Episode #489: Steve Klinsky, New Mountain Capital – Private Equity Titan

Episode #489: Steve Klinsky, New Mountain Capital – Private Equity Titan

 

Guest: Steven Klinsky is the founder and CEO of New Mountain Capital. Mr. Klinsky was co-founder of the Leverage Buyout Group of Goldman Sachs & Co. (“Goldman”) (1981-1984), where he helped execute over $3 billion of pioneering transactions for Goldman and its clients.

Date Recorded: 6/28/2023     |     Run-Time: 52:58

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Summary: In today’s episode, Steve shares how the private equity industry has evolved over his career to go from a focus on financial engineering to a focus on building businesses. Then he talks about the opportunity today in private credit and what the key drivers are to helping businesses grow and generate returns for both the employees and his firm. He even walks us through some real deals, including his sale of Signify Health to CVS earlier this year for a whopping $8 billion.

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Download a copy of YCharts’ latest white paper taking a deeper look into the performance of various portfolio allocation strategies and asset classes during the four most recent rate hike cycles.

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Links from the Episode:

• 0:39 – Sponsor: YCharts
• 1:23 – Intro
• 2:15 – Welcome to our guest, Steve Klinsky
• 2:44 – Steve’s involvement in private equity and LBOs early in his career
• 8:09 – Private equity’s evolution from financial engineering to business building
• 13:28 – The holding period for investments at his firm, New Mountain Capital
• 18:45 – Continuation funds offer flexibility to hold investments for longer periods
• 23:27 – Steve’s framework for deciding what sectors to invest in
• 24:13 – Steve’s case study in Harvard Business Review
• 26:56 – Why Steve is excited about the opportunity in private credit today
• 31:55 – Feedback from portfolio companies on the state of the economy
• 37:36 – What does Steve disagree with most of his peers about?
• 43:27 – How to assess a manager’s skills in building businesses
• 44:59 – Steve’s most memorable investment
• 46:31 – What excites Steve about the future
• 47:54 – Steve’s involvement in education charities and charter schools; Episode #260: Joel Greenblatt, Gotham Asset Management; modernstates.org
• 50:43 – The best ways to think about teaching personal finance
• 52:25 – Episode #482: Meketa’s Steve McCourt & Primark’s Michael Bell – Democratizing Private Equity
• Learn more about Steve: New Mountain Capital

 

Transcript:

Welcome Message:

Welcome to The Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing, and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer:

Meb Faber is the Co-Founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions, and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.

Sponsor Message:

This episode is sponsored by our friends at YCharts. As Federal Reserve rate hikes continue taking center stage, financial advisors and their clients are naturally worried about the state of their investments. That’s where YCharts steps in. YCharts just released their latest Y paper, taking a deeper look into the performance of various portfolio allocation strategies and asset classes during the four most recent rate hike cycles.

Get answers to questions investors and advisors are grappling with to help you make smarter investment decisions, and navigate these dynamic market movements. Download a copy with the link in the show notes. If you haven’t signed up yet, with a 20% discount that’s special for listeners of the show, what are you waiting for? Click on the link in the show notes or visit go.ycharts.com/meb2023.

Meb:

Welcome podcast listeners, we’ve got a fun episode today. Our guest is Steve Klinsky, Founder and CEO of New Mountain Capital, a private equity firm with about $40 billion in assets under management. Steve began his time in private equity before it was even a thing. He Co-Founded Goldman Sachs leveraged buyout group back in 1981. Today’s show, Steve shares how the private equity industry has evolved over his career to go from a focus on financial engineering to a focus on building businesses.

Then he talks about the opportunity today in private credit. He even walks us through some real deals, including his sale, Signify Health to CVS earlier this year for a whopping $8 billion. If you’re a new listener to the show, go subscribe to the show on your favorite platform, and be sure to set it to download each episode so you don’t miss any of our fantastic shows coming up this summer. Please enjoy this episode with New Mountain Capital’s, Steve Klinsky. Steve, welcome to show.

Steve:

Thank you. Thanks for having me on the show.

Meb:

Where do we find you today? I’m looking out your back window. Is that the Empire State Building? Where are you?

Steve:

I’m in my office in New York, and you’re looking out towards the Hudson River, where Sullenberger landed at his plane to [inaudible 00:02:31].

Meb:

Am I looking at a little Canadian wildfire, cloudy situation?

Steve:

Well, you never know in New York City, if it’s Canadian wildfire or just normal day. But, I’m here in New York.

Meb:

Well, I’m excited to have you today. We’re going to talk about a lot of stuff, private equity, LBO, credit. But I want to rewind, and here’s the intro prompt for you, you got your start when, I’m assuming, LBO and private equity… Was that even a phrase? Did they call it that at that time? What was the-

Steve:

I’m one of the original private equity people walking around. I came to New York on October 1st, 1981 when interest rates were 15.84%. Mortgages were 20, the tenure treasury was 15.8, and they were called going privates or LBOs. The whole idea was just starting. I was Co-Founder of Goldman’s original private equity group.

Meb:

The reason I say that is, let’s see, my high school was named RJ Reynolds High School in Winston-Salem, North Carolina, and I definitely got to experience some of the… I was young, so didn’t really quite know what was going on, but definitely heard about the Barbarians at the Gate, and all of the newspaper headlines were about that world. It was definitely foreign to me at that time. But did you ever have any involvement in that particular transaction, or was that too early, a different group?

