Specialty Credit Investing in Technology and Technology-Enabled Businesses

Aron Dantzig:

Hi, Elana. Good morning. Pleasure to be with you. Thanks for taking time. 

Elana Margulies Snyderman: 

Absolutely. So, to kick off the conversation, tell us a little about the firm and how you got to where you are today. 

Aron Dantzig:

Yeah, sure. So, the firm was started about ten years ago. The firm was started by myself and my partner and good friend Riyad Shahjahan. Before starting Cap IP with me, Riyad was formerly the head of UBS's Tech M&A Group out on the West Coast and before that had spent some time in Tech M&A with JPMorgan and before that with Citigroup and Credit Suisse. And from my background perspective, by comparison, I've always been on the buy side. I was credit trained at GE Capital, I spent some time at Lehman Brothers, but I really spent the bulk of my career working for a firm out of New York called Fortress Investment Group, specifically on the credit side of the house, the Drawbridge side of the house, working for a gentleman named Pete Briger. And one of the things that Drawbridge and Fortress I think did very well, and part of the investment strategy from a high level was trying to find interesting opportunities to invest within the credit landscape. And I'll go a little deep into this to help give you a better understanding of what we're doing at Cap IP right now, because I think this is really where the strategy comes from. So when you think of a Drawbridge or a Fortress, these are strategies that are predicated on looking out at the investable universe and frequently they're finding opportunities where there's a high degree of complexity to understanding an opportunity set, potentially a level of complexity that other lenders don't want to try to understand and in doing so, create a more attractive investment opportunity for the firm as a private credit investor. Alternatively, there are situations you might look at where there's a high degree of what we'll call vague or variance between a perceived risk and a real risk. A perceived risk being what the market believes a risk of a transaction or an opportunity to be, and the real risk being what the actual risk is. And if you can deploy some level of expertise or industry acumen to really metabolize difference, then oftentimes also you can find an attractive investment opportunity. When I started at Fortress, we were looking out at the various industries and capital structures and something that we had noticed, which was pretty interesting, and it wasn't actually in the technology industry at the time, it was within life sciences industry, health care companies, pharmaceutical companies, medical device companies. There were thousands of these businesses that were out there generating revenues, but they weren't cashflow positive. And because of that, they had been divorced of the traditional debt capital markets. Well, why is that? That's because traditional lenders look at these businesses and say, "Okay, you have revenue, but you have no cashflow, and I know how to lend on EBITDA or cashflow. I don't know how to lend money to businesses that don't have it. So hence that's not a credit-worthy investment." That was a perception, and the reality was actually quite different. The reality is that these businesses were generating meaningful revenues at high gross margins, had very real enterprise and asset value today. You just couldn't look through the traditional lens from a credit perspective to assess whether they were credit-worthy. But since most investors in the private credit sphere did that, those businesses wound up in something that I call a structural lending gap. And what I mean by that is that there was small quantums of venture debt available to them, and then there was really nothing available to them again until they started cash-flowing profitably. And so, it created an inefficiency. And so I designed a group at Fortress and we built out a team to take advantage of that inefficiency where we would be lending money to these thousands and thousands of mid to late-stage companies that were revenue-generative but not cashflow-positive, had outgrown the needs for potentially more venture debt, and at the same time didn't want to bring in more dilutive equity capital. And it created a very attractive alternative source for these businesses that needed to continue to grow. And the reason I go through that with so much details is it's precisely the same strategy we're using at Cap IP. When we set up Cap IP, Elana, we said to ourselves, "Wow, is there another industry where we see thousands and thousands of mid to late-stage businesses that are generating revenues, but aren’t cashflow-positive?" And the technology industry is just littered with these sorts of businesses, software companies, enterprise hardware companies, all of these businesses, and for all the innovation that these businesses bring out to the world, what's amazing is the way they had been financed historically has been the same, modest amounts of venture debt and then a lot of equity capital along the way. And so, these businesses, by the same token, have decided in this structural lending gap. And so, in trying to invest into a strategy like this where there's not traditional cash flow, it really becomes imperative that you understand not just how to structure a loan, but also how you can understand the businesses you're underwriting. And that requires a certain level of industry expertise. So now when you think about my business partner, Riyad Shahjahan, who started the firm with me, well, geez, all he's been doing for the last 15 years is looking at emerging technology companies, understanding their products, their values, what their assets are worth, what their enterprises are worth. And so the idea in starting Cap IP was if we could leverage that skill set in understanding the businesses, hopefully with my skill sets in terms of being able to underwrite transactions and create structures and loans for these businesses, we could create a differentiated product offering that allowed us to provide minimally dilutive capital to mid to late stage companies and really help these businesses out from where they sat in that structural lending gap, if you will. Since then, we've invested a little over a half billion dollars into the space. Some of the businesses we have invested in have had some very blue chip and fancy venture capital equity investors. Other businesses we've invested in have been completely bootstrapped by founders who have created really interesting businesses and hadn't ever taken institutional capital before. And so, this product has really provided these businesses with attractive means to raise capital into the business as an alternative to equity capital and dilutive more expensive cost to capital. 

