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Paul Yancich & Daniel Eisen – Taking Inspiration From Constellation and Leveraging a Long Time Horizon

Paul Yancich and Daniel Eisen are co-founders of Arcadea Group, a permanent capital holding company.

Episode Description

My guests in this episode are Paul Yancich and Daniel Eisen, who founded Arcadea Group, a permanent capital holding company that has raised $320 million to invest over ultra-long periods of time in typically independent, founder-controlled software companies with strong growth in duration potential.

Prior to founding Arcadea, Daniel and Paul had careers in private equity, growth equity, and buyout. Most recently is Constellation Software, where they both were hired by and worked for Mark Leonard in various senior executive roles in the company. We talk extensively about what they learned in their backgrounds, how Arcadea differs from PE growth equity in Constellation in their approach, and what it means to invest in and grow a company over a very long time horizon. It seems like more and more of these permanent capital vehicles are being created.

If you know any great ones with a unique approach, please reach out and let me know. This is a fascinating area that I want to learn more about.

Clips From This Episode

What value have you changed your mind about?

What's the best business you've seen?

What college class would you teach?

Long time horizon

Raising capital and investor relations

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My guests in this episode are Paul Yancich and Daniel Eisen, who founded Arcadea Group, a permanent capital holding company that has raised $320 million to invest over ultra-long periods of time in typically independent, founder-controlled software companies with strong growth in duration potential.

Prior to founding Arcadea, Daniel and Paul had careers in private equity, growth equity, and buyout. Most recently is Constellation Software, where they both were hired by and worked for Mark Leonard in various senior executive roles in the company. We talk extensively about what they learned in their backgrounds, how Arcadea differs from PE growth equity in Constellation in their approach, and what it means to invest in and grow a company over a very long time horizon. It seems like more and more of these permanent capital vehicles are being created.

If you know any great ones with a unique approach, please reach out and let me know. This is a fascinating area that I want to learn more about.

Good to see you both. Thanks for coming on the podcast. Looking forward to chatting all about software investments, working at Constellation, and why long-term horizons are generally good for business. So, I’d love to just start with your background and work from there.

Paul, do you want to start?

Paul Yancich:

Sure. Start all the way back in, I was born and raised in Cleveland, Ohio. My immediate family is not in business. My father’s a musician. My mom was a nurse. And had a great upbringing there. I studied at Princeton for undergrad and started to go there as a physics guy, that was my goal, is to become a physics major and quickly realized that while I was pretty good at high school, this is kind of this next level up of people that have tenure track potential in the physics department, I wasn’t one of them. I switched to religion and philosophy, which is the other end of the spectrum.

During college, I had an internship on Wall Street, which a lot of kids from Princeton get because of the strong brand of the school and the relationship with the firms, and it was around that time that I started learning about investing, actually, through an uncle of mine who had sold a business, I think in his mid to late ’30s and became my professional investor of his own money. Learned about Berkshire Hathaway and Warren Buffet and worked at as a result of that burgeoning interest and that internship was lucky enough to get a job after a bit at Citi Group in New York City, I worked on the markets division and the analyst rotational program, and landed on a credit research desk covering high yield investment-grade bonds, and CDs, and stuff like that in the energy sector. I spent 2 and a few years there.

And during my time at Citi helping sell some of these bonds basically, and trying to help the DCM guys price them, relative to what was going on in the book that we traded. I got to know some private equity firm that was taking a company public at the same time doing a debt offering.

And when he explained to me his business, I thought it sounded like it should be illegal. And that it was a cheat code versus public markets, debt, or equity investing. He knew all the financials. He knew the PV 10 buildup, which is this technical term for oil field reserves. And he knew the monthly financials daily, if you wanted to, he could tell management what to do. He could talk with management about anything that was going on. And compared to public market investing, where all we had were Qs and Ks, and maybe a CFO call once or twice a year, I just thought, wow, that seems really easy and interesting. I was lucky enough to find my way to a growth equity firm that took a chance on me and brought me in as an associate.

And they’re focused on primarily enterprise B2B software doing Series A, Series B growth investments in 1 to 5 million ARR businesses growing kind of 52 at the very low end to more like a 100 – 200% per year. And as a firm called Arsenal Growth, good group of guys, and it was there that I learned software and software investing and private market investing.

And it was also there that I stumbled across Constellation Software through my brother-in-law, who was a fund manager at a big mutual fund. And then I’ll stop before we get to Constellation because I’m sure we’ll talk about that. But it was a real eye-opener to have gone from knowing nothing about finance or accounting or investing.

I’d never taken a finance business or accounting class in my life or economics for that matter to working at Wall Street, to being at this growth equity firm and then seeing what Mark Leonard and the Constellation team had done in software without debt in an incredibly capital efficient manner and had created this shareholder return which was better than basically 99% of public companies ever. And I thought there’s something here that I don’t understand. And it was obvious that was the kind of the best place to learn as my next step and that’s where Daniel and I met which we can talk about in a bit. That’s me in a nutshell.

Daniel Eisen:

My background, I grew up in a suburb of Toronto called Thornhill, went to school at a small ironically accounting-focused school outside of Toronto called Wilfrid Laurier.

