Paul Giannamore: Right now, you're effectively catching a falling knife. If you can't buy anything on the absolute cheap, it might be good to wait.
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Paul Giannamore: Fat Pat, did you enjoy the POWER conference in Tampa?
Patrick Baldwin: POWER was awesome. I've realized where I got my nickname, Fat Pat.
Paul Giannamore: How so?
Patrick Baldwin: I saw pictures of myself.
Paul Giannamore: There you go. You took your shirt off live at a conference.
Patrick Baldwin: That's true but everyone's seen it. I want to let you know, the camera adds 20 pounds and not 10.
Paul Giannamore: There were some questions though. People texted me and asked me if Fat Pat got an Elon tramp stamp. Unfortunately, it was a decal.
Patrick Baldwin: It was a tattoo. I did get a tattoo, it was just temporary.
Paul Giannamore: I enjoyed the conference. Overall, Seth, Amanda, and the team did a great job putting that thing together. There were a lot of people there but it was not overwhelming. I got an opportunity to at least meet almost everyone that was there. They had live cigar rollers and great cocktail hours. It was a great shindig.
Patrick Baldwin: The cigars passed your test, that's a high bar.
Paul Giannamore: They did. They were great cigars. I was quite impressed with what they had going on over there.
Patrick Baldwin: There's a lot to take in. Every session stood on its own. Incredible people. Seth raised the bar. He wants to do eight more of these over the next 5 or 6 years so good luck. At least the MC bar is low.
Paul Giannamore: Where's the next one going to be?
Patrick Baldwin: Chicago, Chi-town. That's your old stomping grounds. I'm sure you'll find a way there.
Paul Giannamore: I might have to do it. Overall, I enjoyed it. I don't do a whole lot of public speaking anymore. As you know, PB, I used to be on the pest control circuit and do those things. This is the first time I did that in a long time. As you know, it was quite uncensored though. Would you say that my session was probably not for the general audience?
Patrick Baldwin: It would've had an extra rating on it but you did great. Paul, the last time you spoke in front of an audience like that was over two years ago in that hotel, at the U Group.
Paul Giannamore: That's true. It was a much smaller audience. That's right, it was the U Group at that very hotel. Here we are in January of 2023. We've got the FOMC coming out with probably another rate hike somewhere between 25 and 50 basis points. As you can see, Patrick, the short squeezes are on. It's been a rough January as everyone is super excited about a Fed pivot. I have closed out some of my shorts but some of them I'm riding so we'll see how I do.
Patrick Baldwin: My shorts are feeling like I should have taken a playbook from the opposite with George Costanza. I'm watching Tesla and I've got a short on that and it continues to rise up.
Paul Giannamore: PB, if short selling were easy, everyone would do it. I told you when we were in Tampa and you were looking at what I was doing. I put all sorts of disclaimers on it.
Patrick Baldwin: I know. I got them all. I picked up all the disclaimers. I don't even know if you told me to do Tesla but it is what it is.
Paul Giannamore: Tesla's earnings came out. Gross margins were down on the order of 300 basis points. They're spending a lot of money on developing new facilities. To me, it's been a bubble narrative stock. We've seen Goldman Sachs’ profitless tech basket explode. It's been Meme stock mania here in the month of January. I feel like fundamentals are going to catch up with Tesla. I lighten my load on that thing but I still fully believe that over a full investing cycle, that thing is going be down significantly but we'll see what happens.
Patrick Baldwin: We'll see. I'll let you know.
Paul Giannamore: A lot of danger in being on the short side, especially in these speculative markets.
Patrick Baldwin: I've got something. I didn't know Harvey Massey. You were looking to chase down Tony Massey. I never met Harvey. I know the Industry Giant. His name is everywhere. Did you know Harvey?
Paul Giannamore: I did. I met Harvey over fifteen years ago. I hadn't been in pet control very long and I had a meeting down there at Massey headquarters. Tony took me out to dinner and then we spent some time with Harvey. He's a gentle giant, a nice man, built an important business in our space, and did a lot, over the years, for his work family as well as for his community. He was philanthropic.
Subsequent to that, I've seen him probably a dozen times or so over the years. He’s a great guy. I got to spend some time with Tony and he mentioned to me that Harvey was rapidly declining. I was not surprised to hear the news, although saddened. We send our deepest condolences to the Massey family there in Orlando, the entire team, and of course to the industry because he's an individual whose fingerprints are on a lot.
Patrick, I did want to talk about a few things that came up on the U Group discussion, guys like Court Parker, Sean McCauley, and others. They were talking about small deals out there. When I was out there, there was a lot of focus on interest rates and the impact of interest rates on valuation. I was asked a question, when do I think interest rates will start to roll over again? They've gone up quite a bit over the last year.
Patrick Baldwin: It's still going.
Paul Giannamore: Interest rates, of course, have impacts on valuation, although they shouldn't. When you buy an asset, you're buying a stream of cashflow. In the future, the rate of interest shouldn't make an impact on what you're willing to pay for that stream of cashflow. Like a lot of things in life, things are relative. Investors have to determine how to allocate capital. Do we allocate capital with fixed income or do we allocate capital to equities?
Some of the questions popped up. We spent probably half of my session talking about buy-side M&A and some of the expectations that sellers of small businesses have today versus where they were a year ago versus where they're likely to go. Some of the problems that guys were running into are they're trying to buy smaller businesses, sub million dollars. Sellers are asking still for large numbers.
