E299: Why Institutional LPs Are Moving Into Lower Middle Market PE

What does it mean to be a true partner to lower middle market businesses? David Weisburd speaks with Peter Elliot Rothschild about building RF Investment Partners around listening first, designing bespoke capital solutions, and investing as the first institutional capital in family-owned companies. Peter discusses minority versus control investing, the role of trust and relationships, and why value creation in the lower middle market is driven less by financial engineering and more by people, incentives, and execution.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Weisburd?

  Peter, you built RF Investment Partners from an SBIC fund back in 2016 to a powerhouse today. When you think about going back to the origins of RF Investment Partners, what problem were you looking to solve in the marketplace?

• 0:14Speaker 01

  The problem that we were looking to solve when we entered the marketplace was to be able to listen to what lower middle market companies needed. So most investment firms that are out there come with a solution. We come with a mindset of looking to listen to management teams, looking to listen to what the company's needs are, and then trying to customize a solution around those needs.

• 0:34David Weisburd?

  And you like to be the first institutional capital into a lower middle market company. Why is that such an optimal time to invest into a company?

• 0:42Speaker 01

  But when we're entering, we're not taking on a playbook that's already been established by another traditional institution that's been involved with the company for the past number of years. We're coming on board typically with family-run businesses that have been successful in what they've done, but it's really been one way of doing business as opposed to bringing different perspectives to the table, different traditional institutional management teams, where there hasn't been that professionalization that's taken place yet. And one of the things that we can do, again, if we're doing our jobs correctly, is bringing different voices to bear, bringing best practices. Having seen this across numerous companies and numerous industries, we always tell our management teams, you may have done things a certain way for the last 10, 20 years.

• 1:26Speaker 01

  That doesn't mean that that's the only way of doing business.

• 1:29David Weisburd?

  You really focus on bespoke capital solutions versus having one capital solution for every company. How does that give you an advantage over other funds?

• 1:40Speaker 01

  The opportunity to go in to listen to what a management team and what ownership and what a company's needs are is really crucial for us. As opposed to where most private equity firms go in and tell a company, this is the solution that fits for your company, and they use that solution for 90, 95% of the investments that they make. We can go in and listen to the needs of the company. We then take what we hear from the company and from management teams, and then we create a capital solution that best fits those situations. Often, we're investing

• 2:11Speaker 01

  We're investing both debt and equity in every transaction that we do, but it can be more debt heavy and it can be more equity heavy. And we're looking for the optimal risk-adjusted returns for us, while also looking to put in place the best capital structure for the company. It's something that most investment firms don't have the ability to do. And for us to be able to customize solutions is something that we offer that we believe is pretty differentiated.

• 2:34David Weisburd?

  Do not worry that LPs aren't able to place in a specific bucket when you go out and fundraise.

• 2:41Speaker 01

  We absolutely worry about that and we absolutely deal with that all the time. For the larger institutions that are limited partners, they have an equity bucket. For buyouts, they have growth equity, they have a credit bucket. And we're going to be a different solution. So University of Michigan happens to be one of our largest limited partners. And they have a separate bucket that's more opportunistic for the type of investments we make. But for many of the larger institutions, they don't have a bucket that they're looking to fill that's allocated for what we do. And then it's upon us to convince them how the risk-adjusted returns still makes sense. But it certainly is an uphill battle for certain larger institutions.

• 3:15David Weisburd?

  It's interesting because right now there's a philosophical divide between the traditional endowment Yale Star type model with the TPA, which is all about finding the best risk-adjusted return. So many ways you're really aligning with what some consider the future of investing in a future of asset management.

• 3:33Speaker 01

  We believe that we are, but you still have a lot of traditional institutional limited partners who have the mindset of having very defined buckets that they want to invest in. They also want to have scale. And so we're managing today a little under $700 million. We're not the type of platform that's going to be able to allocate billions and billions of dollars to this strategy. And so if you're an endowment that's managing $10, $20, $30 billion, it's difficult because you want to have a strategy within your basket where you can say we're going to allocate $3 billion, $5 billion, $2 billion to a certain strategy. And again, we're much more opportunistic for those groups.

• 4:11David Weisburd?

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• 4:54David Weisburd?

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• 5:37David Weisburd?

