Due diligence on a roll-up: lessons from a luxury optical deal

• Poerink treats due diligence as far wider than the financials: macroeconomics, the industry, the operating model, management, and legal and environmental risk.
• He says diligence fees on a $100 million deal can reach $10 million, so when to put advisers on retainer is a judgement call, and hiring early can show sellers you are committed.
• Banks do limited diligence of their own and rely on the buyer's adviser reports, so thorough reports from the accountants and consultants help get lenders on side.
• A consolidation play needs a large fragmented market with no dominant player, sizeable acquisition platforms, an inefficient market and clear gross margin gains.
• Financial diligence on the optical stores found 250 to 300 days payable outstanding, a supplier practice that was both the deal's edge and its biggest risk.
• He calls unaudited financials at a privately held target a major red flag that needs very good accountants on the financial due diligence.

The stores were getting their inventory for free. When John Poerink's team ran financial due diligence on a group of luxury optical retailers, they found 250 to 300 days payable outstanding on the balance sheet (around 1:07:50). Poerink says the trade had an age-old practice: you buy the inventory, but you don't pay unless you've sold it. When his team asked one owner why he hadn't paid his bills, the answer was that the suppliers never bother them. Frames still unsold after 250 days went back to Cartier in a box, for a credit.

“I've actually won auction processes not by paying the highest price, but having the best structured deal, having the best relationship with the management team.”

John Poerink, Head, Linley Capital

That finding sits at the centre of this Wharton guest lecture. Poerink, who heads the private equity firm Linley Capital, came to deals through corporate M&A, first for the Benetton family and later at Les Wexner's Limited Brands. He tells the MBA class up front that this will not be an accounting class. Instead he takes one small retail roll-up and uses it to show how his firm decides what is a good investment and what is not, pulling students into the discussion as he goes.

“When you do a hundred million dollar transaction, before you know it, you're spending $10 million in due diligence fees.”

John Poerink, Head, Linley Capital

His main argument is that due diligence is much broader than the numbers. Poerink says it runs from top to bottom: first the macroeconomic environment, then the industry and its competitive set, the operating model, comparable transactions, the financials, management and legal. He says buyers become myopically focused on the financials of a business without taking a step back to ask whether they should be looking at that industry in the first place. His legal example is a roll-up of about a thousand gas stations, where leaking tanks can leave you with huge environmental liabilities you didn't foresee (around 32:12).

“If you want to get a bank on your side, it's good to have a thorough Bain report and a thorough KPMG report.”

John Poerink, Head, Linley Capital

Running all of that is the sponsor's real job, in Poerink's telling. His firm manages a team of 30 to 40 people on a transaction: Kirkland & Ellis on legal, KPMG on financial due diligence, Bain on growth strategy, and specialist firms for management assessments. The bill adds up fast. Poerink says that on a hundred million dollar deal you can be spending $10 million in diligence fees before you know it, so you have to be careful when you pull the trigger on hiring advisers. He adds that you can't wait too long either, because the sellers need to see you are committed enough to spend the money (around 34:45).

“If you're doing that with a dominant player in the market, you're dead in the water.”

John Poerink, Head, Linley Capital

A student asks when the next consulting hour stops being worth paying for. Poerink calls that the art of what his firm does, and says it is typically better to have more due diligence information than less. His team often disagrees with KPMG, with Bain and with its own operating advisers. The point, he says, is an outside opinion on each part of the deal, so you are not caught by surprise. Things will never work out exactly the way you expect them to.

The same reports do a second job with the lenders. Asked how banks changed after the crisis, Poerink recalls 2005 and 2006, when banks were throwing money at you and his firm took three times debt when offered four, something he says 95% of private equity firms would not have done (around 44:13). Banks are smarter now, he says, but their own diligence work is still very limited. They lean on the investment bank's material, which he calls usually worthless (while crediting some smaller middle market banks with very thorough work), and on the buyer's reports. Thorough consultant, accounting, management and environmental reports get a bank over the hump.

On consolidation plays themselves, Poerink is blunt: they are incredibly difficult and a lot of them fail. His checklist from the optical deal is a large fragmented market with no dominant player, relatively large acquisition platforms, an inefficient market and clear gross margin gains from suppliers. Where a dominant player already exists, he says, suppliers won't care that you are double the size. In an efficient market the owners pick up the phone to each other and start negotiating together, which he says happened on this deal (around 1:02:23). Luxury optical passed the test: a $400 million niche of mom and pop boutiques, about 3% of a $20 billion optical market.

Management is where Poerink admits to mistakes. In one portfolio company his firm did not hire people to evaluate the whole team, then had to change the CEO. He calls that incredibly destabilising for a $500 million business, where the CEO goes and the CFO follows because they were friends. His test is the track record, and the hard question is whether a team that grew a business from $100 million to $500 million can run one at $2 billion. Usually, he says, not without guidance, added hires or training.

Back to the optical deal. A student points out that the supplier terms cut both ways: if suppliers push payable days down from 260 towards 200, cash flow takes an immense hit. Poerink tells him he hit the nail on the head, because this is what happened, though the lecture runs out of time before he explains how (around 1:09:56). His parting advice is about price. He tells the class that the discipline of buying companies on the cheap is the single biggest driver of returns. Overpay, and even a sound business will disappoint when you sell it.

For anyone running a diligence process, Poerink's point is that the financials are one workstream among many, and that lenders end up reading the same adviser reports the buyer commissions. Plan the timing of those reports, and what goes into the data room, with both audiences in mind.

0:12 All right. Thanks for that. I haven't done anything yet, so I don't know exactly why you're clapping, but I'm going to try and make this very interactive. Okay, so ask questions whenever you want. Raise your hand or just ask questions. I'm going to be focusing on due diligence, but I'm going to take a very broad approach to the whole concept of due diligence. So, this is not going to be an accounting class because I would fail miserably in that. but really take a broad approach to due diligence and and try and explain to you guys how we look at companies and how we go through the whole due diligence process in evaluating what is a good investment pro investment and what is not. I'm going to be doing that on the basis of a investment that we made in a retail business. before I do that, let me let me give you a bit of bit of my background in addition to what the professor just mentioned. I kind of came into this business in a in a

1:16 fairly unorthodox way. I spent many years working for the Benaton family and then later also for a gentleman by the name of Les Wexner who is the founder and majority shareholder of the limited brands that owns all of these apparel and consumer good companies. and I was exposed to kind of the whole M&A sector by doing transactions in a corporate setting. So we did a whole slew of transactions when we were in the Beneton group where the Benithons decided in the early 90s to start diversifying and we bought all sorts of businesses including infrastructure deals. We bought the Northern Italian road networks which still is in the hands of the Benaton family today. we made investments in telecom. We made investments in consumer good companies. and then similarly at the at the limited brands was involved in a similar capacity in a number of fairly large transactions. And I got a lot of exposure to buying these these companies that were typically kind of

