Private Equity Investing with an ESG Lens

During this discussion, Brett will share his outlook for ESG in PE, including Star Mountain's journey and how he got into it? What components Star Mountain focuses on with respect to ESG, and why? Some of the greatest opportunities, challenges he's faced along the way, how you evaluate your portfolio companies in ESG? Your thoughts on the SEC making it more of a priority. And finally, what advice for firms to start their ESG journey? Hi, Brett, thank you so much for being with me today.
Brett Hickey:Thanks, Elana. Always a pleasure.

EMS:Absolutely. So, Brett, to kick off the conversation, tell us a little about Star Mountain Capital, the firm, and your journey of how you started integrating ESG into your remit.
BH:That's a great question, as far as ESG integration, which is one that was actually quite natural. Going back to a little bit about Star Mountain, and how we got to where we're at today. I grew up in a very small town in northwestern Canada, and in a small town, especially one that's very cold, people almost have to work as a community and work together sharing resources, tools, and things that you'd have... borrowing somebody's snowblower, things of that nature. And so ultimately, my journey was one focused on growing up in a community and a culture that I really liked.

When I moved over 20 years ago to New York City to do financial institutions, investment banking work at Salomon Smith Barney, I then was very fortunate to be able to work with some of the largest financial institutions in the world. At the time, I was working at the largest financial institution in North America, at Citigroup, and working with other large alternative asset managers that you would all know the names of.

What became very obvious to me was the opportunity in the lower middle market. The large banks were continuing to focus on larger companies, and the banks were realizing that they really needed scale to optimize their return on equity and their services for clients. But with scale, it became very difficult for them to work with smaller companies. In a similar manner, the larger asset managers all were also focused on scaling their business. And as part of scaling their business, similar to banks, really hard to deal with and service the high labor, high complexity demands of smaller businesses in America.

In addition to that, underserved areas in America. When you think about ESG, part of that is also creating value and career opportunities for people that live in what are deemed underserved areas across America. In New York state, for example, we think of New York City, but when you think about upstate New York and other areas, there's a lot of need for both capital and expertise to help grow businesses, make them more defensive, more sustainable, and more scalable, which of course has a very direct impact on the local communities, where those businesses operate.

And so when you overlay where all the larger financial institutions were going over 20 years ago with the aging demographics, what we saw was a real gap, that was a growing gap, in needs for high quality capital, expertise, and relationships for what ultimately represents a market segment that is about 50% of all of the US GDP and over 90% of the companies in the United States. And so I embarked upon the journey in 2004, managing money, in fact, for three local state plans, where they wanted to have both capital and expertise focused on companies that were growing to create high quality jobs in their state, as well as focused on women and minority owned businesses in their states. And then lastly, which I touched on, the areas that were economically underserved and underrepresented within their states, and most specifically New York, Texas, and Alabama.

During that journey, Elana, I really learned a lot about investing in the lower middle market across the US economy. And I realized that being local matters, you can't do everything to help these businesses across the US, if you're only in New York City, Los Angeles, and the big cities. You need to be able to be local and engage with them. In 2010, over 13 years ago, when I founded Star Mountain Capital, I really took all the learnings from the larger asset manager work that I did at Citigroup, and then the smaller business investing work that I did on behalf of the state and melded them together to build Star Mountain.

With the objective of bringing the large market expertise and capabilities to the high quality, growing small and medium size businesses across America. And also for investors to give them high quality, high governance, high ESG access to, in a customizable manner, what we believe one of the most attractive economies in the world, which is the US lower middle market, where businesses tend to grow revenue faster and in a less volatile manner than the S&P.

So we think it's a market segment that investors should care about. The challenge is how do they access it? And so that's what we built Star Mountain is to really connect those worlds of capital, resources, and expertise, both for investors to help generate high alpha and low correlated returns, as well as helping business owners access high quality, strategic capital to grow their companies with the benefit, of course, of helping society and the community.

And as part of ESG, last but not least, it's a very natural integration, Elana. As you think about growing a small business at Star Mountain, we have something that we call getting middle market ready. Basically, how do you take a company from around 25 or 50 million of revenue to a 100 or 200 million of revenue? And how do you help that business not only grow, but grow safely and grow in a way that they create reliable jobs and careers and economic opportunities for all of their stakeholders?

