More on Europe

I recently read an investor letter discussing the historical correlation between global mobility of capital and the propensity of banking crises.  It concluded the easier it is for money to move (physically or electronically), the more likely a financial crisis.  As soon as people think their institution or country is in danger, they move their money elsewhere and the problem is exacerbated.

This is currently happening in Europe.  Capital is fleeing the already insolvent peripheral countries (Greece, Portugal, etc.) to the core countries (Germany, Switzerland, UK) in a flight to safety.  In actuality, this trend is worsening their stance and banking systems.  A hedge fund manager framed it nicely saying, “Greece is like a business whose revenue base is declining (GDP), who generates revenue through receivables (taxes), who collects only a fraction of those receivables, and who has a huge fixed expense base that it can’t cut without enraging customers (the voters).  This is not sustainable, and definitely not a business you want to lend money to.”

At some point in history most countries have been overly optimistic, borrowed too much, got carried away, and weren’t ready when things deteriorated.  However, there is one risk specifically unique to Europe scaring many investors, including myself: redenomination risk.  What happens if the Euro falls apart?  What if certain countries leave and not others?  What currency will your investment be denominated in?  What will that currency be worth relative to the dollar?  Is there a way to hedge this?

Redenomination is scary, possible, and maybe even probable.  So what's an investor to do?  My best advice is to 1) study the language of each legal document to understand the ramifications of a currency change and 2) be careful when crafting new documents.  As detailed in my previous post, Catalus is now actively seeking European investments.  We are working to understand and mitigate redenomination risk, rather than letting it eliminate potential excellent opportunities.  I’ve included some articles below on the topic.

Banks Ponder Scenarios if Countries Drop Euro

Banks Struggle With Euro Contingencies

An EU Currency Breakup Would Be Unlike Any Other
Banks Prep for Life After Euro
Time to Think the Unthinkable on the Euro

Also, to review interesting investor letters like the one I refer to at the beginning of this post, visit the Neo-Alpha Blog.  

Entering Europe against the Grain

Like the entire financial community, Catalus has been watching European developments with horror and skepticism.  Unlike most of the financial community, we believe that where there is uncertainty there is also opportunity.  It appears that most European banks have restricted or discontinued lending until stability is restored, which means that our type of capital could start to play a larger role in financing growth, acquisitions, and recapitalizations.

Catalus, of course, differentiates between the Continent's countries.  We view the UK and Germany as the most desirable, with Greece and Eastern nations trailing further behind.  For us, the specific company, opportunity, and deal structure is far more critical than the "bucket" within which it falls.  Our focus will remain on existing cash flow and/or hard assets.  In a newly originated deal, our minimum investment will be $10 million (~7.5 million Euro), however it could be less for traded bonds or loans.

No one knows how things will end up in Europe.  It is probable that it will struggle for a number of years to come and possible dramatic changes will be made to how the Euro zone is structured and governed.  Certainly there are countless risks.  Nevertheless, as of today we are updating our website and online profiles to include European investments.  Although we may be getting in a bit too early, we believe in the end Europe will prevail and emerge as a stronger global competitor.

Catalus will start an online campaign to generate European deal flow.  We will be actively searching for companies looking to borrow money and for intermediaries (investment bankers, deal brokers, lawyers, accountants, and others) that can help make an introduction.  If you are in the market, we would love to hear from you at marek@cataluscapital.com.

A Quick View into the Shark Tank

A good friend of mine who is a trader on Wall Street sent me an email saying, “Have you seen Shark Tank?  It is exactly how the public sees private investors.”  I figured I should check it out.  The show is almost like an American Idol... for investing... complete with all the drama akin to Mr. Trump’s “You’re Fired”.  A story is told about an (innocent and naïve) entrepreneur raising funding for his or her next “big thing,” who then pitches the idea to a panel of five (aggressive and merciless) investors.  The high level deal terms are negotiated right there on the spot and the venture is either funded or not.

