← How I Invest with David Weisburd
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- [00:00]
A
You've been at HIG for 16 years and the firm has really grown through your tenure. Tell me about how HIG has grown over the 16 years that you've been there.
- [00:09]
B
HIG is a platform starting in 1993, 75 million first fund, very strong performance. Fast forward to today. 67 billion in assets under management, 19 offices, over 500 investment professionals. And in addition to private equity, a fully developed alternative credit platform with both distressed debt and direct lending. A real estate effort, an infrastructure effort and a growth equity effort in all of those in us, Europe and Latin America.
- [00:42]
A
HIG has really grown from this small private equity fund decades ago to the $68 billion behemoth today. How did HIG grow?
- [00:51]
B
First and foremost, performance. And so very strong performance, especially in the flagship equity product, top decile for a number of years. Really, really strong investor demand that allowed the firm to say, okay, we can raise more capital. Investors are asking us to manage more money. But we don't want to lose our discipline, we don't want to grow out of our space. How do we accomplish that? We need to grow geographically, we need to grow into adjacencies. And so that's what they did. They really grew laterally into these strategies and then geographically, first into Europe and then second into Latin America.
- [01:26]
A
So you're co head of HIG's distress strategy. What is distressed debt?
- [01:30]
B
Good question. The traditional definition of distressed debt is debt with a yield 1000 basis points or more greater than the reference Treasury. So what do I mean by that? For a five year corporate bond, if the five year U.S. treasury is yielding 4%, that corporate bond would need to have a yield of 14%, 10 percentage points, 1,000 basis points greater than the treasury in order to be considered distressed. That's the benchmark that people use to distinguish between that debt's the distress. And that's, that's not. That's where people draw the line. Which might ask you to beg the question why would debt have such a high yield? It's really in yields that start to approach what you would expect to see for total returns on equity securities. The reason for that is a perception of the probability of default and an impairment of recovery. So is this debt going to pay interest for the full life of it? Maybe, maybe not. The borrower's a little shaky. Is value going to be sufficient to cause this debt to be repaid and pull at par in cash on or before the maturity date? Maybe, maybe not. The borrower's a little shaky. And so that increased perception of risk that Increased probability of default is what causes debt to trade at these very high yields.
- [02:37]
A
I'm very intrigued. You said the perception of risk on an HIG portfolio, How much of the portfolio are you expecting to go to? 0. How much to pay back? And tell me about how you construct a portfolio around that.
- [02:48]
B
Yeah, it's a good question. We have a pretty specific and distinct approach to investing. And so our hit rate is very high. And when we do take losses, they tend to be fairly light. You know, very rarely, I mean, maybe once or Twice in my 16 years here, maybe less, have we lost all our money. We focus on first lien debt. So top of the capital structure, first in line in the waterfall to get paid off. We focus on debt that we think is maybe outside of debt capacity but inside the total enterprise value of the borrower. And so while there's some equity risk to it, we think the totality of the enterprise value is sufficient to cover our debt. Our model is much more focus on the safest, least risky top of the capital structure and try to buy things inside of enterprise value.
- [03:35]
A
Just to simplify that, you might have a company that's worth 500 million and has 100 million in debt. You're nowhere near kind of the $500 million in equity value. So even if the company goes down equity value, you're still going to get paid back.
- [03:50]
B
Exactly right. And so prototypical capital structure, if it's a healthy stable business debt capacity might be 60 to 70% of total enterprise value. Well, if the face amount of the first lien debt that we're looking to buy constitutes 90% of the enterprise value, we've got a 10% equity cushion beyond the face amount of the debt and we're purchasing it for something significantly less than that. But if we're buying it at say $0.80 portion of our cost and certainly a portion of our claim is in the equity part of the capital structure that junior tranche.
- [04:23]
A
And being first lien debt, who's senior to you and who is subordinated to.
- [04:28]
B
In almost every case, no one will be senior to you. You're top of the capital structure, you're first in line. Even bank, the bank is typically that first lien debt. And so bank debt is where we focus, then you're going to have most times junior debt being a second lien piece of paper, an unsecured piece of paper. Maybe it's converts, maybe it's mes, what have you and then the equity tranche.
- [04:49]
A
So let's take a step back. How do you source Your opportunities.
