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Welcome to Educational Alpha. I'm Bill Kelly, your host, bringing you on the ground conversations with business leaders, educators and industry colleagues from around the globe. Educational Alpha is sponsored by iCapital, the financial technology company with a mission to power the world's alternative investment marketplace. Part innovator, part educator and part navigator of the alternatives industry, iCapital offers intuitive, scalable digital solutions that have transformed how private market and hedge fund investments are bought and sold. With iCapital, financial advisors, wealth managers and asset managers around the world now have access to everything they need to deliver the return and diversification potential of alternatives to high net worth investors. To learn more, visit icapital.com.
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In this episode, host Bill Kelly sits down with Brett Hick, founder and CEO of Star.
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Mountain Capital, to explore the landscape of lower middle market private credit.
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Brett shares how his early experiences shaped his approach to entrepreneurship, leadership and long term investing. The conversation covers the evolution of private credit, post gfc, structural inefficiencies in the lower middle market, and Star Mountain's strategy for generating value through operational expertise, alignment of interest and AI driven insights. They also address diversification risks, executive underwriting.
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And maintaining discipline while scaling responsib.
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Brad Hickey welcome to Educational Alpha.
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Thanks Bill. Pleasure to be here with you.
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Thank you for your tolerance. I think we had this episode scheduled a couple of months ago and I had the embarrassment of riches that I was so oversubscribed. I said hey, I think there's a good story to tell here, so let's try to do it at a time where we can have the conversation and release date pretty well correlated. And then a couple other things that I'll turn it to you. This could be the second to last episode on the Kaya platform. This is going to come to a natural conclusion and I think this is a very good episode to do that with you Brett. Because I'm in this portfolio phase of my career. I've got a bunch of board and advisory roles, not the least of which is a senior advisor role for Star Mountain and it's a space that I like a lot. I've been an investor in it a long time. You and I have known each other for at least several years, but I at least want to get that disclosure out there. But I'm a cheerleader for this space and certainly for you and your colleagues at Star Mountain. So with that you and keeping to sort of the Educational Alpha format, you have a very interesting and kind of a different background. So maybe you can cover that a little bit first and then we'll get into Star Mountain and the lower middle.
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Market, sure, I'd be happy to. And as far as scheduling goes, nothing good comes easy, as they say. So that's par for the course for an entrepreneur. Perhaps a little bit of background. One is, as I look back and reflect on having three children and think about what were the things in my background in my history that perhaps were influential to me. One was speed skating. So doing individual sports, I was a Canadian gold medalist in speed skating and Canadian record holder and got a bronze in North America. And I think that that was something formative. As I like to sort of joke, I grew up in northwestern Canada where it's cold. So a, there's lots of ice as an advantage for being a speed skater. B, it's you want to move around fast to try to stay warm. After that, I worked on the oil drilling rigs in what people refer to generally as the oil sands area in northern Alberta and Saskatchewan, Canada, for approximately a year to save money to pay for college. The correlation between speed skating, the oil rigs and Star Mountain is not as a crow flies, but what the common denominator is is work ethic and effort. And I think that's been a key pillar of Star Mountain as a firm. My background and also I think what's required of the lower middle market. We're not stock pickers. We're focused on, as one of our investors recently said, shoe leather investing, getting out on the street, beating the bushes, finding opportunities, helping create our own destiny, and really trying to be proud of adding value to businesses. I think the last part of my background, Bill, that's perhaps interesting is in growing up in a small town of about 10,000 people in northern Canada and having lost my mom to cancer at a young age of six, thankfully, my dad being a schoolteacher, the community really rallied behind and helped and supported and that was very valuable to me. It was natural in the sense that it's not like I had anything to do with it, but I grew up thinking that people are a community. People work together, people help each other. That was all I knew. That was a natural environment that I was accustomed to. When I moved to New York to fast forward. After doing a finance and accounting degree at McGill University in Canada, I worked in Solomons with Barney doing financial institutions. Investment banking was really exciting for me at the time. Being a kid from a small town in Canada and at the time working for the largest financial institution in the world, which Citigroup was, was a lot of fun, was a great opportunity. Very formative in my learning, I was very thankful for that because Citigroup not only had obviously big banks, insurance companies at the time, the largest wealth management business in North America. And I was fortunate to be in a role where we were evaluating other funds, structures, managers helping buy and sell managers buy and sell divisions of Citigroup, including working on the Travelers property casualty spin out of the firm and also looking at other funds that wanted to distribute product through the distribution platform. So I was clearly the fly on the wall modeling guy, not the strategic guy. But I was fortunate to see an enormous amount of