Episode 65: What Successful Ecom Brands Know with Anthony Choe, Founder of Provenance

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Transcript

‍Drew Sanocki:

Hey everybody. Today's guest on the podcast is Anthony Choe. Anthony runs Provenance Digital. It's a private equity group that invests in big DTC brands like MeUndies and Caddis and Marine Layer. He's got a great roster of brands and they have a unique approach, which is very similar to the one we talk about on nerd marketing all the time. Rooted in RFM, recency frequency in monetary spend as a way to segment your customer data and increase growth in profits. So Anthony and I actually went to college together, but that's sort of where the similarities end because we both learned about RFM, whereas I used it to operate a very crappy small drop shipper. He used it to start a private equity fund, which has had multiple exits and has grown very big and he's very successful. So I'm really fortunate to have Anthony on the podcast, an old colleague and friend. Hope you enjoy it. Thanks. You are one of the handful of investors I've met that have invested in DTC for a long time. How'd you get into investing in direct to consumer brands sort of before everybody else?

Anthony Choe:

Gosh, the journey really began way back in February of 2000 at the risk of dating myself. So for 20 years after the DLJ experience, I was at a place called Brentwood Associates and we were consumer focused, but at the time, around 2000, we were spending a lot of time looking at.com businesses and realized that a lot of them were burning money on two things, customer acquisition and building their own third party logistics. Well, I guess not. There was no third party logistics back then. So it was building your own one-to-one fulfillment infrastructure. Kind of flipping that around. Looked at the landscape and said, well, actually, certain kinds of catalog companies are essentially DTC businesses. They have large customer files and they have already built their one-to-one fulfillment infrastructure, so it's much cheaper just to layer on websites on top of those companies and play the e-commerce trend that way.

So we ended up investing in a company called Oriental Trading Company, which is tchotchkes and novelties for mothers with young kids at home, and it was a phenomenal business, a very good ride. It turned out to be, I think it's probably still the single best investment that Brentwood has made on the private equity side of things. That was really where I started to learn the techniques around how analytical marketing was when you're selling directly to end consumers. So learning things like RFM, lifetime value, looking at your payback periods, looking at your contribution, looking at retention versus acquisition. All those things for me started back in the year 2000.

Drew Sanocki:

I mean back then I know because that's when I started my first brand. There were no blogs, there's no Shopify. How did you learn that stuff? Where did you go?

Anthony Choe:

Well, candidly, we learned it from the company. The company itself was a fairly large entity, so at the time we invested, it was over a $300 million business. By the time we exited, it was a $650 million business at the peak. It was mailing I think 300 million catalogs a year, if you can believe that. So yeah, I learned a lot from the company. What we could see is there was a lot of customer loyalty and a lot of predictability of cash flow, but then looking at the multiple components of the business, there was almost nobody else to learn from. There were very few businesses that were larger than Oriental Trading Company at that time doing direct to consumer, you could count on one hand probably how many of them were j Crew Lanzen folks like that that are household names. So for me personally, it was learning from the management team how they went about doing it, and during that time, I think to optimize the company itself was learning how to pioneer certain techniques that had never been used before.

For example, the customer economics were so good that when we looked at the mail stream incrementally, that was always incremental investment that could be justified. So eventually we looked at the highest value customers and we were mailing some of those customers over 30 times a year, and the math still said it's still profitable to mail 'em one more time. So we started to do things like contact stream optimization where you're basically doing AB testing saying it is not logical that you should have to mail somebody more than every two weeks. So what if we start AB testing and selectively pulling back to see what happens when we do that? So there were a lot of things that were being tested back then, but it was all from a quantitative point of view. Now, obviously, catalog and digital behave very differently, but the foundation, the math, the ROI math is very much the same.

Drew Sanocki:

That reliance on RFM or the use of RFM to segment your customer data parlays really well into email, but it almost took like 10 years off Oriental trading and LL Bean and Sharper Image and all these catalog brands back then in 2000, and the people who had that skill set didn't become the email marketers of the next 10 years. I don't know if it died, but it took 10 years off and I feel like then there were people like Peter Fader who came back on the scene and started saying, Hey, there's this thing RFM and Jim Novo's, another guy that applies to digital just as much as it applies to catalog. And now again, you hear a lot of the big brands, many of the ones you've invested in are talking like that. Again,

Anthony Choe:

It's so funny that you mentioned Pete's name. So we've been working very closely with Pete since inception, both of what he's doing and what we're doing. So I befriended Pete around 2013 or 2014, I can't remember the exact timeframe, but this is when Wharton was first launching its customer analytics program where they're trying to train a generation of MBAs with statistical underpinning. And in that context, I met Pete and the first time we met, we chatted for probably two hours, and when I heard what Pete was doing, I said, Pete, if what you're telling me you can do, actually do, this is the holy grail. This is what I've always been seeking. He told me at the same time, it's like, man, we got to figure out a way to work together because you're the only investor I've ever talked to that actually understands what the heck I'm working on.

