Episode #194: Doug McCormick, HCI Equity Partners, “I Generally Believe People Underestimate The Duration Of The Time That They Will Be Invested”
Guest: Doug McCormick is a Co-Founder and Managing Partner at HCI Equity Partners and oversees the origination, management and development of the firm’s investments. He joined the HCI team in 1999 and has served as a Managing Partner since 2006.
Date Recorded: 11/20/19 | Run-Time: 51:56
Summary: In episode 194 Meb and Doug kick off the conversation about thinking about a family as a business. Doug discusses the idea that people effectively have two businesses, selling labor in the marketplace, and converting income into financial assets. Doug expands on that by covering the family CFO framework, and that the job of the family CFO is much like a corporate CFO in that they must manage risk and liquidity with the family’s balance sheet. The pair also get into entrepreneurship and thinking about the role entrepreneurship can play in wealth generation.
Meb and Doug then get into common mistakes people make, such as underappreciation of a long horizon. They then transition into approaching conversations about wealth with Family, starting with acknowledgement that wealth without management, values, and education can be a liability.
As the conversation winds down, Meb and Doug cover some ground about Doug’s day job as a private equity investor and some best practices for private equity allocators.
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Links from the Episode:
- 0:40 – Introduction and welcome to our guest, Doug McCormick
- 1:46 – Inspiration for writing his book Family Inc.: Using Business Principles to Maximize Your Family’s Wealth (McCormick)
- 3:38 – The concept of why your family is a business
- 5:58 – Valuing human capital and understanding head of family as a CFO
- 9:29 – How does the human capital structure change the investment process or asset allocation
- 13:22 – Entrepreneurship
- 17:01 – Views on budgeting
- 17:10 – Tools (Family Inc.)
- 18:55 – Hedging your family wealth and insurance for the bad times
- 21:34 – Thinking about creating retirement plans that replace long lost defined pension plans
- 24:18 – Biggest mistakes people are making in operating their families
- 27:57 – Implementing family business strategies
- 31:39 – Education for families in terms of family financial planning
- 33:05 – Doug’s work as a private equity investor
- 34:09 – How HCI Equity Partners vets investment ideas
- 36:08 – What differentiates HCI from their competition
- 40:23 – Common problems HCI runs into as a private equity investor
- 42:02 – Is the landscape harder as more folks have cash on the sidelines
- 43:02 – HCI’s deal flow
- 44:59 – Best practices for asset allocators looking to explore the PE space
- 47:37 – What Doug is excited about
- 49:06 – Big changes to Doug’s beliefs over the last 20 years
- 50:21 – Most memorable investment
- 51:10 – How to people connect with Doug: familyinc.com, @doug_mccormick
Transcript of Episode 194:
Welcome Message: Welcome to the ”Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up podcast listeners? The decade is almost over, but we still got time to have an awesome show for you today. Does your family have a Chief Financial Officer? That’s today’s topic. Our guest is managing partner and the cofounder of HCI Equity Partners. Author of one of my favorite books of the last few years, “Family Inc.” And before starting HCI Equity, he was a managing partner at Thayer Hidden Creek and Thayer Capital, worked in investment banking division of Morgan Stanley and served as a captain in the U.S. Army’s 25th Infantry Division. In today’s episode, we explore some personal finance concepts. We begin with thinking of your family as a business and the idea that as individuals, we effectively have two businesses, selling our labor in the marketplace and converting income from labor into financial assets. We discuss entrepreneurship’s role in wealth generation, managing risk with the family CFO framework and modern thinking about retirement and longevity. Stay tuned as we cover family conversations about wealth and dig into private equity investing, partnering with founders, families and management teams, and best practices for private equity allocators. Welcome to the show, Doug McCormick.
Doug: Thanks very much, Meb. Happy to be here, buddy.
Meb: Doug, I’m excited to have you on. Your book was one of my favorites of this cycle, so kudos. I really liked it. Listeners, the name of its ”Family inc.” Why don’t you tell us a little bit about the inspiration for writing it and what caused you to put pen to paper?
Doug: Sure, man. Well, first of all, I’m honored to be in one of your favorites. I know you read a lot, so that’s very nice to say. And I think candidly, the impetus of the book was my own challenges and personal experiences. Not so much financial distress per se, but as a young person coming out of college trying to figure out what I call the financial game of life, and it’s taken me, I’m 50 now, so it’s taken me 30 years of kind of a trial and error in experience. And so I guess about five years ago or so, I thought to myself, “Boy, if I could share a lot of these lessons, it would be impactful for other people. So I think that was the real impetus, and I think that’s complemented by the financial game of life, I think has fundamentally changed. And your grandparents likely worked in one or two jobs and likely if they did reasonably well in their profession, they were financially secure. And today, we see increased life expectancies, we see increased job mobility, less safety nets, a much more complicated financial landscape. And so the chin up bar, if you will, in terms of what it takes to navigate a lot of these big financial choices, I just think is increased dramatically.
