Wilmington Trust’s Capital Considerations with Tony Roth
The Rise (and Fall?) of Emerging Tech Contenders
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors, Inc.
David Reuter, Partner, LLR
DAVID REUTER: The big names that are in the press, we’re not investing in those companies. We never have and we never will. But there are these little pockets where you see these little great ideas that nobody could dream of unless you happen to grow up in your career in a certain part of a bank that you see this little need.
TONY ROTH: That was David Reuter, a partner at private equity firm LLR in Philadelphia, who has over two decades’ experience in the field.
Welcome to Capital Considerations, the podcast on markets and much more, that’s dedicated to your financial success. I'm your host, Tony Roth, chief investment officer of Wilmington Trust. After a volatile 2020 we're now a quarter into what promises to be an exciting accelerating economy. High levels of savings and strong stock market returns mean investors are moving into this year with high levels of dry powder just waiting to be put to work.
With valuations sky high and growth prospects that seem infinite, the equity growth space has not experienced this level of excitement in some time. Sectors like technology and health care are especially big players and have hugely benefited from macro trends, highlighting their status as an increasingly important piece of the future economy. But at the same time, there are record amounts of dollars to be put to work, implying significant competition for the most compelling opportunities. So, how are private equity investors managing this landscape?
To guide us through our look at private equity today, how it’s evolving in light of current trends, concerns, as well as potential opportunities, we welcome private equity senior professional David Reuter. David specializes in fast-growing companies in fintech and software and was previously a CPA with Arthur Andersen in their audit and consulting practice. David, thank you so much for being here.
DAVID REUTER: My pleasure and thank you for having me. Happy to be here.
TONY ROTH: Terrific. Before we begin, I just want to take a minute to mention that private equity investments may have certain entry points and risks that make them unsuitable for certain investors. So, always talk to your advisor before investing. With that in mind, let’s get started.
David, let’s start by taking a step back and defining some of our terms. You are what we call a growth equity investor, and you play in what we call the middle market space. Can you start for us, please, by just explaining what growth equity is in the private market arena and what middle market means?
DAVID REUTER: Middle market’s a funny term that sometimes I think gets confused in my world of private equity investing and the public market world as well. And said differently, the companies we invest in are very, very small. These are typically companies that are $10, $20, sometimes up to $50 million of revenue and usually have employee bases of 50, 100, or maybe 200 people when we start, and these companies typically are not accessible by the public market. So, we see them as really private market-only opportunities because the scale that they have at the time that we invest typically does not command the ability to—for institutional investors to be in these companies in the public markets. So, while we call it middle market, if you look at it across a public market asset categorization, it would be sort of below small-cap stocks. These would be like mini, mini, mini small-cap stocks.
And then, when we say growth equity, what we mean by that part of the equation is we are trying to drive our returns based on the ability of these companies to grow at a faster rate than the general economy. So, when we invest, we’re typically thinking about a four- or five- or six-year time horizon and we’re looking to double, triple, or quadruple the top-line revenue of these businesses. So, it’s a lot of work to do that, but we believe that the ability for these companies to grow is really where the value creation comes with our model.
TONY ROTH: That's exciting. And when you talk specifically about growth equity, that also implies, or it refers to a certain point in the lifecycle of a company. So, in other words, you’re in a space that’s not startups, but you’re also not in a space where companies are necessarily large enough or mature enough to go public because of their size but also where they are in their lifecycle. Can you just also tell us a bit about what this growth equity term means in terms of the lifecycle of a company?
DAVID REUTER: Lifecycle’s an interesting concept, because we actually invest in some companies that are fairly young. Maybe they’ve been around for five years so they’re—we’re definitely not doing startup venture-type investing, but they’re businesses that after five years seem mature in their customer relationships and their product evolution. But at the same time, we have some companies that we invest that might be 30 years old and have been privately owned and operated, typically by a single founder or a couple founders, and decide at one point they want a partner and want some help, you know, outside of kind of their known executive team and typically bring in someone like us to assist with that.
