Navigating the Lower Middle Market.

0:02 Hello, welcome everybody to another episode of Arthur's Round Table. Thanks for everybody paying attention to the podcast. Super appreciate it, and also the Family Office Insights community who shared it quite freely. Really, really grateful for that as well. Brett and I have known each other maybe 15 years, something like that. Some ridiculous amount of time. Time flies, yeah. So we're super happy to have him today and we're going to start as usual with his journey and then we'll get into it from there. So Brett, thanks for doing this. Really appreciate it. Yeah, my pleasure, Arthur. I my journey is not as a crow flies, as one would say, but there are some threads as we reflect back on it.

0:42 I was born in Edmonton and then our family moved to somewhere north of Edmonton. As those of you that are in the New York Greenwich region right now might be feeling some of the colder temperatures, it's kind of refreshing to me as long as it's not too windy or raining and cold that I don't like, but actually like the crisp weather. Parents are school teachers. Mom unfortunately passed a cancer when I was young. And so the the path as a teacher is to go off and teach somewhere that's less desirable and build your resume and then move to more desirable place to live. And unfortunately that became a place that we stopped. I was fortunate to have parents in the school system and very thankful for the community growing up and being involved in the school.

1:25 Ended up speed skating on the Canadian National team. A post college. I I went to the oil drilling rigs to get some further cold weather for a year to pay for college. A post high school in areas they call the northern, the oil sands and whatnot in northern Alberta and northern Saskatchewan. And I thought that was a good learning lesson because it teaches you you don't try. To do right. Exactly right, that sometimes you you figure out what you want to do by what you don't want to do. Well said. But but with all seriousness, you know, it was a great opportunity to make money and work hard in order to pay for college. I then transferred up to McGill University, finished my undergraduate degree and wanted to work on Wall Street. And at the time McGill had one of the strongest launch pads into Wall Street and was fortunate enough to get a job at Solomon's with Barney back at the time as a division of Citigroup, which I thought was pretty fun as a kid. From a small town of under 10,000 people to new. York.

2:25 Yep, Yeah, In New York. And at the time, Citigroup was the largest financial services firm in the world. And that was pretty fun, and it was a phenomenal learning experience. I was surrounded by a bunch of really smart people doing a lot of different things, a lot of deals, a lot of data, a lot of information, and, you know, pretty creative, which I found quite interesting. And I caught the bug of really marrying some of my entrepreneurial things with finance to launch a fund, which I did in 2004 with some friends and colleagues. We launched our first lower middle market private lending and private equity investment fund. At the time, working with different states in the US to help invest in local smaller businesses which were part of economic development programs, investing in women owned, minority owned and underserved areas within various states in the US. And that was a, you know, great learning experience where you really learned the importance of being local to engage with business owners, build trust.

3:29 That was a lot of fun. Ultimately I then built that into a business where I, I restructured, rebranded and launched a a new trademarkable firm called Star Mountain Capital in 2010 to we, we recently celebrated our 15 year anniversary and I think today we have the largest if not at least one of the largest teams that is independent and purely dedicated in a specialized way to the US lower middle market with roughly 130 full time people and 40 operating partners. So that's and just under 5 billion of assets under management is our Business Today.

4:10 Nice. Nicely done, right? I've seen the growth along the way, so good for you. Brick by brick. Brick by brick and and also I think it's important to note that or at least explain what you mean by lower mid market. I know what that is, but let's let's share. Sure. What, what the business, yeah, that's one of the the, the, the bad things about the finance industry is fraught with jargon. The the way we think of it is companies that generally and most broadly this is probably a little bit broader than it's deserving, but 5 million of EBITDA to 50 million of EBITDA is where we focus. We are not specialists in the startup venture capital world. I think that's a different environment. You are underwriting different things and taking more of a, you know, a bet on different things and a different risk reward. So that's not what we do.

5:01 We also don't want to compete in the larger market where very large asset managers are highly active and very fluid and the market's more competitive. So we don't want the venture more startup risk and we don't want the more highly competitive market risks. And so that kind of squeezes us into that 5 to 50 million of EBITDA world, which we we execute against in direct lending strategies, private equity strategies as well as secondary strategies to really have a lot of data insights and capabilities within that market. Is that deal flow still robust for you? Is there plenty to look at? It is an in fact, Arthur, this is now my 23rd year investing nearly 100% of my Personal Capital in that market. And the reason I continue to do that is the market dynamics today are arguably better than they've ever been one. And I'm a guy that just likes thematic aspects. I don't mind working hard.

