Foreign Investment 2018 – Future Development and Trends
By Brett Hickey, CEO, Star Mountain Capital
Posted: 9th January 2018 08:43
There have been many consequences of the collapse in global interest rates since the financial crisis, but few are as compelling – or will be as permanent – as the influx of investor capital into privately-held businesses in the U.S., often referred to as “private credit” or “direct lending”. As the amount of leverage has increased, making the risk profile of high yield bonds worse, so too has the yield/return reduced. This double negative impact has resulted in many foreign high net worth and institutional investors seeking better capital protection and income from private credit as a fixed income alternative, but as private credit has become more mainstream, the flow of capital into the plainer vanilla strategies has changed many of their risk-reward characteristics for the worse. As a result, increasingly sophisticated foreign investors are now seeking more differentiated private credit investment strategies, where superior risk-adjusted returns can be found.
When we began building Star Mountain Capital in 2010, the decision to focus on private U.S. small and medium-sized businesses – termed in the industry as the “lower middle-market” – was a deliberate one. There were many reasons we decided to concentrate on this segment, but three were paramount: (i) it is the largest segment of the established U.S. economy in terms of number of businesses, with nearly 200,000 businesses that have between $10 million and $150 million in annual revenues, (ii) because the loans are harder and more time consuming to access, underwrite and manage, larger asset managers generally don’t invest in them and (iii) there is an aging “baby boomer” demographic causing a high demand for complex transaction loans such as financing acquisitions and management buyouts in which traditional commercial banks generally don’t participate. The combination of a large market with positive supply & demand dynamics create the environment for attractive investment opportunities, and we predict increasing foreign investor interest in this niche going forward.
What exactly qualifies as a small to medium-sized business? Definitions vary, but we have defined it to include those companies that are large enough to be stable, yet too small to be of interest to more efficient markets. On average, our businesses have revenues of $10 million to $150 million and EBITDA of $3 million to $15 million.
This segment of the economy is crucial. 90% of the businesses in the United States have less than $100 million in revenue, are typically owner-operated, and are not controlled by large private equity sponsors. Here at Star Mountain, we refer to these companies as the “Growth Engine of America,” since this niche is where the most meaningful job creation occurs and economic impact is created. Indeed, the U.S. Small Business Administration (which defines a small business as one with less than 500 employees) calculates that these nearly 30 million U.S. small businesses account for more than half of the nation’s total GDP, 33% of known export value, and 41% of total private-sector payroll. These businesses also generated a staggering 62% of net new jobs from the first quarter of 1993 until the third quarter of 2016.
Within the small business segment, however, we believe there is a core subset of around 200,000 established businesses that are even more critical. These are typically innovation-driven companies that punch above their weight in terms of economic impact. As a direct investor looking for where we could have the most impact, focusing on the lower middle-market was an easy decision.
It also helps that smaller firms can make for very attractive borrowers. They tend to have steeper growth trajectories, are often knowledge-based and tech-savvy, and are able to react quickly to changes in the market. From the perspective of a credit provider like Star Mountain Capital, the combination of prudent due diligence and properly constructed direct lending transactions with the right companies can mean attractive economics for both us and our investors.
As with most market niches, however, this one comes with its share of challenges. Lack of financing is one of the biggest killers of smaller businesses in the U.S., yet since the financial crisis and the increase in risk-capital regulations it provoked, large financial institutions including commercial banks have significantly pulled back from lending to them. Ironically, these lenders curtailed their activity just as the economy was starting to recover, and those same smaller businesses desperately needed access to capital for expansion, acquisitions, and growth initiatives.
Meanwhile, smaller community banks often lack the resources and sophistication required to profitably underwrite loans to small businesses at scale. Since it can be just as much work to close a $5 million loan as one for $50 million, the costs associated with this process mean larger institutions are incentivised to concentrate on larger transactions. Either way, smaller businesses are increasingly left out in the cold when it comes to financing.
On the flip slide, investors confronted with ultra-loose global monetary policies, quantitative easing and plunging interest rates worldwide have seen the yields available from bond markets virtually evaporate since the financial crisis.
The result has been an explosion in private credit formation and direct lending activities on the part of alternative investment managers like Star Mountain. Assets under management in the private lending space quadrupled from 2006’s $147 billion to $595 billion last year, according to industry data provider Preqin, as funds filled the small-business financing void through custom structures able to deliver attractive risk-adjusted returns.
