Insights

  • Moore’s Law Comes to R&W Insurance
    POSTED 10.27.20 Insurance

    While attending a recent M&A conference, I was surprised to hear so many of the participants – including PE firms, M&A attorneys, and bankers – still hold the mistaken belief that Representations and Warranty (R&W) insurance is too expensive.

    In fact, the floor for R&W coverage has actually come down drastically in the past year to the point that a $5M policy can easily be found and it will cost less than $200K, including underwriting fees and taxes. (This figure doesn’t include broker fees, which the big firms are adding to maintain income levels. More on that below.)

    Why the disconnect? These folks haven’t checked in on R&W insurance for a while, and people assume what was true a couple of years ago is still valid. They tend to get their information and updates from conferences. I was happy to spread the good news while I was there, and I got positive response. These folks did not see value in a policy if the cost was $225K, $350K. But if they could get a policy for under $200K, they were interested.

    This significant drop in costs reminds me of Moore’s law. Quite appropriate considering how many M&A deals are done in the tech space. This maxim holds that every 18 months we can expect the speed and capability of our computers to double, while we pay less.

    There are several reasons why the cost of R&W coverage has dropped:

    • The number of insurers offering R&W insurance has more than doubled.
    • Rates have fallen from the 2.5% to 4% range to the 2% to 2.9% range.
    • Eligibility thresholds have decreased from deals at $75M in transaction value to $10M in transaction value.
    • Falling costs have given rise to more policies being placed.

    I expect this trend to hold steady as the increase in R&W policies written has not yet translated into a corresponding increase in paid losses by Underwriters. Due to the simple fact that more policies are out there, reported losses are up. However, most of these cases fall within the policy retentions, so insurers are not having to write many R&W checks to cover damages. Plus, just because they’re writing smaller deals doesn’t mean Underwriters are getting sloppy and accepting just anything. They expect the same due diligence, making the smaller deals just as safe for them as bigger deals.

    It should be noted that unlike other discounted insurance products, these low-priced R&W policies provide coverage just as comprehensive as the higher priced alternatives (depending on the complexity of the deal and diligence completed, of course). You’re not getting lower quality coverage or added restrictions just because it’s cheaper.

    How Low-Priced R&W Insurance Changes the Game

    A sub-$200K priced R&W policy is good for M&A for the following reasons:

    1. Lower costs make the value proposition on smaller deals more “palatable” – especially for Sellers where $1M or $2M less in escrow makes a material difference. These folks can’t take a $1M to $2M hit if there is a breach. R&W coverage is a lifesaver for them.

    2. Lower priced policies more easily enable Buyers and Sellers to share the costs.

    Many Buyers are saying that Sellers want R&W coverage on the deal but don’t want to pay for it. And Buyers are chagrined by that. But if costs are split and it’s under $100K for each side, it’s more favorable, and both sides benefit from having the policy in place.

    As you know, this specialized insurance makes negotiations smoother, lets the Seller keep more cash at closing, and ensures that the Buyer doesn’t have to take legal action against the Seller if there is a breach, which is awkward if the Seller’s management team is on board with the new entity.

    3. The lower price point makes R&W an affordable tool for add-ons, which are expected to increase as PE firms and Strategics look to enhance the value of their portfolio companies.

    With PE firms in particular, thanks to lower cost policy and premium, they won’t just reserve R&W coverage for deals above $100M in transaction value. This lower price justifies using R&W on deals at $30M, which they are doing more of because it’s a lot easier to spend $30M to $50M than $100M. PE firms will transact two to three times more add-ons per year than one big acquisition.

    I saw this first-hand recently with a policy I provided here in Silicon Valley. The company brought in a $90M add-on to an existing portfolio company. The $5M limit R&W policy cost just $175K (including underwriting fees and taxes).

    Overall, with the lower price for an R&W policy, cost is no longer an objection for either party to consider a policy.

    What’s Ahead

    If R&W continues its stellar performance, expect to see even fewer exclusions and possibly lower retention levels.

    But how much lower can the price go? Not much further if R&W insurance is to be sustainable. If the product gets too cheap insurers will not be able to collect enough in premiums to pay claims.

    We’d caution prospective users to be wary of policies coming in under $100K.

    One observation from this drop in premium rates is that the major insurance brokers offering R&W coverage have reacted to this price drop (which they’ve had to go along with to stay competitive) by adding broker fees of as much as $25K. These big firms have big overheads and want to protect their profit margin.

    That’s where a boutique firm like Rubicon Insurance Services shines. In this segment of small market M&A deals, we take a back seat to nobody. We can broker policies more cost effectively and more efficiently because we don’t have the overhead. We won’t charge those broker fees.

    I’m happy to provide you with more information on R&W insurance and provide you with a quote. Please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • Mark Addison | From a $30M Exit Offer to $100M
    POSTED 10.20.20 M&A Masters Podcast

    What motivates Mark Addison, CEO of X Rocket.io? He’s seen too many entrepreneurs, especially first-timers leave money on the table when they exit.

    His firm helps optimize key valuation drivers during M&A negotiations to maximize the money owners and founders take home.

    In one case, he and his team were able to reengineer a $30 million offer… into a $100 million offer. We talk about the three things they did to make it happen and the audits they perform on clients, as well as…

    • The key metrics that predict higher valuations
    • Acquisition trends with PE firms you should be watching
    • Two insurance products you should have in place for any deal
    • The biggest misconception many founders hang on to
    • And more

    Listen now…

    Mentioned in this episode:

     

    Transcript

    Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here, that’s a clean exit for owners, founders and their investors. Today I’m joined by Mark Addison, CEO of xrocket.io. X Rocket provides valuation engineering for M&A exits.

    They optimize the key valuation drivers used in M&A negotiations to prepare companies for larger exits. Now, while personally, my focus is providing a clean exit for owners and founders, Mark’s goal is to get larger exits, which makes even more people happy. So I’m pleased to have Mark join me today. Mark, welcome to the podcast.

    Mark Addison: Thank you, Patrick. Enjoy being here.

    Patrick:  Now before we get into X Rocket and value optimization and all that fun stuff, and again, this is targeted toward technology companies, both hardware, software, etc. Let’s set the table and tell us what got you to this point in your career.

    Mark: Well, depending on how far back you want to go, a couple decades ago, I started as a data quad for SRI, that’s out of Stanford. And I was doing multivariate statistical analyses. It was sort of a precursor to what we call data science today. And I got swept up in the technology. And so I had an early career win where I help the online chat community go to IPO. I’ve co-founded three companies.

    One, a wine importer and direct consumer retailer. Two, a tech marketing company, which is the core of my business. And then three, the M&A business, which we’re talking about today. You know, I’ve been motivated, because I’ve seen firsthand entrepreneurs pouring their sweat and equity and tears and passions and lives into building companies. And then I’ve also seen entrepreneurs exit those companies and sometimes leave a lot of money on the table.

    You know, helping people understand the difference between financial valuation, which is a multiple of EBITDA versus strategic valuation is, which is really where you get the extra value. You know, we recently helped a CEO reengineer a company, they had a $30 million exit offer. And we reengineered that into more than 100 million dollar exit offer. So that was really where we got, where I got to today, where we decided to double down and offer this kind of hands-on consulting to help companies and investors increase valuation. That’s where we are.

