Freddie Bellhouse – Building a Holding Company in the U.K.

Live Oak Bank — Live Oak Bank is a seasoned SMB lender providing SBA and conventional financing for search funds, independent sponsors, private equity firms, and individuals looking to acquire lower middle-market companies. Live Oak has closed billions of dollars in SBA financing and is actively looking to help more small company investors across the country. If you are in the process of acquiring a company or thinking about starting a search, contact Lisa Forrest or Heather Endresen directly to start a conversation or go to www.liveoakbank.com/think.

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(3:30) – Can you walk us through some of the deals you’ve accomplished in your career?

(7:24) – What are some nuances between the US and UK in regards to SMB?

(9:55) – Have you met any people in_______

(11:12) – Are there any European companies that have multiples as low as the US?

(12:02) – Why have you decided to raise a fund instead of raising deal by deal?

(15:03) – What’s an example of a company where you needed to build out the executive team function?

(17:53) – How do you evaluate whether a team is ready for growth?

(19:15) – Have you noticed that most of the compounding growth at a company happens at years 4 & 5? Why do people sell right before that?

(22:13) – The scripted nature of acquisitions

(24:19) – What are the differences in transaction costs between the US and the UK?

(26:21) – What kinds of offers have you received for businesses?

(27:45) – How intriguing is Fordhouse as an acquirer?

(30:27) – What is the longer-term focus in your work?

(33:10) – How do you think about keeping managers happy in terms of liquidity or dividends?

(35:33) – What tends to go wrong when interests diverge?

(37:39) – What causes a mediocre performance?

(40:48) – Is there one company you’ve acquired that’s vastly outperformed the others?

(42:35) – Thoughts on integrating companies

(43:45) – What are some of the example PCV’s that you’ve enjoyed studying?

(46:57) – What college class would you teach if it could be about anything?

(48:14) – What’s a strongly held belief you’ve changed your mind on?

(49:20) – What’s the best business you’ve ever seen?

Alex Bridgeman: I think one interesting way to start would be hearing a little bit about some of the deals that you’ve done so far. So permanent capital is a big thing that you’re thinking about right now, but up to this point, you’ve all done deal by deal. Can you walk through kind of some of the different deals that you’ve done, and did they work, not work? What structures did you find interesting or helpful or most aligned with what you wanted to accomplish?

Freddie Bellhouse: Yeah, so, I mean, we started incredibly small with the sort of first phase, which is this roll up of something we call, the business we now call Symphony was small to the point of the first business we bought turned over – I’ll use pounds, sterling numbers, because that’s simply what we use, but 200,000 pounds, had 4 staff, based in a very little office down in the southwest of London. And really, therefore, it’s not the way we go about buying, or went about buying those businesses is incredibly different to what we do now. So, they don’t really translate into the slightly bigger business we buy now. Nonetheless, it’s an interesting process. We finance those deals using investors, but there’s something in the UK called EIS, which is the Enterprise Investment Scheme. So, anybody who qualifies, any investor who qualifies under that scheme, invests say 100 pounds. They immediately get their income tax back on that 100 pounds. So, let’s say for arguments sake, it’s 30 or 40%. And then if the deal fails or ultimately the investment fails, they get another 30, 40 pounds back. So, they’re really risking 30p in the pound on the investment. As a result, there was some- in order for us to sort of squeeze into that regime, we had to asset which really meant not buying shares at all but buying the business assets and the contracts out into new companies. So that was a pain, frankly, but it meant we could raise money very easily. These days, we are doing share purchases as you would normally expect. And so, things are a bit different. I think the early days of those deals were such that there was no management in place. We were doing everything ourselves. There was a bit of a sort of reality check having been a M&A lawyer for a big US firm. You see your clients transferring hundreds of millions of to complete a deal with a phone call, and when I rang my bank manager to make our first acquisition, I was told I had to queue up at the bank behind the pensioners. So, I soon realized that we were starting right at the bottom. And we did the legals ourselves; I was a lawyer recently, so I still had fresh enough knowledge. And Nick was doing all of the operational work in the business. So, we were doing everything from painting walls, changing toilet seats, to trying to raise money for future acquisitions. And so that phase lasted four or five years, and we raised chunks, small chunks of capital from investors, buying businesses, turning over 500,000, 800,000 pounds in order to build what is now Symphony, which now has its own management team, is run in a place called Crew in the UK, with 150 staff doing its own thing. We also use debt. So, what we’ve come to discover, one of the big differences between the UK and the US is that investment grade or near investment grade debt is available to much smaller businesses in the UK than in the US. So, if you have a business cash flowing at a million pounds or even less potentially, you have access to 7 or 8% debt with good terms, in some cases, even full bullet, so no amortization over four or five years. And so, there is less equity needed here, I think, before you can get to debt or at least less cash flow needed. So, we moved to debt, with sort of an EBITDA of about half million and then grew it from there. That was four or five years before we put management in place. And we started to look at the next phase which was raising a fund.

