Episode 64: Todd Morrissey of Hidden River Strategic Capital  on Alternative Capital for Underserviced Companies

Episode Transcript  

Shiv: All right, Todd, welcome to the show. How's it going?

Todd: Going well, how are you? Thanks for having me.

Shiv: Yeah, excited to have you on. And so why don't we start with your background and about Hidden River and we'll take it from there.

Todd: Sure, that sounds good. So when I graduated college, we're going back to the late 90s, I took a very traditional route to private equity, started, did the traditional two-year investment banking analyst program, and then moved my introduction to private equity, spent a few years at a private equity firm before going back to business school. And when I went back to business school, had the opportunity, I intentionally avoided looking at private equity internships the summer between first and second year. And actually got an internship working in the office of the CFO for the NBA, the National Basketball Association, which I thought would be a really cool way to combine a love of sports with business. And it was a good summer, but at the end of it, as I reflected on it, what it really drove home for me are all the things that I really enjoyed about private equity and the things that make this career, I think, fun for all of us who get to do it. We get to see a variety of businesses, and we get to develop relationships directly with interesting people running good businesses, through the management teams that we partner with. And so that's really what I've spent, you know, 20 plus years of my career focusing on. And we'll lead into some of the story for how Hidden River came to be and kind of why we think we're a little bit different. When I graduated from business school in the early 2000s, I joined one of the larger private equity firms here in Philadelphia, we’re based in Philadelphia. And I spent 15 years at that firm, was a growth equity firm. So the underwriting mindset was equity oriented. But the businesses that we were focused on and partnering with were often management-owned companies. We were often the first institutional capital partner to these businesses. And so that really was more of the same in terms of what I talked about, about what I really enjoy about private equity. So I had a good 15 years doing that. And then when the time came for me to think about potentially launching a new firm, reflecting on some of the things I've learned in the first chapter of my career, if you will. And really one of the things that stood out to me was that a lot of the companies that we talk about, especially in the lower middle market, they don't necessarily care about the nuances that investors like to talk about. And by that, what I mean is, you know, a founder owned, guy who, man or woman who's built their business over the last 20 years, they don't really understand or care about the difference between a participating preferred security that has a clawback mechanism versus a strip of mezzanine debt that has a springing warrant, right? What they care about and what they're looking for is access to the capital they need to execute their strategic vision on reasonable terms that gives them the flexibility to do, to continue doing what they've done. And so, you know, that was really the realization and the thesis that informed Hidden River when I teamed up with my two co-founders, Steve Gord and Kevin Condon, they had come to a similar realization. The three of us saw coming from different angles, they came from more of a credit mindset and a credit shop. I was coming in from an equity mindset. But we saw the same opportunity in the market. And that's really what led to the formation of Hidden River. It takes a couple of years to get a new fund up and running and fundraising and all that fun. But we did hit the market beginning of ‘23, so a little over two years ago, with a 250 million dollar fund and we've got six portfolio companies today, a couple more under LOI and open to business and looking to grow the portfolio.

Shiv: Yeah, and it's a very different approach than I guess LLR where you were previously. That's a massive PE firm with much larger companies and just a different approach to investing overall. So talk about some of the more details of how you guys look at investments and how you're partnering with founders and providing them with alternatives.

Todd: Yeah, absolutely. You're right. LLR is now one of the largest private equity firms here in Philly and one of the larger growth equity firms. When I joined LLR earlier in some of the earlier funds, we were still investing in that lower middle market. And our definition of lower middle market is 10 on the low end, but really 20 to $100 million revenue businesses. We invest 10 to $20 million into these businesses to support their strategic growth objectives. The way that we come to market, I talked a little bit about my growth equity orientation and the credit orientation of my two partners. When we talk to companies, we are coming from a structured capital perspective, which is a term of art potentially. But what that means is we have the ability to invest in both debt and equity. And most commonly, we're investing in both debt and equity into any given transaction. And so what that means from the CEO or the management team's perspective, is when our first discussion with them starts with a focus on what's the business that you've built? What are your objectives for this potential transaction, both personal and business? What are the strategic objectives that you are hoping to achieve with our capital to grow your business? And what are some of the things that matter to you as an individual and as the person running this business? That really is for us the starting point that forms a collaborative discussion with the management teams of Okay, now that we better understand what you want to get out of this and your business model and all the things that we get to learn as investors, let's together craft the right capital structure for you. We're not coming saying, we have a growth equity product that we are going to sell you on and try and fit into whatever it is your plans are and or same approach with traditional private credit funds. We're starting with, tell us about your business. Tell us what you want to do. And then we have the flexibility to move up and down the capital structure, debt and or equity, lots of different provisions and mechanisms that get a little technical, but really are all geared towards aligning with what it is that the existing management team wants to do. And so the other thing that's different for us is, our preference is to partner with management teams who own their business today and who want to continue owning and running their business. So we don't have a mandate where we need to be a minority owner or we have the ability to be a control owner. But by and large, our preference is, you know, let's partner with strong management teams. They've done a great job building a good business. They want to do more of the same. There's a specific need for our capital in terms of a dollar amount. And let's partner with them and let them keep doing what they do.

