PODCAST EPISODE WITH ANDY ELLIS FROM LOCALIZE CAPITAL (PART 2)

With trying to localize capital, it sounds like most of the capital for from fund you are raising from local investors. Is that a big part of your pitch to them is saying now you can invest your money here in Pittsburgh with us?

It's not our personal capital. I wish that I made enough money in my previous job that I could have done this and this is absolutely how I want to invest my wealth moving forward, is to have a significant portion invested within my region in a fashion that makes sense for my long term objectives. I want this region to get better. I want young people to start or continue to move here, start businesses here, work here, start families here, et cetera, et cetera. And it dawned on me as I was living in California and I would get harassed by my aunts and uncles. And I'm going to make them listen to this podcast so they'll both get to hear me say this. But they used to harass us. I had a few cousins that lived in LA with me and they'd say, "I can't believe you guys live in Los Angeles. Why don't you move back to Pittsburgh?" I mean, even my uncle that lives in Dallas would harass us about moving away. And it finally dawned on me a little where I used to start to harass them back and I would say, "Look, we followed your money."

You're a lawyer. You're a doctor. You are some sort of professional. You make money, you pay for your base needs locally. Sure you go to local restaurants and things of that nature, but all of your excess capital, you take it and you invest it typically on the coasts. It's invested with investment firms on the coasts. Typically a lot of the companies that you're invested in are not within this region, and then you harass us millennials for moving away from this city when really we followed your money. The idea being that we want to get more money invested locally and that's absolutely, we think, going to be a huge motivation for why people will invest with us, even just if it's a small portion of their overall net worth. So yeah, the idea is to engage high net worth, ultra high net worth individuals, entrepreneurs, people who still own operating companies, people who have sold operating companies, and single and multi-family offices.

And are they pretty excited about being able to put a dollar somewhere in the region? Does that resonate with most of them or are most of the investors you talk to still like, "No, I just want the best return and wherever I get that I don't care as much." Where do people generally fall?

It's a mix and it's all personal. But the fact of the matter is is that I think a lot of people want to invest locally, but right now their options for doing so are "high risk startups" and real estate. And many of these people already own real estate locally. So their options for bringing money home are small. They don't have an opportunity. And fact of the matter is the majority of them, what they want and need is actually income from a stable asset. Well we actually have that here in spades. We have tons of great multi-generational family businesses that are extremely independent, they manage their businesses with very little debt, they optimize for unlevered free cash flow and they manage for survivorship. They have a playbook for how they have lasted through inflation and recessions and things of that nature, and they don't view their business as a financial asset. They're not trying to optimize their EBITDA to try to ratchet up their enterprise value. They just don't care.

We have that mentality. We have those businesses in spades. And I think it's exactly what people ... These yield starved investors, it's exactly what they're craving and it's in their backyard. And by explaining ... This is what we're trying to do is by explaining that it's so detached from how the young people coming out of Pitt and Carnegie Mellon and all the other universities locally, it's the antithesis of what they are being taught in regards to how they should start businesses. So it's bringing the high net worth individuals who are seeking income together with the people that own these big beautiful cash flowing assets and getting them to agree.

So the fund structure, there's two funds, but collectively we called it a shared risk partnership. Collectively the stakeholders are going to share the risk to invest back into the region to motivate and push entrepreneurs to build and grow sustainable businesses with sustainable business models, and pass down the stories that these multi-generational family businesses have. This ethos and what's been ingrained in them for generations or decades, it's not being transmitted to the next generation of entrepreneurs.

That's the big motivation is if we want to see our region grown again ... We were the richest city in the country at the turn of the last century and everyone's talking about how Pittsburgh, with all of our innovation and all of the tech coming out of these universities, we're going to light the world on fire. We're about to arrive again. If we haven't already. And the irony to me is you talk to a lot of entrepreneurs and you talk to a lot of people in the ecosystem, we ask them, we ask these young entrepreneurs to plan their exit before they've even started running a business. They are starting and building the business, they're optimizing that engine to build something that is designed to be sold. And typically it ain't being bought by somebody in Pittsburgh. Typically it's being bought ... If you can ratchet up the valuation enough through sequential rounds of financing and hit your fundable milestones and build this business, if you're getting bought out a really high enterprise value, traditionally you're getting bought by someone in New York or California. And oftentimes what happens is most of those jobs leave.

