Doug McCormick | How can M&A Masters tap into the power of human capital?

In this episode, I’m joined by Doug McCormick, Managing Partner and Chief Investment Officer of HCI Equity Partners.

He’ll give an inside look at his firm, which partners with family and founder-owned manufacturing, services, and distribution companies in the lower middle market. Doug will break down his firm’s unique strategy that transforms businesses through 3 initiatives. He’ll also share:

  • Why human capital is a gamechanger
  • How his firm’s history has shaped its strategy
  • Why building a team is an art, not a science
  • Insights about helping business owners build legacies
  • And more

Mentioned in this episode:

Transcript

Patrick Stroth: Hello there. I’m Patrick Stroth, trusted authority in executive and transactional liability and founder of Rubicon M&A Insurance Services. Now a proud member of the Liberty Company Insurance Broker Network. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here. That’s a clean exit for owners, founders and their investors.

Today, I’m joined by Doug McCormick, managing partner and chief investment officer of HCI Equity Partners. Based in Washington, DC, HCI Equity Partners is a lower middle market private equity firm focused on partnering with family and founder-owned manufacturing services and distribution companies. And Doug it’s a great pleasure to have you. This is a much celebrated HCI Equity. Welcome to the podcast today.

Doug McCormick: Hey, thanks so much, Patrick. I appreciate you having me on. And I look forward to the discussion.

Patrick: Fantastic. Well, now, before we get into HCI Equity Partners, let’s set the table here with you. What brought you to this point in your career?

Doug: Sure, sure. So first of all, I’ve been in the private equity industry for a little more than 20 years. I think, like many of your other guests, my segue into the industry was investment banking. And so I spent a couple years in Manhattan at Morgan Stanley doing M&A and financings. And while I liked the transactional nature and the content of that, I think I was intrigued by the opportunity to think about a bigger sandbox, and not only be thinking about the transaction, but thinking about the investment implications. And also, you know, how to be a business builder, and the tools that would be required to do that.

So I think it was just an intellectual curiosity more than anything. And I think investment banking is a really good training ground just in terms of understanding the mechanics of transactions. I would note, because I think it’s influenced my thinking in the industry, I had a bit of a non-traditional role before my time at Morgan Stanley. So I was at West Point. So the academy as an undergrad, did active duty time and then migrated to business school. And I say that because the active duty experience was a pretty formative experience for me.

And I think the thing that I would say, to kind of bring it back to my job today, you know, I think one of the big, under-exploited opportunities in private equity is really about practicing leadership, about building good teams and thinking about human capital very strategically and broadly. So I think that’s really interesting and a fun part of the business. But would say in my current role, you know, I’m Chief Investment Officer, but I think, in many ways, you know, Chief Human Capital Officer, and that’s not only fielding the right team at HCI, but fielding the right team at the businesses we’re trying to build, so they can go successfully execute.

Patrick: Yeah, I will delve into human capital a bit. Because I believe that’s one of the newest superpowers out there that if you know how to tap and you focus on it, you can, it’s a game changer. Now, as we look at HCI Equity Partners, I mean, a lot of times we learn a lot about where a company is going by looking at where it’s been. So could you share with us with HCI Equity Partners, give us your history, and then the strategy that you were implementing now.

Doug: Sure, sure. So first of all, we’ve been at it for a little more than 20 years, with one of my co-founders, Dan Dickinson. You know, I think our history has really informed our strategy. You know, so we have had the luxury of really growing up in the industry for the last 20 years. And as the markets become more mature, we’ve had a lot of repetitions to kind of figure out what’s worked well for us and what hasn’t. And I think that’s reflected in our strategy, which I’ll talk about in a minute. But I would say like, fundamentally, you know, again, I just mentioned the human capital aspects of the business. The most differentiated part of HCI really is our people and our culture.

So we have a great team. 24 amazing team members. They’re all relatively long-tenured, except for folks who have joined us recently. We have a great culture. This business is so intense, that, you know, we work hard, and but we also play hard, and we enjoy each other. And I think that creates an environment where people can have fun, feel challenged, live the life they want to create with family, and also feel like they’re part of something bigger than themselves. And so I think, you know, that’s really how we try to like differentiate ourselves in the marketplace. Maybe I just speak a little bit to, you know, kind of our strategy.

And you hit on it, but essentially, we are working with founder and family-owned businesses predominantly, and we’re trying to really transform them through three collective initiatives. The first is consolidation right. Helping them execute M&A to build not only a bigger business, but a better business through acquisitions. We, if you look at our team, we have a pretty mature operations team. And we view that as a critical resource as we help these companies scale. And then the third element back to what I talked about before.

