Simeon Wallis of ValorBridge Partners

ValorBridge Partners, a private holding company founded in 2004, owns, operates or is an active investor in several private companies; it is also a passive investor in a select few private companies as well as opportunistically invests in publicly traded securities. Atlanta, GA-based ApolloMD is ValorBridge’s original portfolio company. ApolloMD is a multispecialty physician services company that provides emergency medicine, hospitalist, anesthesia and radiology services to hospitals, health centers and surgery centers across the United States. It is one of the most successful firms in the physician services outsourcing industry, as evidenced by its history of strong organic growth.

Simeon Wallis currently serves as Investment Director at ValorBridge Partners. At ValorBridge, he is responsible for our research process, investment origination and due diligence. He is also a member of the portfolio management team and serves as a board member for several of ValorBridge’s companies. Prior to ValorBridge, Simeon advised value-oriented hedge funds and asset managers with security analysis. He helped manage Lateef Investment Management’s multi- billion dollar concentrated portfolio in San Francisco and was an analyst with Cramer Rosenthal McGlynn, Evercore Asset Management, and Gabelli & Co. in New York. Simeon has been a guest lecturer at the Columbia Business School in its Value Investing program.

He earned his MBA from The Wharton School of the University of Pennsylvania with a concentration in Finance and his undergraduate degree in History, from Duke University, cum laude.

Graham & Doddsville (G&D): Thank you for joining us Simeon. We really appreciate your time. Could you tell us about your background and how you ended up at ValorBridge?

Simeon Wallis (SW): I grew up in Manhattan. My father had worked on Wall Street but had left by the time I was born. I always grew up with him investing on the side. We had a family business, which was a small chain of retail apparel stores, which, in retrospect, was not a good business. I learned that entrepreneurship is filled with highs and lows, and our family finances reflected that. My father’s investing was a huge benefit — that always stuck with me. Growing up I had exposure to investing with friends whose parents were on Wall Street. I was one of those kids at 10 years old who enjoyed stock- picking contests. The first time I started paying close attention to the market was at 13 years old when I received shares in Disney as a gift and followed Disney for the next decade. I went to Duke for undergrad and majored in history. Duke is a liberal arts school, with no undergraduate business school, but it had what was essentially a minor, called a certificate in Markets & Management, that provided exposure to the business world and investing.

During my semester studying abroad in Australia, I walked into a bookstore and came across a book, which would shape my world view. That book was Den of Thieves by James B. Stewart, a Wall Street Journal reporter at the time. Den of Thieves recounted the great insider trading scandals of the 1980s, and in doing so, detailed the history of activism, the corporate raiders, the use of the highly leveraged finance, Drexel Burnham Lambert, and Michael Milken. That really resonated with me. I believe part of the fascination was growing up in New York with those familiar names, but also the idea of mixing business and history, and understanding how things came to be within the business world. Afterwards, I immersed myself in different aspects of business history. Within my Markets & Management program, my thesis analyzed the leveraged buyout phenomenon through the early 1990s, using KKR’s bid for RJR Nabisco as the lens; there was an outstanding book, Barbarians at the Gate, by Bryan Borroughs and John Helyar. My paper evaluated the market for corporate control, basically activism in today’s vernacular. I was intrigued with how business and history intersected, and how history could translate into future investments. I learned that the context behind events deeply matters. Coming out of Duke, I worked in management consulting for nearly three years in Atlanta. I then returned to New York to work on private-market investments in earlier-stage technology with a venture fund, named Dawntreader. It provided a very different experience in terms of analyzing smaller companies, where managing cash flow was critical and management had a “make or break” impact. However, I realized that I was not exclusively a venture investor at heart and chose to pursue my MBA at Wharton before returning to the public side of investing.

After business school, I worked for Mario Gabelli ’67 covering autos, trucks, heavy equipment manufacturers, and the whole value chain. The value chain encompassed the parts suppliers, the global original equipment manufacturers, aftermarket parts distributors, and auto retailers. Autos and trucks were one of the first industries that Mario followed. I was literally 40 years behind him, and essentially, was challenged to win any arguments about the subject with him. From there, I joined Evercore Asset Management, which was a start-up launched by four ex- Sanford Bernstein buy-side investors, who had received funding from Evercore Partners to build an institutional investment management business. It was a very intellectually and analytically intense place in a great way. It was very thorough research. If we were three years earlier or three years later, it would have been a tremendous success, but when we launched the small- cap value and small- and mid- cap value long-only products in early 2006, the business timing was completely wrong. Because the timing was poor, the business never really got the legs underneath it, and eventually it was folded. It remains a lesson that randomness and luck, such as timing, can play a huge role not just in investing, but in careers. After Evercore, I moved to Cramer Rosenthal McGlynn, which is a more established value manager. There were about 20 analysts, and it was roughly $10B in assets under management when I joined. CRM was mostly long-only with a small long-short product at the time, and looked for businesses that were undergoing change. That change would be difficult to model, or may not have been appreciated in sell-side models, so these were neglected ideas. Often these were value opportunities, names that maybe didn’t screen well, but occasionally an analyst could find interesting angles to gather insights.