And I’d started down the path there. I think I was going to become a CPA, which I’m sure what my parents were keen on unseeing happen and becoming a partner at one of the big four firms. I did, I think, two years of the more accounting-focused stream. And I realized this was not all that exciting and then ended up in some capital markets classes.

And that led to my last semester, they’re doing a work term at one of the Canadian banks and the equity research group. And that’s where I ended up joining after I graduated a couple of years of equity research analysts work in the retail sector which was interesting, but I realized I didn’t want to become an analyst.

I was sitting next to a fellow who had a friend at a private equity firm in Toronto. Didn’t really know a whole lot about private equity, but he was describing it as a cool place to go work and ended up getting a job there. The firm was called TorQuest partners, which ironically is the spot that Paul was working at just before we started Arcadea. They’re a real, top-notch mid-market, private equity firm in Toronto.

Two years stint there in the associate seat coinciding with the GFC so it didn’t do a whole lot of new capital deployment there and a lot of the time was spent in the portfolio. That led to me leaving TorQuest first in a sub-continent and eventually on a full-time basis to join one of the portfolio companies that was going through some tough times sort of underperformance, right from the get-go and was a senior operating executive there for four years, trying to turn the business around.

It was a chain of commercial weight-loss centers as it was franchised. And there’s lots of interesting stories I can share from that time at some point, but it was a real eye-opening experience for me in terms of being a young person, spending a bunch of time in the sort of ivory tower investing, working on Bay Street in Toronto, and then going to the trenches for business and seeing what actually happens day to day and how value gets created.

So a great experience. We were not successful in turning around the business. I think most of us there probably realized that was going to be the outcome. A couple of years before we all started to depart for other roles. And as I was winding down there a friend of mine and now a friend of ours was in Mark Leonard’s seat at Constellation.

It was time for him to transition to a new role in the business. And he knows I was looking for something new to do. He said, Hey, you should come meet Mark. And here’s what my experience is, bands were really neat and it must be a great organization for you to build a career in. So I went to go meet with Mark not knowing a whole lot about Constellation or really about software investing, a pretty different perspective than Paul had going in.

You sit down with Mark and you spend five minutes with them and you realize he’s just one of these world-class people that any opportunity you have to work with, learn from a person that caliber you’ve got to take. And so I joined Constellation and I had to work with Mark for a year. And then went my way through the organization of the subsequent, it goes there for seven years which brought me to Arcadea. Paul and I overlapped. Paul was a couple of iterations after me. two iterations. And so your final responsibility working with Mark, when it’s time to leave the nest and go get a real job and the company is to find your successor. And hired the fellow that worked for me and then he ended up hiring Paul. It was a pretty small group of folks in that world. So it didn’t take long for us to connect and realize we had a lot of-.

Paul Yancich:

And you were one of my interviews, I’m pretty sure. I know Benji was for sure.

Daniel Eisen:

That’s right. Yeah. I would have participated in that betting process. And the funny part about that progression in that role as we all look back there is the successor was sort of an incremental improvement over the person that hired them.

And so by the time we got to Paul all of us who came before, we’re looking at Paul’s performance and abilities, then, gosh, I’m glad I got hired before him because I’m not sure we would’ve hit Paul screen to hire afterward. We all did our job in providing some incremental value to the organization by at least hiring a good person after us.

Paul Yancich:

That’s you just making up for your insult to my intro. Thank you.

One thing you mentioned just there was part of the culture at Constellation was to hire your successor if you were going to move up in the company. Can you talk about a few other cultural elements within the company that you’ve found are particularly unique?

Paul Yancich:

For sure, focus on learning through data as opposed to learning through anecdotes and learning through intuition or mainstream wisdom was huge. You can have an opinion, but the opinion better be supported by data, and data that everyone can see, and data that is of high quality. So some guy’s story is not data that’s of high quality, but measurement of business performance is. Same thing if could think about it studying a, I dunno, a potential CEO, and if you have data on his track record, then you can have an opinion on whether or not they’re a good CEO, but if some people tell you that this is a great gal or guy, and they’re really fun to be with, those are the sorts of beliefs that were shooed.

And that’s a big change from a lot of places, even investment firms who would otherwise characterize themselves as data-driven. I think we can both speak to that having been in other investment operations. And so Constellation was just excellent at making sure that opinions were supported by verifiable data and of sufficient quality.

Daniel Eisen:

Yeah. So one of the cultural values that both Paul and I benefited from was a willingness to put young unproven, but high-potential folks into roles where there was a lot of responsibility in this sink or swim construct. And we both had the opportunity to do that as we progressed through the different parts of the organization.

And I saw that happen quite a bit in the group that I was working with, folks that followed me or joined after I did that were also younger in their career. And people who had the ambition to put up their hand and say, gosh, I’d like to go do this, or I think you can add some value here, being able to have the backing of the key decision-makers to go do that and take a shot of it. In some cases being forced to do it, maybe a little bit ahead of when folks were willing to do it, but people saw that the ability was there. It was really prevalent. I think it gave a lot of folks an opportunity to build a career without some of the direct experience that might’ve been required in other situations.