And bringing it back full circle, the statistical techniques, the buy till dye modeling, it's not built in the same way, but it has very similar principles to RFM techniques that were being used by catalog. What I could tell was what Pete was doing was rather than just creating segments of RF and M like catalog companies were doing, it was going even more granular down to the individual customer level. And to me, that was why I thought it was the holy grail. We very much continue to use that today. It's hard to believe that I've been thinking about these concepts with Pete for almost 10 years, but we were one of Pete's first commercial customers when he launched this platform called Zodiac. His first two customers were me and Nike and Nike liked the company so much in the concept so much they ended up buying the platform before it really fully got launched. But fortunately in the follow-Up act, we continue to be working with Pete. So I feel very fortunate that some of those early experiences informed me that quantitatively approaching certain parts of marketing were really important and we continue to believe that today.

Drew Sanocki:

I couldn't agree more. I think when I first discovered RFM through some catalog marketing textbooks, database marketing textbooks like light dawned on Marblehead, I felt like I had an unfair advantage. I did it the wrong way. I just applied it to my own small dropship retailer. What I should have done is started a hedge fund that traded on it or a private equity fund like you did, and buy companies and implement it. Certainly like getting more leverage out of that knowledge. Does it work? Are you able to identify these companies that haven't implemented RFM or some model based on RFM and then you acquire them or you acquire majority interest and then implement that model and you see an immediate benefit on the top of bottom line?

Anthony Choe:

First and foremost, we're not typically dealing change of control transactions. We're usually doing significant minority transactions. And the reason for that today, so post my 20 years at Brentwood, I launched Providence to focus on, we call it digitally intensive brands. They don't have to be digitally native, they just have to have a digitally intensive component to the business. We're talking to brands at the growth stage. That means different things to different people. For us, it typically means we're getting involved somewhere between the $35 to $75 million range where there's real meat on the bones, there's a real customer file, and a lot of our conclusions that we're doing analytically can be highly statistically significant. That's what we're doing today. But with that as backdrop, I'd say what we're really pleased about is that when we backtest our results, what we predict the 12 month transaction rate is going to be based on our predictive lifetime value techniques that we work on with Pete.

The forecasting error on that cohort behavior is plus or minus 4%. The accuracy of the techniques are almost unbeatable. We're basically within two standard deviations of statistical error. It doesn't really pay to get much more accurate than that, but for us, when we look at those analytics, most of the time people assume that we're using that to vet our financial forecasts. That is a part of what we do and certainly it helps us, I think, to sensitize different outcomes in a more granular way than everyone else. But I think the most important piece that comes out of it is the customer segmentation. By doing the predictive analytics down to individual customer level, what we're able to do is say really precisely identify who are the high value customers and what is their behavior? Because you'll typically see a Pareto principle at play or a Powerwall for example.

Typically we'll see something like 20% of the customers generating 50% of the revenue and two thirds of the contribution. It doesn't mean that you fire everyone else as a customer to become efficient, but what it means is when you're shaping the company's strategy, you shape it around that highly loyal core. The other customers will come along for the ride as well, and they're important too. But when you're shaping the future strategy and the priorities of the company, you should always shape it around that core. That's a key foundation of what we do. I think the other thing that goes a little bit less noticed, I think by financial types but is much more interesting to the brands that we talk to, is we also layer on lots of demographic and psychographic information on top of that. Again, all down to the individual customer level. And what we look to show brands is the vast majority of them have a quote tribe, a unique slice of a psychographic type of customer that leans into the brand that really starts to take shape when the brand is anywhere from five to 10 million of revenue.

So at a very early stage, we can see that tribe get locked in. For us, that's another way to say, well, when you know who you're resonating with and why stay true to that because the profile of that customer does not change as you scale. I like to give the example, I won't use specific numbers. When we first started with Marine Layer and investing with them in 2018, we showed that they have a very specific tribe of consumers that really leans into the brand. They have broad appeal, but in terms of customers who are six to 10 x more likely to purchase with the brand, there's a very unique psychographic tribe that they appeal to. The company has grown by $100 million in all of its channels since we invested that tribe. When we look at the analytics of who that psychographic tribe is, it's exactly the same as it was in 2018 with a hundred million less revenue.