Alex Bridgeman: So, can you talk a little bit more about the UK differences? Because that’s one point we discussed earlier, especially with Nick, was how different or some of the nuances within the two markets. Like that debt one’s kind of interesting. Does the UK government just view small business lending as a prime directive for what they’re looking to accomplish in their country?

Freddie Bellhouse: No. So, it’s not really government led. I know you guys have SBA loans and various mechanisms to get debt at a much smaller level. We don’t, as far as I know, and somebody, some UK listener may tell me differently, but as far as know, there’s nothing specific there from the government that benefits us. They do have equity-based schemes, so the EIS schemes I talked about, et cetera. Here is my theory on it: The UK is smaller. And so, if you take a 5 million cash flowing business in the US, there are just a lot of them. And so, a buyer has the pick of those that are available to buy at any one time. It’s not exceptional. A 5 million cash flowing business in the UK is relatively rare. There are lots of them, but in the context of the total number of businesses in the UK, it’s tiny, absolutely tiny. And so, there is more competition for these sort of if not scaled, scaling businesses at 5 million, et cetera. And so, people are prepared to pay a lot more for them. So the first difference we’ve noticed is the multiples here are much higher. You can feasibly pay, it is obviously very sector dependent, but a pretty boring recurring revenue, asset light 2 million cash flowing business here could cost you up to 10 times. In the US, I understand, at least for fairly boring businesses that are growing, it could be half that. And so, there’s an interesting equity or valuation difference. But at 2 million, we could expect borrow three or four times that EBITDA from a debt provider to part finance that deal, and so the equity check may be similar. What I am incredibly interested in at the moment is how we can arbitrage the difference, which is to say is there an opportunity to have a UK trading platform which raises UK debt to acquire American bolt-ons or additional businesses at multiples that are much more attractive than here, but using the availability of debt at a lower multiple, lower cash flow, and then selling on to a UK or European business that’s prepared to pay UK or European multiples. I don’t know how feasible that is but it is just something we’ve been thinking about since our trip to America given some of the multiples we’ve been hearing about.

Alex Bridgeman: Have you heard of other- like, I imagine UK family offices might be pretty- there might be a couple out there that are thinking along those same lines. Have you met anyone who has kind explored that path more?

Freddie Bellhouse: So, I obviously know lots of business that are transatlantic, so MidAtlantic who operate on both sides, not least from our clients at my law firm. And I know that a lot of midmarket private equity funds will look to expand their UK business either onto the continent or over to America. I don’t know if the justification or the reason for doing so is because of this arbitrage or actually whether it is really just to access bigger markets. You often find UK private equity backed businesses heading over to Scandinavia. For some reason, it seems to be a sort of natural extension. You find the expansion everywhere. I know from firsthand experience as a lawyer that buying businesses in France, Germany, et cetera, can be very difficult given union rules and various other sort of work ups that can frustrate deals for months on end. We are backed by family offices. And certainly, both of those family offices or primary family offices are involved on both sides of the Atlantic. I just don’t know yet whether it is because of this arbitrage or whether they find opportunities in both places really.

Alex Bridgeman: Are there any other countries in Europe that have similarly low multiples as the US?

Freddie Bellhouse: I’m no pro on this stuff. My feeling is that the further east you go, the cheaper the multiples will get. As one of our team members, Marcin, is Polish-English and has done some research into Poland in particular, which is a country that is growing very quickly, in European terms at least. And he’s fairly confident that there is great opportunity there. Our issue is that we just have got plenty to be getting on with here, and I think we’d be stretching ourselves a little thin to be going elsewhere. But we’ve been told, we’ve had a couple big meetings in New York, when Nick met you, that guy suggesting that really Scandinavia should be looked at as well as a natural extension to what we do. We just haven’t looked into it yet.

Alex Bridgeman: So, walk through like the last two or three deals that are kind of coinciding with your thoughts around raising additional capital versus going deal by deal. Has something changed in the latest couple deals where things have gotten harder or you’re seeing more opportunity? Or what’s started to change recently?

Freddie Bellhouse: So we raised a fund two or three years with some absolutely fantastic investors who, as I say, are family office based who have been incredibly supportive who are also long term oriented for the most part. However, we structured the fund to be a sort of fairly typical two and twenty private equity fund style thing. And as a result, when we’ve bought businesses and brought in really top-quality management, the incentive structuring has been with that in mind. There is a sort of three to five year period where we work really hard, we create value and then hope to realize that value. What we’ve come to realize over the last year or two with these businesses going well and we think we’ve got great management on both sides, people who we believe can grow these businesses enormously and have done, is that there is a lot of hard work that goes into the first two years. There is almost a bit of a hockey stick. You invest a bit of your purchased EBITDA into that management, into consolidating the platform to enable them to take on these smaller bolt-on businesses. And once you’ve done the really hard work and you’re starting to see that EBITDA growth and before you’ve hit that sort compounding curve, it gets kicked off to the next person who looks to do their own thing. And whilst the returns can be fantastic, you are somewhat selling, having the hard work, before you start to slowly walk up that curve of compounding benefit and compounding cash flow, which can give you absolutely astronomical equity returns over time. And so really our view is we really don’t want to sell our business. We work really hard on them. In areas that we knew nothing about, we now know a lot about. And it would be a real shame to exit the industry, just to have to go and learn something fresh elsewhere and find another opportunity. So, our thinking around this is we think the area of the market we’re in works. We think the businesses we buy are the right businesses for what we want to do, but now to hold onto them for 15 years, not 4, in order to really give some turbo charge to equity returns.

