Emerging Market SMB Growth Investing Strategies Applied To Developed Market SMB Buyouts
Borrowing from emerging market small business ("SMB") growth investing strategies, there exists today a way for investors to earn private equity like returns, in a superior risk-adjusted fashion, within an enormous, critical, yet otherwise inaccessible & illiquid asset class: developed market SMBs (note: defined as those with $500k to $2.5M in free cash flow)
Having spent a number of years working & living in, as well as visiting, a host of emerging & frontier markets, we’ve been fortunate to have been exposed to a wide array of perspectives, ways of doing business & investing strategies that we’d otherwise have never learned about without these experiences. The insights & knowledge gleaned from this time abroad have been incredibly powerful in helping us shape a more creative approach in how we think about acquiring small businesses in developed markets, though specifically in the U.S. & Japan.
In this post, we’ll highlight one of the more interesting & compelling ways in which investors in emerging & frontier markets deploy capital into otherwise “unfundable”, yet viable, growing small businesses (“SMBs”). We’ll also argue how this unique approach & investment instrument need not be confined to emerging markets. In fact, a slight variant of the below instrument is a very attractive private equity like return investment among a certain subset of developed market SMB buyouts (notably, the risk-adjusted return profile is made even more attractive when holding an increasingly diversified basket of such investments across a growing portfolio of SMBs - more on this later).
So, what exactly is this elusive, mystery investment?
Demand Dividend notes.
In short, Demand Dividend notes are a nuanced form of a debt royalty structure with a quasi-equity risk & return element. Demand Dividend notes grew out of the need to find an alternative to debt, convertible debt & equity, specifically for emerging market social enterprises who are actively driving towards positive free cash flow. At a high-level, some may spot the similarities with revenue lending, for example.
Target investments are very small, early-stage SMBs in need of outside capital to “level-up”. Unfortunately, bank loans & other forms of more traditional financing are all but impossible to obtain given the businesses' stage of development, limited asset base & broader risk profile. Often, the investment managers directly investing into these SMBs by way of Demand Dividend notes play an active, hands-on role in supporting the investee companies, thereby de-risking the investment some, while providing valuable skills & knowledge to the entrepreneur.
As practiced in emerging markets, Demand Dividend notes have the following characteristics:
· There is a distinct focus on capital-lite, cash generative business models
· Investment check sizes most often range from $20k to $250k USD and are in the form of a “term loan” with a usually very low interest rate (~3%)
· Holders of these notes receive distributions based on the free cash flow of the investee SMB. If no cash flow is generated in a given time period, no distribution is made
· The note holders have a claim on a minority of free cash flow – anywhere from 25% to 50%. The remaining cash flow is most often reinvested back into the business to support growth
· Distributions are first applied against the principal investment amount (i.e. the “term loan”)
· There is a 10 to 24 month “honeymoon” period beginning on the date of the investment, where no distributions are made, regardless of whether cash flow exists or not. This allows the entrepreneur to accelerate the business towards more sustainable free cash flow, without the burden of cash outflows during this heavy investment period
· The claim on the investee SMBs’ cash flow remains until a certain pre-determined multiple of the initial investment is reached. Most often, this multiple ranges from 1.5x to 3.0x
There are a few other things to note about this approach & instrument:
· A portfolio approach is paramount given the inherent risk of each individual SMB investment
· The instrument & approach are structured for a reality where due diligence is limited in scope & duration. Quite simply, outside of judging the entrepreneur & the core business model, there isn’t much to diligence for companies at this stage & size. Secondarily, it is very hard to justify meaningful due diligence costs for a $20k to $250k investment
· The nature of the instrument does not over burden the SMBs’ cash flows in any one year should they encounter a growth hiccup or a decline in their cash flow. Conversely, should cash flows ramp more aggressively than expected, investors enjoy in the upside as well. This SMB friendly feature does come at a price (i.e. the high return threshold required before the claim extinguishes), however, remember that these SMBs have few other financing options, let alone ones this friendly
Okay, so, let’s summarize. The below table captures the basics of a Demand Dividend note by way of a hypothetical example:
Alright, so, now the fun part. We feel strongly that this unique investment instrument & approach can be applied to developed market SMB buyouts. How so? Well, let's take a look by first defining what type of developed market SMBs we would exactly be targeting here.
