As part of the Capital Allocators series, Matt sits down to discuss the ins and outs of capital allocation with Managing Partner of Natural Capital, Brad Henry. To begin, Brad goes into what Natural Capital is, moves along to the allocation of capital, and then discusses subjective variables Brad is interested in when looking to invest. Matt then poses the important question on how impactful, and to what degree, networking is in the business world. Metrics, profit margins, and revenue growths are then discussed, and Brad moves into how these variables connect to the real estate world. Brad finishes by giving advice to students interested in jobs dealing with capital allocation.

One of the first really screens that we look at from a performance standpoint for a company is are they cash flow postive, are they generating actually income and obviously gross margin comes into account in that margin as well in terms of what are your operating expenses.

Excellence, professionalism, innovation and collegiality. These are the values the Sam M. Walton College of Business explores in education business in the lives of people we meet every day. I'm Matt Waller, Dean of the Walton College, and welcome to the Be Epic podcast. I have with me today, Brad Henry. Brad is the managing partner of Natural Capital and is responsible for the firm's day-to-day operations. Prior to founding Natural Capital, he served as vice president of the Arkansas Development Finance Authority, Arkansas' Venture Capital and Loan Portfolio with over 120 million in assets. Brad also worked at Stephens, Inc. He's a graduate of Hendrix College with a degree in financial economics and holds a Master's in Economics from the University of Arkansas. Brad, thanks so much for taking time to visit with me today.

Happy to be here. Dean Waller. Thank you.

In this series, of course, we're talking about capital allocation. And you have experience, obviously in venture capital and private equity. So I wanted to just chat with you about that as well. But before we get into that, Brad, would you mind telling us a little bit about Natural Capital?

So we founded natural capital in the summer of 2019. My partners are Brock Gearhart, Marshall Saviers, and Todd Simmons so we're a private equity and private real estate firm. We invest in real estate in Arkansas, and the broader Heartland region, as well as traditional growth equity and private equity. We have made 14 investments to date look forward to making more both in Arkansas as well as the broader region.

Let's get into capital allocation. There's there's lots of in order to, you know, allocate capital, you've got to make sure that the firm you're investing in fits with your strategy. But also, there's a lot of metrics and even subjective variables that you can look at as well. Let's start with some of the subjective variables that you're particularly interested in.

Yeah so, we very much believe in investing in what we know. So myself and my three partners all are from Arkansas. So we know the region well. We also have varied backgrounds, which is why we have a varied investment strategy. For example, Marshall is the CEO of Cushman & Wakefield, Sage Partners, which is a real estate brokerage and leasing firm. And so when we are looking at a potential real estate investment, Marshall is obviously very involved. So from a subjective standpoint, we are very focused on on what we know, we don't really stray from our experiences.

You know, in Arkansas, of course, there's a lot of new firm formation going on right now. But there's also a lot of growth happening with existing firms. One of the earlier podcasts I did in the entrepreneurship series, of course, was with AcreTrader, that's one that is really growing really quickly. And is a high tech- figured out how to securitize farmland and timberlands and really interesting, innovative idea. A lot of times people wouldn't necessarily think Arkansas would have so many of these kinds of innovative companies, but we do. And I've always wondered if part of the reason there is so much entrepreneurship here it goes way back, I mean, you know, Walmart, Simmons, J.B. Hunt, Tyson, ArcBest, Stephens, et cetera, et cetera. Dillards. You know, we've got a tight network in Northwest Arkansas, in the whole state and really in the Heartland region as a whole. But I wonder to what degree the network helps us find opportunities more quickly?

It's a huge part, especially for Natural Capital, we're very relationship driven. When we look at investment opportunities, you know, each of the investments that we've made to date have all been generated through our relationships, either through someone we know well, bringing it to us or us identifying that opportunity through our network. I think, to your point about the entrepreneurial spirit in Arkansas, sometimes I think there's even today with all the success that that we've had, as a state and the companies have had, there's still that chip on your shoulder where you kind of like to do it yourself. And that's a big part of why we formed a Natural Capital is because, you know, many of the companies that you mentioned, were supported either from Arkansas institutions backed them or the families themselves that started those companies continued to reinvest into those companies as they grew. And we wanted to be a part of the solution for that next generation of companies as they spring up and grow because as the region's economy especially of Northwest Arkansas continues to grow, there will be more and more focus on it from outside the region. And that's great. And we want that. But we shouldn't be reliant on capital sources purely from outside the region, there needs to be local capital options to- to support the region as well. And that's a big part of why we started Natural Capital.