Meb: Yeah. The better way to say it is, you’re on your own listeners. Gone are the days of defined pension plans. I remember having conversations in my early 20s with my parents and so many of their peers and experiences were based around, you’ve got a job with a company, you’re there for life. In many cases, not always, but popping around was a rarity versus today I think I know like one friend, I think, who’s post-college has been in one company the whole career. So it’s a challenge too, and we’ll get into this on running your own show. But give me a little bit a bit based on the premise, this concept that your family is an actual business. Most people, I don’t think about their world and that framework. Talk to us a little bit about that.
Doug: Yeah. Well first of all, when I say to people, ”Hey, think of your family as a business,” a lot of times I get a negative reaction like, ”Hey man, this is my soul, this is what’s so important to me and I don’t wanna think about it like a business.” And so, again, a little background into how I started thinking about it. I’ve been investing in private equity for 20 years now, and a lot of what we try to do in private equity is we really get engaged with a business and build a bigger, better business, and one of the key participants in that journey is often the company CFO. And they often are thinking strategically about looking at the financial performance, thinking about where to invest, how to structure the business. And as I spent a lot of time with these CFOs, I started realizing that a lot of the thought processes and framework they were using to build their business could be applied to some of my financial decisions. So, again, when I look at the family as a business, it’s really in the context of making financial decisions. But the basic premise is that we’re all entrepreneurs or we’re all small business owners and we really have two businesses. We have a labor business and basically we’re selling our labor in the marketplace. And if you wanna put that into financial terms, the name of the game is to sell your labor as quickly for as much as you possibly can, and then convert the income you receive from that labor into financial assets. And over time, you’re essentially trading labor assets for financial assets such that when you run out of labor assets i.e. you retire, you’ve got a big stack of financial assets that can serve you during your retirement years. And so, you know, I think that paradigm is really interesting because it allows you to apply a number of business principles to your decision making, which I think is helpful. And I think it also really turns some traditional concepts on their head. For example, if you think about it that way, net worth should include things like the present value of your labor, should include things like your expected Social Security benefits, and that really changes the way you think about things like asset allocation. So I think the framework is important because it allows you, everybody to make their own decisions based on the key variables that are gonna important for them.
Meb: Yeah. And this is an interesting concept because many financial advisors and people don’t talk a lot about, some people call it human capital. Morningstar has done some good research here, and you pointed out. is a major input. How would this change how people think about their holistic situation? You talk about almost, you say your family has to think about it as if you’re the CFO. How would the CFO, how would this change the way that they actually practically live their day, live their world?
Doug: I guess there are a couple things I would say. So let’s just talk about looking at labor as a significant asset. Again, I think it highlights for young people that when you come out of college you often say, “I am broke, I have no financial assets.” You’re putting together your balance sheet and you’ve got very little in the asset category and possibly a lot of debt, but you do have significant assets in your labor. And so just that concept alone I think allows young people to think more strategically about what am I doing with that asset? There’s an opportunity cost to not working. There’s an opportunity cost to go back to school. It allows you to tease out concepts like investing in your labor asset such that you can compete more effectively in the job market, you can extend the capacity of your labor, i.e. if you’re college-educated generally you could work into your 60s or even 70s. So I think that’s a real valuable kind of part of the equation. I think the other thing it allows you to do is think like an investor when you’re managing your career. And I always tell people, “Listen, first and foremost, you gotta be passionate about what you do and you gotta like it. And if you do those two things, you’ll probably be good at it,” and that’s the number one criteria. But then outside of that, you can think about choices that are gonna result in the longest lifetime compensation. And so I often see young people make choices around careers based on a snapshot, like what does that job or profession pay today? And I think a much better way to look at it is, what could I expect to earn over a lifetime by pursuing various careers and thinking more holistically about compensation. It’s not just your base and your annual compensation, it’s things like what’s the brand affiliation I get by going to work at a great organization? What is the experience I’m getting and the skills? What are the portability of those skills into other industries and other markets?
And so I think the framework allows you to be more strategic. I think the other thing it does is it allows you to talk holistically about all of the various things that a CFO in a business could do that you may expect the family CFO to do, right? So it’s not simply managing the checkbook. It’s investing, which people often think about, but it’s decisions on housing, decisions on asset allocation, decisions on risk management in the form of things like insurance. It’s decisions on investing in your labor or helping your kids think about those choices, and ultimately succession planning. Just like a business, you’ve gotta prepare for the next generation of leadership. Arguably a family that has wealth that transcends generations should be doing a lot of preparation and making sure that the next generations have the skills and the values to perpetuate that amazing asset that the family’s accumulated.
Meb: So we’ll unpack each of these kind of in succession because you touched on a few things that I want to go into a little more detail about. The first one is how does this change one’s view on asset allocation and the way to allocate in general? So, are there any general principles that you believe in or that maybe less typical or not as mainstream once you figure in some of the considerations you talked about like human capital and everything else?