So it's funny, the marine layer folks asked, does that mean we're running out of our potential customers? And so when we ran the analytics, we said, no, you're about 4% penetrated. I think you're a long way from hitting the wall even though you have a very specific tribe of consumers. So yeah, the company continues to do well as a result of that. So for us, what we like to do is take that really granular information both on the quantitative and the qualitative, put it together, and when you do it down to the individual level, we can slice and dice and segment the customer base anywhere, which wait till Sunday. This is what's very different for us now than what was possible in the early days of doing it with RFM segments in catalog. Because the hard part about catalog is if you're trying to be very precise and granular and you're trying to go into, let's say deciles, deciles of R, deciles of F and deciles of M, you have a 10 by 10 by 10 matrix. All of a sudden you've got a thousand segments. That's really hard for brands to work with when you have a thousand different segments. So most of the time you have to make trade-offs between granularity and efficiency, but when you can slice and dice down to the individual customer level, there's no such limitation, and so you can do it much more accurately, much more efficiently, and I think that's table stakes in today's highly fragmented brand world that we live in today.

Michael Epstein:

Once you've identified those whale customers, the ones that are driving the larger percentage of revenue or the tribe members, the people that really resonate with the brand, what are some of those ways the brands operationalize that in terms of becoming part of their business strategy?

Anthony Choe:

Again, I'll lean on the marine layer example just because it's a long tenured investment for us coming up on not quite five years that we've been invested in it. The way it's come to life has literally been in virtually every channel that we do, and even on the branding side. So even pre-investment, when we first had the conversation with Marine Lair, we could see with the demographic psychographic overlay that we did, there's a passionate customer that caress deeply about the environment and sustainability. We knew they were already using lots of sustainable fabrics. So we said, Hey guys, whether or not you want to do this deal with us, we strongly recommend that you lean, lean into this and start talking about the importance of this because your customer cares deeply about it and you do too, but you're not even talking about your values here, so we strongly suggest you do that.

They took that and they used that as the confidence to launch something called repu, which is truly recycled garments. It's not just resold garments, but things that are ground down back into raw fiber, spun back into yarn and turned back into new garments, and that's been a really big success for the company from a branding perspective, from a channel perspective, it helped us be very efficient in every channel we wanted to grow to. So we used it for retail site selection. We used it to identify Nordstrom as the ideal wholesale partner. We wouldn't really wanted to start to build a wholesale division around and on the digital side as well. So catalog has kind of permeated every channel that we play in, but it's all about doing what makes sense for the company, not just copying what everyone else is doing, but doing at a pace and a scale that makes sense.

Drew Sanocki:

When you invest in these companies, you take a board seat and you bring your playbook, and do you find that you or your team typically works with the CMO in implementing that playbook? Are there certain pieces of software you bring in or do you insist on a, Hey, we're going to come in and put everything in Google BigQuery and here's the model we run off of? Or do you bring in third party software vendors?

Anthony Choe:

Philosophically, we like to start by saying we're very involved strategically, but we don't want to be running any part of the business on a day-to-day basis. That's not our position to do that, but we do like to sharpen the focus around what we're strategically going to do and not going to do. We give all of our companies discretion and flexibility on, Hey, if you want to use this software package versus that software package, we're never going to force something down your throat. However, in most areas, we'll have strong opinions on who we think are best of breed partners and strongly recommend some folks just based on historical experience, like these guys know what they're doing.

Michael Epstein:

We don't need to run a whole process. The vendor selection process here,

Anthony Choe:

Yeah, it's like you should talk to multiple people just to satisfy your own curiosity, but chances are you're going to come back to this party and want to work with them. So we're happy to make those kinds of recommendations, but again, it's not our job to force the company to do any one thing. We don't like to operate that way. So we always like to work with people that we think are best in breed at what they do, and we very much put post pilot in that category of we'll recommend copilot to almost everyone just because you guys do it the right way.

Drew Sanocki:

Thank you. I was going to ask, you've got this approach, this vision for how to grow a company through optimizing around your highest lifetime value customers and implementing the right segmentation and targeting, and on the flip side, the companies you're looking to invest in are the companies that aren't doing that. It's like, Hey, this company, I don't know, Marine Layer or Cadis or MeUndies, they got up to 50, a hundred million in revenue and they are not doing segmentation and targeting and that makes them a good investment. I don't

Anthony Choe:

Want to say we go in for what we think is broken and trying to fix it, but there's almost always low hanging fruit everywhere in almost all of our companies that we get involved in the unit economics are strong and there's some degree of strong customer loyalty that we want to see there as a foundation. So that's always a strong point to start with, but there's almost an unlimited list of things that the company could be doing better. The goal for us is not to fix everything overnight because management teams have to prioritize one thing and then the next thing and the next thing to do it well. So our approach is you pick that fruit over the course of years, not days or months. The lowest hanging fruit is the lowest hanging fruit, but that's never enough to get you to what makes an investment successful for us, for us, since we're going in with unlevered investments, we're not using financial engineering to try to make any of our return.