information and that's really what helped lead us into Star Mountain. It was seeing that information and realizing that there was a huge opportunity in the lower middle market, roughly half the US gdp. The big banks really didn't want to spend a lot of time with these small businesses because it's not a lot of value. As far as investment banking fee revenue, you don't get a lot of deposits, you don't get a lot of wealth management revenue, you don't get a lot of insurance product sales revenue. But it's a lot of labor. So if you ask yourself, well, why would a bank do it? It's generally and historically because they would charge a higher rate for the labor involved in it. What we observed with the banks back then is they really wanted to go up market. And if you think about the leading banks today, whether it's a Bank of America, JP Morgan, Citigroup and so forth, these are comprehensive, full offering banks. And that's where we viewed back I guess nearly 24 years ago now. That's where my assumption was what the banks were doing that they would continue to do. And with the aging demographics, there was a lot of need for not only capital, but really valuable capital that could help guide and work with these private business owners in America. That was what led me to launching Star Mountain and seeing the opportunity. The part of my background that I think is important in Star Mountain is the culture of working together as a team. That was natural in my growing up. You didn't have a snowblower, you borrowed a neighbors, your neighbor is old, they needed their roof shoveled. Pop up on the roof, you shovel the roof. People just worked as a team. In Wall street that's not the norm. As you know Bill, people are often, not always, but often very focused on their individual themselves, their organizations that hypothetically should be able to work really well together and have a lot of synergies, but aren't really aligned to be doing that. So at Star Mountain we really focus on having that community, having that culture of working together to create that value. And I think that's been an important part to finish off. As far as pieces of my background build, I think are formative to Star Mountain.
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A
I think of the many threads, Brett, that I could pull on that. I don't know if you said it here, but I think I read it in your bio and I know you well enough that you paid for your own college tuition, as did. And being out there on the front line and getting nothing in life and having to earn everything, it doesn't make us better than anybody else. I think it ingrains a sense of entrepreneurship at a young age. And I think regardless of where you go, that's going to serve you well. And I think that seems to be one of the founding principles of your career and also of Star Mountain. And it maybe is an apt comparison to sort of growing up and looking at private credit in the broader sense. And it's still a young industry born out of the gfc. If I'm right, and you can correct that, that where the Dodds and the Franks said no, no, no to the banks post to GFC and the private capital, private lending moved over to a lot of the private capital shops. And it didn't really come into 4 when interest rates were pinned to the floor because it was less interesting. But as rates started to rise, off we went. And if I'm right about circa 2008, this industry is less than two decades old, but it is a bit like a gangly teenager because it's grown so very rapidly and it doesn't quite know how to use its mistakes are made. And I saw an interesting stat just yesterday that S and P put out. They didn't talk about the size of private credit and you can give us a current number, but they looked at the top five who are managing just over $2 trillion of assets up 30% year over year. The next 15 are not even at 2 trillion and they grew at 15% year over year. So you're seeing this very large concentration at the top and deployment becomes an objective and that should not be the driving value proposition for the end client. So maybe you can run with that, Brett, in terms of the origins of private credit. And I think it started with maybe some of the broadly syndicated upper middle market or upper market, and then the lower middle market followed on. But if you could talk about some of the derivative principles that got us into this market in the first place.
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Great points and observations, Bill. What I would add to that is in the gfc. Another fundamental change that happened was a lot of businesses, including some large firms like a Goldman Sachs turned into a bank holding a company structure in order to get assistance from the government with the TARP financing regime. What happened then and friends of mine worked for the government and helping do this and providing a lot of preferred equity type of capital to banks is a lot of the regulators that we're looking would look at a bank's portfolio and if you can kind of put yourself in that role, you have to cover a lot of grounds very quickly. Imagine you look at a portfolio and you see some loans with a higher interest rate. What's your knee jerk reaction and assumption? Your assumption that's riskier? We all learn in life risk and reward. If the rate's higher, it's got to be riskier. What the finance industry doesn't think about often as much is because it doesn't matter in most segments of the market, but in the lower middle market it really does. And in specialized niche sectors of investing it does, which is the labor and resources required. So if you ask yourself, this gets back to what I mentioned earlier, but why would a bank lend to a smaller business if it can't get paid for its later? Well, the answer is it wouldn't. They used to. Different banks like Wells Fargo had a division called Foothills. If it was something that didn't sort of neatly fit in the box of the larger bank, they'd have a division, Foothills, that could take a look and the cost would be higher to get paid for the labor. But that was okay in the gfc. When the government came in to help support a lot of the banks, they really looked at these and said I don't like this, I don't like these higher rate loans. They must be risky. And even though as we all know, the risks and the large losses were predominantly driven from real estate, which is where I sometimes caution people