As we’ve touched on in prior posts, we at Golden Southeast are focused on acquiring an ever-growing portfolio of cash flow streams in the form of simple, capital-lite SMBs defined by their low to no-growth top-line, with $500k to $2.5M in free cash flow. Generally speaking, these SMBs are above-average in quality, sustainable, though have a bit of “hair”. Search funds & private equity investors will almost always avoid these businesses due in large part to their very small size & limited organic growth prospects, leaving very few legitimate non-individual acquirers for such companies. As such, we anticipate being able to buy these SMBs with little buyer competition for 2x to 4x free cash flow (btw, there’s far more to our approach, of course – feel free to reach out if you are interested in learning more & exploring investment opportunities with us). This below graphic may help summarize our target SMB profile:
It should also be noted that obtaining acquisition financing for these types of SMBs is notoriously difficult & subsequently quite restrictive. Frankly, traditional bank debt on any SMB beyond a modest amount is rather dangerous given the inherent realities & vagaries of a small business.
So, how do we propose we finance the purchase of dozens of these SMBs over time?
You guessed correctly – by way of a nuanced form of a Demand Dividend note! Let’s keep it simple & take a peek at the below hypothetical SMB buyout transaction using this instrument. Note, this model is meant for illustrative purposes.
I won’t walk through all of the specifics; presumably the above graphic lays out the pieces of the puzzle rather clearly. I will note a few key elements, though, as it relates to this developed market scenario (note the overlaps & differences with the above emerging market version):
· There is a distinct focus on capital-lite, cash generative business models
· The Demand Dividend note holders receive 80% of the distributable pre-tax free cash flow in this instance (vs. 25% to 50% in the emerging market scenario). This is viable given the nature of the investment (i.e. an owner buyout investment vs. a growth investment) and the steady-state nature of the cash flow stream
· Investment check sizes will often range from $1M to $5M. The "term loan" aspect of the instrument is not necessarily needed in this scenario, as it is in the emerging market version.
· With an MOIC of 1.65x, the all-in return accruing to Demand Dividend note holders is on par with top quartile private equity funds. Even better, such returns are contractually set with meaningful cushion, assuming our purchase price assumptions are valid (we have data to back them up)
· A portfolio approach is preferable, though not required. As it relates to the portfolio approach, think of it this way: we are in a lot of ways creating a “collateralized loan obligation” – though instead of corporate loans of a low credit rating or leveraged loans for private equity buyouts, we are using Demand Dividend notes applied against SMB cash flows – to where a diverse stream of disparate, individually risky SMB cash flows (captured via the Demand Dividend notes) consolidated into one aggregate cash flow stream provides for a larger, more predictable, less-risky & more valuable stream of cash.
· The instrument & approach are structured for a reality where due diligence can be limited in scope & duration. Simply put, the target SMBs are quite small, straight-forward and are not expected to perform much beyond “as-is” post-acquisition. Durability & consistency of the cash flow stream is the primary focus of underwriting, where a more formulaic & repeatable due diligence & acquisition process is followed.
· Similar to the emerging market model, a value-add, hands-on investor provides a degree of de- risking to the investment, while supporting the ongoing durability, sustainability & improvement of the SMB's cash flow
To close, let’s highlight a few interesting observations:
· In using a Demand Dividend note, particularly within an expansive portfolio approach, we are in effect providing structured access to an otherwise inaccessible, illiquid asset class - SMB cash flow streams that are otherwise silo'd, trapped & non-scalable. Depending on the extent to which we scale our acquisition activities, it is not far-fetched to assume that institutional capital becomes interested in this differentiated, high-return private equity like investment instrument. Put another way…as an investor, how else can I gain direct exposure to the backbone of the U.S. or Japanese economy (i.e. SMBs)? Well, one really can’t unless they take direct equity risk within individual SMB assets – which is quite risky, time + resource intensive & quite difficult to exit. Moreover, private equity doesn’t play in this sub-segment of the market for a variety of reasons and we don’t believe there are many, if any, collateralized SBA loan packages floating around…all in all, there are few highly attractive alternatives
· As an equity holder in the HoldCo entity acquiring these SMBs by way of Demand Dividend note financing, we can arguably acquire these businesses for little to no money down in a very risk-conscious way (i.e. financing the majority of the purchase price via Demand Dividend notes whose distributions ebb & flow with business performance; they can’t “trip” an SMB into “default” like traditional bank debt can). It is not hard to imagine the “value creation” accruing to HoldCo equity holders after 10 years of acquiring 40+ SMBs in such a capital efficient manner
Reach out if interested in exploring further - we're actively working to launch acquisition entities in both the U.S. & Japan today.