Private Debt Investing
May 17, 2022
In this episode of the Private Equity Dealbook, Elana Margulies-Snyderman, Senior Manager, Publications, EisnerAmper, speaks with Brett Hickey, Founder & CEO of Star Mountain Capital, a New York-based asset management firm focused on the lower middle market. He discusses his outlook for debt investing including the greatest opportunities and challenges. He will also addresses his due diligence process for providing debt financing, how debt agreements have changed, how the firm is addressing ESG and more.
So Brett, to start off, tell us a little about Star Mountain Capital and how you got to where you are today.
BH:Star Mountain was built with the purpose of bringing large market expertise and capabilities down into the lower middle market, which we generally define as businesses that are established, so not startups, but not in the larger, more efficient markets. They tend to have EBITDAs between approximately 5 million and 30 million per year or revenues between approximately 15 million and 200 million. That segment of the US economy is approximately 50% of US GDP and represents approximately 200,000 private businesses. With an aging demographic, there's a lot of demand by business owners that own these private companies to find what we call value added lenders to help them think about how to take their business to the next level and ultimately exit. That often includes add-on acquisitions, other strategic growth financing initiatives, where they don't yet want to sell to private equity.
So Star Mountain was built with that purpose in mind to focus on, as you say, challenges and opportunities within this market segment. We manage approximately $3 billion today, we're a 100% employee owned firm. From an ESG perspective, we like to eat our own cooking, so we are 50% women and minority. As an employee base, I share the profits of our investing with 100% of our team, including office managers and first year analysts and we really have a hyper aligned culture with each other and our investors. That's a little bit about us.
EMS:Great. So Brett, PitchBook recently released data noting the significant private debt fundraising secured last year, and that private debt is now the third largest private market strategy in terms of assets under management. In your opinion, I wanted to ask you what is driving this trend and can you share your outlook for private debt investing in the future going forward?
BH:The capital inflows into private credit, as you mentioned, have been very substantial. That comes as a result of, one, banks continuing to have different regulatory and other challenges, making it less efficient and making them less nimble to work with business owners and for business owners to often look for partners that can be perhaps more reliable, more straightforward, more transparency in working with them, which the private credit marketplace has generally helped fill that void along with the increased demand, coming from the aging demographics, in one case from the lower middle market where 95% approximately of the business owners are founder owner operated and with the aging demographic that is changing. So what that means, we have a lot more businesses that are perhaps for the first time looking for private credit and private equity capital that increases the demand, some of the challenges with banks decreasing the supply of capital, and that has driven a lot of interest for private credit from a business standpoint.
From an investor standpoint, there has been until recently, and that's perhaps changing now as we're seeing, but quite a low rate environment. Investors have been seeking better yields than what they could get in the more efficient public markets, and now investors, as they're worried about challenges in the economy are looking for safer assets. Again, yield there's many investors from high net worth investors to public pensions and everything in between, insurance companies that want consistent predictable yield. And that's often one of the things that they're looking for within private credit, that's driven not only the historical demand, but views to a continued growth and demand for that, both by investors and business owners.
EMS:Oh great, Brett. And more specifically, what are some of the extreme opportunities for private debt fund investing and why?
BH:Some of the tailwinds that we see include the very macro type of ones around aging demographics. Within the lower middle market, if you compare that to the middle market, so in simple terms, if you can grow your business from approximately under 20 million of EBITDA to over generally speaking, the markets become materially more efficient, and that commands a higher valuation multiple. So if you owned a business, Elana, that did 15 million of EBITDA and you're a baby boomer, you'd be saying, how do I get over 20 million of EBITDA so I can eventually sell this business at a high valuation.
And within that often doing acquisitions or things of that nature can be a very attractive way of growing your business. So that's something that you're looking to do. And for an investor, therefore, if you can invest in companies and find high quality businesses in the lower middle market and help finance and grow them to the middle market, you can perhaps capitalize on a value investing where you can invest at lower valuations, lower leverage ratios, better covenants on average, and then perhaps get some type of equity upside through warrants or structured equity to try to create an asymmetric return where if the business really goes well, you can share in that upside while protecting your downside.
So that aging demographic overlaid with the valuation arbitrage between the lower middle market in the middle market is one of the ways that we believe investors can look for premium returns in the market.
And Brett, on the other hand, what areas do you anticipate the greatest challenges for private debt fund investing and why?