Shiv: And so what are those options? Like a lot of founders listen to this podcast and even myself, I'm a founder that's bootstrapped this business. And when a lot of founders think about their options, they think about either a full exit or full buyout by an institutional investor or a strategic or getting debt, right? But what you're saying is there's a bunch of different options in between to help illustrate that. Like what are those different variations?

Todd: Yeah, no, I think you framed it well. Look, the capital markets are incredibly efficient. There's no shortage of capital in the economy and in the market here. But it's typically when you're an owner and you're thinking about where do I get capital, you're thinking the two bookends. There's the traditional equity markets. Could be growth equity, could be buyout, as you said, or traditional credit markets, which is really two forms. There's the commercial bank market. And then there's increasingly private credit funds. What lower middle market, in particular the market segment that we focus on, what those investor or what those management teams often think is, hey, I either need to sell my company to a private equity firm, but I don't know if I really want to do that. I've got more in me. I want to keep running my business. So I'm not really interested in a buyout transaction. And if I'm talking to a growth equity firm, I want to own as much of my business as possible because I really believe in the thesis I'm going to be building. I don't want to you know, give up 30, 40, 50% dilution to a traditional equity fund. And likewise on the other side, you maybe they can't get all the availability and all the capital they need from a traditional commercial bank. You know, lower middle market businesses, right? There's often a story to it. They might not be able to get all the capital that they need. And then frankly, we also have a lot of discussions with management teams who are just skeptical of private equity and the term private equity in general. So, you know, our starting point of that discussion of, we're little bit different in terms of our approach. Look, we're investors, right? We ultimately want to partner with teams and get returns for our investors. And that's ultimately the business that we're in, but there's different ways to approach it. So, you know, for us to come in and say, we don't have a preconceived notion of whether you should have debt, whether you should have equity, what it looks like. You tell us what your hot buttons are, right? Do you care more about dilution? We can craft a more credit oriented investment solution for you. Do you care about flexibility and limited covenants and, know, okay, well then we can have maybe, you know, a little bit more of an equity or a flexible type of solution. So it is a different approach than, and oftentimes what we hear from the teams that we talk to is, hey, that's pretty refreshing. And, you know, it also, there are times when, you know, an intermediary or an investment bank may come to us and say, hey, this business is raising this much equity for these purposes. And we say, we can do that. But wouldn't it be better for them and maybe better for the company if we thought about this a little bit different? And that also is, I think, a breath of fresh air for a lot of folks.

Shiv: Are you seeing a lot more companies take on debt as an instrument with the way the macroeconomic environment has gone over the last couple of years?

Todd: I think the segment of the market that I focused on, the products, the solutions that we're bringing, the structured capital debt and equity solutions, it's a little bit less tied to the traditional cycles, interest rate cycles and debt cycles. The supply demand imbalance for the market segment that we're going after is sort flipped in the favor of the investor. There are literally thousands and thousands of lower middle market companies who could productively use capital that, and there aren't a whole lot of firms or solutions or firms willing to target those firms. And so what that means is to a certain extent each investment opportunity is case by case basis. Certainly, in times where there's significant credit availability, if a company has the ability to go get all the capital they need at SOFR plus 300 from a commercial bank, that's going to be their best option subject to understanding what the covenants are. But oftentimes, maybe the cash flow dynamics don't support that, or maybe the covenants, and maybe they're looking for a strategic partner to provide more than just the capital, and they want somebody who can help them and advise them and guide them. I would say in our discussions with those kinds of entrepreneurs, people who've built and want to continue owning and running their business tend to be a little more sensitive to dilution. So to your point, if it's available and if it makes sense in the capital structure, I think they are going to tend more towards, let me get that in the form of debt that I know my business can service rather than giving up the upside from additional ownership.