2:18 middle market companies. So anywhere between let's say hundred to a billion dollars in revenues and and the complexities and issues that we dealt with in incorporating these businesses into the larger corporate setting. So then later I went into private equity after I went back to business school and to this day I continue to be in this business and I have to say that I actually love what I do. It's a it's a a tremendously fun and interesting business and multiaceted business. I just have to figure out how this thing works. Here we go. All right. So I told you a little bit how what we're going to be doing today. I'm going to talk a little bit about the private equity core competencies and then really go into due diligence. I'm going to try and stay away from kind of the technical stuff with respect to the technical accounting stuff, but really conceptually try and explain what we do on a day-to-day basis when it comes to due diligence on the basis of a transaction that we did. Now,

3:20 this transaction that I'm talking about is a small transaction. It doesn't matter however because it had all sorts of interesting aspects to it that regardless of the size you'll deal with in a private equity context. Before I start who is who has any experience in private equity has worked in a private equity firm. Okay. Quite a lot of you guys. And in just just Fran what what kind of context were you working in private equity? So I was working in a private equity firm in Spain country. It's a mid-market company. Okay. Okay. We were doing deals from 200 million to 100 million. Okay. And what what were you doing there? so I was an asset. So basically I was in charge of operating models and models and I was in deps with banks. Okay. And helping the the principal in directing the consultants in the in the market and the Okay.

4:15 Okay. Good. Well, let's start then with and we'll go through this fairly quickly quickly. What what is it that we do on a day-to-day basis? I mean, so we're private equity men and women. we work we have a lot of capital that we're backed with and what is it that we do on a day-to-day basis and in our offices? I mean, so we all talk about doing deals, but it's not as easy as that, right? So, Daniel, what is it that we do on a day-to-day basis? Where does the whole process start? Ud Identifying potential targets to acquire and add value if possible. Okay. So identifying potential targets to acquire. Okay. So how do we do that?

5:02 well we usually contact some investment banks or firms that have been approached by by firms that want to sell the company. Yeah. or do an IPO and okay so investment banks right so we depend on what else what else do we rely upon from finding interesting investment opportunities networking what networking your colleagues your friends your family you try to reach as many people potential investors and business owners as possible and this is how you ensure a certain deal flow potential deal flow okay So go ahead. Consulting reports just where they look at the company business and where they see if the company has a strong cash flow and like it's well positioned in the industry.

5:53 Okay. Right. So we we source deals. Utam what else? You can hire a buy broker if you want to target a particular segment of industry. You can hire a buy broker and go to trade shows and have them put together. We one of the hardest thing that we do and particularly in this day and age where the markets have become incredibly efficient meaning there are buyside brokers there investment banks there are people that have networks and friends and family it is incredibly hard to find proprietary deals. So what's the issue of finding nonpropri if you buy if you get approached by an investment bank what's the issue with being approached by an investment bank? There will be other private equity shops bidding for the same deal. Probably the price with that higher. Exactly. So an investment bank these guys you know are probably better in networking than we are and they they have a whole slew of companies that they've developed years of relationships with and they the company is eventually up for sale privately held company let's say just for example and they show it to a

6:57 whole slew of private equity firms. they run an auction process and you end up paying a very hefty price to be able to close that transaction. So sourcing deals and don't forget this is incredibly hard and it's becoming increasingly hard because the markets have become incredibly efficient. The private equity business has become an industry and there are hundreds and thousands of investment banks in Europe and the United States and increasingly so in in Latin America and increasingly so in Asia that are all running after these investment opportunities. It's very hard to find interesting opportunities that are proprietary. Okay. So what else do we do? So we spend a lot of time trying to find interesting investment opportunities. What else?

7:43 Is that all we do? I mean in terms of sourcing it all the things. No, forget sourcing. Let's say let's move on to the next reporting fundraising. Okay, fundraising. I'll get back to that. So, but that's a very important point. I'll come back to that in a minute. What else do we do? Follow your investments. Follow our investments. Okay. So how do we do that? You're usually in contact with management of the firms and you prefer you prefer reports or data for the for the boards. Okay. And you assess them also in aesthetic issues and financial issues and with the banks and all that stuff.

8:31 So we're typically when we do an investment we typically take a board seat in investment. And so several members of our firm will take a board seat and we oversee the investment and the execution of the investment and we oversee essentially management reports then to the board and we we oversee the so that takes a lot of time and it's a difficult process. Okay. What else? We talked about sourcing. We talked about fundraising. I'll get back to that in a minute. maintain relationship with lenders so you able to borrow to find. So we've got fundraising and debt financing. Okay. We're in the business of doing leverage buyouts, right? And to finance these transactions, we need to have debt.

9:16 The whole process of raising equity and debt financing for any transaction is a very very difficult and very complex process. Raising a billion dollar fund, it just doesn't happen from one day to the next. It's a very difficult and arduous process. It's very very competitive. There are a lot of people trying to do what you do. the LPs and the LP community, whether it's pension banks, whether it's family offices or or endowments, they these people know what they're doing and they're very good at picking good managers who have a good organization who have a good setup. So the whole process of fundraising is a tremendously arduous process. It takes a tremendous amount of time. It costs a lot of money as well and you can end up empty-handed too. So the whole process of fundraising and also raising debt financing for transactions particularly in these

10:18 markets and I'll get back to that at the end of this lecture is a difficult process. Okay. What else do we do? So that's it. So we raise funds, we source deals or what else? We execute on the deals we source. Okay. So we execute on the deals that we source, right? which is what? Due diligence, negotiations. Okay. Due diligence and negotiations. do you have any experience in negotiating private equity transactions? Yes. Okay. So tell me a little bit. Is that an easy process? Is a hard process? It's very challenging because often times you need to reconcate between the expectations of the management or the owners or whoever is selling the business and as a fund the return requirement risk profile and so on and so forth. Right? So negotiating transactions is another it's a pretty complex type of business. You have to have it a little bit in your fingers.

11:17 The sellers have to like you. You have to come up with a good bid. It's not only about price. I've actually won auction processes not by paying the highest price, but having the best structured deal, having the best relationship with the management team, having the best developing the best relationship with the sellers and coming up with a transaction that is really doing right by the business and doing right by the company and really ensured that the sellers felt happy to whom they were selling the business to. Now private equity business and particularly in Europe by the way we do transactions in Europe as well has developed a very bad name. the whole concept during the last five or six years, the whole concept of doing these leverage buyouts where you would buy a business at a at a high purchase price multiple and kind of justified that high purchase price multiple by using tremendous amount of leverage and two years into the into the whole investment you're breaking through your covenants and in the worst case going

12:20 bankrupt. So these types of structures and transactions, people becoming much more savvy about that and negotiating and structuring transactions in in a way that in in in in an effective way that you can actually make the acquisition of the businesses is becoming increasingly more more difficult and and and competitive. All right. So I'll just quickly go through that. So we talked about sourcing. we'll get back to about due diligence. Due diligence is incredibly important. Due diligence is not only financial due diligence. It's much more broader than and we'll get get to that in a minute, but we spend a lot of time on due diligence. Now, just a minute about valuation.