As you look at the environment out there, I know we've talked about this on The Buzz quite a bit but it's worth kind of laying it out again. Here in 2023, we closed a transaction, it was with a financial sponsor. Every transaction we have under LOI right now, save for one, is with a financial sponsor or a private equity firm. I gave some stats where the pending in-process transactions, $755 million in deal volume pending with private equity right now at Potomac, and $62 million pending with strategics.
Patrick Baldwin: These are signed LOIs.
Paul Giannamore: Yeah. It gives you an idea of the dramatic shift in the marketplace, whereas this certainly didn't happen this time last year. Two years ago, I would've never expected it. We've got financial sponsors. When we talk about these private equity firms, these are private equity firms that are doing add-on acquisitions. Thompson Street has Pesco so they're doing add-on acquisitions. Of course, you have a lot of other private equity firms that are getting into the space.
GTCR, a Chicago-based fund, acquired a stake in Senske, which is lawn and pest out on the West Coast. You've got a variety of other firms that have made some recent entries and over the next two months or so, you'll probably see another 2 or 3 enter this market. We'll have over a dozen private equity firms operating in pest and allied industry is the amalgamated home services space with pest control being a part of that. It is changing the dynamics of the industry.
Anticimex is a highly levered entity, they've taken a lot of debt. The suppression of yields, low-interest rates, of course, caused the roll-up model. The Anticimex is a great example. When yields are extremely low, money is cheap, and you can go out and buy a ton of different businesses. When yields go up, it gets more and more difficult to do that. In the U Group, maybe the smallest company in there is $3 million or $4 million and then it goes up to the biggest ones, maybe in $60 million, $70 million, or something like that.
Patrick Baldwin: Bug Busters and Senske are on the high end of that.
Paul Giannamore: Yeah. You've got decent size middle-market businesses, they're going out to try to make these smaller acquisitions. Because the big strategics are slowing down, it makes it a little bit more difficult for smaller companies because Orkin, Terminix, Rentokil, and Anticimex have traditionally been acquirers of the $1 million, $2 million, and $3 million players.
Of course, they have massive national footprints so they can buy businesses all over the place and each of them is doing 30 to 50 transactions a year. That's a lot of deals getting done and it supports the market. Not to say private equity firms won't be doing that and they are. We can see Thompson Street’s PestCo doing that in the Midwest. There's not as much small add-on activity now as there has been in recent years, which makes it more complicated for the smaller players.
I fight with a Mexican on this all the time because I tend to be realistic when I look at numbers. As you and I have talked about probably a lot of times on The Buzz prior to this massive run-up in recent years, I was able to size up a company pretty quickly and tell a seller, “You will likely be between X and Y on a competitive process.” If we get super lucky, it's Y plus a few bucks here or there.
It was difficult to do that in 2020 and 2021 because the market was extremely dynamic and constantly ratcheting up. The good news is I always tended to be on the conservative side. I would look at a business, look at returns, and say, “This is a $75 million transaction.” We'd run a competitive process and the sellers would walk away with $100 million and be super happy. You're raising your hand over there.
Patrick Baldwin: Personal experience.
Paul Giannamore: That's right. You guys went through that same thing in 2021. Did the value come out higher than I thought it would, Patrick?
Patrick Baldwin: It did, about 20% higher. You sandbagged us, Paul.
Paul Giannamore: You're welcome. It's one of those things where it shows you that experts in a particular domain can become overconfident over time where if you try to rely on your own expertise as opposed to doing the right thing and testing that in the market. It's the market that sets the price. I don't set the price. I do know that I can look at things and use professional judgment. Most times, I get pretty close but I never know until I run an appropriate competitive controlled process.
The danger for some sellers is when you listen to an expert, you can call me up, we can run some numbers, and I can give you a good idea. At the end of the day, you don't know until you run that process. I would imagine there are probably some folks out there who are less experienced than I am in valuation and I can only imagine the things that they're saying. At the end of the day, 2020 and 2021 were aberrations. A lot of times, in a market, the macroenvironment plays a big role but also supply and demand fundamentals. The smaller firms are having some problems.
What I was about to say is the Mexican and I are always in debate. He's extremely aggressive on everything as you well know. He doesn't like me having public conversations on valuations because he believes that my words somehow set price, the U Group guys told me that. To be frank and transparent, I don't set the price and it's the market. The companies out there that are large and scarce are still, and I'm seeing this live, able to get blockbuster prices. It's down a little bit from Q3 and Q4 ’21 with the number of private equity firms that have moved into this space, this is that consolidation wave.
The real question is how long does this last? Do we end up with some sort of a credit event here in the US, which causes credit spreads to blow out and make it complicated for private equity firms to do transactions? That's the most likely case. It's almost impossible to put a timing on that. If I could time things perfectly, I would've waited for Meme to stop Tesla to hit 190 before doubling down on the short but that's the game that we play.
Patrick Baldwin: With the credit event, are they going to call notes on the private equity, or as long as they're making their payment, they're fine?
Paul Giannamor: I'm Apolitical now as you know, Patrick, but I've always been, as a youngster, a Republican. Back in those days, I was more of a party guy than thinking through the constitution, governance, property rights, sovereignty, and all those things. Now I'm a Libertarian but back in those days, I wasn't particularly fond of Mr. Bill Clinton. I was early high school years.
One of the important things that Bill Clinton did outside of Monica Lewinsky is he took the US government from a long-duration financier to a short-duration financier. If the US government debt was 8 to 12 years in duration because we largely funded the debt through long-term US government treasuries. In the ’90, we had a surplus, yields were continuing to go down, and we moved to short-term duration.
