Estimated Read Time: 8 min

SBA Lending Analysis Part 2: The Best Industries for Acquisition

At Jamestown Capital, we apply a quantitative, data-driven approach to our investments. When evaluating a deal, the industry is one of the most important factors in our process. To compare industries on their relative merits, we take a look at three categories of an industry's performance: durability through economic shocks, growth and tailwinds, margin stability. With these data points in hand, we arrive at an overall ranking of industries for our investments:

Our portfolio is designed to outperform through recessions without paying up for explicit or low yield hedges. For this reason, we look at past economic shocks to guide us to the most robust industries. Covid, the subsequent inflation, and the eventual interest rate increase is the most recent episode we look towards. Further back, the 2008 financial crisis provides excellent data on which industries best weathered an exceptionally deep recession.

From 2020 through 2023, many businesses were put under pressure, despite unprecedented government stimulus. Those that thrived in this environment are especially attractive. US based manufacturing has seen a resurgence in the aftermath of the pandemic, as global supply chains showed their fragility. We expect the on-shoring trend in manufacturing to continue, as tensions with China increase and protectionism continues to drive policies that incentivize domestic production. The CHIPS Act and the early 2018 tariffs are examples of the type of protectionist policy we expect to see more of in the future.

On the flip side, retail did exceptionally poorly during covid. We prefer to avoid retail for a number of reasons. Margins are generally quite thin, barriers to entry are low, and consumer preferences quickly evolve. However, we will make exceptions for strong businesses. LineGear, one of our portfolio companies, sells wildland firefighting equipment in Southern California. While they are technically in the retail industry, their customers are regional fire departments (government entities), where the purchase is non-discretionary. Their products are also essential to safety, preventing a race to the bottom in terms of price. While the recent LA wildfires have been tragic, we unfortunately believe that the trend will continue. Finally, LineGear provides an exceptional opportunity for Jamestown Capital to add value through technology modernization.

Default rates across industries are a strong proxy for margin stability, and vary quite widely between the strongest and weakest industries.

Healthcare has the lowest default rate across industries, and tops the overall ranking at Jamestown Capital. Healthcare has some exceptionally strong properties that make for an ideal target for investment. The barriers to entry are quite high - in many states, only physicians can own healthcare businesses, and HIPAA creates a large regulatory burden that prevents easy entry to the space. We additionally prefer to target areas of healthcare that are non or semi-discretionary and suitable to small-business, such as mental health and primary care. While we believe telemedicine will continue to grow, we still prefer practices that have in-person services backed by recurring revenue. In the future, we see weight management as a source of constant demand, as the FTC continues to dispute the validity of the Ozempic patent. We see this trend bolstering the service offering in the nutrition and wellness sectors.

Despite a doubling in SBA loan activity in the recreation sector from 2020 to 2023, we remain hesitant to allocate capital to this industry. Recreation, like Food Services, is plagued by over-saturation, due to low barriers to entry. Both categories invite passionate entrepreneurs who may be excellent chefs or athletes, but weak operators. Additionally, we believe trends in the industry are difficult to predict, and enduring success hard to find. There have been some recent notable winners in the industry, such as Orange Theory, which is the best performing franchise in our dataset. However, for every Orange Theory, there are many more short lived bubbles. Indoor cycling, cold plunges, and camper vans stand out as recent trends that burnt out in less than five years.

Food Services is the most popular area for SBA lending, but one we attach caveats to when investing. Restaurants are a non-starter - the subcategory has default rates in excess of 5% and is heavily levered to the performance of the economy. Bars often have even less differentiators than restaurants, and are avoided for similar reasons. Supply chain and distribution, however, can provide for interesting opportunities. These are neutral to which restaurants win the brutal competition. Catering is another area we consider, where scale is significantly more achievable than in single-venue businesses.

We especially like professional services for investment, which includes law firms, accounting practices, and IT managed service providers, among many others. Professional services have grown at an impressive CAGR of 4.8% over the past decade, with the lower middle market benefiting from increasing M&A activity. Professional services firms in the SMB space are especially attractive to us, as both B2B and B2C sales can be particularly relationship-based and enduring. We like to specifically target firms that have an opportunity to enhance productivity through technology and automation. With many owner-operators reaching retirement age, many exceptionally strong professional services firms are put on the market, with straightforward opportunities for modernization.

Technology has experienced the strongest GDP growth over the last decade, but is also the smallest area of SBA lending. We apply many areas of exclusion to our technology investments, but remain excited about specific aspects. We explicitly avoid virtually any type of software company, as these investments start to look more like venture capital. This is not part of our mandate and creates issues for portfolio construction, given the fat-tail to the right distribution of returns. We also avoid most purely e-commerce businesses, as we believe the major platforms will continue to expand their D2C offerings, and competition will increase with F2C (factory to consumer) marketplaces like Temu. We get particularly excited about tech-adjacent firms that can capitalize on technology trends, without the challenges of competing with the MAG7 - areas such as datacenter sub-contracting, cybersecurity compliance, and cloud consulting.