On this week’s episode of M&A Masters, we speak with Kresimir Peharda, corporate and M&A attorney with YK Law. Kresimir is the Chair of the firm’s Cannabis Practice.
As federal legalization inches ever closer, we invited him on the show to discuss the ins and outs and the rise of M&A in the world of cannabis.
Listen as he walks us through:
Patrick Stroth: Hello there. I’m Patrick Stroth, trusted authority in executive and transactional liability and president of Rubicon M&A Insurance Services. Now a proud member of the Liberty Company Insurance Brokers Network. 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 Kresimir Peharda, partner and chair of the cannabis practice at YK Law. With offices in New York, Texas and California, YK Law describes itself as the gravity and prestige of big law with the flexibility and efficiency of a solo.
And I asked Kresimir to come on today because in the news, we’ve got legalization on a federal level with cannabis that’s imminent, it always seems to take a little bit longer. But I thought now’s the time before that federal federal stuff gets passed, that maybe we start looking at the ins and outs of mergers and acquisitions in the world of cannabis. So Kresimir, great to have you. Thanks for joining me today.
Kresimir Peharda: Well, thanks, Patrick. Glad to be here. It’s definitely an interesting and ever changing topic.
Patrick: Yeah. And you know, in certain places, it’s, you know, top of mind with a lot of folks. So I’m glad you were able to come and join me. Now before we get into cannabis and specifically M&A and cannabis, let’s set the table for our audience. You know, why don’t you talk about you real quick, what led you to this point in your career?
Kresimir: Yeah, it was actually really organic. Just clients or potential clients coming to me in the first case was a landlord years and years ago, probably more than 10 years ago, way before legalization in California, or I think anywhere, for that matter. Who wanted to rent space to a dispensary. Yeah, in the in the real estate that they held. And so they came to me asking for advice. And at that time, really, I had no good advice to give them which was super frustrating. You know, I had explained that I understood real estate leases, and I could help them with that. But I had no idea what would happen if the police heard about it. Or if the neighbors complained, or somebody came in. I really that was uncharted territory.
So I had to unfortunately tell them to go to talk to a criminal defense attorney. And and that experience kind of snowballed from there. We had other folks, we had people looking to invest in cannabis business. And same thing I can tell him look, I understand securities, and and investments. But because this is illegal, it’s really uncharted territory. But you know, the whole subject matter of the investment is illegal, technically. So how do you how do you manage risk there, there, there was no playbook. And then, of course, companies looking to grow, cannabis companies started coming to me. So I thought it’s time to really, really get into it, and learn about it understanding that it is ever changing, complicated and multi subject matter.
Patrick: We had talked about the the real challenge that you just talked about it here, where you’re taking an industry, which is pretty large, that’d been up until now in the shadows, and now it’s coming into legitimate business. And that’s a real awkward transition, because, as you know, you have a lot of the first legal advice they got was on the criminal side exclusively. And there was no other business, you know, availability or resources there to bring it. So talk about, you know, that challenge on going from shadows into now your operating?
Kresimir: Yeah, well, it couldn’t be more of a contrast, right? Because, you know, 10 to 15 years ago, the only people advising cannabis companies were criminal defense attorneys. And of course, their job is to keep their clients out of jail, you know, limit the prosecution, minimize the evidence that the state can use against their clients. And so their their mandate to clients was always to not have any documentation, make everything oral, everything verbal, handshake deals and all that. Well, now in 2021, we’ve we’ve come really full circle to the opposite situation. The the regulators in California and other states require license holders to provide documentation of almost every major deal.
Not only ownership and financial interest holders of people financing, but any significant really deal that involves any measure of control or significant share of revenues, is going to have to be disclosed and regulators. So the world is flipped on its side. But yet many of the people running these businesses have come from the gray world, the world where they were told for years and years not to have any documentation. So it is a little bit of a battle, to to get folks to understand that the times have changed. And now you really do need to have everything on paper, because it will only help you and it’s expected.
Patrick: Well, I think also the issue is that you’ve got this overwhelming moral view one way or the other with cannabis as a product, you know, virtue or not. And, you know, as we look at it, a lot of us have come around to the belief that look, if if cannabis is no different than, let’s say, a pharmacy, and, you know, pharmacies have, you know, controlled substances, and they and they are regularly putting those out to the public, you know, with prescriptions and everything, but there are controls there. So, if cannabis can go ahead and have guidance, policies, procedures, like a pharmacy, then they should be looked at no differently than Walgreens. And that’s the process I think, you know, people like you are bringing, bringing along there. So, tell us, what does your practice, what are you bringing to the table for cannabis now. And talk about, you know, investors, growers, however, however, you’re structured.