Part of that is having stronger boards and governance. Part of that is bringing in diversity to make sure they really understand their stakeholders and understand their community. Part of that is alignment of interest, the social aspect, aligning interests with their team, aligning interests with each other so that everybody's driving hard together. And then environmentally, making sure that they're sound companies that are adding value to the environment, and not detracting from the environment, sometimes they're small things, sometimes they're big things.

So ultimately what I'm a firm believer of and the way that we operate at Star Mountain Capital is that we believe that ESG is actually highly correlated to driving both more defensive and higher potential returns for all stakeholders, investors, and business owners. And it's creating that path, not just telling businesses, "Hey, here's what to do," but helping them do it, bring resources, bring relationships, bring best practices.

And today, Star Mountain has invested, since our inception, and we've made and completed, rather, approximately 200 investments now, and have just under $3.5 billion in assets under management. And maybe one thing I'll finish with Elana is how we eat our own cooking. I think in life we're all familiar with people that love to opine and tell us what to do, but then you say, "Well, great, how are you acting? What are you doing?" Star Mountain Capital is a 100% employee owned business.

I share, as the founder, the profits and the equity in that manner with 100% of our employees. We have approximately 70 full-time people, and an additional 40 senior advisors and operating partners. And Star Mountain Capital, with those approximately 110 people, we believe, brings more resources and capabilities into this lower middle market than any other institution that is exclusively focused on this segment.

So we wake up every day asking ourselves, how do we create more value for our investors and for the business owners in an aligned manner? And ESG is continued to be a growing part of that, which is very aligned with our mission of more defensible and higher valued businesses that we're continuing to help grow.
EMS:Brett, very interesting and inspirational journey of your deep dive into ESG, and the major impact you've made at Star Mountain and even earlier in your career. So given there are three pillars, love to hear your thoughts on what areas you're really focusing on this year, and why?
BH:One of them is data. Star Mountain takes a data driven approach to everything we do. For those of you familiar with Ray Dalio and Bridgewater, I think there's a tremendous amount of content and he's been nice enough to provide for all of us. Gives me some fun things to listen to when I go for my runs and whatnot, generally consuming it in audiobook format. And he talks a lot about the data, a lot about getting to the right people for the right information, not just listening to everybody who has an opinion on something where they have no expert matter in.

And of course, EisnerAmper would be a well-suited example of people that have expertise and understand what they're doing. To make sure that you're accessing the right people, the right organizations, with the right competency and alignment to help you drive your objectives.

And so to that end, with that data-driven approach, you also need systems. Star Mountain has approximately 15 full-time people in India that help us process data and information on a 24/7 basis. We have also invested heavily in custom-built and customized technologies. Over the last 12 months, we've onboarded many new technologies. Some of them are from a client service perspective to just make it easier for investors to access information, get information and so forth, others relating to monitoring.

If we want to help our portfolio companies, we first need to be able to have the data, understand it, develop trends, figure out what are areas that we can help them more. There's areas that are maybe more obvious. Customers, understanding their customer needs, their trends, understanding what's going on in their competitive environment, which includes macro all the way down into micro. And really making sure that we have that data so that we can then make sure we have the right experts to help bring value to these business owners.

So that's been a big thing that we've embarked upon is using more technology, more data, and as we manage money for public pensions, corporate pensions, both internationally, domestically, insurance companies, foundations, endowments, individuals, lots of different structures, funds you mentioned the SEC, we have different vehicles like a private BDC. We have capital that we work in partnership with the US government and the Small Business Administration, and helping get high quality capital and expertise through the SPSC program into these companies.

All of that requires different types of reporting, thousands of pieces of data. And so that's really important for Star Mountain that we can have the data to give our clients what they want to continue to grow with us, to make sure we can in turn continue to grow with companies. So data, technology, systems, process, procedures, and really strategic thinking is probably the same thing I would've told you 10 or 12 years ago. And it's interesting, it's the same thing I'm telling everybody now. It's just continuing to improve upon what we've been doing.
EMS:Absolutely, Brett. The next question I have for you is, what have been some of the greatest opportunities you've achieved through incorporating ESG into your firm's remit, both on the macro level and the investment level?
BH:One is, and thanks to investors, having a focus on this. Because investors care about ESG, I believe that by showcasing the value where we have, in an aligned manner, helped make more defensive, stronger, higher returning companies, which has led to alpha generation four investors, our investors have been able to see how their desires for ESG can in fact translate into what we target is more compelling, absolute, and risk adjusted returns for our investors.

