Podcast: Fund Shack

Daniel Zwirn is CEO of Arena Investors LP. In this episode of the Fund Shack private equity podcast, he talks to Ross Butler about the opportunities in private markets, and how to prosecute them in a way that truly aligns incentives with underlying investors.

[00:00:16] Ross Butler: You’re listening to fund Shack. I’m Ross Butler, and today my guest is Daniel Zwern, CEO and CIO of Arena Investors, a global asset manager that seeks out special situations across the world. Daniel has some very alternative perspectives on the opportunities in private markets and how to prosecute them. And so we talk about the moral hazard of fund management, the cyclicality of private market strategies, and the opportunities that arise from regulatory and structural arbitrage.

Dan, welcome to Fund Shack. You’re actually quite an unusual guest for fund Shack because arena doesn’t seem to fit in any neat bucket. And maybe that’s the point. Why did you set up Arena? I think it was in 2015. What was the opportunity set that you saw?

[00:01:03] Daniel Zwirn: Well, thanks for having me, and I appreciate being here, as well as the question. I think arena is based on an original business plan I created in 1995. And the point was to create an investment business that was a Warren Buffett style motive franchise, right, where we could effectively be investors first. And in the early mid ninety s, as alternative firms started to get out of the box of being just a PE firm and started to think about building broader based franchises, it was our view that, or my view at the time, that there were two models to do that. One was to become what I referred to as fidelity of alternatives and effectively be a packager of branded beta and bring a long only model to the alternative space, thereby actually effectively making it not terribly alternative. The other way was to look into history and think about the folks who had been really excellent deployers of capital over time and look at the models that they employed in order to do that on a systematic and programmatic basis, such that ultimately we could have the opportunity to create a business that had material intangible value. And so we looked at companies throughout history, or modern capitalist history, certainly starting in the, call it 16 hundreds and onward, although elements of this existed far before that time.

[00:02:24] Ross Butler: So you got the history books out in order to set your strategy? Absolutely.

[00:02:29] Daniel Zwirn: Well, there’s no extra credit for originality here, so let’s go find the best ideas that have ever been and look at reasons why things like entities like the Rothschilds and other of the european merchant houses flourished over centuries, or the global grain traders and how they’ve built their business over the last 200 years into kind of powerhouses, or the Asian Hongs. Look at Ks Lee’s business, Chung Kong, or the quoks, and how they kind of did what they did. And the answer was, it wasn’t because they chose to or set themselves up to kind of be a better picker of securities. They weren’t relying on superior brain power. They were relying on creating scenarios whereby they had some sort of scarce commodity, cash or otherwise, as they looked at a value chain and such that both people examining a transaction, both buyer and seller, or both borrower and lender, whatever the counterparty relationship might be, could have the exact same view on value. But the other guy needed your scarce resource, and therefore you were going to have to pay a premium.

[00:03:34] Ross Butler: So it’s a structural issue they’re looking for. They’re not trying to value things differently and be cleverer.

[00:03:39] Daniel Zwirn: Yeah. They are looking to set the table such that the kind of good stuff comes to them. And they are recognizing that the enemy of long term sustainable profits is moral hazard, which has been the primary reason why financial institutions of various sorts have blown themselves up over the centuries.

[00:03:57] Ross Butler: Could you explain why moral hazard comes into this?

[00:04:00] Daniel Zwirn: Sure. Well, in many instances, whether it’s a hedge fund or a particular type of fund, or an insurance company or a real estate company, et cetera, people aggregate capital with some sort of stovepiped strategy. And the reality is that every single thing that we might look at to which we might apply the label, permutation of industry, product, and geography has its own frequency and wavelength, and it all cycles, and nothing’s ever good all the time.

And so, to take the extreme, as Buffett says, when others are fearful, I’m greedy. And when others are greedy, I’m fearful, right. Typically, the best stuff comes by being on the other side of those who were subject to these moral hazard issues.

And so when you look at the kind of folks that I had referred to who have flourished over centuries, they are on the right side of that trade.

[00:04:56] Ross Butler: Yes, but you’re describing 95% or more of the fund management industry. This is how the world works. It’s almost how the human brain works. You have to categorize things in order to kind of just deal with the world. And I can’t put you in a box. How do I deal with you?

[00:05:14] Daniel Zwirn: Well, I think first off is the premise that it’s, quote unquote, the fund management industry, right. Because many of the world’s best investors choose not to be a part of the fund management industry for just that reason. Right. And what we wanted to be was fundamentally a great investor, and then think about how to capitalize those great investments. And if you look at the kind of best investors out there, maybe that’s in Europe, that could be over time or recent.

[00:05:44] Daniel Zwirn: The Benedettis, right, the Benedettis. Or, you know, Vincent Bolaray doesn’t run funds, he makes money.

John Malone in the United States. And obviously, some of the insurance folks, like Warren Buffett or Prem Wattsa, or there’s a business called Markel, it’s in the property and casualty insurance. But they actually do quite a bit of clever investing, or WR Berkeley. None of those people have funds or need to have funds, right? And so, not that there’s anything wrong with funds, if one can create funds that allow you to pursue things that do make sense when they do, and don’t make sense when they don’t, and not to pursue them when they don’t. And so, again, this notion of fidelity, of alternatives, sometimes make people think that that’s just the only way it can be done. And so the ubiquity of that thought, of that thinking, provides opportunity in and of itself. Because if everyone’s going to kind of close their eyes and look left, right, there’s probably going to be a lot of stuff on the right, and we want to be on the right side of that kind of perception or misperception and effectively be a beneficiary of it.

[00:06:59] Ross Butler: Just operationally, that must be quite difficult to execute, because if you’re raising money for investors, everyone wants to add value right through the chain. And in order to add value, you need a balanced portfolio. And in order to do that, they need to know it’s LP funds, for example. They’re a black box already. So we need to have some idea of what you’re going to do. So that must create organizational complexities on the fundraising fund management side. I shouldn’t say fund management, but you know what I mean.

[00:07:30] Daniel Zwirn: Yes. I think there are two ways that investors or allocators approach that, where it can make sense in the minority of the circumstances.

They are aware of this issue, and they find ways to label it in certain ways that allow them to do the right thing.

[00:07:55] Ross Butler: A linguistic solution to.

[00:07:56] Daniel Zwirn: And they start using things that I have done have been referred to as distressed, or mezzanine, or real assets, or all kinds of things. Right.

At times, I’ll be put into this notion of multistrategy, but that’s more of a hedge fund notion.

Than a private assets notion. So that’s one way, right, where they get it and they find a way to do it. The other is that over time, people start to use kind of convenient labels and they let a few in under the door, and suddenly there’s this thing called opportunistic, and, well, now I have an opportunistic bucket, so I got to fill it, right. And so that leads to its own unintended consequences, among other things. But that is another way that investors find their way toward these things. But definitely, it’s not obvious to many, which is part of the opportunity. Right. And so you continue to find ways to do things that do make sense and avoid things that don’t. And so we do complement our multistrategy funds with what we refer to as excess capacity vehicles. And so there are times when something we’re already doing makes a ton of sense. We’re doing it already, but we think there’s much more to do, and we’ll sell that capacity in a particular geographic or product area that we think is compelling and that runs directly opposite to the normal fund management industry, which says, I’m going to articulate that XYZ is a great thing to do. If you only give me the money, then I’m going to go do it. Right. And then we’ll see how it goes. Whereas we’re saying, here’s a thing that is good. We are doing it. We’re doing it with or without you. But there’s so much to do. Why don’t you do it with us? And by the way, as soon as it’s not good, and therefore doesn’t qualify on a return per unit of risk basis to access our multistrategy funds, we won’t offer it to you. Right. And that’s a good thing. We’re going to keep you out of trouble. We’re not going to put you up a tree. We’re going to protect you. And then finally, I would say at times with some of our best investors, we become both an investment, an investee, but also kind of a quasi consultant, because we don’t actually come in with our kind of peddling our wares in a given area. We have no biases. Right. And so people can ask us, hey, I’m looking at this area, what do you think of it? And we’ll say, well, as an example, someone asked me about certain parts of the residential mortgage business, and they had a fund offering where the fund manager was touting how spectacularly wonderful it was. And what we said is, well, we’re following it, too. It’s not wonderful. It could be wonderful, and we think it’s coming to be wonderful. But this guy can’t raise his fund such that he can have the money when it becomes wonderful unless he tells you it is wonderful now, whereas we will be there when it is good and won’t be there before it’s good. And we don’t have to say that it’s good when it’s not.

[00:10:50] Ross Butler: Yeah, this is very unusual, I think, because truth telling. Yeah, well, that’s very unusual, but also because the alternatives industry has just done so well over the last decade or two. And it’s like, absolutely. If you were going to look at success stories, the natural place is to look at recent ones like Blackstone. And it’s not like a flash in the pan. This is a great company that’s grown over several decades, hugely successfully, but they’re staying within the bounds of industry norms. Why not just emulate them? It’s kind of a bold thing to do to look back to the 17th century or whatever, but it’s paying off.

[00:11:25] Daniel Zwirn: Well, I think certainly if I wanted to invest in Blackstone, I would invest in the company, the stock of Blackstone, because the owners of that stock have been the great beneficiaries of that model.

And over the long haul, that’s where their wealth is being accumulated. And so I would want to be aligned with them in doing that. Any one fund don’t know. Right. Because when you offer every type of product, where’s the differentiation? Where’s the edge? Where’s the alpha?

When you’re in a several trillion dollar market with a trillion dollars, it’s hard to be terribly alternative, right? Effectively, not with respect to them specifically, but ultimately you become the market at some point, right. And so that’s still great for shareholders of Blackstone, and I’d probably be a happy one.

What that means in terms of the fund offering, it just gets more and more difficult to kind of deliver edge. But ultimately, maybe that’s not what people want. Maybe they just want branding. Maybe they know institutional protection of careers. Maybe they want to make sure, hey, no one ever went wrong with IBM, right?

But that said, there’s a ton of super commercial, incredibly bright investing people at those places. And by the way, you could have great investors, individuals, investors at those places, just doing the best they can do with $30 billion in a $50 billion market or whatever it is, right. And they’ll give you the best chance of having the least worst.

[00:13:09] Ross Butler: Yeah. So I completely buy the idea of investors. First, no moral hazard, kind of an unconstrained approach, but that carries with it, surely great operational complexity. So you’re global, for example. You’re not huge in terms of assets under management, but you’re global, and you look at all sectors and across the entire capital structure.

There’s a virtue sometimes in constraining yourself.

[00:13:37] Daniel Zwirn: Well, I think a very frequent response when we talk about being kind of global and multi strategy. You know, I have this wonderful shipping mezzanine private credit guy in Hamburg, and you can’t possibly be as good as him at shipping mezzanine in Germany or whatever. And our response to that is what you have is a big bunch of moral hazard there, right? Where you have hammers that only see nails. And so it is not coincidental that such a guy would keep saying, well, this is a wonderful thing to do, even when it’s not. And so we respond to that by saying, let’s find a way to get the milk of that domain capability without the cow of the fixed cost infrastructure and the misalignment of interest. And then we do that through the creation of what we refer to as joint ventures. And so in addition to our 160 people with a subset of those in the front office, and among our front office teams, we have north american corporate real estate and structured finance, global credit markets, natural resources secondaries and liquidity solutions, european private investments and Asia Pacific private investments. We have over 50 joint ventures all around the world, and each of those joint ventures has very deep, particular sourcing, analytical or servicing capabilities to which we want variable cost efficient and hyper aligned access.

So instead of being in the european shipping mezzanine fund, and you lock up for five or seven years, and that stuff may or may not be good. And then when it’s not good, you start to hear things like it was a bad vintage or 100 year flood or perfect storm or other exposed excuses. You do it when it does make sense and you don’t do it when it doesn’t. And lo and behold, when such a person is investing a good part of their net worth in a ratio set ratio with you, and we’re, of course, making every decision up front, and along the way, we’re husbanding all the cash and all the bank accounts, right? And so we effectively create a sourcing servicing front end for that very particular person or group. Lo and behold, they actually don’t want to do much at all, which is exactly what we want. We want people and partners who never want to do anything until they should be doing something and then when it’s overwhelmingly obvious, that’s exciting. There was an investor, George Soros’s original partner, Jim Rogers, who said something to the effect of that he doesn’t really like to invest. He just likes to look at, find cash sitting in the corner of the room and just kind of sweeping on up. Right. If it doesn’t feel like that, if it feels like you’re pressing, you’re in the wrong thing. And so those partnerships, of which I’ve done over 150 over the last 25 years, mean that we are dealing with hundreds and hundreds of people connected exclusively to our business that have very deep, particular capabilities, such that we are the home team in whatever product or geographic investment area in which we’re involved. At the same time, those are connecting to business units that themselves have a sufficiently wide domain over which they run, like north american real estate as an example, such that there is very little chance that they’re going to have nothing to do, right. So that they’re not going to subject themselves or us to that moral hazard issue.

[00:16:42] Ross Butler: What’s the secret of making those types of partnerships work?

[00:16:45] Daniel Zwirn: In a nutshell, being very upfront with our need for alignment of interest and kind of seeing eye to eye. From a commercial perspective, it’s hard to define, but we know it when we see it. We know there are people who have done a thing for 40 years who are intensely, intensely commercial people, almost like it’s almost more that they are artists versus scientists. And we have real appreciation for that. And a lot of the times when these folks try to speak to more conventional asset managers, they say, well, do you have $100 million already? Who have you done it with?

Let’s look at your systems. Blah, blah, blah, blah, blah, right? All we want is commercial killers, right? And we will supplement the analytics portion or the mid and back office capabilities or whatever other things they lack, so that we get that isolated, pure commercial capability working, putting its ore in the water with us at the same time. And then the final piece, as you point out, is all the system stuff. So we’ve been working on systems of our own since 2004 and have put several tens of millions of dollars into them. And you’re right, it is complex. And you’re effectively running from a mid and back office perspective, is what a bank should be. And so it’s hundreds, if not thousands of accounts and many jurisdictions and FX hedging and lots of checking things, right. And so we use this notion of servicing to start, right? Which is, again, not a thing. You hear that word, you don’t hear that word a lot in, in the quote unquote asset management business. You hear it much more in real estate and other kind of pure liquid assets or asset companies. You hear it in the securitization markets where I heard it was really with regard to what happened in the early ninety s in the US with the SNL crisis, and when all of those bad real estate loans arose, there were folks who created special servicing capabilities married with investing capabilities.

[00:18:58] Ross Butler: Does servicing mean like workout teams?

[00:19:00] Daniel Zwirn: It means everything from checking and onboarding and surveilling all the way through dealing with deep workout.

[00:19:08] Ross Butler: Right.

[00:19:09] Daniel Zwirn: And so this notion of servicing sitting between the front office and the back office, providing operating leverage to both as well as this, is key, as well as a completely dispassionate second pair of eyes on everything you do, such that your front office or your joint ventures don’t subject you to moral hazard through their Stockholm syndrome is key.

And we’ve married that with capabilities that we have in India that I learned along the way in order to kind of create cost efficient scaling of those special servicing capabilities. And so our servicer quester advisors, which was named for the folks in the Roman Republic who were sent out to the provinces to calculate and collect the taxes, is based in Jacksonville, Florida. And Jacksonville is like the current equivalent of what Dallas was in the place with a good tax regime, a good time zone and temporal proximity to a banking implosion. And so non Miami, Florida was a place where many banks failed in the eight crisis. And so there’s an overabundance of great middle and back office bank type capabilities, right. Which we then supplement with our largest office, which is in so, or now Bengaluru. And so that arose from the fact that along with some partners, I created a significant US focused, but mostly India based consumer lending business, AI driven consumer.

[00:20:37] Ross Butler: Lending business as part of arena.

[00:20:39] Daniel Zwirn: No, this is a different thing I did before arena was created. I’ve created several kind of financial institution oriented businesses from scratch. And here we had over 500 people, of whom 90% were in India. And so I kind of became accustomed to how you build financial infrastructure linked to a us base that is cost efficient and highly scalable. So when we marry those three things, free flowing, mandate aligned and variable cost efficient sourcing with the people process and it around servicing, you then start to have material edge to which you could refer as the creation of substantial intangible value in a franchise that has kind of repeatable, programmatic, systematic ways of doing things that ultimately investors should value as a company.

[00:21:30] Ross Butler: Yeah, I don’t know much about these things, but it sounds to me like. So a traditional private equity firm has much less flexibility in terms of interfacing with the market, but also has much simpler operational compliance, fund admin requirements, whereas you have great flexibility when interfacing with the market. Yes, but it means that you need much greater sophistication in your back office.

[00:21:55] Daniel Zwirn: Or running an enterprise.

But that’s where the edge comes. And if you look at great allocators or true investors of capital over the last several centuries, they were very mid and back office intensive. We talk about taking process risk versus value risk. So of course, there’s no free lunch. And so if I want to make what otherwise, from a value perspective seems like free money, it means I’m going to have to work harder in the context of the kind of infrastructure I’m going to need in order to handle whatever we’re dealing with.

[00:22:27] Ross Butler: So just in terms of the products, we spend a lot of time on this show talking to people in private credit, increasingly, but mainly private equity and venture capital.

This feels to me like a very solid way of prosecuting growth in any kind of relatively well managed economy. It doesn’t feel like a cyclical play. It feels like structurally sound approach to helping businesses.

Would you agree, I mean, would you be opposed to just setting up a strategy for kind of, let’s say, mid market european businesses and in the belief that that’s just an ongoing opportunity, or do you also see that as fundamentally over a long enough time horizon, just a cyclical play?

[00:23:18] Daniel Zwirn: Well, we’ve been in a pretty interesting bubble from late nine until late 21, and that made it feel like it was going to go on forever, which is how bubbles always feel. And certainly in Europe, you’ve had many, many bubbles go back to the South Sea bubble, and so it feels good until it doesn’t. And so what happened was that that bubble was created by some highly irresponsible monetary authority decisions starting in 2012 with QE two. The whole notion of QE itself is debatable with regard to its appropriateness in the marketplace and the ultimate rate risk.

[00:23:55] Ross Butler: That has moral hazard.

[00:23:58] Daniel Zwirn: Tons of moral hazard there. Tons of it. And so when QE two happened, this greatest ever asset bubble began to inflate, and it inflated and inflated and inflated. And then, lo and behold, starting in 2020, incredibly reckless fiscal policy made its presence known, certainly in the United States, but in many other large markets. And it was briefly kind of masked with the theoretical imperative brought on by the pandemic. And so what you have now is suddenly a world where there’s inflation again. And as you may recall, again, moral hazard. There was supply chain, and it’s just Covid. And people like to make all kinds of excuses when they kind of start doing the wrong things. And the reality was it was grotesquely reckless fiscal policy, inciterating fiat currencies, making it ultimately impossible for monetary authorities to do anything other than raise rates. And so now in the United States, as an example, we have higher debt as a ratio of GDP than we did coming out of World War II, which was the previous kind of asset bubble of all time, effectively by virtue of the fact that most of the world’s major governments borrowed tremendously and then consequently destroyed a lot of the collateral that they created as a result of that borrowing. And so that left them with no choice in the late forty s and nineteen fifty s to do anything other than have a combination of higher inflation and higher rates so that they could decrease the debt they effectively owed. And so now you’re seeing the same thing. And so we have this massive, massive debt built up against this massive amount of assets that were effectively systematically overpriced, both from the perspective of the enterprise, where asset value is paid, but also in the structure and advance rates and overall pricing of the credit that financed it. And so what happens? Well, it’s got to go the other way. Has to, right, mathematically. And so what we saw is starting in late 2020, a rolling series of train wrecks began and again, jawboning away. This is the greatest thing ever. Let me get my next fund raised before I tell you how bad the last one is, et cetera, et cetera. But the reality was that in late 21, we saw growth implode. Growth in venture implode. And why was that first? It was first because in many of those instances, you actually needed cash for the assets to exist, right? Because they were cash burning. And so you had all these wonderful unicorns with their horns and white horses running around needing cash. And suddenly people said, well, at what price? And it created a catalyst for the recognition of the value, or in that case, lack thereof, that has then precipitated the implosion in that space that has only, at best in the bottom of the first inning. And so there were over 3000 kind of venture blow ups or effectively quasi bankruptcies last year, right, in the venture world. People refer to this thing in the United States called the ABC, which is the.

Oh my goodness, I forgot what the a is for the benefit of creditors. But the point is that it’s a way of burying a bankruptcy in your backyard and pretending that it didn’t happen. And the venture folks are very good at pretending failures don’t happen.

[00:27:29] Ross Butler: So it’s hard to see in the data then on defaults, presumably.

[00:27:33] Daniel Zwirn: Well, there’s nothing frequently to default per se. Right? It just fails.

[00:27:39] Ross Butler: Did Silicon Valley banks collapse play into that as well, as part of the same ecosystem?

[00:27:43] Daniel Zwirn: I suppose not really. That was misunderstood. They didn’t take a lot of actual venture lending risk. They took gigantic amounts of interest rate risk by owning securities without proper interest rate hedging, which is a whole separate matter that was highly misunderstood by the marketplace. And so ultimately, again, the first area that popped was this area in growth and venture. Then in 2022, a number of large scale allocators realized, wait, my assets are way longer than I thought, and I have to make pension payments or endowment related payments or insurance related payments, and suddenly my assets are way longer. And, oh, XYZ mega fund doesn’t come every two years with a new $20 billion PE fund. And by the way, these things could last 15 years, and there’s not distributing any money. And how do I make my obligations set?

