Compounding and long time horizons: a reflection on my disdain for buying to sell

If you are one of the handful of subscribers on my Twitter profile you will know based on my “Old man yells at cloud” tweets that I am a huge fan of compounding businesses over extended periods of time rather than buying with the intention of efficiently selling. I had the delightful benefit last week of joining a webinar led by the Black Search Network which included Jeff Stevens, Managing Director of Anacapa Partners and Will Thorndike, founder of Housatonic Partners and author of “The Outsiders”, a scholarly analysis of eight CEOs who created exceptional long-term value. The agenda focused primarily on discussing the key criteria for identifying attractive search fund prospects but for me, the key takeaway was learning about Will Thorndike and his association with Compounding Labs, which backs businesses with “recurring or predictable revenue, low single-digit customer attrition, long-term secular tailwinds, significant cash flow generation and opportunities for opportunistic consolidation”. That led me down the rabbit hole of William Thorndike’s research on the traits of historical companies that compounded capital efficiently (in tax and cash terms) over the course of several decades. I share my key takeaways from that reading below:

The Pivotal Role of Market Selection and Pacing

When setting out to build the next meaningfully compounding business, a foundational step is knowing where to start i.e., selecting a appropriate market. Attractive markets will share a set of common traits:

• Growing market with long-term secular tailwinds (e.g., manufacturers serving the aviation market will benefit from consumers entering the middle class, and using their newly earned disposable income on local and international travel)
• Fragmented set of prospects for acquisition with common characteristics (e.g., An aeroplane has 10,000+ individual parts).
• Path to value creation: One of Transdigm’s towering strengths is in quickly assessing prospect companies through their 3 P’s framework - obtaining an objective of pricing, productivity and profitable new business. Through a well-defined playbook, the company is frequently able to bring newly acquired businesses to 40+% EBITDA margins within months
• In order to get into a position in which one can wring these levels of efficiency, owners must understand the concept of pacing. It's vital to thoroughly understand the business obtaining a solid pricing benchmark prior to attempting to scale any individual business. Transdigm’s leadership team spent 4 years optimizing its operations before commencing its acquisition-driven growth. Even then, the pacing of acquisitions was slow at first. After developing a blueprint for acquisitions, it is typical to see the company launching multiple acquisitions annually. This initial period of introspection and optimization is crucial, ensuring that the business is primed for the sustainable and efficient scaling that follows.

Acquisition Strategy: Decentralization and Efficiency

• Following the phase of internal optimization, the approach to acquisitions can become the next pillar of strategy. Orienting the culture of the business around structured decentralized pods rather than a centralized M&A function, often leads to greater success. Exercising a muscle that allows completion of numerous smaller, "tuck-in" acquisitions over larger, more cumbersome deals, is typically a stronger indicator of success. Smaller businesses are typically more attractively valued, deals are easier to close, and the businesses are often easier to integrate.
• Creating an organizational culture that allows for decentralized execution of transactions according to universal principles often leads to accretive, high volume acquisitions

Capital Efficiency: A Testament to Strategic Acumen

The efficiency of this model is strikingly illustrated by Transdigm's remarkable growth journey.

• From a cumulative total of $25 million in primary capital (initial capital used to complete the original acquisition of the company's assets), Transdigm has compounded to a staggering valuation nearing $75 billion, while paying out large annual dividends. This exemplifies the potent returns on primary investment capital that can be achieved through a disciplined, strategic acquisition process in an attractive market.

Fostering a Growth-Supportive Culture

Integral to this strategic blueprint is the cultivation of a culture that effectively supports the desired growth. Transdigm’s tailored approach is below

• Decentralized leadership in small sub-teams
• Under-market base compensation, with incentive compensation tied to company stock price appreciation (all team members need to perform to earn above market income)
• Each pod is armed with operational targets and the autonomy to pursue accretive acquisitions
• Everybody is an owner - underperforming leaders are pressured both by leadership and their professional colleagues

Reflection

Becoming a compounding giant is not just about strategic acquisitions or selecting the right markets—it's about developing (over time) a holistic approach that incorporates deliberate approaches to multiple elements of the organization. Once the flywheel is spinning, each additional year will appear easier to get through, a luxury in the dynamic markets we find ourselves in nowadays.