Granted this is reality television I'm writing about, as someone who goes to work everyday as a private investor I have to vent.  The whole concept of the show is completely at odds with what I believe to be the most important aspects of investing.  These investors listen to a five to ten minute pitch about the company raising capital, couple it with the same amount of time for Q&A, and their decision is made.  (I won’t even get into the fact that this show focuses on start-ups, perhaps the riskiest investments of all.)  How can someone make an informed decision about an industry and business they know little to nothing about after a brief conversation? What happened to everything that makes investing difficult? My reality day in and day out consists of extensive industry-specific research, meticulous diligence on financial prospects, investigation of a management team’s track record, and competitive analysis.

So, going back to my friend's email.  If the public views private investors as they are portrayed on Shark Tank, then that’s quite a shame.  What makes me more worried, though, is that based on some of my daily interactions with investors and capital raisers, maybe Shark Tank isn’t too far from reality at all…

The Forgotten Middle

At Catalus our focus is investing in middle market companies.  These are loosely defined as businesses with revenue between $10 million and $1 billion.  I'm not an economist so I won't recite the statistics, but, according to an opinion piece in the WSJ, the middle market produces 40% of our nation’s GDP and employs 32 million people. At Catalus we believe this market is full of potential.  It is the glue that keeps the US economy together and spurs innovation.  It is where tomorrow's leaders are born and how America stays competitive globally.  The general public, the government, and most investors, however, do not share this same outlook.  Most favor larger and public companies.  This makes running a middle market business, raising money for one, or investing in one a challenge to say the least.

So why are things so difficult in the middle market?  First of all, because of the generally luke-warm attitude, it just doesn't have the access to capital it deserves.  This, combined with less sophisticated financial and operational reporting, substantially constrains growth.  I find it odd that venture capitalists have money to burn when it comes to start-ups with huge losses, but when approached by a profitable, consistent, and stable company, there is limited equity capital available.  

Further complicating the situation are the dynamics inherent in the middle market investment community.  The arena is fragmented, highly inefficient, and deal flow is based on networking, word of mouth, and personal contacts.  The result?  Deals delayed or not funded at all because they never crossed the right person's desk.  In recent years, numerous websites have launched attempting to correct this problem by connecting investors and businesses in an open forum.  Catalus supports these sites, but unfortunately most are focused on M&A, not the minority capital raises and lending situations that need it most.

Finally, the WSJ article above discusses the middle market regulatory landscape problem.  In short, it is fickle, contradictory, and constantly changing, making it near impossible for companies and investors to feel confident about the future. 

Despite its difficulties, Catalus remains excited about the middle market and will continue to invest growth capital.  While we are well aware of the challenges, we see even more opportunity and talent.  

How to Invest During the European Crisis, US Slowdown, Fiscal Irresponsibility, and Stock Market Chaos

There is a lot to be worried about in the world today.  If you’re intellectually curious enough to read this blog, then you’re probably well informed of the problems we face:

• One by one, Europe’s nations are failing.  The only country seemingly not at risk is Germany, whose ingrained culture of discipline kept it fiscally and economically prudent while its neighbors did the opposite.  Germany will have to decide whether to bailout Europe and save the Euro or break up the union (read Michael Lewis’s controversial take on it here). 

• US economic growth has stalled, unemployment is up, housing is sputtering, and the Fed is running short on its magic bullets.  

• Over 65% of US government spending is payments to individuals (see WSJ chart), which creates an illogical dynamic where the government’s #1 job is to subsidize peoples’ lives.  The downgrade of the US as a creditor is probably the beginning of a series of negative events, not the end.  

• There is a panicked feel in the financial markets, best reflected by the VIX volatility “fear” index reaching historical highs last week.

These are structural issues that will be around for years (with the probable exception of the notoriously volatile, volatility index).  They affect our decisions and our finances, but there isn’t anything we can do to change them.  Instead, we can incorporate these issues into our decision-making process and take advantage of the opportunities created.  We’ve all heard the many variations of, “buy when people are panicking, sell when they are exuberant”.  It sounds pretty simple, but it's difficult to execute when the headlines are blaring the world is about to end.  It requires a high level of discipline, an avoidance of greed, and the ability to confront fear. 

No matter what is going on in the world today, one thing remains the same: the importance of investing in quality businesses.  Potential return, deal structure, and everything else are all secondary to quality.  A strong business will perform in all economic cycles, and more importantly, will be around after this cycle is over to fight another day.  These are companies that offer a highly desirable product or service that customers value and would not easily substitute.  These businesses strive for integrity and excellence in all of their endeavors, and have shown repeatedly that they can win.

