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How LBOs, Share Buybacks & Private Equity Revolutionized Corporate America: Don Chew’s Case for Transformation – EP270

Donald Chew discusses the evolution of corporate finance, emphasizing the shift from old-fashioned corporate finance, which focused on steady earnings growth, to modern corporate finance, which aims for high returns on capital. He highlights the decline of conglomerates in the 1970s and the rise of private equity. Despite criticism, Chew argues that modern corporate finance has been a success story, citing the doubling of U.S. public company market capitalization in the 1980s and the significant correlation of R&D and selling, general and administrative expenses (SG&A) expenses with corporate value. He also addresses the financial crisis, arguing it was due to mispriced mortgages and government policies, not market inefficiencies.  Donald Chew is the founding editor of the Journal of Applied Corporate Finance, and joins show host Gene Tunny to discuss his latest book, The Making of Modern Corporate Finance, published by Columbia University Press.

If you have any questions, comments, or suggestions for Gene, please email him at contact@economicsexplored.com.

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About this episode’s guest: Donald Chew

Don Chew is the founding editor and Editor-in-Chief of the Journal of Applied Corporate Finance (JACF), a publication he started almost 30 years ago. He has published over ten books on corporate finance, including The New Corporate Finance: Where Theory Meets Practice and The Revolution in Corporate Finance (with Joel Stern), which are both widely used in business schools throughout the United States and Europe. Don has both a Ph.D. in English and an MBA in finance from the University of Rochester.

Timestamps for EP270

  • Introduction (0:00)
  • The Decline of Conglomerates and the Rise of Modern Corporate Finance (5:58)
  • The Role of Private Equity and Corporate Governance (14:25)
  • The Impact of Modern Corporate Finance on Corporate Value (15:03)
  • The Future of Corporate Finance and Productivity Measurement (16:37)
  • The Role of Corporate Finance in Economic Growth (19:27)
  • The Critique of Modern Corporate Finance and Corporate Social Responsibility (27:26)
  • The Financial Crisis and the Role of Government Policy (35:40)
  • The Future of Corporate Finance and the Role of Private Equity (43:21)

Takeaways

  1. Modern Corporate Finance Principles: The shift from prioritizing steady earnings growth to maximizing long-term firm value has reshaped corporate strategies globally.
  2. The Importance of R&D: Increases in R&D and SG&A spending are now critical indicators of corporate value and long-term success, according to Don Chew.
  3. Private Equity’s Role: Private equity has transformed underperforming companies, streamlining operations and reallocating capital for growth.
  4. The Evolution of Corporate Governance: Shareholder activism has replaced hostile takeovers as the primary tool for enforcing corporate accountability.
  5. ESG and Value Creation: Enlightened value maximization is the idea that corporations can address societal concerns while enhancing long-term profitability.

Links relevant to the conversation

Don Chew’s new book The Making of Modern Corporate Finance:

https://www.amazon.com.au/Making-Modern-Corporate-Finance-History/dp/0231211104

Econometric study of benefits to consumers of Wal-Mart:

https://onlinelibrary.wiley.com/doi/abs/10.1002/jae.994

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Transcript: How LBOs, Share Buybacks & Private Equity Revolutionized Corporate America: Don Chew’s Case for Transformation – EP270

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Donald Chew  00:03

If you see large increases in R and D and S, G and A, that is kind of the best indicator of increases in corporate value. And it suggests that, you know, corporations, the investors, are recognized the values of these companies, even though it’s not reflected in earnings, and the companies keep pouring more money into it. So you see these PE multiples going through the roof, and you also see lots of companies with negative earnings. You know, in the old days, in the 70s, only 10% of US companies would have negative operating cash flow. Today it’s over 30% of publicly traded companies are losing money every year.

Gene Tunny  00:52

Welcome to the economics explored podcast, a frank and fearless exploration of important economic issues. I’m your host, Gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode. Please check out the show notes for relevant information. Now on to the show you don, hello and welcome to the show. In this episode, I’m thrilled to be joined by Don Chu, a true pioneer in corporate finance. Don’s the founding editor of the Journal of Applied corporate finance, which he launched nearly 30 years ago. He’s also authored or co authored over 10 influential books, including the new corporate finance, where theory meets practice and the revolution in corporate finance. With a PhD in English and an MBA in finance from the University of Rochester, Don brings a unique and deeply informed perspective to the discussion in our conversation, Don shares insights from his latest book, The Making of Modern corporate finance, exploring how the evolution of corporate finance has helped shape today’s global economy. We cover everything from the rise and fall of conglomerates to the role of private equity and the importance of R and D in driving corporate value before we begin a special thanks to Lumo coffee for sponsoring this episode. Their premium organic coffee source from the highlands of Peru is packed with healthy antioxidants, economics explore. Listeners can enjoy a 10% discount. Details are in the show notes. Now let’s dive into the conversation. I hope you enjoy it. Donald chew, welcome to the program. Great

Donald Chew  02:35

to be here. Thanks for the invitation.

Gene Tunny  02:38

Of course, we’re talking about your new book, The Making of Modern corporate finance, published by Columbia University Press. And the subtitle of it is a history of the ideas and how they help build the Wealth of Nations. Now, as you point out in in the introduction to your book. I mean, this is, this is not necessarily a take that many people will. You know, people might find this controversial. They because finance, the financial industry has been much maligned in recent years, particularly after financial crisis. I’d like to ask you about that a bit later. To start with Dom, could you tell me what do you mean by modern corporate finance? Please.

Donald Chew  03:26

Modern corporate finance is a it’s a different approach to financial management that it’s it’s probably got its roots from academic work in the it started in the late 60s, and then proceeded through the 70s, and has been going on since then. But the basic idea is that, well, let me start with what old core, old fashioned corporate finances that that is the notion that a company’s obligations to its shareholders really consist of just, you know, basically satisfying their needs for steadily rising earnings per share. The job of the corporation, in a financial sense, is just to keep earnings per share rising with the understanding that the price stock prices will sort of rise proportionally in tandem. So the corporate mission is just to produce enough cash flow to be able to report steadily rising earnings per share, probably with minimal use of debt, and you probably want some diversification too, so that you can ensure this steady increase in earnings by by having a diversified, you know, set of industries and businesses. Modern Corporate Finance says no, the aim of the corporation is not to produce steadily rising earnings per share, but to produce high rates of return on capital, higher than the cost of capital, and do as much of that as possible, and and your mission is basically to maximize the long run value of the firm. And in defense of that proposition, you Well, I’m getting ahead of myself. No,

Gene Tunny  04:58

no, that’s okay. Yeah, go. Ahead, yeah, that was the old corporate finance, yeah. And what are some of the names associated with that historically, Jack

Donald Chew  05:08

Welch is the preeminent practitioner of old fashioned corporate finance. He, he viewed his mission as as again, he know he, he never missed an earnings target in his 20 years of managing, being the CEO and and to be fair to Welch, he created the firm with the largest market capitalization of its of it of its era. But it was a diversified conglomerate. It had, it was 50% financial firms in a variety of industries, power, health care, and you name it, but, but, but again, his goal was to keep reporting steady increases in earnings per share, and then when Welch stepped down in 2000 there was no no future CEO was basically able to manage that unwieldy conglomerate that he had produced, Jeff immolt ended up failing, and the conglomerate ended up being pulled apart over time, as were conglomerates throughout the United States. I should say that the failure of old fashioned corporate finance became clear in the 1970s when all these bloated conglomerates were unable to restore their profitability, and they did the S, p5, 100, lost half it’s valued during that point, and then that basically triggered the reaction of active investors who began in the 1980s to start pulling apart these conglomerates.

Gene Tunny  06:38

Right. Okay, so you Jack wells. You were talking about General Electric GE, yeah, what was some of the blighted conglomerates of the 70s? What are the prominent ones? And you said they were pulled apart?

Donald Chew  06:51

Well, General Mills was became. It called itself the All Weather growth company. It was really its core business was cereals, and then it was taken over by a retired former general who decided he wanted to make small submarines. They bought Play Doh and they but the goal, again, was, was to provide businesses that would offset whose fortunes would offset one another and create this corporate diversification. Again, it’s you know, we you you wanted to protect your employees and communities from the business cycle, and the way you did that, in theory, was to buy lots of different kinds of businesses. But the outcome of that was that the businesses ended up all being they didn’t perform well. Some businesses were starved of capital. Others were over invested in, and they all urged virtually to a company ended up being dismantled over the next 20 or 30 years. Other companies were it and T beat Beatriz foods, RJR Nabisco, ended up diversifying into different areas, if we could talk about the RJR, Nabisco, LBO, I’d

Gene Tunny  08:04

like to cover it, because that was one of the fascinating examples. Wasn’t there a famous book about it, the barbarians at the gate? Is that barbarians at the gate? Yeah, that’s right, yeah, yeah. The

Donald Chew  08:15

wonder of all this was that RJR, in the late 80s, was widely viewed as a very profitable company and well run and had a market cap of $12 billion so at that point, a number of private equity firms, one of them was Colberg, Travis and Roberts, began to look inside the operations, and there was a There was a competition to buy the firm, which actually included an offer from the CEO itself, but they ended up paying twice the amount of the firm to take it private, 25 billion for a $12 billion company, and the amount of waste inside the firm led Michael Jensen to basically declare that the barbarians were inside the gate, that Johnson was wasting through cash flow, just to conceal the profit potential the business from his competitors. And, you know, and the rates of return on new investment were from two two to 5% you know, for a new cookie manufacturing company. And so you basically double the value of the company, even if the buyers didn’t make a cent, you know, you know, just by virtue of the, you know, the amount of mismanagement that was going on behind the scenes. Again, colossal waves. You

Gene Tunny  09:33

mentioned Michael Jensen. I mean, that he’s one of the big names in modern corporate finance, isn’t he? Could you tell us a bit about Jensen and his contribution. Please, Don

Donald Chew  09:45

Michael Jensen, with his colleague Bill mechling at the University of Rochester, wrote what became the most cited article in the corporate finance literature in 1976 called theory, the firm, agency, costs and I. Forgotten the rest. But the basic argument is that there is a a conflict of interest between management and shareholders at the very heart of the organization. That means it’s going to be very you can’t expect managers to maximize firm value. They have their they’re torn in two different many ways. And the biggest conflict between management and shareholders is not, you know, corporate jets and perks. You know, that’s that’s one source of conflict, but the big one is over the optimal size and diversity of firm. If you’re a corporate manager with minimal stock ownership and you’re a resourceful person, what you want to do is build an empire. You want to buy as many different companies as you can. Again, which makes you more famous and actually raises your pay given the way CEO pay evolved in corporate America, which was to say that the larger the company you ran, the higher your pay would be. And and again, this is all premised on the idea that CEOs didn’t own much stock in their own companies, which was true in the 70s. But Jensen and meckling set themselves the task of, how do we explain the dominance of the corporation, given this basic conflict at the heart of it, you know, Adam Smith that we go back 250 years, said the public corporation could not work. You know, managers could not people could not manage other people’s money in any kind of operation requiring lots of managerial discretion and control. So what you saw in Smith’s day was, were these joint stock companies that were like canals and turnkeys and regulated banks, but that, but nowhere else. Everything else was closely held partnerships because outsiders could not trust other people with their money. There were no mechanisms that would allow the joint stock company to end up managing large scale operations. Well, well, Jensen found a solution to that problem, in the sense that that there are all these mechanisms, governance mechanisms that evolved over time to give outside shareholders a measure of control. You know, there were audit financial statements, there were boards of directors that were in CEO incentive pay plans, and then and then, there were competitive product markets. You had to sell a product and make money, and then you had labor markets. If you were a CEO and you wanted a good job, you had to do a, you know, you had to have shown the market that you were in the labor market, that you were doing a good job. And then if all else failed, there were supposed to be some outside forces. That is, you know, maybe eventually there were hostile takeovers, but there really was not, not much sign of it, of a hostile market for corporate control. When Jensen was writing his paper, so he and Bill meckling said to themselves, you know, we really don’t understand how these companies work, where CEOs earn just minute. You know, I have minimal stock ownership, they Jensen and Murphy concluded that the average CEO, for every $1,000 increase in the value of the stock, they earn $3 so it was, which was a bit people are being paid like your occurrence. So this, this is that there’s got to be a problem. And then, and then, at the very end of the article, they said, Well, what if managers went out and bought back 99% of the shares using debt finance and then became basically the sole owners of the firm? We are going to propose here that this would lead to wonderful efficiency gains in these corporations if they could transform their structure. And this is basically what happened. This was the LBO that they forecast. They showed us the template and and all of the 80s can be seen as a vindication of this forecast by Jensen and meckling back in 1976 and as I said it is far and away the most cited article in the corporate finance literature, with like 150,000

Gene Tunny  14:06

sites. Yeah, yeah. So this provided the theoretical support for the leveraged buyout, which has been controversial at times. Yes. Can I ask, like, because as an economist, to what extent has the is it economic logic that has led to this transformation in corporate finance? Is it the applicant like fully understanding the economic value and how to maximize the economic value of the corporation, looking at it in a you know, over the future, looking at the discounted cash flow is, is that? Is that fair to say

Donald Chew  14:44

yes and no. I mean, it’s, it’s certainly, it’s part of the answer. But it’s not enough. So you had to, you know, by law and custom, hostile takeovers were frowned on you. Just if you were a Morgan Stanley, you. Not fund the hostile takeover because you were violating, you know, the rule about, how do you how do companies deal with you know, they have their beholden to their investors, and they’re beholden to their corporate clients, and it was a rule, Thou shalt not do hostile takeovers. Everything has to be done with the agreement of management. Well, anyway, that that consensus shifted over time, and active investors became, you know, they they, what they saw was the huge difference in the values of these companies, if they were dismantled, the sum of the parts was vastly greater than the market values of these companies. And as the as that gap became larger and larger, the pressure to actually break them up grew great enough that people like Michael Milken and all the people he funded saw this opportunity. And then when the Reagan administration came in, there were, there were relaxations of some kinds of financial constraints, anti trust, and this, this collocation and and the discounted cash flow met, you know, method and modern finance, all these forces work together to lead to this eruption of the market for corporate control. In carrying out the market for corporate control basically ensured that the principles and methods of modern corporate finance would would go into action, would be implemented. This provided the basis, but, but again, you had to allow active investors to assert their control, their voice, which just didn’t happen in this in the 70s or the six or the fifth, yeah.

Gene Tunny  16:37

Okay, and is it right that there’s a trend towards companies staying private or going private, so going off the the you know, not being listed on the stock the stock market, is that a trend? Is that driven by this new approach to corporate finance?

Donald Chew  16:55

Yeah, absolutely. There’s a bunch of factors here. You know that the number of publicly traded companies in the United States has fallen in half over the last 30 years. The ones that remain are actually much more valuable than the ones in the past. I think the average company, publicly traded company today is is four times what it once was, even so, so the the market value us publicly traded companies, is twice what it once was, say, 50 years ago, but with half as many companies and at whereas the number of private companies is now something like 8000 There are 8000 PE controlled companies, you know, double the amount of public but they are. They’re much smaller. In fact, if you add up all the private companies, they amount to maybe 10% of the market cap of public companies. So what you see here is that the companies with extraordinary growth potential, most of them end up going public, because that’s the beauty of the public corporation for growth is that is the dumb investors like you and me will provide them with cheap equity capital, because we know they have growth opportunities. It’s just clear as crystal you know that these companies will succeed so so for companies with growth opportunities, public equity markets are a great deal, but once you start losing your your luster as a growth company, then eventually your PE multiples fall and they become within reach of private equity investors. And I think it’s now, you know, Jensen has shown us that companies without growth opportunities are generally run better as private companies for all variety of reasons. For if you’re doing a dirty business that the newspapers don’t like, if you’re an oil and gas you want to be out of the public eye, so you’ll end up getting higher multiples from private investors. And you can do stuff in private that just doesn’t look good in the newspapers. You know, you’ll notice that lots of public oil companies are shedding their oil exposure to meet their carbon commitments by selling their operations to private companies. And this all makes perfect sense, and we benefit from it, in fact, because, you know, again, these companies get opera, and I’m not meaning to suggest they’re shady, but, people don’t like one of private equity’s poor competencies is is cutting unprofitable growth. You know, that’s what it’s famous for cutting, and it’s an essential economic function. It’s almost as important as growth itself. The capital for growth us comes from cutting unprofitable operations. And nobody talks about this. You never talk, you know, you never hear about the heroic efforts of PE to streamline and cut limb by limb so that this money can get recycled back into the growth sector. Which is what happens? Yeah,

Gene Tunny  19:54

well, well, I think economists are sympathetic to that, that perspective, if you. Think about Schumpeter with the gales of creative destruction. And yes, also, I think Friedman had one of he wrote an article about how one way of seeing the market outcome, or the mark market efficiency, is the result of competition being an evolutionary process, or a competitive process that weeds out the inefficient Darwinian. That’s it. Yeah, yeah. So, yeah, very, very sympathetic to that. Now don’t Can I ask, I got a question about, like, the contention you make, and this is, I mean, this is fascinating. And this American style corporate finance, a phrase that combines two, if not three, of the most vilified words in today’s English Language Media. It’s brilliant. Yes, it’s very true, social and otherwise, okay, you agree? Okay, yes, I agree. Has for the past 40 years been one of the world’s remarkable success stories. The principles and methods of Finance to continue to be taught in business schools around the world have played a critical role in the productivity of the US private sector. Now that is a I agree, I largely agree, but I want to know what empirical support is there for that proposition.

