Sean Frank | An Expert Investor on Cloud-Based Infrastructure

Transcript

Patrick Stroth: Hello there. I’m Patrick Stroth, a trusted authority in executive and transactional liability and President of Rubicon M&A Insurance Services. Now a proud member of the Liberty Company Insurance Broker 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 Sean Frank, founder of Cloud Equity Group. Cloud Equity is a Wall Street based private equity and mezzanine debt firm, strategically positioned to capitalize on the rapidly expanding industries of web hosting, and cloud based infrastructure. Sean, it’s great to have you here. Thanks for joining me today.

Sean Frank:Thanks for having me, Patrick.

Patrick: Now, before we get into Cloud Equity Group, which we can imagine where your specialty is, but before we get to that, let’s start with you. What brought you to this point in your career?

Sean: Yeah, so interestingly, you mentioned that I have a very nontraditional path into private equity, private debt, we call it the investment management. I actually started my first company back when I was 12 years old, it was a web hosting company. Caught the tail end of the.com, boom, and grew very big very quickly. You know, organically, we expanded into a number of different verticals and internationally as well. When I got into high school, I connected with a guy named Andrew McKelvey, Andrew was the founder of monster.com. And at the time was running a private equity firm in New York called Blackfin Capital is a billion-dollar fund.

And he’s the one who really got me into M&A and teaching me that you can grow your business inorganically by you know, essentially acquiring competitors or similar businesses, and expand that way, instead of just relying on organic growth. And so, you know, over the course of, you know, maybe a decade, we did probably two dozen transactions together and really scaling my business and learned a lot about M&A through that experience. But one of the things I also learned is that I didn’t want to be the CEO of a business. I liked much more the transactional side of the business and negotiating deals and finding deals and adding value to companies and ultimately being able to sell them, as opposed to just keep growing and growing and growing and reporting, you know, to shareholders and sort of the complex needs of a rapidly expanding company.

And so with that, you know, I had the mindset that, hey, I want to do this in a financial cap capacity and not a strategic capacity. And that’s where we founded Cloud Equity Group back in 2013. It was basically to continue building on, you know, our strategy and doing M&A. And then at the timeinvesting in, specifically cloud hosting providers, and you know, do it now on behalf of investors and create a financial product around it, instead of just doing it to grow a single business.

Patrick: Now, when you’ve got Cloud Equity Group, you didn’t name it, Sean Frank Capital. So how’d you come up with that for a name, and then get into Cloud Equity, because you do more than just cloud related business.

Sean: Yeah, it’s a very valid point, you know, coming up with the name was difficult, and I’m definitely not a creative person. You know, I think one of the problems with firms and no offense to them that kind of name after the founders, you create a lot of key man risk around the founder. And, you know, one of the visions that I had in forming Cloud Equity Group is not to just be sort of a single strategy investment manager at the time, we were operating more an independent sponsor model, that really had limited scope is where it gets scaled to being sort of linked to, you know, me and my track recordand my investment strategy, but wanted it really shape it to be more of an investment management firm that can ultimately transition into becoming an asset management firm.

And really scale much more that you can leverage a team instead of just an individual founder and identifying, you know, what the company does, and the skill set that it has. And so, you know, looking forward to that, you know, it was never a thought to name it, you know, Sean Frank Capital, or, you know, any derivation of that. And so the next best thing, I think, is to think about, you know, something that has meaning to the company and its roots and did a lot of research on this. And, you know, how do other asset management firms get their name, and I think a very common thing that a lot of firms do is they’ll named after like, maybe a street that their headquarters was originally on, or, you know, a body of water or a river that’s nearby.

And so, you know, we’re located on Wall Street, that’s where I am right now. And, you know, I think it’s a little too cliche for an asset management firm to be called Wall Street Capital or something like that. The bodies of water here, the Hudson River and the East River. They don’t really sound too appealing. And so that we thought about, you know, where is our strategy starting from and you know, it’s going to be equity investments in cloud infrastructure, and that transitioned to the name Cloud Equity Group. It worked very well for us, or you know, at least initially, because I think it very well described what we were investing in. Becomes a little bit more complicated today in in misleading maybe in potential investors primarily as far as where our strategy is focused, because we branched out a lot more than, you know, when we first started back in 2013.

