Swingbridge LLC

Why We Like Aggressive Capital Allocators

Mon, 13 May 2024 18:52:02 GMT

The Power of Reinvesting Gross Profits the Right Way

At some point or another, we've all heard the phrase "you have to spend money to make money", typically during an introductory Business or Economics class coupled with a simple and informative application of why the aforementioned phrase is true (though not guaranteed!).

In most instances, the lesson is coupled with a case study involving a visit to the grocery store with $10 (or $20 in today's money!) to acquire the necessary ingredients required to make a handful of sandwiches. Assuming one can use the $10 to acquire all of the "goods" needed to make 10 sandwiches, and each of those sandwiches can then be sold to fellow students for $2 each, the savvy entrepreneur can find himself netting $10 of gross profit ($20 revenues - $10 cost of goods); we'll ignore taxes for the time being. The entrepreneur then has a follow up choice:

a) No Reinvestment: quit altogether and keep/spend his money ($10 initial investment + $10 profits)

b) Some Reinvestment: pocket his original investment of $10 and then return to the grocery store to re-run the basic 10 sandwich sale scenario with another $10 (profits) to try to earn an incremental $10 ($20 revenues - $10 cost of goods)

c) Aggressive Reinvestment: reinvest the aggregate $20 (initial investment + profits) by returning to the grocery store to acquire the ingredients needed to make 20 sandwiches this time in search of sales demand that will double his profits to $20 ($40 revenues - $20 cost of goods)

Businesses of all sizes are faced with these types of reinvestment decisions on a daily basis - albeit usually slightly more complex - factoring in the current economic environment, total addressable markets, industry-specific supply/demand considerations, company-level operating capacity, etc.

As we've commented previously, we like to invest in businesses that are VERY aggressive with their reinvestment efforts, particularly when they have demonstrated strong returns on invested capital ("ROIC") profiles over a period of time. To drive long-term business value expansion, most executives are charged with growing their gross profit buckets over time (revenues - cost of goods sold). Expanding these dollars gives them incremental "reinvestment budget" firepower to allocate accordingly across the growth/optimization/maintenance activities required to drive future growth and compounding profits for the benefit of employees and shareholders.

These "reinvestments" typically occur in the form of: i) SG&A spending (via sales & marketing expenses or research & development spend); ii) Capital Expenditures/Software Development Costs (via new plant initiatives or technology/process enhancements); or iii) Acquisitions/JV Partnerships (targeting complementary businesses with adjacent products/services or new lines of commercial activity altogether). While each investment bucket has a different return profile, in both dollar return terms and time horizon, the goal is to earn an attractive payback in excess of the underlying cost of capital in a reasonable timeframe. For example, the addition of new salespeople may pay off quickly via signed contracts, whereas the expansion of a plant or new production line may take longer to yield a solid return due to the long-tail building and development requirements.

As investors across both Private and Public companies, we assess 3 primary things in our initial due diligence.

Aggressiveness - how aggressive is the current and forward-looking capital allocation plan (as measured by Free Cash Flow yield)?

Efficiency - how effective has the return profile of these capital investments been over a multi-year or full-cycle period (as measured by ROIC efficiency)?

Valuation - how attractive is the underlying risk/reward profile of the business at its present valuation (as measured by the upside/downside skew)?

We have talked about these dynamics in greater detail in a previous blog post .

While many investors like free cash flow to be distributed back to them, typically in the form of dividends or share repurchases, investors/portfolio managers are then faced with their own reallocation and reinvestment decisions. In certain situations, this is the right choice for both the company holding excess cash and investors seeking alternative investment opportunities. However, that alternative can potentially create higher volatility or inefficient outcomes vs. an executive team that leverages its existing operational infrastructure to engage targeted reinvestment activities to amplify returns and compound value creation in an effective manner.

It’s a reminder that not all aggressive capital allocation plans are equal and, therefore, trying to measure the efficiency of a business’s idiosyncratic ROIC profile is so important in our process.

To translate these concepts into our actual investment activities, we've spent time analyzing public market data and stock market outcomes to try to common size the impact of various levels of capital allocation aggressiveness and ROIC efficiency across a wide population of businesses, regardless of industry. We've also benchmarked this data against some of the best performers in the stock market over the last decade to confirm that our customized ROIC metrics correlate strongly to underlying share price performance.

When ranked by our internal "Moneyball" indicator (as we call it), which is a customized composite metric that scores a Company by its cumulative ability to generate durable shareholder value creation through strong multi-period ROIC efficiency, here are the high-level outcomes across a population of nearly 200 companies with varying market capitalizations:

The Top 25 ranking names have average full cycle FCF yield of 1.0% with average 10-year equity compounded annual growth rates (CAGRs) of 33%
The Top 50 ranking names have average full cycle FCF yield of 1.7% with average 10-year equity CAGRs of 26%
The Bottom 25 ranking names have average full cycle FCF yield of 7.0% with average 10-year equity CAGRs of 5%
The Bottom 50 ranking names have average full cycle FCF yield of 4.4% with average 10-year equity CAGRs of 5%

Note: Our measure of Free Cash Flow ("FCF") Yield reflects (Cash Flow from Operations - Capital Expenditures - Acquisitions) / Market Cap.

This data highlights the influence of both aggressive capital allocation (low FCF Yield) and efficient ROIC profiles (high "Moneyball" score) into compounding shareholder value over time. Thus, while there are always other quantitative factors and qualitative assessments we evaluate in our underwriting activities, we want to continue to focus on targeting investments that benchmark well against our top quartile rankings to improve the likelihood of generating strong long-term returns while also reducing short-term risk.