    Patrick: Every company in Silicon Valley is for sale. And if you’re in technology, you’re not limited to Silicon Valley. You’re around the world and you’re ideally, looking for an exit. So owners and founders have an eye on an eventual exit, that’s in addition to what they’re already doing. Let’s talk about the difference from what owners and founders expect in reality. Why should they engage specialists to best position them for a larger exit?

    You Want to Be the Worst-Kept Secret

    Mark: And I think early-stage investors will probably tell founders, hey, don’t worry about the exit, just focus on building the company. If you build it, it will come. And, you know, that’s certainly the ethos among a lot of more engineering-led companies, just build the technology and the rest will happen. I think as companies mature, they start to realize that there is more to it.

    And, you know, I think companies, most Silicon Valley companies go through some stages and so there’s usually a founder, CEO, who’s usually an engineer and he’s very product-driven and they’re just trying to find, you know, market fit and engineer the product. And then oftentimes, sometimes it’s the same CEO, but oftentimes, there’s a new CEO who’s going to be in charge of the growth and the scaling. And then as they get even more mature, and getting starting to approach exit, sometimes you’ll see a third tier of CEO come in.

    I call him the Exit CEO and that’s the CEO who’s got a big Rolodex of contacts and that’s the CEO who understands strategic valuation and that’s the CEO who starts to really look at the operations and ready the company for exit. I think this sort of this dichotomy that you are asking about, you know, what’s the founder’s expectations versus the reality. When you start a company, you know, at the seed round, you think you’re just gonna build a cool technology and the world is going to beat its way to your door.

    And, you know, seven to 10 years later when you’re on your C and D round, it’s just a different animal and you start to realize that wow, you know, I have to now be a sector leader and a thought leader. And it’s in, this sector that I started this technology in seven years ago, I invented the technology. but now it’s a noisy, crowded market sector because, you know, I proved that there was money to be made there, right?

    Think about AI, right? Think about early startups there. Now it’s a very noisy market. So now, the reality is, you have to distinguish yourself from all the other competition out there and you have to rise above that noise and you have to establish yourself as a sector leader so that you get the acquisition offer so that you don’t become, you know, the best-kept secret. You don’t want to be the best-kept secret. You want to be the worst-kept secret.

    Patrick: You mentioned when we talked before about there are some key valuation drivers or things that specifically can be done to drive value up. Let’s touch on a couple of those.

    Mark: Yeah, so one of the things that we did when we set up this M&A business, X Rocket, is we interviewed a whole bunch of M&A bankers and brokers and we asked them, What are the key metrics that predict best towards higher valuations? And what we were hoping to do was create this, literally an algorithm that we could just, you know, hammer down into a science, and, it’s unfortunately, not quite, it’s still a little more of an art than it is a science.

    But there are certain metrics, we call them levers that buyers pay attention to, and they’re things like, you know, operational levers and sales levers and marketing levers and customer levers. And we built a proprietary audit around those. So we walk companies through that valuation audit to highlight where the potential weak spots are and where the opportunities are to increase the valuation.

    Patrick: Well, you mentioned before, when you’re talking about one of your success stories there where you took a company that had an exit at 30 million, and you tripled that with the CEO with what you guys did. Let’s talk about that in little bit more detail. And, you know, give us a couple case studies on where X Rocket came in and literally changed the game for the client.

    Finding the Valuation

    Mark: I can give you one case study in healthcare because it’s like textbook, right? So small company, they built onboarding software for physical therapists. The company was 25 years old, founded by three doctors. They were ready to move on and sell. They actually originally came to us for marketing help and put that on hold because they got an acquisition offer. The acquisition offer failed in due diligence, right? Per the conversation that we had earlier and I’ll explain some of the reasons why.

    They came back to us and said, Hey, we get it now, right? We get it that there’s stuff you need to do to attract an offer and survive the due diligence and then attract a good offer. So we set and we looked at the business and this is where it’s easier for us as outside consultants to kind of see the business. They were trying to figure out how they were going to improve the valuation of their onboarding software which ran on a tablet and was sold to physical therapists.

    And that was all fine and dandy. But we discovered, like, literally in the first week, that they had this database with some 22 million healthcare records. In the healthcare world, it’s called morbidities and modalities and outcomes, right? And so morbidities is what’s wrong with the patient. Why’d they come in to visit the doctor? Modalities is what did the doctor do to make them better? Then outcomes is, you know, what metrics did you measure to say that the patient got better?

    And how many sessions did it take and things like that. And what we discovered was insurance companies were starting to come to this company asking to look at that data because they could better underwrite insurance deals. They could better figure out that, oh, you know, if the patient is a 24-year-old athlete, and they’ve got a torn Achilles, it’s this many sessions to get them better. If it’s an 80-year-old sedentary adult, with a torn Achilles, it’s a whole different, you know, sort of therapy, right? And a whole different cost structure to that.

    So the lightbulb went off in our head that, Hey, you guys aren’t a piece of onboarding software for physical therapists, you’re a data analytics company. right? That’s the nugget. That’s the valuation. That’s the big pot, right? And so then we started to do all the things to position the company as a data analytics company. Like we completely wipe the website, right? Because the website was selling to physical therapists. And so we just wiped it clean and stuffed it full of keywords around healthcare and data analytics and predictive data carrier analytics and things like that.

    The sales pipeline, we need to keep that going. So we hired an on-demand sales team to just do a bunch of digital sales and stuff that sales pipelines for that look good. We went through all of the valuation metrics, the valuation levers, and sort of one by one said, How do we optimize this, right? And so our house was tidy and clean, squeaky clean, right? And they were going to survive due diligence this time, because, you know, they knew, they learned. But then the big nugget that unlocked the value was how you position the company. What’s the real valuation of the company?

    So that’s one example. And so within nine months, Carlyle Group came knocking on the door and they were looking to do a roll up and they needed a healthcare data analytics piece and this company fit the bill perfectly. And there we go. So it was a textbook example of going from a failed acquisition and failed due diligence and probably, lower than anticipated valuation to more a successful offer that kind of just, you know, game-changing, repositioning.

    But more often than not, there is a strategic nugget that’s sitting right underneath the founders’ noses. They just don’t recognize it for the value that it is because they’re running the company, they’re fighting the fires, the daily fires. And it’s so much easier for us as outside consultants to kind of hover it 30,000 feet and look in on the business and go, Okay, I see it. It’s plain as day. It’s right here.

    So the second example, it was an ecommerce company, the one that we took from 30 million to over 100 million. That was pretty interesting because it was a founder-led company where the founder actually had been pushed aside by the investors who had brought in a new CEO with a specific mission of getting the company sold. That CEO did bring in a bid. The board rejected the bid as being far too low. The board rejected both the bid and that CEO.

    Founder CEO comes back into the hot seat and now, how do we get the company sold? How do we increase the valuation? So I think we did three things really, really well. One, in the absence of any branding and marketing under that other CEO, things that really languished a bit and the competitor’s sales guys were taking advantage of it. So they were putting FUD in the marketplace that, hey, things aren’t going so so well.

    And do you really want to hitch your ride on to the ecommerce company? So that was either outright killing deals or slowing them. So that’s one where we had to go in and tell the market that no, we’re here to stay and we’re here for real. Two, was on the positioning. In the ecommerce space, there’s open-source software available that’s free and then there’s some very large competitors that focus on the mega-market. And this company is focused on the mid-market but really wasn’t comfortable there.