Not to mention, the insurance companies in Pittsburgh that used to underwrite the insurance for these companies. All of the other tangential businesses and service providers that depend on those businesses growing here and growing where they were planted, that business all goes away as well. So I think it's important stuff. It's not that businesses shouldn't be sold and they should be run by the same people and owned by the same people into perpetuity, but from the outset it's completely contrary to the way business owners and operators here in this region think about their businesses. Right now we're turning these business plans, before they're even businesses, the plan is how do we turn it into a financial asset?

It sounds like with Localize a big part of your mission so to speak is education and trying to teach these owners and even students coming out of school that have been learning about what we talked about the finite and infinite games. They've been taught the rules for the finite game even though they're about to play the infinite game. Can you describe the two and how that education works into what you're doing?

I laid out a little bit of the framework here where it's like as a region, as a city, as a place that is trying to grow and attract more young people and attract more capital, we've set up the rules of the game. I think it's very often helpful to ... Playing finite games is in and of itself not a bad thing, but you still have to understand the game you're playing in the context of the greater meta game at play. And if you lose sight of that, what ends up happening is it leads to a lot of frustration and confusion. So yeah, it's a re-education process in the sense that moving back and getting ingrained into the entrepreneurial ecosystem here, it was so common for me to hear ... And this is something that I heard in my past life selling financial products was, "Oh my gosh, these people are so risk averse. They're so risk averse. It's unbelievable." I always have to pause, and I thought this whenever it was a financial advisor client of mine and I think it whenever I talk to a lot of entrepreneurs.

No, this person is not risk averse. They have an aversion to the risk they're being sold. The ecosystem is trying to suck more money into the system to play this very defined game. Venture capital serves a very specific purpose when done the way it is intended to be done. You're investing across a basket of ideas or businesses. You have a basket of X number of idiosyncratic risks where each idiosyncratic risk has a potential to create such a massive return that if the majority of them fail as they so often do, then just the two or three successes within the portfolio will return a great return. It's a mechanism that is designed to fund very specific things. But given that banks aren't giving loans and money's hard to come by when you're a young person and whatever, venture capital has become this thing where it's thought of as our savior.

You look at a lot of the venture capitalists in some of these small cities, they're looked at as the potential savior. They hold the key. If only we had more money, we would have so many amazing businesses and so much success and so much wealth. We just need more money. We just need more money. So it's re-informing this at an ecosystem level thinking about what is the game we're playing at the ecosystem level? What are the finite games that are being played within the broader, more infinite game that we're playing as an ecosystem? Finite games are from a book written by James Carse. It's like game theory on the edge of like philosophy, which I love to geek out on and think about. But finite games are games where you have known players. There's known boundaries, known roles, and defined objectives.

Thinking about the entrepreneurial ecosystem, we have known players such as incubators and economic development corporations. We have the investors, the institutional investors. We have angel investors and angel syndicates. We have all the universities. There are these known players in the ecosystem. And the thought process is if we can get these ideas out of the universities and start to commercialize them, we can utilize all the resources in the ecosystem, play this game, and the game is to optimize for building businesses that achieve really massive enterprise values where many people within those organizations own stock so that you can reach a liquidity event, whether that be a large acquisition or an IPO. And once we get a few of these really big exits, all of that money's going to be recycled back into the entrepreneurial ecosystem and create more and more and more and that's what happened out in the valley.

So we find ourselves playing this game, but we're looking at a lot of the stakeholders in the region going, why aren't they playing the game? Why don't they see how serious this is? We're building businesses here that can change the course of this city, why won't they give us their money? Why won't they invest in this model? So we've been playing this game for a very long time and there's a lot of frustration and confusion around why so many people don't engage. People get in their heads, well there's no money here in Pittsburgh. That's wrong. It's dead wrong. There is tons of money here. And this notion is perpetuated within the ecosystem also that money's a commodity. And this is something Brent talks about a lot and it plays into some of this game theory stuff, but money's not a commodity because it's attached to people and people have preferences and needs and wants and fears. What we're trying to do is to educate the entrepreneurs and show them look, there's another way. You can actually play a game that makes sense to the stakeholders that are here that are playing an entirely different meta game than you.

They're playing an infinite game. An infinite game is there are both known and unknown players, the rules of the game can change, and the purpose, the objective of the game is to perpetuate the game. So they say there is actually but one infinite game, it is life. The people that run these larger multi-generational organizations are playing an infinite game. They're managing for the very long term, for survivorship, to pass something on to a future generation. And once you start to think about that in that fashion, then their actions and their behaviors start to make more sense. So then we can ask ourselves, well, can we meet them where they are? Maybe they would be willing to contribute resources. Maybe they would be willing to mentor and to invest on terms that actually make sense to the game that they're playing.