- [04:53]
B
Sourcing is important and distressed is a funny asset class for private equity or direct lending. The company's a party to the transaction, they're supportive of it, they've hired a banker. The banker markets the transaction. Distressed debt is not that at all. First off, the company's in trouble. Second off, they're not a party to the transaction. When you're buying debt, you're buying debt from an existing lender, the company is exterior to that. They in many cases don't even know it's happened. There's no banker out there marketing it. And you know, they say success has a thousand fathers and failure has none. Not a lot of people out there actively marketing distress situations. If anything, they're trying to cover it up or hide it. They're certainly not bragging about it. And so you've got to do a little bit of work to go find distressed situations. And so we really focus on three venues. The first, and this maybe is overly simplistic, is we keep an eye on underperforming companies. We focus on the levered businesses, they tend to be sponsor owned. And then we keep an eye on both companies that are underperforming as well as sectors that are facing headwinds. Because if you have a population of private equity owned companies with heavy debt loads and the sector that they're in is facing headwinds, whatever it might be, some subset of those are likely to become distressed. So that's a good place for us to go spend time. Secondly, there's a community of turnaround consultants, restructuring bankers and bankruptcy lawyers. It's a fairly small community at a certain level. We all know each other, we all see each other in cases time and again. We've got some very deep and long standing relationships with those people. We have good two way flow of information and ideas and perspectives. And then lastly, and maybe most importantly, look, HIG is a large company we own, we have a large number of portfolio companies. We have an even larger number of companies we've owned in the past. And so we spend a lot of time talking to those management teams, talking to the banker relationships, talking to the C suite. Who in your industry is doing well, who's doing poorly? Who maybe is a good company that made a mistake, entered into a bad contract or did a bad acquisition? Well, how about your customers and how about your vendors? Who of those are struggling or where should we be focused? And then when we find an opportunity, we'll work with those teams to really understand it at a granular kind of ground level. Talking to an operating team that oftentimes is in that industry. And so the HIG platform, the portfolio and all the expertise and experience that we have is, is the third area we focus on for sourcing. And probably the most important, let's say.
- [07:25]
A
That you talk to the management teams at HIG and they've highlighted a couple companies. What do you do next?
- [07:31]
B
From there we're going to go look at the lender base. We're going to get information either from the lenders or other sources. Understand the financial picture and what we look for is either the existence or the expectation of a dynamic to develop that we would expect to cause lenders to sell debt to us ultimately at a discount. That's key. Ultimately we buy debt at a discount. In order to do that, someone has to be willing to sell it to us. And so you have to find those, those situations and circumstances where those conditions exist or you can reasonably expect them to exist. And so we spend a lot of time on that. That's heavy modeling and heavy diligence, you know, because the companies aren't a party to the transaction. We can't just call up the CFO and ask him 100 questions. They don't have a data room available for us. There's a real element of detective work or investigative journalism to what we do to build a body of facts to be able to derive an investment decision from an investment thesis. Once we've done that, we'll either reach out to lenders, usually through an intermediary, or if we're right in the way the situation is developing, frankly, they're reaching out to us and then we'll start to negotiate to purchase debt.
- [08:40]
A
You have this almost paradoxical situation where you're trying to build relationships through distressed sales. It's almost a paradox, right? You think of distressed sales as, you know, very zero sum situations, but you've built this ecosystem of relationships of repeat business. How do you manage the needs of the immediate transaction with the overall relationships? Managing a venture capital firm is complex. Fundraising, reporting, compliance, it all adds up. But what if there was a smarter way? Juniper Square is transforming the private markets investing experience. More than 2,100 GPs trust Juniper Square's connected software and services in order to raise capital more efficiently, reduce operational risk and deliver a world class LP experience. Want the freedom to focus on delivering investor results? Visit junipersquare.com VC to get in touch with the Juniper Square team today.