    The sales guys were trying to go after deals both higher and lower. And we decided no, we’re gonna own the med market there. It’s a very respectable market sector to own. We double down on that, we really built the reputation around we serve mid-market retailers. And that served us really well. And then the third was around this CEO, he’s very charismatic. He was an underutilized asset. To the first point about rebuilding the brand reputation, what we did was we trotted the CEO out and we got him a lot of visibility.

    And we made him a spokesperson for that sector, for the ecommerce sector. He was a natural for it and he had really good content to share. And we got him, you know, guest columns in media and speaking opportunities and things like that. And we really built him up so he was a thought leader and so that the company by association, became a leader in the sector and therefore attractive to M&A buyers.

    Patrick: See now I’ll show off my age, but what you do with the CEO is you almost, you turn them into Lee Iacocca from Chrysler, where people weren’t buying Chryslers, they were buying Lee Iacocca. And that, you know, that’s one of those value propositions that you can bring in where you’re not necessarily changing the culture and making people within a company forget everything they did. You’re just enhancing them and opening them up to new opportunities.

    Mark: Yeah, I mean, our case, our CEO was a little more charismatic. But yeah, people sometimes will buy into that, you know, that credibility and that story,

    Patrick: Well, now the reason why I wanted to talk to you is not only because of what X Rocket can do for owners and founders of companies but also you’ve got a whole swath of mid-market private equity firms that have been buying these companies. They’ve been cleaning them up. They’ve been doing what they can.

    But their challenge now is they need to find a bigger buyer. And now it’s not just EBITDA that you can bring to the table, you can bring some other things that can really enhance the value because that’s the purpose of private equity, you know, find bigger buyers. And the market for bigger buyers is actually expanding because, you know, the traditional issue was while you would try to take your company IPO.

    If you don’t do the IPO, then find a bigger private equity company or find a strategic. And there’s a whole new class of strategic acquirers out there’s facts, and they have nine and 10 figures to spend. So there’s definitely a market for mid-market, lower middle-market private equity firms to stage up their babies to get them for bigger exits. So let’s talk about what you could do for those types of candidates.

    Bigger Exits for Mid Market and Lower Mid Market

    Mark: Yeah, well, as you said, the PE model is buy low, sell high, right? And do something in between to make the price justify the higher price. So I think among the mid-market, PE’s, what’s interesting is they’re buying inherently smaller companies to begin with. So those smaller companies, they don’t have 5000 employees and a bunch of fat, right?

    And so the classic PE model of buying three companies, consolidating operations, getting rid of all the HR directors and all the redundant positions to cut costs and add value, that’s just not quite as effective. I think at the mid-market, we have to find ways to actually add value, not just subtract costs. And that’s really where the X Rocket methodology comes in. We look at how to add value and create value beyond just the EBITDA and find strategic value that the M&A buyer is going to recognize as strategic value.

    Patrick: Specifically, what some of the things you can do? You were talking about creating thought leadership and so forth. Let’s talk about either scalability marketing, what are some of those levers that you could bring in because the private equities, they are outside of the portfolio, but they’re not that far outside, and a lot of them are probably embedded with their portfolio company so they don’t have that outside view. So let’s talk about that.

    Mark: Yeah. Well, so part of it is being able to scale this. So I know that there are some PE firms that will put in house staff into the portfolio companies to help with certain key aspects. But that’s not a particularly scalable model because you can only put your in house people into so many companies. So one is just scalability, we can come in from the outside. Two is that perspective that you just talked about. Coming in, understanding the market dynamics and seeing the business, you know, sort of, for what it is and figuring out where the strategic valuation is the other one. And then the rest is basically just implementing, right?

    So pulling the levers. So you can have a wonderful idea for, you know, improving the strategic valuation, but then you got to go get it done. And so for example, the case study that we mentioned in the healthcare company, that was textbook, but it wasn’t just going, Oh, yeah, it’s just the database, stupid. Just do that, right?

    And we had to do all the other things to make sure that that was, in fact, the nugget that the company was identified as and that the company could be discovered around and pumping up the sales pipeline and redoing the website so that it was a discoverable company. And in that case, we also did trot out the co-founders because we found out that they were scientists and they were co-authors of some 100 or so of these peer-reviewed medical journal articles. I mean, the real deal, right? Not just a contributor article to Forbes but, you know, a peer-reviewed medical journal article.

    And they were co-authors. And nobody knew that, right? So we wanted to shine the spotlight that, hey, this company, and therefore the data in this database, is real science from real doctors, and therefore really meaningful information. So a lot of it is, you know,  not just having the idea, not just educating the portfolio companies on what strategic valuation is and then having the perspective to find where the strategic valuation is, but then also turning that into real valuation that an outside buyer can recognize.

    Patrick: Now I’ve failed to mention also, and I apologize for this, but also you just released an article connected to our podcast notes here, but there’s another source of strategic buyers out there. Unicorns. Let’s talk about the growth real quick just in terms of pure number. Our audience here already knows that a unicorn is a privately held company with a valuation of a billion dollars or greater. Mark, you just took a headcount on them. Where are we standing now with that?

    Mark: We are standing at 603 unicorns, which means they are not nearly as special as they used to be, right? You can find a unicorn in any forest now. Not just the magic forests.

    Patrick: There’s another bigger buyer for you out there. Mark, let’s talk about, give us a quick profile, who’s your ideal client?

    X Rocket’s Ideal Client Profile

    Mark: So the ideal client for us, as you might gather is a company that’s maybe one to two years away from considering M&A. And this is important because a lot of companies wait a little too long. And this is what was borne out when we did all those interviews with the M&A brokers and the M&A investors, bankers. They love our model, obviously, because higher valuation means, you know, bigger exits for them. But they also see the frustration.

    By the time you’re talking to that M&A broker, they are preparing the two-sheet, you know, the two-page executive overview and they’re shopping your company to potential buyers, right? And a lot of these valuation increases, it’s too late, right? It’s too late to implement these things. It’s too late to clean up your books if your due diligence isn’t all neat and tidy. It’s too late to rebrand the company, right? It’s too late to make your CEO a thought leader and a sector leader.

    You can’t just do that in, you know, a week, right? So our ideal buyer is one to two years away from thinking about bringing in the M&A broker because that way we can work on all of these, the valuation levers that we uncover in our valuation audit. The other ideal client working revenue model, science experiments, as we call them, are very hard to place. They tend to be one-off, right? A certain strategic buyer needs that specific technology, but there’s usually one buyer for that particular technology.

    And what we’re trying to do is create competition among potential buyers for companies. So a working revenue model and not a science-driven. And then an under-marketed company, right? Per the discussion that we had a lot of times or earlier, a lot of times startups these days are engineering lead companies where they really focus on the product and the product-market fit. And, you know, or on scaling the growth and they really haven’t put a lot of attention to the brand.

    And so those under-marketed companies have a huge potential to increase valuation. And what we try to educate founders on is that, you know, if you’re selling your company for some multiple over EBITDA, you can negotiate that multiple, but it’s going to be within a certain range that is borne out by competitors. So buyers go out there, and whether it’s the ecommerce sector or the healthcare sector or whatever, there is a range of multiples over EBITDA that buyers typically buy at.

