gō-jē): The art or science of teaching; education, instructional methods.

The preeminent pedagogies include Montessori, Reggio Emilia, Waldorf and other / unaffiliated. In terms of the number of schools, Montessori has emerged as the leading branded pedagogy by a fairly wide margin. The following section provides a brief history of how Montessori schools came about followed by a high-level comparison to Reggio Emilia and Waldorf in the accompanying chart.

Back to School: The Current Opportunity to Invest in Private Preschools The Montessori educational philosophy was developed by Dr. Maria Montessori, an Italian physician and educator. The first Montessori center was opened in 1907 in an apartment building in Rome and enrolled 50 or so children of low-income working parents between the ages of two and seven. Through observation, Dr. Montessori took note of incidence of deep concentration, repetition of activity and a sensitivity to the order of the environment. It was in this first classroom that Dr. Montessori discovered that when given autonomous choice of activity, the children demonstrated more interest in practical activities and educational materials than in the toys provided for them. She concluded that a self-directed environment would allow the students to develop better self-sufficiency and reach higher levels of understanding. Indeed, four- and five-year olds educated through her methods quickly gained a proficiency in writing and reading far beyond what was expected for their age. These early observations led to the formalization and implementation of practices that became the cornerstones of the Montessori pedagogy. By 1911, the first Montessori schools were opened in the U.S., and by 1916 there were more than 100 schools in operation. The Montessori method later experienced some setbacks in the 1920’s based on criticism from William Heard Kilpatrick, a highly regarded educational figure, with nearly every school shuttering as a result. However, the Montessori pedagogy experienced a resurgence in the 1950’s, and today there approximately 5,000 Montessori schools operating in the U.S.

Common Preschool Pedagogies

The Thesis for Investing in Private Preschools

When strong industry growth, fragmentation and elevated profit margins collide, it tends to create a fertile environment for private equity investing activity. The following graphic and supporting commentary will provide some more color on why private preschools present a compelling investment thesis.

Back to School: The Current Opportunity to Invest in Private Preschools

  1. Compelling reason for existence. As one of the classic “do well by doing good sectors”, early childhood education benefits from both strong social and commercial tailwinds. Further, numerous studies point to lasting benefits of preschool that extend into adulthood. Early childhood education is just one of those sectors that’s hard to argue about – it seems to only offer positives.
  2. Large & highly fragmented industry with strong growth. As mentioned previously, the U.S. early childhood education industry is around $28 billion and growing around 5% annually. The industry is comprised of over 20,000 preschools with the largest direct competitor having an approximate 2% market share. So, given the fairly extreme fragmentation without the presence of nationally dominant competition, there exists an exciting opportunity to build strong local / regional / superregional preschool footprints.
  3. Private pay model. The variety of preschools contemplated here are private pay models that do not rely on government subsidy. This means that tuition is paid directly by families, and preschool operators will thus not be exposed to any political forces that could adversely affect revenue generated through government programs. Think of it this way, as an investor or owner of a private preschool, it would make for a less stressful existence not having to worry about uncertainties created during election years, and your school’s valuation will be better than one that has exposure to subsidies.
  4. Attractive unit economics. Generally speaking, a well-managed mature school can generate $2-3MM of annual revenue with 20-30% EBITDA margins. If you assume a build-out cost of $500k-1MM, then there is good rationale to grow via a greenfield, or de novo, strategy.
  5. Franchising potential. If you investigate some of the larger private preschool operators in the U.S., you will come to find that many of them have sold franchises to independent business owners. Franchising can be an excellent way to rapidly scale a school’s footprint by allowing entrepreneurs to invest the capital to own and operate their own schools. In our case, we’ve invested extensively in franchising, so this dynamic creates a merging of two arenas on which we are presently focused – private preschools and franchisors.

What Investors Want to See in a Private Preschool

With over 20,000 preschools across the U.S. there’s a wide spectrum of operating models and resulting performance. From an investor’s perspective, the following KPIs and benchmarks are generally indicative of a well-managed preschool.

