“A vision and strategy aren’t enough. The long-term key to success is execution. Each day. Every day.” -Richard Kovacevich
In the first four entries of this “historic” series, our quotes focused on perspectives and lessons regarding history. Today’s quote, however, is a shift to remind ourselves of the importance of execution and the respect we must have for execution risk within private investments (and all investments, really). That’s because today, we’ll get a taste of some execution failures and the implications for the outcome of a given strategy. Here we go.
Private Credit Business Development Company (BDC):
When a private equity (PE) transaction occurs, it is often done with a lot of leverage – especially when a PE manager is the buyer; stated with less jargon, when a PE fund purchases a business, significant money is typically borrowed to do so. Those transactions are known as PE sponsor deals, as “sponsor” is effectively just another name for a private equity firm (here’s a relatively concise overview of the private equity structure, if it’s of interest).
Where does the leverage (borrowing) for PE sponsor deals come from? It can come from various sources, but the Private Credit BDC we’re currently discussing is one such source. And while there is a broad spectrum of deals to lend to, this BDC focuses on the “Upper Middle Market” of private businesses. That description simply refers to the size of the companies being bought/sold. Official definitions vary, but this article from Quantive has reasonable ranges to delineate the market, based on annual revenues:
- Lower Middle Market: $5 to $50 million of revenue
- Middle Market: $50 to $500 million of revenue
- Upper Middle Market: $500 million to $1 billion of revenue
To focus on this market segment, which consists of relatively large transactions, a manager needs to have resources (including a lot of money to lend) and access to the PE sponsors doing the deals. The founders of this BDC had incredible success in the private equity/credit world before launching the fund in question, so their network was robust enough to raise a significant amount of capital and source enough deals to manage a viable fund.
The team is equipped to filter through a lot of deal flow. When we invested, they had reviewed about 1600 loans over the previous year to arrive at approximately 40 loans they believed were a good fit (about 2.5% of the loans). They also value giving PE sponsors (i.e., the potential borrowers) a quick “no” to avoid wasting everybody’s time if a situation isn’t a good fit; this can help build trust and working relationships with more sponsors for increased future deal flow.
Most of the loans are senior secured (highest payment priority, backed by assets). The objectives are to generate current income and, to a lesser extent, capital appreciation by targeting investment opportunities with favorable risk-adjusted returns. The anticipated path is still to pursue a liquidity event 3-5 years into the fund’s life by taking the fund public; i.e., it would become publicly tradeable by undergoing an IPO (initial public offering) process when it is believed to add value for investors. Investors would then be able to sell shares in the open market following any restriction/blackout periods.
Aligned with our focus on risk management, the team focuses on less economically sensitive companies (“recession resilience”). The fund has to achieve a preferred return for investors before earning their incentive fee. There are also several ways of mitigating risk within the strategy, including: underwriting and loan terms; loans that are senior-secured and asset-backed; and floating rates that can increase in the event of rising interest rates. At the same time, the fund uses 30-40% leverage to help target its desired income/return characteristics, so it is essential to keep this in mind, as leverage inherently increases risk.
- Structure: Private BDC (business development company), expected to go public at some point.
- Fund life / Access / Liquidity: ~3-5 years (pre-IPO) and then evergreen as a public fund. Quarterly liquidity (subject to gating) as a private fund and then intraday liquidity post-IPO.
- Cashflow: Consistent cashflow is derived from underlying loans.
- Pros: Risk mitigation via underwriting and loan structures (mainly floating rate, senior secured).
- Cons: Eventual IPO will change the private nature of the current structure. Fund-level leverage can magnify risk.
- Where Are We Now? Since the fund marks-to-market monthly, there was a relatively small (tolerable & temporary) drawdown during the COVID onset while income continued to be distributed. That change in pricing was far more related to fluctuation in public markets (“comparables”) than problematic underlying loans or defaults. As with other strategies we’ve discussed, the team was very hands-on in monitoring, restructuring, and working with challenged borrowers to target good long-term outcomes for investors.
Private Equity Multi-strategy Rollup with Income
There was much to like about the premise of this fund. It would acquire a diversified portfolio of private businesses, along with making some private loans. The focus would be on demonstrably resilient, income-producing companies in segments like auto dealerships, IT services, physical therapy, and waste management. Most would be businesses with long track records and consistent cashflow through good and bad times, and – in some cases – the existing long-time local operators would remain in place for greater synergy and consistency. That cashflow component could provide underlying investors with income as the strategy played out. And for added risk management, the managing directors of each of the strategy sleeves would have real operating experience in their area, such that they could step in and run a local business if needed.