Going back to AcreTrader. Carter Malloy, the founder, he had been buying and selling farmland and noticing that he was making enormous returns. And he also recognized how difficult it was to figure out how to actually make it all happen and come together. So his idea of securitizing it really came from his personal experience in Arkansas, with farmland, for example. And in Arkansas, there's so many things going on around for example, retail, because of Dillards, and Walmart, and all the consumer products, companies are here, supply chain management. And now more and more, I would say life sciences and biotech and medical technology, because of things like the Whole Health Institute, the Alice Walton Whole Health School of Medicine, and of course, the I Cubed r that we have here at the University of Arkansas, there's more and more effort to try to commercialize technology. But the people with the capital and the people with the innovations, it's a pretty tight knit community, it's not hard to ask a few people to find out how to get expertise in something or to find someone that's got capital they want to deploy into one of those areas. One other thing I'd like to hear your thoughts on, before we get into some more quantitative kinds of metrics, the founders, the leadership team, and the vision, what kinds of things do you look for there?

So we have a, generally a long term approach from an investing standpoint, from a capital allocation standpoint, and we define that as seven plus 10 years. So when we sit down with a founder or with a company, or- or even looking at a at a real estate investment that we may be looking at, we're underwriting it with a long term view, right? It's not kind of your traditional private equity approach. A lot of times, it's kind of a three years in and then take to market it's very timing based. And market timing is not really something that we try and achieve. And so first and foremost, is just desire investment horizon and our investment strategy align with the project that we're considering. If it doesn't, then it's typically a fairly quick no. So that's, that's one important point, we're very as just individuals, very people focused in terms of supporting the people around us helping them grow, both personally and professionally, you know, very team oriented, it's not a one person wins mentality, or- or you have to have one person to achieve the goals of the group. And so what that culture is like within the company, not just talking to the CEO, but talking to key leadership, and even several steps down where we get a feel for what the culture and the community is like within the company, are the employees supported in a way that if we were running the company that we would want to see. And so those are, those are two very big items that we try and check the box on pretty quickly when we're looking at an investment opportunity. Because we we see a lot and we say no to a lot, we have to have a process that gets us to a kind of a next step relatively quickly.

Obviously, revenue growth and gross margin are things that are of interest that are really important, and figuring out how to value a firm based on multiples of revenue or profit. What are some parameters you look for in that way?

Yeah, you mentioned gross margin. And we actually looked at a we had a investment presented to us fairly recently, and their gross margin for the last quarter, couple quarters was actually negative. And I still remember in one of my first micro classes, my micro professor at Hendrix reminded us that if your gross margin is negative, you might need to consider whether the company is even viable at that point, right? Because you are selling a product for less than it costs you obviously a positive gross margin is a very important kind of check the box kind of factor. I think generally though, one of the first really screens that we look at from a performance standpoint for a company is you know, are they cashflow positive, are they generating actually income and obviously, gross margin comes into the account and net margin as well in terms of what are your operating expenses? From a valuation standpoint, there's a lot of ways to value a company, we typically value it off cash flow or EBITDA. We definitely want to see strong revenue growth, which generally for us is kind of 10+% at a minimum and hopefully that your expenses both from a growth standpoint and a opex standpoint, that those expenses are increasing at a lower rate than your revenue meaning that if your revenues growing 10%, you want to see your overall expenses hopefully growing as an example 5%, right? Something less than whatever revenue is growing because if you're growing expense, obviously if you're growing expenses faster than you are growing revenue, you can get yourself in trouble from a cash flow standpoint relatively quickly.

