Private Equity in Public Markets. Hunting 3x's in 5 Years.

Jeremy Kahan and his brother Michael co-founded North Peak Capital following careers in finance. They both attended Harvard Business School, Michael after a bachelor’s from Harvard College, and Jeremy after a bachelor’s at Yale. Their fund employs a novel strategy that matches their backgrounds: private equity style brought to public equity investing. Kevin Harris from SumZero sat down with the Kahan brothers to discuss North Peak, portfolio management, and value investing.

Kevin Harris, SumZero: During your time on SumZero, you’ve topped our Last Twelve Months, Growth at a Reasonable Price, Micro-Cap, and Technology Rankings. How would you describe your investment philosophy and process?

Jeremy Kahan, North Peak Capital: We describe our strategy as private equity in public markets, which means that we do very deep, private equity-style fundamental research on a concentrated long-biased portfolio. We are looking for businesses where we can triple our capital in five years. We write memos akin to the materials prepared for a private equity investment committee – actually akin to the ones we used to prepare for our investment committees at Onex and MSD Capital, respectively.

We believe that the process of “writing it down” enforces two important disciplines: first, it requires us to slow down and think carefully; second, it helps ensure that we are thorough, that we’ve considered all of the requisite facets of an investment – valuation, return on capital, growth, margins, risks, barriers to entry, customer concentration, performance through a cycle, value proposition, competitive advantage / moat, pricing, etc.

Ultimately, we believe this process is the cornerstone of strong fundamental investing.

In terms of philosophy, we are value investors. For us, that means that we are hyper-focused on value relative to price. It also means that we try to take a defensive posture, thinking deeply about how our investment will do under adverse circumstances, and trying to make sure that in the long term, we are unlikely to lose much money in those scenarios.

Lastly, we believe that good investments take a variety of forms, which is why I’ve been ranked on a variety of your lists. There are no perennial hard and fast rules in investing. What worked yesterday typically won’t work tomorrow, because the algorithms (and the herd) tend to invest in yesterday’s success. That’s what makes it such an intellectually demanding and fascinating discipline.

The only rule that will be forever true is that you should wait to invest your money until you find something that you can buy for less than fair value.

Harris: What is the story behind the launch of your fund? What led you and your brother Michael to launch North Peak?

Kahan: Most importantly, we knew that we wanted to build an investing career together, and we were trying to figure out the best way to express that.

Michael was pursuing private equity as an independent sponsor while I was at Bow Street, and we repeatedly observed how the valuations he was seeing in the private markets were so much higher than those that I was finding in the public markets. This view is contrary to conventional wisdom, which holds that public markets are more efficient than private markets. The conventional wisdom makes sense. There are millions of market participants setting the marginal price of a public stock compared to just a few in a private setting. But the private markets have become extraordinarily sophisticated, with investment banks conducting sale processes with a very sophisticated set of buyers, each of whom is competing to find the best “angle.” Moreover, those individual professionals are under extreme social and professional pressure to invest with a certain frequency, or risk losing their high-paying stations. By contrast, with the rise of ETFs, and the well-documented underperformance of “active management,” public markets have ever fewer people setting the price. And importantly, many of those who do have a host of incentives involving more than just identifying excellent investments: for instance, they are usually incredibly focused on monthly volatility to satisfy an institutional investor set who has relatively modest return expectations.

Against this backdrop, my brother and I decided we could actually compound capital at a higher rate of return in the public markets, and launched in August of 2015.

Harris: What books or investors have most impacted your investment and valuation philosophies?

Kahan: I learned a tremendous amount from John Phelan, Glenn Fuhrman, and Eric Rosen while at MSD Capital. Michael always credits Gerry Schwartz, the founder and CEO of Onex, as teaching him to identify excellent businesses, which is the most important pillar of our investment approach. Marrying that with a keen focus on price, I’d say we look to Buffett (who doesn’t?) and Klarman, who taught Michael while at HBS. Henry Patner, who is a dear friend, now at ESL, is one of the most learned value investors we know, and is always a great thought partner. Greenblatt ideas are simple, yet powerful. If you haven’t, read The Little Book that Beats the Market you should. Bruce Greenwald’s Value Investing is a masterpiece, as is his Competition Demystifed. We are also fans of Howard Marks’ letters.

We could go on, but we spend more time thinking about industry dynamics than we do about investing philosophy per se. In the end, we believe that if we get the micro economics right, we have the best chance of identifying the glide path from a little free cash flow per share to a lot of free cash flow per share. We spend most of our time looking for the most certainty around those paths.

Harris: Your past SumZero ideas seem to indicate an interest and inclination towards technology investing. Could you walk us through your technology philosophy?