Alex Bridgeman: Yeah, that is a common theme I’ve heard from a could searchers recently or search CEOs, that, by the time years three and four come around, they feel like they’re finally starting to get in the groove and are understanding their business a lot more and there’s more leverage available to them to help grow their business. And some of the most productive years can be that 5, 6, 7, 8 in a business or beyond. And if you can last to that point and build some sort of structure or organization that allows you to get there, there’s some really impressive compounding that can happen. But part of that is building executive teams too. And I’m curious if taking one of your companies as a case study, talking about that hockey stick, that J curve of investment, like walk through an example of a company where that executive team maybe didn’t exist or there were only pieces of it at that point. And how did you build out that executive function?

Freddie Bellhouse: Yeah, so I think we’ve got very lucky in the two businesses in the current fund, we’ve got incredibly lucky basically. The existing teams are great. In one case, the existing team is our team. And then in the other case, there’ve been a few changes. In the case of the business where things were changed, we’ve brought in people we would consider to be materially overpowered for the size of business we originally bought. I think in that case, we’ve got quite lucky. We brought in a finance director who was an investment director at ECI, ECI being one of the biggest midmarket firms in the UK, who himself was involved in an IT roll up and has seen it all before. This was a business that recently sold to, I can’t remember the name actually, it’s a Goldman Sachs backed asset for 17 times multiple. And so, he then brought, in through that prior experience, one of the executive team of that business who’s now our CEO. And so, we have two guys who’ve done it. There’s no greater reassurance than bringing in guys who have done and exceeded what you are hoping to do over the next few years. So then, it’s an opportunity to be at the very top table, to be in charge and to make decisions and also to look through the process of ultimately the business being bought by a much bigger backer who has lots of extra zeros to spend and to grow exponentially from there. So, I think we represent a route into a 15-year process of private equity acquisition that can be exciting and obviously very lucrative. And so, I think partly or mainly out luck, we’ve really managed to get some people in that that are really exceptional. Equally, on the other side, the team have just been fantastic since completion. There is no thought in my mind that there should be any change. Everybody stepped up to the plate and is really growing the business and relishing the prospect of growing by many multiples. So, I don’t think there’s any right answer for bringing management in. All I would say is if you’re buying a platform business that turns over, say, 6 million pounds and it has been in existence for 25 years, one could argue that perhaps the people who have taken it from A to B aren’t the right people to take it to 25, 30, 40 million. But that isn’t for sure, so you just have to take each case as it comes, I think.

Alex Bridgeman: How do you evaluate that? How do you figure out if this person or this team is ready for that degree of growth or not?

Freddie Bellhouse: It’s probably an unpopular answer here, but a lot of it comes down to gut. So, spending time with people, and actually trusting people in the initial phase to see how it goes. And then you discover whether it works or not. In our case, we haven’t had to make changes in so far as the people who were there needed changing. It is just not something we’ve had to do. Everyone’s been great. In the case of the IT business, it was very much a case of owners choosing to step back over time. So, we haven’t been in a position where we sat there and thought, oh my gosh, we’ve got to revamp this management team or we’re in serious trouble. And part of that is spending as much time as possible with people before you buy something, really getting a feel for how people work before you commit capital. And these businesses are small enough, so if you spend enough in an office of a smaller business, you really get to feel the culture and everything else and understand to what extent you think it has capacity to grow without needing major overhaul. I have no doubt that in our future, we’ll stumble across some terrible management teams having thought they were great. But so far, we’ve been really lucky.

Alex Bridgeman: That’s good to hear. That’s good. There’s a train of thought we didn’t finish. A lot of the growth, all the compounding growth I’ve noticed has been after years four and five. Have you noticed that, too, in some of the companies and owners you’ve gotten to know or your time as a lawyer, like seeing companies sell right at the point where they’re about to hit their growth spurt? What kinds of things have you seen and noticed?