Donald Chew  21:19

Well, again, I have to, I have to go back to the 70s, when the dot the Dow Jones market lost half its value and the economy was struggling. It was a millez and and Jimmy Carter didn’t know what to do. His politicians didn’t know what to do. Inflation was out of control, and unemployment kept going higher and higher and and, but nobody, few macro economists, looked at what the companies were like, and that’s what my book does. It says these companies, back in the 70s, had been allowed to grow into these bloated conglomerates. There were no outside forces checking this managerial desire to build empires. And so in order to create a productive, prosperous society, you had to cut back these conglomerates and break them up. And this, although painful at first, this ends up creating the basis for more growth. And it starts as shareholder value, and it looks, it looks bad for a while, but ultimately it creates lots of growth opportunities. And I believe the last 45 years have borne this out. Jensen, when he tried to make his case, he looked at he said, well, the market capitalization of US public companies doubled during the 80s. So that’s that’s one data point. Labor productivity a total factor. Productivity statistics went up dramatically in the 80s. Some versions of labor productivity statistics went up. But, you know, these are the best market and operating data we have for that period of time. But then, you know, again, you have to point, I would point to the last 45 years and say, look, it’s been this. Us, equity returns have been 12% a year on average, you know, which is far and way higher than anyone else and and it is just in the process. It’s really a process of continuous restructuring. In other words, companies have to keep putting pressure on themselves, always squeezing out excess capital, always reevaluating every investment. Is it time to get rid of this, give it to somebody else, or is it time to grow it? And conglomerates were terrible at this. Conglomerates always, they starve their best opportunities, and they fed a lot of their and so they were horrible allocators of assets because they didn’t understand the businesses they were in, and and so and I just believe, you just look at the like, what has happened to America in almost every economic dimension is, is proof, you know, is proof of this process. And now we don’t, we don’t see hostile takeovers anymore. We see shareholder activists so and it’s a fundamentally different device, but it operates in much the same way. And in a hostile takeover, you go out and buy control of the company, and that a lot of people didn’t like. Peter Drucker hated that process. He said, This is a violation everything we know about good management, but today’s activists like Paul Singer of Elliot management, he will buy five to 10% of the stock, and he will say, Hey folks, we think there’s a problem out here, like south southwest airlines. So let maybe, let’s have a shareholder meeting and and so it’s all you large investors. I’m going to put the proposition out there. You get the vote on my idea. My idea is that, hey, maybe we should get a new CEO, or maybe you should follow a bunch of steps. But it’s sort of shareholder democracy in action. So and if the majority. Shareholders don’t like what Elliot management is doing. They can say, No, we’re voting against you and what? But what happened in the southwest cases, I think he won four out of 12 board seats. The CEO was not ousted, but he was put on notice, and they now have a the stock price is probably up 25% since they went in there, and the company is sort of getting right, you know, righted back to the way it should be going again. It’s putting the company on notice, suggesting alternatives, and then allowing the large institutional investors, the Black Rocks of the world, to vote on your proposal. And to me, I find that just a wonderful system. And I don’t know if you saw this last week, but the FT did a piece on Japanese shareholder activism. There was a statement by the the the leader of the association, who was welcoming a new era of shareholder of activism to end the 30 years of Japanese stagnation, I said that the Japanese slumbering for 30 years. We think this is the solution to our, you know, our economic melees, which includes a 7% drop in the population for last five years. I actually go so far in my book is to suggest those two things are directly related. You know, they’re just not wrong. Yeah, opportunities for in their quest for full employment, they basically have ensured that there are no employment opportunities for the next generation of workers and Germans heading for the same thing. If you saw what happened in Volkswagen, yeah? Which, to me, is a corporate governance failure.

Gene Tunny  26:44

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Gene Tunny  27:19

now. Back to the show, can I ask about what’s your take on ESG or corporate social responsibility? Ask that because there’s so much bad press about what we’re calling modern corporate finance, about private equity. I mean that there’s the, you know, concerns about job job losses. You look in the popular culture, wall the films, Wall Street, pretty woman, the private equity sort of people, the, you know, the financial markets. Person, Gecko, yeah. Richard gears character, and pretty woman, who’s, I think he’s in private equities, breaking up companies. And Julia Roberts’s character is sort of wondering, what on earth you’re doing, and pull apart companies to make them more valuable, and their concerns about job losses associated with that. And you’ve got issues, you know, various social issues, various social ills in the US. I mean, it’s quite clear what’s your take on do corporations have a responsibility for that. How to what’s the role? What’s the corporate social responsibility there? I think the

Donald Chew  28:27

mission of the corporation, as Milton Friedman said, is to maximize their own but they missed quoted. He is quoted as saying it’s to maximize its own profit. That’s not what they do. They maximize their long run value. And to do that, as you really you have to invest and take care of everybody you know. To maximize value, you have to decide how much, what kind of commitments are, am I going to make to each of my constituencies? How much and but with the idea that if you pay another that Michael Jensen’s rule was, pay another dollar to every stakeholder who matters, as long as you expect $1 in return. Measured. And you know, it’s, you know, the old rule. But Jensen, Jensen has this concept of enlightened value maximization, which is the perception that I hold out in this book. And it is, again, it’s about committing to every stakeholder who matters, making very clear what it is, what we’re going to do for you and what we expect in return, and just getting people on board and again, but all with the idea that this is going to increase the long run value of the whole franchise, and it means you can’t you want to pay, you don’t want to pay too much or too little. You want to get just the right amount. And to me, one of the best illustrations of a really good ESG program is Walmart. Yes, well before the pandemic, Walmart basically increased across the board, their employee pay and then they’ve also they they hire and promote from within. Their store managers make an average of $175,000 a year. They invest in their suppliers. They monitor their suppliers. They brought a lot of them back to America, and though they squeeze their suppliers, they also make sure that they’re working and take care of them. And they have the largest plastic waste facility in the world, plastic waste recovery through repackaging and Doug McMillan, the CEO who is a Walmart lifer, is now the chairman of the US Business Roundtable. In other words, that is the group of the largest, most prestigious US corporations. McMillan, this southern guy who was raised as a Walmart, you know, employee, is now the the head of this large lobbying organization. I you know what? To me, it’s a huge ESG success story, but there’s a lot of ESG failures. There’s a lot of bad ESG that basically doesn’t pay attention to corporate value. To me, anything that any investment has to have its focus on maximizing long run value, but there are lots of ways that you can address social problems through your investments, and it’s that magical, you know, Confluence that ends up, it ends up putting higher price earnings multiples on companies. Investors like to feel good about the things they invest in, and when they do that, your company, you know, Walmart, probably increased its value by 50% last year, and I would wager that 10% of that is just people feeling good about what the company does, yeah,

Gene Tunny  32:02

yeah. I like your comments on, yeah, on enlightened value maximization. I like that because, you know, this is these sort of concerns about corporations, and they’re in the news. They’re in the, you know, lot of commentators are coming quite, you know, very critical of corporate power. There was the extraordinary reaction to the killing of the United Healthcare CEO in New York City, gunned down in in Manhattan. And a lot of people were was almost celebrating, in a way. I mean, no, we don’t condone, obviously, we’re not going to support murder, but people were saying, Oh, you can understand this, because they’ve been ripping off people for years, like it had such a high rejection rate of claims. So yeah, just you don’t need to comment on that. It’s just putting that out there. As

Donald Chew  32:54

my daughter is sending love letters to Luigi man Jones, right,

Gene Tunny  32:59

yeah, yeah, yeah. He’s, he’s a become a folk hero, in a way, hero,

Donald Chew  33:04

right? Yeah, because the corporate pursuit of profit is inherently evil. It’s inherently anti social. And that you could go, take that back to Roman Catholicism, you know, the first time you go into church. But that is what you learn. You know, one man’s problem is evil because it’s it somehow comes out of the pocket of somebody else, and changing that point of view is one of the great contributions of modern capitalism. In other words, when you create, yeah, you’re not hurting somebody. In fact, in most cases, you’re helping somebody. It’s like they asked Jeff Bezos, Jeff, are do you really deserve to have a $200 billion fortune? Can you justify that? And he said, Yes, I’ve created $2 trillion of value for my investors, not to mention all the jobs, all the taxes paid. That just begins. My success is it’s just created enormous wealth for other people. And this is, this is not cheap, so I

Gene Tunny  34:09

Oh no, it’s certainly, certainly not widely appreciated, because now we’ve got people like Bernie Sanders and commentators on the progressive side saying, Well, every billionaire is a policy failure that’s becoming a widespread, you know, contention. The other Yeah. So it’s all very, you know, contentious and up for the up for debate. So, yeah. So, I mean, I think I agree with you. I mean, a lot of the value, like they do create a lot of value. There’s a lot of value from entrepreneurialism. And I remember Robert Barrow, The Economist at forget where he is now is he’s been at Harvard or Chicago, has been all over the place. He has an Institute in Washington. Now, does he right? Very good. I’ll have to, have to look it up. But he once said there are we wrote a column just to the effect that Bill Gates has created more value, or did more good for the world through Microsoft than he has done through his foundation. It was something along those lines. I mean, yeah, yeah. If you look at the

Donald Chew  35:13

I would say the Jeff Bezos is the world have done more for poverty than Mother Teresa than the Mother Teresa’s put it that way,

Gene Tunny  35:22

right? Yeah, through, through, yeah. Lower price goods through, yeah, so, yeah, yeah, yeah, very good. Okay, estimate

Donald Chew  35:33

that Walmart saves the average family $5,000 a year, just just by selling low cost products. You know, that’s consumer surplus and so and look at Walmart might be the only US operation that’s growing in China. China loves Walmart because it understands that its people are being helped by the operation of Walmart in getting these low cost products to them. So, you know, GM is leaving China because they don’t make enough money and because China basically they’re just being squeezed out by state owned enterprises by but government policy in China has chosen to allow Walmart to succeed, and to me, that’s incredibly telling, because they understand the social benefits. That’s my hip hop

Gene Tunny  36:28

question, yeah, yeah, yeah. I’m gonna have to track down that study that’s fascinating about the the 5000 saving from, okay, yeah,

Donald Chew  36:34

yeah. I believe that I’m shooting from that, but I think it’s great.

Gene Tunny  36:39

That’s okay. I know that it’ll be, it’ll be something of that, of that magnitude. I’ve got no doubt. I’ll just, I’ll just, I’m just interested, because that’s a useful that would be a useful empirical study, or to point to, yeah, but that is very good

Donald Chew  36:51

corporate mission. Their corporate mission is to save other people money so they can live good lives. You know that so that they’re saving their consumers money. That’s that’s their, well, that’s their mission statement. And I’ve never it’s

Gene Tunny  37:08

a rather, rather extraordinary story. Was it Sam Walton? Am I getting the name right? Well,

Donald Chew  37:15

that was when rod, yeah, awarded the Presidential, Congressional Medal of Honor, and that’s where he made that statement. He said, we’re going to make our job save other people money, you know, so they can live good lives. So help them

Gene Tunny  37:29

live good luck. Gotcha Okay, right. So now, and as a sort of final part of the the interview, I’d like to talk about the financial crisis, because, look, I largely agree about the theories or the hypothesis, the what you’re what you’re saying in the book. One, one area where I may have some hesitation is it’s an interesting perspective. You argue that the financial crisis isn’t something that violates or is in or contradicts the efficient market hypothesis. So this is Gene farmer’s idea that the market prices of financial products represent all of the available information and the market’s efficient. Can you explain? Please, Don What’s your view on the financial crisis and why you think that doesn’t violate the efficiency efficient markets hypothesis, please. Well,

Donald Chew  38:27

let me start with what I think the efficient market theory says, and then, because that’s generally misunderstood, the caricature of efficient market theory is that the price is always right. And that’s not the theory says that it’s it’s an unbiased estimate of that is it’s either too high or too low on on average. But Fisher black wrote a paper call on the noise theory that said, you know, the average price is within 100% of the correct value, 100% plus or minus. So yeah, and that’s not which just tells you there is a hell of a lot of uncertainty out there about things. Well, it turns out that, the way I read the global financial crisis there, there were something like $6 trillion of toxic mortgages sitting on bank balance sheets throughout the world that people just didn’t realize were out there. They didn’t understand how bad these mortgages were. And I’ve written about this, and I say a mortgage when it’s first issued is expected to lose 1% of its value, and the Basel risk requirements say, Okay, we need 1% backing for 1% expected loss. A corporate loan is supposed to lose 4% of its value, so we need 4% to back that. Well, what happened? What ended up happening is that these mortgages lost 10% of their value. They were, they ended up being and we don’t. We still. Don’t know, even to this day, how much they lost, because these numbers have just, you know, there has been no federal attempt to determine, as far as I know, to determine how much money these mortgages ended up losing, and and the problem, and, and I, I don’t want to I can’t blame the private sector entirely, because these mortgages were were pretty much demand, is too strong a word, but they were certainly blessed by the Federal Reserve that the government with government policy starting in 1992 was to make low down payment mortgages to underprivileged areas. And then that that became, that became expanded to not only underprivileged and low income people, but high income people were also given low down payment mortgages. And the the ability of Fannie and Freddie may to get their congressional their right to operate was premised on their making low down payment mortgages called all a and it meant that if you were I had a friend who was a commercial airline pilot Who bought a house in Hawaii for $750,000 put down 15,000 the down payment, and when down value fell by 40% he just walked away from the mortgage. And this was done everywhere and and as again the mortgage, the loss rate on these mortgages has turned out to be in excess of 10% and then, when you, when you understand that banks themselves were allowed to operate with three to 5% capital before the crisis, you’re just you’re losing money on every dollar. And in fact, if you you, if you compute the amount of if you take that 90% hole in bank balance sheets, it was almost equal to the 600 billion that the government poured into the banks as bailout money, and it, you know, I’m, I’m not doing a good job of explaining this now, but the the money that they put into the banks allowed the banks To continue to operate and if you’re on when you’re a bankruptcy judge, your first job is to say, okay, is this a viable entity? Does it deserve to be rescued, or should it be shut down? Well, what we now know every bank paid back every dollar the bailout money with 10% interest it within a year. But there was one company that never paid the money back, that was General Motors. General Motors has never paid back the $11 billion that company was really made probably should have been shut down. It was. It still owes us taxpayers $11 billion and it was and Obama rescued it. He became the self appointed bankruptcy judge, and, you know, and to this day,

Gene Tunny  43:11

yeah, I’ll have to look into, I didn’t realize that about GM,

Donald Chew  43:15

yeah, they don’t talk about that. That was one of the worst, run. That was one of the worst run companies in America. You know that that cup GM was immune to take over. It was too big, taken over by anybody, and the result was that in 2008 it had one and a half times the number of employees to service a normal market. There were employees that were being paid to stay home. It’s like the New York City school system, you there were people, there were rubber rooms where they said, Look, we have access. We don’t have any work for you. We’re just going to pay you to stay home. And this went on for years, you know, you know. And so this was a company that had somehow was immune to any kind of outside influence, and that’s what you get when you when you have and that’s really the story. The 70s, you know, lots of companies had grown to that kind of Elven time proportion, and that’s why, you know, one of the big predictions in my book was very few macro economists foresaw the ability of US companies to withstand the COVID pandemic, then the interest rate hikes that followed it, but you know, and I felt like I was the only person on Wall Street saying our companies are going to do fine because they’re lean and mean now they they’re not companies in the 70s, but every macro economist model is premised on the 70s, because they all go back and say, Well, that’s what happened in the 70s, but the companies are assumed to be the same ones, because macro just doesn’t look at corporate finance. They’re two as chapter 12 of my book is about what macro gets wrong.

Gene Tunny  44:55

Yeah, and yeah. I mean, I think there’s some some good points there. It’s. The problem of, you know, the data, they’re highly aggregated, and, like, how much detail do you get to get in there? I mean, that’s, that’s certainly an issue. Another issue is, you know, macro hasn’t really, they don’t really have a their financial model or sector model. They don’t really have the banking sector in there very well, if at all, in some of their macro models. So, yeah, I think there’s, that’s a really, really good point you make there. Okay, John, this has been, this has been great. Yeah, I’ve learned a lot about about what, you know, what’s been happening since, you know, 70s, 80s, so compared with the past. So you contrasted the modern cop corporate finance with the previous approach, where you had the big conglomerates, there was an aversion to debt. And I mean, by doing that, you’re reducing your return, aren’t you, because I mean, debt is a way of getting debts. Debts cheaper than equity. Is that the argument? And all the debt lets you leverage up and that enhances the the equity return. Well, it

Donald Chew  46:04

does both. So you, yeah, I mean, debt is really a control device. It basically, if you don’t have, this is the Michael Jensen argument that debt forces you to pay out excess capital. So you, if you So, the rule of thumb is, if you are a mature cash cow, you want as much debt as you can put on it, because you want to squeeze that capital out. If you’re a growth company, you want to avoid debt like the plague, because debt will cause you to pass up valuable investment opportunities. So it’s a very simple proposition, and that, and it it, you know, and it can be seen, private equity tends to go for the mature they squeeze out excess capital from companies without growth opportunities. But although private equity has started to move over into the growth spectrum, to a certain extent, they now operate with, in some cases, more than 50% equity. So the whole movement private equity has been to reduce the amount of debt and take on more growth. And now we see the largest companies, these unicorns, which is a company with more than a billion dollar market. They’re staying private because the costs of raising outside equity are just very high. You know, the I call it the cost of having dumb investors once. If you bring dumb investors into the party, you’re gonna, you’re just gonna have to say more you’re gonna provide more information. And you’re, they’re just not in a position to pay up for risk. So these unicorns are now. They look like public companies. They have the same collection of fidelities and black rocks, but there’s no retail investor. It’s just the smart money all sitting around the table, still very large market caps, growth opportunities, but they can have a private conversation about the value of the company. That ends up it just, it means the company’s worth much more, because you don’t have to spend money educating your investor base. You know, that’s it. There are huge public company, and that’s why there’s only, opposed to 8000 Yeah, and it’s not just Yeah,

Gene Tunny  48:19

absolutely no, I agree. And I agree. And I was just thinking, with all the additional regulation that, yeah, I mean, public companies tend to have more the regulatory requirements are much greater reporting requirements. So, yeah, that’s a good point, but it’s not,

Donald Chew  48:34

it’s not just the regulation and those costs. It’s the if you’re a small company that’s not attracting, not not much growth, you’re gonna, you’re gonna have a very depressed value. They’re all these tiny little companies that went public and they’re now orphans. Nobody wants them. Nobody covers them. So they trade at two or three times earnings. And that that’s a cost. With hindsight, they should not have gone public. They’re going to end up going back into private ownership. But you can’t. Is this? Public investors just can’t. They’re not smart enough to go in and rescue the values of these companies. So it just ends up leaving, you know, leaving them in a no man’s land and and I chopped that up to the the information costs of being a a public company. Gotcha,

Gene Tunny  49:26

are there some notable examples, or prominent examples of those smaller companies that have gone public and it’s not worked out for them? I can’t,

Donald Chew  49:33

I don’t know. I, you know, I wasn’t prepped for that, but, but I’ve heard people talk, no, I Yeah, it’s become a the liquidity is dried up. You know, lots of people will say that. And yeah, you would think, then they would sort the GO, GO private again. You would that would be the natural first step. But, but, but, no, okay, sorry,

Gene Tunny  49:55

no, that’s all right. I was just just wondering, because it was an interesting, interesting point. I. Right. Oh, well, Don just to finish up any final points, anything, any points in the book. You think it’d be worth bringing out in this conversation that we haven’t covered

Donald Chew  50:09

yet? Oh, yeah, let me. Let me take it one more shot. During the last 50 years, earnings relevance has dropped from something like 50% to zero. There’s a book called The End of accounting by Baruch Lev so the statistical correlation between five year changes in earnings and five year movements in stock prices, that’s how accountants track the relevance of earnings. That that statistical correlation has dropped from 50% to zero, and this is consistent with my, my view of modern corporate finance, which is not, it’s not about earnings, but there is one variable that actually has explained an incredible amount, an increasing amount of corporate stock prices. Would you care to take a wager? What it is? Well,

Gene Tunny  50:57

I’ve read the book. I’m trying to remember that this is your it’s the it’s the category. It’s one of the cost categories, isn’t it? Yes. Is that right? Yes. It’s,

