Special Edition, SFTT: Project Incerta
Merchant banking, aging receivables, growth vs. profitability.
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Inaugural Stories from the Trenches post
Earlier I expressed my intent on publishing some stories from the trenches, and if you’ve signed up for behind-the-curtains scoop, you may have found the last few posts lacking. This shall be my first attempt to make good on that word. The format follows a somewhat typical lifecycle of a private equity investment, with the caveats that (i) it was more of an asset purchase which required significant investment in operations, and (ii) Incerta raised additional growth equity mid-way through the hold period. Since there is no tagging feature for individual posts, I will continue to preface these letters with “SFTT” so you can either (i) easily search for them if you want more drama, or (ii) ignore them if you’re here for my takes on recent deals.
While my recent publishing cadence mirrors that of Dom Mazzetti, I expect to bring post frequency closer in line with the first half of the year (so anywhere between every two weeks and every two months). That said, with M&A activity effectively at a halt during a global pandemic, I may explore some other topics to discuss for the near future. You can fill out this 5-second survey if you feel strongly about things you’d like to see covered here:
SFTT: Project Incerta
“Pray that every L just stand for lesson” - Chika
While I was fortunate to work on some fascinating transactions, both from the advisory and the investment side, Project Incerta served as the culmination of my experience at Arcanus Partners and to this day remains one of the most exciting roller coasters of my career. Incidentally, it has also played a formative role in shaping the lens through which I view the dynamics between companies, their vendors and customers, transaction advisors and consultants, and investors.
Investors (especially when writing from their own name) are, understandably, more inclined to talk about successful deals, so you rarely see a first-hand account of deals gone wrong. Hiding behind the facade of this newsletter allows me to discuss the shitshows I’ve seen in my career, Project Incerta being one. For the avoidance of doubt, Project Incerta was an anomalous experience for the investors, advisors, and all others involved with the company, and is not representative of their respective track records.[FN:1]
Dramatis Personae
Avid readers of financial media will not be surprised to learn that no Latin or Greek word was left undisturbed in the efforts of naming investment management firms (occasionally with humorous implications). Since even the caricatures of these names have been claimed elsewhere (e.g., Sub Rosa Capital), we’re left with a limited vocabulary of potential pen names.
Arcanus Partners (AP): a former size mover (herein known as SM) with a small but capable staff who supported occasional consulting engagements and managed his family office; Staffer runs the day to day operations and has been a wonderful friend and mentor to your humble author
Project Incerta: a once-promising business
Vito: CxO type who grew up in a sales-oriented culture who probably listened to one-too-many Grant Cardone podcasts (if you need a visual representation, they kind of look alike); eventually stumbled his way into the CEO role at Incerta
Seven Eight Capital (78C): notorious in its own right, this group was incidentally the primary source of funding for Project Incerta; one-time employer of Savi, an industrious buy-side analyst who could have benefited from taking some more accounting classes in college
Humble beginnings 💡
“As far as you’re concerned, anything short of a company announcing its sale on a billboard in Times Square is a proprietary deal” - PEHub
The senior team at Arcanus was a well-pedigreed group who cut their teeth at large platforms and ultimately set up their own shop at the tail end of their careers to effectively continue some of the work they’ve been doing at a smaller scale and without someone to report to. While their entrepreneurial spirit occasionally landed them in hot water, the group was generally a well-meaning enterprise that functioned with high efficiency and an aura of artfulness to everything it touched. In today’s parlance, AP is best described as a lifestyle business for SM (though he would most certainly debate me on such characterization).
SM spent much of his career advising and investing in a particular niche, and so the bread and butter of AP were consulting engagements for lower middle-market companies operating in that market. On occasion, opportunities to do club deals or take a more active role in such businesses would arise, and SM would consider principal investments of different flavors (buyouts, PIPEs, growth equity) and get increasingly involved with strategy setting and operational aspects.