Really team building, and just acknowledging that, you know, if we’re going to grow a business by 10, or 20x, that’s going to require not only, you know, more labor, but it’s going to require a different kind of leadership and different capabilities. And so we support our platform teams in growing their team, commensurate with the business we’re trying to build. You know, for a lot of reasons we’re super passionate about this strategy. I think the thing that’s so interesting to me about it is most of the value we’re creating is about the quality of what we can do as owners, not so much how to underwrite the business or buy it attractively but rather, can we partner with a management team and help them realize their vision?

I also think it’s, it’s great because it works in all kinds of markets. If you’re if you’re a transformative business, through M&A, operational excellence, and human capital, good market, bad market, I think you can create good value there. And essentially, you know, I talk about those three, those three initiatives. But we view the strategy as teaching businesses to be very good consumers of resources. And that resource could manifest itself in working capital, additional growth capex, m&a, people, or the operational tools that we can help them provide.

So I think that strategy has had some great successes for us. I think it has good prospects in terms of generating investment returns. But I’d also say there’s a real sense of accomplishment, right. We expect to build bigger, better enduring businesses, that are good experiences for the owners, good experiences for the employees, good experiences for the customers and all the constituents around the opportunity

Patrick: Well you’re mentioning, and a whole number of points that I’ve made on this show and why I love working with organizations like yours, and trying to highlight, you know, HCI Equity Partners out there to the marketplace, because you’ve got so many owners and founders out there, that they reach this inflection point. They’re too big to be small, and they’re too small to be enterprise. They don’t have the skill set or the knowledge or the experience to take that next step.

And if they don’t know any better, they’re going to default to maybe a strategic that doesn’t have their interests at heart, or some other institutional exit that, you know, isn’t quite the fit, and they need to know where to turn. And I think that what you’re doing is, rather than just creating something and launching it off and hoping it does well, you want to enjoy the journey. And that’s nice when you and the HCI Equity team is in alignment. I think, you know, with what you’re talking about right now, that must persuade a lot of owners and founders who are probably being pursued by more than just you.

And I think you make a real persuasive case. The other issue is with the issue on the human capital, which I’d like to ask a little bit about more, because, you know, let’s talk about that. Because I mean, is that just rallying, quote, unquote, the troops, but is it rallying the employees, is it management? Let’s talk about that. Because that’s among the things that HCI Equity Partners brings to the table that others don’t. So share with me a little of that.

Doug: Yeah. So I think it’s a number of things. And, you know, candidly, I think about a lot of aspects of the private equity business as science. Like so I think underwriting, q of e, insurance, you know, that’s very tangible, tactical, and the answer is often, right or wrong, black and white. When it comes to building successful teams, I think this is a little bit more art than science. So I think it starts with alignment of vision. Do we all agree on where we’re going? Are we all inspired by you know, what we’ve laid out from in terms of plan? And then I think it relates to things like org design, right?

Like if we’re going to dramatically scale the business is the organization, is the human capital organized in a way that can scale with the business? And then do I have the right people in the seats? And am I supporting those people with the right tools, whether they be IT tools, or whether they be, you know, kind of equipment? And then I think all of that is kind of encompassed by how do we create cultures where people can grow and aspire to great things and make mistakes, but then of course, correct quickly.

So I think it really is a journey that starts with alignment of where we’re going, and acknowledgement that the journey is bigger than the individuals and trust that people are going to work through tough situations together. And I tell you, listen, all these things. They’re always a journey, and they always turn out differently than you expected. And that couldn’t be better. It could be worse. It could be just bumps along the way. But I think an important part of that journey is the trust that you have competent partners who, you know, are kind of there with you for the long term.

Patrick: I think what’s great about this is that what you’re providing to everyone is a purpose. I think that we all in this society, I mean, we have to provide for our families, we have to, you know, pay our own bills, and do that and live our lives. But you know, it’s more than a job. If you could be lucky enough to have a purpose. And it sounds like that’s what you’re facilitating for everybody. And I don’t think you could ever lose in that. If it’s not a fit, it’s not a fit. But my goodness, that’s a great value add.