Freddie Bellhouse: Yeah, I mean, time and time again, so particularly SJ Berwin, our first firm, my first firm, what we actually saw was we’d often see a business time and time again, it’d often be the third or fourth time we’d sold a business through various private equity clients, and it would be 10X larger than it was at the beginning, and you just wonder why did the first guys sell? Now obviously, they have an incentive structure and a fund structure that means that they’re obligated to sell. And they’ve found the type of investors that want the four or five year return. And that’s fine. We know how successful some of these guys have been. But there have been enough cases now, guys- and we see it now in the private equity market with the huge rise in secondary transactions where a private equity fund will buy an asset, run it for five years, and then sell it to the next fund for value so they can keep hold of it. It’s a sector they understand by virtue of having been in it. It’s a business they understand inside out and management team they trust. Why would you offload it if you think there’s room to grow? Even the short-term guys are finding mechanisms to hold onto assets for longer. There are stories of, I forget the asset, but 3i, I think it was 3i, which is one of our big PE funds in the UK, bought an asset for – I’m make up numbers here, but the gist is right – 30, 40 million. At the end of the four year process, it was worth somewhere in the region of 120, 130. But they just made the strange decision to hold onto for a long time. And I was told that the asset is now worth somewhere around 8 billion. And so if you think about the initial capital outlay, let’s assume the first deal was leveraged even 50/50, that 50 million of equity is now somewhat larger. And it would’ve been very easy to sell for 135. They would’ve done very well.

Alex Bridgeman: Yeah, that’s the other side of that, could you actually hold that business all the way to 8 billion? And it takes a really iron gut to not sell at any of those points along that journey.

Freddie Bellhouse: That’s right. I can’t remember when years and years ago that Gates or Microsoft offered to buy Facebook for something like a billion dollars or 500 million or something. I remember at the time thinking gosh, he should take that and walk away. Of course, the rest is history. So, I completely agree; it’s very hard to hold it for that long.

Alex Bridgeman: I was thinking about that story too. Yeah, an offer for a billion dollars, I would- yeah, sign me up. That sounds great.

Freddie Bellhouse: I suspect that’s why you and me aren’t Mark Zuckerberg.

Alex Bridgeman: So, another funny story, I remember chatting with this private equity partner, like traditional private equity firm in California. And not only did he, this was a company he just acquired, not only did he know that he was eventually going to sell, but he already knew and had diligenced with the next private equity firm in like three or four years who was going to buy it from him. So, it’s just such a scripted process, which is impressive.

Freddie Bellhouse: I’ve heard a lot of stories of that. In fact, a very big business I’ve been told about recently that already, as you say, it has a seller. In fact, it has an internal seller at an agreed valuation as far as I understand. It’s a strange world that I’m not really privy to. But certainly, actually even now, our businesses are already being courted by the bigger guys, such that they are desperate, as in all cases, to preempt some kind of auction process. And what we’re at least starting to find is there is almost- it’s nothing’s official, nothing’s written down, there’s no price, but there is an if you get around here, we’re willing take it off your hands for X pretty quickly. And so, you sort of have a feeling that there’s an exit there waiting if you do it right. It’s becoming a lot, but the industry is small, particularly in the UK, there are only so many businesses growing fast. If you’re doing well, everybody knows about you pretty quickly. And we’re getting, in one of our businesses in particular, the management team are getting pestered daily, our LPs are getting pestered daily, and we are getting pestered daily often from the same people who just basically want to be told when things are ready and they can just come in and get it. Now the challenge for us, assuming nothing goes wrong and everything goes well, and God knows where we will be in a years’ time with the state of the economy, but you have to make a very difficult decision as to whether you go to auction or whether you just say, you know what, let’s give it to these guys. We think the number is good. Let’s get rid of it quickly. It’s not a process we’ve had to go through yet because we held onto our first investment. So, I’m excited to see to what extent we capitulate.

Alex Bridgeman: Are there any differences in transaction costs between the US and the UK? If you went to an auction process with broker, banker, whoever, what percentage of the deal would just go to transaction costs in the UK?

Freddie Bellhouse: That’s a good question. In the UK, usually we have a sort of 2-3% EV fee, so 2 to 3% of enterprise value, and then a ratchet, so above a certain multiple that would increase on the incremental amount to incentivize outperformance. That’s often expensive. Legal fees are very expensive. You can half-ass, for lack of a better of a term, legal fees. It’s always a mistake in my experience. Great lawyers are worth their weight in gold. And so, we would assume that you would spend almost as much on lawyers as you would on a sort of corporate finance outfit. And then there a bunch of costs that go on top of that, the marketing of the document and everything else, tax advice. It really does add up fast, and it’s expensive. We find time and time again small business sellers trying to go as cheap as possible on the sale, and it never ever pays. I mean, I can honestly say that often they’ll try and do it without a broker or a corporate finance guy. That’s okay potentially, although when it’s the first time they’ve done M&A, usually it’s not- usually they need someone in their corner that understands. But when they use a lawyer that is not a specialist corporate financier, or at least, sorry, a specialist corporate lawyer or doesn’t have specific experience within the structuring of a sort of acquisition in this way, so sort the peculiarities of sweat equity and various other things, things take five times longer, their legal fees end up being three times higher than promised, everything is challenged. So I think the biggest lesson there is spend the money. But I don’t know what the US costs are. You’ll have a better feeling for that than me. Obviously, you’ve got due diligence across the board; you can do as little or as much that as you like. That can run from 5,000 to 500,000 in our experience.