After a few years at Cramer Rosenthal McGlynn, I received an opportunity to work with a friend at a 40-year old firm in the Bay Area. This was a concentrated fund, 15 to 20 names. There were three investment professionals. I was the fourth, and assets under management were about $3B at the time and rose to $4B. It wasn’t a good cultural fit. My wife and I moved back to New York, where I worked on projects for several small cap managers — Wynnefield Capital, Candace King and Amelia Weir at Paradigm Capital Management, and Ken Shubin Stein at Spencer Capital — before connecting with ValorBridge, which was based in Atlanta. I joined in May 2013 and I worked remotely in New York for several years before relocating to Atlanta last summer. ValorBridge is a private holding company. It was started by accomplished entrepreneurs and operators who built successful private healthcare businesses. The operating companies generate excess cash that we use to make either investments in private healthcare companies where we feel we have some competitive advantage from our understanding of specific customers and pockets of opportunity, or we make long- term investments that would diversify away from healthcare into businesses with comfortable risk-reward profiles. We also invest in publicly traded companies, depending upon our projected return profile. We can move our capital back and forth between public and private markets because it’s all internal capital. We’re not a general partner to any outside investors, and there are only two situations where we are a limited partner in another fund. Over time, my role has evolved from being pure public markets within ValorBridge to straddling both, and when need be, stepping into an operating role. We believe our differentiation is wearing several hats — operators, public equity investors, private market investors — where we take our knowledge in the private companies and apply it to public companies and vice versa.

G&D: That’s a great overview. Could you talk more about the academic work you did regarding activism and the implications of that today?

SW: A professor named Michael Jensen coined the term “the market of corporate control,” which is an academic way of saying the actions of corporate raiders and activists. He believed in the efficient markets perspective that all assets are properly valued in free markets, including corporate assets. My perspective was different in that I believed there were times when the market for corporate control and activism were beneficial to most stakeholders involved; however, in the 1980s, there were points when I believed it was detrimental. An example when it was detrimental was when corporate raiders used greenmail. Carl Icahn was known as one of the leading protagonists; greenmail was when a raider would buy a stake in a company, threaten a hostile take-over, and management would lever the company up in order to pay the greenmailer off to go away, all at a premium to other stockholders. What the remaining stockholders were left with was a highly levered business that had not been improved with all of the debt issued. It’s the worst of all worlds. In good situations — and there were many — an outside investor would come in and say, “You’re essentially in four different businesses. There’s very little synergy between any of them.” It’s a reflection of the conglomeration movement of the 1960s and into the 1970s. The company and its stakeholders were generally better off spinning off the assets or putting the assets into the hands of those who would value it more highly via divestitures, and use the cash to find one or two businesses to grow.

In situations when activists came in with a mindset focused on capital allocation and long- term value creation, it was incredibly beneficial. In breaking up companies, the assets went to owners that either understood those businesses better, or you’re able to take capital and give it to those who can grow their businesses in healthy ways. I don’t believe one could definitely say that activism on the whole was good or bad. There were benefits and trade- offs. I would argue that the good instances greatly benefitted the U.S. economy over the long term.

G&D: Interestingly, there’s an adjunct professor at Columbia, Jeff Gramm ’03, who wrote a book about a lot of these same issues.

SW: Was that Dear Chairman?

G&D: Exactly, Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism. Could you walk us through the big lessons you learned throughout your career and how you apply those to public and private markets today?

SW: Mario had a pool of fifteen to twenty analysts who would sit around a table every morning and he would Socratically ask us about our coverage universe. I followed the automotive value chain, the heavy-truck manufacturers, such as PACCAR and Navistar. I also covered heavy- equipment manufacturers, such as Caterpillar, as well as agricultural equipment companies, such as John Deere. What unites that coverage universe was they shared common parts manufacturers. They had a common supply chain but different distribution. What I learned was there were a variety of business models within a specific industry. The business models had different margin profiles, different capital intensities, different growth opportunities, and therefore they needed to be valued differently. I started to think more horizontally about the nuances of understanding a different business model as opposed to the conventional wisdom of categorizing companies by industries. Mario’s known for his acronym “PMV,” private market value, which is a sum of the parts of a business based upon what an intelligent buyer would pay to acquire that business. In addition to thinking about the balance sheet, we looked for hidden assets or off-balance sheet liabilities, and put that all together to understand the real value to the owner. To think about businesses that way was very valuable because having a differentiated perspective is one of the few ways to outperform peers and the market over time.

For example, John Deere had manufacturing operations and a finance business, Deere Finance, which provided dealers and end customers financing. Screening on Bloomberg or CapIQ, Deere would show significant debt and appear levered; however, diving into the SEC filings, an analyst would realize those are two separate businesses. The finance arm could be valued as a finance company, such as at book value or determine what an intelligent buyer would pay for that portfolio of assets. Then one would evaluate the capital structure of the manufacturing business. Often there would be net cash as opposed to net debt, and an analyst could decide what is the right multiple to pay on its mid-cycle operating earnings or EBITDA. So by valuing one part of Deere on book value and another on operating earnings plus the net cash, an investor could derive a valuation materially different relative to where the market was valuing it, especially if the market looked at it on a P/E ratio basis. Deconstructing businesses and valuing them with the appropriate methods based upon the attributes of the underlying business models proved tremendously valuable.

The other big lesson from Mario was understanding the unit economics of the business. Let’s say we were looking at one of the Big Three auto manufacturers. We’d compare the fully loaded labor costs or healthcare benefits to retirees per car that the consumer is paying for, yet not receiving any value from. That’s a competitive disadvantage relative to another company that spends that same amount on what drives future value for the company, such as R&D. At Gabelli, we invested time analyzing on a per-unit basis of value creation or, alternatively, we would determine what an acquirer would pay for that unit of value. Mario found industries that were consolidating and determined how an acquirer would define value. For instance, in the cable industry, he’d ask, “What’s the enterprise value per subscriber that’s in the subscriber network, and where should it be?” He found huge disparities between the current market value of a subscriber and the takeover value on a per- subscriber basis. If there was a large spread, that was really appealing. This EV and transaction value per subscriber could be used to value any subscription business model.

