Almost all companies operating in America were created and are run with the purpose of providing direct current income to their owners either in the form of wages or profit distributions. Public companies, and those aspiring to become public (such as those within venture capital portfolios), however, generally have a different agenda. Over the last 30 years, and particularly since the development of the internet, the success of the venture capital startup model has changed the way many people think about small companies. So many companies have gone from launch to successful public offering in a few short years that much of the market has become conditioned to the idea that explosive growth potential is the defining characteristic of a value-creating company. In these companies, cash flow takes a back seat and the idea of providing income to owners in the form of dividends is considered on par with admitting failure.
From the perspective of most passive public market oriented participants, the public growth-oriented model works well enough. Investment gains are expected not from profit distributions, but from public market status and growth-driven stock appreciation. This being the case, investors tend to seek out companies expected to deliver growth while avoiding those that have stopped growing. Wall Street reinforces the system with analysts that regularly set and enforce strict expectations around growth, and investment bankers that target companies seen in need of supplementing organic growth with strategic transactions. The effect of all this is companies meeting or exceeding the market’s growth expectations being rewarded with high relative valuations, while those failing to meet the market’s growth expectations frequently seeing their relative valuations fall.
From the perspective of most public companies and those aspiring to become public, the growth imperative created by the current system often creates great difficulties. All products go through life cycles and companies are subject to the life cycles of their dominant products. During the early stages of a successful product life cycle, growth is generally rapid and sustainable. Once a product matures, however, the market opportunity is saturated and the product’s growth rate will naturally decline. This is not a situation that can be overcome with simple application of money and effort. Even Microsoft, one of the richest and most successful American public companies in history, has not found a way to reignite its growth rate after its core products reached maturity. For its inability to deliver the level of growth demanded by public market investors, Microsoft and its management are frequently and sometimes harshly criticized. If arguably the most successful software company in history can find itself under attack for being unable to deliver the growth characteristics demanded by the public market, the hardships faced by smaller and less respected companies must be understood to at times become quite severe.
The companies Meridian intends to invest in are generally 5 to 15 years old, tend to have been one of the original innovators in the markets in which they compete, and continue to be notable leaders in those markets. These companies have established brands, strong customer relationships, are usually profitable, and have the ability to generate significant positive cash flows. These are the types of businesses that almost anyone would be glad to own. The companies Meridian targets tend to have one overriding problem, and that problem arises not out of their operations, but out of their positioning in the marketplace. They are operating under a growth-oriented public company model, and, due to the maturity of their products, these companies are currently unable to deliver the level of growth demanded by growth-oriented investors. As is the case with Microsoft, these companies are subject to frequent, and we think generally unfair, criticism. Worse, they are spurned by mainstream market investors that follow the growth-oriented public company model. These investors believe that without the essential element of growth, there is no driver for stock appreciation and therefore no reason to invest in and hold the company’s stock.
We call the companies in this situation “orphans.” They are businesses that have lost the interest and attention of the stock market’s dominant growth-oriented investor base. Companies in this situation tend not only to be undervalued, they are also commonly pushed by the market into a “grow or go away” paradigm. They are told by their critics that they serve no purpose in their current form and must either find ways to quickly increase their size and growth rate to levels that will find support among growth-oriented investors or they should be sold off to the highest bidder.
The United States equity capital markets system has created a great many orphans in recent years. In the public market, the SEC reports that of the 9,428 companies listed in the United States, only 2,549 or 27%, have market capitalizations above $500 million – the bare minimum for most institutional investors. Left outside of the mainstream market are almost 7,000 companies – many profitable, some dominant in their space – that most of the market’s largest participants ignore because they do not have the size and/or growth profile demanded of successful public companies. These 7,000 companies have an average market capitalization of $103 million aggregating to more than $692 billion.
In the private market, the surge of venture capital investing that occurred during and after the 2000 era bubble has led to the creation of thousands more orphans. According to the National Venture Capital Association, during the 15 year period 1995-2010, venture capital firms invested more than $446 billion in 60,000 reported transactions. Many of the funds that made those investments are now approaching end of life and must find ways to exit their remaining positions. These funds are usually faced with no good options: the default strategy of working toward an IPO has run out of time; selling the business during the current difficult economic conditions would be ill‐timed and likely opposed by many insiders, usually including management.