Loosely, we believe long-term shareholder value creation typically occurs in one of four distinct ways. First, by creating a new commercially viable product or service category and becoming the dominant first mover to capture market share or creating a new product or service that steals market share from legacy incumbents. Second, the traditional "razor/razor blade" model whereby mission-critical products or installed services generate long-term aftermarket products or services consumables (usually of a higher margin nature). Third, financially healthy cyclical business - or businesses undergoing a temporary dislocation - with high ROIC profiles in stable environments that are trading at distressed prices due to short-term factors out of their day-to-day control but capable of taking advantage of the challenging operating environment to reposition for long-term growth. Fourth, acquirers who have mastered the "hub and spoke" operating model and can create incremental leverage through acquisition activity, particularly if using lower cost debt financing.

Targeting investments in aggressive and efficient capital allocators at attractive valuations is in the DNA of Swingbridge. As we continue to emphasize our high long-term investment return targets, for both Public and Private Equity holdings, being fueled by investments in businesses with FCF yields of -2% to 2%, the reason is simple: you have to spend money to make money.

Objectifying Risk / Reward

Fri, 23 Feb 2024 19:32:12 GMT

Investing When the Probabilities Are Stacked in Your Favor

Risk vs reward – a tale as old as time. From the earliest ages in which we can make our own decisions, humans are forced to ponder this often subjective internal calculation when deciding whether or not to take any action.

Should I try to ride my dog?

Should I stay out past curfew?

Should we go for it on 4 ^th down?

Should I eat that last slice of cake (yes, always)?

And on, and on, and on. Whether we realize it or not, every day we are faced with these decisions and we act based upon judgement over if the reward from the action will outweigh the associated risks, making it all worthwhile.

Similarly, investors are constantly faced with a simple, albeit dynamic, risk vs reward proposition when evaluating investments. Generally speaking, higher risk investments offer the potential (but no guarantee!) of higher returns as compensation for their uncertainty and volatility; whereas lower risk investments yield lower returns in exchange for their safety and security, some of which may even be legally guaranteed. Our experience investing across asset classes (Fixed Income, Public Equity, Private Equity, etc.) shows that this trade-off doesn’t always map as linearly as an investor would like but understanding the risk vs reward relationship of any investment across the lifecycle of ownership is at the cornerstone of our investment process at Swingbridge.

Fortunately for investors, unlike the decision around whether or not to eat another slice of cake, we can use actual math to calculate this risk / reward relationship and measure it more objectively.

We define this calculation of upside vs downside relationship as “skew” – a higher skew metric implies that a security has a favorable risk/reward profile offering superior upside reward potential vs its downside risk exposure (i.e., efficient risk taking); a lower skew metric implies the opposite and could result in taking more risk than is warranted (i.e., inefficient risk taking). If we get this directionally right, over and over again, it improves our probability of successfully “buying low and selling high”, which is the end goal for any investor trying to generate strong returns over time - especially if you are seeking to exceed benchmark returns.

In the simplest sense, our skew metrics estimate each unit of return potential relative to each unit of risk exposure for any given security. Or, put another way, at any given point in time, how much upside return potential does a stock/security have measured against its downside risk exposure? To accomplish this, we use financial models to determine what we think are the high (Bull case) and low (Bear case) prices targets, and we then track these on a real-time basis to have a dynamic view of how each stock/security, in addition to the overall portfolio on a consolidated basis, stands at its current valuation.

To illustrate, let’s assume stock ABC is trading at $100/share, and we estimate a Bull case upside price target of $200/share (100% upside) and a Bear case downside price target of $85/share (15% downside). This would result in a skew estimate of 6.7x per our measurements (100% return potential/15% risk exposure), yielding nearly 7 units of upside return potential for each unit of downside risk exposure. It should be noted that while, mathematically, a stock/security with only 6.7% estimated upside vs. 1% estimated downside would also yield the same 6.7x skew metric, the Swingbridge Public Equity Fund is principally monitoring and targeting names with a minimum profile of 50-60+% upside potential to meet our long-term performance objectives.

Our Private Equity investment process undergoes a similar analytical framework – assessing potential upside case exit valuations relative to downside case down-round valuation resets – though we’ll admit there is more art than science to private-side valuations given the early-stage nature and illiquidity profiles among other things.

To further outline using a more real-world example, let’s review the skew metrics for the largest holding in the fund at the beginning of 2023, which we’ll call “Stock XYZ” ( disclaimer: we avoid sharing the actual company name to avoid looking like we’re making any recommendations ). At entry, our upside / downside price targets for Stock XYZ were $170 (Bull) and $83 (Bear), respectively. As such, our average initial cost basis of $98 yielded an estimated skew of nearly 5.0x (~74% upside return potential / ~15% downside risk exposure).

As the Company has continued to execute since we first acquired the shares, growing top-line revenues while preserving margins and accelerating free cash flow generation, our current upside / downside price targets for Stock XYZ have been adjusted, increasing to $198 (Bull) and $132 (Bear), respectively. As a result, in effect, we were able to build a position in Stock XYZ at levels ($98/share) significantly below what is now our most recently updated “downside” price target ($132). Though this doesn’t mean the investment is “riskless”, it highlights efficient risk taking when remaining disciplined to our skew assessments at the time of entry.

Today, Stock XYZ trades much closer to our Bull case target near $200, and as such, our estimated measurement of skew has declined materially. Because of this decline in skew, we have actively trimmed the position back to an average-sized holding in the fund and will continue to reduce our exposure if the skew measurement continues to decline and/or our underlying assessment of the qualitative characteristics of the business and its category leading positioning no longer warrant an investment. We are constantly adjusting our upside and downside price targets, and therefore skew metrics, with new information – including updated management forecasts, industry growth rates, capital structure changes, or tweaks to real-time interest rates and equity risk premiums.

Additionally, it is our expectation that price estimates (both Bull and Bear) for our growth-related names should increase over time as management executes, which will continually increase the skew metrics. This is why we continue to own Stock XYZ shares today despite its lower near-term skew estimate. And when that changes, we can rebalance our exposure to new names, or increase exposure to existing names, within the portfolio at more accretive skew measurements to enhance the overall portfolio view.