You know, but nonetheless, it holds true to our roots and how we started. And, you know, it’s a name that we, you know, continue to keep for, you know, the foreseeable future. Talking a little bit of our history as a firm, you know, as I mentioned, we started in 2013, and more of an independent sponsor model, doing unlevered transactions, really just identifying what we consider to be undervalued, cloud hosting businesses. You know, oftentimes undervalued because of some non operational problem that they had maybe too much debt on the balance sheet, maybe you know, an owner or management team that really didn’t know what they were doing. Messy long term contracts. Things that we had experience in resolving. And that was really our value add.

Coming into these businesses where we can command a discount because of the problems that they had, fix those problems, and, you know, sell it for more than we bought it for. You know, fast forward to today, we’re investing out of what is our fund five on our equity side, where we do buy outs in the lower middle market. And what we broadly define as tech enabled business services, but primarily in three main verticals continue to invest in the hosting space, but also heavily invest in managed service providers and digital marketing firms.

And we’re about to go to market in likely q1 of next year to raise what will be our fund three on our private debt side, which historically in funds one and two have lent to similar businesses that we invest in on the equity side. So within those same, three main verticals, maybe a little bit more agnostic. But with this fund three, looking to branch out, much more agnostically and into other industries, and likely next year because getting our sbsc license and becoming ansbsc lender. So definitely moved a lot and up the capital stack, in terms of the investment products that we offer, the types of companies that we invest in, you know, and all of that in the past nine years that we’ve been in business now.

Patrick: When you think about the name, at least you name yourself something like Stagecoach Capital, which has a little bit, you know, different type of meaning. Cloud it’s still pretty big. I’m just curious, talking to an expert in cloud. Is the cloud space, is it really that fragmented?

Sean: Yeah, there’s definitely a lot of fragmentation. And even with the term cloud itself, I mean, it’s very, cloud is is a branding buzzword. But it can mean eight different things to eight different companies. You know, so the way that we think about the businesses that we invest in, at least on the equity side are service oriented businesses that somehow enable or promote remote connectivity, online presence, all those things. So with the service providers behind the cloud and cloud we’re broadly defining as any type of remote connectivity and remote access.

Patrick: Okay, this is kind of like a channel is out there. Okay. And then with your investments, as you’re been since 2013, you’re scaling up, but you haven’t left the lower middle market to go after the real large ones. You’ve actually stuck to your knitting and stayed here. Talk about that real quick, because there are a couple things that you bring to the table for the lower middle market that I think is essential, because, you know, in the lower middle market, you got organizations that are just, they’re either, you know, too big to be small, but too small to be enterprise.

And they’ve got an inflection point, they’ve got it they got to get across. And if they don’t find out about organizations like Cloud Equity Group, they’re going to default to either a competitor or strategic, or an institution that really will underserve them and overcharge them. So let’s talk about a couple of things. Because you had already mentioned one thing about this is you’re targeting organizations that others look past.

Sean: Yeah, no, absolutely. I mean, we we’ve definitely stayed true to, you know, the lower middle market. And with that, even probably the lower end of the lower middle market.We look at that as as a unique playing field, where to your point, there’s lots of opportunity, especially within our sector, in that, you know, there’s there’s tons of acquisition targets available, but not really a lot of qualified buyers. Mostly because of the size range. And so we really serve what we consider to be a fundamental purpose into the market. And that will oftentimes be the first institutional capital into a small business and we look at ourselves as the conduit that will take that small business from really being a founder and small business, by definition to something that’s investable by another private equity firm.

And so a big part of our strategy is buying up a lot of these companies, being the first institutional capital and really institutionalizing the business that is investable and it’s scalable and that it can go to you know, a larger private equity shop that mightwant to take it to you know, whatever the next level is by their definition. You know, and being that facilitator that transaction. So we look at ourselves as kind of an integral part in the market as a whole and taking filling the gap on where you know, a small business may be, to where an institutional investor may be in helping a company transition from sort of the one level to the next.

Patrick: And you do extensive work with independent sponsors and search funders and those organizations. How does that work?

Sean: Yeah, we do a lot of work sort of, with everyone within that ecosystem. We definitely buy a lot from founder run companies. And so we there might be, you know, three owners, where two, or one or two are looking to exit and we’re kind of creating a liquidity solution for them. And keeping on the third to help, you know, take the transition to business to the next level. We’ve definitely done acquisitions where there’s an owner looking to retire and totally removing it from the picture. And you know, that typically, those would be an add on into one of our existing platforms.

