Our special guest on this week’s episode of M&A Masters is James Darnell. James is the Managing Partner of KLH Capital, a private equity firm based in Tampa, Florida, that focuses on serving family and founder-owned, lower middle-market companies throughout the US. KLH Capital was recently recognized as Private Equity Firm of the Year by M&A Source.
“We’re always thinking, ‘How do we add value? How do we help teams be more successful? How do we help them grow? And, what do we have to do to make that happen?’”, says James.
We chat about KLH’s firsthand experience with buying, as well as:
Patrick Stroth: Hello there. I’m Patrick Stroth, President of Rubicon M&A Insurance Services. 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 James Darnell, managing partner of KLH Capital. KLH Capital is a private equity firm based in Tampa, Florida, that focuses on serving family and founder owned lower middle market companies. In addition to being extremely active with six successfully completed deals in 2020, KLH Capital was recognized as private equity firm of the year by M&A Source. It’s not too bad during a pandemic. James it’s great to have you here today. Thanks for joining me.
James Darnell: Oh, it’s a pleasure to be here. Thanks for having me, Patrick.
Patrick: Yeah, James, I mean, we’re just starting off here. But let’s be honest, okay. You were kind of sad to see 2020 go, weren’t you?
James: Well, you know, in a lot of ways I was, before the pandemic, I spent my life on an airplane as a road warrior. And last year gave me a pretty unique opportunity to spend more time with my family and my kids. And so, you know, while while you know, definitely a challenging year, in a lot of respects was also a blessing in many others. And for that, we’re grateful. But But yeah, like, like many I was glad to turn the chapter on the year.
Patrick: Yeah, well I’d say with with the change in travel and business development, I think sometimes less is more. So I think we’re going to happily adapt to that. If things change up. So before we get into KLH Capital, let’s start with you, James, what brought you to this point in your career?
James: Well, I’ve been pretty fortunate, I grew up, again, a lower middle class family in South Alabama, which is not a really a hotbed for investment banking, or private equity investing. But I had a great family who helped me get to college at the University of Alabama. And in college, I went to work for a small business broker in Birmingham, Alabama, who kind of taught me how to buy and sell companies, and some told me how the business worked. And from there, I was fortunate enough to go and actually help run one of his first portfolio companies as the CFO. And so I got to work inside the business for a few years, you know, really living kind of what we call a wartime, you know, experience, because this was during the financial crisis. And so I get to learn a tremendous amount about how a business really works from the inside.
And that’s actually helped me, I believe, to be very successful as a as a private equity investor myself, just kind of really understanding what the company is going through. And, you know, US private equity guys, if you don’t know this, we actually are the smartest guys in print. And that’s a that’s, it’s in the Bible. That’s how it works. And, and so, you know, private equity, guys like to sit in conference rooms, and say, we’re going to pursue a differentiation strategy, or we’re going to move this or we’re going to do this or whatever. And having sat in an operator’s chair, it’s, it’s helpful to have a perspective to understand that, you know, it’s not always quite that easy. And so I got to do that for a couple years. And then after I did that, my partner Will, and I, you know, saw an opportunity to continue building KLH. Ah, and so then I moved to work here at the, at the firm, and I’ve been doing it ever since. So it’s been a been a wild ride so far.
Patrick: Well, I think that when times are easy, you know, take the learn very much. It’s when times are tough, that all of a sudden, you have to start breaking rules, or breaking habits and and trying something different. So I’m sure you’ve got a lot in your time there as an operator.
James: Yeah, that’s exactly right. We have a saying around here that says, you know, revenue growth covers a lot of sins. And, you know, and when wet revenue stopped to grow and or God forbid, pulls back, then you get to see kind of who’s been swimming naked, so to speak. Right. And, you know, that we learned that in 08, 09, we’ve learned that last year, and, you know, try and learn from those experiences and continue to build build great companies.
Patrick: Let’s talk about KLH Capital. And I tend to get an insight on that companies by with their culture and their founding and so forth by the way, their named. Tell us what KLH get named for?
