DON'T CALL US PRIVATE EQUITY

Arbor Permanent Owners is not a private equity fund.

We make this clear in every conversation we have intermediaries, business owners and investors.

We are not a private equity fund.

We are business owners first and foremost. We’re operators.

We earned the right to acquire businesses.

We have degrees, but we didn’t learn business from a textbook. We learned it from sleeping under the desk, the stress of unpaid invoices and the scramble to meet payroll. We've seen the impact of both good hires and bad ones. There’s no substitute for experience, and no faster way to gain it by building something from the ground up.

We are technically a Holding Company.

We’re a team of operators and investors on the mission to facilitate the transition of Great Australian SMMEs from one generation to the next via an acquisition.

Unlike private equity funds, we are not constrained by an artificial sale / liquidity horizon. Our capital structure is uniquely permanent - allowing us to retain capital within our holding company and compound it over a long time horizon.

The key benefits of this structure are:

• Alignment: We as managers can focus on capital appreciation without time barriers. Also meshes well with entrepreneurs looking to grow their business sustainably over the long-term.

• Cleaner: Investors can take a long-term view without constantly needing to re-invest and pay tax/transaction costs.

• Flexibility: More freedom to evolve an investment thesis and hold other types of investments.

• Transparency: One budget and set of management fees, instead of layers of costs that build up.

• Marketability: Our desired businesses prefer us as a buyer compared to traditional PE - we’re not in the game of ‘buying and flipping’ the business you’ve spend the last 3 decades building.

This structure inevitably raises 2 questions:

• If we’re a permanent holding company, how do you and your investors get liquidity?

• How are we compensated as investment Managers?

We spent days trying to answer these questions in a way that ensures pure alignment between us and our co-investors.

Here’s our memo and what we came up with.

Liquidity considerations

Investor interests (shares in the holding company) are priced based on the Net Asset Value ($NAV), and can therefore be theoretically bought and sold at any time, if there is demand. Given our holding company is a private and unlisted Australian Pty Ltd a liquid market to enable frictionless trading of these interests does not exist. 

Managers will often set policy decisions around timing potential liquidity events. For example, a manager may have the shares valued every three years, and subsequent to the valuation facilitate the trading of shares for incoming and outgoing investors. Share buy-backs are another liquidity option if we believe the intrinsic value of the Holdco is higher than the current NAV. The timing of this event is subjective and open for negotiation between the manager and co-investors in the setup of the vehicle. 

Another option we considered is to provide liquidity to investors when a liquidity event arises in the fund, i.e. realisation of a position, or dividends are paid. Whilst we may pay dividends in the long-term, our aim is capital growth - dividends are unlikely to be paid in the short-term.

As Managers it’s our role to foster an active secondary market for the shares. This would involve a fair effort in investor relations, providing frequent updates to a broader list of potential investors, and advising them of any upcoming parcels of primary or secondary share sales.

It is fair to say that private permanent capital vehicles have the least certainty around liquidity, and are thus suited to patient investors with a longer time horizon. 

This leads us to the next question: if we are not optimising for short-term exits, how do get we compensated for our efforts?

How do we get paid?

The traditional “2 and 20” is a compensation structure that alternative investment managers (real estate, private equity, and hedge funds) typically charge.

The 2% of assets under management is charged as management fees to cover the costs of Investment Manager’s operations and 20% of the profits as an incentive fee above an IRR hurdle, to encourage performance - known as “carry’.

Further, many costs, such as accounting, compliance, and deal costs are often charged directly to the fund, causing more confusion and complexity in the fee structure.

The 2 and 20 model is widely regarded as the norm for alternative investment managers.

As first principles thinkers, we asked ourselves the question - how did 2 and 20 become the industry norm?

The origins of “Carry” 

The origin of carried interest can be traced to the 16th century when European ships were crossing to Asia and the Americas. The business of international trade was a risky business. It was not uncommon to hit rough seas and lose the ship; it’s cargo and the men (not dissimilar to today’s Venture Capital haha).