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• 5:47Speaker 01

  Few of the misconceptions are that all minority investors are the same. And so, we have fairly significant controls and guardrails in place, not just on our equity, but we get those guardrails through our debt investment, where there's not insignificant level of control and influence. As opposed to a traditional growth equity investor that may be, to some degree, more along for the ride, we've got these guardrails through our debt and through the ability to effectuate change with our equity docs.

• 6:15David Weisburd?

  Last time we chatted, you said that being a minority investor requires you to play therapist. What did you mean by that?

• 6:22Speaker 01

  Yeah, so a couple of different things. Again, these are traditionally family-owned businesses that we're investing in. We're the first institutional capital. Therefore, often, family members are involved with the business. And often, the employee base is very loyal to the company, and the company's ownership is loyal to that employee base. What does that mean? Employees who have helped a business get from 10 million in revenues to 25 million in revenues may not be the right individuals who can then help a company go from 25 to 75 million revenues. So dealing with companies and the personalities of both management, as well as with the owners of the business, helping them understand bringing different people to the table at different points in the life cycle of a company can be incredibly helpful. And then honestly, working with a company and the management team on

• 7:08Speaker 01

  a company that needs to be institutionalized, how decisions need to be made. It needs to be based on return on investment, not just on loyalty and on customers that have been around for 10, 20 years. It's got to be in the business's best interest to continue with those decisions or effectuate change.

• 7:23David Weisburd?

  How do you underwrite that risk when you make an investment and you can't actually replace the CEO?

• 7:27Speaker 01

  We're looking at how deep we're going in the capital structure. We need greater downside protection when we're doing a minority investment. So when we do a minority investment, we need controls on the debt, the different covenants that we put in, and then we need a bigger equity cushion to underwrite the risk that we're taking by not being able to effectuate the same controls. So with our equity, we're typically coming in as senior equity, either convertible preferred or participating preferred equity. The participating preferred equity gets all of our initial investment back, plus a preferred return, and then equity on top of that. But knowing that we don't have the ability to go in and effectuate change as quickly, we need a bigger buffer that allows us the incremental time before our capital will be at risk to effectuate that change.

• 8:09David Weisburd?

  In many ways, it's just being compensated for a higher risk investment. The lack of control is a risk.

• 8:15Speaker 01

  The lack of control absolutely is a risk. It means we need to have returns correspond with that incremental risk, but it also means taking less risk, not going as deep. So whether it's an eight times enterprise value business, our last dollar of equity in those situations may be going five turns deep. So we're not going through the entire capital structure. There's more of an equity buffer between our last dollar of risk and where we see the enterprise value of the business.

• 8:41David Weisburd?

  As I mentioned, you have this really flexible mandate where you sometimes own as little as 5% of the business and you could end up owning 65, 70% of the business. How does that change in terms of giving advice to the CEO when you have a small stake in the business versus a very large one?

• 8:57Speaker 01

  We still have rights over certain decisions of being collaborative, but we have to prove ourselves as good partners to the management team. If we own 5, 10% of a company, the company doesn't have to listen to our advice. We hope that they do in certain situations. We think we bring a different perspective to bear, but the company doesn't have to listen. In those situations, developing the relationship, spending more time with the management team, showing them that we're aligned with them, looking to grow the shareholder value is absolutely critical. But to your point, it is different than when we control the board of directors and when we can make changes without having to convince someone that we want to make those changes.

• 9:34David Weisburd?

  They make an investment. It's a majority control. So you now have effective control of the business. You have this 180 day plan. What happens in the first month and walk me through that 180 day plan?

• 9:45Speaker 01

  Typically, we're trying to come up with that 180 day plan in our diligence process. So what we're now trying to do with all of our change of control transactions, which I think is different than most lower middle market companies, is bringing an executive chairman to the table in diligence and then have them in place after we execute the transaction. Why is it different? A lot of lower middle market firms are bringing board members to the table. We want to bring individuals who are former CEOs, not looking for their next CEO gig, but rather be coming into a situation where they can sit on two to four of our boards and spend 10 hours a week working with the management teams, working with the CEOs, helping recruit new managers, being on the inner company management calls that are taking place. But quite frankly, we don't have the time to spend 10 plus hours a week

• 10:30Speaker 01

  on each of these companies. We're going to be more involved talking to CEO, the CFOs on acquisitions from a financing perspective, but on making sure we understand where the sales team is spending their time, putting a true go to market strategy in place. So we start the process in the diligence process of putting the 180 day plan together. We clearly then spend time refining that post investment, but we want to be working with an executive chair person at that time.

• 10:57David Weisburd?

