AI Rollups, the latest fad to take venture capital by storm, point to a different source of excess returns that is only becoming more valuable

Listen on Listen on: Steve Ross was a legend. Starting with nothing but a job at his father-in-law’s funeral parlor, he built Time Warner into one of the world’s largest companies, making a mark on every part of the media landscape. MTV and Nickelodeon were born under his roof. He bought and ran Atari. He helped found the New York Cosmos and, with it, professional soccer in America. When Ross died in 1992, Clint Eastwood dedicated his Best Picture Oscar for Unforgiven to him; two years later, Steven Spielberg did the same with Schindler’s List. Everyone glosses over the boring part. To build the stake he needed to get into the media business, Ross bought and built a string of strikingly mundane companies in the 1950s and ’60s. He started by convincing his father-in-law to let him rent his funeral parlor’s limousines out at night, when they weren’t being used. Then he founded a rental car company, merged it with a parking lot business, bought a cleaning business, and took the whole thing—including the funeral parlor—public as Kinney Services. Ross used Kinney to buy a flooring company, a painting company, a carpentry company, and a plumbing company. He then parlayed this hodgepodge of everyday businesses into acquiring the legendary Warner Bros. movie studio. There’s a puzzle here worth thinking about. Ross essentially picked up a bunch of stones off the ground and traded them in for a diamond. Usually, to make big money in business, you have to do something no one else can do or have something no one else can have. But any competent businessperson could have bought or started the businesses Ross did. In 1990 he took home $78 million, the largest pay package of any executive in America at the time. How did he get there? If you took economics, your introductory textbook said something like this: “Business dynamics cause firms to enter and exit markets so that, in the long run, prices are driven down to minimum average total costs, resulting in all firms earning zero economic profit.” What this means is that no company should be able to make outsized profits for very long. Of course, plenty of companies do make money for a long time, and business strategists have laid out the reasons: Michael Porter’s barriers to entry (you do something no one else can do), and Jay Barney’s costly-to-imitate resources and capabilities (you have something no one else can have). These “moats” protect a company from profit-destroying competition. The businesses Ross bought and started did not have moats. Funeral parlors, parking lots, rental cars, and the rest are easy industries to compete in. You can tell because they are crowded with competitors. Yet in 1969, Ross bought Warner for roughly $400 million—about $3.5 billion today. Without any sort of moat, Ross should not have been able to accrue the wealth needed to buy one of the storied movie studios of the ages. But he did. Steve Ross wasn’t the only one. Constellation Software, Waste Management, HEICO, and many other rollups searched for just these sorts of businesses, and built extraordinary profits by looking where no one else was looking. This entire class of mundane businesses sits right in front of our noses, but both management strategists and most businesspeople just couldn’t see it. These businesses are invisible.[1] How to disappear completely You can’t, of course, make a definitive list of today’s invisible companies; that’s the point. But the building blocks of Steve Ross’ early empire are perfect examples, for their time. Others, like HVAC, trailer parks, and candle retailing, were much more fragmented businesses until someone realized they were invisible sources of profit and rolled them up. Hindsight suggests we are currently surrounded by highly profitable companies that we never even think about, while common sense suggests this is impossible. Your basic econ 101 “economic-profits-go-to-zero” explanation has a couple of assumptions: frictionless entry and exit of companies into an industry, and perfect knowledge of the relevant drivers of success. Economists aren’t naive, so they don’t really believe these things entirely. But they assume they are mostly correct over the medium to long term. Management strategists, on the other hand, saw that the first assumption was grossly wrong: there are plenty of industries in which it’s hard for a competitor to enter the market. In response, they came up with the concept of “sustainable competitive advantages,” which is 90% of the reason business strategy is a different discipline than economics. But both approaches assume the market works like this: (1) an opportunity exists; (2) potential competitors notice it; (3) they evaluate how to enter the market; (4) if they can, they enter; (5) profits are eroded. This all hinges on whether anyone has noticed the opportunity. If they don’t, potential competitors never get to step one. Competitive neglect is upstream of the entire economic and strategy machinery. This is not an asymmetric-information problem, where both parties know the gap exists and have every incentive to close it.

No one searches, so no one competes; no one competes, so the profits persist. The reward for being overlooked is, paradoxically, the opportunity for supranormal profits. Companies are invisible primarily because no one is paying attention to them. There are four main reasons this happens: No. 1, they are unknown; No. 2, data about their existence or profitability is private, missing, or obscure; No. 3, they are misunderstood because their markets are assumed to be mature, shrinking, or too small to matter; or No. 4, they are disdained, because the work is low-status, unpleasant, parochial, or socially stigmatized. It’s obvious that this happens, but it also seems impossible that the absence of information could last for long: dead-end markets eventually dead-end, and stigma could be overcome for a price. Invisibility seems like it should be a brief anomaly; a weird blip in an otherwise efficient market. Over the medium to long term, the market should make these invisible companies visible. How does invisibility work? This is not what happens. Take Constellation Software.

It did this by buying tech businesses. Not exciting ones, but small ones—deal sizes often under $5 million—in niche markets: marina management and ski-lift ticketing software, funeral home record-keeping, library cataloging, oil-and-gas pipeline scheduling. It bought them after the companies’ management or their venture capital backers had thrown in the towel because they were too small and growing too slowly. Constellation is good at picking companies and helping them succeed, but some of its outsized returns come from a different source. The industries it buys into were profitable but boring to everyone else, leaving Constellation to buy cheap and build something big by putting them all under one roof. Constellation recently estimated that there are still 38,000-plus vertical-market software businesses it could potentially buy. These aren’t a handful of backwater anomalies. They are companies across nearly every industry that are ignored by other acquirers, even though they are presumably profitable, since value can be created by buying them. One mechanism that causes invisibility is simple unawareness. Businesspeople hunt for opportunities using data other people have already gathered—and no one bothers to gather data on obscure, small, non-strategic markets. It costs more to collect and almost no one wants it.

Businesspeople also gather information from those they know through work or socially. But some companies sit entirely outside the social networks where investors and executives trade ideas. Even if you have cultivated a diverse network, it is unlikely an acquaintance you have coffee with in New York or Silicon Valley has any knowledge of specialized manufacturing in the Upper Peninsula. Read more by Jerry Neumann We Have Learned Nothing Startup pundits sold us a failed science of entrepreneurship. The Red Queen offers something better. AI Will Not Make You Rich The disruption is real. It’s also predictable. Another source of invisibility is less the absence of information than the habits people bring to interpreting it.