Explanation
1. Sufficient Child Capacity to Support Critical Mass There are exceptions to every rule, but we generally look for capacity of around 150+ students. Using basic assumptions around tuition, this allows for a critical mass of revenue and profitability on a per school basis.
2. Utilization Indicative of Parent / Community Satisfaction High utilization is generally indicative of parent satisfaction with a school, but you don’t always need to see that a school is 100% utilized. While full utilization is encouraging, it doesn’t provide for the best student experience or organic growth outside of tuition increases, so investors will generally look for utilization of around 85%+.
3. Reasonable Operating Tenure There’s something to be said for longevity. If a school has made it past the 3-year mark, it’s generally operating under a viable model. Investors may have some hesitation around schools that have not yet withstood the test of time.
4. Relevant Accreditation NAEYC accreditation is a great stamp of approval for a private preschool operator. It shows that they not only took the initiative to make sure their school met important threshold performance and curriculum standards, but that they also passed. Investors may also take comfort with certain pedagogy-specific accreditations (e.g. American Montessori Society, Association of Waldorf Schools).
5. Strong Reputation; Proven Results Schools with positive online reputations show that they both are paying attention to how their brand is regarded and that they have been validated by parents. Good sites for preschool ratings include GreatSchools.org and Yelp. Assuming a sufficient number of reviews to be statistically significant, it’s hard to see how an investor would get excited about a school with below a 4-star rating.
6. EBITDA Margins in Excess of 20% for Mature Schools Tuition for private preschool has reached a level that should create for healthy profit margins for school operators. Many families are now paying upwards of $10,000 / year (or more) per child to attend preschool. Investors will generally want to see 20-30% EBITDA margins for well-managed schools.
7. Multi-Site Presence For a private preschool operator to be considered a “platform” for an investor, they will need to have proven their ability to replicate results across a portfolio of schools. Using general estimates about profitability on a school-level basis, many investors will want to see around 5 or so schools to provide for both a sufficient base of profitability and conviction that the management team has the capability to expand the company’s footprint by opening and/or acquiring new schools. Given the fragmentation of this industry, and the propensity for owners to operate 1-2 locations, larger operators can be harder to come by.
8. No Headline Issues There is nothing scarier to a parent than the threat of something bad happening to their children. So, prior incidents at a school are going to make investors extremely cautious. Depending on the severity of the issue, an incident at a school could have an extremely damaging effect on a school’s ability to survive and thrive in a local community.

Conclusion

We hope this illustrates why investors are taking interest in private preschools and some of the attributes they will look for in a school operator. As always, we’re here to help, so give us a call to start a conversation.
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1Per dictionary.com

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Why Private Equity Likes Founder and Family Owned Businesses

Read time: 3-4 minutes

“A big business starts small.” (Richard Branson)

Introduction

If you speak with a lower middle market private equity fund about what they look for in an investment, their comments will often include something like, “We like to invest in founder- or family-owned businesses.”  Others may introduce more complicated jargon and say, “We prefer to be the first institutional capital into a business.”  These statements essentially mean the same thing.  Why, though, does this matter?  It matters because there are actually a lot of different types of entities from which you can buy a business, founders and families being one of them, and making an investment in each scenario may require a nuanced approach to dealing with the seller in question.  For the sake of illustration, the table below highlights the common entities form which businesses are acquired.

Seller Type Description
 1. Founder or Family Individuals or a collection of related shareholders that control a privately held company.
 2. Venture Capital Fund A professional source of early stage capital for founder-led businesses that show strong upside potential.
 3. Private Equity Fund Another source of professional capital though for established, profitable businesses.
 4. Employee Stock
Ownership Plan
Often referred to as an “ESOP”, this is a benefit plan that gives workers an ownership interest in a company.  ESOPs are overseen by a trustee who acts as a fiduciary to protect the assets of the ESOP for the beneficiaries.
 5. Another Business Other corporate entities that may seek to sell (or, “divest”, or “carve out”) operating units that are non-core or underperforming.
 6. Public Company Shareholders Public companies can be acquired from shareholders and “taken private” if they are willing to pay a premium to entice the shareholders to sell.

So, given that many private equity funds pursue founder- or family-owned businesses as a strategy, they have clearly determined that acquiring from individuals as opposed to other investment groups or corporate entities is an attractive approach.  This article will explain why, but first let’s understand where all these family-owned businesses came from by learning about the origins of entrepreneurship in the U.S.

