In an effort to build an organic firm track record and to eventually launch a first fund, many independent (or “fundless”) sponsor private investment firms ramp up activity with direct deals.
It is often challenging for such firms to attain a maiden commingled fund at the outset, given the fundraising challenges that emerging managers may face; this approach often clears the path to firm growth and increased investor interest.
Some market participants intend to ‘roll up’ such single deals into a fund, but according to Jeff Collins, the managing partner and co-founder at Cloverlay, who spent many years at Morgan Stanley Alternative Investment Partners (AIP), there are some dealmakers in niche strategies who want to keep things simple and “club-up” — with no intention of ever building out the comprehensive and expensive infrastructure required to serve most institutional investors through a traditional private equity fund.
Indeed, not all strategies (or dealmakers) are conducive to fund structures and multi-year investment periods. Opportunistic special situations sectors aren’t always en vogue enough to garner substantial direct institutional interest, although profitable deals may fall outside the trend cycle and may move through such independent fundless operators before the broader marketplace takes notice upstream. For one thing, risk appetites and investment team bandwidth for assessing such bespoke opportunities may be limited in the institutional investing sphere.
According to Collins, entities or individuals doing deals that aren’t angling toward an eventual fund, have grown in number in the last 18-24 months and may become more prevalent as the current market picture evolves.
This interview examines the independent sponsor and direct dealmaking universe at this time, with a particular inclination toward investments that have a certain barrier to entry, given the often bespoke strategies and sectors that Cloverlay specializes in.
Vailakis: Welcome, Jeff. Thank you for agreeing to share your insights with Alternatives Watch readers. Please speak to what you’re seeing as we near the end of a year marked by COVID-19, market volatility and economic uncertainty.
Collins: Thank you for having me, Nancy. We appreciate the opportunity.
Given the spheres we inhabit, sifting through deals and funds in asset intensive, opaque or broadly misunderstood industry segments, we are seeing compelling investment opportunities in niches that in many cases have been flipped upside down, or in cyclical industries that have been boring over the last 10 years from the perspective of one looking to infuse capital. Many deals are coming from fundless sponsors — industry specialists that are sticking to their knitting and investing in what they know best. And what they know best just transitioned from being crowded and competitive, to being unexpectedly inefficient or misunderstood – and therefore compelling from a return perspective.
These players tend to be super specialized in one sector or sub-sector and are sometimes able to raise the needed capital more easily because of years building their reputation in a specific sector. Examples include non-performing loans in Brazil or wireless spectrum licenses here in the U.S. There is a wide variety of industry experts and investment formats to pursue these opportunities, so it’s a world where investors look to Cloverlay for help — to source, diligence and execute on their behalf.
Cloverlay’s investment platform targets the fundamental value of investments in tangible and intangible assets, and looks for positive skew, or an asymmetrical upside to total return. This return profile can help diversify private market exposures, capture a less correlated return stream, and provide investors meaningful downside protection.
Our approach is format agnostic: in opaque or inefficient segments, the goal is getting capital in the hands of an expert uniquely positioned to exploit the current era. Frequently, that can mean participating in a joint venture, building a new platform or co-investing with an industry insider, but sometimes the best approach leads us to back a small, niche-focused fund manager. We apply our value lens to a variety of verticals where the assets themselves are critical building blocks for larger companies or industries.
Vailakis: Why would an independent sponsor remain so by choice? Isn’t building a platform to take in larger tickets and a broader pool of investor monies (and therefore fees) more compelling if it can be achieved, as fielding every deal to one’s investor network has several pitfalls?
Collins: Well, think about the way carry is distributed. If a sponsor can actually assemble the capital for deals whenever they choose, they can avoid the long-dated, back-ended nature of the traditional European waterfall inherent in a fund structure. For fundless sponsors, carry gets collected as soon as each deal is realized, without waiting for other deals to mature.
Obviously, this reality can be abused in some cases — what should be a fund ends up being a series of one-off deals, if the well-funded fundless sponsor is in high demand. In most cases in our segments, however, an industry expert will have one or two deals within a five-year period. Our partner has completely bought into and focused on the deal we have invested in. We want to be involved in their main event — there shouldn’t be a portfolio equivalent of other deals running alongside us managed by the same partner. We think that fact pattern belongs in a fund format.
Also, I should point out, Cloverlay participates at the smaller end of the market for a reason: typically, size negatively impacts returns. We’ve only seen a handful of situations in the past 30 years where size was beneficial, and differentiating, where a single bid for a $35 billion portfolio led an operator to secure a very compelling deal that others simply couldn’t facilitate. We usually find that if deals are very large there are many more sophisticated eyes looking at it.
Now, on the other hand, chasing people in your network every time you need to close a deal is a daunting task. Initially enthusiastic investors can fall flat upon receipt of deal documentation. Quick turnarounds are often required. Deadlines may not be met. Potential investors get distracted or suddenly go dark.
