E285: The Lower Middle Market: Where Private Equity Still Generates Alpha

0:00Jeff, so you launched Corbell in 2014 after years at Aries. What was the aha moment that convinced you to strike out on your own? I'd always wanted to do something more entrepreneurial. And I'd gotten to a stage in my career where it was the appropriate time. But in terms of the investment opportunity or the aha moment where there was an opportunity here, I was speaking to a friend of mine who owned a small business. And we were comparing notes on what he did and what I did. And he made the comment that it would really be interesting to have an investor like you on my cap table or on my board or involved with my company.

0:38But I would never sell to a private equity fund. So I thought about small businesses. I thought about the lower middle market. I knew that traditional banks had largely vacated the space and were lending much more selectively and much more conservatively to small businesses. I knew that private equity firms were certainly buying small businesses, but there was really no one providing what we would call structured capital to small businesses where we could provide capital for an owner of a business to make an acquisition, to buy out a minority shareholder, to take a dividend and still benefit from private equity style sponsorship and support.

1:18And I thought that void in the market created a real opportunity for me to raise a fund around that strategy and generate off-market risk-adjusted returns for my investors. Obviously, when you were at Aries, you had a lot of infrastructure behind you and a lot of support. What did you underestimate in terms of what you would have to do in order to build your own franchise? That's an interesting question. I I'd always wanted to do something more entrepreneurial, as I as I mentioned. But after 15 plus years of primarily being an investor, the only type of business that I felt like I could run would be an investment firm.

1:59So I thought that if I just rolled out an investment strategy and got a bunch of investors, I could spend my time primarily doing deals just the way I had done deals my entire career and probably underestimated, to your point, just how much work there was behind running a business. And our firm is now a business. We manage over a billion dollars of capital and have 20 plus employees and offices and infrastructure. And that all requires management. And I probably spend as much time managing the firm as I do working on individual deals. I'm not sure I appreciated how time consuming that would be, but it's been really rewarding.

2:41But there definitely is more work involved in running the firm than I think that regular way private equity professionals or regular investment bankers give credit to management for. Using an analogy, you went from being a player to a coach or a manager of a team. What are some of the skills that you had to gain in order to become a great manager over the last 11, 12 years? Well, I think it's a little bit more of a player to a player coach than a full-on manager. Now it's probably more of a manager, but for the first several years when our team was smaller and we had fewer deals that we were working on and less capital, I was really doing both.

3:29Finance businesses are notoriously challenging to grow and manage. So we've made some, I think, really smart strategic decisions about how to grow the firm without sacrificing performance and sacrificing the experience that our employees were getting as investors. As you've grown, Korbel, you've kind of become a victim of your own success from a capital raising standpoint. Talk to me about the journey of building your capital base from 2014 to today. So fundraising is a challenge for, except for the very, very large established private equity firms. For anyone in the middle market or the lower middle market, capital raising is a challenge.

4:13We, as you mentioned, we were somewhat victims of our own success early on and were able to leverage some of the relationships with high net worth individuals and small foundations and family offices that we'd had throughout our career. And they served as the investor base for our funds early on. But as a result, we never introduced ourselves to the market in a more formalized way through placement agents to institutions going on roadshows and attending conferences and the like. So each fund that we've raised, especially as we've moved into different strategies, has been a little bit of a new reintroduction exercise.

4:53while many other funds, they make the investment when they're raising their first fund to hire a top tier placement agent and to create a stable of institutional investors with the mindset that they would be long-term investors in the firm for the current fund they were raising as well as subsequent funds and continue to grow with the firm's capital base. Our investor base, which heretofore has been more individual high net worth investors, as well as much smaller family offices and foundations, they sort of tap out at a certain point and they have different events in their lives where they are not solely focused on investing and deploying additional capital while institutions, that's their job.

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6:53From company filings and brokerage research to news, trade journals, and more than 240 ,000 expert call transcripts. That context turns raw signal into conviction. The first to see wins, the rest follow. Check it out for yourself at alpha-sense.com slash how I invest. Yes. And you've had this unique challenge. You have private credit, private equity, special opportunities, SBIC funds. You're kind of like bringing all these franchises along and you have these different vintages. What are your general principles for how you build the right investors for the right franchise? So the way we've tried to grow the firm, and this is more of a strategic investing decision than necessarily driven by what's the optimal way to raise capital, is we like to say we've grown the firm horizontally rather than vertically.