Steve:

I’m very famous. I’m on page 259 of Barbarians at the Gate. I was a young partner at Forstmann Little, and Ross Johnson comes in to see us, who was the CEO [inaudible 00:04:14] was, “Should we do the deal or not do the deal?” Ted Forstmann, I interviewed him. Ted Forstmann asked me later, what do I think? I said, “I think he’s totally insane,” and I leave the book. So, that’s my one quote. I actually spent about four months working on it. My firm, Forstmann Little, was the second-biggest firm in the world to KKR, at that time. So we took a very hard look at it, and decided not to bid. But I’m happy I didn’t say, “Pay any price, use reset notes,” or a bunch of other things. But yeah, I did live through that. I’ve been involved ever since ’81, in the whole growth of the buyout.

Meb:

By the way, a quick aside before we dig into private equity, when you talk to the younger cohort today, who really only lived in this very low interest rate world, and they start moaning about 5% mortgages, do you sit there and say, “Listen, kid. 5%, people still bought houses when they were 15 and 20.” How do you react to that?

Steve:

I do point out that 4% tenure treasury are not the highest in history and that, literally, the highest interest rates in history were the day before I started work. What happens in this environment, I also grew up through 13 years of stagflation. The stock market was lower in 1981 than it was in 1968. The 70s were kind of a lost economic decade. I was trained in inflation accounting, and all sorts of things growing up. So this is, by far, not the worst economic conditions.

Meb:

Private equity, extremely well-established strategy asset class today. But rewinding 40 years, what did the world look like then? I’m here in LA, so Michael Milken still has a big presence. It’s now because he’s a philanthropist and holds a conference, that he’s, famous for, every year. It’s long forgotten Drexel. But what was it like in the early days, as this industry began?

Steve:

Well, I was Michael Milken’s sworn opponent back in the 80s. I’m friends with him now, and go to the conference, and he’s become a good philanthropist, and doing some good things. What you have to remember is that, in 1981, when the interest rates were so high, the P/E of the stock market was under 10. When I used to sit in the Goldman Merger Department, we would say, “What would a company sell for with an acquisition premium?” 10 times net income was a full acquisition premium. A lot of companies are trading at six or seven times net income. Interest rates were extremely high.

What you had was, after the original recession where Volcker broke the back of inflation the same way Powell’s trying to prevent inflation, and Reagan was involved with that. You had a bull market that started right around ’82 or ’83 that, in one sense or another, has kept going all the way. But back then, there were only 20 private equity firms in the world. I’ve just finished being Chair of the private equity industry, which now has 5,000 firms. The biggest firm in the world at that time was $400 million with KKR, [inaudible 00:07:19] Mill had $220 million of assets under management, compared to Blackstone was $1 trillion, or something like that today, or close to it.

So, it’s totally changed. What has really changed though… The big message I try to get off is, back in ’81, it was about risk creates return, use a lot of debt, because you had a lot of inflation. So if you had 95 parts debt, and 5 parts equity, and 10% inflation, you could triple your money in a year with no unit growth at all, no management skill. Then, as interest rates went down and the stock market went up, you had a lot of wind at your back. Over the 40 years, it’s totally changed, in my opinion. When I talk about New Mountain, my firm today, we talk about it as a business that builds businesses. Where Forstmann Little had eight people when I left, my firm has 225 team members. It’s a form of business today, not a form of finance.

Meb:

Let’s dig into that a little bit because I feel like, if you were to say the words LBO, private equity, the media has a very specific view of what that means. Often, I think they believe, this group’s coming in, they’re firing everyone. It’s like the Raider mentality, Carl Icahn, that’s that seems to be the picture of the comic book, almost, description. But what does it mean to you guys, because you guys practiced it a little bit different maybe than industrywide. But you can give us, what does the industry look like today versus what do you guys specifically look at differently?

Steve:

Again, I think private equity, properly done, has evolved from a form of finance into a form of business. So, take on the job creation number. I think people still think of the old movie Wall Street with Michael Douglas on a giant cell phone at the beach, and they don’t know a hedge fund from a private equity fund. Again, my firm, we’re not a hedge fund. We don’t trade in and out of stocks. We have private equity and credit. But in private equity, we are the owner of the business, we have operating partners.

We track things like job creation. We’ve added or created over 60,000 jobs, net of any job losses. So we’re not in there slashing jobs, we’re building businesses. We’ve had $79 billion of enterprise value gains, and we haven’t had one bankruptcy or missed interest payment in the history of the private equity firm. We do a social dashboard every year and update it. It’s on our website. You can go back year-by-year and track the job creation.

But what it really is, I wrote a big article on Harvard Business Review last year, about a company of ours called Blue Yonder that Harvard Business View printed as a case study of how private equity can build businesses. A company like that started as a little $600 million company called Red Prairie. We turned it into the world’s leading supply chain software company. We added artificial intelligence to it four or five years ago, before people were talking about it. We sold it for $8.5 billion dollars to Panasonic after a seven or eight year hold. That’s what private equity is today, and I can go through lots of other studies.

Meb:

It feels like it has to be because, if you look at the evolution, and we think about this a lot with what we would consider to be sources of alpha. So looking back over the years, you have something that, probably in the 80s and 90s, the reason it went from 20 firms to as many as it has today, and the massive AUM is these great returns. These outsized returns, they draw competition, and this alpha from purely the arithmetic of how people worked that business.