[00:28:38] Ross Butler: Actual mismatch.

[00:28:39] Daniel Zwirn: Yes. And so what happened there was that some of the smarter version, members of that community started selling early, both because they realized they might have an asset liability match, but also because in all likelihood, they realized that there’s a great lag between when value is diminished in those funds and when it’s actually shown through the NaV statements. And so they hit the bid early and got out like Harvard endowment, in some instances, at least. And it was not coincidental that several of the largest secondaries funds of all time were raised, right. As large scale mega funds raised $20 billion funds to buy at Nav, the interest in the other mega fund, PE funds, right, et cetera, et cetera. And so that mismatch presented itself. And all of these come in the form of either cash needs, asset liability mismatches, or, effectively, maturity walls that force the realization of value, because no one wants to admit that they’ve had a problem unless they’re really confronted with it. Then, a year ago, we had real estate arise, right? And we saw that the sudden move in rates meant that certain banks were exposed. And that was further catalyzed by the fact that we realized for the first time that bank deposits can move with a speed and alacrity that they had never moved before, because through technology, you can change where your deposits are very rapidly. And so, traditionally, banks, when they thought about their liability, set a thing called demand deposits, which is people like you and me that just put their money into the bank were valued more highly than term deposits that have specific lifetimes. On the theory that over time, the average demand deposit was eight years or ten years, and it was cheaper than having term deposits that were more expensive at three and five years. But lo and behold, those deposits certainly turned out to be only there when you don’t need them. And they started to move very suddenly. And that exposed a real asset liability mismatch once again, which in the United States further exposed the fact that in the wake of the GFC, regulators, as regulators do, both over regulated and misregulated the US banking system. And they basically said, you’ve stunk up most of the investments that you’ve made. So now you can only buy securities and do Cre lending. So lo and behold, through effectively moral hazard, they said, okay, I’m going to buy securities, abs and other types of securities, but I’m going to go way longer so I can reach for yield in a non yield environment. Right.

[00:31:02] Ross Butler: This is during the 2010s. They’re doing this after the.

[00:31:04] Daniel Zwirn: And all the way through, all the way up. Right. So they went longer and longer, more.

[00:31:08] Ross Butler: Exposure to commercial real estate going into Covid than historically.

[00:31:11] Daniel Zwirn: Well, first they were more exposed to securities and those securities had long duration and they effectively exposed themselves to interest rates more than they had ever been exposed.

[00:31:22] Ross Butler: Right.

[00:31:22] Daniel Zwirn: And then on CRE lending, they went longer in CRE lending with greater advance rates at cheaper prices, where they were most exposed. And they effectively exposed themselves to that as well. And were the victim of the secular change, such that office basically has vastly less value than everybody ever thought it could. And so they did in fact have a perfect storm. But it wasn’t really their fault because they were told they could only do a couple of things and they did a couple of things. Moral hazard, yet again, was it regulation.

[00:31:52] Ross Butler: Or was it regulation by raised eyebrow? Did they have to do it?

[00:31:55] Daniel Zwirn: Well, it so happens that I was involved in two bank turnarounds in the wake of the GFC. And we tried within those banks. As an example, when we looked at doing a loan, no matter how low in risk, that had a double digit coupon. It so happened that in those two bank turnarounds, when we tried to do things outside that box, the regulators were violently opposed because of their systematic misconception that the price of a loan, the coupon, effectively the IRR of a loan, is directly correlated with the risk of a loan, which is frequently not the case. Right. And so we said, here’s this low risk but higher return opportunity. Oh my God, no. And then you have to put up more capital against it and it effectively destroys the Roe. So the banks were literally sitting with their boots on the necks of bank operators, forcing them to regulate. Absolutely forcing them into things that made no sense, right. And at the same time, those people had jobs, they had shareholders, they demanded a return on their equity. And so they were caught in a corner and they effectively created the seeds of the next bank implosion, which is now happening particularly in cre.

And then next came leverage finance. And so leverage finance evolved post the GFC in a very unique way, which was that there know, just the CLO business, just the direct lending business, just the leveraged lending business, just the PE business. Those all were one thing, unbeknownst to most of the participants among those four areas. Right. And so what happened was that CLO equity was marketed post the GFC by saying, well, all of that CLO equity, pre GFC, that went down to a dime on face, came all the way back. So this stuff is bulletproof. It can never go down. It’s wonderful.

And by the way, it’s clo, it has the word loan in it. Doesn’t really give you the ability to understand that it’s ten times levered, right. Because it’s a loan. What do you mean ten times levered? And it should make ten or 12%. So it’s really, it’s great risk reward when it was effectively terrible risk reward. And by the way, if it was such a great risk reward, why were the CLO managers selling it to other people when they could have had it all to themselves, right? In fact, they were owning virtually none of it. And so off the back of that CLO equity, they were able to raise AAAS that financed the right side of the balance sheet of the clos at incredibly low rates from international insurance companies, in many instances at 30 bips or something along those lines. And that therefore created this gigantic wall of capital available to would be leveraged lenders among the CLO managers who then suddenly were interested in buying loans that were higher leverage, cheaper, badly structured, et cetera. And at the same time as the alternative space boosted the opportunities available for access to capital for private credit managers. Lo and behold, the size of those private credits became competitive with the leveraged lending space. And effectively, it was a race to the bottom on pricing between direct lending and leveraged lending. And then finally, given that massive availability of credit at incredibly low pricing with terrible structures. Lo and behold, the PE firms said, well, instead of buying it eight times, I’m going to buy it twelve times because I got to get my fund deployed right, and my roe is going to be okay anyway because my debt is so cheap. The problem is that intrinsically, the post tax, unlevered free cash flow of the enterprises is what it is. And so at that unlevered yield of eight or eight or 10%, if you buy that into a seven or 8% return and you finance it at six or seven with incredibly high amounts of leverage, when rates change and or even if inflation arises and margins compress, lo and behold, you’re going to lose a lot of money. And so the same thing that is happening as we speak to the cre owners, who effectively thought they were buying when they bought core real estate funds, and they looked at those big cash flow producing assets and said they’re so safe. And they kind of intuited that the word core meant their investment instead of the asset, when in fact, they had incredibly levered real estate equity purchased at a five cap, which left them completely exposed, not only to asset prices, but to rates. They’re now sitting on things that are labeled core, that are worth zero. Right. When you think, well, core, maybe I’ll make 3%, 6%, I’m never going to lose my money, right? Except that it’s gone, right. They don’t know it yet because it hasn’t come through the NaV statements, but it will. And so a similar thing is happening in PE in many instances. And ironically, it’s happening in the same way, which is all of the most attractive areas. Enterprise software, healthcare services, business services, which from an equity owner’s perspective, are fabulous because they have franchise value without the use of capital. Right? So your cash flow conversion is very high. Well, at some point, if you have a wonderful business, but you kind of grotesquely overprice it and you borrow tremendously against it, you can have a great asset or a great enterprise, but you just may not own it for long because your creditors now own it. Right? And so we saw the most bankruptcies in 23 that we had since 2010, and those issues are continuing to escalate.

And then finally, in structured finance, we’ve seen escalated delinquencies throughout the structured finance universe in ABS, and we haven’t seen it translate into pricing, because, for instance, many of the, what they call real money, or conventional financial institutions, insurance companies and others that own that credit don’t have to take the losses mark to market losses into their income statement. They could only put it on their balance sheet as long as they don’t sell. So what are they going to do? Not sell, no matter how bad it is. Right. And so that will be arising soon. And so we have this kind of confluence of circumstances in monetary and fiscal policy that have now led to this bubble and its subsequent popping that we’re in the midst of as we speak. And many have raised the issue of it being a golden age of private credit, et cetera, et Cetera. It kind of is right on. New issue, new things to do. And in fact, the entire marketplace, in my view, has evolved into what I would refer to as a barbell opportunity. Whereas on the one side, on the right side of the barbell, we can go after all the busted opportunities created through the implosion of these various bubbles. And on the left side, with the dust clearing, there are new issue areas as we are pursuing in conventional real estate, mortgages, asset based lending, lower middle market cash flow lending, parts of energy lending, lots of great stuff that were kind of horribly mispriced for a decade during the bubble era that are great things to do fresh on the left side of the bound, on the left side of the barbell. And so most of the folks who are touting this kind of left side opportunity are forgetting to mention that they’re loaded with some of the right side of the barbell opportunity that they had a hand in creating.

[00:38:48] Ross Butler: You paint a more worrying picture than I’d probably pick up from what, reading the general business news. So you outline a number of, like, I think you call them train wrecks. And so we started with venture and growth, and that happened early. And then we went through to, sorry, what was next, the fund space broadly. And so that happened with the secondary began to happen. Okay, right. And then there’s the commercial real estate, which you’re playing into now. So that’s actually happening.

The kind of the leveraged finance one that’s slightly more hypothetical, or are you actually seeing this happen now?

[00:39:18] Daniel Zwirn: Well, bankruptcies don’t lie. They’re filing, but you’re getting a lot of amend extend this new term called liability management exercise.

A liability management exercise means you failed. Right. The business was mispropperly capitalized and there’s a restructuring going on. But people are trying to use language to kind of paper over failure of various sorts. And CLO obligations have been much more difficult to find, particularly the equity. The credit has more recently tightened in terms of the right side of those balance sheets. And so that ability to refi is hitting the same type of wall that it did with Cre. And people are going through these amend, extend and pretend exercises in order to hide it.

[00:40:01] Ross Butler: Right. And so this goes back to your fund structure. Are you raising money around these opportunities in order to play into them?

[00:40:07] Daniel Zwirn: Well, within our multi strategy, we’re going after all of it. Right. All that’s good and waiting on all that’s bad. But we are in fact looking at raising capital for on the right side of the barbell, things like litigation, finance, where there’s a lot more opportunity, it’s uncorrelated or special situation secondaries where there’s a fabulous opportunity. And on the left side of the barbell, things like commercial mortgage lending and asset based lending, where again, it was really unappealing for many, many years, and now it’s back around and quite compelling. And we’re doing all of those things in the multi strategy anyway.

[00:40:41] Ross Butler: So I used to think that special situations was like a euphemism for distressed turnaround investment. But the way you explain things, it just does sound like special situations. Let me give you an armchair analog kind of hypothesis, and it might be completely wrong, but sure. My view of the world of the last ten or even 20 years is that it’s been remarkably benign in terms of a trading environment for many companies. And when I was growing up in the felt like if a company was badly managed, then when the economy went into a downturn, that became perhaps an opportunity for a turnaround investor.

But we’ve seen during that, say, 20 year period, much less of that. And I think it’s probably, it speaks to what you were saying about all the intervention. We live in a more kind of intervening global economy and regulators are more regulation, and everyone’s trying to clamp down on everything and let’s say socialize the cost of bad management, whether it’s state bad, you know, economic bad management or company bad management, spread it all out and make sure that things just kind of rumble on and on, right. And it’s kind of in my mind I’ve got this image of you’re trying to squeeze a balloon, the regulator is trying to squeeze a balloon, but eventually opportunity pops out because you can’t keep it in. And so from your perspective, let’s say the opportunity set, perhaps maybe 30 or 40 years ago, might have been selecting a region and looking for badly managed companies within it. But now it’s kind of, you can do it in a more macro way because the problems and the stresses are a result of something more macro like regulatory arbitrage.

[00:42:22] Daniel Zwirn: Yes.

[00:42:22] Ross Butler: So that’s how a relatively kind of, I don’t know, mid markety type operation is able to prosecute a genuinely global strategy. Is that a reasonable kind of.

[00:42:32] Daniel Zwirn: Yeah.

The asset management industry loves using labels in order to kind of make the sale easier. Right. Distress isn’t an asset class, it’s kind of a state of being. And so it can happen everywhere for all kinds of reasons. And so we like that. And so it doesn’t mean the underlying enterprise or asset is flawed, it just may mean the capitalization of it is right. And so that happens everywhere in every way with regard to the environment. Certainly in the US, one of our greatest presidents, Ronald Reagan, once said that some of the scariest words he’d ever heard were, I’m from the government and I’m here to help.

There’s no economy and no private market situation that governments can’t ruin. And certainly we saw it in the UK in the early seventy s, which was an economic disaster wrought by kind of leftist policies that have shown their flaws in 100% of the time that they times that they’ve been implemented since they were created as a notion, starting with the late 18 hundreds. And so those circumstances gave rise to the availability or to the market’s openness. To have someone like Margaret Thatcher come and start to kind of clean up the mess, typically there has to be an implosion wrought by the socialists before somebody of kind of liberal economic thinking is permitted to kind of gain traction. And we saw that here. You guys jumped the gun a little bit. You hired someone, a prime minister and a chancellor, who kind of committed the sin of telling the truth, and we’re quickly bounced from office. Right.

And so these policies create opportunity.

Bad government policy creates more and more and more opportunity.

And so we think there’s an incredible opportunity arising here because of this terrible combination of monetary and fiscal policy that was pursued for in the former case since 2012 and in the latter case since 2020.

[00:44:33] Ross Butler: The other thing I noticed from looking at your website and some of your investments is distressed investors, which isn’t the right term, obviously, but we used to call them vulture funds in this country. They have a bad reputation, or not a bad reputation, but you know what I mean. It’s like potentially the unsavory side of things. And I was looking at your investments and I felt like there was greater social utility in a lot of what you’ve done.

[00:44:57] Daniel Zwirn: Absolutely.

[00:44:57] Ross Butler: Than the average kind of mainstream vanilla private equity thing. And it’s like you’re rescuing things and some of them are, like, good in every way, like rehab centers and so on. But sometimes they’re just hotel chains that have been struck by Covid or whatever, and you’re going in. And for me, there’s huge social utility in that. But it’s so easy if you use these narrow category bands to think, oh, well, they’re the guys that go in when everything goes wrong, you know what I mean? Seems so unfair.

[00:45:23] Daniel Zwirn: Well, you would think that the appropriate rationalization of an economy’s assets ultimately minimizes the cost of capital for that economy, the more straightforward that process is. And so, of course, that’s the, you know, Europe specifically, as an example, has a long history of kind of demonizing opportunistic capitalists. And so that is incredibly.

[00:45:48] Ross Butler: And so, like ESG, for example, is huge. And that’s. ESG is another area where you might get a kind of an arbitrage, because regulatory arbitrage is very clear, right? There are rules, yes, but ESG, it’s much less clear, but it still creates mindset sets and kind of swim lanes, which in certain types of assets just become off limits, not necessarily because they’re bad, but because people think other people might think they might be bad. And so suddenly that must create opportunities as well for a flexible investor, I guess.

[00:46:20] Daniel Zwirn: Well, I think things like that, I’m a member of certain and have been a member of investment endowments, and when ideas of those type arise, my question is always, well, how much return are we willing to sacrifice? People gave us money to endow this institution. How much of their money and the return we would have gotten on it, are we willing to sacrifice to express our social views through their money? And suddenly the answer is so, you know, I think the issue is, where do you start as an enterprise, from our perspective, whether there’s ESG or not ESG, there are things we will do and things we won’t do, no matter who’s telling us whether that’s good or bad or the other, because we’ve thought through what is kind of decent and virtuous and things that we feel comfortable knowing. The world knows that we’re doing and those that don’t. And there are things that we avoid that no one’s told us not to, that we do anyway. And there are things that we’re going to do that actually do make sense, no matter what they say, because they do make sense, right? And so that means that we’re never going to be involved in things like greenwashing, because we never had to think that way.

And the reality is, in the case of energy is do we want to deal with climate deniers? No. Do we want to deal with polluters? No. Do we want to deal with people who are destroying their communities? No. Do we recognize that energy transition is a 40 year reality, not a four month or a four year reality. Do we want these quote unquote dirty areas to be cleaner?

Absolutely. And so our views on those things don’t change, don’t have to change. And so therefore we’re not running toward it and then running away from it and then running toward it again. Right. And just like you saw here in Europe where it know, we’re all about ESG, and then suddenly people were faced with a possibility of a cold winter without russian energy and they’re like, oh my God, forget it, let me just get my coal right. And so we’re consistent in how we do things because we thought beforehand about who we’re going to be and how we’re going to operate. And we stay with that because it makes sense.

[00:48:30] Ross Butler: And it sounds like you don’t borrow your sense of morality from kind of the industry norm, which is, I think the problem with ESG, to be honest with you.

[00:48:36] Daniel Zwirn: Well, and of course that goes to the entire notion of being a seller of branded beta. Right. And so much of the alternative space is in the marketing business, not the investment business. And so if you’re in the marketing business, you do what sells.

[00:48:51] Ross Butler: So I get the impression that you’d rather be seen as like one of the grand high finance merchant banks of the future than, I don’t know about.

[00:49:00] Daniel Zwirn: Grand, but certainly merchant capitalists. Absolutely.

[00:49:02] Ross Butler: So what’s your ambition for arena investors over the medium or long term? What’s your vision?

[00:49:08] Daniel Zwirn: Well, I think it is to be a true kind of merchant capitalist and continue to provide our stakeholders and our investors a kind of unending stream of that which does make sense and keeping them out of trouble without having to make x post excuses with regard to having allowed this machine that we created to permit those folks to negotiate the shoals that you typically find when you’re kind of getting through cycles in the economy. And so there’s an opportunity to be a true kind of merchant house. And frankly, at times we have found that we have an excess of intellectual property. And so some of these things we actually provide for third parties in very difficult circumstances of workouts or operational improvements.

We do that for ourselves, but we also do it for third parties.

[00:50:03] Ross Butler: And what do you like to deal with as people? What’s your culture. Like if I’m a counterparty to you.

[00:50:09] Daniel Zwirn: I think we’re pretty pleasant. I would say certainly that in our world there has tended to be a preponderance of folks who have grown up in the kind of Rockham Sockham commercial mortgage or mortgage sell side world generally, that views every relationship as a counterparty relationship.

We, given 150 joint venture partners over 25 years, do like to have long term relationships with our partners. But I think we’re clear about who our partners are versus who our counterparties are.

And we talk about being what we call tough but fair. And so when we do have disagreements, we always start with, here’s the right thing. Let’s just do the right thing. It is unfortunate that in many instances we actually find Burton Malkiel and the efficient market notwithstanding that very much people will trade off their greed for their ego and not do things that would actually make them richer if they only just kind of focused on the money.

[00:51:19] Ross Butler: There’s a psychological aspect to what you do, I think.

[00:51:22] Daniel Zwirn: Quite a bit. Quite a bit. Yes.

[00:51:24] Ross Butler: Yeah. Brilliant. Well, look, it’s been fascinating speaking with you. Thanks very much for sharing your views on the world, and best of luck with what lies ahead.

[00:51:32] Daniel Zwirn: You’re welcome. Thanks again for having me. I enjoyed it.

Hans Lovrek stumbled on Medieval Florentine documents that showed structures were being used to align interests in ventures with high information asymmetry that were uncannily similar to today’s limited partnerships.

Through a method of historical institutionalism, Hans demonstrates how the same techniques have been used to solve similar problems, down the ages, and that today’s private equity industry is based on ideas that successful trading nations have used before.

This episodes was recorded in March 2019 and is released on podcast for the first time in December 2023.

[00:00:00] Ross Butler: You’re listening to fund Shack. I’m Ross Butler, and this episode of the Fund Shack podcast is from our back catalogue, recorded in March 2019, but it’s never been released on podcast platforms. And as it turns out, in private equity years, this is a mere blink of an eye. So in this holiday season, I thought you might appreciate a thousand-year perspective on private equity.

Hans Lovrek structured the first Austrian private equity funds in the late 1990s. Since then, he has allocated almost €500 million to around 70 different private equity funds. He is currently an advisor to several of the larger Austrian private equity programs through his consulting practice, commender private equity. I first came across Hans when he gave a presentation drawing on some very interesting parallels between merchant trading of the Middle Ages and current private equity practices. And I was really intrigued to hear some more. So he joins me now from Vienna. Hans, these are fascinating parallels between the medieval commander, after which you named your firm, of course, and modern private equity. Can you tell us a little bit more?

[00:01:08] Hans Lovrek: Well, it’s interesting, maybe how I came across these parallels. It was probably in the year 2004 or five, when, as you said, I was looking for a name for my advisory company, and I was studying history and doing research in the history of bankruptcy, which in itself is an interesting topic. And I found among the assets of some bankrupt florentine banks, I found those commanders. And after uncovering my school Latin and reading those contracts, I was amazed how similar they were to the LPS I was concerned with in my everyday work.

And so over time, my focus very quickly changed from the history of bankruptcy to those commande. And I went to my professor and he liked to tease me because I was one of his older students, and he said, Hansi, that’s again so clever.

If you can explain to me where those similarities come from, you come back. And so I came back a year later after reading Douglas north and Oliver Williams, who got Nobel prizes. And kind of the theory to explain those similarities is called historical institutionalism, where you use history as kind of a laboratory to better understand modern institutions, because in social sciences you can’t have a laboratory environment because the environment changes all the time. And so you also end up with a principal agent theory. And then I got fascinated by the topic and wrote a thesis on it.

[00:03:23] Ross Butler: So how widespread was the commender structure? Is this a curiosity or was it kind of an.

[00:03:29] Hans Lovrek No, it was more or less. That’s the amazing thing. Unchanged over.

The oldest proofs I found are in the 6th century. Imagine.

And it goes all the way to the 14th century. So we are talking 600, 700 years.