While private debt has become an interesting sector for global fixed income investors, it is also a complicated one. Deal flow must be constantly curated and each transaction is highly customised to the individual borrower. Due diligence (when done correctly) is exhaustive and time-consuming, and deals come with multi-year portfolio monitoring requirements to ensure successful repayment.
Accordingly, direct lending transactions, particularly in the lower middle-market, are best done through specialist platforms like Star Mountain Capital. This is especially true for overseas investors; the challenges inherent in sourcing, vetting, customising and monitoring a portfolio of complex U.S.-based debt transactions are hard enough to do when you are local, but they become exponentially more difficult to accomplish at scale from afar.
For instance, Star Mountain’s disciplined due diligence process serves as the first line of defence in terms of risk mitigation. It is a thorough process that requires a significant investment of time in order to craft the intimate portrait of a borrower we require, and it is almost impossible to do (at least successfully) from overseas. Moreover, engagement with a private debt platform in the U.S. can provide international investors with scale and geographic diversification that would be otherwise impossible to attain, and allows more of their capital to be put to work within one of the strongest legal environments for investors in the world.
At the same time, portfolio companies can benefit from a U.S. domestic platform’s additional non-capital resources. In Star Mountain’s case, it is a core element of our business model – our team includes private equity partners, former C-level operating executives and more than 25 advisors and operating partners to help add value to our portfolio companies and inform our due diligence process as subject matter experts.
Lastly, there is a cultural benefit within Star Mountain where we see a high demand for “purpose” in the lives of our team and top performing employees who value the fact that we help create jobs and improve the values of small businesses across the U.S.
We are often asked about the risks of investing into smaller companies. A common misconception is that smaller means risker. According to a Moody’s market study, leverage on a company’s balance sheet is actually four times more relevant than company size with respect to the likelihood of defaults or other financial challenges down the road. In fact, the size of the company has the least relevance. Star Mountain’s target market, the lower middle-market, is characterised by companies that typically carry much lower leverage levels than their larger brethren.
Taken together, we think there are compelling advantages for foreign investors in accessing the U.S. lower middle-market through fund platforms. Strategic partners like Star Mountain bridge the growing chasm between traditional banking and smaller businesses, providing smaller companies with crucial growth capital through custom debt structures tailored to their specific requirements, while extensive due diligence, deeply curated relationships and tight financial covenants with borrowers reduces potential risk.
Most importantly, foreign investors can gain critical exposure to one of the most dynamic portions of the U.S. economy while earning strong risk-adjusted yields both isolated from mark-to-market volatility and less correlated with equity and traded credit markets. It is an attractive mix, and in our case, it is complemented by partnership-style fund investments in other lower middle-market funds in order to maximise diversification across industry, geography, style and vintage year.
The bottom line is that there are few sectors that can deliver strong cash yields and attractive total returns done in a prudent and disciplined manner. With private debt transactions in the U.S. lower middle-market, this sector is one of them, and we believe this trend will continue for the foreseeable future supported by some of the positive trends discussed herein.
Disclaimer: This article is not an offer to, or solicitation of, any potential clients or investors for the provision by Star Mountain Capital of investment management, advisory or any other related services. No material discussed in this article is or should be construed as investment advice, nor is anything in this article an offer to sell, or a solicitation of an offer to buy, any security or other instrument.
Brett Hickey has been structuring, analyzing and managing private equity, mezzanine and U.S. Government sponsored investment funds for over a decade. Prior to launching Star Mountain Capital, Mr. Hickey was the Co-Founder and President of a multi-manager platform including 4 U.S. state sponsored small business investment funds through which he made over 50 investments in small and medium-sized businesses. Mr. Hickey has extensive experience performing due diligence on, selecting and building small business fund managers and has helped structure over a dozen larger funds representing a few billion dollars in assets.
Brett can be contacted on 001 212-810-9044 or by email at email@example.com
2007 U.S. Census
U.S. Small Business Administration, https://www.sba.gov/sites/default/files/FAQ_Sept_2012.pdf
U.S. Small Business Administration, https://www.sba.gov/sites/default/files/advocacy/SB-FAQ-2016_WEB.pdf
2017 Preqin Global Private Debt Report, Figure 3.1, pg. 24.
Moody’s Analytics RiskCalc 4.0 U.S., 2012.