on asset based lending and say, oh, I have an asset to protect me. Last time I checked, real estate was also an asset and was a big part of the gfc. And so some assets are protective and hold value, some assets don't. And that's a caution I would mention to some investors as far as chasing any type of opportunities that may have more risk than they appear to. I think that's just an important thing for investors to understand. Why that matters, Bill, is that it's not one market of credit and one market of lending. Different ends of the market and different strategies behave extremely differently. So your point of the enormous amount of capital inflows into the large end of the market is very true. And that as a consequence of that, we've seen rates come down, we've seen covenants and risk quality deteriorate and we're starting to now see some losses. Does that mean it's systematically a bad sector? I don't think so. Personally, I think probably there will be more losses than investors might think of. But ultimately we're in a white hot economy. If you're worried about losses there, what do you think about the equity and the equity valuations? The credit gets wiped. Equity doesn't usually fare too well in any bankruptcies or restructuring I've ever participated in or observed. And so I think that's important to understand the large market, the capital inflows into the large market and then basic laws of supply demand. Going back to real estate. And many of you may see things in the paper now, but homes in the United States now not selling so quickly, you went through a big boom and a big demand for housing post Covid. Now some of that's cooling off and all of a sudden we're seeing houses not move as quickly. It's basic supply demand in any investment asset class. So in the large end, where you have rampant capital inflows, that's very different than the lower end of the market where Star Mountain operates, for example, because you don't have the large capital inflows, the banks are less competitive. So I think that is important to just distinguish why everybody likes to say things and talk their own book. And of course I'm not going to be any different surprise anyone today. But I'll provide the why. Because I didn't launch Star Mountain because this is what my dad used to do, or this is how I grew up, or this is what firm previously did. I built Star Mountain because I identified a very large market opportunity and a need and something that could add real value to investors and real value to business owners and real value to the economy in ultimately growing, protecting and developing high quality businesses in America. And so we approach that in a very different manner. And we're never going to be one of those top five largest asset managers in the world. And I'm very content with that. Those are a few points, Bill, that I think are interesting. We can talk more on any aspect of it if you'd like a lot.
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Of different places to run with that. And I want to maybe stick with this theme about maybe some of the fundamental differences between say the top five, as we alluded to before. Or these large gps versus the lower middle market and players like Star Mountain. And I think it's a fair observation to say when you're at that large end of the market, I want to come back to Covenants definitely, but they're really underwriting and hopefully underwriting well credits. I would venture that Star Mountain is underwriting entrepreneurs because these are smaller companies and probably family owned, baby boomer owned. And the demographic play of the lower middle markets is a very important piece to understand. So maybe you could talk a little bit about whether or not you are underwriting entrepreneurs and whether you are or not, the makeup of the demographics and why this market is so uniquely different.
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B
Similar to your statement, there's a bunch of things I can pull on on there. Let me try to be safe and provide data behind it. So one of the things I'll tie back to the opening of my background. I approached and came into this industry extraordinarily naive. I remember when I was doing deals at Citigroup and I'd ask one of my manage directors is this dollar is in billions or trillions? And I'm like, don't you know? I said listen, this is all infinity to me. So I have no context of it. Yes, I can do math well, yes, I great grades, calculus, all that stuff. But I didn't have context. And so what I did and how I built my business was all very data driven. What makes sense? Why, what's the data? What can I be comfortable with? And when I launched my first lower middle market fund doing lower middle market lending over 21 years ago now with my partner David Apollo, which ties into a point before which I'll get into in that lending actually has been going on for many decades. The large market grew really rapidly post the GFC because of challenges in banks. The banks were never really great in the lower middle market. And as a consequence of that, the lower middle markets had different lenders, including myself and partners of mine for many decades. In fact, one of my partners I think is called three decades now us to lower middle market private lending myself just over 21 years. So that's a little bit about some segments of private credit, including Star Mountain and our team have been doing this for lots of decades. Some segments are people that came out of investor banking and this is newer and that growth with respect to what people are underwriting and what the lower middle market underwrites, I think first of all a data point that I think is very valuable. I was fortunate to get an award by the Foreign Policy association along with the managing partner, McKinsey Consulting earlier this year in that. One of the things that I really admire about McKinsey is they provide a tremendous amount of data research and analytics. And one of the pieces they have is they produced a book called CEO Excellence in that they did approximately. I can't remember the exact details, this will be directionally accurate, but about a 30 year study of businesses and they tried to say what things drive a correlation to the success of any business, private or public. And they assigned approximately a 60% value attribution to the CEO. So to your question, does Star Mountain underwrite the