13:08 how do you know what you pay for a business? Sylvia, what should you pay for for if a company walks or an investment banker walks through the door, gives you all sorts of information about the business. So, how do you determine what the valuation should be for the business? So, you you market based relation. You want to see what other companies paid for the business. You run your LBO model seeing what your return is because you know what your return requirement for your fund is. So, you have the maximum level how much you can pay, right? You look at that number compared to what other transactions the market went forward to get some kind of estimation of value. Okay. And so how do you determine that ultimately what price you should be paying for the business?

13:54 I mean you can do all that work but so what so you have all this all this information. What I mean what are you going to pay for in the end for the business? What really truly determines what you what what you end up paying for the business? Depend on the competition. If there's other bids in the process, it will bring the price up. If there's no competition there, you will try to go as low as you possibly can. Yeah. There's competition there. It will determine how many how many rounds there are. They will tell you you need to bid a little bit more to the next round. Okay. So, finally at the end and then you will get some guidance from the banks where you stand within bidding and then on based on that you will decide if it's worth for you to make spend more time to find symmetries to way to spend to pay more for business return. Okay, Diego, you you wanted to make a comment.

14:43 It was the same thing. I mean, that's your walkway. You should try to increase your your return by providing other sources as you said, you know, by having relationship with the management and bringing ways that you can add value to the business to pay as lowest as you can. Okay. the the whole concept of valuation has gone completely haywire and certainly during the last four or five years. The people have been overpaying for these assets for years and somehow justifying the price by using a lot of leverage. That whole game has changed now. the the debt financing that these companies used to be able to get for for justifying these types of deals are no longer available.

15:29 So it's becoming increasingly more difficult to justify a high valuation, a high purchase price for a particular business. financial modeling. So just just very quickly, so how how who who's run leverage buyout models here in the past in a private equity context? So you guys here Utam to tell me a little bit about okay what's what's really the concept of the leverage buyout model? The key concept is basically forecast free cash flow. Yeah. and and figure out how much of your debt can you pay down and what would be the what kind of what kind of EBDA would you have when you're trying to exit the company and and and and what would be the final return to the equity holders right is the basic concept of okay so it's a very simple concept right you basically look at the cash flows of the business you kind of try and identify how much debt and what kind of capital structure this business can sustain over the pairs and and it spits out what

16:33 what what what does it spit out at the end? The return to the equity holders, the cash and cash and and the IR, right? So the cash and cash return and the IRI and the and the IR so a lot of people will understand how to do this and develop leverage buyout models. What's really the important part of that? To figure out what are the key u growth drivers, what are the key drivers of the business activity. Okay. and and model the business. if there's seasonality, then you figure out what is the right time period. If there are other structural drivers, then you to identify what those are and what are the drivers behind. Okay. So the whole concept of of leverage buyouts is not so difficult to understand and and actually running leverage buyout models is not that difficult. The whole point is is what you're really putting into that. And if you really understand the underlying asset, the underlying business, how the the financial operation of the mi of the business and what the future cash flows of the business are going to be. And if you get that wrong, you can very very quickly the whole investment can go south and before you know it, you can go

17:36 bankrupt. we talked about debt and equity financing. we talked about negotiations and deal structure. a little bit about exit planning. it is I have come across many many investment opportunities where we were kind of talking about an investment opportunity said well should we do this yes or no and and we were very much on the fence about this particular investment. when you make an investment, have a very very clear idea of actually what the exit is going to be because if you're on the fence of it about this particular investment opportunity in good times and you want to sell it in five years from now and the business has done so so you're going to have a hard time selling the business down the line. So don't buy businesses that are unsellable just because you are desperate to get a a particular transaction done or don't underestimate the the difficulties that you might run into of

18:40 investing in certain companies and certain businesses where it's very difficult to exit out of the transaction because the business is virtually unsellable and there are certain companies that are very very difficult to sell. Go ahead. So in your opinion because if if we're talking also about the largest or the the largest number of competitors that you have in an auction your price is going to be higher. Yeah. So it means that if you have a business that is difficult to sell and you have the opportunity of analyzing that business maybe you're going to get a better price but you're going to have some more problems in the exit plan. Yeah. So my question is how you can make a business that is not very sellable into into a you know convert it into a a sellable business in in in a time period of well that's exactly where your due diligence comes into is is is evaluating this business and thinking and being creative in your thinking and thinking okay what is the likelihood of taking this business and setting it up for a a much more interesting business a much more interesting operating model [19:44] healthier cash flows a better management team and what is the likelihood of succeeding in let's say a matter of four or five years and and to whom might we be able to sell that business and you'd be surprised how many businesses are bought with people not thinking about how they're going to exit and there are I have come across hundreds of companies that are owned by private equity firms that they've had for 10 years and these companies come up every two or three years, then they hire another investment bank and they try and sell the business again and nobody wants to touch it. Don't underestimate it. You could be stuck with a business that's doing, you know, $500 million in revenues and it's just a a business that an investment in an industry. Take an industry, I mean, we were talking about it earlier about the printing industry. Printing industry is going through a tremendous demise. There are hundreds of private equity firms that made big investments in the printing sector because they, you know, they had the wrong strategic approach. Now, so now these companies are owned by these private equity firms.

20:48 Nobody will touch them and so they're continuing to hold them. You know, they still cash flow. They've paid on the debt, but they can't sell them. Go ahead. Is it more industry and sector driven or there are also certain aspect or characteristics of a business that when you see you should run away? It can it can be it can be a structural I'll give you an example. we're actually looking at a business right now in the aerospace and defense sector. It's a business that and these businesses can be actually very very good and we've got some very very good advisors in in this sector but they're in the business of buying and selling parts to airplanes. Okay. not commercial airplanes but actually military planes. And this company has bought this huge inventory of of parts of military aircraft from a wide variety of European and US manufacturers. the problem is that there are two problems with this

21:51 business. The ownership structure make it very very complicated. There are a number of investors and a family office that's involved in this company that and the family is running the business. And secondly, the inventory hasn't been properly cataloged. So they really don't know what they have. It's actually fairly big business. It's a big business that has a huge amount of inventory that is actually cash flowing quite nicely. but they haven't cataloged their inventory. And we're talking about millions and millions and millions of parts. And so they're trying to find somebody who has the guts basically to step into this business to make a valuation of the business to spend a huge amount of money in inventoizing all of these spare parts of these planes and making a bid for the company. It's not so easy. You know, you have to have somebody who's willing to do that. Anyway, there are many examples like that of these quirky companies that can actually be large, but they're very difficult to sell or to buy. Okay.