In fact, Mohammed’s wife, Kadisha was her name, her father was a venturer. And so it’s more or less venture finance that financed his ascent to become a political and religious leader. So it was always this profit. The important factors was the profit share.

It was, in those days, 25%, and it was always 25%, as it is always 20%. Now, that’s an interesting topic we might talk about a little later. Very important is limited liability, because otherwise a venetian family couldn’t take other people’s money to invest, because if they would have lost the money without the limited liability, the whole family would have gone bankrupt and they would kind of be expelled out of venetian society. So limited liability, if you want, is the second important ingredient, and the third is the limited duration of those venture finances.

It was then for one caravan, for one project, for one voyage like it is today, mostly for ten years, and for very similar reasons, because thus the investor had the opportunity to decide if he wants to reinvest in the next project or not. And on the other side, the general partner was forced or was very much motivated to perform, because otherwise he wouldn’t have gotten any money in the future.

[00:05:52] Ross Butler: Okay, before we look at some of the specific structural aspects and linking them across, can we just step back and in very simple terms, explain who in this analogy is an LP and who in this analogy is a GP and what typically are the GPs doing?

[00:06:06] Hans Lovrek: Yeah, so the project I was most concerned, and probably that’s the majority, were the sea voyages across the Mediterranean Sea. So a ship had to be built or chartered or bought, and it had to be equipped with a large crew. Mostly it was galleys in those days. And so they would go typically from Venice to Alexandria in Egypt and then to Constantinople, do their trades and come back after several months or even a year if they got stuck during winter. And the gps were the merchants on board. Sometimes the captain was also a GP at the lps were, on one hand, the aristocracy, but it is amazing to see that it was really a retail business there then. So there were nuns invested and the church was.

Was, especially in Venice, where I know most about it, was quite widespread. So a typical ship, and the ships went in convoys in later days, was like a large fund with many lps going for a multiple month expedition.

[00:07:51] Ross Butler: Right, so you’ve got presumably mainly rich people, but also the church and perhaps even some widows and orphans. They’re putting their money together and they’re financing these expeditions.

[00:08:03] Hans Lovrek: Yes.

[00:08:04] Ross Butler: And so they’re looking for a structure that ensures they’re going to manage their risk, presumably, and have a fair share of the upside. And so this is how the structure has developed.

[00:08:18] Hans Lovrek: It is interesting. There is a spanish professor, she teaches in Valencia, and she showed that, or let’s put it this way, the commander only became important after Venice stepped up the regulation to a higher level. Many people will not like to hear this, and I don’t like to hear this, because the end of my fund of fund business, the happy end, was regulation. It was solvency too, but so I’m biased in the other direction, normally. But in Venice, it is shown that regulation was a prerequisite for the rise of the commanders. Before they had something called sea loans, and sea loans had this limited liability if the ship would go under or would be taken by pirates. But it had a fixed interest.

And this was not a perfect reflection of the party’s interest, because from the investor’s point of view, the risk was high that the ship would be lost. And if it would be a home run, as we would put it today, he would still get only his interest. And from the merchant, from the GP’s point of view, if he’s very successful, everything is good, the upside will take care of itself. But if the business is difficult, he still has to return all the money plus the interest, and thus be forced to lose all his profit. But the big difference, and this is what I’m aiming at, is the accounting for a sea loan is so much easier than for a commander or limited partnership, because for a sea loan, you just have to return the principal plus the interest, and that’s it. But for a commander or a limited partnership, you have your income, you have the cost, you have to bribe the customs official, you have to have security and everything, and in the end, you do the profit share.

And especially in those days and today in some areas as well, it was too much of a moral hazard for the GP.

And so what Venice did is they regulated kind of the whole voyage of the money and the goods. So every ship had a scribe, all the goods were sold and bought by public agents. In the important points, like Alexandria, there would be a consul and a venetian warehouse and a venetian court. And only then, when the investors were confident enough that everything is going to be fair and accounted for, there was a sudden rise in around 1241 230, where you can see that the sea loans were reduced.

Most of 80% of the investments were commander. And this with a very large volume, so it’s a larger volume, so it’s a nice story how regulation can create an environment for venture investing to thrive.

[00:12:15] Ross Butler: I assume we are talking purely in the sense of analogies and people coming up with similar structures to solve similar problems. Or is there some kind of direct line of sight between this type of regulation and the commender rules and today’s european?

[00:12:30] Hans Lovrek: No, there seems not to be. And from my point of view, this makes it even more interesting because one comes to the conclusion that there are certain types of risky ventures, that financing for risky ventures that demand a certain contractual structure.

And so it’s kind of significant. And this is what this historical institutionalism wants to show, that in a totally different environment, a similar risky structure was financed in a very similar way from today.

And so if you want, the theory is the LPS is the institution of choice to finance this kind of ventures.

Information asymmetry being the key element.

So the doge of Venice in the twelveth century knew as little what his merchant, his GP, would be doing in Constantinople as the chief investment officer of a pension fund, knows what his guys are doing in Silicon Valley. And so it’s very comparable structures that are financed by comparable institutions.

[00:14:12] Ross Butler: Yeah, I suppose some people might be thinking, well, this is a stretch in terms of the asymmetries of information. But it’s not just that the pension fund guy just doesn’t have access to the networks. He’s also investing in a black box.

[00:14:24] Hans Lovrek: Exactly.

The problems arising out of these situations are very similar. You are confronted with moral hazard after you assigned contract.

How do you make sure that the GP doesn’t cheat you? Today it is via auditors and so on. And before you sign the contract, the whole story is called adverse selection because the gps knows about his abilities and track records so much better than you know about him. And so we try to deal with a very thorough due diligence. This is why we do this, very thorough due diligence because of the informational symmetry. After you signed, you’re locked up. And this is the similarity because of course it is stretched. But I mean, for a german speaker it becomes more obvious because a limited partnership in German is a commandit Geselgia and it is identical. And obviously the commandit Geselja comes from the word commander.

[00:15:44] Ross Butler: Can we drill into some of the specific aspects of the structure that kind of gave you your eureka moment? So you’ve already mentioned the split of.

[00:15:54] Hans Lovrek: The carry is interesting. Let’s talk about the carry. And one of my favorite is, you know what a cheapy clobber is, Ross? Not everybody does.

[00:16:04] Ross Butler: I do. But could you just give a…

[00:16:09] Hans Lovrek: Let’s talk first about the GP clawback.

And when I did due diligence here in Austria, very few people knew. It’s really a specialist insider thing. It is if in funds during the lifetime of this fund, the GP gets too much profit share in the beginning, and the performance of the fund gets less and less as time goes on, which is very often the case, because the longer living companies are often the difficult ones, then the lps need a methodology to get back the profit share that the gps got too much in the first part of the. In excess of his real profit share. So this is called GP clawback.

And there are different methodologies to do this.

The best, of course, is that if it’s made clear in the lps that the GP only gets his profit share after all the capital is returned, and then there is anything in between. There are escrow accounts where the GP has to put half of his money in the escrow account and so on.

And I read in an islamic commentary, which was from eleven six, citing a scholar, his name is Shabayani, and he wrote in the 7th century, if someone gets 1000 Diraham to invest and he comes back and he is successful and doubles the money, and he returns 750 deer hums to the investor and keeps his share of 250 deer hums to himself and then reinvest. And then he reinvests the principal and loses it. And so Shabayani says he has to return his 250 because the profit does not arise before the capital is returned.

And I really use this in one due diligence in New York. I remember it because it was exactly this discussion. And I said already in the 9th century, everyone knew that you have to first return the capital before you are allowed to start thinking about your profit share.

[00:19:16] Ross Butler: I was going to ask you if you’d ever actually had any practical use of.

[00:19:25] Hans Lovrek: It’s something that is very useful. That is very useful, because what I do think, and this is what people from IlPA, would you pronounce it? Ilpa.

What people from IlPA think is that most of these rules have very good reasons, have very good reasons why they are like this. And we’re talking about profit shares, but there are of course, things like human risk and so on, or fees.

In those days, there were no fees, so the GP had to finance his own personal cost out of his own pocket. Only his burial was financed. If he would die in Constantinople, the investors had to pay for his burial. But all his other cost was pre financed by himself, and he was leaving off the profit share of 25%.

[00:20:29] Ross Butler: All right, well, maybe in that there’s an explanation for why we’ve landed with 20%, they’ve landed with 25%. They didn’t have the fees. But also there is kind of danger money as well. You’re not going to die in Mayfair doing. Hopefully not.

[00:20:44] Hans Lovrek: That’s one of the reasons. But still, the whole question about this homogeneity of profit share, then 25 and now 20%, is kind of mysterious. It’s kind of mysterious because now, and even then, people were very able to quantify risk normally. So if you have a more risky venture, you will pay more interest for your loan and so on. But in this case, obviously, people were not able to quantify risk because it is a black pool, because there is information asymmetry.

And so people seem to tend to conventional solutions and a convention is what you think that I think that you think. I will propose to you.

And so there is a Mr. Shelling, who wrote a book about it, about focal points. There’s a certain tendency to, if you try to make those judgments, to focus on the smallest possible denominator. So the first option would be half two, which is not fair. The next would be a third, and then you end up with a fourth. So this is one of the theory, but it’s not clear yet. And I tried to find out. I tried to find out and I wrote emails to people from the petroleum industry in the beginning of the 20th century and to the first hedge funds, which I think were in the 40s.

Someone must have reinvented the 20% profit share. And from there on, it did not change. It did not change.

It’s the same for a very conservative UK buyout fund and for an ukrainian startup, it will always be, nearly always 20%. You know, the exemptions of paying capital, taking 30, or special agreements of lps and gps, but in the center, it’s 20%. So if you really find out, let me know.

[00:23:26] Ross Butler: Maybe standing back a little bit, there’s a big kind of ongoing debate about the private equity structures and whether they’re fair and whether they should be rebalanced or whether they should be optimized.

Given your historical perspective, what’s your opinion on this?

[00:23:44] Hans Lovrek: Well, the striking difference between those medieval and the modern contracts is the length.

A normal private equity commander was a one pager.

It just set the date and the parties where the merchant intends to go.

The 25%, which defined that this is now a commander contract, and when he plans to return. And this was everything. This was everything with my legal background was always hoping or praying for was an international. So the reason for the contract being so short was that all the rest was clearly defined in statutes. So here you have the one from Pisa, from. What is it? It’s the oldest one, I think it’s 1126 or something.

And then you had common law, and so everyone knew what to do.

And in the german environment, if you do a limited company, you can do it in the bar on a one pager, because it’s Ross and Hans being the party. We give it a name, we give it a purpose, we write who gives how much money in the limited bud, and that’s it. And all the rest is in the law.

And I think this is a big hindrance for the development of private equity, that there is not a codified institution.

And this is how I made my business, because very few people in Austria then knew the international private equity market and were desperate going through these 270 pages of the Fpas. The longest documentation was 3000 pages and so legal, only with side letters and stuff. And so I think this is that in many markets, and especially for the retail market, people are reluctant to do this because it’s just too complicated.

And this is what ILPA should be aiming at. If there would be an international codified structure, like if you buy a stock on the quoted stock market, I don’t have to go through all the Amazon contracts. I would never think about the contracts that Amazon wrote to get their stocks on the stock exchange. So I think that’s one big problem.

[00:26:59] Ross Butler: Given the time proven nature of limited partnerships, it is odd that the world of financial modeling, the legal world, even the academic world, has always just seen it as a kind of a curious interloper. And it’s idiosyncratic.

Hans Lovrek: Exotic. Yeah, exactly. It’s quite exotic. And there is no need for it. There is no need for it because in reality, the properties of the private equity contracts are very similar.

The profit share, the waterfall, the time, the prolongation and so on. And to discuss this in the due diligence process is just a lawyer’s game.

[00:27:47] Ross Butler: Are LPAs just a lawyer’s game? What do you think? If you’re watching on YouTube, why not leave a comment with your thoughts and press the like button? If you’re on a podcast platform platform, please give us a rating and a review.

Yaron Valler is a founder of venture capital firm Target Global. He is a successful entrepreneur and investor, and was part of the team at Intel that invented the Pentium Processor. In this episode of the Fund Shack podcast, he talks to Ross Butler about how AI will change ‘everything’, virtual reality, how government’s should direct innovation and risk capital, and much more.

[00:00:00] Ross Butler: You’re listening to Fund Shack. I’m Ross Butler, and today I’m speaking with Yaron Valler, a founder at Target Global, a venture capital firm with offices in London, Berlin, Barcelona, Tel Aviv and elsewhere. Founded in 2015, the firm has invested in 15 unicorns, had 21 exits and seven IPOs. Yaron has been a successful entrepreneur. He’s invested in dozens of companies, he’s had several billion euro exits, and before Venture capital, he was part of the team at intel that developed the Pentium processor Yaron. Welcome to Fund Shack. I don’t like talking about themes that everyone else is talking about, because I tend to feel like the value is elsewhere, but that’s not always the case. And I think it might not be the case with AI. There’s a lot of hype around it, but that could be for a good reason. What’s your view on AI?

[00:00:46] Yaron Valler: First of all, thank you for having me. It’s great to be here.

I think that like any paradigm shift or any revolution, there is a lot of substance, and then there is a lot of hot air.

And over the next few years, we’re going to separate the hot air from the substance. The advances in AI are staggering. Right? It’s going to change. Anyone who’s played with it, who tried to even do something as simple as edit an email, which is something that I did last night, has seen the impact that this can have on our lives. Anything from content generation searches, creation of academic content, creation of books, is something that we’re seeing now, creation of artwork. So the impact of this revolution is astounding. I think that we are only scratching the surface now when we are talking about things like customer service and classification of transactions. So things that are very trivial, relatively, we’re going to start seeing AI integrated in every walk of life. I think that interaction with medical professionals is going to change because of AI. A lot of the diagnostic procedures are going to change.

I think that banking is going to change in a profound way.

I think that industry, in some cases, when we look at the integration of vision into industry, visual inspection, this is going to change whole industries. You mentioned the fact that I was part of the team that created the pendulum with Intel.

Finding faults in silicon is a huge challenge.

Training an AI to find these faults, training an AI to uncover things that would have taken a human a very long time to uncover, especially in the resolutions that we’re talking about when we’re talking about semiconductors, is going to be a major change for this industry.

We can talk about the agricultural industry, that’s going to change profoundly because of AI. So we’re going to see profound changes in quite a few industries, I think, where I think that there might be some, shall I be polite, over exuberance in the market is around the rails for AI.

The creation of LLMs, and the number of LLMs that the world would actually need. And the value that will be generated by these LLMs, I think, is the last point. I think that here we need to be careful. We need to stick to more traditional valuation methods when we look at this technology, like when we look at every technology.

Otherwise, we are risking the creation of disparity between the valuations of these companies and real value, and this can lead to a crash, which would be very dangerous and would impede the market.

[00:03:55] Ross Butler: Okay, you’re going to have to explain the distinction between those two things a bit more for me, because I understand. So, first of all, you outlined a fantastic range of potential applications and industries, but then you said that there might be exuberance in the LLM, the large language model domain. Could you explain what the differences are?

[00:04:16] Yaron Valler: In every industry? You create rails, and then you create applications. On these rails, the applications have very traditional ways of evaluating their potential, right? You look at the market potential of the application, you look at the savings that it creates, you look at the additional revenue that it creates, and you can value the application.

When you’re talking about an underlying technology, you need to think about which applications, which unique applications it can generate or it can energize.

And then you need to ask yourself, what new markets is this creating? So, valuing an underlying technology is always a more complex task than valuing the application.

The risk is when there is exuberance in the market, that you value the underlying applications incorrectly, the underlying sorry infrastructure incorrectly. And when you do that, you create a risk, an ongoing risk of disparity between prices and actual value.

And you could see that in almost every bubble that we had. You can see that in the bubble that formed around rails for crypto. You can see that in the hype that was created even around ecommerce during the.com boom. There is a very, very big difference, and therefore significant importance to the differences between the valuation that these businesses garner, which is affected by the fact that private markets are not always rational, and the underlying value, and therefore the need to evaluate the distinction between LLMs, the applications that they enable, the actual markets that they open, the world of acquirers, for these LLMs, there is a need to value those very carefully.

[00:06:10] Ross Butler: So the hierarchy of, say, an AI industry would it be a small number of LLMs upon which various applications are built?

[00:06:18] Yaron Valler: I believe so.

[00:06:19] Ross Butler: Right. So if I could take like an analogy like the Internet, because it’s very hard for people outside of the AI industry to really understand. Everyone says huge potential, but it’s hard to understand what is the potential. And so 25 years ago, everyone was talking about the Internet, and I guess the Internet has swallowed the world. But you’ve got a couple of Internet giants that are clearly Internet companies, like Google and Facebook. But in another sense, almost every other business is a.com business, but they just tap into it with their own website. Now, maybe this isn’t a relevant analogy, but let me keep going with AI. Will you get the situation where you will have a very small number of AI superpower companies, do you think? And then every other company will in a sense use AI. It’ll be an AI company, but it will use it in a very vertical, application specific way.

[00:07:10] Yaron Valler: I think that what makes this question more relevant is the amount of computing resources that are needed to deal with AI. First of all with the creation of LLMs and then training of LLMs, and then later with the querying and interaction with LLMs. So you need massive compute resources, and when you need massive compute resources, then you need someone that has a lot of infrastructure and that restricts you to a relatively low number of providers. However, we are seeing that implementing localized LLMs that have specific applications doesn’t require such heavy infrastructure. I think that what we will see is slightly different than what we saw with Google, where the provision of the services, or with Facebook, where the provision of the services is so heavy that you end up with a relatively small number of providers. By the way, also there, I think that this is a reaction to the market, and I think that had the market behaved in a certain way, maybe this in the long term will also be something that will be disrupted. I think that we’re seeing a lot of developments in the data center arena that will also disrupt that side, the infrastructure side. But let’s stick to LLMs for now. I do see a myriad of companies that have local instances of LLMs, either homegrown or adapted from things that are available, that are running on their infrastructure, in some cases even running in the edge. So running in the actual devices especially, I mentioned semiconductors before. So even in the edge you’ve got very substantial compute resources when you are running a semiconductor design or a semiconductor fabrication operation.

And therefore I see instances of LLMs, localized instances of LLMs that are being run on these relatively limited infrastructures.

[00:09:18] Ross Butler: Right. So it could be more decentralized.

[00:09:21] Yaron Valler: More decentralized, yes, it could be more decentralized. And that is exactly the counterweight to my previous answer, because if it is indeed decentralized, then there could be place for more LLMs, and there could be a lot of value derived from these smaller LLMs.

[00:09:36] Ross Butler: And so let me go back to your first kind of statements, which was about the huge amount of potential applications.

What’s the kind of the golden thread that runs through all of this, from agriculture to medicine to investment banking? It’s not presumably just huge efficiency gains.

There’s something else going on. What does AI actually promise to provide?

[00:10:00] Yaron Valler: Let’s take an MRI.

Deciphering the MRI requires skill.

It requires a good eye, I guess.

And if a computer, an AI, could identify a tumor when it’s 1 mm, as opposed to a doctor that would identify it when it’s 3. Guess that there is a substantial advantage that is created here.

This is a relatively simple to understand medical applications. Medical application. Let’s take something as benign and as painful as taxes classifying your expenses in real time. I’m talking about a business classifying your expenses in real time and adapting them to the tax legislation, something a machine needs to understand the tax legislation. Again, it’s not a complex task. You’re talking about a lot of data and a lot of conditional data. Basically an algorithm that a computer is very apt at understanding. You combine that with access to your bank account, and suddenly you can get your tax preparation work at the end of the year. Can become a lot easier, can become a lot easier, if not automatic, certainly more accurate. I’ve given you two extremes of applications, right? Two very different applications that both will have very significant impact on our lives. I think that this is when you are talking about AI.

You’re talking about mainly two things. One is pattern recognition. Intelligence is usually highly connected to pattern recognition, so AI is good at recognizing patterns. The second thing you’re talking about, and that’s where it gets more interesting, is when the AI stops being passive and uses what it learned and used that in order to generate new stuff.

I’ll give you one example that is overlooked, but is, I think, an incredibly powerful example, and it’s something that I use AI for quite a lot.

I want to write an email to you, and I want that email to be persuasive. I want it to be persuasive in a way that is persuasive to you, not persuasive to someone else.

If an AI analyzed all of the emails between me and you for the past few years and identified the ones that you reacted to more favorably and adapted the language of the current email that I’m sending to you so it would fit these patterns and therefore I could be more convincing.

This is something that has tremendous value and something that you can do today.

[00:12:53] Ross Butler And it’s something you do.

[00:12:55] Yaron Valler: Yes, of course, an off the shelf thing. I did some prompt engineering. I use a few LLMs to do that.

And yes, I’ve basically asked or analyzed a bunch of old email communications and several times had really good results with an LLM producing basically new email that is taken from concepts, from a summary, a skeleton that I write.

[00:13:28] Ross Butler: And you look at it and think.

[00:13:30] Yaron Valler: And adapting it to Ross, because we know that, or we’ve seen in the past that Ross reacts favorably to certain things.

[00:13:38] Ross Butler: So for my sins, I’m moderating a panel next week. It’s a bunch of private equity coos. And the question is, how can AI improve private equity firms investment processes? You’ve kind of given me, I mean, it’s much more broad than private equity investment.

