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  • What's Private Equity losing sleep over? Insights from 50+ investors

What's Private Equity losing sleep over? Insights from 50+ investors

"No clear evidence that portfolio teams lead to outperformance"

This week was heavy on networking and learning. On Wednesday, I hosted a sold out Rollupeurope networking event in London. On Thursday, I dropped in on a FLEX Capital (of the “rollup farm fame”) conference in Berlin. 

Did I learn anything new? 

You bet!

Here are some observations from speaking to 50+ PE firms and HoldCos, grouped into three themes:

  • Why value creation is all the rage in PE these days

  • Which verticals smart money is staying away from

  • Building “lender ready” Finance teams that don’t cost the earth

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Mid-market PE is all about value creation these days

As one LP said at the FLEX conference, the ZIRP era returns recipe was “equal parts leverage, multiple expansion, growth and cost optimization”. 1, 2 and 3 are more challenging these days. One LP went as far as to say he does not care about PE PortCo leverage as he can replicate it more cheaply on his end. 

A fact not lost on the many LPs who have been cutting exposure to generalist mid market PE firms. 

Industry response? Double down on the fourth lever. Go all in on value creation. Hire operating partners. Talk up sector specialism.   

Not all LPs are convinced though:

Across our dataset of 80-odd GPs, there is no clear evidence that large operational teams lead to fund outperformance. What is evident is that the associated recharges to portfolio companies have become meaningful profit centres for some GPs

A German foundation

Predictably, PE folks were not going to take that lying down. They retorted with some stats.

A senior advisor to a $15B fund stood up to say he is one of 10, whereas the market standard for large-cap funds is 1 FTE per $2-3B AuM. Moreover, contrary to established practices, at this firm senior advisors do sit on investment committees. Which is not to say they are not invulnerable. Following 2+ sequential quarters of underperformance (based on pre-agreed KPIs), a new operating partner steps in. Sounds like a short leash to me! 

Is software still the goose that lays golden eggs? 

I was astonished by the number of mid market PE firms that I met in Berlin that all specialise in enterprise software. You can safely multiply that by two once you factor in HoldCos like Chapters Group (primer) or Forum Family Office (primer). 

More alarmingly, the supply of owner operated VMS firms is being depleted. According to one panellist, modern enterprise software businesses are quickly discovered by PE firms that move downmarket in pursuit of deal flow. 

With that said, VMS still is the safe bet as horizontal businesses without proprietary data are most at risk from disruption from AI on the one hand, and from big cloud providers on the other. Of course, one exception to this maxim is vertical software for the industries which themselves face extinction e.g. call centres. 

Te esteemed political analyst Constanze Stelzenmüller drained residual optimism from the audience by somberly ticking through the list of existential macro risks for Europe

When it comes to value creation, US PE > EU PE. So what?

A panellist representing a large wealth manager with $30B AuM across 60-odd GPs shared an anecdote. Two GPs bid on the same asset, a US firm and a European firm. The US firm won. 

Their bids were 5% apart. However, their value creation plans were miles apart: 

  • The US firm assumed a 15% higher EBITDA in Year 1…

  • …in part based on 30% layoffs in the first month

  • Leverage 3X+ of NTM ARR vs <1X ARR

What is my takeaway? 

No this is not a Michael Jackson LinkedIn post and I am not going to slag off the hapless European. 

One, I am going to pick a niche where US GPs cannot / do not want to reach. Two, I am going to co-opt the LPs that might be tempted to fund competition. 

No full time CFO? No problem! 

You have just raised some funds and you are out hunting deals. How much overhead can you afford? 

Worry not: a white-glove fractional CFO service from NEXG2EN starts from only $3,000/month. 

Some of you may baulk even at this price tag, on the basis that freelancers on hourly rates are a better proposition. 

Maybe. Depends on the use case, I suppose. However, as the NEXG2EN CEO Mayuresh Deosthale explained at our London networking event, cheaper is not always better, particularly when you constantly need to improve disclosure to keep up pace with growing lender requirements. Sector expertise is crucial given the intricacies of software accounting (how to recognize revenue, what is included in cost of sales / gross margin).

I spoke to Mayuresh daily when I was the CFO. I have lost count of the number of times I’d get worked up after learning about a new lender covenant or a malfunctioning NRR calculation…and then he would calmly fix it!

How to prepare for lender conversations

Linus Noren, the founder of WACCWISE, a tech focused debt advisory and brokerage firm, sees a clear break in lender requirements at +/- $10M revenue mark, for example, annual audits. 

Just like kids, rollups grow up fast (I have a 5 year old).  

According to Linus, the number one reason why debt deals fall apart (asset quality aside) is the poor coordination with the accounting team is to blame. Probability of failure is particularly high when the accounting team is not familiar with the serial acquirer business model. 

Let’s say you have sorted the Finance team, however, your debt raise is still 6-9 months away. How do you keep lenders warm? Send them monthly / quarterly updates. No need to recreate the wheel: you can repurpose existing IR materials. Highlight the momentum but be careful to include the forward-looking projections you can deliver on. Try to meet them face to face as often as possible.