A Brief History of Entrepreneurship in the U.S.

Ever wonder from where the word entrepreneur originated?  Turns out it dates back to 1723, and we adapted it from the French word entreprendre which means “undertake”.  Today, we define entrepreneur as follows1:

  • Entrepreneur (än-trə-p(r)ə-‘nər): One who organizes, manages and assumes the risks of a business or enterprise

In the United States, entrepreneurship has a rich history that spans hundreds of years.  Famous Economist and Nobel Laureate Milton Friedman once wrote, “Ever since the first settlement of Europeans in the New World, America has been a magnet for people seeking adventure, fleeing from tyranny, or simply trying to make a better life for themselves and their children.”  One could even argue that America, as a nation, was in a sense built by investor-backed entrepreneurs.  For example, in 1607 the Virginia Company of England sent three ships on a four-and-a-half-month voyage to colonize American plantations.  The 100 or so passengers that disembarked settled and developed what became Jamestown, Virginia.  Relevant here is that the Virginia Company was a joint-stock company which allowed for investment in ventures with limited liability if the business failed, which was a good thing because it ultimately went broke.  You win some, you lose some.

While not often regarded for his entrepreneurial skills, Daniel Boone could be considered an early archetype of the American pioneer / entrepreneur who in 1799 departed Kentucky for a fresh start and settled along the Missouri River on a thousand or so acres of land then part of Spanish Louisiana. It was the Western migration of Boone and others that is credited with establishing the foundation for capitalism’s success in America.  During this period, a majority of these pioneers were farmers, eking out a living on small family farms, and it’s important to keep in mind that the cost of failure for such pio-preneurs was not merely financial, many paid with their lives.  In the early years, Westward migration proved challenging due to the limitations of undeveloped routes amidst the wilderness, but ultimately wagon-based travel became feasible followed by steam-powered locomotives which revolutionized human transportation.  It was the railroads that were both fueled by and facilitated future entrepreneurship.  Interestingly, some also cite the railroads as the origin of modern managerial systems given that the expanse of the railroads’ operations required new methods for managing organizations with a distributed geographic footprint.

It’s hard to believe, but prior to 1811 there had been a mere seven companies incorporated in North America.  This all changed when New York State permitted incorporation by law upon filing out the proper paperwork which freed the process from bureaucratic legislative acts and politics.  As a result, the number of corporations started in the U.S. increased dramatically, and the state of Pennsylvania alone incorporated more than 2,000 businesses between 1800 and 1860.  Consequently, the American dream of being in business for oneself expanded to include small merchants and independent craftsmen.

During the latter part of the 19th century, further Westward expansion and government incentives for industries such as the railroads, banking, and land acquisition led to tremendous opportunities for profit, which allowed entrepreneurship to flourish. During this period, entrepreneurship can also be credited with propagating capitalists, innovators, prospectors, financiers, and businessmen who created and expanded existing businesses.  It was this period that gave rise to big business and many household name companies within oil, steel, tobacco, shipping, railroads and banking.  These industries were largely unregulated, though, which led in some cases to monopolistic power and the inevitable ensuing regulation to establish a more stable business environment for companies of all sizes.

Continuing a trend that began in the latter part of the 19th century, the 20th century ushered in a dramatic increase to the scale and complexity of business in the U.S.  In many industries, small enterprises had trouble raising capital and operating at a scale large enough to efficiently produce goods for an increasingly sophisticated and affluent population. In this environment, the modern corporation, often employing hundreds or even thousands of workers, further rose in prominence. This period was responsible for the formation and success of such businesses as Ford Motor Company (1903), Hewlett Packard (1939), McDonald’s (1940), Wal-Mart (1945), Southwest Airlines (1967), Microsoft (1975) and Apple (1976).

Fueled by the internet, the 21st century has been marked by lower barriers to business formation and the creation of a new array of tech-enabled manufacturing and service-based companies both large and small.  We’ve come a long way from the pioneering ventures of early settlers and those who sought better fortunes in other parts of the U.S.  While the look, feel and focus of American entrepreneurs has changed over the years, the drive to undertake and build profitable businesses has endured paving the way for the successful family businesses of today so frequently sought after by private equity investors.