Doug: Yeah. So, I think there’s all kinds of really interesting asset allocation models out there, and I believe them to be valid, but I generally believe them to be valid in the context of evaluating the best risk-adjusted returns for a portfolio of financial assets. And if we step back and say, yeah, but this is a business and it has all the things that we previously talked about, like labor assets and also things like maybe the family home, things like possibly a pension or Social Security, which is effectively a government-sponsored pension, I do think that changes the practical asset allocation, because fundamentally, most families are overexposed to things that look and behave like fixed income. And so I personally believe this labor asset that I talk about is very much like a fixed income instrument or an annuity. For the most part, individuals are relatively highly employed and they get paid annual payment very much behaves like an annuity. So I would look at labor as behaving like fixed income. Real estate has its own kind of risk return characteristics. Social Security absolutely behaves like fixed income. And so when I look at all of those assets that the family has to manage, I generally find that especially young folks are way overexposed to these fixed income type assets and underexposed to equities. I generally am biased toward in your financial assets be very heavily focused on equities given the holistic kind of family exposure. The other thing that I think is a common, a short sight of the traditional financial model relates to duration. I generally believe people way underestimate the duration of the time that they will be invested, and long duration in my mind allows you to endure greater short term volatility. So, that in my mind is another reason on why the family CFO should embrace a lot of equity exposure given those other assets and how they behave.
Meb: Yeah. There was, I’m trying to remember who it was, but there was a researcher maybe five, 10 years ago, it might’ve been [inaudible 00:11:59] who was making the philosophical argument that if you’re young you should actually have one-and-a-half, two times leverage exposure to the stock market. But the big problem with that is on paper it makes sense, but most people can’t handle stocks at their regular volatility, forget one-and-a-half, two times leverage. It’s enough to drive someone crazy. But it’s fun because we talked about this on our old blog posts, listeners will link to it in the show notes, but it was something along the lines of a chair lift conversation on asset allocation where you could make philosophically different arguments, but what it really comes down to is can people actually implement it, which is the hard part.
Doug: Yeah, I totally agree. And so two comments there. I think there’s always a big disconnect between what is intellectually correct and then knowing yourself well enough to appreciate, can I stay the course once I’ve set a plan in action. The other thing I think is worth noting. I talked a lot about all these assets that the family CFO can manage. But if you think about it broadly, again, in many cases families already do have leverage, and so again, if you’re backing up and looking at the whole family picture, you may have real estate debt associated with your home mortgage, you may have school debt, you may have consumer debt in the form of credit cards. And so I think many families have embedded leverage in their portfolio without even trying.
Meb: Stocks have debt as well. That’s a well thought out comment. You talk a lot about entrepreneurship. You seem to be a big fan from one who’s been doing it for awhile. It’s also can be exhausting to the entrepreneurs listening to this. What are general thoughts on it? How should a family think about it?
Doug: There’s this joke, which is probably a bad joke, but I like it, which says that ever since I became an entrepreneur, I sleep like a baby. And then the punchline is I wake up crying every two or three hours. And I think any entrepreneur can appreciate that dynamic. My own experience has been that I think entrepreneurship is broadly misunderstood and many people, when we think about entrepreneurship, we think about the amazing successes that were big risks, big bets, and big payoffs that are featured in the press, so the Amazons and the Facebooks of the world. And while I think those are amazing examples of exceptional entrepreneurship, I don’t think they really apply to most of America. And so when I think of entrepreneurship, I’m thinking of something much less ambitious, candidly, but also much lower risk. And it’s being a small business owner, working for yourself in your local community. And so when I look at it in that vein, I think a couple things happen. One, the success rates go way up. The need for outside capital goes way down, which is often a big stumbling block for many entrepreneurs. And I think fundamentally, it’s a better business, if you will. There are really four reasons I say that. The first is, both the labor markets and the capital markets are very efficient and very competitive. And what I mean specifically is the median income for college educated Americans is something like low $40,000, and if you wanna make $70,000 you’ve gotta have a really differentiated skill set, you’ve gotta compete. Similarly, the capital markets are super efficient and if you get 5% year in, year out and after inflation returns, that’s probably not bad. But what I find is when you combine your labor and your capital in the form of a business, you can often create barriers in a way that you can drive much higher returns on your labor and your capital. Said differently, I can get to make a lot more than median income and I can also take my invested capital in the business and drive return on tangible capital way in excess of what I think I can generate in the market. So that’s one. The second is, in the businesses that I’ve described, these small family and founder-owned businesses, I often see the entrepreneur working very late into their life stage, but in that last 10 or 15 years, they’ve managed a very good life-work mix, and so it’s a way to extend your working capacity without sacrificing the quality of your life. So you’ve increased your earnings capacity by doing that. The third is, if you do it really well, you create a business that you can ultimately sell. And then the fourth is, this is generally a more tax-efficient way to create wealth because you’re creating most of your wealth through capital gains as opposed to income. And so for those four reasons, I’m a big believer in entrepreneurship for people who are highly motivated, confident in themselves, willing to work really hard and believe they’ve got some talents.
Meb: Yeah. There’s probably no better path to real life-changing wealth in many ways than building a business and compounding it. It doesn’t mean it’s easy, of course.
Doug: No, no, it does not. And I will say, most of the entrepreneurs I talk to, they love it as well. And so it’s that sense of accomplishment, it’s the sense of building something, sense of autonomy. So it’s not for everybody, but I think it’s a really interesting conversation for the family to have as they think about these big choices.