6:08 And that's perhaps the thread between oil rigs, speed skating and Star Mountain is labor. You know, we're not afraid to work hard, but we're not people that think we can outsmart the market or time the market or be smarter than everybody else. We just think we can have and we have a very specialized business that gives us a lot of competitive advantages and we're willing to do slightly smaller deals with really a focus on returns and on alpha and low correlated returns. So the market today is more robust than ever, one because of aging demographics, you have more private business owners in America today than ever that are in their, you know, 60s and 70s and saying, OK, I need to do something with my business.

6:54 And we really sit down with them and understand their business and be a solutions based partner. Maybe you have kids you want to transition it to, maybe you don't. Maybe you have partners who want to transition, maybe you don't. Every situation's a little bit different and it's that labor involved to sit down, understand the business, come up with investment structures, pair that with specialized resources that really resonates with some of the best businesses in America and that aging demographic just creates a demand for capital. The second thing that we like is that if you can grow a business from the lower middle market, let's just say you grow a company from 10 million of EBITDA to 30 million of EBITDA on average, you can probably increase the valuation multiple by maybe 50%.

7:41 So that valuation arbitrage taking a company from a less efficient market into a more efficient market allows you to capture a premium, you know, return on the business and systematically capture that valuation arbitrage, which is another thing that again business owners want to do. We want to help them do it obviously. And we want to do that, you know, with our capital and our investors capital, which also for taxable investors ends up creating a lot of long term capital gains and tax advantages, which the category of luck. Last year, the QS ES program also updated. And so now there's a further tax advantage potential for many people. But that aspect drives more deal flow than ever, right? So if you think about that, you've got aging people and you say, well, if I'm somebody sitting there with a $15 million EBITDA business and I can buy 2 of my competitors that each do 5 million of EBITDA, now I'm worth more and I can buy their EBITDA cheap.

8:38 Oh, and then there's a big tax advantage aspect to it. So it's like that just drives capital demand. And at that end of the market, your big branded asset managers, I'll call them, aren't generally interested. You know, your big investment banks, the deal size are too small for them to get the fees. So the market remains inefficient with fewer competitors, at least fewer big scale competitors. And so I think in my 23 years, this is probably the most robust we've ever had it. So the deal flows there. And then is it fair to say that the model is still, as I understood it when we talked a few years ago, is exactly what you said, you're taking a smaller company with a lower multiple just because of its size, aggregating it by merging other similar companies into it.

9:31 And then it's more interesting to that acquirer that you're not competing against, but you might want to sell that aggregated entity to them. That's right, yeah. And if if you look at the larger middle and large market private equity firms, many of them have a lot of capital and a lot of capital they want to deploy. If you look at capital formation, there's been a huge increase in capital formation going to, I'll call it the Black stones of the world and KKRS and so forth that have big fundraising teams and you know, large funds and those managers in general that have been, you know, very successful, great firms continue to grow and they have capital they need to put to work.

10:12 So they generally aren't going to want to mess around with a whole bunch of smaller little deals. That's too time consuming and labor intensive and you need a specialized business to do it. It's almost like, I don't know what a simple analogy is, but if you think about going fishing or is there a different fishing rod you need to go fly fishing and deep sea fishing or something. But it's even though you're still fishing, you know, there's it's a different way to find these companies, a different way to analyze them and a different way to actively work with them in the lower middle market than it is a larger market. But if you can build those companies up and professionalize that into the larger market, now you've got a very large buyer universe and a lot of low cost debt capital and financing capital, which I'm sure you know, you've all read about the influx of private credit in the large end of the market. Well, that's very positive for valuations, right? When people can finance things easily and cheap, that's good. That's good.

11:12 So that's financing things easily cheap on the exit side. And just because there's not a lot of people playing in the lower middle market, you also can command higher, I'm like I say fee, but you can charge higher interest rate because nobody else is really interested in doing the heavy lifting that you're interested in doing not. That's right, the. Value that you're, you're creating for somebody that's got a $10 million business and they're going to aggregate it to 30, right? That's right. It's, it's a bit of a step chart. So if you, if you, one of the things I like about our business, it's what I think of as a Warren Buffett style of investing, meaning a value based investment where you know on the debt side of our business, it's low leverage, it's strong covenants, but it's also a higher interest rate because the market's less efficient and there's a lot of business owners looking for capital and their use of proceeds is high.