Once you start adding dozens and hundreds of firms and gazillion dollars, it has to become a true alpha-generating value-add source. That seems like the way it is to me, because most of the academic literature, if you wanted to just get the average private equity manager, well, you probably don’t want that anymore. The people always talk about, you want to be in the top quartile, or half, or whatever it may be. So it would seem, presumably, that a lot of the value-add would come on the actual work you have to do, as opposed to just the financing transaction. Do you agree, disagree? Does that sound about right?

Steve:

Well, I agree. One thing I would say is, all the statistics I’ve seen is that even the average private equity fund has outperformed public equities over 1, 5, 10, 20. Public equities have obviously outperformed government bonds. Which last year was, I’m told, the worst year in government bonds, long-term bonds, since the Napoleonic Wars. Private equity did much better. So, that’s the average fund.

There is a much wider dispersion to returns in private equity than there is in public equity management because it is a skills-based game. It’s like restaurants. People say, “What is private equity like?” It’s like saying, “What is a restaurant like?” You have everything from Le Bernardin to the Bodega with Ptomaine poisoning, because it’s up to the people who run the firm. Which, what it really is, private equity is a form of governance where we’re empowered.

A firm like New Mountain is empowered with capital. We are given years to put it to work. We get to choose the industry, choose the management, choose the strategy, get involved in any issue we want to get involved in and show, at the end of the day, that it was wise to trust us, and that takes years to develop that trust with your LPs. But good private equity really is value-added.

So a company, some of your listeners might know about it, that trades on the stock market today, is a Fortune 500 company, it’s a business called Avantor. We bought it originally, around 2010, for $290 million. Today, it’s worth over $20 billion. It was going to be a discontinued division of Covidien company called JT Baker. We renamed it, made it an ultra-purity life science supplies. It’s now, after Thermo Fisher, one of the two biggest companies in the world in lab supplies, and so forth.

None of that would’ve happened as an orphan division within a big company. So it’s industry selection, it’s the ability to run things privately where you’re not under 90 day pressures. Totally, rationally, you can attract better management talent if they’re not just a division manager. This is really their company. They really have ownership and focus on it, and you can just do things better. So I ultimately think it’s a form of governance.

Meb:

When you invest in a company, what is you all’s mandate on how long you’re going to hold these? Because traditional, when I hear private equity, in my mind it’s like, “All right, you got a seven-year clock that’s running for this fund. You either got to sell it, you got to do something with it.” But you guys often, in some cases, tend to hold these companies for longer periods. How does that work at your shop?

Steve:

At our shop, our investment questions that investment approval committee have never changed. We’re now a 23-year-old firm that’s gone from zero assets to $40 billion of assets. So we always ask two questions in Credit Committee. One, is it safe? Do we really think we can get our money back, hopefully with a double, even if the world is bad? I can talk about how we try to do that. Two, do we really think we can make a 30% gross return or better if we achieve our plans? That’s what we’re trying to do to approve a transaction. The normal holding period we show on our computer runs is as soon five years, and some are out sooner and some go longer.

One thing that’s happened to the whole private equity space in the last three or four years is a concept of continuation funds where, let’s say you’ve had companies and they’ve run their full lifespan, but they still have a chance to double or triple again over the next four or five years, there’s now the mechanism of continuation funds where LPs can get cashed out at the mark, or they can keep going with some fresh LPs who want to go longer. So, you have the option. On the ones that deserve to be held longer, there’s now a way to hold those longer with your LPs consent. But the computer model is based on five years, normally.

Meb:

You mentioned briefly, and we can dig in here on, all right, we’re going to make this decision to invest and we want to be conservative that, even if it goes bad, we’re going to try to make a return. I’d love to hear you talk some more about that. Within that, how much harder has the sourcing and deal-making become now that there’s so much money and so many competitors? I imagine in the early days you could probably find the enterprise value, the EBITDA companies, trading really low. It’s like you would have to almost muck it up. Now, I imagine the valuations have increased. Maybe talk a little bit about how you view that challenge.

Steve:

Let me talk about what company we’re looking for and how we set it up, and then turn to how we source it. We’re very focused on protecting downside while going for high upside. I’m not going to give my returns ’cause I don’t want to be accused of marketing on your show. But, that’s what shooting for. The safety factor comes from a few things. To me, one of the great, great luxuries of private equity is you get to choose what industry you want to be in for the next 5 or 10 years.

My grandfather and grandmother had a store selling winter coats in Detroit, and I grew up in a family business. One of the great luxuries, I don’t have to be standing in a store in Detroit selling winter coats in the mall. I get to be at life science supplies, or digital engineering. We’re the biggest manager of wind, and solar, and EV charging station. Number one, you can pick an industry that’s good for the future. You’re not stuck in aluminum smelting for your entire life. Because almost no industry stays good forever. Most companies have their time in the sun, and then it gets very hard.

One, we could always be there for the right time. Two, a firm like mine usually only uses four times debt to EBITD on average, as we buy something. Much, much lower debt levels today in private equity than there were back in the early 80s, in the original days of private equity. We’ll talk about our… We have a $10 billion credit arm as well. When we lend to those type of companies, we’re usually under 40% loan to value, where the private equity sponsor is putting in over 60% with his own money, and we’re the senior 40%, and we’re even more conservative than a normal private equity firm when we buy, and sometimes use no debt at all. So it’s not about levering up a bad industry and hoping things work out.

Three, most debt today has no covenants except to pay the interest. So you don’t get triggered by a weird reporting rule, and you have time. If there’s ever a problem, which does come up periodically, we have a team of 225 people, we have 35 full operating partners on our staff, and 40 others that we call on. Plus, we employ 67,000 people. Or more than that, actually, it would be one of the largest companies in America if were a single company. And, we can put an operating skill. So, that’s how you protect the downside.