And I think for us the definition of growth stage really has to do with their performance over the last few years. So, we want to see a few different things. We want to see a maturity of the executive team that we think can continue leading the company into the future. We want to see proof points with their product into the actual market where they have customers that appreciate the product and have kind of evidence that the product, you know, has a value proposition and a product market fit, and then the business has proven that it can scale and grow, that it has the infrastructure systems, processes, people to be able to do that.
But it is interesting to see such a wide range of ages of businesses that we meet, some of which have been around for a short time, some of which have been around for a long time and everything in between.
TONY ROTH: So, when you think about what you guys bring to the table as a sponsor, which is to say somebody that’s coming in, taking a chunk of equity, but providing for that equity cash, is that basically what the tradeoff is? Or are you guys also providing expertise and experience and other things for the company? Or is it mainly just a cash for equity kind of transaction?
DAVID REUTER: Yeah. So, we think of ourselves as 50/50 split. Fifty percent of our value proposition to these companies is providing the growth capital to enable them to either diversity their own balance sheet in some cases or take on primary capital to invest in the businesses and accelerate their growth. And then the other 50% is more subtle. But at LLR we have a team that we call the Value Creation team and we’ve got almost 20 people on that team today. And these are what I’ll call functional experts. These are people that typically have 20 or more years of experience in certain disciplines that match up with what our companies’ business models look like. So that would be things like sales, marketing, product development, executive talent development and retention, helping with mergers and acquisitions.
And so, people on our team actually partner up with the management teams of our companies in each of these functional areas and help our companies get better at how they do what they do. So, it’s an outside set of eyes. It’s a lot of wisdom and experience that has worked in these similar business models for many years and can come in in an unbiased way but also aligned way, because they’re invested in these companies along with us, help these companies improve the way we do things.
So, we think it’s about half and half. We think capital is half of the equation. But we also think these services that can I think increase the odds that the companies will be successful at accomplishing their growth objectives, we think the capital plus the help married together drives to a better recipe and better outcome for us. So, we’ve put a lot of energy in our own firm into growing that part of our operation over the last 10 years.
TONY ROTH: Thanks for that, David. I think it’s really fascinating and, frankly, compelling. And one of the things that’s so important for us as investors is that we recognize that roughly 60% to 65%, call it two-thirds of the investment opportunity set from an equity market cap perspective is in the public market space. But about a third of it is in the private market space. And we really promote portfolios for our clients that have a combination of both. We think that it creates better diversification. A lot of the opportunities may be in the private market space maybe not correlated with the economy for different reasons.
But also, in the private market space, for the reasons that you just articulated, there is the potential to get, if you will, what I might call a—an experience or intellectual premium for the skills that you bring to the company in addition to the premium for the capital that you bring. Whereas, in the public markets you’re just bringing capital. But there’s opportunity to get more than that in the private markets due to the additional value you’re injecting through your experience and your skill set. And that’s why I think that if carefully selected, the returns in the private market can really significantly exceed those in the public market.
From our perspective, you know, we’re just seeing this massive pivot in the economy as we reopen. Are you sensing that this is a pretty rich opportunity for you to find the right kind of companies that are benefiting from that wave? How would you sort of rank this period going into it compared to other periods?
DAVID REUTER: Sure. I’ll tell you my secret. I try to ignore the macroeconomy and ignore the noise of the stock market and just try to find, you know, good strong companies that we think can grow. But, you know, right now is an interesting time, because every business has had a 2020 COVID pandemic work from home impact. Some are negative, others are positive, and some are unknown.
So, every business that we’re looking at that’s new, we’re trying to overlay that lens to it to figure out, you know, what temporary COVID impacts affected them, what permanent COVID impact affected them. And it’s really guesswork because this, the whole pandemic experience is a new thing for all of us obviously and we’re trying our best to, you know, to avoid things that we think have meaningful downside potential. There are definitely some businesses that we’ve seen in the market that had really obvious massive COVID benefits that you could also see tapering off very quickly. So, for instance, there were a couple businesses that were trying to be sold last year that were doing virtual events. So, they were replacing the in-person tradeshow with online tradeshows. And then you just wonder do people want to do online tradeshows or do they prefer the in-person and you, you know, you don’t know the answer to that.