Kresimir: You know, so personally, I come into this industry, having been in three startups, two in real estate one and healthcare. So I understand regulated industry, but, you know, regulations here are kind of at another level. And what I would say my personal view is that, really, cannabis is going to be really kind of like alcohol and should be treated like alcohol in the future. So I think that’s the direction we’re headed in. As a brief aside, having the one of the challenges we’re gonna have, you talk about legalization, one of the challenges we’re gonna have in the future is, what happens if the federal government if Congress decides to, you know, tomorrow? And I’m not saying they will, but tomorrow legalize it, what happens to all the state regulatory regimes? Right, because my clients and clients out there throughout the states have spent a lot of time and money preparing for and complying with the state specific rules.
So if the federal government tomorrow were to say, okay, it’s now federally legal, I think nobody knows exactly what what that would do to all the state by state licensing systems. So that is, that is one thing I would say. In terms of what we do, you know, so our approach really, or I should say, my approach is one coming from also representing a lot of public companies. NASDAQ and NYSE companies. And understanding that they have, you know, tremendous burdens, which actually, there’s some parallels to what cannabis companies have to go through, of course, they’re doing it on budgets that are a fraction of the size. But it’s, it’s really, you know, they’re forced to do regular reporting one way or another.
And the way we look at, you know, the business is it has to be multi specialty. It has to go through a corporate lens and a regulatory lens, at a minimum, but then you you layer in employment, because there are very specific labor laws that apply to cannabis. You you layer in IP, where cannabis companies basically cannot get trademarks on their key property. So they have to do workarounds. You layer in taxes 280E and some of the complexities and structure. And so the point is, we have a kind of a multi specialty approach to the industry, because there’s so many different areas that impact even a relatively small player in the business.
Patrick: Well, and and I can only imagine that with with the confusion from state to state, I, these companies aren’t multistate, are they?
Kresimir: Well, so you know, some are, and you know, that that means that, that we’re working with either people who are licensed in that state or within our firm, or we’re partnering with folks who have local licenses throughout various states, because we certainly don’t have don’t claim to have a person in you know, every single state out there. But, you know, once once you have, I think, a very in depth knowledge of a state that is, let’s say, a little more challenging like California, I think it’s a lot easier to then work with a local partner in other states to help clients reach their goals.
Patrick: Well, when when we talk about regulations, there are a lot of people that if they’re not in a regulated industry, it’s a full time job, stay on top of that. And it’s really unique because regulations do have a lot of impact, particularly with people who are investors or don’t realize their investors? And so why don’t you talk about just some of the impacts that regulations have on cannabis companies.
Kresimir: Sure. Yeah, they’re massive, really. They’re massive. So in California, as an example, and this will vary, Colorado is different. But in California, the regulations will control the type of structure you use on your M&A transactions. You’re basically limited to stock purchases, and mergers. Asset purchases are not allowed. You know, the visibility. So you know, if you’ve ever tried to do timetable for a deal in M&A, you understand this, this this issue, it’s extremely difficult to come up with, with any kind of reliable timetable, or calendar and you know, list list of items to do. Because everything is so new for the regulators.
Now, now, this is getting a little better. But you know, drilling down a little bit, you have to keep in mind that even with with a single target, so let’s say you are the buyer buying a single target, they may have locations in multiple cities, and they may have multiple licenses. So each city is a stakeholder in your M&A transaction. And each administrative agency at the state level is also a stakeholder in your transaction. So you can imagine if you have multiple targets, multiple licenses, multiple cities, the level of complexity that you need to manage, that’s just on the regulatory side, not not even having to do with the M&A transaction itself.
Patrick: Well, and on top of that, if the regulator’s this is all new to them, if they haven’t made determinations, is this something akin to tax, where, you know, they’ll they’ll decide it later. So you may be on the hook for some violation after the fact?
Kresimir: Well, haven’t seen that. But But the challenge is that, you know, a client will will understandably say to me, well, how long do you think it’ll take to get through the approval process at the city? And so in some cases, we can say, well, based on our past experience, you know, it’s been, it’s been this long. But sometimes, you know, it’s a new city, or sometimes it’s a novel transaction, or, or, you know, there’s additional complexity. And so, past experience is not going to be a guarantee of future results. Now, having said that, the development in California that, hopefully is going to be positive is three state agencies have merged into one, which in theory is going to reduce the variability in the process.
But I was just on a webinar last week, put on by the LA County Bar Association, and they put out the question to the panelists, and, you know, basically everybody, you know, are they are they still seeing variability between different clients and different analysts at at the state level, specifically? And the answer was, absolutely. It’s, there’s still a lot of variability. And that is challenging, right? Because your clients will want to know, when, how long, how much? And those are difficult questions to answer just for that reason. And that’s not really obvious from the outside. It’s difficult to appreciate that an analyst within a state agency is going to differ from another analyst. So that makes it difficult on everybody on the deal.
