Capital Talk: Sound Harbor

Some time after the financial crisis and looking to refinance its balance sheet, Precision Valve Corporation, the inventor and world’s largest manufacturer of aerosol valves, was facing a challenging lending environment. Market and business conditions made it difficult to refinance with its traditional bank lenders.

Enter Sound Harbor Partners, a private credit firm founded by Carlyle Group alum Michael Zupon and led by him and Dean Criares, a former Blackstone Partner. In 2011, Sound Harbor partnered with British private equity firm MML Capital Partners to provide the company with debt and equity capital to refinance its existing debt and recapitalise the business.

Sound Harbor senior advisor Daniel Ajamian, a former president of a Carlyle-owned plastics business, joined the board as an observer. The company recruited new management, consolidated its operations, developed new products and enhanced its profitability.

In June of last year, Precision refinanced Sound Harbor’s debt with lower cost capital, leaving the firm with a minority equity interest in the company, according to Zupon.

Zupon cites the deal as an example of the kind of transaction Sound Harbor has sought out since its founding in 2009. The firm, which Zupon created in anticipation of a groundswell of opportunity for private credit managers that he thought would arise from the financial crisis, currently manages $1.5 billion across its Capital Solutions and Loan Funds businesses.

The Capital Solutions fund provides private credit to mid-market businesses and its loan funds invest in below investment grade syndicated loans. Via both funds, the firm is currently invested in over 300 companies. The majority of the firm’s capital is in its SHP Loan Funds, and while Zupon admits that investing in this sliver of the credit markets, where cov-lite is rampant, is inherently risky, he also says that to him, the potential reward is worth the risk.

“We invest in risk markets. If you don’t take any risk, you won’t make any return. So an important component of delivering outsized returns is having a confidence and a willingness to assess and take on risk,” he tells PDI.

So far, his approach appears to be paying off: Sound Harbor’s Loan Funds have distributed 19.6 percent annually since inception, while the underlying loans have returned 1.3 percent more than the Credit Suisse Leveraged Loan index on average on an annualized basis.

The SHP Capital Solutions Fund, which invests across the capital structure, returned 18.2 percent net annual returns to its limited partners as of June 30 this year. The firm uses a proprietary risk assessment system, TracePoint, to track companies and independently determine their creditworthiness based on a variety of factors. The Capital Solutions Fund invests between $10 and $50 million in US midmarket companies with annual EBITDA of $15-$100 million, through a range of instruments including secured loans, senior to subordinated debt and also equity co-investments.

Zupon believes this helps the firm offset some of its riskier deals and also to stay diversified, and enables it to work with companies that might need a variety of types of capital. It also means Sound Harbor can invest throughout the market cycle as it advances, allowing the firm to pounce on opportunities as and when they arise. “One of the great things about private credit is that there are a variety of entry points you can take to manage your risk. So when you compare private credit to private equity, private equity enters at the bottom of the capital structure and they have to pay the market rate in order to secure a control position in the company or to effect a buyout,” he explains.

Private equity firms often have to enter at seven to 11 times EBITDA. “Whereas in private credit, you can enter anywhere from the first turn of EBITDA typically to 6 times EBITDA, and the availability of deals goes up during poor markets. That really defines why we think private credit is such an extraordinary opportunity: you have banks exiting the market and the ability to tailor your entry into the capital structure depending on the market environment you’re in.”

SETTING UP SHOP

In founding the firm five years ago, Zupon was joined by principals John Thompson, John Corbett and Joshua Parrish that same year. Zupon was previously a partner at Carlyle, where he had founded the firm’s leveraged finance business. Corbett joined from Banc of America Securities, where he was a vice president in the Leveraged Finance Group. Parrish was a vice president in the high-yield capital markets group of Credit Suisse, and Thompson came on board from the Commercial Industrial Finance Corporation, where he was a credit analyst.

Zupon, who serves as chief investment officer, says he saw private credit management as an immense opportunity following the global financial crisis and wanted to start a firm that would be solely focused on this strategy. Since then, Sound Harbor has launched its two funds and acquired a portfolio of Landmark CLO vehicles that is managed by a team led by Bill Lutkins, a Sound Harbor managing director who has worked on the assets since 2004.

Another milestone was passed in 2012, when the firm brought on Dean Criares, formerly a senior managing director at The Blackstone Group, where he had founded Blackstone Debt Advisors and at one stage served as co-head of the GSO Debt Funds Group, overseeing a business with $15 billion of loan assets under management. Criares and Zupon know each other well, each having started their career at Canadian lender CIBC.

They both worked in the Acquisition Finance Group at CIBC for seven years and Zupon says they both saw opportunity to grow a private credit business that would leverage the infrastructure of a top private equity firm. Later Criares became an early supporter of Sound Harbor, having invested in one of its first deals through the Capital Solutions fund. Most recently, the firm hired additional research analysts Deborah Strek and Jamie Walker, both of whom had previously worked with Zupon and Criares, to help analyse below investment grade companies.

With both partners having come out of large private equity firms (albeit ones that manage large books of credit as well), Zupon says he is interested in working with a variety of a private equity sponsors, rather than have a single large firm, like Blackstone or Carlyle, as the primary source of his credit deals. At $1.5 billion, Sound Harbor’s growth has been fairly modest thus far, but Zupon says the firm is now sufficiently built out to expand its business. It has a total of 17 investment professionals on staff and a fully developed product line-up, and is ready to start taking in more capital.

Most of the firm’s original investment capital came from Sound Harbor’s partners, as well as single family offices of high-net-worth individuals and former colleagues of Zupon and Criares. Since then, the firm has begun to attract capital from large financial institutions.

In September of last year, Sound Harbor announced a strategic partnership with Macquarie Credit Investment Management to launch a series of CLO funds.