22:57 okay. So we talked about so what we do on a on a daily basis from a from a private equity perspective and and actually all of these facets of any type of deal making this business tremendously fun and interesting. This guy called me and he said look you know I have this this this idea there are all these luxury optical retailing stores here in the United States and they're incredibly profitable. It's a very fragmented market and I know all the owners of these stores because I've sold stuff to them over the years and you know I think that you guys should take a look at this with me and back me about and potentially making an acquisition of a number of these companies in the luxury optical retailing business. So, and he told us a little bit about the about the sector and about the business and sounded like a pretty interesting idea. We were stores all across the United States, potentially even in Europe. They had pretty high margins. It was a fairly fragmented

24:02 market. So, we said, "Okay, what let's let's take a look at it." So, where does this process really start? So, what do we do next? So, we have this idea. We have this guy who walks through the door with this idea and he says, "Well, I have relationships with a number of these owners of these types of companies and you know, you you guys should back me in doing this." So, what what would you do next? Gus, were we were you in my shoes? Well, I have to ask for a business plan. What is he doing with the I don't know he wants money for the money, right? So you can really assess if these plans are worth your time and your money and your effort or not. Okay. So it starts with you know doing a little bit of due diligence on this industry right. So what this guy said there were all these stores all across the United States. in this this this little group that he was talking to was like 25 stores. So it starts with kind of a due diligence

25:05 process. So what what is it what we're trying to do with with due diligence? What does it really mean? Aaron, you're trying to verify I mean for this specific case, you'd probably be trying to verify the economics of the store and you know what what he thinks is achievable, whether that can actually be achieved. Okay. But it's it's it's think of due diligence and kind of like a more broader concept. I mean what is it that we're really trying to do through due diligence? Go ahead. I mean that's it comes to that by the way I mean obviously we we have to do kind of the financial analysis of and the the the the understand let's say the economics of these stores but what else in a broader broad view I think you're just trying to confirm your investment pieces exactly what you're valuating it right so due diligence is really kind of trying to understand the benefits and and and the liabilities of proposed investment and and and trying to understand kind of the past, the current situation of the business and where it's going to go in the future, right? And in

26:10 addition to that, you're basically trying to understand really get a a a a a very very thorough understanding of this business. how it operates in its environment and and use that information to come to an accurate value valuation of the business and and and develop predictable financial models. So, and this is this is really one of the hardest things that we do in in the private equity business. There are so many businesses that we see on a daily basis. Now we must have looked at probably about 500 transactions in 2009. Okay. So we looked at 500 500 transactions and so we're constantly seeing these these these opportunities across a very wide range of different industry in industries and sectors in the consumer in the industrials and manufacturing aerospace and defense sectors. And there's certain similarities between companies in each of these different industries.

27:13 However, every single company is different and it's it's very difficult to develop a nose for what is a good company and what is a bad company. what is a sound financial operating model and what's a a bad one. It's not that easy and you can't look at financial statements of a company and just say, well, okay, this looks pretty good, you know, pretty good EBIT down margins, pretty good cash flows. Yeah, it's it's much more complex than that. And it's and and it requires also a certain intuition with respect to the business, but also being able to put together all of these different due diligence aspects that you're looking at not by yourself, but with a wide team of people and boiling it down to your understanding of the business and evaluation.

28:05 Okay. So what it really involves is from top to bottom looking first at the macroeconomic environment. So, we've got this optical retailing business and it really starts with doing a macroeconomic analysis and how these businesses and industries kind of develop with in in fluctuating macroeconomic environments. Okay. So, so from the macroeconomic environment, what what what what's the next step? Where do we then go into Carlos in terms of the industry? What in terms of next what what what other due diligence elements are there apart from kind of macroeconomic environment seeing how the industry performs in a particular macroeconomic environment?

29:03 Sure. So once you've assessed the industry, you probably want to dig into the specific aspects of the firm, both the firm's operating performance and then the management team. Okay. All right. So we look at the the the the financial operating model, the operating model of the business, you look at comparable and precedent transactions. and then we obviously do financial due diligence, right? in addition, you look at management. It's very very hard to do a proper evaluation of management. I've done I've made so many mistakes with that where you can have great management teams that are great PR people when it but it really comes down to really running the business. they may not may not be as good as they as they claim to be. So it's very hard to do a proper determination of how good the management team is of a particular company. Go ahead. Yeah, I have one question. So in the situation described it seems like it was a case different from you know what the company you're going to acquire and you jump on it and

30:05 you do whatever you need to do. Now it seems like there is a theme that you I mean your friend thinks it's interesting and you're going to explore. So how do you go about this particular phase of establishing a strategy? how to go about a certain you know interesting theme rather than looking at a specific company and try to dig deeper on it. Well, I mean, what we we did, this guy walked into and it often happens like this. this guy, but even if an investment banker comes to you with a a CIM that thick, you you still have to take a step back and you have to say, okay, how does this this business that we're looking at, how does it perform in a particular industry, right? So where is the company positioned according to its competitors and how does it perform? How does this industry in general perform in the US market or in the US, European or Latin American market. Okay. So you have to always have to kind of take a step back and say look at the industry and is this a viable industry that you want to invest in and what is the competitive set in this

31:09 particular industry. pretty you know you've got you guys have done this a hundred times before but people sometimes forget to do that. So they look at they become myopically focused on the financials of the business without kind of taking a step back and said well should we really even be looking at this industry in the first place. So with this optical situation we kind of looked at the industry we looked at at and I'll come to come to you know some of the work that we did in in a minute and we decided actually well this could be a really interesting situation. Okay so financial due diligence you look at management legal big mistakes are made in private equity type of in investments without doing proper legal due diligence. It's not I don't do that. We get whole slew of lawyers. Our lawyers are at Kirkland and Ellis and they evaluate the transaction structure but they also evaluate the assets that we're buying and you can make some big mistakes with respect to buying these type of assets where you find out that they're huge liabilities. I'll give you an

32:12 example. most most recent example that we dealt with is we looked at doing consolidation play in kind of gas station type of businesses. So these are gas stations across the United States. They have you know 200 300 gas stations three or four different companies with maybe a total of about a thousand gas stations. notoriously difficult business when it comes to liabilities and environmental liabilities because these gas stations turns out are leaking gas into the ground, right? So these gas stations have been around for 25 years or so. they have these kind of tanks.

32:56 They leak gas into the into the ground and before you know it, you've bought a thousand of these things and you're dealing with huge huge legal and u and environmental liabilities that you didn't foresee. this is a more kind of obvious example, but they're less obvious examples that if you haven't done your legal due diligence and your environmental type of due diligence properly, literally you can get notice from one day to the next and your investment is virtually gone because you didn't foresee something properly. So spending the money on due diligence, but also managing the due diligence process effectively is incredibly important. And what we do is we already manage this process. I mean we're not, you know, doing the legal the the legal due diligence ourselves. We hire people to do that. we have a whole team of 30 40 people working for us in a particular transaction that do all of these different aspects. We have KPMG working on the financial due diligence or

33:58 certain aspects of financial due diligence. the the management assessments there are and here again this makes private equity investment investing in the United States a little bit easier. There's a whole industry in people who do management evaluations. You know what it's it's always been worth spending the money on these types of situations and in a minute I'll give you an example how we made mistakes. Sure. Go ahead. In your view, when's the right time to hire outside firm for due diligence or legal and financial due diligence after you sign or any agreement for you to be the only bidder? When do you bring them to board?