Effectively, Bill Clinton, through his treasury department, put the United States government on a floating rate NINJA loan so no income, no job, and no asset loan. The rate floats because of its short-term duration, 2, 3, or 4-year paper. That means that, at some point, because we've got a heavily inverted yield curve, we've got short-term rates up very high.
At some point, the US government is going to find it difficult to finance itself. That period is getting closer and closer. The Federal Reserve has 1 of 2 options. They can crush demand and be extremely hawkish in order to crush the economy and get short-term yields down so that the government can ultimately fund itself because that's what it's going to need to do. They can pull a Japan and they can do yield curve control, which effectively means they go out and they buy longer-duration treasuries. They go and buy the ten-year treasury and they buy various different bonds up and down the yield curve.
Effectively, the Fed starts to control the US sovereign debt market, which once you do that, it's almost impossible to get out of. When we talk about our credit event, it starts with, “I want my money.” People want their money back. It then turns into a situation of, “I need my money back.” We end up having liquidity issues. If you look at BREIT and a variety of different REITs out there with regard to stopping redemptions, these things start solely and then happen all at once.
As far as private equity firms go, they've raised a ton of money, and they've got a lot of capital commitments. What ends up happening in situations like this is a fund goes out and raises money. I might say, “Private equity firm, I'm going to invest $100 million in your fund.” I write you a check for 10% today, $10 million bucks, and then that additional $90 million, you're going to call out over time as you start to build the assets in your portfolio or in that particular fund. It might be 24 to 36 months.
You might, every four months or so, call me up and say, “Paul, send us another $10 million.” Once I've committed that capital, a lot of these LP and GP-type fund agreements are written differently but there are some common threads and one of which is once I've committed the funds, if I don't pony up that money, I have to pay a penalty. There are penalties to me, the investor.
At some point, if the funds in my hand become more important than putting them in the fund, I might be willing to pay those penalties because I'm seeking safety and having that liquidity in my hand. We could potentially see some of that. I almost think though with PE in the US pest control, there's a limited amount of platforms.
We're doing a platform acquisition and we set the closing date, it'll be February 28th, 2023. We're going to close a platform acquisition for a private equity firm. It'll be an entry deal so it'll be one of those guys that were roaming around Pest World that wanted to get into the space, they finally found a platform, they're doing DD, and it's going to close at the end of February 2023. There are only, in my mind, many of these entry deals that can effectively be done.
We talk about 20,000 pest control companies but the majority of those, more than half are a man in a truck. You start to lose big companies quickly as you go up that scale. There's not that much room. The good news and why the Mexican is excited is that, on the whole, we've seen valuations fall. Companies that are scarce, profitable, and upscale are fetching wicked numbers because private equity firms want to get these and they want to have a platform. If the market does roll over, they've got a vehicle from which they can go out and make acquisitions.
Patrick Baldwin: The private equity that's already in pest control, is there going to be an issue that you see keeping it all together? If they're going to call for the capital that they've raised or that's been pledged to them, they go out and make a call, and then whoever their investors are don't have that money and pony up penalties instead, is there going to be an issue?
Paul Giannamore: I'm talking about the global private equity industry. There are probably some significant private equity issues on the horizon. Remember, private equity is illiquid and it's marked to market on a sometimes monthly, sometimes quarterly, and sometimes annual basis. It's not often marked to market. It lags public markets. There are a lot of NAV values and funds that are higher than they are based on the market dynamics. Pest control is small that that's probably not so much the problem. The private equity feast, at least in pest control, will be relatively short-lived because there's not much to buy from a platform perspective.
Patrick Baldwin: If I may go back to what the U Group is looking at and their theory of what they want to do is buy these $25 million, $1 million, and $2 million maybe, and tuck them into their current platforms. The U Group is not doing a platform, they're not private equity, but they have these twenty or so businesses that combine to form the U Group.
What do you say to the buyer that's still living in 2021 and has heard these crazy multiples? Let's say Fat Pat is a $500,000 business. Fat Pat heard that you can sell your business for five times gross revenue. You approached me and I'm like, “I'm only going to sell to you for $2.5 million.” What do you do as the potential buyer coming in that situation to reground them on what's reasonable?
Paul Giannamore: Sometimes it's difficult to have those discussions because some of the players that you might be talking to are not particularly sophisticated so you're not going to be able to say, “I've ran a DCF and here's what this looks like.” It's hard to whip out comparable transactions, statistics, and show them to the seller. I have often said that if you're running a privately held pest control business and you want to do acquisitions, you have to be opportunistic, and you have to be patient. You have to be willing to talk to a lot of folks in your service area.
I had a guy who called me up and said, “I've been approached by private equity firms and some strategic acquirers and I do $7 million in revenue and somebody gave me an offer for $10 million.” He answered some emails from private equity funds as well as search funds. He said, “The offer that I have in hand is $10 million. I was hoping to get $15 million. Do you think I can get $15 million for it?” I'm like, “You're going to get in the $20s.” He said, “No way.” I said, “Even in today's market, you could potentially push it all the way up to $28 million or $29 million. I don't know.”
Patrick Baldwin: Not just based on gross revenue though.
Paul Giannamore: No. I'm not just doing it based on gross revenue. I signed an NDA and I said, “Send some stuff over.” I had one of my analysts run a quick model, I took a look at it, and I said, “Wait for a second here.” This guy had apparently been living under a rock for many moons because he had zero ideas of what was going on and a lot of guys are like that. They're not listening to The Buzz, they're not watching Bubble Trouble, and they're not paying attention to this stuff and that's fine, they're focused on their business.