What these business segments had in common was fragmentation (i.e., they consisted of many small businesses rather than being dominated by large players). Fragmented markets could provide the opportunity to purchase what was already a good, local “ma & pa” business and add it to a portfolio of similar businesses for greater efficiency, scale, and (ideally) profitability. This concept is known as a “roll-up” strategy, as these smaller businesses are rolled up into a more significant consolidated business. Bigger businesses appeal to a different spectrum of potential buyers and typically command higher multiples for valuation.
A brief aside on multiples and valuation: A straightforward way of valuing a business is to use a measure of financial performance, like EBITDA (earnings before interest, taxes, depreciation, and amortization), and multiply it by a…wait for it…“multiple” to arrive at an overall enterprise value (here’s a deeper dive on the topic, if interested). The critical point for our conversation is that the multiple isn’t static. It can fluctuate throughout market cycles, with particular business segments going in or out of favor, BUT it also can vary significantly based on the size of a business, with larger enterprises commanding higher multiples than smaller companies.
Extrapolating from the above (and, again, using a simplified example), if I have a business with an EBITDA of $1 million, and the current multiple for that business is 10x, then the value of that business would be $10 million ($1 million times 10). If I roll up 10 of these same businesses into a larger entity, then my combined EBITDA should now be $10 million (and ideally more because of synergies, efficiencies, etc.), BUT that new, larger business can fetch a higher valuation multiple (e.g., 15x instead of 10x). Thus, I would have a company worth $150 million (at 15x) instead of just $100 million (at 10x), and $50 million of additional enterprise value was created, mainly because of the larger size.
Some of the segments may not sound very resilient at first glance, but here’s why they arguably can be:
- Auto Dealerships: their economics are far less related to new car sales than is immediately apparent. Financing can also be lucrative. Used car sales and parts/service can do better in recessions because people may opt for pre-owned cars or keep their vehicles longer (hence more maintenance) during more difficult times.
- IT Services: these are based on multi-year subscriptions with reliable cashflows.
- Physical Therapy: Pain doesn’t suddenly disappear during a recession, and treatment is often covered by health insurance, which most people tend to retain throughout cycles.
- Waste Management: garbage collection and recycling are pretty consistent daily/weekly necessities. On the other hand, carting (i.e., removal/hauling debris from construction sites) could be more economically sensitive with potentially more variability throughout cycles, so it’s essential to understand the underlying revenue drivers.
To date, many things have gone awry with the strategy, but I can sum much of it up as “poor execution.” First, it seems that too much was paid for some of the acquired businesses, but that’s only the beginning of the problem. When a fund exceeds $10 million in assets and 750 shareholders, it must file form 10. The finance team was (in hindsight) unprepared for this more rigorous requirement, which (as I understand it) included having to redo past years of accounting for many of the underlying companies – years when the fund did not even own those businesses. That issue resulted in unexpected delays in financial audits, demanded far more resources than initially expected (i.e., more cost), generated a turnover of auditors and financial executives, and this all led to even more delays.
Significant delays in filing financial audits are (obviously) not a good thing and can begin impacting creditworthiness. Auto dealerships, as one example, typically rely on substantial borrowing to carry vehicle inventories, so credit may be needed to run a viable business. And, as we’ve learned, then there is a domino effect that can create even more issues:
- Lacking audits violates terms (aka “tripping covenants”) of loan agreements with lenders and can stop investors from coming into the fund (investors like current audited financials).
- Lenders can then force the fund to do things like halt income distributions to investors, depending on the exact terms of loan agreements.
- Investors who face a reduced value of their investment and are no longer receiving expected income become unhappy.
- Lawsuits alleging everything from mismanagement and inappropriate sales practices to “Ponzi schemes” emerge, often from law firms who seek out any opportunity for class-action cases.
It’s also worth touching briefly on the progression of the waste management sleeve, as well. A large part of this approach focused on New York City, and a vital component of NYC waste-management pricing is being able to resell recycled materials that are collected. As I understand it, the number-one buyer of these materials used to be China, but they completely dropped out of the market. Then the number two buyer – a papermill – burned to the ground. These two things rapidly and utterly destroyed the profitability of the waste management portion of the strategy. So, even if there is a very longstanding and consistent market for a business, we really must consider whether that market can essentially vanish overnight, as we’ve witnessed firsthand.
To sum it up, for now: this is an illiquid vehicle with limited transparency. There seems to be progress on multiple fronts, but we have to wait and see how it all turns out. As the fund’s ability to generate enough return to earn incentive fees is extremely unlikely, they are most likely looking for ways to liquidate the existing portfolio at a reasonable price. We have learned and will continue to learn a lot from this experience, but one thing is for sure – execution is absolutely critical – as we’ve alluded to in today’s quote.