How do you take the ... Maybe it's not exactly private equity what Localize would be doing, but that model seems to be a very finite model in that you acquire, run, and then sell at some point. So what are your thoughts around trying to meet them at their infinite game using a buyout strategy of sorts?

It's something I think a lot about and I think that our strategy's going to evolve through time. Everything I'm about to say is a result of we're just getting started. This is the first time we've done this. People do similar components of what we're doing. We're trying to bring those things together and do it underneath one umbrella for a common purpose. So the things that I wanted to do away with were the notion of making an investment strictly for the exit at a higher price. If you think about the three stakeholders, the LPs that we're engaging, they're frustrated potentially with Johnson & Johnson's business plan not changing in decades and the price changing by the picosecond and they can't understand why. They're having trouble with holding for the long term where there's this massive liquidity mismatch with all of their assets.

So they're looking at these businesses and what they want is they want to participate in the operations of this business that is generating free cash flow. The way we're structuring the fund one, which is what we call the recap fund, is we want to invest in these multi-generational family businesses. We don't want to take a control stake. We want to take a passive stake. We want to buy passive preferred shares to participate in the business. We're less interested in the upside, but we do want a higher yield. The cost of the capital to them is going to be higher than if they went and got a bank loan. We're investing in that way with passive preferred shares. The other motivation is if you're trying to change the nature of the investments you're making and the types of companies you're investing in, you're changing that portfolio math. Like I was talking about, venture capital is a very specific thing and there's portfolio math that is associated with that.

If we want to invest in growth companies in our region, geographically constrained, which is difficult, well we need to change the terms of the investment. We also have to change the LPs that are coming in. The idea being the operating companies, the people who are staunchly independent and own these multi-generational operating businesses, they are the perfect partner for us because they have the capital and they have the insight and the time preference that allows us to make these investments in a different way. So what I mean by that is in the growth company portfolio, to start, we're utilizing the Indie VC style investment terms. So again, it's non-exit based. It maintains a significant amount of optionality for the founders of that business. So we're not doing a cash for equity transaction with these growth stage companies. We're giving them cash and in return we're getting an equity option. That equity option is only executed when the founders decide to do one of three things. Raise more money, in which case we get first right to refusal and we will support them in that and help them raise, if they sell, or if they IPO. Then whatever underlying equity option we still have in that company, the investment will convert to equity.

Say they don't do any of those three things and we get into year four after the investment. We start taking a percentage of net revenue and we take a percentage of net revenue until we've made three times our money back. Every time we take a percentage of net revenue, they're buying back a piece of underlying equity option that we own. So they're shrinking the potential dilution from the investment. What that allows us to do is provide liquidity to our LPs and to keep our incentives aligned with the founders so that they can maintain the optionality where if four or five years down the road they say, "Hey, you know what, maybe this is not a venture scale business. Maybe this is not a winner take all scenario or a winner take all market. Maybe this isn't a land grab. Maybe I don't need to raise hundreds of millions of dollars to get where I need to go." We don't have skin in the game that forces us to get them to do that. So we're keeping our incentives aligned where they can maintain their optionality. So it's non-exit based.

The reason that the operating companies are the perfect LPs to invest in this portfolio from my perspective is if they own their pro-rata ownership in our growth fund, they're going to own it as a result of other LPs from within our location, within our city, buying a piece of their company. So what happens, just as a hypothetical, we invest $5 million in XYZ manufacturer, the LPs are investing in XYZ manufacturer, that's a multi-generational family business. We want them to continue to run it for survivorship and unlevered free cash flow. XYZ manufacturer pays a dividend to the LPs. That $5 million goes to buy a pre-tax stake in the growth company portfolio, and that changes our ability as portfolio managers to invest on different terms in the growth company portfolio because our IRR clock does start at year zero with negative $5 million. XYZ manufacturing company, the family that owns it, got five million in, five million out. So our IRR clock doesn't start until they pay their first dividend at the end of year one. That's how we're changing the dynamics.

So we're not investing in the old boring manufacturing business to try to apply leverage and flip it at a higher multiple or at some point down the road for a higher price. Likewise, when we're making investments in the growth company portfolio because the nature of our patient capital, instead of having to swing for the fences we can hit doubles, and because that pro-rata ownership is essentially owned on leverage, we can provide very attractive IRRs and we can trade the market that's in front of us. We don't have to use financing terms that work really well on the coasts, and use those financing terms and try to make the companies here look like a business model that should be venture-able. We can actually trade the market that's here. People can build real businesses and scale them sustainably with our terms.



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