Shiv: Yeah. In those instances, do you find, especially I'm looking at some of your investment criteria and you're looking for companies with 30% plus gross margins and positive EBITDA and things like that. So those kinds of companies have enough cashflow to fund growth and initiatives that they might want to bet on. So it's the additional capital for bets that they cannot fund from their growth and ongoing operations, things like acquisitions or okay.

Todd: Exactly. That's exactly right. You know, a company that has sufficient cash flow to support its own operations, you know, they're not, they're not going to be calling us. They're not going to be interested in us. Where our discussions start is usually, again, founder owned management owned companies. They built a really nice business and all of a sudden, you know, maybe there's an opportunity to buy their competitor down the road and they could, you need eight to 10 million bucks, but they don't have that on their balance sheet. And while they're at it, maybe I could hire a few salespeople. Maybe there's an opportunity to expand into a new market. And maybe as an owner, I want to put a little bit of money in my pocket and I'd like to diversify my network. So that's usually the impetus for, hey, I could really productively use 10 to $15 million to do some really interesting things to my business that I can't do based off of my own balance sheet. And again, I don't want to go sell to a private equity firm. I don't want somebody coming in and taking a whole bunch of ownership and, you know, calling my baby ugly, if you will, and pointing out all my mistakes and telling me how to run my business. I built a really nice business. I want to keep doing what I'm doing. And I'm looking for a capital partner that can help me kind of accelerate the growth with the opportunities in front of me. The most prototypical transaction and the most common deal that we would do, again, is in that $10 to $20 million investment size. It's going to be a mix of debt and equity. And the use of proceeds often are a specifically identified growth opportunity, often an acquisition, maybe a little bit of a recap, you know, minority recap to the management team. And oftentimes, there may also be sort of a cap table cleanup in the sense of if there were friends and family investors who initially invested or there's some passive investors who want to, you know, be taken out, we're open to that as well.

Shiv: Interesting. What about, and just help me understand the kind of profile of companies. you investing in service-based companies, tech companies? Like, is there a specific profile that you look at?

Todd: Yeah, so our, a couple things. One, our focus of hybrid debt equity direct to company direct to management, right? We're not sponsor finance. We are the institutional capital partner to these businesses. You know, those businesses are hard to find. And we'll probably talk a little bit about, you know, some of the things that we have to do on that end. But, you know, because of that, we don't want to narrow the scope too much, right? We are not specialized on any specific end vertical. So the way that we think about at the highest level of our strategic focus is really driven by business model and transaction dynamics. And you mentioned it before, service-based businesses, that's the highest level screen. We focus on service-based business models. That's pretty wide, right? There's a lot of segments of the economy that can be service-based. When we drill down a little further, you touched on, we're looking at the unit economic model, the gross profit margins of the business. Are they cashflow sustainable? We want our capital to be going to enhance and grow an existing business. If a company needs capital to fund operating losses to get to that next level, we're probably not going to be the right partner for that. But those are the kinds of dynamics. It's service-based business models. And on the transaction dynamic, again, I keep coming back to it because it's core to where we focus. We're partnering with management teams. want to back their existing strategy. And we want management teams that want to continue owning and running their business and are looking for a capital partner that lets them do that.

Shiv: How do you look at innovation? Inside a lot of these companies, especially if they are service-based or let's say even just high gross margin and have cashflow or generating positive EBITDA and they want to invest in a certain area, like acquisitions are more on the nose and easy to kind of figure out at least like here's the enterprise value of this entity we want to buy and kind of underwrite that investment. But innovation is a little bit different than that, right? Because there's more risk involved. So, but at the same time, a lot of these service-based businesses would have innovative areas that they want to invest into, but may not have the capital or see it as like a distraction risk on their current cash flows of the business. So how do you underwrite something like that?

