What is the "special sauce" in a founder-led business?

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Founder-led businesses have received a lot of attention lately, with research from Credit Suisse revealing they have generated an alpha of around 3.7% compared to alternative bureaucracy businesses. This differentiation comes from an entrepreneurial spirit accompanied by an understanding of the business that many incoming executives could never develop.

However Michael Goldberg cautions against buying into this philosophy blindly, and you should instead spend the time to understand management's approach, regardless. 

"I think that (founder-led outperformance) inherently makes some sense, but I'm not sure that we've proven causation. I think there's a case we made that it's more correlative and related to the stage of the cycle that these businesses are in ...

The earliest stages of their lives tend to be the growth stages. If the founder has done a good job, they'll pass the ball on to a more bureaucratic sort of structure. So I wonder if the special sauce that we're talking about is related to the stage of the business or the person who's leading it."

Ultimately, it is essential to build a complete picture to ensure any investment is in "the right business at the right price, with the right leadership and the right plan."

One such company they have invested in is RPM Automotive (ASX: RPM), in which CSVF recently invested in and signed up for a convertible note in the process. 

Convertible notes stand out to Goldberg given its ability to offer "equity exposure into a business that we like while maintaining debt like risk." 

"If things go badly, most times you can just ask for your money back. If things go well, you can convert it into equity."

In this fascinating Expert Insights video with Michael Goldberg, executive director at Collins St Value Fund, we explore examples of stand-out founder-led businesses, the power of convertible note, and the incredible role they can play in a portfolio. 

The Collins St Value Fund has delivered a 19% p.a. net return since inception in 2016 – around 8% p.a. higher than the broader market and is the #1 fund in its Morningstar universe over the 3 and 5 year period to 30/09/2021.

To find out more about the high conviction, unconstrained and deep value approach that underpins this performance, backed by a truly investor aligned zero fixed-fee model, please click here 

Edited transcript

Why are founder-led businesses so attractive from an investment perspective?

I think there are clear benefits to founder-led businesses. Absolutely. 

Certainly, the founder will have knowledge and insight into the business, unlike any employee ever could. Certainly, they're going to be entrepreneurial and they're going to be energetic about driving the business to get the best outcomes. And most importantly for us, is they're going to have their interests aligned with ours, because if they're going to own a significant amount of stock, then their interests are in getting the best outcomes for the business, which is obviously in our best interest as well. But I don't think it's a special sauce and I've certainly read some articles including on Livewire and elsewhere suggesting that historically, founder-led businesses tend to outperform the alternative (I'm not even sure what we'd call the alternative, bureaucracy businesses?) by 3 to 5%, depending on the sort of country. And I think that's correct. 

I think that inherently makes some sense, but I'm not sure that we've proven causation. I think there's a case to be made that it's more correlative. I think it might be perhaps as related, if not more related, to the stage of the cycle, that these businesses are in. 

After all, businesses will start off as founder-led, and companies tend to go through their earlier stage or the earlier stages of their lives tend to be the growth stages. Before, if the founder has done a good job, he'll pass the ball on to a board or to a trustee or to a more bureaucratic structure. So I wonder if the special sauce that we're talking about or identifying in that outperformance is related to the stage of the business or the person who's leading it.

Now, obviously, if the person who is leading it is good, I'm not actually fussed if they're the founder or if they are someone who's been brought in later. The key for me is that their interests are aligned. I suppose, the risks though, for a founder-led business, apart from the obvious, if the founder were to be struck by lightning or something untoward were to happen to that individual, the business could be thrown into turmoil. 

But, I suppose the same energy that I just claimed as a positive, could quite easily become toxic. If someone has a majority position in the company, then instead of focusing on what all of the shareholders want, they might just focus on their own best interests. So there are certainly big, big positives. And if the company can have the appropriate level of governance and leadership put in place behind the founder, then those are the sorts of businesses that you absolutely want to be involved in, but it's got to be the right business at the right price, of course, and it's got to be the right leadership with the right plan.

So, no doubt, if you can find the right kind of leader from early on, you'll do exceptionally well. But it's got to be the right business. It's got to be the right leader and there's got to be a great plan for after the leader progresses to the next stage of the business operations.

Michael Goldberg
Managing Director and Portfolio Manager
Collins St Value Fund

What are some examples of founder-led businesses that you like the look of?