So part of me wonders why more companies don’t just blatantly copy the Constellation model. There’s of course likely structural elements of Constellation that are really hard to replicate. But from your experience there, what might be some of the hardest elements of Constellation to replicate if you were to try to recreate that model? 

Paul Yancich:

Discipline comes to mind. People generally in large groups are not super disciplined. And discipline seems to evaporate once scale comes into the picture, that with private equity firms, except, like Union Square Ventures, which just raised 300 million every time that it could raise probably 30 billion.

I can name another firm that doesn’t try to double the fund size every time they grow up. Every time they complete one, it’s very rare. And the Constellation version of that would be discipline around investing. And so, the bigger private equity firms raise a bigger fund, they want to do bigger checks because if you just hire more people that GPs don’t make as big of fees. And what do you know, the returns come down over time. There are obviously exceptions to that, some of the really great firms, but typically discipline evaporates. And you see that in public markets firms, I think, you see that in private market firms. And for sure you can see that in businesses, Constellation being both a business and an investment firm.

So I think that’s incredibly difficult to replicate and the reason they have historically been pretty good at that is due to the culture of data-driven decisions, which I mentioned earlier, and also some of the very powerful figureheads of the business, ensuring that that culture was pushed through and celebrated often.

Daniel Eisen:

Yeah. I also think in the contract of a public company the willingness to have humility or not being caught up in the noise of being a promoter, that is evident with all of the key leaders there, aren’t being the best example of that if you listen to any of his earnings calls. That’s an incredibly rare quality to have. And that sort of approach to business from an outward-facing perspective is reflected in the business as well, keeping this level of humility and focus on executing and not promoting that there’s not many folks who have had that sort of success that Mark and his team there have had, and have done that with the lack of public acknowledgment, public stature. I think it’s a key part of what Nate has made the business successful. It’s just a rare attribute to have to find a bunch of folks who think like that and conduct themselves like that.

Paul Yancich:

I think frugality is correlated with that. Everyone rides economy, nobody’s staying at the Ritz, people aren’t eating at the high-end steakhouses on trips. And those little signals really get talked about and will permeate a business.

And we’re very cognizant of that building Arcadea. What kind of office do we have, what’s the coffee machine in the cafe, and what our policies are on travel. These little things definitely add up and you get huge leverage out of them.

So then taking it to Arcadea, what two to three things from Constellation did you want to bring over into your own firm? Like data-driven, decision making, and frugality is probably a big one, but we’d be curious about other elements that you wanted to incorporate.

Paul Yancich:

One difference from Constellations is we’re very much focused more so on organic growing businesses that kind of, we think about picking up where Constellation leaves off.

And so 10% kind of minimum all the way to 50, 60% that takes a much more of a focus on what can go right than what can go wrong. And I think it skews us a little bit more towards probably a bit more modern businesses and maybe a different set of playbooks and best practices that we can hopefully bring from our days in growth equity and bring those to bear in the otherwise high discipline construct that we know how to operate. That’s one difference.

Another is that we’re very happy to have folks roll equity alongside of us. We don’t have this burning need to own a hundred percent of businesses. We think that particularly for younger founders and the more quickly growing kind of higher quality businesses. It’s almost a bad sign if somebody wants to completely sell to you, it means that you’ve probably paid too high of a price. And you like seeing somebody else re-up and put their money where their mouth is on evaluation. And we like equity ownership for our employees, our teammates, the people who are running our businesses. That also goes for the folks who are selling businesses to us. And so we would love a large number of our companies, particularly those ultra high quality quickly growing businesses to have long-term equity partners alongside of us.

I guess Daniel mentioned a little bit also that we’re far less focused on our profitability. We’re much more interested in what can this become in over 15 years. We also don’t necessarily fully believe that to grow, you need to burn capital. This is a bad thought that VC and growth equity have taken far too down the logical path. So we do believe in capital-efficient growth, but that being said, we’re happy to take bigger swings, we think, and let businesses even burn capital for over a period of years if they’re achieving those really high growth rates.

And that’s really important to us because if we just pull the profitability lever every time, which is appropriate to lower growth business, what you have happen is this flywheel of what’s normal for the firm, what are people comfortable with, what do people know they can propose without getting critical feedback in front of their peers and an investment committee, that leads to the next generation of portfolio managers or CEOs, and then all they know how to do as to profitability, and then what are they comfortable with, looking at businesses to invest in that are low growth and around you go. And we don’t want that wheel to start spinning too quickly. And if anything we’d want it to spin the other way.

Daniel Eisen:

We’re also quite open to using leverage in the right situations. Constellation was famous for basically using none over its history, other than a couple of exceptions. And we’ve learned from our investor base about how that can be applied judiciously to augment returns in the right situation.

And it’s something that we’re quite open to where it makes sense. Certainly not all the way to the traditional private equity model of extreme leverage, but where it makes sense and we can use it judiciously and it doesn’t overly fragilize the business. We’re going to take advantage of it. They were investors and we want to get returns and you can augment returns with debt capital.