7:40We are keenly focused on what we call the lower market, which is even below the lower middle market. Businesses between 50 and 100 million dollars of enterprise value, plus or minus 10 million dollars of EBITDA. These are small businesses playing a market that is highly inefficient and gives us an opportunity to generate outsized returns for investors due to the transactional inefficiency in that part of the market, as well as the strategic guidance and support and help that we can provide these companies. So as a result, as we've tried to grow the businesses with the firm, which all firms are required to do, rather than take our successful$100 million first fund and then just raise one multi-strategy fund after the next in sequence, we've tried to raise different strategies all focused on the lower middle market.

8:29So our Our first fund was a SBIC debt fund. Rather than raise the second SBIC debt fund, our second fund was a special opportunities fund. And then our third fund was an equity fund. All around the same size, focused on the same part of the marketplace so that we could leverage the relationships and the reputation that we built in that part of the marketplace without necessarily outgrowing our strategy. So every two or three years, we are raising the subsequent fund in the series of that strategy. So the last fund that we closed was an equity fund. The next fund that we're raising is in our special situations, distressed and special situation series.

9:13And then after that, we will raise our next private credit fund. So every two or three years, we are raising a new fund from some similar investors and some different investors. And we're at a stage where each of the funds that we are operating is at a different stage in their lives. So while one fund is in the investment stage, another fund is fully invested and in the harvest mode. And the third fund is close to fully harvested and in the fundraising mode. So each of the different strategies are at a different point in their investment life, if you will. Having all these responsibilities across funds, both investing, managing, fundraising, How do you give yourself scale?

9:58How do you build out the team around you? We built a really strong team over the years with very low turnover. And the senior people with the firm have been here for a long time. They started as fairly junior investment professionals and they've been trained and grow with us. So they understand our DNA and our investment strategy and our approach to risk-adjusted return. I have a partner with whom I have a very close relationship who I worked for at Aries for many years. And he's my partner and our chief investment officer. So the two of us really together run the firm and sit on top of all of the investment strategies who have respective deal leads and deal teams.

10:41But one of the things that we've done at the firm that I think is unique and we're still able to do at our small size is all of the investment professionals work across all of the different funds and all of the different strategies. They're all personally invested in those funds and they're all promoted in those funds. So that allows each individual to not only develop their skill set across different investment strategies, but also create opportunities for whatever would be the best deal for the Corbell franchise at any point in time without trying to shoehorn a transaction into a specific strategy because he or she may have a greater incentive personally to do that.

11:22You can kind of align everybody around the success of the overall firm versus the individual funds. Exactly.

11:33it's it's somewhat of a paradox but recruiting for private equity firms how do you get people excited about funding businesses in the lower middle market and how do you get people to see past the dollars and cents of you know their their salary and their carry and their economics support for today's episode comes from square the all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place. Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground.

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13:17without the management fee base that some of the mega funds have. It's difficult to retain top talent and to recruit and retain top talent and compensate them appropriately. We try to create a more entrepreneurial experience in the long term. The ability to work across different products, private credit, private equity, and special situations helps young junior investors hone their skills and develop flexible investing capabilities. And we align their incentives. So even at a very junior level, all of our investment professionals receive promote in all of the different funds. So we try to convince them that if we do a good job investing our capital, albeit at a smaller base, and we generate meaningful profit dollars for our investors and promote dollars for ourselves, you are a participant in that early on.

14:12So while their base salary might not be comparable to where the mega funds pay people, they will get carried interest and other incentives that can create long term wealth for them. So your funds have been very active on the SBIC side and accessing the SBIC capital. Tell me about that and what has drawn you to this capital pool as a franchise? So our first fund was an unlevered non-SBIC fund, but we recognized early on that the SBIC program was a really, really attractive one for emerging managers. And the way the SBIC program works, and it's been around for almost 100 years at this point, the Small Business Administration started a program called the Small Business Investment Company Program, where the government provides attractively priced leverage under attractive terms to investment firms that they vet very thoroughly to invest and stimulate investment in small businesses.

