Studying outsiders: Blending the advantages of public and private equity

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In this Q&A, Portfolio Manager Mark Whitaker and investor and author Will Thorndike of Housatonic Partners discuss their collaborative investment approach Public Permanent Capital (PPC). Mark and Will highlight why PPC, focused on strong capital allocators with extended time horizons, is particularly relevant today.

About the authors: As the portfolio manager, Mark is the fiduciary and investment decision-maker. Will, as a consultant, was a thought partner in the design of the strategy and provides ongoing research and idea generation that informs Mark’s decisions. He also interacts with clients and prospects to help explain the strategy.

How did you develop the core investment idea for a longer-term, public-market-equity approach?

Mark Whitaker: The idea came from a client conversation about private equity. The client loved the returns they were able to generate, but they had issues with allocating to the people they wanted, at the time they wanted, and in the size they wanted. It felt counterintuitive to have their best assets sold over and over again on a recurring basis. I was brought in to help provide a potential long-term solution for these clients.

The first person I thought of was Will Thorndike. I came across Will in 2011 when Warren Buffett’s annual shareholder letter was released, and in it, he highlighted Will’s wonderful book, The Outsiders. I grabbed a copy, devoured it pretty quickly, and, shortly after, sent a handwritten note to Will. We met, fostered a friendship, and have had many reasons to interact over the years, sharing books, podcasts, and ideas. I thought Will would be a perfect partner for us in this endeavor.

Will Thorndike: Over the years, it’s been clear that Mark and I have extremely high overlap in investment philosophies. So, when Mark shared this idea for a longer-term public-market strategy, I was immediately energized and intrigued. I’ve spent my career as a private-equity investor and my firm is distinguished within the broader private-equity field by a bias for much longer-than-normal holding periods.

The Outsiders focuses on a group of exceptionally high-performing CEOs. Over the long term, industry players are basically dealt the same hand. If one company meaningfully outperforms its peer group, we think that’s worthy of study. We found the primary area of overlap between these outperforming CEOs was capital allocation. As the CEO of a company, there are really only three ways to source capital: harvest free cash flow, issue equity, or raise debt. And there are only five things to do with that capital: invest in existing operations, buy another company, repurchase shares, pay a dividend, or pay down debt.

The core idea behind Public Permanent Capital is that the decisions CEOs make across how to source capital and how to deploy it have a gigantic impact on returns for shareholders over the long term.

What is Public Permanent Capital?

Mark: PPC is our longer-term public-market strategy which seeks to combine the attractive qualities of private equity — such as higher expected returns, long holding periods, and proven capital allocators — with the positive aspects of public equities, like scale, liquidity, and lower fees. Notably, we believe the approach overcomes some of the frustrations of both public and private equity (Figure 1)



What makes a long-term, capital-allocation-focused approach relevant today?

Mark: Our approach was developed with the objectives of compounding capital with a multi-decade time horizon and aligning our clients’ interests with skilled capital allocators at companies focused on long-term per-share value creation. This last point is particularly relevant today. We think having a strong balance sheet with a skilled capital allocator in times like this is analogous to handing dry powder to a top-decile private-equity general partner heading into a downturn. In this environment, this strategy offers those investors a high-quality, liquid, low-turnover, and low-leverage portfolio.

Will: Importantly, capital-allocation decisions that create significant per-share value occur very sporadically over long periods of time. Within any 10-year period, we’ve found there are three or four decisions that accounted for the lion’s share of the value creation. Those decisions were inevitably made at times of market or macroeconomic distress. In moments like these, we look to combine exceptional CEOs, resilient business models, and relatively unleveraged balance sheets. We believe the current environment is an opportunity for these CEOs, who we believe are heading into this downturn with the ability to be nimble.

