Robert Smith is the Founder, Chairman, and Chief Executive Officer of Vista Equity Partners. A March 2018 Forbes profile described Vista’s performance: “Since the firm’s inception in 2000, Vista’s private equity funds have returned 22% net of fees annually to limited partners, according to PitchBook data. Annual realized returns, which reflect exits, stand at a staggering 31% net. His funds have already made distributions of $14 billion, including $4 billion in the last year alone. Not surprisingly given those numbers, Vista has become America’s fastest-growing private equity firm, managing $31 billion across a range of buyout, credit and hedge funds.” Vista owns many businesses including Marketo, Tibco, Omnitracs and Infoblox to name just a few. You can find a full list on Vista’s web site.
- “We are very disciplined buyers.” “You think about Warren Buffett and Henry Kravis, and to a great extent, Columbia seems to mint a whole bunch of people who understand value investing and go about it in a different way.”
In addition to degree in chemical engineering from Cornell, Smith obtained an MBA from Columbia University Business School. There is little doubt that at Columbia Smith was taught that value investing as an analytical style is very different from value investing as a statistical factor in an index fund. When you hear someone say something in the news or on social media like “Value stocks were up [or down] today” they are either (1) talking about value as a statistical factor or (2) are confused about the difference. To illustrate, the difference, Charlie Munger was not talking about value as a statistical factor when he said: “All intelligent investing is value investing — acquiring more that you are paying for. You must value the business in order to value the stock.” What Munger means is: are there any types of intelligent investing where the objective is to pay more than an asset is worth? There are some assets for which an intrinsic value can’t be easily computed, but that is a different question than whether an asset should be purchased at a discount to its value. A business like Apple or Amazon can be a value stock if you are engaged in value investing as an analytical style.
A disciplined buyer like Vista only buys a security or asset when they can make the purchase at a price which represents a bargain when compared to its value. Buying an asset for more than it is worth hoping some greater fool will buy it for even more in the future, is neither disciplined nor investing. Another Columbia graduate named Warren Buffett believes: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
Another point that has been made by Munger is also relevant to what Smith is talking about in the first quote in bold above. Munger has made it clear several times that Berkshire is a buyer of moats. Munger has said: “We buy barriers. Building them is tough.” Vista is also a buyer and not a builder of moats from scratch. The skills and systems required to buy a moat at a bargain price are not the same as the skills and systems required to build one from scratch.
- “No one was doing buyouts in tech startups.” “These software companies were truly value plays, from my perspective.”
You must know one or more secrets in order to acquire something for less than it is worth. As Charlie Munger says: “Everyone has the idea of owning good companies. The problem is that they have high prices in relation to assets and earnings, and that takes all of the fun out of the game. If all you needed to do is to figure out what company is better than others, everyone would make a lot of money. But that is not the case.” Howard Marks puts it this way: “If you are investing based on a fact that everybody knows, it can’t possibly constitute an advantage and it can’t possibly have been omitted from the price. So, you must have some knowledge that is different from that of others.” Smith understood early in his career that “software is eating the world.” Unlike Buffett and Munger, Smith decided that he did have a circle of competence when it came to technology stocks and that conclusion has translated into superlative financial returns for Vista. Smith decided to “fish where the fish are” and to acquire some unique skills related to that type of fish he wanted to catch. Smith was trained as a chemical engineer but realized that he needed to become an expert in software.
- “Software companies taste like chicken. They’re selling different products, but 80 percent of what they do is pretty much the same.” “We exclusively focus on enterprise software.”
I suspect that in making his “software companies taste like chicken” comment, Smith is referring to systems which can be implemented that improve what Harvard Business School Professor Michael Porter calls the “operational effectiveness” of a business. Porter has said: “Operational effectiveness is about things that you really shouldn’t have to make choices on; it’s about what’s good for everybody and about what every business should be doing.” Of course, how a business is operated based on systems is very different from how it implements a strategy and develops products. I’m skeptical that Smith believes a successful business can have goals that are purely financial. People working in a business are most productive and fulfilled if they know their work has a purpose that isn’t just financial. My view is that without a purpose that is far greater than “let’s double EBITDA” the financial result of investing the business will be disappointing, even if the business is enterprise software. Even if doubling EBITDA is the primary purpose of the company, that business will not be very good for very long if there is not also a sense of purpose among the employees. For example, the best product development people are motivated by helping customers do something important that creates new value for customers. Without great “product people” the franchise of the business will inevitably deteriorate. In short, all financial engineering and no genuine product improvement makes for a shorter lifetime for any moat. Of course, just because Smith believes 80% of what these businesses do operationally can be the same, that does not mean that he believes that the 20% that is different isn’t what drives the creation of most value at a business.