Alex Bridgeman: What kind of offers have you received for businesses? And what makes some more attractive than others? Is it just price, or is there some other element that you care about or would find interesting?

Freddie Bellhouse: I think price is obviously foremost. When you get the price is the other one – are you being paid on completion? Is there some kind of earn out or deferred amount? As an investment fund, we sort of have a blanket no to any deferment earn out anyway so that we can return capital to LPs. But the only other thing that we care- Well, you care about the business itself. You want to make sure that the business or at least the people in the business are looked after. The only other bit there is time, time to do the deal. Trusted acquirers of businesses are worth their weight in gold because you know they are just going to get on with it. They are not going to sweat the small stuff, and they are going to do the deal. Some acquirers in the UK have a reputation for taking forever and challenging every tiny little issue with a business, and God knows that every business has its issues. And so, I think outside of price, you’re looking for someone who’s done it all before, understands the nature of business, and is willing to get a deal done quickly subject to sort the red flags, there being no big red flags from their due diligence providers and finance guys. Often, the business cycle dictates how long people take. When things are very hot, businesses can be bought in a couple of weeks. I think when things cool down, people take their time a bit more.

Alex Bridgeman: So, on the flip side, how intriguing are you as an option for folks wanting to sell their businesses when compared to some of the private equity firms that are hounding your own team on a daily basis?

Freddie Bellhouse: Yeah, it’s interesting one. What we’ve always tried to do is be is almost anti private equity. All of our offer documents, all of our sort of marketing and everything else is generally positioned to not use private equity jargon, to keep things really simple. Often, the way we present offers is it’s not on multiples of EBITDA or anything else. It’s just on here’s what you get then, then, then, and really getting to know sellers over time. One of our sort of heuristics, internal heuristics, is that we’ll go across the country for a 30 minute coffee in person because, well, a seller needs to trust you. And you want to see the whites of the eyeballs as it were. You really want to understand who they are, what they’re doing, if they’re running a good business. And so much of our time is taken up with meeting people, kissing lots of frogs, and being personal, really personal. Our communications are personal, phone calls. We’re not spraying and praying like most are. And I think we tend to get into businesses who have often said a blanket no to private equity because we take that really, really personal approach. We don’t have a team of originators who just are blasting everywhere. It’s just me, Nick, Marcin, and James who will go and see people, and we are the decision makers as well, so we can speak truthfully. The other angle we have, of course, is that we’re not LP backed, we’re not backed by institutional LPs, we’re backed by family offices. There is a sort of softening, a softened process for timelines and various other things as a result. And we can really talk to being a bit more committed to legacy in the long term than I think the average midmarket private equity fund can. I know I read a recent article from a lady in the US, I think she was a broker, who was saying exactly the same thing, which was private equity, midmarket private equity funds trying to come down and buy businesses are having a terrible time because they’re trying to apply the same sort of outreach process to owner managed businesses that they do to sort of auctioned or broker led midmarket businesses, and it’s a disaster. People need to trust you. So that’s really how we built all our systems and processes to hopefully earn the respect and trust of the guys that we want to buy businesses from and obviously look after those businesses after they’ve sold them.

Alex Bridgeman: Yeah, certainly. So, talk about some of the structure you’re hoping to build now for more of a longer-term focus. What’s that looking like in your head?

Freddie Bellhouse: Yeah, we’ve still got a decision or two to make there. But one of the things we’ve doing for the last few months is chatting to everybody we can about PCVs and permanent structures. A few, I think, have been on your podcast. And so, where we are sort of landing is what we want to create is as much alignment between investor and us as possible. We think that’s going to be possible because hopefully, what ultimately can come down to is are you co-investing alongside your investors, and do you have similar liquidity to your investors? As soon as those things are misaligned, behaviors vary very heavily and sort of increasingly over time as sort of a divergence. Because we’ve got this fund in place and we hope, fingers crossed, we make a return from it, that is a liquidity event that allows us to potentially take a bit of a longer-term view on illiquidity alongside our investors to benefit from that compounding. And so, as a result, what we are trying to build, the structure we are trying to build is as simple as possible. We’ve dealt with far too much complexity in the current fund. And so, the aim is sort of to take the reverse position, which is a company, a hold co, however it’s- whatever structure it is, whether it’s in the UK or elsewhere, one class of share to the maximum extent possible held both by investor and by us, buying businesses that we know how to buy underneath that hold co and not having a time horizon. So importantly, we won’t now, over the years of experience, go into another structure where anybody else has decisions other than us. So really what we’re looking for is an investor who appreciates simplicity, the complete alignment of interest in terms of share classes and liquidity, and is willing to stick it out for the benefit of compounding. And so really, it’s as simple as that. If we want to see liquidity, our investors need to see it as well. And as a result, we’ll hopefully take the kind of decisions that will benefit both of us on an equal basis. We have seen- I can see divergence becoming a very big issue with some PCVs. Essentially you have management who are increasing desperate for liquidity over time and who are looking for ways to get it without having to pay out large sums to investors, which sort of compromises the sort of compounding nature of that cashflow. And so, we’ll see. We’ll see if we get there. Hopefully it’ll be nice and simple, but God knows lawyers and tax writings have an ability to complicate things over time.

