East Los research and tech-enabled value proposition
Independently Sponsored: East Los Capital link to article: https://www.trivest.com/independently-sponsored-january-2021/
Without Research, You’re Just Another Dealmaker with an Opinion
The Value of Research & Technology in Due Diligence
TONY HILL: Welcome to Independently Sponsored, Anthony. It’s great to be kicking off the new year with you. It’s also hard to believe that the last time you and I met in person was in October of 2019. We were sipping on an interesting “signature cocktail” at McGuireWoods’ annual independent sponsor conference. Do you remember what it was?
ANTHONY VALENCIA: How can I forget, it was the “classic” Long Island Iced tea. We both seemed to be thinking the same thing: I haven’t had one of these or thought of one in 25+ years but now I remember they were kind of tasty back in the day.
TH: Ha! Exactly right. Kind of a throwback…
So, let’s get down to business. I must say, I was thrilled to hear you wanted the theme of this month’s interview to be on research. I understand that research is one of East Los Capital’s three pillars of strategy and differentiation. Could you briefly put those into context for us?
AV: Sure, when my Partner, Emanuel Pleitez, and myself were developing the strategy for East Los Capital we pulled from our respective professional experiences in an attempt to address some of the areas that we felt were lacking in the lower middle market. My background is that of a Wall Street securities analyst/portfolio manager and Angel investor. Emanuel also shared a Wall Street background having started his career at Goldman Sachs in sales & trading and then moving on to work at a lower middle market PE firm and as an operator at a number of companies. In between all of this, Emanuel was appointed by the Mayor of Los Angeles to serve as a trustee for the LA Fire & Police Pension Fund. In this capacity Emanuel helped allocate capital to over 150 private market funds which gave him some very specific ideas about what areas could be improved upon in the LMM space. All that being said, we developed what we believe is a unique strategy which consists of (1) research, (2) tech-enabled sourcing, and (3) technical operations as the three pillars of our investment strategy.
With respect to research, we wanted it to permeate all aspects of our firm so that in addition to the fundamental top down/bottoms up style that I focused on during my career on the public market side, it also drives our tech-enabled sourcing model as it identifies which sectors we concentrate on and our technical advisers provide an in-house expert network to assist in our fundamental research process on day 1 of looking at any new opportunity.
TH: Thanks for that overview. We do a lot of research at Trivest on the execution front, but we’d like to be doing more of it on the business development and strategy front. How is research influencing your overall strategy, sector-targeting, etc., and can you provide a concrete example?
AV: We concentrate on 5 sectors in which one of us has previously made institutional level investment decisions. The sectors are media/internet, healthcare, software, services and consumer. All of these are large verticals with many sub-sectors included in each. For instance, media/internet would also include e-commerce, ad tech, and a variety of other online centric businesses. We have discussed the three pillars of our investment strategy, but I think it’s important to point out that the core operational strategy revolves around tech enablement or “techification”. We look for industries and/or companies which are operating with a low level of technical utilization and can be materially improved with respect to both the top line and margin structure by implementing a world class technology plan. Our technical advisers, who we will talk about in more detail in a bit, assist us with this implementation. So while we are using research in the traditional sense of financial statement analysis and creating detailed models with forward looking projections, we are also utilizing research to determine which ponds might have the best fish. We use research to determine which sectors have the best combination of sweat equity upside from our technical improvement strategy combined with attractive secular trends and reasonable valuations.
We are less concerned with financial engineering and more focused on growing a quality business and taking it to the next level. On that front, we are very valuation conscious even though that doesn’t appear to be in vogue these days with all of the aggressive central bank interventions going on around the globe. We think that it is very difficult to deliver returns for an investment that you overpaid for and usually this situation arises from overestimating potential company growth rates. One of my pet peeves as a public sector equity analyst was the growth rate model which often consisted of sell side analysts putting their finger in the air and saying something to the effect of “yep, 20% growth feels about right…” We do our best to correlate a company’s growth rate to something tangible and then use that estimate in determining what we can pay for a business and still generate attractive returns. Sometimes the company that appears to be the least expensive is not while the company that appears expensive isn’t, relative to its growth potential. We use fundamental and industry research to solve these investment challenges.