    And you can be on the low end of that range of the high end of the range, but it’s a pretty narrow range for negotiation. You’re leaving money on the table if you’re not getting strategic valuation layered on top of your financial evaluation. If you’re looking at selling your company, if you’re looking at increasing your revenue because you think you’re going to get seven times EBITDA as your multiple on sale and you’re going to be focused on that, that is good.

    But if that’s all you’re going to get the company sold far, you’re leaving money on the table. You need to get strategic valuation and that is by being a sector leader. That is by having competition among buyers. They want you and only you. There’s a great quote I have, we work with a lot of security companies and there’s a sales guy, I’ll never forget. He goes, Mark, nobody wants to buy the second-best security technology. There’s no market for that. There’s only a market for the most best.

    Patrick: Excellent, excellent. Well now you’re with the M&A and I’m not sure if you’ve had direct experience with us but have, tell me about any experience you or your clients have had with the M&A transaction insurance rep and warranty, or views with insurance at all.

    Directors and Officers Insurance 

    Mark: Yeah, rep and warranty, especially what you do, Patrick is I think underutilized. I don’t have any direct experience with it because I think it’s underutilized. My experience is with D&O insurance, directors and officers insurance, and that, I’m just in general, a big believer in have good insurance because I think it’s a sign of just a well-run company. But especially to D&O insurance, when you’re trying to recruit board members, you have to have D&O insurance in place because, you know, board members, they tend to be wealthy investors, which means they have assets that they need to protect.

    And they might really love your company and might really want to come onto the board and really want to help you out but it’s just not worth the risk to them if you haven’t bought a D&O insurance policy to protect their assets because now they’re basically signing their assets to your company. And if, and, you know, people who go to court usually look for the deep pockets. And if your potential director is one of those deep pockets, you better have insurance to protect them.

    Patrick: Yeah, I think it’s important to know that a lot of times the facilities that are providing insurance for these companies, they have commercial insurance and the benefits insurance and so forth. They overlook D&O or they don’t have the capacity or the bandwidth to provide D&O. They go elsewhere for that. I think it’s very, very important.

    It gets overlooked that, you know, not only if you want to attract good board members, but if you’re a seller and you’ve got a tight group of shareholders, you’ll still need a D&O policy because your buyer is going to require you to have it because the buyer doesn’t want past lawsuits against the former owners to be brought when they take over the company.

    Mark: Yep, yep. They don’t want a skeleton in the closet to come out and cost them a whole lot of money.

    Patrick: Oh, yeah. Then we were involved in a deal once and I can tell you where we had the widow of a founder that passed away and, you know, we processed the deal, they opted not to get insurance. But within about a week after the deal closed the news about the deal was in the LA Times and how the widow was due to get her half of the money, which is about $60 million. Out of the woodwork, wife number one showed up and widow number one, you know, we were looking around. We had never heard of this. So it does happen.

    Mark: Yeah. And the rep and warranty, from how I understand how you’ve described it to me, I mean, that’s a no brainer because that means that the seller will be able to take more money out of escrow rather than leaving it in escrow to effectively be a bond against, you know, unforeseen stuff that could come up later on.

    Patrick: Exactly. Within the purchase and sale agreement, the seller puts down a number of disclosures about the company, the financials and everything, the buyer performs due diligence on those to ensure they’re accurate and within the agreement, it’s, there’s an indemnification clause that says essentially, if the buyer suffers a financial loss as a result of those seller’s reps being inaccurate, the buyer contractually can claw back a certain amount of funds or all the proceeds from the seller.

    So the seller has the sort of Damocles hanging over them because there could be something out there unknown to the seller, the seller has no control over after closing, and saying the buyer will hold them accountable.

    Well, rep and warranty is an insurance policy that literally steps in between the buyer and the seller, steps in the seller’s shoes and says to the buyer, if you suffer financial loss, we the insurance company will pay you your loss. Show us the loss, we will pay you. And if you’ve got an insurance company stepping in, there’s little or no need for the buyer to withhold funds in an escrow. So seller not only gets more cash at closing because it’s not held up in escrow but they don’t have this huge indemnity obligation that’s going to be stalking them for years after closing.

    And so they get quality of life, free of fear and everything. And the buyer, they’re assured that if something does happen, they can collect. And the beautiful thing is, I will tell you as an insurance person, price is a non-issue with rep and warranty. I know people might not think that. But here’s the thing, if you’re the buyer and the policyholder is the buyer of the company, okay? The seller will gladly eagerly pay the premium so the buyer is protected. Because if the buyer is protected, there’s no escrow. So buyer, you’re getting this great protection and somebody else is paying the bill. I mean inside it.

    Mark: Well, I mentioned earlier that more companies than you think fail due diligence and it’s not because there was something inherently wrong with the company, it’s because the buyer got skittish. And when you’re in due diligence, you’ve got lawyers, right? And the lawyers don’t get all passionate and excited about technology. They’re paid to find, you know, they’re paid to figure out well, could there be a widow number two that could materialize on the seeing? What happens if so and so dies?

    They come up with all kinds, that’s what they’re paid to do. And so buyers tend to be really skittish, and I can imagine that when the policy is in place, they can just relax, those lawyers can sign off and the deal can get done. And, you know, as you know, from deals, time is your enemy, right? So the faster you can close the better off you are because the longer that deal lingers, the more opportunity there is for something to go sideways.

    Patrick: Mark, how can our listeners find you?

    Mark: Two ways. Our website is xrocket.io. And my email address is m.addison with two D’s @xrocket.io.

    Patrick: Well is outstanding. And Mark, really appreciate this because that’s what we’re trying to do is find ways to add value that’s just not on the books. And here’s the nice thing, if you engage an organization like X Rocket, okay, not every firm out there is doing this. So you’re going to have a competitive advantage by engaging Mark. And I’ll tell you, it doesn’t hurt just having a conversation. So Mark, thank you very much for joining us today.

    Mark: Patrick, thank you so much for having me here. I enjoyed this conversation. Always good to talk to you.

  • Must-Have Insurance For Your Next Add-On Deal
    POSTED 10.13.20 Insurance

    If you’re involved in lower middle market M&A deals, you should know that Representations and Warranty (R&W) insurance is now available to cover transactions as low as $10M, offering tremendous benefits to both Buyers and Sellers.

    This isn’t common knowledge in M&A circles, even though it’s been more than two years since insurers started entertaining sub-$100M transactions.

    The pandemic has disrupted the normal route that this sort of news gets out: M&A conferences, where insurance companies share details on product development and product changes.

    If I wasn’t sharing this with you now, chances are, you wouldn’t know about it.

    That’s why I’m compelled to share that R&W policies created for lower middle market deals are available, and, although costs are rising because of the immense number of deals seeking this coverage, they are cheap – costing $225,000 to $240,000 for a $5M Limit R&W policy.

    This makes R&W coverage perfect for add-ons, which have been an increasing focus of PE firms in order to add value to existing portfolio companies.

    According to a recent report from Axial, the online platform that connects Buyers and Sellers, “Add-on acquisition activity in the United States has experienced a steady, near linear growth since the early 2000s.”