Todd: We typically, if kind of what you're getting at is, more software or tech businesses or tech enabled service companies that want to invest in growth capital for R&D type purposes. To a certain extent, that's the primary utilization of capital or the primary reason for a deal. That's probably not going to be for us. Where we focus within those service-based business models that we focus on are things like distribution companies, logistics companies. We have some commercial B2B business services companies. These are companies that are not, they're certainly tech enabled. They're certainly utilizing technology. And we do have, you know, a couple that we're looking at now that also have some proprietary technology that they're using as their service offering. And we would, you know, invest in those all day long. If it's a situation where, we've got, we're, you know, we've got the next great innovation in technology, and we've got a big R&D and a bunch of developers, you know, if that's a big part of the thesis. In part, that's not really what our capital is used for, but that takes an expertise in my experience that I don't know that we necessarily have in order to go in and understand why this particular technology product is going to be better than some of the other innovative things. There's certainly a healthy market for that and that venture capital type of thinking. There's a lot of experts who are very good at that. We're at a different level of focus in terms of where we play.

Shiv: And so that makes a ton of sense because the risk profile of something like that is quite uncertain, right? You don't know if you deploy a million dollars here, what you're going to get back. So I totally get that. How do you look at your exit path or your return on these investments? Like, is there a time horizon or are you happy to continue partnering? Obviously, if there's a debt component, you have an ongoing rate of service that you're getting back. But if there's partial equity involved, like, how do you look at that, the return on that?

Todd: Yeah, I would say almost all of our deals are going to have, well, 99% of our deals will have a debt component. We do have the ability to invest in all equity, but our typical target would be in any given investment, probably two-thirds debt, one-third equity, somewhere in and around there. And again, we've done deals that were 100% debt, and we have the ability to do 100% equity. So you're right. In terms of an exit horizon, there is going to be a maturity date on the debt. But the way that we think about it, you know, our companies often describe us as, you know, a flexible lender with an equity mindset. And so what that means for us in terms of thinking through time horizons, like every, you know, uncreative private equity firm, we underwrite our business models and our, you know, the models that we do, we underwrite to a theoretical five-year hold. We ultimately do need to get liquidity back to our investors. So we do have the appropriate liquidity mechanisms. But if somebody comes knocking on the door in year two or three and there's a good value on the table and management is aligned,that now is the time to sell and it makes sense for everybody. We'll be open to that. We're going to take direction from our management team. Similarly, you get to the end of that five-year period. If there is additional runway and growth opportunity and value creation opportunities that exist and there's an opportunity for us to continue supporting those businesses, we'll do that as well. We don't have, any other than obviously within a fund construct, getting back liquidity to our investors, we need the mechanisms to do that. But that's going to be more on a case by case basis. There will be a maturity date to the debt. Oftentimes, that is a trigger for either a liquidity event for our equity as well, or a discussion about that equity piece and how we get liquid on that. But we try and be responsive to each situation. And it's largely going to be driven, again, if we're partnering with and relying on our management teams to continue doing what they're doing, executing and creating value. They're often the best barometer for when's the right time to think about exiting.

Shiv: And is that five year time period the amount of time you're taking or you're assuming that your debt will take to get paid back?

Todd: Yeah, so I mean, typical five or six year type term debt, our debt is all is usually I don't want to say 100% of the case, but it's cash flow friendly in terms of no amortization. Obviously, there's going be an interest rate period on it, we prefer, or an interest rate term on it. We prefer cash flow that gets generated by these businesses, invest it back into the business and invest in the growth of the company and the value creation of the company. But typically it would be a five or six year term on our debt.

Shiv: And then at the end of it, like, so once you have that one third component of equity, you have less of an expectation on that to cash out over that five year period. If it happens, great. Otherwise you're happy to kind of stay as a partner.

Todd: We can and then ultimately, you if we're in a minority equity position, obviously there's, you you need to be from an investor, a fiduciary standpoint, you need to make sure you have the mechanisms to ultimately get liquidity and, you know, that's going to be again a collaborative discussion with our management teams, but that's right.