Happy to give a real-world example. We spend a lot of time in the cloud services space. This is an area that we believe is under the radar of a lot of firms and isn’t well understood by those who have looked at it. I have been following the cloud infrastructure space since its inception as I covered Amazon back when AWS was the super fast growing but little understood segment that was offsetting the company’s low margin e-commerce business. Emanuel has hands-on experience in the space as both an investor and an operator, so we believe we have insights that most investors do not. With respect to large public cloud infrastructure players (Amazon, Microsoft, Google), Wall Street is concerned with the law of large numbers and declining growth rates while we think the opportunity for the services players in the LMM is outstanding. The fact that the infrastructure layer has become so large that Wall Street is concerned (prematurely, we think) about slowing growth means that the tools and hardware necessary for literally every company in the world to transition to the cloud is now in place. And someone is going to need to transition all of these businesses to the cloud which is where our cloud services thesis comes into play. We know from our research that while headlines say a large percentage of Fortune 1000 type companies have transitioned to the cloud, the actual number of workloads is a substantially smaller number. And for companies in the lower and mid-market, this divergence is even more profound. So with the cloud services companies we get a “twofer” in that we can improve on their businesses by adding technical expertise from our networks which allows them to transition from a fee for services staff augmentation type business with less scalability to one of a managed services provider with the ability to scale and provide commensurate margins. In addition, the addressable market of customers is huge and we are still in the early days of the cloud/digital transformation which is a wonderful setup for these companies. Our research validates this investment thesis.
TH: That makes sense. What’s your take on how commonplace that kind of research-driven approach is these days? Are most groups putting in that kind of organized effort upfront, or do you think it’s more of a hodgepodge?
AV: There are a lot of great firms out there with super smart people, so we don’t want to act like we invented the “research wheel” so to speak. However, our take is that most groups tend to think of due diligence and research as being in the same bucket. In many cases research is just another box to check off of the due diligence checklist and in some cases it might even be outsourced for all practical purposes. Part of the reason for this, of course, is that PE has historically been very focused on achieving returns via deal structure and financial engineering as opposed to driving growth. One of my areas of expertise during my career was the media space and I observed a number of high-profile PE deals in the space in which the sponsors appeared to be laser focused on deal structure and less focused on whether or not the underlying sector fundamentals, secular trends, and unit economics would be able to support the leverage and aggressive forecasts that were embedded in the transaction. Some of these deals turned out to be disasters due to not properly understanding some of these issues. Firms that operate under more of a generalist model probably are not in a position to do as extensive research as it becomes an ad hoc exercise depending on the particular deal that might be the current focus. Firms with a vertical focus should have greater insights, but then the question is what is the DNA of the firm? If it is one that is populated by former bankers who see themselves primarily as deal makers, then research may still fall by the wayside.
TH: Last month, we did a deep dive with Matt Joen of Timoneer Strategic Partners about deal sourcing. The title of the episode was “Sourcing Hard or Hardly Sourcing?” Tech-enabled sourcing came up briefly, but it wasn’t a core part of their origination strategy. Per your intro earlier, at East Los Capital it is. How is your focus on research dovetailing into effective tech-enabled deal sourcing?
EMANUEL PLEITEZ: Our research allows us to get deep into the industries on which we decide to focus. As we fine tune the business models and specific attributes of businesses we like, we then turn to our proprietary database of over 40,000 companies in the lower middle market and identify a specific opportunity set of targets. Our database is comprised of different data sources from the well-known databases other firms may know to our own proprietary data we get from sources you cannot scrape or which don’t have APIs. The specific opportunity set of targets is then prioritized by companies that have not received funding yet from any private equity and venture capital firm. We’re currently negotiating with a company in the cloud services space that we identified through our database. We had no prior relationship with the company and they apparently had not spoken to another private equity firm about investment.
TH: I love it. Tech-enabled deal sourcing is still my jam, so I have to ask: What tools and/or platforms are you guys using?