In the illustration above, we talk about individual securities only. At a portfolio level, we consolidate each individual security’s skew metric and apply the weighting of that security’s size in the aggregate portfolio to measure the weighted average estimated consolidated skew metric of the entire portfolio, which we’ve described before as targeting to remain > 5x (and should always remain superior on a risk-adjusted basis vs. the broader stock market indices like the S&P 500). We strongly believe that over time if we can continue to monitor a growing population of attractive stocks that fit the target Swingbridge criteria, and invest in a concentrated sub-set of the highest quality names at decidedly attractive skew metrics (while preserving a consolidated portfolio skew estimate > 5x), we will continue to preserve an efficient risk/reward profile for the fund and ultimately drive long-term outperformance of the S&P 500 index.

It really is the same concept as daily decision making, only with the ability to use actual numbers and math as a guiding light. We view this as a much better, and more confident, way to invest compared to just trusting our guts. Though we’re perfectly happy to trust our guts when it comes to weighing the risk / reward of eating that last piece of cake.

Swingbridge's 2024 Predictions

Tue, 23 Jan 2024 16:12:28 GMT

What We Expect in 2024, Even If We Might Miss the Board

Every year, countless businesses and investors/investment funds write about their predictions for the coming year. And, every year, most of those predictions don’t happen. But, these predictions are often drivers of broad investment theses. And, well, it’s fun to guess.

So, despite the expectations of failure in our role as prognosticators, here are 10 predictions of what’s to come in 2024 from the Swingbridge team:

M&A activity will pick up dramatically, highlighted by a large ($20B+) acquisition of a popular consumer technology brand by one of Apple, Google, or Amazon. This will be noteworthy because it will be a business used by many, and further drive the antitrust conversations as the acquirer expands into yet another key line of everyday consumer businesses with the acquisition. ( note: we’re not making a prediction on the specific company that will be acquired given the potential conflict coming from our holdings in the Swingbridge Public Equity LP )
While the Fed will start cutting the Fed Funds rate in 2024, they will do less cuts than most economists are projecting (popular opinion is 5 or 6 cuts in 2024). The inflation concerns have decreased considerably following the prior increasing rates cycle, and now the Fed has to reverse course to avoid going too far in the wrong direction. With the stock market near all-time highs, a strong labor force, and continued Global supply chain pressures, the Fed will attempt to navigate a soft landing by being conservative in the number of cuts they make.
AI will continue its climb in popularity but will be slow to see mainstream adoption by year end. With more and more businesses looking to deploy AI-related concepts in their product offerings, this is a topic that dominates the headlines. And to be sure, we believe the concept is here to stay and will significantly impact the future (not really going out on a limb there, perhaps!). But we think it is going to take more time for the application of AI in everyday life to be accepted by most people, and that’s going to come sometime in 2025 or beyond.
The Venture Capital industry at large will quickly forget the lessons of the past 18 months and get back to deploying capital at increasing valuations with a growth at (nearly) all costs mindset. Of course, everyone now remembers that ultimately, unit economics and a path to profitability truly matters (duh!). And the mid-stage (Series B/C/D) growth type companies will still be put under microscopes for their valuations. But these VCs have capital to put to work and 18 months of investing patience feels like a life-time - time to start deploying and not being so picky once again ( /sarcasm )!
A few (call it 3-4) prominent, previously well-financed, venture funded start-ups will unexpectedly shut down in 2024. Back to point #4 regarding the challenges mid-stage growth companies will face, there are many businesses out there that raised a ton of capital at high valuations during the peak and have been able to coast through the tough past 18 months on that cash despite offsides unit economics, without the public knowing. At some point in 2024, the music is going to stop, the financing won’t be there, and they will realize there is no path forward for their business.
The Private Credit market is going to start to bubble over, with an influx of borrowers struggling to service their higher interest payments. The Private Equity world is largely built on debt leverage. But this is a good reminder that leverage doesn’t change the direction of business results, it simply exaggerates them - for better or worse. With so many businesses turning to higher-rate private lenders when banks were more conservative over the past 2 years, the burden of those interest payments will start to add up, resulting in a sharp increase in defaults in 2024.
The IPO market is going to “reopen” with strong performance for investors. One of the (perhaps many) benefits of the tighter capital financing period of the past 2 years is cream rising to the top - the best businesses have leveraged this period over their struggling competitors to get even stronger. This results in these businesses being better primed to come to the public equity markets, which matches the “quality demand” from public equity investors. After showing some patience, 2024 will be a year for these businesses to take action with their IPOs, and investors will be rewarded.
The stock market, as measured by the S&P 500, will have yet another double-digit percentage price appreciation year. On average going back 100 years, the S&P 500 rises just over 10% per year on a total return basis, so calling for a double-digit return isn’t that ground-breaking. However, following 2023’s +26.3% rise, the S&P 500 has increased by 18% or more in 4 of the last 5 years, with 2022 the only down year. The combo of Fed easing + Presidential election + a generally strong economy drives the prediction that more is coming (ok, fine, we’ll say another 18%+ in 2024).
Bitcoin will be in roughly the same position - both price and public adoption - at the end of 2024 as it was at the start of 2024. To be fair, Bitcoin is back en vogue (some might say it never left!) following the 2023 price increase of ~150% to $42K, giving crypto bulls some ammo in their fight for more Global recognition. And the early 2024 launch of the BTC ETF is expected to attract more everyday investors. Still, it feels like it’s the passionate BTC bulls who keep propping it up, while it remains to be seen how much any average investor cares. Hard to see this changing in 2024.
Investors will favor real asset businesses over software / technology businesses as a delayed impact from higher interest rates. As dollars continue to be spent on infrastructure & supply chain projects, we expect the trend towards real assets to pick up in 2024. The last 10+ years have seen higher margin, scalable software companies get higher valuations compared to asset-heavy businesses. As rates normalize, and investors consider their software investment losses and 2023 rates-driven pressure on the Commercial RE sector, the market will appreciate the value of real assets again.

