Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

Let's begin this episode on Lifco and Halma as part of our IP Fieldwork podcast series. Let's start with a bit of time travel. Take us back to the first time you came across Halma and Lifco.

It was a good long time ago, probably Halma first, actually. I think it wasn't exactly a unique way that I came across them. The performance of each company speaks for itself. If you add a bit of obsession with holding companies that actually compound, it leads you to take a deep look at both of these businesses and a few others.

What's fascinating is the overarching question between organic and inorganic growth. The reason I've spent so much time on these businesses—Lifco, Halma, Danaher, Berkshire, and Constellation, as well as the Nordic industrial acquirers—is because of that question about inorganic versus organic growth.

One perspective that makes sense to me is that it's very difficult to compound organically only for decades. Imagine our business, for example. How do you compound that organically at higher rates of organic growth? I'm not talking about GDP plus; I'm talking serious organic growth rates, double digits for decades. You have to be an operational execution machine. You need new products and be good at R&D. It's super difficult.

This also links to one of my favorite Buffett quotes. Not to turn this podcast into a Buffett fanboy session, but he says something along the lines that some businesses just shouldn't grow, and that's fine. Berkshire is happy to buy businesses that don't grow if they earn enough cash to warrant the price, and if that cash flow is durable because they can redeploy that cash elsewhere.

I think this concept of it's okay if you can't grow organically, if you can buy quality businesses with durable cash flow and have a rigorous, disciplined capital allocation process to redeploy that cash flow elsewhere, that's inorganic growth. That fascinates me. I think businesses like Halma and Lifco have mastered or cracked that over time, and many other companies have as well.

Part of our core research has been to explore how and why they've done that, when it goes wrong, why it works, and how each company has a slightly different approach to that overarching strategy.

Let's look at why these two companies, in particular, lend themselves to a very fruitful benchmarking exercise. There are two parts to this. One we've covered in an earlier episode on operations. This piece, in particular, relates to M&A. Let's get into that.

The original observation was about how Lifco is so lean. They have, I believe, three people at their headquarters and manage to generate two billion euros in revenue. At Lifco HQ, there's Per, the CEO, his right-hand man who acts as an operating group manager overseeing several subsidiaries, and the CFO. That's the entire HQ for a two billion euro business, which is quite remarkable. It's probably the closest you'll get to a structure like Berkshire Hathaway, albeit in a different style.

It's incredible for a business with over 400 million in operating income to have only three people at HQ, with no HR or sustainability team, and minimal overheads. Despite this, they're still growing organically with high returns on capital. Their organic revenue and operating income are growing healthily, more so than other holding companies. The original question was how Lifco can operate this way.

The comparison to Halma came because I've studied Halma for years. It's UK-based, has been around since the 1980s, and has a long public track record. They are very similar in size, both generating around two billion in revenue with similar operating margins of over 20%. Both have grown organically in revenue and operating income over long periods and trade at similar multiples in terms of EV over EBITA.

Both companies employ a similar strategy, which is buying quality businesses, decentralized structure, growing the operating assets organically but redeploying that capital into new acquisitions to drive inorganic growth. The combination of the organic growth and the inorganic growth gets you to you low double digit revenue growth total, if not a bit higher depending on the on the starting date.

The big difference is Lifco's HQ has three people, while Halma has 50 to 70 people. Lifco manages 250 subsidiaries with this lean team, whereas Halma has just under 50 subsidiaries. Despite having more assets, Lifco is leaner but generates a similar amount of operating income as Halma.

This was the starting point of our exploration of these two businesses. In previous conversations, we studied their organizational structures and learned that their company philosophies are different. This difference also affects their M&A strategies.

From the outside, these businesses appear similar, deploying similar strategies and performing well. Some might argue Halma owns higher-quality or larger businesses, but both focus on redeploying capital. Yet, their operating philosophies differ significantly.

Our research focused on the M&A aspect, aiming to speak with individuals at both companies responsible for acquisitions. We wanted to understand how they were incentivized, which was the core essence of our research.