[00:13:54] Yaron Valler: Pattern recognition is probably the best answer, right? You try and identify patterns with entrepreneurs, you try and identify patterns with industries.

It would be tricky to code it. Building the model for analyzing investments, because this is, maybe I’m just processing what you’re saying because in private equity, maybe it’s a bit more structured. When you come to do venture capital investments, they are a lot more visionary. Initially, there’s less stuff to analyzE, right. When someone comes to you with an idea, you analyze the potential of the idea.

[00:14:30] Ross Butler: But does that make it more or less applicable to it?

[00:14:33] Yaron Valler: I think it would be less applicable. I think it would be less applicable, whereas private equity would be more applicable because it’s more of a number driven analysis. It’s interesting, but I’m sure it will disrupt the investment industry as well.

[00:14:46] Ross Butler: But you don’t use it formally, say, at Target Global, for your investment screening or anything like that, just because it’s so subjective.

[00:14:52] Yaron Valler: No, we don’t. We use it for a few things.

Again, something trivial. Generating investment memorandums.

The team writes investment memorandums, but is it the best use of the team’s time to proofread them and to write them in a way that is comprehensive enough, that is something that is handled, that is a day to day task that AI is assisting us in, but not in investment screening.

[00:15:20] Ross Butler: And in terms of your role as an investor looking for exciting new companies with AI in mind, is there any specific things that you’re looking at in terms of an AI enabled company.

[00:15:29] Yaron Valler: So all the stuff that I mentioned before, I’m looking for real world applications.

I’m less interested in the trivial applications. We mentioned customer service before, not that customer service is by any means of the imagination, by any stretch of the imagination, an easy thing to achieve. It’s just a relatively well trodden application with very large companies that are doing good work in it. But I am very interested in applications that are very hard. Integration of vision, for example, in order to affect traditional industries, which I mentioned before.

[00:16:05] Ross Butler: That’s a difficult thing to do, presumably.

[00:16:07] Yaron Valler: If it’s a very difficult thing to do, how do you know? You’re looking at melons on a packing line. How do you know that this is a good melon? This is a bad melon.

[00:16:19] Ross Butler: How do you know it’s a melon?

[00:16:20] Yaron Valler: Yeah, how do you know it’s a melon to begin with?

But there are so many applications I mentioned in traditional industries that affect all of our lives. I’m very interested in that. I’m very interested in what’s going on in the medical world.

I think that this has the potential of profoundly changing our lives. And I think that a lot of what I do, I do because I think it’s interesting and relevant for our lives. And I think in medical we’re going to see amazing applications.

I’m much more keen on finding out where it disrupts.

Real life technology touches the lives of all of us rather than when it touches a select few. Because I think that you get better applications, you get better returns like that. At the end of the day, we are money managers and they need to create returns.

The broader the applicability of a technology is in some cases, not in all cases, it holds a direct correlation to returns.

[00:17:30] Ross Butler: Yeah. And this is what makes you a good early stage investor, presumably because you can’t just come on board after there’s some financial proof of concept you need to understand.

[00:17:39] Yaron Valler: I would hope so. Identifying the right teams and identifying the technology potential is probably a skill that.

[00:17:50] Ross Butler: I’m more comfortable with, although they’re two quite different things. You got the technology, but then you’ve got the teams, the managers, the personal soft side as well. Both so important, but quite different.

[00:18:01] Yaron Valler: Yeah. I think that the good venture capitalist is in some ways a good psychologist. Right. It also has an impact on how you work with the companies later.

A lot of what I do is be a sounding board for the CEOs. So you become, I hope, good judge of character and a good judge of the capabilities of team and the potentials of team, of teams.

[00:18:31] Ross Butler: So what kind of character trait would turn you off?

[00:18:34] Yaron Valler: Would turn you off?

[00:18:35] Ross Butler: Yeah. Well, most people would ask what would turn you on?

[00:18:37] Yaron Valler: Yeah, exactly.

Being a lightweight, someone who is not serious about what they do. And this is something that you can tell very quickly when you talk to a person.

I remember, without mentioning the name of the entrepreneur, one of the best entrepreneurs that I had the pleasure of working with, we were doing a funding round, and one of the VCs, one of the Sandhill road VCs that they were pitching to, started arguing about unit economics and got to the resolution of a few cents. And then the CEO stands up, he says, no, if we do this, this and this, these calculations, then we see that the difference is indeed four and a half cents, but we should do this, this and that. And then we see that we have a surplus of, whatever, $0.30.

It won the meeting. It won the meeting. Not because it was true. At the end of the day, such forward looking statements, especially when you get to the resolution of cents and dollars, are largely, I’m trying to be polite, uncorrelated with reality, but what it did was impress upon that fund the level of granularity in the thinking of that CEO. And that was the important thing. So you look for someone who knows their market, very detail oriented, knows their market, but at the same time is sort of a big personality, someone that doesn’t have these traits, less likely to be a good CEO.

[00:20:07] Ross Butler: I get the impression, and maybe this is a little bit unfair, that for a long time, maybe about ten years ago, venture capital, particularly in Europe, was basically a consumer Internet play. The Pokemon goization of venture capital with developments like AI. Are we looking at more of a deep tech play going forward, do you think?

[00:20:30] Yaron Valler: This is one of my pet peeves, right?

I think that European innovation in general has been largely application innovation. That’s probably a better way of referring to it than Internet. Yes, there has been a lot of Internet development, but even if we look at what is classified as deep tech in Europe, the vast majority of startups are building applications on stuff that other people, on technologies that other people created.

You see a lot of innovation, a lot of technological innovation in big companies in Europe.

As you might know, I’ve lived for a long time in Germany. Companies like Siemens, for example, are incredibly innovative.

But you don’t see what is very prevalent in Israel, which is a large number of startups that are creating very basic technologies, bringing them to market and exiting based on these basic technologies. In areas like cyber or quantum, or semiconductors, or even software infrastructure.

Europe is woefully short on these categories. It needs to change. It needs to change. And the role of the sovereign and the regulator here is to help drive this change.

I’m jumping to another point or a question that you didn’t ask. No, but the importance of governments in venture capital is often misplaced, or the power that they can bring to bear is often misplaced. What the government should do is help solve inefficiencies, help solve problems, not scale and bolster what is already working.

When talk about the UK, when the British Business bank is allocating funds to a fund, it should try to affect what that fund does in a way that is good for the long term planning of the British economy. If it doesn’t do that, then it is not a strategic tool.

It’s not the government’s role to help me make money. It’s the government’s role to help push forward the UK economy and set it up for success for the next few decades.

And it would only be able to do that if it has an impact on where these funds are allocated.

Governments don’t do that as much, they’re more generalists, adopting a somewhat less affair approach, allocating capital to funds and letting the funds make decisions. And here I think the governments need to be a bit more strategic. You’re asking me when we spoke before the recording, we spoke about AI in the UK. And of course, in light of the Prime Minister Bletchley park summit on know, very important that the UK is taking AI so seriously. Very important that it’s looking at the ethical sides of AI. What it should be doing more of is impacting where investment money goes to. And that would be a practical way of really embedding the cultural values that we think are important, that we as Westerners think are important.

And that’s largely the topic of the conference. Right. Having Responsible AI, safe AI, by carefully directing government investments, you can achieve two goals. You can A, embed what is important for your society into technological development and B and more importantly, you can push technological development and push development of the economy subsequently into a direction which is beneficial for the country.

The downside of it is, of course, that governments are not very good at doing either. So when they start intervening, sometimes they’re too heavy handed and that ends up achieving exactly the opposite result.

[00:24:43] Ross Butler: Well, this is what’s been running through my head as you’ve been speaking. On the one hand, I’m kind of convinced, I guess my follow up question, therefore, is, where should the British government be trying to direct the money?

[00:24:56] Yaron Valler: It’s another one of my pet peeves.

If you look at the Britain was a massive success in semiconductors, a lot of semiconductor fabrication plants, very sophisticated things. What that did was help proliferate the impact of tech to other parts of Britain. Tech should not be a London phenomenon, and it is too much of a London phenomenon right now. You want people in Manchester and Liverpool and Bristol and places that are further from London to benefit from access to higher paying jobs, to benefit from access to technology. And more than anything, when you look at it as a country, you have to assume that your talent is spread evenly across the country, so you’re not harnessing vast majority of your talent when you are restricting tech to London. Now, why are semiconductors, and in general, things that are more capital heavy, more important in this respect? Because it lets you train a huge number of people in technology, and then these people create startups afterwards, a generation afterwards, sometimes there’s going to be some creative destruction. When a company is shut down and people start forming startups, it proliferates the tech economy again. Israel is a much, much smaller country than the UK, so it’s hard to draw parallels. But if you look at the proliferation of semiconductor fabrication plants in Israel, which has been basically pushed by the government into the south of Israel, which is traditionally a less affluent area, this has had a major and very deep impact on that region in all walks of life.

I don’t want to digress to politics, but even when you’re talking about the integration of Israeli Arabs, or Arab and Jewish populations in Israel, this had an impact because it moved the factory to an area which was more equally populated by Jews and Arabs. So it even assisted in that goal, in a goal that has nothing to do with the proliferation of tech. You can think about social equality, you can think about, especially when you’re trying to draw parallels to the UK and huge salary gaps between London and other.

[00:27:31] Ross Butler: Places in the UK, the problem is, I think, I don’t doubt at all that Israel has been hugely successful here. But I just wonder whether there is a problem of scale. The EU tries to do precisely this. They try to foster a venture capital ecosystem in Latvia and in Athens, and they’re trying to do it everywhere. And it’s been, I think, pretty unsuccessful, because everything’s concentrated in Berlin and just, I think maybe you can do it in a kind of a small, cohesive region, but when you get to a certain size, and maybe, I don’t know where that size is. It’s probably smaller than Britain. It becomes difficult.

[00:28:08] Yaron Valler: But that’s why I’m talking about manufacturing. I’m talking about things that are on the periphery of tech. I’m not talking about.

You are right that talented people usually congregate, and there is sort of an untrivial correlation between certain cities and tech hubs, and that will probably continue.

What I mentioned was, or what I meant. Sorry. Was that when you build plants, when you build highly technological fabrication plants, or anything that requires a large number of employees, you are creating a generation of tech savvy people. That generation will then go on and create startups. Whether these startups will be created in Bristol or in London later, I don’t know.

But there would be more people from these areas that have access to technology, understand technology, and can create companies. And I think if you had to pick one area, which I think governments in general, not just the British government, should be concerned about and should be active in, it’s that it’s making sure that the impact of tech and the proliferation of the financial success and that tech has, would get to sort of further reaches of the country. Again, I mentioned semiconductors. Looking at Germany. Germany is now investing €40 billion into building semiconductor plants in eastern Germany.

Traditionally poor area, traditionally less educated, less affluent, less connected to Western values. All of these things are going to be disrupted.

[00:29:55] Ross Butler: Now, the silicon manufacturing, is that an example, though? So, for example, can we translate this over to AI? Is it manufacturing, or is it more like the foundational technologies we were talking about at the beginning? But if a policymaker needs to think about this in more abstract terms, what are those terms that they know?

[00:30:15] Yaron Valler: In this specific example?

It’s, of course, manufacturing. It’s not technological development. What I’m counting is that the second generation of people, or the third generation of people will create.

[00:30:27] Ross Butler: Right? And it’s manufacturing because that’s what brings together a large number of people.

[00:30:31] Yaron Valler: Correct. And trains them. That’s the issue, again, when you talk about the proliferation of tech.

If you take, I’m trying to remember furthest town in Britain that I’ve been to Inverness, and you allocate venture capital to Inverness, the likelihood that this will have a positive effect is limited. If you make an infrastructure investment in Inverness, you train a very large number of people, and then you expect these people in a decade, maybe later, to come up with their own creative ideas. I think that has a higher chances of success.

[00:31:13] Ross Butler: So you’ve convinced me in principle. Now we have the little problem that in practice, politicians probably won’t take your advice on this. And if they have the opportunity to direct investment strategically, they put it into some political pet project, like some tenuous net zero technology development.

Yeah, I guess it’s a balance. It’s how much can you trust the politicians to do the right things if you give them the.

[00:31:38] Yaron Valler: You know, I’m drawing a lot of parallels to Germany. I mentioned before that I lived in Germany for many years, and I’m full of appreciation to the way the German government has been managing its influence on tech. One of the things it did very well was to create public private partnerships.

The seed fund that is at least partially owned by the German government, HDGF, is a public private partnership. Private companies are providing most of the capital and are influencing where that capital is deployed. So you’re mitigating the risk of having sort of irrelevant political considerations by creating a public private partnership. And again, this is something that Britain could do.

[00:32:30] Ross Butler: So, going back to the investment world and the general opportunities and deal flow we’ve spoken about AI, are there any other large themes that you’re looking at that excite you?

[00:32:41] Yaron Valler: Certainly a theme that has been very important or discussed substantially in the last few years is augmented reality and its effect, again, its effect on daily life and every walk of life from, I mentioned, medical applications before, like surgery, but going to office, and basically every application that we have. So that’s something that I’m very excited about.

I have one substantial investment in that field in Britain that I’m very excited about. I’m very excited about the proliferation of computing and software into SMBs. I think that many business processes in SMB, in small and medium businesses, sorry, have not benefited as widely from computers as they could have.

But then lastly, the thing that I’m most excited about, and this far away, and is perhaps not a good venture category for now, but would become one, is the quantum leap in computing into quantum.

That is a complete paradigm shift, and I don’t think I, or most other investors can imagine the impact that this would have on our lives. And anything from finance, banking, cryptography, communications, everything we do will be disrupted.

If this revolution is successful, or when it is successful, computing will just look completely differently. Everything we do, the way we interact with computers will become different.

The amount of data that computers can process will become different. The way they interact with us will become different. The way we think about secrecy will become different. What we think about privacy will become different. So it will really be a fundamental change. And I can’t imagine, to begin what it would look like.

[00:34:56] Ross Butler: Oh, good. Because nor can I when you said, it will all look different, because for me, I feel like I’ve been reading about quantum computing in the Economist for 25 years, and you’ll probably read for.

[00:35:05] Yaron Valler: Another 25 years before we see it.

[00:35:08] Ross Butler: To me, it just means, well, we have incredibly powerful computers, and they will be incredibly more powerful, but I can’t see beyond.

[00:35:14] Yaron Valler: Yeah, but power is everything. At the end of the day, think about something as trivial as passwords.

What is the use of passwords when the computer can crack your password in fraction of a second?

How do you encrypt your financial data? How do you keep your privacy?

But this is just a sort of simple to understand and application. But think about, we mentioned medical technology before. Think about the vast amount of data that you have to process in order to make decisions. And what if you can process and cross reference your diagnosis as a patient in a fraction of a second with the whole database of medical knowledge that is out there?

How would that make a decision? Making different decisions could be arrived to a lot quicker, a lot more efficient, and the decisions that the medical staff makes would be a lot more effective.

Think about things like high friction trading. You have to analyze massive amounts of data in order to make decisions. It would make algorithmic trading. It would remove the human advantage in algorithmic trading, so it would level the playing field. It would make the way the stock market behaves completely different.

We’ve been trading stocks and bonds same way since 16th century.

The way we trade is largely based on information gaps between the traders, right? Uneven information, uneven expectations. That could all change, and that could render entire markets ineffective. So I really don’t know what the world would look like.

Think about self driving cars again.

Making a good decision is a factor of the amount of data that you can process and the speed you can process that data in.

Undoubtedly, computers are better at making deterministic decisions than humans, right? They’re not good at making judgment calls, but they’re very good at making deterministic decisions.

[00:37:29] Ross Butler: Although with AI, presumably they’re getting better at making.

[00:37:31] Yaron Valler: They’re getting better at it and then add quantum to it. You can make the model so much more complex that they would really mimic the human brain, and you can go on and on and on and on. Basically, the combination of processing power and memory is everything. Your sole advantage over a computer today is that you have more memory, you have more flexible computing power, so you’re better at doing a lot of things. You’re not good at doing specific things, you’re not good at multiplying matrixes, for example. You’re very good at making logical deductions.

[00:38:09] Ross Butler: I also have a body.

[00:38:10] Yaron Valler: Yeah, but I’m not sure that’s an advantage.

No, because I carried a lot of units, but I’m referring only to brain power now. So I’m saying that it would make a computer closer to what we are.

[00:38:27] Ross Butler: Yeah. And this is where people start to get a bit worried because it does sound a bit scary. I was thinking about this on the drive over, actually, and I was thinking, well, why weren’t people worried about the Internet in the same way as they’re worried about AI? Because clearly the internet has had a hugely destructive as well as constructive role in human society. We never really spoke about it. We just saw the opportunity. Now we’re very conscious of the AI threat, maybe because of all the Sci-Fi movies and not so conscious of the opportunity. I would say.

[00:38:59] Yaron Valler: I think that, know, I’m going to make a somewhat controversial statement.

[00:39:04] Ross Butler: Go on.

[00:39:06] Yaron Valler: I think that the west is too consumed with whether we should do things and not with whether we’re capable of doing them. The reason I’m saying the west is because we are forgetting that we are the minority of people that live on this planet. And frankly, if we don’t do certain things, other people will, and then they will have an advantage over us.

Anything that can be done will be done. If we don’t do it, China will do it. If we don’t do it, Russia will do it. If we don’t do it, someone else is going to do it. And we are eroding our competitive advantage by hamstringing ourselves with these considerations. That is not to say that ethical considerations don’t have a place, they do, but they need to always bear in mind that someone else will do what you don’t want to do.

[00:40:02] Ross Butler: So it’s not whether we should do it, it’s how we should go about doing it.

[00:40:05] Yaron Valler: It’s which controls we should have in place and how we should go about it and not whether we should do it. I think we should do anything that the technology is allowing us to do because otherwise that makes complete sense.

[00:40:18] Ross Butler: What are you going to do? Not invent the nuclear bomb or invent it and then make sure that it’s.

[00:40:23] Yaron Valler: Never used, that the other side doesn’t have it or whatever you’ve tried to prevent proliferation. Absolutely. And which American president said that foreign policy is speaking softly and holding a big stick? Roosevelt.
So you need to speak softly and hold a big stick. And if you don’t hold the stick, then someone’s going to hold the stick over your head.

[00:40:42] Ross Butler: Could we talk mean, your company is called Target Global. Can we talk about geographies? We have spoken about the UK and Israel, Germany. YoU’re a fan of the policy there. Are there other regions where venture capital, growth capital is know, one of the.

[00:40:58] Yaron Valler: Things that we’ve tried to do is explore other regions and where we have seen quite a bit of success and I’m very keen on doing more in these regions is Africa, the Arab world. I think both of these regions have a lot of characteristics that make them interesting for technology.

In the case of Africa, we are shareholders in biggest digital bank in Africa today, called CUDA.

Not many people know what is the population of Nigeria, but Nigeria is two thirds. Yeah, it’s almost as big as Europe.

[00:41:40] Ross Butler: Right.

[00:41:40] Yaron Valler: So it’s an unbelievable market and very young.

[00:41:45] Ross Butler: It’s going to be more populous than America in about 20 years or something.

[00:41:48] Yaron Valler: It’s unbelievable and mobile first and young. And so you’ve got all of these and lack of infrastructure. So you’ve got so many things going for this region.

Again, speaking about the proliferation of tech and the proliferation of startups. This is our mission. This is our mission as a world.

I am a huge believer generally in humanity, in the fact that everyone should have the same opportunities.

A lot of the political strife that we are seeing and the violence that we’re seeing in the world is tied to economic disparity.

It’s impossible to have a lasting peace with economic disparity and with educational disparity. So it’s our duty to do these things. Now, you speak about regions with a massive number of young people.

We didn’t speak about the immigration into Europe, which is, in my mind, the only way the continent will survive long term.

So the proliferation of technology, the proliferation of knowledge, the proliferation of affluence.

We want to live and we want our culture to live, these are things that, from very self serving point of view, we should be keen on and we should engage in.

And that’s why I’m so excited about the investments in these regions. They’re woefully short on investments, especially in Africa, and all the characteristics that make investments successful.

[00:43:24] Ross Butler: Is this hypothetical? Is this something you’re looking.

[00:43:26] Yaron Valler: No, no. We have done quite a few investments in Nigeria, we’ve done investments in the UAE, we’ve done investments in different, different drivers in the Arab world, but also very distinct needs that the Arab market has a lot of young people in some countries, large segment of the population that prefers to work from home for a variety of reasons. So many things going for that region, a lot of educated people, and again, think about the unrest that the world has experienced from that region. The only way to mitigate this and to fix this in the long term is by proliferation of education and economic affluence.

[00:44:14] Ross Butler: Strange time at the moment for doing deals. Have you, like everyone else, slowed down your rate of investments?

[00:44:20] Yaron Valler: We have. We are more picky. We are seeing a lot of competition in later stages because the number of companies has decreased a little bit, valuations have decreased, and a lot of players came into that market.

What’s probably more telling is if we look at earlier stages and there we’re seeing less money flowing into the market.

And I think that if this trend continues, we will have sparse vintages in 2024, 2025, probably 2026 and beyond, because it will take these startups three years to get to a more advanced stage.

But yes, everyone slowed down, everyone became a bit more careful about valuations and this indeed affects the industry. But we just had our Investor day on Monday and we had a really great presentation from the head of capital markets at Morgan as the opening keynote, and she showed data about the resurgence of IPOs, the resurgence of. So again, this is a cyclical phenomena and I think that long term we will see a return to know. I don’t see this as having a lasting effect on the industry. I think that we are going to see some heartbreaks, but that’s how it is.