Meb: All right. So let’s say you kinda got this concept of a holistic picture understood. And by the way listeners, Doug’s got some great tools on his website we’ll link to as well that lets you get this picture. And you actually talk about in the book this concept of income statement and balance sheet for the family, but also your views on budgeting are a little atypical. You wanna talk about that a little bit?
Doug: The income statement, balance sheet, those are the ways that companies kind of measure their as is state. It’s kind of a report of what’s recently happened in terms of how much surplus am I creating and then what are my assets and my liabilities. So the transition is the family CFO should look at the family incoming receipts versus outgoing expenditures in a similar fashion. And I think it’s a healthy exercise to periodically review that on a quarterly basis or an annual basis for the family to lay out the balance sheet, lay out the income statement, look at changes in balance sheet over time. And my own experience and talking to others suggests me to believe that budgets are really not that helpful. I think they take a lot of time, people end up tracking minutiae, and at the end of the day what matters is did I bring in more than I put out? Has my balance sheet improved i.e. from this period to the next? Has my net worth gone up? Have my assets increased? Have my debts gone down? And I think if you’re forced to take that high level picture and you watch the longer term trends, that at least for me has been a more powerful way to see my progress rather than evaluating did I spend too much on Starbucks coffee or whatever my vices.
Meb: Yeah. There’s more and more online tools that I think that are helpful. I mean, Mint was one of the originals, but a lot of the, Robos also have some good tools on personal capital and others as well as the ones we’ll link to on your site. So as we think about building sort of a bulletproof life and as a CFO would think about it, and as we think about it here or with our company as well as our own lives, we’ve touched on a number of things, the human capital, the financial capital, which is really a big buffer to the bad times, but also talk about sort of hedging your family and life to unexpected or expected, but maybe a little more rare and unfortunate events, and talk about insurance.
Doug: Sure. One of the things I love about the family CFO framework is it forces people to see the range of things a CFO should be doing, and many people myopically focus on how much wealth am I creating and am I gonna be financially secure? And that’s super important. But the number one job of the CFO is, A, do I have liquidity immediately to handle short term unexpected problems? And B, do I have a safety net such that if I find my labor underperforming, which is unemployment, do I have some kind of liquidity that I can fall back on to avoid financial distress? And so item number one in risk management is the important aspect of liquidity, and I could have liquidity in terms of just cash on the balance sheet or access to funds that may be liquid but volatile like equities, etc. That’s a really important way to manage risk. We talked about debt. I have a belief that debt is a valuable tool to the financial planning on a long-term basis. And so one way to manage risk is ensure that your debts are secured by assets that generally appreciate rather than depreciate, which results in very long duration and relatively good low amortization and low interest rate type stuff. So long winded way of saying finance most of your things in the context of home mortgage as opposed to consumer debts. And then just on insurance quickly. First of all, I tell everybody I believe insurance is a loser’s game. Your expectation of payout is likely to be less than what you put in. Having said that, it’s a very valuable risk mitigation tool and a lot of people, they think of insurance, they immediately think of life insurance. That’s obviously important, but I think often underappreciated are other kinds of insurance such as obviously health insurance, disability insurance, umbrella insurance. So, all of those I think can be valuable tools. I personally believe insurance products are good risk mitigation tools. They’re not necessarily good investment tools unless they’re complicated with some tax strategies around gifting to follow on generations.
Meb: We touched on this in the very beginning, but we’d like to kind of come full circle to it. The world has changed in thinking about retirement and assets where our parents’ generation certainly had these defined pension funds and today people don’t. How do you think about ways to think about retirement and under that umbrella, would love to hear your thoughts on annuities and concepts like that as well?
Doug: Yeah. I think there are a couple things that I encourage people to think about. First of all, you look at what’s happening to life expectancy, it’s no surprise that also worker longevity is increasing as well. And so I think the concept of retiring in your early or mid-50s is really being kind of reconsidered by many in that age group. And I think I would say I believe there’s all kinds of studies that suggest that people that are active and still working are actually healthier and happier, but also just financially working longer is a great way to insulate yourself from some of the changes that are happening in the financial landscape. The second easiest way to really insure yourself against this extra retirement is by deferring Social Security. And essentially what you’re doing is you’re back ending the insurance benefits around a longer life expectancy. And then I do think that annuities can be a valuable form of insurance. We all talk about life insurance and everybody understands that life insurance essentially pays a benefit when you die. Annuities can be linked to your life. And essentially in my mind, that’s a great hedge against living longer than expectations. So we all think about that as a very positive thing to have the opportunity to have a longer life expectancy. And it is, but from a financial perspective, it implies a greater financial need. And so annuities purchased very late in life or annuities purchased with a payout date that starts late in life, you essentially get a meaningful insurance benefit above and beyond the return on capital.
Meb: Annuities are in an area that I think there’s probably some real potential, I tweeted this the other day, for disruption. The average annuity fee is north of 2%, and even Vanguard has some that are not super cheap. And so this concept of being able to lock in investors to investing is something we spend a lot of time thinking about. I don’t have a good answer yet because the public markets and even the automated services, people can still behave poorly. But if you had to lock up your money for 10, 30, 50 years, it’s a good thing in my mind. But the problem is for most of the solution these days, they tend to be expensive.
Doug: Totally agree.
