My guest on this episode is Andy Ellis, a managing partner of Localize Capital in Pittsburgh which, as the name suggests, focuses on investing in companies and entrepreneurs around the Pittsburgh area. Little known fact about me, I used to live in Pittsburgh as a young kid and was extra excited for this conversation because of that. Andy grew up in Pittsburgh, worked in Southern California, and eventually moved back to Pittsburgh to help form Localize.
Andy and I talk extensively about the structure of Localize and how they choose to invest in companies over a very long term, with a core idea being to look for owners who think not just in years, but generations.
You may have heard of the concept of finite and infinite games, a concept written about by author James Carse. A finite game has known players, a beginning and end, and set rules, whereas infinite games have known and unknown players, no end, evolving rules, and the goal is to perpetuate the game. If this concept sounds interesting, this conversation is for you as we discuss this concept in the context of private equity and entrepreneurship.
Went to school in Cleveland, Ohio, returned home to Pittsburgh after school and started with an investment management firm here in Pittsburgh. Was on an internal sales desk here in Pittsburgh for a few years before having the opportunity to move to an external sales position in Southern California. So was able to stay with the same company, continue to work with all the people that I had been working with, but was able to move across the country, live in a new place, and meet new people. Spent a little over six years in Southern California in a few different beach towns when I came up with the idea for Localize, which is the current thing that I’m doing, and Pittsburgh was a natural place to come and test the thesis. And I can dive into that if you’d like. Being from Pittsburgh it was convenient, easy, and comfortable. And moving from a place that was very high cost and prohibitive toward taking risks, moving back to a place that we were very familiar with and that has a comparatively very low cost of living, put us in a position with the amount of money we had saved, take the leap and to take the risk.
When I was working at the investment management firm I had made friends with a gentleman who did a lot of macro-credit analysis, and he was a short seller. And he typically ran his portfolio from about 70% to 100% net short. I found this very intriguing for a few different reasons. One, it provided us with a product to sell to people that wanted to hedge equity exposure, which was a nice thing to have because what I was doing was I was a wholesaler of mutual funds, and it enabled me to open up a lot of doors that otherwise would have been difficult to open. So I was drawn to it from that perspective, but more than anything I was drawn to the analytical framework of my mentor who ran the portfolio, that he was able to be 70% to 100% net short the market at all times and was able to withstand raging bull markets.
So you think about it, in order to do that you have to have a high level of intellectual honesty and really be able to build out an analytical framework and very stringent risk parameters. So I was really drawn to the way he viewed the world, the analytical framework or prism through which he viewed what was going on in the world. So I started to follow that pathway and he was very gracious with his time. I asked a million questions, a ton of very simple questions, trying to get to the root of a lot of different things, and he very frequently was recommending books to me that were extremely difficult to read. And I think that might have been one of the ways that he weeded people out whenever they would ask him questions potentially. But I read the books. I read some of them multiple times and highlighted and took notes and came back with questions.
I was really drawn to his analytical framework and the way that he thought about the world and how he managed portfolio risk. I had thought about potentially getting into short selling and trying to join his team, but I also saw that it was a really tough job and he, most of the time, was thought of as a pariah or an idiot, and he was very frequently alone doing his analysis and running the portfolio. Then when the market hit the skids, he was the most popular guy in the building. So the life of a short seller can be very lonely and that would be very, very difficult for me. So I didn’t want to be a short seller and at the time I was learning from him, that was mainly through my 20s. I guess that I was mature enough to know that I didn’t know anything. I was learning a lot from him, but for every one thing I learned there were 15 things that I uncovered that I just didn’t understand, that I had yet to learn. So I didn’t have a clear pathway or understanding of what it is I was supposed to do with the knowledge and thought processes that I was learning from him.
It took quite a long time to come up with my own thesis and take. One of the things that I really admired about him too was, he writes every week. When you go to his blog, he wasn’t just reading Austrian economics and saying, “I subscribe to the school of Austrian thought.” He took bits and pieces of their analytical framework and would weave it into his own analytical framework. So everything from Canes, to the Austrian school, to George Soros’s Alchemy of Finance, to Henry Coffman, to Kindleberger, to you name it. The list goes on and on. It was nice because I could read the books but then also read his commentary and his thought process on it, which was really interesting. So here I’m learning his analytical framework and his view of the world, learning about how his view of the world was informed by these things, and trying to figure out well, what’s my take on that? His portfolio, like what he does, is a manifestation of all of these things that he’s learned. What is that thing going to be for me? It took a long time to come to that and I’m happy to say that I think I’ve found something that I can be bullish on as opposed to be a short seller and be thought of as a bear.
That’s a long-winded way of getting to the genesis of what we’re doing now, but one of the things that I talked about a lot with my mentor was this notion of there being two economies, there being the financial economy and then there being the real economy. That was always something that intrigued me and I would ask him a lot of questions around that and talk about regulation in one versus the other. Like is the tail wagging the dog or is the dog wagging the tail? Because these two things work in conjunction with one another. Is there correlation, causation, how does that shift through time?