34:45 Well, actually this is a very good question because one of the things what keeps us alive and what keeps our business alive is the management fees that we get from LLPs, right? And hiring Kirkland and Ellis and the accounting firms is an expensive proposition. And when you do a hundred hundred million dollar transaction, before you know it, you're spending $10 million in due diligence fees. So the you have to be careful as to when to decide that you pull the trigger on hiring all of these people on a retainer basis on a particular transaction. That said, you can't wait too long because you have to show the sellers that you're also committed enough to actually spending the money. So and this goes back to kind of the negotiation process. In some cases, we've actually hired our due diligence team earlier on in the process because we

35:47 were very eager for the particular investment to show the sellers and the investment bankers and the lending institutions that we were very committed to this particular transaction. So if you further along than your competitors and the other people that are bidding for the transaction, that can actually help you getting getting the deal done earlier and sooner ahead of the time that some of your competitors are. So timing is a is a critical issue in this game because particularly the investment bankers but in in many cases also the sellers want to get the deal done as soon as possible. So one of the things that you see for example is I don't know if you how how familiar you are with the process of doing private equity transactions but it typically starts with signing an NDA then you get a investment memorandum from the investment bank then you submit an indication of interest which is basically an indication of kind of the valuation range that you guys are that that you're interested in bidding for the company and then you're selected

36:50 with a smaller group of people you're left on the basis of the valuation that you put forth in your indication of interest. You're left with a smaller group of biders and then you have to make your final bid in the form of a letter of intent. Now the difference between a letter of intent and an indication of interest. Does anybody know what that is? What's the core difference between a letter of intent and indication of interest? A portion of letter of intent is binding once the once the LOI is executed. I just make sure that I got that right. LOI has two sections like at least the ones that we drafted. The one section is a binding. Okay. So the portion of the LOI portion of the LOI is a legal binding contract. An indication of interest is say okay we'll probably you know we'll pay you this this for the business more or less.

37:35 A letter of intent is actually a contractual agreement. So there's a portion of it that is indeed binding. And the the the other important aspect of a letter of intent typically is that you have exclusivity meaning that nobody once they've both both parties have signed it nobody else you basically are protected to spend all your money on due diligence to be able to work towards a closing without being outbid in the process. Okay. Is that clear? Go ahead. so more and more they're you know like the Bane and Mckenzies of the world they sell like you know businesses to to be fun. Do do you use that a lot or do you do do you do it in Absolutely.

38:19 And I mean these business these businesses are around not because you know some some publicly listed corporation needs help to you know to figure out what their strategy is going forward. Not only that, but these these all of these consulting firms have huge private equity operations where they help people like us do do work and in fact what they do Bane does growth and strategic analysis type of opportunity. You say okay we have this company it's grown 10% 10% kager over the last five years. Okay, pretty good growth numbers. It's a $500 million in business. How can we take this business from $500 million in revenues to a billion dollars in revenues over a period of five years?

39:09 Okay. And what are the problems? So, we hire Bane to do a whole analysis and figure out and do a very very precise and careful analysis on on you know what the likelihood is and to mitigate some of the risks there and and and to to ensure that we have a good plan in place. Go ahead. back to this the growth I don't know if this is within growth and strategic analysis but consolidation typ is a common type of thesis you'll have in private equity do you when doing a consolidation play such as this that depends on multiple acquisitions do you how do you go about understanding if it's actually feasible if those owners will sell if you actually have a chance to get it's a it's a really good question and consolidation plays are is there's a lot jargon in this business and a lot of kind of oh yeah consolidate we're going to do a consolidation play in this industry. Consolidation plays are incredibly incredibly difficult to do and a lot of them fail. and I'll get to that in a minute.

40:13 There are so many things that you can diligence on. A lot of your consultants work by the hour. How do you think about whether that marginal dollar or marginal hour of time should be spent or is this enough when we need to make a decision? Well, that's the art of what we do. And no, it really is and it's a very good question. I mean, why should we be spending, you know, $500,000 on Bane to put, you know, a thick report together of something that we could probably do ourselves? Well, we couldn't do, we definitely couldn't do it as good as Bane does it. what I've what I found out is is typically if you're managing a process like this where there's so many moving elements and there's so much to think about, it is typically better to have more due diligence information than less. And and and because what you're getting is really you're getting on one particular aspect of the transaction an outside opinion and you can disagree

41:17 with them. And by the way, we often disagree with our consultants in these deals. We often disagree with our with KPMG on a report that they put together. We we we disagree with Bane. We disagree with our our consultants, our operating adviserss on these particular transactions. but but it does in the end mitigate some of the risk and it doesn't leave it what it what it what's very important is that it it it leaves you with a situation that you're not caught by surprise. and things will never work out in the way that you actually expect them to to. There's always something in a particular transaction after the trans after you've done the transaction that it doesn't just didn't work out in the way that you expected it to or you come up come up some sort of surprise happens in the transaction that you didn't expect.

42:18 By doing the due diligence and covering all of these aspects and working with people who already know what they're talking about and working with people who are very thorough and give you an outside opinion, you mitigate some of the risks and you eliminate some of the surprises. Go ahead. Quick question. Part of the diligence is also done to get the lending community over the hump. Yeah. To understand some of the risks. Can you comment on how that's changed from their perspective? post the crisis. So are they looking more for deeper supports or deeper analysis? Yeah, it's a it's a very good question and it has changed actually. I would be amazed sometimes in kind of 2006 2005 how easy the banks were and just as a little sideline the the use of leverage in these types of transactions is a dangerous game, right? you're playing with fire because the more leverage you use, the the the

43:22 thinner the margins are between being able to service the debt and your and your cash flows. And if you get it wrong and if you're caught and if you haven't done your due diligence properly, you'll find yourself in a situation that you don't have sufficient cash flows. It's as simple as that. You don't have sufficient cash flows to service the debt, right? and you blow through your covenants and it all gets very very ugly very very quickly, right? Because the banks will have you by the nuts and the it's it's really an unpleasant experience. I mean, I've been through it and it becomes a very very nasty game because the banks are basically I mean, you know, you have good banks and you have bad banks, but you know, typically if you've really overlevered the transaction, you really get into into into serious problems.

44:13 in kind of 2005 and 2006, I I was amazed sometimes how easy the banks were and how laconic they were with respect to financing transactions. It was amazing. I mean, they were throwing money at you. And I actually and believe it or not, we did a number of transactions whereby we went back to the banks and said, "Well, thanks for your offer in leveraging this at a four times leverage multiple, but we'll only take three." And they couldn't believe it. They said, "Well, you should take four. You know, we're offering you four. Why you wouldn't you take it?" And by the way, 95% of the private equity firms would take four. so this the the and the banks were were laconic with respect to and bad in their due diligence process. They basically kind of followed the lead of the private equity firms and kind of towed to the line of what the private equity firms were telling them. That has changed now and you know the banks are becoming smarter about who they lend to, who they work with from a private equity

45:16 perspective and how thorough their due diligence is. And the banks what happens is the banks work with a combination of the work that you provide them. So, it's sometimes good, I mean, if you want to get a bank on your side, it's good to have, you know, a thorough Bane report and a thorough KPMG report and a thorough management report done by a human resources firm and and you know, a thorough environmental report because it gets the banks over the over the over the hump to to lend you a large amount of cap capital for the transaction. So it has changed and the more thorough that your due diligence work is the easier the process is.