Meb: You put out the book and now for a few years. One, would love to hear any feedback you’ve had from readers, but also are there any sort of mistakes that you think people are making as they operate their families? And feel free to use any personal anecdotes as well. But anything that you think is common missteps or anything else or people, I would love to hear the feedback as to the book too?
Doug: So, I think the feedback has overall been positive, but candidly I think that may be a, a sampling bias, right? No one seeks me out to tell me they didn’t like it. So.
Meb: Oh, well, let me state the opposite because we somehow find all those people. So that is not the case by the way. So maybe just everyone loved it because people tell us every day how dumb we are.
Doug: Yeah. Yes. So I haven’t had many people waste their time to tell me that they didn’t like it. So I’ve had some nice comments. And I think for the most part, I think it accomplished the objective I was trying to balance, which is I think there’s kind of a dichotomy in the book market on this topic today. You have a lot of really rigorous, really interesting analyses that are super valuable for the community to read, but unfortunately I don’t think are very holistic and they’re also not very accessible by main street America. So Jeremy Siegel I think is an amazing writer and I love his work, but I questioned how holistic is it and how accessible is it to all the folks that could benefit from that information. The contrast to that is I think there are a lot of other holistic financial health books, if you will, that are not rigorous enough and don’t leave the reader with a specific action plan or takeaways about how they could change their lifestyle. And so for me, the best compliment has been, “This is a user’s guide for navigating the financial game of life. And I read it once. I read it twice. I dogeared pages 76 and 82, and I’m gonna go back to it when I make big financial decisions because it grounds me in a framework where if I apply the framework I should have some confidence in the decisions I’m making.” So I think that feedback is the highest compliment that I’ve gotten.
I’ve also gotten a fair amount of feedback from the veteran community. I am a veteran myself, and I think the veteran community has a unique challenge in transitioning out of service into the civilian labor market. And I think this is an interesting resource for that community to take advantage of all the great skills and experiences that they have and translate those into everyday professions. And so that’s been very rewarding as well. I think the common mistakes are some of the things we’ve talked about, and I think it’s an aversion to equities at the expense of less volatility but less longterm wealth accumulation. I think we all have a tendency to underappreciate the very long duration that we are playing with here. You know, I often hear people anchored on, “Well, I’m gonna retire in, when I’m 65 and therefore I’ve only got 10 years.” And my point would be, “Yeah, but when you retire at 65, from that point to 90, you’re still gonna have 25 years of consumption, so your duration of being invested is much longer than the 15 years.” And so I think we all have a tendency to underappreciate that planning horizon. And then the last one is not necessarily something that people are making mistakes on, but I would tell you from talking to others, thinking about this issue and then my own personal life experiences, finding good ways to teach family members these skills and these values, I think everybody consistently struggles with.
Meb: Yeah. That’s actually a great segue, because I think we’ve talked a lot about this on the podcast, and I don’t know that there’s any easy answers. But how should one think about say, okay, you listen to this awesome podcast and Meb and Doug, going back, you’re the matriarch, patriarch of the family, whoever you may be and say, “I wanna implement this across my family,” and maybe it’s intergenerational too, grandparents, grandchildren, whatever it may be. How do you go about it? There’s a lot of competing interests and forces at play, competing various levels of education, emotions, family dynamics, all that messy stuff. How do you think about that?
Doug: I think that is, you’ve described the reasons it’s so challenging, right? It’s such a collection of different forces at play. I think the first thing is it starts with an acknowledgement that in my mind, wealth without proper management values, education, can actually be a liability. And I’m sure you and I, we could all name lots of examples of young adults who were blessed with wealth and didn’t have the maturity and the values to handle it in a way that it was actually detrimental to their wellbeing, to their self-esteem. And so I think that acknowledgement, there’s a downside to wealth and you’ve gotta treat it as if it can be dangerous, is a real important start. I think families that have managed to perpetuate wealth over many generations start with the premise that your biggest asset is your career and your education, and that’s how you find value, and that’s how you find self-esteem, and they really emphasize the importance in every person’s success. So if you come from a family where you’re always financially secure, then all of a sudden, how do you define your success? I think it comes from other kinds of accomplishments. I think starting these conversations early when they’re not so emotional and introducing the concepts at a very young age is super important.
In the book, I use my dad and my relationship as a way to kind of tease out a lot of these concepts. But my dad was an educator and one of the things he did at a very early age was he literally introduced me to these concepts, took me to meetings with his stockbroker, took me to stockholders meetings as a way for me to just become familiar and not be intimidated by some of these things. An open dialogue, an open conversation about these topics is important and that starts with the patriarch and the older members of the family being willing to acknowledge the mistakes that they’ve made because I think there’s a general tendency where we all want to talk about our winning financial decisions and not our losing, and no one ever talks about the investments that they lost money at the golf course. And so being vulnerable and being able to share the mistakes you’ve made in the lessons learned I think is key to that. The last two I would say is I think you got to give kids an opportunity to fail when the dollars are small because ultimately this is experienced-based learning and if they don’t fail until it’s big numbers, that’s gonna be expensive failures. And I think incentives matter. And so I’ve seen lots of different family dynamics where you’re giving kids opportunity to use the money, but you’ve gotta tie that with incentives and accountability to ensure that it’s been used wisely.
