David Kirk Interview With Private Equity Media
Fund Manager Q&A - David Kirk
By Adrian Herbert
As published in Australian Private Equity & Venture Capital Journal, November 2017.
Q: Why did you decide on a listed investment company model to raise additional capital for Bailador? A listed company obviously provides capital raising advantages over the conventional investment fund model, but doesn’t it open up additional risks through the unpredictability of the stock market, particularly noting that listed investment companies often trade below their net asset value? And surely that is likely to be exacerbated in a volatile area like technology investing?
A: “There are several reasons. The first is that at the time we were thinking of expanding our initial private trust; we had three investments. They were all going well; we didn’t want to sell any of them, but we had used up all our capital.
“The traditional way to raise more capital would have been to sell an investment, return the money to investors, ask them to commit their money back and go on to raise a larger fund. But we quickly decided that it didn’t make any sense for our loyal trust investors to sell them out of our best investment. We could see a lot of future growth and wanted to hold that investment significantly longer.
“That business was [online hotel room distribution technology company] Siteminder. At that time, Siteminder had a valuation which would have returned us about three times our total investment. Siteminder is now valued at over eight times the money invested so it is clear we were right not to sell.
“That led us to consider a broader issue. In technology investing you are going to find that if you identify a great new investment in year four or five of a conventional 10-year fund you are going to be really up against the wall with the fund length –you really won’t want to sell that business early but you are likely to be required to do so to return money to investors.
“It seemed that a conventional 10-year private fund wasn’t the best vehicle for this type of investing, bearing in mind that in technology investing the best investments are addressing global markets. They can grow to be huge, but that is likely to take more time than an investment at year 4 or 5 in a 10-year fund can accommodate. Take a company like [small business accounting software business] Xero (ASX: XRO). Say your fund had invested in that business in its early stages about ten years ago. The company is still in the expansion phase now and the value is continuing to go from strength to strength. It would have been very regrettable to be required to sell.
“Secondly, we felt that a model where you would have access to permanent capital to build up a portfolio for the longer term would be better. The manager would make investments as opportunities arose, and would make sales similarly. Cash would be returned to the fund, distributions would be made consistent with our stated policy and commitment to shareholders. But the fund would still be able to retain some of the capital returned and continue to invest that to compound returns for investors.
“Third, a publicly listed fund opens up the opportunity for retail investors to invest in expansion stage information technology, an investment class which has only previously been available to high net-worth investors and to private venture capital funds. We think that it is compelling.
“Finally, we knew a public fund would provide an opportunity to raise capital efficiently, particularly time-efficiently. The time it normally takes for principals to go around raising capital could be focused on making good investments and helping grow the value of those investments.
“Now, to address some of the potential downsides. There was always a risk − and we have seen that risk come home to roost in the last year − that we would trade at a discount to net asset value (NAV). In the first 18 months to two years since listing we traded a little bit below NAV but close to NAV. In the last year that has drifted off, largely, we believe, because of a lack of news flow. The main news the investment community is looking for is crystalised valuation and capital return through exits. We do adjust the valuation of our investments when there is a third-party investment or they have operated for more than 12 months without a change in value − the value of eight of our ten investments are now validated by third-party investments − nevertheless, we hold our investments conservatively because it is absolutely in our interest to make sure that when we do exit we exit at a price that is significantly above our holding cost.
“We haven’t had any exits but the average increase in valuations of our investments over the last year was 27 per cent so we have had pretty solid increases in the individual valuations. We haven’t had a full exit, so we have not had the big media event and been able to return money to shareholders yet. That has seen our share price drift off. Shareholders will have different views of what is the appropriate way to think about an investment, but for me, and what we have tried to stress to our shareholders, is that this is a long-term investment. Short term movements in the Bailador share price really have very little relation to the value of the 10 investments in our portfolio.
“These companies will grow in value over an extended period of time. They have got a great tailwind from the growth in technology and opportunities to grow to service huge markets. They have also got great growth economics; very little new capital needs to be invested in them once they reach a certain scale. We are very confident that the great majority of the companies we are invested in are going to deliver great returns and the reality is that, regardless of the share price discount to NAV, what shareholders will receive in distributions following exits will be determined by the NAV and the exit price. Shareholders’ returns are not, in the end, related to the share price on any given day. They are going to get the value of the company when it is exited.
