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Term Sheet — July 3, Private Equity Ownership Structures, TA Associates Q&A

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QUESTIONS WITH A DEALMAKER

Happy Wednesday, Term Sheet readers. Sincere apologies for delays in receiving this newsletter over the past two days—we’re experiencing technical difficulties from the back end. Hopefully, at least for U.S. readers, the hubbub of July 4th vacation plans eclipsed the absence of Term Sheet from your inboxes in the early hours of the day. Term Sheet will similarly take a pause on Thursday and Friday, with Polina returning Monday. Please do continue directing deals to polina.marinova@fortune.com.

Valuations appear high—a concern among both private and public market investors. It’s hard not to ask to ask the question: When will the pullback hit, as we continue through the longest bull market in history?

Private equity firm TA Associates, with $14 billion in assets under management and a focus on growth, is sticking to a strategy that it says has a higher likelihood of surviving an inevitable market correction—and that is not about focusing on discounts, but finding businesses that have recurring, reliable revenue.

While the firm doesn’t see an imminent downturn, it also doesn’t assume the good times are bathing in an elixir of immortality.

“There will be a downturn and there will be a correction of some sort. And when it comes, we would much rather be in high quality businesses with great cash flow characteristics and great predictability,” TA Associates Chairman and Managing Partner Brian Conway said in a Q&A session with Fortune

That comes after TA raised $8.5 million for its 13th fund roughly two months earlier. That fund plans to focus on profitable, middle-market growth companies in technology, health care, and financial, consumer, and business services.

Conway spoke to Fortune about TA’s investing thesis and how the firm ties ownership to performance.

For those more familiar with private equity, TA Associates is known to source deals through cold-calling potential acquirers. In 2018, TA emailed over 15,000 companies and called over 6,700. That resulted in over 2,400 visits for a team of 102 investment professionals. 

It takes a lot of perseverance, with one vice president sending his number to a CEO by piping it onto a cake, after previous contacts failed to elicit a response. While the company is not in TA’s portfolio, the vice president is still in contact with its chief executive.

But Conway explains the benefits of TA’s strategy, and why it’s more methodical than most assume.

Tell me about TA’s strategy in light of higher prices in the market.

When prices are very high, you can stick to paying with lower prices, but in our experience, you get stuck with lower quality businesses with less sustained growth over a five or six year period. 

So we decided that since prices are going to be high, we would much rather pay higher prices for high quality businesses. We realized that the number one determinant to our returns was sustained earnings. And one metric of a high quality business can be recurring or highly repeating business models, such as a subscription software business, or a payments processing company where you have predictable long-term customer relations and predictable growth.

We also looked at a group of publicly-held recurring revenue companies, and they continued to grow through the recession, whereas the ones with lower recurring revenue companies first went flat and shrank. 

In reaction to high prices, we’ve been able to shift the portfolio so that 80% or 90% of it is now firms with recurring revenue, high margins, low capital requirements, high free cash flow, intellectual property-based businesses as opposed to commodity businesses. 

There will be a downturn and there will be a correction of some sort. And when it comes, we would much rather be in high quality businesses with great cash flow characteristics and great predictability. That will matter a lot more than if we initially paid a much lower price or much lower multiple going in. 

From the point of cycles, a downturn is overdue. But if you look at the fundamentals of the economy, it’s not perfect but it’s pretty healthy right now. 

We don’t see imminent signs of a near-term slowdown, but it wouldn’t be prudent for us to assume that this will just continue. Like every other private equity firm, we’re modeling what does the recession case look like and how did businesses like this fare through the last down cycle. 

But barring a geopolitical shock—a breakdown in China-U.S. trade negotiations or an armed conflict between the U.S. and Iran—things look pretty decent right now.

TA also has a fascinating way of dividing ownership based on performance. What does that look like?

We assign credit for every investment when it closes. Then by changing unvested carry and using ownership contributed back into a pool by partners that have retired, we realigned ownership as often as annually with attributed performance. A given investment might close with two partners that sponsor it who get the overall majority of credit for that.

The carry is aligned with that long term performance record. We look at the long-term record based on at least 10 years of realized performance, so one or two founders don’t have an overwhelming majority of the carry or the management company. So if someone generated 5% of the long-term performance but is only 1% owner of the carry, then their carry should go up. Conversely if someone is 5% of the carry but much lower than 5% of the performance, then their carry should come down. There’s also formula by which carry owned by managing directors translates into ownership of TA’s management company.

