“Traditional capital markets are still important for people because of the liquidity and ease of access they offer,” Dovich says. “But after ’08 it became obvious to me we ought to go one step further and expose clients to alternative strategies.”
Often not available to many investors because of the high minimum investment required and liquidity restrictions, private equity and mezzanine funds are two alternatives that Dovich’s firm has analyzed and recommended for certain clients. Those not in the super high-net-worth realm can still get in with a smaller investment through Dovich’s firm since client investments are consolidated through a separate legal entity created by the firm.
Tom Lalley, a principal with Dovich’s firm, recently sat down with two alternative investment firms based in Cincinnati that have a robust presence in the private equity and mezzanine lending field: Paul Swanson, managing partner of Hauser Private Equity, a hybrid private equity fund and Rodger Davis, managing partner of Northcreek Mezzanine, which specializes in mezzanine, senior debt and equity investments in lower middle-market companies as a licensed Small Business Investment Company (SBIC).
Tom Lalley: What are some of the mechanics and time line in your funds?
Paul Swanson: We call our strategy a hybrid model to invest in other private equity funds and also make direct investments in select companies. We raised $100 million in 2014 with the strategy to diversify among private equity funds and allocate a certain portion to a co-investment fund. We put money in buyout funds that purchase controlling stakes of at least 51 percent in companies with significant growth potential. We also invest directly in some of the same companies in which the buyout funds invest.
Rodger Davis: Barry Peterson and I started our first fund in 2010 as the tightening senior credit market created a void in the credit products available to lower middle-market companies. This disruption in the credit markets created an ideal opportunity for us to solve the financing needs of lower middle-market companies. Our first fund, with capital of $72 million, is off to a good start, with a number of realizations and a portfolio of strong companies. We launched our second fund in February 2014 with capital of $180 million and have invested nearly half of the capital available.
Our strategy is to invest in lower middle-market companies with strong management teams that have shown a resiliency to manage through economic cycles. We invest in basic businesses diversified by industry and geography, allowing us to mitigate risks associated with any one industry or geography.
TL: Northcreek specializes in mezzanine loans. What are those?
RD: It is a loan second in priority to a senior bank. It is called “mezzanine” because it resides between senior debt and equity on a company’s balance sheet. You take on mezzanine debt if you need capital over and above what a traditional bank offers but you don’t want to raise additional equity. We call it interim capital and it can be used for a variety of purposes – as growth capital, to buy-out a partner or acquire a business. Typically, mezzanine debt carries a higher interest rate than senior debt and sometimes includes equity upside through warrants.
TL: Could you speak to the primary risks associated with these types of investments?
PS: You can almost look at us as a private company mutual fund. If you are going to dip your toes into private equity, this is about as de-risked as it can be because we are so diversified. You are going to have a piece of 250-350 companies around the country. It’s always hard for individual investors to pick the right fund. We are going to pick 25-30 funds for you. You are going to diversify the heck out of a $1 million investment.
RD: Entrepreneurs like our funds. They’ve been in situations where they need capital and have struggled with the increased regulatory nature and scrutiny of traditional banks. Entrepreneurs understand the value of our mezzanine product and its importance in the capital structure to support the growth and strategy of the business.
TL: What advice would you give investors in evaluating risk in a private equity fund?
RD: Make sure the fund has a real strategy and a proven track record. There are many private equity funds that have an eclectic mix with no proven strategy. We articulate exactly what we are going to do: invest in lower middle-market companies with resilient revenues with basic, understandable business models. Our track record supports this strategy.
PS: Our funds have a rule to limit any one investment to 15 percent of the fund. And we are big believers in being the first institutional money to go into a company. We see that the first big transformative chance to make money is when that first institutional money hits.
RD: The big risk comes when you invest heavily in an industry, which we don’t do. That’s why you need to look at the size of investments within the fund and the industry diversity across the fund. For example, we have a $180 million fund with our average investment of $5 million.
PS: You also have to ask how quickly you need a return. For example, a mezzanine fund like Northcreek’s is going to return quicker because it’s based on debt. We are based on equity.
RD: People also need to understand these investments are illiquid. We invest the money over five years or more. Through the investment period, you generally receive distributions but your core investment is long-term. That is not for everyone. Some people need the liquidity available with other investment options.
TL: It would seem you have a lot more flexibility in investing the capital of your funds. The downside of liquidity in public markets is you have to constantly be delivering the right message to the marketplace because you are judged daily, even by the minute.
PS: I think the private equity markets outperform the public markets over time because you are making the right decisions for the business for the right reasons. You are not judged by investments every quarter hitting numbers. What’s going on today doesn’t affect our business today. We aren’t going to buy or sell something because of the market volatility. It gives us flexibility in our funds to ride out the storm and do what’s best for the long term.
TL: When we invest in you (through Dovich), we are further minimizing client exposure. The tradeoff is lack of liquidity for potential higher returns. The higher minimums allow the marketplace to achieve higher returns than publicly traded markets. However, the key to determining whether these types of alternative investments are appropriate is a complete understanding of a client’s financial goals and objectives. Because of the risks involved, please consult your trusted advisory team before considering any of these types of alternative investments.
John D. Dovich & Associates is located at 625 Eden Park Drive, Suite 310, Cincinnati, OH 45202. For more information, call 513.579.9400 or visit www.jdovich.com.
John D. Dovich is a Registered Representative of Lion Street Financial, LLC (LSF). Securities offered through Lion Street Financial, LLC (LSF), member FINRA & SIPC. Investment advisory services offered through John D. Dovich & Associates, LLC. LSF is not affiliated with John D. Dovich & Associates, LLC.