Alex Bridgeman: Have you thought about building in ways of like having secondary sales or liquidity or dividends to managers or investors over time? Because I imagine, a management team, they can’t go 60 years with not a dime coming to them. Like there needs to be some value eventually for the value that they’ve created.

Freddie Bellhouse: Yeah, so what it ensures though, where you have alignment, is that where you want to see liquidity, your investors at least have the option of that liquidity as well. So, there are a couple of things. One is we’ve often been advised, our big meeting in New York, which is the reason we were there and Nick met you, was with a big private equity guy whose big comment was, look, the sooner you can return the original invested capital to investors, the less they care about timelines kind of thing. So there is an argument to say, well, okay, let’s get these businesses cash flowing to X, let’s spend the next year or two either dividending out that cash flow to get people as close as possible to being sort of out from a committed perspective, or you could do that quickly with some kind of recapitalization and share buyback, whatever it is, and then you can proceed to benefit from the compounding going forward because investors don’t care at that point. They just want to see how far- they’ve left their winnings in only and want to see how far they can go. There’s a lot to be said for that, and that’s something we’re sort of thinking about. What we’ve also seen, which is really interesting, is giving management an ability to borrow against the share value over time. So, you can release some of the value on a tax efficient basis but still be committed in the business with sort of rump of that value, and you’d allow very small percentages of value at the time. So I think there are going to be ways, but really what we’re trying, we’re really keen to ensure is that if we’re cash flowing ten, we really need some liquidity, that okay, we may own 10% of the business, so we can take one and the investors can take nine, but at no point are we going to take one and the investors take nothing, or at least they’re going to have optionality to take that nine. What that incentivizes over time is us building such a huge pipeline of cash flow over time that it’s not an issue. Otherwise, I’ve just it all before. I’ve seen the divergence of interest over time, and things can get pretty nasty pretty quickly in my experience.

Alex Bridgeman: Do you have any anonymous examples of that divergence being particularly unhelpful to that compounding process? Like what tends to go wrong?

Freddie Bellhouse: Yeah, it’s usually- what’s interesting is it’s not- the two scenarios that people think about are always the blow away success and the disaster. But actually, in most cases, it is the really mediocre performance. It is the kind of you’re not hitting sort of your base model. You are kind of just doing all right. So, the investors have their cap table and it is not doing that well. You’re not getting to the kind of cash flow numbers where you are confident the management are getting their return. So, you are four years in, management aren’t really seeing any capital appreciation or at least not enough and are thinking gosh, I’ve got to do this for another 15 years, I could go and do something else. The investors are thinking gosh, I’m not really getting a great return on this money or at least I haven’t gotten liquidity for the return there is, and that’s where things go wrong. So that’s why it’s so important to have an investor base you can see who are in it for the long term and committed to it, both morally and legally, and for management to understand that it needs to go well for them to get paid. So quite often, you’ll have a scenario where management are looking to get paid in that very mediocre scenario when investors haven’t received as much as they should. So you are into things like hurdle rates and all that kind of stuff we like to avoid. That is a scenario where management has no choice but to double down and to make this thing work in order to get paid rather than rely on management fee or something else to get fat when investors aren’t seeing a return, and we see that quite a lot. So, to give you an example in this current fund we have, our management fee is just enough to cover our costs. There’s no profit making. There is no attempt to get fat from income so that we’re maximally aligned. And I think that’s probably one of biggest things to make sure we keep right when we go forward. We’re not- if we wanted to manage assets and take fees, we’d try and raise 300 million. We wouldn’t raise 30 or 40 million, which is the plan to sort of maximize return on equity.

Alex Bridgeman: Yeah, certainly. You can do well at the 300 level with management fees. Do you think that mediocre performance, is that a function of, I imagine it’s a combination of a whole bunch of stuff, but just poor companies acquired, not A team managers, bad incentives? Like what’s kind of like the mixture of all of those different things, maybe more that I’ve forgotten too?