    Axial reports that 90% of acquirers are looking for add-ons right now—it’s a very robust market.

    Also noted in the report: add-ons represented 43.2% of buyout activity in 2002 and that had risen to 71.7% by 2020.

    Add-ons are often a smaller investment with potential for greater returns.

    The benefits to Sellers in an add-on deal are:

    • Greater value as part of a larger company
    • Cost synergies add to the bottom line
    • Access to larger customer base
    • Enhanced purchasing power and financial leverage

    Overall, this type of deal allows Sellers to strengthen a “weakness” keeping them from the next level. And the outlook for add-ons keeps getting better and better because Buyers in these deals are focusing on blending company cultures more than ever before. Add-ons are being done more “thoughtfully,” with conscious attention brought to successful integration—it’s not just “buy and forget.”

    The greatest benefit of an add-on is that it’s a “second bite at the apple.” Sellers retain a portion of the new entity, giving them potential for additional money when the new entity is eventually sold.

    For example, the owner of a $20M company agrees to sell for $15M cash and roll-over $5M (25%) in shares of the new firm. Later, when the new firm is sold for $100M, that 25% is now worth $25M, 5-times the original $5M roll-over figure and $5M more than the value of the original company.

    There’s a catch. Add-ons are smaller and less experienced in M&A than their counter parties.  Once a LOI is signed, Buyers with huge leverage can exert great pressure in negotiations, which creates tremendous stress on the Seller.

    The acquired company might feel cornered and bullied into agreeing to take a lot of risk and liability away from the Buyer – like take on a sizable escrow. Traditionally, the Seller could be at risk of losing 10% to 30% of proceeds if there is a serious breach. And they have to swallow the fact that they’ll only get a portion of their money at closing.

    Sellers have to wait a year or more – and the money sitting in escrow can be exhausted in the event of a breach that the Seller had no control over.

    That’s where Rep and Warranty comes in.

    Removing Risk With R&W Insurance

    One way to remove some of the contentious issues in a deal is through R&W, which enables Sellers and Buyers to transfer their M&A risk to an insurance company. This specialized type of insurance is helping add-ons be successful.

    Until recently, this powerful tool was not available to smaller (sub-$50M deals) due to cost and target companies not having thorough financial documents or Buyers developing key diligence reports.

    As detailed in my previous piece “Moore’s Law Comes to R&W Insurance” greater competition among M&A insurance companies has driven down premium levels and simplified prior eligibility criteria. To read the Moore’s Law piece, go to: https://www.rubiconins.com/moores-law-comes-to-rw-insurance/

    Insurers no longer require audited financials (a deal-breaker for lower middle market companies). Thanks to low costs, R&W is the ideal fit for sub-$100M acquisitions – especially add-ons. However, as I mentioned, due to increased competition in the last several months costs for these policies are going up.

    Currently, a $5M policy will cost $225,000 to $240,000.

    Another caveat: While deals as low as $10M are eligible for R&W insurance… not all insurers are offering coverage at this level. Due to a surge in M&A activity, the big national insurance brokers don’t have the staff available to handle all the applications coming their way. So, they’re focusing on deals with a transaction value of $200M+.

    If your deal falls under that threshold, you should be looking at a smaller firm that focuses on that level of deal—R&W coverage is still out there if you want it, you just have to look a little harder.

    (Also, keep in mind that Transaction Liability Private Enterprise (TLPE) insurance is available for deals with a Transaction Value of $250,000 to $10M.)

    Having this coverage in place makes for a much healthier environment post-closing, where you didn’t have to grind down the target company in negotiations. These are the folks joining your team, and if they come limping in, you can bet they won’t be as enthused to make the merger work.

    In the tech community, Buyers are especially reluctant to penalize their newest partners by using up escrow funds. So they have a dilemma. Do they eat the loss… or risk demoralizing their new partners? With a R&W insurance policy in place, that dilemma is gone.

    You want people to hit the ground running. How?

    Make sure they get as much money as they can with as little risk as possible. If you are the Buyer, the R&W policy is zero cost to you. And it can be applied directly to the purchase price which Sellers will eagerly accept.

    You want these transactions happening fast. You want to integrate the new group into your team in a positive way to ensure a successful transaction. What better way than this tool – Representations & Warranty insurance.

    It has withstood the test of time. It’s worked for the big deals, and now it also works for the lower middle market deals.

    What To Watch Out For

    As the R&W insurance market has matured, different insurance companies now favor different M&A profiles. Some prefer larger risks over $200M. Some prefer lower middle market – $50M or less. So when selecting a broker, make sure you work with one who is focused on your market segment.

    You could go to a “brand name” institutional broker for your lower middle market deal. They are not bad people, but they are focused on their bigger deals. They don’t have the bandwidth to handle the smaller transactions. If they have two or three billion-dollar deals going, they can’t handle a dozen $20M deals at the same time.

    Another wrinkle is that, due to lower priced R&W coverage, some brokers will add in extra fees to supplement revenue and maintain profitability per deal.

    I’m a broker with hands-on experience with the Representations and Warranty insurance product, specializing in insuring lower middle market deals.

    To learn more about the protection R&W coverage offers, I invite you to contact me, Patrick Stroth, at pstroth@rubiconins.com.

    Article Updated: September 01, 2021

  • Mark Gartner | Turning Targets Into Acquisitions
    POSTED 10.6.20 M&A Masters Podcast

    Mark Gartner is head of investment development at private equity firm ClearLight Partners LLC, which is dedicated to the lower middle market.

    Over his years in the industry, he’s seen a sea change in how PE firms go after potential targets, from “smiling and dialing” to using CRMs and data to guide their strategy.

    He talks about other elements of his approach to potential acquisitions, including how he always has a value proposition in mind when making contact.

    Part of that strategy derives from the fact that many of the ClearLight team have actually run companies and know the reality of operating a business – they’re not investors working in a vacuum.

    We talk about that, as well as…

    • Why 75% of companies utilize rep and warranty insurance
    • The reason they focus on lower middle market companies
    • The ideal target profile they’ve identified – and how it’s evolved over time
    • Where he and his partners see the greatest opportunity right now
    • And more

    Listen now…

    Mentioned in this episode:

     

    Transcript

    Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here, that’s a clean exit for owners, founders and their investors. Today I’m joined by Mark Gartner, head of business development at ClearLight Partners.

    Based in Newport Beach, California, ClearLight Partners is a long-established private equity firm dedicated to the lower middle market. And at the expense of showing my bias, I would say there are fewer places on this planet that are more beautiful than Newport Beach, California to have your office situated. So, Mark, I envy where you are. Welcome to the podcast. Thanks for joining me today.

    Mark Gartner: Yeah, pleasure to be here. Thanks, Patrick.

    Patrick: Now, before we get into ClearLight, let’s set the table. Tell us what led you to this point in your career?

    How Mark Got to This Point in His Career

    Mark: Yeah, good question. As I look back, I would point to a series of decisions that all seemed like good ideas at the time. I would say in most cases they were. But I started off in investment banking, like a lot of folks who get into private equity, first with a boutique out of Memphis, Tennessee, and really valued that experience working for a firm called Morgan Keegan, which a while ago now got bought by Raymond James. So fewer people are familiar with the Morgan Keegan name, but had a wonderful experience there. And that was really my exposure to the m&a process.