G&D: Can you provide some comments from your experience at Evercore?

SW: At Evercore, I worked for Andrew Moloff, a portfolio manager who, better than anyone I’ve known, persistently questioned his analysts to help them understand what the key drivers to an investment were. He was a teacher. Andrew’s approach was comparable to what I would eventually learn in studying Lean management as the “5 Why’s” by going through ideas with the analysts through repeated questions to understand what the investment controversy was, often better than management understood it. The methodology was very similar to Rich Pzena or Andrew Wellington at Lyrical where the analysis is driving toward deriving normalized earnings in five years based upon the capital structure and margin profile of the business. The objective is to understand whether the reason the stock price is currently depressed is based upon a temporary factor or a structural change that would be difficult to fix. It was a great lesson in understanding the questions “What’s the right valuation?” And “What are the right earnings to assume in a normalization process?”

G&D: Your team can invest in the public market, in private market investments, and reinvest funds back into the underlying business itself. How do you decide where to allocate capital?

SW: We do a back of the envelope IRR calculation, thinking five years out. On the public side, our holding period might be three to five years. It might be on the early side of that five-year IRR. Price will be a component of the process. With the private investments, we actually expect to hold longer than five years; there’s more opportunity to influence the outcome because we’re going to have more control.

Additionally, we can invest anywhere in the capital structure. We can provide capital as debt, mezzanine securities, or common equity. We have a lot more flexibility in our ability to mitigate risk on the private side. The tradeoff is, of course, that it’s not liquid. If we’re in the public markets and we realize we made a mistake, you can just sell. However, on the private side, we have to invest significant time to exert influence and affect change.

For private investments, we concentrate on the compounding of intrinsic value through owner earnings growth. It’s more of a growth perspective and operating perspective, whereas on the public side, we are more of a price-sensitive investor, where we’re looking to double our money over three years. A bigger driver of that in our public investments is the normalization of the earnings multiple, as opposed to growth of earnings or cash flow. There are two levers to returns — the earnings or free cash flow and the multiple. On the private side we focus on growing cash flows. On the public side, we tend to focus on situations where we expect that the multiple will rise to some level where it historically had been as earnings will probably revert back to a normal level.

G&D: Are there times when you’re comparing the public and private opportunities side- by-side? Is there a certain amount of capital that you want to allocate to each part of the market?

SW: We ask ourselves, “What’s our opportunity cost? What’s the risk-reward from being in the public markets versus private markets? What is our IRR in the public markets and the private markets?” One of the advantages of being in the private markets is by definition they’re less efficient. They’ve become far more efficient because now 100 private equity firms will look at the same deal, but proprietary deals still come through relationships. In the public markets, there’s nothing proprietary. Today it is harder to find compelling opportunities for us given valuations. Whereas on the private side, we can find one- off opportunities that might be more compelling. For example, there could be times when our own portfolio companies can make a tuck-in acquisition and pay 3x trailing twelve month pretax earnings, adjusted for amortization. It’s hard to beat that. That’s inherently (with no growth) a 33% pretax return. Then add growth or cost reductions from synergies, and return on capital can rise to 80% or 100% quickly. It’s difficult to find those opportunities in the public markets, but if we were in 2009–10, and we were to see great valuations combined with ample liquidity, then that’s incredibly appealing. In the private markets, there’s a deal process. Deals can take two or three months, at a minimum. They can take six to nine months with the due diligence and negotiations. It’s slower than public market investing, and valuations can still move during the process. We look at IRR based upon our opportunity set.

G&D: What does a typical private market investment look like for ValorBridge?

SW: On the private side, I’ll break it into healthcare and non-healthcare. The two founders of ValorBridge, Chris and Beau Durham, have a background in healthcare. Both have law degrees and Beau also has an MBA, but they both ended up going into healthcare over time. Within healthcare, we are far more comfortable finding earlier-stage companies that are attacking a market niche where we see a big opportunity based upon our knowledge of the healthcare industry. We can leverage our existing relationships, such as our relationships with hospital systems, to accelerate the growth of these smaller companies. In the last year, we purchased a hospital out of bankruptcy, where we were already a service provider in that facility. We own a web- based scheduling company for emergency rooms that functions similarly to OpenTable with a comparable value proposition. A patient gets hurt, knows that s/he should go to the ER, goes onto the local hospital’s website and schedules a time to go into the ER (assuming the injury isn’t life or death), and can go home to rest on his/her couch in front of the TV as opposed to sitting in the emergency room for 4–5 hours. We own the majority of a tele-health or mobile health company. We can leverage a network of doctors with whom we already have relationships. Due to these capabilities, we’re willing to invest in earlier stage healthcare companies. For our non-healthcare investments, these are in more established businesses that should grow free cash flow at nice levels for owners based upon our research that the management team is far superior to its competitors’. We directly own stakes in an industrial distribution and service company for gas stations and fuel depots. We own a sizeable stake in a company that buys distressed consumer credit portfolios from issuing banks that are in charge-offs, where we can purchase them for pennies on the dollar and manage the collections process. I consider this an investing business at its core. We own passive stakes in other companies, such as an industrial gas distribution company and the largest manufacturer of wine bottle closures in the world. In our established company investments, we focus on EBIT somewhere between $1 million and $10 million. We target companies with well-laid out growth opportunity, where there’s nice organic growth and potential for tuck- in acquisitions. We seek businesses run by highly skilled owner-operators within their niche and who think about the world in a similar way to us. We’re less willing to go with a startup or a very young team in that type of situation.