12:13 So if you're going to acquire EBITDA cheap from a competitor, is it worth it to pay us an extra 1 or 2% interest, especially if to your last point, we can actually help you build a Better Business that's worthwhile. And so all across our business, we're really built to drive alpha in a systematic manner. And if you think about the alpha, you know, 1, you know, definition of alpha or pure alpha is getting paid for labor. And that's how I viewed life. I'd rather get paid for labor and doing the hard work and having a specialized engine that I would say, well, I'm going to pay a really high price for this company. I hope it's going to keep going up or whatever the risks that you're taking, you know, hoping that you can do things.

12:59 And that's just again, it's a, it's a different way of operating. I get much more comfortable, lower valuations, lower leverage entry points because what we've found and I think data would support is it's harder to lose money. And that's always one of our pillars that start around is let's start off, but not losing money, easier to make money if you don't lose it, but then you've got the valuation arbitrage and whatnot. And if you think about cash flow streams it, it's an asymmetric return of cash flows, right, because it's harder to lose money. But it's, you know, you don't have to change the world to take the company from recently one of our companies grew from 10 million to 150 million of EBITDA. Now that's an asymmetric outlier at the high end, but it's not like we found Google or something like that yet. You know, the amount of returns we can make off that and tax advantage returns is quite compelling. So we we like that.

13:56 So I don't want to compel you to give tax advice, but the QBs thing, QSBS, my understanding is it needs to be AC Corp at the onset of the entity. Is merging a new company provide an opportunity to cause it to be AC Corp for the new aggregated company? It does, yeah. Yeah, this is in the category of of luck. I guess the the being 1/4 Irish maybe pays off every once in a while and this certainly is one of those where many of our companies qualify in their size base. They didn't really under the previous code, but the updated one in July, they do, which is very exciting for us and our investors. And yes, we can sit down and structure the company as AC Corp when we make that investment.

14:49 And then you can help, you know, acquire other competitors, further professionalize them. And you know, and the government's trying to motivate people to ultimately make smaller investments where you can't. It's hard to get rich on management fees, right? You create wealth from returns and performance and that's really what we're built at Star Mountain. We invest a lot of our own Personal Capital. We share our carried interest with 100% of our employees. So we're all here to generate you know asset returns, whereas you know we're not doing multi billion dollar deals where you can make the kind of money on fees. So that program works out great for both are what we call value added lending where we'll do a loan with a piece of equity and within our private equity business.

15:34 And then we're actually looking into that now that our secondaries business which has some further tax advantages to it including where we can buy a discounted portfolio of loans or an LP interest from somebody in a private credit fund at a discount to par. That pull to par can create a long term capital gain benefit again for tax investors, obviously not giving tax advice so forth, as you alluded, but these are all things that can create, you know, meaningful value and, and, and there's there's perhaps some QSBS underlying value within that that we're further exploring as well. Got you. Isn't it also interesting or true that the people at the higher, the institutions at the higher part of the market are often times having non tax investors so they're not paying tax whether it be a a, A? Public pension fund or something? Fund something like that so.

16:35 That's, that's generally right. Yeah. I think most larger funds are, are typically going to have a lot of institutional investors and, and at Star Mountain, we're roughly, you know, half institutional investors and half, you know, taxable family office and individuals and so forth. That way at the end of the day, your non taxable investors just care about the overall returns. And one of the other things that they like about Star Mountain and the lower middle market, in addition to the alignment aspect of our team, which is very important to them because they don't want to lose money. They know downturns can come and inevitably do. They want people that are going to really work hard through potential challenges, but they also want less correlated investments.

17:16 And if you think about one of the benefits of the lower middle market is you can access companies like a special needs school bus transportation company or a pet hotel boarding and grooming business. A business that can be very might be slow growth, basic boring, but in the event of a market downturn, slow growth basic boring is good, right? So something that can have a good total absolute return, but be very uncorrelated to geopolitical risks, you know, large market technology and so forth, AI and whatnot, which may continue to transform, but certainly I think has created tail risks that we see a lot of investors now saying I want to find some things that are good investments and less correlated.

18:02 And, and obviously you've seen a run up in commodities and other things like that, but some people are saying, well, what does gold do for me? How does it create cash flow? Well, it doesn't. So in this case, you're finding things that are less correlated that have a fundamental purpose and a value to them. And that's that's where a lot of the institutions and some of like the large family offices that are really focused on generational wealth protection are getting very acutely focused right now. Yeah, totally makes sense. When there was a lot of talk about, you know, the the trades businesses, the H back and so on and so forth. Did you find that activity in that area was interesting to Star Mountain?

