1) The specialty finance industry was hit hard in the downturn. With three such companies in your portfolio, do you still see it as a viable investment space?
Specialty finance was dead, but we’re beginning to see renewed interest in it. In the heyday, those businesses were traded off multiples of earnings, and at their low-point, were traded off multiples to book value—typically at discounts to book value. Today, they’re still being valued on a book-value basis, but we’re comfortable with the thesis that, if we could buy a well-managed specialty finance business in an asset category we view as durable, that now is actually a good entry point to invest in those businesses. The hope is that when you’re looking to exit three to five years from now, you’ll be valuing them off of multiples of earnings, and you can take advantage of the arbitrage.
2) Have you changed your approach to investing in the industry since the market collapsed in 2008?
Our view changed in one area. It was a reasonable assumption—pre-credit crisis—that if you had a good business model, a good asset class and a good management team, you could find a way to finance your balance sheet—either through securitization, the wholesale funding marketplace or some sort of alternative funding mechanism. Frankly, the biggest lesson learned over the 2007-2009 period is that that is not a reasonable assumption. You need a very diversified funding source, a mixture of several sources, and you need to be able to lock in long-term financing commitments. Otherwise you’re taking on a whole level of risk that isn’t present in non-financial services investing.
3) Have any of your portfolio companies been hit due to a lack of diversified financing?
We had a credit card issuer [First Equity Card Corp.] that was completely dependent on the whole-sale funding environment, and that company is basically in wind-down mode now.
4) What’s an example of a strong specialty finance portfolio company in your portfolio?
Healthcare Finance Group. It’s a commercial lender to the health care vertical market. The key as to why that business continued to thrive is that our competitors all went out of business and HFG had locked in very long-term financing so it wasn’t naked during the height of the storm. It was able to expand market share and recognize historically high spreads between its cost of capital and what it was able to charge customers.
5) HFG was a 2005 investment. Any plans for an exit?
Not anytime in the near future. As good a company as HFG is, it is still going to be governed by book value if we try to sell a specialty finance business in this market. We don’t need to sell it today, and it continues to grow very nicely for us. The logical time to consider an exit will be when the markets are more hospitable from a valuation perspective—when they are more earnings-driven as opposed to book value-driven.