It’s going to make sense for us to do that and that can make a difference when it comes to buying high-quality businesses at the prices that they’re trading at. If you can use leverage to get you over the line or make sure that you’re competitive with folks who have a shorter-term horizon, they’re going to be extreme with leverage to optimize a price, we will definitely do that.

Paul Yancich:

Yeah. That’s a tactic, not a strategy. And we see some other kinds of aggregator businesses in the software space and not Constellation but smaller shops really almost embraced leverage as a strategy. And as a result, if that’s your core strategy, you have to get really profitable businesses and pay a low price. And then, all of a sudden we’re in that flywheel, I talked about, ok you’re buying a 0% organic growth business, your whole portfolio is 0 or 1% organic growth, what type of habits and patterns are you building in that organization? The IRR may be great and your capital efficiency may be through the roof, but typically low growth businesses that are highly levered don’t seem to last. That’s not a formula historically that has worked out well for protecting equity ownership. And you know, we want to use leverage like Daniel said, but also have it be an adjunct as opposed to the core a centerpiece of the strategy.

Can you share a rough high-level overview of how Arcadea is set up and then perhaps the general profile of your investors? No need to identify any of them by name, but just what are the types of folks who have signed on to Arcadea?

Paul Yancich:

Sure. I’ll start with the structure piece. You can do the investors, Daniel. So we’re a whole co-permanent capital, 320 million Canadian as is about 260 US. And those obviously depend on the day and the effects rate. And we have to call that capital to down as we use it. And then the idea is that’s the only capital ever needed. That’s certainly the only capital we want to raise.

And then this is a classic compounding vehicle where we will leverage the free cash flow from businesses, such that they make free cash flow. And we’re happy by the way, with businesses that are not making much profit, which is a key difference from Constellation.

Some other, the softer aggregators out there redeploy that cash into new businesses over time and so on and so forth for hopefully a really long period. And our investors are aligned and structurally obligated, so to speak, to be alongside us for a long time, which we had no pushback against from the investors that we chose.

Daniel Eisen:

Yeah, emphasize when we talk to folks in the market that we have shareholders, not LPs, and we often have a question of who’s your LP? What does your LP base look like? And always quick to correct that we have new LPs, these are shareholders, and that’s a really important distinction for folks that understand how the fund world works.

And that a shareholder is somewhat interested in value creation for long periods of time. At least that’s the ideal shareholder. And LPs tend to be a little more focused on fun lives and return of capital and finite periods of time, which is not the model we put together.

So in terms of the profile of investors, all folks that are investing their own capital. So there’s no agent principle dynamics here. These are all principles. Most of the folks are individuals or their collections of individuals investing their family’s capital all of whom are ultra accomplished in their own right. A bunch of folks in investment worlds. Some people will come from the operating world and it’s a small number. This is a group of folks that we can get around and go into a Gauguin park on a camping trip and everyone would fit around I campfire.

These are folks like Mitchell Rales who found the Danaher a number of years ago and the Ferris Danaher spin-offs, folks who have come out of the SPO partners investment firm incredibly accomplished a couple of the former partners there a bunch of others of that ilk who are pretty private with where their investing activities these days, but are similarly accomplished from those folks. So, people who think about investing from a multi-decade compounding perspective, that’s the key theme there.

Paul Yancich:

Most of them have just the ad. They have these long visions for their money, hundred-year visions. You can Google and see what the Rales family is doing with Glenstone and their passion is pretty easy to see. And, that’s the same with all of our investors. Nobody is in this to get a big boat in 7 years or something else silly like that. There’s a purpose and a mission behind all the capital. And it’s no surprise to us now, looking back that folks with these long missions and a bigger vision for what they’re doing with their money correlate with long-termism and surprisingly, a lot of institutions who ought to have the longest horizon out of anyone an endowment for a university, hopefully, you’re thinking in 500-year slugs, but those were the entities that were most focused on what was the quarterly nav approach going to be.

And that just screamed short-termism as opposed to we didn’t get a single question like that from any of the folks that we ended up going with they’re focused on what happens in 15 years when you need to transform the business into something it’s not today, not what is my distribution call right in year 4.65 if the markets are down.

Sounds like a nice tip from investors. You mentioned earlier that the types of companies that you’re after don’t necessarily need to have free cash flow. I’d love to just expand on just the parameters that you’re looking for within these companies and perhaps how they differed from your time at Constellation. Is there an opportunity that you see to a different degree in a different type of company or a company in a different state that you wouldn’t have looked at a Constellation?

Paul Yancich:

Our criteria are, I’ll do the easy part, Daniel. You do the second harder part. The easy part is we’re looking at 3 to 20 million of ARR with growth of at least 10% up to 50, 60, sometimes 70%.

The businesses can be cash flowing or not, but capital efficiency for us is a big thing. So that correlates with mostly bootstrapped or lightly backed companies, sometimes corporate own assets. The businesses that have been able to do a lot with a little that typically tells us that they are constrained and therefore they’re making tough product decisions.