One metric that is looked at a lot, especially in SASS Type models is how efficient the marketing and sales dollars are. In other words, they'll look at gross profit in period two minus gross profit in period one divided by the amount spent on sales and marketing in period one, it's basically the idea that you spend money in period one on sales and marketing. When period two, it's got to have some kind of result. And so by looking at the change in gross profit, it's a way to look at how efficiently that is. There's lots of ways to measure that kind of a thing. Is that something you look at and consider those kinds of variables?

Yeah, definitely, if we're looking at more of a software or a services company, that is a metric that we track, I think we also generally look at ARPU, average revenue per customer per user from a software standpoint, where you want to see that increasing or the revenue that you're generating per customer is increasing, because especially with software technology companies, right, there's usually a heavy spend heavy investment upfront on building the software. And so you're, if you're a younger company, you don't have as many customers, right, or users, that metric might be fairly low. It might even be negative for a little while. But the expectation is, once you've kind of built the core software, you'll still have some maintenance expense and some some other investment that you'll have to do into that software. But in theory, right, that should start to scale relatively quickly, where you see that revenue per user revenue per customer really start to increase over time.

Brad, a lot of what we've been talking about so far is more relevant to your investment in firms. I know you also invest in real estate. So let's talk a little bit about that. I'd like to hear about how you think about real estate investments, and even think about how you know how much leverage to use-

Sure

-in making those investments.

So generally, we don't quote over lever our projects, we typically have, you know, kind of 65 to 70% leverage on our project. So basically, we're putting more equity into the project than what's standard, you know, typically, banks will let you go up to 80%. We do that for a couple reasons. One, just to de risk the project a little bit where there's there's not as much leverage. So if for some reason there is a little hiccup in cash flows or in the project, right, we've got some buffer there, it also allows us to negotiate a little more favorable terms from the bank, not so much from an interest rate standpoint or anything like that, but for more just overall covenants that they require from us. But our first screen really from a real estate standpoint is what type of cash flow that can be distributed to us as the investor can generate, we generally like to see a stable recurring distributions from an investment that we make on the real estate side, that's usually any real estate investors generally looking for cash flow, at some point, sometimes folks are willing to wait a little longer if it's a development project, right, you're not going to see cash flow during the construction period. But the goal would be to generate that cash flow, you know, whether it's a multifamily project or industrial project that, you know, once the tenant has taken, you know, occupancy that they are starting to generate cash flow relatively quickly, if it's an in place investment opportunity, meaning if the building is already built, that's a different analysis than say, if it is a new construction, right, we typically look for a higher overall return over time, just because of the risk associated where you have a time period where you're under construction, you're not generating income. So we are looking for a higher return from a you know new construction project as we would if it was a in place building as well and we look at growth rates in the region that we're investing in in terms of demographics. So a lot of my background, my economics background really comes into the real estate investment opportunities that that we see. But at the end of the day is where are you from an opex standpoint, and an overall cash flow standpoint is very important to us on real estate side.

In closing, I'd love to hear your advice for students that are interested in jobs in some area of capital allocation.

Sure, I think the biggest to really put yourself ahead if you're a student that whether it be MBA or an undergrad is really the more you can develop your skill set specifically in Excel from a financial modeling standpoint, that can really put you ahead of many other candidates for for job opportunities. Perfect example, for our firm, we're a small firm, we have three full time staff. We're actually looking to add two more analysts, but we're growing so fast, and we have so many opportunities in front of us that to be able to train people is not something that smaller firms like ours really have the ability to do yet that's different at a large firm like Stephens Inc, which I've worked at before, you know they have a six week training program that you know new hires go through. And a lot of it is really just training them on how to properly use Excel and and use it as a tool to review investment opportunities and allocate capital. We just don't have the time to do that form of training. We have the ability, we just don't have the time. And so the more you can really develop your skill set from a financial modeling standpoint, within Excel, uh can really, really differentiate yourself specifically at least from the candidates that we see. So that that would be something that I would really and I know the University has a financial modeling course and I would recommend everyone take that but then if there's opportunities even outside that course to develop your skills, I would highly recommend it.

Brad, thank you so much for taking time to share your wisdom and experience with us. We really appreciate it.

Thank you so much. Dean Waller. I enjoyed the conversation and I hope you did as well.