They're not thinking about buying something or selling something, I get that. He was so out to lunch on the realities of the marketplace and when he talked to me and he's like, “I can't even believe what I'm hearing.” I'm like, “That's where we are.” The smaller players are of course more difficult because oftentimes, I'll hear somebody that has $1 million in revenue business who wants $5 to $10 million for it and that's not the market.
If you're a buyer, let's say you own Fat Pat’s Pest Control or you want to go out and buy one of these things, you got to take control of the situation. Number one, I don't even ask these sellers what they want for their business. I execute an NDA. You can get away with not even executing an NDA. If they don't ask you, don't do it.
Get some materials, start thinking about the business, and put together a 1 or 2-stage term. One page is better than two. The less you put on a term sheet as a buyer, the better off you are and send it over. Now you're anchoring to a lower number and you start to drive that discussion. “Paul, what if I offend the guy?” At the end of the day, you're not out there trying to make friends. You're out there to buy an asset for less than its intrinsic value. If you do that every once in a while, you're going to get lucky.
I'm not saying for you to be egregious or unfair to people but at the end of the day, there's no price tag on these businesses. The price is bargained at the negotiating table. As long as you, a buyer, can use something reasonable and logical and you can explain it, I would be starting at five times trailing EBITDA would be a good number. Pretty much for some of these smaller businesses, it puts you in $0.90 to $1 as a revenue multiple.
Patrick Baldwin: Even a sub-million dollar business, you've got to dig into the EBITDA.
Paul Giannamore: Yeah. Cashflow becomes less and less meaningful the smaller a business gets because with a $500,000 business, if you're buying it, you might go and say, “Wait a second, I'm taking these accounts and I'm taking a couple of technicians and I don't need this office. I don't need Dolores, the chain-smoking stenographer from Long Island who has been working here for 37 years, I can get rid of her.
Patrick Baldwin: I love you, Dolores.
Paul Giannamore: You can get rid of a lot of folks. For me, it's more of a gross margin game when you're acquiring one of those smaller businesses. From a valuation perspective, yes, you should be using cashflow because, at the end of the day, that's what you're buying. You should be paying the seller based on the cashflow that the business is kicking out and not based on the synergies that you're going to create.
A $500,000 business does $100,000 per annum in cashflow. Once you buy that, you get some revenue enhancements so you're cross-selling some stuff to their maybe pest-only clients. Maybe you get a few price increases and you get rid of Dolores and a few others. Now, that $500,000 business under your ownership is doing $300,000 on the bottom line. The five times I'm talking about is the five times $100,000, which is a $500,000 deal as opposed to five times the $300,000, which is what you've created, which of course becomes a $1.5 million deal. That's how you can go out and create value.
You want to be in a position where, with the smaller guys, you try to put the lowest amount you can possibly put up front whether that's 50%, 30%, or 20%. I would attempt to always buy a business with less than 50% down and the rest being held back on paper. Don't get too emotionally attached and tied into winning the deal. Don't worry about the competition. The smaller sellers will always run off at the mouth, “I talked to this guy and talked to that guy, they're going to give me this.”
Everyone that owns a pest control company always has an offer on their business, “I was offered $10 million for my business.” “Were you?” “I had lunch with a guy and he told me that maybe a business my size code fetch around $10 million.” That's not an actual offer. Even if it is an offer, offers don't mean anything to me until money gets funded at a closing table because a lot happens between a verbal offer and ultimate funding.
For buyers, patience in 2022 will be rewarded, patience when you're going out to buy things. We've got a massively inverted yield curve. There's constant talk about the recession. Recessions or busts tend to be inversely proportional to the boom. We've had a massive boom. The Fed is still hiking into a downturn, which is new.
I would ignore the noise that we see in the day-to-day financial press and think logically about what's going on here. We've still got a robust employment market. We're starting to see layoffs. We've got an extremely inverted yield curve. We've got the Fed that's still pushing the tightening agenda. We've got quantitative tightening. We've got equity markets that are bouncing around. There's a massive lag in this change in monetary policy between when hikes are made and ultimately impacts on the economy take place.
If things look rosy today, it doesn't mean that they're going to be very rosy 6 to 12 months from now. This stuff tends to impact equity evaluations severely. Back in 2020, 2019, 2018, 2017, and all these preceding years, we've had a constant run-up in valuation. If you bought something for $500,000 today, an asset, back in those years, the following year, you could expect it to be worth more and it’ll continue to go up. Right now, you're effectively catching a falling knife. If you can't buy anything on the absolute cheap, it might be good to wait. That's my opinion on it.
Patrick Baldwin: Current events aside, current dynamics of the market, what's happening? They say, “Don't catch a falling knife.” Let's step aside from that for a second. Let’s Paul and Fat Pat have been, every year, going to get their continuing education units together. I see you once a year, we're in the same neighborhood, and the same community but I'm much older and I'm ready to get out.
I'm going back to that $500,000 example. $500,000 gross revenue of Fat Pat‘s Pest and you're like, “Fat Pat, whenever you're ready to sell, I'd like to have a discussion.” One day, you called me, I'm off my rocker, and I drop a $2.5 million number by you. What's step one for you as you're the sophisticated buyer and you're the sleeper that no one knows? It’s like, “Paul's a sharp guy that does pest control.” What do you do as far as sitting in that buyer’s seat to help get me back into reality?
Paul Giannamore: I would say, “Fat pat, you've got a $500,000 business and you're doing $100,000 per year in cashflow.” You want $2.5 million for it. You're asking me to pay you 25 times the pre-tax cashflow for that business. I can go out and pretty much buy most of the S&P 500 for a lower multiple. You're asking me for a higher multiple than most extremely large international publicly traded companies are getting.