    And then I joined a firm most people are not familiar with called Houlihan Lokey, their industrials group and focus on plastics and packaging transactions to kind of round out almost three years as an investment banking analyst. And then I was looking for a buy-side job and I interviewed with a lot of firms, mostly in Chicago, which was where I was at the time. And at one point, I think I’d cold emailed ClearLight, not knowing anything about the firm, not knowing anything about Newport Beach. I’m actually from Cincinnati, Ohio originally. And they responded, so every now and then a cold email works, or it did back in the day. This is back in 2007.

    Patrick: It was meant to be.

    Mark: It was meant to be, yeah. And they brought me in for an interview to be part of this proprietary deal sourcing program they wanted to develop. They were looking to recruit ex-investment banking analysts who could sort of eat what they killed and really be on the phones trying to source transactions by calling business owners directly and then work on those deals once you kind of brought them in house. And to me, that was very entrepreneurially exciting at that stage of my career to kind of live the full lifecycle of a private equity transaction.

    And, frankly, everything that they promised that program would be for the most part became true. And so I was at ClearLight for four and a half years, was kind of romanced away to another fund up in the Bay Area for two and a half years to focus on building them a deal sourcing program, and then was welcomed back to ClearLight in 2014 for my second tour of duty, so to speak. And, you know, I’ve been focused since that time on building, you know, what we think is a high-functioning, you know, institutional-grade deal sourcing engine to bring in as many deals that fit our criteria as possible.

    Patrick: Yeah, that’s part of the magic there is, you’ve got these great theories on what you can do with targets is identifying the targets, and then, you know, making a good enough case for that target to want to be acquired.

    Mark: Yeah, that’s a really good point. And I think what that kind of touches on a little bit, or maybe I’ll just touch on it, is the evolution of how the sourcing strategy has changed. You know, we started out looking for proprietary deals, you know, just kind of smiling and dialing. And at that point, this is probably 13,14 years ago, you could do that because not as many funds were doing it. Then business owners started getting bombarded with calls and they just kind of stopped returning phone calls. So the strategy had to pivot.

    And then we switched to kind of intermediary coverage, you know, getting to know all the relevant investment bankers that were producing deal flow that we found interesting, and there’s over 1000 of those entities out there. And so that was a very real process to get up to speed on the population of intermediaries out there, and, you know, adopting a CRM and using data to help, you know, guide our activities. So that was a very interesting exercise. And then, you know, other funds adopted that strategy as well. And so one of the things you alluded to is making the case for a company or an industry.

    And I think one of the really exciting strategies that’s working today is defining a thesis for a given industry, sort of calling your shot, if you will, and then going out and approaching companies in a more intelligent way, in a very purposeful way, given that you’ve already said I want to be in this space. You’re a company whose door I’m knocking on quite intentionally. Would you like to talk about a deal? And we’ve discovered that actually works pretty well.

    Patrick: At the risk of getting ahead of ourselves here, let’s back up a little bit and let’s talk about ClearLight. And then we can go into that. You know, with ClearLight, tell me how it was founded and then describe the focus that they have and you have because we’re both in the same area here. We’re looking at the lower middle market as opposed to middle market.

    ClearLight Partners’ Unique Origin Story

    Mark: Yeah, great. Yeah, so ClearLight’s origin story is pretty unique, I think. You know, we actually grew out of an operating company, there’s only so many funds that can lay claim to that. This is about 20 years ago, our founder, was running a residential security business on behalf of a Japanese publicly-traded company who had bought the security company in Orange County, as it turns out, and it was effectively a turnaround situation.

    Our founder had advised the parent company previously, as an attorney, incidentally, had learned to speak fluent Japanese in his spare time in between undergrad and law school and actually studied, I believe, in Tokyo and was able to nurture on that proficiency in the Japanese language.

    And so he earned the trust of this Japanese entity to run their US operation. And so I think at the ripe age of 31, despite a career in law, he was installed as CEO of this home security company called Westech, Westech Security Group, which, if I understand correctly, was around 35 million of revenue, was on the verge of losing money and it was his task to turn it around. And over a 15-year period through a combination of organic growth and acquisition, he got it up to maybe 250 million of revenue.

    And it’s sold to a strategic buyer for about $300 million. And rather than send the money, the proceeds money, back to Tokyo, he was entrusted with that capital to continue investing in other US-based businesses via a private equity structure. And so ClearLight was established in the year 2000, with that inaugural fund of 300 million, and we’ve subsequently raised a second and a third fund, each 300 million, with every dollar we’ve invested to date coming from that Japanese entity.

    And so having this sort of single LP structure, kind of, in a sense, makes us a hybrid between, say, a family office and a private equity fund in the sense that we can invest over a longer time horizon if need be because we’re not subjected to the fundraising cycle. Yet we are staffed, motivated, incentivized, structured, to deploy capital routinely, you know, not by hobby, which is, unfortunately, how family offices have developed a reputation. So it’s been really the best of both worlds. And they’ve been an amazing partner, you know, for now, over 20 years.

    Patrick: Well, and it speaks to the success because there’s just the trust and, you know, and that’s how these successful funds create lead to other funds is you’ve got very happy investors that are, you know, they trusted you with a little bit of money and now they can trust you with more money and they just keep rolling it over.

    Mark: Yep. That’s a great way to think about it.

    Patrick: Yeah. And so tell me about the targeting the lower middle market. The reason why I ask is that I personally believe that the lower middle market owners and founders there are the real entrepreneurs that are in a space where they’ve created value from nothing and just need to get to that next step. And the unfortunate thing is, I think a lot of lower middle market founders are underserved because they don’t know channels and access points that organizations like ClearLight Partners provides.

    Mark: Yeah, it’s a good question. I think, as an investor, what you’re really looking for is inefficiency, you know, in the market, and as funds get larger enough to chase larger and larger deals, that market, the competition for those deals creates a very high level of efficiency. And so you have to ask yourself, Is that where there is the most opportunity?

    Maybe I’m biased because I’ve spent most of my time in the lower middle market but I think about how a lot of private equity funds for instance, don’t have dedicated deal sourcing teams, are not using CRMs, are not comprehensively canvassing the universe of intermediaries who produce the deals are looking for, are still establishing kind of EBITDA thresholds of 5 million when you can find really great companies kind of in that three or $4 million EBITDA range. And to me, that just really presents a lot of opportunity.

    And to your point, business owners in that size range probably have been underserved by equity capital providers, or at least there hasn’t been a focus on them. And I really think that’s changing. And, you know, some of the best deals, or at least a couple of deals I could point to that we’ve done, that have produced really nice returns have started with a very small, very modest starting point.

    So yes, there’s more risk to starting at a smaller scale and the companies might need to be invested in and have management teams built out and have proper systems kind of put in place. But if that’s all done correctly, it can produce a lot of opportunity. So I’m a huge fan of the lower middle market. You just have to know kind of what you’re getting into and, you know, learn the playbook, if you will, to create value. So I’m a big fan of it.

    Patrick: Well, you started, ClearLight Partners started as an operating company. And so let’s talk about, and we referenced this earlier, where you have a value proposition to make to these target companies as you are actively going out there, talking to them. What’s the message that you deliver that’s different? What are you bringing this a little different?