It's a hundred percent driven by growth, and that growth has to translate into profitability over time. So we go in saying, well, is there enough juice there in all these different areas to earn our target rates of return? We're not the cheapest source of capital out there, and it's because what we're trying to do and what we're trying to help companies with is time consuming. In our part, our approach is a little bit more focused, so we're willing to be more concentrated on the investments that we make to deliver on the promise that we make to brands. We have to be able to spend time with them and hold their hands through some of this process. For us, we're looking to make three x plus returns on our investments. Generally. That means at a minimum, the company has to double or triple in size on the top line to be able to achieve that. Sometimes the opportunity is driven by more profit falling to the bottom line. There's lots of areas where we try to help on that front as well. Not just revenue growth, but making the operations more efficient, equally important in our view.

Drew Sanocki:

So we've had other people on who, other private equity groups that invest with the intent to create a holding company, combine businesses, get them bigger, get some multiple expansion. That is not what Providence does. You do it primarily through internal growth. We're going to optimize what they're doing and help them on the marketing side and get growth that way. Organic internal growth

Anthony Choe:

In our view, the evolution of the consumer space, the reason why it's created so much brand fragmentation, and we can see this from the dynamics, the demographic and psychographic tribes that are being created around the same categories, is we truly think that we're now at the top of Maslow's hierarchy where the brands that are being very successful today, it's about self actualization. That doesn't mean anything fancier than just consumers want to lean into brands that help them be the best version of themselves and reflect themselves and their values. So with that, we feel like it's hard to take a bunch of different brands in the same category, put 'em all together and say, we're going to be authentic in attacking the same market space because the market space isn't the category, it's the mindshare of the consumer. Different brands appeal to different consumers, and so just because you happen to be in the same category, I don't think means you're going to occupy the same kinds of consumers mindshare.

That's number one. I think number two, the modern day holding company, we've had this conversation with lots of folks. The way that holding companies used to arise, it was always sort of either backend or product level synergies, right? So there was administrative GNA that you're eliminating, or maybe there's some supply chain benefit where your cost of goods are suddenly far better in some cases. That's going to continue to work today in most cases. It's not to the extent there's a modern day holding company, in my view, I think it's going to work very differently. The second biggest line item in most companies that we look at is the marketing line after cost of goods. In my view, the modern day holding companies should have a collection of brands that appeals across a wide variety of categories, not the same one, but are targeting the same type of customer.

Because you can start to get some leverage out of the marketing line by co-marketing together, but I don't think you're going to get it on the cost of goods because now everyone has outsourced their manufacturing relationships and I don't know, consolidating SaaS platforms. There's not much benefit to that. You're not going to get any savings, but any meaningful savings by doing that. So it's not the backend, it's not the cost of goods. I think it's on the marketing side. So that's my personal opinion. I haven't seen anyone do that yet, but I think to the extent there's a next generation holding company, it should be along those lines is my personal view.

Drew Sanocki:

What's your advice? I mean, we've got a lot of people who run direct consumer brands who listen to this podcast, CMOs Apparel, CPG, a lot of categories that could be relevant. What's your advice if you were speaking to somebody who is probably at the 10 to $50 million level now with a decent DTC brand?

Anthony Choe:

I would probably break it down into two levels. One is the business of brand building usually takes a good amount of time. We've seen this in a number of different cases, both in our existing portfolio. Lots of times for a brand to really break through, it takes about 10 years of hearing the message, seeing it consistently, and it eventually permeating people's psyche. I don't know when we got to the stage of you need to create your brand in three years and exit, and if you don't do that, you're not successful. That was never reality either historically or in today's world. So in my view, it's a long game, not a short game. Play it accordingly. Don't beat yourself up too much if you're not the overnight success because the vast majority of successful brands aren't overnight successes. They take 10 plus years to build. That's number one.

Number two, I think what I feel bad about for many brands is that they've been given advice that tells them to go from guardrail to guardrail, which is nobody cares about profitability, grow as fast as humanly possible. That's all that anyone caress about. And then more recently, in the past 18 months, it's just kidding. Stop everything you're doing, go in the other direction, get as profitable as humanly possible. Well, when you're a growth stage brand, you actually have to balance both of those things. It's not one extreme or the other. And again, I think if you have a longer view, the view that brands need to be created over a 10 plus year horizon, it's much easier to make those kinds of trade-offs, those kinds of trade-offs were always the right ones, which is balancing the right amount of growth subject to the best profitability you can generate. And they're always two sides of the same coin. The balanced middle path has always been the right one.

Drew Sanocki:

It's great. Really interesting.

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