The Theory of the MidCo

"The art of good business is being a good middleman."

Eddie Temple, Layer Cake

The musings of a fictional gangster played by Michael Gibon would, at first glance, appear to have little practical application in  the world of legitimate business. However, Gabon's quote is actually an excellent summation of one of my favorite frameworks through which to view the investable world - the Midco.

The MidCo is the love, respect, community...and the dollars too. Wait...no...that's the kwan.  But there is certainly kwan to be minted by an archetypal MidCo.  So what is a MidCo?  The MidCo can be broadly thought of as a for profit toll collector.  He sits at the intersection of a transaction between two or more parties who are attempting to engage in commerce.  He can take either a virtual or physical form.  The purest form of a virtual MidCo requires almost nothing, save a mobile phone, a Rolodex and moxie (think real estate or mortgage broker).   A physical MidCo generally provides a transportation, communication or logistical function allowing commodities (including information) and goods to move between two points (think toll road or natural gas pipeline).  However, not all transportation related businesses are MidCos.  A physical MidCo must own the permanent infrastructure connecting the counterparites (e.g., telephone network operators).  This eliminates trucking, airline and shipping companies and is a key determinant of profitability and operating leverage (more to come on these subjects).   

So what makes a MidCo a MidCo besides its general role as an intermediary?  There is some ambiguity  in certain instances (i.e., are railroads MidCos? answer - probably) but I wouldn't go so far as to invoke Justice "I know it when I see it" Potter Stewart at this point.  Below are my top 4 "you might be a MidCo ifs" in no particular order:

1) You have great free cash flow potential -  Virtual (vs. physical) MidCos have minimal asset intensity.  They create a connection between two parties and get paid for this linkage.  They trade in the commodities of information and contacts.  A few of the purest examples include corporate recruiters, real estate brokers, investment bankers, third party logistics providers and one of the great MidCos in the history of humanity - Google.  This lack of asset intensity is important because it translates into a tremendous capacity to generate free cash flow.  More capital intensive physical MidCos do exist (e.g., electric utilities, phone/data networks) but they can still be cash machines due to their operating leverage as well as propensity to be natural monopolies (more on this later).  Furthermore, physical MidCos often enjoy a stable, annuity like cash flow profile which allows investors to justify the significant capital investment.

2) You have tremendous operating leverage - Operating leverage refers to the marginal profit a business generates with each additional unit of sale.  The profit growth of a business with great operating leverage significantly outpaces underlying sales growth.  This is true for most MidCos for several reasons.  First, MidCos often price their tolling fees in relation to the size of the transaction facilitated.  This translates into tremendous operating leverage, especially for virtual MidCos.  A few examples include real estate brokers and investment bankers setting fees as a percentage of transaction size.  This might also apply to Citywide Change Bank if they actually charged a fee for their services (note: they do qualify for #3 below):



Second, physical MidCos often operate  permanent infrastructure with strategic value whose costs of operation are largely fixed relative to the amount and size of transactions processed.  This allows their profits to grow at a significantly faster pace than the volumes transported or processed.

3) You do not take principal risk - By principal risk, I mean that the success of an endeavor is tied to a specific outcome (e.g., corn futures will rise; the Giants will cover their spread, pastel scarves will sell well this spring, etc.).  MidCos usually do not sell anything and tend to be service and transactional oriented.  If they do sell something, they usually fill an advisory role (e..g, M&A banker) or have an arrangement in place that protects their profit margin (e.g., electric utility).  This attribute largely eliminates retailers whom some may consider MidCos simply because of their role in connecting consumers with producers.  Retailers are not really MidCos because they take merchandising risk, a form of principal risk in my mind (they are also capital intensive and have limited operating leverage).  A retailer needs to correctly forecast the wants and tastes of its target customers in order to succeed and this requires that they properly invest in inventory to stock on their shelves .  One could argue that dominant retailers in non-discretionary categories such as Wal-Mart (WMT) are MidCos.  I'm open to this point of view especially given the  logistics acumen underpinning much of WMT's success.  I do consider distributors to be MidCos albeit  weaker versions, given their role as logistic providers; their  lower capital intensity (quicker inventory turns / fewer locations vs. retailers); and the lesser merchandising risk that they bear. 

4) You enjoy the Network Effect - This applies to the most defensible MidCos.  The Network Effect (NE) refers to the phenomena whereby a good or service gains value as the number of its users increases.   In its most extreme manifestation, this can lead to a natural monopoly (think QWERTY keyboard).  EBay is a great example of a MidCo that benefits from the NE.  As the number of EBay users grows, so does the depth and breadth of the virtual marketplace that it manages.  This creates a virtuous cycle whereby buyers find the site more useful as the offering of products grows and sellers find the service more useful as the potential audience for their products swells.  Other obvious examples include financial exchanges, search engines and social networks.

So who cares, right?  Well, the reason the theory of the MidCo can be useful is that it provides, what I think, is an effective rubric through which to identify attractive investment candidates.  Many of these companies are already appreciated by the market but may not be thought of as MidCos (e.g., MasterCard, ADP).  Other companies are clearly viewed as MidCos and may even be referred to as "midstream businesses." Yet others may be ignored on both accounts.  Take TPCG, a niche chemical producer...it turns out its core business, C4 processing, very much qualifies as a MidCo business and it now appears that the market is taking notice. 

On my next post, I will induct my first member to the MidCo Hall of Fame.