In a recent article, The Wall Street Journal reported that investment firm Tide Rock buys up small companies as private-equity firms do, but it shuns the often steep debt that buyout shops use to fund acquisitions.

In another article, The Deal reported that Tide Rock seeks companies that either have strong reoccurring customers, are resilient because they have diverse customers or operate in an industry with low volatility, or that sell essential products or services to loyal customer bases.

What is the Tide Rock team getting right that others miss, and what can we learn from it?

We ask Tide Rock President Brooks Kincaid how unlevered buyouts work, what that tells us about the leverage accepted in traditional private equity, why that matters for founders looking to exit or grow, and Tide Rock’s operations mindset.

 

Chris Gale  00:02

Brooks, thank you very much for coming on. I am super excited. Gale Strategies loves working with Tide Rock because what you guys do is just fascinating, especially in today’s environment. Folks coming onto this know that Tide Rock practices unlevered buyouts, which usually throws folks from the very beginning because buyouts are usually levered. We’ve all been reading about how much leverage there is and how much debt there is out there. So, before you tell us about Tide Rock, any insight on how leverage somehow became the orthodox/normalized thing out there in all of this credit and debt that’s in the private capital markets these days?

Brooks Kincaid  00:59

First off, Chris, glad to join you, and look forward to chatting here.

To answer your question, I think at the end of the day, it’s great to use other people’s money to make money for you. Debt can – or at least in general – end up being a lower cost of capital. And interest is tax deductible. So, those are both attractive elements that can lead to it being a tool in the leverage buyout structure. As someone who’s trying to raise capital, it makes returns look good or makes an investment potentially pan out. Debt can make returns look better in a spreadsheet. If you’re modeling it versus living in maybe the real world, you can underestimate the risks of investment and the ability to support that debt. So, the positive impacts of it help drive its use. If you start thinking about some of the risks, though, you may underestimate the impacts of sizable, unexpected events, which in the last couple of years have been particularly notable, are things like the loss of a major customer, a global pandemic, COVID, material supply chain shocks. Things like that don’t necessarily make their way into financial models as cleanly as the use of leverage might.

The use of leverage allows for a fund to also buy bigger companies. You can make your equity dollars go further and, in buying bigger, not be overly concentrated. You can effectively just spread the wealth a little bit more. That all sounds really good, and that is a core reason why it’s become a pretty common use. But it does underestimate the risk that exists. That is particularly true when you start looking at the use of leveraged buyouts when you’re investing in smaller companies. They are just more exposed to some of the risks for which debt is not a great tool. Some of the uses of debt and the covenants and other things that come with debt make it a square peg in a round hole, at least in our view, for use with small businesses.

Chris Gale  03:27

I like that you’re pointing to risk. Just to be clear, when we’re talking about debt or leverage, we’re talking about transaction leverage, like you would have a line of credit, I imagine?

Brooks Kincaid  03:45

We’re talking about amortizing transaction leverage. For example, we’re buying a company, and a third party is coming in to support and contribute to the sources of capital necessary to close that transaction, like underwriting the deal alongside the equity sponsor and then putting in a structure for the repayment of that debt in both interest and principal. That is different in our view from what I would consider growth-oriented capital – be it equity or the use of a line of credit. There are certainly working capital needs in all businesses that lend themselves to using a tax-efficient, interest-bearing line of credit, but that is very different than covenant-related amortizing debt.

Chris Gale  04:32

Perfect. Okay, so you used the word “growth” and used the word “risk” before. I know the story of Tide Rock, but if I first hear what you were saying about leverage before, are you saying that Tide Rock purely protects against risk? Or what do you accomplish for investors on the upside? What’s the attraction to Tide Rock for investors?

Brooks Kincaid  05:01

The attraction for investors to Tide Rock is that we can deliver the alpha that can come from investing in smaller businesses without the same risk that you might otherwise expect if you were to structure it in a leveraged buyout transaction. What we also do is further reduce the risk by focusing on effectively returning capital, or returns, to our investors sooner by virtue of consistent quarterly distributions. So, if you think about it, an investor comes in, they have principal at risk in any private equity environment. They’re putting that principle at risk to get returns back from that. In our world, because we make distributions consistently and at a high yield level, our distribution to paid-in capital, the sort of realized returns, is right out of the gates. So, a quarter into investing with Tide Rock, you’ve taken principal risk off the table because you’re getting a distribution out. If you’re doing it in a leveraged buyout transaction where you’re not receiving those distributions, you’re betting on the total value to paid-in capital, and the large majority of that is in what’s considered residual value to paid-in capital, so paper gains and all of that are terms related to the return that an investor is expecting on their capital. In our case, we are aiming to provide very high total value to paid-in capital, or multiple of invested capital, but along the way, making sure that our realized returns are there, which, at the end of the day, just reduces the risk for our investors. That’s what we’ve been able to demonstrate and attract investors to from the very beginning, as we’ve been able to do not only on an individual company basis but throughout all of Tide Rock as we grow our portfolio and further reduce risk via diversification. That combined return profile has become very attractive for our investors.