“We believe the opportunity now is to scale the business, as both the investor demand grows and we become attractive to broader institutional clients,” Zupon says. “Dean and I have track records building and growing some of the most successful private credit investment businesses in the world, and we’ve built Sound Harbor on a foundation that we think is first-tier institutional quality. But we’re really principally focused on delivering investment outperformance, and the growth will follow that, not lead it.”

SCOUTING FOR DEALS

When it comes to research, the firm has a rigorous process for ferreting out lucrative investment deals, vetting and then closely monitoring them once the investment is made. For the SHP Loan funds, for instance, the firm has analysed over 2000 sub-investment grade companies.

Of Trace- Point, Zupon says: “It’s a proprietary series of ratings our research analysts place on over 300 companies that they’re monitoring on a continuous basis. The ratings focus on risk ratings, recovery ratings, value ratings and an outlook that’s integrated into an online investment platform. We are constantly screening for driving defaults out in the syndicated loan portfolio and attacking extraordinary return opportunities through our Capital Solutions Fund,” he adds.

Sound Harbor primarily covers five industries: general industrial, consumer products, media and telecoms, healthcare and energy. Zupon says he likes these because they’re the five pillars of the US economy. “We focus on those sectors because we think that having an industry and an operating edge enables us to generate a private equity insight into the long-term value of the business,” he says.

On the broadly syndicated loan side, Sound Harbor will usually participate in $250 million-plus loan deals that are typically led by the large investment banks, where the firm’s own investment will range from $5 million to $25 million that have 20 to 100 other participants.

On the direct lending side, as part of its Capital Solutions business, Sound Harbor participates in both sponsored and unsponsored deals. “The two pieces of the business are very distinct in the way that we invest, but the core expertise that’s necessary to make good investments in credit are identical in both,” Zupon explains.

ON MANAGING RISK

Zupon doesn’t concern himself with covenants, and insists covenant-light loans aren’t necessarily riskier than loans with covenants. What he does worry about are default rates, and Sound Harbor does its research with an eye towards reducing those in any of his portfolios.

He says: “Covenant-light loans historically have not had any material difference in both default and recovery rates than loans with covenants. In robust markets, loans that have covenants typically have them because they have significantly greater business risk to them, so we don’t believe that loans with financial covenants are a significant indicator of credit quality. We’re looking at fundamental measures.”

The firm’s process involves doing fundamental value analysis on the companies it pursues. It studies leverage ratios, free cash flow generation capabilities, customer concentration, industry cyclicality, the underlying equity market value and volatility, as well as, deriving from all of the above, the potential for recovery.

“The TracePoint system allows us to have a documented process that measures credit quality throughout the cycle and therefore keeps the team disciplined in the face of market bubbles,” Zupon explains.

“Because we’re looking at the same measures in 1999, as we’re looking at in 2003, as we’re looking at in 2008 and that we’re now looking at in 2014.”

Based on their findings, the analysts make investment recommendations to the firm’s investment committee, which are then recorded in the database and measured over time – “so that, as credit risk rises, our portfolio will provide a leading indicator because the research analysts are feeding those ratings through the system. As the market deteriorates, we’ll begin to see a quantifiable rise in the portfolio’s risk ratings. Because the system allows us to follow hundreds of these private companies, it provides an extraordinary insight into the overall market and where we are in the cycle,” Zupon says.

The firm also favors Professor Michael Porter’s five forces analysis model to identify companies that might underperform or suffer defaults. The model looks at the company’s competitive positioning within its industry, the bargaining power of its customers, the bargaining power of its suppliers, the threat of new entrants and the threat of substitute products. Take coal for instance, Zupon suggests: “Coal right now is really underperforming as a result of the economic costs of pollution and the low cost of substitutes from natural gas, so as a result we’ve been avoiding coal as a sector – with the exception of investing in bankrupt coal and power businesses, where we can be investing against assets at substantially less than the capital costs that have accumulated.”

Another example illustrating the analytical power of Porter is Blockbuster, the erstwhile video rental store that was brought down by the arrival of substitute products. “What we’re looking for is pattern recognition, because I think after you go through a series of bankruptcies because of substitute products in TMT, everyone’s going to be worried about the next Blockbuster, but you can apply the same lesson to coal.” Zupon explains.

LESSONS LEARNED

In a recent presentation to the Turnaround Management Association, Sound Harbor listed its ten commandments on credit investments, encapsulated in short statements such as “sell when you can and buy when other’s won’t”; “understand the difference between cyclical, secular and structural risks;” “when you do have a problem, run to it and pick up the phone;” “form your own opinion on value”; and “learn from your mistakes, but don’t wallow in them.” 

On the latter axiom, Zupon offers this: “When you have an investment mistake, the best thing you can do is identify it early. Because oftentimes, those mistakes can be addressed in a way that can result in extraordinary returns. A number of the better investments that I’ve been a part of in the past had started out underperforming their initial targets. It’s really that willingness to work through the challenges that offer the rewards. And that requires a willingness to raise your hand and ask for help.”

At Sound Harbor, Zupon says the firm’s default rate has been less than half the market average. Looking ahead, Zupon is adamant that specialist debt investors such as Sound Harbor are well placed to take advantage of rapidly changing market conditions. He also thinks credit funds face a more favourable competitive dynamic than private equity:

“There are hundreds and hundreds of private equity firms attacking what is a shrinking M&A market. In private credit, there are really only dozens of first-tier firms attacking what is a growing market. Many of those firms have been extraordinarily successful, but we believe that limited partners need to seek out and identify emerging private credit managers who have a great track record and a focus on a differentiated investment process, and we think that’s the opportunity that Sound Harbor is well positioned to grow into.”