Editor’s note: Lower middle-market companies form the economic fabric of the nation, but they can be tricky and labor-intensive to finance, and traditional banking institutions have increasingly avoided them since the financial crisis. Accordingly, a number of alternative investment managers have successfully specialized in the niche, among them Brett Hickey’s New York-based Star Mountain Capital. FINalternatives caught up with Brett recently for an in-depth look at his company, his current thoughts on this segment of the market, and his belief that the right corporate culture is a core ingredient in building a prosperous enterprise.

FINalternatives: Brett, tell us a bit about Star Mountain Capital.

Hickey: Star Mountain is a specialized lower middle-market investment firm founded in 2010 with approximately $500 million of assets under management. We focus exclusively on investing in established U.S. lower middle-market companies across a three-channel approach of (1) direct investments in lower middle-market businesses, (2) strategic limited partnership investments in lower middle-market funds and (3) purchasing secondary limited partnership interests in lower middle-market funds.  Through this distinctive platform, we are able to provide investors with diversified, scalable and fee-efficient access to this large and underserved market where we believe superior risk-adjusted returns are available due to the market inefficiencies. A key differentiator is the proven large market expertise and resources that we bring to these smaller businesses. Part of our value-added platform comes from our strategic investor and advisor relationships who also provide Star Mountain with more than just capital.

You describe Star Mountain as investing in a single asset class. Can you explain?

90% of the businesses in the United States have less than $100 million in revenue, are typically owner-operated, and are not controlled by large private equity sponsors. We call these companies the “Growth Engine of America,” since this niche is where most job creation and economic impact is created. Star Mountain is built to specifically address the challenges and opportunities of investing in these established smaller U.S. based companies. We invest into this asset class first and foremost as a direct investor, and also as a strategic fund investor.  As the latter, we make both strategic primary and secondary fund investments whereby we purchase assets and fund positions from other investors in lower middle-market funds. This approach provides us with substantial information, deal flow and portfolio management competitive advantages, all of which allows us to create what we believe are superior investment products.

You have built an extensive roster of advisors and operating partners. How does this ecosystem help your portfolio companies?

This is one of the ways we bring large market expertise, relationships and resources to smaller companies. Our advisors are aligned with personal capital invested and carried interest in our investment returns. They provide a wide range of value to our team, our investors and the companies in our portfolio. For example, we have human resources advisors to help us source, analyze and develop a leading team, tech advisors to help us build distinctive and cutting-edge capabilities, and a broad bench of industry experts that assist not only with due diligence of potential investments but also in helping to maximize the value of the portfolio companies in which we decide to invest. In fact, we have recently added several advisors, including experts in the healthcare, consumer products, and public relations sectors.

How has the market for what you do shifted since the financial crisis? Has the disintermediation of traditional banks resulted in greater deal flow?

Banks have certainly retreated from more complex lending, especially if they feel they need to get paid more for their underwriting time. This can result in regulatory scrutiny around why they have certain loans with higher interest rates and queries as to whether it equates to higher risk. This has been helpful for us and has kept traditional commercial banks from being competitors. That said, we often work with banks as partners on deals where they will provide revolver facilities and we provide strategic term loans that have been carefully structured to achieve three things: The borrower’s growth objectives, maximum returns for our investors, and protection of our capital. Banks are generally good at asset-based lending, which can be done more rapidly, and loans to larger companies backed by private equity firms where the information has been cleanly packaged for them.

Some people think that smaller, lower middle-market companies represent higher risk for investors. Do you agree? How do you gauge and mitigate these risks?

This is an interesting topic and our answer might surprise you. We believe smaller companies are riskier than larger ones; however, there are other risk metrics that are far more relevant than company size. Most notably, the amount of leverage on a company’s balance sheet is much more predictive of problems down the road than the amount of a company’s revenue. Our smaller company loans generally have substantially lower leverage and far more protective covenants embedded in our transactions, which on balance, actually make our loans less risky than the larger markets – at least based on our experience and studies by both Moody’s and S&P.  In addition, due to the limited competition at our end of the market and healthy deal flow, we’re not in a rush to close investments and can do far deeper due diligence on prospective borrowers. This includes site visits, discussions with customers, spending considerable time with management teams, etc., all of which we believe helps us better understand and assess our risks.

A recent Moody’s Analytics report concluded that the amount of leverage is over four times more relevant than the size of company in determining default risk factors. In fact, size was the least important variable in the study. Another data point: According to S&P, default rates are significantly lower for smaller loans, likely driven from the competitive market dynamics of the larger loan market.  Lower leverage results in a greater ability to service debt obligations and provides more equity cushion to work through potential challenges.

