Avoiding Bad Deals and Recognizing Competition

Welcome back!

Today we’re going through another round of explaining my investment analysis process a bit. These are some “second-level” considerations to think about when making an investment decision.

Sometimes when looking at a private credit or public credit loan, I often wonder what the hell the analyst underwriting this must be thinking. Do they just want to put money to work? Why aren’t they pushing back on this answer, or on this credit docs point?

I wanted to write about how to figure out how to avoid the pitfalls of investing in a bad deal in a hot market. As I kept writing, I realized a lot of it comes down to reps, process, and fundamentally understanding what the company does and who they compete with.

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Sometimes, there’s some real headscratchers in the market, where I’ll take a step back and think “This doesn’t seem like a good business, why does everyone love this?”

Well, I’ll tell you what, I’m not an old guy, but I’m not a green guy, I’ve seen a lot of the companies that issued debt when I had just started my career subsequentially file or have to restructure. Companies that were doing fine for 2-3 years and then it fell apart. And companies that were slow out of the gates, never quite meeting their base case, and eventually just dealing with an unsustainable capital structure.

I think it ultimately comes down to the fact that these companies had something going on from a competitive or industry standpoint that folks glossed over. It wasn’t in the CIM, and it wasn’t inherently obvious. Or maybe it was an obvious risk, but investors thought it was manageable.

A lot of this may come down to not understanding the competitive forces a company is dealing with. While there’s a lot of risks for why a company may fail, I think a lot of it fundamentally comes down to competition and not giving your customer a great value prop. Maybe they’re also losing share to a direct competitor or to a technologically enabled competitor who is going to cook them.  

In this edition, I want to talk a bit about trying to think about how a company stacks up vs. the competition. Some of this comes from being able to answer the following questions:

Obviously, there’s more questions to internally ask than these, but it’s a good framework, because, to be frank, figuring out who gains and maintains market share is harder when your initial set of materials are pretty lender decks and CIMs (coupled with brief and non-substantive replies from bankers or sponsors).

1) Identifying how much market share your company has.

2) How they compete.

3) Who the upstarts in the industry are and how viable they actually are. It’s pretty hard to unseat an incumbent overnight, but you’d be surprised by how lackadaisical some companies get.

4) Whether there’s tech or e-commerce pressure.

5) Whether margin pressure is to be expected – how they price products vs. how pricing has been historically.

6) Is there limited differentiation in competition or is it possible to build a moat and build a customer advantage? Is this a sticky product? Is this a must-have or is this a “nice to have”?

7) How are new customers funneled in and retained? What is the distribution and funnel?

8) What’s the alternative? This is probably the most important question that gets glossed over – put yourselves in the shoes of the consumer or decision maker and figure out if you would actually buy this. It’s a great exercise.

9) Why do customers actually need this and what are they buying or not buying instead?

10) What are their customers/counterparties doing? What do the customers/counterparties think? Are the counterparties trying out new solutions or seeking alternatives?

There’s countless other examples and frameworks I included in my Conducting Initial Due Diligence and Nuts & Bolts Analysis HYH Premium pieces.

Here’s a defining weakness of companies that let themselves get eroded by competition: One key lesson I’ve learned is that some of the Companies that end up doing poorly are Companies where their customers HATE them. This is far from a one size fits all approach – but in a lot of stories it’s true. Consumers for example might hate their practices and find the company predatory. That’s not a relationship to have if your product isn’t painfully sticky. People could hate their Gym subscription, but they don’t have to be stuck with them for too long. That’s why the FTC making canceling very quickly is a big win for consumers, but bad for more predatory consumer companies.

Of course, I don’t want to say these are all bad businesses - you just need to compare them to relative value and define tail risk. Everything has a price. You just need to be appropriately compensated. S+275 vs S+450 is material, as is S+550 vs S+750. Everything has a price, you just have to find it.

Some companies that customers hate are still good businesses:

I did a survey once asking people on Twitter what are companies where customers hate them but they’re still successful. Among those examples were Airlines, Banks, Health Insurance companies, Cable companies (Comcast was mentioned a lot, they’ve actually struggled with the decline of Linear), credit card companies, and phone companies. People hate how much health insurance premiums cost, but you’re stuck with them.

But we’ve seen a lot of firms in this industry fall off. While I think the blocking of the Spirit Airlines sale was really dumb, a lot of people celebrated the downfall of Spirit due to their poor customer service. I’ve never taken Spirit just because of the bad reputation they have tbh.