In any event it is clear that Smith has a strong belief in the value of the standard operational systems that Vista has developed:
“Nobody ever taught these guys the blocking and tackling of running a software company. And we do it better than any other institution on the planet.” “What we need to change, we have changed before, so we know how to do it.” “If you are a software executive, how do you build your commission structures or run your go-to-market strategy? How do you find and train talent? Who teaches you those things?” “Financial performance of a company is just a trail in the sand of the operational performance. “The more standardized the input, the more standardized the output. You have to design your system, and you have to believe in it.” Vista Standard Operating Procedures — “VSOPs” in the firm’s lingo. “We have applied VSOPs again and again successfully in software companies, no matter what sector they are in — from energy to healthcare.” “We capture what we have learned and transfer skills and know-how to our companies and, through a systemic approach, leverage our investment team, Vista Consulting Group, and our portfolio managers.”
This systems-based approach to improving operations at an enterprise software business is Smith’s first secret. If Vista can buy a software business at the right price Smith believes Vista can substantially improve operations and increase the value of that business. He points out that Vista’s acquisitions are a bargain “only if you actually know how to change the operations of those businesses.” Unlike Buffett and Munger, Smith does not insist on buying a business with management already in place. For example, Vista usually brings in new management and often a new sales team as part of its operating plan. Vista may also buy other businesses in the same vertical as part of a roll up.
- “Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software.”
This statement describes Smith’s second secret. Because the amounts enterprises pay to use their software are much more creditworthy than most people imagine, Vista has been able to buy companies at an attractive price and then use this secret to gain better financial terms from lenders and suppliers when it uses leverage to do so. Smith was one of the first people to buy enterprise software businesses with leverage and the results of what he has done speak for themselves.
- “Listen to who is the critical thinker about the platform as opposed to the product.
It is impossible to be in the technology business today and not understand the power of platforms. Platforms can generate network effects which are the most important source of competitive advantage in the business world today. What a business wants is a product or service that gets more valuable the more people use it. This causes what are called “demand-side economies of scale” to benefit the business. I have written an post on network effects that you can find in the index to this blog.
- “The fourth industrial revolution is real and it is global. It relies on the ability to harness the data that is captured from real-time interactions that are taking place within the networks of their customers.”
Most people have heard someone say that “data is the new oil.” What they mean is that due to the rise of cheaper storage and developments in artificial intelligence, data has become a key source of competitive advantage. This change in the business world means that a race is on to create continuous and near real time connections with every customer and every device and to create systems which can extract intelligence from that data which can be turned into more valuable products and services. Every business that has an attractive future is quickly becoming a SaaS business, even if the company sells some sort of device (see my recent blog post on “SaaS plus a box.”).
- “Moats have to be dug over time. It may take 15 years to create a moat.”
Especially in the world of enterprise software, the sales cycle can be so long/time consuming that generating network effects can take many years to accomplish. The good news though is that for the same reason the lifetime of the customers acquired can be far longer as a result. In other words, it can cost an enterprise software company much more in time and money to acquire a customer than in a business in another sector of the economy, but the lifetime of that customer relationship and the moat in an enterprise software business tends to be longer.
- “The importance of developing intellectual property cannot be underestimated.”
Other than network effects, the ownership of key intellectual property is the next best way to create the sustainable differentiation necessary to acquire a moat. There are patents and then there are patents. They are not all created equal. I have many granite patent cubes in my office so I do believe they have value, but how much value they have is not completely clear.
- “The world is awash with capital and ambition which has led more PE tourists to invest in the highly specialized area of software.”