So one of the things that brought me back to Pittsburgh that I think is so interesting and it helped inform a little bit of what we’re doing with Localize, there’s a gentleman named Henry Hillman. The Hillman family owned an industrial empire. They owned many businesses. And when Henry Hillman inherited this industrial empire in the ’70s, he liquidated a lot of the companies. He sold these businesses. These were real economy businesses. And one of the things that’s so intriguing is a little known fact that Henry Hillman actually funded two very prominent … He didn’t fund, he seeded two very prominent private equity shops. He was 33% of KKR’s first LBO fund, and he was 50% of Kleiner Perkins’ first venture capital fund. The venture aspect is interesting because given that Carnegie Mellon is here in Pittsburgh, he wanted them to run Kleiner Perkins out of Pittsburgh and they told him hell no. They were going to California and it probably was … I mean based on path dependency who knows if that would have materially changed anything, but they went to California and the rest is history.
Point being he was liquidating these businesses and turning them into financial assets. And that was decades ago, and now you look around and year after year more businesses are being turned into financial assets, as opposed to privately held businesses that are run for different timeframes, with different preferences, with different … Essentially using this operating company to optimize for different outcomes, it’s becoming more and more potentially uniform as a result of the capital that is buying and owning these companies looking more and more similar.
You’re saying the financial economy is using the real economy for different means than the real economy might intend those to be? So, instead of the business owner running the business for themselves the way they’d like, there’s a financial piece of the economy that comes in and manipulates it to a different set of means?
Yeah, and it’s maybe less about intentionality or what this part of the economy wants or that part of the economy wants. It, to me, has just more to do with when you own a private asset and you’re running a private company, you could … People buy and run companies for different reasons. That might be one portion of your portfolio that you strictly bought and use to run a loss, to offset some sort of gain that you get somewhere else or something of that nature. But when people are buying up those assets for the sole purpose of using it in a traditional private equity fund, those traditionally have pretty similar objectives. The types of LPs that deploy capital into those funds typically have certain expectations about what type of risk it’s going to bear and what type of return they can expect as a result of it, and what type of timeframe they can expect that in. So again, the podcast that you’re doing is interesting because I don’t know if this has existed all along or if it’s just becoming more apparent as a result of Twitter and podcasts and things of that nature. To some extent family offices have been doing this forever. It seems that there may be some sort of a shift toward a longer term focus in having sustainability and survivorship and generation of unlevered free cash flow into perpetuity as a more attractive option.
So it seems like there could potentially be some sort of a shift. Maybe there’s just more of an appetite from LP based to want to invest in that type of private asset. I don’t know.
And is Localize specifically a vehicle that’s backed primarily by the capital of your other various partners or are there investors who come in as well?
We’re in the process of raising two separate funds, two separate strategies, that work in conjunction with one another. I come at it from a perspective of more of a macro perspective, it’s called Localize for a reason. We want to localize assets. I’m generally a happy go lucky guy. Again, I didn’t want to be a short seller. But I still find myself having thoughts about beautiful cash flowing assets that are owned for the purpose of applying leverage to them and potentially flipping them down the road that are owned by a private equity firm across the country. One example is just after moving back we took our kids to this really great amusement park that is for small children. It’s not like massive roller coasters. It’s called Idlewild. It’s up near Ligonier, Pennsylvania. It’s east of Pittsburgh. I think it was funded by the Mellon family. But it’s one of the oldest parks in the country and it is a beautiful asset to our region. And I’m sitting there, I’m standing in line and looking around at all these people shelling out money for soft pretzels and slushies and buying their kids all these gadgets and having all this fun.
And given my previous work I got to see what people invest in for retirement, and I couldn’t help business think here we are standing in this beautiful asset to this region that we all support and love, and we come here and we spend our hard earned money on, and I’m looking at all the people walking around spending this money and I’m thinking to myself that guy has T. Rowe Price, that guy’s in Vanguard, they have all these different retirement accounts and I bet if I stopped and asked them they’d have very little clue what they actually own in their retirement accounts. Some of them would. Some of them might know a portion of the assets they own. But generally what they’re doing is they’re looking for income in retirement, yet here we stand in one of the oldest parks in the entire country that’s in our backyard and it is literally owned by a private equity firm in Spain.
I know that we couldn’t possibly repatriate all of our capital and invest it in all local assets, but it also seems to me that there’s an opportunity to at least bring some of the capital home and to create a market whereby people who are seeking income from assets that they understand and can see and feel and it means something to them, it seems like there’s an opportunity for them to seek a portion of that income for retirement within the region.
With trying to localize capital, it sounds like most of the capital for from fund you are raising from local investors. Is that a big part of your pitch to them is saying now you can invest your money here in Pittsburgh with us?