Incerta started off as a typical engagement. We were working with a company that was looking to shift its business mix from services to more of a product-type offering and wanted to tap into AP’s (basically SM’s) resources to make that happen. After some canvassing, we identified a product that would be a good fit, identified the only company licensed to sell the product in the US, and began trying to negotiate a strategic partnership.
As we were ironing out the details, our original clients grew increasingly less responsive and enthusiastic about the deal, to the point where they eventually ghosted AP completely. To this day, I do not know what happened. A google search on the management suggests some personal finance troubles recently, but nothing out of the ordinary during the time of our engagement. Needless to say, the planned transaction was not consummated.
The product we identified, however, was a ripe candidate for the type of business model we proposed and SM decided we could buy up near-exclusivity rights (current owner wanted to maintain some portion of this but was not in a position to scale), incubate the business, hire a management team, and hold it as a portfolio company of AP.
Building the business 🏗️
“Remember, when you become a big-shot investor, I’ll still call you to fix my computer” - Vito
I had a few paragraphs drafted on Vito but decided we can save that for another time. All you need to know is that Vito hooked up with my school’s career counselor, and that set off a chain reaction that (years later) landed me a job at AP and him the CEO job at Project Incerta. Unfortunately, I have not had any luck getting M&I/BIWS/WallStreetPrep to include this story in their “off-cycle recruiting” guides.
Given Vito’s sales-oriented approach to, well, everything, he focused his efforts on building the sales engine of Incerta. This left the majority of the day to day operations of Incerta to the rest of the team at AP until we could justify some headcount.
The strategy was straight forward - we would reposition this product, which was somewhat neglected by the current owner. Instead of selling it for a high upfront cost, we would effectively give away the hardware and charge a small license fee every time the software was used. The problem was that this required an enterprise-level software security system (compliant with industry regulations), adjustments to the UI/UX (despite limited ability to edit the source code), and adjacent hardware to be bundled with the product.
For a period of almost six months, I was “reassigned” from any and all other work you may expect an analyst to do at a firm like AP and became the defacto Chief Technology Officer who also moonlighted as a trainer for sales reps and new clients when Vito was overbooked (always).[FN:2] Fortunately, we did eventually hire some additional operations staff for Incerta, primarily to assist with managing logistics and monitoring IT issues.
In the meantime, SM was working his magic, trying to secure partnerships and alliances with more prominent and better-funded industry players to get Incerta on the map. Some of these came to fruition, and at one point, I had some very insightful conversations with a (former) head of state while we knocked back vodka tonics.
Investor relations 🤑
“I can’t even” - Staffer
With the sales force ramping up and a skeleton back office more or less in place, we still needed to secure some form of exclusivity to the product. So we went out to raise some external capital. The “friends and family” round, led by AP, already created a shit show of a capital structure. Note that was pre-Carta and other cap table software, so yours truly had an extremely fun time trying to account for every warrant, conversion, and contingent security in the cap stack.
The first step to doing a proper capital raise was getting the company’s financials in order. I might lose traditional PE readers here, but those who’ve worked in LMM or even VC will know the struggle. Despite meetings with outsourced CFO firms, AP decided that this would be a medium-term solution, and for the time being, we could get away with our own bookkeeping. Anyone who spent more than ten minutes in a private equity role should’ve known to use Netsuite, but for one reason or another, we opted for QuickBooks (which is a major PITA for smaller companies)[FN:3]. Absent a dedicated accountant, I was granted another hat to wear. Fortunately, I was able to train one of the admins at AP to do the bookkeeping and invoicing, which significantly decreased my burden. Admittedly, it would have been prudent to have a proper accountant review everything, but neither the company nor its investors were interested in spending more money than was absolutely necessary.
After what seemed like a million meetings, emails, and calls, Incerta secured funding from a large institutional investor that was known to have a sleeve for esoteric deals. There is enough press on 78C for me to avoid listing any particular details, but I will note that my experience with the group oscillated between being in awe at their ingenuity and having concerns about their governance.