G&D: At what point do you begin considering exit opportunities? How do these factor into the IRR consideration?

SW: Our perspective going into an investment is that we wouldn’t invest in any business that we wouldn’t be comfortable holding for a very long term, at the very least, longer than the typical private equity fund’s investment cycle. We won’t buy with a perspective of when or if to exit. That said, we’re all rational capitalists. We’re approached all the time about acquisitions of a portfolio company, and if we receive an offer that is extraordinarily compelling, we have no problem consummating that transaction. But the bar is high. Very rarely do you find buyers who are willing to pay up for five years’ worth of free cash flow growth and place a fair multiple on something five years from now.

G&D: How much leverage does ValorBridge employ?

SW: I believe private equity investors understand this aspect well while a far smaller percentage of companies in the public markets truly appreciate this. Leverage should reflect the cyclicality of the business’ cash flows looking full cycle, especially at the trough, not just the most recent few years’ or trailing twelve months’ EBITDA. Leverage magnifies returns — good and bad — to the equity holder. The more stable the business, the more leverage it can carry. Therefore, in sustainable growth businesses, profitable growth accrues more and more to the shareholder. Look at John Malone and look at the team at TransDigm. What they understand is that if an investor considers how enterprise value compounds over time, with the appropriate leverage structure, equity compounds even faster over time to the owner, assuming returns greater than the cost of capital. Liberty and Transdigm can run at higher levels of leverage because in cable and in aftermarket aerospace, the revenue growth doesn’t have to be fast. Modest organic revenue growth, combined with operating leverage works to have an extraordinary impact on the per-share growth of equity. At the same time, in more cyclical businesses, it’s pretty foolish to employ even a moderate amount of leverage. These cyclical businesses are often asset-intensive and have greater operating leverage. What’s helpful to me is to understand the reason for the leverage — is it to fund operations of a capital- intensive business or is it to create a more efficient capital structure for the equity holder? Not appreciating this is how an investor ends up in trouble. We realized that with our businesses, with the more cyclical ones, we will be overcapitalized with equity at points in time. Given our inability to accurately predict changes in demand, we’re comfortable with the overcapitalization because it’s our capital that’s on the line. There are other businesses where we can run at 3.5x EBITDA and feel pretty comfortable with the growth in that business, knowing the pipeline and competitive positioning. It’s dependent on taking a long-term view of the variability of unlevered free cash flow.

G&D: When you decide to invest in a business but have a variety of options of where to invest in the capital structure, how does your team make that decision?

SW: Mezzanine financing has been the initial way we’ve established a relationship to help us understand whether we like management and to determine their ability to run a business. Often we can provide mezzanine capital at terms below what the company could receive from a traditional mezzanine lender. We might charge 200 or 300 basis points below market; but to establish that relationship, it’s still a good coupon for us. We’re collateralized well. In the capital structure we’re above the CEO and the founders who own common equity so that helps us to get insight into how they run the business. Later, we would have additional discussions about keeping the mezzanine piece, but also investing in the equity to help facilitate growth, or do a swap. It’s the “crawl, walk, run” perspective of establishing a relationship. If we do like each other, then we’re happy to help them grow by providing additional forms of capital, whether that’s preferred or common equity.

G&D: How often, when you are providing mezzanine financing and testing the waters, do you determine that you don’t want to invest the equity?

SW: Very rarely. It might have happened once in the four years that I’ve been here. It reflects the due diligence process that we do with management before making the mezzanine investment. We won’t go into a situation to provide mezzanine financing where we don’t like the management team. There are one or two situations where we’ve done both mezzanine and equity at the same time, and the mezzanine ends up protecting the equity if things go sideways for some period. We protect the equity slice with the mezzanine because there are going to be convertible features for capturing equity if there is a restructuring.

G&D: How do you and your team properly incent the operators?

SW: Our best situations have been when management has not taken very much capital — in the form of equity — off the table. Reducing equity stakes is usually a yellow flag, if not a red flag, for us. More often than not, management had a different shareholder that wanted to exit, and management wanted to stay engaged in the business. They’re just looking for a different partner. We can install incentives that focus them on profitably growing the business over time so that the owners will see very good rates of return on their capital. We don’t want to come in and buy 80% of a company and have management take too much skin out of the game. It speaks to one of the mental models that we use in both private and public markets. I call it the “3 P’s”. We think about price, process, and people. The people part is tied to incentives. The price is tied to the IRR, or if it’s an acquisition or internal capital project, what’s our return on investment. The process part is thinking about the competitive advantage that we see. 3Ps is really IRR/ROIC, competitive advantage, and incentives.

G&D: How much do the private and public investments influence one another in terms of lessons learned or themes?