Vista’s success in the private equity world has attracted imitators. These competitors will only be successful if they have the right circle of competence. Some of these firms are doing very well in the private equity part of the technology industry and some are not. The easy pickings that Vista once had in buying technology businesses are in no small part gone now that Smith’s two secrets are more widely known. Whether these competitors of Vista will be able to be financially successful in this part of the private equity business is unclear. Smith and Vista clearly know their way around the enterprise software business, but I am not so sure that the same thing can be said about many of the private equity firms that Smith calls “tourists.” As Warren Buffett likes to say, risk comes from not knowing what you are doing.
- “We don’t underwrite to hope. We underwrite based on critical factors for success under our control.”
Failure can happen for many reasons including situations that involve a business or investor: (1) taking a dependency on something that is within the control of someone else or (2) depending on a lucky break to happen. Smith wants to invest when he knows Vista can generate a positive return based on known capabilities. Smith has said: “I am most proud of our system being a loss-prevention mechanism.” Smith told the Financial Times: “We manage money for teachers and firemen and municipal workers. We have never lost money on any buyout investment. The last thing they want us to do is be irresponsible with capital and we take our fiduciary responsibilities very seriously.” You may have once seen a television special shown at Christmas entitled: “Rudolph the Red-Nosed Reindeer & the Island of Misfit Toys.” Sometimes there is value in finding a business that is “misfit” if you have the skills to fix it. There are some notable former misfits in the Vista portfolio. I suspect that Smith looks for “fixer uppers” rather that “turnarounds.” As Buffett has said: “Turnarounds seldom turn.” It can happen, but focusing on turnarounds would not have produced Smith’s “we have never lost money” record of success.
- “The pace of change has accelerated.”
What Smith is saying here is evident to anyone who has been involved in a real business over the last few decades. That there is some sort of stagnation going on in the business world is rubbish. Sometimes during the business day I feel like the character Ned played by William Hurt in the movie Body Heat who says at one point: “Sometimes the shit comes down so heavy I feel like I should wear a hat.” If you are constantly amazed by the pace of change you see in your business, your brain is working correctly. That is really happening. If a professor tells you that the pace of change has slowed because “we are out of new ideas,” the best response is: “bullshit.”
- “Everyone asks this question around the world. How can we be the next Silicon Valley? You can’t.” What [a city like] Denver has to be is the next Denver. What Denver can do is figure out how to be the best Denver as opposed to be the next Silicon Valley. Denver has attributes that no other place on the planet has.”
What a city or region should be searching for from an economic development standpoint is comparative advantage. Smith is correct that there will never be another Silicon Valley. The goal of any region should be to harvest the benefits of unique “agglomeration economies.” Michael Porter describes the objective: “clusters tend to attract specialized human resources to their region because the multiple firms in the cluster provide a deep local labor market in the skill-sets sought by employers.” A major research university is vitally important to a city’s economic vitality since they tend to be a key driver of unique regional capabilities. If a city does not have its own research university it should affiliate in some way with one or more research universities in other regions. My blog post on what a region or city can do to create a more vibrant and adaptable economy is here: “A Dozen things Seattle can teach others about jobs, economic development and building a better city.” https://www.geekwire.com/2016/12-things-seattle-can-teach-others-jobs-economic-development-building-better-city/
p.s., A few more thoughts from Smith:
“The important thing was the challenge from my mentor was more than to teach me something about this obscure integrated circuit. It’s a challenge that has reaped rich dividends for me over my entire career. It is the joy of figuring things out.”
“Running your own race demands trusting yourself even when others don’t.”
“With the process of discovery, you fail a lot. And you learn a great deal from those failures, so the next time you can avoid those mistakes.”
“This is not a lifestyle business. And if you want to make it a lifestyle business, this is the wrong business to be in.”
“You got to have grit. And grit mean getting turned away from thing 14, 16 times, calling someone every two weeks, every day for 5 months and then finally it materializing in something that you want.”
“I started Vista because I knew no private equity firm would hire me. I saw what they were looking for… So I created my own firm.”
“The most important thing you can do as a young person is to become an expert. There is no substitute for becoming the best at your craft.”
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