46:01 Okay. Go ahead. In regards to the banks is still the banks are still relying on on your due diligence or are they trying to get themselves into the data to engage their consultants? Well, I mean you have the banks have have have three sources of information, right? They have the information that they get from the investment banks, which is usually worthless. I hate to say it. I don't know who's an investment banker here. There you are. So, we're we're typically Erica and and don't but we're we're you know, we take the CIM and we love kind of like getting on the phone with the investment bankers and kind of saying, well, that doesn't make sense or you know, I'm really kind of grilling the investment bankers. but if we didn't start there, where would we end up? Of course. Of course. So and and by the way there are definitely I'm making a gross generalization but but there are definitely investment banks that do really really great jobs.

47:02 And it's not actually the big investment banks necessarily that do great jobs in putting CIMs together. There are some smaller investment banks like middle market investment banks that are incredibly thorough, incredibly reliable in the information that they give us. So the bank the banks work with three sources of information. They work with materials from the investment bank and the due diligence material that the investment bank puts together for the debt providers as well as the private equity as well as the buyers and they work with the materials from the private equity firms. And in some cases the bank is thorough. They do their own due diligence work. But it's very limited and it it doesn't cease to amaze me how limited the work typically is from from the bank. the they get on the phone they take all the material in they do their own analysis but they don't spend money themselves on doing their own due diligence work typically they don't go ahead each fund has its own way of doing business and is there any item in your

48:04 checklist that's like black or white just it's a no like for instance if you don't like management you can go like oh go change management hours are there an item that's very sensitive or items that are more sensitive than the rest well in your way of doing business. Well, what we one thing is that we stay away from kind of the financial engineering trickery. Okay? So, doing overpaying for businesses and using high levels of leverage and kind of thinking, you know what, we can wing it. we stay away from that type of stuff. And that's kind of a trader mentality to doing private equity. It's like buying an asset just for the sake of buying it and and assuming that you're on kind of the growth curve and thinking that you can flip it in two years. A lot of transactions were done that way. Okay.

48:46 Okay, so you'd buy a business for 10 times and you'd use a a seven and eight times leverage multiple in the transaction and think, you know, in two years we can sell it again because we're in a high growth market and you know a a exuberant M&A market and as long as we stay on that growth curve, we can make money that way. We've stayed away from those types, fortunately stayed away from those types of transactions. What we do is we really focus on the operating side of these businesses. We have about 60 to 70 excee of major for Fortune 500 companies, ex CEO of Coca-Cola, ex CEO of Ipsco, ex CEO of Campbell Soup, XC CEO of one of the largest spare aerospace and defense spare parts type of business. we bring these people in in an advisory capacity to transactions that we do in particular sectors. So we're very very kind of strategic focused, operating focused and we want

49:49 to buy businesses to create bigger, better, more profitable businesses. So we're not in the financial engineering game. We're about supporting actually and you're talking about management supporting management teams to take a $500 million business to a billion dollars in sales and how do we get there and then support that growth plan with an equity infusion. Now as far as management is concerned you have to do your due diligence in management because particularly in the middle market sector if you get it wrong with respect to ma management it is a huge headache to change management in the process I've actually just b gone through one in one of our portfolio companies and thank god it worked out fine but we made a mistake we did not do thorough due diligence we actually did not hire the people that we should have hired to do an evaluation of the entire management team. And we thought, you know what, that's I think these guys can can do it. And and turns out they couldn't. And we had to change

50:53 management. We had to change the CEO. And it was a huge problem. And you know, it it's incredibly destabilizing to a business. If you're doing if you do that to a a five billion dollar business or 10 billion dollar business, it's different because there's a huge organizational structure. typically in that business that is very very difficult to destabilize. So the CEO you know maybe it's you know people talk about it but it's not going to be incredibly destabilizing to the business. If you're dealing with a $500 million business it can be and you know there's some magic between the whole management team and the whole operations of the business. If you change the CEO then somebody else leaves the CFO leaves because they were friends and you know before you know know before you know it you have a big headache on your hands.

51:37 Go ahead. So just I'm just curious as to your views and your experiences and how you evaluate management. It seems to me to be one of the most toughest spots to really get your head around. I'm just curious as to what guidelines you follow or what you suggest in order to make sure you don't make a bad mistake. Well, I mean the easiest thing is is just to look at their their track record, right? So, what type of businesses have they managed in the in the past? And what happens is what you typically find is that the management team of a of a $500 million business that you look in their past and they've been there for 15 years and they've grown the business from hund00 million to $500 million. But can they manage a $2 billion business?

52:22 And the answer is probably no unless you give them a lot of guidance and sometimes we do that. So sometimes we make the bet on the CEO or the CFO for that matter. But when we give them a lot of after having run the reports and and after having these due diligence people come in, interview them and making an assessment of their core abilities. sometimes we need to complement their skill set with adding on other people or in some cases even giving them training as we go through the process. So, so the and you know the the firms that do these types of reports and these are the typical headhunting firms that have also a p whole private equity business to their to their services to their consultancy services. They do these types of evaluations and they come up with a whole report and they say, "Well, we think that this CFO has these types of skill sets, but if if if

53:27 you want to get take this business, if you're asking us if if he can manage a $2 billion dollar business, the answer is is no, but there are some solutions that we can provide rather than actually changing out the CFO. Okay, any other questions? All right. So, that's the, a quick quick overview of kind of the the the the due diligence work that we're constantly, faced with on a day-to-day basis and how incredibly important it is. We started doing some research and we said, "Wow, this this optical retailing business in the in the United States is huge. It's like a 20 billion dollar market. It's a very cyclical business." the incredibly competitive business but dominated by lens crafters and pearl and then also later on by Walmart that have you know if you walk into a Walmart you have these you can buy a pair of pair of glasses you can actually have your eyes checked and walk out of there you know

54:30 spending $60 or so and you have a pair of glasses eye care centers of America is another huge consolidator of kind of mid-market optical retaining stores in in the United States. large these stores are typically very large with an eye doctor on on on the premises and fairly low average ticket price. and actually this this has gone substantially lower also with the advent of mult Walmart and sales per square foot of about $400 per square foot. and these businesses were typically kind of high volume type of businesses with low margins, low store ibita margins. Okay, so not really an attractive business, you know, it's very competitive. Why why the hell would we want to get into this? So, but then we did some more research and when we looked at the luxury optical be retailing sector was this subse segment of the of the optical retailing business

55:33 here in the United States also in in Europe for that matter where there was a very small subsector was about $400 million in sales only 3% of the total market very fragmented ownership there were these mom and pop type of stores very small type of boutiques very high sales per square foot and a very high average ticket price and incredibly high gross margins. Okay, so these were mom and pop operations that were selling Cartier and kind of proprietary these very small proprietary brands and people were walking in there and spending $1,200 for a pair of sunglasses. Okay. So, or or spending $2,000 for, you know, gold rimmed diamond encrusted special Zeiss lenses type of glasses and very high store ibita margins. And also what you notice is that these businesses were non-yclical. that the people that frequented these stores were true luxury buyers that would buy were willing

56:39 to spend high dollars on these fashion accessories what what had really become and and regardless of the macroeconomic conditions these stores typically did well. So okay kind of interesting opportunity. So we started getting intrigued about this opportunity by looking at the industry and the competitive set and we said well you know what this could given the fact that there's such a fragmented ownership this kind of reeks of you know potentially an interesting consolidation play opportunity. Okay so what are the car who asked a question about consolidation play earlier? Okay, Carlos. So what what what are the characteristics of a good consolidation play opportunity?