18:46 It is. And then we've made a lot of money during it in fact, including with HVAC businesses and others. And and if you think about the US economy, it's largely a service based economy that's hyper fragmented. You overlay that with the aging demographics and that valuation arbitrage and you kind of have a perfect storm. And so that dynamic persists. Now, what I don't think you want to do is chase hype, right? Because there's some things like, for example, one of my partners made a lot of money doing a consolidation of car washes. They built it up, sold it to Goldman Sachs. Everybody had a very successful exit. Then we recently looked at this other car wash business where people just felt like, oh, on paper, yeah, you just put up a whole bunch of car washes and it'll all be this profitable. Then you sell the higher market.

19:33 Every makes a lot of money. Well, yeah, but what if you have three car washes on the same block and people only need one? Now all of a sudden you're fighting for labor. You have to drop your prices. And now all of a sudden you have a car wash you have to pay rent on. It might be unprofitable. And all of a sudden, an asset turns into a liability. And that gets ugly really fast. And so I think people that chase hype, you know, sometimes they get lucky. But rarely are they systematically successful. And that's where it's just like Start Mountain. Like we don't invest in real estate, we don't invest in the energy sector, We're not investing in public markets. We know what we're good at. We're specialists at it. And I think whenever you see people kind of dabble in things or chase things that sounded interesting, just because it can be a good investment doesn't mean it will be. That's right.

20:26 And in your example, the car wash, you know, seven years ago there was you could basically buy a car wash and have zero economic investment because of the tax benefits associated. That went away, of course still interesting business, but not like it once was. And maybe your friend participated in all that. There's a lot of tax benefits as I recall. So let's. Yeah. I think you also don't want to and that's where you look at your investor base, what you're doing. I don't think you want to make, I think you want to look at tax opportunities as an extra bonus, but you want to be fundamentally good investment that then has an extra potential, the icing on the cake if you will, but make sure the cake is solid. I think people that chase the tax things that sometimes there's like a window of time where that works, but then inevitably you end up having people that, you know, typically face losses and things.

21:22 And we've seen it solar and different things as well recently that again in a period of time where people made money and a lot of people lost a lot of money there. Yeah, that I think that's right. So can you talk a little bit about your historical performance? I can to the extent of of what I can specifically share if people have, you know, questions they want to understand more about as business owners or as perspective investors. Our team would be delighted to talk to them about, you know, for qualified investors, what type of strategies and structures we offer to help, you know, them achieve their total return income, diversifying tax advantage and other potential benefits that they'd have. But but generally speaking, we performed very well. I guess that's enabled us to grow both in protecting capital, generating, you know, solid current income on our income vehicles and really staying true into our market opportunity that as we talked about the aging demographics and whatnot has continued to become a more compelling market. What we haven't done and when I used to do asset management M&A 25 years ago, you'd see people build a good track record and then kind of jump up market with a bigger fund and then all of a sudden they're in a different market and it's much more competitive and then their returns of course diminish. So I think staying true to your market is critical. And that's where I think, you know, in our case, we've had to be focused on investing a lot of our own Personal Capital because you can't grow your management

22:54 fee base to the same level. So the way you create wealth is really making returns with your own money. I also think that the discipline that creates with your team is very different when people aren't trying to chase fees, but they're really focused on investing their own capital. And it's hypothetically what we're all supposed to be doing. But if you look at people's incentives, often the incentives are not as aligned as one would probably hope. Yeah, incentives matter. There's no question about that. As long as somebody understands them, they matter. Sometimes people don't understand them. Yeah, yeah. Well said. Yeah, So what? What's on the horizon for you guys? Anything new you care to share?

23:39 Yeah. We're, we're really excited about our secondary's business. I think, I think a few things. 1 is, you know, different products we have, there's been a lot of noise in the market now, but some of the larger market lending and while a lot of people still want different forms of credit, which makes sense. I think a lot of people now are saying, well, I still want some credit, but where can I find some diversifying credit to what I'm already invested in? So I think we're seeing a lot of interest there, especially as rates are coming down. The ability to generate a potential premium yield is of interest. The second thing is within secondaries, as the market is bigger and more fragmented, you just have more people that may want early liquidity in lots of different types of funds. So again, we always like things where you have positive information advantage, motivated sellers and a big market opportunity.