EP: Well, we can’t share all of our sources, but some are common as I just mentioned like S&P Capital IQ, Pitchbook, Crunchbase, Mattermark, and Clearbit. As other investors who have worked with these databases can attest, these databases only get you part of the way there, as not all their data is correct. And since we’re dealing with private companies, there are key data points that you’ll never find in any database or at least not in a database you can buy or scrape. We then turn to teams abroad we contract to help us identify other data attributes about companies we care about. You can find data on companies hiring executives or product and partnership announcements. We also like companies that have not raised any institutional funding in the past. We update our database regularly and score companies in order to prioritize our outreach to CEOs or other key decision-makers. Critical to all this is being able to integrate our company data with our CRM. We still like Streak for its simplicity and ability to keep us inside of GSuite. Once we’re focused on a particular set of targets or type of company, we engage our Technical Advisors through various media including WhatsApp and Slack to help us engage these companies.
TH: Let’s change gears. Independent sponsors and private equity firms alike stress the importance of being “differentiated.” A strong research arm seems like a no-brainer in that regard. In addition to giving you a leg up with deal sourcing, how is research differentiating you when it comes to presenting deals to potential capital partners and, later on, your value-add during due diligence?
AV: Let me take the due diligence portion first, we tend to do a lot of research and due diligence prior to the LOI so capital providers seem to be impressed with where we are on the knowledge curve early in the process.
But you bring up a great point with respect to how research affects the manner in which we present deals to prospective capital providers. Our research process allows us to have a high level of conviction in our ideas and we subsequently come to capital providers with a view of the world—not just a deal.
We are thinking about the long game and want capital providers to value our research and think of us as thought leaders in our respective verticals as opposed to someone who just brings them a deal within a certain EBITDA and valuation range.
For some capital providers, it may not be a fit if they are rigidly focused on only a few specific metrics which may be somewhat static in nature. We have a growth equity style so we are always thinking about where an industry will be in 5-10 years and how we can best position a company to exploit those future opportunities and avoid the inevitable land mines along the way. Some of the more forward-thinking capital providers seem to value this approach and our ability to find companies in a space that we like.
TH: When it comes to working with independent sponsors, we’re as flexible as PE firms come, and work with partners of all shapes and sizes. That said, it makes a big difference when an independent sponsor brings unique sector and/or process expertise to bear. In your case, you seem to be serving up not just an attractive platform investment, but a full-developed investment thesis backed by hard research. I like it. I think we’d make great partners, guys.
OK, so far, we’ve touched on what East Los Capital is doing on the research front. Let’s now talk about how you’re doing it. What role are technologists playing at the firm?
AV: We have approximately 30 people that we affectionately refer to as our “family of advisers”. At most PE firms, these folks would be considered operating partners and they certainly serve in a similar role at East Los Capital. But to your point, approximately 2/3 of these people have worked as software engineers or product managers in a technology company. And a slightly larger percentage have been Founders or CEOs of software or technology-enabled companies. Many of these people have experience at best-in-class Silicon Valley tech firms such as Facebook, Amazon, IBM, Google and other household names. We feel very fortunate to have such high caliber technologists associated with our firm and we have identified a variety of ways in which they can be involved in a portfolio company ranging from a full-time operational role to that of Board Member.
Many of the companies that we look at in the LMM do not have access to these types of people for a variety of reasons ranging from geography to affordability. And in some cases, these companies innately know that they need “something” on the technology front but don’t know exactly what that might be. So, these technologists can be game-changing for the smaller companies that predominate in the LMM. But in addition to the operational role that they may play, they also assist us from day 1 in our research process, as we effectively have our own in-house expert network that we can utilize when evaluating sectors to focus on for sourcing or during the various stages of research and due diligence.
TH: That’s quite the roster, and quite the endorsement of your model and team. Congrats. We too don’t utilize an operating partner model, but we do have a deep bench of executives and thought leaders we turn to—called the Trivest Executive Network—to support deal execution and portfolio company management. Great minds…
Well, Anthony, in accordance with the blood oath you took when you agreed to do this interview, it is now time for the ceremonial telling of a humorous M&A story. Please, regale our readers, would you?