  I've never met a private equity fund that doesn't claim that they provide value add. What does that look like at a smaller company, a sub $50 million? Enterprise company.

• 11:07Speaker 01

  I agree with you. I think every investment firm says that their value add, as I think you said to me the other day, there are more McDonald's or there's more investment firms now in this country than there are McDonald's franchises. The reality is investment firms try to say that they're smarter than everyone else. When you're working with a lower middle market company, it's not financial engineering that's taking place. You're dealing with personalities. Personalities are critical for us being able to get in and help a company think through spending the money on the right management interviewing, using recruiting firms from an interview process.

• 11:42Speaker 01

  Making sure you've got the right go to market strategies in place, aligning your employee base with the financial goals of a company, having more employees have ownership outside of just three or four of the senior management team members. And drilling down so that employees at a different level can see how their financial wherewithal will be tied to hitting certain KPIs. Often financial firms and investment firms are saying, if we hit certain EBITDA goals, there's going to be a bonus pool for mid level managers. Mid level managers don't understand what EBITDA is. They're looking at revenues. They're looking at gross profit. They're looking at customer retention and customer service.

• 12:17Speaker 01

  But drilling down into some of those KPIs, that if a company does well in those KPIs, it's clearly going to then lead to higher EBITDA margins, higher retention rates with customers, making sure turnover within the staff gets cut down. But you have to give the employee base the ability to see tangible KPIs that they know how they can hit to lead to good things and have bonus tied to those KPIs, not just tied to EBITDA figures that they don't know how their jobs really affect.

• 12:44David Weisburd?

  To really distill it down to each individual employee so they understand how his or her effort and his or her incentives are tied to the overall picture of this.

• 12:53Speaker 01

  I would say we're still in the third inning of this. I'm not going to tell you that we're, you know, the best out there by any means. We still have to constantly effectuate change. And I'll tell you, a former CEO of mine used to have the mentality of improve 1% every week. And so constantly looking to get better at what they do. It's exactly what we're trying to do. We're trying to bring the operating aspect of it with these executive. Executive Chair people who can help us effectuate that change because invariably we get focused on transactions. And we'll go in and out working on a new investment, working with an M and A opportunity, but having consistency. And also having, we do something called a CEO summit, which I think is also somewhat unique for a lower middle market firm that does both control and non change of control transactions.

• 13:37Speaker 01

  Is critical. We're bringing the minds together of both our advisors as well as with a group of our CEOs, which we find very helpful.

• 13:45David Weisburd?

  Tony, about the CEO summit.

• 13:47Speaker 01

  Each year we bring, we invite all of the CEOs of our portfolio companies with our advisors. And then we have a group that actually facilitates the different sessions that we'll have at that CEO summit. This is something that's done typically by large multimillion dollar platforms. We've tried to take this down to the lower middle market where if you're a business service company dealing with. Go to market strategy, dealing with how do we deal with employment issues, whether it be on turnover. It's great listening to us as financial guys. I say that a bit tongue in cheek. It's better when a CEO has that network in place and has the ability to talk to other CEOs dealing with the same issues.

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• 15:08David Weisburd?

  You mentioned this 1% compounding. Talk to me about the compounding in your career. Have you seen a snowball effect to the compounding in your career? And if so, in what areas?

• 15:17Speaker 01

  The biggest thing is from a relationship standpoint, and I'll, I'll explain. RF was founded as a relationship first with a relationship first mantra across the organization. We had 18 of our former CEOs, CFOs and board members invest in the platform when we initially launched the platform. We've tried to, to, to maintain partnerships with each of our service providers. So we've taken the approach that every individual that we've touched. Is an ambassador in the market for us. And where that compounding takes place, unfortunately, as you get older and older, is that the world becomes smaller and smaller. So those 18 CEOs, CFOs and board members are the best references for us.

• 15:58Speaker 01

  When another CEO says, I'm looking to take an investment from you, you're not the only caper provider. Who can I speak with? And we can point to all these CEOs, CFOs and board members and others. So they refer us deals. They're able to weigh in at times if we're looking at an industry that they're familiar with. But that has compounded and that has helped both from a deal flow perspective as well as with getting operators to trust us more on the front end. When we find good operators and good partners, we want to keep those people as close as possible. And then it's on us to keep that communication level going, even when we're no longer investors with that company.

• 16:37David Weisburd?

  Last time we chat, you said that deals are 70% people. What do you mean by that?