But I’ve also teamed up with independent sponsors, search funds, and you know, other intermediaries and providing a capital solution, whether you know, we’re going to come in and offer our expertise in managing the investments, executing on the roll up and helping to scale the business, or just being a capital provider to them, provided they have the necessary expertise. And you know, in those situations, oftentimes, facilitating you know, that acquisition, and, you know, future add on to that platform

Patrick: For context, what type of enterprise value are you targeting in for your, for your acquisitions.

Sean: So we’d like to say that we invest opportunistically. And with that, it means we don’t necessarily have a minimum. And in theory, we don’t have a maximum. I’d say, the broad range and in sort of enterprise value on the transactions that we’re doing today, you know, we’ll be anything from, you know, maybe three, 4 million on the low end to, you know, probably like 15, 20 million on the high end. It’s really where we see kind of the most opportunity within our strategy and with our space, again, where we can come in, be oftentimes the first institutional capital intothe business and really turn it from a small business into a real company. And execute that sort of in line with a roll up strategy, you know, structure, structure, the investment with debt, and you know, other things to help enhance the equity returns.And ultimately flip at a higher market segment to another private equity buyer. So I say, opportunistically, because we’ve done transactions smaller than that, you know, small add ons that were just, you know, merging into to a larger platform, whatever. And we’ve definitely done acquisitions larger than that, where, you know, we may offer sort of sidecar, you know, investment opportunities to existing LPs or outside investment partners.

Patrick: And I think you’ve got a compelling story for owners and founders at that level, because the bigger players will almost, they don’t mean to do it, but they’re almost going to be condescending, because they’re like, you’re really small, we can’t scale down to you know, your services. And you come in, and you’re going to have, they’re right in your wheelhouse.

Sean: Yeah, absolutely. And I think that’s one of the competitive advantage that we have. I mean, it’s some of the marketing materials, we we’ve coined the term, I don’t know if it existed before us or not, micro private equity. And that, you know, we’ll be the guys that are doing a lot of these smaller transactions to, you know, create a larger company and a larger transaction for the bigger guys. And it’s really the value add that we give to our investors is that we’re willing to kind of roll up our sleeves and help in those areas where you know, larger financial providers, or capital providers might not be willing to or might not be able to help. And ultimately provide the capital solution in sort of this lower segment of the lower middle market. You know, where then we can create a company that’s more appealing to you know, there’s other guys.

Patrick: When you’re bringing on a company, and you’ve got the management there. I’m just curious when we didn’t talk about this earlier. So I hate to catch you off guard. But can you share with me any kind of situation where you just were explaining what you’re going to do going forward with the organization and management is sitting there, and then you see a light bulb go on, where they’re just you could do that? Where you just completely give them an epiphany.

Sean: Yeah, you know, it’s, it’s very common, I think, in the transactions that we do. And when we’re speaking to sellers, whether they’re looking to, you know, exit or stay on or, you know, whatever their plans are, because, you know, we find oftentimes, at least at our entry point is the founders would have started a company, whether intentionally or not, you know, it scaled to some points that probably they never anticipated would get to that point. And they’ve plateaued, they don’t know how to get to the next level, they need a strategic capital partner that can offer the expertise and help them. Maybe they need a capital infusion to help them to reach thisgoal, for whatever reason, you know, they need capital for the business. You know, maybe in line with a liquidity event that they’re looking for, or maybe just take the business to the next level. And so in being able to come in and identify, hey, you know, this is the reason the business has plateaued. This is where money needs to go into. This is like how we can monitor the performance of, you know, the return on investment of that capital into the business and different KPIs and metrics that we should look at. You know, it really helps to kind of sell us, you know, almost instantly to the founders and say, hey, these guys actually understand business. They might not understand my business and my nuances, specifically, but they understand businesses andhow they run and how to scale and how to grow them. And that’s often where we can find alignment with founders and owners of companies and say, hey, we can be the value add strategic partner for you, because this is how we look at the business. And this is how we can scale it.

Patrick: And I know we’ve talked a little bit about this, but if we can summarize it, you know, give me a profile of your ideal target. What are you, who are you most looking to help?

