Lessons From Capital Returns
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Lessons From Capital Returns
Atlasview Insights -- bite-sized weekly insights that are relevant to all business owners, dealmakers, and investors.
Happy Wednesday folks!
Thanks for joining us for another edition of Atlasview Insights. We’re back with another week of sharing bite-sized insights that are relevant to small business owners, dealmakers, and investors.
If you are not familiar with Atlasview Equity, we are a private equity firm specializing in software and tech-enabled businesses. You can learn more about our team and investment criteria: here.
In this newsletter, we cover:
Lessons From Capital Returns
Our Favorite Reads
Insights From Our Team
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We look for the following characteristics in our partner companies:
Industry: Software and tech-enabled businesses
Business Profile: Sticky B2B customer base
Size: Minimum $1m EBITDA or $5m ARR
Geography: The US & Canada
Whether you’re a business owner interested in working with us, or an intermediary with a deal to share, always feel free to reach out and get in touch with us!
Lessons From Capital Returns
Today we wanted to share some lessons from one of our favourite books, Capital Returns. It’s a collection of letters from Marathon Asset Management from 2002 to 2015.
The book’s premise is that capital flows dictate a lot of what happens in an industry, and the economy at large. It’s good to zoom out and look at the bigger picture to help understand why businesses succeed and fail at generating sufficient investor returns.
When it comes to investment returns, capital flows can easily trump management, strategy, unit economics, and business model. Being on the right side of capital flows can generate sizeable returns. And being on the wrong side of capital flows can absolutely destroy your returns.
As an investor, having a sense of capital flows will allow you to understand which industries/businesses to pursue or avoid. It’s like understanding which casino tables have rules that are rigged in your favour before placing a bet.
On Capital Cycle
This diagram is basically the crux of the book, or what the author refers to as “Capital Cycle Theory”:
When an industry experiences growth, it will attract excess capital from investors (mostly due to investors over-extrapolating growth). Two main things happen when too much capital flows into an industry:
Supply increases: the excess capital attracts new competitors to start up
Capex overspend: businesses spend too much on assets (or even worse, opex)
The result is that investor returns worsen subsequent to excess capital flows. Conversely, when capital is sucked out of an industry – investor returns will, generally, subsequently improve.
There is no such thing as a “secular growth” industry. Every industry is cyclical, it’s just some cycles are longer than others. Before making an investment into a business, it’s important to understand where it stands in the capital cycle.
On Prisoner’s Dilemma
When too much capital flows into an industry, a prisoner’s dilemma scenario ensues with incumbents. It becomes an arms race on who can spend the most on capital expenditures. The businesses become overbuilt and need to maintain that high level of capex in order to be competitive.
What’s interesting is that we’ve actually witnessed this exact scenario play out in software businesses firsthand.
On Consolidation vs Fragmentation
Is an industry consolidating or fragmenting?
If an industry is consolidating, that means supply is decreasing and it’s a telltale sign of capital flowing out. Consolidation occurs when dominant players start to acquire or merge with other players. Or even when the dominant players remain strong while other players go out of business (and new ones aren’t popping up). As the number of firms in an industry starts decreasing, investor returns generally increase.
If an industry is fragmenting, that means supply is increasing and a telltale sign of capital flowing in. This happens when new entrants start up or divestitures and spinoffs of existing businesses occur. As the number of firms in an industry starts increasing, investor returns generally decrease.
Analyzing the nature of and the number of incumbents in an industry is a core part of Porter’s 5 Forces framework. This is critical to understand before investing in a business.
On Supply vs Demand
Focus on supply instead of demand. Demand is hard to predict and can change rapidly for a multitude of (often illogical) reasons. Supply only reacts to demand or to capital flows, and usually lags behind, making it much easier to forecast.
Too many investors get awestruck by rapidly increasing demand or how quickly an industry is growing. But if there is nothing to ensure a supply/demand imbalance, the businesses will not generate outsized profits (and investors will not generate outsized returns).
On Investment Bankers
Though the author was critical of investment bankers – he did acknowledge that they serve a key function in our economy and possess valuable information. Investment bankers grease the wheels of capitalism, they make deal activity happen and capital flows smoother and more efficiently.
Investment bankers, being in the business of M&A, know exactly which industries are consolidating and which industries are fragmenting. As well, being in the business of raising capital, they know which industries capital is flowing into.
When speaking with investment bankers, ask about their recent mandates & successful deals!
Our Favorite Reads
Insights from our Team
Operations
Investing
Atlasview’s Investment Criteria
We look for the following characteristics in our partner companies:
Industry: Software and tech-enabled businesses
Business Profile: Sticky B2B customer base
Size: Minimum $1m EBITDA or $5m ARR
Geography: The US & Canada preferred
Whether you’re a business owner interested in working with us, or an intermediary with a deal to share, always feel free to reach out and get in touch with us!
About Us
Atlasview Equity is a private equity firm specializing in software and tech-enabled businesses. We combine patient capital with proven operational strategies to deliver predictable results for our stakeholders.