Donald Chew  51:06

yeah, it’s, it’s R D, increase in R D, increase in S G and A and S G selling general and administrative expense. Well, during the last 50 years, that number has jumped from 25% of total assets to 55% which is amazing. And so yeah, the question, what is in SG and a that wasn’t in there before? And it’s all kinds of stuff like marketing and promotion, employee training expenses, all kinds of intangible expenses. And this stuff gets, you know, it gets expensed. It’s not capitalized, but it’s really, it’s kind of a modern day form of r, d, you know, Amazon has a ton of that stuff. And what we’ve discovered is that the the this, the correlation with those two variables and market prices, is is really remarkably high. So the one variable that you want to see, if you see large increases in R and D and S, GNA, that is kind of a the best indicator of increases in corporate value. And it suggests that, you know corporations are, you know they’re the investors are recognized the values of these companies, even though it’s not reflected in earnings, and the companies keep pouring more money into it, so you see these PE multiples going through the roof, and you also see lots of companies with negative earnings. You know, in the old days, in the 70s, only 10% of US companies would have negative operating cash flow. Today, it’s over 30% of publicly traded companies are losing money every year, and then every couple of years, they go back and raise private equity. They raise they raise public they raise equity from private sources because the public markets can’t invest in it. They don’t want to buy a company that’s losing money every year, but they go back to the Chase Manhattan Bank and get private equity so and the popular press thinks that these companies are zombies, but they’re not zombies. They’re actually quite valuable companies, but you won’t see it on their P and L’s. And I find this a really remarkable phenomena. I just, you know, I haven’t seen, there’s two or three academics that are talking about it, but it’s just, so, yeah,

Gene Tunny  53:27

but so what’s justifying the valuation? I mean, you, you show there’s this correlation between that, that those expenses and R and D and their value. So, but what are people who who are buying these, these companies, are investing in these companies. What are they seeing? Are they seeing that they’re building eventually, they’ll, they’ll earn a ridiculous amount of money, or that, or they building up an asset, intangible assets, knowledge, software, or whatever, that will be bought out by a Google or by, well, yeah,

Donald Chew  54:02

okay, it could be either those two. Okay, yeah. I mean, it’s probably more likely to be bought out by somebody else, but, but it’s the Amazon story. I mean, Amazon really didn’t show earnings a long time and but to their investors, the idea that these were investments and that they had phenomenally high margins, you know, once they turn cash flow positive, that you can see the amount of dollars they would earn on each you know, because the the requirements for future capital were so limited that they were bound and they were going to become money machines. But it’s hard to again, it’s hard to communicate that to a public market. But if you get a small people and group of people in the room, they share their your vision, and then, you know, for now, it’s private equity, but eventually, when the growth opportunities start to materialize and the cash flows, then it becomes public but the wonder of Amazon is that Jeff Bezos had the confidence to do this. You know, this is. When he did, I mean, because he had no earnings. I remember my firm, stern Stewart was once hired by an investor to determine if Amazon was going to go belly up. They were so concerned because he had no earnings, and so they had to hire us to then, you know, to verify that this was actually a solvent operation. And then that’s, you know, it’s really about, you know, smart investors versus dumb investors. You it’s hard to communicate with dumb investors, so you need to find and but Bezos had the confidence to say, I can keep doing this. He had his credo in 1997 and he got a following, and then he became, he basically conditioned these investors into following and rewarding him. You know, the larger his losses, the larger the stock price game for a period of time, which, which is the way a smart market should work. So anyway, more than

Gene Tunny  55:54

you want to know. No, not at all. I mean, I find it, I find it extraordinary that the end of accounting. So I’ll have to read that book. I haven’t read it, and it sounds, had you heard of it? No, I hadn’t, actually, not until I read your book. That’s, yeah, that’s fascinating. I mean, there are all sorts. I mean, as an economist, I’m often, you know, like economists often think, sort of try and look through the what accountants produce. Or, you know, because accountants don’t always represent things the way that economists would. So sometimes things the way accountants show things are not helpful. So yeah, it’s interesting about the end of the end of accounting. Yeah, yeah, I have to look into

Donald Chew  56:40

that. Very good. Are you trained in accounting or finance or

Gene Tunny  56:45

Well, I mean, I I’m an economist. So I’ve done, I’ve studied accounting, and I’ve studied some finance. I used to work in the treasury here in Canberra, and I work as an economist now. So do cost benefit analysis studies and business cases and things

Donald Chew  57:01

I really look forward to hearing what you have to say about my macro chapter, the chapter 12, yes,

Gene Tunny  57:08

well, I like the point you made about economists not not properly, considering that change in the corporate the composition of corporations, I’m gonna have To go back and read that more closely, but I think that’s a that’s a very compelling point, and I’ve got to think about what that means for how economists might model that. So yeah, I can’t. I probably haven’t got much to say on it at the moment that’s as profound, but yeah, leave it with me, and I might shoot you a note about it. Big debate

Donald Chew  57:42

is about productivity. Yes, you know, how do we measure it? And, you know, I just think, and people, a lot of people, think that GDP just doesn’t provide any grounds for measuring productivity. So the you know, but with the measures we’re getting from the national income accounts, just don’t. They don’t do a good job of reflecting inflation, but they’re even worse. Yeah, they’re even worse than reflecting productivity. And we can just kind of go after Robert Gordon and suggest that he was, you know, way too pessimistic about productivity growth in the latter part. So that’s the argument, yeah. And one, one last, are you a Robert Gordon, yeah, I like,

Gene Tunny  58:25

I think that’s a very good book. The I mean, his argument is that, that we’ve already, we’ve had major general purpose technologies, and we haven’t. We had that in the industrial revolution, then the second industrial revolution, yeah. And then the third industrial revolution with ICT, or the internet mate was actually, but, yeah, there was, or maybe back in the 80s with ICT. But what we’re seeing now isn’t quite of that same magnitude, and he’s pessimistic about productivity growth, but that’s before the modern I mean, AI is giving me cause to reflect on Gordon’s thesis. I think, yes, yes.

Donald Chew  59:06

Okay, well, anyway, I take issue it with it in my chapter 12 and and this is based on the work of an economist named James Sweeney at First Boston. But he says, when he my favorite line is, when, when I, he says, when I go in to talk to a CEO about Gordon’s book and productivity decline, I get laughed out of the room. You know, they they just don’t rot because the productivity doesn’t show it. Just can’t show up in GDP, the numbers they’re using just can’t reflect the quality. You know, you can’t make these quality product adjustments that are required to make something comparable and so. And my argument is, yeah, look at stock price. You want to see productivity gains, at least projected forward stock prices is the place to look, not, not at GDP. And I’ve got, I’ve been talking to the chairman of Columbia’s accounting. Department, and he’s very excited by that idea. In other words, the idea that macro actually suffers from the same problems that accounting suffered from, but finance is correct. Finances basically said, Look, accounting is just a point of departure, and you’ve got to look at many, many other things so you can get the stock prices. Macro economists are still stuck back with GDP, and they’re not looking they don’t trust stock prices. They just don’t

Gene Tunny  1:00:29

think, yeah, that’s true. And I think the reason is that economists suspect that that time, I mean, stock markets can the market pricing can be wrong for a significant period of time or divorced from fundamentals, so prior to the.com crash, for example. So I think that’s probably why the the macro economists are skeptical. Yeah, but yeah, I’ll let me reread that, because I must confess, I think I just skimmed that, whereas I focused on the the earlier chapters and the discussion of Jensen and Nick lean and but I’ll have to come back to you on that, because that’s a it’s an interesting argument. I agree with you about the difficulty of measuring productivity. I think that’s, yeah, that’s, that’s well appreciated by economists. And there’s a lot of you know, there’s a huge literature on this. There’s conferences, but it is something I haven’t looked at in a in a little bit, so I’ll have to, I’ll have to go back to that.

Donald Chew  1:01:24

Okay. No, I’d love to hear what you have to say. And one piece of business here, when we end up doing this recording, my thing will just be, will just be audio, if you should. Yes, yes. Confused to use, yeah, okay, that’s my hope.

Gene Tunny  1:01:44

Okay, yeah, yeah, just audio, yeah, just for sure, yeah. No, no problem at all. No, no, no,

Donald Chew  1:01:48

I have problem at all. All right, this is, it’s been a hell of a lot of fun. So

Gene Tunny  1:01:54

Excellent. Well, I hope you, hope you get on some other shows, and you your book is, you get, you get some good interviews out of it, and good coverage. Because I think it’s, it’s an argument that that needs to be made, and it’s, it’s a bit of, it’s counter to a lot of the popular understanding, the popular views on on corporate finance. So I think it’s, it’s definitely a welcome addition to the literature. So I

Donald Chew  1:02:22

ask you one more question. You think the book is written sufficiently clearly, or that it could actually be an introductory finance type? I view it as a supplement to a corporate finance and that’s what I’m trying to promote events. So if you’re teaching, if you’re using brilliant Myers in your finance 101, do you think undergrads or non finance types would be able to process the information in the book? Or do you think it’s too

Gene Tunny  1:02:56

maybe a third year a third year student or third year undergrad, yeah, yeah. Okay. I mean, that’s just, yeah, yeah. I think it could, I think it could be a good supplementary text, certainly that, like all of the history there, and the discussion of, I think, you know, the discussion on Jensen and mecklen is great, okay, and I think you’re very, you’re very clear about your, what your how you see this adding value and the market for corporate control. I think that’s all good stuff. Yeah. I think it certainly could be, could be, could be valuable there. I mean, it’s the sort of thing that, you know economists should read too. I mean, anyone doing a graduate graduate study should probably read as well, just to make sure that they understand how this matters in the real world. Like that’s what I think, is I like about the book, because often, you know, you see these, you know, there are these articles or these famous theories that are talked about, and they’re presented in a textbook, but you don’t often, some what’s hard to do is often relate it to the real world. So I think what you do, well in that book is is actually relate these concepts to the real world. So okay, good. Now that’s music my ears. Very good. Yeah. That might because your background in in working in the in the sector, or your journal, is it Journal of Applied corporate finance?

Donald Chew  1:04:20

Yeah, is your journey and win the way back past. I did a PhD in English and American Lit, so I was going to be an English professor. So then I got into this red took my first econ class when I was 27 so I’ve been, yeah, I’ve been trying to, like, I tried to communicate with my old finance, with my old literature, literature friends, and it’s two different disciplines. You know, everybody that I went to graduate school with shares all those beliefs that I end up they don’t find finance plausible or or socially constructive. You know, they. Mind stay, you know, exploitation, yeah, exploration of everybody but themselves. So anyway,

Gene Tunny  1:05:09

yeah, but I think you, I think you make a good case for for why that isn’t so, and why it’s actually added value. So I think, again, great, great contribution to the literature. Don, thanks so much. I’ll put a link in the show notes to your book, and I’ll encourage listeners to get a copy again. Yeah, terrific. Well done. And yeah, look forward to chatting with you some time again in the

Donald Chew  1:05:33

future. I hope you do it soon. Thank you very much. Gene, take care. Bye. Thanks. Don,

Gene Tunny  1:05:37

right. Oh, thanks for listening to this episode of economics explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact at economics explored.com or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you, then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week. You

Obsidian  1:06:25

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Credits

Thanks to the show’s sponsor, Gene’s consultancy business, www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple Podcasts and other podcasting platforms.

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Podcast episode

The Tax Guru the WSJ says has Wall Street’s “Strangest Hustle”: w/ Andy Lee, Parallaxes Capital – EP237

According to the Wall Street Journal, this episode’s guest Andy Lee is “The Tax Whiz With the Strangest Hustle on Wall Street”. He’s the founder and CIO of Parallaxes Capital, and he joins us to talk about tax receivable agreements (TRAs). Andy explained what TRAs are, how they come about for companies going public such as Shake Shack in 2015, and why he’s investing in them. Disclaimer: Nothing in this episode should be construed as financial or investment advice. 

Please contact us with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored

You can listen to the episode via the embedded player below or via podcasting apps including Google PodcastsApple Podcast and Spotify.

About this episode’s guest: Andy Lee, Founder and CIO of Parallaxes Capital

Andy founded Parallaxes Capital in 2017. Previously, he was with Lone Star Funds, focused on investing in the Americas. He began his career at Citigroup.

Andy graduated from the University of Illinois at Urbana-Champaign with a Masters in Accountancy and a Bachelors in Finance and Accountancy.

Andy has been featured in publications including Wall Street Journal, Capital Allocators, Institutional Investor, NBC, Forbes, ReOrg Radio and Fitch’s LevFin Insights. He has spoken at events and conferences for organizations such as the Association of Asian American Investment Managers (“AAAIM”) and leading academic institutions including the University of Illinois, University of Pennsylvania and Texas Christian University (“TCU”)

When Andy is not working, he enjoys taking his corgi (Taco) on long walks.

Fun Fact: Andy, rarely one to back down from highly ambitious goals, ran a marathon less than 180 days from ACL, MCL and PCL surgery.

Source: https://parallaxescapital.com/our-team/ 

What’s covered in EP237

  • Introduction. (0:00)
  • TRAs for companies going public in the US. (6:18)
  • TRAs agreements and their value for private equity investors (i.e. pre-IPO owners). (12:52)
  • Tax refunds, risk management, and investment opportunities. (19:57)
  • TRAs and investment strategies. (24:47)
  • TRAs and their potential as a diversified investment. (30:55)

Takeaways

  1. TRAs convert future corporate tax savings (e.g. from depreciation expenses) into current income streams.
  2. TRAs provide long-dated, typically 15-year income streams that can be sold by pre-IPO owners (e.g., private equity investors).  
  3.  Private equity firms use TRAs to increase their earnings from the sale of businesses they’ve invested in. 
  4. Ideal Candidates for TRAs are large, stable companies with predictable long-term profitability (e.g. Shake Shack), rather than high-growth tech startups which often lack immediate profitability.
  5. US tax expertise is required to properly analyze and invest in TRAs.

Links relevant to the conversation

WSJ article about Andy, “The Tax Whiz With the Strangest Hustle on Wall Street”: https://www.wsj.com/finance/investing/tax-whiz-strange-hustle-wall-street-d51ddbc6 

Parallaxes Capital: https://parallaxescapital.com/ 

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Transcript: The Tax Guru the WSJ says has Wall Street’s “Strangest Hustle”: w/ Andy Lee, Parallaxes Capital – EP237

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Andy Lee  00:04

Tax is the largest asset class in the world that no one’s ever heard of. It’s a very much part of the fabric of our society. Like there are so many avenues through which tax assets are expressed and are monetized.

Gene Tunny  00:26

Welcome to the economics explored podcast, a frank and fearless exploration of important economic issues. I’m your host gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you could join me for this episode, please check out the show notes for relevant information. Now on to the show. Hello, and welcome to the show. In this episode, I talked to the man that the Wall Street Journal has described as the tax whiz with the strangest hustle on Wall Street. It’s Andy Lee from parallaxes capital and we’re talking about tax receivable agreements T RAS. What on earth rtra is and why has Andy invested in them? How did companies like Shake Shack end up bound by T IRAs? Stay tuned to find out. Please be aware that Andy’s firm parallaxes capital is a big investor in TRS and nothing in this episode should be treated as financial or investment advice. I would love to hear your thoughts on the discussion that I have with Andy today. So please get in touch and let me know what you think. And if you have any questions, my contact details are in the show notes. As sponsor this episode is Lumo coffee a seriously healthy organic coffee with three times a healthy antioxidants of regular coffee. Lumo coffee offers a 20% discount for economics explore listeners until 30 April 2024. Be sure to check out the show notes for more details. Without further ado, let’s dive into the episode. Enjoy. Andy Lee from parallaxes. Capital, welcome to the programme.

Andy Lee  02:09

Thank you for having me.

Gene Tunny  02:11

It’s a pleasure, Andy, I’m keen to learn about this very exotic, very interesting, and, you know, asset class I hadn’t heard of before before I learned about what you’re doing these tax receivable agreements, so keen to chat about that to start with? Could you tell us about parallaxes? Capital? What’s the idea with the name? How did you come up with the name? Absolutely.

Andy Lee  02:38

So a parallax is an astronomy term. Whereby you look at a planet from a different vantage point to arrive at a different perspective of an object. So there are several meanings in the name, the first being an ode to my old firm, it was called Lonestar funds. And so looking at a person having a different perspective, the more secular meaning around was that many people look at problems from a singular point of view. And in order to solve an equation, like you need to look at it from multiple perspectives, to arrive at multiple solution sets. And so the plural of parallax parallax cysts. And so that was as parallax was unavailable. parallaxes was, and so that was helpful. But also it talks a little bit to my faith. I’m a Christian. And as a Christian, and we’re not so much focused on the here and now, but more focused on eternity. So a very long term perspective.

Gene Tunny  03:41

Very good. Yes, it’s a it’s a good name. I always remember those that classic 1970s film with I think it was Warren Beatty, the parallax view, which is one of those great 1970s conspiracy films that I’d recommend. So yeah, very, you know, top marks on the name. So well done. I’ve got to ask me, what is parallaxes? Capital? What? So if you’re a, you’re a fund manager of some kind, or what are you actually doing?

Andy Lee  04:10

So we’re an investment manager based in the in the US and we have raised six funds dedicated to the strategy of monetizing tax receivable agreements. So a tax receivable agreement, think about it, like a long dated annuity that is not too dissimilar from a streaming royalty on metals or mining, musical royalties of pharmaceutical royalties. So long data annuity like cash flows, that we provide upfront liquidity for to holders of these assets in order for them to have to recycle that capital to do other more productive items.

Gene Tunny  04:55

Gotcha. Okay, so, a couple of things there just immediately long dated how long and by the upfront liquidity? I mean, what is this? Is this a repurchase agreement? Or are you? Are you buying them outright? What’s, how do you how are you? What’s that involve?

Andy Lee  05:16

So are the two questions the first duration lies? It’s typically a 15 year piece of paper. Just to provide a perspective on it, we actually have fun one was a 21 year of fun to hold the paper. I know I look very young as an Asian American, it’s a gift, as I’ll call it. But people weren’t sure if I was even 2001 When I went out to raise our first fund. On the second question, it is the latter. Do what you suggest that we buy these outright from counterparties, including the likes of private equity, their CO investors, management team as well as founders, providing them upfront liquidity for what is otherwise a unloved and misunderstood asset.

Gene Tunny  06:02

Okay, gotcha. Right. And what is the asset itself? So there’s obviously a stream of income coming from somewhere for this to be valuable, what is the actual underlying asset? Absolutely.

Andy Lee  06:18

Think about it almost like a tax refund, that one might receive after they file their taxes. So some here in the US, every April 15, individuals have to file their taxes, fulfilling their tax obligation to the United States. Oftentimes, many of these individuals have overpaid their taxes. And so on April 15, they would file your taxes, the US government would say, hey, Jean, you’ve overpaid your taxes by 100 bucks, we’ll pay it to you in two months. For many individuals, they might want the money immediately. And so there are businesses such as the likes of an h&r block, that would say, June instead of waiting for $100, in two months, we’ll give you $95. Today, a Buy It Now price, we do the exact same thing. But not for consumers. We do it for corporations, where they have 15 years of refunds available to them, that would come due. And so instead of waiting every year to get that annuity, they want that money today. And so we prospectively provide them that factoring solution upfront proceeds.