It’s not our personal capital. I wish that I made enough money in my previous job that I could have done this and this is absolutely how I want to invest my wealth moving forward, is to have a significant portion invested within my region in a fashion that makes sense for my long term objectives. I want this region to get better. I want young people to start or continue to move here, start businesses here, work here, start families here, et cetera, et cetera. And it dawned on me as I was living in California and I would get harassed by my aunts and uncles. And I’m going to make them listen to this podcast so they’ll both get to hear me say this. But they used to harass us. I had a few cousins that lived in LA with me and they’d say, “I can’t believe you guys live in Los Angeles. Why don’t you move back to Pittsburgh?” I mean, even my uncle that lives in Dallas would harass us about moving away. And it finally dawned on me a little where I used to start to harass them back and I would say, “Look, we followed your money.”
You’re a lawyer. You’re a doctor. You are some sort of professional. You make money, you pay for your base needs locally. Sure you go to local restaurants and things of that nature, but all of your excess capital, you take it and you invest it typically on the coasts. It’s invested with investment firms on the coasts. Typically a lot of the companies that you’re invested in are not within this region, and then you harass us millennials for moving away from this city when really we followed your money. The idea being that we want to get more money invested locally and that’s absolutely, we think, going to be a huge motivation for why people will invest with us, even just if it’s a small portion of their overall net worth. So yeah, the idea is to engage high net worth, ultra high net worth individuals, entrepreneurs, people who still own operating companies, people who have sold operating companies, and single and multi-family offices.
And are they pretty excited about being able to put a dollar somewhere in the region? Does that resonate with most of them or are most of the investors you talk to still like, “No, I just want the best return and wherever I get that I don’t care as much.” Where do people generally fall?
It’s a mix and it’s all personal. But the fact of the matter is is that I think a lot of people want to invest locally, but right now their options for doing so are “high risk startups” and real estate. And many of these people already own real estate locally. So their options for bringing money home are small. They don’t have an opportunity. And fact of the matter is the majority of them, what they want and need is actually income from a stable asset. Well we actually have that here in spades. We have tons of great multi-generational family businesses that are extremely independent, they manage their businesses with very little debt, they optimize for unlevered free cash flow and they manage for survivorship. They have a playbook for how they have lasted through inflation and recessions and things of that nature, and they don’t view their business as a financial asset. They’re not trying to optimize their EBITDA to try to ratchet up their enterprise value. They just don’t care.
We have that mentality. We have those businesses in spades. And I think it’s exactly what people … These yield starved investors, it’s exactly what they’re craving and it’s in their backyard. And by explaining … This is what we’re trying to do is by explaining that it’s so detached from how the young people coming out of Pitt and Carnegie Mellon and all the other universities locally, it’s the antithesis of what they are being taught in regards to how they should start businesses. So it’s bringing the high net worth individuals who are seeking income together with the people that own these big beautiful cash flowing assets and getting them to agree.
So the fund structure, there’s two funds, but collectively we called it a shared risk partnership. Collectively the stakeholders are going to share the risk to invest back into the region to motivate and push entrepreneurs to build and grow sustainable businesses with sustainable business models, and pass down the stories that these multi-generational family businesses have. This ethos and what’s been ingrained in them for generations or decades, it’s not being transmitted to the next generation of entrepreneurs.
That’s the big motivation is if we want to see our region grown again … We were the richest city in the country at the turn of the last century and everyone’s talking about how Pittsburgh, with all of our innovation and all of the tech coming out of these universities, we’re going to light the world on fire. We’re about to arrive again. If we haven’t already. And the irony to me is you talk to a lot of entrepreneurs and you talk to a lot of people in the ecosystem, we ask them, we ask these young entrepreneurs to plan their exit before they’ve even started running a business. They are starting and building the business, they’re optimizing that engine to build something that is designed to be sold. And typically it ain’t being bought by somebody in Pittsburgh. Typically it’s being bought … If you can ratchet up the valuation enough through sequential rounds of financing and hit your fundable milestones and build this business, if you’re getting bought out a really high enterprise value, traditionally you’re getting bought by someone in New York or California. And oftentimes what happens is most of those jobs leave.
Not to mention, the insurance companies in Pittsburgh that used to underwrite the insurance for these companies. All of the other tangential businesses and service providers that depend on those businesses growing here and growing where they were planted, that business all goes away as well. So I think it’s important stuff. It’s not that businesses shouldn’t be sold and they should be run by the same people and owned by the same people into perpetuity, but from the outset it’s completely contrary to the way business owners and operators here in this region think about their businesses. Right now we’re turning these business plans, before they’re even businesses, the plan is how do we turn it into a financial asset?
It sounds like with Localize a big part of your mission so to speak is education and trying to teach these owners and even students coming out of school that have been learning about what we talked about the finite and infinite games. They’ve been taught the rules for the finite game even though they’re about to play the infinite game. Can you describe the two and how that education works into what you’re doing?
I laid out a little bit of the framework here where it’s like as a region, as a city, as a place that is trying to grow and attract more young people and attract more capital, we’ve set up the rules of the game. I think it’s very often helpful to … Playing finite games is in and of itself not a bad thing, but you still have to understand the game you’re playing in the context of the greater meta game at play. And if you lose sight of that, what ends up happening is it leads to a lot of frustration and confusion. So yeah, it’s a re-education process in the sense that moving back and getting ingrained into the entrepreneurial ecosystem here, it was so common for me to hear … And this is something that I heard in my past life selling financial products was, “Oh my gosh, these people are so risk averse. They’re so risk averse. It’s unbelievable.” I always have to pause, and I thought this whenever it was a financial advisor client of mine and I think it whenever I talk to a lot of entrepreneurs.