We believe there are two sources of failure at play here.
First, for the sponsor, their capital network was not as reliable as they hoped. The deal is now dead, and the sponsor’s credibility may have been destroyed with her counterparty — all because the financial backers didn’t show up.
Second, from the investor side, we think very few LPs uphold their end of the bargain throughout the co-investment process. Did the investor communicate where they stand? What diligence items would change the probability of closing? Did the lack of an articulated process effectively burn the deal makers time? Most importantly, was the investor ever truly in a position – from a domain expertise and decision-making standpoint – to get this deal done on a timeline? Was the investor simply aspirational? One of our goals at Cloverlay is to help sponsors with the first point, and to deliver on all aspects of the second – this is why we get a number of deals done that most LPs may never see.
In our segments, there is quite a broad dispersion of quality among potential partners and operators. Unlike some other private strategies, partner selection skill matters – because there is usually no secular tailwind lifting all boats. Some institutional investors will choose to secure these less correlated exposures through a partner like Cloverlay — we sift through all the potential partners and business models, evaluate the behavior of strategic and financial players and assemble a coherent portfolio of 15-20 positions over the course of a few years.
Vailakis: Jeff, you like to play in spaces that discourage investor ‘tourism’ in the form of players looking to edge in on something they don’t know very well, at a time when nearly everyone is searching for yield or great buying opportunities. The sectors that have natural barriers to entry are more compelling for you. Please explain and perhaps give a favorite example.
Collins: Sure. One barrier to entry preventing a ‘tourist’ from entering our space is that frequently there is no dividend or yield in the deals we do. Instead, there is a multiple of capital focus over a period of years, and it requires patience. For our target assets, there is no EBITDA. There are no public comps for analysis or for increasing mark-to-market valuations along the way, so these line items may sit on the books at cost for a period of years. Meanwhile, value is being created, assets are being repositioned or repurposed — but given the nature of the niche, it will take a while for value to be reflected in the numbers. What is the value of an irreplaceable dark fiber network with only a few current customers? How will another owner with a relevant skill set enhance that value over several years? These factors are hard to fit or summarize within institutional portfolio reporting and interim monitoring assessments. As a result, these types of opportunities struggle to attract capital due to the delayed or lagged impact on performance, which typically is crystallized upon realization.
Vailakis: Over the last few years, I’ve heard a lot about avoidance of asset heavy deals in the lower middle market in anticipation of a downturn, as players didn’t want to find themselves ‘trapped’ in scenarios in which they were say, servicing an expensive car fleet in perpetuity with little upside. Many have been repositioning their portfolios for a while now. But you and your team are all about deals with real assets behind them. Tell us more.
Collins: We invest in tangible or intangible assets, generally on an unlevered basis, when things are confusing or misunderstood. Our industry partner is charged with repositioning these assets over time to create exit value. The entry point we seek is typically below intrinsic value or replacement cost. We look to hit doubles and triples consistently in our portfolio, and we believe this differentiated approach deserves a place on most investors’ balance sheets. As equity investors focused on total return, positive skew, and downside protection, we own something of real value no matter how the world behaves post-investment.
For example, in the case of our cacao plantation, the upside case is to create platform value as the largest producer of a popular commodity in a newly actionable, advantaged geography. But if floods happen, and blight occurs, and we picked the wrong partner, we are still able to sell cattle land on an unlevered basis to recover the majority or all of our original cost. That is the definition of positive skew, and that is why we focus on asset value, rather than EBITDA and growth. The tradeoff is that we never expect to make 7x on any deal. The value of a 747 freighter will never increase 7x. The way you make money for investors in that segment is to buy wisely, in a certain era, when others are scared, or have just been burned, or don’t understand the unit economics. Those results are generally in the 2.5x range, not 7x. So again, it’s all about where our approach and risk/return profile might fit within a broader institutional private portfolio.
Vailakis: Please speak to what is most interesting to you as you anticipate the next round of the investing cycle.
Collins: As asset intensive companies face a myriad of COVID-19 related problems, they are increasingly retreating to core to protect and continue to finance their primary business. We expect to see a number of individual asset sales in the form of shuttered business lines, corporate carve-outs, and peripheral assets that no longer have a home inside the larger corporate parent. Such deals typically need to get done quickly, they are so niche as to not have a viable investment banking community to create an auction, and so truly off-market deals can land in the hands of industry insiders.
As an example, over the past 20 years, rail companies have acquired storage facilities, railcar cleaning and re-lining operations, and everything else that is synergistic to their core offering. Those rail operators could be selling individual non-core assets on an iterative and rapid basis if we go into a heavy default cycle, as some anticipate. As we move into such a phase, we may acquire some smaller, well-positioned assets for less than the scrap value of the metal they are made of. That is what we seek to do at Cloverlay.
Vailakis: Thank you for sharing your current thoughts with the community, Jeff.
Collins: Thanks again for having me, Nancy.