- [09:36]
B
You're right in one of the aspects of what we do is we almost never own all the debt and we own a portion of the credit facility. And so when you're talking to borrowers, when you're going through whatever process you may or may not be going through, you're working with other lenders, it's a cooperative process. There's usually a committee you need to work together because you all own the same debt to get to the best answer for all of you. By the way, you didn't choose to work together. We just bought in. Oftentimes we don't know who else holds it until lenders organize. It's a little bit like a surprise party wherein you're a dark room, you don't know who the other guests are until someone turns the lights on. And then you look around and say, oh, you're at this party too. But it's a small world. The way we manage it is just try to be forthright and say, here's what we're doing, here's why we're doing it, here's why we think it's the right thing to do. It's a small world and it's a long life. And so, you know, I started my career at Morgan Stanley and one of the old sayings there was doing first class business in a first class way. You don't queue too far from that. You're going to be okay just doing things in a forthright manner.
- [10:39]
A
You have a unique product in that you have nice kind of teens return, but there's obviously it's not very tax efficient. Does that impact your LP base? Is it mostly kind of a non taxable LP base?
- [10:52]
B
It is. And you know, if you look at our return stream, broadly speaking, about 50% of it is from interest income and about 50% of it is from capital appreciation. And so you're right, it's not the most tax efficient way to invest. Our LP base does gravitate towards tax exempts. Not 100%, but it does go that way. Conversely, some taxable investors, family offices, high net worth, even though it's less tax efficient, seem to really value the current income component of our strategy. And so that offsets it a little bit. But yes, we do have a maybe higher than average tax exempt concentration in our LP base.
- [11:34]
A
You guys make a thesis and see if you're on track. How do you create the discipline to make sure that you're not revising what your thesis was and how do you institutionalize that in your process? Thank you for listening. To join our community and to make sure you do not miss any future episodes, please click the follow button above to subscribe.
- [11:51]
B
Thesis creep is a thing. And yes, it is human nature to retrospectively want to be right. And so we, what we do is we do it quantitatively. And so for every investment we make, we have a three statement projection model. It goes into the investment committee deck. We then take that model. It's done quarterly. In each subsequent quarter, we compare the company's financial report, what they actually did to what we thought they did at that time on a quantitative basis. And so by just doing it with data and hard numbers based on what we originally thought, we get a very clear yardstick on how they're performing. And so that's what we do, that's our discipline, to prevent ourselves from kind of recasting the thesis as subsequent events unfold.
- [12:37]
A
You've been in this asset class for 27 years, 16 of those at HIG. What are the characteristics that make somebody great at distressed debt?
- [12:47]
B
Good question. I'd say two things. One is, this is going to sound counterintuitive. Maybe you need to be a little bit of an optimist. Every distressed situation is bad, right? It's not called everything's great, it's called distressed for a reason. There's going to be some problems and you have to be kind of in a level headed way, able to look at those problems, acknowledge them, but also see beyond them to the potential or see beyond them to other pockets of value. And so it takes a certain level of positivity. It's very easy to look at a bad situation and say that's bad. I don't want to touch it and move on. But no one gets paid to be a professional deal assassin, right? No one's interested in someone who only kills deals. We're hired to invest our LPs money and so we need to find opportunities to invest. And that takes a certain level of creativity, takes a certain level of optimism. And then the second characteristic I would point to that I think is pretty important besides the basics of kind of intellect and rigor and discipline and all that is curiosity. And so you have to be curious as to, okay, why is this business the way it is and why did they do that thing that turned out to be not so good and what is the reason that this happened? And so just that desire to just that niggling itch to go figure something out, like why is it this way? And it might appear obvious, but maybe it's not obvious. And I don't quite understand this. So I got to keep pressing because it's bugging me. People outside the industry, or maybe new to the industry will say, well, I'm looking for good businesses with bad balance sheets. Okay, That's a myth. Like that debt was put there for a reason and it was incurred based on a set of representations and promises that weren't met. And so why did that happen? Right. Why was someone wrong here? Too much debt just doesn't magically appear on an otherwise good and stable and growing business. It's there for a reason. Understand why? And now you're on your path to making a good debt investment.
- [14:39]
A
It's a mix of right brain and left brain thinking.
- [14:42]
B
I think so.
- [14:43]
A
So talk about your portfolio. So how do you make sure that your portfolio is diversified and what factors go into your portfolio construction?
- [14:50]
B
We spend a good amount of time thinking about portfolio construction. And so diversification is famously the free lunch in portfolio construction. We avail ourselves of it as everyone else does. We have 40 to 60 investments at any one time in a fully ramped portfolio with an average position size of about 2% with an upward bound in the mid to high single digits, call it 7%. And very few of our investments even approach that.