Shiv: Yeah. Do you see founders and entrepreneurs kind of taking on this type of a model? Like it definitely can be freeing because you can do certain things that you wouldn't be able to do with, without a financial partner. But some of these avenues, then the entrepreneur is kind of taking on the risk of betting on the company all over again without a true full equity financial partner. And so that's kind of the trade off between those two extremes, right? Whereas if you have like a full buyout fund or a true equity partner, you have this, you don't have this looming debt that you are on the hook for that you kind of have to pay back. How do you see that trade off?

Todd: Well, I think that trade-off really only exists between if you're talking about a pure growth equity fund that invests 100% equity, because almost every business, when you get to a certain scale, is going to have debt on it. mean, buyout firms, they don't fund buyouts with 100% equity. There's debt that the company or the investors will have to refinance out. And I think we're in a very similar mindset, a very similar situation. The way that we think about and go to market and talk to our management teams is, hey, we're a private equity firm just like everybody else. We've got capital. We want to support our businesses with capital. And whether the right solution for that is a debt security or an equity security, we can do any and all of it. So yes, to the extent there's debt that needs to be paid off because there's a maturity to it. But I don't think that's all that different from most middle market businesses who take on a financial partner, unless it's, again, a pure equity partner.

Shiv: Right. So yeah, I guess what you're saying is a traditional or buyout fund would buy it in the form of equity, but then they're going to partner with the bank to raise debt to actually fund the transaction. In this case, you're kind of doing both.

Todd: We're doing both and we're doing it in a much more flexible way because I think a lot of times the equity partner may say, hey, I'm bringing the equity capital to do this transaction and I've got a commercial bank that's going to put three to four times debt on the business that provides additional capital to help fund the transaction. The terms and the covenants and the lack of flexibility that typically comes with that three to four terms of debt that they're going to be bringing on, even if it's not coming from them, is a lot more onerous than the discussion we're having again because we are lending to the business, but we're also an equity investor and a partner to the management team. So we're wearing that hat as well.

Shiv: Yeah. And I guess the other trade-off is that in the instance with you, the founder is actually still in charge or still running the business with control. And so there's more options. Whereas in the other instance, like the PE fund is the owner and they're kind of directing strategy in a lot of ways.

Todd: Yeah, that's a huge difference to the extent, and I don't want to paint the private equity industry in general with one broad brush, but to the extent, other firms take an approach of coming in and saying, hey, Mr. and Mrs. CEO, you've built a nice business here, but we've got it from here and we're going to give you a bunch of money and then we're going to kind of direct the operations and we'll kind of help get you to the next level, so to speak. That's what you hear people often talk about. There are firms that are very, very good at that and they have resources. We are 180 degree from that approach. Our approach is you've built a really nice business. We want you to keep doing what you're doing. We understand that if you had some access to capital, could do it. You could do the same great things you're doing on a bigger scale. Let us help you do that. But you are, you we want to be executing your strategy and your plan. So again, that first discussion we have with them is to really understand their vision and their strategy for where they want to take the business, not because we want to poke holes in it or help them change it. But because if we agree with that strategy, we want to partner with you. If we don't, we don't really see it as our job to tell them that they need to change their strategy to fit what we think as an investor. It's a nuanced difference, but when you get in front of an entrepreneur, it's a pretty big difference.

Shiv: Yeah, I guess it also opens up a big part of the market that is, I would say, I don't want to say undercapitalized, but underserviced by institutional investors. I think there's like a whole market of great companies that are growing at reasonable rates that are profitable, that just never crossed the desk of a full buyout fund because either they're not big enough or not profitable enough or not growing fast enough, but they're good businesses and they exist in every city. So do you find a lot of competition as you're coming into some of these companies for capital?

Todd: Yeah, you're right. And I talked about it before, right? You got very established bookends of the market, traditional growth equity and buyout, and you got private credit. And those are largely larger companies. And you've got thousands and thousands of companies that have either haven't hit the radar of those segments of the market or have voluntarily opted out of it because it's not what they want. And so that is the market that we're going after. And it is relative. Again, the market is very efficient. But in terms of a segment of the market, it is largely underrepresented relative to those other bookends. And so we're certainly not the only firms doing it. again, that supply demand imbalance is almost flipped in favor of the investor when you think about the number of, to your point, good companies, solid business fundamentals, strong management teams who just could productively use capital that they're not going to those bookends. The number of those companies relative to the number of firms like us is flipped. And it's a better market to be going after in our estimation and is really the reason why Hidden River was formed. But it's hard to find those businesses as well. If they've opted out and we're not in the business of let's call up our 30 best equity buyout firm relationships and have them send us their deal flow so that we can help support, provide debt to support their buyout. That's not what we're doing and we're similarly not in the, you know, the sell side business of, you know, call up the top 50 regional investment banks and say, send us your books when you're sending out, when you're sending out, you know, 50 books, we want to be book number 51. So finding these companies is difficult and it takes a commitment to kind of understanding the market opportunity and then being willing to kind of roll up your sleeves and, and do the work to find them and then structure them.

