This article is sponsored by Kennedy Lewis Investment Management
Launched by alumni of CarVal Investors and GSO Capital Partners, Kennedy Lewis Investment Management opened its doors in the autumn of 2017. A little over a year later the firm exceeded its $500 million target for its debut fund, which invests across the credit spectrum and focuses primarily on four specialty verticals: power, intellectual property, non-traditional education finance and life sciences. It is planning to launch its second fund with a $1 billion target early in the fourth quarter of 2019. Managing partners David Kennedy Chene and Darren Lewis Richman say their key to success is finding niche market stresses that few other people are exploiting.
Why did you choose the four verticals you did?
Darren Richman: The verticals selected themselves to a large degree. We spend a fair amount of time looking at where the stresses are in the market. Generally, those stresses are stoked by secular, cyclical or regulatory-induced forces.
So we try to identify where the disruption is in the market and from that try to understand what is causing that disruption, and then that’s really where the fertile opportunity set is. You have a number of sectors that are going through secular change. There have been very few cyclical sectors in the last five or seven years. Most of these opportunities have resulted from secular changes.
In this over-bought market, we want to be as uncorrelated to the broader equity and credit markets as possible. Each of our verticals have minimal correlation and are focused on areas of the economy that are contending with disruptive forces.
Why is power interesting to you all?
David Chene: We like power because it’s a complex sector that most people take for granted. The US power markets are in general contending with all of the forces that Darren mentioned. There are seven different power regions in the US. We are focused particularly on the Texas power market, particularly newly built natural gas plants. We like Texas because it’s an electrical island; there are no subsidies in the form of capacity payments, which are the norm in other power markets around the US. Because only free-market supply and demand drives power prices, we can efficiently analyse interesting relative value investment opportunities.
There has been a tremendous amount of capital lost investing in Texas power over the last 10 years, whether it was [the Energy Futures Holding bankruptcy] or other restructurings. Wall Street firms without the requisite power expertise chased thermal power generation deals at over-priced valuations and the capital has yet to return to the market. This has provided an opportunity for experienced power investors to find less competitive, undervalued deals.
As capital receded from the region, the market has been given the opportunity for the excess capacity to be absorbed. Additionally, in the last few years we have seen high-cost plants, particularly coal-fired, come offline, resulting in a tightening of supply and demand. Improving fundamentals are resulting in higher power prices and the chance for newly built generation to earn outsized returns.
Intellectual property is another area in which you invest. What’s the opportunity set there?
DR: A trend that isn’t seen by the naked eye is that a growing portion of Fortune 500 balance sheets are made up of intangible assets; today 80-85 percent of these balance sheets are made of intangible assets compared to 20-25 percent in the 1970s. IP presents a huge opportunity that is mostly being overlooked by the mainstream investment world.
Boards of directors of these IP-driven Fortune 500 companies have put management teams under increased pressure to either stand-up IP divisions or sell non-core IP assets. Historically, when companies were looking to shed non-core assets, we saw excess real estate divisions being sold off. Today, as companies think about shedding non-core assets, we are seeing IP included in that conversation. IP is a compelling opportunity for investors with the requisite experience to source and structure IP deals. We also like that the performance of IP assets have historically shown less correlation to the broader markets relative to corporate credit and real estate.
What is attractive about non-traditional education finance?
DC: We’re constantly looking at creative ways to invest in sectors undergoing stress or transition. Perhaps no sector is more troubled than the student loan market; 40 percent-plus of all student loans are in some sort of deferment or outright default.
We believe the problem stems from a lack of alignment of interest for schools to help place students in desirable jobs (ie, most universities haven’t been held accountable to their own students because they aren’t delivering a job or an outcome that is sufficient to providing a living wage and paying off the interest burden on the student loans).
“We believe the [student loans] problem stems from a lack of alignment of interest for schools to help place students in desirable jobs”
Some managers focus on buying discounted tranches of securitisations attached to student loan portfolios. However, in our view, these strategies don’t help solve the underlying problem. So we started thinking through how we could help solve the issue by better aligning interests between schools, students, and financing counterparties.
This led us to income-sharing agreements (ISAs), which is an idea that was invented by Milton Friedman in the ’50s. The basic concept is that a student pledges a percentage of his/her pre-tax earnings, capped at a multiple of tuition cost in order to finance higher education; students essentially only pay what they can afford. We are focused on financing short duration education programmes where there is a structural shortage of labour in the economy and, therefore, the outcome is highly certain.
Life sciences has been well-trafficked compared with your other verticals. What was the appeal?
DC: The upper middle market is far more competitive than where we play; our typical deal structure is somewhere between $25 million-$50 million and structured with delayed draws. We source directly through management teams and rarely compete for a deal in this space.
Our loans are first lien, have low LTVs (~25 percent) and are focused on companies that have FDA approval, reimbursement rates set, and possess commercialised technology. Our money is generally being used to build out sales forces and grow product distribution, rather than fund the development of a new product.
Do you have a flexible fund structure, or is it rather narrowly defined?
DR: Our fund mandate is flexible, which allows us to invest in opportunities overlooked by managers with strict rules-based capital.
When you think about the credit markets, as big as they are, there is a tremendous amount of capital that is just rules-based. CLOs need a rating, BDCs need a cash yield, distressed funds need a certain discount and insurance companies can’t risk a downgrade or defaults as they may be hit with additional capital charges. As you think about the size of the market, and then reduce it into the rules-based ‘lanes’, most credit structures need to fit very specific requirements. Kennedy Lewis can cut across each one of these lanes, which allows us to capture better risk-adjusted returns.
DC: From a portfolio perspective, we’re not trying to be all things to all people. We aim to populate the portfolio with uniquely sourced and highly structured deals with ample downside protection and upside optionality; capturing the best risk-adjusted returns is the focus. Our goal is to construct a largely uncorrelated and highly differentiated portfolio.
Did your unique fund structure and verticals require the education of potential investors?
DC: Our fund structure took a little education. We looked at investments that we’d made at our previous shops and realised we were most successful in situations where we had one to five years from initial investment to monetisation. We therefore decided to go with a short duration structure – a two-year investment period with a two-year harvest plus a one-year extension. Overall, investors were highly receptive to the structure; the larger firms have raised longer lock capital and investors have become frustrated with the pace of capital deployment and underwhelming returns.
The verticals required some education, as did our sourcing channels. Investors want to know you have an ability to originate unique deals. In this market, investors are looking for uncorrelated returns which have made our verticals an easy ‘sell’.