The Benefits of Investing in a Founder or Family Owned Business

Finally, and without further ado, here are some of the main reasons why lower middle market private equity funds like investing in founder or family-owned businesses:

  • There are a lot of them. One estimate is that there are 28.8 million small- and medium-sized businesses (SMBs) in the U.S. and that 19% of them are family owned.  So, 28.8M x 19% = ~5.5M family-owned businesses into which private equity can flow.
  • Aging Baby Boomer business owners are seeking liquidity. Of the ~5.5 million family-owned businesses in the U.S., nearly 4 million, or ~75% are controlled by Baby Boomers.  And, given that Baby Boomers are defined as those born between 1946-1964, that means that the Boomers are now aged between 55-73.  To that point, 47% of family business owners now report that they intend to retire within the next five years.  So, we are amidst a wave of estate planning-driven business sale activity that is buoying the population of target companies eligible for PE funds.
  • Most family-owned businesses do not survive generational transitions. Sad but true – only 30% of family businesses survive the transition from first to second generation ownership. Even worse is that only 12% survive the handoff from the 2nd to 3rd  It’s like the old saying, “Shirtsleeves to shirtsleeves in three generations.”  Most business owners are all-too familiar with these statistics and related adages, so they are looking for a safe set of hands to usher their life’s work into the future while creating a lasting home for their employees to continue their careers.  In many cases, private equity funds are the perfect acquiror insofar as they manage companies by profession and will increase the odds of a successful change in ownership.
  • Ability to develop a rapport with the founder and/or owners of the business. When you acquire a business from a corporate entity or institutional investor, the discussion is largely around price as the chief determining factor in whether the seller will transact.  However, deal discussions with a founder or family are much more nuanced.  Founders, rightfully so, want to know that what they’ve bled, sweat and cried for is going to endure into the future.  So, this creates an opportunity to build a meaningful relationship with the founder to ensure that there is a shared vision and a strong working chemistry insofar as they will continue to be involved after the deal closes.
  • The founder or family will often retain some ownership. I don’t know about you, but the notion of buying 100% of a company from a founder who has no intention of remaining involved with a company post-closing is scary to me.  This would be like someone throwing the keys at you after purchasing a car, wishing you well and then screeching off into the distance never to be seen again.  Not a good sign.  The best transactions are where the prior founder or family retains a meaningful amount of equity in the company and is aligned to help continue building the company with you.  After all, these are the people who architected the vision, strategy and culture to get the company to the point where a PE fund would want to invest in the first place.
  • Tangible growth opportunities. Once a company starts to generate substantial cash flow, the incentives to grow it can be at odds with the perceived risks of disrupting a comfortable lifestyle that a business owner has come to enjoy.  Said another way, if an owner is generating $5 million in EBITDA and is making more money than they ever dreamed they would, why undertake the investment and risk associated with growing the bottom line?  This dynamic is prevalent with many founder and family-owned businesses and creates the opportunity for a PE fund to execute on numerous “low hanging fruit” growth initiatives that have not yet been pursued.