And at the end of the day, I think that's really critical, Elana, because everybody talks about wanting to do good and so forth, but they want it in a context in the investing world of also generating better returns and safer returns, less volatile returns, and various other objectives that they have. So I think that's really key to show and measure what we're doing, how we do it, and what we continue to do that way. So I think that's one, is it has allowed us to both attract and develop very deep relationships with a very diverse set of investors that we're certainly very honored to have as partners with us at Star Mountain.

The second thing relating to ESG is the companies that we attract. I believe that the highest quality companies across the country care about who they're working with. At Star Mountain, we refer to ourselves as being the partner of choice to high quality, growing, established, we don't deal with startups, but established small and medium sized businesses. And to do that, we believe that these business owners care about who they're working with.

Star Mountain Capital has a charitable foundation. How are we giving back? How are we involved in the community? When we talk about ES&G, let's extract the S and talk about social and alignment of interest. Well, we may say, "Alignment matters and you should do that and you should give some equity to your team," well, as a business owner sitting there saying, "Well, gee, you're asking me to give up my economics." Well, I did, and I can tell you why I actually think that's in my personal financial best interest. Because I believe at Star Mountain that has helped us attract, retain, and motivate some of the highest quality talent available and to work together as an aligned team.

And as we think about sports as an analogy, the best sports teams are rarely just a different group of high caliber people. It's how everybody works together. And sometimes it's not necessarily the most talented only individuals. It's really that teamwork and collaboration and economic alignment, I believe, brings out the best in teamwork and collaborative thinking as well, which drives value for all businesses. So I think that the way we operate has helped us attract to work with the highest quality business owners, which then becomes a bit of a self-fulfilling prophecy, because they in turn help you generate better returns for your investors and that cycle continues.

The third pillar, as I think about the pillars that you mentioned, is our team that way. So it's the investors, it's the team, and for example, Star Mountain has now won best places to work by both Crain's and Pensions & Investments' for the last three consecutive years in a row. And I believe that it's our attention to ESG and how we operate at Star Mountain, with the mirror on ourselves, in addition to what we do with our portfolio companies and how they really lean into that as well.
EMS:Oh, great, Brett. On the other hand, as I mentioned in my introduction, a lot of PE firms and other investment firms face a lot of challenges when looking to integrate ESG. Love to hear challenges that you face at Star Mountain, and your approach to overcoming them.
BH:Look, it's expensive. There's no two ways about it, right? If you take a step back and say, "Great, all these investors want all this data and information." They're not willing to pay you a higher management fee for it, right? That's just what you have to do. And that's one of the real challenges in the lower middle market, and one of the things that has become a major barrier to entry for other asset managers in our end of the market is the intense labor complexity.

As we see the labor market cooling today, we all know we've come out of one of the longest bull market expansionary periods in history. Especially if you really, from an employee perspective, appreciate that the pandemic really didn't pull people out of employment for the most part, largely due to a lot of the government stimulus. And so if you think about that 12, 13 year run, it's created a dynamic where you have a lot of labor cost pressure, you have fee pressure from investors, now you have another cost pressure of more data, more information, more things you have to do, more team you need to build, more technology, you need to invest in.

Ultimately, I don't think there is any simple silver bullet solution. It's really strategy, process, procedures, people working together, integrating, having everybody being very aligned, very driven, transparency, setting KPIs, setting measurable goals, and just continuing to chip away at it. For example, Star Mountain Capital opened our Tampa Bay Florida office last year. We did this research and actually came to the conclusion, over three years ago, that we were going to open an office there focused on high quality places to work in a way that's very culturally aligned with Star Mountain, health, wellness, work/life harmony. As I will take from a McKinsey Consulting recent book they came out with, instead of the work/life balance, it's how do we harmonize it and integrate everything.

Because we know our 24 hours is fixed and finite, at least as far as I'm aware. So it's how do we get the most out of it? And to that end, we found Tampa to be great. Now, with the pandemic, we paused, reassessed everything, and again, came to the same conclusion that we thought Tampa made for a great fit for Star Mountain. I'm not saying for all firms, but based on our New York City headquarters, the ease of access back and forth, our engagement into a lot of local small communities across the United States, where we have team local, and have that local presence in over 20 cities across the US, Tampa was a good fit for us. And we think for a lot of our younger team, having families and so forth, there are a lot of benefits.