Meb: So many of these, it’s easier said than done. You know, I think for a lot of people the, it’s great advice on letting the children fail, but hard for a lot of parents. Certainly hard. And, you know, I’m sure this exists and I’m sure there’s, almost every wealth management company around the country does some version of this, particularly the ones that are targeting family offices, but the ability to have a almost, whether it’s online or in-person curriculum or bootcamp or almost like a family university where everyone could go through a program that doesn’t know how to do all these things, it sounds like a great business idea to me.
Doug: Just on that one. I think it’s one of the big challenges of our public education system. You know, there’s really very few standards from financial education perspective. The numbers are changing, but less than half the states have a graduation requirement related to financial literacy. And so I wish that the school would make this a bigger priority. But I think in many cases the curriculums are underdeveloped and as we said, it’s difficult. There’s some value elements to this that make it challenging to teach in a school environment.
Meb: Yeah, yeah. At the same time, it’s just I think a great business opportunity for too much work, we talked about earlier, entrepreneurship. But I think someone gets it right, would love to… So anyway, readers check out the book, ”Family Inc.” It gets really awesome. Everybody needs a CFO. And I also like, this is a nice balance between what most of the community, the writing, comes across the desk. And I fully embraced the fire, sort of community on cutting your spending. But this is also saying, “Hey look, labor and capital is just as important, if not more important and more fun.” Let’s talk about your day job. What do you do when you wake up every morning? What pays the bills for you?
Doug: Cry like a baby. So my day job is a private equity investor. I’ve been doing it since 1999, so about the 20-year mark. And I co-manage a firm called HCI Equity. So we are a middle market private equity investment firm. So we’re buying businesses, enterprise values of, call it $30 million to $100 million. And we’re longterm investors. We’re trying to partner with founders and families and management teams. We partner with them to bring capital and strategy and hopefully operational capabilities in a way that collectively we can dramatically grow those businesses. So I say this in partial jest and in some sincerity, my, i’ve been at it 20 years and I finally feel like I’m getting good. But it’s one of those businesses where it’s learned by doing, it’s an apprenticeship business. You gotta get a lot of scars to really get good at it because it’s a humbling business, but a really interesting and fun one as well.
Meb: Just talk to me a little bit about the actual belief system framework where, how do you guys actually vet process, evaluate targets? How’s the, is it fun-based? Is it through individual deals? How’s it all work?
Doug: So first of all, we invest in a fund at a time, so it’s a blind pool of capital with roughly a 10-year kind of duration. I think that’s important because, you know, we talked about duration and the family situation and I think duration in my business also allows me to take a longer term perspective allows me to think about investments that have longer term payouts. And so I do think that is fundamentally a different mindset than what you see in the public equity markets. Like, I don’t really care about quarter to quarter performance. I care about am I, do I have a strategy, does that strategy allow me to garner a lot of value, and am I developing the organizational capabilities at the company to execute that strategy? As you think about how we source deals and look at deals, first of all, I’d say we try to have a lot of shots on goal and then we take very few. So it’s a very selective gain. We probably look at well over 1,000 deals a year. When I say look at, it could be a very superficial evaluation or a very deep evaluation. It’s the top of the funnel, if you will, and the things we end up doing, I think we end up doing, because they’re highly aligned with our strategy and our strategy is one of finding small businesses, small platforms in very large fragmented markets where with management we can compliment them with resources to dramatically grow. And that growth hopefully will come both organically and through acquisition. And we think there’s a pretty, to say as a standard playbook would be inaccurate, but there are a number of work streams that we employ on those businesses that are often relatively common regardless of the specific industry or the business.
Meb: So now allocators are tossing money at you. What do you guys say is your sort of secret sauce, value-add, big differentiator on what you guys do? How do you talk about that?
Doug: Let me back up on private equity market and then I’ll shift into how that influences us. So in the financial markets, my view is success breeds mediocrity and failure. So anytime an asset class outperforms, you get more assets into the asset class and that creates more competition. And we see that exact trend in private equity. It’s grown, I don’t know, 10 fold here in the last 20 years, and I’m sure my numbers are off, but directionally am pretty right there. So the asset classes become much more mature. It’s become much more competitive. I still believe on a relative basis to public equities it will be an attractive asset class, but I think the return expectations should be less prospectively than they have been historically. I think what that means to us is as that market continues to mature, if we’re not getting better every day, we’re getting worse. And so we continue to try to evolve in a way where we’re better at underwriting and we’re better positioned to bet on our ability to positively impact the business than the business’s ability to meet its forecast on a standalone basis. Practically, what that means is we try to have domain expertise where we understand the industries and the business models very well, and we can bring value to that portfolio company through our network and our operating capabilities to really be a, almost a strategic partner rather than simply a capital provider.
Meb: Do you have any sort of examples, and you can use the name or not use the name, of portfolio companies that you think would be a good walk through on kind of how you guys operate?