executives and business owners that we're investing in? 100% we do get Star Mountain value. The fact that these business owners have a lot of skin in the game and a lot of money at risk. It's not just a salary with bonus options if things go well, but they care a lot about protecting downside. You can see where as a lender like that alignment and we like the focus of people wanting to fight tooth and nail to protect an enormous amount of their personal network. Just like myself as a founder of Star Mountain, I have much farther than 90% of my personal net worth invested across our firm and business. I'm very focused on not just growing, but protecting our assets, as are the business owners we invest with. Where I think that matters is I think all people should be under routing that. And I think the data from McKinsey is very clear around that. And I think often investors get enamored with different risks. Look at WeWork and you look in hindsight and say, well, XYZ person was doing ABC things, selling stock, this, that and the other investors tend to not care about risk and be complacent if things are going well. And then they look back in hindsight and say, wait a minute, this went from 47 billion to 7 billion or something and just wiped an enormous amount of value. And they look back and say, well, this CEO or this executive is doing xyz. Of course that's a problem, but everybody knew about it selling stock, all the different things, different potential conflicts while it was going on, but it was moving up into the right. And I think that's one of the dangers of an economy that we're in right now, Bill. When things keep moving up into the right, investors hear noise, noise of political risk, war risk, aging population, declining populations, a whole bunch of different unknown challenges. And then they maybe pause a little bit, but then they're either whether you call it buying a dip or just back in, I think in any white hot market, you get risk, complacent. So I think people should underwrite executives more. Ultimately, if you think about it, if you have a CEO and you've been a CEO yourself as well, Bill, if you're focused and you're heading the game, that's leadership. You're going to create a great organization and do the best you can. You're going to attract great talent, motivate great talent. One of my board members who's the CEO, wheels up George Matson, says one of the CEO's jobs is being a pacesetter. He was a former partner at Goldman Sachs and you know, he talks about all that working with CEOs and you got to drive that pace and drive that focus and that then brings the next layer in, that brings the next layer and so forth. So we do underwrite that. I actually think it's a fallacy for investors to not be underwriting the executives. And I do think it's one of the risks of how some investors invest. When you're buying a piece of a loan, you saw it with First Brands recent blow up. In hindsight, people say there was fraud, there was this, there was that, fine. But also a lot of underwriting things were missed. And one of the things we're supposed to underwrite and find is risk. And fraud is certainly a risk. And nobody's perfect, nobody can perfectly get it. But I think one of the dangers of being a participant in a whole bunch of deals, investors can feel like, oh, I feel safe because I'm very diversified and there's some truth to that. But diversification statistically loses its relevance pretty quickly. If you look at just mathematical probability, statistical analysis, and you overlay that with what people would call a diversification. If you get a whole bunch of people saying, well, Bill underwrote this and he's an investor, so I feel comfortable. And Bill said, well, this guy may be comfortable and this investment banker sold the deal. But did the investment banker have any money at risk or were they getting paid a fee for closing the deal? You kind of go down the food chain and in an environment where people are perhaps too complacent for risk and there's a lot of money that needs to get put to work. Because that's one of the other things about some of the market, Bill, is the permanent capital has to get immediately deployed and investors do the best they can with the parameters that they're given. If you have to deploy a lot of money quickly, you got to do the best you can. And that Makes it harder to underwrite people, harder to really underwrite a business, harder to find risk, harder to find fraud. And so my guess is that there's probably more risk out there than investors realize. And yes, we at Star Mountain underwrite the executives a lot. We also are focused on the cash flows. Star Mountain does not invest in startups. We do not invest in unprofitable businesses. We're focused on businesses that are proven, established and growing, and they want us to help them take their business to the next level. We call it getting middle market ready in our portfolio optimization model. Within that, a growing business attracts talent, retains talent, motivates people. We think that's important. And we look at cash flows. At the end of the day, businesses don't go bankrupt often because their loan to value is out of whack. It's because they don't have cash to pay employees, taxes, interest, principal and so forth. Again, if you go back to the gfc, which you mentioned, there were a lot of people, a lot of business owners, people would come to us say, I've got all these assets, I just need money, I don't have cash, I'm not broke, I'm not in distress. I'm like, well, you are. You have obligations you can't service, and you have these assets or investments that you may not be able to get anything from. And I think that that ultimately is a key fundamental part of underwriting. And if you look at the data from folks like Moody's, S and P, Pitchbook and others, there's three decades of data that shows which ends of the market have lower default rates and which ends of the market have higher recovery rates. The lowest recovery rate are businesses that are not financially profitable. And I think that's where there's a lot of concern today as well, around some of the AI, inevitably, AI. And we're big users of AI internally, so we employ a lot of people at Star Mountain building and optimizing technology. And I think it's fantastic and we're excited about it. But inevitably there will be probably overspend over Bill and things that folks don't fully