You're asking me a dollar per dollar of earnings. You're asking me to pay you more than I would have to pay Rentokil and Rentokil is in 67 countries and has been around for 100 years with a proven track record of growth year over year. That doesn't make sense why I would do that. I would push it back to you. You want $2.5 million for $100,000 per annum in cashflow. What's my cash on cash returns of that investment?
If you do some very basic math, you're saying, Paul, I want you to lay out $2.5 million today. for a stream of cashflow that, today, is at $100,000.” I realize that's going to grow over time. $100,000 in cashflow that I got to pay $2.5 million for implies that I'm getting a 4% return. One of the things right off the bat that I would say to you, Patrick, is I am better at $2.5 million and putting them in two-year US treasuries, that's four spots, 60.
I can get a 4.6% return and I've got a liquid sovereign asset that I can turn over tomorrow and get liquid on. That's basic math to figure out what your return is, the purchase price. You take the cashflow and divide it by the purchase price. This is back in the napkin-type math but it's something that somebody can do with a phone, calculator, or a pen and a napkin. It's similar to a cap rate on commercial real estate.
In a market, you want to be close to targeting 30%-plus returns. Using basic math, that would imply that that's roughly a $330,000 or $340,000 enterprise targeting a 30% return. You might say, “$500,000, that’s 80% recurring. A strategic might come out and pay $600,000 or $700,000.” Sure, they might and that's okay. if somebody else wants to pay for it, sometimes you're better off letting them have it from a returns perspective.
Could you justify it? You could say, “I'm going to target a 30%-plus return on that $500,000 deal, which means, on a standalone fair market value basis, I can afford to pay $333,000 for it.” I'm going to be able to get rid of Dolores, she gets paid $58,000 a year, and I'm able to do a few other different things. Maybe I can bend my front-end returns a little bit and pay a little bit more for it because from a post-synergy perspective, once I acquire that thing, I will be above a 30% return.
That's the zone between when we talk about the difference between a fair market value and investment value. The fair market value is all that a seller has to sell, which is $333,000. The buyer might be able to create value all the way up to a $700,000 purchase price. The delta or the range between $333,000 and $700,000 is where the price is bargained at the negotiating table.
The further you, Patrick, get away from $700,000 as the buyer towards the $333,000, the more value you create. the closer the seller can bring it from $333,000 up to $700,000, the more value they're extracting from the bargaining session. That delta between firm market and value and investment value is where value is extracted from buyer to seller and vice versa. That depends upon the level of sophistication between the parties. That depends upon the level of competition and judgment. There’s a lot that goes into it but that's what the playing field looks like.
Patrick Baldwin: Where do you get the 30%? That's a hurdle, right? Where do you come up with that? That's Paul's versus others out there.
Paul Giannamore: In a normal functioning market outside of the era of quantitative easing, when you think about private equity investments, private equity investors would typically target equity returns on common equity somewhere in the high 20s to mid-30s. It gets higher for VCs but for typical growth companies, you would probably be in the high 20s or the low 30s.
As you start to move up the capital structure from equity, of course, you get preferred equity and then you go into junior and subordinated Mezz debt-type things. In that situation, you would have a 12% to 15% coupon or interest rate, and then there would be warrants so you would get an all-in return in the high teens or low twenties.
Of course, as you continue to go up the capital structure, which becomes a safer investment, then you get into senior and then fully collateralized type loans. That's how returns are targeted along the capital structure for a privately held business in the pest control space. I am all about using historic implied returns, meaning if you take a long-term time horizon, 20, 30, or 40 years, privately held businesses in the pest control space should be targeting 30%-plus returns on their equity. It has changed quite a bit in recent years.
I, for one, don't believe hundreds or thousands of years of financial history are simply undone by dramatic fiscal spending and reckless monetary policy. I believe everything ultimately goes back. I don't think this time it's different. It's going to have to play out. If you're a sophisticated investor and you're looking to grow your asset over a long-term period of time, you've got to determine what your hurdle rates are.
Any investment that you're making, if you're going to greenfield a new operation, you might greenfield a new office and decide, “I'm going to use door-to-door sales guys.” What you should do is calculate how much cash you're going to have to outlay in the near term and what your return is over time and determine what your internal rate of return on that particular investment will be. Compare your investments one against the other to determine the best use of capital and that's allocation of capital.
That’s particularly complicated and not extremely relevant to the average $1 million, $2 million, $3 million, or $5 million pest control business. You're probably not floating around a million different capital allocation decisions. When it comes down to making an acquisition, you will always stay safe if you say, “I need a 30%-plus return on equity. Let me look at the financials that this company is kicking out and let me determine how much I can pay based on that rate of return.”
You can also pretty easily size up what an investment value would be once you get post-synergy. Unfortunately, it takes time to learn. You've got to do some deals because everyone goes into it upfront and optimistic, “I'm going to be able to do this, that, and the other.” It never works out that way. That's why acquirers, that are serial acquirers, tend to at least get better over time at doing acquisitions because they screw a lot of things, they lose people, they calculate returns wrong, and they don't take into consideration various aspects of synergies.
If they make an acquisition and they test it over time and they measure their returns and they figure out what their mistakes are, they will always get better. When you're going out and you're doing maybe your first deal, that's why you should even be more conservative. You should say, “I'm going to give myself a lot of room to screw this up,” because you will and that's great because you need to screw things up to learn.
Patrick Baldwin: Yes, and start small.
Paul Giannamore: Yes.
Patrick Baldwin: Also, give time to learn from your mistakes. If I start small and repeat small deals but don't give myself time to learn, I'm going to keep making the same stupid mistake.