The upside is, as you’re buying these businesses, besides whatever growth plans they have, you have your own plans of, we normally buy a $500 million size company that a founder might have built, or a division that was a forgotten division. The founder may never have built his Salesforce, may never have done an acquisition, may never have taken his company around the world. There’s usually so many things that even a good founder hasn’t done, or a good little niche mid-market company hasn’t done, that we could add. That’s how you get the big return. So it’s not about taking more risk, it’s about safety and business building.

Meb:

I was just thinking in my head, I do a lot of startup investing, and yours is obviously a little later stage, but the challenge of seeing a magical business, like the one you were talking about, invested at $200 million, and then seeing it roll and get to the point where everything’s working, it’s compounding.

I imagine it becomes, at some point, a pretty tough decision on, “Hey, we are kind of getting to the time horizoning of selling this. But actually, we think this could be a $20-50 billion company.” We saw Sequoia start to do some new fund offerings where they’re now managing public stocks and stuff. How often does that become, where you guys are sitting around debating and you’re like, “Well, what do we do here?” It’s a good problem to have, let’s be honest.

Steve:

That’s, again, where this continuation fund idea comes in. One other thing I should say is, let’s say you start with a debt with a company with four times debt to EBITD, and the earnings go up but the debt goes down. You can set the debt back at four times EBITD, on the higher EBITD, and be able to pay money out to your investors. So there are ways to be paying cash out to the investors, and get their risk off the table before you sell the company.

Then, let’s say you’ve gone to the end of what is a normal holding period for a private equity firm. You bought it three years into the life of the fund, and you’ve held it for five years, so your investors have been with you for eight years on that fund. Again, if you really do think you can double or triple again, you can let the investors who are tired get out, or just want to have liquidity get out, and other investors in the GP can say, “Well, we’re taking this company with investors who want to be there for the next five years, and keep it going.” That’s the continuation fund idea I was talking about.

Meb:

What’s some of the opportunities look like today? Is this pretty fertile time? Is the romp up in interest rates causing any gyrations, good or bad, in the industry? What’s the world look like in 2023?

Steve:

Again, I think private equity has been one of the strong performers through this very difficult period of COVID, and inflation, and everything else we’ve been going through. I think if you just look at the asset class, it has outperformed, and I’m very happy the way my own firm is performing. It’s partly because, on private equity valuations, when you have a private company, it’s based… Our valuations are half based on discounted cash flow, a quarter on merger comparables, and only a quarter on public trading comparables. Even there, you rarely use the most extreme optimistic comparables, so you just don’t get thrown around as much.

If your earnings are growing and you’re going off of DCF, you don’t get the gyrations you can get with the markets sometimes. I’m also not talking about the unicorn, no earnings type companies, I’m talking about more established. So private equity has really outperformed again in this last period. I don’t think it’s a fake, I think there’s truth in that. Then the current environment is that, deal volume is way down because the line of companies that want to sell is probably longer than ever. They don’t want to go out in this interest rate environment, announce, and auction, and fail, and be embarrassed.

There’s a meeting of the minds of where purchase prices are versus seller expectations. That’s still settling. But for a firm like ours, we’ve continued to be very active both selling, we just sold a company called Signify to CVS earlier this year at a good multiple, ’cause it was so strategically important, and we’re still buying. What we’re doing is, I didn’t get into this, but we pick the sectors. We have 12 sectors and 25 sub-sectors, this gets back to the sourcing that I forgot to answer, where we have team leaders and full teams. In every one of these sectors we’ve chosen top down over the years, they’re scanning hundreds of companies in those sectors.

We look at a thousand companies a year at confidential letters to buy 10. So in this environment, when people are scared to sell, it’s a better time to go out and approach them and say, “Hey Meb, we know you want to sell, you don’t want to say it, but we’ve admired your company, we’ve tracked you, let’s go off and negotiate.” So, we’re doing those type of purchases. We just did a big carve out for PerkinElmer, that some of your readers may have read about. A couple billion dollar piece of all their lab equipment, and life science supplies, and all that. Because, carve outs, the corporation wants to do with someone they trust to get the deal done, and it’s about certainty. So, we’re doing that. There are companies that have fallen in stock prices, that might be good go private. So there’s lots to do, but it’s not just big auctions.

Meb:

When you say 12 sectors, is it basically everything you’re looking at? Or, are there certain areas that you’re more drawn to or seeking out?

Steve:

We’ve slowly evolved this list over time. We have a top-down process we’ve done every year for about the past 20 years to say, again, “If we’re looking forward for the next 10 years, what has the chance to grow, good times or bad, for the next 10 years?” So again, we’re not in fashion retail, we’re not in aluminum smelting. We’re things like life science supplies, healthcare IT, digital engineering, smart energy transition, those type of businesses.

We have 12 sectors staffed up with senior deal partners, operating partners, younger people, every expert we can find, it’s like fishing holes. We hope every one of those will produce fish, and you can catch two in one month, in one hole, and nothing in the other, and then it could switch next year because they’re all productive areas, and we only buy when we cross that investment thresholds that I described to you earlier.

Now, compared to your question, how was it in the old days? In the old days, when I was at Forstmann Little as the second biggest firm in the world during the RGR period, and all that, we had only eight team members. I was the new deal guy. We had the founders, the Forstmann’s. I was basically the senior guy outside the Forstmann Family, and I was like the rug merchant. I would sit and let the investment bankers come in and lay their wares out before me and go, “Not that one, this one.”