57:27 What does it mean a consolidation play? Why the hell would you go through a cost consolidation play? generally you have to believe that well first of putting together these individual assets that there you'll have more advantages putting them together either from the cost side or revenue side. Okay. So there is value to add to consolidate the industry. but what what so just be specific. So what what kind of so you're consolidating these businesses whe what regardless of the industry what kind of benefits you have by consolidating them? So you can have in terms of suppliers so you can have just one centralized negotiation with an important supplier. Okay. you can so what does that do? Reduces your cost of goods sold, right?

58:11 you can have lower marketing costs because then you can have a unified brand and you can so you can get the same number of customers if it's only one brand. what else? So you said marketing, you said gross margins, marketing. What else? Benchmarking within the store just like knowing what works and what doesn't work. okay, you you mentioned something also revenue. So you can transfer best practices. Yeah. And has increased the overall revenue growth. Right. So best practices, gross margin, marketing. What else? I mean you reduce competition, right? You can get your back office in terms of GNA cost, you can really reduce that. There's a huge amount of leverage. and just I mean there there's an intangible aspect of it which is just by having more of these stores located everywhere and you create a brand awareness that potentially leads you to to be able to charge higher prices. Okay. Right. The the the thing that you have to realize with

59:15 consolidation plays that bigger is not necessarily better with consolidation plays. It makes businesses more complex. You really need to know what you're doing. the the whole the opportunities that we were just talking about are not necessarily always there and in fact in many cases they're not. But in this particular case in and particularly in the retailing business and the luxury retailing business and luxury optical retailing business, we kind of discovered by doing the due diligence that we were doing that you know what this actually meets all of the aspects of what good consolidation plays are really about. It's a large fragmented market. There no dominant players. very important that there are so many consolidation plays that have been done here in the United States and in Europe during the last 20 years where they do consolidation plays while there are a couple of dominant players in the market. Why the hell would you do that?

1:00:15 Oh no, just because we can be create a bigger we have a bigger share of the pie. Well, but if you're doing that with a dominant player in the market, you're dead in the water. So consolidation plays are actually in the in the truest sense of the word they could should be done when there's no dominant player in the market when you have a fragmented market and by consolidating that you become the biggest the the dominant player and the biggest player in the market. in this business. It turns out if you really looked at the luxury optical retailing business as a sub- sector from optical retailing business because these two businesses the mid-market type of business had actually nothing to do with each other. It sold different products. It was a whole complete different game. So you could look at the luxury optical retailing business as actually a business that was a business as its own. And by doing the consolidation of a bunch of these operators, you could actually become the dominant player in the market. Okay. So very important not to do consolidation plays with our dominant players because there's no point. so

1:01:20 consolidation will create an immediate market leader a large the other thing is is to find acquisition platforms that are relatively large. Meaning doing consolidation plays with hundreds of little players can be an absolute nightmare because the process of actually consolidating companies is very complex, very very difficult and the sum of the parts you end up with a with a with a with a bad business that that that has is is virtually like creating a new business. inefficient market very very important very very hard to find typically these businesses that operate in these businesses know everything about each other okay so it's very hard then to do a consolidation play because they all start talking and when they start talking what happens what's what's what's the problem of having a a very efficient market and trying to do a consolidation play in

1:02:23 efficient market what they start negotiating with each other exactly they start they start talking to each other. They literally pick up the phone and say, "Hey, were you approached by these guys?" "Yeah, so was I." So you start colluding and it happens. Trust me, it it happened to us. It happened to us in this situation. So now it h didn't happen in in such a bad way that we couldn't do the deal, but okay, gross margin opportunities have to be clear cost of goods sold opportunities. There are many consolidation plays that are done and people talk about consolidation about cost of goods sold opportunities because we're a bigger player and we can go to the suppliers and we get bigger discounts.

1:03:06 Well, if there's a dominant player in the business, you go to your suppliers, they say, "Well, so what? I don't care if you you've got, you know, I don't care if you're double the size or triple the size. you know, you're still not my most important customer and the discounts that you're asking for, you're not going to get them." And end of story, okay, because it's actually one of the most important aspects of the consolidation play that you have immediate gross margin improvement. Okay. economies of scale and operating expense opportunities. Clearly, by consolidating businesses, you need to have a clear and wellthoughtout plan, and you need to have done your due diligence and get people involved that really know what they're talking about when it's when you're discussing operating expense improvements and benefiting from the e economies of scale such as SGNA opportunities when consolidating all these businesses under one roof.

1:04:03 Because if you do it badly, it actually ends up costing more rather than less. Okay. Just kind of curiosity in the luxury market. How do you kind of press the supplier that where their brand is also extremely important and where you already have kind of a 65% gross margin because in this case by we were betting on the fact that we would become the most dominant player and I'll get into some of the aspects as to why we were the most dominant player after the consolidation but take Cartier for example example, right? They have they want to be in the highest end stores in the United States. Well, there only a handful of them, you know, the 10 kind of major cities here in the United States. They may have, you know, one or two kind of really high-end stores and Cartier wants to be in those stores. If you own all of those stores, trust me, they'll talk to you. Okay, go ahead. One question. one of the most important

1:05:07 issues in the luxury business is inventory management. And when you have much bigger scale it's much easier. So how do you factor this in your analysis if if gross margin is not possible to improve through this scale? Well, gross margin is import is possible assuming assuming assuming you'll get just a little I'm not sure to what extent the fact that you have a big scale kind of helps your investor see this and I'm asking to what extent is okay I'm going to get back to your question because it's actually the most one of the most important aspects of this deal that we discovered while we're doing due diligence while we're doing the financial due diligence that that's it okay I'm talking too long and too much all right so the what we I'm going to skip this. You already understood that this was a a consolidation opportunity.

1:05:57 you guys have done this a hundred times. Porter's five forces analysis. Don't forget it's really important. It really is. It may seem m mundane, but we do this stuff every single day. barriers to entry supplier power buyer power relationships with suppliers and you'll see down the line that it's a very important aspect in any case when we financial due diligence. So we look at the balance sheet income statement and the cash flow statement of the business obviously and and one thing not to forget is who is doing really the financial statements. There are thousands of privately held companies in the United States, large companies that are unaudited.