understand. All the inner correlations of different businesses in the AI sector, as we observed a little bit in the O1 market environment. Every market's different, of course, but that's where you have people investing in businesses, Bill, that they say, well, this has a lot of enterprise value and my loan and my leverage is low. Well, low compared to what? If you looked at we work, which we talked about, and you said, well, it's $47 billion valuation. And let's say you lent money at half of that 50% loan to value. Say I feel safe lending it $23 billion of debt. I'm not saying that's what it had, but this is just illustratively. You can say, oh, I feel safe. Well, that quickly got wiped out down to 7 billion or so, and it needed cash. And so I think that's where for us at Star Mountain, it's underwriting real businesses, business owners and real cash flows. Assets are something we look at as well. But I think investors can get a false sense of comfort in value. I'll give you one last thing that it's not irrational how this happens. If you're a venture capital fund and you're investing in a whole bunch of software businesses, do you think build the venture capital funds and their investors accept that some of those will be a zero? Absolutely, absolutely. So you can say, well, it's okay, hey, I'm investing in this, it might be a zero, but hopefully I'll get a couple fives and maybe a 10x and net net. If I can get a 2 or 3 multiple or better for my investors, I'm happy, so that's okay. But if you're a lender and you're lending against that and you say, well, I've got loan to value protection maybe, but the risk of that might be something that's a complete binary wipeout and we've started to see a little bit of that in the market. Whereas the way I get more comfortable saying risks can happen everywhere. Do you have a fighting chance to work through the challenges? Do you control the loan? Do you have industry experts that know the sector? Do you have covenants and legal protections? Do you have an operational team? Does your fund structure give you flexibility to work out and work through a loan? There's a whole bunch of things we have at Star Mountain, our 10 C's of risk that we go through in every deal. I'll stop there, but people are one of them for sure, as are predictable cash flows, as predictable as possible. Anomalies happen, macro and idiosyncratic. And that's where covenants and operations and control alone matter.
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A couple observations and then a follow on question. So the concept of diversification means understanding the risks you're underwriting. You said something earlier which I think is so very important, that if I'm going to be in one of these large gps, there's nothing wrong with them necessarily. But you got to understand what you're underwriting and if you're in two or three of them, you might find out that you have a tremendous concentration in AI or data centers. And if you're okay with that, that's okay. But you really have to know what's going on behind the wall, and that really is the GP's responsibility. The OP will do some due diligence around fundraising time, and they've got to be asking the right questions, and then it's up to the GP to invest on their behalf. You mentioned VC a moment ago, Brett, and a question that a GP will ask of the aspiring entrepreneur is what's your moat? And I think the same should apply to a due diligence question to you at a Star Mountain. What is your mode? And you mentioned a couple things that maybe you can run with some or any one of these around. The importance of covenants, the importance of operational alpha. There is a valuation multiple that you have working in your favor, which you alluded to before, being probably one of just a handful of lenders in the mix gives you tremendous upside as well. And then you also, and I know this from working with you and the team use of AI, not only in the due diligence process, but working with your portfolio companies in that regard to. To use this as effective way of adding value. So what is Star Mountain's moat?
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B
If I can double click on one point you made before this build, I think this is really valuable. And you may recall from our agm, one of our other senior advisors, Jim Boyle, that was the CEO of Hancock and has invested for decades. And insurance companies ultimately have a lot of credit in their portfolio, very focused on not losing money. One of the things Jim warns investors, is that in a downturn, things are often much more correlated than they seem. And that's where I don't think that large credit is bad. I don't think it's a bad risk reward. I don't think it's a bad investment. I think there's a lot of really smart, really focused good folks there. And if you look at the relative value of that compared to many other investment strategies, that could very well be a good value. What at Star Mountain, we focus on and how we often complement that and work with our investors. They say, I want something that's a good absolute return, but I also want it to be a true diversifier relative to those risks that you're going to have. Naturally, more correlation to big tech, more correlation to AI. So investors today are more concentrated than they've ever been in history in big tech. And in a limited number of public companies, just statistically, and the price to revenue valuations have recently surpassed the highest valuation ever in reported history. And so as investors think about some of those correlations, you now have AI. And for the first time in US history something has out spent the consumer, which is investment in AI. From a GDP perspective that AI is now levering up. So we now see large technology companies that have bigger market caps than ever in history, more concentration than ever in history. Now they're actually levering up and adding more debt to fund these big infrastructure and AI investments. And so the amount of correlation to your point an investor might have in that is very possibly way more than they appreciate. And I think that's where a lot of institutions and also family offices and wealth managers have said, well if there is a downturn, if this happens, what are some things that are going to be less correlated to that risk? So if you think about a roadside repair business, unfortunately for all of us when we're