Sidecar Investing in Europe (Part 1)

Escaping Base Rates and Underwriting Uncertainty

The TL;DR

This multi-part write-up will focus exclusively on medium-sized serial acquirers with outsider type of characteristics, mostly self-funded, headquartered in the UK and Sweden with operations spanning the globe.


Mergers and acquisitions are often viewed with some reservation among public shareholders. After all, most acquisitions fail to create value for the buying shareholders, especially on a per share basis. On hindsight, the prices paid and the synergies calculated seldom make any sense, and thus only the acquired company plus the bankers, stand to gain. These base rates related to M&A, are also deeply ingrained in most finance alumni sifting the world for investment ideas. Perhaps this could represent some type of opportunity?

The Map is Not the Territory

What if you could find a group of companies following a proven M&A playbook and combine that with the opportunity to invest against a long runway with high returns on capital?

What I’m referring to, more specifically, are companies run by owner-operators, whose culture is deeply anchored on value creation. This can often be accomplished by operating in fragmented end-markets, running decentralized structures with a vibrant entrepreneurial spirit, and allowing for both organic and inorganic growth via bite-sized acquisitions, not elephants or “transformative” acquisitions with complex integrations.  These companies have different labels; some call them “buy & builds” and some call them “serial acquirers.” The label is not important though and, more importantly, the sidecar model does not just apply to these specific companies. Think of it more like an investment philosophy. Let’s look at some companies with >5 years of history and then explain the concept in more detail:

All (Good) Investing is Sidecar Investing

Sidecar investing was first introduced to me by Richard J. Zeckhauser in his paper “Investing in the Unknown and Unknowable.” The analogy can be described as follows:

The investor rides along in a sidecar pulled by a powerful motorcycle. The more the investor is distinctively positioned to have confidence in the driver’s integrity and his motorcycle’s capabilities, the more attractive the investment.

Sidecar investing essentially means you`re placing your bet on the management, who themselves are great investors, and you are holding on for the ride – hence the sidecar! In other words, a rare species that combines the best of both worlds: management teams that are excellent operators as well as fantastic investors.  

There’s also a big element of trust involved – after all, you`re sitting in a sidecar, remember? Trust and culture are one of those intangibles which can`t be neatly siloed or excel-ranked. However, you should not bet on a single jockey, hoping he or she will never leave the company. What you should look for is a company with an everlasting and celebrated culture around value creation (yes, easier said than done).

Notice that there`s something deeper going on here, it’s a virtuous cycle; the management is doing the work for you and you are piggybacking their ability to compound capital and to adapt to changes in the environment. This frees up time for you as an investor where you don’t need to find new investment ideas every month, which further increases focus and the quality of your ideas.

But don’t we always as minority shareholders invest in public companies and ride along in a sidecar, trusting management to be both good operators and great investors? If you are managing other people’s money, you probably have limited partners who have underwritten your ability to compound their capital, so why is this any different? Which also begs the question:

If a minority of investors can beat the market by investing intelligently, why can’t a minority of managers create value by acquiring intelligently? – Pat Dorsey

In fact, parts of the investing community may have issues with sidecar investing. After all, what are portfolio managers paid for? Media headlines some time ago on funds charging fees for all-in positions in Berkshire Hathaway comes to mind. Perhaps there is some merit to this, but investors should remember that their scorecard is not computed using Olympic-diving methods: degree-of-difficulty does not count (as the saying goes). Besides the analytical framework for sourcing and identifying these companies, let us not forget that what matters is the destination, hence staying the course and reaping the full benefits of business compounding.

Positive Skewness

Identifying companies with excellent owner-operators could best be described as a holistic process with a touch of creativity. Some may look at serial acquirers from a surface level and attribute historical performance solely in terms of multiple arbitrage. Buy companies at low multiples, integrate successfully, and the market will apply the acquirer’s multiple to a bigger base of earnings. This is only partly explain the story though.

Therefore, it is worth pondering over why the sidecar opportunity in serial acquirers “exists” and what variant perceptions this area represents. Skilled capital allocation (or investing) could be described as having the following attributes (partly @Pat Dorsey):

  • A focus on the end destination, not the path.

  • Unpredictable - Impossible for the sell-side to model

  • Unconventional - Creating value via acquisitions when most companies destroy value

  • Lumpy - Value creation is financially messy and comes in spurts rather than a smooth line.

A big source of variant perception is represented by the fact that growth for these companies is a function of “ebb and flow”. Some of it is organic and some inorganic, with the latter being highly unpredictable, both in timing and in size. In other words, this group of companies do not lend itself particularly well to the agenda of the sell-side, trying to pinpoint a 12-month price target. Keep in mind that these companies, for the most part, don`t provide any guidance (and rightly so).