My myself and living in Greenwich, your commute time back and forth to New York, that's a challenge, that's a friction. The pandemic has taught all of us that we don't like commuting, I think for the most part, but in-person engagement is important. And so figuring out all these things, I think that one has to have the courage and conviction to do the research, spend the money, and make the investments, whether it's new offices, whether it's developing technology for your team's home offices, we did that when the pandemic hit. People are like, "Really? You're going to pay this to build my own local home office?" "Absolutely, we are for you."

And to me, it would be kind of foolish not to actually, because we want our team to maximize productivity. And so investing in people and just taking that dynamic approach. Because ultimately, ESG I believe can drive long-term value, but it's a short-term cost as far as an asset manager is concerned. I don't think there's really any two ways about it. We've got to invest more in more people, more technology, more processes, and nobody's paying you extra to do it. It's just an incremental cost that I believe is prudent for one to bear.
EMS:Absolutely, Brett. So I want to talk about Star Mountain's due diligence process and how you use ESG when you evaluate portfolio companies.
BH:It's a multi-pronged approach. We start first from a macro perspective, and then we work down into micro. We use various third party firms including EisnerAmper and others to help bring in expertise, where they may have specializations.
And so let's start macro. We don't invest in the energy sector, and I'm not here to say the energy sector is bad, for sake of clarity. We've made a decision based on our objectives to focus on less volatile sectors and more defensive sectors in how we believe we've created a formula to optimize alpha. How do we optimize absolute risk adjusted returns? So this isn't a negative on the energy sector. But I, for example, spent nearly a year working on the oil drilling rigs after graduating from high school in Canada, which is how I paid for college. And in fact, when I started investing in the early 2000s, including managing money for the state of Texas and investing in local underserved areas of Texas, did some oil and gas investing.

And I would attribute it more to luck than skill. The fact that we did well, candidly, and I think as I've grown wiser, hopefully, with age and take a more data-driven approach, have realized the difference between luck and skill and persistency. And so from a macro perspective, we focus on end sectors that we believe are growing, that we believe are defensive, and we try to avoid sectors that we think may have ESG, political, or various other headwinds associated. There's lots of challenges in life. One of our jobs we think, is to identify as many of them as possible, and mitigate as many as possible, because there are always going to be unknowns.

I wish I could say we were smart enough to have predicted the pandemic. We weren't. We had to deal with it, thankfully, we dealt with it well. But that's an example of starting macro, figuring out the sectors and then you build the right team. So for example, we don't invest in the real estate industry directly either. So if you ask me about real estate investing and so forth, we are not experts in it. We don't do it. I don't invest in a team who are experts in it. We don't invest in the public markets. So again, we don't have a team that are experts in that.

We really focus on designing the investment strategy and then building a team, process, procedures in an aligned manner to execute against that. So as you go down more micro from that macro industry selection, there's geography is another example. Right now, in particular, we see the US and Canada, which are our primary market focuses to invest in, as the fastest growing and most resilient from a GDP perspective. So that's positive as we think about headwinds and tailwinds.

You talked a little bit about regulation with the SEC and ESG from a regulatory matter, while no government can ever really be perfect, I think the US has a great system on a relative basis, globally, which we like as far as investing, investor rights that we can have, governance, if there are challenges, knowing how to deal with them, having the legal expertise, the operating capabilities to do it I think is very important. As we think about one of the advantages that the United States, and in a similar manner Canada, but the United States really has a big advantage on. Investors should view it as a safer place to invest from a regulatory perspective.

That all factors into our ESG, because G, governance, right? Then you get into the social aspects of it, people. The US has a very vibrant entrepreneurial economy, which it has had for decades. People are thinking about ideas, coming up with ideas, how do we make things better? How do we mitigate things that are not great? And that's really a pretty special part of the US ecosystem, which I think has maintained the US's position as being resilient. And that doesn't mean other economies aren't great and don't have strengths, they certainly do. But I think that the US economy is really still very strongly poised on a relative basis there.

Environmentally, Star Mountain's view there is we are just not focused on negative environmental impact sectors. And then making sure that the businesses we invest in have strong policies and procedures. And some of them are even really small. Things like not wasting plastic bottles. So everybody at Star Mountain gets their branded water bottles with their names on them. We give them to our clients.