Sean: Yeah, so we like founder run companies, because, you know, we found those, those guys that know their business the best and know their employees the best and they’re most come devoted to the business, it’s theirs, it’s their baby. And, you know, we tend to get sort of the best post close assistance from them and longevity from them. You know, but with that, I mean, we’re looking for businesses that are at least stable in top line revenue. Ideally, there’s growth there, we’ve done transactions where the business says maybe have slight decline in revenue. But that’s not necessarily ideal for us, we like strong margin. We like strong operating teams, particularly strong management teams, because at the end of the day, those are the people that we’re going towork with and empower and train and work alongside with to help grow the business. You know, and businesses that are have a good service oriented culture. Like I said before, the types of businesses that we invest in are all service providers. And so companies that pride themselves in providing high quality, good service to their end user, whatever the customer may be, I mean, those are oftentimes the businesses that we align best with, and we see kind of the best long term value with.

Patrick: That’s thebest way to protect that repeat of repeating revenue. Reoccurring revenue.

Sean: Exactly. Exactly. I mean, across all our verticals, I mean, we’re talking about recurring revenue businesses, and we’re talking about, you know, maintaining customer relationships, growing those relationships over time, you know, how can we grow with our customers. And so you know, the service quality aspect of that is very important to us.

Patrick: As an organization that has been around since 2013 and that’s longer than a lot more than half private equity firms out there today, you’ve seen the development of this risk transfer tool called reps and warranties insurance, because that’s something thatwas a non issue, because it was very expensive, very cumbersome, back pre 2015. But now, it’s become just ubiquitous throughout the, throughout the private equity sphere. And it’s accelerate mergers and acquisitions and reduced the downside for a lot of parties, which we think is a real big value add that the insurance industry delivered to the M&A community. But don’t take my word for it, Sean, good, bad or indifferent, what experience have you had with rep and warranty insurance?

Sean: Yeah, no, I mean,I think it provides a very fundamental purpose. You know, like you said, I think it helps derisk a lot of transaction and sort of having a third party entity that has credit worthiness that can stand behind the reps and warranties that are typically written in the APA. Exactly, you know, one of the risk centers that we have, you know, often buying sort of, again, these, this lower end of lower middle market businesses, often from the founders is that, you know, how much credit worthiness does the founder have, at the end of the day, or the seller entity have at the end of the day when we’re buying the business to stand behind those reps and warranties. And so, you know, in some cases, we can mitigate that a little bit. There might be personal personal guarantees from the owners on certain reps and warranties, there could be, you know, obviously, customary escrow hold backs or, you know, set off against, you know, delayed payments, things of that nature. But having reps and warranties insurance is really kind of a good way for us to derisk further and get better credibility and ultimately to be able to offer a higher price to the seller, because we’ve derisked that a lot. But I think also it helps in that it allows us to be a little bit more competitive in our offer structure, especially, you know, when we might be the first institutional capital in and maybe we’re competing with non sophisticated buyers who aren’t really familiar with reps and warranties and you know, are willing to offer 95% cash at close and, you know, all these other things that institutional buyers typically wouldn’t offer. You know, from a seller standpoint, obviously, those structures, you know, look more ideal. And we see them, you know, more often than not in kind of our competitionand the size range and the companies that we’re competing against. And so being able to mitigate and say, hey, we don’t need to have, you know, an escrow for two years as 10% of the purchase price, and you know, all these other things. And we can offer something much more in line with your competition because we can offload some of that risk to a third party. It really helps us to be more competitive in the landscape.

Patrick: Well that’s fantastic. And with the size of deals you’re going after a lot of them are sub 20 sub 30 million enterprise value. A year ago, those were almost uninsurable by traditional rep and warranty, they were just too expensive, okay, just for the cost to do the diligence just to be eligible for the insurance was a big barrier to entry for a lot of organizations. And that leaves a lot of sellers where they can’t get the protection even if they’re willing to pay for it. The great news is there’s a new program out there where it is a sell side policy, but it can insure the seller, and in fact, the buyer from buyer’s loss from a breach of the seller reps. And these deals can be as little as 500,000 in enterprise value, up to $30 million. The maximum policy is 20 million. But in that range, you’ve got that option now where you got to pricing that as a fraction of reps and warranties, it’s maybe $12,000 to $15,000 per million in coverage. And so we’re very proud that we’re able to get that kind of product out for organizations like yours, where you’ve got a very eager seller that’s looking for some protection, they’ll work with you however you need. And now you have a tool for them. And we’re very, very happy to have that out there for firms just like Cloud Equity Group, because this is the area that we wish to serve.