Elana Margulies Snyderman: 

Aron, I loved hearing your journey of how you got to where you are today. So, as a follow-up, I would love to hear your high-level outlook for specialty credit investing in technology and technology-enabled businesses. 

Aron Dantzig:

Yeah, sure. I think the specialty credit market for investing in technology businesses has been really interesting and compelling for several years now, due to some of those inefficiencies we chatted about earlier, Elana. I think as we go back three or four years, it's hard to believe we were in the throes of COVID not too long ago. But during that time, what you saw, and we can think about 2021 and 2022, was this extremely low-interest rate environment which encouraged just hundreds and hundreds of billions of dollars of equity capital to be deployed into the technology space. And so, when you look at 2021 and 2022, we see somewhere between $200 to $300 billion of equity capital that has been invested into the tech sector. What's really interesting about that is those dollars were invested at historically very high equity valuations. And so, you've created a universe now where there's been thousands and thousands of businesses that have either been created or grown larger due to this massive amount of equity capital that's been invested. But at the same time as we've walked into 2023 and 2024, we see these businesses have their equity valuations compressed, simply because the market has reassessed some of these very high valuations for these technology businesses. And so, because of that, we see a lot of businesses out in the marketplace right now that are what we call enterprise value rich and potentially liquidity poor, simply because these businesses need to continue to fund their operations. The challenge for these businesses almost creates the opportunity for us on the private credit landscape, which is for many of these businesses, which are very good businesses. They have real value. They could be acquired tomorrow. They're very likely not worth what they raised money at in 2021 or 2022 from a valuation perspective. And so, as these businesses need capital, their options are somewhat limited. If they bring in additional equity dollars, it's likely to be a down round valuation, which no business particularly wants to have. Or if they sell the business, it could very well be at a suboptimal valuation. And so, for us, this creates a really attractive dynamic. Now, when we think about the opportunities within the market, we do an upside-down analysis. I know a lot of investors like to say, "We're going to go focus on this area specifically." And we take a somewhat different approach. We say, "We're credit investors, so we would like to invest in technology businesses that have the most attractive, attractive credit attributes." Well, what are those attributes? Things that have high levels of visibility, reoccurring revenue streams, high gross margins, strong unit economics, very attractive liquid M&A profiles, meaning a lot of folks would like to buy the business, variable cost structures. And so, with that as a backdrop, okay, which sub-sectors have these sorts of characteristics? And those tend to be more B2B or business to business sort of technology companies. So, you can think about enterprise hardware or enterprise software, data analytics, data measurement, IOT, these sorts of businesses tend to have longer term contracts, really good ability to understand historical churn ratios, high gross margins, and they're very good businesses from an underlying credit perspective for loans and lending capital. So, those are the sorts of businesses that we tend to be focused on. I think the opportunity sets for businesses that have shown the ability to continue to invest in growth, to continue invest in products that are wanted by their customers, continue to show really strong dynamics out in the marketplace are really good candidates for us. So, when we think about the environment, those are the sorts of businesses that we find most attractive from an opportunity set perspective. 

Elana Margulies Snyderman: 

Aron, as a follow-up, I'd love for you to take a deeper dive into some of those greatest opportunities you see in your space and why. 

Aron Dantzig:

I think from the best opportunities we're seeing, they're frequently within the B2B sector. So, we have seen historically when you transition from 2021 to 2022, there was this idea of growth at any cost, burn as much money as you can get wherever you need to go. And as you saw the equity capital markets, the public markets retreat from that, and to move into more of a space of how can this company become cash flow positive? Can it become accretive? Certain businesses were more successful in being able to cut their operating expenses and grow their revenues than others. And those are the sorts of businesses, Elana, when I think about B2B sorts of businesses that are the most compelling. So whether it be a company that's in the enterprise software business or who's got a niche application for small boutique hotels, whether it's a company that's serving know the GRC space and the governance risk or compliance space, businesses that have been successful in continuing to grow revenues with muted or reduced cash burn are really the businesses that create the best investment opportunities for us today. 

Elana Margulies Snyderman:

Aron, on the other hand, what are some of the greatest challenges you face in your investing space and why? 

