Intro to Pulling Threads

Welcome to Pulling Threads - Our periodic deep dive into things we're curious about.

We're taking the first dive to explore the thinking behind our thesis at Southstone. After that we promise to not talk our book and instead focus on, well, everything else. Our challenge is to not skim - give it a 10 minute read and see what happens.

Going Deep

[Expert status] Across different investments and projects, I’ve become an expert on ABA clinic waitlists in California, vape shop market share, allergist compensation models, and leading-edge repair techniques for wind turbines. Each required going deep - reading everything there was to read, talking to the experts, collecting data, asking lots of questions, and then putting pen to paper to summarize it and answer the “so what?” I love going deep. I love it in the way I love a hard workout. It’s work, but it’s incredibly rewarding.

[Recently rare] Going deep used to be common, a default pattern of life. A generation or two ago, we lived in our hometowns for a lifetime, vacationed to the same beaches each summer, read novels, and worked at the same company for 35 years. The world has changed in some good and remarkable ways, but somewhere along the way we’ve lost the skill and desire to go deep. Even in the 17 years since Netflix went digital in 2007, we’ve traded epic shows like The Wire or Breaking Bad for TikTok. So much now comes at us as the quick take, the digital short, the bite sized LinkedIn post that offers a distilled version of everything you need to know about recruiting or diversifying your portfolio or maximizing your vacation. Somehow, The Wire feels closer to Moby Dick than today’s 15 second shorts. I’m admittedly part of the “problem” here, as both a consumer and a producer; but I lament that we’ve neglected and forgotten the long form.?

[Pulling Threads] As we launch Southstone, Jeff and I want to fight against that inertia and push to go deep again, not only as we analyze companies and build relationships, but also as we create content and engage with our networks. There’s a time and place for short bursts on LinkedIn, which we’ll continue to do (I’m starting to suspect Jeff is already having a little too much fun there…) but we also wanted to cultivate a community focused on longer form content about topics we find interesting - economics, culture, business, faith, sports. Drawing upon our natural curiosity, we’re calling it Pulling Threads. We’ll send it out once per month and hope it’s a fun, thought-provoking way to engage with us on something we (and hopefully, you) find interesting.??

This first week we explore our thesis for Southstone.?

The silver Tsunami exists

[The data] At this point, you’ve probably heard of the Silver Tsunami - the impending wave of businesses owned by baby boomers (ostensibly with silver hair) that will transition over the next 5-10 years. Everyone’s talking about it, from SMB Twitter to the McKinsey research publications: millions of businesses with aging owners, hundreds of thousands transacting per year, trillions in value, and a significant portion of owners without a plan. It’s a compelling case and, at face value, we believe it.?

[Perspective] It’s hard to get the magnitude right, but in some sense it doesn’t really matter. Is it 1M SMB or 5M? Whether 250,000 companies fit our target profile of 25,000; the pond is big. The same logic goes for the demographic wave and timing. Our perspective is that we have considerable runway, but this too doesn’t totally matter. Businesses will continue to get started and sell whether we are in the 3rd inning or the 7th inning of the trend.

[Abundance mindset] We’ve found this macro data supported by the high degree of openness and cooperation of others playing in this space (what I’ll call micro PE). Before launching Southstone, we spoke to a number of folks operating in the space; not only did everyone take our call, they also shared insights, docs, perspectives, and contacts. There’s an overwhelming abundance mindset here, which we view as corroboration of the large pond and limited head to head competition.?

It’s not shooting fish in a barrel

While we agree with folks on the size of the pool, we disagree about the ease of capitalizing on it. Finding, acquiring, leading, and growing small businesses is hard. It’s not shooting fish in a barrel. That’s part of the reason there’s so much opportunity for return – it’s an inefficient market – but it’s worth highlighting the challenge as more and more folks start talking about it.?

I won’t go into every detail about why it’s hard but let’s dive into sourcing to make the case.?

[Vs. mid market PE] As a comparison, let’s consider mid-market PE, which I’ll define as companies with $10M–$50M in EBITDA. Investor bankers lead most of these transactions, working with a dedicated team to understand the business, prepare financials, identify buyers, craft growth narratives, and run a competitive auction focused on price. You might have to overpay for one of these companies, but it’s not particularly hard to acquire one if you’ve got the capital.?

[The wild west] Deals in the $2-5M of EBITDA range, however, are a different story. Brokered and off-market deals are the wild west.?

While brokers play the same intermediary role as investment bankers, their processes, teams, and fee structures are different. Usually, it’s just one or two people, often with less experienced M&A backgrounds and lacking the teams and resources you’d see in investment banking. Fee structures vary, but often they are flat fee, incenting them to maximize volume of deals vs. purchase price. I’ve met some incredible and talented brokers along the way, but it's a different process and game than a typical banked process.

What this means is that…

1)? ? ? Getting connected to deals is more random. Deals are not sent to a buyer list carefully curated by an associate thinking critically about fit but rather a function of chance - did you happen to check their listing this week? Did you read an email last month?

2)? ? ? Information is more opaque and sometimes wrong. Revenue figures and EBITDA figures are often unreliable. Mostly they move in one direction, but not always. There's more work to be done on the buy side to verify.