[00:45:59] Ross Butler: Yaron, thanks so much for sparing your time for Fund Shack.

[00:46:02] Yaron Valler: My pleasure. Thank you very much for having me.

Sanjay Panchal is a partner at Livingbridge, a leading international growth capital investor, where he specialises in healthcare. In this episode he speaks to Ross Butler about the opportunities for private equity investors across the healthcare sector.

[00:00:00] Ross Butler: You’re listening to Fund Shack. I’m Ross Butler and this week I’m talking with Sanjay Panchal, a partner at Livingbridge, a leading mid market private equity firm. Sanjay focuses on healthcare, and in this discussion he explains the dynamics and the opportunities in this complex sector from an investor’s perspective.

Sanjay. Welcome to Fund Shack. You focus on healthcare at Livingbridge New Invest. Healthcare is kind of it’s a big sector to get your arms around. How do you at Livingbridge approach it?

[00:00:31] Sanjay Panchal: Yeah, you’re right. Healthcare is a really massive sector and very varied, actually. Lots of different business models, lots of different end markets, lots of different subsectors to get your head around. So it can be quite a difficult market to navigate and try to think through. But the way we think about it at Livingbridge and if I talk a little bit about how we approach private equity generally and then parlay that into how we break that down into healthcare, it hopefully helps provide a bit of a framework, but that’d be great.

We largely play in the mid market in the UK and so we’re investing in businesses generally making a few million pounds of profit and above and helping them scale and grow. And if you think about it, if you think about the sort of broader UK economy, it’s a low GDP growth economy. And our job as investors is to spot the areas of that economy which are growing faster than GDP and materially faster than GDP, because we want to be finding businesses that are growing at 20, 30% a year. And so the beauty and the challenge in that is actually what you’re constantly having to do is repoint where you’re spending time, because the markets are constantly changing. And where that growth comes from, as sort of subverticals and sectors go on, their natural maturity curve means you have to constantly look for new, different pockets of growth. And so the way we approach it at Livingbridge is really thematic investing, so really identifying key trends and growth trends in the healthcare space and in a market, and then understanding how we can bring to bear our capability and our experience into helping and supporting companies that are playing into that ecosystem. So we’re constantly looking at where is change happening, where is innovation happening? And in healthcare in particularly, it’s very much also linked to where is funding going and where is capital going?

And that’s both NHS funding, but also in the private sector, where are healthcare dollars getting spent, or pounds getting spent, rather? And then we also think about it in the context of where can our experience as an investor in the things we’ve done in the past really allow us to win and play and make a difference? I guess underlying all that is a philosophy we’ve built in healthcare, which is really focusing in on businesses that want to drive a change in outcomes. And we really believe in the fact that as a healthcare provider, if your sole purpose or your reason to exist is to drive better healthcare outcomes, the commercial outcomes sort of follow from that. We want to partner and like to partner with businesses that share that same philosophy who come from a real care ethos and also businesses that as part of that, really focus on being the best employer in their market. Because as you’ll see, a lot of healthcare businesses are very much people driven. 40% of NHS spend is on staff.

So people are the lifeblood of delivering health care. And the key to growing really sustainable healthcare businesses is actually being able to recruit and retain individuals and empower and inspire them and also give them the tools they need to deliver great care.

[00:03:32] Sanjay Panchal: So it sounds like we’re talking about service businesses really rather than because you’d include like biotech and stuff into healthcare.

[00:03:39] Sanjay Panchal: Yeah, in the main, as a house, we are largely focused on service businesses. That includes technology as well. But if you look at the wider healthcare ecosystem, you’ve got very capital intensive businesses, things like hospitals, but those are in the main and you think about elderly care homes, but those are in the main profile of investment that’s more suited to either large corporates that play in that space or real estate investors. So we are typically playing into service business models. Yeah, right.

[00:04:07] Ross Butler: So you spoke about themes, but you also spoke about change. I thought you were going to say, oh, well, we look at themes like aging population, et cetera, et cetera, et cetera. And that’s a theme that doesn’t really change that quickly.

[00:04:20] Sanjay Panchal: Yeah, we do look at really large themes like that. So actually that’s where we start from. So we say, actually, what are the big ten? We call them tenure truths in a market. So what is the direction of travel in an overall market? And then as a result of that, which are the business models that will play into that change? So a really good example is a business that we invested in in 2018 called Helping Hands. And Helping Hands delivers care in the home. And we recognized as part of our tenure truth, that actually, one, you’ve got an aging population, but two, a lot of care was moving to be out of hospital and into the community and there’s a strong imperative to move care closer to the home. If you look at the number of hospital beds in the UK, they’ve gone from about 200,000 beds in the early two thousand s to about 140,000 now. So the acute capacity and that’s partly driven by the fact that there’s more day procedures, so you’re able to do procedures more efficiently and therefore you might need less capacity, but also a strong imperative to move care closer to the community. So we spotted that as a trend, as in a ten year truth, and we spent a lot of time building relationships with businesses over a long period of time. So we spent ten years, I think it was, getting to know a Helping Hands before we even did a transaction with them. And some of the other big tenure truths are technology adoption, healthcare, looking at the care in the community, in life sciences, there’s a huge change in the way drug pipelines towards more complex molecules and more complex indications. And that’s driving a lot of different activity and a lot of pockets of growth in the life science ecosystem. And so, yeah, we do try and identify these very long term trends and then see what business models can play into them.

[00:05:58] Ross Butler: They sound very, very different types of businesses. And while private equity firms are great at service businesses playing into the complex molecule, I mean, this is a specialist endeavor even for the people that are investing in the companies that are doing it.

[00:06:14] Sanjay Panchal: So our job, another way to think about it is our job is pattern recognition. What we’re trying to do in a lot of these instances is identify the common themes and the business models that exist and how we can play into them. Let’s use Helping Hands as an example. Helping Hands is a business that a core part of what it does is recruiting and retaining clinicians and nurses. And actually that capability and that skill set is very common to a lot of different business models and a lot of different business. So even when you’ve got very specific end market dynamics, there’s common themes in those businesses that we as a private equity house can bring to bear. And that’s kind of the value we bring as an organization, which is to actually say we’ve seen this ten times before in a bunch of different scenarios. And actually our ability to and our focus on multiple sectors really does make a big difference in understanding that pattern recognition because you get to actually see it across a load of different sectors.

[00:07:07] Ross Butler: I guess in that example, your healthcare specialization allowed you to see the opportunity. And when you bought the business, the value creation drivers and levers were actually relatively known to you because exactly.

[00:07:18] vYeah. And we see that that’s a very common theme for us. We see our job is to identify those patterns and then understand how we can leverage our experience. Our capability to help the companies we work with often bypass the mistakes we’ve made and miss them, but also bring capability to help them scale. If you’re thinking as a founder of a business, most of the founders we work with, they’re really passionate about the markets they work in. They have a really clear vision about what they want to build and they know what great service and product looks like for their customer base. That’s very different to understanding the ingredients of how to scale a business.

What does the best CFO look like? How do I think about making an acquisition in the US. Because I’ve never done that before. And that’s where that combination of their vision, their understanding of their market, combined with our capability of how to scale and how to execute, all the while having the same empathy in healthcare in particular, that’s a really powerful combination. And so our philosophy is all about, is this business in a better place than we left it? Have we genuinely brought value to the table, to that founder, and helped them realize their vision? A really good example is a business I sit on the board of called Nourish Care, which is helping elderly care homes in the wider healthcare ecosystem transition from paper records into digital records. And Nuno, the founder there, incredibly passionate about it, has really aligned on philosophy in terms of driving better care outcomes as the ethos of the business. We think of it as a care business first, before technology business. But actually, Nuno has no idea. He didn’t have any idea how to make an acquisition or hadn’t done one before.

We’ve helped build a C suite around that business to make sure it’s got the right talent around it, to help it scale and really maximize the opportunity that business has.

[00:09:16] Ross Butler: Yeah, it’s so interesting how you come at things, because you could have come at a deal like that as a technology investor and applied a cookie cutting approach to that, and maybe it wouldn’t have made much difference, but maybe you wouldn’t have won a deal in the first place.

[00:09:28] Sanjay Panchal: Yeah, no, exactly. And it’s that combination of we’ve got a lot of healthcare experience and a lot of software experience, so we’re able to bring that empathy and that ethos, that care ethos, and that quality ethos from a healthcare perspective. But then we also understand what are the ingredients to scaling a software business model. That’s a really powerful combination and something that we think really differentiates us and.

[00:09:50] Ross Butler: The level you’re investing. You’re dealing, as you mentioned, with founders and entrepreneurs.

Is there a type? Do they tend to have medical and care backgrounds? Presumably they do, but maybe not.

[00:10:02] Sanjay Panchal: Funny enough, increasingly we’re seeing people from non care backgrounds come into care. Partly there’s an opportunity, and then also partly there’s a need for innovation. And so you see a lot of people looking at parts of the healthcare ecosystem saying, something’s broken, I can find a solution and fix it. Particularly in technology, where you get a lot of engineering and a lot of technical understanding and just applying it to a different use case, really.

[00:10:25] Ross Butler: The other thing about the medical profession in general is that it’s full of really smart people. They’re very specialist.

And I guess it’s a shame that there isn’t a culture of being able to dip in and out of being a heart surgeon and an entrepreneur. I guess that’s just not what the system caters for. But you can imagine that a heart surgeon has lots of fantastic ideas about how to make the system better.

[00:10:48] Sanjay Panchal: Yeah, it’s partly what I love about being in the sector, actually. You’re generally working with very bright, very thoughtful individuals who you can just have a very rational and really fulfilling conversation with about what they want to build and how they want to go about building it. And particularly in healthcare, and particularly in life sciences as well, you just find really smart individuals and it’s a pleasure to work with them.

[00:11:15] Ross Butler: I felt that you were a little bit modest in your description of living bridge at the start because it’s a wildly successful growth capital and mid market house. And yes, you’re in the UK, but you also have a real international presence. How does that feed into this sector?

[00:11:30] Sanjay Panchal: We’ve got offices in the US and Boston, an office in Australia, and interestingly, in Australia we’ve done two healthcare investments, actually three. So we’ve done invest in a business that does physiotherapy clinics. We’ve got a GP clinics business, and we’ve also got a radiology teleradiology business.

And actually it’s a really interesting theme we’re sort of thinking about actively is as healthcare becomes more specialized, the ability to apply disciplines across geographies becomes more relevant. If you think about it, historically healthcare systems have been quite independent, particularly where you’ve got state funded provision and therefore the funding models and the nuances of navigating those systems to a large extent still the case. But particularly in the acute sector, and by that I mean hospital and secondary care, the specific specialties are becoming much more multi jurisdictional. So for example, gastroenterology or dermatology, these are very specialist disciplines that you can actually scale across different geographies as long as you’re able to navigate the funding system and the nuances of that.

[00:12:40] Ross Butler: Can you give me an example of say, gastroenterology? What element of it is scalable?

[00:12:45] Sanjay Panchal: Yeah, so what you could have is, for example, in the US you see this a lot now you have specialist gastroenterology clinics. So whereas before what you’d have was hospitals doing everything. You get a reconfiguration of the footprint where you get specialty businesses really focused on specific disciplines and the care pathway becomes much more specialized.

[00:13:03] Ross Butler: And how they tend to be funded, are they still funded through the state system or does it just so it.

[00:13:09] Sanjay Panchal: Depends on the individual jurisdiction. So what you can have is similar to what we have in the UK, where a lot of it’s publicly funded but privately delivered, or you have private pay or a mix of both.

And that’s becoming a more common theme that we’re seeing as well.

[00:13:22] Ross Butler: Do you see many healthcare opportunities where it’s kind of a consumer driven trend and choice?

[00:13:29] Sanjay Panchal: We’re seeing the increasing consumerization of healthcare, and I think the way I’d characterize it is consumers wanting greater visibility and control over their health.

To be honest though, that hasn’t really necessarily parlayed its way into the private sector from an independent self pay perspective growing is we still think there’s lots of opportunity there, but it probably hasn’t fulfilled its potential yet. I think it’s probably the best way to describe it. The other interesting thing is that the expectations of consumers has really changed in terms of the service they expect from a counterparty more generally. And then that’s really driven by how most industries have moved online in some fashion. And therefore the definition of customer experience is really changing. And the healthcare landscape has really lagged in its ability to keep up with the expectation of the consumer on customer experience. So NHS patient satisfaction is, I think, around 14%.

And this is where we see a big role in technology playing, in actually delivering a better customer experience, if you want to call it that, into what can be a state funded environment.

[00:14:41] Ross Butler: Let’s talk about deal making for a minute, generally speaking, rather than like, maybe right now. What kind of competition, what level of competition do you have? What types of competitors do you have for assets? And then at the other end, where do you look to typically exit?

[00:14:57] Sanjay Panchal: The UK mid market is quite an established ecosystem, so we will be competing, as you’d expect, with other mid market funds. We’ve probably got one of the longest running franchises in healthcare specifically, and built a very strong track record in healthcare. Increasingly, you’re seeing US competitors come to the UK, particularly in the life sciences arena.

[00:15:20] Ross Butler: And right now, are you seeing decent deal flow? I know generally it’s a difficult market.

[00:15:24] Sanjay Panchal: No, this year is a much quieter market, so I would say deal flow, and in healthcare in particular, is probably down 30%, 40% year on year. That’s partly during COVID there was a flight to resilience and there was a lot of interest in healthcare, particularly as people saw it as very resilient, very stable. But the general markets, particularly as interest rates have increased, meant that private equity activity has just come down generally across the board. The other aspect you’ve had is in the biotech world, funding for biotechs has taken a material hit, so that’s probably down 30% year on year. And that’s just because real allocation of capital, from institutional capital and funds into high yield instruments.

[00:16:10] Ross Butler: Yeah. And how big roughly is your current portfolio of healthcare investment?

[00:16:15] Sanjay Panchal: So we’ve got, I think it’s ten healthcare assets at the moment across a number of different themes that we’ve been tracking for a long time. So we’ve always been very strong in social care and really focused on the high acuity end of social care, where you can make a real difference to care outcomes as a provider.

Our last three deals have been in healthcare technology, so we’re seeing a lot of change in healthcare technology and a lot of adoption of healthcare technology now, particularly post COVID.

And then we’ve made our first investment into the life sciences space in 2021 and then we’ve got a number of business that also play into the NHS as well as some of the consumer healthcare trends that are happening.

[00:16:57] Ross Butler: How did you end up focusing on healthcare? Is it just a personal interest?

[00:17:00] Sanjay Panchal: I’ve always believed that our sector can be used and drive a lot of good, and healthcare to me seemed the most logical place where you could have a real positive impact on society and at the same time really demonstrate that commercial success and positive healthcare outcomes can coexist. That’s something we’re really passionate about. By being commercially successful, you can reinvest in delivering better care and continually improving the way you think about care outcomes and delivery.

That really gets everybody on the same page because then you’re all in it for the same thing, which is we’re all trying to improve care outcomes, we just happen to do it in a commercial context.

[00:17:38] Ross Butler: The ethical element of this really does sound like your lodestar. It’s the guiding light that you have that helps you find good commercial opportunities.

[00:17:49] Sanjay Panchal: It also really helps us think about the businesses we want to partner with, because when you have that as your North Star, everything else kind of falls into place. And there’s real alignment between us and the founders because you’ve got a sense of what we’re really striving for here, and it really helps bring into focus your decision making.

[00:18:08] Ross Butler: You’ve recently done a deal in the life sciences sector, as you mentioned. Could you tell us a little bit about that?

[00:18:12] SSanjay Panchal: We probably started in 2017, looking more closely at the life sciences space and really trying to break it down into where does opportunity set? And there’s a few big trends coming back to your point, around ten year truths that we recognize, and we’re not the only ones to recognize it, but these are the structural changes that were happening in life sciences that are really driving a lot of the opportunity today.

The first trend was that drug pipelines becoming much more complex and much more specific. So the years of having really big blockbuster drugs, they’re not behind us, but they’re less of an influence. So what you were having is pharmaceutical and biotech companies developing drugs that are much more specific indications targeted towards much smaller patient populations.

[00:19:02] Ross Butler: Right. So not general aspirin and pain relief?

[00:19:04] Sanjay Panchal: No, exactly specific. Really specific. So this type of cancer or this type of so you had much more complexity being introduced into drug pipelines. The second thing was a structural shift in what pharma did and what they outsourced and where the development in that ecosystem happened. So effectively, what you had is much more the development and discovery of drugs moving from pharma into the biotech world and people raising capital on the basis of creating a specific molecular drug that they would then sell into a pharma company or commercialize on their own, which we’re increasingly seeing, but in the main hitting milestones. And then effectively being able to trade on that value and sell them into pharma. And what that meant was that these biotech companies who are quite resource light, so you raise a bit of money and then you do some research, started becoming much more dependent on an external ecosystem of providers to help them do very specific things. So my drug discovery activity, how I think about regulatory affairs, how I think about manufacturing, batches for clinical trials, all this activity, biotech companies were largely virtual and then they would use third party service providers. So that created a whole ecosystem of providers around the biotech world that could then serve in a way that wasn’t happening before. Secondly, the pharma companies themselves were then becoming also similarly looking to become more, call it asset light. So instead of having all their resource in house, looking to have more variable resource. Because if you think about it, your drug pipeline over a ten year period may vary quite significantly, or a 20 year period. The core role of a pharma company is to identify really novel therapies that you can bring to market and commercialize and successfully do that.

But you don’t have to be an organization that does everything from top beginning to end the discovery, the manufacturing, running the clinical trial. So the outsourced provider community into pharma companies started growing massively as well. And that just created a whole bunch of business models that probably didn’t exist 2025 years ago. The third big trend was that.

[00:21:16] Ross Butler: Can I just ask you about that?

[00:21:18] Sanjay Panchal: Yeah.

[00:21:18] Ross Butler: So that’s been going on for a couple of decades now. Where are we in that? So it’s fascinating the way you explain it. Like there’s these monolithic companies and a part of them is kind of crumbling away as they outsource it and that’s creating a whole entrepreneurial ecosystem.

How far has that run? Is that ecosystem now more or less established or are there constantly new opportunities?

[00:21:40] Sanjay Panchal: So the way to think about the life sciences ecosystem, the way we think about it, is in three big buckets. So you’ve got discovery, which is trying to identify potential targets to be a drug. You’ve got the clinical side of it, which is demonstrating that that drug works or it doesn’t, and then you’ve got the commercial side of it, which was selling the drug. So those are the three big buckets of activity and each of those is on its own journey of maturity with respect to how much is done by third party provider communities and how much is done by the pharma companies themselves.

[00:22:12] Ross Butler: Are you interested in all three?

[00:22:13] Sanjay Panchal: So I think our current view is that the first area where there was a lot of maturity about sourcing is largely, in our view, mature now other than specialists. And we could talk about VeriMed is the clinical side and you now have what are a relatively established set of CROs who run clinical trials for pharma companies. Now, the interesting dynamic there is when I talked about this biotech dynamic, some of these biotechs are now starting to try and run clinical trials themselves and go further up the value chain.

And what’s happened is you’ve got this huge CRO community, but they’re largely facing into big pharma. So actually it’s quite a complex matrix because you’ve got pharma companies, so big pharma, let’s call it mid size pharma and biotech, and then you’ve got a service provider community that is kind of catering to each of those segments. So the large CROs today are largely focused on the big pharma business. They match up against that. But then there’s a whole ecosystem of CROs on the clinical side that are playing into the smaller customer segments as they start to do more of that activity.

[00:23:20] Ross Butler: So in a sense, they’re specialists, but they’re becoming less and less specialists because obviously they’re trying to expand their position as well.

[00:23:26] Sanjay Panchal: Exactly.

But that whole ecosystem relative to the other parts is pretty mature now, right?

[00:23:33] Ross Butler: Yeah.

[00:23:33] Sanjay Panchal: So we think it’s harder to play into other than very specialty disciplines, where, for example, biometrics, which VeriMed does, which is all the data analysis around clinical trials, where it’s a very special discipline that is increasingly being procured independently by the pharma companies rather than using the CRO for them.

[00:23:52] Ross Butler: When I hear biometrics, I think of just like, CCTV scan.

[00:23:55] Sanjay Panchal: Yeah. So biometrics in a pharma sense is three disciplines data management, statistics and programming. And in very simple terms, what it involves is all the data analysis that occurs around a clinical trial. So you can imagine when you’re conducting a clinical trial, you’re giving patients drugs, you monitor the effects on them, you’re constantly getting data back and how you then synthesize that to demonstrate that this drug is causing this impact on a patient. All the statistical analysis around that is biometrics more generally.

[00:24:27] Ross Butler: Right.

[00:24:28] Sanjay Panchal: And so three years ago, we spotted that this was increasingly being done independently of the full service CRO world, and therefore we were lucky enough to invest in VeriMed. And that was us really bringing to bear our thematic investing. We spotted that that was a theme. We met every business in the UK that did that. And what was very different about VeriMed was that it really fit with our culture and our ethos. The business was really focused on being the employer of choice and really delivering high quality work.

[00:25:02] Ross Butler: How did you find the business?

[00:25:04] Sanjay Panchal: So that was that we have a direct origination team that reach out to companies on our own volition. And while a lot of the market today in terms of private equity transactions will be intermediated by an advisor in the middle, that relationship prior to that event happening means that you often have a better chance of completing that transaction proprietary deal.