Freddie Bellhouse: So, well, I guess it varies depending on what you’re buying, what sector you’re in, all the rest of it. For us, we’re in roll up. So, we’re buying lots of businesses within a single sector. The risks, the biggest risks are around buying poor businesses. So, we don’t worry too much about valuations. We tend to get businesses at good prices. Our concern is that there is a sort of culture or set of systems and processes that is really, really bad news in the business you’re buying. And those are often the things that are very hard to discover before you buy them. And so, where you have a platform and it’s bolt-ons that have gone well, there is good culture, things are fitting well together, you can have one bad purchase that is almost like a sort of cancer in the business, and it can make everybody else unhappy over time. So, often mediocre performance is buying four good businesses and a couple of bad ones. And the bad ones are just dragging everything down culturally, not from a processes and systems perspective. But really the biggest single risk for us in what we do is poor integration. So, integration means, it’s partly culture, it’s processes and systems, and it’s also incentives. All that is packed into a process of integration. And with integration, it’s the hardest, it’s the single hardest thing to get right. It takes time. It takes grit and determination. And I think when people get into the roll up game at whatever size, they can make their excel spreadsheets look fantastic. We’re going to buy lots of businesses at 5 times and then we are going to sell them at 10, it is going to be amazing. What the excel spreadsheet can’t tell you is the absolute horror show that will exist in the two years post acquisition where every change is resisted. Everything that could go wrong goes wrong and often at the same time, which is not something you want, and the hard work that it takes to get through to the other side. And so where you see poor results, you often see what we call a bag of bits, disparate businesses, not really working together, separate cultures, no one responsible for revenue growth in any one place because you’re buying small businesses with the owner leaving, and a business that can’t be sold. And it’s just, these things often don’t implode. They just slowly get worse, and it becomes exponentially harder over time to grown them. So really that’s just a slight tangent. Our team is majority operationally based or integration based. And our biggest value add to our businesses is working on integrations in a very formulaic, process driven way. Having done 25 of them now, we have an instinct for what to avoid and what not to and what to do quickly. I think that is probably our biggest value add and our biggest de-risker when it comes to hopefully outperforming mediocre businesses.

Alex Bridgeman: You don’t have, within the 25 deals you’ve done, there’s not like one business that’s dominated them all, right? There’s not like the clear number one company that you’ve acquired. It’s a handful of similarly sized companies, or is there one that you kind of view as your cornerstone company?

Freddie Bellhouse: So, most of those acquisitions were our first roll up, which they were very small. So no, there was no one business there that was much bigger than the others. And that’s hard work. Not having a dominant business with systems and processes in place is very difficult because you have to create everything from scratch. In the case of our IT business, we bought a great platform business that, with a few tweaks here and there, was able to take on other businesses. And with our accounting business, they’ve got a great setup there that’s perfectly placed, particularly from a cultural perspective, to take in other businesses. So, there’s no one business. Although having said that, Zenzero, our MSP, is easily our biggest business at the moment, but we’ve put the most capital into it. So no, there is no real answer there sadly. Although we would like in most cases for the platform to be the biggest. What tends to happen is if you buy a platform at 10, and you ultimately buy a bolt on at 12 two years later, it can be a very painful process to change processes and systems between them. Rather than having the platform be the biggest and everything to be subsumed into the systems that exist there, most of the bolt-ons we buy are significantly smaller than the platform and therefore are not well equipped to or at least don’t have their sort of operation in a place where it can sort of challenge the mothership as it were. It tends to just take on what the mothership has. So, we’ll see. And we’ll see which one gets biggest. I guess that’s an exciting thing to find out in the next two or three years. I wouldn’t like to bet.

Alex Bridgeman: So, integration wise, do you think it’s easier to integrate the smaller deal or the similarly size deal?

Freddie Bellhouse: I think what’s more important there is that it’s easy to integrate bigger- Well, it’s easier to integrate tiny businesses and large businesses. From a tiny perspective, it’s because you can manually handle every single bit easily, and it doesn’t take long. In the large businesses, you’ve got usually great management teams who aren’t owner managed, second line management. There is a structure in place which allows you to share in the pain and hopefully there’s some experience there which sort of makes things a bit easier. The toughest ones are the bigger the owner managed businesses that don’t necessarily have the structure or the management structure underneath the owner manager. That’s when it’s hard work. You can’t do things manually, but equally, there’s no one there to help you. So that’s when, thankfully, I can step out of the way, and Nick and James have to do all the hard work. I can just go and look for another business to buy.

Alex Bridgeman: Perfect. That’s a great setup. I do find permanent capital vehicles really interesting, and it’s fun to have seen how many have come out of the US, and some are taking similar approaches as others, and some have come up with some really interesting terms. What are some of the example PCVs that you’ve really enjoyed studying or just anonymous models that you find particularly interesting and you think could apply well to what you want to do?