driving, probably don't appreciate them. But there's something that happens if you think about a preschool chain. You ask yourself, well if AI does have some challenges, if the market drops, are kids still going to go to preschool? And you think about a lot of the businesses in the lower middle market that have an idiosyncratic risk which will tie into your moat question. But they have a very low market correlation risk. That's really a key driver for investors in what Star Mountain offers. How we address the idiosyncratic risk which every business has big and small, is active portfolio management. So I believe Star Mountain is the largest dedicated team to the lower middle market in credit in the country with about 130 full time people and 40 operating partners. And our moat starts with one. We understand our sector, we understand our space. My partners and I, many of whom have been doing private credit for north of 30 years, we have a substantial amount of our personal capital at risk. We have worked through and invested through many cycles. We know how difficult working out a challenge really is. On paper everything's easy. But when you actually have to make tough decisions, whether it's laying people off, shutting down divisions of businesses, lots of different, very consequential things that need to be done. You really need experts that's not just reading a balance sheet and reading the past. They need to be able to form strategies, execute and implement those strategies. And that's why we have a big private equity team in house. Much more like private equity ultimately. And so Star Mountain's moat starts with the labor intensity of the lower middle market keeps competitors out. Then we overlay that with a specialized business that's purpose built to address the challenges and the opportunities. We're well aware that if you can successfully combine three smaller businesses into a bigger one, the valuation goes up a lot. That reduces your risk. And then if you structure securities such as warrants or structured equity attached to your loan, you can also get some asymmetric upside and some incremental return to further increase your risk adjusted returns for an investor. And when you put that into a diversified portfolio, those warrants and those equity positions help reduce risk and add upside. And so those are the things it's being able to really have a purpose built business, understand it, have purposeful origination. Not just waiting for the phone to ring, but back to the shoe leather conversation. We have people local in over 20 cities across the country and everybody is alive. All of our team shares in the carried interest and profits. All of our senior investment team has substantial personal capital at risk. That is a requirement for joining Star Mountain. Just like I think if I was invested in somebody else's fund, it would be a requirement to me that they have skin in the game. While as a CEO of Star Mountain, it's a requirement to me that everybody helping make investment decisions at Star Mountain has a personal capital at risk. And I think that's important as well as the alignment. Some firms are built where people get paid for a loan to close. Our team gets paid for loans to successfully be monetized at the end and then having that real operational expertise. So those are some of the key things I think, Bill, that I wish we had patent protections and so forth around our business. But it's really about a purposeful, thoughtful business. And that's all we do every day is work in the US lower middle market.
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A
And I'll add one more, maybe X myself when we talked about this when we were together in New York just a couple weeks ago, the Senior Advisor network. Brad, I think it is awesome how you promote that as an asset because it is a unique one to Star Mountain. And every private capital firm has their senior advisors but it's usually five or six people. They're very involved, maybe some of the portfolio companies. And you've got this kitchen cabinet of very diverse backgrounds. As I said to you. I look around and say how did I make the cut here? And it is really quite impressive. People that have worked as asset owners, asset allocators, worked for branches of the government. Credit to you. It is a very interesting group. I learn A lot from them as well. I would add that to some of the moat protection I see inside of Storm Mountain, Bill.
- [35:39]
B
I think that gets back into my background. And your first question here is we want to be surrounded by the smartest people possible that are very focused on helping us do every single thing we do. Stress testing what we're doing, reevaluating what we're doing. As with yourself, where people have personal capital invested and share in the carry. So you want us to be as successful as possible. That's exactly what I want and that's ultimately exactly what our investors want. It's all about protecting and optimizing our investments and returns that way. And being a founder employee owned business enables that because we don't have our ownership owned by. Nothing wrong with being publicly traded or something. But our ownership isn't the stock market, it isn't other outside investors, it's our team and it's people that are adding value to finding underwriting and helping our portfolio companies be as successful as possible. And what's become a thankful, partially self fulfilling prophecy is the success that we've had helping grow great businesses now really makes us a partner of choice with some of the best private business owners in America. And that's exciting because when we first started the business, it's a dream, it's a thesis and so forth. Now it's selling results, it's selling success and ultimately if you can attract better business owners and add better value, you will ultimately drive better financial outcome for investors as well. To me that's exciting and why we've actually doubled down on whether it's AI or whatever else we're doing. In continuing to expand horizontally with the different investment strategies we have, staying in the lower middle market where we have distinctive competencies, I don't think we add any value to the larger market. There's great players there, great capabilities and we have no ambition to try to compete with them. Nor do we think we would have a value proposition for investors trying to do that. So we don't.