So, I think each company we look at you need to try to tease out the negative impacts and the positive impacts and then try to project those forward into a return to normalcy. And I think we’re trying to play more in the middle of the fairway and stay away from the fringe things that maybe even had—either had huge benefits or huge drawbacks that don’t have as much of a swing. And we see a lot of businesses that I think are attractive and that we feel like are going to be stable on either side of it.
So, we think there are a lot of interesting opportunities. We think that a lot of the things that have happened because of COVID were accelerated but were going to happen anyway. I’ll give you an example.
We looked at some automotive technology businesses that help people buy cars online. And I'm personally certain that nobody likes—it takes an average of eight hours to buy a car in an auto dealership and you can buy them now online in one hour. I'm 100% sure that nobody liked the eight-hour trip to the dealership and the haggling over price with the sales manager. And I'm 100% sure that those people would prefer to buy it online in an hour and have it brought to their house for a test drive and then signing electronically.
There’s some things that were accelerated and nudged forward, you know, by the pandemic that won’t reverse back. Whereas, on the flipside, you know, I think video conferencing, you know, is overblown and is going to swing back because I think people like to see people. There’s some things that are here to stay and other things that are going to swing back and we’re trying to find the right pockets of where to play.
TONY ROTH: I think what’s interesting about your practice is that you do focus in the tech space. In other words, your expertise in looking at companies are tech companies, which in many, not all cases of course, but in many cases have benefited from this, if you will, acceleration of the digit—the digitization of our economy. I mean you can look at some stats, for example, where over the last 20 years the IT sector in the S&P has moved from 18% to almost 30%. And if you look over just the last ten years and you include the new communication services sector and you look at consumer discretionary, which is to a large degree dominated by some big tech companies, it’s gone from about 30% to 50% just in the last ten years of the S&P.
So, your expertise it seems is, I think, really particularly timely right now in looking at companies. And so, when you look at, when you source opportunities are you finding that the change in the economy due to the pandemic is sort of accelerating the potential opportunity for a lot of these companies, you know, like the example you just gave? Is that a fairly typical example for the companies you’re finding?
DAVID REUTER: Yeah. I do. I think it’s—I think what it’s really done is it’s pushed people to adapt faster. And so, like one example is just video conferencing. I know for myself I did very few video meetings prior to the pandemic and the key reason was in my office, both at home and in my office at work, I didn’t have a camera. It was just that simple. You know, $100 camera, you know, was bought during the pandemic at home and in my office and now I can do video calls and I'm certain I’ll do a lot more of them post pandemic. So, it was that nudge not just of me, but everybody I know didn’t have a camera either.
So, nobody was really equipped, you know, other than maybe, you know, big companies and big conference rooms had nice fancy, you know, video setups where they could do big meetings. But at the individual level, most people didn’t really have the setup. So now everybody has the setup, so now it’s a lot easier. So, I think that transition, you know, was accelerated where everybody bought the cameras at the same time and now everybody is equipped to do video conferencing.
So, we’re seeing things like that in a lot of categories. And the stats that you quote, just about the lift in the technology weighting in some of these indexes, I actually would argue it’s even higher because I think when you look at like a bank, for instance, I mean all the energy of a bank is going into software and technology R&D to facilitate electronic payments, to be able to get closer to the consumer through apps or, you know, mobile properties. And all the competition that the banks are facing are these startups and these next generation banks that are doing things direct to consumer, you know, with much lighter weight interfaces than kind of the big old heavy banking system. So, I almost feel like so many companies today, when you really look at their core, are turning themselves into technology-based companies.
TONY ROTH: We’ve talked a lot about this in our thought leadership where we talk about the, you know, it’s a little bit of a mouthful, but the horizontal digitization of the economy, which is to say that all sectors are really technology companies in some shape or form. And when we look at capital investment in the economy, it is dominated by technology infrastructure for companies. And we’ve seen a big jump in capital investment from an economic standpoint during COVID and a lot of it had to do with companies really building out the necessary infrastructure for work from home.
There’s a lot of sort of frontline visibility on the enablers, sort of the true traditional tech companies that enable all that stuff. And so, there’s a lot of money chasing those opportunities. You know, it’s not like you’re looking for a, you know, in your practice some kind of obscure, you know, chemical plating company or something like that, right. You're looking at the stuff that is sort of dominating the media in many cases. So, are you finding that there’s a lot more competition and that sort of there are great companies you would’ve liked to have gotten but that people are just bidding levels that are not—the math doesn’t work? Or how is that side of the equation for you?