Doug: I’ll probably just give general examples, but 90% of the businesses that we’ve invested in have been family or founder-owned as opposed to institutionally-owned. And so I point that out because there’s just a fundamental different mindset about how we think about managing the business versus how families and founders often think about it. And it results from the fact that for most founders and families, this asset represents 90% of their wealth, and they generally look at the asset as the annuity that funds their lifestyle and their family. That dynamic has a very different profile than the one we bring, which basically says we’re gonna get all of our return when we sell the business. And so we do two things. First of all, in most of our deals, the seller is partnering with us, and so we’ll buy roughly 70% to 80% of the business. We’ve given them significant liquidity and they’re gonna reinvest 20% to 30%. We love that dynamic because they’re aligned with us. When we win, they win. And I also often say it kind of makes them dangerous. And I mean that in a good way. Like, they’re not worried about their financial security at that point and it allows them to be comfortable with taking a little bit more risk on the business. And so we do finance a number of our deals with some amount of leverage, which is a tool we use to drive returns. But then once we’ve changed the mindset of that owner, given that risk profile I just talked about, then the conversation changes to how do we grow this business faster? And it allows us to do things like invest aggressively in IT systems, invest aggressively in growth strategies that may not bear fruit for a year or two or three. It allows us to build a team based on where our long-term goal is of five years, not next year. And then it allows us to think differently about how could we support the team in buying their competitors in a way that allows us to scale, allows us to build a better business, and also brings better value to our customers. And so those things that I talked about there, those are very general, but in almost every situation, those generalities end up having specific action items and kind of work streams associated with them.
Meb: You mentioned earlier you had some scars. What tends to trip up these sort of operations once you acquire a part of the business? What are some of the common problems you guys run into?
Doug: In the lower middle market, we say we buy main street type businesses, so lots of industrial services. I think customer concentration can be a big problem and it’s a frequent thing with many of these smaller businesses where they have a customer that could be 30%, 60%, 70% of your revenue. And so thinking about how you underwrite that, how you get comfort with that I think is super important. Industrials have a tendency to be a bit more cyclical than some of the broader markets. And so kind of understanding where you are in the cycle I think is important. So those are kind of on the underwriting side. But I think, you know, we look at buying businesses as, it’s kind of like the game of golf where you could say you’re never gonna win the game of golf on the first hole, but you can lose the game on the first hole. And so we don’t feel like we ever buy so well that that’s the game over and we have a successful investment when we purchase because we think we’re buying things at approximately market values. So it’s really about what we do to build a better business, build a bigger business. And this is gonna sound cliché, but it’s teamwork, it’s getting the right players on the field and it’s getting alignment of incentives. And I think one of the evolutions for me as an investor is I think investors have a tendency to look at numbers and financial performance as the end game, and what I now appreciate is those are just the scorecards that are being driven by people and strategy. And so if you don’t have the people and strategy, right, you’re not gonna get there.
Meb: You mentioned earlier, you’ve been through a few cycles, both with public and private markets. Are you seeing the amount of assets and just dry powder? Is that causing you guys headaches as far as bidding for deals or are valuations coming up? Is it becoming more competitive? What’s the lay of the land look like?
Doug: Yes, yes. It’s absolutely more competitive and that’s a double-edged sword. It’s more competitive when we’re selling assets, and so we’re benefiting from that competition on exits, and it’s more competitive when we’re trying to deploy capital and we’re struggling with that side of it. And that’s kind of where I get back to my comment where we are underwriting with some expectation about what can we do with this business to see and drive more value than somebody else? And increasingly I think to be successful, you have to be convinced and then deliver that you have a game plan that’s gonna allow you to drive value.
Meb: What’s the deal flow? You mentioned 1,000 deals. Is this people just emailing you after they listen to the ”Meb Faber Show?” Is it just your friends and family network? Are there brokers? How do you guys get a deal flow that’s quality?
Doug: Yeah, it’s all of the above. There is a very developed kind of 50 years evolving middle market M&A community. So there are a number of really good institutional investment banks out there and they’re not the ones that you hear about on Wall Street,. You know, so it’s not Goldman Sachs and Morgan Stanley, albeit they’re doing tremendous amounts of M&A advice as well. These are much more kind of M&A boutiques who are helping family and founders and other financial sponsors buy and exit deals. And so those firms probably represent a significant majority of the deal flow, but then we spend a lot of time on the edges trying to generate deal flow that we believe is a little less competitive and a little more proprietary. And so, some of that is we come up with a thesis, we find a manager and we’ll proactively try to get into the market and solicit businesses in that space that we think would be receptive to a partnership. Some of it is intermediaries that are more non-traditional. Could be a broker, could be an accountant, could be a lawyer that this is not maybe their full time activity, but they may have a relationship and a network that’s relevant to the thesis we’re trying to execute. And then I would say we think about a platform as a great vehicle to follow on deals. And so the best way for us to get deals done in a space is to have an asset in the space. And our success rate, once we get an asset in the space, we’re much more likely to be able to source and credibly convince other business owners that we’re an interesting partner. That is often done with management team.
Meb: If we were to switch sides of the table, put on our allocator hats, what’s some of your advice to people that are, whether it’s individuals, advisors, institutions that are interested in private equity or current allocators? As some of the best practices is from someone who’s been operating for 20 years now, what should they be thinking about? How should they be thinking about this asset class to do it in the right way versus kind of what you see is common mistakes that people make when they do allocate to private equity?