In the near-term, if a company where you are a sponsor doesn’t hit its targets, we will claw back a portion of your [current compensation] bonuses for the first two years of an investment—we are trying to incentivize people to invest, but not just throw anything against the wall. 

But that could raise problems with teamwork, with folks effectively focusing on eating their own kill?

We have one strategy and one fund meaning we share gains that carries all in one fund whether you are in the tech group or health care group, whether you are in Boston or Menlo Park. There are no separate incentives based on geography or industry. We all have incentives in the same carry. So simply hoping that you do well by everyone else doing badly means you’re not going to do very well. Overwhelmingly, you’ll own a bigger piece of a shrinking pool. 

Financial and otherwise, we reinforce the culture. Frankly we just won’t tolerate jerks. Outside of compensation, junior people won’t be asked back, and senior people will see their ownership go down or they’ll stop advancing if they’re not demonstrating that they’re good culture carriers and citizens of TA. 

Previously, you mentioned trying out a personality test in the recruitment process that only reinforced what you already knew about successful hires. How do you objectively measure if someone is a jerk or not who is already in the firm? 

Most recently we did a 360 degree review of managing directors with a third party professional moderator in which each person got feedback after 10 to 15 interviews. Then there were both quantitative feedback and ratings back to colleagues on what they do well and what they need to work on—some elected to work with coaches. 

There are then unattributed quotes from peers on what people think. So for example, a peer may say: “I really like your collaborative approach and the way you give feedback in investment committees.” Also maybe you interrupt people in committees all the time and aren’t displaying active listening skills, those kinds of things—it’s a way to give qualitative feedback in a structured way with professionals.

It’s expensive, and the most expensive part is how long it takes—but I found it worth it. The whole process took six months with 22 managing directors. We had actually seen it at one of our portfolio companies and thought it was helpful, so brought it back in house. 

We try to foster an environment where good news and bad news travel at the same speed, continuous improvement is emphasized, and where we try to be direct and honest. The ownership is just one part of an overall culture we are trying to foster. 

Our system is, as I say, accurate but not precise. We’re not going to get it right to the second decimal place. But we’re going to get it right.

TA is known for the so-called cold calling model—the firm sent over 15,000 emails as initial contact to companies last year. It’s a lot of work. What is the logic behind it?

We don’t like the term cold-calling or dialing for dollars because we don’t think it describes what we do.

We start with a deeply informed view of the kinds of industries, segments, and trends we would like to invest in. So we focus on trends as opposed to say passively waiting for a banker or company to propose investment opportunities.

As a result, most of our deals end up being proprietary with [no competing buyer]. It’s not to buy companies for less than fair market value—instead, we’re not rushed or played off by competing buyers. It allows us time to dig into terms, do the due diligence, and make good decisions about the companies we choose to invest in. 

Maybe 30 years ago we used to subscribe to regional business journals and cut out wanted ads with scissors, basically with the assumption that if it is hiring, then it must be growing. 

It is much more scientific now.

We have an in-house app developer. We also have an expensive proprietary asset that’s been around since the late eighties, but we’ve been using for the last seven to eight years to find acquisition for portfolio companies—an origination engine with over half-a million companies in the database. Most companies we invest in were already on it. Since 2010, we’ve really focused more on how can we grow portfolio companies strategically and financially through accretive acquisitions not for a fee, and last year we made 66 acquisitions through our portfolio—and the majority were through the platform. The idea is to help the company build their own muscle to do this. 

In terms of data sources—it’s everything you can imagine. We have technology that we are investing in to source deals, we get trade show lists, and interview industry participants.

Can you give an example of this method in action?

We were looking for years for companies that would benefit from the biopharma boom—and we only invest in profitable companies. 

So we now have a company based in Fargo, North Dakota that had no institutional investors. This company is basically a supplier to the industry, so the analogy would be Levi Strauss selling blue jeans to the gold rush or arms to the combatants.

It produces a protein that is used to deliver gene therapy to the patient so their customers are the biotech and pharma industry who are trying to make sure they can get on a reliable basis these plasmids and RNA gene editing enzymes for research to clinical trials for commercial FDA approved products. I’m careful not to give out the name of the company for compliance reasons. (Fortune did independently find a Fargo, North Dakota-based firm in the space named Aldevron also backed by TA Associates).  

Now Director Ethan Liebermann called up the company as an associate at the firm (Liebermann was an associate between 2007 to 2010). Then he went to business school and returned, when there was finally an opportunity to invest in the firm in 2017. And Fargo is not an easy place to get to—it gets bitterly cold in the winter so they needed to be highly motivated to do that.