No, this person is not risk averse. They have an aversion to the risk they’re being sold. The ecosystem is trying to suck more money into the system to play this very defined game. Venture capital serves a very specific purpose when done the way it is intended to be done. You’re investing across a basket of ideas or businesses. You have a basket of X number of idiosyncratic risks where each idiosyncratic risk has a potential to create such a massive return that if the majority of them fail as they so often do, then just the two or three successes within the portfolio will return a great return. It’s a mechanism that is designed to fund very specific things. But given that banks aren’t giving loans and money’s hard to come by when you’re a young person and whatever, venture capital has become this thing where it’s thought of as our savior.
You look at a lot of the venture capitalists in some of these small cities, they’re looked at as the potential savior. They hold the key. If only we had more money, we would have so many amazing businesses and so much success and so much wealth. We just need more money. We just need more money. So it’s re-informing this at an ecosystem level thinking about what is the game we’re playing at the ecosystem level? What are the finite games that are being played within the broader, more infinite game that we’re playing as an ecosystem? Finite games are from a book written by James Carse. It’s like game theory on the edge of like philosophy, which I love to geek out on and think about. But finite games are games where you have known players. There’s known boundaries, known roles, and defined objectives.
Thinking about the entrepreneurial ecosystem, we have known players such as incubators and economic development corporations. We have the investors, the institutional investors. We have angel investors and angel syndicates. We have all the universities. There are these known players in the ecosystem. And the thought process is if we can get these ideas out of the universities and start to commercialize them, we can utilize all the resources in the ecosystem, play this game, and the game is to optimize for building businesses that achieve really massive enterprise values where many people within those organizations own stock so that you can reach a liquidity event, whether that be a large acquisition or an IPO. And once we get a few of these really big exits, all of that money’s going to be recycled back into the entrepreneurial ecosystem and create more and more and more and that’s what happened out in the valley.
So we find ourselves playing this game, but we’re looking at a lot of the stakeholders in the region going, why aren’t they playing the game? Why don’t they see how serious this is? We’re building businesses here that can change the course of this city, why won’t they give us their money? Why won’t they invest in this model? So we’ve been playing this game for a very long time and there’s a lot of frustration and confusion around why so many people don’t engage. People get in their heads, well there’s no money here in Pittsburgh. That’s wrong. It’s dead wrong. There is tons of money here. And this notion is perpetuated within the ecosystem also that money’s a commodity. And this is something Brent talks about a lot and it plays into some of this game theory stuff, but money’s not a commodity because it’s attached to people and people have preferences and needs and wants and fears. What we’re trying to do is to educate the entrepreneurs and show them look, there’s another way. You can actually play a game that makes sense to the stakeholders that are here that are playing an entirely different meta game than you.
They’re playing an infinite game. An infinite game is there are both known and unknown players, the rules of the game can change, and the purpose, the objective of the game is to perpetuate the game. So they say there is actually but one infinite game, it is life. The people that run these larger multi-generational organizations are playing an infinite game. They’re managing for the very long term, for survivorship, to pass something on to a future generation. And once you start to think about that in that fashion, then their actions and their behaviors start to make more sense. So then we can ask ourselves, well, can we meet them where they are? Maybe they would be willing to contribute resources. Maybe they would be willing to mentor and to invest on terms that actually make sense to the game that they’re playing.
How do you take the … Maybe it’s not exactly private equity what Localize would be doing, but that model seems to be a very finite model in that you acquire, run, and then sell at some point. So what are your thoughts around trying to meet them at their infinite game using a buyout strategy of sorts?
It’s something I think a lot about and I think that our strategy’s going to evolve through time. Everything I’m about to say is a result of we’re just getting started. This is the first time we’ve done this. People do similar components of what we’re doing. We’re trying to bring those things together and do it underneath one umbrella for a common purpose. So the things that I wanted to do away with were the notion of making an investment strictly for the exit at a higher price. If you think about the three stakeholders, the LPs that we’re engaging, they’re frustrated potentially with Johnson & Johnson’s business plan not changing in decades and the price changing by the picosecond and they can’t understand why. They’re having trouble with holding for the long term where there’s this massive liquidity mismatch with all of their assets.
So they’re looking at these businesses and what they want is they want to participate in the operations of this business that is generating free cash flow. The way we’re structuring the fund one, which is what we call the recap fund, is we want to invest in these multi-generational family businesses. We don’t want to take a control stake. We want to take a passive stake. We want to buy passive preferred shares to participate in the business. We’re less interested in the upside, but we do want a higher yield. The cost of the capital to them is going to be higher than if they went and got a bank loan. We’re investing in that way with passive preferred shares. The other motivation is if you’re trying to change the nature of the investments you’re making and the types of companies you’re investing in, you’re changing that portfolio math. Like I was talking about, venture capital is a very specific thing and there’s portfolio math that is associated with that.