Doug: First of all, I think it’s in the context of relative performance, so I think you have to think about this asset class as it’s illiquid, it’s arguably more risk and therefore you should expect compensation, but that compensation is gonna be basis points over the public mark, it’s not absolutely uncorrelated. I think there’s some measurement error in correlation here in my mind. The public equities are marked to market every day. Private assets are trying to mark to market, but they don’t perfectly. And so I think there is a fair amount of correlation given overall economics. But I think the things that make firms successful in the long run are continuity of team, consistency of strategy and the commitment to stay the course on that strategy and capabilities that allow the team to be more than simply good investors, but good business owners and good business builders. I’m biased when I say this, but I think the lower middle market is particularly interesting relative to the really big large cap stuff, both from a return expectation perspective as well as lack of correlation, but I’m probably biased given that’s where I’m playing.
Meb: And so that middle market area, a lot of what people talk about when they talk about early stage VC or angel investing is the power laws where it’s only a handful of the investments are these multibagger big outcomes that dominate the returns of the portfolio. Is that something that you see in kind of area you’re in or is it more of a traditional across the board, single, doubles, maybe your occasional triple? How’s it work?
Doug: We look at ourselves as kind of late stage leveraged buyout private equity, and it would be much less volatility, much more consistency in kind of multiple capital return, but very few outliers, not a lot of 10X deals in that kind of environment. So I do think it makes the underwriting a bit easier because I don’t know how you underwrite the next Facebook, but if you can see a track record that has some consistency around outcomes and not that much volatility, I think that’s reassuring.
Meb: As we wind down the year, we’re getting darn close the end of the decade and you look out to the horizon, what are some of the things you see or you’re thinking about or that you’re excited about over the next 10 years? Anything you’re working on? Open-ended question. Anything on the brain?
Doug: I’ll pick one, one positive, one negative. I feel like the rate of change and the rate of innovation is continuing to accelerate. You look at metrics, like every person in the world now has unlimited access or has, in theory, has access to a phone which has access to more written language than it’s ever been available before. And I feel like I see that innovation continuing to accelerate. And so I’m very excited about what that means for humanity and the quality of life and the rate of growth. So I think that’s the positive. I think the negative that I struggle with is I see no conversation, no concern about deficits across the globe or federal debts. And I just don’t know how that story unwinds in a way that is gonna be good. But I also don’t know the forcing function that’s gonna cause that conversation. Pete Peterson wrote a book called ”Running on Empty,” I think around 2000 that talked about the deficit and the debt and it seemed prescient to me at the time and 20 years later it’s less of an issue from a public discourse perspective than it was 20 years ago. So I’m humbled by even trying to fathom how that gets resolved or discussed.
Meb: And as you look back over the last 20 years, I should have asked these in order. As you look back over the last 20 years, anything you majorly changed your beliefs about or anything that 5,10, 20 years ago you would’ve thought about totally differently than you do today?
Doug: My own evolution as an investor has been from being more and more quantitative and trying to derive the answer to being more comfortable with qualitative solutions. And so like now, I guess, I would say at a very, at an early age as an investor, for me it was the numbers really drove the decision making. The more experience that I’ve gotten, I think I’m more comfortable in taking faith in the strategy and the team and the ambiguity of building a business as opposed to the numbers. As a result of that, I see myself gravitating to different situations than I would have 10 years ago. I think that’s probably the big one for me. The last one I would say is, I value the interpersonal aspects of the business more. Can I work with a person? Can I trust that person? Some of that’s probably my patience, but some of it is lessons learned in when you don’t have those things, it’s really problematic. I think we underestimate the cost of not being able to work with somebody.
Meb: Yeah. As you look back, what’s been the most memorable investment? Good, bad? Anything in between?
Doug: Oh, I’ll share with you what I love about the business most of all is I feel invested with these teams in a way when they have success, I feel tremendous pride in success. When they don’t have success, man, I’m living it and just hating the experience. And so like again, I think it gets back to the alignment and being invested. I’ve so enjoyed the journey in every business that we’ve been involved with and I’m proud to say kind of good outcome, bad outcome, I’m still close and still have a personal relationship with those partners because we’ve been in the trenches together and you learn a lot about people not only when things are good, but when they’re bad, and I’m thankful for that experience.
Meb: Yeah. Doug, it’s been a lot of fun. Where can people track you, follow what you’re up to? Where’s the best spot?
Doug: Sure. I’ve got a little website, familyinc.com, and it’s got all the info on the book. It’s got my contact information, so that’s probably the best place to go. And the book’s on Amazon and I’ve got a Twitter account, which I’m woefully absent on, but, you know, every once in a while get motivated.
Meb: Doug, it’s been a blast. Thanks so much for joining us today.
Doug: Yeah, man. Appreciate you having me. It’s fun conversation. Thank you
Meb: Listeners, we’ll post show note links. Check out his book. It’s well worth your time. ”Family Inc.” Subscribe to the show on iTunes, anywhere else podcasts are found. Shoot us some firstname.lastname@example.org. Thanks for listening friends, and good investing.