Gene Tunny  07:37

Ah, okay, I think okay, this is starting to make sense. Right. So what type of companies are we talking about? I mean, what from my reading? And looking into this, it looks like is this is this highly relevant to the tech sector to startups?

Andy Lee  07:55

I wish I’m the only one, it may not be the most relevant that attack sector is primarily driven by the fact that many tech firms here in United States are very focused on growth at all costs, relative to profitability, many of them, or the vast majority of the tech sector runs unprofitably Primarily because the market prior to 2020, to value them on growth, more than they did on cash flows, primarily because they believed that these were long data annuity streams. And the SAS businesses were long data annuity themes, and that whenever they stopped growing, they will become incredibly profitable. That obviously then come to fruition whenever growth stopped. So that’s not the where we primarily transact names that we’re are associated with, include the likes of a REMAX, a Shake Shack, yeah. Duffin Phelps, so large corporates that are investment grade near investment grade businesses, there’s also the Edit element that as quickly as a tech business disrupts a industry itself is vulnerable to being disrupted. And so for an investment manager like myself, focus on the space that we’re in, like, we don’t focus on the next year or next five years, we have to believe that a business is going to be a going concern for 15 years. So that’s a very different perspective or lens that you have to look at a opportunity, primarily because you might be a great business today. Do I believe that you’re gonna be a great business in 15 years, if you’re not a great business? Senior, you might be a great business for five years that will result in me getting a return of my capital. Ultimately, I’m in business to get a return on my capital. And if you’re no longer in business in your six, I got my money back. And then I just wasted a huge opportunity cost for my investors.

Gene Tunny  10:08

Yeah, yeah, gotcha. And how does this tax receivable agreement? come about? Then? And also, I mean, okay, so I guess maybe I need to go back a bit. What’s generating this, this tax refund primarily? What is it that that is generating these potential tax refunds that will be coming in the future and that you’re able to then you buy you effectively buy those tax refunds off the companies? So I guess I’m interested in what’s generating them, if there are any sort of commonalities. And also then how do you go about making that agreement? What’s the contract look like? Is it regulated? Or is there a standard form? Can you tell us a bit about that place? Andy?

Andy Lee  10:55

Yeah, absolutely. So the most common version of that is, whenever a company is going public, they enter into a specific tax transaction in the US transforming their business, from what we call a flow through, which is a partnership or an LLC becoming a C corporation, that transaction is known as the up seat transaction, that transaction enables the company to be a beneficiary of large tax assets that will become available to them over 50, typically 15 years. So that’s an incredibly valuable asset. As a result of entering to these transactions, they enter into the agreement, the agreement is relatively rote. It’s while it’s a cottage industry, much of it has been rinse and repeat it over 30 years has been around since the 1980s. And so something that as well Warren precedents, as well as presidential documents for them to follow. And so for us, these are ultimately ended up in the hands of what we call a natural holders. So in the private equity context, private equity firms have tenure fun lives. So they take a company public, and oftentimes, they sell down the equity within the 10 years that their funds allow for them. These, if you took a company public in your A these assets, then start a 15 year clock. So in your two to three, it will be your 11 for private equity fund, you’re looking to move on and sell these positions. And that’s where we stop at we’re a second during market liquidity provider for these

Gene Tunny  12:51

assets. Rod okay. And I mean, you talk about large tax assets. What if, if I understood your terminology correctly? What are you talking about? Are you talking about what is it is a depreciation or is it the things that Yeah, Okay, gotcha

Andy Lee  13:10

items that can be depreciated or amortised. So raw. What what what’s an item that depreciate a car? A building on land is not depreciable because like obviously land is the land. But things are amortised include things that aren’t intangible in nature. So customer relationships, among others, that might be available intellectual property, among others.

Gene Tunny  13:37

Gotcha. So this is a way for these companies to to get well to get to get cash to reinvest in their operations or to you know, for working capital, whatever. Can you explain what is it? What’s in it for them? Because I mean, they they sacrifice this, you know, the this tax, you know, this expense that they can use to reduce their, their tax liability in the future? They get the upfront cash, what is it? Is it is it out of desperation that they’re going into these agreements. So how

Andy Lee  14:11

I would make a slightly different connotation. Remember, I mentioned that the sellers are private equity firms, or investors among others. So at the time of the IPO, these assets are owned by the company. Remember, pre IPO, the Board of Directors got our fiduciary duty is to maximise value for pre IPO shareholders, the public markets, we as in the US have seen a massive move away from active to passive investors. active investors are very focused on understanding what intrinsic value are, and so they’re very focused on understanding the free cash flow capabilities and generation of a business. However, on the other side of the equation passive Investors are more algorithmic, algorithmic or systematic in nature and are focused on among other things, revenue, multiple growth rates, EBIT, da multiples, price earning, none of which really captured the value of tax assets, primarily because they’re less standardisation across things such as capital expenditure, and intensity of a business, working capital, cash taxes. And so as a result of not necessarily the attributes that they seek being captured by the evaluation metrics, these tax assets are ignored. And so private equity firms are saying, Look, this fundamentally improves the free cash flow generation of a business. If you’re not going to give us an incremental value, incremental value for it, we’re going to extract it for ourselves by entering into a tax receivable agreement. So the holders of these cash flows are more sort of private equity firms. As a result of the finite fund lives, we step into the breach to provide liquidity to.

Gene Tunny  16:12

Okay, we’ll take a short break here for a word from our sponsor.

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Gene Tunny  16:47

Now back to the show. What’s an example of a private equity firm as a Carlyle Group? Is that the sort of group you’re talking about, or KKR?

Andy Lee  16:57

Yeah, all of these massive mega funds all have trs, primarily because they had it for the investment manager themselves when they went public. And subsequent to that the principals realise the disconnect in how the the various markets private and public markets think about it differently. And if they’re extracting value from their portfolio companies, as private equity got more and more competitive?

Gene Tunny  17:25

Yeah. Yeah. I mean, it’s, it’s interesting to me, it’s one of these, these niche types of investments. I mean, honestly, I hadn’t heard of them before. You know, actually, there’s not Nishioka. Well, tell me more. 

Andy Lee  17:42

Tax is the largest asset class in a world that no one’s ever heard of. It’s a very much part of the fabric of our society. Like there are so many avenues through which tax assets are expressed, and are monetized. In the US, we have the concept of tax credits, that are now that were historically transferable or monetizable. And now they have direct pay. I don’t know you’ve been to Europe, with your significant other, and may have gone shopping in that regard. In the in Europe, there is what they call it the value added tax for which is a foreign or you can get a refund at the airport. Yep, there’s a huge business, global blue, that’s currently owned by Silverlake, that generates hundreds of million dollars of EBIT da by running the VAT tax refund programme at the airport. Similar to the example I gave you on individual taxes, that in commercial business that basically says to travellers whenever to depart in the EU, hey Jean, instead of waiting to get a check to Australia for that 1000 euros will just give you $700 Today, and they earn a sweat relative to that. There are so many businesses like that, across that run the gamut. And the lack of understanding creates the opportunity because it is the single largest opportunity set that doesn’t have commercial elements to it. And intellectual capital that has been brought to bear. Why is that? primarily driven by the fact that tax professionals here at least here in the US, when people hear attacks, they literally run away all the plug your ears, that like that’s the last thing they ever want to talk about. Every year we have to file on April 15. People consider it like being worse than going to the dentist. So like it’s something that is a very misunderstood and underappreciated even though there’s clear value add that can be created an economics that can be derived from it. Yeah,

Gene Tunny  19:56

yeah, for sure that that example you gave is a very good one. And that’s really helped crystallise in my mind. And so you’re, you’re doing what they’re doing. But with, well, you can compare what you’re doing with what they’re doing, you’re doing it for big corporations or for the private equity companies that have invested in them, they want to get out, you come in, you provide some liquidity, and you take this stream of these, these benefits that they can get from reducing their taxable income so that they will pay you that benefit associated with that in the future. You’ll get it from you get it from the company itself, too. Can you tell us what the agreement like who’s the contract or the Yeah,

Andy Lee  20:42

the agreement is between the TRA holder, then the private equity firm, now parallaxes. And the company every year, yeah, post tax filing season, the company has obligated to deliver a notice to the holders, if they utilise the asset, and the calculation of the refund, at which point of time, they have to repatriate the refund to the holder of the TRA. And so for which every q4 is a little bit like Christmas, we a little bit of an early Christmas, where we started collecting payments for the underlying payment stream. Gotcha.

Gene Tunny  21:24

Okay, so with the example you gave of the business was a silver like the global blue that does the refunds, or they will pay you up front? The VAT or the VAT refund? And they there’s a there’s a discount applied? So they get a benefit they’re taking on? Suppose they’re probably taking on less risk if they’ve got receipts? How do you think about that risk? I mean, what risk is there from, from your point of view? And how do you manage that risk? Yeah,

Andy Lee  22:00

yeah, three primary forms of risk that we manifest. The first and foremost is credit risk. So in global blues example, the EU governments failing and choosing not to, or stepping them on the pavement. For us, it’s more, it’s entirely around is the business going to exist? To the point about do I believe that this is a durable franchise, and will be around in 15 years. And so I have to believe that the company is a going concern will be a going concern, profitable and will exist in earnest. And so that’s a big part of our underwrite. And our focus on these businesses, we’re not looking for a flash in the pan, were looking for long, durable franchises. One on credit risk. The second risk is you never lose your tax asset. Like in the same way, if you don’t go, you don’t use a global blue solution, you still are eligible for the refund for multiple years. So you can go, you can fly back to Australia, on your next trip to Europe, you can file your tax refund. And that has we can do it’s the exact same thing, tax assets never get lost. They’re merely deferred. And so that has the potential to impact our IRR, which is a time weighted measure. But obviously, it’s an extent we collect it, then it doesn’t hurt our total profit dollar or mo YC on the opportunity. The last aspect is around corporate tax rates. So think about a tax acid as being the derivative of two variables, one at the tax asset itself, the notional value of a tax asset, so think about a net operating loss of 100. Think about the tax rate being your price to let’s just say 25% 100 by 25 results in a $25 cash flow. To the extent that tax rates went down and to 20%, then the tax acids 100 by 20, or $20 to the extent and went up 100 by 40, then you get $40. And so relative to most other asset classes, we have an inverse relationship to the primarily because if tax rates went up, equities likely would see some form of a correction downwards. Conversely, on the way up, ever when tax rates went down, equities would likely rally. We have an inverse relationship to that. And so for many of our investors, they view it as a nice tail hedge relative to potential policy changes here in the US.

Gene Tunny  24:47

Gotcha. Okay. So you mentioned a term before MOC. So that is multiple on invested capital. So just clarify that. That makes sense. Right? So, yeah, just thought I’d ask you about that, that risk. Because, you know, whenever you’re swapping these, or you’re taking on these, or that the stream of benefits and you’re providing upfront money, that can be risky. And we saw what happened with Lex Greensville, from the green cell family, which is a dime in Brisbane and Queensland, which is south of Bundaberg, which is where the green cell family farm is. And, you know, he was he was doing great things, but then, you know, he got into got into trouble because he thought he found this, you know, this this thing, this part of the market that no one really was properly servicing before and was providing, you know, he was buying the invoices, I think, wasn’t he and then we’re providing that supply chain finance. And then, you know, it was all working until the pandemic and and companies started delaying payments, and then the whole thing fell over for him. So he was in. And that was a real shame. What happened there real, real, real shock. So yeah, I just just wanted to ask you about the risk, because I like I just wonder, is there a risk here that? Yeah, I just want to make sure you’re I mean, I’m sure you are, you’re crunching the numbers, you’re highly experienced in this in this industry?

Andy Lee  26:22

Yeah, I think for Greensville, I mean, Dale had on the asset side of the equation, to your point, there started to being deferrals or delays to the cash flows that they were receiving, there was a little bit of an asset liability mismatch, whereby they was the liabilities they borrowed heavily, and would deliver at an incredibly aggressive rate. And so that resulted in them being unable to fulfil their obligations on the liability side of the equation today. We have also achieved securitisation. Today, our book is unlevered as we have paid it off, but that is something that we are incredibly conscious about. And look, there’s always that under inherent tail risk. The point is like you should never have too much of a mismatch. And so inherently, it’s we’re always very concerned about not having too high of a leverage level that we will be unable. Should there be shortfalls in our expectations or under writings. Yeah, yeah.

Gene Tunny  27:30

Right might have a look at some of the, what you’ve got on your website. There are some interesting things here on your website here. So I’ll put a link to that in the show notes. So parallaxes capital is an alternative asset manager and as a market leader in monetizing tax receivable agreements. Okay, so I think I’ve got a much better understanding of what that’s all about. And the stats you’ve got on your website, I don’t know if these are still current, but it says 20 Plus tax receivable agreements, purchase so they’re, so they could be large companies like Shake Shack or whatever. REMAX you mentioned that you’ve got these tax receivable agreements from and then it’s $750 million of an discounted principal balance purchase? Could you explain a bit about what what that seven 50 million figure means? Please, Andy,

Andy Lee  28:25

absolutely. Remember the example that I gave you as to the value of a tax asset such as a net operating loss multiplied by a tax rate of a 25%. We own across our portfolio $750 million of cash effective tax assets. So if you want to understand what our notional number is, you do that 750 divided by a 25% tax rate. And you would end up with like $3 billion of notional. So 30 million is what our portfolio over the next 15 years will deliver back to us should deliver back to us. Rod,

Gene Tunny  29:06

okay. And do you provide any indication of what the potential rate of return to investors is?

Andy Lee  29:14

on a net basis? We deliver call it a 15% return. Ron, okay.

Gene Tunny  29:21

Gotcha. And, Ron, so that’s obviously going to compare favourably to to more traditional asset classes, but of course, you know, risk associated with that, and nothing we’re saying here is we’re not I’m not offering any financial or investment advice, of course. Right. And who’s investing in your funds? Andy? So you’re in New York City, I believe. Who who’s investing in your funds? Is it family offices? Is it is it investment, Marilee

Andy Lee  29:54

endowments and foundations as well as small pensions? Right and Oh, CIOs,

Gene Tunny  30:00

endowments, foundations and small, small pensions Did you say confirm

Andy Lee  30:05

as well as address or CIO firms?

Gene Tunny  30:09

Sorry, I’m not familiar with that acronym IC, sorry, what type of firms and

Andy Lee  30:14

outsource Chief Investment Officer firm. Think about smaller endowments may not have the sufficient scale to hire their own research teams to allocate capital. And so they aggregate capital into a larger firm, who then deploys money on their behalf in an outsource format. As a result of that bundling, they’re able to capture economies of scale as well as gain access to best in class managers,

Gene Tunny  30:46

broad Okay, without necessarily recommending, in particular, outsourced CIO, cio firms, you know, any examples of them? I’d be interested in following up on those I can’t say I’ve really come across many of them. There

Andy Lee  31:00

are some huge ones such as a partner’s capital. A Hamilton lane, a stepping stone. Yeah, a Cambridge associates. A RCEP.

Gene Tunny  31:15

Yeah, right. Now, it’s fascinating. I mean, one of the things that our previous guest on my show, David Bahnson, who’s with oh, gee, the name of his firm escapes me, but it’s quite a, he’s got quite a reasonable amount of funds under management. He’s over at over on the West Coast. I mean, one of the points that he makes on on his capital brief show is that the the capital markets in the US are just so deep. There’s just so much. So so much money, obviously, with so much talent and so much creativity and innovation. And, you know, this is what I’m learning today is what I’m seeing today. Is is part of that it’s part of that story. It’s it’s all it’s it’s really fascinating. Yeah, so yeah, thanks for thanks for all this. I’m sorry. So my questions might be, might be a bit bit basic, but I’ve, yeah, there’s

32:14

a lot. We’re all learning together.

Gene Tunny  32:16

Very good. Very good. There’s a lot I’m unfamiliar with in this in this space. So it’s really good. My final question and it relates to a book I’ve been listening to recently. It’s Tony Robbins, his new book, The Holy Grail of investing. I’ve been listening to it on Audible. I don’t know if you’ve come across it at all. But it’s, yeah. It’s very good. Because I mean, one thing about Tony Robbins is that he just knows all of these ultra successful ultra wealthy people and he’s able to pick their brains. So he’s talking to people like Ray Dalio and, and I think Paul Tudor Jones, I think was a client of Tony Robbins. But what he picked up from Ray Dalio is this idea of this holy grail of investing and he asked Ray Dalio for some advice and, and Ray Dalio is best advice to him was, what you’ve got to find is eight to 12, uncorrelated investments for your portfolio. So he’s talking about things that, yeah, they’re uncorrelated, so they’re not going to vary. You know, what’s the right way of thinking about this there? Because the returns are so I suppose unexpected or random relative to everything else, that if you get enough of them, then you should you can outperform the market. So even if the markets in a downturn, you can still be, you can still be doing okay. So I think that’s the that’s the basic idea. I probably haven’t explained that well enough to come back to that. But I think it’s an interesting concept. And, I mean, how do you see this your tax receivable agreements? How do you see them as part of a diversified portfolio or as part of trying to achieve this, this collection of uncorrelated investment assets that Ray Dalio would call the holy grail of investing? Do you have any thoughts on that?

Andy Lee  34:10

Yeah, absolutely. So like, look, there are so many different opportunities that are as a result of an inefficient and inefficiency, opaqueness of a market as well as size of markets that create incredible moats for one to be able to harvest what I might describe as alpha from it. And that alpha isn’t necessarily something that is academic in nature, is just driven by inefficiency. That can be an opportunities like what global blue does. They have a regulatory moat. Like, no one day Oh, there’s only one kiosk at any given airport. There’s only one way for you to get a refund unless you want to go Go home and send multiple stamps and mailing your refund, that inherently has have some exposure to obviously discretionary spending, among others, but you’re looking for opportunities where they’re just such inefficiencies and markets that you’re able to harness that operational alpha, um, that can be created as a result of sourcing. And so like, I think Elliott says, is incredibly well, that they seek to sweat their assets. What they do isn’t difficult. It’s just incredibly laborious. And so that’s what we try to do at parallaxes playing in non traded markets, ie there are no brokers. Unlike a, you can’t buy this on a Bloomberg or on your friendly broker, like those are things that that require you to go out and transact on a individual by individual basis. Is it hard to do? No. Is it something that many want to do? Also very much, that’s not something that many desire to do? The best and the brightest here in the US aren’t looking to make their living and become a master of universe and tax? That’s just not something that occurs? No,

Gene Tunny  36:14

no, certainly isn’t. I think it’s so fascinating. You mentioned I mean, alpha, so you’re going for that excess return, you’re talking about excess return relative to typical market returns. And then you mentioned Elliot, and I’m trying to remember the I don’t know, I can’t remember the name of the whole firm, but as Elliott, the is that the firm that buys distressed debt, and then Sue’s the countries that it’s that it’s bought the debt from

Andy Lee  36:41

most famous for Argentina. Yeah, gotcha. Or Argentina or seizing having seized a warship from Argentina. Rot.