The company has exceeded ours, and frankly management’s expectations because of the overwhelming demand in the market. So it is an example of when we had a thematic idea, and people went out on the road to source that investment years before there was an opportunity to invest.

VENTURE CAPITAL

Belong.Life, a New York City-based social network for cancer patients, caregivers and healthcare professionals, raised $14 million in Series B funding. IQVIA led the round.

Getaround, a San Francisco ride-sharing firm, acquired Nabobil, a Norweigian car rental platform, for $12 million. Read more.

Immunicom, a San Diego biotechnology company focused on treating late-stage metastatic cancer, raised $11 million in Series B funding. The investors were not named.

DoNotPay, a San Francisco-based startup that has used artificial intelligence (AI) to create a robot lawyer, raised $4.6 million in initial funding. Felicis Ventures led the round, and was joined by investors including Index Ventures, Founders Fund, Highland Capital, Tuesday and Coatue Asset Management. 

Polyrize, a Tel Aviv-based cybersecurity company, raised $4 million in seed funding. Glilot Capital Partners led the round. 

Current Ways, a Santee, Calif-based firm with electric vehicle charging solutions, raised $3 million in funding. First Analysis led the round.

PRIVATE EQUITY

Fortress Investment Group is close to a deal for Majestic Wine’s stores, per Sky News citing sources. Read more.

Cimarron Energy Inc, a portfolio company of Turnbridge Capital, acquired Hy-Bon/EDI, a Midland, Texas-based maker of compressor packages for handling low pressure gas stream applications. Financial terms weren’t disclosed.

Eden Capital acquired MITS, a Seattle-based business analytics platform. Financial terms weren’t disclosed.

Keyfactor, a portfolio company of Insight Partners, acquired Redtrust, a Spain-based provider of digital identity solutions. Financial terms weren’t disclosed.

Single Digits Inc, a portfolio company of GI Partners, acquired Sunray, a Carlsbad, Calif.-based hospitality network design and management firm. Financial terms weren’t disclosed.

WM Partners acquired Ultima Health Products Inc, a Cortland, Ohio-based maker of sugar-free electrolyte hydration products. Financial terms weren’t disclosed.

Exabeam, backed by Sapphire Ventures and Lightspeed Venture Partners, acquired SkyFormation, an Israeli cloud security business. No financial terms were disclosed. 

OTHERS

Fosun International Limited acquired Tenax Capital, a London-based boutique asset management company headquartered in London. Financial terms weren’t disclosed.

Dun & Bradstreet, a Cannae portfolio company, acquired Lattice Engines. Financial terms weren’t disclosed.

NCR Corp. acquired D3 Technology Inc., an Omaha, Neb.-based developer of SaaS and cloud-based banking software. Financial terms weren’t disclosed.

 ECi Software Solutions acquired Pacsoft, a Westbrook, Maine-based provider of inventory management and point-of-sale software solutions for hardware retail and trade businesses.

Varian Medical Systems, agreed to buy a number of cancer treatment products from Boston Scientific for $90 million.

EXITS

ACON Investments acquired a majority stake in Fleetwash, a Fairfield, N.J.-based mobile fleet washing service company, from DFW Capital Partners. Financial terms weren’t disclosed. 

Mason Wells sold Nelipak Corporation, a Cranston, R.I.-based designer of thermoformed packaging for the pharmaceutical industry, to Kohlberg & Company, LLC. Financial terms weren’t disclosed.

Pamplona Capital Management will acquire a stake in Loparex from Intermediate Capital Group.

Tekni-Plex, a portfolio company of Genstar Capital, acquired Lameplast SpA, an Italian healthcare packaging company, from Aksia Group. Financial terms weren’t disclosed.

F+FS

e.ventures raised $400 million over two oversubscribed early stage funds: a $225 million U.S.-focused fund based out of San Francisco and a $175 million Europe-focused fund based out of Berlin.

RiverPark Ventures plans to raise $75 million for its third fund, per a SEC filing. 

Henry Kravis, a KKR co-founder, invested in ParaFi Capital’s flagship fund, per Bloomberg. ParaFi manages $25 million and focuses on crypto. Read more.

PEOPLE

SV Health InvestorsDementia Discovery Fund named Dr. Jonathan Behr as a partner. Previously, he worked at the JDRF T1D Fund.