That’s not how the world works anymore. Now, a good private equity firm is super knowledgeable in a space, super strategic, has done other deals, really knows the space, has real insights. It’s not just the generalist banker saying, “Oh, I’ll lever that one.” It’s really evolved into a much better field as it’s gone on.

Meb:

You mentioned earlier the Harvard Business case study, and we’ll put a link in the show notes. By the way, listeners, Harvard Business Publishing does $200 or $300 million a year in revenue. Talk about great businesses, they have a good one. But anyway, you had a comment called talent per dollar ratio. What do you mean by that?

Steve:

This to me is a really, really key point of private equity that I tried to refer to. What I mean by that is, what management talent, what investment talent, can you apply to any given company, at any given size company? Again, I only want to talk about the ones that are public that I can refer to. But a business like Avantor, when it started, it was the 13th and smallest division of a public company. It got no attention. It wasn’t the future of their business. It wasn’t on any wins. So what great manager is going to dedicate his life to be a division manager of the 13th and smallest division? You’re just not going to get the best talent, and you’re not going to get the best thinking about it.

It’s a little bit like taking the kid out of the orphanage and bringing it at home, and now it’s your kid. When that business comes out and it’s owned by a firm like ours, we have ownership. What carried interest means is, besides putting… We put over a billion plus into our own companies of our own money, plus you share in the profits. So a great manager would like to come over and run that business because now he’s an owner, he’s not a division manager of a conglomerate. He’s the person building this business, and we can build teams, plus our own firm that gives attention to a company it could never get as either a family business that can’t access that, or a division of a big public company that can’t access that.

Meb:

Yeah. One of the things that you alluded to, but I’d love to dig in, because we haven’t spent that much time talking about on the show. We’ve talked about private equity a fair amount, but private credit and direct lending. What portion of you all’s overall pie, is that a big piece, a little piece? Then, what does that actually mean for the listeners?

Steve:

It’s a very important piece of our firm. It’s about $10 billion of our assets. Part of it trades publicly on Nasdaq, called New Mountain Finance Company, that some of your listeners may have seen or looked at. We also have private versions, which we call Guardian. We have CLOs. The way we do it is, there’s a total overlap of skillsets because, again, if you pick an industry that should be a very good industry for the next 10 years, and you know it deeply, and you don’t buy the equity because someone else buys the company, we use that same analytical team to drop down and say, “Well, we’ve never had a bankruptcy or missed an interest payment at the equity. We can be a lender to this business that some other firm bought.”

We’ve had an incredibly good track record in credit, where we have extremely low base points loss in credit, because we’re using all the knowledge of an owner of businesses to make the loan decision, and we’re generally under 40% loan to value. So let’s say there’s a great software company, and another private equity firm buys it for 20 times EBITD, we can be the senior six or seven clicks of financing with 13 or 14 clicks of equity underneath us, and we feel very good about the safety of them [inaudible 00:28:32]. So, that’s how we play it.

The great thing about private, I think private credit or non-bank lending is one of the great still undiscovered asset classes. It’s getting more discovered all the time, but it is floating rate debt. So as interest rates are brought up, it’s been better. It’s not like long-term fixed bonds that got killed, it actually got better as rates ran up. You can have very sophisticated teams making very specific loans versus a general bank book. We also don’t have deposit or bank runs, something like our public arm is permanent capital and you’re not subject to runs on the bank, and some of the things that the government’s had to bail out. So it’s been a great asset class socially, great returns, and we really like it.

Meb:

Who’s really adopted it? Has it been institutions mainly at this point, or the big real money shops?

Steve:

It’s probably 30 or 40% institutions, people who like dividends, because it’s not meant to be a stock that appreciates, it’s meant to effectively trade at book. But the cash yields, I’m simplifying now, and I’m not trying to promise anybody, they’ve been basically 10% cash yields every year. Then, as interest rates run up, they’re closer to 13. It’s the expectations people have. Then you have full liquidity because you can trade in and out. There are private versions where you don’t have the volatility of stocks trading. You’re not as liquid, but you also don’t have to worry about marketing your book to market every day. You market more to just book value every day. So, it plays both ways.

Meb:

To the extent you can, would love to hear an example, and you don’t have to mention the exact name, but a recent transaction. Walk us through, almost like a case study, of how you think about a deal in this direct lending private credit world versus a traditional private equity LBO. I also wonder if they comes to you like, “Hey, this is entering LBO. Actually, just kidding, we’re not going to do this, but we can do the lending side.” Just to give the listeners a little more color on how something like this would work.

Steve:

Again, take the software sector, which is obviously going to be a good sector. I mentioned the Blue Yonder deal, which we bought a software company, we paid a low multiple, ’cause it was a sleepy little business, and we spent years building it up. So, that was a private equity deal. Now, there are many deals done by other firms like Vista, and Thoma Bravo, and other firms that are buying software businesses. They might be great fundamental franchises, let’s say, as an enterprise software business with 10,000 clients. It’s a good franchise. We know the franchise. The question is, how much does someone want to pay for that?

So let’s say Vista or someone pays 20 times EBITD, we don’t necessarily want to go outbid them and get into an auction and pay $21, but we feel very comfortable lending $6 or $7. We first look at it, are we going to buy control? We only generally do that where the seller wants a relationship with us, doesn’t want to put us through an auction environment, more mid-market type companies. If we’re not going to buy it, but it’s a good company, we immediately tell our credit people, “Well, we’re not buying it, but you may want to lend to it.” I use bad analogies. It’s like a fishing boat. You go out to catch a marlin, you hook a 500lb tuna, and you get to keep the tuna. You’re out fishing, you know these spaces, and it either fits in one bucket or the other bucket.