1:06:45 Okay. So, who's really doing the financial reporting? If major major red flag, if they don't have audited numbers, beware and get some really really good accountants to do the financial due diligence for the firm because you'll find a lot of mess and a lot of problems in those books. And you'd be surprised how many companies are out there that don't have large companies that don't have audited financials. Okay. in any case, when we're doing the financial due diligence of this business and when we were looking at the balance sheet, we discovered some interesting things. you were talking a little bit about the inventory. the biggest asset in this business, this is is obviously the inventory, right? This we're not talking about a steel steel manufacturing plant that has huge amounts of assets and needs a large amount of assets to generate its cash flows and its profits. This business the the only asset and the only real asset that the business has is

1:07:49 really apart from some intangible assets is really the the inventory. Now, it turns out unlike the middle market sector or the the the the the mid-tier kind of optical retailing business is the way that these guys were financing their inventory was incredible. I I couldn't believe it. When we were doing the financial due diligence, we discovered that these guys had 250 to 300 days payable outstanding on their balance sheet. What does that mean? What? Exactly. So, they're basically getting their inventory for free until they sell it. It turns out that the luxury optical retailing business has this kind of age-old business practice that you buy the inventory, but you don't pay. and you don't pay

1:08:53 unless you've sold it. So, but these guys all had, we started looking at one for the next acquisition target. It turns out all of these guys in the same situation. We couldn't believe it. They all had like 200 250 and we would ask them say, "Well, why haven't you paid your bills?" He said, "No, no, they never bother us." Okay, great. So, we these so what essentially was happening is that they were buying the inventory and they weren't paying for it. Not only that, if they didn't sell the inventory within 250 days, they would literally get a box, they would wrap up the Cartier frames, put a big sticker, Cartier SRL, wherever it was, and send it back, and they get a credit. Go ahead. So, that's obviously an attractive thing, but I would be worried about that as a buyer because you know, if they figure out that they own the inventory and it's just a matter of finding a customer, then I would think that there would be a lot of potential for competition from web- based u you know e-commerce sites that could

1:09:56 sell that inventory for them. In other words, it would sort of disintermediate the retail chain. No, because this is such a high-end type of business that the inventory that was taken back by the by the suppliers was actually destroyed. Go ahead. to Aaron's point actually there's another risk factor which is if the industry practice starts to change then your working capital most like firms like try to improve the working capital margin over time but if the suppliers start pushing down the AP days from 260 to 250 to 200 that would have that can have an immense impact on the cash flow of the business. Yes. So that would be a risk factor and you know what you hit the nail on the head because this is what happened. So, we went through all this financial due diligence and in the interest of time, I'm not I can't go through all of it, but you kind of identified the key aspects of this.

1:10:51 this we were going to do this consolidation play where we're going to have substantial benefits from a gross margin perspective. Now, just one little side note here. It's very very difficult to predict what those gross margins are going to be because you just don't know, right? So in your financial models and your kind of predictions of where the business is going to go, you don't really know. So here again, the due diligence and getting expert opinions and getting outside information and outside opinions in this whole process is very very important to narrow it down and that you really mitigate as much as possible some of the errors that you're bound to make in making these predictions in consolidating you know 10 or 20 of these businesses. So but we were pretty comfortable that we were going to get these gross margins improvements and in fact we did. We got we got our predictions pretty right from a financial perspective. We had KPMG in there. We did we we didn't find any red flags and if we did find them we kind of dealt with them. We did a very very good transaction. We negotiated very very

1:11:55 cleverly. It was a beautiful transaction. So, in any case, I've I've kind of jumped through this this whole due diligence process, but the the the point I'm trying to get across is is that when you do your due diligence work, and people have the tendency to think, oh, it's all about financial due diligence. It's not. It's due diligence really is a much broader concept. It's understanding the business, understanding the environment in which it operates and truly understanding the business's operating model and the people that are managing your business. And if you think of due diligence in that concept and you get the right people involved because you can't do it all by yourself, there's no way that you can do it by yourself because ultimately what we do is we are the managers of this process. We lead the process. we are the the the leaders of this team of, you know, 40 50 people that are working on a particular transaction that all know really well what they're talking about and and putting all of those pieces together.

1:12:59 And if you look at due diligence from that perspective and not think about only the financial due diligence, then you're on the right track and and it will mitigate some of the risks and it'll ensure that you don't make big mistakes that you're inevitably going to make in this business. and you learn from your mistakes. so we talked about the management and by the way just we had brought into this transaction an incredibly smart guy. Bernard Andrews is a former CEO of AIA Sensors America which was one of the largest players in the mid-market type of sector and he was incredibly valuable to us in how we structured this transaction. this was I was just talking a little bit about how we projected the business going forward, how we were going to grow the business. It was a combination of organic growth and new store openings and also acquisitions. We did a very thorough analysis of the exit considerations for this business. there were a lot of strategic buyers in

1:14:02 the sector that were very interested in buying a consolidated platform and that remains true to this day. and we still haven't exited this opportunity, but we will someday soon. Here are some of the the comps that we ran at the time. okay, in the interest of time, I'm going to skip forward and just talk about two last things. when you do a leverage buyout transaction, what are kind of the key and I I really want to leave leave this with you because this is really so important. The whole structuring a leverage buyout transaction is not that or let's say the concept of the leverage bio transaction is not that that complicated. you're leveraging cash flows. You're buying a business leveraging their by leveraging leveraging the cash flows. but what are what are the four key drivers of any leverage buyout model? What are

1:15:05 the four key drivers of your IRRs? Tell me. I tend to think of five, but I'll try to one is sales growth. Second is profitability. Yeah. Third is free cash flow conversion. Fourth is leverage and five I think is multiple arbitrage. Okay. right now what what are the what is the single single most important one of that of those five? growth generally operational growth because that gets multiplied. Okay. But what does that lead into? Stable predictable cash flow. Yeah. Okay. Just mention that. Sorry. of these of these four you mentioned five. what is the well they're correlated. what is the single what what's the single single biggest driver of your return of your IRS? I mean, if you're doing a leverage buyout model and you're playing around with the numbers and when you look at leverage that's

1:16:08 generally a onetoone gain. When you look at the growth in your free cash flow, right? There's a multiplier effect to and so that's really where the growth comes from your operational growth. I would say it's multiple arbitrage. Okay. where listen if you have the discipline of buying companies on the cheap and really being disciplined in that sense it's your single biggest driver of your returns and what I'm trying to leave with you guys is just do yourself a favor and don't overpay for businesses because if you overpay for a business you're going to be stuck with it for years and even if it's a good sound cash flowing business you you try and sell it and you're still going to be disappointed with the returns of the business because you overpaid for it. And multiple expansion and multiple arbitrage by creating bigger, better, more profitable businesses and by really doing some hard work and spending the money on improving the business and really making a great

1:17:12 company out of it. That's where you really get your multiple expansion because people want to buy great businesses. People will buy great companies. People will buy companies that are well-run. And if you find companies that are run so so and you can really fix them and improve them and make them bigger and better, you're going to make a lot of money in the whole process. And