Issue #23: Micro PE in Public Markets

In high school I started an investment club. We met once a week in the computer lab to review that week’s chapter of The Intelligent Investor and examine our mock portfolios. Turns out, I wasn’t a good manager of high school students at the time (probably not any better today) and the club didn’t last long. But it gave me the chance to learn through teaching. The concept we talked about the most was stocks being ownership in a company, not just a number on a screen.

I tell this story because the concept finished sinking in two weeks ago when I was thinking about Ian Cassel’s micro cap strategy and something clicked. Ian’s strategy is a micro private equity strategy executed in the public markets. Then Dan Rasmussen’s papers, podcasts, and talks about using private equity strategies in public markets clicked as well. Buying small, profitable, stable companies at low multiples isn’t an exclusively private market strategy. So, if an investor wants to buy small, profitable, and stable companies, what are some differences executing that strategy in private vs public markets?

Putting numbers around it, let’s say the upper end of micro PE is $5 million in EBITDA at a 6x multiple resulting in an enterprise value of $30 million. Using $1 million enterprise value as the floor, I ran a screen for any U.S. based public companies between $1-30 million in market cap and found 1,671 companies. On the private side, according to the NAICS there are 395,055 companies with $2.5-10 million in revenue as of March 2020. Obviously this looks at revenue rather than earnings, but even if these numbers are off by 100,000 in either direction when looking at earnings, it’s clear the opportunity set in the private markets is orders of magnitude larger.

One of the biggest differences between the private and public versions of the strategy is capacity. Ian Cassel runs a $6 million fund to invest in micro caps, and he’s targeting companies with enterprise values all the way up to $50 million. Brent Beshore and his team at Permanent Equity on the other hand run funds of $50 million and $248 million. There’s a tipping point here where deploying larger amounts of capital becomes easier on the private side and I suspect Ian at $6 million is nearing the top end. This may be more balanced if an investor can make tender offers for larger blocks of stock, but I’m not familiar enough with the concept to comment.

Part of this constraint is transaction costs, which in the public strategy are passed to the company level in the form of compliance costs associated with being a public company and trading fluctuations. Buying a private company takes anywhere from 45 to 180 days and transaction costs shift to the investor. It may take even longer to accumulate a full position in a public company, which may not be traded often and could change dramatically in price over your acquisition period. If you start buying a public position and it moves from a market cap of $25 million to $30 million on no news over your acquisition period, is that $5 million increase in market cap not a transaction cost?

Unless you buy a majority stake in a public company, you will not have the control to change strategy, hire and fire staff and managers, issue dividends, or use leverage to acquire your ownership stake, all things which an investor would be able to do in a private company. You might be able to get in the ear of a public company’s CEO and influence his thinking and strategy, but ultimately internal decisions aren’t for you to make without a controlling stake.

In private transactions, leverage can be used to spread equity across more companies. With $10 million to deploy, I could acquire anywhere from 2-10 companies depending on deal structure. But the mechanics of deal structure are largely eliminated when investing publicly as I can only buy as much public equity as I have myself. Although, one could argue starting a micro cap focused hedge fund to invest your own capital while taking a fee for investing others is a form of leverage, but that’s a more complex strategy.

To conclude, who is each strategy for? For investors looking to deploy more than $10 million in a micro-PE investing strategy, I’d argue you have virtually no choice but to invest in private companies or become an LP in small and micro cap hedge funds. For investors deploying under $1 million (like myself), there are compelling benefits to a public micro-PE strategy namely being able to diversify your holdings across multiple holdings of different market caps. With under $1 million, I can take acquire shares in a $4 million market cap company and a $30 million market cap company in a timely fashion while passing transaction costs on to portfolio companies.

The space between $1-10 million is more grey. One could execute a public strategy, invest across search funds, become an LP, or invest directly. If the investing is all self-directed, I’d lean towards picking one rather than trying to do several at once. Buying private companies is a very different process than buying public companies and trying to do both sounds overwhelming. Better to stick with one and build a circle of competence before expanding.

If anyone wants to add to my train of thought, or sees something I missed, please reach out or reply to this email. I’d love to chat further.

Capital Notes

  • Permanent Equity released results from a survey of 336 business owners about the impacts to their business.

  • KKR released a macro focused report on the impact to the economy and debt levels.

  • Will Schoeberlein writes in this thread about Japanese government support of small business transitions.

  • Tim Ludwig hired a CEO for one of his portfolio companies and talked about the search in this thread.

  • Li Lu gave a speech titled The Practice of Value Investing which was outstanding.

  • Erik Berg wrote about lessons learned from over two years of weekly writing.

If you found an interesting article, podcast, or interview that I missed, please let me know, I’m always looking for interesting stuff.

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