And with that, let’s see all the ways we’re wrong in 2024!

Swingbridge: Investing to Win

Mon, 23 Oct 2023 20:25:53 GMT

With a Focus on Long-Term Equity Capital Allocation

The existence of Swingbridge is based on a core belief that wealth creation in the World is largely dependent on long term equity capital allocation of mostly US-based businesses. There are many reasons why we believe this to be the case but it is not our intent to defend or debate this view here, as those who disagree are unlikely to change their view. For us, it isn’t about winning a debate or convincing people to take on our view, rather, our singular focus is to produce the best results for our investors.

Investing is a basic activity, finding high rewards per unit of risk to drive economic returns on capital. This applies at all levels: at the company level, the portfolio level, and so forth. We call high reward per unit of risk skew and we will continue to emphasize this metric during our investment analysis, as we constantly monitor our current portfolio and assets in the market that compete for our time and dollars.

Our sole intent at Swingbridge is to win with our investment results. The best measurement of winning is beating the appropriate index. The most commonly referenced of such is the S&P 500, but there are many arguments for other benchmarks. While we will try and articulate which benchmarks are relevant to us within any given strategy, candidly, we dont believe it matters all that much. If our investors believe we are winning against whatever benchmark is most representative of the competing market, then that is what matters. As they say ‘ beauty is in the eye of the beholder ’ and we don’t want to lose sight of pursuing absolute returns by being distracted by relative returns.

We also understand the value of trading - markets have unique structures and if you take advantage of them over any period of time there are opportunities to win. That said, most trading work that is worthwhile is done over very short periods of time which requires extraordinary infrastructure costs such as technology and can create very high transaction costs such as turnover (having to find another idea quickly) and taxes (short term cap gains).

We are not traders ourselves, but we would be happy to consider an investment in ‘trader businesses’, as we have in the past. Many of these exist and just like any other business in which we conduct investment analysis, we will ultimately measure skew against the other investment opportunities available to us, and then invest accordingly with a long-term view. There are a variety of types of businesses to invest in, so how we find them is a real key to our success, and this is our constant pursuit.

Typically, large businesses have large followings and small businesses have small followings. As such, it is logical that investing in small businesses in the private markets can have very significant benefits as they are undiscovered, underutilized, etc., and there is ample opportunity for growth. As businesses get bigger, their followings get bigger, which inherently suggests less opportunities to improve those businesses. It would follow that for those large businesses, it is a better use of time to invest via the public markets, where the capital allocation strategy may be poorly understood by the public relative to our own views, and the option to take liquidity exists should our investment analysis not play out as expected.

Regardless of which side of the public vs private markets we find ourselves on in any given moment, the ability to take a longer term approach is what we believe enables us to build a thesis, grow our conviction, and execute. And that is what will lead to our ultimate success.

At Swingbridge, we are building our team out over time to win. A constant pursuit of continuing to understand the game, refining our game plan, and having the right team members to execute is paramount to our growth. This is not a new concept. That said, we are 100% committed to excellence in results. We have a thesis that drives our business and an internal set of values that support that commitment. Our game plan will continue to be refined as we evolve but that is the basic rules of the game.

If any of this is of interest to you, please don’t hesitate to reach out to us.

Embracing an Active Approach to Public Equity Investing

Wed, 26 Jul 2023 15:46:23 GMT

When Investing, Timing is Everything

We have spent previous blog posts talking about how we invest in the Public Equity markets at Swingbridge. We have also mentioned our stated mandate to outperform the S&P 500 over the long-term. To accomplish this, we have chosen to take an active approach to the management of our fund.

It is a popular debate in the world of investing as to whether or not an active investment strategy can truly outperform a passive, index-based investing strategy over the long-term. The legendary investor, Warren Buffett, famously challenged the hedge fund industry in 2008 with a million-dollar bet that the S&P 500 Index would outperform a basket of hedge funds over a 10-year period. And at the end of the 10-year period, he was proven to be correct. ( As an aside, Buffett himself is an active Investor, and the real purpose to his bet was to point out how the typical hedge fund 2% / 20% fee structure puts a major drag on Investor returns; the Swingbridge Public Equity LP has a significantly lower fee structure ).

But it wasn’t that simple throughout the bet. Due to the broader markets stumbling shortly after the bet began in 2008, it wasn’t until nearly 4 years into the challenge at which point the passive index cumulative return surpassed that of the hedge funds. And even as they approached the final years of the bet, the cumulative returns of each strategy were neck-and-neck. And so, the real takeaway, perhaps, is that timing matters .

It is our belief that the broader S&P 500 index is now trading at valuation levels that are historically consistent with mediocre long-term returns as measured by our upside/downside skew metrics. In the simplest sense, despite a modestly growing economy and expected earnings growth in the coming years, the index trades at a valuation multiple that doesn’t offer enough “excess” return potential to justify the possible downside risk exposure, when compared to other investment opportunities including individual stocks. This doesn’t suggest avoiding broader U.S. stock market exposure altogether. However, by utilizing these metrics, we are able to gain a sense of the underlying attractiveness of the broader market and overall investment climate, as well as to benchmark against our own investment opportunity set.

One of our expected challenges to investing in a passively managed, large capitalization index like the S&P 500 for the next several years is likely to be the current aggregate concentration among just a handful of mega capitalization stocks. This includes Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta, which together account for nearly $11 trillion of market cap and, more importantly, nearly a 30% combined weighting within the S&P 500 index. To be fair, these companies have earned their current valuations through dominant category leadership, superior products, and aggressive capital allocations strategies. But the concern here is that these businesses are not immune from the Law of Large Numbers. As an example, growing from a $3 trillion valuation to $5 trillion ( in the case of Apple ) is highly difficult absent consistent growth expansion at excessively high levels, all while facing competitors who also want a piece of the pie. And if just seven companies represent 30% of an index, the return profile of that index becomes highly contingent upon the performance of those seven companies .