And I'm a firm believer in that, is that not everything has to be big and changing the world overnight. It's small steps that we all can continue to make as we put solar panels on our homes, as we drive electric vehicles. It's making as many decisions as we can as a firm and then helping implement those within our portfolio companies from that perspective.

Lastly, as we get into diligence, people is also a big part of it, ethics, integrity. Our view in life is that challenges will happen. Do you have the right people that have the right skills, alignment, focus, and passion and purpose to work through the challenges? And if you think about the great businesses, they sort of grow up and to the right, but it looks like an S, it's not a straight line. And what you want to do is be able to capitalize on the opportunities, mitigate the challenges, rinse, repeat, and over a long period of time, that is, I believe, how Star Mountain has driven a lot of value, as have our highest performing portfolio companies that we're invested in.

And so when you get into the diligence, knowing how to evaluate people, how to develop teams, that organizational structure, and then, of course, you get into the governance, the financials of businesses, really making sure that they have a strong understanding of threats and opportunities that they have. Understanding who their customers are, how their customers are doing, making sure you have as diverse of a customer base as possible, as resilient of a customer base as possible. Understanding the value proposition of a business to maintain a profitability margin, understanding the employees and the trends on employees.

Can you access the employees that you are going to need? Can you access employees that are going to be sustainable with you? What cost pressures might you have that might again impact that profitability margin? And so it's a process, Elana, that at Star Mountain, on average, takes us typically three to four months of doing a really deep dive into the companies to try to assess all of these things.

And the challenge within that is, it's very time consuming. And so over the years we've become very focused on what's the key next question to get us comfortable. And if we can't get to a yes, we try to be very respectful to the businesses, pass on the opportunity, see if we can refer to somebody else to help them on their journey. And then focus, therefore, the deeper dive that we're going to do on a smaller subset of the companies where it gets very granular and very time consuming.
EMS:Brett, we've covered a tremendous amount of ground today and I really enjoyed hearing your story of how Star Mountain embarked on the ESG journey. So one final question for you today is one piece of advice, without giving away all your secrets, for other PE firms to embark on their ESG journey.
BH:Having started my career doing asset management, M&A, I saw firms face their challenges mostly in two different areas. One was strategy. And so the first one is making sure that enough time is spent on the investment strategy and refreshing that. We live in a world that is ever evolving. Just because something worked really well for the last 10 years doesn't necessarily mean it's well positioned for the 10 years to come. So having the time to wipe off the whiteboard again and really look and hone in on that strategy.
The second was organizational structures of businesses, the team, the alignment of the team, the value system of the team, the economic alignment of interest with the team. Ultimately, that's where we saw a lot of business breakdown, fights with partners, people spinning off and so forth. And so I think that in the alternative investment space, if you can have great strategies and be very clear on them, you can then really define your team and help work with the team.

And as the CEO and founder of Star Mountain Capital, I put a lot of my time in both of those, and I'm not our chief investment officer. And I think that's important, because I believe that, especially a lot of smaller firms, those roles are often combined. They're very both very important roles, but they're different roles. And when you start your business, you almost have to be both. Like nobody's going to give you money, most likely, unless you're a good investor and a proven investor. So you kind of have to be grow into a CEO.

But then in my case, for example, it's understanding that I didn't have a lot of management experience. And so that's why I went, found a great program at Harvard Business School to invest time into, and also joined the Young President's organization saying, "I need to learn to be a better manager if I'm going to be successful in my journey in what I'm doing." And so that's the last thing I would say, is just identifying all of our strengths and weaknesses and how do we fit together as a puzzle, as a team? And work on that.
EMS:Well, Brett, I wanted to thank you so much for joining us. I really enjoyed the conversation.
BH:My pleasure. It's always a fun topic, and I think there's a lot of opportunity within ESG and within strategy. And working with different firms and institutions like EisnerAmper I think can really help bring a lot of different value to businesses. And looking at their company and looking at their asset management firms and figuring out how do we do everything we do better? And 2023 is likely to be an eventful year, to say the least. And hopefully, we will all maximize on the opportunities and minimize the challenges that we will likely face over the next 12 to 24 months.
EMS:Absolutely. Well, Brett, thank you again for joining us.
BH:My pleasure. Have a great day everybody.

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