How Private Equity Helps Founder and Family Owned Businesses

Explanation
1. Wealth Diversification For many entrepreneurs, their business represents their largest single financial asset.  This concentration of wealth created by the business creates an inherent risk to their net worth should something happen to adversely affect its valuation.  Therefore, a transaction with a private equity fund helps to diversify a business owner’s net worth by generating liquidity (i.e. cash) for the founder or family owner.
2. Team Development While many family or founder-owned businesses can generate strong growth and profitability for a time, they will ultimately stagnate if they haven’t invested in a team that can manage a larger organization with its new assortment and complexity of challenges.  And, we routinely see certain departments that have been under- or undeveloped such as Finance or Sales.  The good news is that private equity funds are in the common practice of helping companies supplement their teams with high quality talent who can help the business get to the next level.
3. Business Building Beyond team development, many founder and family-owned businesses have not fully embraced best practices regarding systems or process.  In order for small companies to become big companies, they need to be built upon a framework that will support the transition to a larger organization.  This applies to things like data capture & analysis, workflow management, compliance, and financial controls.  Given that private equity funds invest across a portfolio of companies, they have an excellent vantage point to identify and help implement the necessary systems and/or processes to help management teams drive their business forward.
4. Financial Sophistication Private equity funds have earned a reputation for taking an analytical eye to the businesses in which they invest.  Frequently, a founder or family-owned company’s prior reporting processes will evolve under new ownership to become both more strategic and granular.  Business owners will get a flavor of this during the due diligence process when an investor begins analyzing the business to better understand it.  A test of whether a fund is focused on the right things is if an owner gains new and valuable insight about their company that they had not previously considered.  The end goal is for a company’s investors and management team to know precisely where the key drivers of value exist and focus on the areas that really move the needle.
5. Capital For Growth Don’t forget that private equity funds often reserve capital to support the growth of their partner companies beyond what it takes to close the deal.  For many businesses, growth via the acquisition of smaller businesses in the same industry can be an excellent way to increase scale and profitability.  So, if you aspire to acquire smaller businesses and fold them into your organization, make sure to ask any investors with whom you are speaking about their ability to fund future deals.
6. “Two Bites of the Apple” In many cases, a private equity fund will want the founder or family shareholders to retain some ownership following a transaction.  The helps ensure that the person or people that drove a company’s prior successes are aligned with the new investor’s goal of supporting future growth. The amount of retained ownership varies for each deal but generally ranges from 10-30%.  By holding onto some of the equity in the business, owners stand to benefit from the next exit if the business increases in value.  In some cases, we’ve seen the proceeds from an owner’s second transaction, or the “second bite of the apple” exceed proceeds from the initial transaction.

Conclusion

We hope this sheds some light on why private equity funds like investing in founder and family-owned businesses.  As always, we’re here to help, so give us a call to start a conversation.

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1Merriam Webster

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

This is Why Culture Eats Strategy for Breakfast

This is Why Culture Eats Strategy for Breakfast

Read time: 2-3 minutes

Culture is a hot topic these days. By now, you’re probably familiar with Netflix’s famous 100+ slide deck outlining their corporate values and have enjoyed Simon Sinek’s highly viewed Ted Talk musings on how good leaders make people feel safe.  However, it seems we’re hearing ever more about how this elusive dimension of organizational behavior is being embraced by top companies. Why it’s taking root so prominently now I can’t say, though Winston Churchill might have been onto something when he said, “Americans can always be counted on to do the right thing, after they’ve exhausted every other possibility.” That is to say, perhaps companies are now concluding that financial success is, after all, an ensuing result of creating a cultural framework that enables high-quality teams to achieve as opposed to something that is pursued without regard for the softer side of how you get there.

This is Why Culture Eats Strategy for Breakfast

To be clear, this blog is not about how to create a good company culture. There’s been plenty written about that, and I’m still not fully convinced that culture isn’t just a reflection of senior leadership’s behavior and how they reward the cardinal virtues they espouse. What I’d like to explore is why I think that Peter Drucker’s famous, “Culture eats strategy for breakfast” line has withstood the test of time and is presently top of mind for leaders at the helm of companies large and small. To do that, I’ll share the following ways that strong cultural dynamics have contributed to the success of organizations with which I’ve been affiliated. So, without further ado, strong cultures…