    Mark: Yeah, I mean, as it relates to our operating heritage, I think sometimes between, you know, operators and investors, there can be kind of a communication disconnect. You know, let’s say you’ve got investors who’ve only been investors, or who were investment bankers and then became private equity investors.

    There’s a manner of speaking that might not be compatible, you know, with how operators kind of describe their world. And then there also can be a lack of empathy for what it takes to execute strategy. And so if you look at our firm, starting with the senior-most leadership, these are people that have had p&l expertise. And that story kind of ripples throughout several people on our team who have run companies before, in some cases, run companies for private equity funds, and in even some cases further started companies themselves.

    So it just lends itself to, I think, a more productive discussion and kind of bridging that communication gap and really understanding what it takes to execute strategies. That’s a huge part of what we offer. When you couple that with kind of the single source of capital and the longer investment horizon, we think, you know, in a fairly commoditized private equity world right now, we think it makes us different, but it’s just all a matter of getting in front of those owners so we can actually tell the story.

    Patrick: It’s important that you talk about the empathy that you have because there’s a danger if your investor only focused, you’re going to fall into that trap that cynical people describe private equity. And that cynical thing is for words, just buy low and sell high. And, you know, that’s not comforting for owner-founders out there. And so it’s great that you guys are stepping out, and that is different out there from a lot of other folks. Why don’t you give me an example, you know, one of the deals you’ve done, or one of the success stories you’ve had?

    Mark: Yeah, I think one of my favorite stories involves us getting into the fitness industry, which is important for a couple of reasons. One, we had never done a deal in fitness previously. And this was a franchisee. And this is before franchising was as hot of a space as it has become. And so, you know, one of our partners, you know, really deserves a tremendous amount of credit for having the vision to get into the industry to get into this deal. And so this franchisee in question was a Planet Fitness franchisee, they had 12 locations in two markets, they were generating healthy EBITDA, the unit economics were very compelling.

    And if you know anything about the Planet Fitness model, it’s all about value. So it’s the low-cost model. And this is also at a time, I think, before the world became so focused on recurring revenue, but fitness is yet another industry that is based upon recurring revenue that perhaps wasn’t appreciated for it in the way that say, a security company was, you know, back in the day or has been. And so, you know, we took a bet on this particular business and it just paid off so well.

    You know, we got into a couple of additional markets, so bought new territories, opened up clubs organically, basically didn’t acquire a single club in our journey from 12 locations to north of 60. And this is over a five-year period. And there are some really great things that happened during that time. Built out a management team. You know, the president of the company was given the opportunity to assume the CEO role. So that transition was done effectively.

    A former ClearLight employee was actually able to step in as the CFO of the company, which proved invaluable kind of given his understanding of kind of how we analyze businesses and just the strong rapport we had with him. And, you know, the business, the exit of that deal generated basically the best financial return in the firm’s history in a five-year period. It just exceeded all expectations. So it’s just one of those great success stories where everything lines up well and you make a huge difference in the lives of people at that company. And it was just a really rewarding journey to observe.

    Patrick: Well, that breaks the stereotype of fitness centers being not the greatest investment in the world. So that’s really telling. I’m just thinking from personal experience, just seeing things in the bay area where his centers are coming and going. With this thing, were you dealing in just one geographic region? Are you regional, are you cross country?

    Mark: In that case, we had pretty disparate locations. I believe we were in San Antonio initially and in Nashville, I want to say, and got into Sacramento and then Pittsburgh and then also Canada. And so literally all over the map. And I know there’s a strategy that people like to embrace of building kind of regional density and the view that that kind of enhances valuation or kind of positions you best to enhance valuation. But in this case, we benefited just fine from having disparate layers. And it was, again, it was a great run.

    Patrick: Well, and let’s transition into just a little bit broader on the profile. What’s the ideal target profile that you’re looking for?

    ClearLight’s Ideal Customer Profile

    Mark: Yeah, and this has evolved over time. I mean, if you can believe it, back when ClearLight was getting started, we were trying to figure out a strategy. We even did a few venture deals, some of which that actually panned out okay. But then we pivoted to kind of traditional middle market, you know, LBO investing back when LBO is still a term that people used.

    But I think, you know, we’ve done deals buying from other private equity funds, but our passion is to invest in founder family-owned companies. Has been for a while now. I think that presents a lot of opportunity for professionalization, for investment into the business that, you know, not to the fault of the business owner, it’s just many business owners, you know, get their business to a point where they’re generating three, four or five, 6 million of EBITDA, life is pretty good.

    You know, why do I need to take the risk of over-investing in the business or taking risks with the business? And so we think that presents a lot of opportunity. We like situations where the business is in an industry that’s healthy and growing. So it’s very clear and easy to understand macro story, supporting the growth of the business.

    We don’t really invest in story situations or turnarounds. It’s usually kind of up into the right, organic industry growth that’s beating GDP for some compelling and sustainable reason. And then from there, it’s underwriting the business and try to understand, you know, is this a company that we’re excited about where, you know, we can understand the risks and box those accordingly and, you know, proceed with the management team to hopefully, double, triple EBITDA.

    Patrick: And that’s where you guys really add the value to because the skill set for owners and founders where they’re killing themselves to get to a point where they’re three, four million EBITDA, the skill set to go up to 10 million EBITDA is a completely separate set of skills. And oftentimes, you’ve got to bring out other people, and you can risk it by yourself and try to do it yourself or find partners, you know, in private equity who have not only done it before, they’ve done it in your industry before and they’ve got the roadmap and you’ve got the resources and the knowledge to bring to bear.

    Mark: Yeah. And then the other point I should have made too is we certainly welcome the involvement as shareholders of the founders, insofar as they want to retain equity alongside us. That’s actually a better situation than buying 100% of someone’s company. And it’s that proverbial second bite of the apple, which everybody talks about. But when it works, well, it does exactly what it’s supposed to do. And the second bite of the apple can be extremely rewarding. So that’s when things go well. We like to see that happen.

    Patrick: Yeah, to talk about rolling equity into future funds. Yeah, we came across our, we, a founder-owner sold his company for 20 million, retained, rolled 5,000,000, 25% into the new firm. And a few years later, they sold the, they sold the new company for 25, $30 million dollars. So his 25% actually was worth more than the entire amount of his company previously. And they took that and rolled it on in and I just, that’s a win-win-win, which I’m surprised more of those stories are out there right now.

    Mark: Well, and it’s also a good vote of confidence, frankly, when the owners want to retain equity. It’s a little scary if someone wants to throw the keys at you and kind of disappear in the sunset. So

    Patrick: In those cases of disappearance and so forth that, I do want to ask you, you know, in your involvement, both with ClearLight Partners and before, tell me about your experience with rep and warranty insurance. Good, bad or indifferent?

    Mark’s Experience With Rep and Warranty

    Mark: Yeah, it’s a good question. I was reflecting on this a little bit because in my seat on dealer origination, it’s not a product that I’ve had as much exposure to. I’ve mostly been an observer of market trends and listening to it come up as a topic of discussion. And I was able to research on rep and warranty because I was interested about, you know, where the product came from, where it’s been.

    Apparently, the product has been around since the late 90s. And it was created as you might expect, for fun, I wanted to free up money from escrow to get paid, you know, more at closing versus having some percentage of the purchase price being locked up for 12, 18 months, whatever it was.