So only building what customers really want as opposed to visionary product development, growing, where they have confidence that they can grow and they have high product-market fit, as opposed to push rope and selling a bunch of stuff to hit a quarterly bookings number for your VC or your growth equity investor.

And also these capital-efficient businesses that we focus on typically have a higher degree of pride in their culture and higher employee satisfaction and customer satisfaction. The capital efficiency thing is the simple way to identify a lot more important elements of businesses. That’s where we’re focused. North America, Europe, Australia, New Zealand are all places we’re really comfortable. And you’ve done a lot of investing personally in the past.

Daniel Eisen:

The harder question around this sort of stuff with Arcadea versus Constellation. The best way to answer that question as a starting point is to think of the competitive set of other folks in the investing world that we’ll be talking to the same sort of businesses that we are. People who are coming from the growth equity world or the more aggressive mid-market private equity, software investors that align with businesses that have this 10 plus percent top-line growth and potentially a lower margin profile, at least at the start than some of the folks Constellation great acquirers of vertical software businesses, but maybe a little bit lower on, the growth curve.

And I think where that really manifests for us as we think about investing for the long term.  Having the support of a small group of shareholders who are interested in multi-decade outcomes means we are less tied to IRR than other folks may be. IRR matters. It’s a metric that’s relevant to how folks are measuring investment outcomes.

But we’re thinking as much about MOIC as we are IRR and in some cases a little bit more. And the challenge with the IRR gain, if you’ve got really strict IRR rules if you don’t have strong cash flows in the early years, especially if you’re not getting to an exit in 3 to 4 years, that leaves you to emphasize profitability versus growth and focusing on strong near-term profitability.

This is the classic product you’ve got with software businesses: Do you want to invest in growth or do you want to slow growth and extract more profits? If you really think about investing from a strictly IRR gain, then it tends to fall a bit more towards the slower growth, but higher profit.

And if you’re less focused on IRR and there’s an opportunity to grow a business organically at significant rates over long periods of time, then you’re going to underwrite that investment and not be so focused on whether your IRR was 26 versus 23% or 22%. You’re going to get to that great MOIC outcome. And in 10 or 15 years.

Yeah, we’ve talked a lot about the indefinite time horizon so far. I’d be curious, some of the researcher learnings that you’ve seen from studying companies that have more of a longer-term time horizon and are less transactional and not rushing to a quick finish line. Can you talk a little bit about some of that philosophy and how it’s influenced you?

Paul Yancich:

Some attributes of businesses that seem to do really well over time. Include some of the elements we discussed earlier, like discipline, it’s just the classic buffet circle of competence stuff. You’ve got to prize the core. The core is beautiful. And usually, particularly in the software context, the markets are much larger and longer tailed than folks think.

And so not getting distracted by the new flashy widget or seam in the market that gives investors incredible FOMO pain is an attribute that leads to long-term success in duration. That duration of growth is what we’re more excited about. Then the absolute extent of growth for sure.

Daniel Eisen:

So we think about that question in the context of a traditional investment firm model and transactional costs are real. And whether that comes from what you’re paying your advisors to sell the business or our taxes and everything, giving compounding the ability to do it free tax and pre-transaction fee is the best way to extraordinary outcomes.

And in the investment world, it’s not a common approach because most folks who raise capital want to see a big payday in 3 or 5 years with a carried interest check and that leaves the transaction fees. And do you find these great businesses that you’re forced to sell because of that and the returns that you would have generated over 20 years? Holding that business is far in excess of what you generate selling it in 3 years and seeing someone else accrue those returns just through the slippage and in transaction costs.

There’s lots of studies out there that show what has happened to great quality businesses that have traded hands to multiple financial sponsors and the outcomes for what the investors and the original investors could have been had they held it all the way through. We’ve heard that from some folks in our investor base that have come from a more traditional fund model about businesses that they’ve invested in and ended up exiting and seen it excel with subsequent owners is saying, ‘Gosh, this would be a pretty different outcome for our firm. If we could have held it for 20 plus years.’

I think that same dynamic has reflected in some of the history of Constellation with how it’s existed privately and what publicly, what so many investors who some of the original investors were and motivations to sell and what those stakes could have been like today versus 10 years ago, whatever they sold.

Paul Yancich:

One other interesting element to riff off Daniel is this transaction costs idea. The other transaction costs. It’s like a foregone learning curve, scaling costs if that makes any sense. So what I mean by that is you buy business, you invest in a business, you don’t really know it. You had spent maybe a few years getting to know the business from afar.

We close in four weeks from LOI to close or faster, depending on the situation, as opposed to 3 months or these big 8-month exclusivity. That people for some reason feel they need it. And so you get in there and maybe after your fourth year, you start to really understand the business and it gets very easy to be able to understand what matters and what’s going wrong. You finally build trust with the management team, you understand the customer’s voice and it’s just getting good, right? Like the rest of the time forward is a cinch to oversee because you have teams that you trust and you understand the business and the game slows down in that market.

So by selling businesses quickly private equity, growth equity, et cetera, you’ve given up all of these gains in efficiency, in oversight leverage that you could otherwise have. So that’s another non-economic I guess not easy to measure the economic cost of short-termism.