- Structure: Private equity structure (limited partnership) with all capital accepted upfront.
- Fund life / Access / Liquidity: Unknown (Originally expected to be ~5 years)
- Cashflow: Originally derived from underlying business cashflows but are currently halted.
- Pros: The overall premise (and limited parts of the underlying strategies).
- Cons: Everything else.
- Where Are We Now? Continuing in a “wait and see” holding pattern.
Life Settlements
It may be pretty intuitive that 99% of term life insurance policies never pay out the death benefit, as it’s akin to renting insurance for a discrete period during which a person is typically not expecting to die. Less obvious, though, is that most permanent policies (aka “whole life”) also do not pay out the death benefit – even though they are supposed to be in place for your whole life. If a policy is underfunded, it may simply become too expensive to keep in force as the insured person ages. Or – at some point – the idea of taking the cash value of a policy may become more appealing than continuing to pay the premiums.
According to Wikipedia, “a life settlement is the legal sale of an existing life insurance policy (typically of seniors) for more than its cash value but less than its net death benefit, to a third party investor.” If done correctly, it should be a win-win: the original policyholder gets more cash than they would have if the policy were surrendered, and they get to use this cash while the insured is still living. The third-party purchaser, on the other hand, can generate value from the death benefit paid at the insured’s death…as long as that death benefit is more than a) the purchase price of the policy, plus b) the premiums that are paid to keep the policy in force.
While it can sound a bit dismal (profiting from one’s death), life settlements can be very helpful to people in getting them additional cash while they are alive, sometimes for policies that would otherwise lapse with no cash value at all. It’s also tricky business, as no one knows when someone will die. However, like insurance in general, life expectancies can be more accurately estimated as the pool of policies becomes larger. So, I believe that consistent success in this space requires significant scale (for diversification) and sound underwriting (for accurate life expectancies and pricing of policies).
Potentially appealing aspects of investing in life settlements are limited volatility and relatively consistent returns, with little-to-no correlation with other asset classes. Like reinsurance (which we covered in Part 3 of this series), life settlements should have almost no relationship with stocks, bonds, or the broader economy. A situation like COVID was, perhaps, an exception, as we had an economic downturn coupled with increased unexpected deaths (bad for stocks, good for life settlements), so there could have been some negative correlation for that brief period.
The main hurdle for investing in life settlements was to get comfortable with how the underwriting could incorporate (in my opinion) ever-increasing life expectancies that stem from a better understanding of human health and the medical treatments that go along with this. Concisely, this is known as longevity risk – when someone lives “too long” (also an important topic within financial planning, as we don’t ever want people to run out of money). We learned that a life settlements manager is rarely interested in owning policies of healthy people, as the math doesn’t work. And, for the older, less-healthy crowd where life settlements could make sense, there are two other important considerations: 1) New treatments don’t (usually) suddenly extend life for those close to death’s door, but rather help younger and middle-aged people to live longer ultimately, and 2) each new policy is underwritten with the latest understanding of what life expectancy is.
Even with all of the above in mind, this strategy’s fund manager underestimated longevity risk, and many of the policies had to be reduced in value based on an update in the valuation process. Part of that change was a result of acquiring a competitor believed to have more accurate underwriting technology. Thus, existing investors have had to endure some unexpected volatility and a “resets” of valuations to align future fund returns with expectations. The fund has also implemented gating, as redemption requests have exceeded the liquidity provisions set by the fund terms. We’re now about half a year into this “next chapter” of the strategy, and it so far has been more aligned with expectations.
The risk/return and correlation profile of life settlements has lured more investors and managers to this space in recent years. We’ve seen additional strategies emerge, and this strategy’s manager has cited a similar phenomenon. More demand has compressed overall expected returns in the space and can make it more difficult to source policies at acceptable prices.
- Structure: Hedge Fund (limited partnership)
- Fund life / Access / Liquidity: open-ended hedge fund with multi-year lockup (varies by shareclass), semi-annual liquidity (subject to gating)
- Cashflow: Variable, derived from underlying death benefit payouts, but does have a degree of reliability because of some level of deaths occurring each year.
- Pros: Low correlation to other asset classes. Typically low volatility and relatively consistent return profile.
- Cons: Potential to be adversely affected by longevity risk and underwriting process. Increased competition in this space.
- Where Are We Now? Monitoring how the funds’ revisions play out vs. expectations going forward.
In the next and final (seriously) installment in this series, we’ll cover three more strategies, now moving beyond the accredited requirement to funds available only to qualified clients and qualified purchasers.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