• 16:43Speaker 01

  I've been married for close to 25 years now. And I found that no matter what issue comes up, whether it be in a marriage or whether it be in an investment in a lower middle market company, you can't fully predict what that challenge is going to be. No matter how you underwrite a deal, something unpredictable is going to take place. And it is comparable with a marriage sickness comes up, issues with children, issues with parents, et cetera. Making sure you're sitting around the table with the right group of partners has been absolutely critical for us. You can't fully underwrite the challenges that come up. You can try to underwrite the partnership that's in place and make sure that you're surrounded by people who want to be collaborative,

• 17:24Speaker 01

  who want to all work together in order to make sure that the right outcome comes to be.

• 17:30David Weisburd?

  Or what's that thing that's aligning everybody in in the partnerships network?

• 17:34Speaker 01

  There's a trust. So we have a fiduciary responsibility to our limited partners that if something happens, we have to be first and foremost concerned about their interests. And I would tell every limited partner that, and I would tell every company management team the same thing. Our interests are not always 100% aligned with management, with ownership that we're backing. But being upfront and having that level of trust is critical. So we've been involved in difficult situations. We've been doing this a long time. I wish I could say that every outcome was a positive outcome. It hasn't been. But knowing that you're sitting around the table with people who are honest, they're upfront, they treat you well, but they're not acting underhand, is something that we pride ourselves on, and it's something that's served us well.

• 18:21David Weisburd?

  Your job is part EQ and part IQ. Obviously, you have to look at the models, you have to look at the operating plans, you have to prognosticate in the future, that I would argue the IQ side. You also have to judge the CEO, specifically when you're in minority control positions where you can't really replace him or her. How do you go about gauging the psychology of the CEO before investing?

• 18:46Speaker 01

  It's a great question, and we've certainly made plenty of mistakes in the past, even though we pride ourselves on that side. Anyone who tells you that their hit rate is 95%, you probably shouldn't invest in. We look at past relationships, past partnerships, how people have treated customers, how people have treated employees, how people have treated, whether they've raised some capital, even though we're first institutional capital, but other owners of the business, that other founders, it's fairly indicative of how they're going to act on a go-forward basis, and really digging in on that. So I'll give you one example, although it's a small example. We work with a firm that does background checks. You can get background checks done for $800. We typically spend about $3,500 per background check.

• 19:30Speaker 01

  The individuals that we use for that go extremely deep, wanting to understand everything in the person's history and really digging as far as they can. Because understanding how someone has treated a former partner, however one defines that partner, it's going to be indicative of how they treat their future partners. So if they've, if they have not treated well a former owner in the business and look to sue them, guess what? We have to assume that they're going to be litigious on a go forward basis. So we think looking at those trends of how people's actions in the past, looking at, again, digging much deeper into their background, at least helps us fully assess what type of partners people will be. But again, it's, it's a huge challenge, I think, for all investors.

• 20:11David Weisburd?

  You make investment. You do all the underwriting. Part of this is probabilistic. You realize the CEO isn't listening. What do you do next?

• 20:23Speaker 01

  It's a problem and it's something that we think about all the time. We try to have in our docs as much of an ability to have a seat at the table as quickly as possible. That can be through the equity, equity docs that we have in place. That even if we don't have control, we have approval over going in a number of different directions. And then from a debt standpoint, it means we're not going to take over a business if a company has, runs into a covenant. What it does do though is it brings us to the table very quickly. To your point though, if a company is performing and performing well, and we want to effectuate a change and we're in a minority position, it's very difficult to do that. We try to maintain good relationships with all of our CEOs so that they realize that we're all aligned.

• 21:07Speaker 01

  We're all, we're all trying to grow shareholder value for us, but also for all shareholders. But we can't force the issue in a minority situation where a company is performing.

• 21:17David Weisburd?

  You've said that the private equity industry, and specifically a lower middle market, is shifting away from just capital towards value add. What makes you believe that there's an evolution going on?

• 21:28Speaker 01

  It has to take place. Limited partners are dictating this. If you're a limited partner. Just backing an investment firm that says we're the smartest individuals out there. Here's what we can do. I think there's a specialization that has to continue to take place that we've seen over the last 10, 15 years take place. But I think there's also a piece where you can't just rely on financially engineered returns. Everyone has access to capital today. I work in Manhattan. There's probably 15 firms in my building that have capital. They all think that they're the smartest individuals. If I were in an LPs position, I'd want to see, do you have a track record of actually effectuating change, increasing EBITDA? Not that you invested and you bought at a seven times multiple.