Chris Gale  07:22

Okay, so then I’m going to ask, maybe, the public relations question. You’ve talked about the benefits in return for the investor, the positive side, and the absence of the negatives of debt. So, you and the team that built Tide Rock in the early days, in the chicken and egg sequence. Was that debt bad? Can we do something without debt? Or was it [a case of] we really want to achieve higher returns? Maybe if we get rid of debt, we can do that.

Brooks Kincaid  07:58

I think, to some extent, it’s a both/and. The original premise is that we believed that the micro market or the lower middle market was a sector with inefficiencies that was an area of opportunity for us. We believe that, to be successful, we need to have a greater focus on operational improvements and fundamentals of value creation in our investments versus financial engineering – in broad strokes, let’s say the financial spreadsheet, leverage-oriented model that I was referencing before I put that in sort of the financial engineering bucket. With that, we were saying, ‘Hey, we’re going to focus on driving fundamental value creation,’ and that was going to enable us to build successful businesses that not only would be able to generate free cash flow but also create equity value growth or multiple expansion over time. So, from day one, we said, ‘Hey, we’re not going to lever our transactions because that won’t allow us to then efficiently pass through returns on a regular basis to our investors, and it will distract not only ourselves but our operators from the fundamental value creation and operational enhancements that we wanted to have them focus on.

If you think of a smaller company, there is a lot of fish to fry. You’re a CEO or a management team. You are fundamentally focused on value creation or operational enhancements. It’s complicated to then also have to think about managing your covenants and third-party banks, who, frankly, don’t care as much. They care more about making sure that their debt gets paid back, and so that creates another distraction relative to the focus on value creation. So, to your question, it was that they were the chicken and the egg at the same time. We were able to start small, at least from a focus standpoint, number or quantity of companies, make sure that we were able to execute upon that thesis, that we could drive fundamental value creation through operational enhancements in an unlevered structure, and create value that attracted additional investment dollars, which allowed us to go do that across multiple companies, which further reduced risk it by diversification. That snowball started to roll, and now it’s become easier for us to do that at scale.

Chris Gale  10:38

This is, maybe, my last question contrasting Tide Rock explicitly to the LBO or the sort of classic private equity model. But I know that some folks are on this call who are also taking on what is the standard orthodox model in their particular industry and challenging it anytime you’re presenting something new. I remember when Ryan was working with the Wall Street Journal on this. Tide Rock is doing something different. When did you start seeing investors and also sellers start to realize after seeing you that they were accepting something that you shouldn’t accept in private equity, in that amount of leverage? And when did you start seeing people understand that Tide Rock represents something that I think we’d like to see as more of a standard if more firms could do it?

Brooks Kincaid  11:39

I think, like most things, ideas are great. Proof is better. As we grew in scale, we started to show this was a model that worked not only for one company, not only for three companies, not only for five companies, that then started to build upon itself and investors who had, let’s say, larger pools of capital to allocate, maybe being concerned of, ‘Hey, I like this strategy, but I like it as a one-off,’ versus ‘Can I deploy $10, $50, $100 million behind it to do it at scale?’

As we started to show that, yes, not only could we do it on an end of one, but we could do it across five companies, 10 companies, etcetera, that started to build upon itself. That was complemented by the fact that, as we were scaling, we were also further reducing risk by virtue of diversification. That was really the tipping point. I think for sellers, it depends on which one you ask. So, for certain sellers, I think a lot of them resonated out of the gates with – ‘I’ve never liked debt. I didn’t want to have debt on my business, and I understand that maybe that prevented me from growing. I’ve always wanted to grow, but if push came to shove, I was not going to threaten my livelihood and my net worth by putting debt on the business.’ They were told by their advisors, ‘Hey, this is the only option that exists. Either you’re going to get sold to strategic, or you and your people may or may not exist anymore. You can get bought by a private equity firm, but you’re going to have some leverage on the business, and if you want to roll equity with them, you’re just going to ride that risk.’ They didn’t know that we existed. So, there is an education that comes with each of our engagements to help the sellers understand how we’re different, why we’re different, and what that means for them, whether they’re looking to completely exit and move on, or they’re or they’re or they’re going to roll some equity, and they want to be part of a second bite at the apple. Fortunately, that education resonates pretty well with a lot of them because they philosophically are aligned with it. That’s just something that we have to educate them as we go through the process.