Patrick: Also, just another challenge here, because banking is not possible. You had mentioned this earlier with without a structure. These have to be stock purchases, or mergers. What other elements of an M&A transaction is unique to cannabis? I’m just thinking one where they’re not getting, you know, any bank loans for this.
Kresimir: Right, right. So, no bank loans until relatively recently, normal, insurance was difficult to get, that’s changed, I think, and is changing. I mean, there are a lot of things, one thing that comes to mind is, you know, the and we talked about this, one of the challenges you have is that with so many stakeholders in your deal, oftentimes these stakeholders will literally control your deal. They will tell you what to do, when to do it, and how to do it. So you know, the the case that really comes to mind is when you have a condition of precedent, for the for the buyer to sign off on a deal, the obtaining of governmental approval.
Well, we’ve had the regular tell us that our client has to waive that otherwise they will not even proceed and in approving the deal, and they will not even tell us how long it will take to potentially approved the deal. So you have a regulator who’s not just a you know, kind of signing off on the deal. They’re literally controlling how you structure the deal. The timing of it, and the risk that the buyer has to take, in this case.
Patrick: In your in your experience, how large the transaction value size, are these deals that you’re seeing?
Kresimir: Oh, I mean, you know, we’re seeing anything from the low seven figures to to, you know, up to about 50, 60 million on the higher end. So, you know, I think the way I look at everything in cannabis is probably about a 10th, the size of what you would see in CPG. And that’s just the nature of the industry by by its, you know, relative youth and being relatively early in the process and relative lack of access.
Patrick: With, you had mentioned also with insurance, which is an industry and you know, the property and casualty insurance market is coming around, and there are resources there to ensure product inventory, crime, trip, just your basic business trip and fall, work comp, all that’s out there. I would caveat that until now, rep and warranty, which is the backbone insurance for mergers and acquisitions. They haven’t signed on yet. I think there there’s still a lot of unknowns out there that they’re waiting for, which is why, you know, we can’t draw on any experience that way.
And it’ll be it’ll be a US company, largely that steps into that. I anticipate Lloyds of London, they still have a very traditional view and look at this as a vice, and they don’t want to promote a vice. And that’s just a cultural thing. That that we will see what happens. But aside from insurance coming around, what other improvements business wise, you know, for operating a cannabis company are happening? I’m sorry, this is off script. But I’m just curious if you’ve seen other evolutions, because the law is obviously evolving.
Kresimir: Yeah, well, so. So one thing would be banking. There definitely is more banking available. Certainly I know of banks locally and regionally that are providing banking. So that is definitely a positive. And then for the MSOs, the multi state operators and and the larger private companies, you know, that they actually can get institutional debt. It’s very new, kind of brand new, but it does exist at the top end of the spectrum. So that is an interesting development, we’ll have to see if that trickles down to kind of more of a mid mid market and lower market in the cannabis industry. But but that is a hopeful sign of, you know, interest rates below 10% on institutional debt, which is, you know, surprising because that, you know, a year ago, that would be unheard of.
Patrick: Wow. Okay. And I can just see that we’ve got I mean, by any metrics, usage is up. And so it’s it’s a growing industry, it seems like now is going to be a little bit easier to conduct business as as things go on. There are more business services and resources being brought to bear. You know, Kresimir, what kind of advice would you give a first time cannabis M&A, you know, buyer? I mean, that’s targeting something, what advice would you give?
Kresimir: Well, so a couple of things. Don’t underestimate the regulatory complexity. You know that that’s going to drive that’s going to drive a first time buyer crazy, because the level of uncertainty that you’re going to have is much greater, I think, than any other space. Really think about the tax liabilities that you are taking on. Assuming you’re, you’re you’re actually buying the business via stock or merger, because we found that most of these targets have tax liabilities of some sort. And then you have to remember that if you’re taking on this business, you take on all that liability. So that means the principal, the interest plus penalties, so those liabilities very quickly become seven figure, even in smaller deals. So that’s that’s a huge, huge issue. And that’s a tough one for the buyer to suss out because really it requires them to really do some forensic accounting, to try to get at that, try to at least scope it. So that’s, that’s another one.
And something that they probably didn’t think about is, I think it’s critical in all deals, but but in the cannabis industry, it’s actually more important that you have a reasonable relationship with the buyer. And the reason for this is until such time as that there was an actual transfer of the license, the state, specifically the state and oftentimes the city will will not even interact with buyer or buyer’s representatives. So the buyer is completely dependent on the seller or the seller’s representatives to make progress in the transition process. So if you have a seller that’s unmotivated, or becomes ill, or the key person, you know, flies out to Hawaii for six months, you’ve got real, real logistical problems in your deal. And that’s not something you see in other industries to this degree.
