“The Scalability of HoldCos”
A recent article questioned the scalability of Horizontal HoldCos. I agree, there are limitations to all companies and investment strategies. Growth eventually leads to lower returns. That is the law of the jungle and HoldCos are no different. That is why James Simmons caps the greatest hedge fund ever, Renaissance Medallion and it is why, as Howard Marks says, trees do not grow to the sky. There is a limit to growth. Period.
The principal issues to scalability mentioned in the article are:
1. Small businesses inherently do not scale well or lose their edge as they scale.
2. As we buy bigger companies, expected returns will come down due to competition from PE.
3. A lack of management capacity running so many companies.
4. A lack of centralized efficiencies. I agree that many small businesses cannot scale, but not all face this problem.
Some businesses stay small because that is what the owner wants. We entered the restaurant space acquiring 3 locations. The owner had built a wonderful brand for 30 years and was happy with his 3 locations. That brand now has 20 locations, and our restaurant group has 40 in total. Small businesses can scale. Part of our job is identifying which ones can and then making it happen.
I agree that as we move up in the market, buying bigger businesses, multiples will increase. There is no doubt about it. I am OK with that. Again, I am not just maximizing returns based on multiple paid. I believe there is value, aside from leverage, which we can add to make those companies better. I also believe the Permanent Capital structure, without its daily quotes and liquidity, will lead to better long-term compounded returns for most people. The average mutual fund owner has returns which are less than the fund. Why? Because they buy and sell at the worst possible moments. Real Estate is a great investment for most not just because it provides leverage, but because the holding periods are so much longer due to a lack of daily liquidity. It allows for the magic of compounding to work. I believe the same with Permanent Capital.
The article mentions that a HoldCo will always prefer a new acquisition versus reinvesting in an existing business. The HoldCo structure does allow for capital to flow where the best return is; that does not imply a new acquisition is better than reinvesting in an already-owned business. This comes down to management. The key to building a successful Horizontal HoldCo is top-level CEOs running the operating businesses. I truly believe that if I had unlimited AAA CEOs, I could own unlimited businesses. I will always reinvest in a business run by one of my top CEOs before buying a new business. Why? Because the expected return is not just the predicted % return on dollars invested. It is also the likelihood of it working out. Reinvesting in one of our businesses, led buy a top CEO, is a much higher % play than acquiring something new.
Yes, it is true that a Horizontal HoldCo does not lend itself to centralized efficiencies like Vertical HoldCos. That is the price I pay to have a wider field of acquisition opportunities. I believe that will eventually lead to a longer runway of growth. It will lead to more opportunities to buy great companies at reasonable prices led by people I want to work with.
It also increases my reliance on finding many quality CEOs. This continues to be our greatest threat to scalability. The ability to attract, retain, and nurture top-level CEOs. Aside from looking at opportunities, it is what I think most about. How to find the best people, create an environment they want to be in, and align their incentives with the company’s.
I do not know how the HoldCo story will play out, no one does. What I do know is there will be some extremely successful, some blow-ups, and a lot in the middle. I do know that it fits my investment profile and more importantly it fits what I want to dedicate my time doing. I love building a HoldCo and could not have designed a better “job” for myself.