It is crucial to remain prudent and cautious at all times, good or bad.  During times of excessive optimism, don’t forget that challenges are just around the corner.  When the problems do come, don’t let them render you immobile.  Times like today can offer the greatest opportunity.  Apply the same rigorous analysis and diligence that you always do, while following the principles of integrity, diligence, and discipline.  You might surprise yourself. 

What's More Important: Growth or Return on Investment?

Investors are obsessed with growth.  Articles and investor reports constantly hold a microscope to growth rates and how they are changing.  The attention seems to be on revenue, rather than gross profits, EBITDA, and net income.  Why does everyone marvel at growth analysis when investor returns can be equal or better from steady, repeatable cash flow?

The companies I like generate relatively consistent levels of EBITDA and cash flow from year to year (in other words, they are boring).  They may grow a little or fall a little (gasp) but they have healthy profit margins, strong balance sheets, and have created a niche in their market.  Historical growth and future prospects are important, but don’t get my attention like sustainability of the existing revenue stream.  Will the business keep its historic revenue and profitability for many years to come?  If so, it’s a quality company offering a service/product that people want and growth will take care of itself.

I think growth is generally overvalued.  For example, in the early stage tech sector, barely-profitable businesses are being valued at many billions of dollars, with astronomical multiples.  The only way investors are making outsized returns is unprecedented growth or the “greater fool theory” (investors manage to sell their holdings to another round of even more bullish investors).  Meanwhile, the blue chip tech companies like Microsoft, Intel, and others are very modestly valued.

Maybe people focus on growth because they think it’s the only way to make outsized returns.  I don’t buy it (pun intended).  A pretty simple analysis can prove my point.  Say an investor buys a middle market business that has been around for 20 years making relatively steady results.  He pays 4x EBITDA, keeps this identical profitability for 5 years, and then sells it for the original purchase price.  The result is a 20%+ annual compounded return from dividends.  If moderate leverage is used (provided by Catalus of course) it becomes 30%+.  Add some normal business growth and the return accelerates further.  The assumptions can vary, but the opportunity to make substantial returns remains.

The Only Thing Certain About Financial Projections is They are Wrong

Over the years I’ve personally built dozens of financial models (ok maybe hundreds but I wouldn’t admit that in public) for companies ranging from $1 million to $10 billion in sales.  Models forecast revenues, expenses, cash flows, and scores of other unpredictable metrics.  They are built on a set of underlying assumptions about growth rates (note: in models things are always growing) and ratios between various metrics.  Some small and simple businesses have financial projections that are relatively straightforward extrapolations of recent trends.  For complex companies with a series of input costs and multiple streams of revenue based on supply, demand, and pricing, projections can get unbelievably robust.  Whether models only occupy a few of your precious excel tabs or kill an entire forest to print, the only thing I can tell you for certain is they are wrong.

Nevertheless, I still believe in the process of building a model.  If you’re the buyer of a company or an asset, creating a truly comprehensive financial forecast helps you learn the key drivers of the business and how sensitive profitability is to those items.  If like me, you provide financing to people acquiring assets, a model can tell you if the person who built it is crazy!  I’m shown “hockey sticks” all the time (a euphemism for exponential growth).  If you show me projections of 25% growth on a company that has averaged 5% in the past 5 years... well that's all I need to know.

I believe past performance is the best indication of future results, especially when compared to a guess (model).  If your company made $10 million in EBITDA for the last 5 years running, I’ll put good money on that rate continuing for the next few.  If your profitability declined 50% in 2009 during the recession and then recovered, I’ll bet the same will happen the next recession.  If you’ve built up companies and created profitable ventures in the past, then yes, you’ll probably do it again.  I focus on historical results and quantifiable assets and cash flow to determine value and an investment's prospects.  I dig deep into the company to understand the underlying drivers, trends, changes in the industry, management team, supply, and demand to see what has changed.  I look for steady, increasing, or somehow replicable cash flow and/or hard liquid assets that I can sell if things go wrong.  A forecast model won’t give me any of that information... but at least it will tell me if you’re crazy.