[00:25:24] Ross Butler: Holy grail. And that was one of those.

[00:25:26] Sanjay Panchal: Well, yeah, so they put an advisor in and other people have to look at it eventually had a relationship, of.

[00:25:30] Ross Butler: Course, eventually they’re going to get advised, but you’re in early, as it were.

[00:25:35] Sanjay Panchal: Exactly. And there’s an understanding there’s a relationship there that you can leverage.

[00:25:38] Ross Butler: Yeah. And how’s it going?

[00:25:39] Sanjay Panchal: Yeah, great. It’s a fantastic business. It’s a really exciting end market and what’s really reassuring to see is that business has been able to scale its headcount without the impact of quality. Because often when large businesses grow, it’s harder to maintain. And particularly in healthcare, it’s really important that you have really good clinical governance and quality all the way through the organization.

And part of the reason we thought vermit is really attractive is because their focus on quality. And that’s proven out as we’ve invested and we’ve just made our first acquisition in the US.

And as I’m sure you’re aware, the largest farmer market exists in the US. And a lot of our customers will want us to do US work. So we now have an on the ground presence there, which is a business. We help the company identify, help them transact, and now we can go from there.

[00:26:27] Ross Butler: What about digital? Because particularly we’re here in the UK with the NHS, it’s a huge institution. Presumably the only way to make that more efficient is digitization. There can’t be any real downsides to digitization, can there? And that’s just all think, you know.

[00:26:41] Sanjay Panchal: There’S a lot of benefits to technology, but we have to be very cognizant of how we deploy it. And this is where this sort of care ethos and outcome ethos really comes to the fore. Because actually, first of all, when you introduce lots of technology solutions into an organization, that’s a lot of change management that needs to happen. And actually we see our job when we invest in healthcare technology businesses is really helping educate providers who in a lot of instances may be adopting a technology solution for the first time. Or more importantly, they’ve got staff nurses, clinicians, who are stressed enough as it is with their day job and then having to learn how to use a new tool, even though there’s massive benefit to it. But that initial learning curve and changing the ways of working and the behavioral patterns, that’s a massive change management program, a massive cultural program. So implementing technology, it can’t be viewed as, let’s just go sign up to a new tool. It’s got to be really fundamental to how the organization thinks about changing the way it operates and works.

[00:27:50] Ross Butler: Yeah, because people have got to use it.

[00:27:52] Sanjay Panchal: People got to use it and we need to recognize that actually these people have very busy day jobs and they’re very stressed with what they do.

There’s a huge amount of pressure on the system generally and so introducing technology can be quite hard and in that respect, you have to be patient about it as well. But it’s our job to really educate and help. People understand the benefits technology can deliver. The other thing that we really think about a lot is what I guess you could call digital exclusion and inclusion, which is ensuring that technology is accessible for all. And that’s both in terms of how it’s designed, but also the ability for people to access technology. Because you can imagine a scenario where you’ve got a digital pathway for care. And by that I mean the triage is digital on your phone. You upload a picture, you answer a bunch of questions, and then you’re sent into a referral pathway. And ultimately you maybe end up with a face to face appointment or not. Or you’re asked to input a lot of data about yourself, or you have to do it completely remotely. And somebody might be living somewhere where there’s a bad Internet connection, for example. So there’s all these aspects to getting people to actually use technology and engage with it and making sure it doesn’t exclude elements of society and groups of society who are either less digitally savvy or have less access.

[00:29:15] Ross Butler: There’s a massive generational component to this as well, where it’s not just that the older generation didn’t grow up with technology, it’s also that technology does become harder as your digits become less malleable and your eyesight starts to go, it all becomes harder. I know, exactly.

[00:29:30] Sanjay Panchal: And so therefore exactly so when designing solutions that have technology in them, this kind of needs to come to the fore in terms of be at the core of how people think about it, ensuring access and usability and education of technology so you can take people on that journey and make it easy for them.

It’s a really big something know, we talk about a lot at nourish and ensuring that actually our technology becomes usable and accessible for people.

[00:29:54] Ross Butler: And I’d imagine as you come across like a really cool digital company focused at healthcare, you can then take that, because if I’m a software engineer and I know that healthcare is a great application, that might not be the first thing I think of because I’m a tech guy. I love that stuff.

[00:30:09] Sanjay Panchal: Exactly.

[00:30:09] Ross Butler: Whereas you can bring that perspective and say, hang on guys, everybody sits in.

[00:30:13] Sanjay Panchal: Their own echo chamber, right? So it’s very easy to not have perspective of how another user might think of it.

[00:30:19] Ross Butler: And is there any symbiosis between your digital investments and your view of services?

[00:30:27] Sanjay Panchal: What we’re increasingly seeing in healthcare in particular is that combination of technology and service and particularly on the sort of acute side where, if you imagine what we’re trying to do is for somebody who’s got a specific problem, have the most efficient pathway through the healthcare system that might involve a digital solution at the beginning that helps you work out whether you actually need to see somebody or not. And it might involve end up with you seeing a clinician. And actually if you want to really have a solution that makes that whole process both from a customer experience, a clinical outcome and a system efficiency perspective, those all need to be joined up in some way.

And so I think you’ll start to see more of an integration of technology and service as time goes on because it becomes imperative for the system to deliver the change it needs.

[00:31:21] Ross Butler: So maybe we could try and round up with kind of more because this all sounds like great stuff and it’s a very broad sector and you’ve done a great job of kind of passing it for us. Do you have a view on the role, the importance of private equity and growth capital in healthcare? Because I look at some sectors and manufacturing or whatever and I think if private equity wasn’t there, that wouldn’t be positive, it might not be the end of the world. What role in the kind of the round in the macro is private equity playing for the positive in the healthcare sector, would you say?

[00:31:55] Sanjay Panchal: Let’s start with some of the challenges that the system’s got and some of which are structural.

So, if you look in the UK, the capital investment that’s gone into healthcare is typically so for example, the UK has got 16, I think it’s around 16 MRI and CT scanners per million people in the population. Most European countries have 33.

[00:32:18] Ross Butler: Wow.

[00:32:18] Sanjay Panchal: Or in the in the has 85.

[00:32:21] Ross Butler: Amazing. So we got half of European neighbors.

[00:32:23] Sanjay Panchal: Yeah, half our European neighbors and part of that system. So Germany’s got an older population. There’s certain characteristics, but in the main, we’ve had a significant amount of capital under investment into the UK. And so therefore our estate and our system has been started with that development that it’s needed. And secondly, if you think about what’s going to change the system and what’s going to really drive it’s innovation, people coming from outside the sector into the sector, coming up with new solutions and novel ways of changing things. And I think private equity is a great way to facilitate and bring that to bear to the sector to really enable innovation in the space.

[00:33:03] Ross Butler: Great. Well, Sanjay, thanks so much for coming on the show and explaining that very interesting sector.

[00:33:07] Sanjay Panchal: Thanks very much.

Marcus Maier-Krug is partner and co-head of portfolio management at Arcmont. He has been working in private credit since before the global financial crisis.

In this episode, recorded in November 2023, we discuss what constitutes alpha in private credit, what it’s attractions are as an asset class, whether it can retain the market share it has taken from the traditional banking world, the different mindset and culture of private credit lenders vis a vis their borrowers, and much more…

[00:00:00] Ross Butler: You’re listening to Fund Shack. I’m Ross Butler, and this week I’m talking with Marcus Maier-Krug, partner and cohead of Portfolio Management at Arcmont, a private credit manager founded in 2011, which was acquired in 2023 by Nouveen, an investment manager with over a trillion dollars in assets under management. Marcus has a huge amount of experience in private credit and we’re going to look at the state of the market today, the drivers and opportunities, how things could evolve as we head towards 2024 and beyond.

Marcus, welcome. Fund Shack thanks for having me.

[00:00:32] Marcus Maier-Krug: It’s a pleasure to be here.

[00:00:33] Ross Butler: It’s a strange market at the moment in terms of private equity and deal making. What do things look like on the private credit side?

[00:00:40] Marcus Maier-Krug: I think private credit has been very eventful over the last ten to twelve months.

There’s been an unprecedented amount of volatility in the market and that’s had an impact on portfolios of private credit managers, and it’s also had an impact on origination and the origination opportunities that we have. So while there’s been a heavy impact on M and A volumes for new deals which have been under pressure for the last ten months, there have been new buckets of opportunities which have opened up for private credit managers in that time period through, for example, liquid market substitution deals which really were not available in the past.

So it’s been a time period where private credit managers have had to adapt and some have adapted better than others, but I think overall it’s just been extremely dynamic.

[00:01:33] Ross Butler: Okay, so let’s get into all of that. But first of all, I’ve got to confess, I’m not a huge private credit expert and so I was wondering if you could just walk us through the basic types of products that Arkmont have in terms of private credit and what they mean.

[00:01:46] Marcus Maier-Krug: The fundamental thing to understand is the main difference between private credit and what you would potentially get on the liquid market is you’re tending to get a bespoke piece of financing which is negotiated with a limited amount of counterparties. So typically one private credit fund, maybe a small club of two to three private credit funds who will then hold all of that financing themselves rather than the traditional leveraged finance model where you have an underwriting bank who come to a set of terms and then try and syndicate that out to as many potential syndicates as they can find, retaining only a very small sliver of that.

And the debt then becomes publicly traded. And that’s one of the big differences between private credit and what you can get on the liquid markets in terms of the actual product. There’s very little difference in a sense because most private credit managers, and certainly Arkmont, have the ability to play up and down the capital structure. So really we can provide anything that a private equity sponsor might be looking for. Whether it’s a senior secured deal, whether it’s a unitranch deal, whether it’s subordinated debt, equity, co investments. There’s really a range of things that we can provide. And one of the main attractions of private credit is that we have that flexibility. And so the sponsor can really think about what structure works for them and what do they need and how can we potentially find something that fits within that parameter.

[00:03:16] Ross Butler: Does that have an upper limit? So if I’m going to do a monster buyout 5 billion or something, it.

[00:03:20] Marcus Maier-Krug: Does by virtue of fund sizes of private credit players. So generally we would say we would underwrite something of, let’s say 500 million to a billion is where we would probably cap out on a single deal. Many of the larger private credit managers out there would have similar types of limits. So you can probably club a deal of a billion and a half, maybe slightly more than that. There does come an upper limit at some point just because it then becomes cumbersome to get more people together into the group. So yes, there is a limit at some point, but that limit is constantly increasing as fund sizes have increased for private credit managers.

[00:04:03] Ross Butler: And so if I’m at that limit or beyond it, do my options completely change or can I have a private credit component in there and then also do the investment banking syndicate?

[00:04:12] Marcus Maier-Krug: So increasingly previously, you probably then would have gone straight to the liquid market, and frankly, in the past, you would have gone straight to the liquid market at anything above €500 million deal size. Because the liquid market was then accessible to you, you had a minimum level of investment size for it to be traded and liquid, which is a fundamental requirements for those investors.

And at that point you were getting better economics, pretty much a guaranteed financing because the bank would underwrite it for you. And so that was a very attractive option to take in the past. That has changed given the volatility in the markets and now really private credit players will be a very serious contender at those deal sizes. And so I think that is a fundamental difference and has changed. And once you get to very large deal sizes where potentially they can’t be clubbed by private credit alone we have seen situations where private credit provides incremental financing on top of an existing senior deal. And that could be at the time that the deal is done, for example, in a subordinated position, it could be done as an incremental or add on financing after the deal is done. And that’s been one of those new buckets that’s opened up for private credit has been deals that have been liquid market deals who are looking to make attractive add ons but can’t raise the additional capital in the liquid markets given the volatility or can’t get certainty of that. And they really need that certainty in order to acquire the target. And so private credit suddenly becomes very attractive because partially enabled by the very loose documentation that you have in those liquid deals, it allows the borrowers the flexibility to go out and seek financing from other parties while providing a similar level of security. So we can actually come into deals like that, provide very significant financing firepower for acquisitions, benefit from the same security package and sit alongside the existing senior bank in a separate document, but benefiting from the same security with better economics.

[00:06:14] Ross Butler: Everything you just said, does that pertain globally or to Europe, or is it different in the US?

[00:06:19] Marcus Maier-Krug: That is, broadly speaking, global? I think the major difference to the US market is the US market has developed a model where deals are generally clubbed by more parties than they are in Europe, that market is a bit more developed. And so you have tended to see, ironically, the private credit market becoming somewhat like the traditional liquid market in the sense that you will tend to have one or two private credit funds which will originate a transaction and that’s a very important part of the puzzle. And once they originate it, they may actually underwrite that deal and then parcel it out amongst a few other funds. And so funds might come in and take quite small pieces, whereas in Europe, vast majority of the transactions are still done by very small clubs or even sole deals. So most of the deals that we do are either sole deals or we are potentially one out of two parties.

[00:07:17] Ross Butler: Is that a function of maturity? Will we follow the US or is there some structural difference that it’s possible.

[00:07:23] Marcus Maier-Krug: And I think we’ve seen that happen already at the larger end of the market where it’s just, for diversification reasons, not possible to do such large deals entirely by yourself. And so you do need additional players to club those deals up. Whether or not we follow that model down into the smaller size deals I think is uncertain. But generally we have tended to follow the US in many other things, so it wouldn’t be entirely yeah, yeah, great.

[00:07:50] Ross Butler: OK, so let’s get back to the state of the market today, which you’ve already given a summary of what’s deal flow looking like.

[00:07:58] Marcus Maier-Krug: So deal flow is good overall for us, but I would say it has been a quite interesting year. The reason I say that is because the headline numbers are deal volumes are declining and that is a fact.

And so the overall universe of deals, if you want, at the top of the funnel has been decreasing.

Now, generally speaking, that would be negative for private debt, but there have been some mitigating factors that have offset this. And one of those factors has been the opening up of new segments for private credit which previously were not available to us and those segments are primarily related to liquid market deals. So deals which previously would have gone entirely to the liquid market, which now come to us given the state and volatility in those liquid markets, just because.

[00:08:53] Ross Butler: The banks can’t get the deals done.

[00:08:54] Marcus Maier-Krug: Correct and they’re nervous to underwrite. And so those are deals where if you want transaction certainty, and that is one of the main benefits of private debt is it provides the private equity house transaction certainty and financing certainty at a price, but it does provide certainty. And previously those deals were effectively guaranteed in the liquid market model with very strong underwrite from banks that went away and that opened the door for private credit funds to come in and look at those transactions.

And not all of them go private credit’s way, but some of them do. And that’s a whole universe of deals which previously didn’t exist.

[00:09:33] Ross Butler: The second, can I just ask, is that a transitory opportunity or do you think it’ll stick?

[00:09:38] Marcus Maier-Krug: So it’s a very good question and I get asked this all the time by investors.

[00:09:42] Ross Butler: Good, I’m glad I’m asking the right question.

[00:09:46] Marcus Maier-Krug: I think it is both in the sense that the opportunity such as it existed over the last twelve to 24 months, even if you go as far back as COVID Lockdowns, when really private credit was your only option, that sort of level of penetration of private debt will not hold. The liquid markets will reopen. We have seen certain segments of that market start to reopen and when it does, there will definitely be issuers who will prefer that route. But I think I liken this in a way to the development of private debt in Germany over the last ten years. And I have a lot of experience there just because that was primarily my focus area.

And what you saw there was a transition away from banks, even in the lower mid market mid market, which was historically always very strongly bank dominated in.

[00:10:46] Ross Butler: Germany, the land banks and things like.

[00:10:48] Marcus Maier-Krug: That correct to private debt over a period of time where the share of private debt has now risen to over 50%.

And the reason for that is that once people have the experience of using private debt, they notice that there are certain benefits to having private debt and there will be issuers in the future who will continue to value those benefits and they will continue to want to use a private debt solution, even if it’s more expensive.

So we think that there is a part of that market which will be permanently retained, but it’s clearly not going to be as large as what we’ve seen over the last twelve to 24 months. That has been a very unusual situation, but nonetheless it provides a permanently new market for us, which previously was virtually nonexistent.

[00:11:35] Ross Butler Right, okay, I’ll let you get back to your mitigating factors now because I derailed you on the specific liquid market opportunity. So my question, let me remind you, was what’s deal flow? Like you said, it’s looking down. But there are several factors, right?

[00:11:50] Marcus Maier-Krug: The first one was the fact that we have these new pockets of deals and that’s been very helpful in offsetting the overall decline of the deal universe.

And in addition to that comes the fact that both fundraising for private credit players as well as portfolio management for private credit players has become more difficult over the last twelve to 18 months. And that’s something that we see across the board.

[00:12:20] Ross Butler: So less competition?

[00:12:21] Marcus Maier-Krug: Less competition. People are busy fighting fires in their portfolio. People in particular people who’ve been set up with skeleton teams, unlike ourselves, who have a very deep bench. They will struggle because it’s very time consuming to work these situations out.

And in addition, clearly if there’s more of a struggle in fundraising then those players are going to be much more careful with the capital that they deploy, if they have any capital to deploy at all. And so that’s really created bifurcation in the market where many of the smaller players are struggling and many of the larger players are able to take advantage of that. And so there’s a bit of a sort of classic flight to quality in a sense. And so the big guys are getting bigger. We’re fortunate enough to be one of those big guys and that has helped us as well when it comes to conversion rates.

[00:13:13] Ross Butler: Right?

[00:13:14] Marcus Maier-Krug: And I think the final point is the quality of deals that we’re seeing in the market. So previously you had a very large funnel at the top, but the reality is you declined the vast majority of those opportunities because they simply weren’t high quality enough for us. The reality now is as the markets have become more volatile and difficult, those more challenging deals oftentimes don’t even make it to the market. And so the selection of credits that you’re seeing is generally higher quality. So you have a higher conversion rate. Purely off the fact of that as well.

[00:13:45] Ross Butler: I guess the fourth factor is the one you mentioned earlier, which is that while there’s very few primary buyouts going on, there is a lot of buy and build activity.

[00:13:52] Marcus Maier-Krug: Correct.

Again, it’s an advantage that people who have been in the market for a long time and have very large portfolios like ourselves, can take more advantage of than newer or smaller players. And for us that means that there is a substantial portion of our deployment every year which comes out of our existing portfolio because those companies will be busy looking for acquisitions for add on targets, they may require add on financing for other purposes, being building new facilities, investing, whatever it might be. And so those are attractive opportunities for us to increase our deployment with businesses that we already know and like in effectively an exclusive situation because they’re never going to go to an outside source for that. They’re always going to consider us in the first instance. And so that’s another very attractive cornerstone for us that helps to offset maybe some lower New Deal activity.

[00:14:47] Ross Butler: What does the deal look like at the moment? In terms of the process?

[00:14:51] Marcus Maier-Krug: The terms I’m hesitant to get into specific terms, but in terms of the process, what has been noticeable is that the amount of time that processes tend to take has expanded. And that’s a virtue of the fact that debt advisors who are oftentimes involved here in these transactions are more hesitant to force people out of the process early at the risk of being left at the end with no one. So there was a period of real worry about obtaining a financing at all and so those processes have been much longer than they were before. There’s been earlier and more pronounced involvement from financial sponsors as well, also from the management teams. There’s much more handholding through the process, more involvement and contact with the management teams to really sell the business, as it were, to the potential financing parties. Much of that fell away and it was very similar in the last financial crisis. I still remember to this day we were working on a transaction and we were actually penalized for asking too many questions and they said if you keep asking questions then we’re just going to drop you out of the process because you’re being too difficult. And lo and behold, after the crash people were suddenly very willing to answer our questions and they should be because we’re a major part of the financing.

[00:16:17] Ross Butler: What’s your due diligence like?

[00:16:19] Marcus Maier-Krug: It’s a combination of vendor provided information. So there’s usually a very extensive vendor information package which will include an analysis of the market, an analysis of the company, its position, potential growth prospects, competition, et cetera. Financial analysis, legal tax analysis. These reports in total, all created by the vendor, will run anywhere from two to 600 700 pages. So it’s a substantial amount of information.

In addition to that, it’s always customary that you will have a similar set of information from a potential buyer. They will engage their own firms, their own consultancies to do all the same type of work that the vendor is doing. So basically kicking the tires from their perspective. And so depending on how many buyers you’re working with on an individual transaction you may get multiple sets of that buy side information. Now, on top of that, we will always make an effort to check things independently. And we use various expert networks that we can tap on to speak to competitors of the business that we’re looking at, maybe suppliers, customers to really get a feel for is the information that we’re being fed both by the vendor and the buyer. Legit and does it check out?

And I think that’s very necessary. And then the third part of the due diligence is our own experience and frankly we have a huge investment team who’ve been investing for a very long time, they know many of the issuers and even if they don’t know the specific issuers, there’s a real value to understanding markets which can be in certain instances, extremely complex. So a classic example is the German healthcare market. When I was working at my previous employer at European Capital, it was impossible for us to do a German healthcare deal because our investment committee sat in the US. And they just fundamentally didn’t understand that you could have a state funded healthcare system. And the dynamics of what that means and why that makes those potential assets so attractive were completely lost on them.

[00:18:31] Ross Butler: It’s quite common outside of the US.

[00:18:34] Marcus Maier-Krug: That’s the bizarre thing.

And so once you’ve built up that experience, you understand how the system works and again, it will be different, the regulation will be different for every little subvertical within that market. That’s valuable, that allows you to immediately be up to speed, immediately understand a business, be credible in front of the management team. And that’s important to win deals because the management team are a very key decider in this process on which fund they ultimately want to go with.