Kahan: We love the technology sector. First, technology companies often possess our beloved cocktail of strong and sustainable top line growth as well as operating leverage. It’s hard to not love a business with 80%+ gross margins, when it’s also growing 20% annually. When you start to think about how much gross margin is being added relative to the current profitability, you suddenly find a universe of businesses that have the potential to increase their profitability by multiples.

Moreover, many of these businesses, especially the SaaS software businesses, have a recurring revenue business model with extraordinary revenue visibility.

Sometimes we joke that technology has been pretty important, since they invented the wheel. It certainly seems to us that it’s a good place to park meaningful capital over the next two decades.

Lastly, I’ll note that technology companies are also in dynamic sectors that have the ability to be misunderstood by the market. Many of the companies are new (relative to say P&G), and therefore people don’t know how big they will become.

Of course, the “problem” with the technology sector, from the perspective of a value investor, is price. With Softbank leading a frothy fundraising environment, sometimes companies trade at astronomic multiples that would make some of the authors of the books I just referenced blanche. Here, the key is to pick your spots very carefully.

We don’t invest in the technology sector broadly; we are making a few large investments with idiosyncratic asymmetric risk reward.

Harris: How diversified of a portfolio does North Peak run? What are your high-level thoughts regarding portfolio diversification?

Kahan: We typically run about 125% long by about 50% short, with a substantial portion of the short portfolio an index short. We typically have 10-12 long holdings and 3-5 short holdings. While this is regarded as highly concentrated compared to most hedge fund investors, on the long side, that model mirrors the construction of a typical private equity fund, which often has 10 to 12 investments in a fund. After having been involved in the private equity industry for many years, we observed that it’s quite rare for a private equity fund, that is typically shooting for a 2.0x – 2.5x multiple of capital on each of 10 investments, not to return capital. In other words, an investor who makes 10 investments with the genuine intention of making 2.5x on each, has to be quite wrong to end up in a place where his or her capital is impaired in the aggregate. That’s why we believe that this portfolio has sufficient diversification to protect our capital.

We believe that most managers are too diversified. Why not take the capital from your 50th best idea, and put it into your 1st best idea? Isn’t that going to help you compound capital at a higher risk-adjusted rate? Presumably, and by definition, in the manager’s judgment, the best idea has a better risk-reward characteristic than the 50th best idea. We believe that the reason that most managers do not do that is that they are optimizing for lower volatility, and not optimizing for compounding capital at the higher rate of return possible.

Many investors dislike the volatility associated with a concentrated fund. We also don’t like volatility, but we’re temperamentally willing to endure some volatility for significantly higher than average returns. Warren Buffett famously said that he’d rather have a lumpy 15% than a smooth 12%. That philosophy guides our thinking.

Harris: You’ve submitted a handful of shorts to SumZero during your time as a member. Could you detail the role that shorts play in North Peak’s portfolio?

Kahan: We spend 85% to 90% of our energy on the long side of the book. First of all, it represents much more of the exposure (125% points of long exposure, versus 20%-25% points of alpha short exposure). Second, for all of the obvious reasons, we size our shorts smaller. Short exposure increases when the market moves against you, and shrinks when it moves with you. You have to worry about the cost of borrow, as well as short squeezes. Also, shorting profits have a short-term tax character. Markets move up over time. In every respect, the deck is stacked against shorting.

So if a 15% long triples (which is our objective), we have the potential to earn a profit of 30% of our capital or 25% after tax. If a 6% short, which is larger than our typical short, triples, it falls by 2/3, or becomes worth 2%, so we earn 4% of our total capital, pre-tax, or 2% after tax. It’s just not possible to move the needle with the individual shorts.

That said, if you believe in 50 cent dollars, which we do, you probably also believe in 150 cent dollars. When you find one, you should short it. And we have done so quite successfully. Since inception, in a market that has been up roughly 45%, our single name short portfolio has made money. This is an accomplishment that we are very proud of.

We also use shorts to create interesting stub trades (we have one on now), paired trades, and to manage tax efficiency. In the end, shorting is a valuable tool, but, if we continue to be successful, unlikely to be the leading driver behind that success.

Some people turn that around to say why short at all. We respond with why not short when you can. It’s another avenue to make money. It also pays well when you most need it. And lastly, our shorts have funded our long book to be 125% of capital, effectively creating profitable leverage.

Harris: What role do online research tools like SumZero play in your research process?

Kahan: We look for ideas in a variety of ways, and certainly like to tap into talented communities of investors in order to source ideas. That said, we tend to spend more of our time identifying opportunities through screens, benchmarking and reading. If you follow the herd too closely, it’s hard to find differentiated ideas.