Compared to recent years in which the passive index investing environment was more favorable, the biggest risk to this approach today - which represents a long-standing tenet of investing - is that there are periods of time where great companies do not equal great stocks to own. Could these large businesses see a stalling in their historically high growth rates, which impacts their valuations going forward, and ultimately leads to a major headwind for the underlying S&P 500 index? We believe it is certainly possible, particularly with a number of these big technology companies facing renewed competitors and regulatory scrutiny due to their sheer scale and influence. And how long will passive investors, who have been magnetized to the reliability and predictable performance of these mega cap names, continue to enjoy the realization of above average market returns from this basket of stocks? Time will tell, but nothing is permanent in the world of investing.

Of course, no one can say with any degree of certainty where the broader stock market will be 1 month, 1 year, or 10 years from now. But given the above, it seems reasonable to us that more risk tolerant investors staring down the growing likelihood of below average long-term equity returns via a passively managed / indexing strategy approach may seek alternative ways to enhance their long-term equity return profile.

There are two main approaches to effectively accomplishing this. First, “leveraged beta” strategies – the process of using implicit/explicit leverage or other means of optionality to in effect increase the underlying portfolio basis so any return generation is either magnified on the original investment dollars or done at reduced risk/cost. Second, “active management” strategies – the process of using individual stock selection to identify opportunities in companies that will deliver better investment returns than that of the overall market or comparative index.

While both mentioned strategies have their pros and cons, our approach within the Swingbridge Public Equity LP is to employ an active management strategy, which is comprised of investing in companies that generally have more individual “beta” than the overall S&P 500 index as a result of their aggressive capital allocation plans, industry exposure, and/or growth profiles. And while businesses with higher beta, by definition, have more underlying potential volatility ( risk and reward ), we seek to manage and mitigate this via robust metrics and disciplined processes that help us better capture realized upside return relative to that potential volatility.

At a consolidated portfolio level, we aim to maintain an estimated portfolio skew greater than 5x ( i.e. 5x return potential relative to each unit of downside risk ), which currently compares to a long-term S&P 500 index skew less than 1x by our measures. While that in and of itself doesn’t guarantee strong outperformance vs the S&P 500 in the coming periods, it does shift the probabilities of success in our favor given our more attractive risk/reward weighting, particularly if we are diligent in underwriting and disciplined with risk management.

On the other hand, investors employing leveraged beta strategies need to consider or manage to a variety of “macro-level” inputs, including valuation, economic factors, seasonality, market internals, and other sentiment-related indicators - all of which impact the value of their optionality. There are a number of practitioners who employ these strategies and some are hugely successful. However, it is our view ( and in better alignment with our skillsets ) that we are better off with our active management approach:

Step 1: Identify and monitor a pool of individual companies with highly attractive characteristics

Step 2: Invest in a concentrated subset of the best companies in that pool

Step 3: Manage that portfolio through disciplined processes

We also believe that it is simply easier to buy and sell quality businesses at attractive prices than to consistently predict the behavior of the broader capital markets.

As we outlined in our A Glance at the Swingbridge Investment Playbook blog post, it is our strategy to invest in a concentrated portfolio of ~15 companies, at attractive entry points, and with clear sightlines to value creation. In turn, this gives us ample opportunities to use the market to develop a strong thesis of where value for each company may be at any given moment, and what related action may be considered. And it is this approach that forms our active management investing strategy. When we reach what we view to be an “attractive” price, we buy. When we reach what we view to be our target “realized” price, we sell. And of course, when our original thesis has been “eliminated” due to management action ( or inaction ), we also sell.

When taking this active approach, combined with our consistently managing to a total portfolio skew greater than 5x, we believe it will help us preserve better performance against the S&P 500 index over time. And we believe the timing now is right for this approach.

Understanding Cap Stacks

Mon, 26 Jun 2023 15:59:05 GMT

A Look at the Many Different Forms of Investor Capital

As an Investment Company, like any other, we are constantly evaluating opportunities to provide Companies with capital to allow them to operate their business. In exchange for that capital, we receive something in return - most often equity ownership in the Company - that will allow us to share in the Company’s future cash flows and/or realized value growth, and thus, see our capital grow over time. This is the basics of investing.

Of course, “investing” is a far more complicated concept than described in the above paragraph. And among other things, the “something” that Investors receive in exchange for providing capital to Companies comes in a variety of forms, based upon the Investors’ specific interests. From the lens of the Company, this variety of forms is what makes up their capital stack .

What is a Capital Stack?

In short, all the capital that a Company has accepted over time to help them finance the operations of their business is represented through the Company’s capital stack, also known as the "cap stack". The cap stack itself shows the various types of capital they have accepted, and it shows the order of seniority of each type with regards to the capital providers getting their capital ( hopefully plus a return! ) back at some point in the future.

Within the world of Private Equity, debt and equity are the two main categories of Investor capital within a business’s cap stack. But there are different types of each, which allows for both flexibility and complexity when a Company builds out their cap stack over time.

Here is a look at the possible layers of a cap stack ( note: generally speaking, Companies might have some of these but never all of these):

See a detailed explanation of each layer of the cap stack at the end of this post.

The gist of how a cap stack works is that the more senior a capital provider is on the cap stack, the more certain their future investment returns will be, and the more control they will have over how the Company uses their capital. As a result, the less expensive that capital will be to the owners of the Company.

As a Company works its way down the cap stack from debt to debt/equity hybrids, to equity, the cost of that capital gets more expensive. This is a requirement of the capital providers as they agree to give up some of that seniority and control.