Sean: Yeah, no, for sure. You hit the nail right on the head there. I mean, you know, historically that has been a hurdle, particularly in smaller transactions is that you know, the risk reward there is just not there as far as underwriting and you know, how it can impact the return on the investment. But having a product like this, that kind of trickles down to more of the lower end of the lower middle market, like where we compete, or even maybe smaller than the deals that we’re doing for definitely fills a fundamental purpose within the M&A landscape and you know, adds a lot of value to, you know, buyers and sellers in the market.

Patrick: Yeah, and the more tools we can have for you guys to, you know, help your targets get a clean exit, the better. Now, Sean, as we’re going through, I mean, we blinked and we’re midway through 2022 already. There’s all kinds of headwinds out there that everybody’s talking about, and there’s, you know, concern and so forth. What trends do you see going forward between now and into, into into 2023? Whether that’s M&A in general, cloud, or just Cloud Equity Group in particular?

Sean: Yeah, you know, I think it’s gonna be very interesting to see, I think there’s a general consensus that our markets and our economy is probably heading to the, you know, likely in sort of a worse state, you know, a year from now than it is today. You know, with rising interest rates, and inflation, you know, and everything else that going on. And so I think within the M&A landscape, it’s going to create more fragmentation, which for us, as an investment manager, our strategy we look at as a positive. You know, on the lower end of the market, where we might be competing for deals with people who are relying on big financing, or SBA loans or a second mortgage on their homes, or, you know, those smaller strategic operators, I think that credit is going to tie in. And so we’re going to see less buyers, and it’ll allow us to command more value on our deals, being you know, one of fewer capital providers that’s still providing liquidity solutions or capital solutions within that, that size segment. And on the higher end, I think it’s going to create more of a demand for private equity put on capital, as investors are looking for sectors and areas where they can find positive returns and, you know, good returns on their investment, you know, it’s going to create more of a mandate for these private equity funds, particularly the ones that already have the capital committed to, you know, put out the capital and generate strong returns and, you know, outperform the market. And so, you know, I think we’ll continue to see that top end industry consolidation. And so at least where we are, and being that conduit from the small businesses to taking them to institutionalized investable businesses, I think it’s going to create a lot more upside for us in our transaction. And so I don’t want to say that we’re excited to see the economy performing badly, but I think at least within you know, our business model and our investment strategy, you know, it’s going to work out to be, you know, strong next couple of years for us.

Patrick: Do you anticipate being more of a buyer market than a seller market going forward?

Sean: I think it’s gonna vary based on size segments. But yeah, I mean, it especially at our entry points, I think so for sure. You know, in the industries that we invest in, they’re, they’re typically low barrier to entry industries. And so we see a lot of people start companies, either because it’s a natural, you know, upsell or cross sell for their existing business, or because they just want to launch a new business. But they get to that plateau that I mentioned before, where they can’t really continue to scale and they need a partner and so that, that infusion just creates sort of a wide funnel of a lot more opportunity for us to buy. And so you know, when those buyers dissipate, because they can’t get the financing, that they need to do those transactions, it’s going to create a buyer market for us. You know, but on that top end that industry consolidation, I mean, private equity, we’re, we’re looking to exit, they invest with committed capital. And so you know, even though you know, credit might, you know, tighten and, you know, all these other things, you know, they still have committed capital, their funds that they need to invest out of, you know, and generate their returns. And so, you know, I think, at least in our entry point, it’ll, you know, continue to be or become more of a buyer’s market, you know, and then it’ll be interesting to see what happens on the high end.

Patrick: I just think it’s fun, it’s a lot easier when we’re down in this area. First of all, there are a lot more targets and a lot more companies down at this, this level than the billion dollar level. And also, it’s a lot easier to get a large return when your purchase is a 10 to $20 million purchase, as opposed to 200 to $500 million purchase. And so I think some really, really good things are going to be favoring our respective practices. So Sean Frank from Cloud Equity Group, how can our listeners find you?

Sean: I think the best way to find me would just be on our company’s website. That’s just cloudequitygroup.com I also have a personal website where people can find me it’s just seanfrank.info.

Patrick: Okay. Fantastic. Well, Sean Frank from Cloud Equity Group, real pleasure having you on today.
Thanks for joining us.

Sean: Thanks for having me, Patrick.