Gene Tunny  36:48

Yeah. Wow. Okay, I’m gonna have to cover them in a future show. That’s fascinating stuff. Okay, Andy, that that’s been do

Andy Lee  36:57

something that many are unwilling to do. Yeah. How many investment firms are willing to confront a country and confiscate a warship?

Gene Tunny  37:08

Yeah, it’s, it’s bold. It’s certainly Absolutely. Right. Okay. And it has been terrific. I’ve learned, I’ve learned a lot. And yeah, so again, it’s an illustration of just those deep capital markets and just the level of, of ingenuity, the level of rigour that is being applied to finance Well, in the US and worldwide. So this is, this is terrific. Oh, finally, I should ask is this just is this mainly a, what you’re doing this? Is this mainly applies to the US, does it? Or do you see it happening in other countries

Andy Lee  37:50

that technology can occur all over the world? Um, that’s likely not something that I thought parallaxes can pursue. Primarily because tax is a very local domain of expertise. You’re not going to have a US tax preparer. help prepare your Australian taxes. They’re just not familiar. They’re barely familiar with Canadian bumper rules, or Mexican tequila taxes. They’re very much not familiar with Australian. It’s just a local domain of expertise. Gotcha.

Gene Tunny  38:20

Okay. Right, Andy, anything else before we wrap up?

Andy Lee  38:24

Nope. Thank you so much for taking the time. No worries, I

Gene Tunny  38:28

will put a link to parallaxes capital on your on the in the show notes. And yeah, refer them to to your material. So if you’re interested in you’re in the audience, and you want to learn more about tax receivable agreements, you can you can check out Andy’s website. Andy, you’re obviously one of the great authorities on this issue. So I would definitely refer people to us. So Andy Lee from parallaxes capital. Thanks so much for your time. I really enjoyed the conversation. Take care and be well rato thanks for listening to this episode of economics explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact at economics explore.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting outlets you then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.

39:47

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Credits

Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business, www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

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Podcast episode

Alternative Investments & Investable Mega-Trends w/ Ben Fraser, Aspen Funds – EP231

Ben Fraser, Managing Director of Aspen Funds, argues “there’s a huge opportunity to get into fossil fuel production.” He discusses macro-driven alternative investments, investable megatrends, including the disruption to energy markets as advanced economies decarbonise, and the outlook for the US economy, particularly inflation. Disclaimer: this episode presents general information only and is not financial or investment advice. 

Please get in touch with us with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored

You can listen to the episode via the embedded player below or via podcasting apps including Google PodcastsApple Podcast and Spotify.

About this episode’s guest: Ben Fraser 

Ben Fraser is the Chief Investment Officer at Aspen Funds, where he combines his analytical nature with a passion for delivering outstanding client service and strong returns through out-of-the-box investments. With a professional background that spans over a decade, Ben has become an expert in the field of investment management and has worked for several reputable financial institutions.

Ben is the co-host of the Invest Like a Billionaire podcast, where he joins his father, Robert, co-founder and CFO of Aspen Funds, along with co-founder Jim Maffuccio, to discuss economic trends and best practices for alternative investing.

Prior to joining Aspen, Ben served as a Commercial Lender at First Business Bank, one of the top SBA lenders in the nation. There, he specialized in government-backed loan originations, specifically SBA and USDA loans. Before that, he worked as a Commercial Credit Underwriter for Crossfirst Bank, where he personally underwrote over $125MM in C&I and CRE loans across various industries.

Ben also has experience working in the asset management industry, having served as a key member of the team at Tortoise Capital Advisors. At Tortoise, he helped grow institutional managed accounts from ~$3BN AUM to ~$7BN AUM.

Ben holds an MBA from Azusa Pacific University and a Bachelor of Science in Finance from the University of Kansas, where he graduated magna cum laude. Ben’s commitment to excellence and his ability to deliver strong returns for clients make him an invaluable asset to the Aspen Funds team.

What’s covered in EP231

  • 00:00:04 – Global Energy from Fossil Fuels (excerpt from interview)
  • 00:00:33 – Introduction to Economics Explored Podcast
  • 00:01:06 – Guest Introduction: Ben Fraser of Aspen Funds
  • 00:02:08 – Aspen Funds’ Investment Focus
  • 00:05:17 – Accredited Investors and Investment Opportunities
  • 00:06:04 – Expanding Accredited Investor Definitions
  • 00:08:47 – Alternative Investments and Client Strategy
  • 00:11:29 – Investable Megatrends for the Next Decade
  • 00:13:03 – Inflation and Energy Market Outlook
  • 00:15:37 – Private Credit in Real Estate
  • 00:20:37 – Commercial Real Estate Market Dynamics
  • 00:23:42 – Energy Investments and Fossil Fuel Outlook
  • 00:29:10 – OPEC’s Influence on Oil Prices
  • 00:31:28 – Gold, Bitcoin, and Investment Hedges
  • 00:35:09 – US Fiscal Policy and Debt Concerns
  • 00:38:40 – Closing Remarks

Takeaways

  1. Macro-Driven Alternative Investments: Aspen Funds focuses on macro-driven alternative investments, which involve understanding long-term economic trends to identify investment opportunities.
  2. Investable Megatrends: Aspen Funds has identified investable megatrends for the next decade, including higher inflation for longer and an energy crisis due to a transition to green energy.
  3. Opportunities in Real Estate: Aspen Funds sees opportunities in private credit within the real estate market, particularly in the midsection of the capital stack, where risk can be reduced while achieving good returns.
  4. Energy Market Insights: Ben Fraser discusses the impact of transitioning to green energy on fossil fuel production, highlighting potential supply shortages and investment opportunities in fossil fuel production.
  5. Views on Gold and Bitcoin: Ben Fraser comments on gold and Bitcoin as alternative investments, acknowledging their role as hedges against fiat currency but cautioning against heavy allocations due to the risks involved.

Links relevant to the conversation

Aspen Funds

Invest Like a Billionaire Podcast 

Transcript: Alternative Investments & Investable Mega-Trends w/ Ben Fraser, Aspen Funds – EP231

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Ben Fraser  00:04

Right now about I think it’s 83% of all of our global energy needs come from fossil fuels. And that’s usually pretty shocking number for people to hear. They think we’re way farther along. Right. You mentioned nucular, which I’m a huge proponent of, but that only makes up I think it’s less than 5% of total global energy needs.

Gene Tunny  00:33

Welcome to the economics explored podcast, a frank and fearless exploration of important economic issues. I’m your host gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode, please check out the show notes for relevant information. Now on to the show. Hello, thanks for tuning in to the show. This episode, we’re joined by Ben Fraser, Managing Director and Chief Investment Officer of aspen funds, which offers alternative investment opportunities for accredited investors that concentrates on real estate credit and energy markets. In this episode, Ben explains what he means by macro driven alternative investments. Ben and I discuss what he sees as investable mega trends. And we also talk about the outlook for interest rates in the US economy. Among other things, venture is some great insights into what’s coming up in energy markets as advanced economies decarbonize right, oh, we’d better get into it. I hope you enjoy my conversation with Ben Fraser of aspen funds. Then Fraser from Aspen fans, welcome to the programme.

Ben Fraser  01:50

Hey, thanks for having me, Jean.

Gene Tunny  01:52

Oh, it’s good to have you on Ben. And I’ve been listening to episodes of your invest like a billionaire podcast that you do with your father. So good work on that. And I’ve got a couple of questions coming from that, to start with grass. Q, what’s the what’s the pitch of aspen fans? Like, based on what I’ve seen, you’re focused on macro driven alternative investments. What do you mean by that, then?

Ben Fraser  02:21

Yeah, well, great question. And, you know, it really kind of ties in both to our podcast platform as well as what we do on the investment side. But the podcast invests like a billionaire is really intended to educate, you know, what I call the everyday millionaire strategies and tactics that the ultra wealthy are using, and have been using for many, many decades in growing and preserving their wealth. And usually, the biggest difference for what we find from the ultra wealthy calm institutional investors, family offices, the endowments, and pensions, relative to say the retail or the everyday millionaire, is the allocation to alternative investments, and specifically private alternatives. And that usually is comprised of the private equity, hedge funds and real estate really being one of the bigger ones. And so what we’ve found is there’s a huge gap of knowledge for the retail investors in understanding how to invest these asset classes. That’s really kind of what we we focus on. But then comes the question of, well, where do I invest, because there’s a myriad of opportunities to invest in kind of the alternative space. So then we use our framework that we tagged, you know, macro driven alternative investments, and really comes from the experience a lot from my father’s background, which we could talk a little bit about this, this driven kind of focus here of our economic themes. But really, the whole idea behind the tides are different than the waves, right? We can understand that there’s economic tides that are you know, seismic level shifts that happen usually over a slow period of time like these, these tectonic plates that are shifting, right. And we don’t really necessarily does nothing big are kind of boring, you kind of see it happening. But those create the the tailwinds the rising tide that lifts all boats that position you if you’re as an investor in pay attention to these, and a way to outperform because of where you’re positioned. And so what we usually kind of use that phrase for macro driven is we’re looking at it top down approach, we’re looking at what are the long term economic trends that are creating opportunities that then we can take advantage of as investors and outperform over a period of time from a allocation perspective, not just a individual investment perspective? Rod

Gene Tunny  04:58

Okay. So, your, your clients, the people who invest with you, you’re focused on accredited investors, is that right? So that’s a segment of the market where people have a particular level of income or level of net worth, is that correct? Right?

Ben Fraser  05:16

Yeah. So you’re in the US, we have a definition called accredited investors. And that’s basically driven by the SEC that says, you have to meet some minimum requirements to be able to invest in a lot of these types of deals. And so it’s really kind of driven from the regulation side of it, though, we do try to educate people that aren’t quite there, you know, the not quite yet accredited, because there are opportunities, and we actually believe the expansion of that definition will continue to go downstream. Because some of the changes they’ve made to the rules for accreditation have actually been expansionary to include more people over the past decade. And so we’re hopeful that they continue to make it more accessible for people. Yeah,

Gene Tunny  06:04

yeah, I’m interested in that, because I’ve been listening to Tony Robbins, his latest book, The Holy Grail of investing. And I mean, he has a case talking about the value of alternative investments. And he’s saying that a lot of people are locked out of them. Because of they don’t meet this accredited investor threshold. And I think he mentioned that there is or there was an act of Congress last year that is requiring the SEC to now bring in a test whereby you can establish your credentials as an accredited investor, if you pass the test to do you know where that’s up to you? Is that something you’re following, then? Absolutely, yeah,

Ben Fraser  06:46

that’s, that’s a pretty big deal. That’s kind of what I was referring to is, you know, from, from our standpoint, having a certain number financially, whether the income you make or the net worth you have is is an okay proxy to establish? Are you sophisticated enough to invest in something as gentle if you have to make a good amount of money and you have a lot of money? You know, theoretically, you’re, you’re, you’re smart enough to make these decisions. But what about the people that have studied this as a career and they’re maybe earlier in their career, and they want to make inroads into the alternative space, they’re trying to expand it based on knowledge, not just purely based on financial status. And so I don’t know the exact status of over that sat, it seems to me from what I’ve read recently, that that is either in play currently or about to be in play as an option. So it still requires a test, right. And there’s, you know, something you have to pass, I don’t think it’s terribly difficult, but it is an extra layer. But by doing that, you can, theoretically become accredited just through passing a test. Now, they’ve also included, they did this couple of years back where they, if you worked for a provider of alternative investments and operator or sponsor, after one year anniversary, you become what’s called a knowledgeable employee, to where you now have access to invest as an accredited investor into these types of investments that are being offered by your firm. And so, you know, I’ve told young people and love people that work for me, you know, I’m encouraging them to hit that one year mark, as to, hey, you’re now credited. So, you know, we’re going to try and wait minimums, or we can and make it easier for you to participate in a way that it’s comfortable for you at this point. But yeah, there’s definitely a cool trend for that. And we’re hoping that it continues, because there’s definitely some pretty big advantages when investing in alternatives. Right

Gene Tunny  08:47

now, I mean, the alternative investments so they can bring higher returns, obviously, there’s higher risk associated with that. Well, how does it work? I mean, if I come to you, so say, I’m a high net worth individual and I come to you and invest the funds, I come to Aspen funds, do we sit down? Or do you work out a portfolio? Do you say, you work out there’s this allocation, alternative investments is this much in domestic equities, this much international this much fixed income? How does that work? Ben?

Ben Fraser  09:18

Yeah, you know, it’s probably a little bit different than what you’re describing sounds more like meeting with a financial advisor. And, you know, to be clear, we’re not financial advisors. We don’t ever anticipate being that and I think there’s a role for a financial adviser, though, I do think a lot of the big shops they just kind of create echo chambers that don’t really know what they’re talking about and they just spout here’s the three things you should do. And honestly, isn’t that helpful, but we actually work with a lot of investment advisors that understand the importance of alternatives in a portfolio and actually are pretty big feeder system for us to help their clients allocate to what we’re working on. But you know, Working with us, it’s it’s a little bit different in the sense of, we have a few different opportunities, right, and we try to present here’s the characteristics of both the risk and the reward of each set of opportunities. Here’s the reason why we like you, I believe it. But ultimately, it’s up to you to decide what fits your investment profile, what fits the status of where you’re at, in your career, and your areas, spectrum and all those kinds of things, then, you know, we can help provide information, but we actually legally cannot give advice because we’re not advisors. So it’s really more of a here’s, here’s all the options, you get to pick and choose what what works best for you. And I always recommend, right finding an advisor that likes alternatives can be actually a great resource because they can help you not only on the portfolio allocation standpoint, a lot of times they can help you on the tax implications, and the basic financial planning of say, a budget and those kind of things. Estate planning, asset protection, a lot of broader topics that are important, but way outside the scope of what I’m an expert in, right.

Gene Tunny  11:06

Okay, gotcha. On your website on the Aspen funds website, which I’ll link to, in the show notes, or might have been on your podcast website, you’ve got the there’s a webinar about investable mega trends for the next decade. Could you tell us so what are some of those mega trends that you’re looking out for?

Ben Fraser  11:29

Yeah, so it kind of stems back from our approach of finding the best opportunities. And, you know, what’s, what’s different about us and maybe other operators, or sponsors of investment offerings is we’re not a hammer and everything is a nail, right? Well we try to do is identify where are the opportunities first, right, without any dog in the fight without us forcing a square peg into a round hole. And then we’ll actually create the strategies, build the teams, and put together these kind of investor friendly structures. And in terms to put together an offer that fits is supported by by these trends. So for us, it really comes down to where do we really believe the opportunity is because that sets the, the, you know, the next levels of dominoes to determine what how we present offerings for investors. And so, our research, we kind of consolidated into what we call an investable megatrends for the next decade. And so we these are trends that we believe are in play right now, and will be in play for a long period of time, that are really shaping the economy, and both right now and in the future. And those that are standing up, see this, and position themselves will be rewarded by the market. And so that’s really how we’re looking at it, you know, some of the things and we have a whole presentation, it’s a very long presentation. So I won’t get to all the details in this interview. But you know, some of the snippets, and we’ve been saying this for a little while, is we believe inflation is going to be higher for longer. And that has now become more popular sentiment. But you know, was it for for a period of time where inflation is more transitory. This is a short term phenomena. And there’s really two reasons that we believe are driving inflation likely been higher for longer. And this is, again, mostly in the US. But one of those being the huge labour shortage. And so we’ve really, since COVID, ended pressures in the BNF cover, we had a huge spike in unemployment. And then that kind of came down. There’s an interesting chart that we have in our presentations that, you know, shows there’s this huge gap that has continued to grow over the course of the past year to have job openings relative to those looking for full time employment. And it’s a pretty big gap by a factor of a million to several million job openings that can’t be filled. And a lot of it’s because the labour left the market after COVID, a lot of late stage career, folks took early retirement, a lot of dual income families went to single income and one of the spouses decide to stay home. And so the reason that’s important is the labour shortage puts a lot of pressure on wages increasing, which is very inflationary, because the primary driver of GDP is consumer spending. And so if the consumer continues to have more earnings, and they continue to spend that that will continue to contribute to a higher inflation number. And the other one is really we think it’s playing out right now, but we haven’t seen we go into the early stages of it and we think we’re at the early stages of a an energy crisis that we hadn’t seen in a long time. And it’s really going to be driven by a supply shortage of fossil fuels. As we’re making a transition into more green energy, renewable energy sources that is really being driven by a political narrative that, hey, as best as well, attention at its worst is creating a huge gap of understanding what it’s going to take to make this transition. And really putting ourselves in a really bad position from a production and supply standpoint of fossil fuels over the next several decades that we believe is going to be pretty, pretty severe.

Gene Tunny  15:38

Right? Yeah. Yeah. I mean, we’ve got some of the world that energy issue here, arguably in Australia to their concerns about reliability of the network as our coal fired, power stations are decommissioned or shut down over the next couple of decades. And so that’s, that’s a big issue were grappling with here at the moment. And there’s a big debate about nuclear energy, and whether that’s an alternative and that that’s becoming incredibly political. Over here, so yeah, good points, then can ask how do they affect your, your investment strategies is mean, inflation higher for longer, okay. Yep. Yep. Yeah, that that’s, that’s plausible. And then the energy, shock or crisis, or whatever you want to call it? How does that affect your investment choices?

