Behind the Buyouts: HCI's McCormick on Consolidating Fragmented Markets

He's here to talk to us about the firm's investment strategy, its portfolio companies, and the state of M&A in 2025. Doug, thanks for joining us.

And so right after graduation, I had a five-year stint in active duty, concluded that was a great experience for me and really foundational to, I think, some of my leadership styles today, but ultimately decided it was an adventure, not a career for me, and I was going to do something else.

So I got out, went back to business school at Harvard, studied undergrad as an econ major, and so wanted to get back into something closer to that. Studied finance, spent some time at Morgan Stanley, and then ultimately migrated down to DC in 1999 to join a mentor of mine, Fred Malek, at Thayer Capital.

And after several years of being in the business, decided to co-found my own firm with two other partners. We did that in the early 2000s. And so I've been at it for almost two decades now and often say I've had the luxury of being an investor, but also an entrepreneur and a business builder.

And so I've found it tremendously rewarding and always growing, sometimes nerve wracking, but a lot of fun along the way.

You know, when I was 24, I was leading a platoon of 30 individuals. And so it's a real great kind of testing ground. And I think a lot of the leadership principles I learned then, even the very different circumstances, apply today in how I run the business.

But candidly, I think in many cases, the leadership challenges at the portfolio companies are greater than the leadership challenges at the firm. And so a lot of this applies to portfolio companies. But it's really kind of three key themes. The first is the concept of servant leadership.

And I think that's an approach where As a leader, you're trying to create the environment with the resources and the clarity of mandate that allow people to maximize their potential. The second is this whole concept of clarity of mission or clarity of mandate. And I think that the services do a great job of that.

And the last thing I'd say is a concept of this called principled leadership. Essentially, that's how you think about your values and how they influence the way you run the business. So anyways, I've enjoyed practicing my leadership style in a very different environment here for the last 25 years.

And that's also reflective of our strategy, which is very hands-on in the very lower part of the middle market. And I think that's a strategy that requires more kind of human capital per dollar of asset managed.

And very simplistically, our strategy is to create exceptional return by targeting or driving what we call transformational growth in these very large fragmented and stable markets.

And so when I say transformational growth, if we execute a strategy that's got M&A as the foundation of growth, well, we would expect to be able to grow a business by 10 times its original size. And so essentially, we're getting these very small entry points in these very large markets.

And then we're helping the team grow rapidly through M&A. And then we're also trying to scale the team at the same time so that they have the organizational capabilities required to run a business of greater complexity and greater scale. And I think we apply that strategy around a couple different key criteria.

The first is, I mentioned, really large fragmented market that's very stable. For us, the ability to underwrite follow-on M&A is every bit as important as the growth prospects of the business. We apply that strategy around three different types of business models. One is technician-based services, which we'll talk more about today. The other is distribution businesses.

And the third is what we call kind of basic manufacturing. And our general belief is Business models are durable. So if you can underwrite effectively and understand deeply the value drivers of a business model, that's a recipe for success. And on the contrary, it's very hard to predict growth rates of certain markets five and 10 years out.

So we have more conviction in our ability to underwrite a durable business model and then try to drive growth through M&A and other things.

And then the last thing I would highlight is this strategy forces us into thinking the lower part of the middle market where often we are first institutional capital in and we're partnering with families and founders to provide them liquidity, but also help them realize their ambitions of growing through M&A. So that was a mouthful, but that's the strategy and the firm

overview in a nutshell.

Has it always been the case when you started the firm or have things changed as you went about investing?

And so as a general matter of my belief, especially in this market, because it's had tremendous success. Tremendous success has resulted in tremendous growth, which means increased competition, right? So in the last 25 years that I've been involved, you've seen a dynamic where prices of assets have gone up.

And for the most part, leverage has stayed the same or gone down. And so the only way to replicate those really attractive returns that the industry's experienced is to do a better job of adding value during your ownership period. And so I think a couple of things that have evolved for us is, number one, we continue to get better as the market does.

Number two, we've seen that M&A can be really a great value driver and help us achieve those growth ambitions that we're trying to accomplish.

And as we've executed those strategies, I think we've realized the importance of having a really capable operations team to help these businesses keep up with the change that's resulting from the M&A. And so we've invested heavily in our ops team, and I think have gotten better at finding the points of engagement that provide real leverage to the management teams.

And so we have some folks that are great at human capital, great at marketing, great at supply chain and logistics, great at kind of Lean Six Sigma. And so I think it's more around that functional expertise than it is the end market application.

And in many cases, a couple. So two, three, four is very comfortable for us.

Maybe you could walk us through how that partnership came about and how it's grown over the years under HCI's leadership.

So think about all of the installed refrigerators, fryers, and ovens across the country in some kind of retail format, whether it be restaurant, grocery store, or convenience store, or sometimes institutions like army depots or universities, et cetera.