James: Well, KLH was actually formed as kind of a joint family office for a couple of high net worth, you know, guys here in Florida, who were mainly managing their own money, and the K, the L and H were their initials. And my partner Will and I were actually the first you know, employees who were working for them to help them do their deals and help them manage their personal portfolio. And over the years, we did really well, we made them a lot of money. And we raised a fund and we invested that did really well and so on and so forth.
And over time, my partner Will and I actually did an MBO of our own and bought our firm from the guys who had originally started it and, and so we have kind of first hand experience going through what we help our portfolio companies do, which is, you know, help the people who have built the firm realize liquidity and value for what they’ve created, but also enable the younger generation to continue to have a runway in the path to grow their careers and build wealth for themselves. And so that’s what we got to do here. So yeah, the K on the L and H, the KLH, or just, you know, the, the name of the firm that we were, we managed to buy and, you know, represents kind of the brand that we’re trying to build.
Patrick: And you continued the brand, you didn’t go ahead and name it Darnell.
James: Yeah, that’s right. We I mean, look, we toyed with the idea and we said, Hey, well, what if we change the name of it? or what have we rebrand or something like that. And we just felt like there was actually true value in the name out in the marketplace. And when people we believe when people say, hey, I’m working with KLH, that means something and and that represents something that you’re going to get a fair deal with people that you can trust, and you’re going to be treated with integrity and respect. And, and we believe that that helps us win deals and invest in the right businesses. So for those reasons, we decided to keep it.
Patrick: Well, yeah, your focus is on owner founder lower middle market companies, you haven’t scaled up. What why is that tell me about your direction there and if it’s a passion or a business choice. Why lower middle market and not upstream?
James: Our passion for this segment of the market is really rooted from, you know, kind of our heritage of where we come from, you know, we grew up working with, you know, founder and owner, operator, you know, businesses that have never been, you know, exposed to institutional capital. So, you know, firms that don’t have great financials. Firms that don’t have maybe the best websites. Firms that don’t know how to put a fancy board deck together in a fancy spreadsheet together to explain things to the smart CFA guys in New York and Chicago with their fancy ties and things that so these businesses, you know, are great companies that have a tremendous amount of potential to grow and realize higher levels of success and help, but they need they need help getting there, they need a process, they need a guide, who can help them reach their full potential.
And that’s what, that’s why we really exist. And so, you know, the size of the companies have changed over the years, as just the amount of money you know, that we manage, you know, it’s changed. But But all of our companies have in common is that they’ve reached an inflection point in their life cycle where they’ve built a lot of value in the company. And the owners of the business need to realize some of that value. But they want to align themselves with a partner that shares the same vision and values for where the company can go, that they have. And my job and our job here at KLH is to equip them to realize that vision and, and do it in a way that everybody is able to enjoy and have fun while we do it. So that’s why we exist.
Patrick: Yeah, I think that’s fantastic. That’s why we really want to highlight firms like kale h capital, because I sincerely believe that the lower middle market on top of the very, very large marketplace out there, there are a lot of companies in that space that truly need help. They’re great companies. But if they don’t know about KLH Capital, or firms like yours that are committed to firms their size, they’re going to default and go to a higher priced institution, where they’re not going to get great response time, they’re not going to get the resources that fit their needs. And they’ll get overlooked, they will get overcharged, but they’ll get overlooked. And it’s just not a fit.
And a lot of these organizations, like you say they don’t have the clean financial state don’t have things that are presentable and staged, like, I guess, staging a house. And so it’s organizations like yours, that can look through that and see the value. And so that’s why we love highlighting organizations like yours. Now, James, you know, what does KLH Capital bring to the table? You’ve got experience as the operator, and you are looking I’ve got, I figured that you’ve got the patience with organizations that aren’t as, quote unquote, pretty or claim, but what do you bring to the table that helps the fund and makes a good partnership?