Are there a few notable examples that you’ve studied over the years of companies that have been able to have either consistent ownership or they’ve taken this long-term thought or mindset to the extreme?

Paul Yancich:

One that comes to mind is Madison Industries run by a really great CEO named Larry Gies, who we’ve had the good fortune to be able to speak to you a couple of times. They have been around for quite a while and had a strategic shift some years ago towards permanent ownership.

And from what we can tell and from what we know it’s worked out really wonderfully. Everything there is focused on permanent ownership, decentralization autonomy, co-equity incentives, just like we talked about and they are yet another example of how, in particular, in the private context, a huge, hugely successful private company unified shareholders and this long-term vision can work.

And I think that from an outsider, looking in, they’re getting to this Nirvana place where they are becoming the preferred home for the businesses of the sort that they look at. And that also can only be attained when you really hold onto your stuff. And people can talk about how great it is to be with you for long periods of time. That’s an example that comes to mind.

Daniel Eisen:

That’s a pretty good one in the operating model construct I mean, Epic Healthcare, EMR, or EHR, whatever the term is, an amazing business and a team of folks and the ownership group there. But their head down focused on executing, not caught up with trying to gain the market,  go public or raise money or any of that sort of stuff.

It’s just an unbelievable business. They haven’t been able to build just by executing over years and focusing on the thing they’re trying to build for the long-term. I’d love to know that business a little better as I’m sure other people would, but it was the outsider and having been involved in businesses that are competing with epic or around that ecosystem it’s just every time you of run up against them, you got to shake your head and say, gosh, what an amazing job that done in their space.

We’ve alluded to long-term operations and investing throughout this episode. I’d be curious about what a long-term operator of a business looks like over 10, 20, 30 years?

What sorts of decisions are they making? What are they avoiding? What are they not doing? What does that look like?

Daniel Eisen:

A really classic example here always has that question from the oldest of a different perspective of what folks who think about the short-term going to do as a starting point then how we would think about things differently as a long-term owner.

So the really classic example here is around how you treat your customers. And it’s really easy in high-quality mission-critical software businesses to get really aggressive with pricing with our customers because it’s tough to replace it both from a system point of view and a workflow point of view.

So you can buy a good business, do a really big price increase on really aggressive contractual terms with their customers. You effectively forced them into accepting it because they can’t switch and in a sort of reasonable timeframe. And then you combine that with some practices to underinvest in the support team or underinvest new product development to really optimize your margins from the investor point of view, you end up with an amazing showing some top-line growth, you get that big bump from the price increase, and maybe you get optimized for subsequent annual increases margins look great. And holy cow, what an amazing asset. And then you also leverage on that and you can really generate some great outcomes as the investor when you’re going to sell the business.

Three years from now, from the customer perspective, everyone starts to get pretty disgruntled here. So they feel abused and both from a pricing perspective and instances where someone is underinvesting in the product itself, they’re taking this thing. That’s so critical to their business and they’re making it.

They’re not adapting the product to allow the customers to grow. At some point, whether it’s 3 years, 5 years, 7 years, 10 years, those customers are going to leave as hard as software is to take out. It’s not forever and it can make life painful for customers that they’re going to end up leaving.

So if that replacement cycle is 7 years and you own the business for the first three, it’s great. That’s someone else’s problem. If they’re gonna be. Of the business for 10, 20, 30, 50 forever.  It was a pretty different approach there. And as a new investor coming into the business with that long horizon, sure, you might make some adjustments to pricing to reflect the value you’re delivering to customers where there might be a bit of a mismatch, but you’re going to do it a lot more incrementally and collaboratively with customers. And that allows you to establish this trust or in those cases, continue to trust that the previous owner has built with customers that you’re going to keep delivering value with folks over really long periods of time.

That’s what most customers in enterprise software businesses are really looking for. They always need the latest and greatest flashiest thing. They want to make sure that what you’re providing them is continuing to support the business, align with them, to grow and optimize, and that they’re getting value for what they’re paying for.

The other operating dynamic that this can flush out in is folks who come in and are very focused on short-term profitability, whether it’s a manager or an owner worrying about hitting a profit number to satisfy the debt obligation, or it’s a management team that’s in the business, worried about hitting their profit number to get a certain bonus payout.

This one happened in terms of ability to, or willingness to invest in a team. And so you’ve got a business that has been around for 10 or 15 years. It is a great business with a really experienced core of developers there. At some point, those folks are going to leave the business and you’ve got to start backfilling your team to support that transition for whenever it’s going to happen. And the business might otherwise need it at that point of time. But you’ve got to start bringing that next generation, whether it’s younger folks here or elsewhere in the. Going to suffer through those short-term profits. And knowing that at the right time that this is going to be reassessed when you don’t do that.

And you’re just worried about, gosh, you need to make sure EBIT starts 35% for the next three years. I’m not going to do any of that. So you do that. Your team gets older and older. All of a sudden, you’ve got this cliff in 3 years, in 5 years where the experienced folks all leave and you’re sort of left with nothing in a very dramatic fashion.