“That is absolutely no different from a private fund. But with a private fund you don’t have the public day-by-day marking to market. So, if you have got a calm head and agree with Warren Buffet and Benjamin Graham that Mr Market is a manic depressive – over-valuing one day and under-valuing the next – then it is of no particular consequence that the market misprices the assets today. If you are a long-term investor and you hold your investment in Bailador, when we start to exit you will get the value of the investments at the time we exit them. Because our investments will be converted to cash, returns to shareholders will be based on the value of each exited company. We figure the market will be smart enough to give us dollar for dollar for cash when the time comes and some of that will be distributed directly shareholders.
Q: You are saying Bailador shareholders should be patient and pick the time they sell shares to take into account exits made by the company?
A: “Yes, I agree with that, but ideally we don’t want our shareholders to exit at all but remain patient investors and enjoy the long-term growth in value of our investee companies. Of course, that is the same for many companies, but I think you need to go into an investment in a portfolio of technology companies knowing that it is a medium to long-term investment and that the underlying companies, while having great prospects, are relatively small businesses at the beginning. By relatively small I don’t mean that small; typically they have $5-$10 million of annual revenue at the time of investment and in 2017 the portfolio grew at an average of 37 per cent.
“These companies are growing revenue at 35-40 per cent so you can see that value is going to compound quickly but it will take some time and we don’t want to sell them early and nor do we want to mark up the values too quickly. We want to see the companies growing steadily and grow faster than the valuations at which we hold them and expect to sell them.
“We have only been listed for three years. While I totally accept that is a long time for shareholders to have to wait to see our business model justified by an exit, the fundaments are that the underlying portfolio is doing well, we have a lot of confidence in the businesses we have invested in, and shareholders are going to see great returns when we do make exits.
Q: What do you see as the key advantages of a listed investment company over the conventional private ventured capital fund model?
A: “I would say permanent capital which allows us to invest and re-invest; fundraising ease and the public company structure.
“Although private fund managers might take a different view, I like the discipline of working in the public company space; the discipline of audited accounts, monthly NAV statements, having to communicate effectively with two or three thousand shareholders and having to present at annual general meetings. I think those are good things not bad things.
Q: But, operating as a long-term investment company, isn’t it hard to orchestrate news events that will excite stock market investors?
A: “Yes, that’s right. There are lots of things going on all the time and every month you can read reports of what investee companies are doing − you can see that they are making progess in all sorts of ways − but the big event, the sale or partial sale of a company for a high value, a liquidity event … that comes along somewhat infrequently.
“That said, it is difficult to find a better place to invest your money than in a great young company that is growing well. Look at Siteminder, it is still growing its revenue at about 40 per cent a year and is probably growing its value at a similar rate. It is difficult to find anywhere to put your money where you are going to get a capital gain of 25 per cent a year or more, compounding. You just don’t want to take your money out of an investment like that.
Q: Bailador has a narrow focus on internet-related businesses. Isn’t this a rather risky approach? Wouldn’t the risk profile be improved by including other areas, maybe medical technology or high technology manufacturing?
A: “The focus is internet-related businesses and IT generally. We focus on those sectors because we know the business models and we are comfortable with them. This has led us to make investments in software as a service (SaaS) businesses and online marketplace businesses. Our most recent investment [online furniture business] Brosa is an e-commerce business and is the first such business in the portfolio. Brosa has a different economic profile to the other businesses in the portfolio but we like the look of it.
“Our investee companies operate a range of different business models and, given they are generally addressing global markets, there is no constraint on market size. Two of our businesses, Lendi and Brosa, only address the Australian market today but both are addressing huge domestic markets, in mortgage lending and furniture retailing respectively.
“So, I would say the main answer to the question is that we are good at what we know, and we believe we have selected the best economic growth models. Now, if we were to consider investing in medical technologies, say for example medical devices, in that case we would have manufacturing risk and working capital requirements associated with the physical device.