And from those capital providers’ perspective, the range of possible investment outcomes widens as they move down the cap stack. Senior Debt providers know that (assuming proper underwriting) their downside is limited because the odds of them losing all of their money are very low while their upside is capped because they are charging a set interest rate. Conversely, equity holders know that they carry more risk given if the business goes bankrupt, they are unlikely to receive any return of their investment after the Company repays outstanding liabilities (including debt), but they also have unlimited upside if the business value is to grow substantially.

For each Company, it is an important decision to think about the type of capital they want to take to operate their business. Of course, not all companies have the fortune to just pick and choose from any of the types listed in the cap stack diagram above, but to the extent they are choosing between two options, they need to consider the costs and benefits.

Today’s Funding Environment

As we’ve found ourselves in a recessionary period, or at least concerns about a potential economic downturn have increased, banks have chosen to be more conservative about who they lend their capital to lately. Layer in the Silicon Valley Bank collapse back in March 2023, and we’ve reached a point where it’s very difficult for Companies to successfully source Bank Debt today. We see this in our everyday interactions with our portfolio companies and clients as they seek out Bank Debt.

Because Bank Debt has become harder for companies to access lately, we are currently in an environment where Non-Bank Debt is becoming even more popular. There are a lot of companies that want debt financing, and they are turning to the private credit lenders who are eager to lend their capital. Anecdotally, we have had numerous discussions with our bank friends who have indicated expectations for this to be the case going forward in the near-term. This situation combined with the costlier nature of Non-Bank Debt could pose an issue at some point in the future if we do head into an economic slowdown, but we’ll reserve macroeconomic predictions for another time.

In the end, not all capital providers are created equally, and each Company’s specific situation may make one option better than another. At Swingbridge, we work with many Companies to think through this decision and find the best approach. By leveraging our years of experience in the Capital Markets, we are able to help Companies get to the financing solution that best fits their business, positioning them for the best long-term success.

*** For those who want to read more detail about each item on the cap stack***

1. Senior Bank Debt

Banks tend to be very conservative. They don’t typically lend out their money unless they are very confident they’ll get it back. As a result, their threshold for which types of businesses qualify to borrow their capital is quite high, and more importantly, they make sure that they get their money back before any other capital providers. Bank Debt is always the most senior position on the cap stack.

In addition to the seniority, Bank Debt is typically structured with strict, shorter-term maturity dates, variable interest rates that increase in rising rate environments (aka protect the bank by getting more expensive for borrowers), and numerous covenants, which are rules the business must follow to continue borrowing the bank’s money. On top of this, Banks will have a right, called the “first lien”, on the assets of the Company, which means if necessary, they have the legal ability to take ownership of the Company’s assets and sell them to recoup their capital.

Of course, in exchange for all these terms that protect the bank, Bank Debt is generally considered the “cheapest” source of capital for a Company, because it will traditionally carry the lowest required return via low interest rates. If a Company is able to check the required boxes to qualify for Bank Debt, it is often (though certainly not always) a great option to include on their cap stack.

2. Senior Non-Bank Debt

If a Company has Bank Debt, there is no other “Senior Non-Bank Debt”, as there can only ever be one “Senior Debt” position on a cap stack, and that would be the Bank Debt. But, for the many businesses that don’t have Bank Debt, once they bring on any debt to the cap stack, it’s technically “Senior Non-Bank Debt”. If it’s the only debt on the cap stack, it doesn’t really need to be referred to as “Senior”, but when there is other debt that is subordinated to it (more to follow), then it qualifies as such.

Non-Bank Debt is debt that comes from private credit lenders. This could be individuals or Family Offices providing a loan to a business, or any of the many institutional funds that focus on this investment class. And because it can come from so many different types of capital providers, it can come in many different forms. That being said, like Bank Debt, it typically carries a set date when the capital must be repaid, requires periodic interest payments, and it’s not uncommon for it to come with some covenants and liens, as well. However, unlike Bank Debt, it is more common to see fixed interest rates, as opposed to the variable interest rates traditional to Bank Debt. Typically, the constraints put on a business by Non-Bank Debt are less than those required by Bank Debt, so the interest rate tends to be higher (more expensive) than the rates associated with Bank Debt.

3. Subordinated (Junior) Debt

The last of the “traditional” debt on the cap stack, Subordinated Debt is no different than Senior Non-Bank Debt, other than when they both exist on a Company’s cap stack, the Subordinated Debt is lower in seniority to the other debt. This is why it’s sometimes referred to as “Junior Debt”. While the general features are the same, the cost of Subordinated Debt will usually be more expensive - via higher interest rates - than that of the Senior Non-Bank Debt.

It is not uncommon to see some portion, if not all, of the Subordinated Debt interest rate to be “accrued”, rather than paid as cash. In this case, the interest owed each period is added to the total amount of investment that must be repaid at maturity, rather than being paid out at the end of each period. This helps businesses preserve cash in the short-term that they otherwise need for operating their business.

While the general terms, outside of interest rate, may be very similar for Subordinated and Senior Non-Bank Debt, because the Senior Debt will usually put more restrictions on the business, it is less common to see many restrictions, or covenants, associated with Subordinated Debt. This makes this kind of debt an attractive option to many businesses since it allows them to run their business more freely - but the higher interest rate must be considered.

4. Convertible Debt

This is a very common type of debt that might be seen on the cap stack for a Venture Capital funded Company. The purpose of Convertible Debt is to help a business get to a point of operational performance that will allow them to be more marketable to other Investors, to (typically) raise equity capital at that time.

There are two main unique aspects of Convertible Debt relative to other debt. First, the interest is almost always accrued, rather than paid in cash each period. Second, in most cases, the original investment and accrued interest eventually gets converted into equity of the Company, rather than getting repaid. Because of this, while it is debt on day one, it is traditionally thought of more as an equity security. Thus, the graphic above refers to it as being a hybrid of debt and equity.