James: The primary thing that we bring to the table is experience helping companies make the transition from you know, family owned or entrepreneurial led businesses, to companies that can run with the premier middle market businesses, you know, in their industry, right. And so there is a large chasm, if you will, between where these companies are today and where they need to get to, both in their maturation, their leadership, their systems, all those types of things. And that’s not a knock against where the companies are today. Because those businesses are great companies.
They created a lot of value. You know, they’ve done well they’ve created a lot of wealth for the you know, family or the entrepreneurs. built it, but it has potential. And that’s what we’re really about is helping them unlock that potential. And so we spent a lot of time working with the leader on developing their team, right. And so leadership development of, you know, the C suite, which gets a lot of attention, but also that second tier of managers to make sure that that that entrepreneur who maybe has never been on a true vacation in the last 20 years, because he’s always going to be in the thing can can can build a team where he can really truly disconnect and get away.
And yes, that we spend time with him working on things like that. We do a leadership forum, we invest a lot in coaching, we do a lot of things like that, to help those teams, we spend a lot of time on systems and infrastructure. So technology is a obviously a very powerful force in the world today, for entrepreneurs who have been reluctant to invest in technology, because they’re not quite sure of the payback on it, we’re able to come to the table and say, No, no, no, no, look, this absolutely works. If we put in, you know, a route based GPS software into your fleet, you know, we can look how many, you know, road miles, we can say driving every year and what this means for gas and repairs, and maintenance and insurance.
Like, here’s the payback, we’ve done it eight times in the last two years, like, hey, let’s put in this new earpiece system, which will give us access to all this, you know, data and analytics that will help us make more data informed decisions, which will, you know, hopefully make better decisions, but also help us create more equity value, you know, for the company down the road, as we’re thinking strategically about our options. So think about a lot of things like that. And then there’s just kind of the housekeeping of how you run a business, how you do your accounting, how you do your insurance, what bureaus your real estate situation look like. And so we’re able to kind of help with all of those types of things, you know, both at a board level, and if the company needs, you know, kind of at a at an operational level with some of our operating partners that we would bring in.
Patrick: I think that’s unique in what you say here, where you’re not just helping the C, the C suite, you’re going down a level to middle management, the folks that have to implement and monitor and actually get feedback. And I can’t understate how important that is because particularly when you’re incorporating new technology, and you probably have a lot of cases, we’ll talk about, you know, your your target your target profile clients, but in portfolio companies, but I can imagine that not everybody embraces new technology, the same way. And there are some that will actually really fight and you talk about the the GPS routing, because I had experienced with that with moving and storage company where they really thought the division manager or whatever, really fought the new electronic GPS systems. So it’s helpful to have that that guidance, not just the checkbook.
James: Yeah, no, that’s exactly right. And we’re, you know, is, as you even said, that I’m thinking about one of our portfolio companies right now, where the CFO is, is is fighting me on the idea of putting in a new inventory management system, because, you know, he kind of likes it, how he likes it and stuff. But the problem is, it doesn’t, you know, allow for the centralized purchasing and things that we need to do to be able to make the business more efficient, more lean, and so, but that’s, that’s the job, right? I mean, and this is where we, you know, there’s, I got a lot of kids, so I think about things and, you know, in kind of the parenting paradigm a lot of times, right.
And you can use the carrot, or you can use a stick. And, you know, we don’t ever like to pull the stick out. And so it’s just a matter of, okay, maybe you’re not a carrot guy, maybe you’re a strawberry guy, but there’s nothing I can do to help you, you know, get you to where I want it where I want you to go. And, and, you know, sometimes I gotta nudge you along a little bit. But, you know, once once, once everybody’s able to get over the reluctant fear of like, you’re here to change everything, then then we’re able to generally make a lot of progress in some of these initiatives.