And so once again, if you get back to our strategy, really large market, food service equipment repairs, about a $10 billion plus market, very fragmented. and also a very nice, long-term stable demand profile.

This market generally grows slightly more than GDP, but the install base is so large and so vast that in any given MSA or region, things will break pretty predictably. And so it creates a nice, stable market, which we can then use to go as an attractive backdrop to scale through M&A. So that was the premise that initially attracted us to this.

I say we don't necessarily try to underrate end markets. In this particular case, we felt like we had a couple angles. We also own a big business called Amercare Royal whic does food service consumables to many of the same customers that Tech24 would sell to. So we had perspective on that customer set.

And then our operating partner, Bob Hund, used to be president of Manitowoc, which is a food service equipment business. So he also had some perspective. So And I think as we looked at this opportunity, we said we had the market backdrop that was very nice for us. We had some perspective from ACR and then we had our operating capabilities.

Ultimately, we trafficked in this space for probably almost 24 months before we found a platform and finally found Tech24. They were initially looking to do a refinancing.

But as the deal played out, this transaction happened right in the front end of COVID and So we ultimately just bought a majority interest in the business, knowing that we were going to have to navigate the volatility of COVID. So that's a snapshot of how we got in. I

So we did a bunch of scenario analysis and ultimately convinced ourselves of a couple of things. One, that if we capitalize the business with very low debt or almost no debt initially, we would have the flexibility to kind of manage through it.

And the second is, while we didn't know how long COVID was going to last, and the implications to this end market, we did feel like ultimately this business model would remain intact. At some point, people are going to go back to restaurants. At some point, this equipment will break with usage. And so it was really about navigating that period of uncertainty.

So relative to our investment case, I think we were surprised on the upside to a couple things. We assumed demand for the services would decrease dramatically. And some of that did happen. But two things surprised us. One was When you shut down a kitchen, the demand for this kind of service stops. But when you start it back up, you often break things.

And so there are often incremental services associated with a startup. The second is many restaurants quickly figured out that takeout packaging away from home food was the way to service the customer set. And so takeout grew exponentially. And that still created the demand for these kind of services. And the last thing that I kind of find is almost amusing.

We didn't appreciate how reduced traffic patterns would impact the efficiency of our technicians. And so we had fewer technicians doing more work because they could get to the job location more efficiently. So ultimately, we were able to navigate the most challenging parts of COVID pretty well.

And at the same time, I think we had a landscape where a number of entrepreneurs felt like it made more sense to join a larger, well-capitalized business to navigate this uncertainty than go it alone. And so we were on a really successful run in the course of 30 months. I think we did 24 acquisitions.

And so we're really able to scale the business in this period as well.

The game plan go forward is pretty much do what we've been doing, just continue to do it faster. And in terms of parts of the market that are really interesting, I think grocery store is a pretty interesting market and we're relatively under penetrated there. Convenience stores are growing exponentially. relatively rapidly compared to other restaurant options.

And so I think that's a place that is also interesting to us. But I think, you know, our continued focus will be really driving growth through M&A. We have a national footprint, but it's focused on the major MSAs. There's still lots of areas that we think we could have greater concentration.

It's probably a market in excess of $100 billion. Very recession resistant because demand profile is a combination of miles driven and age of the installed vehicles across the country. So really predictable demand profile. And we also like... the complexity of the supply chain. And in this case, complexity manifests itself in two different ways.

One is you've got parts complexity. Parts don't fit on different vehicles or different models. And then you also have channel complexity, where you can get a part through the place you bought it. You can get your part through a commercial repair shop. You can get your part online potentially. And so the disparate channels also create complexity.

And in our mind, a distribution business is most effective when the industry presents what we kind of look at as an hourglass structure, where you've got a lot of fragmented supply base, and you've got a lot of fragmented buyers, and the distribution business is serving as that critical choke point to aggregate the basket of goods and then distribute it or fulfill it

efficiently. So we felt like it had all the interesting market attributes. I would tell you, we got a lot of, I don't know if pushback's the right word, but a lot of feedback from investors. And we thought about this deal that Everybody was kind of fixated on the rapid displacement of combustion engine from EV.

And so it's a little bit of contrarian play that I think has actually worked well for us on the following fronts. While EV continues to grow rapidly, since we did the deal in '23, the expectations for EV penetration have come down dramatically. So for this business, that has positive implications. But also, we got really comfortable with this install-based concept.

Even as the EV market grows rapidly, the install base here is... going to be around for a long time and require servicing and as it ages, require more service. And then lastly, our core assets are in kind of the Texas market and in the penetration game. Those are relatively lower penetration areas.

So for a bunch of reasons, we thought it was pretty interesting and a little bit of a contrarian play.

But the integration lift for a technician-based service business is a lot lighter. And in distribution businesses, to get the real value of the acquisition, you've got to be able to integrate. You've got to be able to consolidate purchases. And the IT integration, I think, is a heavier lift. So the deals are chunkier, i.e. bigger, and we do them less frequently.