Aron Dantzig:

I think some of the challenges we face in the investing space, I think you can look at it in two pieces. Certainly, there are certain sub-sectors within technology which are not particularly good candidates for lending. So, the problem with lending or something you certainly want to avoid with lending is you want to avoid situations where there's the potential for what we call binary collateral outcomes. What does that mean? That means the company might be really successful or it might not be successful at all, which may be a perfectly good investment for an equity investor, but that isn't a very good investment for a lender. Why? Because for lenders, you get your money back and that's normally a pretty good outcome as opposed to a traditional venture capital firm who can afford to take some zeros on some investments because they might hit a seven, eight, or nine terms return on another one. So those sorts of businesses are challenging for us and from us as a firm, where we try to avoid is businesses, again, that have what we call these binary collateral outcomes or potential. So, things that have more of a consumer preference angle, things like potentially gaming, technology gaming companies. I don't have a particularly good sense what's going to be the next Angry Birds. Businesses which are susceptible to changes in consumer preferences, e-tailers. So, I think those are some of the more challenging areas that we've seen. I think away from sub-sector focus, again, businesses that have been unable to reduce some of their historical cash burn, which may have been perfectly okay two or three years ago, is becoming increasingly problematic now. So oftentimes we will see businesses that have not really reduced their operating cash burn, but at the same time their revenue growth is not so high to substantiate it. So, you might see some very tepid revenue growth with a lot of cash burn, and that's a term that we define as almost as empty calories. Sure, you're growing your revenues a little bit, but not relative to the magnitude of the cash burn. So not only does that require the business to more frequently access the capital markets to stay in business, I think critically those sorts of businesses are more difficult from an acquisition environment from strategics because strategic acquirers are always mindful not to acquire a business that's going to have a lot of cash burn, such that on an aggregated basis, the P&L on that business continues to be reduced. It's not accretive to the business necessarily out of the box. And so, I think those businesses are more challenging. I think we're seeing some of those credit investments that were made broadly within the market over the past few years coming home to roost right now. And I think those are sectors that we've been trying to avoid. 

Elana Margulies Snyderman:

Aron, to shift gears, ESG and DEI have been top of mind for the industry, and I would highly welcome your thoughts, how your firm's addressing these topics. 

Aron Dantzig:

Yeah, sure. I think from a high level, just from a macro perspective, Elana, the ESG element to what we do is just intrinsic to investing in the technology. The ability for people to work from home, not get in their cars and buy gas during COVID or even working from home now, what enables that? Whether it's your video, whether it's your computer able to tap into your company's servers remotely, whether it's software that you utilize that allows people to be efficient from their homes, technology intrinsically has very favorable ESG elements associated with it. But I think more specifically, ESG and DEI really has some critical considerations with technology and technology enabled businesses. It's just not an ethically significant factor. But there is certainly things that we incorporate into our credit investment approach. From a due diligence perspective, we are assessing a company's environmental impact, their governance structure, their social responsibility initiatives. This includes their understanding around energy efficiency and data privacy practices, and really policies around the employee welfare. And then we're obviously also focusing in on businesses that have a positive environmental or social impact. So be it renewable energy, sustainable change, health care access, any of these businesses are going to have helpful ESG components to them. So, I think beyond just the ethical considerations, there's the financial considerations. And the financial considerations are simply that more diverse leadership teams tend to be more effective in financial performance and hitting operational goals than businesses that don't have it. And so when we're able to parlay an ethical and social focus of ours with the firm, with the reality that many of these investments that are in a more inclusive on the DEI space, we create a real win-win situation for our investors as well as our own investments. So, it's been a very positive element. It's something that we look at on each investment that we look at, and I think something that will continue to have unique focus for us. 

Elana Margulies Snyderman: 

Aron, we've covered a lot of ground today and wanted to see what your future plans are for the firm. 

Aron Dantzig:

Yeah, I think the firm is actively out deploying a capital and looking at interesting situations to partner. We've very fortunate to have a great group of limited partners who really believe in our mission. And I think moving forward, we are as excited as ever about the opportunity set. As much private credit has raised from an AUM perspective, we're firmly of the camp that to prosecute our strategy well, to do it well, you really need to have this expertise. And all Cap IP does is technology lending. So when you think about all those hundreds and hundreds of billions of dollars that have been deployed historically and the myriad of companies that are out there that are going to need to continue to financed, to continue to bring really fantastic innovation into the world, I think Cap IP is going to be really well positioned to help partner with those businesses. And so, our plans are to continue to do what we've done historically and to hopefully just do it on a larger and larger scale so that we can partner with more and more businesses. 

Elana Margulies Snyderman:

Aron, I wanted to thank you so much for sharing your perspective with our listeners. 

Aron Dantzig:

Thank you. Thank you for the time and for all the great questions this morning. 

Elana Margulies Snyderman: 

And thank you for listening to the EisnerAmper podcast series. Visit eisneramper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business. 

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