BH:I think there are a number of them. One is we've been in a bowl type of a market with a pandemic blip for the last 12 years or so, and in the larger markets that are more efficient and much more competitive that has yielded higher EBITDA adjustments, that has yielded higher leverage ratios in some cases, and understated leverage ratios because of those EBITDA adjustments. And then also on top of that lower covenants, and that can generally pose a lot of risk. S&P recently came out the reports saying that the private equity buyouts have on average 92% of the loans being covenant-lite. So the vast majority. Lincoln, one of the largest third party valuation firms in the United States recently had a report saying that EBITDA adjustments, meaning what was the actual EBITDA year company generated versus how it was underwritten was a 40% premium on average. That's very high. So if something says it was six times levered, it's actually about nine times levered.
So I think that... To me, that is concerning, of course it really only matters if you generally either invest in companies that aren't defensive or we have a macroeconomic downturn, but I think there's a lot of risks out there that have been there for a while and on top of that with rising interest rates, there are perhaps many businesses that may struggle to service and pay those higher rates that they're now going to have to do overlay with the potential supply chain and other cost increases. You could have cost increases due to labor, which is systematic across all businesses and industries right now. So there's a reasonably high probability of that. Labor last year, I think, on average in the US increased by around 11% for labor costs, then you have potential supply chain issues, which are disrupting everything from Apple to Tesla and everything in between.
And that means you may have demand for your product, but if you can't sell it, you can't trade revenue in EBITDA. So that's a cost problem and a profitability problem. And then you go to the other side of the income statement, which is revenues, and the question is, can you pass on cost increases to your buyers of your products or services? And that's where I think that investors need to be very cautious and really do a deep dive, because there are lots of different potential risks, both at a macroeconomic level and at idiosyncratic level. A layer on one more thing for you that relates to your question and your point of the large amount of capital inflows, and this is something that I think investors need to be very focused on, is it's not just about fees, it's what are you getting for your fees?
So when investors think about managing fees, some of them I think are blinded. It's almost like when you hire an employee, you look at what's the cost and what are you going to get. Right. You do a cost benefit analysis. But when it comes to funds, often that's less the case and they take a more generic view. What that has driven is a lot of credit managers or some, I should rather say, to build teams to raise money and put money to work, but perhaps not have been either able to, or willing to invest the resources to manage those assets. So, should we have a big challenge and a downturn, I think it's an important consideration for investors to ensure that they're investing with managers that have the ability to work through the challenges that could occur in their portfolio operationally and legally, such as with covenants and so forth.
EMS:Brett, to shift gears a little bit, I wanted to discuss your due diligence process for providing debt financing and how, if at all, has it changed the last couple of years since the pandemic?
BH:When we look at diligence, Elana, is top down and then bottoms up, and then you could probably say a bunch of infiltration from the sides. So let's start with top down. We really look for businesses that have lower cyclicality and are defensive and can absorb idiosyncratic and macroeconomic shocks better than others. So for example, as you may know, I worked on the oil drilling rigs for a year in Northern Canada, where I grew up, to pay for college. I used to invest in the oil and gas sector during the early 2000s. We at Star Mountain don't anymore because it's a very cyclical sector, cyclicality, market timing, very difficult. Sometimes people will get it right, sometimes they'll get it wrong, but that's tough to do. So our view at Star Mountain is we're looking for less cyclical and more recession, resilient businesses.
So that's at the top of the funnel, what industries have a higher probability of allowing you to protect capital and then also generate alpha. So real estate, for example, can be protective, can be cyclical, however, it's hypercompetitive. Whether people do or don't know real estate, they feel they do. They feel they can touch it, see it, understand it. So it tends to be a much more competitive asset class and basic laws of supply demand, when lots of people compete for the same asset, just like a house, as an example, price goes up, which we've seen in the US for the past couple years. And so that's another asset class that we stay away from, and we believe it's... There's sectors like that you're either a pure play specialist in or you're not.
So that would be examples of the top of the funnel. Then we look at aspects from the income and really focus on the predictability of revenues. What product or services are you offering? Who are your customers? How diverse are they, how likely are they to want to continue to buy your products or services in the future? What are your competitors look like? What other offerings could they have to have something instead? So if you think about certain luxury retail items, if we have a market downturn, some may not be as defensible, some maybe. We generally avoid those type of retail investments. Thin margins... If you have businesses that have a very low margin, that means that if either your costs go up a little bit or your price of products or services you sell comes down a little bit, you just don't have a lot of profitability. That creates risk. And then ultimately we at Star Mountain tend to like businesses that have more variable expenses. The pandemic was a great example of that, so that if you do have challenges, you can have a fighting chance to do something about it.