And then you’ve got to scramble and you end up with a team that has little experience with the product and doesn’t get the benefit of working with the experienced folks to bring me up along the way. That over focus on what next year’s profit number looks like without regard for how the business is going to be better.

And they’re going to evolve in seven years is an example that we’ve seen happen. Ourselves and businesses that we’ve been involved in there, or, around.

Paul Yancich:

Yeah. And to be clear, that can happen in a short-term ownership model or in a permanent ownership model that is short-term focused because they’re too IRR focused or they’re too focused on getting to that next deal pulling them in a crank and just getting the cashflow out. Let’s go set it and forget it and get onto the next one.

On the positive side, and you touched on this a little bit, Daniel, what do you do if you’re focused on the long term? The area that I was going to go to also had people. And it’s exactly what Daniel mentioned. It’s not about age per se, but if you have somebody who’s if you only have a team who’s been in that market and you aren’t bringing in outsider perspectives, newer folks earlier in their careers and new set of energy you will, I think get stagnant and you can start to be in an echo chamber and start to believe that everything to be done in the world has been done. There’s no more progress to be made.

And other reasons why I was so focused on growth is growth fixes that in so many ways, in that you’re growing, you have new opportunities for people. So you get to see which people are constantly stretching themselves and reaching for development. And that is a signal around who you should be weeding out over time and who you should be pouring more into, and also you just need to hire more people for growing. And so you get these new injections of thinking energy, ambition, prior experiences into the business. And you may not be focused on that in a profit-driven, short-term context for all the reasons Daniel mentioned. The other area that I think this shakes out is if your goal is selling the business in three years, whether you’re low growth or you’re super high growth, you start to build the business based on what you think buyers will want to see.

And that’s the job of a growth equity or private equity investor: it’s to sell the company. It’s not to build the company. Selling is the Lodestar. That goal and all the other goals underneath those are micro-goals or subservient to selling. And who do you sell to typically you sell to some other buyer, not the customers that doesn’t happen and product decisions pricing strategy how the company is organized.

Is it really a tight consolidated, one big legal entity? Or do you have this messy, but oftentimes more effective string of pearls that are operating in Federation. All of these really important strategic long-range decisions are influenced by the gravity of your exit universe.

And when you don’t have that on the horizon and you’re focused on the business being way better in 15 years, as opposed to just extracting the cash in the first couple we think you ended up. Wonderful businesses like at LaSeon where those guys weren’t worried about who they’re selling the business to, or how to make it as attractive as possible for the public markets or selling it to some big strategy.

And they were focused only on making it as wonderful of a company as possible for the end-users. And I’m sure that over time they built some discipline about also how to make it as good of a company as it could be irrespective of where in addition to making it a great user-focused kind of product-led.

So, If you’re looking at these companies as an investor, trying to pick your next investment, what are some signs that you can look for in these companies that identify with that long-term horizon? Is it respecting customers investing in people, pricing, are those the things you look for, or are there a few other things also that are helpful and gauging whether this company already has some of that long-term culture in place?

Daniel Eisen:

A big one is certainly the team and what the team looks like. What’s turnover been like in the team over time. And it’s seeing folks that are churning through senior execs every couple of years versus having an experienced group of people growing with the business over time.

That’s certainly a signal that we look for.

That can’t be the only one though. And what you’d really like to see is an experienced group of folks that have grown with the business, also a willingness to have brought in some younger people over time. And everyone in the business can be a 20-year veteran because that leaves a little bit too much or too much towards the status quo and not the willingness to invest for the future.

So that’s certainly a pretty material one from a transaction point of view, Paul mentioned this before, but willingness of folks to maintain a material equity stake in the business, especially when it’s a growing business, that’s an important signal that we would look for that folks are thinking about the future of the business.

And one of the really high-value signals that is pretty uncommon. But when you see it, you get pretty excited about it as folks that have taken a disciplined approach to investing in something new in the product or in the business. So they’re building a new module. They’re gonna expand into adjacency, but they’ve thought about it as a growth opportunity And they’re thinking about that as gosh, I’m going to spend X dollars, and here’s what the market is. I’m going to think about that part of the business differently than my core business. That’s an amazing second of seeing you don’t see that very often, but when you do and certainly get to get excited about it.

What college class would you teach? If it could be about any subject you wanted?

Daniel Eisen:

I like to answer this question not from a college perspective, more from a high school perspective. And for me, it would be a personal finance class. I know that’s probably a common answer that folks may give, but this idea of giving young people grounding in how to manage cash flow, and what investing is, just the whole world of what it means to manage your own money and your personal financial situation.

It’s just really underinvested from an education standpoint. And most of the folks that I know that have competency there have developed it because they are in the finance industry and all these folks who are not it seems like black art, whichever really shouldn’t be.

Sounds good. What strongly held belief have you changed your mind on a strongly held belief that you can be a great investor in the private markets without ever having stepped foot into an operations context. So coming out of Sydney. I had no operating experience at all outside of a deck cleaning business that I had in college.

Paul Yancich:

I strongly held the belief that you can be a great investor in the private markets without ever having stepped foot into an operations context. So coming out of CitiGroup, I had no operating experience at all outside of a deck cleaning business that I had in college.