Freddie Bellhouse: The obvious sort of big ones, your Constellations and all those guys that obviously have done incredibly well are fascinating reading and obviously hugely exciting to sort of try and replicate. Our stablemates, Westerly Group, I think you had Ross on the podcast, we have a shared backer. Speaking to those guys who’ve done just an enormous amount of thinking in the space, far beyond anything we’ve done to date, it has been incredibly illuminating. And obviously Ross and Westerly have backed a number of guys doing their own things within specific sectors. And across all of those and others that we’ve spoken to, things vary heavily. There is a huge difference in how people are incentivizing management, encouraging LPs into these structures. There is clearly no right way to do it. Nobody has settled on the right way. And as you sort of intimated to earlier, the biggest issue seems to be around liquidity. We’re trying to solve that by not needing it, frankly. And if we can not need it, then we don’t have to worry about it. That’s sort of the goal we’re taking over the next couple of years. So, we see guys with sweat equity classes, incentive shares, payouts based on returns over time. We see ability to borrow against equity, ability to co-invest at par but later on, so if co-investing at par, when you enter the hold co, the price of the share, the nominal value of the share, even once value has been accrued, can management invest at the original value later to see upside. There are tax issues with that generally, but it’s something we’ve seen. So, there are all these sort of imaginative ways of trying to artificially create liquidity when there naturally isn’t any, and I’m sure most of them will work in one way or another. But I think in our case, we’re just trying to keep it simple hopefully. We have come across a few, I’m sure you’ve spoken to them too, I won’t say names just in case they don’t want anything public, but they have kept things incredibly simple. And they go out to market to raise money on a value basis, the equity value, and raise on that basis. There is some liquidity at that point as well. But otherwise, they’re totally aligned with investors in every other way. And that works too. The issue you’ve got there is if you’re going into a fresh hold co, quite often, you don’t have value in the business. And so, you don’t own value in the business to be able to give away. There needs to be something at the beginning that allows you accrue capital value. So, there’s no easy answer. We’re still scratching around for it. But I think our preference for simplicity will mean we go down a very sort of basic route in that respect.

Alex Bridgeman: Yeah, I hope so. It’ll be fun to watch. First closing question for you. What college class would you teach if it could be about any subject you wanted?

Freddie Bellhouse: I thought about this; I think for me, the most valuable thing you could teach an 18-year-old is probably around personal finances, around some of the basic investment things we all know as a result of being involved in the sector that applies to you individually that just isn’t taught by parents or by schools. Debt, the importance of not being in debt, the importance of compounding what little capital you have over time, the incredible opportunity that you as an 18-year-old have to build value over the 60 years that us near 40-year-olds don’t have. And so don’t waste time. So, I think the basics of that, the basics of capital, leveraging yourself, and I guess all things that point towards sort of not trying to get rich quick, but trying to build value over the long term. I think it applies very much to what we do in our work worlds, but equally it took me a very long time to not try and find the easy solution to get rich. It took me sort of 20 years to realize that. And I think if I can impart some of that painful learning to 18-year-olds, I think that would probably be the most valuable use of my time.

Alex Bridgeman: That’s a great one. What’s a strongly held belief you changed your mind on? Perhaps it’s the get rich quick versus take a while to do it.

Freddie Bellhouse: That’s certainly one. For me, actually, it’s a bit of a weird one, but it’s the utility of belief itself. So, in the case of religion, I grew up in a- I went to a school that was very religious. I sort of rejected it and threw the baby out with the bath water in terms of its utility. And I think one of the things I’ve learned over the years, as I got slightly older and particularly with children, is that belief itself, whether it’s religion or something else, it can have an enormous amount of utility. It doesn’t even have to be true. I think ideology, some are good, some are bad, but it really allows people to be far more powerful in their search for what they’re after, whether it’s good or bad. So, I think the biggest belief I’ve changed is potentially laughing at or disregarding other people’s beliefs that I think are silly when in reality they have a huge amount of utility or a set of heuristics that enable that person to better themselves. I think that is probably my biggest mind change.

Alex Bridgeman: That’s really good one. I haven’t heard it articulated that way before, but that makes a lot of sense. What’s the best business you’ve ever seen?

Freddie Bellhouse: I mean, this is the sore one for me because it’s essentially zero incremental cost to serve software businesses of various types, particularly I’ve seen in very regulated sectors, perhaps in training, for example. So, let’s take an example of a company that operates in a highly regulated sector – water, something like that. There are requirements for their staff to pass various tests on an annual basis. Those tests are only going to get more onerous over time or there are going to be more of them required by government regulation. And if you are the incumbent provider of those sort of software tests that are usually quite easy to pass and are not a large part of a client’s P&L, and therefore, they have zero incentive to go look for someone else, you’re going to get incremental business over time from those clients, you’re not going to lose them, and there is zero cost to serve the marginal user. They are money printing machines. They are now also very competitive and very expensive as a result. We’ve built up our expertise generally in people businesses and improving them or tech enabling them over time. And so, it’s probably not our domain, but I get very jealous of people who own those types of businesses that grow nice and quickly and have defensible regulatory moats and are sort of margin machines. So, one day, we’ll get a hold of one I’m sure.

Alex Bridgeman: Yeah, I certainly hope so. Thanks so much for sharing a little bit. It was great to meet Nick in New York. And I hope that you guys are both coming back to the US at some point soon, and we can meet for dinner or something else. That’d be really fun.

Freddie Bellhouse: Yeah, thanks so much for having me on. And yeah, it was great to speak.