That last point, to to the advice to buyers is understand that in many states, you have to work very, very carefully with the buyer to structure the transition so that the business does not close down. Historically, in California, the regulators would would say, if there is no person from the seller side that’s staying on in any capacity, then the business would have to actually shut down and and the buyer would have to start anew essentially. File a new application and begin the process. And obviously, that is devastating for a buyer who’s thinking that they can just continue the business to have to shut down even two or three months, makes a material impact in the financial projections and the whole deal. So I would say that’s, that’s another key point.
Patrick: I mean, the question out there, I asked all my guests is what, you know, what trends do you see going forward? Pull out your crystal ball. And you know, if you’re right, you’re going to be a genius. But where do you see legalization going on a federal basis?
Kresimir: I think what I see is very likely is on the banking side, that we get some movement, that’s probably the safest. I would say within the next year, I, I believe that we’ll see some movement on the banking side, because that’s a lot easier to swallow, then an entire deregulation decriminalization of the whole industry. And partly because the banking industry is behind, and law enforcement tends to support it. And it just makes sense from a crime and practicality standpoint. Nobody these days wants to be dealing in cash, not even the tax authorities. So that is one thing.
I think we’re gonna see some changes, probably on rep and warranty insurance coming, you know, whether it’s next year or the year after that. I think we’re gonna see more and more banks provide, you know, accounts. It’ll get easier to bank and, and my hope is that, you know, within a year or two, we’ll start to see more debt be available at more reasonable terms, so that these companies can can do it in a way that makes more sense. And they’re not paying, you know, hard money lenders exclusively. They’re not paying, you know, 15%, 20% to try to grow and expand these businesses.
Patrick: Wow. Why would you think that also, maybe there’d be a little more efficiency on the regulatory front too. Usually, you get regulators that really like to cling on to their rules, and and their standards, but you you reference, you know, three, three organizations, consolidating in California. Do you think the state regulators might ease up on some of this stuff?
Kresimir: Well, I’m hoping that the experience level will will improve. That there’ll be more standardization. I mean, the thing that makes it tricky is this variability, every analyst having a different understanding of what the regs are, and that makes it difficult. You know, a lot of times when they’re pushed on that, they they just regurgitate the regs so they don’t take kind of any responsibility, kind of for the enforcement side of it, or the interpretation side of it. So I think that will improve. Hopefully, the cities will have more experience. Just working through transactions, transfers of ownership, transfers of locations, so it will get easier, but it’s going to take time.
Patrick: Okay. This has been fascinating. There’s gonna be I mean, there’s more to come down. Kresimir, would you, would you, because I got you on tape right now. Would you agree to come back as as things change? You could update us?
Kresimir: Sure. Absolutely. Just throwing another thing out there. Another thing that kind of hit the industry is the US Postal Service now formalised the ban, basically on on mailing vapes through the mail, and that’s going to have an impact, I think a negative impact on the industry. And it’s not clear to me that that was really the intent Congress had, but that’s where we are so basically THC, CBD is is no longer going to be able to be mailed through the mails with very few exceptions.
Patrick: We’ve got, things are changing constantly. So the story has not been, it’s been written but it’s still in progress.
Kresimir: Oh, very much very much.
Patrick: Great. Well Kresimir Peharda of YK Law, how can our audience members find you so that if they have a deal coming up they can they can, you know, avoid some of these pitfalls?
Kresimir: Sure, pretty easy. Our website is yklaw.us. So it’s dot US as the ending. And my email is kpeharda, k p e h a r d a @yklaw.us.
Patrick: Great. Kresimir, thanks so much for joining us today and just a lot, a lot of great insights. Appreciate you being here.
Kresimir: My pleasure, Patrick.
On this week’s episode of M&A Masters, we speak with Michael Kornman of NCK Capital.
NCK Capital acquires controlling interests in lower-middle market companies and takes them to the next level with “right-fit” capital structures, inspiring management incentives, and nurturing support.
Michael says, “We love the lower middle market. It’s a great place to build value…” Listen as he walks us through:
Patrick Stroth: Hello there, I’m Patrick Stroth, trusted authority in executive and transactional liability, and president of Rubicon M&A Insurance Services, now a proud member of Liberty Company Insurance Brokers, a nationwide network of specialized insurance brokerages. 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 Michael Kornman, managing partner of NCK Capital. Based in Dallas, NCK Capital acquires controlling interests and lower middle market companies and takes them to the next level, with right fit capital structures, inspiring management incentives, and nurturing support. Michael, I’m really looking forward to this conversation today. Thank you for joining me.