It doesn’t really count as a few buddies than me. And I really never thought that was going to hold me back from being a great private markets investor as long as you can write well, and you have hotly followed Twitter handle, then isn’t that the goal and isn’t are those the steps to success I’m saying obviously facetiously, but like it’s this idea that you can just be the best analyst and the best prognosticator ever, and you don’t have to be the man in the arena at all.

Constellation for sure changed forcibly in a sense, changed my view on this. Seeing what you can do as an investor in terms of quickly sizing up a business, knowing what’s possible, increasing your confidence levels in what is possible, and how fast it can be done. What are all the implications financially in terms of the return for the business, was just amazing.

And the only way you can get that is by stepping out of the ivory tower and getting out of your Excel models and off your banker calls. If you’re at a PE firm and having Deloitte do all of your DD for you, and instead actually getting into a business, getting screamed at by customers, having people come to you with personal problems, seeing a screwed up support ticket, failed implementations.

And these are all things that  I was lucky enough to go through and Daniel as well. Literally data breach and getting customers come off the edge after crappy implementations, but also being there for the positive side and seeing what it really means to have a happy customer successful implementation.

And we don’t consider ourselves the best operators in the world, but there is a lot of learning that can be done in a short period of time in the operating world. And if you think about it, like you’re taking the shrink wrap off of the academic learnings that anyone can pair it back.

If you hear them enough times, I think that’s the right framework to grasp onto. So that’s something that I know Daniel and I both believe fundamentally. And we’ve already alerted all of our head office investment folks who are all high-quality winners with unique backgrounds and lots of ambition that they will have to go step into a business.

And so every investment we look at, we say, would you want to go run it? And if the CEO retires and we can’t find somebody else, are you prepared to go run this business for six months to three years? We want to instill that in our culture.

Daniel Eisen:

Yep. Think this is something that Arcadea is the best equipped at, in the part of the market that we’re targeting for businesses to partner with is the experience that Paul and I have. There’s really not many other folks, if any, who have that breadth of experience when it comes to operating in the vertical market.

And combining that with this lens of long-term ownership you’ve got to help create value in businesses. And we get that question occasionally from folks we’re talking to. It’s I can get capital from any work and sell my business anywhere. I want to be able to enhance the business and grow it and make it better.

And how are you going to be value add as investors and you can’t do that as having been a professional investor your whole life? You gotta be able to contribute to that value creation

plan from both a strategic and tactical perspective. And that’s something that we can certainly bring to businesses.

And we look forward, as Paul mentioned, to getting the folks that work with us in Arcadea today that same level of experience.

Absolutely. What’s the best business you’ve ever seen?

Daniel Eisen:

Yeah, we’re going to be a little bit cheesier at this answer, but it’s certainly Constellation and we have the benefit of seeing it up close as an aggregate. And just a remarkable business. The fact that it’s so decentralized and there’s no reason that you couldn’t see a bunch of folks leave the business and without any real change to the trajectory or performance of the business, that’s like an amazing construct for a business at that scale and success.

Paul mentioned a couple of these things earlier, being able to maintain discipline around that operating philosophy, despite the business scaling remarkably over decades this concept of understanding incentives and how it influences behavior and being very cognizant of that, not being flighty or, too ad hoc with how folks are rewarded.

It seems easy. It’s super hard to do and not reduce any business that is able to do it better. And obviously, the compound was sort of just the raw performance. Most folks outside of the software world. And even within the software world if you’re not thinking about folks who are acquirers have never heard of Constellation and despite this, like unbelievable success, there’s very few businesses that can boast of this level of performance over this longer period of time. There’s a lot to admire there and I certainly haven’t seen a business as good as Constellation in my career.

Paul Yancich:

There’s just zero dependencies throughout the business which Daniel already talked on, talked about, but it’s worth reiterating. They’ve done it. They’ve done without any balance sheet fragility.

So they’ll basically not leverage some debentures, but it’s nothing. And with consistency and super high capital efficiency, it is hard to think of many better businesses out there. And it’s amazing business. I don’t think that necessarily means it’s the best home for every business that’s a software business. And I think they’d say that, and we’re not the best home for every business either. But just from an academic perspective, there’s not many other things like it. I think we’d put Danaher up there as well as one of the best. And we’re lucky to have the founders as one of our backers and somebody who we can call on and we speak with frequently for advice and did it a little bit a different way. There aren’t many others up there in that level, that’s for sure.

Absolutely. Absolutely. Thank you, Paul and Daniel, so much for sharing some time today. Love hearing about what you’re working on with Arcadea and your time at Constellation and looking at long-term businesses really a lot of debt. So thank you so much for sharing. This has been fun.

Daniel Eisen:

Our pleasure. And thanks for showing interest in what we’re doing and we’re in this for the long run. I think we’re probably all around the same age, too. Probably a little younger than at least me, but looking forward to being able to talk five years, 10 years, 20 years about how we’ve been able to build our business.

Yeah, I’m looking forward to it. 

Paul Yancich:

Thanks a lot, Alex.

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