If we want to invest in growth companies in our region, geographically constrained, which is difficult, well we need to change the terms of the investment. We also have to change the LPs that are coming in. The idea being the operating companies, the people who are staunchly independent and own these multi-generational operating businesses, they are the perfect partner for us because they have the capital and they have the insight and the time preference that allows us to make these investments in a different way. So what I mean by that is in the growth company portfolio, to start, we’re utilizing the Indie VC style investment terms. So again, it’s non-exit based. It maintains a significant amount of optionality for the founders of that business. So we’re not doing a cash for equity transaction with these growth stage companies. We’re giving them cash and in return we’re getting an equity option. That equity option is only executed when the founders decide to do one of three things. Raise more money, in which case we get first right to refusal and we will support them in that and help them raise, if they sell, or if they IPO. Then whatever underlying equity option we still have in that company, the investment will convert to equity.
Say they don’t do any of those three things and we get into year four after the investment. We start taking a percentage of net revenue and we take a percentage of net revenue until we’ve made three times our money back. Every time we take a percentage of net revenue, they’re buying back a piece of underlying equity option that we own. So they’re shrinking the potential dilution from the investment. What that allows us to do is provide liquidity to our LPs and to keep our incentives aligned with the founders so that they can maintain the optionality where if four or five years down the road they say, “Hey, you know what, maybe this is not a venture scale business. Maybe this is not a winner take all scenario or a winner take all market. Maybe this isn’t a land grab. Maybe I don’t need to raise hundreds of millions of dollars to get where I need to go.” We don’t have skin in the game that forces us to get them to do that. So we’re keeping our incentives aligned where they can maintain their optionality. So it’s non-exit based.
The reason that the operating companies are the perfect LPs to invest in this portfolio from my perspective is if they own their pro-rata ownership in our growth fund, they’re going to own it as a result of other LPs from within our location, within our city, buying a piece of their company. So what happens, just as a hypothetical, we invest $5 million in XYZ manufacturer, the LPs are investing in XYZ manufacturer, that’s a multi-generational family business. We want them to continue to run it for survivorship and unlevered free cash flow. XYZ manufacturer pays a dividend to the LPs. That $5 million goes to buy a pre-tax stake in the growth company portfolio, and that changes our ability as portfolio managers to invest on different terms in the growth company portfolio because our IRR clock does start at year zero with negative $5 million. XYZ manufacturing company, the family that owns it, got five million in, five million out. So our IRR clock doesn’t start until they pay their first dividend at the end of year one. That’s how we’re changing the dynamics.
So we’re not investing in the old boring manufacturing business to try to apply leverage and flip it at a higher multiple or at some point down the road for a higher price. Likewise, when we’re making investments in the growth company portfolio because the nature of our patient capital, instead of having to swing for the fences we can hit doubles, and because that pro-rata ownership is essentially owned on leverage, we can provide very attractive IRRs and we can trade the market that’s in front of us. We don’t have to use financing terms that work really well on the coasts, and use those financing terms and try to make the companies here look like a business model that should be venture-able. We can actually trade the market that’s here. People can build real businesses and scale them sustainably with our terms.
Are you pitching them a very long horizon or are you saying that you can return their capital at an ongoing rate?
We can be a little more patient. So taking 3X on the investment seems like a high cost of capital, but when these emerging growth companies have no other option, we need to try to unlock that capital by making it attractive to these LPs. But where we do have some leeway is not taking cash out of that growing business really quickly because we have to. The complexity of the operating companies, the families that own those operating companies, owning their pro-rata stake in the growth company portfolio, because they own that pro-rata on leverage we can stretch those payments out which allow the companies, the underlying growth companies, to recycle a fair amount back into their business for growth. So the idea is from years 4 to 13 if we can recoup greater than a 2X return at a portfolio level from revenue share, that’s a healthy return. Oh by the way, if you’ve, in that time period, built sustainable businesses that can recycle the free cash flow that you helped them generate, they can recycle that back into future growth, and these are good, healthy, sustainable businesses, our LPs still own an underlying equity option in those businesses. Some of the biggest exits that we have from the Pittsburgh region are not high tech growth companies.
There was a dog food company in Meadville that did co-packing or white label for Rachel Ray, sold to Smuckers for $1.9 billion. That took decades and generations to get there, but a lot of our LPs have a perpetual mindset because they’re family offices. Owning that underlying equity option in a really healthy business that has the ability to grow, particularly if they’re operating in a relatively nascent market, potentially attractive to them.
When you think about these cash flowing businesses, is there a type of business that you like or dislike? What sorts of businesses are you going after and is there a requirement on the characteristics of the owner specifically as well?