I can't tell you all the secrets of the fund because I'd be giving too much away, but I can talk about a couple of the businesses that we've previously invested in. One that I think was spoken about as well with you guys in the past, is Paradigm (ASX:PAR) run by Paul Rennie. That's a biopharmaceutical company. Paul's got a rich history in this space as a scientist. And he really, really drove this business from when we first got involved around about a hundred million dollar market cap business to currently about a $450 million market cap business.

So again, that energy and that drive and that understanding of the business, really enabled him to take it from what was at the time, essentially a startup, pre-stage two clinical trials to the point where it is now, on the precipice of running the stage three clinical trials, and now being a much more serious business. But he as well, he's built a wonderful team behind him, and if he would ever step back from his leadership role, he's built the business around him to ensure that he can go forwards and the business will be safe and sound moving forwards.

One that we currently still own, but also bought a while ago is Litigation Capital Management (AIM:LIT). I think we might've actually spoken to you guys about that as well in the past. That's run by Patrick Maloney. Historically used to help fund class actions and things like that. They're now moving more into corporate litigation and they're buying packets of litigation from corporates, like the BHPs of the world, or whoever the case may be. Again, he's got some exceptional insight into the business of litigation and funding. He's been doing this for some 20 years. And again, he's built a team around him, certainly in the last couple of years. That means that if he were to retire at some point in the not too distant future, not that I expect that he will, and I certainly hope that he won't, but that those steps have been put into place to make sure the business will go well into the future.

Perhaps most recently, and I'm fairly sure we have not spoken about this one with you guys yet, is RPM Automotive (ASX:RPM). We've met with Clive and Lawrence over the last couple of months, and we've recently bought a position in their company and also signed up for a convertible note with the company. And we've been very impressed with their approach to growing their business. It's very much in the growth stage. We've been very impressed with their insight into the automotive space, especially tyres and wheels, and also safety equipment.

But more than that, and this is I think something that's often overlooked when people assess management, is their understanding of the importance of capital management. Recognising that it's not just about growing the business at any cost, but they need to make sure that they are getting the best bang for their buck in terms of how they raise that capital, and making sure that they don't overpay for assets, that they go, gaining revenue growth at the expense of earnings per share. So, this is again, another team that we've been very impressed with, with their insight of the business, but also their operations and the team that they've built around themselves.

What is a convertible note and why do you invest in them?

They're all going to be different because they specifically take into account the needs and interests of the company that's raising the capital, but also the company that's providing the capital. So, I suppose broadly speaking, a convertible note means that a lender will give money to a company. That money will be either at some point in the future, paid back in cash, or is convertible into equity in that company, hence the term convertible notes. They tend to have a coupon attached. They tend to have a maturity date and they tend to have either a fixed price at which they'll be converted or some sort of model that will be predetermined before the contract is signed. So for us, we view it as a way to gain equity exposure into a business that we like, while maintaining debt-like risk. So if things go badly, most times you can always just ask for your money back. If things go well, you can convert it into equity.

So one of the guys in the office essentially said... I thought it was very cute. He said, a convertible note is like getting a coupon and a lottery ticket. So if things don't go well, you still do really well out of the coupon. If things go exceptionally well, you can make some exceptional returns out of owning the equity.

How do you go about constructing a portfolio with convertible notes?

Our general view is, if we're going to take the time and put in the effort to identify these good businesses, we want to make sure that when we ultimately invest in them, that we're buying in a sufficient enough quantity so that it can make an impact on our returns. So ordinarily, if we find a business we like, we're going to look to buy between five and 10% of our net investible capital into that idea. Depending on the quality of the idea, that'll be closer to 10, depending on the risks, it'll be closer to five.

So in terms of allocating towards equity or convertible notes, I think the attractiveness of convertible notes being debt-like downside makes it far more attractive to me. I would be happy if a greater portion of our portfolio could be put into convertible notes because of that risk-reward trade-off. But of course, we also need to take into consideration the liquidity of the portfolio, because we are an open fund and people can come in and go out every single month. Although we haven't had a lot of outflows over the lifecycle of our fund, we need to cater to that. And so we look to have about 60 to 70% of our portfolio in what we would call liquid assets. So either cash or companies that we could sell down within a week or two without really fundamentally impacting the share prices. So even though I'm highly attracted to those convertible notes, again, you get that equity upside and you get much better defence against downside risk, I don't think that we're likely to have more than 20% of our portfolio ever invested in those sorts of positions.

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