Michael Kornman: Thanks for having me, Patrick.
Patrick: So, Michael, before we get into NCK Capital and what you’re doing, which I think is next level, with transitions and so forth, which our audience is really going to enjoy. Let’s set the table, we’ll start with you. What brought you to this point in your career?
Michael: Yeah, so I you know, my brother and I founded in NCK Capital in 2014. And before that, we had built and run a number of lower middle market businesses, and a few different industries. And so we felt we were well positioned to, to add value to the you know, lower middle market companies. And also had a unique perspective where we, you know, walked in the shoes of a lot of founders. We’ve we’ve dealt with the same issues they they’ve dealt with and understand those on an intimate and very personal level. And so we, we thought we’d be we’d stop building companies, you know, from from a dead stop and start start investing in the lower middle market.
Patrick: And now, as we transition to NCK Capital, I always like to find out about companies, you know, how they’re named, because NCK Capital is not necessarily your initials. So give us that background, then walk in and tell us about NCK Capital.
Michael: My last name is Kornman with a K. So everybody assumes that it’s something something Kornman, but that’s not it at all. Grant and I have three daughters, Natalie, Claire, and Kate. And we were originally going to name the company, oldest to youngest. So Claire, Kate, Natalie, we got the URL, we were building out the marketing materials, and it kept looking like Chicken Capital. And so we just, we just couldn’t deal with that. So we rearranged the letters, we got the NCK. And it’s our daughter. Grant does have a son. He came after we founded the firm. He’s still he’s still, you know, a beneficiary. So it’s okay.
Patrick: Well, yeah, he will, we’ll find something separate for him down the road, that’ll be something, it’s amazing, you’re not the first guest to, you know, share with us that getting the URL had a big role in how the name ultimately came out. Si it’s just one one thing for the new age. Now you’re focusing on the lower middle market, you’ve been around for a little while. Explain why lower middle market? What is it about that, and your thought process?
Michael: Yeah, we love the lower middle market. It’s a it’s a great way, it’s a great place to build value. You know, there’s, there’s so many lower middle market companies, and there’s so much capital in the middle market, that need folks like us to grow these companies to the scale that they need so that they can invest in them. And so we’re generally the first institutional capital not always, and we have, we have two portfolio companies that we acquired from other private equity firms.
But generally we focus on family or founder owned businesses. And we love it because it’s just, the market seems endless and, you know, our story, we’re a family. You know, Grant and I built the firm. There’s other people here now, but you know, it really resonates with sellers. And so we’ve, we’ve had, we’ve had good results.
Patrick: Yeah, I think that in addition to having the lower middle market, where it’s is a vast market out there. I think that’s where you can really make big change because so many owners and founders out there, they work hard, they’re very successful, but they can only get a company their company to grow so far. And then they get to that inflection point where they’re, you know, they’re they’re too big to be small, they’re too small to be enterprise. And they don’t know how to take that next step.
And it gets scary because it, without organizations like NCK Capital out there, you know, they may default and either go with a very large institution or a brand or go to a strategic which may not necessarily have their best interests in mind. And so the more options that are out there and the awareness that we can we can bring to the lower middle market is our way of serving this market. Because if they don’t know about this, they’re at risk of being underserved and overcharged and we can’t do that to the owners and founders out there.
Because they’re, they’re the back backbone out here. A big distinguishing element of NCK Capital is that you do, and you mentioned this on your site, you target family owned businesses, as opposed to a startup and so forth. Talk about that focus a little bit more. Why that’s so personal? Is it just because you guys, you and your brother are family?
Michael: Yeah, we walked in their shoes, we’ve dealt with the issues that that small business owners deal with. And these are, I mean, make no bones about these are small businesses still. I mean, we we invest in companies with two to 10 of EBITDA and our sweet spot is really like two to six. So these these companies definitely are in the early stages of their of their lifecycle. And you know, we have we’ve, we understand what it’s like to have invested personal capital over a long period of time.
We understand what it’s like to, to build out an organization where you where you have real issues with people and challenges and you know, you’ve you’ve you fought in the trenches alongside those people for a long time. We understand what it’s like to build a culture, and develop that culture, and how important that culture is to founders. And, you know, so we’re user friendly, that’s really important to us. And I think that’s, that’s one of the reasons we’ve been successful.