Doug: Well, Patrick, my sense is most of the entrepreneurs we talk to, right, they’ve kind of got gone through several stages of life, and they’ve accomplished a lot of the financial goals. And I think once they become, you know, financially comfortable, I think they care a lot more around, hey, what’s my legacy going to be? I’ve started this business, and it’s in my hometown, and I know, the employees and my customers in the community. And I want this to be financially very attractive. But I also want to put the business with a steward, who can help it fully realize its potential.

So I think that’s an important part of what we do. You know, it’s, and it doesn’t, it’s not a fit for everybody, right? So it’s not just about making the financials work. It’s about making the financials work with someone who’s aligned from a values and vision perspective. And just big picture, I would say, and this isn’t about HCI, but it’s about private equity in the lower middle market. You know, I think it’s a great aspect of the American success story that’s under-told, right.

And so, you know, for entrepreneurs, an important part of the entrepreneur lifecycle is a successful exit, right. To turn your life’s work into capital that can fund consumption for the rest of your life and your family. Like, that’s an important part of that journey. And I don’t think we’re celebrating it enough as a society back to your point. I mean, that’s a wonderful part of the American dream.

Patrick: Yeah, absolutely. With this, because you’re in this perspective at the lower middle market, is that why HCI Equity has been around for 20 years. You haven’t gone upmarket, you’ve stayed around here. Is that why?

Doug: We’re also acknowledging that the skill set of what we do fits very well in this market, and it doesn’t necessarily translate well into to the bigger market. So you know, we’ve developed a set of tools, we develop an operations team that pairs very well with founder and family-owned businesses who are looking for an institutional partner. And so we’re pretty committed to running that playbook successfully delivering good product to our investors, and being you know, along for the ride with our operating company partners.

Patrick: At the opening, I mentioned that you’re focusing on owner-founder companies that are in the manufacturing services and distribution which I would almost call it industrials. Okay. Explain why that sector or sectors for your focus. And in that, you know, give us a profile of your ideal target. What are you looking for?

Doug: Sure, sure. So, first of all, I think the reasons we target those areas is we’ve had historic experiences. So candidly, some of it is where do we have an angle? Where do we have a competence, where we can bring that to the team and have them benefit from it? I think the other, the other thing I would say is, if you think about those kinds of businesses, for the most part, we’re not trying to compete with businesses where we’re buying a lot of intellectual capital. And meaning that we win every day by the quality of our execution and the quality of our people.

And so if you think about the strategy that articulated about building exceptional teams, the business models that we are pursuing are pretty well aligned with that. So we also think there’s better value there. Better value in the context of how we buy assets, but how we can, you know, create value through scale and quality of operations. You know, is you think about, like, what does it bring to, I think, you asked what does it bring to the table for the potential partner?

Patrick: Yeah, yes.

Doug: Listen, I think first and foremost, like, we intend to be and think, we are pretty good partners. And that means, you know, we’re leaders, we bring integrity, and we try to add value. I think this market has evolved in such a way that many sellers want reinvestment opportunity and they want someone that they can believe is going to help them realize the full financial potential. And in many ways, I think we view ourselves as facilitators to help them build their vision, right?

So we can be their M&A arm, we can help them build the team, we can support them with the operational challenges, and really help them evaluate investments that will be required to scale. So could be opening a new facility, it could be expanding into new territories. And we’re pretty well equipped to help them, you know, basically support the analysis and then help them think about getting the assets in place to do that. I would just highlight briefly, I think a lot of private equity firms have developed this operational capability. I think ours is differentiated around two areas.

The first is, we’ve been growing it for the last decade. And it started with what I would call operational excellence. Like, how do we do our businesses with the most productivity and efficiency possible? So it was very cost-focused. How do we take out costs? How do we buy freight better? How do we drive manufacturing yield in a way that’s going to be cost-efficient? And what we’ve discovered over time is that’s a really important part of the journey.

But there’s also a whole set of skills around how do we implement salesforce excellence? How do we drive a financial function that’s got great excellence? How do we use IT strategically? And how do we use human capital? And so we have a member of the team that focuses exclusively on org design, you know, recruiting, retention, incentives, etc. So I think that operational capability has really become, you know, one of our secret, kind of secret sauces, if you will.

Patrick: Yeah that mixes with the cliche out there. And people think about private equity as well. They’re just going to do some financial reengineering. And then you know, cut costs and so forth. And then voila, you’ve got a better return. And so and you’re completely the antithesis of that. Is there anything with regard to you know, your proximity with Washington DC? Or talk about your region.