Paul Giannamore: There will be a disequilibrium, so to speak, especially at the small end of the market with the small players. What they want for the business, they want yesterday's price. In fact, a lot of them don’t even want yesterday's price, they want a price that was never available to them, and that always happens.
How do you do that? You date a lot of targets and you don't fall in love with any particular one and you use conservative methodologies to value those businesses. You send out a lot of term sheets. Over time, you'll find yourself in a position where you'll get deals done and you don't get concerned at all about losing an opportunity to somebody.
Patrick Baldwin: Paul, I realized that Fat Pat is never going to get $2.5 million for his $500,000 dollar business.
Paul Giannamore: Correct.
Patrick Baldwin: Unless you took advantage of someone or got lucky. As a buyer, you want to continue to build a relationship and not get mad, I'm guessing.
Paul Giannamore: I would try to take an emotional approach to all of this. Build their relationship, don't take any of these negotiations too personally. This is a business negotiation so you got to do what's right for you and your family.
Patrick Baldwin: Eventually, I'll realize that there's not a $2.5 million offer out there and come back and say, “Can we chat again?”
Paul Giannamore: That's right. What'll end up happening is those sellers, over time, because they do things in a haphazard and wonky way, go out and they'll talk to a lot of different potential buyers. Acquirers are like, “This guy is either crazy or he's completely out of his mind or he's entirely wasting my time because he thinks I'm a moron and I'm going to pay him that money.” Over time, what happens is they frustrate.
Anyone that's out there doing deals on the buy side can relate to this. You get these sellers out there who have frustrated a lot of different buyers and then they don't want to deal with them and now it's like, “Jim, I talked to you four times before and you always wanted way too much money. Nothing's changed from my end. I have no reason to believe you're serious.” They lose part of the acquisition pool, which makes it easier for you.
Patrick Baldwin: Going down on a limb here, running through the scenario. If you make the time as the buyer, to me, the seller, you're saying, “Let me show you why I don't think $2.5 million is reasonable or attainable.” You show, “Here is the 25 times earnings or the 4% cash on cash return.” I don't know if you turn around and do that but if you sit there and educate me as a seller and what that implies compared to the S&P 500 in your example, then you've educated me in the process and I’m more likely to come back. That helps build that relationship. It helps anchor my thought process, which is like, “I was crazy to think $2.5 million.” I might even be embarrassed for a minute but eventually, I would come back to you
Paul Giannamore: As you should be.
Patrick Baldwin: I'm always embarrassed.
Paul Giannamore: These are opaque markets. Typically, sellers always talk about potential, like, “\This business has so much potential if it was run by somebody other than me. It would go gangbusters and blow up.” They use all this hyperbole. At the end of the day, I do believe to the extent that you can, as a buyer, take control of the valuation discussion from the get-go. Explaining those things is helpful in educating sellers.
Quite frankly, the worst thing in the world is for somebody who's got $50,000 in the bank who's starting to plan to retire, and who thinks that their business is worth $2.5 million and they're making all the, “Honey, we're going to move to Arkansas and we're going to buy a house and we're going to retire because, after taxes, I'm going to have $1.5 million.” It turns out that it will be a fraction of that. It's good for them to know that now. You can help people by educating them on that.
Patrick Baldwin: I love it. When buyers are looking at a book of business, commercial is a wide spectrum from dental offices, restaurants, or apartments to high-end food processing and agriculture. Is a dollar of pest control residential the same across the board no matter if I'm including quarterly inside, outside, or bimonthly pests? These pests are warranted. How deep are they going and chasing that?
Paul Giannamore: Remember, valuation is always very subjective. There's no objective price or objective value of something, specifically when we're talking about the purchase and sale of businesses. Let's take private equity and push it aside for a second and say that all deals are done by strategics, industry players, Orkin, Rentokil, Anticimex, Terminix, and the regional players. Everyone is going to have a different view at a different point in time based on what their objectives are.
Rollins might be trying to ramp up commercial so they're more excited about doing commercial deals, which they have been for many years. Other firms, Terminix, for example, was always historically up until the acquisition of Copesan, more residential focused, and they would like to buy residential general pest because they wanted to cross out termites and play in the residential game. Every acquirer will have a different view as to what that business is worth to them based on how it fits with their operating profile.
I had this discussion with Richard Rollins, who is the grandson of Randall, who is the southeast division president for Rollins. He's down here in Puerto Rico. We were driving back from Dorado and we were talking about lawn care. The debate came up, Orkin does lawn care in Florida. I didn't even realize that they're doing lawn care under the Orkin brand.
There's always that age-old debate that if you're going to do pest control in Florida, you have to do lawn care. He's like, “I don't believe that's the case. There are plenty of specific market data and reference points of companies that are not doing a lick of land. You think about Frank Miller’s, Frank and Cindy's business, impact. It was a pretty big company and I don't remember them doing any lawn care. There are a lot of companies out there in Florida that is focused on pest and termite, for example, not doing lawn care.
A lot of us in the industry believe this is the way it's done because it's the way it's always been done. When we hear, in the echo chamber, that being said enough, it becomes the truth when there's no empirical data around it. I do like some of the thought processes that certain private equity firms bring to the industry because they don't bring the same prejudices that the current operators do and they're willing to look at things differently in a market that is evolving, albeit slowly.