Ben Fraser  16:35

Yeah, absolutely. So if, if we believe inflation is going to be higher, for longer, it really kind of sets the stage for where opportunities will kind of be over the next several years. If that’s the case, right here in the US, the Federal Reserve is really become the point of a lot of conversation, a lot of emphasis in trying to decipher what their approach is going to be. And they’ve been pretty clear from the get go, Jerome Powell stated, they need to get to a sustained level of comfortable GDP growth, which he stayed is 2% and Intel, and when that happens, they’re going to maintain a more aggressive monetary policy to bring inflation back into check. And so obviously, we’ve come way down from the highs of a year or two ago, you know, six and 8%, inflation numbers, you know, we’re down into the threes, which feels like a huge, you know, improvement, which it is, but it’s still very far off the mark. And there may be periods where we kind of dip down to the twos potentially. But given the things I just shared, that we think are systemic issues that are going to be very inflationary, they’re gonna have a hard time keeping interest rates or inflation to where they want to be. And that really drives monetary policy and interest rates. And so we’ve seen, obviously here in the US the fastest increase in interest rates that we’ve ever seen, that has caused a pretty big shock through the commercial real estate market, that we think is still being digested and will really start to play out over the next price several years, depending on what happens, but what our approach is that because inflation is gonna be higher, for longer interest rates will likely be higher for longer, the markets already priced in several rate cuts. This year, I think that’s pretty optimistic, or even heard some economists say that they think we could see six rate cuts this year. I think that’s very, very optimistic, given some of the numbers we just saw reported for q4 for both GDP and unemployment numbers. And, you know, we’re actually even seeing a probability now have an interest rate increase in very small probability. But you know, that’s back on the table if these numbers continue to come in, and you know, beyond expectations, and so we’re this driving opportunity is where we kind of see the biggest opportunity in the real estate market right now is in private credit. And so what that means is playing in this kind of mid section of the capital stack, if you understand what that means, but basically, generally in every deal, you have a senior lender, and you have equity investors, right. And right now, both of these parts of the capital stack are standstills. The lenders are pulling back, they’re tightening credit, they don’t want to put more money out, thanks for getting nervous equity investors, they’re getting capital calls, they want to preserve cash, they don’t want to put more money into deals. And so it’s providing opportunity for the market to come in across the middle part of the capital stack. So you can actually reduce your risk because you can get priority of payment. And you can help inject Apple into a project that, you know has a great path to stabilisation, a great path to reach its ultimate value, but needs a little bit of capital to get there, you come in with with pretty incredible rates of return for pretty minimal risk at this point of credit cycle. So we think it’s a great opportunity, kind of in this transition of the credit cycle, to take advantage of well positioned real estate and good markets with good operators that just need a little bit of extra cash to kind of take it to that next level to make it through and ride out was probably gonna be a pretty bumpy ride in commercial real estate the next few years. Yeah,

Gene Tunny  20:37

yeah, for sure. So I saw your you know, I listened to your episode on what’s been happening with the banks, and he was stunned by just how bad commercial property suffered in the States during the pandemic, and I mean, we had a bit of that, but the, the the plunge in values looks a lot larger in the States. Where’s the market at now? I mean, what’s it like? I mean, are there just parts of CBDs? That are the empty office buildings? Is that is that essentially what’s going on? What what’s the what’s the story there, Ben? Yeah,

Ben Fraser  21:14

so it’s, it’s interesting, because you see the headlines saying commercial real estate is down 30% or 40%. And, you know, as we all know, headlines are usually exaggerated, exaggerating what’s really going on. And while there are certain parts of the market, they’ve definitely been impacted to that degree, what most people think of when they hear commercial real estate, when they think of the big distress. In course, real estate is office. And, you know, when I say commercial real estate, I mean, the whole broad spectrum of all types of real estate, including office, multifamily apartments, you know, single family residences, industrial properties, retail, et cetera, et cetera, et cetera. So there’s lots of components within that big category. And everyone’s performing differently. So there’s some measures of Office that say, Yeah, values are probably dropped 30 to 40%. And, you know, I still think it’s a knife that’s, that’s falling, that we don’t really know where it’s going to where it’s gonna land, because we don’t really know what the value of an office property is that, say 50% occupancy and not probably going to improve from here on, you know, what’s the use case of that property going forward? How much is it worth? Well, I think the market is trying to digest that. But in other asset classes, we’re seeing a pretty different story industrial real estate, it’s actually it’s probably the least impacted by some estimates, it’s maybe only been impacted five, maybe 10%. Values. Retail similar way, apartments are probably the next biggest impact. And a lot of it’s because some of these really hot markets here, the Sunbelt markets are, we’re we’re very, very, the guy very aggressive in the prices. And so we’re seeing kind of a tail off some of these these high prices, but long term trends still support strong values, and housing and multifamily. And so it’s really trying to decipher, you know, here’s the big the big picture narrative, but then where’s the real opportunity to where maybe there’s a dislocation between the headline understanding the narrative and the actual underlying data. And that’s we’re always trying to look for that gap. Because if the market believes there’s a big issue, but the data supports something different, that’s where you can kind of come in and capture the opportunity.

Gene Tunny  23:36

Okay, we’ll take a short break here for a word from our sponsor.

Female speaker  23:42

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Gene Tunny  24:11

Now back to the show. And what about energy? Ben? What what is your analysis? What does that tell you about where your investments should be focused?

Ben Fraser  24:25

Yeah, so try continuing what I was saying a minute ago on fossil fuels. We’ve really seen a pretty big shift or the past decade from investment into new production. And if you think about fossil fuels, it’s very different than real estate where real estate naturally appreciates. Over time with inflation. The fossil fuels naturally deplete over time as we pull more resources out of the ground, there’s less and reserves and by some estimates, it’s somewhere between you know, five to 8%. have total global production is depleted every year. So just by normal usage and demand, numbers, we’re depleting about 5% of all the production that we’re using every year. And just to maintain the same levels of production, there has to be new levels of investment to find, you know, new wells and new reservoirs and build out the infrastructure to increase production, or just to maintain production. So, what’s been interesting is about 10 years ago, we saw a pretty big shift from the the political narrative of the environmental societal governance standards that have been imposed on not only the operators of these assets, but also the capital allocators. And so a lot of the allocators that are investing into different energy verticals are being either penalised for investing in fossil fuels, or they’ve been rewarded for investing in renewables. So it’s created this incentive structure that is moving capital away from fossil fuel production and development into other technologies. And I’m not saying we should suspend all investment into green energy, you know, that, you know, to put on the fossil fuels, but we can’t do the the inverse of bomb or capitalist to new technologies and, and not realise the impact that would have in current energy needs. Because right now about, I think it’s 83% of all of our global energy needs come from fossil fuels. And that’s usually pretty shocking number for most people to hear they think we’re way farther along, right. You mentioned nuclear, which I’m a huge proponent of. But that only makes up I think it’s less than 5% of total global energy needs. And we’re not seeing these these big shifts, we’ve been trying to invest herbal energies for many, many decades. And so to think we’re going to be 100%, the transition to green energy in the next 10 years is just completely irrational. So what’s really happening is this lack of investment is going to cause a future supply issue, right, because as we’re not reinvesting that supply curves continuing to decline, and By most estimates, including the most far left leaning the most renewable, energy focused agencies are predicting that demand for fossil fuels will at least be the same 10 years from now, but most estimates actually anticipate that’d be higher, because we have population growth. And here, at least in America, and so they’re, you know, JP Morgan, just put out a report a month or so ago, predicting a 7.1 million barrel per day shortfall of oil and gas, actually just oil, just oil needs per day. By 2030. If if we don’t have a massive course correction. And so the opportunity is we really believe there’s a huge opportunity to get into fossil fuel production. So we’re investing a lot into these operating wells at really good prices. And we’re, we have pre distort prices right now. But we also think of the probabilities and, and, you know, there’s probabilities to the upside and price as we kind of go later into this energy. kind of issue. Yeah. Good

Gene Tunny  28:30

points there. It’s just I was just thinking that, you know, Saudi Arabia and, and Russia, they’ll be, they’ll be happy because you’re talking about oil, and, you know, potential, you know, shortages and, you know, implications for prices, higher prices in the future. They’ve been trying to engineer that, haven’t they recently, so there was a report in the Financial Times. Yesterday, so OPEC plus members extend production cuts in bid to boost oil price. So they, they’ve been trying to get that up. And it’s been, it’s been quite stubborn that even with all of the geopolitical tensions, I don’t know if you’ve been following that at all.

Ben Fraser  29:10

Yeah, yeah. Yeah. I mean, it’s there’s a lot of game that ship that goes on with with OPEC. And, I mean, what’s interesting, now people don’t realise is that the US is actually the largest exporter of oil in the world. Right. So Saudi Arabia is huge. And they’re, they’re a big player in this, but most people don’t realise that the US is actually the largest. So we have a pretty big place to play in this global geopolitical thing. But in the short term, there’s a lot of, you know, supply cuts or, you know, we’re going to flood the market and there’s a lot of kind of gamesmanship to a certain degree on the short term, you know, prices but at a certain point, you know, supply is inelastic because you can’t just flip a switch and all of a sudden, you know, we just have so much more oil there’s there’s a stir certain range, right, they can they can reduce supply the short term and just keep certain wells not producing. But if your capacity is x, you can’t do more than that, right. So at a certain point, there’s going to be this divergence between supply and demand. And I think that’s where, in a longer term timeframe, we’re gonna run into some bigger issues. But in the short term, I mean, I don’t mind higher oil prices, because I’m a seller of oil, because of my made the investments that we’ve made. So, you know, it’s been interesting to there’s been a lot of shift of the market from kind of years past, here in the US, at least, where, you know, they’re, they got a very aggressive and drill and very aggressive and trying to produce as much oil as possible, kind of flooding the market and got a little bit in front of their skis to where prices dropped massively. But the the market is kind of pulled back today was kind of like these higher oil prices, and we’re okay to, you know, not massively increased supply, because one we’re getting, you know, bad mouth from the politicians and two, will make a lot more when prices are high. And so it’s kind of created this really unique environment where we’re, we’re sitting it kind of elevated prices from a historical standpoint, and, you know, some of this interaction interplay between OPEC in the US, and, you know, other players of oil, like Russia, are, you know, intentionally keeping prices higher in the short term, and I think it’s only going to continue wrong.

Gene Tunny  31:29

Okay. That’s a good insights there, Ben. Now, before we go, I’ve got to ask, I’ve got some of my listeners would describe themselves as libertarian, and they’re very much in or they’re, they’re concerned, or they’re Austrian economists, you could say and they’re very much concerned about the actions of central banks and their money creation and all that and the risks of fiat money. And so they’re very, they’re very interested in gold and I see gold as you know, that’s what is it? It’s was it 2600 Or something an hour or maybe 2100 USD announcer saw the other day, so it’s getting it’s getting up there near the, the historic high. And, you know, so gold’s something that is up again and Bitcoin is dead, it’s had a bit of a surge, particularly since the these Bitcoin ETFs have been allowed. Do you have any thoughts on gold Bitcoin? Where does that fit into your evey alternative investments that you’re looking at?

Ben Fraser  32:33

Yeah, I think they definitely are categorised as alternative investments. This is outside the scope of what we invest in as Aspen. But we definitely comment on gold a lot in our podcast, because we have a lot of listeners probably like you that, you know, want to get have a hedge against, you know, fiat currency. And I mean, I haven’t been around the game, as long as some, but you know, to me, it’s whenever there is maybe undisciplined from central banks, all the gold bugs come out and say, See, we told you so and I think there’s an element of truth. But it also never plays out the way that they expect. It For Me, gold has always had an identity identity crisis, right? Is it a currency? Is it a hedge store value? I think there’s an element of it’s all the above. But I think Bitcoin is also confused the use case for gold as well. Right. And so I do think it’s good to have hedges, I think it’s good to have as a portion of the portfolio, just like a lot of these different things that we’re saying. But people that have really heavy allocations into gold and, and other Kryptos for that matter, I think, take a lot of extra risks, they probably don’t need to, because of, you know, some of these things that are hard to know where they go, I think, you know, the I used to be a much more staunch Austrian economist and, you know, hard money, kind of side of things. But from what we’ve seen since COVID, the modern monetary theory, principles have played out and just certain degree have kind of worked and I think I’ve had to kind of readjust some of my initial thoughts because we would have expected a massive amount of, of deflation throughout the game, we are seeing some higher inflation, but definitely not to the degree that of the stimulus and monetization of what we saw over the past few years. And so I think it definitely can drive higher inflation, but I think it’s only to a certain point. And meanwhile, we’re having a really strong assumer in the US a really strong economy from a GDP standpoint, that continues to support a stronger dollar and so, you know, I’m not, I’m not a, you know, gonna take a big bet against the dollar. anytime soon. And, you know, I think it’s good to have edges, just like anything. But I also think it’s important to have have that imbalance and and measure.

Gene Tunny  35:08

Gotcha. Yeah, yeah. Yeah, I wouldn’t be necessarily betting against it anytime soon that that’s for sure. One thing I guess I should ask because just before we go, because this is something that does, as an external observer, looking at the US and looking at the budget situation, and that big structural deficit that the federal government has, and the debt to GDP ratio just keeps climbing. And, you know, you’re always there’s always talk of a potential shutdown from time to time. And it just, I just wonder, Where are we going to get to a point where there will be a US fiscal crisis at some stage, I’ve had one guest on from Cato Institute’s she was warning against that in the future. Do do you have concerns about the state of US public finances?

Ben Fraser  36:01

Yeah. I mean, it’s no one likes a budget deficit, right. I mean, there’s a lot of reasons that doesn’t work. The thing that’s interesting now is the US of all developed economies, you know, is doing the same thing everyone else is doing, and probably to a lesser degree from a debt to GDP GDP standpoint, you know, we we have one of the better ratios. And you also think about inflation, what does that do to borrowers? Right, it benefits borrowers, if you have higher inflation, the value of the dollars, you take on now, and you pay back later are worth less. And so the US government being the largest borrower, I don’t think I think they want to get inflation down for other reasons, you know, whether it’s political or keep the economy in check, but they also don’t mind a little bit of extra inflation in the short term to erode the value that they gotta pay back. I think the bigger question becomes, at a certain point, do you know government bonds become less attractive than, than other countries and people aren’t willing to take the risk on the government be able to pay back the all the money they’re printing? So I think, at a certain point, yeah, maybe the, you know, that things have big fiscal breakdown. But as of now, I don’t see that happening. Is it happening anytime soon? And, you know, when we’re able to continue to pray, and we saw buyers for, you know, all the bonds, then we can continue to keep it going.

Gene Tunny  37:37

Yeah, that seems to it seems to be the case for the moment. It’s interesting. You mentioned the Yeah, it doesn’t look as bad as some other countries. I mean, you’re talking about I suppose Japan and Greece, I mean, Japan show that you could actually, oh, it’s just extraordinary what Japan has been able to get away with for decades now. Yeah. And the US seems to be, you know, just just keeps going along there. The other point you may, which is a good one is on inflation and inflation, eroding the real value of the debt that’s got to be paid back. There was a famous study by I think it was Robert Eisner in the late 80s, which showed that a lot of the the budget deficit was in the 80s was being offset by that reduction in the real value of the debt, which was quite a clever paper at the time. I put a link in the show notes. It’s very good. Good piece of work. Yeah. Yeah. But I’ve been it’s been terrific. Any, any final points before we wrap up? Now?

Ben Fraser  38:34

This is a fun conversation. And I love love the good question. So appreciate you having me on.

Gene Tunny  38:40

Very good Ben. We’ll all put a link in the show notes to Aspen funds and also invest like a billionaire podcast, which I’ll definitely recommend. I’ve been getting some great insights out of it. I think you’ve got a great interaction with your with your dad on the show. So yeah, really, really good stuff. So again, thanks so much for your time.

Ben Fraser  38:57

I appreciate it dude with fun

Gene Tunny  39:00

rato thanks for listening to this episode of economics explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact at economics explore.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.

39:47

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Credits

Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

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Podcast episode

Uncovering the Secrets of Valuing and Selling Businesses w/ Arthur Petropoulos, Hill View Partners – EP211

Show host Gene Tunny is joined by Arthur Petropoulos, founder and managing partner of Hill View Partners, a company specializing in mergers and acquisitions, business sales, and capital advisory services for middle market companies. They discuss how Arthur finds, values, and sells businesses, as well as the wider economic impacts of his work and the role of private equity. They also explore whether we should be concerned about modern-day Gordon Gekkos and how the business landscape has changed since the 1980s. 

Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored

You can listen to the episode via the embedded player below or via podcasting apps including Google PodcastsApple Podcasts and Spotify.

YouTube clips

What’s covered in EP211

  • Business sales and capital raising with Hillview Partners. (1:22)
  • Business brokering process and outreach strategies. (5:18)
  • Business valuation and acquisition strategies. (8:10)
  • Buyers and sellers in mergers and acquisitions. (14:47)
  • Business sale process and foreign investment constraints. (17:34)
  • Selling a business, focusing on narrative and information sharing. (24:18)
  • Private company sales and legal risks. (28:00)
  • The role of capital markets in the economy. (38:05)
  • Private equity’s role in the economy, including pros and cons. (44:10)

Links relevant to the conversation

About this episode’s guest Arthur Petropoulos:

https://hillviewps.com/leadership/

Arthur’s YouTube channel:

https://www.youtube.com/channel/UCZu4Nl6i5IseEJBqp1IPd3g

Hill View Partners social media:

https://www.linkedin.com/company/hillviewpartners/

Transcript: Uncovering the Secrets of Valuing and Selling Businesses w/ Arthur Petropoulos, Hill View Partners – EP211

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It was then looked over by a human, Tim Hughes from Adept Economics, just in case the otters missed anything whilst they were munching on fish. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:01

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host Gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory, evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode, please check out the show notes for relevant information. Now on to the show.

Hello, thanks for tuning in to the show. I’m delighted to be joined this episode by Arthur Petropoulos, Founder and Managing Partner of Hill View Partners, which specialises in mergers and acquisitions, business sales and capital advisory services for middle market companies. We talk about how Arthur finds businesses to sell, how he values them and how he sells them. We also talk about the wider economic impacts of the work he does and the role of private equity. Should we be concerned about modern day Gordon Gekkos or were the 1980s different from today? Okay, let’s get into the episode. I hope you enjoy my conversation with Arthur Petropoulos.

Arthur Petropoulos from Hill View Partners, thanks for coming onto the show.

Arthur Petropoulos  01:22

Good to be here. Gene. I appreciate it. I like, contents great, listened to a bunch of it and happy to add to the archives.

Gene Tunny  01:30

Excellent Arthur, what I’m looking forward to is learning a bit more about what you do and in Hill View Partners and the broader community that you’re part of the broader industry. One of one of my favourite podcasts is David Bahnsen’s Capital Record. And David’s someone who’s always talking about the strength of American capital markets, and just what that contributes to the economy. So yeah, I’d be keen to explore that with you. To start off with, could you tell us a bit about what you do at Hill View Partners please?

Arthur Petropoulos  02:06

Sure. So fundamentally, our company helps companies do two things. We advise and assist companies in the sale of their business and we do the same for companies that are seeking to secure capital. So you can think of it investment banking business brokerage intermediary, but the simplest way to explain it is when you think of a real estate broker, or help people sell real estate, we do the same thing, but with businesses, and we’re helping people find capital for those businesses. And it’s a real area of specialisation and focus, privately held companies generating one to 10 million in pre tax profit, typically owned by families, entrepreneurs, small groups of investors. So in the broad scale of the economy, it’s kind of that line between the lower middle market and middle market, that’s our area of specialisation. And really where we focus.