We often discuss the purpose of fieldwork as a way to discover new insights beyond what can be gleaned from a thorough reading of all available filings and industry research. When it comes to the questions we explored in these pieces, could you walk us through your thought process in building the research case? How did you determine who you needed to speak with to gather the information you believed would be crucial in understanding why and how these operating philosophies differ? Let's examine how you went beyond the filings and structured the primary research learning journey for yourself here.

In exploring how these companies approach M&A, it was clear we needed to speak with someone who had been employed in that role at both companies. Understanding how these businesses are organized was critical. For instance, Lifco has three people at headquarters and 250 companies. Imagine managing 250 businesses with just three people. Even looking at Lifco's filings or trying to source information outside of them doesn't clearly show how they're organized. You have to dig through to find these businesses and see who's running them.

A significant part of the research was understanding Lifco's structure. We realized there's a layer between Per at the headquarters and the operating system; you can't have 250 direct reports. Finding those people who filter information for Per and understanding their role was crucial. We then examined the M&A side, which is more organized by sectors with sector teams and a more bureaucratic or traditional organizational structure. It's still decentralized compared to other companies in the FTSE 100 or 250 but is different from Lifco in terms of decentralization.

It was challenging to find people who could explain how Lifco operates. Many employees didn't publicly describe their roles accurately. Some people effectively manage or are responsible for up to 10 or 15 companies, yet this isn't widely advertised. This raises questions about governance and culture at Lifco. How can someone be on the board of 15 businesses? It suggests that board meetings might not be as frequent as in other companies, giving insight into the governance and culture.

The research on the organizational structure took about three to five months. Once we understood it, we could explore the M&A side. The M&A side at Lifco is unusual. Per has five to eight analysts, or quasi-analysts, who are former brokers now delegated to source businesses in certain geographic regions across Europe. In contrast, Halma's structure was easier to understand. They have a sector-based M&A team with three or four sectors, each having an M&A team of four to five people. This gives them about 15 M&A people, providing a decent supply of people to source from.

The initial work was to explore how Lifco operates and what that means for the business's philosophy and culture. Then we moved on to the interesting part of M&A, speaking to M&A people from both sides.

These topics emerge as part of a broader stream of work that dates back seven, eight, or even 10 years. It's fascinating to consider how different companies approach growth and how they can outperform their peers over extended periods. I want to ask you to elaborate on what you've found that is relevant not just to these businesses, but also for anyone trying to assess the quality of an organization that takes inorganic growth seriously.

The challenge lies in identifying companies that truly understand this concept before they've been doing it for 20 years. Public markets have a tendency to believe that companies must grow, and there's a perception that M&A is bad, implying that growth must be organic, which is quite difficult. There are exceptional executors and operational leaders who can build and expand products, like Google, Facebook, and Microsoft, but most businesses probably shouldn't or can't grow organically. Public markets and management teams often delude themselves into thinking they can achieve organic growth.

Companies and management teams that recognize this and have a rigorous capital allocation policy to redeploy cash into M&A systematically are intriguing. This is part of what attracts me to holding companies that can compound, like Halma, Berkshire Hathaway, and Constellation. The key is finding these companies early, before everyone else. Understanding how companies are organized, how they incentivize their operational and M&A staff, provides insight into building an organization that can compound over time.

There's no single solution to this. It's about understanding the many layers of an organization to determine if someone comprehends this approach. The challenge is executing it correctly, buying businesses, incentivizing people properly, and standing the test of time.

It's interesting that you speak to many people, operators, and investors looking at these kinds of businesses. I wonder what you make of this. As time goes by, you start by looking at how to do this, who does it best, and what makes them the best. The more you delve into it, you find that some businesses defy benchmarking. There are several ways to climb this mountain, and it can be dangerous to think there's only one way. Business books often suggest the "Five Things to Do to Win" or "Three Ways," but a lot of that feels unhelpful.

Of course. These companies are doing two billion in revenue, so we're comparing them at a point in time. There are many differences between the businesses, which we explain in terms of org structure, M&A incentivization schemes, and overall business philosophy. However, there are also similarities, such as being diligent about how much you pay for assets and having a decentralized structure. Both companies believe in decentralization and not issuing equity. Compared to the wider corporate market, they have more similarities than differences.