The best deals, however, often come as referrals. This won’t surprise many, but we think most underestimate the time required here to develop this network. From folks much further along than us, we’ve heard it’s not until year 3 that you start to see the benefits of that network and year 10 until it’s really humming. That’s a long time.?

It’s one of the primary reasons I have reservations about search funds. Search funders spend 12-36 months building and cultivating a network, acquire one company (if they’re successful), and then walk away from perhaps the most valuable thing they’ve done – establishing a proprietary deal network.?

And that’s just the challenge of finding good mid-sized companies—arguably the easiest part. The real work is stewarding them well: managing culture, hiring talent, leading change—all with a team that may have different skills and desired outcomes.

[Ice fishing in flip flops] The image Jeff and I often come back to here is a group of guys heading into a blizzard to ice fish in flip-flops and Hawaiian shirts. Sure, there are plenty of fish out there, but most people talking about it have no idea what they’re getting into—or how unprepared they are.

Hard means alpha

The challenges I’ve outlined are exactly why we believe it’s worth it. There’s alpha here because it’s hard and an incredibly inefficient market. Where there’s a mismatch of information and limited competition, there’s tremendous opportunity.

[Sub-institutional] One of the best aspects of micro-PE is that it’s sub-institutional. These challenges create a natural barrier to institutional capital and professional buyers, keeping purchase multiples low. It’s simply too much work for large PE funds to sift through smaller deals or get involved in tactical hands-on operations. It’s also impractical from an investment size. If you have to deploy $500M, there’s no feasible way to make fifty $10M investments.?

This results in significantly less upward pressure on purchase multiples. Competitive processes among professional buyers increasingly anxious to deploy capital drives multiples to 10, 12, 14 times earnings. At the sub-institutional layer, however, you can still find solid deals at 4-6 times earnings. It’s a different game.?

[Simple math on 5x deals] When you can buy good companies for 4-6 times earnings (ideally cash flow not EBITDA, but we’ll save that for another post), the math to good returns gets a lot simpler.

If you buy a company for 5x cash flow and do nothing to it but maintain its performance, you’re looking at a 20% overall return. Layer on a little seller debt and some modest growth, and now your returns get to the 30% range. The hard part remains finding good companies and helping them grow, but that feels a lot more straightforward and sustainable.?

[Upside] The basic returns math works in a long-term-hold strategy, but there’s also significant upside if you’re able to create product for the aforementioned institutional buyers. If you acquire sub-institutional companies at 4-6x and then grow them (organically or through M&A) into the $5-10M EBITDA range, then all of the sudden you’re in a new arena and can sell for 8-10x.

A more aligned model?

With a strong conviction around what we wanted to do, the natural next question was how to do it. After months of speaking with a number of folks in the space and modeling out different scenarios, we landed on a structure with two distinctive aspects: a very long hold period and a no fee, cashflow share waterfall.?

[Long hold] We think that all good things take time. Roark has held Arby’s for 20 years; Atlanta Westside Presbyterian (where we both go to church) was around for 13 years before moving into a building and “scaling;” Monday Night has taken 15 years to grow into a 6-site, award winning brewery. Good things take time.?

We think this is especially true for small businesses, which often have small management teams and limited experience with growth. Many have been family-owned for decades, and establishing trust—the basis for any change—can take years. A long hold strategy lets us play the long game, building relationships, culture, and investing in people and projects with longer-term payoffs.

The other reason we prefer a long hold period is that it allows us to handle year-to-year variability - lumpiness if you will.? Many businesses generate stable cash flows over the long term but fluctuate annually. Take, for example, a hurricane cleanup business in South Florida: depending on the season’s severity, profits may vary. $1M one year, $5M the next. Traditional PE, bound by a narrowly defined 5-7 year shot clock and a mandate to sell, cannot take the risk of having a down year or two when it’s time to sell. Long-hold strategies, however, we can invest based on average earnings - both as we look backwards to value a business and forward to project cash flow distributions. It’s one of the biggest opportunities we see in the market.

[Fees and carry] Our structure replaces the traditional '2 & 20' model with a straightforward, no-fee cash flow distribution split. Traditional PE charges 2% fees on AUM and 20% carry on returns, typically above a preferred return. This model works well for large funds focused on buy-and-flip strategies, where most value (for both LPs and fund managers) comes from exits.

The downside for small funds and long-term-hold funds, however, is that the standard ‘2 & 20’ model incents them to neither stay small (where we think there’s alpha) nor hold for a longer period (which we think makes sense for smaller companies). The conversation in the room quickly becomes how can we deploy this fund, to raise a bigger fund, and collect more fees. At that point returns, let alone actual distributions, can become an afterthought.? Returns are just the icing on the cake.

These dynamics, along with our deep admiration for a few funds that have achieved tremendous success with similar no-fee models, led us to pursue structures with stronger alignment and shared upside. We ultimately chose an 80/20 split on distributions until the return of capital, followed by a 65/35 split. Simple and achieves our goal of alignment. In a base-case model, this structure offers us ~1-2 points over the '2 & 20' model, but we believe that better alignment will generate even greater returns for investors. We get paid how and when investors get paid.?

The net of it

In summary, we’re excited for the adventure ahead.?

Excited to be playing in a very large and inefficient space. Excited to go in eyes wide open about a significant challenge that we feel uniquely equipped to tackle. And excited about the potential to build something special for employees, operators, and investors.?