- [37:44]
A
I have two questions that I'll let you get back to. Adding value for your clients, which is why we're both here ultimately. One micro and then one macro on the micro side. Just maybe on the same theme I hear in the news cycle credit spreads are tightening and specifically that is true. I don't know what is going on the lower middle market so much and if I oversimplify it, that's where the risk is. Your underwriting and something could be attractive. But if the spread is Too narrow, it no longer is. So if I think about lower middle market, is the probability of default less, all things being equal than the broadly syndicated, and then the expected recovery in the event of default is that higher. And if that is, it gives you a lot more wiggle room inside of that spread. So just maybe some broad observations of credit spreads and then we'll move toward a close.
- [38:32]
B
If we look at the past, which is a good starting point, I like to say, well, what happened in the past, what's happening today? And how can today change the future to make it the same or different relative to the past? So over the last roughly 30 years, the lower middle market segment has had a materially lower default rate than the larger segment of the market. Based on some data, roughly a 75% lower default rate. And then if you have a default, then the next question is, well, what's your probability recovery? And the largest and best recovery rate has been also the lower middle market as segmented within the 0 to 50 million of EBITDA segment based on third party data. We don't do the studies, of course, we have all the data and we look at, we have our own proprietary research as well and that's similar to what we have observed. So historically the lower middle market has been a better place to protect capital and you can also get a higher spread from it. Why do larger managers not focus there as much? Well, if you need to deploy $50 billion in a year, it's hard to do that at $25 million loaning costs. And a lot of investors need very large sums of capital deployed on their behalf. That all makes sense. In the lower middle market we're able to retain the spreads. As we look at risk, what do we think about the future in the larger market? We've seen a lot of rampant capital inflows which you mentioned before that has resulted in covenants going down and other potential risk increases. As I would say, is any part of the economy that's white hot public equity markets. Anything you have a lot of capital chasing thing, Nothing is immune from an increase of risk. The lower middle market thankfully has not had that rampant capital inflow and overlaid with the demand for capital increasing in the lower middle market, which it generally isn't as much in the larger markets, a little bit it is. But what drives the increase more uniquely in the lower middle market is aging demographic. It's a private business owner that says, I have a $5 million EBITDA business, I don't want to pass it on to my children. Or they don't want to take it over. And I've got a competitor of mine that's willing to buy me and I'm willing to roll some equity because I still like the business, but I want to work 20 hours a week now, not 60 hours a week. That aging demographic, it's motivated sellers of private lower middle market businesses that creates the demand for more capital. Again, you get into supply demand, there's not a whole bunch of new capital coming in. And in fact, banks in the lower middle market have generally been more challenged and the demand is up. So therefore that enables Star Mountain to still get the covenants and the protections and do the fundamental type of underwriting that we believe has led to the lower middle market having lower loss rates over the last 30 years and we think will persist in into the future. So that's, I guess, a little bit of the past, a little bit of what's going on and why we assume that now you're going to have outliers, Bill. So I'd say the one thing you have to watch out for is your, I guess, gangly teenagers. Some gangly teenagers turn into phenomenal athletes, some don't. Ultimately, that's where I think investors need to be very discerning. Just because the lower middle market has had lower defaults and better recovery rates in the past based on third party data, doesn't guarantee an outcome if somebody runs fast and loose. If somebody invests in a bad sector, the bad way can't add operational value. That's a different risk. And that's why we get into the executives that were underwriting an alignment of interest, which if you talk to people like Warren Buffett or honoring the late Charlie Munger, he'll say, show me how people are motivated and I'll tell you how they behave.
- [42:26]
A
Absolutely. I do want to finish with Outlook toward the Future. And as a mentor once said to me, the future is unknowable. And by the time it unfolds, I don't think anybody's going to go back and say, what did Bill and Brett say about the future? Were they right or wrong? So it gives us a little bit of license to think about it. I hearken back to my days at Boston Partners where small cap was a way you could get exposure to innovation. I don't think that's true anymore. We could just park that thought for the moment, accept it as fact. But if we brought a fund to market, we had to tell the end client or the consultant who is in the middle, when are you going to shut this fund down because you reach a certain size and it's not impossible, but harder to add value. I don't think this is a 26 or maybe even 27 issue for Star Mountain. But the better you are at your craft, the more growth you beget. And managing that and still being able to be an effective player in the lower middle market starts to bring on new sets of challenges. So I'm sure you've given this some thought. It's not a near term problem for you given the size of Star Mountain and the size of the market, and you still have a lot of addressable market to penetrate. But how do you think about growth and what is Star Market? You just passed your 15 year anniversary. What does your 20th or 25th anniversary look like and what are some of the challenges and opportunities to get there?