The “conversion to equity” feature of Convertible Debt is the most important term, as it dictates the price of that equity at some unknown point in the future. It usually is driven by a discount to wherever the next equity investment valuation prices and a cap on how high the equity valuation used for the conversion can be. This is designed to allow the Company to reward the Convertible Debt Investor for providing the necessary capital by giving them a lower equity price than what the next equity Investors pay.

Also, note that this post ignores SAFE notes, which are very similar to Convertible Debt but importantly not debt on a Company’s cap stack. SAFEs, which stands for “simple agreement for future equity”, function enough like Convertible Debt to be included in this section.

5. Preferred Equity

This is the other “hybrid” debt and equity structure listed on the cap stack graphic. While Preferred Equity truly is considered equity, and not debt, on a Company’s Balance Sheet, in the world of Private Equity, it typically acts more like debt in that there is an associated required dividend payment that looks like an interest payment. And on top of that, typically there is some period of time after which the Company is responsible for paying back the Preferred Equity capital provider’s initial investment. Because of this, many capital providers view Preferred Equity and Subordinated Debt through a very similar lens.

One important distinction between Preferred Equity and the other forms of equity to follow is that it doesn’t tie to ownership in the Company - despite being “equity”. Instead, it is simply a layer of equity that must get repaid to the capital provider prior to any other equity providers receiving payments. Because of this, some Preferred Equity capital providers will require additional Common Equity (or warrants / options to buy Common Equity for a negligible cost) to increase their capital return potential should the business value increase following their Preferred Equity investment.

6. Convertible Preferred Equity

This is the most common security that will be seen on a Venture Capital funded Company cap stack. Each time a Company raises equity capital, they will usually issue a different class of Convertible Preferred Equity, referenced by a letter (i.e. Series A, Series B, etc.). Naturally, these designations have turned into identifiers for various stages of business within the Venture Capital investment world, and certain VC funds limit their investment focus to specific stages.

While this security on its own acts a lot like the Common Equity of the Company, it is placed in a different class on the cap stack to ensure its “Preferred” feature in the event of any distributions being made. The combination of the “Convertible” and “Preferred” features of this security give the capital providers the same upside as Common Equity owners should the value of the Company increase - in which case they would convert their Preferred Equity to Common Equity - while preserving some seniority to Common Equity in the event of any lower-than-expected distribution amounts. Like most of the cap stack classes more senior than it, it typically comes with some protections over what the Company can or can’t do without approval of the Convertible Preferred Equity owners, albeit less than that of traditional debt covenants.

7. Common Equity

The last piece of every Company cap stack, and as a result least senior, is the Common Equity. This represents the true equity owners of the Company. It is considered “common” because it typically includes owners who are employees of the Company who have earned their equity rather than “purchased” it by providing capital. In this sense, the capital providers and workers who own Common Equity are all aligned on the success of the business given they share equal rights to future cash flows or distributions. Common Equity owners carry the most risk since every capital provider on the cap stack has to be repaid before they receive a dollar. But as a result, when things go well for the Company and its valuation increases dramatically, it is the Common Equity owners who have the most upside on their investment return.

A Glance at the Swingbridge Investing Playbook

Wed, 24 May 2023 17:54:15 GMT

Using Burritos to Help Explain the Approach

We spend most of our time at Swingbridge investing in both the Private and Public markets. The strategy across the two, and the skill-sets we utilize for both, generally overlap. At the same time, the two separate markets do have different sets of available information, which ultimately lead to different processes. In this case, we talk about our Public market investing playbook.

As we outlined in our last post , our mandate at the Swingbridge Public Equity LP ( a concentrated portfolio pursuing a Private Equity / Venture Capital replacement investment strategy ) is to drive long-term outperformance relative to the S&P 500 via an active approach to investing. To achieve this, we need to construct a concentrated equity portfolio through the constant evaluation, monitoring, and investment in companies that pursue growth via aggressive capital allocation plans, demonstrate a proven history of generating "economic value add” to the franchise via strong returns on invested capital, and trade at valuations that have attractive upside potential relative to downside risks over the long term.

In order to find Company's that meet this criteria, we must constantly have a robust pipeline of businesses that we are evaluating. To improve our “Top Funnel” investment opportunity set filtering, we have built a customized screening tool that:

Quickly evaluates the first two criteria above (i.e. aggressive capital allocation & ROIC effectiveness)
Ranks individual stocks, relative to a broader population, via unique metrics that show a high correlation to strong long-term equity returns

In the simplest sense, any publicly traded Company that is aggressively investing for growth (organically and/or inorganically) and has a proven history of yielding strong ROIC profiles, should undoubtedly rank high on our list of potential investment candidates. These companies generally have a proven track record of efficient value creation throughout economic cycles, whether fueled from: 1) effective operational expense spending (e.g. sales & marketing or research & development); 2) aggressive investing in organic growth projects/capital expenditures (e.g. new product launches, unit/store expansion, or enhancements to PP&E capacity); and 3) the consistent pursuit of strategic acquisitions (e.g. merging with competitors or acquiring adjacent products/services via tuck-ins).

To illustrate how this works in practice, take the example of Chipotle (tkr: CMG), which is a widely known and familiar nationwide quick service restaurant brand ( note: though we enjoy their burritos from time-to-time, we do NOT own $CMG in the fund nor do we recommend it in any way as a current investment ).

Over the last decade, Chipotle has nearly doubled its store base from 1,595 locations (2013) to 3,187 locations (2022). This growth was fueled by aggressive capital allocation in addition to efficient value add via its ROIC effectiveness. Over the last 10 years, Chipotle spent over $3.0B of cumulative growth capex at highly attractive paybacks/economics on new store openings, resulting in an average FCF yield / market cap of just 2.0%. This activity checks the first box in our evaluation.