    And so it’s easy to understand why a product like that would be created. It wasn’t really embraced until maybe 2007, 2010. People were accustomed to doing things the way they’ve always done them with escrow being some set percentage of the purchase price and so forth. I’m told rep and warranty insurance really gained traction to a law firm, a fairly prominent law firm who got behind the product was really recommending it to their clients and like I said, Maybe 2000, 2010.

    And I would say my extreme awareness of the product, you know, really started to come into view upon my return to ClearLight, maybe 2014 or so you just started hearing everybody wanting to talk about it. And if I understand statistics correctly, this is a little anecdotal, I’ve heard that in private equity-backed deals, maybe 75% of deals at this point are utilizing rep and warranty insurance. From my perspective, it has a couple of advantages, certainly to the seller. You know, you get more of your consideration paid to you at closing. From a buyer’s perspective, there’s also advantages.

    You know, if you have to go after a claim, you know, you’re dealing with an insurance company, as opposed to your new partners in the deal, which I could imagine would create for some awkward conversations, as you’re, you know, in the early innings of a transaction trying to build a company together as friendly colleagues. So it’s very clear to me why the project has, you know, become increasingly in fashion. You know, certainly in the recent, some of the recent deals we’ve done, without citing any specific examples, I know that it has been something that’s been utilized and I would expect that trend to continue.

    Patrick: Yeah, well, the biggest development out there is that rep and warranty initially was a product, the reason why I didn’t gain traction was it was prohibitively expensive and it was limited in what it covered and what it didn’t cover. In the technology sector, particularly for years, it would exclude any IP-related reps, which is is a deal-breaker in Silicon Valley.

    But because of good success and good traction and a copycat industry, other insurance carriers would get into the mix. And with competition comes two things, a broader improved product and lower prices. Today, rep and warranty can now be brought to bear for a transaction as little as $10 million. Were the minimum price, you know, all in including underwriting fees and taxes and everything, a $5 million rep warranty policy is under $200,000 total costs.

    I mean, rep and warranty is now available for add ons, where is it did make a lot of financial sense when the pricing was probably a multiple of where it is now. And it’s not only less expensive, it’s simpler to secure. And so that’s where we want to get the message out, particularly to the lower middle market, because two years ago, if you were under 100 million dollars transaction value, you probably wouldn’t be eligible for rep and warranty.

    Now, that’s not the case. So it was great being able to have it out there where it really does make a difference. Now, Mark, from your perspective, and I want to go to an article you just posted not too long ago called Never Let a Good Crisis Go to Waste. You had as we’ve been mired in this COVID-19 pandemic settle in place on again off again in California, especially, but what do you see out there for m&a going forward? And you had a great piece, we’ll link it to our notes here, but tell us what you see.

    Where M&A Might be Headed

    Mark: Yeah, I know I wrote that piece, I was just tired of all the negative headlines. I mean, it really weighs on your consciousness. And so I said, What’s the contrarian thing to do here? Let’s talk about how the glass can be half full amidst all of it. I mean, one of the alarming statistics is now an estimated third of our population is suffering from anxiety and depression, if not both. I mean, that’s like 100 and 10 million people. You know, wandering around their house, you know, depressed or anxious because of COVID. It’s like, we all need a little bit of cheering up here.

    So I tried to sprinkle a little bit that optimism through the article. And one of the quotes that I love that I just discovered in writing the article was something John F. Kennedy apparently said. And he said, When written in Chinese word crisis is composed of two characters. The first character represents danger, which is pretty easy to understand, but the second represents opportunity. And I think, therein lies the opportunity to find the silver lining amidst all this.

    And so, you know, I was reflecting o,n you know, what are some of the sectors or themes that are surviving if not thriving, you know, kind of amidst COVID? Because there are some green shoots, if you will, or some very nice signs of life amidst all of this. I think it’s important to focus on those. So I just kind of talked about a couple of them. I mean, recurring revenue is an easy one to point to. That’s interesting in its own right, has been for a while. Not a new idea, but recurring revenue-generating businesses are doing, for the most part, you know, pretty well right now.

    Similarly, and I’m saying this having just invested in an IT services company, companies with remote monitoring capabilities where you don’t have to be physically present to deliver some good or service are doing great as well because you can do what you need to do from the safety of whatever coronavirus-free location you happen to be in. Those companies are doing well. You know, I look at companies like our ice cream business, and I pointed things that I’m calling small consumable luxuries where there’s like a high ROI on happiness.

    You know, you buy a $6 milkshake or whatever it is, and that’ll cheer you kids up, get you out of the house. You know, so there’s all sorts of things like that that I think are doing okay. I look at like, at-home convenience services, having your groceries delivered to you. All these things that have given rise because in large part our behaviors have changed to be well-positioned. So, you know, thinking about specific sectors that might be kind of interesting.

    You know, I mentioned the depression and anxiety issues, I point to outpatient behavioral health, you know, sitting with a therapist and talking through your problems, there’s a lot of people who need help. And some of these issues often go untreated. And I think at the same time, some of the stigma around behavioral health is coming off. And I think there’s a lot of people that could benefit. So that feels like a classic do-well do-good industry that has been largely untapped by private equity for various reasons.

    And it’s pretty interesting. Express car washes, fabulous industry, hiding in plain sight for way too long, you know, high margin recurring revenue, you don’t have to get out of your car, very COVID-friendly, you know, really nice business that kind of plays with our kind of multi-unit retail strategy. We’d love to do something there. We talked about fitness, there’s no way around it. Fitness is going through some hard times right now, for the obvious reasons, but as soon as people can get out of the house and feel comfortable exercising again, it’s just gonna go gangbusters, in my opinion.

    And I think that it kind of correlates interestingly to the depression issue because fitness, you know, offsets, you know, kind of gloomy moods. You know, you get out there and you generate some baritone. And then I mentioned kind of IT and other tech-enabled services for the reasons I mentioned before, recurring revenue, remote monitoring. I think those businesses should do pretty well, too. So, you know, not an exhaustive list. There’s others. Some of the stuff is pretty obvious, but you know, trying to find, or trying to view the glass as half full, anyway.

    Patrick: There has been that trend of pre-COVID to have fitness being brought from the outside into the home, particularly with peloton. We’ve only been in our home so much, I think that trend is going to go back. And just the desire of being around other people and being in another facility away from the home is a real good idea. Mark, how can our listeners find you?

    Mark: Oh, gosh, yeah, so I’m on the ClearLight website. I’m, I think, reasonably easy to find there. But people are welcome to email me, call me anytime. Early often, we love hearing from people who want to chat about any of the topics we’ve discussed in this podcast. Or maybe they know a company or are running a company that could benefit from capital at this point. Even if it’s early, it’s always good to have those conversations to kind of get to know people. So feel free to visit our website. Email addresses on there, phone number, and give me a call anytime.

    Patrick: And without showing any bias again toward ClearLight with our other guests and our other colleagues and partners out there. I will say though, if anybody is interested, have had a chat with ClearLight and see if you can swing a quick visit to their offices because like I said, there are fewer places on this planet that are as beautiful as Newport Beach. So Mark, an absolute pleasure being here. We’re going to talk again.

    Mark: Alright, thanks, Patrick. Enjoyed it.