DAVID REUTER: I think each year the market gets a little more competitive, a little more efficient, and a little more expensive. And I think that trend has been consistent with actually no gaps.
Even in the 2008–2009 recession, the companies we invest in did not trade at lower values. They just—maybe they didn’t increase year, but they kept marching up a little bit. So, I think we have to work a little bit harder and a little bit smarter each year to do what we do. But with that said, there are still so many of these businesses in the United States. There are just literally thousands of them that I think we can still do what we do well and that there are sufficient opportunities for us to kind of pick through if we find that we can invest in reasonable valuations that can drive value creation.
Now, with that said, if we had the team on the field that we have today 20 years ago, we probably would’ve produced 5x the returns that we can today. Just we’ve gotten so much more sophisticated.
TONY ROTH: Right. So much better. Yeah.
DAVID REUTER: But the market has as well. So, that’s unfortunate. I wish it was easy, you know, easier playing field. But to your point, you know, the companies that we’re investing in, there’s still a lot of niche business models and business opportunities that not everybody sees. So, you know, the big names that are in the press, the Ubers, and the Airbnbs, and the Facebooks, and Salesforce, and Apple, you know, we’re not investing in those companies. We never have and we never will.
But there are these little pockets where you see these little great ideas that nobody could dream of unless you happen to grow up in your career in a certain part of a bank that you see this little need. And all of a sudden, you have this flourishing business, and you have, you know, this really good market position of doing something that’s very specialized and very important and sold to a lot of different types of customers that I think is still under the radar.
TONY ROTH: Could you give us a quick, an example of one of those that you’ve recently, you know, over the last couple years, just real quickly?
DAVID REUTER: Yeah. So, there’s one that we actually just exited that kind of comes to mind as being, you know—I think what you’ll appreciate being in the banking sector.
They were started in the late ‘90s. And what their intention was in the late ‘90s was to digitize financial documents. And so, they wanted to, as an example, help you close a home mortgage or close an auto loan but using a digital form. Instead of a paper form with a wet signature, they wanted to use a digital form with a digital signature that would be in a digital vault. And they were so far ahead of their time in the late ‘90s and they raised money and they lost it and they raised more money and they lost it.
And we met them about five years ago and the business was about $10 million of revenue and they were just starting to like actually get market traction, because finally—there were so many barriers and impediments to moving a digital document in regulation, in law, in process, in systems that they had to interface with. The lenders just weren’t ready for it.
And so, when we met them, what was interesting was auto was probably the most-penetrated category at about 25%. So, if you went into an auto dealership, 25% of them had a system where you could sit at a computer and you could fill out your whole auto loan right in the computer and digitally sign it and take your car and go. And then what was really neat about it is the dealership would then sell the loan to a warehouse lender or a floor plan lender, who would then sell it to a bank and the bank would then securitize that loan in a big pool.
And so, in the digital world you had this digital document and each of the owners of that loan, from the warehouse lender to the bank to the securitization investor could just point, you know, a little digital file at that original note and then, you know, sort of take ownership of it without a lot of effort. Whereas, the analog notes or the paper notes that had a wet signature, they literally had to be FedExed around the country to be put in different locked file cabinets of these owners and if you lost it, you know, what do you—then what do you have at that point? And so, it just was sort of rife with errors that everybody kind of read about, especially in the ’08-’09 kind of mortgage regular signature world.
But when we invested in this business five years ago, mortgages in the US were still under 1% digital. So, 99% were still paper. And you fast-forward to the end of last year, the company made a lot of progress. It quadrupled in size to almost $40 million of revenue and it increased its penetration in many of the end-market asset categories. But what was interesting was home mortgage was still only 1% digitally penetrated and that was kind of the, you know, the golden goose. Everybody was trying to figure out how do we unlock the ability to do this digitally.