24:37 And then what's also interesting about secondaries is if we do have a market downturn, it tends to have a bit of a counter cyclical aspect where people are more panic selling and you can buy them assets cheaper. So I it's not a hedge, but it kind of acts in a similar capacity. So I like that in My Portfolio. I also like the taxable advantage aspect that you can get from purchasing ordinary income assets at a discount. And then within our private equity business, the tax advantage aspect around the QSPS we talked about, I find those really compelling in addition to just the aging demographics aspect. So we, I guess we, we, we love all our children and at different at different times that each act better than the others, but they, they all tend to perform pretty well across cycles. Yeah, There's been a lot of talk and some wringing of the hands of many people that are looking for liquidity that just can't get it, whether it be an healthy interest in a fund or as an early shareholder in a company that hasn't gone public yet, right, or is about to.

25:45 Yeah. And if people are looking for early liquidity, please feel free to reach out to us. We, we, what we don't do again is the venture capital stuff. So the shares in a company that didn't go public, that's a different world, a different way of you're kind of analyzing what you hope's going to happen in the future. We're better at analyzing fundamental cash flows, fundamental businesses and more of that value based investing. But if people are invested in private credit funds, private equity funds, private credit assets, private equity assets of companies and funds that investing companies that do 5 to 50 million of EBITDA. Again, if we can be helpful, we'd be delighted to see if we can be helpful in any capacity on that front. But I, I think that there will be more and more people that are invested in lots of things that are much less liquid than they hope they are.

26:36 And I think that fortunately for some creates challenges. And usually the flip side of a challenge is an opportunity. And so we're pretty geared up. And some of my partners that were, you know, executives at Fortress in the great financial crisis, you know, it made a lot of money in the downturn. And we're pretty geared up, you know, to be defensive in what we're investing in, but also to look to capitalize on opportunities that we think are to some capacity inevitable over the, you know, quarters to come. So just just to be clear, you're interested in LP interests and funds in the segment that you can analyze as opposed to the more venture shares that have?

27:25 That's right. Yeah, Yeah. And if people want, we can help try to connect, you know, if they're friends of yours in your community, Arthur, we'll always try to be helpful to some other folks that are the venture space around there. But that's, we won't be a buyer of that, but we can help the people connect into that world. The the venture world is a different world. I think you need to be, you need to live and breathe that and the risk reward profiles a bit different. We at Star Mountain really focus on trying to have the highest probability band of returns possible. We're OK not getting a 50% return our money. We just again, we don't want to lose money. We want to try to make that, you know, mid to high teens and things go well again to the 20s. And if you can kind of systematically target those type of returns across cycles, you know, that's really been what's worked well for us.

28:13 Does we, we could do a whole segment on the QSBS stuff, but does some of that pass through not just in the value of the company that is now sold for the entrepreneur in, in, in the tax advantages of that, but does that pass through to your LP's as well in some way? It does. It's a huge benefit. That's why I'm personally putting a lot of more of my capital into that at the moment to say, in fact, we just had one deal where the the greater than you know, 15,000,000 of profits for your pro rata peace or 10 times your money. You can't have to think about that for a second. But if you actually, you can actually get over 10 times your money potentially depending on a lot of circumstances tax free. Now, not often are you generating more than a 10 times return on your capital, but fantastic if and when it happens.

29:10 But yeah, it's, it's a it's a very for a US taxable investor. This current window right now is incredibly compelling in my opinion. I'm, I'm heading pretty deep into it because, you know, there's no guarantee the next administration will continue any issues. You just never know. But it's the aging demographics is there today, the valuation arbitrage is there today and the, you know, the tax advantage opportunity. And so that kind of trifecta is, is pretty compelling and maybe for some of us a bit of a once in a lifetime even. Yeah, it might be. In fact, we didn't know what was going to happen to it right when it came through the regulations and came through well. So let's do this if it's OK with you, let's do another one whenever we have time to do it with you and talk about that or or some other subject more specifically and get into the weeds a little bit.

30:04 Yeah, we'd be happy to. Yeah. And we host some in person things we'd be delighted to kind of think about with your team as well. It's great how you guys get together and share content information all together and always a pleasure, Arthur. My pleasure. Yeah, it was great. Brett, thanks for doing this and thanks everybody for listening in. Please feel free to share it. I feel like a YouTube promoter and, you know, click here. But yeah, thanks for thanks. For somebody told me something about TikTok. I've never been on TikTok, but you said or have I? Yeah, I guess it's, I mean become pretty substantial. The most interesting thing that I've heard that just recently on social media is that AI agents now have their own social media program and they're talking to each other, which doesn't sound good, but you know, progress maybe. Yeah, that's funny.

30:54 Thanks, Arthur. A pleasure. My pleasure. Thanks, Brett. Thanks everybody.