Yeah, a lot of it comes down to mentality. Getting to know and understand how they think of that asset. Are they thinking of it as a financial asset? Well, it’s probably a little less attractive to me. Are they thinking about it as a means of storing wealth through time to hand on to future generations? Well, if that’s the case, they probably have a feeling around running lower debt levels than their financial advisors are telling them they could. And they know, well that’s how we’ve been able to withstand cyclicality. That’s how we’ve been able to withstand recessions and the like. So a lot of it comes down to mindset but the characteristics are then manifested in how they run their business and how they manage their balance sheet and really what their optimizing that business for. So what is potentially really attractive to me from a mindset standpoint also is we do have entrepreneurs coming out of these universities that are operating in these extremely nascent markets of AI and robotics, and it’s really interesting cool stuff.
And in the traditional model of investing in them what we’re asking them to do is to guess what the market’s going to need eight years from now and go make that. What’s potentially way more interesting is if we have an LP base that owns an entire asset, owns an operating business, that is in a cyclical business, they have to plan around that cyclicality and actually many of them have a mindset where they know some of their competitors, especially the ones that are backed by private equity, are not planning for that cyclicality or seasonality potentially as they should. So what happens is is there’s downturns and there’s opportunities for consolidation and they can be the beneficiary of that because they’ve maintained a really healthy core. So if you can take that mindset where you’re always looking for growth as this older, more boring cash flowing business, you’re always looking for growth, but you’re really only going to swing for the fences maybe one year out of 10. And even then you’re not really swinging for the fences.
But you’re willing to wait for that fat pitch. If you can take that mindset, someone that has to operate a business in a very cyclical industry, and transfer some knowledge that they’ve learned over decades or generations to a roboticist who is trying to commercialize something, they might have some sort of a product that they can sell to someone at a profit, but it might be a small market. Might be a small but addressable market. That’s not attractive to traditional venture. But if we can fund them in a fashion that allows them to build a smaller, but sustainable component to their business to generate revenue and to generate free cash flow that can be reinvested back into research and development, how nice would that be? If you were actually generating enough free cash flow that every time you wanted to do more R&D you didn’t have to go beg an investor for it. And further dilute yourself. So that’s the idea is that if we can bring that mentality of operating a large business in a cyclical industry and take that patient capital approach to these roboticists and to these people that are commercializing these really interesting things, there’s a potential that there are a few companies where that might be a more attractive option for them.
And if they can sustain on the nascent market as it becomes less nascent, they will be very well positioned to swing for the fences. And at that point in time my bet is that when they start asking people in Pittsburgh for money to capitalize on that growth opportunity, they’re not going to come back saying these people are too risk averse. Because these people will already be engaged with them they’ll already see them working, they’ll know that they understand their business and can operate a profitable business, and now when there’s a growth opportunity that’s massive, they’ll see how much money and how much support you can get from a city like Pittsburgh.
So with your two funds you have venture type investments in one fund, i.e. creating new businesses, and then you have ones that have existed for quite a while and are more at the cash flowing level. How do you think about the two types of investments? Usually when I come across a micro PE or permanent capital type firm, they’re usually just doing the cash flowing and not venture. How do you think about combining the two?
Well we’d like to take smaller businesses and get them to a place where we could potentially recap them in the future. So we want to optimize them for free cash flow generation. So again, it’s transferability of learned lessons for building sustainable cash flows. Who better to educate and invest in in a fashion that allows these growth companies to optimize than the people that have already done it even if it was their great-grandfather or great-grandmother that funded the business? They understand how nice it is to own a goose that lays golden eggs. That’s the way that I think about it. So some of these companies may be venture-able that we’re investing in, and they are opting for personal reasons not to go the venture route. Others just might not be venture-able, but they can still fit into our mold because as a result of the complexity of the structure we can invest in a fairly diverse basket of growth companies. And again, to Brent’s point about money not being a commodity, money is attached to people and when you’re giving somebody money on specific terms that directs their behavior, we like the Indie VC style terms because we believe that it will influence people to optimize for building sustainable revenues, building real good core businesses.
And that’s what’s so important is we’re taking things that people are doing in the permanent capital space or in the junior equity space, we’re taking what Indie VC is doing, and we’re doing it under one umbrella, in one region, for the idea of creating more sustainable, large businesses here in this region.
Do you have a few examples of companies you’ve come across or founders you’ve come across who have the finite mindset and then some who have the infinite? What things do you generally see are characteristics that each of them have? We’ve been talking about them generally, but do you have any specifics?
Yeah, so I won’t go into specifics on the finite layers, but I can be more specific about the characteristics that I see. And James Carse talks about this, I think, in Finite and Infinite Games where it’s almost mandatory when you’re playing a finite game to engage in some self delusion. So if you’re playing football … Did you play football, I think, right?
I did. I played wide receiver.
Okay. Perfect example. You catch the ball. If it wasn’t drilled into your head that this is war, you must win this game, you must score a touchdown in this certain period of time so you can win the game, that’s the objective. So you catch the ball and running down the field, and some massive guy is running at you and he is going to kill you. There’s enough time on the clock, but you need to get as far as possible. You don’t care. You don’t want to go out of bounds. You don’t want to stop the clock. You need to engage in enough self delusion that this is so supremely important to you and your brothers in arms on the field that you must not go out of bounds. You have to lower your head, lower your shoulder, and take the lick. You have to engage in that self delusion of making it this extremely important thing when in all actuality in regards to your broader life, it’s almost silly. Like if you really take a step back and get rid of the delusion of it just being a finite game, it’s a game. It’s a game right?