Shiv: Yeah, this is more of a meta question, but why is it that private equity ignores companies like this? Because I feel like in every city, there's so many quality companies that are profitable, that have recurring revenue or a loyal customer base, and there's good retention, but it just doesn't look like the premium asset that everybody's kind of competing for that's software and B2B and has high LTV, you know what I mean? And why is it that not enough capital is chasing some of these other companies that are kind of the bet on which a lot of economies are built and there's like hundreds of these companies inside every city.

Todd: I think to a certain extent, I mean, you alluded a little bit to it. There is sort of a trend or not a fad, but sort of a momentum play in investing, right? I mean, software has been hot in sectors get, you know, hot in terms of the growth and the opportunities and the number of companies that are raising capital. I think also, you know, private equity, again, I think is an incredibly efficient model. But I think a lot of firms, if you build, if you raise bigger and bigger funds, the deployment of the capital becomes very important. And that segment of the market that we are going after, the deal sizes are going to be smaller. The certainty of a deal getting done is lower because oftentimes the companies that we're talking to, they're not even sure if they want to raise capital. They think they could use the capital, but they're not sure. There's no deal on the table. There's a lot of education and discussion and back and forth. And so if you just think about, you know, private equity firms that are sitting on a lot of money that want to deploy it and they want to deploy it into good investments. There are more efficient channels, if you will, to go find deals that are on the table. If I get a book from a regional investment bank, I know there's a deal that's going to happen. And then I'm picking and choosing of the deals that I know that are going to happen. Where do I want to be most competitive? I know I'm spending my time on something that is going to happen. Hopefully it's on the terms that I want and I win the deal. That end of the spectrum that we're focused on. You know, it's a lot more work and it's a lot less certainty and the check sizes are smaller. And so that's another thing, frankly, when we built Hidden River and launched Hidden River, I mentioned before, we're a $250 million fund. That fund size, I think fits really well with the segment of the market that we're going at. You can efficiently deploy and build a nice diversified portfolio writing 10 to $20 million checks. If we had raised a billion dollars and had to write 100 to $200 million checks, you're almost forced to move up market. as fund sizes have gotten bigger, you almost have to look at bigger companies.

Shiv: Yeah, that's a really great insight. Yeah. And there's way more funds that are a billion plus than less than 250 million. And so you have that part of the economy that's a little bit underserved. But I do see this trend changing. I've seen more PE firms emerge that are looking at business services or home services and those types of companies that are profitable and recurring and in a different market. So it's interesting to see the way you guys have done it. That's a lot of great insight, Todd. If there's a ton of founders that are listening, if they want to get in touch with you, what's the best way for them to find you?

Todd: Well, the best way, I mean, you can always call and all of our contact information is on our website, but hiddenrivercap.com, H-I-D-D-E-N-R-I-V-E-R-C-A-P.com is our website. All of our contact information is there. We obviously enjoy hearing from and having lots of conversations. And as I just alluded to, it doesn't have to be around, hey, I'm raising capital. Is it a fit for you? It can be, I heard something or I've got this question. We often are kind of brainstorming with folks and happy to be a sounding board. And if a partnership comes out of it, great. And if not, you know, we're in the business of trying to support entrepreneurs, whether they're in our portfolio or not.

Shiv: That's awesome. And we'll be sure to include all of that in the show notes along with your website and other contact information. With that said, Todd, thanks for coming on and sharing your wisdom. I think a lot of the founders and even investors listening probably got a lot away from it. So thanks for doing this.

Todd: Absolutely. I appreciate the discussion. I enjoyed the time. Thanks for having me.