Gene Tunny  02:53

Right and what sort of businesses would they be? I’m just trying to think I mean you’d have some professional services businesses, do you have bakeries or…

Arthur Petropoulos  03:02

So if you think of kind of the, and the reason why we started the business and folks in this space is I spent about 10 years in New York, doing this both on the investment banking side of helping companies as well as the private equity side of buying companies. And what we found is there’s this doughnut hole of sorts, where very large companies kind of work with the Wall Street investment banks, and then very small companies work with the local business brokers. But there’s a huge swath of stuff in between. So you might have a software company that it’s kind of it has a very specialised niche that generates a million or $2 million in profit a year. I think everybody thinks of software’s giant companies are just growth growth. There’s plenty of kind of very niche software’s dashboard, task force management, pricing tools for particular industries, whether it’s construction or satellite dish installation, it could be anything, right. And those companies are a lot of what we do a b2b and b2c services. So you could think of window cleaning companies we’ve sold or gutter cleaning or roofing companies or, you know, irrigation, those are broad Real Estate Services, then there’s just general kind of like specialty manufacturing or distribution companies. So we sold a company that sold cleanroom supplies into pharmaceutical companies. There’s another company that manufactured component parts that went into aeroplanes. And so what I will say the consistent theme for companies we represent so we really, we’re agnostic of industry, so so long as it fits the profitability criteria as well as kind of the complexion of ownership. But what you find after iterations and iterations is that companies in the size that we represent, are not competing on the cost of capital. They do not provide commodity products, and so whatever it’s b2b or b2c services products offering, where we’ll be is there will be something specialised about it, there’ll be something niche something proprietary, there’ll be something they do better than anybody whether they have just better economics, whether they have access to certain markets or customers, or whether they just have a capability or an aptitude that’s unique. There’s usually something so that’s, you know, that’s part of the fun. And part of the exercise is as we’re talking to new people, figuring out what kind of that secret element is to their, to their respective business.

Gene Tunny  05:18

Right? Can I ask you, how does it, how does it work? I mean, so say you’re in business broking. And you’re selling some of these businesses, you’re trying to get the best price for the the seller, and then you get obviously commission, I don’t need to know, you know, that’s probably proprietary and confidential, but I’m interested in, like, do they pick up the phone? Or do you go actively looking for these businesses? You’re in Rhode Island, are you driving around Providence, and you go up to New York City? I mean, how do you how do you do it?

Arthur Petropoulos  05:51

No, so I mean, look, we endeavoured to make this business a national and international business from the get go, because I think historically, it has been a hyper regional business where you have, you know, three guys sitting at the back of a bar, you know, drinking with the guy who owns a local lumberyard, right, or whatever the business may be. And I think as things have evolved, where middle market businesses have, now they’re doing much more national and international work, we find that there, it’s really about just having the dialogue with people and really understanding the objectives and facilitating the process. And so we work with companies all over the states, as well as international to a lesser degree, but Western, Eastern Europe, Southern Asia, then a small amount of Middle East, but it’s really about finding the business that meets kind of the size, ownership complexion, I think season and in the business lifecycle where they’re looking to accomplish one of these goals. But it’s a because it’s not, it’s not a hyperlocal business. Because there’s you can’t just drive up and down a main street or high street and find a lot of these things. They’re kind of, there’s more of them than you think in some places. And there’s less than you think in other places, right? It’s a it’s a quirky business, because you might not realise but there’s a large like, you know, pillow manufacturer down the street from you, or a software company that’s in just this nondescript building that does this thing. And so, our outreach, we do some direct outreach, whether it’s email, whether we’re chatting on LinkedIn, with people, we put out content that on LinkedIn, as well as YouTube, we have two videos going out every week, kind of just explaining different categories, we get a lot of inbound conversations from that. And then I think some of the best relationships and conversations you have are from other happy customers. And so every time a deal closes, and our client’s very happy, they do tell their friends and say, Hey, we know a firm that did a real good job for us and that and engenders some goodwill. So, you know, I think there’s this kind of direct outreach inbounds there’s some warm outreach from kind of relationships and referrals. And then there’s just kind of goodwill generated by I think, good results.

Gene Tunny  08:04

Good one, and in that process of the sale, like getting it ready for sale, are you, are you involved? Are you providing advice on business operations, governance, that sort of thing to try and improve the value of it at the sale?

Arthur Petropoulos  08:20

Yeah, I think there’s certain things that, that are malleable at that stage of the game. There’s other things where it’s a matter of characterization and kind of just understanding it and documenting because a lot of times the processes are there, the people are there. And it’s just a matter of kind of memorialising precisely what the different people do, how are they cross trained? What are their capabilities? What are the processes of the business relative to origination and sourcing of new business operations and the administration of the company as well as kind of the execution and fulfilment of the actual work? And so, most of these things are there. They just need to be crystallised as part of the narrative. And but look, there are time to time where as we’re having those dialogues, where there are things that, hey, you know, it would if this, we don’t want, we call kind of like single source reasons for failure, right? And so if there’s one employee that does this one very important thing, who else could do that if they couldn’t, right? Or if you’re getting certain raw goods from one particular source, what happens if you can’t get it from them? And so I do think it’s kind of parsing through each part of the business and trying to poke holes in it, that has a lot of good dialogue, because the more we can try to poke holes, the more we either get the answers as to why there’s a safeguard or, you know, it allows for the implementation and incorporation of a safeguard and mitigation means at that juncture.

Gene Tunny  09:46

And how would you know, if you’re getting a fair price, I mean, how do you know what sort of sort of price to to aim for there? Is it multiples of earnings or the how do you actually work that out? And also how do you do it across all these different industries you mentioned you’re industry agnostic. I mean, yeah, that you mean, you must have to get across a lot of new industries really quickly. How do you do that, Arthur?

Arthur Petropoulos  10:10

Sure. So by virtue of focusing, I think on the size of the profitability of the company, and by virtue of that it must be profitable. Capital tends to kind of work in different ecosystems. And what we find is that the delineation of ecosystems is much more predicated on the size of the company than necessarily the industry in terms of capital and in terms of acquirers, right. So you have, if it’s a not profitable business, but it’s growing fast, and it’s that venture capital world, or growth equity, right, that’s its own ecosystem, whereas private equity for the profitable companies that we work with, strategic acquirers in the middle market, that’s its own ecosystem. So it’s fascinating, but you’d be surprised at how many of the counterparties on the other side are looking kind of agnostic of industry as well. And more specific to size and complexion. And then kind of large private equity, and publicly traded companies have their own ecosystems as well. So we focus on our one ecosystem, which is important to do. And then but there is always kind of a specialised research that’s necessary for a particular industry, because there are quirks and idiosyncrasies with any industry as we’ve done, you know, 100 plus transactions as Hill View Partners, and I’ve done 100 plus transactions in my life before starting the company, you do learn kind of which, where to look and how to research different industries. And so it’s not so much that you need to know every industry, but you have to know what to look for in every particular industry. So as we kind of get into any particular new ones, and there’s not many that we have not been involved with, but we still take a fresh look towards it. You know, it’s a matter of finding who are the active parties, we have our own internal database, as well as some, we subscribe to external databases and Cap IQ, PitchBook Data, there’s a handful of them out there. And we do a lot of our own kind of proprietary research. I think the difference in largely what we do is, many intermediaries will just kind of gather all the information, puke it to the universe to 20,000 people and just wait for the phone ring. We are proactive, not reactive, we do a lot of research upfront. That way we’re pinpointing who to reach out to. And what that ultimately does, is A) it mitigates a lot of the kind of typical pain points. So shrinks the duration limits, distraction keeps the discretion generates better results. But also, it really fine tunes the conversation. So getting back to your question about multiples, that’s usually a good place to start, right? The fundamentals are the driver. So if we look at it, you’ll see like different stratas of size will usually have different multiple ranges. So a company that does a million dollars in EBITDA will generally trade at four to seven times EBITDA, a company that does 2 million will trade at five to seven, five to eight, maybe 3 million you probably see six to a four, 5 million, maybe you start getting towards nine, 5 million plus, can you get to 10 at 10 million, can you get to 12 times but there’s this multiples expansion. And candidly, I mean, that’s a lot of the private equity thesis, right is if you buy 10 $1 million companies for $6,000,000. Six times multiple for a million dollars of EBITDA for each acquisition, once you have 10 of those together, it’s worth 10 to 12 times EBITDA right? So that’s how you spend 60 and it’s worth 120. But our logic, our research is finding what the comps are, looking where it kind of falls in the strata. But then also, by doing research about finding where our client is the missing puzzle piece for someone’s bought a puzzle, right? So yes, well, you know, if we sold a company that made a certain type of widget, that mega widget company just doesn’t have this one thing to sell, right? We want to talk about that as a buy versus build opportunity for them. So yes, you have the fundamentals but the two other reasons why companies are bought are A) access to certain end markets, but B) proprietary capabilities. And so if it’s something special about what the company does, or if it has very unique access, then we can pivot the conversation to say, Well look, yes, you may think that there’s $1 million EBITDA company’s worth $6 million. However, it would cost you $15 million to start this company from scratch, to build, to take time the resources to allocate to try to build this. So maybe you can buy it for split the difference, right? And so what we say is we wanted to the fundamentals are the starting point. And then the access to capabilities and pivoting the dialogue to buy versus build. Those are the enhancing factors that hopefully we can get even better but to answer your question more simply a lot of research and a lot of conversations. That’s how we know we’re getting the best results.

Gene Tunny  14:46

Yeah, good one. Okay. And can I just clarify some things so you’re on the the sell side, you’re a business broker or an investment bank, or you’re similar, are you similar to an investment bank?

Arthur Petropoulos  15:00

Yeah, I mean, the key differentiator is investment banks deal with security. So they’re dealing with publicly traded companies for the most part, and we deal almost entirely with privately held companies. So that’s why we’re an M & A advisory firm would be the phrasing because we don’t deal with securities.

Gene Tunny  15:15

Yep. Gotcha. Okay. And private equity so they’re on the buy side. And is that companies like Carlyle Group, is it Carlyle is it?

Arthur Petropoulos  15:26

Yeah, so Carlyle, KKR, Blackstone are the really big ones. TPG, I mean, there’s a lot of them. And then there’s different stratas of them for size. There’s industry specialists. But yes, that’s generally the buy side are, so it used to be you’d have kind of two big buckets, you’d have private equity that were funded just to buy companies and sell them. And then you had strategic acquirers that were basically just large companies that would occasionally acquire smaller businesses or different capabilities. But now you have lots of strategic companies have have created corporate development and strategic acquisition groups. There’s private equity that buys strategic companies. And so it’s a bit more of a continuum. But yes, generally speaking, that is the buy side is companies and financial buyers and strategic buyers that are looking to make acquisitions. And we represent solely the sell side. So the companies that are looking to either sell or receive that capital.

Gene Tunny  16:22

Okay, so you mentioned your private equity, strategic acquirers. Could that include individuals or is it generally corporations at this or companies?

Arthur Petropoulos  16:34

So what’s interesting about the companies we work with, I was just telling someone, I believe we have the broadest swath of prospective acquirers for a company, right, like, if you were selling that bakery, you probably wouldn’t be selling it to a person or a few different people. Now, if you were selling a billion dollar company, you’re probably only selling it to private equity or a very large strategic company. But in our businesses say you’re selling a $2 million EBITDA company for $12 million, or $15 million, right? The buyers for that are going to be incredibly broad, it could be a publicly traded company, it could be a private equity firm, it could be a family office, it could be an independent sponsor, a search fund, a high net worth individual, right. So yes, it runs that whole spectrum. From of, of both size, and I wouldn’t, sophistication is not correlated entirely with size, right. So like sometimes the best buyer that knows something inside and out is just a person who’s obsessed with one particular field who really wants a company. And sometimes it’s the largest corporation. So the important part of our job is to just, you know, we say kiss a lot of frogs to find the prince, right or turn over, a lot of rocks to find gold, but it’s having all those dialogues, both within each category, and then across categories to make sure we’re finding the right the right home for a business.

Gene Tunny  17:54

Right and how long does it typically take to sell a business? Like once you get in touch, or once they get in touch or you find the business? You get the the contract to, to, you know, you’ve got the agreement to, I mean, I imagine you’re going to be an exclusive seller is that correct? You’re that…

Arthur Petropoulos  18:14

Yes.Yeah.

Gene Tunny  18:16

Gotcha. Okay, what what’s, how long would it typically take?

Arthur Petropoulos  18:19

This is not a shameless self promotion. But if you weren’t using Hill View Partners right, these processes can take, you know, 18 to 24 months. We want in the part of why that proactive versus reactive process is important is we want six month processes we want offers within 100 days. And then after the 100 day mark, it’s really the confirmatory diligence from an acquirer, but we have the process broken down and crystallised into different component parts. That way, the day we sign an engagement with a client, we are getting the information that we need, putting our materials together and doing the research about the acquirer so that we’re out there in the market within two to three weeks talking to people. We’ve pushed the dialogues through a process of asking people for follow up questions, having conversations, Zoom meetings, indications of interest, letters of intent, there’s, we have a lot of steps along the way to keep shaking the tree, if you will, right. And so that way, every time you shake the tree, things fall away, and things fall away, right. And that’s the fastest way to get to the conclusion, while not losing any of the substance cohesion or comprehensive approach to it. And so we find our processes we can run in a six month process, if sometimes it’ll slip a month or two, depending on if the diligence has taken too long, depending on negotiations, but largely speaking, six months start to finish. That’s the goal, and we stick to it.

Gene Tunny  19:44

Gotcha. And in the US, what are the rules around foreign investment like so if you’ve got a foreign company or or you know, high net worth individual wanting to buy a business in America, how does that is that a constraint is there, are there barriers there?

Arthur Petropoulos  20:01

I mean, not really because it doesn’t tend to be, you know, if you’re getting the foreign investors that will come and acquire businesses in the states are largely part of larger organisations that have a global business that’s doing something, right. Like the probability that someone’s going to want to move from Dubai to Oklahoma to buy a water hauling company is probably low. So, you know, candidly, we’ve had people I mean, look, I mean, it’s more likely, you know, that hey, someone’s moving it from, you know, from London and, and they want to buy a business in New England somewhere. I’ve seen those things. So Oh, no, it’s it hasn’t been an issue on our part. I guess there were a couple businesses that were a little sensitive relative to they sold into the aerospace and defence industry. So there was some prohibition against even then we were just told, like, don’t even bother talking to people in these countries, because couldn’t sell to them anyways. But that’s, that’s where we’ve seen so less about the individual or more if there’s kind of sensitive stuff that’s going into government agencies or something that they don’t want to have the exposure to foreign ownership.

Gene Tunny  21:09

Yeah, yeah. Just back on the sale process. So do you have a Expression of Interest process? And then you have a tender process? So how does that work?

Arthur Petropoulos  21:18

Yeah. So so we don’t we don’t go out there with an asking price on something, right? I mean, we can give some guidance in the sense that if someone says, Well, what are they looking for, this or that we can say well, you know, we’re seeing comps, we’re seeing transactions for companies like this falling in this range. Because we don’t want it to always just focus on the dollar amount too because the structure matters, the transition period for ownership matters, what happens to the stakeholders, the employees, the community, the buildings, that whatever it is, right, there’s a lot of variables. And so we’ll provide a little bit of guidance. But largely speaking, we let the process determine the price because the people we’re talking to are sophisticated parties, they know what these things trade for. And, and I think people know, we’re pretty communicative in the sense that we say, Look, if, if you’re looking to just kind of kick the tires and lob something in here, like don’t waste your time, like don’t waste our time either. And so we’re able to get down to the real bonafide parties quick. And in the process. Typically, there’ll be dialogue questions going back and forth, we have a data room that we populate, but we’re usually asked for an indication of interest, and then a letter of intent. So what that means is, send us an email tell us generally how you valuing this, how are you looking at structure this or that, because then we can have a constructive dialogue with the prospective acquirer so that when they finally put something forward on letterhead, they now have a good sense as to how probable it is that it’s gonna work. And it’s kind of had some dialogue, if you will, or discussion. So we like to have information sharing conversations, indication of interests, and more communication form a letter of intent. And a lot of that happens from day 60 to 90 of a process.

Gene Tunny  23:02

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Gene Tunny  23:37

Now back to the show.

Can I ask you about how you promote or advertise the businesses? I’m just thinking about real estate. And I mean, you look at some of the things that real estate agents are doing now particularly in, in capital cities in Australia, where people are mad about real estate, you know, they’ve got these cinematic type videos, they’ve got the the houses all dressed up, they’ve put a lot of work into it. And they’ve got these really impressive videos. I imagine you have a prospectus of some kind, like, how do you how do you promote it?

Arthur Petropoulos  24:14

Yeah, I would say there’s less style points in this business. Right? The because it’s less of an emotional acquisition for the most part, right? Like it has to make fundamental sense for companies to buy things. They’re buying capabilities. They’re buying access, like you know, it’s slightly a different sale than saying like, you know, imagine drinking you know, hot chocolate on the veranda on a Friday night, right? So, the product or if you will, or the thing that’s actually transacting has a slightly different approach. Now, that being said, must be professional must be crisp, clear, concise, but the substance of the narrative is more valuable than the form if you will. And so we communicate to the to the prospective acquirers. We have materials that we put together, it’s in our space, we found like the 100 page pitch book, you just everything gets drowned out in, in the one page thing is far too brief. So we have a happy medium that provides kind of the high level overviews of all the things that are important. We have data rooms that we support back, but we kind of sequence or phase the sharing of information. So that way we make sure people are focusing on the optimal or the key elements of it first. But yeah, so it’s it’s, it’s clean, it’s crisp, it’s direct. It’s not as not as razzle dazzle as some other things. But the goal being to communicate the narrative clearly, communicate the value proposition clearly to the prospective acquirer, and getting their attention. Because, you know, the trick in this business sometimes is that if we’re representing a small company to a very big company, the hardest part of that dialogue is getting the first part of their attention, right? If we can get their eyeballs on it, and they like it, well, then it just creates traction amongst themselves, right? Because now they’re saying, Well, this is interesting, want to look at it want to learn more, and they have their own momentum. And at a certain point, they don’t really care what I want to tell them, they care what they want to look at, right? And so they say, Well, I want to learn more about this and learn more about that. So you can’t drown them out with your own narrative. But you do have to make sure you’re giving them enough for not too much and get the attention. And then if the attention leads to interest, it kind of becomes self fulfilling at that point.

Gene Tunny  26:24

Gotcha. And what if, say, I’m looking at, I don’t know a plumbing supplies business in Milwaukee or something like that, could I actually, and I’m a prospective buyer, could I line up a visit to the, the company’s premises and talk to the management?

Arthur Petropoulos  26:41

Sure. At a certain point of the conversation. So we try to phase things out, right? Like, you should be able to, if you are the plumbing supply distributor guy, and you know, this business, right, so we have to kind of validate prospective buyers. So what’s your track record? What’s your history? What’s your industry knowledge? What’s your financial capability to do these things? And let’s say you check out on all these things, well, then you really should be able to give an offer, or at least a skeleton of an offer just based on numbers and conversations with ownership, right. And so there is a certain, so only when we get to like a high level structure, that you would, you can at least put the ? on the back of an envelope. And that ownership can get on board with that we then pivot to you know, whether it’s an in person meeting, facility review, I think the problem with a lot of intermediaries is they allow too much access too soon. And it’s like, you know, this isn’t a field trip, right? Like, we’re not looking to have like 25 people come around and kick the tires and things because it creates an environment of instability for the employees. It’s not good, right? And so you really don’t want to do that until, you know you have something and we try to push. And it’s a tug of war sometimes, but we really try to push things as far as we can. Before we’re doing anything, that could be a disruption.

