Arcadea’s founders think that PE / HF money is a liability. Is that fair?

Sator Grove is a self-styled “permanent capital investor rooted in love”. Judging by the portfolio make-up, a lot of their love - and money - has flowed into VMS HoldCos. Chapters Group. Upliift. Arcadea. 

All three companies have appeared on Sator Grove’s podcast called “The Art of Investing”. 

It’s a very good podcast. 

A few weeks ago, the founders of Arcadea - Paul Yancich and Daniel Eisen - were on. For those not familiar with the business, the Toronto headquartered Arcadea is a “private market, long-duration investor in founder-controlled vertical software companies with ARR of up to $20M and growth up to 150%”

I won’t recap the whole episode, but it revolves around 3 key themes:

1. An insider’s view on Constellation Software

2. A master class on how to build careers and networks that eventually allow you to raise $$$

3. Differentiation from other VMS aggregators

Given the intensifying competition in the VMS space, I was intrigued by Team Arcadea’s take on #3. 

They did not disappoint!

According to Paul:

Paul promoted the same idea on another podcast about a year ago: 

Does this mean that PE / HF backed HoldCos like Valsoft (Coatue, Viking), Everfield (Aquiline backed - read our deep dive), Cordance (ditto); and Big Band (Talisman, Parker Gale) are at a disadvantage to the likes of Arcadea?

I examined Paul’s argument from two perspectives to see if it holds water.

Perspective #1: Know your enemy 

First things first: Arcadea’s investment strategy pits it not only against VMS HoldCos, but also against crossover PE / growth equity firms like PSG Equity, TA or Francisco Partners. All 3 love platform builds, with add-on acquisitions as small as single digit $M ARR.

In fact, Arcadea’s pitch to founders sounds a lot like PSG’s - but with a) a much less known brand and b) a (lot) longer holding period. 

Secondly, I am not sure how many retiring owners of mature VMS businesses know, or care whether the acquirer is backed by a hedge fund, a university endowment or an exited entrepreneur.

It’s a whole different ball game with younger businesses whose founders want, or are being asked to stick around. 

Bottom line: when you are facing off against much larger, established US firms, brand positioning becomes key for winning deals. Especially if you are not acquiring 100% upfront and/or want to minimize the cash component. 

Perspective #2: Deconstructing long-term returns

Undoubtedly, for HoldCo founders there is value (symbolical and practical) in aligning themselves with compounder rockstars like Constellation Software or Danaher Corp. Whether as an alumnus, the founders of these firms investing in your vehicle, or both. 

However:

1. It’s not like PE backed aggregators do not have access to this talent / expertise

2. No investor can “guarantee” success

Don’t believe me? 

Raise your hand if you think Constellation Software would not have happened without the $25M seed ticket from OMERS / Ventures West.

And what do HoldCo purists make of Mark Leonard’s decision to raise capital from TD Capital / Birch Hill Partners (a PE firm) after the OMERS relationship broke down? 

I am not saying that investors do not matter. What I am saying is that HoldCo long-term, risk-adjusted returns are an output of a multi-factor model. As you can see from my Constellation example, investor identity / type is not necessarily an input.

The factors that matter are these 3:

1. What you are acquire…

2. …at what price

3. How your HoldCo is structured

Let’s break it down. 

The first two factors are target / asset level inputs. You may point out that I omitted the operational value add. I did not: by default. it is included under the first point. Asset quality determines the extent to which acquirers can cut costs / raise prices / etc. without impairing franchise value. 

Factor #3 is the one I obsess about. Once again, let’s break it down:

• Management incentive scheme

• Capital structure

• HoldCo ROI

Not surprisingly, these are all topics in which investors wield outsized influence. 

Set target returns too high, and the HoldCo will go on an acquisition spree buying garbage businesses with junk debt. 

Push hard for “platform value add” (whatever this means), and you will end up with an overstaffed, controlling, political HQ that disrespects founders. 

And the worst? 

Poorly designed incentive schemes. Unrealistic KPIs. Unequal distribution of spoils, and the jealousy it feeds. No liquidity. Boards mesmerized with the founders and oblivious to the goings-on within the organization. 

Choose investors who have a grip on these issues.