Bank Said "No"

This week in the New York Times there was an article about the type of lending we focus on at Catalus: “Bank Said No? Hedge Funds Fill a Void in Lending”.  Banks are extremely conservative today, lending only into the most attractive geographies, requiring a very conservative LTV (loan to value) against hard/liquid assets, and expecting robust cash flow relative to loan payments.  We partner with businesses that have been rejected for bank financing, wouldn’t be eligible, or didn’t get the full amount needed.  Catalus provides capital where banks won’t.

I always tell borrowers, “Get as much bank financing as you can.  It is the cheapest capital available.  If they don’t give you enough or if they don’t give you anything, Catalus will try to work with you to fill the gap.”

The difference today in the lending markets of large versus smaller companies is striking.  Blue chip companies like Johnson & Johnson, IBM, Google, and Microsoft are issuing debt at some of the lowest yields in corporate history (I’m talking 1-2%).  The high yield index, tracking a basket of junk bonds, is also at historical lows after being at an all-time high during the apex of the financial crisis.  Institutional investors who can only invest in investment grade debt or public markets are desperate for yield.  On the other hand, companies not large enough to tap into public markets live the story described in New York Times article.

Investing in a smaller private business warrants a higher return because it is more complex and risky.  Larger institutions are scrutinized daily by thousands of analysts, investors, the media, and other interested parties.  They use the highest quality auditors, law firms, and advisors.  Information about the history of the company, the management team, and the financial performance is readily available.  None of this holds true for the private markets.

When Catalus partners with a private company it’s a very personal experience.  We seek companies and people we believe in and get fully educated on the business, the industry, and the management team.  Our investments are viewed as long-term partnerships and our financing package typically includes a minority ownership stake and a board seat.  In this role we are active by making introductions to potential joint venture partners, working to improve efficiency/operations, conducting financial analysis, and assisting in the evaluation of acquisitions and expansion plans.  Our goal is to add enough value that when our partner companies want additional capital they come to us first.

Getting Comfortable

Goal #1 is not to lose money.  Goal #2 is to generate an adequate return on capital.  However, too often people seeking investments focus on Goal #2 and don't provide sufficient information to evaluate the risks of Goal #1.  Anyone raising money needs to see things from the investor's perspective.  An investor that is serious about a deal will want to know essentially everything and anything relevant to the transaction or business, preferably in an easily digestible format.

Often a potential partner will mention a report or document and say, “I don’t know if you would even be interested in that information.”  Of course I would!  If it’s relevant, I want it.  Even if it's barely relevant, I still want it.  This person has usually been in the industry for 10-30 years, and I have 10-30 days to get on his or her level... I need information.

Many investors say they need to "get comfortable” with a deal before moving forward.  It’s an odd phrase, but completely accurate.  Every detail needs to be understood to determine the risks of a deal going sour.  I need to "get comfortable” with the people I’m partnering with, the strength of the underlying business, the value of the assets, the transaction structure, and the factors that could cause things to go sideways.  I want to know how the business operates, how employees do their jobs, what customers want, what type of demand there is for the product, what the competition is like, what the challenges are, what type of character or track record my potential partners have… you get the point.

A while back I was speaking with the CEO of a company in which I was considering investing.  We were in touch for several months and I considered myself thoroughly educated on his industry and business.  I read industry materials, evaluated tangential businesses, spoke to other investors in the space and the CEO at length, and asked hundreds of questions about the business.  Even though I learned something new every conversation, I still felt I had a pretty solid handle on the deal.  Then, out of nowhere, in some obscure data I requested I found information indicating the company was essentially outsourcing a major function.  This had never been mentioned and I was shocked.  When I confronted the CEO he explained he did indeed outsource this part of the business and promptly explained why.  His reasoning was perfectly logical and I didn’t see any drawback to outsourcing.  Nevertheless, I was quite spooked.  I had spent months learning about his company and industry, but somehow this piece of information slipped through the cracks.  The CEO didn’t seem to think it was a big deal, and exhausted himself explaining why outsourcing made sense.  He didn't understand my concern wasn’t why they outsourced, it was he never told me the outsourcing existed.