Patrick Baldwin: Here's where I'm going with my question. I know pricing is important, with the end of mind. An acquirer is not going to want to buy monthly general pest control, inside and outside, in Waco, Texas. I'm thinking quarterly because that's what Rentokil-Terminix or Orkin, those are the two big ones in the market right now here. That's what they're going to do, quarterly. They would probably prefer exterior-only on a recurring basis. What can I do as far as getting my price per service up without blowing that model up? I include all these pests and like, “We don't like all those pests included.” Going all the way to the line without pushing it to maximize my residential pricing.
Paul Giannamore: This is the age-old discussion. I remember in Tampa, there was a little bit of discussion on this topic as well. On residential general pest, you have a spectrum. On the one end of the spectrum, you have the annual service, which is Chuck Steinmetz, and the whole Sears thing back in the day where you come out and you do an intensive first treatment and then they're basically on a warranty for the entire year. That is an extremely difficult business and it’s one that none of the acquirers do and would be interested in, the annual service.
On the other end of the spectrum is monthly residential. For the same reason, that is a complicated one. You don't want to be at either far end of that spectrum. When it gets down to every other month or quarterly or tri-annual, I'm not focused on the price per service. I'm always focused on the price per annum. What are you charging for general pest control on a program for a year?
Granted, if you take that per annum number, let's call it $500. You got a $500 per year general pest program. We'll have to do some math. Patrick, remember I'm not a mathematician. At $500, it's $1.25 per service on a quarterly basis. On a tri-annual basis, it's $1.66. The lesser the service frequency is the more you're making per service and there's a trade-off between geography.
Over the last several years, I have noticed that there's been a lot of companies moving from quarterly treatments to tri-annual and a lot of them in the northern markets will call it seasonal, meaning we will come out and service you in the spring, the summer, and the fall. You're in Wisconsin and there's two feet of snow in December, January, and February. We're not coming out but you're paying for the full year. If you have any problems in the winter, we will of course come out and treat those.
To me, somewhere between quarterly and tri-annual seems to be a great service frequency. In California, there are still a lot of folks doing bimonthly or every other month services. When I talk to those operators, they say to me, “We've got to do it every other month because it's hot out here and we get a lot of bugs. If we don't do it every other month, the pest pressure goes up.” I never know if that's truly been tested.
I don't know if it's the way it's always been done but I can tell you that with my own eyes, I have seen folks in similar markets in California. Some do tri-annual, some do quarterly, and some do every other month. I don't know what the truth is. I'm not an entomologist. I'm not even a pest control operator. I do think it makes sense to test that. If you can slow down the frequency and do less services per annum, there's probably a balance.
We dealt with this with Killingsworth. Killingsworth had a low service frequency and Anticimex added some additional services to stop callbacks and they've felt like, “We will be able to route this better if we have more service frequency.” I do think you can use your business as a living laboratory and test it. If you're trying to figure out, “I'm doing quarterly right now but I'm in a cooler climate. Maybe I want to go to seasonal.” Start this year and start selling at the same price that you're selling quarterly. Start some new customers on a seasonal program. You're doing spring, summer, and fall. You're on call. They're paying for a pest-free environment. Add some accounts.
Patrick Baldwin: Holy crap, Paul, “Spring, summer, and fall, we're on call.” Did you come up with that?
Paul Giannamore: There you go. I didn't even think about it but yes. That's a good thing to try.
Patrick Baldwin: Tony talked about that way back in episode five, how he wished he would've gone from quarter to bimonthly, or maybe he did do that to cut down and retreat so he can route it better. Going back to what you said, your first focus is residential, you're pricing per annum. Number two is frequency.
Paul Giannamore: If I'm an acquirer and I look at it and I say, “You're doing annual services, Fat Pat.” It's hard for me to convert those annual services into quarterly, which is what I'm doing. You're doing monthly and I'm doing quarterly, you get on the far end of the spectrum and there's a real mismatch, and they worry about degradation of accounts after a changeover.
If you can figure out a way, at least on the residential side, to be more in the media area of the bell curve, which is 3 times per annum to 4 times per annum, that sets you up closer to the operating profile of acquirers, and it'll make it easier for more of them to integrate your business. We've had episodes on you shouldn't build your business around what acquirers want or don't want but it's also probably pretty good to don't build your business around things that none of them like, like selling chocolate bars and whatever else.
Of the comments that we've gotten in the almost three years that we've been doing The Buzz, the discussions about separating the billing protocol from service, getting rid of service fees, getting on monthly recurring billing, and selling a pest-free environment almost like a warranty product is probably the biggest comment that we've heard. The most change people have made in the business is doing that.
The industry is making strides and it has been and has been even before The Buzz to say, “This is what a pest control company does.” We come out, we take care of your pests, and then we maintain a pest-free environment through preventative pest control. If you can continue to sell that as your message, you'll do very well.
One thing that we talked about at POWER, a few of the questions was, does it ever make sense to do one-time services? Should I do a wasp job or should I only sell, like, “If you got a wasp problem, you got to sign up for a plan.” I don't know that it makes sense to be the guy who never does any of it. It sounds cool, like, “I never do any one-times. I'm 100% percent recurring.” In a lot of ways, those are paid leads.
You're advertising, you get a lead for a wasp, and somebody's got a stinging insect nest and they need it removed but they don't have pest issues. That might not turn necessarily into a recurring plan. If your team is trained right to try to sell recurring pest control and you can get them out on site and they can do a little bit of an inspection, there are some benefits to doing one-times. There are zero benefits to doing all one-times. We can take everything to an extreme.
Patrick Baldwin: Paul, I'll do your wasp job for $42 a month.
Paul Giannmaore: Yes, exactly.
