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Brett Hickey, Star Mountain

Investing in the growth engine of America

Q&A with Brett Hickey (pictured), Founder and CEO, Star Mountain Capital – Star Mountain is a specialised asset manager focused on investing in the largest segment of established businesses in the US economy – private businesses that generally have between USD10 million and USD150 million in annual revenues or USD3 million to USD15 million of EBITDA (often referred to lower middle-market companies, though based on how certain managers characterise the space, one might say we invest in the “lower end” of the “lower middle-market”). 

What is the investment philosophy at Star Mountain?

There are many ways we think about our philosophy. 

One, is to be a flexible and solutions oriented partner to those we invest with. Being open, listening and creating structures and solutions to help accomplish everyone’s goals in an aligned manner. While this consumes more senior resources, it generally produces superior results for everyone. 

Two, is to be one of the best at everything we do and only focus on areas where we have strong core competencies. As part of this, we ensure that each part of our business adds strategic value to the other to form competitive advantages across each vertical. 

Lastly, we have an acute focus on the fact that people matter and invest a lot into our team and culture as well as into analysing the teams and cultures of the businesses we invest in. 

We believe in the value of data, information and resources and as such, have developed a comprehensive business model with a robust investment in technology. On a look-through basis, we have had approximately 300 private company investments in our portfolio since inception and have looked at over 10,000 transactions in this US lower middle-market. 

To maximise our knowledge and build superior investment portfolios, we created a synergistic three-channel approach to investing in US lower middle-market companies:

  1. Providing capital directly to established, small and medium-sized companies; 
  2. Investing as a strategic limited partner into other lower middle-market funds; and,
  3. Making secondary investments, providing liquidity to limited partners in other lower middle-market funds. 

How would you personally characterise your approach to investing? What previous career experiences have shaped you in this regard?

As we are very data and information driven investors, we need a lot of information and the systems to properly analyse our findings. We research thoroughly and dive deep into the analysis from multiple angles to make informed decisions. 

We also believe that to be a top performing investor, you need to have a specialised business model which provides you with competitive advantages on deal origination, underwriting, portfolio management and also an often-overlooked element, human talent recruiting and retention. We think of running an investment business, rather than simply running a fund, meaning we think about our own management, systems, etc. in order to make repeatable and continually improving investment decisions. 

We approach investing in the following manner:

1. Macro Trends Analysis

  • It is very hard to make money when trends are working against you so we try to have positive trends where we invest. 
  • ​Our focus is on the market inefficiencies of established, US private small and medium-sized businesses that are large enough to be safe but not so large to where the highly competitive capital markets add a lot of competitive risk pressures. Part of this benefit you could describe very simply as “positive supply / demand characteristics” between capital desires and availability. 


2. Define the Investment Objectives Outcome

  • We think a lot about the “goals of our investing”, not unlike someone building a car thinking about a combination of factors from safety and durability to speed. We find many smaller investment managers in particular, overlook the aspect of “what am I trying to deliver for my investors” including current yield, stability, capital protection, overall IRR and MOIC. 
  • For us we view that capital protection and stability of returns are of high importance and as such we are able to refine our investment strategy to focus on elements which achieve the highest returns relative to risk. 


3. Refine the Investment Thesis

  • For example, through our 20-year analysis specifically on this market, we found that the risk-reward of investing in commodity driven-businesses, such as oil & gas did not provide additional return relative to the risk so we now avoid it. This doesn’t mean you can’t make money in commodities, but it does not fit our investment goals around capital protection and stability or returns. 
  • We also found that businesses were willing to pay a higher rate, without us necessarily needing to take additional risk when:
    • They were less organised to run an efficient capital markets process, which we did not find has any correlation to their operating capabilities in running the business. Generally this means not investing in companies owned by larger private equity firms (often referred to as being “non-sponsored”). 
    • The businesses had a highly attractive use of proceeds. In our case this is often acquiring a company at an attractive valuation. Stated otherwise, the value creation was much higher than our cost of capital for the business owners. 

They were using our capital not as a permanent part of their balance sheet, but more so to finance a valuable event. This means we are often getting repaid in under 4 years. 
How would you characterise the opportunity set for your Diversified Credit Income Fund III, as US small and mid-sized businesses look for alternative financing arrangements?

It is a large market of approximately 200,000 businesses with limited competition from traditional commercial banks who are focused on simple, “check the box” type of lending when it comes to smaller companies and also not focused on by larger asset managers due to the labor intensity of putting relatively small amounts of capital to work compared to the amount of capital they need to deploy each year. 

There are approximately 75 million people in the US who are generally between 50 and 70 years old and a “baby boomer” population continuing to age creates the demand for transition capital by many business owners. 

There is also a large driver for our type of acquisition capital in that smaller businesses know that as they grow, they generally enter a more efficient capital market segment which increases their valuations. For example, two companies each worth USD50 million, might be able to merge and be worth USD150 million. This creates a valuable desire for businesses to merge, combined with a natural ageing selection of who wants to be the combined business CEO, and who would like to take more chips off the table, for example. 

What does a typical investment in this fund look like, in terms of size and duration of loan, target returns, use of warrants etc?

Star Mountain’s loans are typically secured with low leverage and robust covenants.  Interest rates are generally over 10 per cent and some type of equity upside alignment with the business owners, often in the form of warrants. We think of the warrants as “free equity” from a capital at risk perspective, however, we have to put time, resources and labor into creating value for the business owners so nothing is truly free in life, however, it does create an attractive return proposition for our investors, especially those who are tax payers and can realise this part of the return as a long-term capital gain. Our all-in gross return on unleveraged assets are typically targeting 17.5 per cent-plus inclusive of the warrants and other fees, across our portfolio. 

Why is this an appealing strategy for institutional investors to consider? 

Our diverse base of institutional investors (ranging from insurance companies to bank-owned wealth management platforms) tends to value some of the following characteristics:

  1. Capital Protection through substantial diversification, careful investment selection, low-leveraged loans and robust covenants. Our Fund II’s average total debt / EBITDA is 3.5x. 
  2. Stable, Current Income. Our Fund II’s most recent quarterly distribution was 4 per cent cash (16 per cent on an annualized basis) and we generally target 2.5 per cent+ per quarter. 
  3. Private Equity-Style Returns. We target 15 per cent+ total net returns over the life of the fund. 
  4. Low Cyclicality. Our funds generally perform well across market cycles. A recent study we completed on investments done in this market from the last 17 years, showed positive returns in every single year with average gross return on unlevered assets of over 16 per cent. 
  5. Positive Tax Benefits. For our investors who are taxpayers, the warrants and other equity components typically come in the form of long-term capital gains. 
  6. Low Correlation to Other Assets. Many investors are concerned with markets at all-time highs and like the fact that our portfolio of companies ranging from specials needs school bus transportation companies to urgent care clinics, have limited correlation to the public markets, real estate and other asset classes where many investors have a lot of capital investors. 

What are the firm’s aspirations for 2018 and beyond, given that the US has just introduced the most drastic tax overhaul in 30 years?

As I sit here on a Sunday afternoon, I can truly say that we love what we do and want to continue building a leading culture and long-term focused investment platform to attract like-minded investors, business owners and team. We are proud to have won many awards in 2017, including Crain’s Best Places to Work and believe that if we continue to focus on our team, disciplined underwriting and long-term relationship mindset, that our investment performance will continue to follow suit. 

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.

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