But I think you'll see this business doing one or two deals a year during our course of ownership period. And I think that should give us... shot on some pretty explosive growth here as well.

And then the other thing I think is really interesting. I do think we're relatively well positioned, especially compared to new vehicles. So if you think about new vehicle sales slowing down, average age of the install base increasing, require more service. I think that all kind of hangs together. But as a distributor, Some of our suppliers have China exposure.

And so I would expect our input prices to go up as well. And in a distribution business, we generally feel like that's okay because we can pass those prices along to our end customer so long as we're cost competitive with the market and so long as it doesn't dramatically decrease demand.

And I think these kinds of purchases are generally, they're not really discretionary. You got to fix your vehicle. And so I think we will navigate tariffs pretty effectively here, I think.

So Lawn Pro is essentially residential lawn care, more, not so much mowing, but fertilization, kind of taking care of the lawn. And so we'll talk market and then migrate down. Very attractive market like Tech 24. It's a $10 billion market. It's super fragmented and it is consumer facing. And so it does have some recession element to it.

But what we find is the return on investment for the homeowner is pretty high. You have your yard fertilized, you see how green it is, your neighbor's is, and if yours not, you know, you feel competition. So we have a really good retention rate with our customer set. And I think I would say the two things that make this a really attractive opportunity for us.

The first is quality of business model. This is a highly recurring, relatively high margin subscription-based model. So our customers sign up in the beginning of the year and they'll sign up for a year subscription. And we find that as long as we execute well and service them well, Nine times plus out of 10, they're going to renew the next year.

And so it's back to this predictability concept, very predictable business with nice margin attributes. I think the other thing we were excited about was the immaturity of the consolidation. And so we often say internally, HVAC is a great market. Everybody loves that market to consolidate it. But there are 65 consolidators in that space.

I'm high spotting on that number, but it's a lot. And so that creates competition, which makes, I think, successful execution of the play hard. And so as we think about opportunities to run that play, a very important part of our analysis is how many consolidators are in the space?

What's our conviction that we can get acquisitions done at a reasonable velocity to kind of get to our end state? So we've been fortunate that the long-term space kind of fits that dynamic. So we've been in this one since June of 23, and we've consummated 14 acquisitions so far. I think we have three more under letter of intent.

So you should see continued good traction there over the next several months. And I think one of the best validations for us as we see the progress in these businesses is the quality of teams we can attract. And so we've attracted a great team here that we're really excited about as we execute this strategy.

And it's still far enough south that you still have a pretty significant growing season. And so the amount of care per yard required is still pretty good. And so we've had a Great opportunity to create a pretty strong regional player here. And then we're pushing the boundaries on what the size of that region is.

What we found, and by the way, super stable, what we liked about this market is because of new product introduction from the consumer companies and outsourcing, a lot of the large branded companies are outsourcing some of the manufacturing. we felt like this market was consistently growing at two to three times the end market demand.

So really nice, big market, fragmented, stable, and some predictable growth. And so it's kind of the same playbook that I articulated for Driven. We did less acquisitions, but they were more substantive. So the platform plus three really nice acquisitions. And this business also had opportunities for a lot of organic growth.

And so we were able to really supercharge some investments in new equipment and new facilities to complement the acquisition growth. So ultimately, I think we grew this business more than 10 times revenue.

We started with a regional player with less than 500,000 square feet of manufacturing space and exited with a national footprint and I think two and a half million square feet of warehouse and manufacturing space. So a really good opportunity to scale the business. And it's still a relatively small player in that market with a lot of white space.

And so we exited that this spring. And the management team's intact. They're working for another sponsor now. And I think it's going to be a great run for them too.

And so there's a lot of really nice assets that I think are waiting for the right time. And it felt like we were getting some momentum in Q1. And obviously, with the introduction of tariffs, I think that creates a whole bunch of variables that make the M&A environment challenging to navigate.

I would say I think it's dangerous to apply a one size fits all assessment of the market, though, because I think in some cases, investors still have to get money deployed. And so they migrate to the markets that are least affected, most insulated and very few that actually could benefit substantially.

And so I think it's a little bit of the world of haves and have-nots where markets like food and healthcare, I think, are going to be in high demand because people can convince themselves the demand profile is intact and the supply chain volatility is navigable.

I think other businesses that have meaningful impact to the consumer or the supply chain dislocation, those are going to be, I think, on hold for a while is my take.

I think in the current environment where there is no clarity on policy because there are ongoing negotiations, I'm not sure you're well compensated to jump into the deep end of the pool right now, if you will. But I think clarity, I'm hopeful, is a couple months away. And that gives people the backdrop to make longer term decisions.

And I would say you can look at this as a half glass empty, half glass full. I think any time a market is dislocated, it creates tremendous risk and also tremendous opportunity. And I think it's a little bit of an art of trying to find that opportunity in the chaos.