Chris Gale  13:59

I want to come to operations. You were talking about the philosophies of some of these sellers or some of these businesses that you’re acquiring. Some individuals listening here are big fans of operations and know an awful lot about very operationally intensive businesses like electronics manufacturing. You have this insight about leverage, but you were talking earlier about enabling the operations, enabling the execution of these companies. What advice or lessons can you share with others who’ve come to realize that insights are cheap if you don’t have the operations down? What do you do there?

Brooks Kincaid  14:52

Like I said, from day one, the focus was on fundamental value creation. You need to have successful operations across all aspects of the business to do that and to do that well, particularly given the sort of size and scope of business that we are typically buying, or our entry point. Our focus early days was not only on the fundamental structure – okay, we’re unlevered – but then also on how are we going to support our businesses? And we wanted to say, ‘Hey, insight is necessary. It is important. But if it’s insight alone, you’re then exposed to too many exogenous things that you can’t control.’ That’s not something where were comfortable with. So, we wanted to complement the insight thesis, and investment thesis, with a playbook orientation. We were going to say ‘Hey, we’ve learned a lot as it relates to operations, be it in sales, actual operations, finance and accounting, talent acquisition, marketing, all aspects of some fundamental business operations. We’re going to distill a lot of that learning and love and leverage that to provide a bridge to our companies from their current point where we come in, to what they need to be as they realize their fullest potential. And the earliest of those was focusing on the top line, on revenue, most often our sellers, founder, owner, and closely held business. They have a very high-quality product service. They’ve got some unique aspect or differentiation that is attractive to us, but the world doesn’t know about it. And between two choices, many have said, ‘Hey, I’m focusing on making sure that I maintain that quality product and service, and I don’t want to rock the boat at least. I don’t want to rock it too much. I mean, I don’t want to take on risks that I’m uncomfortable with. I don’t want to change my lifestyle.

There becomes an artificial constraint on the company’s growth. One of our earliest insights and focuses, is on saying, ‘Okay, how do we come in and start to apply a playbook mentality to relieving that constraint and allowing for the business to start growing?’ We have an internal saying that the sale solves all problems now – obviously not all problems, but it certainly helps – and a growing company then provides for the investment into resources and other aspects of operational enhancement that are necessary to support that growth and continue that growth. We initially focused on providing the playbook to sales, then translating that down into the supporting elements of sales – talent, marketing, corporate development, finance, and accounting – everything to make sure that we can support a growing organization. We went as far as to structure our organization to reflect that. A typical company at our entry point isn’t going to have a CMO, isn’t going to have a talent acquisition department, isn’t going to have a finance and accounting department, or maybe they have an accountant, but not a CFO. They probably don’t have dev, and they certainly don’t have someone who’s focused on operational excellence. We have constructed Tide Rock to have all of those things – and not just external accountants. They’re fundamental parts of Tide Rock, and that allows us to function as a bridge for the companies as they go from where we start to where we are trying to take the company and realize its highest and fullest potential.

Structuring that way also allows us to make sure that the specific functional elements of the playbook are appropriately communicated to the appropriate people in the organization. So, we’ve got a CEO, but we want to make sure that our VPs of sales in the companies are operating according to the playbook at the highest and best potential, and they’re operating their business in the best way possible. The controllers are the same thing. So, if we can professionalize and improve all aspects of or all functional areas of business, we help the CEO execute upon the insight that we had and give him or her a significantly higher likelihood for success. That’s ultimately our game. We believe a playbook, operations-oriented perspective towards insight-driven investment pieces is going to have a much higher likelihood of success if we focus on the operations versus just the insight.

Chris Gale  20:03

Excellent. I was smiling there. Brooks probably understands, because we have a list of questions, and I have questions, and Brooks, much like my middle school teacher in theater, kept up with me when I jumped to the chorus and in the middle school musical. I think you covered both points. The one thing I wanted to maybe ask is we haven’t touched on fit-for-purpose yet, and I know that you guys have talked about fit-for-purpose and the benefits on many levels, including operations. What can you tell us about that?