AV: Well, in keeping with the old school theme that we started this interview with, I am going to have to go back in time a little bit to my public equity days to tell a story that eventually ended up with a fairly noteworthy M&A transaction. It is a little bit outside of the realm of the lower middle market but hopefully your readers will find the situation I found myself in somewhat entertaining.
One of the Portfolio Managers at my prior investment firm had possessed the foresight to establish a position in Pixar Animation Studios at the time of its IPO. I joined the firm several years later and inherited coverage of Pixar in my role as the firm’s media analyst. The position had grown to such a size over the years that our firm had become the second largest shareholder only to Steve Jobs. In fact, we owned approximately 20% of the company and the holding, not to mention the size of it, had become a topic of robust internal debate. There were concerns about the scalability of the business: could the company ever graduate from releasing only one film every 18 months and, despite their enviable record of one blockbuster after another, what would happen when the inevitable flop finally occurred? And with our position being so large relative to the size of the company, would we ever be able to exit it, if necessary, without moving the market materially? I was positively disposed towards keeping the position, and I had regular communications with the CFO and other people at the company. At the same time that this internal debate was going on at my firm, Pixar was publicly discussing the possibility of not renewing its distribution deal with Disney and relations with the Disney CEO Michael Eisner and Pixar had become frosty in full public view. I decided it was time to do an in-person company visit, so the Pixar investor relations team set up a two-day agenda of meetings for me. During the first day, I was to meet with four different writer/directors of films that were in some stage of development. I spent a large portion of my professional life meeting with CFOs and CEOs of companies and discussing financials and corporate strategy, and this was something that was second nature to me. But it was rare for me to meet with people on the creative side, so I spent an inordinate amount of time preparing for these meetings. Working and living in Los Angeles I knew a fair number of people in the film industry, so I picked a lot of brains on what might be interesting and helpful discussions to have with these directors. I remember flying up to Pixar headquarters in Emeryville a day early just to sit in my hotel room and review all of the questions I had prepared.
The next morning, I arrived at the company and was escorted to a conference room where my meetings would be held. I had been told beforehand that there was a slight possibility that I might do a meet-and-greet with Steve Jobs, but that as a practice he did not meet with Wall Street analysts. Minutes later, Mr. Jobs came into the room and, as I went to introduce myself, he told me in a manner that can only be described as brusque, “I cancelled all of your meetings.” I remember thinking to myself, I must not have heard him correctly, as it sounded like he said he cancelled all my meetings. Then, he repeated himself and, this time, I heard him perfectly clear.
At this point, we just stared at each other for what seemed to be a very long time—although I am sure it wasn’t—and I finally blurted out something to the effect of “we own over a billion dollars-worth of your stock and I have to figure out whether we are going to the sell the position or not.” At this point he said, “look, don’t be mad at the IR people, it’s not their fault. I came in this morning and saw who you were scheduled to speak with, and I can’t have you speaking with these people. They are not used to speaking to financial types like yourself and they might say something that they shouldn’t, which could then create problems for all of us. I’ve cleared my morning and I can spend as much time as you need to understand what we are doing here at the studio, and you are going to learn a lot more from me then you would have learned from them.”
And so, I spent a substantial amount of time that morning with Mr. Jobs as he explained his vision for the studio, and I came to better understand that the culture of the company and their unwavering commitment to excellence was a much larger risk mitigator than Wall Street understood. I also came to the conclusion, independently, that it was only a matter of time before the company would begin accelerating its release schedule and that there was no way that Pixar and Disney would ever be going their separate ways. The meeting went so well that I ended up meeting with Mr. Jobs every year until 2006 when Disney acquired the company for $7.4 billion.
TH: WOW. Did not see that coming! That’s incredible, not to mention made for TV! I’m surprised that scene hasn’t appeared in any of the recent Steve Jobs biopics. Nicely done holding your own there. I probably would’ve folded like a lawn chair in your shoes.
Anthony, it’s been a pleasure speaking with you today. Thank you for your time, insights on research, and a truly remarkable story. I definitely want to hear more about Steve Jobs the next time we meet in person. Long Island Iced Teas on me, of course!