Once we have determined how aggressive, and more importantly, how efficient a Company is with their capital allocation plans, our next step is to assess the true “economic value add” created relative to the actual weight of value granted by underlying market results, as measured by stock price performance. This analysis allows us to target Companies with a long track record of under-the-radar enterprise value creation, both relative to the total population of stocks, but also ranked versus select industry peers.

To demonstrate, when measured and evaluated by our customized metrics, Chipotle’s “economic value add” would rank in the top quartile of potential investment candidates among our total Top Funnel investment population. And further, it is among the best performers when filtered exclusively among the restaurant sector. This checks box number two for us.

After confirming that a Company is an aggressive and efficient capital allocator that has truly created "economic value add", the final analysis becomes a review of the underlying risk/reward skew profile – how much return we believe the stock can generate relative to its potential downside risk based on where it is trading at any given time. We determine bull, bear, and base case price targets via a range of valuation analyses, recent LBO transactions, private market comps, and more. The goal is to ensure we only pay a price consistent with shifting the probability of strong expected returns vs downside risk in our favor ( and just as importantly, preserving the total skew of our consolidated portfolio > 5x ). While Chipotle has been a fascinating operational growth story, Investors have piled in over the years and the total market capitalization has more than tripled from $15 billion at the beginning of 2014 to over $55 billion today, resulting in a current upside/downside skew profile that is unattractive relative to other options. This is where Chipotle misses the mark on our analysis.

Chipotle is an example of a business that scores well on two of our three key investment metrics. But by missing one of those metrics - valuation / skew - due to being further along in its lifespan, it isn’t a fit for our fund at this time. We believe staying disciplined to only owning Company's that can check all three boxes is key to our outperformance going forward.

That said, while we don’t own Chipotle, we do hold a position in a smaller restaurant company pursuing its own aggressive nationwide expansion campaign with a tenured history of highly attractive payback metrics on each new location. Our expectation is that this holding can generate long-term value add via executing comparable ROIC effectiveness relative to Chipotle. And, unlike with Chipotle, since we are able to own it earlier in its growth lifespan, and at a much more attractive long-term risk/reward skew profile at current levels, we believe this investment can deliver long-term performance results that are similar to what Chipotle has realized for its investors over the past decade.

Aggressive capital allocation + ROIC effectiveness + attractive upside/down skew profile = long-term outperformance. This is the key to the investing playbook within the Swingbridge Public Equity LP.

The Swingbridge Recipe to Drive Long-Term Returns

Tue, 09 May 2023 13:15:28 GMT

Taking the Long Road With a Focus on Attractive Upside/Downside Potential vs the Index

Our job at the Swingbridge Public Equity LP ( a concentrated portfolio pursuing a Private Equity / Venture Capital replacement investment strategy ) is to drive long-term outperformance relative to the S&P 500. To achieve this, we need to construct a concentrated equity portfolio through the constant evaluation and investment in companies that are:

Aggressively pursuing growth via dedicated capital allocation plans (organic and inorganic)
Demonstrating a proven history of generating “value add” to the franchise via strong return profiles on capital and operational investments (as measured by returns on invested capital, or “ROIC”)
Trading at valuations that are attractive enough, through a longer-term lens, to generate strong upside-to-downside skew characteristics (e.g. consolidated portfolio skew of > 5x estimating upside return potential relative to downside risk exposure)

Simply put, this is not a passive, index-based investing strategy. On the contrary, in the aggregate, we believe that if we can invest in a small portfolio of category-leading companies that are: A) growing faster than the average company in the S&P 500; B) better allocators of capital than the average company in the S&P 500; and C) are priced more attractively than the aggregate S&P 500 valuation , we have a strong likelihood of achieving our objective over the long-term. Additionally, we increase our probability of success by targeting and monitoring investments in category leaders that seek to be winners in their respective industries.

In recent years, however, investors have continued to seek the comfort of index investing and passive allocations. And for many investors, and for a variety of instances, that approach makes sense. However, when we look at the market construct today (as measured by the S&P 500 skew profile outlined below), we believe the opportunity to achieve excess long-term returns via a concentrated equity portfolio of equities with aggressive capital allocation plans and favorable skew profiles hasn’t been this attractive in a long time.

Following a highly volatile capital markets environment in 2022 and early 2023, and with news flow and geopolitical events seemingly getting louder by the day, investors have been engaged in a multi-quarter dance with a dynamic risk/reward tradeoff. This has ranged along the risk curve from the certainty and preservation of “nominal” capital offered by cash on one end to the potential but not guaranteed “real” capital appreciation from equities on the other end – both book-marking the theoretically “stable” yield profile of bonds.

As of the end of April 2023, our estimate of the long-term skew for the S&P 500 index (measured as upside return potential of ~15% vs. downside risk exposure of ~24%) was just 0.62x with an equity risk premium slightly below 2.0% (and 10-year U.S. Treasuries yielding ~3.5%). While no one knows the future, these levels are consistent with mediocre long-term passive index returns. At the Swingbridge Public Equity LP, however, we look to continue to invest our portfolio with a long-term skew profile in excess of 5.0x, in hopes of positioning the Fund with a superior risk/reward profile relative to the 0.62x skew estimate of the S&P 500.

To add some context behind these estimates, at the market peak near 4,800 in the S&P 500 in Jan. 2022, our estimate of the long-term skew went negative, implying a rapidly deteriorating risk/reward profile. And then at the market lows near 3,500 in the S&P 500 in Oct. 2022, our estimate of the long-term skew was nearly 4.0x, implying a markedly improved risk/reward profile. This highlights the aforementioned dynamic dance that investors do with risk and reward, absent short-lived swings in underlying momentum, structure, and psychology.

When taking a long-term investment horizon approach, as we do, the short-lived swings matter less, and the recipe for success remains consistent. Pick category leaders that are successfully investing in growth with upside/downside skews that outpace that of the S&P 500.