[00:19:02] Ross Butler: As you alluded to earlier, it’s a difficult market, difficult trading environment, how’s that affecting the types of transaction opportunities you’re seeing, but also the work that you are doing with your existing portfolios.

[00:19:16] Marcus Maier-Krug: So on new opportunities, it’s been beneficial for us in the sense that terms have generally improved from where they were and that has really been almost across the board. So whether it was restrictions in the documentation, whether it is around pricing, whether it is around leverage, all of those terms have, generally speaking, improved. And that’s partially a function of the dynamic I mentioned before, where getting that certainty of financing is more difficult than it was in the past. And so some of those borrowers are now more willing to be a bit more constructive on some of those terms.

And part of it is mechanical in the sense that interest costs have risen, base rates have risen, so the overall interest burden for those companies, given the same leverage, has increased. And so more conservative financial structures are frankly just required because the cash flow just can’t support them otherwise. So it’s been, generally speaking, quite good because everything has moved closer in our direction. The flip side of that has been on the portfolio and clearly these same dynamics, whether it be the volatility in the markets, whether it be the various economic pressures that we’ve seen over really since, really since the COVID lockdowns, it’s been unrelenting in terms of different pressures that we’ve seen on the portfolio. All of those are a real challenge. And I think one of the strengths of private credit is that we tend to be in a sole financing provider position or potentially one of two or very small group of financing parties. So it gives you an outsized control in the documentation, which is something that you’re lacking on a liquid market deal.

And so what that’s meant is it’s meant very heavy involvement by private credit managers to deal with a lot of these stresses, whether that be addressing potential Covenant breaches or other issues in the document.

Those are all these kinds of issues, restructurings that might have had to take place depending on how difficult a situation is. They’re all very time consuming.

And as I said, I think it’s again going to benefit those larger players because they have the bench to really dedicate the resources to work on those situations without losing the capacity to originate new deals.

[00:21:55] Ross Butler: At Arcmont, do you have dedicated resources or do they tend to be the same people who are doing the deals?

[00:22:01] Marcus Maier-Krug: So they tend to be the same, but the reason they tend to be the same and in my opinion it is the better model than having a separate dedicated workout team, which by the way is also the same model that the banks use, which is quite unpopular.

[00:22:18] Speaker A: Is because what’s the model the banks use?

[00:22:20] Marcus Maier-Krug: The banks will tend to use dedicated restructuring departments and that’s unpopular and that’s unpopular. And the reason it was unpopular and it really showed itself. It’s a classic example. One of those things I mentioned earlier of the experience that people made with the banks, for example, in Germany after the financial crisis was very negative because they did a deal with someone and then after the crisis, or in the crisis, they had to maybe renegotiate some of those terms or restructure that deal. And suddenly the counterparty that they’re speaking to is a completely different person they’ve never met before with a completely different agenda.

[00:22:56] Ross Butler: It creates a misalignment of interest, complete misalignment. A lot of problem in GFC with some Scottish banks around that and it.

[00:23:02] Marcus Maier-Krug: Was very, very similar in Germany and it was quite a negative takeaway from many financial sponsors. And so that’s why I think that model is not ideal. You want to have the same partner. But on top of that, I think the reason it’s useful and the reason why we like to do it with the existing deal team rather than a separate team is also the familiarity that you have and the knowledge that you build up on the market and on the business when you’re doing your due diligence. There’s a real benefit to reading through thousands of pages of due diligence, doing these due diligence calls with third parties, meeting the management team. You build up a knowledge base of what this company does, who their competitors are, what the dynamics in the market are. So when something happens, you can better assess what that means and that allows you to take better decisions. And the third aspect to that is if you keep it with the same deal team, they’ve probably built up a relationship with the management team since the due diligence process and into the portfolio monitoring process, which is something we major on. So it allows you to have a very close dialogue with the management team and rather than waiting passively for a problem to appear, you have the proactive ability. And again, this is very different from the liquid market where you’re 2% of a giant syndicate. You have zero connection to management. You get a management presentation once a year on the budget and that’s it. And in our model, because we’re so important and because we’ve built up this relationship with the management, we can phone up the CEO anytime we want and we can say, hey, we’ve been seeing that material prices have been drastically increasing. How is that going to affect you going forward? What does that mean for your business? And they can explain that to us. They have no obligation to do that, there’s no legal obligation to that. But we’ve built a relationship with them which allows us to then react far more proactively than just sitting there passively and waiting for something to happen.

The final point is if you unfortunately do have to go into a situation where it becomes a very heavy restructuring, there are certain jurisdictions and it is very jurisdictional based. Enforcement law is very jurisdictional based, where management plays an outsized role. So in certain jurisdictions, like France or particularly Germany, you have fiduciary duties by management teams to place a business in insolvency if they believe the business is at risk. And the worst thing that can happen to you is to be in the middle of a discussion, of a restructuring discussion and we all think we can get to a positive outcome, but management gets nervous and they decide to file for insolvency.

And so that advantage of being able to speak to them, to know them personally and reassure them that we’re going to come to a positive solution and support the business that helps preserve value for everyone.

[00:25:56] Ross Butler: So I’ve been thinking about what’s the alpha in private credit because it’s quite obvious to some degree in private equity that private equity firms are different in what they do. It wasn’t obvious to me before we started talking what was different in private credit, but now it is more obvious. And it seems to me it’s subtler, it’s more nuanced, and it’s about kind of taking the time, because it sounds like you could do a lot of what you do through basically just signing off and box ticking. And there’s a world of difference between that and actually being, I guess, diligent, properly diligent. Is that where your alpha comes from? And in addition, let’s talk a little bit about Arkmont and your culture because that’s going to be embedded.

[00:26:37] Marcus Maier-Krug: So I think that it is one of the major drivers and one of the major drivers for our success certainly has been the investment mindset of the team. That’s very important. If you look at the senior profiles within our team, they’re always from an investment background. They’re not bankers. So they think of investments differently. They think about a position where you’re negotiating a deal and you own that risk for an extended period of time, three years, maybe even seven years. These tend to be seven year deals. So it’s a very different mindset of looking at things and it also changes the way that you think about solutions to problems.

And that’s quite important because that will change the way that you structure these deals and also the way I think more importantly to your point of how do you really provide better performance or generate better performance than other private credit managers? Partially it’s being able to originate transactions and win those off the back of your relationships with the private equity sponsors and that’s something you build up over a very long period of time.

And the other part of it is not losing capital for us, it’s really a game of managing the downside. And that’s why I say it’s important to have those large teams because if you have the large team and you can dedicate the resources to dealing with difficult situations, you can make sure or at least you have a better chance of avoiding capital losses and that can really swing the pendulum one way or the other.

[00:28:08] Ross Butler: So you’re not a bunch of investment bankers that decided to jump ship like ten years ago and set up your own operation?

[00:28:15] Marcus Maier-Krug: No, that sounds a bit derogatory to investment bankers. It has been a very different mindset and it’s reflected in the way that we discuss investments as well. So I was at my previous employer in a model where the investment committee was the three most senior people in the firm of our parent company and as I already alluded to, they were miles away from understanding the dynamics on the ground in Europe and frankly, Europe was a footnote to them.

Our investment committee process, while we formally take investment decisions across the entire partner level, which is already a fairly large group of people. So we’re not talking about three people, we’re talking about 8910 people.

In addition to that, all our investment committee meetings include our entire investment team of over 40 professionals up and down the ranks. So really as far down as the analysts, all the way up to the partners.

[00:29:07] Ross Butler: And they all have a vote.

[00:29:08] Marcus Maier-Krug: They don’t have a vote, but they’re part of the discussion and they’re encouraged to be part of the discussion and anyone is free to challenge anything in that discussion and opine on anything in that discussion. And that’s really important because there are a lot of things that maybe I myself as a middle aged white man don’t necessarily have the best opinion on or I’m not very connected to, but someone else maybe does. And those views need to be reflected for us to take better decisions.

[00:29:33] Ross Butler: The thing that we haven’t dealt with, we dealt with the. Specifics of the market at the moment. But if you zoom out, what are the fundamental attractions from an investor perspective of private credit at the moment? What’s the sell?

[00:29:45] Marcus Maier-Krug: I mean, private credit has become increasingly attractive for a variety of investors, and part of it is that it naturally provides more diversification to what they had before, because it’s effectively just a new bucket for them, where they don’t necessarily have assets allocated. So it’s access to a different pool of issuers, which therefore naturally provides some diversification to them. But more importantly, the attractions are that you have an inflation hedged product. So all our investments are floating rate investments. So as interest rates have increased, economics to our investors have increased.

[00:30:24] Ross Butler: Is that the same with the traditional liquid market?

[00:30:26] Marcus Maier-Krug: It can, it doesn’t necessarily have to be so. So in the leveraged loan market, most leveraged loans will have floating rate elements. In the high yield market, it can be fixed or floating.

And so that also helps with the valuation of those products and the volatility that you therefore have in the valuations of those products, which is something that investors absolutely hate. So investors don’t want to have to deal with something that is constantly jumping up and down in valuation. It creates all kinds of headaches for them in terms of allocations.

And so it’s very attractive in that sense. Personally, I also believe part of what is attractive in private debt for investors is that you fundamentally have a different position, and in my opinion, a better position than some of these liquid market deals. So the documentation is better. We have covenants on virtually all our deals, which is unheard of in the liquid market. It’s virtually all covenant light. So you have a document that has better controls. You’re getting paid more than you would for an equivalent liquid loan market deal.

You have a better ability to potentially control the outcomes because you have more voting power by virtue of being one of two or three, rather than hundreds of syndicated people. And you have a senior secured product, so you’re first ranking in any sort of recovery. So it’s very powerful, I think, and has a lot of advantages. And the one major disadvantage that of course you have to accept with that is it’s just not liquid and you can’t trade it.

[00:32:04] Ross Butler: So what’s your view on private credit? Because you’ve been doing this a long time. Given that it’s a relatively recent addition to private markets, I think you’ve been doing it since something like 2006, correct?

[00:32:15] Marcus Maier-Krug: Yeah. So I originally started to help set up the European arm of at the time, american Capital Strategies BDC, and they were one of the many US players that came into the European market. And at that time, the market was very much a subordinated debt market. That’s what private credit was. It was mezzanine primarily, and then later second lien and pick. And that market effectively got taken apart by the financial crisis. It was very difficult time. I spent a lot of time restructuring a lot of those deals. You’re in a terrible position because you’re subordinated. So it’s very difficult to avoid capital losses in those scenarios in a scenario where there’s that much stress.

Really. Out of that came the private credit model that we know today, which is the senior secured lending product and it comes under various different names including unitranch. But fundamentally the shift was from subordinated to senior secured and that has dominated the market right now. And I think that is a product which will probably continue to make up the lion’s share of the market as we go forward. But there will always be a need for people to provide other bits of the capital structure whether that is subordinated debt or anything else or even equity.

[00:33:40] Ross Butler They would be specialist providers presumably then.

[00:33:42] Marcus Maier-Krug: Well, we have that same flexibility. All right. And I think that’s the beauty of the model is for us. For example, we in the last 18 months started up our Capital Solutions strategy. So this was a new arm for us where our real focus was on performing high quality credits, where we provide senior secured loans. And what we saw was we were originating out of our existing network, a lot of businesses which didn’t actually fit into that mold because maybe it was a sector which we traditionally don’t like something cyclical like automotive or consumer discretionary. Maybe it was a company turnaround or it had some other unique feature that made it unattractive or not suitable for our traditional standard direct lending funds. And previously we had to decline those deals and we would decline those deals. And what we found is setting up the Capital Solutions strategy allowed us to then take those deals and say well, this isn’t suitable for our main fund, it’s not suitable for the risk profile of those investors. But private credit can provide a solution here because ultimately the advantage of private credit is the flexibility that we have. So we were able to take those deals and say well we can provide a solution, we expect higher returns but we can lend to this business and we can find a structure that works for us. It’s not a flat no and that is very accretive. And I think as you go forward, many of the private debt managers are going to try and leverage that origination capability as much as they can because that’s where the real value is. It’s in the origination is getting those loans in.

And then as long as you have the firepower, the breadth of the team and the flexibility to find an appropriate solution for them, it can be something that’s very attractive and leads to deployment.

[00:35:35] Ross Butler: Yeah, that’s very convincing because it’s very easy to turn down something based on a textbook problem or more like a policy actually like no automotive. But the value is often in the context and that’s where great private equity value comes from. But presumably it’s also where great private credit value will come from. But it requires judgment. It really is not a box ticking exercise, I’m guessing.

[00:35:57] Marcus Maier-Krug: No.

[00:35:58] Ross Butler: Arcmont was recently acquired by Nuveen, which is a very large investment manager. How does that affect things on a day to day basis or how does it affect your sell really from a.

[00:36:09] Marcus Maier-Krug: Day to day perspective? It hasn’t affected us at all, which is good know we would consider ourselves and Naveen clearly agreed when they agreed to buy us a very high quality manager. So we’re clearly doing something right and we shouldn’t be changing what we’re doing. And Naveen takes the same view. And on our day to day operations it really hasn’t changed all that much. So we still originate amongst the partner team in Europe. We still have the same investment committee discussions that we had previously, we still deal with portfolio management and workout situations the same way we did before. But now we have this partner in our journey, in Naveen which has incredible resources and along with our sister firm Churchill, which is the US private credit arm that sits underneath Naveen, there are a number of strategies which are really interesting to look at, either from Churchill in the US. And bringing those strategies into Europe or even just being able to club up on deals, which, as we mentioned, are becoming increasingly large, more cross border, as we kind of look into the more liquid, market substitutional, larger deals. And so having that additional firepower from Churchill, having the ability to more easily work around US borrowers and US dollar financings which are oftentimes key components of global businesses, which are the larger businesses that we’re now looking at, that is very advantageous.

So that’s why we’re really excited about the partnership with Naveen. At the same time, I know I’m personally very happy that we haven’t had drastic changes in the way we operate because that can always lead to the situation I mentioned earlier, which we had at American capital, European capital, where decision making was taken out of our hands in a way and sent to the US. Which never leads to an optimal outcome. You always want to have decision making on a local level.

[00:38:23] Ross Butler: Yeah, I’m sorry, I want to jump back, I’m going a little bit back and forth, but things keep popping into my head. So I understand the benefits of private credit as you’ve explained them, but we’re not necessarily dealing with a static market. Presumably the investment banks are going to look at the sponsor deal flow that they always had, realize it’s being taken from them and adapt accordingly.

[00:38:49] Marcus Maier-Krug: They’ve tried, but their systems and their structures are fundamentally just set up differently.

And we saw that with the market in Germany. Again, I go back to the market in Germany because it’s the one I know you know, banks were not happy to lose share to private debt funds and their initial reaction was extremely adversarial. But the reality was frankly, they were unable to provide underwriting for some of the structures that we were able to provide. Be that because the leverage was higher, be that because we were looking at an instrument which maybe they couldn’t provide. So they will tend to not hold subordinated debt. The capital requirements on their end are far too intense for that. So they’ve had to deal with adverse regulation on their end, which has made it much more difficult for them to underwrite deals. And at the same time they lacked the flexibility that we have in terms of structures and they’re slower and that’s just purely down to their internal decision making processes.

So it made it quite difficult for them to compete. And their solution for this initially was to say well, there are certain parts of the capital structure that only we can provide and traditionally that would be a revolving credit line. It’s something that very few private credit lenders will do. It’s a fundamentally fairly unattractive piece of paper for us because it’s primarily undrawn and it can be drawn and repaid continuously. So there’s a lot of operational heavy lifting that comes along with that piece. And what the banks tried to do is they tried to say, well, if you don’t take term loan financing from us, we’re not going to provide the RCF.

That did not go over well with their primary clients, which of course is the financial sponsor community.

That did not work. And ultimately there were various different constructs that were then developed either trying to give the banks part of the term loan in exchange for providing the RCF, sometimes on a super senior basis. So this is the sort of first out, second out structure you may have heard of, but ultimately it has ended in a market where I think fundamentally the solutions are very different and bank solutions are still relevant, particularly in Germany where the banks are still very much open to underwrites as well as in the Nordics. And that is one type of deal. And then there is a private credit deal which will be attractive for other reasons and people will just have to decide what makes sense to them. And if a sponsor is looking for a very responsive, fast moving party, a financial counterparty which has access to significant follow on financing capability, which a bank will not have because they will tap out at a certain hold. And if you then want to raise more capital, you have to bring additional banks into the syndicate, which means more work, more credit committee decisions, et cetera, et cetera, then really if you have any of those two parameters then private credit is a more attractive solution and you’re willing to pay marginally more for that.

[00:42:11] Ross Butler: Well, let’s conclude with this. You’ve been in the market a long time and it’s grown a lot in the last few recent years. Where’s it headed? Is there much more growth left in it?

[00:42:21] Marcus Maier-Krug: I think there is, and.

[00:42:24] Ross Butler: I think.

[00:42:25] Marcus Maier-Krug: The exciting part of where that growth is, is in new opportunities that previously were not necessarily accessible to us. And the liquid market substitution part of the market is something I never really thought would be relevant to us and it was created by volatility in the market and combined with, I think the flexibility of people like us to adapt very quickly and provide solutions for a problem like that. So there will be other issues that crop up in the future which will provide opportunities for us. And again, I think the beauty of private credit is flexibility. So if you have the flexibility, you will be able to take advantage of those opportunities. And frankly, in Europe the penetration of private debt is still much lower than it is in the US. So purely even in our core markets, I think there continues to be growth. But on top of that, I think there are always these interesting events that come along which create additional opportunities for those people who are creative, fast and flexible and that ultimately is the advantage of private credit.

[00:43:30] Ross Butler: What about kind of fund sizes? Is your expectation that the market will grow because more funds will come along or is there room for kind of large and mega private credit funds in Europe?

[00:43:42] Marcus Maier-Krug: So the market is already extremely bifurcated and so what we’ve seen is you have a very large number of smaller funds and you have a small number of large funds.

We count among the larger funds and we’re in a very small handful of funds. And I think the dynamic which has developed over the last twelve months, given the volatility in the markets, is that those large players are becoming bigger and those smaller players are struggling. And I think it’s my opinion that that will be a trend that will continue over the next few years. I think it will benefit those large players. I think there will be consolidation in that space because fundamentally the model works best when you’re big, when you have a big team and a lot of actual financial firepower, and that benefits you at origination, that benefits you at deployment, that benefits you in a workout situation, and it benefits you in raising new funds from investors. And I think that creates a bit of a cycle that should really be powerful tool for the large existing players there.

[00:44:57] Ross Butler: Great, well how about you come back in year or so and we’ll see where the market’s at. It’d be great to have an absolutely, I’d love to come by. Thanks very much.

Alejandro Alcalde Rasch is a senior director in Advent International‘s portfolio support group. He joined Advent in 2010 having been chief transformation officer and head of supply at Gröhe AG and a partner in McKinsey’s chemicals practice.

In this Fund Shack podcast, Alejandro talks to Ross Butler about the genesis of Advent’s dedicated portfolio support group, how it has grown over time, what he looks for in value creation professionals, how the team works alongside deal executives and the importance of a value creation plan.

[00:00:00] Ross Butler: You’re listening to fund Shack. I’m Ross Butler, and today I’m speaking with Alejandro Alcalde de Rasch, Senior Director in Advent International’s Portfolio Support Group. Alejandro joined Advent in 2010 and his job is to help improve the performance of portfolio companies. His previous roles include chief transformation officer and head of supply chain at Grua when it was a private equity backed company, and before that he was a partner at McKinsey. Today we’re going to get under the bonnet of private equity value creation. Alejandro, welcome Fund Shack. Can you just explain to us what the portfolio support group is? So what does portfolio support group mean?

[00:00:37] Alejandro Alcalde Rasch: Well, thank you very much for having me, Ross. And yeah, what’s portfolio support group? What’s our mission? Our mission is to support management in everything around the value creation programs that we want to get implemented in our portfolio companies. So we’re coming with a slightly different background than our colleagues from the deal team side. So typically we have a combination of consulting experience in the first place. So kind of learning the toolbox, what are the different tools in the toolbox that you have? And then ideally we’d like to see colleagues who have also been able to implement, to use those tools in practical life. So my background is kind of representative. So first at McKinsey, learning a lot about operations excellence and strategy consulting tools, but then also within grow, I was responsible for actually getting those tools into action. And so we like to see people who have this dual experience, and then our mission is to sit together with the management teams and to align on the value creation plan, set up the right governance to execute those value creation plans, and then support as we go along with the implementation of all the different programs.

[00:01:57] Ross Butler All right, so would it be fair to say that typically people in the portfolio support group would have more industry experience like in companies, than people in the deal investment sIde?

[00:02:08] Alejandro Alcalde Rasch: I would say so, although we have a lot of people that also have a background which is outside the finance, the pure investment banking world. But on the portfolio support group side, yes, we love to see people who have also gotten their hands dirty and who have practical management experience, because then it’s also easier to interact with the management teams. They probably recognize that there are commonalities between yourself and them, and it’s also for you, it’s probably easier if you have sat in the same chairs, if you have also been responsible for getting value creation plans implemented, because then you know what’s difficult, what’s not so difficult, and you know the challenges and you have probably a better understanding of the situation, the management teams will be in?

