Why We Didn’t Change Our Investment Philosophy After COVID-19
As a firm, we’ve learned a lot during the last year of the COVID-19 pandemic, about ourselves and the companies with which we are partnered. From these lessons, there will certainly be operational changes that we’ll carry forward and that our partner companies will implement post-COVID.
However, at least one thing has not changed for us: the qualities that we look for in potential partner companies have remained the same. In a time when lenders have tightened parameters for their funding and private equity firms and other sources of capital have shifted their investment criteria, we take pride in remaining unchanged in this regard.
At the core of our investment philosophy is the belief that great people build great companies. In fact, the number one consideration for us when evaluating a company is the people, and it often is the deciding factor (as opposed to just one item on a checklist). We may believe so strongly in a leadership team that it means we will partner with a company despite other areas that may not exactly fit our criteria. The opposite is true as well; we may pass on an otherwise impressive company if we don’t have the trust and connection with the management team. It’s that important to us, and this hasn’t changed because of COVID. We will still look for companies founded or led by driven, authentic people and will look to forge relationships with those people before, during, and after any transaction.
In addition to the people themselves, one area we pay a lot of attention to when deciding whether to invest in a company is its culture. People create the culture of a company, and the best businesses build a culture that unites those people around shared goals and where each employee is empowered to elevate the company. When learning about a company, indicators like communication practices, employee retention rate, development and promotion from within, and the amount of cross-training employees have the opportunity to engage in can tell us a lot about the culture. Even a company’s recruitment methods can be telling: the more current employees that refer potential hires from their own network, the more likely the company is a place that people are proud and happy to work at.
COVID-19 did not change the importance of a company’s culture for us; if anything, it’s amplified it. For companies that pivoted to a remote work environment, the culture – the quality, frequency, and transparency of communication and the relationships among team members and leadership – was a major factor in determining which companies transitioned relatively smoothly to a remote environment versus those that struggled. For consumer-facing companies like restaurants, or manufacturing companies, or any company that couldn’t pivot to a remote environment, the quality of the culture, the ability of the leadership to make fast changes to ensure a safe work environment and transparently communicate to all team members differentiated successful companies. In both cases, companies with high levels of employee retention will continue to be well-positioned as we come out of the pandemic, as they will not have to worry about rebuilding a team in the aftermath. We will continue to look for companies that exhibit a strong culture, knowing that in good times and times of challenge, this is always an indicator of future success.
Throughout our 17 years of business, we have found that in terms of financial criteria, our sweet spot is between $1 million and $5 million of EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization are taken into account). This isn’t arbitrary. In the companies we work with, a floor of around $1 million provides a sufficient foundation of cash flow to not only buffer against unexpected challenges, but also to invest in growth initiatives. For larger companies, while $5 million is not a hard ceiling, we’ve found that for companies below that threshold we are able to provide more value and help grow the business: scaling infrastructure, rounding out the leadership team, or supporting capital expenditures are common examples.
None of this has changed because of COVID; are you seeing a pattern? In fact, during COVID, we found our thinking put to the test – and validated. When we said, “buffer against unexpected challenges,” that would be an understatement when referring to the pandemic. We understood some of our companies’ revenues may take a hit, but in all cases, having this flexibility in earnings meant we could stick to our long-term strategy even while navigating through the worst of the crisis. In the case of some of our portfolio companies, it even made sense to continue to invest in major capital expenditures that were in the strategic plan prior to the pandemic; taking cues from our partner company management, we never closed the door on this, which is often the first to get shut down in downtimes. All of this has reinforced our EBITDA criteria. We carry forward this idea of a liquidity buffer in good times and bad even after we’ve partnered with a company. Said differently, we don’t over-lever companies, which is one reason we believe our partner companies have navigated COVID relatively well while still maintaining focus on long-term goals.
We’ve never subscribed to the investment philosophy that one data point defines a company; we tend to take a holistic view. In addition to EBITDA, another important metric we evaluate is revenue retention, which is closely tied to the customer relationships a company has. In prior economic downturns, companies with strong, long-lasting customer relationships with high degrees of trust and consistent, proven quality outcomes may have seen spend levels contract in some cases due to declines in the customer’s business, but it is rarer to experience outright customer losses. This trend remained true during the COVID-driven downturn, while companies that are contributing less value to customers were more likely to see sharper declines during the pandemic. We will continue to prioritize companies that form strong customer relationships and who excel in building trust and transparency with their clients.
Not every business model lends itself to long-term, contractual relationships. That’s why customer diversity – or low customer concentration – is also important to us as we learn about companies. This has always been a crucial point of review for us, even in companies that have high revenue retention. Theoretically, a company could have 90% revenue retention, 80% of which is comprised of one customer whose spend has been consistent or increasing in recent years. Despite the high revenue retention, we would still take pause at the high concentration. The risk of loss of that customer, or a substantial spend decline with tha customer, are amplified during an economic downturn. On the flip side, we’ve seen throughout our years of partnering with companies that businesses whose revenue is spread out over many different customers are better protected against economic disruptions. In these cases, even if some customers cut spending completely, the majority of the company’s revenue isn’t lost.
While this is not a comprehensive list of everything we consider when learning about a company, it does give good insight into how we think about those companies. We invest across four sectors, which include industries hit hard during COVID like food and beverage and aerospace manufacturing; we’re not immune to or unfamiliar with the challenges and hardships those companies have faced in the last year. However, we believe that the qualities we’ve described here determine a company’s success over the long term, during good times and challenging times, through peaks and troughs of economic cycles and through once-in-a-generation disruptions like COVID-19, and that has always been the lens through which we view potential partners. Over the past year, we’ve been proud to continue to support the companies in which we’re investors. In 2021, we expect to invest in four new companies, and the qualities we’re looking for are the same qualities we’ve been looking for since our firm was founded 17 years ago.