Doug: Yeah, so actually not really. So I’m a, as I mentioned, former military guy. So we have done, you know, probably 20% of the portfolio has been defense products related or federal services. But I wouldn’t say it’s like the core of what we do. There’s a little bit of overlap there from DC. But honestly, like, we just think DC is a great city. Love the kind of work-life balance of the DC metro area. And we’ve been here for 25 years. So it’s just it’s been a good mix of great talent pool in terms of attracting good team members, good quality of life.

Patrick: Well, one of the things that’s really helped the explosion of private equity are just the volume of successfully closed M&A deals. And a lot of that success over the last five years is directly tied to an insurance product called reps and warranties insurance. And what it does is it transfers a lot of risks away from the deal parties, rather than pointing fingers at each other and getting contentious. There’s a way where risk is transferred to a third party with very deep pockets, and it enables negotiations to go smoother.

If something does blow up, it’s addressed and remedied, and the two parties aren’t at each other. And I think it’s been one of the real nice elements that the insurance industry has brought into mergers and acquisitions. But you know, don’t take my word for it, Doug, good, bad or indifferent, what’s been your experience with rep and warranty insurance?

Doug: Yeah, no, it’s an interesting tool. So first of all, I would I would just agree with you wholeheartedly. The growth of this product has been tremendous. And in some ways, that’s the probably the best endorsement for the quality of the benefits. And as it has grown dramatically, I’ve actually seen the market get a lot deeper, and a lot cheaper. So if it was interesting and good, you know, five or 10 years ago, it’s even that much better in the context of the number of participants that can help provide a really credible solution.

So generally a fan. I would say, particularly in the lower middle market, you think about a transaction. It’s one of the biggest events that an entrepreneur will experience in their lifetime, represents a lot of wealth. And in many cases, they’ve never done it before. And so it can be daunting, it can be very emotional. And what I find is that the product actually, you know, kind of takes some of the emotion out of the discussion. And to your point, it allows people to allocate risk in a more kind of dollars and cents basis, as opposed to, you know, a direct win or a direct loss from one of the involved parties.

So I found it to be most relevant in kind of the lower middle market where I play where you’ve got families and founders who are trying to ensure that whatever deal they cut, is really the deal that they can expect to, to monetize in terms of, you know, supporting their family, etc. I guess the other thing I’d say is, you know, I think, and it’s a mixed bag, but I think insurers are very good at facilitating detailed diligence that results in very good disclosure. And so in my mind, there are two aspects to that.

One is it does sometimes limit the coverage, because through that process, they will conclude there’s an item here, which we’re not comfortable binding from an insurance perspective. But I think somebody was going to have to cross that chasm anyway. And so having a third party kind of force a diligence, which allows them to effectively underwrite, it narrows the pool of controversial issues, but I also think they’re generally pretty darn competent in helping through their diligence, identify the important issues that need a, you know, a different solution than a straight up bind.

And I guess the last thing I’d say is, it’s probably good news, bad news. I don’t think we have any, or very little experience actually making a claim. Which, you know, there’s probably two sub-points to that. One is it highlights how emotional this topic is, but it rarely turns out to be a significant business issue. And then the second is, I would say, while I haven’t made any substantive claims on the policies, there’s lots of data in the marketplace, that would suggest that they pay out very well. And when you need, the coverage it’s available to you.

Patrick: I couldn’t agree more. I would say on the claim side, what happens is less than 15% of the policies actually have a claim that gets paid. The nice thing is, is that the leverage that you know, the policyholders have over the insurance company because of the reputation of rep and warranty insurance is such that an underwriter would really be short-sighted if they delayed or denied payment of a claim. because we have a bunch of repeat buyers out here. The reputation for this policy rides on their ability to keep a promise.

And so, you know, rep and warranty insurers are especially sensitive and making sure that, you know, they get the claim, right, they get paid. And they don’t necessarily open up the checkbook and write a blank check, but they sit down with the buyer and work it through and come to resolution. I’d say 75 to 80% of rep and warranty claims are paid and settled in less than a year. And if you have to, without insurance turn to the legal system to you know, squeeze blood from a stone or claw back money from a seller, that’s going to take a much longer time.

The other issue that I want to bring up today is that, you know, rep and warranty has been a great tool for deals that were higher priced, above $30 million in purchase price. They require a great amount of underwriting. They are fairly expensive, but there’s a lot of value in that. But it doesn’t answer the question, what do we do with add ons. Companies that are between 5 million and 25 million in purchase price, they may not be eligible for rep and warranty. There is a new sell-side product out there. It cost $15,000 per million in coverage.