  • …encourage risk taking that leads to innovation. If the standard of performance is perfection, then people will simply talk themselves out of otherwise good ideas for fear of diminishing their internal status (or worse). However, when it’s OK to make mistakes in the name of progress, employees will take initiative and experiment with new ideas. More often than not, these ideas, while good, won’t move the needle and may even fail. However, without feeling safe enough to try something new, the truly game-changing ideas that allow you to stay ahead of your competition will not come to fruition.
  • …allow people to be vulnerable to promote problem solving. If people aren’t comfortable sharing challenges holding them back, then they’ll simply stew in frustration for fear of seeming like they aren’t up to the demands of their job. This will consequently hold the company back from progress it could otherwise be making. However, when people are willing to articulate problems and approach colleagues for advice, then the maxim of two heads being better than one will prevail. True success is when people can be vulnerable in front of a group of peers and/or superiors to access the best of their collective wisdom.
  • …reduce the energy wasted on fighting internal battles and focus on beating the competition. In many companies, an employee is forced to fight battles on two fronts – the external (i.e. against the competition), and the internal (i.e. against culture and the agendas of other employees). From my experience, external competitive forces are sufficiently formidable to require complete and undistracted focus. The challenge is that internal struggles are real and often result in a host of counterproductive emotions, most powerfully, worry. I’ll admit that of all the nights I’ve lost sleep in my career, the vast majority have been due to internal issues. Imagine how much stronger your organization would be if 100% of the team’s energy was focused on beating the competition.
  • …motivate people to show off their superpowers. This begins with the understanding that each person has a “genius” and that a universal yardstick of ability simply cannot be applied to everyone. If a culture singularly exalts a narrow skillset, then people won’t be energized to exhibit lesser-valued skills that a company may desperately need. There’s a reason it’s beautiful watching cheetahs sprint and dolphins jump acrobatically in the ocean – while different, those behaviors are what those animals are the best at, and they don’t hold anything back. What if observing your team was as fun as watching Blue Planet? Or, better yet, X-Men?
  • …speak to the person, not their position, to engender respect throughout the organization. There are hierarchies within every organization and roles that are more glamorous than others. And, usually, people are keenly aware of where their activities stack up in the pecking order of internal respect. One of the faster tactics I’ve seen to demotivate an employee is to engage with them as though their role deserves inferior treatment. Conversely, when a person is treated with respect, regardless of function, it has a way of helping that person find meaning and dignity in their activities which can compound to create unforeseen benefits to the business.
  • …recognize achievements that advance important goals. No better way to get a team to keep doing more of what works and less of what doesn’t than to acknowledge strong performance. If this praise comes from the top, you can all but guarantee that others will follow suit. I’ve had bosses make my entire week just by saying “good job” about something I didn’t think they had noticed. All things being equal, happy employees have got to outperform the alternative.

While not an exhaustive list, I can say that I’ve experienced both the good and bad sides of these dynamics. Goes without saying that I’ve functioned at my best when I’ve felt safe enough to innovate, been comfortable asking for help, didn’t worry about internal frictions, knew that my skills were valued, felt respected and received recognition. Interested in your thoughts – how else do strong cultures make employees and companies better?

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Franchisors vs. Franchisees: Why Private Equity Likes Both

Read time: 4 minutes

“Long-term consistency beats short-term intensity.” (Bruce Lee)

Introduction & Definitions

It’s official, private equity investors like franchises. This wasn’t always the case, but in recent years, there’s been a wave of private equity funds investing behind multi-unit concepts of all varieties. During 2018, significant franchisor acquisitions by private equity funds included Jamba Juice ($200 million), Sonic Drive-In ($2.3 billion) and Zoe’s Kitchen ($300 million) to name a few. In 2019, we’ve seen CorePower Yoga, Hooters and Whataburger attract new investors. What’s interesting is that a historical preference for franchisors has become more balanced in that private equity funds are starting to take material interest in franchisees as well. So, we thought it was worth exploring the nuances between the franchisor and franchisee model and explaining a few of the reasons why private equity sees strong investment returns potential in both strategies.

Introduction & Definitions

To start, let’s define the relevant terms1 :

  • Franchisor – The entity that establishes a brand’s trademark or tradename and a business system. Franchisors make money by charging its franchisees up-front fees and royalties as a percentage of revenue, typically around 5-6% (though there are exceptions to this rule of thumb).
  • Franchisee – Often a small business owner that pays a royalty and an initial fee for the right to do business under the franchisor’s name and system. Outside of royalties and, sometimes, marketing or other fees, the franchisee keeps whatever profits they generate from operating their business. When successful, it’s common for franchisees to own multiple units within a franchised system.

A Brief History of Franchising in the U.S.

A Brief History of Franchising in the U.S.

Not only was he one of the Founding Fathers of the United States but, you guessed it, Benjamin Franklin instituted the first franchise system in 1733. When he wasn’t busy inventing the lightning rod, bifocal glasses, swim fins, a stove bearing his name, and a much-needed update to a sadistically inflexible urinary catheter, Mr. Franklin evidently found time to strike a deal with one Thomas Whitmarsh to establish Whitmarsh as a printer in Charleston, SC. The deal was that Franklin would rent space for the printing operation and provide any equipment in exchange for one third of the profits over a six-year period. At the end of the term, Whitmarsh would be able to buy the equipment back from Franklin and work for himself free and clear. Whitmarsh went on to print such reads as the South-Carolina Gazette and local copies of Poor Richard’s Almanack. Franklin replicated this model in other cities that had either no printers or light competition by partnering with employees that demonstrated good work ethic.