Meb:

That’s going to be a nice tuna, man. You can sell that thing on the market for a pretty penny.

Steve:

That’s the goal.

Meb:

As you guys probably have more lines into CEO’s operating companies, both portfolio companies, but on the lending side too, what’s the feedback about, here we are, summer 2023, about the economy, about what’s going on in the world? It feels like everybody keeps waiting on this recession to happen. Everybody keeps waiting for the Fed to stop raising rates, and on and on, inflation to come down. What are they saying? What’s the feedback from your portfolio companies?

Steve:

Well, what I would say, the big picture armchair economist, and this is not to favor one president or another president, but the US economy had already started to come back strongly in 2020 under the former president. So GNP was up by I think 33% Q3 of ’20, 7% in Q4 of ’20. I think the government overstimulated in ’20. The Fed didn’t stop them. So what we saw at our companies… ‘Cause we own about 40 companies in 40 different industries. We get a lot of data just real time by owning different businesses.

The worst inflation, and the worst labor shortage and supply shortage squeeze, was really around September of ’21, before people were talking about it in the newspapers. We could see how much it was hitting our businesses, and we worked with our businesses at our level to really manage them through it, how to ask for pricing, how to control supplies and so forth. The story ever since then is, the Fed’s been trying to catch up to the inflation to stop it, because they didn’t want to go through the stagflation of the 70s again. Everybody’s trying to figure out when they’re going to stop doing that, and when will enough be enough with the Feds.

Obviously we’re up into the 5’s, that’s what crashed long-term bonds, that plus bad management crashed Silicon Valley Bank, and almost killed the banking system. The actual economy inflation is clearly lessening, libraries loosening up, things are not that bad. The real question is, when will the Fed say, “Hey, it’s good enough,” and not keep beating up the economy. I think James Gorman said he was happy with 4’s, 4% unemployment, 4% inflation. I’m not sure the Fed’s going to settle for that.

The worst thing is, they may just keep banging and banging to try to get inflation all the way back to 2. That last couple percent of inflation may be really tough to squeeze out, and very miserable. I think that’s the biggest risk, is just how tough the Fed wants to be to not just let things be okay, but to actually get back to their target. I describe it as rainy, soggy weather. It’s not a crisis like ’07, ’08 was a crisis, COVID was a crisis.

Our businesses, on the whole, were up double-digit earnings growth last year our portfolio was up even more than that because we made exits. So we’re just soldiering on. If you have a weak company, over-levered, and you can’t pass on price, you will see more defaults. But in general, for a reasonably strong company, it’s just like rainy weather.

Meb:

As the listeners who are allocators are thinking about this asset class, these style of strategies and funds, how should they think about it? Is private equity, is it just a carve out of their equity exposure for the institutions you talk to? On the private credit, is that simply a carve out of the bonds? How do they think about it? Or, they put it in some alt bucket where they’re like, “This is something totally different?” What’s the best practice for someone who’s going to make an allocation?

Steve:

One thing, I just read this in Institutional Investor, so I’m not sure. Or Pension and Investments, I guess. The 60/40 model is slowly evolving potentially to a 50/30/20 model where 20 is private assets in general. Look, I think for private equity, it’s very much dependent on, all private equity is not the same, the same way all restaurants are not the same. Who is the manager of the fund? What is their style? Are they value-added? In general, it’s always been a better time to go into the asset class after the bad news hits.

The worst thing to do is to say, “The market’s down now, I’m not going to invest in it,” because number one, these funds get drawn over three to five year periods. Number two, the best opportunities, as a buyer with new money, is after the bad news, not at the boom. It’s almost the reverse of the rear-view mirror, as far as how to pick when to enter. The best private equity people, institutions just allocate every year to the class, to the best managers they can find.

On non-bank lending, floating rate credit. I just believe it’s been very much underutilized by institutions. I always wonder why a pension fund who’s desperate to make 7% doesn’t take floating rate debt at 10% and say, “Well, that made my life easy.” Why they wanted to be in fixed income at 2 or 1 or 0, that’s a huge risk, which obviously has hurt them in the last year.

Also, I would say, if you look at the public debt funds, the BDCs, they traded much higher yields than REITs do, much higher yields than other income do, because it’s a newer class. I don’t think it’s been well understood. It used to have a much weaker set of managers 10 or 15 years ago, those guys are out, and now we’re good. You have Aries, and KKR, and Blackstone, and more professional organizations. So I think it’s an underutilized fixed income yield, that people should use more.

Meb:

When it comes to this, and you don’t have to narrow this just to private equity and private credit, so feel free to take this wherever you want, I have a long-running Twitter thread where I talk about views that I hold, that the vast majority of my professional peers do not share. So, 75%. If I say something, all my professional friends would be like, “No way, dude. That’s crazy.” What do you view, the investing world could be specific to private equity and credit, anything that’s non-consensus in your mind?

Steve:

Yeah, I got a bunch of them. I got a huge amount of them.

Meb:

Good. Well, let’s dig in.

Steve:

All right. Well, let me start with one. People always say risk and return go together, “You must take more risk to make more return.” That is wrong. That assumes an efficient market casino where skill has no role in it. If I go into the boxing ring with the heavyweight boxing champ, I will have all the risk and he will have all the return, risk of return do not at all go together because boxing a game is a game of skill, and he’s a better boxer.