Of course, there is a downside to focusing on smaller companies. Our investments are very time consuming to source, analyze and manage, particularly when you factor in that each of them is relatively small compared to the larger markets. We believe our higher returns are driven more from the labor we need to invest than the risk we take, but it is certainly important to understand what to look for and how to analyze and manage smaller company loans.

On the macro side, how will rising interest rates impact Star Mountain? Are you seeing secondary activity increasing?

We do not believe rising interest rates will have much of an impact on our portfolio. We are more of an absolute return strategy across various market conditions, and are not making bets on interest rates. Some of our loans have floating rate structures, while others have warrants and other equity positions that should increase in value, on a systematic basis, if the market is growing and rates are increasing.

Meanwhile, the secondary market for illiquid investments has substantially grown over the past few years. This is valuable for us and our investors, as it makes our investments much more liquid than they used to be.  To date, our investors have not sought early liquidity, as they like our high yield, low leverage exposure, but we have certainly seen increased activity in the larger markets which, in turn, is driving growth in the secondary market.

What about a downturn in the stock market? How will that impact Star Mountain?

Thankfully, smaller companies have a low correlation to the public markets, so we don’t believe there would be a substantial direct effect. We have done a lot of research on the economic impacts of recessions, and as a result, have made the conscious decision to stay away from more cyclical businesses such as real estate and energy. Our team and partners have been investing in the lower middle-market for over 20 years and we have found that provided discipline is kept in underwriting and portfolio management, these loans still perform well even in a deep recession.

We think of our strategy as “all weather;” it should continue to perform well in a market downturn. Ultimately, our investment approach is a defensive investment and we’re getting paid more for market inefficiencies and labor than the risk we take. That said, we do track market-related risks, and look at industries that could have more cyclicality or where there could be derivative effects on our portfolio

You speak often about corporate culture and building purpose-driven businesses. Can you expand? 

I think our culture at Star Mountain is one of the most important drivers of our success. Sure, we can hire extraordinarily smart people and do all the number-crunching required to make informed decisions about investments, but in my view, the real secret sauce of any successful organization is how its people operate, think and collaborate together.  I like to call it cultural capital. Point to a successful company, and more often than not, you will find an abundance of strong cultural capital sustaining it.

Great cultural capital inside companies is like a fingerprint; no two are the same, and what works for one may not work for another. But in my experience, they do share certain characteristics. They have aligned individual goals with that of the company – an alignment of interests – that in our case is accomplished by including 100% of our employees in the carried interest of our funds. Other things are more esoteric – a desired sense of purpose, passionate focus on technology to improve our operations, and support of outside-the-box thinking about what we do. We also focus on the things that make Star Mountain a comfortable and engaging place to work, like fresh and healthy food, standing desks, lots of windows and sunlight, etc.

I believe this nexus between business and purpose is where most successful organizations thrive. In fact, a truly great corporate culture is the greatest single asset of a truly great business. Yes, some companies that are able to invent and market the next gee-whiz gadget can be wildly successful, but organizations that focus on creating the most cultural capital possible are usually the ones that end up with the most sustainable, scalable and rewarding businesses over time.

You were a competitive speed skater in Canada prior to your Wall Street career. What elements of that environment have you found applicable to launching and growing a successful alternative investment company? 

My life has taught me that goals are achievable with a focused plan and hard work. I have always been very mathematically and statistically oriented, and as such, have never been a fan of short cuts as they tend not to have a high probability of success. I do believe in innovation, which also takes time, resources and effort.

Speed skating taught me that hard work and discipline pays off and that training, determination and focus will yield results. I paid for college by spending nearly a year on the oil drilling rigs in Northern Canada, and that experience taught me that sometimes you have to build stepping-stones to get to your longer-term goals. Hockey, part of the DNA of many Canadians, taught me that a strong defense can win championships.

I’ve learned something from every environment in which I’ve lived. I grew up in a small town with limited financial resources and a single parent who was a teacher, which taught me that working as a team and community creates value for everyone. McGill University, Harvard Business School and involvement with the Young Presidents’ Organization (YPO) have each taught me the true value of life-long learning. On a more personal level, losing my mother to cancer at the age of 6 taught me to live a purposeful and community-oriented life. I think of my team of business partners as family, in fact, two of them were in my wedding party.

Taken together, these experiences have all lead me to building Star Mountain Capital, which can be summarized by four core elements. First of all, we invest defensively in established, smaller companies with low leverage. Secondly, we get paid for work where we concentrate on more labor-intensive loans to private businesses that have complex capital needs, such as financing an acquisition. Third, we help these companies grow, employ more people and create value in their communities and the economy as a whole. Lastly, with respect to team, our most important asset, we focus on high quality people who want purposeful and engaged lives – we find these people maximize long-term value as aligned partners in what we do.