- [43:48]
B
I think I'm fortunate to have started and launched my first fund 21 years ago. Why? Because I made some mistakes and I had some learnings in the finance industry. One of the metrics everybody loves say is Aum, that's your chest pumping, that's your bravado and so forth. I'm sure I had, and I'm sure friends could tell you that I had some bravado when I was young as well. When you are an entrepreneur and a founder at a young age and you go through challenges, most people seem to in life learn a lot more from challenges than they do victories. It's an old adage that we all know well. If you were an investment banker now your first time in private credit, you've never really had challenges. Face them or your first time CEO and you're pumped up around and you've never really faced challenges. You may think about risk differently. I think about risk in a lot of different ways and one of the things that we have avoided is chasing markets and chasing shiny coins. So one of the things that happens in asset management often is that insatiable desire to grow and have the chest pumping. Aum, we've had lots of investors say, hey, I'll give you X amount of money at really low fees. It's not about fees. We're not here to get rich at Sir Mountain with fees. We're here to have the right team with the right focus to invest my personal capital, my partner's capital and our investors capital, your capital bill. And if you said to me you can pay a 50 basis point higher management fee and get a 3% higher return, I'll take a 6 times return on my money all day long. Thank you and tell me where to sign up. But investors I think sometimes miss that and they really say, well I just want to do things low of fees as possible instead of as high a quality as possible. Instead of asking where are your fees going, what are they doing and are they adding real value? Just like if you buy a car, different cars at different prices and you look at them and you say, well, what's the value proposition? Am I getting something for what I'm paid? And the answer is yes, sometimes, maybe no. It all depends on what you value. So what we've not done at Star Mountain is take big volumes of capital at low fees because that forces you to do fast, quick moving deals. You can't afford the resources to do that deep dive due diligence that really active portfolio management. I don't want to put my money into that. So we don't do that. So we've grown at a good rate, but we've grown in a prudent manner. And I think that's an important aspect. And in hindsight, Bill, I think I'm happy that I face different challenges 20 plus years ago in growing the business and the GFC and so forth because it makes you really look at risk and understand how difficult things can really be. And I think that's why we hold true to what we're doing. So in the future. Star Mountain, our objective is to be the best lower middle market asset management firm in the U.S. ultimately we want to be driving real alpha and low correlated returns for investors. And that's what we want them to come to us for, be known for and have a high quality, high integrity team that continues to protect capital and deliver good results and build a culture and a place that people can hopefully be proud of working at and investors be proud of investing and working with us and ultimately adding real value to society and the economy as well, because that also does matter to us. That's one of the things that's fun about this is building better businesses, builds better livelihoods, better communities, better money for investors. And there's a really nice purposeful alignment there that I think is something that I believe the high integrity of people at Star Mountain also validate.
- [47:34]
A
Independence is a very powerful thing when you can afford to have it. And certainly that's been part of Star Mountain's ethos. And as a director, if I look at law firms and accounting firms taking on private capital or my intern as is now on the clock from some Baker scholar at Harvard, when I was expecting to have a one hour appointment and it's done in 10 minutes. So these are not necessarily good because there's another entrepreneur equity holder standing there and rightfully so. They have expectations too. But I think the more you can align your mission around a smaller number of like minded people with less intermediaries between you and the end client, everybody prospers, particularly the client at the end.
- [48:16]
B
Of the day and I think they'll be clear with people. Synergies and conflicts are often in a very similar moat and it's about making sure that investors try to be clear in how we're investing, what we're doing, what matters to us. When I talk to people about how we hire, the type of team we have, how we manage, how we operate, how we underwrite, why we do that, why we think the type of team we have matters, these are conversations that we have and ultimately investors have to decide whether they value those same things we are, that we're putting our money and effort into. I bring it into just like buying a car, if you want to buy a Tesla and say, well I value XYZ things they do, or buy a gm, whatever it is, it's about being very clear in what you're doing, what you're delivering so that you can provide that value to investors at the end of the day. And that's what we remain committed to.
- [49:10]
A
A great way to leave a bread. Enjoyed the conversation. I wish you and your family the best of the coming holiday season. I'll perhaps see you in the waning days of December. I'm not sure, but definitely into the new year. So keep on keeping on. Thanks Brett.
- [49:23]
B
Awesome Bill. Thank you all. Happy all this everybody.
- [49:27]
A
Thank you for listening to Educational Alpha. I'm your host Bill Kelly. Learn more about the Chaya association and subscribe to the show@kaia.org that's C A I A dot org. See you next.