So when you hear the mathematical models, they’re assuming… In public equity investing, it may or may not be true. I’m not a public equity investor. But, you don’t have to bet more at roulette. You have to pick up the ball and put it in the slot you bet on, and that’s called owning a company, managing it, understanding it deeply. I don’t agree with this general assumption that risk on a return only comes from more risk. I think that misses the whole glory of investing, which is to actually build a business, or really understand something different.

Meb:

The funny thing about that is, for a long time, when the academics started talking about factors and beta being one, it was actually, not only was risk not aligned with return on a very academic public stock sense, it’s actually 180 degrees backwards. So a lot of the low volatility funds that have come out in ensuing years have demonstrated, actually, that if you invest lower volatility versus higher volatility, it’s actually a better way to invest. It’s one of those funny quirks of thinking about the world. You think, in your head, it makes sense to be a way, but then it actually is opposite, which I love. You mentioned you got a few, anything else come to mind?

Steve:

On the risk, Richard, again, I’m not trying to comment on public equity investing, but I’m talking about where you can actually own the company, or credit where you really can deeply understand it. We put a big emphasis on industry selection as the first key thing to think about because, what I’ve seen in my 40 plus years, the biggest mistakes are when the industry melts underneath you. Not to hit on anybody’s deal, but if you buy a toy store in the mall against Amazon, from the day you made that decision, your ability to manage it, to fix it, you’ve set your fate.

Or if crypto melts, and you have your money in crypto. Or back in the year 2000, everyone was in the alternative telephone CLEC space that melted. So that’s why we spend a lot of time on, what sectors do we want to be in? We’re going to hold it for five years, someone’s gotta to think about the next five years. So, where do you want to be for the next 10 years? You can always go where the world is going or the puck is going. We start with industry selection.

Another thing I would say is, the other way I think people should think about the world, there are 8 billion people getting up every day in the world, trying to make their life better, their family better, their neighborhood better. So there are always positive streams of something going on in the world, some idea, some avenue, some improvement. What we try to do at my firm is pick those positive streams, join them, accelerate them, and that’s the fun. That’s the non-cyclical, you can do that in all times.

Another thing I would say, people talk about venture capital versus private equity, and where do things fit? The other thing I would say is, there are some venture capital ideas that are much more successful if you take the venture capital idea and apply it to a safe private equity base with cash flow and customers. Just as an example, we had a business called Ciox, started by the head of biostatistics at Harvard and the head of biostatistics at MIT, one of the two great companies in advanced math for drug trials.

There was a little VC software opportunity that’s essentially a chess computer to run a billion permutations of a drug trial. It could have been a standalone VC deal, but we bought it, put it in as a product line of this company. Again, they have cashflow customers, salespeople, credibility, and it’s much better way to build that business. So it’s not that VC builds companies and private equity kills them. It’s private equity starts with a safe base and then adds technology and growth to it. So that’s somewhat contrary to some way some people think about VC.

Oh, on growth, I’ve been on growth panels where people start off defining the growth category as no earnings. I go, “Wait a second, that’s not how we think about growth. We think about growth as growth, like you grow.” So there’s a lot of things where we’re a little different than people. But, I think it’s extremely common sense. Pick a good industry, keep it safe, treat it like a family business, and build it.

Meb:

I was smiling as you were talking about the toy stores. I spent a lot of time and Spencer Gifts as a kid, just salivating over, pining for, the lava lamps and the plasma balls, and all the other-

Steve:

And, the black light posters. I used to go to Spencer Gifts all the time.

Meb:

The older crowd can resonate with that. The younger crowd, sorry, but I don’t know what the modern equivalent would be. But man, they were awesome. So let’s say someone’s going to allocate to private equity, to private credit. It’s not your firm, but let’s say you were allocating to a manager. What main one or two question would you ask about assessing their skill at actually building businesses? So not just identifying a deal but, “All right, I’m going to ask this question to trust out if these guys are any good.”

Steve:

It’s a very difficult and important skill to distinguish one private equity from, from the other. There are gatekeepers, like Hamilton Lane. There are some great staffs that the pension funds and the institutions. So it is, itself, a very sophisticated form of investing. The key things are, you have to analyze each firm the way you would a business. What is their strategy? What is their team? Are they going to keep the team together? Will they evolve as the world evolves?

Because sometimes, people had the lucky… They were all great in oil while oil was rising, and their record is great, but that’s not necessarily the right play for the next five years. Is it a sustainable culture and an approach? Are they really building it versus wasting it down over time? What’s the talent coming up? How do they split the carry? A firm like mine, everybody gets to curate every deal, from the receptionist on up. We build our talent from the inside. There’s dozens of things about building a good firm that we could talk about separately. So, there’s a ton of analysis on just, what is it as an operating business? It’s an operating business, not a investor.

Meb:

The question we’ve been asking everyone at the end is, what’s been your most memorable investment? This could be at your company, it could be on your own, it could be good, bad, in between. But just the first one seared into your brain, what comes to mind?

Steve:

Well, I’ve had two acts in my career, the Goldman/ Forstmann Act for the first 20 years, and the New Mountain Act for the second 20 years. In the first 20 years, a company I was most proud of was a business called General Instrument that I owned for Forstmann Little from 1990 to 1999, started as a very mucked up conglomerate. We focused it down, and turned into the world’s leading cable and satellite television equipment.