The 78C investment (somewhere between growth equity and a recap) bought the fund a significant ownership stake and was structured to fund in several tranches, with subsequent funding contingent on the operational performance of the business. While the company was generally on track, cash collection became a severe issue with clients delaying payments and receivables growing at a rapid pace. Part of this was probably an overly enthusiastic sales force that prioritized client acquisition over client service. Another part was some strategic partnership, which, in my opinion, got the sweeter end of their respective deal.
Understandably, this gave rise to concerns, and our new overlords at 78C began getting increasingly involved in monitoring monthly cash flows. Savi, who was tasked with evaluating and monitoring 78C’s investment in Incerta, did a solid job of trying to understand the business and the cash flows. Nonetheless, he would occasionally ask for clarifications on issues like accrual vs. cash accounting, which made me concerned for other investments he may have been monitoring for his employer. His requests were typically forwarded to me with the preface of “oh boy” and “I can’t even.”
C.R.E.A.M. 💸
“WTF is this AR aging summary?” - Everyone
Equipped with new financing, a handful of partnerships with larger strategics, and a national sales force, Icerta grew its customer base at an impressive rate. However, given the industry dynamics, cash collection turned out to be more difficult than any of the underwriting scenarios.
Despite the strong momentum and a clear path to EBITDA profitability, the cash burn was more significant than what AP or 78C were willing to support. It didn’t help that some decisions around external consultants were either premature or NPV negative. In retrospect, the right move would have been to cut back on growth and focus on servicing the existing client base, but virtually all the decision-makers wanted to prioritize revenue growth over profitability.
Faced with an imminent liquidity shortfall, Incerta needed another tranche capital injection. At this time, however, 78C was losing confidence in management and began scrutinizing every expense incurred by Incerta. Separately, 78C faced some unrelated issues which stifled its ability to continue funding Incerta based on prior commitments and began exploring options to either cut bait or salvage their initial contribution.
The Aftermath 🍩
“I suspect there was money stolen from us, but I’m also pretty sure we stole funds elsewhere, so let’s not dwell on the past” - Former Incerta investor
Without getting into the how’s or the why’s, 78C eventually assumed majority ownership of Incerta and replaced the senior management with another team (who had limited experience in the sector but enjoyed a track record of resuscitating struggling PE-backed businesses). To the best of my knowledge, they actually did apply breaks to the growth machine and focused on improving cash flow and servicing the existing install base.
I had the privilege of driving several hours to the relocated HQ and walking the new management team through w̶h̶e̶r̶e̶ ̶t̶h̶e̶ ̶b̶o̶d̶i̶e̶s̶ ̶w̶e̶r̶e̶ ̶h̶i̶d̶d̶e̶n̶ the operations, IT infrastructure, and potential paths forward for the business. For my troubles, I was offered to join the business full-time and leave my gig at AP. Although joining a group of senior operators who were routinely hired by top funds to fix messes had some appeal, the commute alone made me quiver at the thought. The experience did nudge me to explore other opportunities, and I landed at a boutique investment bank to focus on more traditional M&A advisory.
AP scaled back on principal investing for some time, focusing instead on its consulting business. Although, recent reports suggest they’ve been taking increasingly active roles with some of their investments. Sticking true to the 80’s banker stereotypes, they continue (seemingly single-handedly) to support NYC’s fine dining and nightlife establishments. Lifestyle business.
Footnotes:
One exception is the original company (AP’s client) that nearly got Incerta for themselves. The management’s professional track record is a mess, and Incerta would not have made it as far as it had had it been absorbed into their business.
This was one of the few times I got parachuted into a PortCo, and a comparatively effective experience. Another time (at a different firm), I was taken away from the typical sourcing/diligence/monitoring work to help a PortCo with the kind of admin support that could have been found on Upwork or Fiverr. Note to senior dealmakers: reassigning a $$$ employee to $ tasks is NPV negative for the sponsor.
This is partially my fault for suggesting QB, but also arguably the Staffer’s mistake for not yelling at me to find something more appropriate.