If you allow yourself to do that it seems like almost ironic or silly. Point being, when you’re seeing people who are engaging in that self delusion in the sense that they’re like live action role playing what they think it is to be an entrepreneur. That’s what the model is designed to be in some regards. Because if in fact you are the CEO of a company, your role is to wear many hats, especially in the early stage, but is to be a capital allocator. You have different ways that you can get capital. You can utilize debt. You can sell equity. Or the cheapest thing of all is sell something to someone at a profit.
Well, if no one’s going to give you money in the form of debt, well that option’s out. If you don’t have a product to sell yet because it’s such a new business, selling things to clients is out. Well your only option to get capital to allocate toward growth is to be an actor, is to sell a vision, is to go around and tell people why your vision of the world is going to be. And all you need is their money. And once you have their money, you are the person who is going to allocate that capital toward growth, you’re going to hit your fundable milestones, and you’re going to go back and you’re going to raise more money from more people at a higher valuation to give them a markup. And then you’re going to do it again.
If you’re running a business, if you’re an entrepreneur, and you’re treating your primary job as CEO as actor, or show person … I’ve heard people say their job is to be the showman. If you’re doing that out of a sense of that being more fun, more sexy, less scary, or just being the thing to do, as opposed to going and hearing no a million times from customers and asking them why, and figuring out if you could actually build a product for them, that’s to me what I’m considering playing the finite game. You’re playing a game. If you’re starting from a place of how do I add value to a customer? How do I sell something to someone at a profit? How do I take the proceeds of that sale and reinvest it into systems that can allow me to do this perpetually through time to compound returns? That’s what a business is. Again, if you have something that is unfundable and you can’t sell it, then you need venture capital. There’s only one group of people that are crazy enough to make those investments. That’s what venture capital is for in my perspective.
They’re playing the finite game. The most abundant examples of people playing the infinite game come from these larger, more mature operating companies that are hiding in plain sight. But in the early stage space, perhaps an example of someone that I work with, I help advise him and he has an early stage company, maybe an example of that would be interesting. It’s a gentleman that runs a robotics company and he has this really … He went to Carnegie Mellon undergrad, PhD in engineering from Carnegie Mellon and developed a technology while getting his PhD. He graduated and started to commercialize it and he could sell … It’s very similar to what I was laying out earlier. He can sell this technology, this piece of robotics that he has created, he can sell it to people at a profit, but it is a relatively small but addressable market.
A lot of the advice he was getting when I met him was forget that, forget the profit, forget selling into that small market for a profit. What you have could potentially be an amazing product five or six years down the road. All you have to do is go out and raise some money, build the product, tell the market what it needs … And it’s in the prosthetics space. So he does prosthetic foot and ankles and he does exoskeletons and things of that nature. So why not raise a whole bunch of money and create robotic prosthetics and create a business around that? Well he had seen so many companies take a lot of venture money and they create these really truly amazing prosthetics, but because it’s difficult to prove the efficacy of these products, it’s not like going to the eye doctors where they tell you lens one or lens two, okay, lens two or lens three, okay, lens two or lens four. There’s nothing like that when you’re trying on a foot or ankle prosthetic. So he didn’t want to create something that would never get prescribed to people because the insurance companies wouldn’t pay for it because they couldn’t prove the efficacy of it.
So he created this robotic prosthetic foot and ankle that is an emulator that can spit out data and the hope is that some day you could use it to prove the efficacy of these prosthetics. So the questions that I was asking him when I met him were very much based on what is it you want? Why are you doing this? He was clearly going through an existential crisis and I like to say that I threw gasoline on that fire. And what he ultimately I think … The conclusion he came to, what he wanted was this idea of selling this thing into a small addressable market to generate free cash flow that can be reinvested to … His dream is to have his own robotics skunk works. You can’t do that if you take someone else’s money on a venture track. You need to be very acutely focused on making one thing, commercializing it, and selling it.
Are there other private equity firms in Pittsburgh that exist or are there others that have a somewhat similar mindset to acquisitions?
No, there’s more traditional. There’s a few traditional private equity sponsors. There are a handful of fundless sponsors. Funny enough I just talked to a guy earlier today who used to work at Bain Capital and used to do mezzanine debt for them and he’s in Chicago and he told me because of where valuations are in the private markets, a lot of these big players in private equity are starting to do these passive preferred stakes or these junior equity stakes in private businesses so that they can start to cultivate relationships should they ever want to sell in the future.
So I found that to be interesting because again, that’s part of our game plan. We want to cultivate relationships and set a similar mindset, show these people that we have a similar mindset, and that we want to keep these assets here and to remain stakeholder centric and independent and we think that there will be opportunities as a result of that to do things above and beyond buying small, passive shares of these companies.