15:17And what that attractively priced leverage effectively does for managers of these funds and for investors in these funds is it enhances the return profile. So our first SBIC fund was a 2017 vintage fund. It was a$350 million fund with$175 million of private capital and$175 million of very, very low cost fixed rate debentures. The interest rate environment at the time was different than it was now. So the average borrowing cost was probably sub 2 % on that fund. And as a result, that fund was able to generate mid-20s returns on both a gross and net basis. So all of the fees and expenses associated with managing and running a private equity firm and paying promote to the GP was more than offset by the attractive leverage that individual investors in this SBIC fund were able to access because of this license.

16:19Sometimes you have the SBIC funds, the net is actually either the same or higher than the gross. So you might have a 20 % gross, 21 % net. It's pretty wild. Why do you think more people are not focused on SBIC funding and are not taking advantage of it? from an investor standpoint or from a managed gp standpoint it's just a very it's just it's an onerous process it's a difficult process the initial licensing process and um and we now are on our third sbic fund so with each successive fund it's gotten a little bit less painful but it's a it's a thorough process and there are a lot of gps who don't have the right track record the right team composition, the right background, the right strategy, and the patience to go through what is a difficult bureaucratic process.

17:12And then once you're a part of the program, we're certainly advocates and think it's a really special community to be a part of that we benefit from in many ways. But a lot of people outgrow the program. So that's the other challenge, is that we, as I mentioned earlier, have focused on growing our business horizontally rather than vertically and have stayed in the lower middle market with smaller funds. But most GPs are constantly striving to raise larger and larger funds. And the SBIC program, as you would imagine, because of its mandate to support small businesses, is capped out at a certain level of leverage and restricts the size of the businesses that you invest in.

17:57So it's somewhat impractical to raise a billion dollar fund or several billion dollar fund because you're limited not only to one hundred and seventy five million dollars of leverage currently. So one hundred and seventy five million dollars of leverage. The benefit of that leverage is significantly muted if you're a billion dollar fund. And then more importantly, the restrictions on the investments that you were able to make out of your licensed SBIC fund are limited in their size. So businesses cannot have more than a certain number of employees, depending upon the SIC code, get your initial license and join the SBIC program, and then you age out of it in a few years if you're successful.

18:43And what about on the LP side? It seems pretty attractive to be part of this, participating essentially as part of this leverage. Why is that not more popular? I don't think the SBIC program or managers have done a great job marketing the opportunity to smaller institutions, to family offices, to individual investors. They've done a great job marketing to banks. So banks, a number of banks are investors in SBIC programs and they receive CRE credit for investing in small in SBIC funds. So that's been a very significant portion of the LP base historically. more and more GPs are trying to expand that LP base and go out to non-lending institutions as LPs, the way a regular way non-SBSC private equity firm would.

19:38And I think that the program needs to do a better job on a collective basis to access some of these investors. But these are small funds and institutions have become traditional institutional investors have become larger and larger and their alternative asset allocation has become larger and larger and they're really restricted from investing in small funds. So that's a limitation as well. You have a unique vantage point in that you have special sits, you have private equity, you have private credit, you have these SBIC funds and these bills of capital. What part of the market is most interesting to you today, Q4 2025?

20:21The special situations part of the market is really, really interesting right now. Well, I think the overall lower middle market continues to be much, and it's a self-serving comment, but continues to be much more interesting from an investor standpoint than the middle market or larger cap private equity or the public markets. The inefficiency continues to be an important driver of value and the ability to, in an old school private equity way, help make the businesses that you invest in better and more profitable should drive outsized returns. Within the lower middle market, I think the special opportunity space is really ripe.

21:02If we think about what happened during the pandemic, the government infused a lot of capital into small businesses through the PPP program, as well as the Main Street Lending Program. Both of those were artificial orders of small businesses, some of whom have grown well out of the pandemic and have benefited from the PPP loans that they have not been required to repay and are well positioned to repay those main street loans, which are required to be repaid. A number of those businesses have continued to stagnate or have taken a downturn since the pandemic and are looking at what people recognize as a pretty significant maturity wall of Main Street loans that are coming due in 25 and 26, towards the end of 25 and into 26, that will place a lot of pressure on small businesses and on the lending market.

21:57The traditional lender, the lending market have continued to consolidate. The regulatory environment has made it such that they are less inclined to lend money to small businesses, particularly on a levered basis. And the emergence of more and more non-bank private credit funds have been lending very aggressively to smaller businesses or businesses in the middle market. That goes back two, three, five years, and more leverage in this part of the marketplace should create opportunities for distressed and special situations investing. So I think the next three to five years will be an important time for funds of that ilk.

