Activist Value Investing in Small and Mid-Cap Companies

EMS:

Hi Donald, thank you so much for being with me today.

Donald Zilkha:

Hi, Elana. Thank you so much for having me on.

EMS:

Absolutely, Donald. So, to kick off the conversation, tell us a little about the firm and how you got to where you are today.

DZ:

Zilkha Investments is a natural landing pad for a career of dealmaking and front-facing client contact. I started at JP Morgan and there I was assigned to the tax shelter department where clients of the bank, high-net-worth clients, would provide us with transactions to analyze and look at with the idea of saving or deferring taxes. It was a great way to look at specific companies, how they evolve, how their cash flows build, how the balance sheet and P&L work together with that and it was a really great way to launch my career. I was moved after the tax code changed into restructurings and in restructurings I was dealing really with the other side of the fence. In other words, how to get the bank's money back. It was a different environment, a different philosophy and eventually while I was working on many of these loans, somebody who ran JP Morgan's worldwide merchant acquisitions business, a man called Jack Kath came over to my desk and said, "I understand you speak French." I said, "Yes, I do," and he said, "Well, I need somebody to come with me to Europe tomorrow because we're doing an acquisition for international flavors and fragrances, and we need somebody who can be the analyst and also speaks the language." So, I went there for the deal, they were happy with me and eventually over the next few years, I traveled for JP Morgan and became co-head of their merchant acquisitions group for Europe, northern and southern. And that was very exciting. I was young, great amount of responsibility. And I stayed with Morgan for about five years in total, seven years in total before I moved on to James D. Wolfensohn Incorporated. Jim Wolfensohn had been head of corporate finance at Salomon Brothers and as head of corporate finance at Salomon Brothers, when the firm was sold, he decided to create one of the first boutiques and I was to be his M&A expert. I was one of the first five people to work there. We agreed that Wall Street had moved to a much more fee-driven type of an environment, and he wanted to go back to the advisory side to work with clients, build trust, and actually do some strategic thinking with them before we went on with the acquisitions. It worked well. It was once again back to the future sort of a thing, and I had tremendous relationships that came out of that. I also was one of his general partners to his venture capital fund. And there really, I was brought in because some of the market had hit a poor moment in the cycle, and then when that cycle sort of collapses, it collapses quickly. So, I worked him out of several of his deals before I went out on my own. I moved out on my own really with the Jim Wolfensohn model. In other words, with advising clients, I'd build a reputation in Australia and that reputation in Australia allowed me to pick up some of the top five blue chips over there to do their M&A activities, strategic advisory activity. And in a period of seven years, I had done $3.5 billion of M&A now. I guess in today's environment, $3.5 billion of M&A is nothing. It's a single deal. But in those days, it was important, it was significant. So, then one of my clients decided not to pursue an acquisition that I'd analyzed for them, and I decided to move forward with that one. And that acquisition was Colt's Manufacturing. It took about 19 years to work the company out. It had been in bankruptcy, and we returned 20x investors' money. We did several other discrete transactions before starting a venture fund, which I did in 1999. For those of you who'll remember, 1999 was a very easy time to raise money, a very hard time to deploy capital. And so, we did deploy capital and we did it carefully. But within two years, the market collapsed. The venture market collapsed. And as you know, when venture markets collapse, everybody leaves the room at once, the ballroom at once. And so, people leave lots of treasures on the table and on the floor and we saw those treasures. We were able to negotiate with many of the larger firms to buy out their positions for pennies on the dollar and to work our way through and work our way out of a triage of maybe six investments. But in the end, by 2007, we'd gotten all our investors twice their money back, which was a heroic effort at that time. And it gave us the reputation that we stuck to things that we didn't drop things, and that was very important for our investors. So, when we decided in 2006 to launch, but really launch officially with our first investment in 2008, Zilkha Investments, we had not only our own money, but also some high-net-worths and some friends who'd been with us before who agreed that it made sense to go into these special situations in small and mid-cap businesses. And so, we've done well. We love the idea that we have liquidity. We love the idea that we can apply our analytical skills, our ability to engage with managements because that's very important. And to understand these businesses and perhaps improve the message that's that's out there, which has really caused the companies to be selling at a much lower price than they should actually be selling for.

EMS:

Donald loved hearing your journey of how you got to where you are today in the start of Zilkha Investments. That segues nicely into the follow-up question I had for you. Given your focus on activist value investing with a focus on small and mid-cap companies, love to hear your perspective on the space.

