A friend sent me an article about private equity consolidating segments of the automotive market, specifically tires and service centers. CCAW Automotive Group operated in this market, so I know it well.

I’m not surprised that private equity is targeting this market, because it’s fragmented and inefficient and requires significant capital to hold inventory. Rising interest rates are likely pressuring profitability of smaller players. This makes the market attractive to private equity funds looking to execute a roll-up strategy. In my opinion, it’s really the only viable strategy for this mature industry. Growth is slow (probably 3%–5% annually), so growing organically is hard because you mostly have to take customers from someone else. Buying smaller players and integrating them into a larger organization so economies of scale can be leveraged is a good strategy.

I wouldn’t be surprised to see private equity consolidate parts of this industry and then sell to a large upstream player (manufacturer, distributer, etc.) who could benefit strategically and financially. Then again, the consolidated segments could be taken public if market conditions are favorable. I’m curious to see how this plays out and hope the end result is a better experience for consumers.

Today I talked with a founder looking to start a new brick-and-mortar business. His model is interesting. He’s renting out space in a building designed to cater to an overlooked segment of entrepreneurs. It’ll be recurring revenue, and he already has a few customers committed once he launches. We talked through capital for his project. The revenue potential of the business is capped based on the square footage of the real estate, so it won’t be high-growth. He wants to do debt, but he’s faced some hurdles in getting financed with banks because their underwriting is more conservative. Venture capitalists would love to invest in him, but that isn’t an option because the company isn’t high-growth.

We started talking about the perfect situation for him, and it ended up being a mix of equity and debt. The equity would be permanent capital, meaning the investor isn’t targeting to sell in a certain number of years like a PE or VC fund. They would plan to be an owner and receive profit distributions in perpetuity. The debt would be normal term debt with fair terms. The kicker is that he’d like to do this type of deal with a single person or capital partner.

The more we talked about it, the more I thought about how big the market is. Many entrepreneurs building traditional businesses would probably benefit from a capital partnership like this, especially if interest rates stay at current levels or go higher.

This week I’ve connected with two founders approaching the end of their runway. One of them is out of cash and terminating employees. Another has three or so weeks of runway left but just agreed to terms on a new financing round. The founder is glad his company will live to fight another day. He’s sad about the expensiveness of the capital.

The round will be a down round. It will have a significantly lower valuation than the prior round and includes other terms that will leave previous investors and employees with little to no equity in the company. Existing team members will have equity, but materially less than before. The company will survive, but the CEO is aware that this round will have a negative impact on the company’s culture and relations with employees and previous investors.

Raising capital was challenging in 2022. Some founders opted to use their runway and wait until things improved in 2023. But things haven’t improved as much as they’d hoped. Many are at or near the end of their runway and must make difficult decisions.

Financial services for consumers and small businesses is likely the next big market for Apple (see my posts here and here). In October, Apple announced a new savings account product. And today, Apple announced that the product is live and paying a competitive 4.15% APY. Given the Silicon Valley Bank failure and the changing banking landscape, Apple may have decided to use challenges that traditional banks are encountering to its advantage.

I think the banking industry is prime for disruption. Banking has been slow to evolve, which frustrates consumers and small businesses. I can’t wait to see how consumers and the banking industry respond to Apple’s latest foray into financial services.

Looks like we’re one step closer to iBank.

The collapse of Silicon Valley Bank has heightened people’s awareness of uninsured deposits—deposits that aren’t insured by the FDIC if a bank fails. The limit is usually $250,000, but it can be more in certain situations.

Today I read a Bloomberg article about this topic. It discussed various ways a depositor can increase their FDIC coverage. The main way is to use a service that spreads your cash among accounts at multiple banks. The more banks you spread your deposits across, the more aggregate FDIC insurance you have and the lower your uninsured-depositor risk. The article went on to include a list of players who offer this service. The article is definitely worth a read if uninsured deposit risk is a concern.

The article also subtly mentions that these products offer competitive interest rates as compared to traditional depositor accounts at traditional banks. This is a win for savers that haven’t seen rates on deposit accounts keep up with the Federal Funds Effective Rate. The willingness of depositors to move funds to different institutions and search for higher yields will likely have a bigger impact than many people realize. For the first time in a long time, banks will have to compete for deposits and reward those who save—something we haven’t seen in almost twenty years.

