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Firm offers a twist on private-equity model
Thursday, December 22, 2016
Every private-equity firm says it's different than all the others but most of them are the same, so competition in the industry is intense. But I recently met the management team of a relatively new PE firm that actually is different. And after investigating how it stands out, I think they have a shot at gaining market share and making investors a few bucks over the coming years.
Founders Advantage Capital Corp. (which trades on the Venture Exchange under the symbol FCF) was created by some of the same people who put together Alaris Royalty, which has done very well by investors since its humble beginnings a little over a decade ago despite hitting a rough patch recently.
Alaris co-founder Stephen Reid is the chief executive of FA Capital and billionaire Clay Riddell, an oil-patch tycoon and savvy investor who backed Alaris from its earliest days, is also a major backer of the new company.
To understand how FA Capital is different, you first have to understand how traditional private equity works. Typically, a PE firm will gain control of the target company and pay for much of the purchase price by having the company borrow more money.
Usually the PE firm will want to own a very large percentage of the company, if not all of it. PE firms also usually like to have a lot of say in the running of the business. This isn't necessarily a bad thing because they can sometimes add value.
But here's the problem, as Mr. Reid explained it to me: The entrepreneurs who built the businesses are often the best people to run them, particularly if they're still growing at a decent clip. But entrepreneurs don't like being told what to do. Plus, many entrepreneurs want to take some money off the table but also want to maintain a bigger stake in the business than is typically offered by a traditional PE.
There are alternatives, companies such as Alaris, which provide cash in exchange for a top-line, usually single-digit royalty. But this creates a problem not for the owners of the target company but for the investors in the public company.
"Royalty companies end up taking equity risk but not getting equity rewards for it," Mr. Reid says.
Looking at what's happened with Alaris, it's hard to argue the point: A couple of the firm's investments soured, which drove the stock price down about 30 per cent in the past year or so.
It was with all this in mind that Mr. Reid started looking for a new model that would avoid these pitfalls, and he came up with the concept behind Founders Advantage.
To illustrate, consider the firm's largest deal to date, Dominion Lending Centres, a major mortgage brokerage firm. Founded a decade ago, Dominion has grown to become the dominant competitor in its field with 40-per-cent market share, little debt and a stable business. It's a private-equity buyer's dream.
When co-founder Gary Mauris, a serial entrepreneur with two previous wins under his belt, decided to entertain offers to take some cash off the table, he was approached by a number of firms.
He opted to accept FA Capital's offer despite the fact it was lower than others. He declined some bidders because they wanted to buy all of the company. He turned down other PE offers because he disliked the idea of having outsiders tell him what to do and also because they wanted Dominion to borrow a lot of money to help pay for the acquisition.
"It didn't make sense," Mr. Mauris says. "They were buying me out with my own money."
He ended up doing a deal with Mr. Reid who offered to buy 60 per cent of the firm with a majority of the board seats.
But here's the twist: While Mr. Mauris and his partner are entitled to 40 per cent of the base profits, they are also entitled to 70 per cent of any increase in those profits.
The reason this works is that it gives founders - a small business's greatest assets - the incentive to keep working hard rather than taking their money and going to the beach.
"It was very smart of them," Mr. Mauris says. "If you're an entrepreneur in your thirties, forties or early fifties and still have energy and plans this is the best kind of deal. These guys are going to win more mandates."
Dominion has been active with acquisitions since doing the deal and Mr. Mauris believes he could double earnings before he's ready to call it a day. Putting that in perspective, the biggest bid Dominion received was signficantly higher than the offer they accepted. If Dominion doubles its earnings and is then sold for the same higher multiple, my calculations say FA Capital will triple its investment, not even counting distributions.
And if you doubt that Mr. Mauris believes in the FA model, you shouldn't. While he and his partner weren't offered shares as part of the purchase price, they asked for them and are now among the biggest shareholders of the company.
Disclosure: The author personally owns shares in Founders Advantage Capital Corp.
Fabrice Taylor, CFA, publishes the President's Club investment letter, for which The Globe and Mail provides marketing services and receives compensation.
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