The seller is the policyholder rather than the buyer. Policy is triggered when the buyer notifies the seller of a breach and a financial loss. Seller notifies underwriters about it. Underwriters bring those same attorneys that they would do on the buy side to sit down and negotiate with the buyer. It’s an efficient model. It’s a little bit streamed down from a but side rep and warranty both in the process, and in the cost and in the timing. But is built to handle these 1000s of smaller, I mean micro market M&A deals.

And we want to make sure that’s out there so that it’s great for the buyer or for the seller, because in the absence of rep and warranty, they’re kind of assuming a lot of risks. This takes it away. For the buyer, it’s really helpful because they can go ahead and rely on a source of remedy, not the seller. And it works, it works forward. So we’re excited about that. The name of that program is called transaction liability private equity or TLPE. And as we’re speaking with organizations like yours out there that they may have big platforms, but they’ll have multiple add ons. This is what we would call another way to deal with this.

Doug: That makes a ton of sense. You know, I would have told you for platform investments and things with EBITDA greater than 10 million I think this is like highly penetrated in insurance products. So you called it. 95%, 90%, something like that, I would think. And we see the preponderance of insured deals in these small add-ons is way lower. And so I think I have interpreted that as the market just hasn’t been as deep and cost-effective. But it sounds like that’s being addressed through this product innovation, which makes a ton of sense.

Patrick: I mean, as markets go, innovation comes and there’s opportunities and they will be filled by this. Now, Doug, as we’re going forward, we’re wrapping up. I mean, boy, you blink and we’re almost done with the first quarter of 2023. What can you tell us? What trends are you seeing now that were a couple of weeks into the year? What do you see either on a macro level or for HCI Equity Partners?

Doug: Yeah, so I would tell you listen, I’m not sure I have a crystal ball. But I have a view. And I think that view informs how we are trying to manage the businesses and I think some of it is having a view, being open to new information and being willing to pivot and change that view quickly. But I’m, you know, pretty much in the camp that I think inflation is coming down relatively rapidly. A lot of because there were some, some key aspects to mostly supply chain and recovery of that, that that drove inflation.

So I’m relatively optimistic that the Fed is going to be accommodating throughout the course of 2023. And I think that puts us in a position where, you know, we’ve got a soft landing, or maybe not even a soft landing a, you know, decent expanding economy by the end of the year. So our view is pretty constructive. So that means we’re still in the marketplace looking to consummate transactions. I think we’ll do three, we’ll complete three deals here in q1, they’ll all be add-on acquisitions. And I think that’s an interesting, you know, kind of takeaway. It’s probably not that insightful. But I think a lot of the activity is less around platforms in this environment, more around add-on acquisitions.

I think they’re smaller, they’re easier to finance. And they’re often, you know, a bit strategic. And so you can see your way fit, even in a volatile market to find a way to get deals done that are good for both parties. I think I’d say listen, I think financing is going to continue to be challenging. And I think capital is just gotten more expensive across the board. So that’s not only like on the equity side, but on the debt financing side as well. So anyways, I think it’s gonna be a choppy couple quarters, but I’m relatively optimistic about the trajectory we’re, we’re coming out of 22 in.

Patrick: Does the cost of capital, will that have an impact on valuations or pricing? Could that soften that up a bit?

Doug: I think it has to, I think it has to. You know, listen, first of all, the I think the pricing that you saw early in the pandemic, when interest rates were zero was also not sustainable. So I don’t think that’s really the right basis upon which to think about, like, what things should trade at on a go-forward basis. I think we’ve just experienced, you know, probably two ends of the spectrum. You know, the good market in 2021 was too good.

And the market we saw here at the end of 2022, I think was an overreaction as well. And I just take comfort in, you know, good businesses are going to continue to be in demand. There’s a ton of dry powder out there from a private equity perspective. And so I think, you know, good businesses still traded at attractive values, maybe not the, you know, kind of extreme multiples that some things were trading at here in earlier than 2021.

Patrick: Doug McCormick, HCI Equity Partners, how can our audience members find you?

Doug: So, I guess, first of all, we have a company website HCIequity.com. So h c i e q u i t y.com. And then I’m pretty active on LinkedIn. I think that’s a great platform. So Doug McCormick at LinkedIn.

Patrick: Well fantastic. Doug, it’s been a pleasure finally to meet you after a couple of years of being around HCI Equity Partners. And so thanks so much for being here today.

Doug: Yeah, appreciate your time and interest, Patrick. Thanks again.

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