Patrick: Well I think the other observation I make with what you’re what you’re saying here is that unlike the perception of the non M&A perception, where you’re not involved with this on a daily basis, when you come up, you’re experiencing mergers and acquisitions, as from what you hear the news is Company A buys Company B, those are right, you cannot remove the human element in mergers and acquisitions, okay, it is really a group of people choosing to partner with another group of people with the objective that one plus one equals five. And if you try to remove that human element, you’re you’re not going to you’re not going to move forward. So it’s great that you guys focus so much on the training and the education and the coaching. Coaching is great. I mean, and that that’s a new development in education now is everybody now has a coach.
James: Yeah. Now that’s exactly right. I mean, you know, I think 20-30 years ago when you know, the idea of private equity and you know, we’re called today, the lower middle market came to be, you know, it was really just financial engineering, right? If you bought a company cheap enough and didn’t go bankrupt, then you were generally gonna make money but did you use debt Just, frankly, was pretty simple, not a lot of work. But these days, you know, you have to do that. But like, it’s not necessarily about, you know, what you pay for a business, you know, I mean, because everybody kind of understands what fair value mean is for most companies, and nobody’s really going to give their business away anymore.
It’s about creating value, you have to actually create value, or you or you don’t have a reason to exist. And so that’s what we, in my partners, and I wake up every day thinking about is like, okay, we’re very fortunate, we have eight companies that we are fortunate enough to be partnered with right now. And Lord willing, another eight that I don’t know about that are out there somewhere, you know, today, and we’re working on thinking about how do we add value to those guys, you know, how do we help those teams be more successful? How do we help them grow? And what do we have to do to make that happen?
Patrick: Well, I’m sure those eight companies are looking for you right now change. Why don’t you guys, give me the profile of your ideal target. What are you looking for?
James: So we focus on industrial service and distribution businesses. And sometimes light manufacturing businesses that are typically going to be between 20 and 50 million per year in revenue, that we think have the potential to double over, you know, the next 4,5,6,7,8 years. And those are those are the types of, you know, if I was to describe the perfect woman, if you will, or the perfect deal, that that’s what it would be, you know, sometimes we go smaller than that, sometimes we go bigger than that. But those those are the type type companies on the surface.
But once you kind of check the box on that, because that’s just two bullet points, like does it meet this yes, or no? It is really about the situation, you know, where a family or an entrepreneur has built a business, they’ve created some value, and maybe it represents the vast majority of their net worth, they need to do a deal, right, they realize they need to do a deal, they need to be thinking about succession planning, they need to be thinking about their estate and liquidity and taxes.
But they want to preserve their heritage, because identity to business people, particularly men, and the women were differently, but for men, our identity as the leaders and the bosses in the kings, if you will, of these kingdoms is very important to them. And these kings want to be thought well of, in, in, in their communities when they come and when they go. And so you know, that means doing a deal with people that can help them make sure that they feel good about their name, and what they built and how they, how they left, if you will, kind of thing and so the people that are concerned about that, or whatever, we were the right fit for those folks.
Patrick: Now, so the majority of your portfolio companies, management stays on or owner founder stays on, and you’re bridging that as they go to the next chapter of growth? Or are they looking just for exit?
James: We strongly believe in investing in managers who have a demonstrated track record of success in running their business. So sometimes, you know, if you have a team of three people, maybe one person wants to leave immediately, one person wants to leave in two or three years and one person wants to retire in five years, you know, so you see you kind of are constantly, you know, configuring the team. But if somebody just wakes up one day and says, hey, I want to sell my business and you know, head to Cabo, then we’re probably not the right fit for there’s, there’s groups out there that absolutely would be a good fit for those entrepreneurs.
But that wouldn’t be for us. And so, you know, we’re looking for somebody who’s, you know, generally in their 40s, or 50s, right, they’ve run hard for 20-25 years, they’ve got another five or 10 years left. But they’re also understand the way the world works. And, you know, they maybe they’ve gotten their business to somewhere where they need some help kind of reaching that next level. And, you know, as part of that, you’ve got to do a transition. And so that those are the types of situations that we’re looking to help with.
