The White Paper Work Continues
Diversification can get a bad rap in the investing community as “diworsification,” which is to say that if you are spreading your bets too thin, you’re not mathematically making any bets at all. Of course, a mitigating factor here when applying this framework to small, private companies is that these companies tend to be volatile and, as I’ve said before, can be at all times a few consecutive bad months away from a crisis. What that means is that if you are trying to build a compelling long-term return stream in our space, you need to be cognizant of aggregating highly disparate assets. Further, your odds of diworsifying among small, private companies is difficult because you can’t practically go out and acquire 100 or more all at once like you can in the public market, so the risk to be aware of is concentration, particularly if it’s inadvertent.
And that’s the twist re: diversification among small, private companies. Ones that look different can actually be quite similar and ones that look similar can actually behave very differently. So what makes a small, private company a disparate asset?
When it comes to public companies, for example, accepted vectors for diversity include size (even though almost all public companies in the overall scheme of things would be considered pretty big), industry, geography, and growth profile/valuation. Among small private companies, however, size doesn’t really apply, since none are big enough to not be fragile and nor, for the most part, does growth profile/valuation. That’s because valuations tend to cluster around the average and also because, as we like to stay around these parts, no business stays small on purpose, so the growth of any mature small business is definitionally being blocked by something.
That leaves industry and geography, which both apply and should often be considered in tandem, though on a more refined scale (e.g., it’s not US versus EMEA, but the Sun Belt versus the Northeast). For example, a pool company in Arizona makes a lot less margin on service than one in the Northeast because in geographies where it freezes and thaws, there is more price insensitive seasonal pool opening and closing revenue. And a fence company in a geography with soft soil will have better economics than one operating in rocky soil because of the throughput on putting up posts.
So if you’re building a portfolio of small, private business, here are some other vectors to consider:
Seasonality: A fireworks distributor will generate a much more reliable stream of cash flows when paired with a Christmas ornament manufacturer than it will with a pool toys manufacturer.
Business model: A service company that gets paid upfront will generate a much more reliable stream of cash flows than a construction business that has to try to collect 20% retainage.
Weather: We didn’t realize until it happened how much a rainy month in the Southwest would impact our pool, fence, and waterproofing businesses all at the same time.
Deal structure: If all of your deals have earnouts, it might be a long-time before you generate a reliable stream of cash flows, so if you do a deal with an earnout, you might complement it with a deal that includes a preferred return.
People: Your portfolio is significantly riskier if all of your operators want to retire within three years than if they don’t.
The point is that if you’re building a portfolio of small, private businesses then you’ll want to be as highly diversified as you can be, but also that what makes for diversification in this space can be incredibly idiosyncratic. So be aware of what your exposures are and aren’t with the goal of turning inevitable individual business volatility into a more reliable blended return stream.
-Tim