Despite Franklin’s earlier claim, many sources credit Isaac Singer, the founder of sewing machine manufacturer Singer Corporation, with the creation of the modern franchising model in the mid 1800’s. Like Franklin, Singer used franchising as a means to quickly expand. Singer distributed his sewing machines throughout the U.S. via a network of licensees that paid both a licensing fee and were required to teach people how to use the sewing machines.

The bottom line is that franchising has been around for hundreds of years and has withstood the test of time. Thanks to these and other founding fathers2 of franchising, the U.S. is now home to over 700,000 franchised businesses. While there are not yet as many private equity firms in the U.S., perhaps 1-2 thousand depending on who you ask, the amount of capital they have raised should make it no surprise that they’ve discovered ways to generate strong investment returns in franchisors and franchisees alike.

 

What PE Firms Want to See in a Franchise System

Investment criteria across private equity firms for franchises may vary, but it’s safe to assume that most professional investors are going to look for one more of the following attributes when looking to back a franchisor or franchisee:

What a “Good” Franchise Looks Like to a PE Fund
Lender Product or Service that is Staightforward and Can be Consistently Replicated A system’s growth will usually be driven by franchisees, so the product or service needs to be something that can be quickly mastered by a small business owner and/or employees that may not have prior experience in the industry. Further, franchisees will need to consistently meet the brand standards set out by the franchisor such that the system upholds a consistently strong reputation across its network of operators.
Lender Product or Service that is Sustainably “On Trend” Systems that benefit from sustainable and easy to understand tailwinds are going to be more attractive to private equity investors. Most private equity funds are adept at discerning trends from fads, so if the shiny new product doesn’t appear to have staying power, then they may pass on making an investment.
Lender Universal Appeal Across Geographies3 Some products or services may be relatively more embraced in certain geographies than others. A good example might be a food concept that is cherished in one part of the country but is not portable to other markets based on regional dietary preferences. So, investors will look for systems that are thriving within their original markets as well as new markets that they’ve entered. Example: Have you ever been to a part of the country that doesn’t have a McDonald’s?
Lender Sufficently Long Operating History Much like how investors evaluate non-franchised businesses, it’s comforting if a franchise has an operating history that suggests long-term viability. If a system is too young, investors may pause in favor of those with more longevity.
Lender Critical Mass of Units Systems that offer a critical mass of units, say 50 or more, tell investors a few things. First, they’ve been able to attract a good number of franchisees who were willing to incur the fees, development costs and risk associated with starting up a new location. Second, if the locations have been open for a while, then it suggests longer-term viability of the concept, though investors will also want to know how many locations have closed. Third, the larger the system, the more resources a franchisor will have to support their growing network in areas like marketing. Lastly, larger systems will have survived a lot of growing pains that smaller franchises experience and often emerge more ready to support future growth.
Lender Good Unit Economics Unit economics are the financial investment and results one might expect in opening and operating a single location. The basic ingredients to a good unit economic profile include return on investment (ROI) from build-out costs and same-store-sales growth, but there are a lot of metrics one can analyze within a franchised system. For more information on unit economics see “A Crash Course on Unit Economics” below.
Lender Successful Franchisees Good franchisors want franchisees to be successful and happy. It’s a good sign if you see a high incidence of multi-unit franchisees – this suggests that a franchisee was sufficiently happy with the result of their first location to open additional locations. Systems with successful franchisees will be better at attracting new franchisees and have better prospects for growth.
Lender Runway for Future Growth PE funds want to see that systems offer sufficient “white space” to permit growth during their ownership period and beyond such that they’ll be able to attract buyers when they seek to exit. In other words, there needs to be enough undeveloped territories to allow future investors to make a good return on their investment.