As for some of these cable companies, there’s been a lot of distress there as customers are churning away.

Tbh, if a customer doesn’t need you and there’s limited switching costs, then having a poor reputation will come back to bite you.

Figuring out if the deal is a bad one:

I feel like this is the hardest thing that a lot of finance professionals deal with. Given they’re more deal guys, they may not have the actual touch of using a product and wearing the hat of a customer, or the company man who knows his product inside out. If there’s a software you can demo I would go demo it. If there’s product reviews you can read, so do that. Especially among industry expert blogs. There’s a lot of software developers who rate the software they use on websites.

This tweet below was very timely - it’s a good reminder a lot of the execs at these companies hate our guts and think we’re morons:

There’s another weakness too – and that weakness is relying too much on GLG or other expert network experts. Some of those conversations I love. Sometimes the light just clicks and you’re like “holy shit” I get it now, this company is so fucked. Other times you’re listening to someone who is shooting from the hip, doesn’t have a full understanding of the situation, or is too far removed from what’s actually going on. Some are spiteful ex-employees who got let go. Some are literally googling stuff on the fly while you’re on the phone from them. But hey, sometimes I absolutely love these calls. I don’t mean to sound like a total prick, but sometimes you walk from these calls thinking – “Jesus Christ, this guy spent 30-40 years in this industry and he still doesn’t know anything”. This is an unfortunate takeaway that happens. You get a guy who tells you a war story or has funny anecdotes, but lacks substance and was like a passenger at his company for dozens of years. This happens in corporate America all the time and is why anec-data is tough to take to heart sometimes.

There’s two other ideas to learn about industries or companies you can toggle through though: 1) A lot of random arb is found via YouTube videos. I actually learn a lot from watching YouTube videos – whether it’s via marketing materials the company put out, customer reviews, or an industry expert talking about it. I value this a lot as a visual learner. Secondly, I recommend X and then go search the ticker. The downside is occasionally a bunch of crypto tickers now flood the tickers you were initially looking for. But it’s still very possible to find some candid takes from equity professionals and customers.

There was an amusing scene in Succession where Logan Roy asks Kendall what his big plans are for improving the company. Kendall mumbles through his answer with a bunch of nonsensical jargon and Logan laughs at him. My point being, regurgitating the CIM or the 10-Q only goes so far. What matters is being able to actually explain the mechanics of a business. This is part of why I’m a big believer in doing & executing being substantially more valuable than reading and studying.

What’s also easier to forget too is that if you don’t like the answer you’re getting or think you’re not getting enough information, then you can always say No and not accept the seller or sponsor’s answer. Sellers need to understand that if they can’t address your concerns or elaborate on a key part of the investment summary then that might be a red flag or warning sign on proceeding further.

I’ve really pissed people off over the past few years by asking the same question over again. And I do so because I fundamentally don’t understand or accept the answer. A more challenging diligence point is not a 2-4 sentence response. You shouldn’t accept an answer if it doesn’t feel right in your stomach - the best PMs/MDs have curious minds and press further when they don’t accept an answer.

Reps matter: At the beginning of my first year when I did buyside recruiting I felt like I was fumbling the bag a bit in terms of landing that next great seat. I think I was, but I think I also didn’t have enough high quality reps early on. Going through the same process over and over again, with precision and continually improving execution, is how you become a better investor. And it’s how you start flying through building investment memorandum materials faster. The quantity of how often you do something, coupled with the quality of your work, is how you can become a pretty sharp investor by the time you enter your late 20s. What you’re still missing at that stage is experience, and the benefit of seeing things another thousand times over like more senior guys have, but that’s what the Investment Committee is for – the wise and older members who dictate future investments are the ones who have been around the block and are getting paid for decisiveness. But my point is, you are much more useful as an investor at age 27 than you are at 24. I believe there’s a significant jump up in sophistication around that age range.  So seeing deal flow, putting together investment materials, building models, and doing all the key investment steps over and over again (while following the right framework and never deviating) can really set you up well. That’s why it’s somewhat hard for people to pick up a new industry (regardless of age and experience).

There’s a lot of benefits from seeing a company from a 5-year investment period as opposed to having only spent a couple of quarters on the name. This is why the shops that go really deep on diligence, or the shops that have had the same guy or team focusing on healthcare for a decade, can benefit from reps and deep diligence as opposed to too much of a generalist and bouncing around coverage strategy.  

That’s all for this edition. Until next time!

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