Gene Tunny  28:00

Gotcha. And you mentioned so you’re trying to validate or vet the buyers, is that that’s a risk mitigation measure I it? Are you, I mean, you’re I guess you want to protect the legacy of the business for the person who sells it. Like, what’s the what’s the thinking there?

Arthur Petropoulos  28:19

It’s not so much from a, I guess it’s qualitative in a way, right? Like, we’re not gonna we don’t want to sell businesses to criminals, or people who have bad track records, you know, in terms of like treating employees and stuff. But, you know, we also don’t, you know, it’s not like, oh, I don’t want it to what’s the Aussie word, you know, a bug in some way, right? Like we don’t like so it doesn’t get to that level, where it’s like, I don’t want these kinds of people or those kinds of, it’s really about capability. It’s about, you know, it’s about industry experience knowledge, feeling comfortable, that they would be a good steward of the business from a fundamentals perspective. Because you’d be surprised. I mean, you know, we always joke and say it’s separating the prospects from the suspects. But it’s, you there’s, there’s a lot of people out there that I think are looking at businesses is like, you know, when you sell a house, right, like you ever sell a house and you put the house for sale, and take buyer, the neighbours show up? Yeah. And it’s like they’re not buying the house. And it’s like that same neighbour, it’s like their hobby is to go look at houses every weekend, right? And they just go in and they like, eat the food and kick around and like, take some paper towels. And so in business, you’d be surprised that a lot of the same names show up and so we want real buyers, but we don’t want to waste any time. There’s no value. There’s no style points to fluffing up the numbers of interested parties on the front end. It’s no good for anybody. So it’s more about capability and are they a bonafide prospect. And and you know, qualitatively, are they going to be the right steward. It’s less about, you know, did they go to a proper preparatory boarding school. It’s more about actual capabilities.

Gene Tunny  30:01

Yeah, yeah. And is this regulated Arthur? Like I imagine it’s not SEC, but are there state regulations around this? I mean, what’s the

Arthur Petropoulos  30:10

Yeah, and there are there are SEC regulations pertaining to private company sales, you know, relative to sizing and structure of deals in a way that does not kind of conflate with securities. And then state by state, there’s different considerations depending on on what it is, for the most part, though, this is it’s kind of free market, third party transactions to other people who are owning things. And, you know, not many of these transactions are going to be either, you know, pivotal to national defence, or, you know, under like, Hart Scott Rodino Act for like, antitrust and stuff like that. I mean, these tend to be, you know, if you said, What is kind of the typical situation, it’s a company that does a thing, either for a particular product or geography, there’s a giant company or bigger company that does it everywhere else, and wants to get access to their geography, and they kind of bolt them on. So. And that’s, you know, sometimes it’s merger of equals, sometimes it’s just one person, but a lot of times it’s kind of the aggregation strategy that’s looking to bolt something on. And so it is regulated, and there’s certainly laws and rules to it. But it’s not to the same level of securities, because not dealing with, you know, selling shares, small amounts of shares to large number of kind of passive investors.

Gene Tunny  31:31

Gotcha. Is there much legal risk on the seller side, I’m thinking, I mean, you know, with any sort of tender process or auction, there’s always, you know, there’ll always be a significant number of people where there’s the the winners curse, so to speak. How do you deal with that?

Arthur Petropoulos  31:47

Yeah, so part of the negotiation. And so once we have a deal, basically, under a letter of intent, you enter into the diligence phase, in which case, the buyer puts forward a purchase and sale agreement for the consummation of the transaction. So unlike real estate, where you have a purchase and sale agreement that you sign, and then you enter into diligence, in corporate transactions, you sign a letter of intent, you do the diligence, and then the purchase and sale agreement is signed, kind of coterminous with the closing of the transaction. But within that, within the purchase and sale agreement are representations and warranties both ways, right. There’s disclosure schedules, so that a seller would have to say, Are there any pending litigation? Is there any complaints? Or what are the customers you’ve lost? There’s things that have to be put in there. And from a buyer’s perspective, they have to say, what they are willing to take, you know, at face value. And so the way we an old, an old mentor of mine said, reps and warranties are there for, you know, fraud, willful misrepresentation, things like that, to protect buyers against, but it is not in what he called, he said, It’s not schmuck insurance, right? It’s not, it’s not insurance that you paid, you didn’t pay too much, or you didn’t know this and do that, right. Like, this is a business between sophisticated parties. And so if a seller sells a company, you know, without using a person like us, and they don’t get a good price and don’t get a good structure, they really don’t have any recourse to complain about it, because that’s the deal they agreed to. Buyers similarly if they, you know, if it’s not, if it’s not in the contract, then then it’s, it’s not part of it. So point is, it sounds more adversarial than it is. There’s just kind of customary reps and warranties that very clearly define what the post transaction risk or exposure is from both parties. They are negotiated pretty heavily by the attorneys. And, you know, as it pertains to the business elements, we get involved as well. But our general positioning on it is we want to protect the buyers from fraud from, you know, willful misrepresentation things we don’t know, which don’t happen with the clients that we work with. But what we don’t want is for anybody to just say, like, I bought the company, I mismanaged it. And now I want, you know, some money back because I didn’t do the right thing, right? That’s not That’s what we avoid. And nobody really asked for that. But we don’t want it to be grey.

Gene Tunny  34:15

Right. So do you engage the lawyer or does the seller engage the lawyer?

Arthur Petropoulos  34:21

It depends on the situation. And it depends on what kind of an attorney a seller’s using. And so sometimes, if a seller is using a corporate attorney for a lot of activities that they’re with they’ll say, hey, I really want our attorney in the mix here. And that’s perfectly fine. We work with lots of people’s attorneys and that usually when we get the letter of intent, negotiated but not signed, that’s typically when they come into the process review that and then we work alongside them shepherding diligence. But there are other times where people say like, you know, I you know, my attorney is a great guy. He’s a great friend. You know, he helped me buy my flat in Brisbane, but you you know, I have a $50 million business, maybe he will play a part in the process. But do you have someone that you can bring in that just does corporate transactions all day, in which case, we have a global network of people that we’ve worked with, that we can bring in, depending on the locale of the business. So it’s situational. And we can work with clients either way, depending on their preference, but we always keep a strong roster of, of attorneys. And I, what I’d say is the right types of attorneys, because you can have, you know, anybody can pick up the phone book and call up the most expensive law firm in the world. But it’s where do you find kind of that optimal mix of value and capability? And so whether it’s people that have spun off of the big law firms running smaller boutiques that are slightly off the radar, or are more tactical people, we like those kinds of relationships.

Gene Tunny  35:46

Yeah, very good. I should ask Arthur, how did you get in, how did you get into this? I mean, you mentioned you worked on Wall Street. Could you just tell us a bit about what you studied? And did that help you get into Wall Street and then your path to Hill View? Partners, please?

Arthur Petropoulos  36:03

Yeah, sure. So when I grew up, my father used to read, he had a very broad spectrum of books he was interested in, and ideas. And so I remember, you know, it was gonna be Plato’s Republic or Aesop’s Fables. But he read a lot of history books to us. And so I remember going through like, you know, Amerigo Vespucci, he was travelling the world selling pickles or the Dutch West Indies Company was fine, you know, whether it was silk or spices, but it felt like the history of the world was the history of business and war for other things, but business, right commerce, and, you know, the idea of a finite amount of resources and an infinite amount of want. And so when I studied more and I would get into like the industrialization of America, and, you know, Carnegie Steel turning into US Steel, and all of these aggregations, I found the combination of business transactions of finance of growth and in aggregation of industry to be fascinating. And when I grew up, the only people I knew that who really had their hands in these things were always attorneys, you hear like, oh, this attorney just helped this person sell this company. Because I do think particularly in days past, I think a lot of attorneys kind of served a dual role in these things. And they still are, you know, key advisors to companies. But so I went to law, I studied undergrad business, I actually wanted, I wanted to get a minor in music theory, I played the piano. But I remember my mom said, if you want to play the piano, you can just leave school and stay in the living room. But we, but anyway business was the key focus in undergrad, and I went to law school, and law school doesn’t have majors, but you can effectively create your own focus. And so we created or I focused on corporate transactions, both from a mergers and acquisitions and financing perspective. And it was when I was in law school that I was reading the case law, you’d have to study of your KKR and acquiring Nabisco and Philip Morris, and this and that. And when you started reading all of these cases, you’d say, well, who is that? And how do they work? And how does this work? And so once I figured out, what is an investment bank, what is a private equity firm? How does capital work, who are these lenders, that’s when I think the world kind of opened up and I said, Ah, like, there’s this whole ecosystem of corporate transactions and all these participants in it. And then I realised, you know, although I believe the law degree is phenomenal in terms of understanding the allocation of risk and structuring of things. I found that, you know, the investment banking was a bit more firmly in line with where my interest was. And so it’s not an atypical path in the sense that I think Lloyd Blankfein and Brian Moynihan and Sam Zell like they all actually had law degrees, because I think they went through a similar kind of learning exercise. And so even that’s, that’s how I was in law school. And then did whatever a young guy looking for a job, you know, picked up the phone and found lists of names and called and called and called and got a job helping middle market companies sell themselves and then went to the buying side and had a few jobs in New York and then said, Hey, we should start our own thing, came back to Rhode Island to do that. And here we are today a little wiser, and with a little more grey hair.

Gene Tunny  39:19

And I mean, there’s no disadvantage to being in Rhode Island I imagine is there?

Arthur Petropoulos  39:24

You know what, there was a time but I think it predated me a little bit where if you wanted to be in finance in the States, it was either really LA or New York. And then you saw outposts pop up in Houston for oil and gas businesses or, you know, Florida because of how many New Yorkers moved there. You know Boston for pharmaceutical businesses. But my notion when we started Hill View was it was already felt like no one really cared where anyone was, as long as A) you could get to where you need it to be, and B) you produce results and B was far more important than any other stuff. So, so no, I mean, I think like we sit right between Boston and New York. So it is a nice hub to kind of do stuff locally, but we’re doing things all over the world at this juncture. And, you know, again, so long as we produce the results, then, you know, it doesn’t matter if we’re in San Francisco or Saskatchewan.

Gene Tunny  40:05

Yeah, yeah. Because even if you did take a meeting in New York City, for example, what’s that a couple hours away is it at most?

Arthur Petropoulos  40:19

Yeah three hours.

Gene Tunny  40:21

Three hours. Gotcha. Okay. Righto. So before we wrap up, Arthur, I’d like to ask I mean, like what do you see as the value that you’re adding to the economy or the business brokers, then we might talk about the other side of it, the private equity, because there are a lot of there’s a lot of negativity out there about private equity, a lot of concerns about market concentration, and these leveraged buyouts and all of that. So could you just talk about what you see as the benefits to the economy of you’re, what you’re doing to start with please?

Arthur Petropoulos  41:04

Sure, I believe that, you know, capital and transactions are kind of the the oil that facilitates or greases the skids for the economy in the sense that transactions have always taken place. But if you read about, you know, John Rockefeller going through Standard Oil, I mean, he was just kind of bludgeoning people and buying things for nickels and in like, you know, there was a lot of unfair competitive practices. Whereas I think, as the capital markets, and as the M & A markets have evolved, it’s facilitated things so that they happen faster, so that they happen in fairer terms for the selling party. And ultimately, I think, allow for the evolution of industry on a quicker and more efficient basis. And also, I think bolster, economic, competitive positioning, you know, particularly for domestic companies, versus kind of international, you know, many times like you have US conglomerates, competing against, you know, state run organisations in other countries, right. So the only way you’re going to compete is on scale and is own size and is on innovation. You know, there’s always that joke about politics, they say, the number one rule of economics is the idea of scarcity, that there’s more want than there is stuff. And the number one rule of politics is to ignore the number one rule of economics. And so I forgot what economist said that but so in reality, right, there’s scarcity. And there’s, there’s scarcity of talent, there’s scarcity of stuff of services of goods. And so the further you can evolve any particular industry, it does allow for even as painful as it can be the reallocation of human capital, to things that are less efficient, right. And so it’s almost this, like, it does push things forward, like, you know, irrespective of how much anybody could complain about, you know, life in America in 2023. Like, it’s hard to argue that, like, your life is not just as good as like a mediaeval King, right, like you have. I mean, literally, I’m sitting in a chair right now, I’ve got the Library of Alexandria, in my pocket, I can have more pizzas show up at my door in a half an hour than then I can ever eat. I mean, it’s like, it’s amazing. But the only reason all of these things happened is because, you know, the guy said, Hey, I have one pizza place, I could own 10 pizza places, and we should do delivery. And then so, you know, Little Caesars and Pizza Hut and Domino’s. Right. And so it’s like, I think that there’s, there’s places and ways to kind of rein in just the pure animal spirits that can come out with that. But at the same time, I mean, that is why for all of our black eyes, you know, the, you know, the most capital, capitalist focused countries have been the most economically dominant because they allow for that. And I think that the part that we play as intermediaries in the capital, intermediaries is facilitating the efficiency of that exercise and allowing for innovation and consolidation on a quicker and effective basis and protect while protecting the interests of those who contributed to the evolution right to the sellers of companies.

Gene Tunny  44:10

Gotcha. And what about on the buyer side, the private equity, do you have any thoughts on on that side? There’s this caricature of Gordon Gekko going in and, you know, the concerns about loading companies up with debt and stripping money out of companies and, and sacking lots of workers. Do you have any thoughts on that? Do you think private equity adds value out there in the economy?

Arthur Petropoulos  44:37

Absolutely. Because I mean, I think that they very much are the facilitators of innovation and consolidation. Right? It’s capital. It’s looking for return on capital that’s doing that. But you know, taking a few steps back, you know, if you think of the United States economy, a lot of that kind of Gordon Gekko element was a bit of an idiosyncratic situation. So you had, you know, let’s say, we leave World War Two and all all of these conglomerate companies start to form, right? Because they basically apply like war learned processes and they just say, we’ll buy everything right and putting it together. And so you had, you know, CBS owned the Steinway Piano Company, and you had all these, like things that came together because they figured they could just run the same process. And so you hit the 1970s, you have huge inflation, because of too much money printing and we won’t get into that. And then Nixon takes the dollar off the gold standard, inflation goes through the roof values of companies go down. And so you start to see all of these companies where it’s like, you’ve got five different companies combined, that all do different things, and no one knows how to value any of it. Because it’s like, you know, the same company owns Jello pudding that owns like, you know a concrete company, or whatever it might be. So the initial premise of it was buying under, under, misunderstood assets that were put together incorrectly, and disaggregating them in a way that allowed for a better value of each constituent element. Secondly, there was a lot of, you remember the Gordon Gekko speech about, you know, tell their paper company when he’s saying like, all of the executives own 1% of the company, and they’re just pillaging it from cash. There was a certain glut of industry in that time period of inefficiency, that was losing kind of our competitive positioning on a global basis. So you can make the argument that and this is where it gets tricky it because, yes, there were a lot of layoffs. But truly it created efficiencies and companies that allowed them to be globally competitive reallocating the human capital to industries, you know, that made that were more ripe for innovation. Now, there’s pain that goes along with that. And then it’s not to be ignorant of the fact that there were a lot of greedy people involved, right, like all of that leverage was not necessary to accomplish these things, it was just a way of choosing the, you know, choosing the return. So the pendulum goes back and forth. And anytime it goes too far, it will pull back, what I would say is that the modern incarnation of private equity has largely been one of innovation and scale, right. And so buying up a lot of small companies and aggregating them, I think, the biggest myth in private equity in today’s environment. Now, I’m not saying if private equity goes out and buys a bloated software company and fires a bunch of people. But you know, that wasn’t making any profit. But I’m saying when private equity goes out there and buys an aggregation of distribution or manufacturing companies, they want to keep the people, the people are the valuable part. That’s where there’s scarcity. So in today’s environment, that notion of over levered like financial engineering and layoffs is really, I think, a relic in private equity in today’s environment does a lot more, I think, good than harm, and a lot of those excesses have been had been pulled in. That’s not to say, you know, there’s not exceptions to that. But in today’s environment, they are a accelerant of aggregation and innovation, I think in in industry as they consolidate different businesses.

Gene Tunny  47:59

Okay, very good. Arthur that’s been terrific, I’ve learned a lot I learned, I hope you don’t mind, I grilled you over the process and what you do exactly. And I mean I learned a lot about how this, these transactions occur. So thanks, heaps for that. That was great. Tell us about your, your outreach, or your YouTube and newsletter or whatever, please. That’d be great.

Arthur Petropoulos  48:23

Yeah, so I’d say check us out on YouTube at Hill View Partners, if you just typed in Arthur Petropoulos, you’d come up on and on LinkedIn our company page Hil View Partners both on YouTube and LinkedIn, we put out two videos a week, talking about just different topics in the mergers and acquisitions and capital world kind of recurring themes, almost like an FAQ of the things we’re always talking about. And then reach out to us, either on LinkedIn, myself, or the company page, or on our homepage, hillviewps.com. So hillview, P as in Peter, S as in sam .com, where you can reach out and set some time up as well. But that’s where to where to find us. And on a, you know, on a closing thought, not to get too philosophical, but I think I think anytime you kind of take a position, that something is just entirely wrong or entirely right, or you’re you’re missing a lot of the nuance, right? And so a lot of the economy has excess in both ways. Right? And so, there are, you know, have there been situations where, you know, companies have been too greedy? Yes. Have there been situations where, you know, look at the industrialization of what America had lots of greed there, right? Look at situations where the unions were too greedy and look at how the steel disappeared in the 1970s. Right, so like, so I think the key to being good at our job, and I won’t extrapolate it enough to say good at anything is like you must understand nuance, you must understand subtlety. There’s four sides to every story and the truth sits somewhere in between and so it’s our job to kind of see reality for what it is not necessarily what we wish it would be. And by virtue of taking that kind of sober yet realistic look on things you know, we’re not, we’re not people that are always cynical and say it’s bad. We’re not people that are always optimistic and it’s always good. But we say, life is hard. The world can be a nasty place. But there are glimpses of good and nice things along the way. And we, we, we like those. And so any event for what it’s worth, that’s our that’s our view of the universe that you didn’t ask for. But this is a this has been good Gene, I appreciate it.

Gene Tunny  50:22

Very good, Arthur. I’ve really enjoyed it. And yep, I like having rounding it out with that philosophical thought. So I think that’s terrific. So yep. Very good. Arthur Petropoulos from Hill View Partners. Thanks so much for the conversation. I really enjoyed it.

Arthur Petropoulos  50:37

Likewise Gene. Appreciate it.

Gene Tunny  50:41

Righto, thanks for listening to this episode of Economics Explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact@economicsexplored.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.

51:28

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Credits

Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.

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