This week I received a somber update email from a founder. I’ve known him for years and supported him whenever I could. I didn’t invest in the company, but he keeps me on his update email list so I can track his progress.

This email said they’ve run out of cash. They’ve been trying to raise capital for months, with marginal success, and they’re nowhere near breakeven. Employees are being terminated.

I wasn’t totally surprised, but this was still sad to read because the CEO and his team have put years into building this solution. I believe the problem they’re solving is real and experienced by a segment of the population. But I suspect it isn’t painful enough for a material number of customers to happily pay to solve it. Said differently, this solution may be more a vitamin than a painkiller.

In an environment with abundant, cheap capital, companies building vitamins can raise capital. When capital is expensive and less abundant, these companies will struggle, and some will fail.

This is my one-hundred-fifty-ninth weekly reflection. Here are my takeaways from this week:

• Financial leverage – I spent part of this week thinking about leverage in the financial system. Leverage is common in business, but when it becomes excessive it can cause problems. I believe there’s a high probability that there’s a material amount of leverage in the financial system that we’re unaware of. It’s hidden for now. When it’s exposed, it may cause problems.
• Being present – I carved out time this week to celebrate with family, shutting down everything else to make sure I was present. I’m glad I did.

Week one hundred fifty-nine was a steady week. Looking forward to next week!

I had a chat with someone who’s early in her career. She’s evaluating a variety of career paths, including working for a start-up or a venture capital firm. When asked what she was looking for in her next opportunity, she said one thing that stuck with me. She wants to be at a place where she has the latitude to make mistakes and perfection isn’t the expectation.

People learn by doing. Sometimes that means the outcome won’t be as planned. When that happens, people often reflect to figure out what they did wrong. Environments that allow for mistakes also allow for learning and growth. They have a culture of bias toward action. People feel empowered to try new things and experiment. When perfection is the expectation or mistakes are viewed negatively, the opposite culture is the result. People hesitate to act until they’re confident the outcome will be what they want. They’re less likely to experiment. Managers often end up involved in every decision made, which makes things slower and more bureaucratic.

Unexpected outcomes aren’t mistakes unless you don’t learn anything from them. I prefer to think of them as slightly painful learning experiences. Environments that embrace learning from doing instead of perfection attract the best people and can produce outsize outcomes.  

I listened to a friend’s prediction about the direction of the economy. He’s certain we’re heading into a deep recession. When we’ve faced dynamics like today’s, certain things happened that led to a deep recession. Because those things happened before, he’s certain they’ll happen again.

I don’t know what’s going to happen, but I’m not comfortable with my friend’s approach. Everything he knows for certain is about the past. The current environment might be similar, but it isn’t exactly the same. It’s not a certainty that the future will play out just as the past did. I believe the past repeating itself is one of a variety of possible outcomes. We could go into a deep recession, but various other outcomes are also possible because factors are at play today that didn’t exist in the past. Each of these possible outcomes has some probability of occurring. Stating with certainty that a particular outcome will happen ignores that fact.

The world is full of randomness. Anything can happen.

I listened to Mark Leonard, founder of Constellation Software, share his thoughts. His company buys small software companies—it has acquired hundreds since it was founded in 1995. The software companies it targets are profitable and growing.

Mark spent over a decade as a venture capital investor before founding Constellation. He compared the venture model to Constellation’s model, and here’s what jumped out to me:

• Venture capital – The goal is to create companies you can sell either through an IPO or outright sale. The focus is on preparing the company to be sold to someone else, not necessarily building a business that can last a lifetime. He didn’t say this, but most funds have a ten-year life cycle—they’re liquidated at the end of the cycle and proceeds are returned to investors.
• Holding company – Holding companies like Constellation are built using permanent capital. The goal is to keep the capital invested in portfolio companies long-term. There’s a buy-to-hold mentality. This changes decision-making. You build relationships with founders and managers that will last a lifetime. You’re building a business with the intent that it will be around for decades, generating cash.

I love hearing origin stories, and Mark’s makes it clear that he wanted to build companies he could hold forever, not a decade. Given the current interest-rate environment, I wonder if we’ll start seeing more investors embrace the holding-company approach to investing in smaller technology companies.