And then lastly, because it's a complex aspect. So just a few nuggets here, is balance sheet. If you look at Moody's or S&P, they have a lot of great data. Over the last 25 years, they each did different studies, and what S&P found is that the larger loan market had on average at three times higher default rate, because we believe of what Moody's data shows you. So Moody's data had a predictive analysis where it showed that the amount of debt you have on your business accounted for the highest indicator of you going into a default. And so for us at Star Mountain taking a very data driven approach, we want to keep leverage low. So whether it's an idiosyncratic risk that you face, a macroeconomic shock, if you can keep your debt low, you have a higher chance of being able to work through whatever problems you may face. I'll call that a balance sheet related item.
EMS:Brett, so with everything going on from an economic perspective, inflation, how, if at all, have terms in debt agreements changed the last couple of years?
BH:It depends at which end of the market. In the larger markets, as I referenced earlier, it's been a very borrower friendly market and as a result of that, many of legal agreements have loosened. In the lower middle market because generally speaking of the complexities, the labor intensity to find these companies, to underwrite them, to manage them, and for relatively small dollars to deploy that is made it a lot less attractive for the larger asset managers, the larger pools of capital. And as a result of that, the supply demand dynamics have remained more favorable in the lower middle market, which has allowed for the legal terms and protections to stay stronger on a relative basis.
And so generally speaking of the lower middle market, we have not observed a lot of changes. I think in the larger markets, the really smart investors appreciate that they won't have as many covenants as they used to be able to get and so the really good ones are hyper focused on the quality of the management team, the quality of the businesses, and really focusing on the success of the business. And as long as the business is successful and maintains valuation, then of course their loan should be protected. So I'm not suggesting you can't be protective there, its just it's a different dynamic and there has been more of a shift there, less so from a governance perspective in the lower middle market
EMS:And Brett, as a follow-up, what are some suggestions you have for companies to be best prepared as they contemplate an exit?
BH:It's a great question. And it's something that first off is a multi-year preparation generally. So if you're a founder owner of a business, you should be thinking about taxes, estate planning, so on and so forth. I'm obviously not a tax expert. That area's where your firm can obviously be much more helpful to people. But those are things that on an individual basis to do the right way often is a two year type of preparation. And then the business itself, I would say that's probably close to a two year preparation as well. Sometimes more depending on how aspirational your exit objectives are. And generally speaking, shifting into the business perspective, not the ownership perspective, which is where you can help people more is to really come up with your end game plan. Who are your likely buyers? What is your most likely exit outcome? What do they value? What do they not value?
So for example, you can have a business that is likely to be bought by a competitor that doesn't care about your operations and your system. They're really just buying your revenue. They want to grow their business, diversify their customer base, and they want to increase their margins by being able to reduce your cost of your business and having an accretive acquisition. Well, that should lend you towards thinking about where you should invest your money, perhaps more in sales, marketing, and so on and so forth versus your internal technology and operations.
On the other hand, you may have a business that is in an industry that has a lot of opportunity for consolidation, where you can acquire little competitors. And if you already have a good size business, you might say a private equity firm is likely to pay you a higher valuation because you have such a strong platform they'll pay up for that because they can use that platform to then buy other little competitors at lower valuations to bring down their average purchase price multiple of all of the EBITDA that they're buying and developing. And so in that case, you'd say, I want a deep management team. I want to show that I don't have key man risk. I want to have really strong systems, dashboards, KPIs, and so forth. So it really depends on, and ultimately it comes down to get your end in mind, and then you work backwards, and every business has a very different outcome. There's good investment bankers that can help you think about bad consulting firms and so forth to assist with that game plan.
EMS:Great. And Brett, we'd be remiss if we failed to discuss ESG and how it's become more prominent in evaluating companies. And I wanted to ask you how your firm is approaching this.
BH:ESG is a great topic, and it's something that at Star Mountain we've always been very passionate about. And maybe it comes back to every... We always try to think about origin, especially as you have little kids, and you try to think about what things were good from your past and not good and how do you give them the best life possible. And as I think growing up in a small town, very community centric, you work together, you care about your community, you care about your geography, you care about your nature and the environment because you're living in it very actively. You're not blind and sort of ignorant to other things. I don't mean ignorant necessarily in a bad way, other than you just don't see, it's not visible, not top of mind. Whereas if you can see everything as transparent, people are much more likely to say, oh, this really matters. This makes a difference in how I'm treating the environment or how I'm treating my community, my peers, people I work with.
And so that really has been a big foundation. And when we founded Star Mountain Capital, we took a view that you can build a finance business that's hyper aligned, that's a great place to work, that's a lot of fun, that cares about the community. And in the lower middle market, it's easier to do that. Quite frankly, I always like to have probability on my side instead of trying to outsmart other people. So in the lower middle market, let's just go through ES and G really quickly. First off, I believe good leadership is leading by example. So at Star Mountain Capital we do a whole bunch of things, environmentally, whether it's branded water bottles for people to... Broad range of little things to industries that we don't invest in and industries that we do focus on investing in.