SW: They influence each other greatly. A mental model we use, which we first employed on the private side, is a deep understanding of the “drivers of value creation for the equity holder” — three of the four are operating drivers and the fourth relates to capital allocation. On the private/operating side there are three drivers of profitable growth — the first is revenue growth, or gross profit dollar growth for certain types of businesses. The second is operating margin expansion and the third is reducing the capital intensity of the business, often reflected in improvements in working capital turns. For the public companies, we add a fourth driver: shareholder yield. Shareholder yield is often revealed in the Financing section on the Statement of Cash Flows. Is money flowing out of the business, and is it paying off debt and reducing the share count? Or is money being brought into the business, increasing debt, and raising share count? It’s traditionally been owner- friendly when you reduce the amount of capital in the business. We also use another mental model that started with how we work with our private companies, but has transferred to evaluating public companies and their management teams. We uncreatively call it “VSD”: Vision-Strategy-Drivers. John Wooden famously used a pyramid to explain his drivers of success. We borrowed that. Vision would be at the top of the pyramid, Strategy would support the vision and the Drivers would be the base, supporting strategy. For our established companies, we want them to have a ten- year, high-level vision that helps employees, key suppliers and customers, as well as the board, have a good sense of where our management team is taking the company. It motivates employees that they are part of a special company. It distinguishes us in our customers’ eyes because we’re seen as more aggressive in addressing their needs than competitors. This leverages the concept of starting with the end in mind. The Strategy answers the question “How are we going to achieve our vision?” Namely, it identifies what are the key operational items the company will need to execute on, what are the key capital and operational investments that will have to be made to support the executing the priorities, how competitors are likely to react and what are the trade-offs that will have to be made, since everything has an opportunity cost. Lastly, the Drivers are the critical activities that management will focus on and that can be measured in order to execute the strategy. As we developed this framework, we saw how it is applicable to evaluating publicly traded companies, especially in conversations with management. If a management team can’t credibly and lucidly describe how they are allocating their key resources toward specific objectives that they want to achieve over the medium to long term, I believe any investment thesis beyond reversion of the earnings multiple is difficult to make. This is particularly true for compounders. The last few years I’ve guest lectured at Columbia in the Value Investing Program in Chris Begg’s section of Security Analysis. I use 3G’s Ambev investment and Heico as case studies — from annual reports, interviews, shareholder letters and articles, one could clearly see where management was taking those companies using the VSD framework. We put more faith in excellent managers than many traditional investors, especially value investors. Management, in our belief, matters more the longer a position is held. In our opinion, the premium the market pays for outstanding management relative to average management is frequently too narrow.

On the public side, we typically buy what we believe is the best management team in an out-of- favor industry. We have deeper conviction that they’re going to make owner-friendly decisions and less likely to impair capital. It’s also a belief that management can make a difference in key situations. That comes from operating companies, allocating capital, and serving on boards overseeing executives. The difference can be dramatic particularly the decisiveness and focus on the critical few decisions and inputs that can have disproportionate impact on profitability and sustainability of the returns on capital.

G&D: How do you evaluate a management team when you’re trying to look at so many different options in the public space? What tools do you use?

SW: I don’t want to visit or speak with management until I’ve thoroughly researched them and the investment controversy. I want to avoid their influence in how I approach thinking about the business. I want them to address my critical questions and I need to spend time to determine what those are beforehand. A great executive can simplify the business and her thought processes in her communications. She remains consistent in how she talks about the business and what she is focused on. She communicates in easy-to- understand terms devoid of company and industry jargon. Decisive in actions, makes difficult decisions quickly and is candid about industry conditions. She is honest and transparent in communications. I determine this by reading ten to fifteen years’ worth of shareholder letters, interviews and conference call transcripts. I ask, “Is the management team focused on the key drivers of the business? Do they understand what their relative competitive advantage is? Its source? Are they focused on the same metrics year after year?” This sense of what to do and why do it is internalized. One lesson I’ve learned in operations is that it’s very difficult to manage and influence employees. Simplifying and creating clarity in terms of where a business is headed and what matters enables organizations to take actions more quickly and to be more responsive to changing dynamics. Great managers understand a business creates value satisfying customers or adapting to the marketplace, not at the headquarters. The frontline people need to understand what management is thinking because they reflect management’s thought process around what matters. Clear communications and incentives are the best way to do that. Great managers understand their relative competitive advantage and focus the business’ resources in that area. A great example is GEICO and Berkshire. Buffett understood that the direct-to- consumer model enabled the company to avoid higher cost distribution than competitors. As a result, he could 1) invest some of the savings in lower prices for customers and 2) increase spending on customer acquisition in the form of advertising that GEICO was a better value proposition for consumers.

If he was thinking short-term, GEICO’s advertising budget would have grown at a far slower pace than it has. But Buffett sees the tie between the competitive advantage and the long-term value of an additional policy holder to GEICO’s intrinsic value. I’m sure many value investors have been fooled when management teams say the right things. After William Thorndike published The Outsiders, value and fundamental investors were telling management teams, “You have to read this book. This is the way to do it.” The management teams listened and spouted out, “Buying back shares. Returns on capital.” I believe that ultimately burned many fundamental value investors because management lacked a true understanding for why the actions of The Outsiders mattered. As Seth Klarman has said, you either get value investing or you don’t. This was the same thing — it wasn’t internalized. An investor who sat down with management probably could have determined this if they applied the “5 Whys” line of questioning to why this approach to capital deployment was correct. After looking over longer periods of communication to assess authenticity, I focus on the proxy filing to evaluate incentives. Performance-based compensation tied to return on invested capital and free- cash flow growth are great. Ignoring the balance sheet or capital base is a red flag. Adjusted EBITDA is a negative for that reason. Adjusted EPS is even worse.

G&D: Can you talk a bit about the types of companies that you’re looking at for the public portfolio?