A new incentive model was created to incentivise shipping enterprises to embark on these long distance, often treacherous journeys. The ship’s captain would take a 20% share of the profit from the carried goods, to cover costs for the voyage and the risks it entails - hence the name ‘carried interest’.

Fast forward to the 1950’s - Alfred Winston Jones, the father of the hedge fund industry, was the first to use a 20% incentive fee in his hedge fund. As the decades progressed, emerging hedge funds followed suit and added a fee of 2% of annual asset management to cover their startup and operating costs. 

In the investment industry, the “2 and 20” model has become so pervasive that it has become the most widely adopted structure for alternative investments.

Why the 2 and 20 model doesn’t work for us

Whilst widely adopted by funds management businesses, it doesn’t work for us.

Here’s why:

• The traditional model creates misaligned behaviour between GP & LP - The 2 and 20 model incentivises traditional PE funds to raise larger-and-larger funds to buy bigger companies, pay higher prices, make short-term decisions, and bill the investors and portfolio companies fees for everything they do. We have had several successful fund managers admit to us behind closed doors that they are in the game of building AUM for management fee’s sake, and are not overly concerned with long-term performance and the carried interest.

• We are not a funds management ‘business’ - We are investors. We’re not in the “business” of investing. This is an important distinction. The only way we should grow our bank account is by growing financial returns for all investors. This ensures pure alignment between us and our co-investors. We consider ourselves custodians of great businesses, not carriers of cargo across treacherous waters.

• Nature of illiquidity - by nature of illiquid portfolios, calculating true cash IRR is uncertain until an exit. In traditional PE funds, the time horizon is 5 - 7 years, where most IRR hurdles are met when an asset is sold/realised. As our goal is long term capital compounding, IRR is not a suitable metric to measure our performance. We measure our performance by 3 North Star metrics - ROIC, Free cash flow per share and compounded book value NAV growth).

Ownership models for Holdco Managers

The PE short term model is common and well documented. 

But long-term investment structures are less common. In our research, there wasn’t a well trodden path of compensation structures for holding companies in private markets. 

But we found a few, mostly in the USA and who we regard leaders in this strategy.

How we designed the investment structure Arbor Permanent Owners

With all the above in mind, here’s where we landed with the investment structure for Arbor Permanent Owners.

• Corporate structure is Australian Private Company Pty Ltd

• Co-investors are issued Preference shares, with 1x liquidation preference

• Founder shares, including our personal capital commitment is treated as Ordinary shares. There is no other way we can “earn” more shares in the holding company. If we want more, we have to buy them off our co-investors.

• Managers are paid a fixed salary and set an annual operating budget with our co-investors for operating costs (accounting, legals etc.)

• Dividends/distributions can’t be paid to Founder/Ord shareholders until a 50% of contributed value of Preference Shares have been paid to preference shareholders.

• The 1st liquidity window opens in year 5, with an annual liquidity window thereafter. Investors have the option to transact their shares via secondaries. We will help to facilitate these transactions.

We concluded this structure was the most optimal way to ensure 100% alignment between us and our investors.

If you have questions or feedback, I’d love to hear it. Send me an email.

About Arbor Permanent Owners

Arbor Permanent Owners is a Serial Acquirer holding company that acquires and invests in exceptional, private businesses, deliberately built for long-term success. Our goal is to be the long-term custodian and permanent home of Great Australian Small and Medium Enterprises (SMMEs).

We are actively looking for businesses with the following characteristics:

• Business Model: B2B industrials: manufacturing and mission critical services

• Business Size: $3 to $6 Million of EBITDA

• Business Profile: Sticky B2B customer base

• Business HQ: Australia

We are backed by a small group of co-investors, collectively on a mission to preserve the legacy of Great Australian SMMEs.

If you are a sophisticated investor and would like explore co-investment opportunities with us, please email us at [email protected]