Enemy #1 of investors is uncertainty.  You hear it all the time in the stock market- the press reporting prices dropping because of some event creating uncertainty.  If you take away anything from this post I hope it is this: you have the power to eliminate uncertainty for investors.  Provide them with information about everything and anything that impacts your business in any way, shape, or form (you'll have to put in the work to provide it in a format that isn't overwhelming).  Investors can then take that comprehensive education and evaluate whether or not they can "get comfortable” with Goal #1. 

Welcome to Catalus Corner

Welcome!  My name is Marek Olszewski and I’m the Managing Partner of Catalus Capital.  Given the rising popularity of blogs, I was surprised to find there are almost none written by practitioners of private investing.  It seems the industry is rather closed off to outsiders, so I feel a blog by a fund manager will be valuable.  My first post will be an introduction, but in the future I will discuss specific deals I’ve worked on, share my views on the marketplace and current popular topics, and of course get Catalus some exposure (investors are rarely purely altruistic).

Catalus is a fund that invests in middle market companies, and has wide flexibility to consider a diverse set of opportunities.  We would generally be placed in the Private Equity bucket, but more specifically are a mezzanine firm.  We make minority investments in companies or projects, typically in the form of preferred equity, subordinated/senior debt, or mezzanine loans.  Catalus does not buy entire companies, we don’t take control, and we don’t buy common equity unless it’s a part of a larger deal.  We feel this role is the best way to execute our strengths, as we’re not business operators and don’t want to specialize in any one industry.  Catalus wants every transaction to result in a genuine partnership.  We help evaluate major decisions and projects, and want to reinvest in our partners after the initial deal.

Our target investment size is between $3 million and $20 million.  This is an abnormally wide range, and over time you’ll find this isn’t our only atypical trait.  Our first level of screening simply looks for cash flow of over $2 million in EBITDA, or assets that can serve as sufficient security for our investment.  If a company has neither then we immediately, but politely, pass.  The deals we consider fall into 3 categories:

1.  Business Growth: A company has been in existence for a number of years, has been growing, and has been profitable.  There is an experienced management team in place that is passionate and dedicated.  They have identified an opportunity to expand, and require additional capital in order to execute.  Examples can be an acquisition, purchasing more inventory, opening new locations, hiring, or buying a couple million dollars of tuna (true story, we passed).

2.  Private Equity Financing: We will help finance a PE firm’s acquisition.  They will typically put up 30-50% of the money as equity, and we will help finance the rest.

3.  Asset Backed Lending:  If someone has a hard asset that has a quantifiable value, we will consider lending against it.  This can be anything from oil wells to real estate to an old military bunker (passed on that too).

If you have a deal for me to look at, please email me at marek@cataluscapital.com.

With regard to my background, before Catalus I was a Managing Director in Nasdaq’s Corporate Strategy/M&A group.  We looked at acquiring companies around the world including financial technology firms, internet companies, workflow solution businesses, investor relations products, clearing funds, and exchanges.  The very last deal I worked on was the NYSE bid.  I also worked with the heads of Nasdaq’s five business units to grow and to determine their strategy.  This corporate business experience helps me share a unique set of skills with our partners that most investment funds don’t have.

Before Nasdaq I was at Fieldstone Private Capital, an energy and infrastructure focused investment bank.  I worked with large energy companies, developers of greenfield projects, and investment firms on transactions involving wind farms, ethanol plants, power plants, and oil/gas fields.

I attended the University of Pennsylvania, where I majored in Economics and got a minor in Urban Real Estate from the Wharton school.  I’ve also passed the Level 2 CFA exam (haven’t quite had time to do Level 3 yet).

In high school and college I turned a hobby of selling and installing car parts into a small business brokering and dealing cars around the world.  Around the same time I served as an advisor to an exotic car club start-up, Velocity Club.  I had a supporting role in starting the business and completed my responsibilities the day of the launch party (it was a good one).  The Velocity Club was how I originally met Michael Freeburg, my partner in Catalus.  He runs and owns Greenwich Wealth Management, a firm with over $1 billion in client assets.  Mike and I have worked on countless projects over the years and I am lucky to have met him.  Without Mike, Catalus wouldn’t exist today.

Although I’m new to the blogging world, I’m excited about it.  Tell me some topics you want to read about and hopefully we can learn from each other.  Talk to you soon.