SW: On the public side, we’re value investors. We focus on buying companies that are at modest valuations relative to either their normalized earnings or normalized free cash flow, three to five years out from now. We’ll place a modest multiple on that profit or free cash flow, credit management for share repurchases if that’s part of the company’s history and determine, given our expectations, whether we could double our money in three years or quadruple it over five years. Since our capital is more permanent, we take a longer time horizon. We tend not to trade around our positions. We focus on industries that don’t have structural change, where demand may be cyclical, yet the product or service that’s offered is a necessity. We seek returns on capital or returns on equity over a cycle that are slightly above average. We’re not trying to outsmart the market, just take advantage of swings in the psychology of others by being more patient. We look through what the investment controversy is in order to determine whether it is temporary or structural. We’re buying companies that we believe have a competitive advantage, are the lowest cost operator, and/or have the best management team in their industry. We look at the margin profile and return on capital within the industry to see who’s at the higher end. We’ll look at the unit economics and productivity metrics, such as revenue per employee or profit per employee to compare quality of operators in an industry. In some situations, all of these will align, where the investment controversy is temporary and we can look past it. We’ll buy the best manager and we are willing to pay a turn or two more on earnings for the better management team, as we believe over the long-term, they’ll out-execute competitors and the profitable earnings growth will be there. The multiple premium may expand.

G&D: It seems like a lot of your analysis regarding management is comparative across companies within a certain industry. Does that require your team to focus on a certain number of industries that you know better than others? Do you tend to compare management across verticals?

SW: We probably haven’t consciously compared management teams across different industries. We focus on business models. For example, it is better to compare the unit economics and performance of the CEO of AutoZone to the CEO of an auto manufacturer or to the CEO of an industrial distributor? I’d argue it is the latter. If we’re looking at a management team that’s in a distribution business, we believe we understand what the right incentives should be. We’ll use that information with our private companies too. We’ll say, “If I understand the business model dynamics in public companies and the two or three things that matter, how can I apply that knowledge to some of the private companies, where I’m not confident that industry management teams are thinking that way?” Once we understand certain industries or business models, these fall into our circle of competence. There are complexities to the business, but the complexities in most situations don’t dictate the outcome; the 80/20 rule usually applies. Once we understand the core pieces of information and levers in the business model, we get comfortable quickly. Then we’re just seeking to understand the idiosyncrasies.

For example, on the public and on the private side, we’ve invested in insurance companies. There are niche aspects of insurance companies, and there are different types of insurers, but at its core, an insurance company has certain traits. It’s about risk transfer. It’s about assessing how well a company has priced and managed risk. Insurance companies are just a pool of capital. A policyholder is giving capital upfront in return for the promise that it will receive a payoff if an event occurs. There are nuances, but at its core an insurance company and financial services firms are not inherently very different. Some of the industrial businesses that we’ve been involved in, or even consumer packaged goods, often take a commodity, process that commodity and sell the output in a brand. Commodity to value-add. A skilled investor needs to understand the operating dynamics of that type of business. Brands are about trust. So it is important to understand how the brand is perceived by its customers and potential users, not what the company says itself. We’re willing to admit that there’s a pretty large “too- hard” pile relative to the time we want to spend. There is an opportunity cost for time and we want it to be high enough so that only ideas that can meet our self-imposed return hurdles can make it through. There are certain businesses where if we can’t get our head around it relatively quickly, it’s just not worth our time. If we give up some of the opportunity set, that’s just a tradeoff in how we do business. We want to try to keep things relatively simple. We pick our spots. We would rather benefit from the fear and greed psychology that is reflected in the multiples that others will pay for quality, well -managed businesses, than to try to get complex situations right.

G&D: How do you size positions and how do you determine the composition of the public portfolio overall?

SW: In our public portfolio, in a steady state, we’d have about fifteen positions, of which the top five would be over 50%. Because we are not constrained by the expectations of volatility or concentration risk, we can be more aggressive in allocating to positions where we think the risk-reward is more compelling or let our winners run a little bit more. One core practice at ValorBridge is to determine where we can align our relative strengths with what we see as institutional weaknesses in different aspects of investing. For example, private and public investors almost never have a fluid flow of information and communications between them. How can we put ourselves in the middle and use the information from the private side with public companies, and vice versa? Institutional investors typically want to see certain items, such as benchmark weightings. We don’t care about that because this is our capital. We want the best IRRs, and we’re willing to hold longer term and look like an ugly stepchild. We try to use what we perceive as disadvantages in the system to our benefit. Where we have a weakness, we just try not to be there. We don’t have 20 analysts, but we can go after companies that the sell-side hasn’t focused on much, or invest in opportunities that U.S. investors may not consider. For example, we owned Norbord, a Canadian-listed company that had a disproportionate share of its operations and profits tied to the housing rebound in the U.S.

G&D: Does this also allow you to be more involved in small-cap companies?

SW: Yes. At the low end, we’ve invested in market caps between $150 million and $300 million. We do want some level of liquidity. Twice we conducted due diligence with the thought of becoming activist; those were sub-$100 million market cap companies and we passed on both. We’ve owned companies with $100B market caps because we felt the concerns were over short-term issues.

G&D: You mentioned activism, which occurs on the private side often. How does your internal team approach that regarding public investments? Do you look for specific activist opportunities?