Patrick: One of the things I think is really exciting, because you’re coming from an operating background, so you’re not trying to kind of financially engineer these these organizations, you know, from maybe, you know, performance to great performance, just by cutting expenses, and moving moving around numbers. I think you got an operational tilt. I’m just curious with some of the things that you’ve experienced, have you ever had an experience where you’re sitting with the the portfolio company, the management team, and they put their trust in you. And you talk about well we’re going to try doing X, Y, and Z, and you just see this epiphany, where they just look and they just like, I didn’t expect that, wow, we can do that. Did you have any kinds of things, this is kind of off script, but you know, that those things happen.
Michael: It happens, it happens regularly, and it’s really fun to see. I mean, so our focus in NCK is, is in addition to buy and build, which is obviously a common common strategy in private equity. We really focus on companies that where we can, we can get organic growth. And we think that that, you know, that’s, that’s really important. We like businesses with high cash flow conversion, that, that we can, we can grow organically. We like businesses that we can deploy, you know, whether it’s a digital marketing strategy, or, or a more sophisticated sales and marketing marketing strategy, or, you know, or, or some, you know, some of the more traditional people process and technology and operations.
You know, we like businesses that we can grow in a way that a founder would understand. And so those conversations are do happen, and it’s, it’s fun to, to riff and collaborate with, with founders and sellers and oftentimes, you know, sellers are rolling over a substantial amount of equity. And, you know, that’s, that’s an important part of our process is educating them on kind of how how we approach the world. What we’re going to do post transaction and explain to them you know, kind of our excellent returns and, and that that helps us win deals as well.
Patrick: Well I think one of the scariest things out there for anybody, I just from personal experience, I’m getting emails constantly about marketing, lead list strategies, all these things, and I can imagine, you know, if you’re the owner, or the founder, you’re you’re operating your business, you need to get sales up, you don’t know how, and it’s such a gamble. I mean, it can be very expensive. If you don’t know what you’re doing, it’s really really scary. So I think that your experience there on helping them bridge that gap on you know, opening marketing channels, sales, bringing in people, those are all the scariest things for owners and founders, because they have so much to risk and you give them peace of mind because not only do you have the resources, you’ve got the experience and you can just walk them through that.
Michael: I mean, some of these founders want to stay on and continue to run the business but want to take a substantial amount of money off the table. And you know, their analysis up to this point is hey, I can grow this business but I’m gonna it’s gonna reduce my distributions. And you know, I’m gonna have to go it alone, where, you know, we come in and we’re, you know, we, we’re a team. So it’s a lot of fun to collaborate with these, with these folks. And the the leverage you get is, is huge.
Patrick: Now I’m gonna go back to something we talked about, at the very beginning about, there are a couple of elements that distinguish what NCK Capital does, again, as a Californian, it’s like the software approach with business. But you are doing a couple of things here. If you could just give us a sentence or two, just how you mean it. And we’ll start with right size capital structures.
Michael: Yeah, I mean, that’s a really great, great question. In the lower middle market, these small in the, in the lower end of the lower middle market, when you start to start to grow these businesses, there’s definitely a J curve. There’s definitely a dip in EBITDA. And so you just have to make sure that, that you’re, you’re planning for that. Because if you if you in generally it’s through over equitizing the business, but if you use that, or the wrong kind of debt, or or too much debt, rather, we all use debt. But it can be it can really be painful and disruptive in the in the early part of the investment period.
So we just like to make sure that that you know, we’re set up for success and you know, there may be a, you know, period where things things are a little less smooth than you’d like. I mean, generally, the inflection point in our experience is two years. The first few years you’re investing, you’re growing and you know, it really takes about 18 months to two years for the EBITDA to really really be able to grow to materialize.
Patrick: That’s a term that a lot of people tie in with family offices, they call that patient capital. But you know, if you know that out front that you’ve got this time window, don’t panic let’s just go through it and I mean at our age now 18 months goes by really quick. You’re gonna get to the other side. So you bring that on, and I think that’s very helpful because it also brings the temperature down. Especially following you know, the closing, I’m sure management is they roll over they want to hit the ground running and they’re they’re very stressed. They want to make a good impression. Relax, you know, you want that so that that’s a great way to ensure success. The other thing you mentioned is not just management incentives but inspiring management incentives. So talk about that a little bit.
Michael: Yeah, so a lot of times we’re we’re recruiting managers from outside the business and and that’s where you experience a lot of a lot of growth just hiring fantastic people that you know, some of these businesses just haven’t had exposure to people of this quality and sophistication before. And so, you know, our focus is we really we really view those management teams as partners and a lot of people say that. You know, we’re really focused on wealth creation for them, and that is we want to make sure that they’re they’re focused on the long run, they’re focused on you know, ultimately the exit and you know we we get really excited when when when our our management team partners build considerable amounts of wealth in these in these deals.