Patrick Baldwin: Make the wasp your annual pricing. That's a good recap. Paul, you recapped three years of The Buzz if you listen to this one episode. It reminds me of David Dart's interview. You're like, “If you listen to this one question answer, it's the best thing.” Thanks, Paul.
Paul Giannmaore: Mr. PB, I want to poll our friends and family in the industry out there. What is the email address once again for The Buzz?
Patrick Baldwin: I want to know why you're asking. Are you selling chocolate bars or cookies?
Paul Giannmaore: Tell the email address first.
Patrick Baldwin: TheBuzz@PotomacCompany.com.
Paul Giannmaore: Mr. PB and I are about to switch some things up. We've got some things here in the pipeline for The Buzz. It's been particularly busy as of late. We've had some great interviews but we're going to be doing some different ones here soon. Why I wanted PB to give the email address is I would like to poll you and determine what are some of the most important questions that you have for us in The Buzz, whether it's for Patrick, myself, or any guest that we might get on the show. What are some topics you want to hear about?
One of the things that I've been thinking about a lot, Patrick, this year or going into this year, I thought it would be particularly interesting to start to poll more from outside of pest control onto The Buzz. We had this chat in Tampa. I have often preached that some of the best ideas come from outside the industry, comparing yourself to fast-growing businesses in other areas.
What I would love to do is broaden The Buzz this year into broader resi and commercial home services. Of course, pest control is always in our hearts but I would like to expand it and get some folks that are doing things in tangential industries to come on. My capacity over here, 80% of what I do is pest control but 20% of that is I'm in waste management. I'm in HVAC, janitorial, and all these allied facility services businesses not only in the US but also in Europe, Asia, and around the world.
I see some cool things and I think to myself, “That would be interesting if a pest control company did that.” It reminds me of the discussion that I had with Jared Borg. There's a video where Jared Borg never regrets being bold or something to that effect where he talked about the appliance company that came to his house and gave him all those different ideas about the welcome mats and all those things.
I have, as of late, been doing some transactions here. I've been focused on pest in the last 3 or 4 years because if I didn't focus on pest, I wouldn't sleep at all. In recent months, I've traveled around and done some pretty cool transactions. I want to start pulling some guys in that are doing things like, for example, restoration, HVAC, or waste management. Not only from a customer relationship management perspective but the things that they're doing on the marketing side are different. It might help cross-pollinate some ideas as to how to grow a business. What do you say, Patrick?
Patrick Baldwin: I love it. You talk about the echo chamber that I've experienced in pest control for over fifteen years. It's time to explore. I've got a couple of people lined up for this but I'd love to get some questions coming in.
Paul Giannamore: I want to understand how our audience feels about that and if they want me to go hog wild. I'm going to ask Peter Korda. Patrick, as you know, Peter ran Scott's lawn service. I put Peter up there as one of the top five most intelligent individuals I've ever worked with. He reported to Jim Hagedorn, the CEO of ScottsMiracle-Gro. He ran the lawn care business for some years and then ultimately went over to Empire Carpet. They had a private equity event. He is a sharp and sophisticated operator in a route-based field services business.
He hired me in 2011 and I did a 4 or 5-year engagement with Scotts, which allowed me to learn a tremendous amount, specifically traveling around the country and watching this guy. Of course, it was lawn care. at the end of the day, you're sending a technician out into a truck to service somebody's home not only from a marketing perspective but how the technician carries himself, how he deals with the customer, and communication. All of that stuff is much the same. I want to maybe bring Peter on here. There are a ton of different folks in different industries. Patrick, there are even a couple of tech CEOs that I know in YPO that would be phenomenally helpful to pest control and resi and commercial services guys.
Take the time, send us an email, and let us know if you like this idea or if you do not. If everyone says, “No, we just want to talk about pests. Don't do it.” That's fine, we won't do it. If you want us to expand your horizons, which I'm pretty excited about doing, let us know and we will do it. Patrick, what we should do is we should let the audience decide.
Patrick Baldwin: Done. You are a political man after all.
Paul Giannamore: Today. When you're reading this, I want you to send us an email, TheBuzz@PotomacCompany.com. Expand or not to expand. Give us questions, comments, and suggestions. If you have not reviewed us and given us awesome five stars on Apple or wherever else you may enjoy this podcast, shame on you. You should do that. With that, Patrick, I will say, in closing, I've counted and over 73 people have come down to Puerto Rico to visit us. It’s a ton. We had a lot of folks. There were 27 this week, believe it or not, Patrick. I didn't add those. I didn't think about this last week. It's over a hundred.
We've done a lot of management meetings down here. I'm not counting people twice. We've had a lot of acquirers come down here for due diligence. I am starting to hold a lot of meetings with clients down here. If you want to come down to Puerto Rico and spend some time with me, the Mexican, and the staff, track us down, especially while the weather's nice down here. By the time summer comes around, I'm going to be out of this hot box. Come down and visit us.
Patrick Baldwin: Free entertainment with the Mexican.
Paul Giannamore: There’s no such thing as free entertainment with the Mexican.
Patrick Baldwin: This is awesome. Send in your emails. Paul, have a great weekend.
Paul Giannamore: You too.
Patrick Baldwin: I'll see you next episode.
Paul Giannamore: Till the next episode, PB. Thank you.
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Dylan Seals: I want to remind you right now to go ahead and subscribe to The Boardroom Buzz. We have got some incredible episodes coming up that you're not going to want to miss. Also, if you've enjoyed the podcast, please go to the Apple Podcast app and leave us a short review. We'd love to hear from you. Thanks so much again for reading and we'll see you next episode.
Episode five
David Dart
TheBuzz@PotomacCompany.com
Apple Podcast