A Crash Course on Unit Economics

Given what is often a large number of units operating within a franchise system, there is no shortage of data that can be analyzed. However, the essential metrics for most investors are relatively straightforward and relevant across franchised concepts. The good news is that some of these metrics will be profiled in the Franchise Disclosure Document (FDD). The graphic below summarizes how investors will usually look at and assess unit economics:

 

Common Unit Economics Analyzed by Private Equity Investors
Build-Out Costs Build-Out Costs
The initial fees and investment required to open a new location.
Should be examined in connection with how much EBITDA a mature location will generate, and how quickly. More modest build-out costs make systems accessible to more prospective franchisees, but build-out costs need to be taken in a broader context of return on investment.
Time to Profitability Time to Profitability
How quickly a unit becomes cash flow positive.
Will be important to franchisees with less liquidity to weather the cash burn phase. All else equal, a system where franchisees become cash flow positive faster will be more attractive.
Time to Recoup Build-Out Costs Time to Recoup Build-Out Costs
How quickly a franchisee earns back build-out costs from a unit’s profits.
A franchisee’s ability to quickly recoup build-out costs will allow them to open up new units to their benefit and the benefit of the franchisor.
Time to Maturity Time to Maturity
The length of time until a unit achieves steady-state Revenue and EBITDA.
Like other unit economics categories, faster is better. A good benchmark is under 3 years for a unit to achieve maturity, but this varies and needs to be taken into consideration alongside other unit economic categories.
Mature Revenue, or “Average Unit Volume” Mature Revenue, or “Average Unit Volume”
The point at which Revenue growth slows to a long-term rate.
As you might expect, bigger is better for AUV. The greater the Revenue potential, the better the opportunity to generate profits for franchisees. A good benchmark for AUV is $1MM+.
Mature EBITDA Mature EBITDA
The point at which EBITDA growth slows to a long-term rate.
The amount of EBITDA a location generates is critical for a franchisee. It’s the difference between the owner “buying themselves a job” vs. buying themselves a profitable business that generates cash flow that can be reinvested in new units or distributed to shareholders.
Build-Out Costs / Mature EBITDA Build-Out Costs / Mature EBITDA
A ratio that highlights how much upside exists between the cost for de novo units relative to an expected sale multiple.
This is as close to a golden ratio in franchise investing as you are likely to get. This simple calculation will tell you what it costs, in terms of an implied EBITDA multiple, to open new units. In this case, the lower the number, the better. Example: If build-out costs are $500k, and a mature location will produce $250k of EBITDA, then the ratio is 2x.
Same-Store Sales Growth Same-Store Sales Growth
The annual growth rate of a cohort of units that were opened for a full year or longer.
A unit’s growth rate will typically depend on how long it’s been open – younger units should grow at a faster rate than those that have been open for several years. So, it makes sense to look at growth rates by year of opening. However, same-store sales growth can also be analyzed across an entire portfolio of stores to give a sense for the general health of the system.

The Pros and Cons4 of Franchisors vs. Franchisees

Now that we’ve covered what franchising is, its history, what an investor looks for in a franchised business, and the ABCs of unit economics, we can finally share why investors like investing in both franchisors and franchisees. Like any sector, there are positives and negatives, but for many investors the pros far outweigh the cons in franchising. The following table highlights the respective merits and limitations of investing in franchisors and franchisees from an investor’s perspective:

The Pros and Cons 4 of Franchisors vs. Franchisees

Conclusion

We hope this sheds some light on how private equity funds evaluate franchises and why they have made substantial investments into both models. As always, we’re here to help, so give us a call to start a conversation.

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1Definitions from franchise.org.

2William Metzger (pictured above) purchased the first independent car dealership from General Motors in 1898. By working with franchisees in exclusive territories, OEMs like GM and Ford were able to bring their products to market more efficiently, and over longer distances. Famously, Ray Kroc (above) opened the first McDonald’s franchise restaurant in 1955. Shortly thereafter he set up the company that would become the McDonald’s we know today. By working with franchisees across the U.S., Kroc grew his system to over 100 restaurants by 1959.

3The exception to this rule is if a concept is more regional yet the region supports a sufficiently large addressable market.

4Believe it or not, Benjamin Franklin is also credited with developing the idea of a Pros and Cons list.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle- market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.