Patrick: Kinda fun, kinda fun when you watch that. The, it ensures just everybody everybody’s interests are aligned and what why wouldn’t that be. Because I’m personally have an abundance mindset. So if that’s being passed out that just only inures to the benefit of all which is which is fantastic. And it also speaks to a track record for future investments down the road. I think I think that is just credibility, that can’t be questioned.
The final thing you talk about again, as as Californians, we look at this, we’ve talked about nurturing, and culture and things, which I there are a lot of people that look at that sideways, maybe 5, 10 years ago. But then the book, Infinite Game came out with Simon Sinek. And you’re seeing a change in mindset with management, looking at things like culture, where they’re, they’re, like, grading it, they are measuring it, and so forth. Let’s talk about what you do when you’re talking about nurturing.
Michael: Yeah, well the first thing we do when we talk about culture, well, we provide a lot of support to our management companies. I’ve never walked in I’m sorry, to our management teams. I’ve never walked in to a company where people were sitting idle, and they were they had a lot of extra capacity. But we you know, they’re they’re dealing with, you know, day to day issues running a business. And we all agree as a as a, as a team, there are certain initiatives that can can add a lot of value that that may or may require outside resources. It may be us at NCK Capital.
It may be it may be the right consultants, but we like it could be something like, sourcing the right vendor for additional marketing initiative. It could be selecting a new site for you know a new location, geographic expansion. It could be really, really anything that an executive team member would do, that they may not have, have capacity to do. So we will parachute in, we’ll help will work alongside of the management teams. And, and, and get those high value initiatives completed. But we also back to the culture discussion, we we really believe it’s important to understand the culture of the business and understand the people and no matter how much diligence you do, it’s really hard to, to understand that completely pre acquisition.
So when it comes to culture, which we think is an incredible accelerant for, for value creation and growth, we take a I wouldn’t say a passive approach, but a more patient approach in stepping back and observing and learning. And that’s, that’s just, you know, I think there’s a lot of everybody’s pressured to move fast in this business. I think that’s one place where you just can’t move move that quickly.
Patrick: Yeah, I think that’s everybody mistaked culture for well, we’ve got a very formal dress code, you know, attitude versus, you know, relaxed dress code. No it’s how you do things. There are some some organizations that are comfortable, just do putting as much, throwing as much on the wall as possible, see what sticks. Then others don’t want to go step by step on a process, and you’ve got to get that kind of synched up. And and and you do this. And I’m remiss, are there particular industries that you target?
Michael: Yeah, so we really like services, businesses. And that could be any service that provides an essential service to another, any business that provides an essential service to another business. Could be tech enabled service, it could be environmental service company, it could be a we have a building services company in our portfolio. Really, we like healthcare services of certain types.
We really like all all all sorts of service businesses. We also kind of what, it’s a little bit different and not in everybody’s investment criteria is we really like for-profit education. We have two, well, we just exited one, we have two vocational schools in our portfolio. And, and really, really like education, businesses of all types. Not just schools. Specialty distribution businesses, we’re working on one now. And then niche manufacturing, where we, those are our four buckets.
Patrick: Okay, fantastic. When we talk about mergers and acquisitions, in the lower middle market, we’re dealing with, you know, two parties. We got a one party that that’s experienced, that’s almost always the buyer. And then the less experienced is the seller where they don’t sell their business every day, this is usually their one time. And when you have situations where you have a deficit of experience, fear and distrust can come in, where you know, once I say we’re going to do X, Y, and Z, and this is market, this is how it works. And then the unfamiliar side is just like, wait a minute.
I didn’t see this coming. And so there’s always the real danger for these deals happening. And they look good on paper, but when you’re dealing with people, okay, we’ve got those elements of fear and greed out there and you can’t get around that. And so as you go through the myriad of the process with due diligence, and everything else, and all these things can side track a deal and sometimes it comes down to the people. What we’re very proud about in the insurance industry is we found ways because with fear, it’s fear of risk and fear of loss of money, and so forth.
And what’s been nice is the insurance industry has come in with an insurance product called reps and warranties insurance. The buyer suffers a financial loss as a result of a breach of the seller reps. Now the seller is looking, saying wait, I’ve disclosed everything to you. You’ve done diligence. If I didn’t know it, I didn’t know it. And the buyer says I’m sorry this is market we have to do this. We have to you know put this little backstop on, it’s what everybody does, and we just have to do this to go forward.
And so there’s an element of distrust. Well, if you’ve got a rep and warranty policy, all of a sudden an insurance policy takes the place of the seller’s indemnity obligation. Seller gets a clean exit. If the buyer suffers a loss, buyer’s made whole. And so it’s just been a real revolutionary product that’s accelerated deals getting closed successfully. It’s lower the temperature, it’s done a lot of wonderful things. But you know, don’t take my word for it. You know, Michael, good, bad or indifferent, what experience have you had with rep and warranty insurance?