And then, again, COVID was the nudge. We had a really good year last year because as rates were really low and consumer demand to refinance was very high, but people couldn’t meet in person because of COVID, all of a sudden, all these mortgage originators said, you know what? We should’ve bought that system last year so we could sign these documents digitally and not have to see people in person and notarize them virtually. And that really led, you know, to a very strong sales year because people wanted to catch up. But that was like a little pocket, you know, inside of financial services that I think was very interesting.
TONY ROTH: What’s also interesting about that is even though you sort of said at one point that over the 25 years that your entry point multiple, if you will, to EBIT or EBITDA or whatnot is higher, I would imagine that you're also getting the same thing on the exit side because there’s more interest, right, in the—in companies that are a bit larger, etcetera. So, that’s sort of evening itself out, I suppose, right?
DAVID REUTER: That's right. That's right. And I mean we hope that’ll continue.
TONY ROTH: What are you seeing around the fact that companies seem to be—I don’t know if it’s a trend really because you're so—you’re really—you guys are really focused on the very lower end of the middle market. But it does feel like there are a lot of companies, the Airbnbs or the DoorDashes or Ubers or whatnot that are staying private for longer. It seems natural then the conclude that investors are missing big opportunity, public market investors, by not being able to get access to private markets. And it’s just another reason why firms like yourself have, you know, played a bigger role and the opportunity set is even more critical.
DAVID REUTER: Yeah. I think that’s true, Tony. When I started my career in the ‘90s, I felt like every private company that I met—this is pre-LLR and during the early days of LLR. Every company that I met; the CEO’s ultimate aspiration was to go public. It was a bit of a rite of passage.
And I don’t know if it was Sarbanes-Oxley or just the pressure of living with quarterly earnings, but the luster changed in the 2000s where I found that every CEO that I met felt the opposite. The last thing they wanted to do was be a public company CEO. They liked being private. Maybe the company should be public someday, but not on their watch. And it really changed from a sentiment and kind of a lifestyle perspective in this country.
Probably over the last 10 years, I think the IPO volume has been fairly low. And, you know, something has changed in the last two years, you know, around that. You know, it’s you’re seeing it in the SPACs and you’re seeing it in the, you know, much bigger IPO flow over the last couple years for these technology businesses that consumers and even, again, I'm not an expert in it, but even the sort of propensity now like for day trading that’s kind of come back with Robinhood and these other apps. You know, it’s like a lot of that had died down, you know, from being very popular in the early 2000s to I think just, you know, sort of from like a lifestyle perspective in the U.S. just being less popular, less in vogue.
So, it feels like the retail investor has kind of woken up again and is interested in, you know, what stocks can I get access to. So, there’s kind of a rejuvenation and I think some of the investors in our category have had a rejuvenation to take companies public because the valuations can be so strong. I think SPACs kind of follow that same trend.
So, I think you have a little bit of a juxtaposition now where I think you’ve got mixed point of views. You’ve got a lot of CEOs that still don’t want to go public. I think the maturity that the overall private equity market has found over the last 20 years also has enabled companies to trade between private equity firms. So, I think you see a lot of transactions from a venture firm to a mid-market private equity firm like us and then to a, you know, large private equity firm later that then I do think extends the lifecycle that the companies can enjoy private company world but still have some of the liquidity and other things that the public markets used to be the only vehicle for.
TONY ROTH: Yeah. And it’s interesting that there’s been, in the media there’s been a certain measure of pressure on the regulators, including the SEC, to sort of find ways to open up some of that private market exposure to more retail investors, as you just alluded to. And one other thing that you just alluded to, the SPAC phenomenon and that’s an interesting one.
We had a podcast recently on SPACs to explore that space. It’s unclear the degree to which it’s going to continue. It actually feels like it’s cooling off a little bit. And, frankly, a lot of the post-SPAC IPO or post-IPO SPAC valuations have not been as attractive as you might’ve thought given a lot of the headline media conversation. But how has the SPAC phenomenon affected the balance between public and private investing in your mind?
DAVID REUTER: I'm definitely more of a skeptic on SPACs personally. I don’t fully understand their purpose, because I feel like we had a vibrant and effective methodology of taking a company public, which was hiring a banker, doing a road show, gathering support for the investment and then floating the offering. And that’s kind of worked well for the last 100 years or whatever. And the concept of the SPAC, the interesting thing that people don’t totally realize is you have these promoters that are getting 10% to 20% ownership in that ultimate company really just for putting it together and it’s a very heavy tax. And these companies have the pressure of raising money with a limited timeframe to then go buy another company.