Move Along, Nothing to See Here!

Investors new to serial-acquirers, relying on optical cheapness, with a gravitational pull towards “valuation” heuristics like <10x next year’s earnings = cheap, 10-15x = ok, and >15x = expensive, may face some difficulties in this area. It’s easy, but also intellectually lazy, to assume that you are “late to the party”, but multiples can mislead and it’s all about recognizing the deeper reality.

Case in point from Swedish Lifco: how can you intelligently incorporate these lumpy acquisitions in a DCF-model? For the record, ROIC has averaged >20% including goodwill.

Value Creation is Messy

It’s worth pointing out that as sidecars investors, we`re participating on a different time scale. Welcome to the business time scale where value creation comes in spurts rather than a smooth line and where the path to riches doesn`t correlate perfectly with the incentives of the marginal price setter. This is the outskirt of the time spectrum, where earnings guidance is futile and where the end destination is what matter, not the path. However, you should still be keenly aware of any data points signaling the degree of management execution, culture drift, and the quality of the compounding trajectory. Stay in the sidecar (but don`t fall asleep!)

Escaping Base Rates

The playbook for most finance alumni is to think everything in finance has mean-reverting attributes. Heck, the original framework for value investing was partly based on mean-reversion. Why should one expect, as a default, that a company with a reinforcing culture around business building and positively skewed capital allocation will mean-revert in terminal year 5? Why not focus on the exception from the rule?

Doesn`t “the market” know these are exceptional people and price it in? That is the beauty - skilled capital allocation is systematically mispriced (hypothesis). An unknown, yet positively skewed future can`t be predicted or modeled - undervaluing and hiding in plain sight - @Sidecarcap

If you can identify the minority of managers highly skilled at capital allocation, you should probably apply a different lens to the compounding trajectory. This is where creativity, trust and underwriting the unknown and unknowable come into full play, perhaps 4 words shunned or scuffed at in certain value circles, but bear with me. We are entering a domain where intuitive thinking and deeply ingrained mental models need to be questioned, paused, or abandoned. This time you need to put yourself in a position to reap the full benefits of long-term value creation.

Another benefit of being a sidecar investor is that you can finally thrive in market drawdowns, despite running a fully invested portfolio but where the underlying companies have some flexibility at hand. Lower prices could mean more optionality, hence more opportunities for intrinsic value growth. This could take the form of market share growing organically or via compelling acquisitions or perhaps share repurchases at attractive prices. If you zoom out, it is mind-boggling to witness how much intrinsic value growth can be generated by exceptional people, compounding good decisions, over long stretches of time.

Root Systems, Antifragility and Internal Diversification

One helpful model when it comes to sidecars and serial acquirers specifically, is thinking in terms of the root systems of plants and trees (a term coined by @LibertyRPF applied in a different context). Some companies may have a single but fairly shallow root, represented by a single product sold to a single customer in a single end-market. A fragile three-legged stool in most scenarios!

Alternatively, one could a own a company run by owner-operators, serving different customers in different end-markets, running decentralized structures and a highly opportunistic approach to M&A. Not the usual conglomerate blueprint but one coherent assemblage of interconnected and mission-driven people. In other words, a root system sprawling in all directions and over great distances; they are a lot harder to pull out, and may survive better even if large sections are cut off. With this internal diversification, owning <5 companies could mean that you`re more diversified compared to a portfolio comprised of >5 single-product companies.

The Opportunity

The best time to plant a tree was 20 years ago. The second-best time is now. - Chinese proverb

I think there is a tendency in the value-investing community to overdose on the usual suspects from the book, “The Outsiders” by William Thorndike. That covers Berkshire Hathaway, Constellation Software, Fairfax, Teledyne, TCI, et.al. Fantastic companies but we can all agree the best would be to track every successful company ahead of time when the companies were small. Realistically, however, there is a trade-off between track record and both the size and the length of the growth runway. What ultimately matters, from a now perspective, is the future, and how much capital these companies can deploy, at what rates, and for how long.

In terms of serial acquirers specifically, it’s also worth highlighting the 20-year tailwind of low-interest rates has to some degree lifted all boats relying on external financing to fund their acquisitions. Interest rates and multiples are also linked. In other words, the future may not duplicate the past for some of these companies.

This multi-part write-up will focus exclusively on medium-sized serial acquirers with outsider type of characteristics, mostly self-funded, headquartered in the UK and Sweden with operations spanning the globe.

Let’s buckle up!