When you get into it, if you want to build a holding company, there are nuances that reflect the people, culture, philosophy, and history of the organizations. The challenge with these businesses, whether it's Constellation or Berkshire, is that as they get bigger, it becomes exponentially more difficult to grow. If you want to grow inorganically by 10% a year and you're doing $450 million in operating profit, you need to acquire $45 million in EBIT per year. If you're buying businesses of $4 million, you need to acquire 10 a year. Halma has 50 businesses, and they need to acquire 10 a year, which they've never done before. So, these businesses end up buying bigger companies.

That's when you venture into the McKinsey realm of synergies, and it becomes destructive M&A. Part of the reason I explored these nuances is to understand why they've been successful and to recognize potential limitations when they're doing two billion in revenue.

You've highlighted that there are broader patterns from this benchmarking that might be applicable elsewhere. However, it's important to be cautious about what those patterns are. As you mentioned, there is discipline in purchasing, discipline in execution, and perhaps clarity in your capital allocation framework. There is also clarity around your approach to not issuing shares, emphasizing capital discipline.

Decentralization is significant in that they buy businesses, and this is where it becomes nuanced. Typically, they don't purchase them to integrate but are looking for synergies. However, when you examine it closely, they are much more flexible. They can integrate businesses into a platform. I think it's just common sense and good business judgment, but you can't exactly state that in an annual report.

I think it's important to note that you can become enamored with one of these businesses and sometimes get caught up in thinking it's the only way. In reality, there are many ways, and while there are common patterns, there's a question about the extent to which management character, values, and the actual people involved determine how these systems are organized. As we move towards the end of this episode, perhaps we can explore that further.

Yes, of course they have. In Halma's case, the organization is largely structured because the former CEO wanted a certain number of reports. That might be optimal for Halma and him, but maybe not for others. I think those types of decisions are critical in how a business is organized and scales. This piece was about that. Objectively, these businesses have been phenomenal. Both are among the top-performing securities in Sweden and the UK, respectively, over the last 20 years. They've been the best. Whether that will be the case over the next 20 years is the question.

I'm not saying there's a silver bullet with this research. We're exploring nuances with these two businesses to provide insight into how they work. For example, with the M&A piece, how they incentivize their M&A team gives you significant information about how they think about creating value. They are completely different in their focus on inorganic growth, yet they both incentivize their M&A staff differently. They organize and pay them differently.

Two things broadly matter; assuming you're acquiring the same quality of businesses, which maybe they're not, but I think they broadly are and they have the CEO that kind of determines that. But the amount of capital you deploy and the multiple you pay are like two pretty credible variables. Then the business obviously has to get signed off, in Lifco's case, by Per and, in Halma's case, there's four parties involved; the board, the divisional head, the sector head and so. So even then you can see how there's just various different accountabilities and governance. But actually, the way the M&A team are paid are completely different and the way they're organized are completely different. And just who has responsibility and accountability is completely different on the deployment of capital. Maybe I'm way off here, but I think that's important to understanding the growth rate from here in these businesses or how much capital they can redeploy for the next 20 years.

That speaks to the central question which is, how do these systems evolve and keep going and keep performing as they scale?

You see what Constellation does; they spin these out and create new groups. There are various differences in this piece that are important to understand the nuances of the organizational structure, how they organize people, and a bit of the history about why they may be organized that way. Like you mentioned about Andrew Wilkinson, the personal dynamics of how a business is organized, and the M&A side. If you are serious and it's a core part of your strategic plan to redeploy capital for inorganic growth, understanding how the M&A team is incentivized could help in understanding the future of that business.

Let's wrap this up by discussing what other threads we're pulling on in this more operations-oriented research as it relates to serial acquirers and industrial holding companies.

Briefly, there's still work to be done on the M&A side because it's not too clear how to incentivize an M&A team. These two companies have completely different methods, and maybe that's not perfect.