Everyone thought Japan was going to destroy the all US electronics companies, we fought back. We were the US HDTV standard that no one ever thought a US company could invent. We helped do the cable modems, and video on demand, and that whole world that we’re all used to, really came out of that company over. It went from $1 billion in value to $20 billion in the 90s. So that was what I was most thinking about when I started New Mountain.

At New Mountain, what I care most about New Mountain is the firm itself. I don’t take credit for any individual deal. So what I’m most proud of is New Mountain as an institution, and how we do things. But we just had a great sale on Signify this year, went from $500 million to $8 billion in a very bad market. Or Avantor, $290 to $20 billion. So, there’s a lot of good ones. But I really think about the institution, not a deal anymore.

Meb:

As you look to the horizon, you mentioned first 20, next 20, what are you thinking about? What are you excited about? What’s on your mind? Either for yourself personally, or for the company. As we look out into the future, what’s on the brain?

Steve:

I tell young people this, “I love the private equity field,” and the credit’s part of that, “And have remained very excited about it.” First of all, I’m a terrible golfer. Don’t have a sailboat. Bad at everything. Would much rather have a nicer day in the office than be lost in the rough on the golf course. But what’s so fascinating me about private equity is what I just said, you can choose where you want to be for the next number of years.

So anything that’s exciting, interesting, a positive trend in society, we can become part of and move. We’re not stuck in whatever we inherited from our grandfathers. We’re always going to be moving that way. We could actually build things, we can do it under the covers of privacy where we don’t have to explain it to people, we just have to come up with the right end result. The institution has gone from me all alone in a rental office, 23 years ago, with $0, to some of the best operating people there are around. We employ over 70,000 people at our companies. So building things is just a huge fun, and I think we’re better at it every year. So as long as I have good luck, I plan to keep doing this.

Meb:

One of your interests outside of work that is a big passion is thinking about education. What’s some of the initiatives you’re working on there? How do you think about that, in particularly this weird post-COVID world, internet dominated AI taking over everything? How do you think about education? What’s some of the ideas and concepts you’re working on?

Steve:

First of all, I think business is a good thing socially, so I’m not trying to do charity to make amends for business. I think business is a positive way to live your life. I’m very involved in education and children’s health charities for a long, long time. The main ones there, they’re after school centers in New York, in the public schools that I first set up about 30 years ago in memory of my brother who passed away, that’s still run, that New York Times has written articles about. So, I still do that.

I’m the Chair of Harvard’s Public Education Policy Group. One interesting thing in my career is, I took a year off between Forstmann Little and New Mountain, was in Harlem in a church basement writing the application for the first charter school in New York state. So I was very involved in charters, which I still commend. But, the politics are just so terrible that I’ve just gotten off the playing field years ago on that.

Meb:

We did a podcast with Joel Greenblatt, and some others, talking about some of the struggles with that.

Steve:

The politics are vicious, and I’m pro public schools in every form. But, I’m just trying to make some good public schools. Where I’m really active now, and my major thing, and I hope your listeners do pay attention to its, there is a way to really help lower the cost of college for lots and lots of people by using basic, old-fashioned internet technology to create a public library of college courses for everyone in the world.

So I created something called modernstates.org. 400,000 people are using it. It’s the biggest free college for credit charity in the world, I think. What we did is very simple. There’s a set of exams from the college board, like the advanced placement, but they’re called the CLEP exams, where anyone of any age could take them. Let’s say you pass the college algebra exam, and go to Ohio State, or Texas State, or whatever, they say, “Oh, you came in with college algebra done.” So, you saved the time and money for that course.

We hired 33 of the best professors we could find in the country, had them do a course which we paid for, now give away for free to everyone at modernstates.org, with readings, with practice questions, and then we pay the exam fee. So you can get basically one year of college, at almost every state and community college in the country, plus private schools. Not at Harvard, but at Ohio State, Michigan State. It’s called modernstates.org. So if anyone in your family, your neighbor, your distant cousin, someone you know wants to help pay for college, or dropped out and get back to college, they should check out modernstates.org.

Meb:

I love it. Last question, as you think about this world of personal finance, people love talking about, is it teachable? There’s not many high schools that teach investing, for sure, but even personal finance at its core. So, what’s your suggestions? Or, do you have any general ideas on the best ways to think about educating the adolescences, all through even college age, on this topic?

Steve:

Again, the way I think about business is, it’s a creative act as part of the whole human society organizing itself better to make progress. Whether you’re a songwriter, or you’re a scientist, or you’re a manager or you’re owning a company and reorganizing it and improving, it’s all the same creative instinct to organize the world and make it better. Business is one of the most complex forms, because you’re dealing with multiple people in different industries.

I’m a big reader of history. I was a economics and philosophy undergrad who reads nonfiction all the time. My head of private equity, who’s one of the great deal partners around, was a literature major. It’s not mathematical modeling, it’s understanding the world’s society, people, how to build organizations. To me, doing the education, charity, or doing a New Mountain transaction is the same exact thing. I would tell people to read history, learn the world, see where it’s going, figure out what you want to get involved with. It’s not a finance course.

Meb:

Steve, it’s been a whirlwind tour of everything, private equity, credit, and even more education. Thanks so much for joining us today.

Steve:

Thank you so much for having me. Really, really great to be on your show.

Meb:

Listeners, if you enjoyed this episode, check out the link in the show notes for episode 482, with Steve McCourt and Michael Bell, about how they’re trying to democratize private equity today. Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at feedback@themebfabershow.com. We love to read the reviews. Please review us on iTunes, and subscribe the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.