Brooks Kincaid  20:48

So, fit-for-purpose, meaning sort of how we fit for people who are looking to sell their company or at least bring on a partner, I think there are two different profiles, both of which Tide Rock has unique value props for. The first would be a closely held founder-led company or seller who is looking to retire, either because of personal reasons, just they’re ready for retirement, health reasons, etc. Tide Rock’s value prop for that seller profile is, one, we are going to be a good landing spot for their legacy and their people. Our orientation is towards growth, versus, say, coming in for cost reduction and so we’re going to be giving them their employees, that opportunity to go and realize career growth and expansion and to build upon their legacy. Some of these people have spent 10, 20, 30, 40 years building this business. They want to see it continue beyond them. And that’s certainly a value-prop we provide. Number two is that we don’t have a third-party dependency for sources of capital. We are the decision-makers. I’m the head of our capital employment side of things, so myself and our investment committee decide whether we’re making the deal or not. We are not dependent upon a third party to decide whether they are going to fund the deal, which can drag on both in terms of time and just deal execution risk and then three timing.

 

So, because we have the capabilities in-house, our ability to execute diligence and make a just yay or nay decision is in a matter of weeks, not months. We can execute a deal from LOI to close in 45 to 60 days, not six months or nine months. And when you’re running a business and you’re looking thinking about exiting, it’s difficult to both do a once-in-a-lifetime transaction, while also having to wear the multiple hats that inevitably, the owners and CEOs of these small companies typically do. So, when you combine all of that, that’s a fundamental value prop to that profile of the seller. The other profile that is applicable, and we’ve had several of this type, are parties who have realized that they’re starting to reach a ceiling with either their capacity or their risk tolerance, etc. They do fundamentally believe in the growth proposition for their business, and they see it. So, they’re looking for a growth equity investor. They’re, they’re comfortable giving up majority control, which we require, but they want to take a second bite at the apple. So, we allow them to come in with philosophically aligned preferences for growth orientation, lack of risk, adding leverage, and an opportunity to realize the benefit of that direct role along the way via quarterly distributions. So, it’s not only on the come, they’re getting it every quarter, and the opportunity to go realize additional value, equity value growth, which, if we realize our investment objectives, should give them sometimes equivalent to what they took out on the front end.

For founders or sellers, that combination of values is really important. One other thing I would add is that there’s also an option value for them of being able to continue to ride and see that second bite of the apple but understand that it’s not solely dependent upon them. Yes, we’re going to come in and give them a lot of resources and support functionally, but we do also have a top internal talent acquisition department that can help identify who’s going to be the new torch bearer of the company. As this person eventually wants to take retirement, we can then go find the right person to take over that CEO reign as the company grows and scales and potentially moves on to another chapter of ownership.

Chris Gale  25:15

Fantastic. We have time for questions from the audience, and I do have one here. How do you source deals in the micro-EBITDA environment you’re working in? How do you find these businesses and these founders and the types of operations you’re looking for?

Brooks Kincaid  25:45

We have a couple different channels. We built a sizable corp-dev department internally. And so over time, we’ve developed an engine for sourcing and finding companies in our size range and investment area. And we spend a good amount of time on direct B-to-B outreach, engaging with founders and owners and their advisors to make sure that we’re not only aware of them, but also when they are interested in selling, and so there’s a lot of direct proprietary sourcing that we do, and that serves two functions. One is not only the proprietary platform science, the initial investment in a company, but our model is often investing in the company and pursuing organic growth, but also inorganic growth. One plus one equals three. So that corp-dev department can source a new platform, but once we’ve got a new platform, they can then also go and source purpose-specific add-ons for that company. That’s one channel another is we maintain a broad network of relationships with other deal-sourcing providers. We have brokers and buy-side individuals, people who are boots on the ground, talking to founders and owners all the time, and ultimately resonate, can provide can connect us with sellers for whom our value-prop resonates. Those are the primary channels we don’t generally engage with, investment banks and conventional like big bake-off processes when they just don’t generally fit for us, and given the size range in which we play, those are typically less applicable. The last part is, we also engage with a lot of advisors. So even including this, the former owners of companies that we buy typically know owners of other businesses, and if their experience has been positive with us, as many have had, then they become a very good deal referral channel for us.

Chris Gale  28:07

I don’t think I can slip in an additional question and finish on time. So, for any remaining questions, we will circle back to you directly, if Tide Rock will help us out with that. Thank you very much, Brooks. I really appreciate this. Thanks, everybody, for joining, and happy holidays.

Brooks Kincaid  28:31

Thanks, Chris. Happy holidays everyone.