Patrick: Are you limited geographically for the area that you target or all over the country?
James: KLH invests all over the country. We generally spend more time west or excuse me, east of the Rocky Mountains as you would expect the based here in Florida, it’s just a little bit easier to get to. And so it’s a little bit easier to be in front of our management teams. But we have invested in Colorado before we’ve chased deals in Washington and California before. We’ve got businesses now in Texas and New Jersey and Ohio. And so really anywhere anywhere Delta or Southwest flies we are will be there.
Patrick: Now I don’t know if it’s accurate to connect you with with University of Alabama but I get kind of a feel that another unique element that you’re looking for is a sense of competition. Somebody who enjoys competition and enjoys pressing their limits and pressing about their envelope for performance because it sounds from what you said earlier that you’ve got firms that want to make it to the next level, and they want to be up with their competitors and stuff. So you’ve got, you’re looking for organizations where management has kind of a fire in the belly.
James: Yeah, no, that’s exactly right. I mean, there’s no such thing as a free lunch. And so, you know, in any industry, that is making money, you know, there’s somebody out there plotting to, you know, take that from right, the famous Jeff Bezos quote, right, your your margin is my opportunity, that that exists in more than just, you know, selling books over the internet, as Barnes and Noble learned. And so, you know, for all of our businesses, we preach that and so we, we kind of train, we practice, we work hard, we do the hard things, because it is about winning, it’s about growing, and, sure you got it, you got to have a fire in the belly, you know, to do that, and that’s part of, of making sure that people are the right fit for what you’re trying to do.
You know, I mean, if you if businesses are a, you know, I wanna say a cash cow, but essentially cash cow type companies that were really, really dominant, successful, and, you know, they’re just kind of rotten out or whatever, then again, that’s great, I hope to own a cash cow myself, personally, one day that I can, you know, continue to milk into my later years. But, you know, for investors like us who are passionate about building great enduring businesses, those might not be the right candidates to start with. And so that’s where it’s so important to understand. You know, you’re you’re the business owner and the management team, what is their vision? Where did they see their business go? And, and can you actually help them with what you know, that you’re good at, so that you can be aligned from the beginning in what your strategy is, and what your goals and and what your objectives are.
Patrick: One of the things we have to remember with mergers and acquisitions is that, you know, it’s not all done in a vacuum, there is risk, there are dangers out there. And I can imagine what you come across a lot of times, James, with the portfolio, companies that you’re targeting their first time, M&A folks, and so they haven’t been used to this whole process. And they don’t realize until they’re in the negotiations that they can be held personally liable to the buyer, you if you know, there are any financial problems that happen post closing or something unknown comes out that wasn’t turned out very diligently.
And so for the first time, the these owners and founders realized that, hey, I don’t have a corporate veil to hide behind it is being in my money that’s at risk. And that creates a lot of tension and a lot of fear. And one of the things that developed over the last couple of years, especially great for the lower middle market, is there’s an insurance product out there that can literally take the indemnity obligation that the seller has to the buyer, and transfer that over to an insurance company. So buyer has peace of mind that if something does, you know, unforeseen happen post closing, they’re going to be made holding, their financial loss will be covered. And for sellers, they know that they’re not going to be risking a clawback or a very large escrow.
That’s going to be held back for several years, because, you know, the insurance policy is stepped in, and the products been reserved for mid market deals. It’s called reps and warranties insurance. And in the last year and a half, you know, the news has been a little stunted, because of the pandemic and just can’t get the news out about it. But now you’ve got transactions down in the $15,000,000. 15 to $20 million dollar level that are now insurable, which wasn’t the case in 2019 or 2018. So, you know, I’m just curious James, you know, good bad or indifferent what experience have you guys had rep and warranty on your deals?