Let's say you work for an M&A team, and your role is to buy businesses. You buy a business, let's say, for argument's sake, at five times normalized operating income. How do you get paid? How should I incentivize you? Do I incentivize you based on the amount of capital you deploy? For instance, Lifco obviously wants to grow more, so the more companies they can buy, all else being equal, the better. Capital deployed has to be a variable, and the multiple has to be a variable potentially.

Do you have any control over the multiple? Are you negotiating that, or do you have an influence in finding off-market deals versus broker deals, which impacts them more? There's a lot to consider. If you buy a business at 5X, we have to decide how you get compensated—capital deployed, multiple paid. How do you work that out as a percentage of what? Some companies work out a year one return.

For example, if you pay 5X, the enterprise value is five times the normalized operating income, resulting in a 20% year one yield if they maintain that rate. Let's say you've got a cost of capital minus that, and then you get a year one return. Do you get paid a portion of that return? Other companies work out some kind of terminal value of that business. Lifco doesn't value these assets at 5X; they have a 40X multiple. But they might say, actually, this is worth 10X to us.

The M&A person buys it at 5X, and they agree the terminal value is 10X, creating that much enterprise value for the business, and you get a small portion of that. Some companies do that, which is a more generous way to compensate M&A staff. Exploring how companies pay M&A staff is an ongoing project. We did that work last year on Constellation Software and saw a lot of M&A staff leave. Part of the reason was they were underpaid compared to what they could get elsewhere.

They have an escrow scheme where part of their bonus can be paid in shares, but many people weren't happy with that and how much they got paid. It's not an easy task to incentivize these staff, and it can encourage underlying behavior. If people try to deploy lots of capital at bad prices, or the inverse, buying at 5X or 4X multiples that don't last a few years, that's a problem.

That's still a huge part of the work. We'll also do some research on how different companies operate these assets and go deeper into these entities to understand how they grow them. A big part of these businesses is assuming these companies take cash flow from these assets and redeploy it elsewhere. How do you ensure those assets get enough capital to grow if they have a capital expenditures program or an R&D project that needs capital?

How do you have that conversation and framework to ensure you're comparing taking capital from that business and deploying it elsewhere versus reinvesting it in that company? That's an art that is quite tricky.

You mentioned avoiding the risk of this becoming a Buffett fanboy chat. Let's also avoid the risk of this becoming a serial acquirer fanboy chat. We've published historically on Storskogen. Could you add a little about the topics on your mind that might foreshadow what's coming up over the next year regarding failure modes for these institutions? We're interested in situations where attempts to grow inorganically over extended periods have not worked.

I mean, there are plenty of those.

Right.

We've looked at SDI briefly. These are still in motion and evolving. They've been challenged and struggled for a number of years. Storskogen, SDI Group, and a few others have their own challenges. Storskogen probably tried to acquire too many companies too quickly. They had people doing M&A who weren't necessarily incentivized or aligned with the business. SDI Group is a different case, showing how difficult it is to scale these businesses beyond a certain size. If you're trying to do one transaction a month, that's a lot. You need to know what you're buying and have the infrastructure to do that. Doing it lean is incredible. This brings us full circle to how incredible Lifco actually is.

Yes, just how extremely unusual the businesses we've focused on are. They're outliers. I don't know how you feel about it, but it's pretty hard to do well over an extended period. It's hard to do anything well over a long time.

Well, if the fastest way to blow up a company is to redeploy capital into loads of poor investments, this is the easiest way to blow something up, which probably scares most people.

While looking smart short term, because the top line is growing.

Yes, and funny enough, the most read article last year was on purchase price accounting, the accounting policy used when buying assets. It's also probably the easiest way to commit accounting fraud for most companies. So there are legitimate reasons why people don't look at this stuff and probably should avoid it.

I like that you've said that. I wanted that out of your mouth as part of this episode.

It's the easiest way to blow things up and do accounting fraud. Forget everything we said for the last 45 minutes.

Basically, avoid these businesses for as long as you can. There are a few that make it, but they're few and far between, and it's mostly a waste of your time.

On that note, we shall end. See you next week. As always, this is for informational purposes only and should not be relied upon for investment decisions. Please do your own research.