SW: You mentioned private equity, and there are many cases where public equity investors will say they take a “private equity approach” to investing because they employ a long-term holding period and after significant fundamental research. I believe that perspective is off the mark. Value creation in the private equity business model comes from the willingness to engage at a board level and control two key things. First is having significant influence over capital allocation decisions, and second is having significant influence over the management team, including picking the C- suite and the incentives that are implemented. In the public markets, this only occurs if an investor joins the board for several years.

The firms that I believe have executed this “private equity in the public markets” model effectively are ValueAct in mid- to-large cap companies and in small caps, it’s Wynnefield Capital. Wynnefield, which flies below the radar, has been around for about 25 years with phenomenal returns. Nelson Obus and Max Batzer have done a really tremendous job. To do this effectively, a firm has to devote the resources to be involved three to five years at a board level. That’s the right mindset. We try to determine how we can have an impact on operating improvements, incentives, and capital allocation decisions. At the same time, we have to be willing to accept a lack of liquidity because that’s a trade-off for joining the board. We haven’t found the right situation where we’ve been able to partner with a management team where they wanted to bring in a concentrated investor to help build the business in the public markets. In one situation we considered, it was an industry executive that had followed the target company for years, knew that the existing management was ruining the business, and sought capital to help effectuate change. We came close as the valuation was incredibly compelling if we could change management, but we passed due to our research. We realized that the business was inappropriately levered, and the more work we did on the operations and capital structure, the more we became uncomfortable with existing management’s ability to generate ample cash to service the debt. We didn’t think our new management team would have the time and balance sheet necessary to realize the company’s intrinsic value.

When we look at small caps, we’re looking for good managers who would be good partners, as opposed to an antagonistic situation where we’d become activists. It’s really special situations where we have someone in place that we know would be an ally to help us run the business. Down the road, there might be a real opportunity for us to exert that type of influence. But given current multiples and debt levels, it’s probably not very fruitful now.

G&D: Would you like to talk about some past public market investment ideas?

SW: On the public ideas, one that ended up being very fruitful for us and is representative of our approach was the title insurance company Fidelity National Financial (FNF) in 2013. FNF operates in a relatively consolidated industry. It provides a necessary service unless there are legal changes to eradicate title insurance, which we didn’t see on the horizon. Bill Foley ran the company, and if you look at his track record, it is very similar to John Malone’s at Liberty. Foley has deftly used the public markets to buy and sell assets, timing the markets very well to create significant value for his shareholders. He’s willing to run with some leverage and make very difficult decisions very quickly. He simplified his business. He very much fit the profile of what we were looking for. It was pattern recognition. He’s created, I believe, close to $40B worth of enterprise value from deals and compounded returns for shareholders at very high rates. He built a company called Fidelity National Information Systems which he eventually spun out. He has used a tracking stock for his financial crisis-era investments, FNF Ventures (FNFV), to highlight value and repurchased shares when FNFV traded below intrinsic value. He acquired previously spun-out technology businesses when valuations were depressed, and he’s spinning that out again as Black Knight Financial Systems. That’s one of those structural aspects that we try to take advantage of. Many investors are wedded to how financial models look in spreadsheets. Yet our operating experience has taught us that business is not linear and often value creation doesn’t model well. We bought FNF at 8x to 10x our estimates of normalized earnings, and we received all of Foley’s capital allocation prowess for free. We held FNF for about two-and-a-half years and when we started to sell the publicly traded portfolio, we exited FNF. With the spin-off of FNFV and other maneuvers, FNF was a very good investment for us. Foley represents another aspect that we look for with managers, which is managers from outside of an industry, who can apply what they’ve learned from outside that industry to the new industry. That allows the manager to do things that are different from the conventional wisdom. Foley’s background was in the military. He has a law degree. He eventually bought a title insurer out of bankruptcy, and then proceeded to roll up the industry. It was a very different perspective from the traditional, slow-moving insurance company competitors and the executives who grew up in the industry.

G&D: Any current holdings or ideas?

SW: Currently we don’t have any investments in the public market. One thing that’s been on our radar is another insurance company, Assurant (AIZ). Assurant has been a quirky, niche insurer that has consistently evolved the products and services that it’s insuring. Occasionally it becomes very cheap when investors believe that a line of business AIZ is in is about to fall off a cliff. Management has been very good capital allocators, knowing to repurchase shares when investors price in Armageddon and to increase the dividend when investors are not concerned. Over the last decade, AIZ had been an aggressive cannibal of its own shares, as share count has declined greatly when AIZ traded below book value.

About two years ago, the chief of strategy, Alan Colberg, was promoted to CEO. Colberg came from outside the industry. He was an ex-Bain partner who possessed a materially different perspective for growth, and quickly made difficult decisions to exit legacy businesses that were structurally challenged; Assurant received good value in exiting them. An investor could follow Colberg’s playbook, which was taken out of one of Bain’s published books, Profit from the Core. He focused on providing additional services to existing customers in highly profitable niches, where he could make tuck-in acquisitions and use capital to grow in a relatively low-risk way. When we normalized for the different segments of the business, the upside when we were looking at it, about 18 months ago, was a double. The stock price was around $65, and we thought it could be worth upwards of $125 to $130, looking out several years. The process is still going on. Assurant is about $95 a share now, and we believe that there’s still upside. We haven’t allocated much into the public markets recently because we’ve had some private opportunities that are more compelling.

G&D: Is that more a consideration of how good the private deals are, or are you just not seeing adequate returns in the public markets?