• 22:11Speaker 01

  The market went up and you were able to exit at 12 times multiple. You have to be able to point to, here's the value that we created within these companies. Not just we got lucky from a timing standpoint.

• 22:24David Weisburd?

  Taking a step back, what's your biggest critique of traditional buyout funds?

• 22:30Speaker 01

  There's a lot of very successful, financially successful, private equity managers that are out there. They think because they've been financially successful, that means they know more than operators on how the operators run their business. And that means that they can say, we're the best partner you can bring to the table. When I go and I talk to my management team, I spend the first 10, 15 minutes saying, let me introduce myself, please. What can we answer to you about our firm? Because again, entering a marriage is very important that people understand who we are, not just that we're going in to ask a thousand questions to a company. I just think that that's critical. Traditional private equity firms, not all, but many of them go into a company and they've got their

• 23:14Speaker 01

  their five minute marketing plan of here's why our firm is the best. Here's why we're great at what we do and let us tell you why our solution is the best fit for your company. I think that's the wrong approach. I think we all need to be better listeners to go into actually listen to the management teams, listen to see, are we the best fit for what they do? And can we make it work for what we do? But as opposed to saying, we've got a pre-described capital solution every time that's going to work for your company.

• 23:44David Weisburd?

  You mentioned that you had 18 former CEOs that backed you and board members that invested. What practical benefit does that bring to you on a day-to-day basis?

• 23:54Speaker 01

  It was probably the best decision that we made for a variety of reasons. Our first large institutional LP made a tremendous amount of reference calls on us. So we were launched in 2016. Our first vintage fund was in 2018. That institution called up, the number of reference checks that they did on us, called up co-investors, called up former LPs, called up CEOs of former portfolio companies. When they did so, and we didn't just have these 18, I had co-investors and everyone else who had been affiliated with us. It sends a very strong message when every reference call gets asked the question, "Would you invest in RF?" And they say, "Well, actually, we have.

• 24:35Speaker 01

  And by the way, we're paying the same management fee and we're paying the same carried interest that every other investor is." That's a very strong message to send to LPs. For CEOs of companies that we're pitching, that we're trying to show we're value-add. David, to your point earlier, every investor can say that they're value-add. It's less meaningful when it comes from me. It's much more meaningful when they call up three CEOs that we've worked with in the past, who say, "These guys were great partners." It's not just unsuccessful situations. We've had two CEOs act as reference calls where unfortunately, the investment did not turn out optimally for us. And the question that gets asked is, "Well, what were they like as partners?" Again, we have to represent our limited partners.

• 25:18Speaker 01

  That is first and foremost where our responsibility lies. As long as we treat people well, we're rational parties around the table, we're being collaborative, we're being upfront. Those reference calls where things, the situation didn't turn out well, are almost more powerful than when they did turn out well. And so, last piece, you ask about how those relationships have helped us outside of reference calls. They also have been great ambassadors for us, recommending that other management teams, other CEOs, other owners, reach out to us selectively when they're looking for capital, whether it be a change of control or whether it be a minority situation.

• 25:51David Weisburd?

  Do you think it infused a different DNA or evolution of RF investment partners, given that you started with almost taking money from the customer?

• 26:01Speaker 01

  There is a piece of that. It's very personal for me and maybe that's almost more important from where we come from. Each of our initial LPs, the first $30 million that we raised were from all individuals who were in our personal networks. And so for me, when you have a $5 billion fund dealing with large institutions, I think all too often it can be very impersonal. For us, when you take money from your mother, your brother, CEOs that you've worked with for five, 10 years, former co-investors, et cetera, everything is very personal. And so every investment, no matter how good or how poor that investment turns out, it's all personal. So we take it very seriously, but it also means that

• 26:44Speaker 01

  we're used to touching a lot of people and staying in touch with those people and being very concerned about what our reputation is in the marketplace, to limited partners, to advisors, to former CEOs and CFOs and different management teams, but also to the existing management that we're looking to invest in.

• 27:03David Weisburd?

  Well, Peter, thanks so much for sharing your story and looking forward to continuing conversation in person.

• 27:09Speaker 01

  David, thank you for your time.

• 27:10David Weisburd?

  That's it for today's episode of How I Invest. If this conversation gave you new insights or ideas, do me a quick favor. Share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.