Lower Middle Market Investing

EMS:
Absolutely. To kick off the conversation, tell us a little about the firm and how you got to where you are today.
MT:Happy to. As you mentioned, Bow River is a Denver-based, private markets manager. A little bit over two billion in assets under management at this point. Firm was founded in 2003 with a core focus on lower middle market buyout investing, and since then has grown horizontally by adding new strategies over the years. The first of those was an opportunistic real estate strategy that's now on fund three, software growth equity fund that's focused on lower middle market software buyouts that's on fund two. And then I service portfolio manager on our fourth strategy, which is an evergreen private equity fund.

As the name would suggest, we are a perpetual vehicle that accepts monthly subscriptions at lower investment minimums than most of our traditional funds. The goal on my strategy is to provide a highly diversified exposure to private equity across manager, vintage year, geography, strategy, and to do that on an immediately invested basis so that our investors can start compounding a return right away with no J curve.

By way of background, I've spent basically my entire career at this point focused on private equity structures that are designed for more of a wealth management type market, including serving as PM on the largest fund of this type in the US. I joined Bow River to get this strategy off the ground. Take a similar approach but focus much more on middle market and lower middle market private equity investing.
EMS:Great, Mike. Given your background and experience in the lower middle market space, love to hear a high-level outlook going forward.
MT:Absolutely. I think, long term, very constructive on lower middle market private equity. I think the lower middle market tends to have the best out-performance potential in the broader buyout market. You're dealing typically with smaller, less sophisticated companies where you have a number of different value creation levers and you can pull to generate value as an investor. Most of the time, on these smaller founder-owned businesses, the private equity firm is the first institutional capital and can really just help with basic ways to institute operational best practices. That can really drive a lot of out-performance over the life of that investment.

On the back end when you're looking to exit, you have way more flexibility on sale options. In large cap private equity, you're typically limited to an IPO or a very large strategic buyer. When you move into the lower middle market, you can exit to the entire ecosystem of middle market and large cap private equity managers that now exist. You can exit to smaller strategic buyers, you can exit to larger strategic buyers. It really opens up a much broader suite of exit options.
All that being said, lower middle market PE does tend to have the widest dispersion that you see in the buyout space. So you do have potential to outperform or underperform depending on who you work with. I think it's really important to make sure you're working with best-in-class GPs with really unique sector-specific expertise. That's something that we really look for in my fund when picking managers to work.

All that being said, near term, I definitely think there are some headwinds in private equity overall. That's still going to hit the lower middle market, I believe. Obviously the macro environment is quite challenged from inflation to recession worries. All of that's going to impact some businesses, but I do think it's very sponsor specific, asset specific depending on where you are focused as a manager.

Overall, I do think lower middle market private equity tends to fare a little bit better, at least in certain sub-sectors. Because the large cap end, you're so tied to performance in public markets, particularly given the reliance on IPO for an exit, so your valuation benchmarks all tend to be public companies. As you move into the middle market, lower middle market, these are very niche sectors, niche strategies, and a lot of them can continue to grow well even if there's broader macro headwinds on a number of different industries. So I think there will be challenges over the next year that we need to work through, but I think overall, lower middle market PE should be well positioned verse some of the larger investments out there.
EMS:Mike, as a follow-up question given your outlook for the space this year, what are some of the specific opportunities you see looking forward, and why?
MT:Yeah. In my strategy, I'm focused a lot on opportunities in the private equity secondary market, particularly sales of LP interests in private equity secondaries. If you look across the institutional investor realm, be that large pension funds, endowments, virtually everyone is really over-allocated to private equity right now. Most of them were at their target allocation going into 2022. Given the sell-off in public equities, public bonds, and then the relative out-performance of private equity over the period, almost all of them are over target.

This is against the backdrop of a record number of PE managers in market. I saw a stat that I think ... something about 70% of private equity managers are raising a fund right now. That puts an allocator in a tough spot, where if you want to maintain your GP relationships, you're going to have to sell off some non-core assets to free up room to continue to allocate to those. All that bodes very well for the secondary market. We've seen a big uptick in sale volume from these institutional investors. There's certainly secondary capital out there to buy it, but I think it's shifted from very much a seller's market to a buyer's market over the last year. You've seen pricing reflect that, where discounts have really widened out on purchases, even of high quality fund interest.
The other near-term opportunity we're leaning into a bit is opportunities in private credit. My fund is private equity focused, but we have flexibility to move into credit when it presents attractive relative value. Given how much banks have pulled back over the last year, direct lenders have really stepped in, have been able to dictate much more attractive terms than they could a year or two ago. Tighter covenants, wider spreads, and all of that against kind of a backdrop of just lower overall debt levels, which really helps with interest coverage ratios, things like that. All of that I think makes credit, given the senior position in the capital structure, somewhat more attractive than traditional equity near term.