James: Sure, we’re big fans of the rep and warranty policies. We use them for virtually every, you know, transaction, we’re involved in both as buyers or sellers in businesses. They’re particularly helpful when we’re investing in a new business because, you know, the indemnification agreements that you referenced are essentially like a prenup, you know, in a marriage, and it’s just really, really awkward. You know, when you’re engaged and you’re planning a wedding and they’ve been so excited to have to talk about well, but you know, if something goes wrong, we do we are going to sue you for this and sue you for that.
Like it just it just I’m telling it is extraordinarily awkward dynamic to start a relationship on. And so it’s so much more helpful to be able to say, hey, look, here’s these reps, you’re telling us that your customers are real, and your employees are real, or whatever in this company is going to ensure that and if they’re not, then this company, then this insurance company will be on the hook for that. And, and so, you know, you don’t have to worry about any of these reps and we’re all good, right? And it just allows the relationship to really kind of skip over that. That part of the house, they skipped over the part because she’s gonna have to negotiate it, but it just sets up a fresh paradigm for the relationship when you start out.
And for us as investors, it gives us a lot of comfort, because we’ve been in the situation before where, you know, God forbid, you do have a claim, but this is your CEO who is running your business, do you really want to make a claim against your, you know, CEO, or your management team, you know, is running your business for you, you know, kind of thing. And so, before the rep and warranty policies came to exist, the indemnifications, while they gave you, you know, some level of comfort, they weren’t really that valuable, you know, for a lot of people. And so we see a lot of benefit on the on the buy side. And of course, when we’re, you know, fortunate enough to be, you know, exiting some of our investments, we don’t want to be exposed to contingent liabilities for years and years down the road either. So, so we use them there.
And I do, you know, agree with you, Patrick, that they have become much more feasible for smaller deals. I’m under loi on a business right now, that’s a 16 and a half million dollar purchase price, you know, investment. And it’s an add on for one of our existing portfolio companies. And we’ll be using, you know, rep and warranty insurance for that transaction. And, you know, the cost is kind of getting baked in to the cost of the deal, and everybody understands it. And it’s really, it’s really not that big of a deal, not that big of an impediment to being able to get a great deal done.
Patrick: Yeah, I think that’s the nice development of the marketplace now is it used to be kind of an act of Congress to bring this tool in, and it almost was, you know, had an impact on how the deals were negotiated with slowing down. And the cost was prohibitive years ago. And it’s become a very, very elegant tool, thus accelerating deals. But James, as we record this, we’re now into the new year. We’re coming up on spring. And I’m just curious, you had a great 2020. What do you see going forward? Either on a macro vision, or just for KLH Capital in your space? What trends do you see for the year coming forward?
James: That’s a great question, Patrick. I mean, we feel that fundamentally, the the economy in the US is is quite resilient, quite strong. The fact that we’ve been able to do as well generally, as we have, despite the pandemic, I think, is a testimony to that. And we, of course, are super sensitive to the people who have been, you know, negatively affected from, you know, just a health perspective, but also their businesses as well, because not every company has done well. We have companies that haven’t done well. And we have some companies that have done well. You know, despite all those things, the economy is fundamentally strong.
And so as the vaccines continue to be distributed, and people become more comfortable with the new normal, and you know, states begin to open up that were otherwise, you know, more more conservatively locked down. We just think the economic engine is just going to continue to pick back up, we see unemployment, continuing the pickup, or unemployment continuing to decline as people, you know, come back to work. And now we’re very, very excited. We’ve got big plans for the year, last year was our best year ever. And we’re hoping that this year is our best year ever. Of course, there’s a lot of work to do that. And we’ve got to wake up and hustle every day and be able to create value for our companies. And that’s what we’re trying to do. So, we’ll we’ll be back to it. As soon as as soon as we roll off the air today.
Patrick: James Darnell of KLH Capital. Thank you very much for joining us today. Just a great system there. And I’ll tell you, you got a competitive advantage, particularly against strategies because you’re going to take those owners and founders and give them that winning edge. And I can’t tell you how much that resonates from you. Thank you so much.
James: Thank you, Patrick. I really appreciate your time. Thanks for having me.