Mark: We’ve studied our companies through prior downturns — like the global financial crisis — and what we saw was that they were able to make rational opportunistic decisions, often when their peers were retrenching. And that’s the sort of nimble behavior we would expect to see — and have started to see — in the current environment. We’re expecting companies to be opportunistic and plant the seed for what will be the cash-flow growth for the next decade. Importantly, many of these companies have held up well through the crisis, and we expect a number of interesting capital-allocation opportunities in the months ahead.

What differentiates this long-term-oriented investment universe and opportunity set?

Mark: We’re seeking resilient businesses run by owner-minded executives, who we believe are highly skilled in allocating capital and thereby have the ability to create truly differentiated performance. Twenty years ago, I researched two similar-sized companies making beverage cans with identical customers. Today, the stock of one is up 60% and the stock of the other is up 1,600%. And it’s not because one made a better can than the other. The difference is a handful of really important capital-allocation decisions that one company got right, and the other company got wrong. That’s the core of what Will and I are trying to find.

Will: We have a decades-long perspective and we’re focused on businesses that we feel we can understand their likely business and industry structure ten years from now. We look for metrics including recurring revenues, high returns on tangible capital, and underlying organic-growth opportunities. Next, we look at a set of criteria around the capital allocators — the CEOs at the helm of those companies. We seek CEOs with a demonstrated history of significant value creation through capital-allocation decision making. We’ve found over a long period of time, the best predictor of future capital-allocation ability is past capital-allocation track record.

Mark: An example of a company that does this well could be a simple insurance company. The common business model in insurance is to take in a premium dollar and buy bonds. In my view, one or two insurance businesses recognize the importance of capital allocation, and they’ll take in that premium dollar and look at a broad opportunity set. They could buy public equities, they could acquire competitors, they could buy noninsurance companies, they could buy bonds, or they could do nothing, but we think opening up that broad opportunity set is what an owner would do.

How do you identify strong capital allocators?

Will: There is a very distinct personality type that Mark and I screen for to find exceptional capital allocators. We would not reach for the traditional CEO adjectives like strategic, visionary, and charismatic. Instead, we look for adjectives like pragmatic, flexible, rational, cool, analytical, and opportunistic. A lot of these skills are qualitative in nature and may not be identified by quantitative screening or computer-generated models.

Mark: We also keep an eye out for a few behavioral tells. For example, we seek CEOs that don’t participate in their quarterly earnings calls, companies that don’t split their stock, CEOs that don’t promise future behavior, and CEOs that don’t seek a high public profile.

Will: Another characteristic that’s common across the group is frugality. An example of that is Tom Murphy, the long-time CEO at Capital Cities, a broadcasting company in the ’60s, ’70s, and ’80s. When Murphy first joined Capital Cities, he ran their first television station, which was located in a dilapidated former convent. He had to turn that business to profitability and the only requirement that the chairman gave was to paint the building. When he got out there, he decided that the best course of action was to paint only the two sides facing the road. Implicit in this was a message of frugality and focusing on what’s important. That resonated throughout the culture at the company. These stories abound in our approach.

How does your bias toward longer-term holding periods impact your relationships with companies?

Mark: We expect to have extremely low turnover but with constant oversight. We think of our interactions with companies a bit like board members, in terms of the nature of the questions and the issues we’re bringing up. For example, last year, we engaged with one board to make sure they were appropriately considering retaining their CEO. We think this individual is terrific. He’s relatively young and we could see other companies being interested in his services. We wanted the board to be aware of a shareholder’s perspective, and to make sure they were thinking about hanging onto that executive for his entire career.

Will: We’ve found in those sorts of interactions that our longer-term ‘supportive-partner’ perspective is highly differentiating versus shorter-term investors engaging with these management teams. It’s led us to be able to develop relationships with CEOs that we hope will bear fruit over a much longer time period.

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Authored by
mark whitaker
Mark Whitaker
Equity Portfolio Manager
Andrew Tubman
Andrew Tubman, CFA
Director of E&F Strategies
Will Thorndike
Founding Parnter of Housatonic Partners