As we look toward kind of mid-2023 and beyond, I think there's going to be a big opportunity to move back into direct investments and buyout transactions. You're already starting to see multiples come down on new deals to kind of reset to reflect the higher cost of debt in the market today. I expect that to kind of smooth out and stabilize up by mid-year and plan to really reallocate there quite a bit. Longer term, I think there will be some opportunities in venture capital and growth equity, but I still think it's way too early there. I think we're just starting to sort out where things are going to bottom out in growth and venture.
EMS:Great. Mike, on the other hand, what are some of the biggest challenges you anticipate this year in your investment space, and why?
MT:Yeah. I think I just hinted at probably the biggest one, which is I think growth and venture are going to continue to be challenged near term. This is the segment of the market that's been most impacted by the rising rate situation. Valuations have really just started to reset, unlike a lot of the publicly traded technology peers. Groups in the VC growth space are doing everything they can to kick the can down the road and avoid raising capital right now at lower valuations. Most of them took advantage of raising it at really high prices in 2021 and early 2022. They're going to try to kick the can down the road as long as they can, but eventually they are going to burn through cash, at least if they're not cash flow positive. I think when those companies do come to market, it will be at very punitive terms and you'll see a pretty big impact to valuations.

The other segment of the market that worries me a bit is large cap buyout. If you look at a lot of deals that were done in late 2021, kind of the peak of the market, really high entry multiples, really high levels of debt, all done on very heavily adjusted EBITDA numbers. I think if some of the synergies that were assumed and the assumptions that were made on those adjusted EBITDA figures don't come to fruition pretty quickly, you can see a situation where some of these companies are in a pretty tough spot on the debt and need to go into a workout situation. So I think large cap's probably most impacted by what's happening in the markets, especially the pullback and debt markets, and what's available in the leverage loan market. Those are the two areas that worry me the most.
EMS:Great. Mike, to shift gears a little bit, wanted to discuss ESG and DEI, which are obviously top of mind for PE firms. Wanted to hear how Bow River is addressing both of these.
MT:Yeah, Bow River, we take this topic very seriously. We've built ESG criteria into both the corporate level as well as our portfolio management practices. We believe that this is a way to generate value for our investors on the one end, but at the same time help really mitigate serious investment risks on the other. We have an internal ESG committee that handles all of the implementation, execution of Bow River's ESG policy. That's all focused around three key pillars. One, sustainability, two, people, and three, governance. Sustainability is a key focus across the portfolio, but really, in real estate is where you see that most immediately impactful. Obviously when you're doing ground-up development, energy efficiency targets are really crucial. That's something that we are very focused on, on the real estate end.

Diversity and inclusion is a key part of our people pillar. We have a firm goal to match our employee demographics to those of the state of Colorado by 2025. We're also planning to start actively reporting gender and racial ethnic group representation at the firm using the template that's been put out by ELPA. We've also partnered with a number of best-in-class organizations to help us achieve these goals. We compiled a third-party ESG advisory board that's made up entirely or nearly entirely of thought leaders and experts in ESG implementation and reporting. This group is obviously going to help us implement the plans we already have, but more importantly, keep improving the ESG policy over time and making sure we're on top of the latest trends, best practices.
EMS:Mike, we've covered a tremendous amount of ground today. Wanted to see if you have any final thoughts you'd like to share with our listeners.
MT:Yeah, I guess I'll share a little bit about just what we're planning at Bow River long term. My focus personally is on continuing to grow the evergreen fund, and just dynamically allocating what we think are the best opportunities we see in private markets, and hopefully continue generating consistent returns for our investors.

As a firm, Bow River just wrapped up fundraisers on our three flagship strategies, raising over a billion dollars of capital. The goal there is going to be deploy those vehicles successfully over the next three years and hopefully generate solid returns. Longer term, as we grow the firm, we'll obviously continue raising our flagship funds and deploying across all of our existing strategies. We do hope to continue to iterate and grow horizontally by adding more strategies over time, on both the evergreen and the traditional side of the business. Really, the goal is to build what we believe to be the leading private markets firm in the Mountain West region in North America.
EMS:Well, Mike, I wanted to thank you so much for sharing your perspective with our listeners.
MT:Happy to. Thanks so much for having me on, Elana.
EMS:Absolutely. Thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.

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