From a social aspect, we are 50%... First off, we're 100% employee owned. Second is that we share profits with 100% of our employees, as I mentioned earlier. So great shareholder and team alignment there, and everybody very focused. Now, selfishly, that's what I want. Right. I want our team driven, focused passion about protecting capital and creating returns. So I actually think that ES and G can be very aligned with investors and profits and from a governance perspective, Star Mountain, with nearly 60 full-time employees, we also have approximately 40 senior advisors and operating partners that help us run all aspects of our business. And then we also have a charitable foundation, Star Mountain Capital's Charitable Foundation, where we do other things in the community that are truly non-profit in nature and in supporting whether it's children, Ukraine recently, or we support a lot of things around health and wellness and so forth.
My mom died of cancer, I was young. So that's something I'm passionate about, and I'm sure almost everybody has unfortunately been impacted by the big C. So we're really trying to do things like that. A healthy food in the office for everybody. During the pandemic every month, everybody was getting a healthy food package. Some people drank the greens drinks. Some people said, I can't really stomach that stuff. But at least we give it to people and they can choose. And then if we look at leading by example, then with our portfolio companies, governance is a really easy one because as you further institutionalize your business, going from the lower middle market to the middle market, it makes you a safer business and more valuable.
So what we do at Star Mountain, instead of trying to motivate people with the stick, we try to motivate with the carrot, to say, here's how this can make your business more valuable. Here's why we do it, here's how we do it, and here's why we think you should do it. And we're a shareholder with you, and this is in all of our best interests. So we've also trademarked the collaborative ecosystem at Star Mountain, where we'll help you find board members, build your board members, manage them other senior executives as an aspect of a governance, and try to help educate you on why shareholder alignment, how you treat employees, things you do, why that stuff matters. And if you want to attract today's best talent, if you want to attract them, retain them, motivate them as we all know. Right. You got to be all in all the time because as people say, there's a war on talent. And so if you want to have the best business, you've got to be hyper focused on people.
And today's young generation, which I really applaud them for. They really care, not just about the shiny coin, which there's still that motivational element, which is why alignment, I think is big, but they really care about purpose and impact. And lower middle markets, smaller companies, it's easier to feel more impactful in 100 or 200 person company than a 10,000 person company. And so I think there's a big benefit for businesses in lower middle market to really continue to attract and retain talent, which I think is a critical driver of investment success as well because at the end of the day, a lot of business performance comes down to the right people, the right process, the right procedures.
EMS:Brett, we've covered a lot of ground today. So I wanted to see if there are any final thoughts you'd like to share with us today.
BH:Appreciate that. We're passionate about what we do at Star Mountain. I guess I'd be remiss to say we're hiring. We're actively looking for a bunch of people. So please feel free to go to our website, check the career center. We recently opened an office in Tampa Bay, Florida, forward thinking about employees, had nothing to do with me wanting to have some beach house or something, which for the sake of clarity, I do not have and I do not have there. It was totally data driven on where do we think can be a really high quality place to develop and grow talent where they can have high quality lives, and especially when you think about diversity and inclusion, a cousin to ESG, if you will, is one of the issues that I think my mother faced when she worked at IBM, was trying to be a mother and try to work full time is very difficult, especially with communing.
So having our office headquarters in New York City, it's tough if you want to have a young family and you're commuting a lot, and your kids' sick, or your kids got a sports game or whatever it might be, we wanted to create an environment where that commute time was very low. The friction was very low. So we're always trying to think about things and make forward decisions, asking two years, whether it's worked out well or not, and I'll let you know, but at minimum, we're really trying to put a lot of thought and a lot of effort behind not just lip service, but trying to really make a difference and focus on attracting and developing the best people.
And also from a diversity perspective, the other thing that we do is a year round internship program, which I'm proud to announce that we have trained over 100 students now in our year round paid program and hired nearly 30 of them full time through that. Which has been a very distinctive talent development aspect that we've done at Star Mountain and I think it's about 60% have been women and minorities. So there is a gap in socio-dynamics that way. And I think to do something about and change, there needs to be development. So I won't go any further than that, but I always love asking people, what are you doing about it? So I try to lead by example and say, we're not just trying to give lip service. We're trying to show that we're putting our time and our capital behind making change.
EMS:Yeah, Brett, absolutely. Well, I wanted to thank you so much for sharing your perspective with our listeners today and thank you for listening to the EisnerAmper Podcast series. Visit einseramper.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.
Transcribed by Rev.com