I’m fascinated by what companies will do as valuations grow and increase. They’re going to do something to try to find those returns. What are they going to have to do beyond just paying higher multiples and using more debt to do it? I’m fascinated behaviorally by what sorts of tactics and strategy they’re going to need to use.
Instead of totally taking your ball and going home, you can use it as an opportunity to cultivate relationships. And the way I look at is if we can show these business owners that our incentives are aligned with theirs, that we value patient capital, that we are truly stakeholder centric, sometimes people just have to sell, sometimes there is no good continuity plan. And what I don’t want is for that asset to then be financialized. Why can’t we replace patient capital with more patient capital? So that’s the mission. That’s over a longer arch of time what we’re trying to do.
If you could teach a class in college about literally anything you wanted, what would you teach and why?
I am so not qualified to teach students anything I feel like. And I really should not be shaping young minds. But I think it would have to be some sort of seminar style course and having something to do with philosophy in business, and having like an open architecture like conversational way about it. Because I feel like that would be fun. I would enjoy it. Think I could stoke some decent conversation. But more than anything I would be able to learn a ton from the students as a result of that. So yeah, that’s what I would want to teach, something along those lines.
And then what was the most fortunate event that happened to you that was completely random?
Cheesy to answer about who I’m married to, my wife, but totally random event would be that we actually grew up three doors down the street from one another. So her family moved to Pittsburgh from New York when she was young and my family moved on to her street a few years later. And we never dated until after college actually. Totally random thing that has changed the course of my life.
Did you know her as a kid?
Oh yeah, we have pictures. Her family used to vacation in Cape Cod where her grandparents lived and we went up there on vacation one year and there’s pictures of us as kids outside of a restaurant in Cape Cod, and the first Steelers game I ever went to, her dad got tickets from work and gave them to my dad. I think the first concert I ever went to was John Cougar Mellencamp and they were his tickets from work also and our family went with her family. So yeah, we spent a lot of time together actually. Unbeknownst to me, she had a crush on me growing up. I had no idea. She’s going to kill me for telling this on a podcast but in her diary it says Catherine Claire Ellis.
That’s awesome. What a great random event. That’s my favorite so far. What’s the best business that you’ve come across?
There is a concrete plant that is beneath the liberty bridge just across the river from … It’s across the Monongahela, as we say in Pittsburgh, just across from downtown Pittsburgh there’s this concrete plant and it says Frank Bryan. You can see it from the other side of the river and it’s a company that I’m super recently fascinated with. Just the history and everything. It was actually in one of the Batman movies that was filmed in Pittsburgh. There was a scene where they shot there. But it’s a company called Bryan Materials and it is crazy, crazy cool. 135 years, fifth generation, started as an excavation company. The great-great-grandfather started it. His name was Frank O’Bryan. There was a lot of bigotry toward Irish back then. So he was doing excavation at the time and he painted … And I hope I’m getting all the history right, but it’ll be close enough for, I think, people to be somewhat fascinated. He changed his name from O’Bryan to Bryan and changed the spelling and told people I think that he was Welsh Protestant, and painted his buggies that he used for excavation orange.
So this is 135 years ago. So it’s in the fifth generation is working there now. They own a dredge out in the middle of the Ohio river and they dredge the river. And on the dredge it creates gravel and sand. So they own the dredge, it spits the gravel out one side into barges that they own, sand out the other side onto barges that they own. Tugboats, towboats that they own come and pick these barges up and they sell this stuff to concrete plants all around the region and also use it to supply their own concrete plants. They own their own cement trucks. Pretty sure they probably have a limestone quarry. But like this entirely vertically integrated business that has been here forever. And 135 years is a long time. But just super interesting, super intriguing. I met one of the fifth generation and talked to him over coffee for two and a half hours and I didn’t want the meeting to end. I wanted to learn more. He was telling me so many amazing stories about just relationships they have with builders in the region that go back three generations. Just really amazing stuff and the way they think about perpetuating that business, playing the infinite game, is just really intriguing to me. And just so many amazing stories.
How do they make sure that the next generation keeps the business in the family and doesn’t get bored or want to do something else and so none of the kids take it on? How do they keep that going?
It’s who they are. There are way more kids than two kids in the fifth generation, but only two of them are involved. I don’t know if this is what they do, but many family companies will set up separate boards of governance. So there’s a board of governance for the people that are running the company, but then also a board of owners. And the purpose of a board of owners would be to educate the owners on what it means to be patient capital and why maintaining the health and longevity of this goose that lays golden eggs, the perpetual capital base, is what allows it to be perpetual. And it provides a lot of people with a nice lifestyle. So it’s like this sense of duty and separating it out where the economics for the people who are engaged in the business have an incentive to perform well above and beyond the incentive that the owners have to just be patient capital and not mess with anything.
That’s fascinating. Thank you very much Andy for joining me today. This was awesome. I’m fascinated and I’m looking forward to chatting very soon.
Thank you for having me on and getting my nerves out on my first podcast. It felt pretty good and appreciate you inviting me on and spending some time talking.
Of course. Talk to you soon.