DZ:

So, Elana I think... I hesitate to say that we're an activist in a way. We've come up with a term called optionistic, which means that we have the option to move one way or another. Really to us, activism entails really more short-term views to increase value. Something like stock buybacks or adding board members or replacing board members, replacing management, selling off a subsidiary, those can enter into our wheelhouse, but it's not really the main focus. Our main focus is really to find good companies with long-term growth prospects. And we're willing to get close to managing partner with them as they move forward in their journey to have their value recognized in the markets. And so, we find companies that are so undervalued, and the reason we find that they're undervalued is mainly because management doesn't communicate their value proposition correctly. So, we help work with that, and we can always get the board seat if they believe in us, and we haven't had a need to. We're very disciplined in our approach. We stay in touch with them. Since our portfolio's concentrated, we only have between five and ten main holdings at any one time. So, that's how we view ourselves in the optionistic side is we can exit very quickly, or we can stay with them. And if we stay with them and the value doesn't increase, we can move with some of our other friends in the private equity area to take the company private with the support of management and everybody else.

EMS:

Donald, as a follow-up, what are some of the specific greatest opportunities you see in your space and why?

DZ:

I think the greatest opportunities have to do with the fact that we're in the U.S. market in small and mid-cap. The U.S. market is the envy, I think, of the world. When you get down to it, for the past four decades, technology-driven productivity improvements have entered all aspects of U.S. industry. And we've got some major companies worldwide, huge companies to show for that, that are in the portfolios of most institutional companies, companies like Apple, like Microsoft, NVIDIA at this point, all those, and those are not the companies we focus on. There are opportunities that are really for the large institutions from that side, they understand them probably better than we do. But what we've noticed is that in technology, an idea begins to percolate. One player comes into the market and is followed by 10 to 20 others. Those 10 to 20 other players over time, some of them where the model maybe wasn't the right one will fail, others will run out of capital and will be acquired by some of the stronger players or those who do attract the capital and we find ourselves in a situation where three or four years out, the market is consolidated, there are a handful of players remaining, and we're really looking for the company that will take the lion's share of the market share. That's what we're really focused on. Those companies are the winners. They'll be the ones that will survive best and that will either become very large players or be acquired by one of the large players. And that's our goal when we look at the technology side of that but we're not only in technology. We find that there are many old-line businesses that are either converting that have been behind the curve and that in and of itself is an interesting opportunity. We looked at a company called Mattel several years ago, right around COVID, and we had a huge gain in that because we understood the company enough detail, we understood what management was trying to achieve, we understood how we thought it would play itself out in the market, and the company was a huge winner for us.

EMS:

Donald, on the other hand, what are some of the greatest challenges you face in your space and why?

DZ:

So, some of the greatest challenges have to do with the market is very dynamic. Things change very, very quickly. So, for us to be able to succeed, we have to focus on strong companies, good companies that have strong balance sheets, that have recurring revenue, that have positive cash flow, strong managements. And so, to sort through that and you also need a strong corporate culture. That's very important. So, we have to be comfortable that the people who work in the company are happy to be working there, they're happy to get into work because otherwise you lose all your best players. So, that's something we focus on, and we have to understand. The other thing is sorting through the massive amount of information that comes out, some of it useful, some of it completely useless and sometimes misleading. So, we sort through that. And so, in order to achieve that and going through that, we then find ourselves in a position where we have to be able to act before other people because there are a lot of people in the market who are very smart who are looking at perhaps the same things. So, we have to be able to be the first mover and also to engage with management and try and reformulate the message so that it gets out in the proper way.

EMS:

Donald, we've covered a lot of ground today and wanted to see if there are any final thoughts you would like to share with us.

DZ:

So, I can tell you that because of what I've said before in terms of the dynamic, in terms of the way the markets are moving very quickly, we've had to move our firm from being a pure special situations firm to focus more on a fund structure. Because what we found is when we approached our investors and asked them for a commitment on a target opportunity, it took time for them to make their decision. We're asking to put in between $1-5 million in any specific investment. And during that time, very often the opportunity went away from us. So, we've changed now our focus to a fund focus and we're doing very well. We've been able to achieve since inception, about 22.4% net. And we think that we can do that most readily with up to about $500 million under management, which is what we're seeking to gain. We'd probably stop it at that because our focus is obviously not on management fees. Our focus is on capital gains, our money is involved, but to best serve our investors, the fund structure works best, and I think though that for the next several months as we continue to accumulate capital, that's going to be our main focus.

EMS:

Donald, I wanted to thank you so much for sharing your perspective with our listeners.

DZ:

Elana, thank you for having me on. I appreciate your time and for letting me speak.

EMS:

And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.

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