@SMB_Attorney Realistic assumptions as a start. Maybe also a disclaimer that your specialization in SMBs enables wildly high % returns are not and never have been market. You're getting dragged on this not because it's impossible. Rather, because it is unlikely.
@Cribdilla 1. What is the issue with my assumptions? 2. This is untrue. 3. Here is the data from Stanford, given the average and number of data points would you still characterize these returns as unlikely?
JFC are we really doing this? If 30-80% annual returns are normal for you then get off Twitter, quit law, raise a fund and get to work. Your expertise as a Forest Gump, SMB capital allocator is where your time would be best spent. And I mean this with all due respect. 30-80% ain’t normal.
@Cribdilla @MatznerJon @SMB_Attorney Such a great tweet
@shawngorham @Cribdilla @MatznerJon I’ve given you the market terms. I’ve given you the Stanford study supporting them. Quibble with the numbers, argue substance and assumptions, I’m here for it. But no need to make it personal and resort to ad hominem. Disappointed in Shawn and Jon, also.
@SMB_Attorney @shawngorham @Cribdilla @MatznerJon Suspect the returns really can be pretty tasty He doesn’t brag at all, but @tsludwig has done very well w this strategy
@moseskagan @SMB_Attorney @shawngorham @MatznerJon @tsludwig I didn’t say it can’t be done. I also think - like everything else - low capital costs have goosed returns at the recent exits. The snark he got on the original Tweet was pretty tame.
@Cribdilla @moseskagan @SMB_Attorney @shawngorham @MatznerJon @tsludwig Eric is not misrepresenting, on a good deal 30% investor returns are the target for self-funded search investors. Obviously nothing is guaranteed and small business can be fragile. Also the barrier to a “fund” is the limited amount you can deploy on any one investment.
Wow, came back to a lot of notifications. Respect everyone in this thread, but here are my observations: 1) Stanford search study of mid-30s IRR is inclusive of exit proceeds/valuation of equity — it’s not solely cash flow based, so not apples-to-apples comparison with original tweet. 2) Stanford search study is also based on traditional search deals. Those deals are 1) better investor economics, but 2) lower leverage, but 3) higher growth businesses — unclear where self-funded search deals from past 4 years will shake out compared to traditional search deals, especially given floating rate debt. 3) Self-funded search investors have far lower long-term upside than traditional search investors as they only end up with 20-30% of common equity. 4) I don’t see as many deals as Eric, but it seems rare to me that self-funded searchers with 90% leverage are sending much cash to investors at all in first couple years. That cash is used to build a cash buffer, fund capex/WC, or pay down debt. Obviously the debt pay down is creating equity value on paper, but it’s not cash flow. 5) That all said, it’s certainly possible for LPs to get 30-80% of their capital back in the first year or two, especially given their pref in cap stack — with 90% leverage and 4x multiples, the out-the-gate cash on cash should be in the 50%+ ballpark. 6) But in reality, I think that rarely materializes, given the J-curve, unexpected costs of transition, and working capital/capex intensity. 7) Sustaining 30%+ cash on cash to investors after pref is paid back is hard given investors only own 20-30% of the common and put in 80-100% of the equity check. But doable with sufficient growth & time. 8) Long story short — it is possible to generate those returns as a passive LP. It has surely happened in the past 4 years. It does not strike me to be the norm, nor should it be the expected case for LPs during underwriting. 9) I think the expected case should be moderate EBITDA growth (including a J-curve) to a 5-year theoretical exit with limited multiple expansion = 35% IRR to investors. If the model shows lower than that with those assumptions, you’re probably paying by too much / investor economics are too weak. This is a HEAVY case of YMMV.
@guessworkinvest @jhobfoll @Cribdilla @moseskagan @SMB_Attorney @MatznerJon @tsludwig @FetaFund @Slackwatercap @bentigg This is the post in my mind that I didnt have the words to articulate like you. Great response. Incredible writer of a complex subject made understandable
Good takes. On #8, remove multiple expansion and adjust for normal market growth CAGR vs this latest bull run and I think the IRR is prob meaningfully different. The counterpoint would be IRRs from a decade plus ago were still high but then one could argue valuations / unlevered cash flow yields were higher than too.
@guessworkinvest @jhobfoll @Cribdilla @moseskagan @SMB_Attorney @shawngorham @MatznerJon @tsludwig @FetaFund @Slackwatercap @bentigg Was offline much of wknd and I see convo has somewhat moved on, but thought I’d come in and add thoughts / just corroborate a lot of what Guesswork so brilliantly said based on my experience (spent 2 years in MBA immersed in traditional, did a self funded structure for my deal).
Exactly. Thanks for articulating this. Takes a finance guy to sort through the fog. That said, different investors want different things. I don’t love IRR. It just creates a bunch of redeployment risk. If I could invest in long term holds & figure that the 1st 3-5 years will be skinny as the business pays down debt & invests for growth but have some assurance they’ll hold & cash flow after that, I’m good. You can’t eat IRR.
@guessworkinvest @jhobfoll @Cribdilla @moseskagan @shawngorham @MatznerJon @tsludwig @FetaFund @Slackwatercap @bentigg #4 is spot on. Obviously the post was far too cavalier. I had no clue it would see this level of response. In fact, I ran it previously, word-for-word, and it received a universally more positive and proportionately cavalier response.
@guessworkinvest @jhobfoll @Cribdilla @moseskagan @SMB_Attorney @shawngorham @MatznerJon @tsludwig @FetaFund @Slackwatercap @bentigg This is a great response. @Derek_CayneQofE you’ll like this outline
Great points and very thought-provoking. I agree that using the Stanford data really doesn't shed much light on the self-funded search space, there are too many differing variables between these types of deals. In your point #2, another big factor impacting traditional search returns is that the multiples paid are typically higher, 6.2x EBITDA in the latest study excluding ARR driven acquisitions. But to your point, the higher multiple appears justified because they are buying nicely growing businesses with on average 22% EBITDA margins and 17% EBITDA growth. I also think the Stanford study highlights an interesting point that a few very good deals can sway outcomes significantly, which is pretty much always the case in investing! But in the latest study, the aggregate ROI for search funds was 5.2x but this dropped to 3.4x just by excluding the top 5 deals. If a newcomer is coming to this space as an investor, you could make an argument there's probably adverse selection and they may not see the very best deals, driving their returns down.