Weekly Thoughts: Add-Backs and MCISRE
Here are two things that caught our eye this week:
As small business investors, we are very familiar with the concept of “add-backs,” expenses that artificially decrease the true run-rate earnings of a given company. Analyzing and accurately calculating these expenses is a crucial element of our diligence process since our transactions are generally based upon a multiple of EBITDA and the validity of proposed add-backs can have significant consequences for the final transaction price.
Cash flow adjustments, however, are not limited to the small business realm. For example, this week we read about some creative financial adjustments during the sale of the Ultimate Fighting Championship (UFC). When the company was initially put on the market, earnings were estimated to be $170 million. In an attempt to raise more debt financing, the company presented adjusted earnings of $300 million — a figure that conveniently allowed lenders to remain compliant with regulatory guidelines limiting lending levels. To bridge the $130 million gap between current and adjusted earnings, the UFC pointed toward expected increases in television contracts and licensing agreements under new ownership. From the Wall Street Journal:
“One technique for companies looking to lower their debt metrics is known as ‘pulling forward,’ that is, earnings that haven’t happened yet but are expected from merger-related cost savings or recent business shifts, said James Fitzpatrick, a portfolio manager at investment firm CQS, which has increased its loan investments over the past year.”
While we have seen our fair share of creative add-backs, we are generally concentrating on non-recurring expenses or off-market owner perks that will disappear post transaction. The elimination of these expenses for valuation purposes requires confidence that they do, in fact, exist and what remains reflects the true earnings power of the ongoing business. On the contrary, the inclusion of anticipated revenue growth or post-transaction efficiency gains for the purpose of securing additional leverage is a step too far in our minds. Ultimately, one of the reasons we choose to focus exclusively on small business acquisitions is that we can structure deals where our ability to add value represents a source of return rather than a necessary condition for the maintenance of covenants.
This Veteran’s Day, we spent time reading about how elements of the military are incorporating certain entrepreneurial tools and methodologies into their workflow. The Marine Corps Intelligence, Surveillance, and Reconnaissance Enterprise Accelerator (MCISRE) is essentially a tech incubator intended to foster innovation within the branch. Jennifer Edgin, Chief Technology Officer of the Intelligence Division at the Headquarters of the Marine Corps provides some background:
“If you asked 100 people to describe a United States Marine, they would probably use words such as ‘Warrior,’ ‘Fierce,’ ‘Patriot,’ ‘Honorable,’ and ‘Tough.’ Marine Corps culture transcends generations and is rooted in the values of courage, honor, and commitment. Marines are known for adapting to change and overcoming obstacles and adversity to meet new mission requirements continuously. Three years ago, Marine Corps Intelligence outlined a mission to harness the disruptions occurring in the new frontier of warfare, the Electronic battlefield. To achieve this mission, we established a framework that leveraged Marine Corps tenacity, agility, and adaptability to create a persistent culture of innovation.”
To achieve this goal, MCISRE provides a structured forum for active duty Marines to work with technical experts from various fields to identify problems and potential solutions through a collaborative and iterative process. While the specifics of their work will likely never become public knowledge, we think the structure provides useful insights into how all organizations — regardless of size — can foster innovative business practices. For instance, strategic conversations around “big picture” issues often lack tangible outcomes and thus produce no results. To tackle this problem, the program forces participates to first identify a problem in a straightforward, simple way. Elgin explains:
“One of the most difficult exercises for our cohorts is distilling ‘world-hunger’-level challenges into discrete, focused problems we can solve in 12 weeks. We learned that if you cannot define your problem in one sentence that a 7 year-old can understand, you don’t understand the problem. If you want to create innovative solutions, you must start by defining real problems. Real problems—when defined properly—have metrics that quantify the scope, magnitude, and impact.”
Structurally, the program also goes to great lengths to ensure that ideas that make sense in a PowerPoint actually work for soldiers on the ground. Furthermore, to ensure ideas do not lose momentum in the vast bureaucracy of the military, the program is organized so that once an idea is presented to senior leadership during an official demo day, leaders are required to provide an immediate “go/no-go” decision on whether or not the idea will be transitioned into practice.
While MCISRE’s approach to fostering innovation is seemingly simple, it serves as an excellent example of the benefits associated with interdisciplinary study. These practices may be normal in innovation hubs like Silicon Valley but they can be game-changing when applied to other industries. This is a reason why we encourage our portfolio companies to cast a wide net when looking for new ideas, as inspiration can frequently come from unexpected places.
Have a great week,
Your Chenmark Capital Team