- [15:15]
A
So no matter how bullish you are, you have that 7% cap, correct?
- [15:19]
B
Correct. And you're just never going to see us exceed it. Even if I wanted to, others in the firm would stop me and I don't want to. We have pretty tight risk controls and we really prize diversification and we'd never, never ever move away from it. So that's table stakes. That's easy. We industry, we diversify by company. I just described by industry. What's maybe not as obvious, but I think important and especially in our asset class is diversification by causal factor. And so maybe I'll by example, in 2015 and 16 in the energy sector, the oil patch in the US rolled over supply, demand imbalance, energy prices fell, profitability of energy related firms fell. Sponsors have been very active in that. Energy is a good place to borrow money and have been a good place to lend money for a long time. And so in 2016 in particular, the addressable universe of distressed debt opportunities was disproportionately weighted towards energy. When you look at energy companies, they fall into broadly four buckets. You've got upstream, which is natural resources stuff in the ground, you've got downstream, which is refining and pipelines. You've got service businesses that can be fracking businesses, it can be water businesses, it could be staffing businesses that help support both the construction of wells and then getting the product out of the ground. And then you've got manufacturing businesses where perhaps a disproportion of their end markets are energy related. And so in 2016, you've got four different industries there. Well, if you made six to eight investments in each of those four industries amongst companies that were active in that space and distressed at that time, you would say, okay, I've got 24 companies and they're diversified across four different industries. That's a pretty diversified portfolio. I feel decent about my risk. And then if natural gas went to a dollar, every single one of those companies would be in trouble. And you'd find out that while you had on paper diversification, you had a concentration of 100% to this one causal factor, which is the price of the natural resource and a correlation of risk in your portfolio that you really are unhappy about at that point. That's something that we look at pretty closely and try to make sure. The reason it's important for our asset class is because it's something I touched on earlier, where distress tends to rotate from sector to sector. And so if you're deploying capital outside of a credit crisis, maybe two or three industries are having a hard time at any given moment because some macroeconomic factor is out of whack or something else happened. And so because of that dynamic, it's easy to find that causal factor, concentration, because that's what caused these companies to become distressed in the first place. And so you have to work pretty hard to avoid it. And so that's something that we really spend some time thinking about and making sure we don't have excess exposure to, you know, energy prices is an easy one. Interest rates is maybe even an easier one. But things like wage inflation are a little more pernicious. Home building rates, mortgage rates, what have you, there's a number that cut across where you say, okay, I don't want too much exposure to that dynamic, to that causal factor.
- [18:26]
A
What's interesting about that, a lot of people don't even track that causal factor. It's not only important, intuitively, it seems like even more important than geographical concentration. If you have a widget factory in Ohio and you also have a coal mine, that doesn't necessarily mean that you're not diversified. If it's completely different industries or if you have companies of the same stage also doesn't mean that you're not diversified. They could be completely uncorrelated.
- [18:46]
B
Exactly right. If you're looking at a population of companies that are providing a broad variety of services to cash flow, negative VC funded Emerging tech companies. And there happens to be a chill in the air when it comes to VC funding. You're going to find out you've got a lot more correlation in your portfolio than you first suspected.
- [19:04]
A
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- [19:38]
B
I'm not sure that I didn't know it, but I probably believe it more strongly now. Just a laser like focus on the quality of the business. I probably attach more importance to, to the quality and stability of a management team than I did 16 years ago. When evaluating a company, I've just found that that's an important factor. There's no line for it in your spreadsheet, in your financial model, but it's, it's something that. And so if you're looking at a distressed company, one of the first questions I'm going to ask is what's been the recent turnover in the management team? And if the CEO is exited in the last four months, that business isn't doing well. I don't care what's going on. You don't swap out your CEO unless you're in somewhat desperate straits. That's an incredibly disruptive move. It puts you back on your timeline as a private equity sponsor at least 12 to 18 months, if not longer. It's something you do when you absolutely have to, not if you want to. And so if you see a company that's undergoing CEO or CFO turnover, you need to be fairly cautious in approaching that because things are not good. And so that's a factor I probably didn't give enough weight to earlier in my career that I, that I pay more attention to now. And really just a laser like focus on the fundamentals. What are the unit economics, what's going on in the industry, what is the competitive position? What is the capital efficiency in some of the basics that everyone kind of espouses? But they're very, very important.