And I think what I'm seeing just, and this is just through the news, I'm seeing companies that were valued by what I believe to be smart, thoughtful private investors six months earlier at one price, trading into these SPACs at three or five or ten times that price. And that sound bite makes me nervous that, you know, like nothing fundamentally changed about the company. Why is it worth five times more today because somebody famous, you know, has a SPAC and wants to buy it?
So, that makes me nervous. And I think if I were an investor in that SPAC, you know, I'd be worried that, you know, that things revert back to the mean and that the company that was thoughtfully, you know, valued before is going to move more towards that over time and you’re just helping these promoters, you know, gain access to a piece of the company for free. So, I'm suspicious of kind of their existence and their purpose and even just the, you know, celebrity-ization of them, of what that really does at like finding good investments.
TONY ROTH: Yeah. It seems like the, one of the phenomenon clearly is sort of a transition of some of the value leakage, if you will, from the bankers to the small group of sponsors, if you will, of these SPACs. That's clearly one phenomenon that it presents. And when you juxtapose what happens with a SPAC relative to the kind of shop that you guys are running, certainly—well you, you’re obviously playing in companies that are smaller. But nonetheless, they’re not typically adding the non-capital value creation I would say that you guys are. They’re really just sort of adding the, primarily the access to capital and because of their celebrity oftentimes in a pretty supercharged way.
DAVID REUTER: And I'm also suspicious of whether the banker fee if like actually is just transitioned to the promoter ownership, because they are hiring bankers to float their SPAC offerings and paying a banker fee, you know, on the cash capital that they’re raising. So, I kind of feel like it’s like triple-dipping, because they’ve got to pay the banker fee to raise the initial SPAC, they’ve got to pay the banker fee to raise the pipe into the SPAC when they complete the acquisition, then they take their promote. The management team at the company has a promote.
So, you’re kind of paying these like three layers of tax and I think that the SPAC sponsor piece is definitely net new relative to if a company went public and just sold 10% or 15%, you know, into the public float. They would pay the banker fee once. You have the one management incentive pool and you kind of missed.
TONY ROTH: David, thank you so much. This has been a great conversation.
Let me provide three key takeaways, as I always do in our conversations here at Capital Considerations. I think the first one is that growth equity investing is an area that for discerning investors and sponsors continues to present really interesting opportunity, particularly in the context of the booming economy and that valuations, you know, often get too high. But for, you know, patient investors that know how to source deals it’s still, it’s a very good opportunity set right now.
The second one is that there is a particular, I think, excitement but also continue—continuing with the theme we just framed, opportunity set around technology, whether it’s formally a technology company or whether it’s a company that may be in a different space that provides some type of technology or is using technology in a different way, in a nontraditional tech space. And this whole digitization of the economy and adoption of technology is still dominating really the evolution of our economy. And for folks like yourselves that are real experts in technology and can find those non-obvious companies it’s also a great time to be in that space.
And then last is that the private market space arguably is even more important than it has been in the past and retail investors need to work hard to find smart ways to get access to companies at the growth stages that they may be at before they go public. Notwithstanding SPACs, we are seeing a lot of companies stay private longer than they have in the past and we’re seeing a lot of tremendous value creation at that stage before companies go public, if they ever go public.
And so, that’s something that we’ve been doing here for our clients for a long time. Obviously, it’s what you do for a living. And we think that the trend and the importance of private market investing is only growing as the total set of public market companies continues to shrink and as their valuations continue to stretch higher and higher.
So, David, I want to thank you so much for being here today. Hope to have you again at some point for an update.
DAVID REUTER: Thanks for having me and happy to be here and wish everybody well through the wrapping up of the pandemic.
TONY ROTH: I want to thank our listeners for joining us and I encourage you to visit wilmingtontrust.com for a roundup of our investment and planning content. You can subscribe to Capital Considerations on Apple Podcasts, Spotify, Stitcher, or your favorite podcast channel to ensure you get updates on future episodes. Thank you again for listening.
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