“We don’t have to deal with any of that. Capitalised development costs are equivalent in some ways, but we know SaaS and we know marketplace businesses. We have a pretty good understanding of e-commerce businesses as well, so we stay within our area of expertise.
Q: Bailador invests in businesses that have an established business model and proven revenues but with the team’s knowledge of your area of focus couldn’t you invest at an earlier stage at lower valuations?
A: “Yes, certainly. But we are very careful about valuations at the stage at which we invest. We would pay lower dollar values were we to invest at an earlier stage, but at a higher valuation multiple − usually multiples of revenue − so in that sense they would not be less expensive.
“We are comfortable investing at the stage at which we do, and at the larger dollar valuations because we feel that businesses at this stage are significantly de-risked. The risk return profile is better.
“We also feel more comfortable with an investment strategy which sees us highly engaged with the companies in which we invest, sitting on the boards, working closely with other stakeholders and with founders.
“With the $130 million fund we have today, investing in early stage businesses, which would mean putting $500,000, $1 million or $1.5 million into lots of different companies, would mean we would be invested in a lot of companies. In a way we feel that is more a strategy of spreading money around hoping for the best. We would not be able to be as engaged with investee companies as we are.
Q: You feel it is better to use your team’s knowledge to pick the companies you consider have the best potential for success and engage closely with those?
A: “Yes, because we are so closely involved with our investee companies we can only have a small portfolio. We have six investment professionals and we are all very involved.
Q: Bailador exclusively makes minority investments. Wouldn’t the interests of your shareholders be better protected if you made majority investments and gained control of the investee companies?
A: “Our initial investments have always been significant minority holdings, but we have moved to majority investment in one case over time by making follow-on investments. But generally we take minority investments and rely on significant minority protections in the shareholders agreements that we negotiate.
The most important point is we are working in partnership with founders and founders are crucial to the success of these companies. They have worked hard for three, four, five or more years to get the business to the stage it is at when we invest; it is their energy, their drive and their vision which is going to make the company successful.
“The nature of our investing is that we provide capital to support entrepreneurs in growing their companies. That does not really fit with having a majority stake. All of our protections are for the downside so that if things don’t go well we have some protection. But in terms of the upside we are hand-in-hand with the founders and that is the way it should be.
“We are there to support the founders. We help them recruit staff and set up the right organisational structures, but they have to run their businesses and achieve success.
Q: Do you only invest in businesses where you are convinced the founders are the right people to be running the business?
A: “Totally. Technology, market opportunity, growth momentum, size: they are all very important things but the most important thing of all is the quality of the people.
Q: Will the number of investments be limited by the size of your investment team?
A: “Yes, we have got six investment professionals and that currently limits our portfolio to around the current size. There are ten companies in the portfolio. We could possible go up to eleven or twelve. We are on the boards of all investments except one, where our investment is not large enough to justify a board seat, and we work closely with all the companies. Six investment professions is probably the right number to work with 10 to 12 portfolio companies.
Q: So, there are unlikely to be many more investments as Bailador is currently structured?
A: “Yes, that is correct, but the investment company’s value will grow as the individual portfolio companies grow.”
Q: One investment team member, is now working in US. What does that mean for management of the portfolio?
A: “Well, it is an exciting development. Andrea Kowalski is Canadian and she wanted to go back there for family reasons. So, it was partly her initiative, but we sat down and talked about it and determined it could be great for us having a team member based in North America. She is now resident in New York and three of our companies now have their head offices in the US, one in New York and two in Silicon Valley, and most have an office in the US. Andrea is able to work closely with portfolio companies over there, being in the same, or a close, time zone.
“But most importantly, because Andrea is in the US she is going to be able to help facilitate exits. Many of the world’s largest tech companies − the companies that typically acquire developing tech companies − are in the US as well as a lot of legacy companies that will need to buy technology companies to make the transition to internet-related business models. Consequently, we feel confident many of our exits will be to strategic buyers in the US. Having Andrea there to meet their teams in person and work with them and help manage the exit processes with advisers on the ground will be great for us.”
Disclosure: The writer holds shares in Bailador Technology Investments.