- [20:59]
A
What's something that you thought was important 16 years ago that's not that important today?
- [21:03]
B
Some of the tricks and traps of the bankruptcy process. If you're a clever distressed investor, you can do some neat kind of clever maneuvers inside a bankruptcy court to Maybe position your debt a little more favorably or try to squeeze out some other holders or slip a term in there or apply some capital at just the right moment to create an edge. And that feels good. It feels like you won there or figured something out that other people can't. But what I've learned over time is the cleverness and the maneuvering. And bankruptcy in some cases is just rearranging deck chairs on the Titanic. And the most important thing is that the business either has value or it doesn't. And the cute little thing you did in bankruptcy or the, you know, the equipment pool claim that you picked up from insurance company at a really attractive price, it's not important. What is important is this business is doing well and it's on a stable footing to emerge from bankruptcy and grow in the future or it's not. Get that part right and you're going to be fairly happy. Get that part wrong and it doesn't really matter what you do in court.
- [22:02]
A
I'm really curious. Over 16 years, you're not only working on deals, you're building a competency of working on deals. You're building your edge in the marketplace. What has compounded for you in 16 years and what is basically just continuously start from zero every single time that you do it.
- [22:17]
B
Compounding is twofold. Relationships is number one. And so we've got a handful of restructuring attorneys that, you know, some of whom I've worked with for over 20 years now. And so when we start on a new endeavor together, we're already on second base. Right. I've got enough history with this individual and they have enough history with me that there's a lot of things that almost go unspoken. And we know right away how we're going to approach this, what we're going to do, what we're not going to do. If we're faced with a decision how we're going to handle it, how are we going to treat other stakeholders who maybe want to work with us and cooperate or not? So that's been something that's compounded, another thing that's compounded. And really we've piggybacked off the growth of the firm. There's real scale benefits to being part of a larger alternatives firm. We just have access to a much deeper and wider information net data set than we would if we were independent. And so as the firm has grown, that advantage has grown. So that's something that's scaled. We are getting better and better every year at taking full advantage of it. We're a pretty Networked firm and a very collaborative firm, but we're also a big firm. And so getting to every single person who knows every single thing that you want to know can sometimes be a challenge. And we're getting better at that. So those are two things I'd say that have scaled. One thing that hasn't scaled is sourcing. I mean, every going and finding deals, you know, every day is a new day, every day is a new challenge. Finding deals is frankly not that hard in our space. Finding good deals and good value really is.
- [23:49]
A
What would you like our audience to know about you, about HIG or anything else you'd like to share?
- [23:53]
B
I think we have a pretty distinct identity as one of, if not the preeminent alternatives, firms in the small mid cap space. We've got a long standing culture of value orientation and cash flow centric investing. We gravitate towards complexity that goes hand in hand with being a value investor. And we have a pretty distinct approach and culture at the end of 2023 and we got a large number of LPs together, it's very well attended, it was a great event, a lot of fun. And at that, each strategy presented to our LPs, you know, here's who we are, here's what we're doing, here's what's going on in our market, and here are some representative transactions to give you a flavor. And then we had a number of our portfolio companies come present as well. And it was very well received by our investors. But we did get a piece of constructive criticism which is as each strategy presented, they kept saying the same thing over and over again in terms of how they approached investing, what they gravitated towards. Small and mid cap, value oriented cash flow centric seek out complexity. And by the end of the second days, the LPs are like, Guys, time out. We got it. You don't need to say this for the 12th time. And it wasn't something that we did with forethought. It's just a natural result of each fund its strategy putting together its own presentation and having this commonality of approach and culture across strategies and geographies that made it a little more redundant than maybe we wanted to. So it was kind of funny, but also it was a little affirming that as the firm has grown, we've been able to keep that culture pretty constant.
- [25:21]
A
Said another way, the opposite of small is large and efficient. The opposite of value is growth, which you know, if you go back 100 years, value value has outperformed growth. The opposite of complexity is commoditized trade, so it makes sense why these are sustainable sources of competitive advantage. Jackson look forward to continuing the conversation live, sitting down, Boston or New York very, very soon.
- [25:43]
B
Thanks David. Appreciate it.
- [25:45]
A
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