SW: It’s the latter. Generally, we haven’t seen compelling valuations. As I mentioned, in the last year we purchased a hospital we knew out of bankruptcy. Several portfolio companies had reinvestment opportunities at rates well above what we could receive in the public markets. In the public markets, we’re looking to double our money every three years. We generally don’t like when there’s a very levered balance sheet. What’s been cheap the last few years is where there’s been some balance sheet concern in addition to being in a commodity business. That’s not the right risk for us. On the private side, valuations are not great either, but occasionally we find ideas from proprietary deal flow or provide capital to our operating companies for tuck- in acquisitions at 3x pretax profit. As I mentioned before, that’s hard to beat.

G&D: That definitely sounds compelling. Do you have any advice for students?

SW: For students who want to get into this business, the business is changing significantly on the public side. I see parallels between what’s occurring with the traditional retailers and the threats posed to asset managers and hedge funds. Competition is emerging from low-cost sources and technology; for retailers, the threats are the Costcos, Dollar Trees and Aldis of the world, and for investment firms, low- cost passive vehicles such as ETFs and index funds. It’s also coming through technology- driven interaction with the end user, whether it’s Amazon and the Internet-based direct-to- consumer business models in retail, or quants, factor-based investing, and robo-advisors with computer-driven investing models for the traditional investment firms. These competitive threats may result in fewer analyst opportunities; anyone who wants to join our industry needs to be 100% committed to it, and eat, sleep, drink, and breathe investing, and understand their own personal points of differentiation for a potential employer. Our industry attracts a concentration of type-A driven people because of the financial rewards it traditionally offered. The past may not reflect the future, so someone considering an analyst role has to be comfortable that salaries may decline. I believe it’s just being cognizant that there has to be a true love for investing.

A second piece of critical advice I have is the importance of removing one’s ego. Ego is the driving force behind most intelligent people’s mistakes. To quote Ryan Holiday, “Ego is the enemy.” It’s a desire not to look wrong in front of peers. It’s uncommon that the simple question that’s in the back of others’ minds is asked publicly. Nobody wants to look like they didn’t get an investment absolutely right. The more that a person can take ego out of the decision-making, I believe the further a person will go in this business. Understanding as early as possible what the most important question to ask that identifies the critical few data points or research topics that your superior — PM or senior analyst — focuses on will go a long way. Invariably, your boss, and to whom he or she reports, are your customers and if you make your customers happy, you’ll be successful. The better you can make them look, the better you’ll look. The mistakes that I’ve made have been not focusing my attention around getting the right information quickly so that I could have a deeper and more productive conversation.

G&D: Do you have any thoughts on what the industry looks like when the shift from active to passive settles down a bit?

SW: I still don’t know whether this is secular or cyclical and I believe we’ll learn this when stock prices decline 30% or 50%. Traditional active managers need to demonstrate their value through significant outperformance to justify their fees over the full cycle. If they can outperform in that environment, it will benefit the industry. If there’s not that significant gap between what an index and what active management is able to generate during a downturn, then fee pressures will continue. The cost structures of twenty or more analysts, a full sales team, and all the compliance is just not realistic unless the firm has hundreds of billions in AUM. I envision the industry ending up with more boutique managers that have between three and seven investment professionals, including PMs, who may have a little bit more compensation at risk. They’ll carry lower overhead and be able to compete more on fees. For investment management firms the incremental dollar that comes in really flows to the bottom line. There’s significant operating leverage. Assets have been trending down for active managers. Cost structures have to decline to mitigate the impact and labor is a large percentage of the cost base.

I don’t know how valuable the tenth or twentieth analyst on the team, who covers a tiny slice of the market, really is, especially when much of the initial financial analysis can be done better with computer analytics. The value over time will come from the qualitative insights that drive performance. For example, the ability to ask specific questions of management teams, of industry consultants, of expert networks, that will have a lot more value going forward than the financial model. Active managers need to focus on the opportunities that won’t score well on factor models but where there’s a high probability of market-beating returns.

G&D: You mentioned cultural mismatch earlier. Any thoughts on that subject for students?

SW: Culture is the most important thing to understand about a company, and to understand about one’s self. Everyone should understand his or her strengths and weaknesses, and seek environments that allow strengths to thrive. There’s a self-awareness component, and perhaps I didn’t have enough self-awareness earlier in my career. Every organization is political and understanding the politics of people and personalities is critical. Coming back to the difficult situation that I placed myself in, the nature of that organization was that there were strong egos. I tried to overcome other people’s egos by arguing my perspective with objective, quantitative data; that wasn’t how arguments were won in that organization. I should have done a better job of finding former employees who had worked there to get a better sense of how decisions were made, and the relationship between senior management and others in the organization. There wasn’t an investment style difference, but there was a research difference, whereas at Evercore, I believed there was an emphasis placed on very deep-dive research, which tended to be very quantitative and analytical. Why is this number volatile? Why is that changing? Let’s go back four annual reports, make all the adjustments, normalize it, and understand what was going on in the spreadsheet, and let that analysis drive qualitative questions. The San Francisco situation was a very small team. There’s a dichotomy in how organizations will handle differences of opinion — some say, “Culturally, we want to have a diversity of thought and opinion. While others will take the other side. “We want to make sure everybody is exactly on the same page when thinking about this.” I misread the situation. I thought it was the former, and it was more the latter. My strengths did not align with what they wanted for how their team was constructed. It comes down to culture and how much research you can do on your own strengths and weaknesses that tie into that culture. If there’s not a good fit, even if it’s a great opportunity, it’s probably not the right opportunity.

G&D: That’s excellent. Thank you so much again for your time.