Michael: I mean, it’s the greatest thing since sliced bread, right? I mean, we we we just exited one of our portfolio companies. So reps and warranties, warranties policy there. You know, of course, reduce the escrow, maximize proceeds to the seller. It made negotiation of of the purchase agreement considerably easier. And you know, we’re excited being in the lower middle market that that’s now available. It obviously started in the middle market. And is is, you know, a tool that is available to us in the lower middle market. And I just, we use it everywhere we can.
Patrick: But I’m very pleased because you know, especially for the lower middle market, there’s been a little bit of a threshold. Because while rep and warranty does come down to smaller deals, there’s there’s a point at which the cost for due diligence to be eligible becomes a barrier to entry. And this is largely on deals where the transaction value starts falling below 20 million. A lot of buyers do not want to incur the expense to do all the diligence to get there. And at this time in 2021, the insurance industry is so full with the larger deals, there’s absolutely no bandwidth to even entertain small deals.
What I’m very excited about is that there is a new facility out there. Provides a sell side policy. But it’s one where it’s designed exclusively for micro market deals where the transaction value goes from under a million to 10 million. Where the policy we can ensure that deal all the way up to full transaction value up to 10 million. There is no underwriting fee, there is no diligence process required. It’s just an application. And it’s designed to address that area. And you know, we’re using this as a platform to get the word out because even though a lot of lower middle market deals are involving companies larger than 10 million, you always have add ons.
And it’s really nice if you can backstop you know, a sub $10 million add on where the seller has a policy at the seller’s expense so the buyer has some protection. And so it’s called TLPE. So I want to make sure that we just make a mention of that. Because for NCK Capital forward as they go on, this could be a fit on some areas where the traditional rep a warranty policy just just doesn’t work.
Michael: Sounds like a fantastic tool to have in the toolbox, especially for add ons. So that can make, make that, make those a lot easier.
Patrick: Thanks a lot. Thanks a lot for your comments on this. I’m glad that you know you got you got that one deal done. It’s interesting. We’re we’re kind of curious with private equity, the view of private equity is they are very reluctant to incur insurance premium expenses. If they can transfer risk, however, they can limit their expenditures, they won’t hesitate. Rep and warranty is the one exception where they they gladly go. And I’m very proud, because it’s been the good performance by the insurance companies.
They’ve kept their word. They’ve delivered on claims. And so we’re very, very happy. But as we get back into, you know, NCK Capital, Michael, where I mean, I blanked, and we’re already planning for 2022. You know, could you tell share with us, what trends do you see as we go end of 2021 into 2022? Either macro or NCK Capital in particular?
Michael: You know, sentiment is mixed. Some people think that, you know, there’s going to be reduced deal volume in 2022. And everything and some of the proposed tax changes were driving the, or anticipated tax changes, were driving 2021. Deal volumes, obviously 2021 was incredibly busy for everyone. You know, I’m a little more optimistic. I think there’s I think there’s a lot of businesses that are waited to come to market due to you know, they wanted to get some, some some time away from the pandemic.
And I think there’s going to be an enormous number of great businesses in the marketplace. One of the things that I think that we’ve, we’ve seen just from a deal structure standpoint is it’s been more structure in deals this year, then then, I mean, earnouts were dead pre pandemic. I mean, they’re just, they just weren’t, weren’t very commonly used. And you’re starting to see those more and more. And I think that’s really interesting. So I think that’s going to be I think that trend may continue on into 2022 as well.
Patrick: Right. I agree. I see no end in sight with M&A. I think that we’re just going to get a lot more creative as we go forward. And I think that tax issues, taxes are gonna go where taxes are going to go, that should never be your primary motivator for doing things. I also agree there have been a lot of sellers that have been on the sidelines because they’re kind of refilling their balance sheets, and just upping their value as they go along. Well, Michael Kornman with NCK Capital, how can our audience members find you?
Michael: Yeah, I thank you for asking. Our website is NCKcapital.com You can find both Grant and I there. And, you know, really a pleasure to chat with you today, Patrick. It’s a great podcast. I listened to it regularly and I I was honored that you invited me on so. So thank you very much.
Patrick: Thank you so much. And I will just as a shameless plug for NCK Capital, I would say too and we’ve got quite a few audience members out there that are family owned businesses that are owners and founders out there. Give NCK Capital a quick look, especially because I think they’ve got a soft spot for you. And that always works to everybody’s benefit. So Michael, thank you again.
Michael: Thank you so much.