22:39And your ability to take advantage of these special situations is based on this competency that you've developed in lower middle market around some mix of private credit and private equity. It's almost like a hybrid. Exactly. So we raised our first distressed special situations fund coming out of the pandemic. We came to the conclusion, and we weren't entirely right, because we didn't realize that the government was going to infuse so much capital into the capital markets to support these businesses. But we thought there'd be a number of businesses that would be challenged coming out of the pandemic.

23:12And our primary investment vehicle was our SBIC direct lending vehicle. So we didn't want to put more challenged companies, more challenged credits in a levered licensed SBIC fund. It wasn't what we told our investors we were going to do, and it wasn't what we told the SBA we were going to do. That fund was intended to invest in healthy, growing, performing businesses, not businesses facing challenges. So we went to our LPs. We hired a former bankruptcy attorney by background to help us run that fund. And we went to our LPs and said, we think there's going to be a very significant opportunity here for distressed and special situations investing.

23:52And that was in 2020. That fund has performed very well. We've made 12 or so investments, have generated north of 30 % gross in mid-20s net IRRs and have made some investments as distressed buyouts, some investments as secondary purchases of loans from banks. And we think that that marketplace is really ripe for continued investment activity. And the fact that we have five, six years of investing experience in 10 plus companies and understanding this marketplace and developing a network of restructuring advisors and restructuring attorneys gives us a real opportunity to identify some of these opportunities and then execute on these investments, which have a level of complexity to them.

24:40that regular way loan refinancings or regular way buyouts don't have. You're obviously playing a very different part of the market as you did in Aries, but presumably you take a lot of learnings from there. What are some of the key insights that you took from Aries to how you run Corbell? I think Aries at its heart is a great investment firm in understanding and appreciating and structuring risk versus reward. And I think that's what we've become very good at as well. We've taken that DNA forward and brought it down to a less sophisticated part of the market where some of those financial engineering tools are more differentiated, even than they were at ARIES back in the day.

25:24But we recognize that the best way to make money for investors is not the straight down the middle of the fairway buyout that everybody else is competing on. We look for transactions that have some complexity to them. Our investments are generally structured where we feel like we can attach into a capital structure at a point with terms and protections and a rate that is a very attractive return profile with disproportionate upside versus downside risk. and you mentioned you're building out all these infrastructure and all these relationships with the different players in the special situation space, in the private credit space.

26:07A lot of these end up going through distress, going through bankruptcy. How do you build brand equity and relationship equity in a space where you're constantly dealing with things like bankruptcies and sticky situations? It's a good question. I think that the most important thing is delivering on what you say you are going to deliver on. The advisors in the space, it's a small ecosystem of restructuring lawyers and advisors who participate in these situations. People need to move fast. Advisors need to pick capital providers who they know are going to deliver on what they put in a term sheet or what they put in an LOI.

26:46And if you develop a reputation of being somebody who retrades at the 11th hour, you're not in the business for a very long time because nobody's gonna take your LOIs or your indication seriously. It's also important to deliver with capital on a timely basis. So you have to be able to move quickly and efficiently. So it's not only you can't retrade on terms and pricing, you also can't string a process out when these businesses are often liquidity challenged, facing the prospect of missing payroll, missing interest payments in a situation where they need a capital solution quickly that they can count on.

27:25That's another competitive advantage. The advisors in this space don't go out to 100 different private equity firms the way an investment banker who's selling a healthy middle market widget company sends a teaser out to 100 private equity firms so they know could write an X check and close a deal without tremendous time pressure and consideration on the situation, and they're truly trying to maximize value. While here, the advisors need a solution that they can count on. If you go back to 2014, before you saw Corbell, as you were coming from Aries, what is one piece of advice you would have given yourself to either accelerate your success or help you avoid costly mistakes?

28:06I think I mentioned it earlier in the context of fundraising. I think if I would have made a more concerted effort to market the story and the firm to longer term institutional investing partners, it would probably have made subsequent fundraising more less challenging than it's been. we didn't need to pay fees on placement agents early on, and we didn't need to offer fee discounts early on. And the fundraising process was pretty painless and straightforward for us. And we thought that if we could get things done quickly and get back to investing, the results would speak for themselves and the results would speak for themselves, and the investors would come.