[00:02:59] Ross Butler: Oh yes, particularly not just working in a company, but working in a private equity backed company.

[00:03:03] Alejandro Alcalde Rasch: That certainly helps. It’s always good when I can introduce myself and say that, well, I’ve sat on the same side of the table as they are sitting right now.

[00:03:14] Ross Butler: So what might be helpful is maybe to go through the chronology of a deal from your perspective, because I think most of our listeners will be very familiar with the investments, of course, perspective. So I guess the simplistic way to think about your role is the deal guys come up with, they find a company they like, they do their due diligence, they buy it and they pass it over to you to improve it before exit. How does it actually work?

[00:03:38] Alejandro Alcalde Rasch: No, the reality looks slightly different. So first of all, it’s always good if we have the chance to get involved already before the deal is executed or done. So in the ideal world, I would be joining our colleagues during the due diligence phase. I would be also attending management presentations, expert meetings. It’s always good if you get to know management early on and they also have a chance to see you as part of the larger private equity company team.

So very important early on that you’re part of the definition of the value creation pLan, at least how we see it.

And then subsequently, once we’re in the lucky position that we won the deal, we’ve signed the deal. Then to use the time between signing and closing as much as possible and within the restrictions that the deal situation may provide to already work on. What are the next steps?

How are the first 6 months going to look like? What are the things that we would like to achieve and if there is a chance already to pre align these with the management team?

[00:04:53] Ross Butler: I’m just slightly intrigued around the dynamic between the investment professionals and the portfolio support group professionals, particularly at this point, because let’s say I’m an investment guy and I really want to do this deal, how do I view the portfolio support group person? How do I most effectively use them at that stage?

[00:05:12] Alejandro Alcalde Rasch: That’s a good question, because actually kind of tricky. We are probably the ones in the team who have, because of our background and our say, own management experience, consulting experience, we probably have a good sense for what is actually doable in a certain given time span. At the same time, our deal professionals at Advent, they are working within sectors, so they are also very knowledgeable about the sectors, probably have deeper sector experience than most of us because we tend to be generalists. We work across the entire portfolio and in many cases we are also working with them for the first time in a sector, potentially.

And then our role is to kind of look at the deal hypothesis from the point of view. How can management actually get this implemented? Are these the right levers? How is the sequencing of the levers looking like? What could be potential third parties to support with the implementation of things?

Are we having any perceived GPs in the management team that could become an obstacle for implementing things? What resources would we like to bring to play? And then together we’re working on the investment thesis. But obviously at the end of the day there is an investment committee that has to look at the deal from the different angles and together we’ll come up with a decision on what to do with the company. But we are really a supporting group. It is the deal captains who make the calls together with the investment committee.

[00:06:53] Ross Butler: I can imagine that must be hugely beneficial just from a kind of a grounding perspective to know what’s realistic. I’ve got that smart acronym in my mind, specific, measurable, but I think it’s attainable or something like that. If you get enthused about a deal, you can maybe run away with yourself. And to have someone to say, hang on, this is going to take a lot longer than you think could be quite helpful. Does that happen or am I not giving enough kudos to the investment guys?

[00:07:22] Alejandro Alcalde Rasch: I think you’re not giving enough kudos to the investment professionals because we have a quite experienced team who have done similar deals before and who have a very good assessment of what’s actually doable. And in many cases we would have already worked with these individuals before on a past deal. So we tend to be quite well aligned between ourselves. And then very rarely we have these situations where we would completely disagree on things. And then it’s ultimately also, it’s a kind of managerial decision to go for it or not go for it. And I can’t even recall a single deal where there would have been complete differing views on what’s actually doable. I think we have a lot of experience in working together.

For example, I’m spending a lot of time in the chemical sector and since 2011 2012 I’ve been working with one senior partner constantly on different chemical deals. And we know each other quite well. So we have a shared, shared experience. And I think over time we have learned on, okay, if someone says something, you learn what the specifics are that you should be listening to and where to focus on. I think experience matters a lot. I think in this.

[00:08:54] Ross Butler: Yeah, if you can develop some rapport with your investment professional partner. That’s got to be helpful.

[00:08:59] Alejandro Alcalde Rasch: And the same applies not just for the very senior guys. Because of this strong sector dedication, we have also people on the more junior levels that have repeatedly worked in the same sector with the same people. So we’re quite experienced team overall with a lot of sector experience, and that clearly helps.

[00:09:18] Ross Butler: How large is the portfolio support group?

[00:09:20] Alejandro Alcalde Rasch: We are more than 40 people globally. Within advent and Europe. We are twelve soon. 13.

[00:09:26] Ross Butler: Yeah. So that’s got to be one of the largest teams, I would imagine.

[00:09:29] Alejandro Alcalde Rasch: Well, we have built it up over the last 13 years. So basically on average one, one person per year. And I think it is very difficult to actually grow these teams faster than. Much faster than this. We have had a few years when we certainly had some step changes, but say on average one person per year. And that has worked well for us. We tend to have a team with high tenure. We had only one person leave our team in the last 13 years.

[00:10:04] Ross Butler: So how do you hire? So obviously you need the geographic component, but do you also look for not just specific, are you looking for specific skills, specific sector expertise, or is it more general business acumen?

[00:10:16] Alejandro Alcalde Rasch: We follow a model whereby the people in our group are generalists. So we’re not following a functional model. There is basically two archetypes of how you can do this. One is where people would follow a functional perspective. So you have one expert who does commercial excellence, one expert who does lean, one that is focused on procurement and so forth. But you could also follow a more generalist approach where you say that one person tries to cover the entire value creation plan. And we’re in this second camp, with few exceptions. So over the last three, four or five years, we have started to build up more functional expertise, particularly on the HR and digital side of things, where we have people who are working on multiple portfolio companies in parallel, and who are working alongside the generalists on a specific company. But our basic philosophy is that one portfolio support person should be able to handle two in some situation, three portfolio companies in parallel, but then cover the entire value creation plan. And then on an as needed basis we can pull in specialized resources. We call them operations advisors. They are not employees of Advent, but they work on an exclusive basis with us and support the management team on very specific programs. So it could be someone who has very deep it ERP experience, someone who has been a CPO in the past, who has very deep procurement expertise. And we bring these people in if there is a specific need in a portfolio company.

[00:12:09] Ross Butler: Can I just ask you about those operational advisors, they are not employees.

[00:12:15] Alejandro Alcalde Rasch: So we have a contractual framework agreement with them and we are on a case by case basis bringing them in. They are not running consulting projects within a company, so they are more mentoring, challenging, supporting the functional owners within the portfolio company.

[00:12:37] Ross Butler: So Advent has had this portfolio support group function for quite a while now. But you were one of the early movers. And people in recent years, say, people, your peers, private equity firms have been speaking a lot about this. They’ve been building out their own teams. You’re an early mover, you’ve come up with this model. To what extent have you been involved in kind of shaping it? I assume when you set up something new, it’s very difficult to get it right off the bat. Have you come up with the model that you’ve just described, or has it evolved?

[00:13:07] Alejandro Alcalde Rasch: When we started this in 2009, that was when we were in this recruiting process, when I was also considering that role, we had a senior partner at Advent who had done a lot of kind of due diligence, due diligencing what other private equity funds have been doing. And he had an initial idea of what portfolio support could be doing. And well, then I was the first hire in Europe.

And basically I just got a very simple framework which was, don’t screw up anything in the companies and be helpful, just be helpful. Start with little steps. First, support the management teams on smaller tasks. And then over time, probably in the first one, two years, we developed concept of chief transformation officer, how to define AVCP and how to break it down into initiatives, how to track all of this, finding the right ecosystem to support the management team. So preferred third parties with whom we would be working with. And then gradually over time, it just developed into what we have today.

So nothing was preconceived in the beginning, but it felt very natural, I think, over time. But it could have easily gone wrong if the first one or two assignments had gone sour. And probably we would have rethought a few things. But yeah, I think it has worked nicely for us. But that’s the way how advent is doing this with this generalist pool and then a number of functional experts in working across the entire portfolio, in the different sectors that we have for other private equity funds, they may follow a different model that can equally be successful.

[00:15:04] Ross Butler: So it’s been evolutionary.

Yeah, that’s interesting, because advent is known for getting this right, for doing it well, I would say, generally speaking in the market, because there is certainly a theoretical tension between an outfit that historically has just been all about doing deals. I’m not talking about advent, but private equity in general about doing deals and then bringing in this extra component. And so the way you describe it, that you’ve kind of grown organically, that’s probably a good way of doing it.

[00:15:36] Alejandro Alcalde Rasch: Yeah, I think at least I would think that it only goes this way. It has to be an evolution, not a revolution. I don’t think it makes. If you have something that is already working nicely and if you have strong sector, dedicated deal teams, then you’re looking at, okay, what is a complementary capability that would support the management teams and also the advent colleagues in trying to make this deal even more successful. And that is this transformation value creation capability that we can bring to play. I think what’s also important is to have a general attitude that the management is at the center of the value creation and that we are only there to support the management team in being successful in what they are doing. And once you have this basic understanding, then you look at, okay, what can help management be successful? And you think about, okay, it’s about the governance, it’s how you set up these plans, how you check whether we are on the right track. That’s one element. The second element is of course a content element. So commercial excellence, for example, it may be the first or second time that a portfolio company is going through this. But for us at Advent, it may have been the fifth, 10th, 15th case where we’re doing this. So it’s also bringing past experience into play. And then it could be that there is someone, for example, on a functional level that needs support, needs a mentor, he or she is probably doing the first carve out. There is a lot of experience needed in how you carve out an IT system, how you set up your own ERP and so forth. And then if you have a network of people that you can bring in who have done this before, but who don’t want to do it themselves, but rather support someone in being successful doing it. I think then you have the different elements that are required to make this deal hopefully successful besides all the other macro things that need to work out.

[00:17:43] Ross Butler: I would imagine then that soft skills are going to be quite important because if the management are leading the charge on this, it’s kind of easy for private equity to go in and we’re in charge and we’re changing management if it doesn’t work out. But if you’ve got to partner with people, they’ve got to trust you and to some degree like you, I guess.

[00:17:59] Alejandro Alcalde Rasch: Yeah, well this is, I think the whole trick, because on paper, everything sounds relatively straightforward. You think, okay, we’re bringing the best of two worlds and bring them to play and we share our. But the reality is much more complicated, actually, and every deal is different.

I’m working a lot in chemicals, so chemicals has been during my consulting time, has been my deep spike, and it’s now also at Advent. We have a tremendous flow of chemical deals in the last years, and so I’m repetitively working in that space. But if I look back to the different deals we have done there and that we’re still involved with, all these companies are different, even if they are working in the same subsector. You notice that the management teams have totally different approaches and they need a totally different way of handling and interacting. So we have very independent management teams that do not like and rely on external advice so much because they have a doing mentality where they rely a lot on their own teams. And then we have other teams who have maybe a different background, different heritage. They come from parent companies that were used to using a lot of external advice and also rely on them. And so the value creation plans tend to be completely different, not necessarily in terms of the levers, but in the way how they are implemented. And so is also the approach that you need to have visa vis the management teams. I think the most important thing is that you need to establish a trust based relationship, no matter how the setup is in the company.

And you also need to spend a lot of time with the management teams, ideally on site, not just with the C suite, but also with N minus one, N minus two, N minus three, to really understand what the opportunities are within the company. So I tend to work a lot on the governance level, but then also do a lot of deeper dives when I would be working with the individual project teams to understand what’s going on.

[00:20:20] Ross Butler: When I was thinking of questions to ask you, I kept thinking, well, the only answer to that is it depends because it’s all so context specific. So I thought, well, we need to raise it up. And I did think that one of the uniting factors would be that people have just got to trust you and get on with you.

What’s the spectrum of engagement that you would have with a portfolio company? So from this company is doing really well, very light touch through to actually things are going a little bit wrong. We need to get involved. Can you give us a.

[00:20:51] Alejandro Alcalde Rasch: As you said, it depends.

I think there is one thing which has to do with how long we are now working together with a portfolio company. So in the beginning, certainly after the closing phase, it’s probably the most intense time because everything is new. Very often we have carved out situations. There is a lot of stuff that just needs to be done in the first month.

If it’s not a carve out, it’s probably the first time that the management team is exposed to private equity owners. So they may not have the experience in working with us. And so there is a lot of time that you spend on talking through, okay, how should we set up the VCP? What are the right levers to address? How should we sequence them? Do we have the right resources in play? So in the beginning, say the first year, actually it’s quite intense. It can be two, three days a week. And then over time, when things get more mature, when everything is a little bit more settled, your interactions will be a little bit more punctual. So maybe it’s a day a week, then there is a second one, which has to do with, okay, in which situation is the company?

Certainly if there is a bigger acquisition, then there are more hands on deck required in order to integrate that company. So there could be another spike later. As you mentioned, if the company is going through more turbulent times, I don’t know, there is a need maybe to look into the cost base. Then you would also probably go deeper and spend more time. It really depends. In an ideal situation, you have everything kind of going smoothly and then you just focus on a few interactions per week. But yeah, it all varies very much. There are times like the current situation, particularly in the chemical space, where a lot of hands are required on deck. So it’s certainly intense times. If you have seen this before, you know how to handle this and you know, what’s the best way of supporting the management teams.

[00:23:06] Ross Butler: If I may just jump back to a couple of specific value levers, as they’re called. You mentioned that. So you’re mainly generalist, but you are starting to hire a couple of more specialist people. And you said digital and HR. I can kind of imagine why you’d need specific digital people. It’s technical and specific and so on. But HR as well. That strikes me as slightly more of a generalist competency.

[00:23:25] Alejandro Alcalde Rasch: I think it’s all about people in the end. Yeah, we say the management team is at the center of the Value creation plans, and the management team is a broader definition. It’s not just the CEO CFO CIO, but there’s also a management development agenda. Underneath. You want to have people in the right people in the right positions underneath, you want to understand whether the organization itself is developing more muscle in terms of people development, bonus systems, retainment ESG agenda is also quite an important element.

So the requirements are just increasing. The war for talent is real, so handling search firms is also not trivial. You need to know who are the right partners for which types of positions. And so we thought that it would be a very good investment into building up this institutional muscle on the recruitment side, but also in the management development side.

I think two years ago we started in Europe, what we call the Advent Leadership Academy, where we have a little mini MBA type of program where we bring in talent from the different portfolio companies together, go with them through academic classes, but also give them a better understanding of what private equity is all about, and where we want to identify talented professionals early on and give them exposure to colleagues from other portfolio companies. So that’s another example for a program that has been initiated by our HR leadership team.

[00:25:15] Ross Butler: So from speaking with various people in the industry, I’ve kind of noticed a general trend away from if there’s a problem, we’ll just change. We’re just bringing different people towards kind of nurturing or trying to improve or support and mentor existing managers.

[00:25:35] Alejandro Alcalde Rasch: I think every change in the management team is always a disruption. So if the basic hypothesis is in an ideal case, we have already a successful management team, or we support the management team in kind of developing additional muscle, exchanging people is probably the last resort, at least from my point of view, that you should consider. So I’m always proud if we have a management team that doesn’t change over time and that together with us is successful in implementing the value creation plans. Actually there is sometimes a tendency to personalize issues that are probably not personal issues in reality. So you have a problem, a challenge in the commercial space and then because of lack of other, say, other reasons that you identified for this not being successful, you think, well, that has to do with the chief sales officer, and then I exchange the chief sales officer and everything will be good again. I think sometimes too easy to go into that solution.

So I think there may be situations where it’s unavoidable that you need to, need to make a change, but that should be the last resort.

[00:26:59] Ross Butler: I think it’s a very blunt instrument, isn’t it?

It indicates that you have an action diagram maybe needed.

[00:27:06] Alejandro Alcalde Rasch: There may be situations where a company has fundamentally changed because it’s a business that started with a size X and then three years later it’s three X because of acquisitions, mergers, and then people may not have the experience of managing a larger organization, or there is a fundamental change in the industry. It’s consolidating. It’s moving away from, I don’t know, a top line driven game to a more cost focused game. And then you may require a different set of leaders. This can happen, sure, but it should be from my point of view, I don’t feel good if we have to.

[00:27:47] Ross Butler: Change someone, what about bringing in third parties? So presumably there are situations where you diagnose this specific need. What’s your criteria for bringing them in and what do you look for?

[00:27:59] Alejandro Alcalde Rasch: I think it’s important to first sit down with management and step back into, before we talk about third parties, is to look into, okay, what is the challenge? What do we want to accomplish? What is required in order to accomplish this? And then the first question is, do we have the right resources on board already today in order to deliver this? Then you sit down with management and try to identify who would be the right third parties to support us for this specific challenge. And then we bring in some third party resources that we know from our past that have been successful, but also management may have had already very good experience with somebody else. And then we typically start a beauty contest, whatever you call it, RFP process, and then try to identify who are the right partners for this specific situation. So it’s not that we come in and say, no, you have to do this project with consultancy XYZ because we always do it like this. I think that’s not a recipe for success because you want to have management accountable and in the driver’s seat. So they should be ultimately the ones who make the decision in the end.

[00:29:16] Ross Butler: Right.

[00:29:17] Alejandro Alcalde Rasch: Obviously, we would be trying to influence that. Yeah, we would certainly object if we don’t think it’s the right third party. But very often you have two or three choices, and then it’s also very often not the name of the third party advisor. So the company behind, but it’s the individuals.

These organizations have become so big.

[00:29:39] Ross Butler: Yes.

[00:29:39] Alejandro Alcalde Rasch: And I think also there is the, or should I say the standard deviation, has become bigger of what you actually get. And so ideally, you work with someone who is already trusted by management, whom you trust, too, and you like to see people that you have seen in the past already and who have delivered impact.

[00:30:02] Ross Butler: I guess from a private equity firm’s perspective, that flexibility allows you to see more people in action. You’ll get a greater breadth of understanding.

[00:30:10] Alejandro Alcalde Rasch: Absolutely. I mean, I come from one consultancy, and I always thought that what we were doing was the best thing that could ever happen in a specific space.

But then when you see what all the others have to offer, then you realize that you only knew so little in the past. Yes, and that the space out there is just huge. But it’s also tricky to navigate in that space. You need to find the right ones for this specific situation. And one firm that may have worked nicely in one situation may not be the right one in another situation. Just because the context is different, the management team is different, the style of management may be different. So you need to be quite flexible and adaptable to it.

[00:30:53] Ross Butler: So the value creation plan, it sounds like the key document is kind of like your North Star. As you travel through this process, you kind of write it, I suppose, at the start of the investment. How often in practical terms, do you actually, or you, the management team, refer to it and refine it and adapt it as it goes along? Or are you just up and running by that point?

[00:31:14] Alejandro Alcalde Rasch: Well, it starts basically with the deal thesis, which is obviously driven by the deal team. The deal team is looking into different investment opportunities. And for every investment opportunity, there’s always the question, what do you want to achieve with this company? What are the value creation levers and so forth? And then when you get done involved during due diligence phase, you bring in your own input, your own experience from your past portfolio company situations. And then this evolves to a point where this becomes part of the final investment thesis memorandum, right? But then latest after signing, you also want to look at, okay, what is management’s view? So you take your investment thesis, you combine it with the management plan. Already during the due diligence, the management will have presented a five year plan to you with some value creation ideas. And then you try to blend the two.

In many cases, you will find that the things are complementary, that you had an idea in one particular function and management had something else in another function, then they are additive. Sometimes you find that their level of aspiration was maybe lower than what you thought could be doable. And then you need to align it with management. You sit down, basically you go through, okay, this is what we learned during due diligence.

Let’s now talk about what we learned in the due diligence, what your plans are. And then we try to combine the two things. And then we have kind of a starting value creation plan. It’s kind of the things that we would be doing in the first two years or so. Obviously there are sometimes longer term things that we need to initiate. Like if it’s a roll up in a certain sector, you need to already think very early on, okay, what are the different acquisition opportunities? And they may or may not work out, but say on the more homemade things that you can do internally, it’s difficult to think more than two years on.

And after two years, it makes sense to just sit back and rethink what is kind of VCP 2.0 and kind of what are the things that we should add. It’s very rare that an initial deal hypothesis is still valid five years later. I mean, the core elements will still be valid, but the way how we get there may be different. So it changes over time. And if you’re in turbulent times, like in the last years, where you have to cope with supply chain disruptions, you have to cope with energy crisis, you have to be very flexible.

[00:34:07] Ross Butler: Because I was thinking, say you’ve got a three year plan, but you can’t exit exactly when you want because the timing has to be right and so on.

[00:34:14] Alejandro Alcalde Rasch: Yeah, timing. Timing is one thing, but also the industry such can go through different cycle, cycle phases of a cycle. So in chemicals, for example, a longer period of challenging times, let’s put it this way, right than it used to be a few years back.

[00:34:33] Ross Butler: What’s causing that, out of interest? I don’t know about the chemicals energy.

[00:34:36] Alejandro Alcalde Rasch: It’s disruptions in the supply chain.

It’s plants that are being taken out by suppliers, by competitors. So there is a quite radical change. I think you see similar things in the pharmaceutical industry. We had a terrible 2022, very challenging because of supply chain disruptions. Products that are coming from China, from India, precursors into pharmaceutical products that have gone through turbulent times. And then 23 is a totally different year. You see that all these things that didn’t work so well in 22 all of a sudden are coming into place again, and that you go back from seizing up smaller growth rate into a much higher growth rate just the following year. So you need to be adaptable with your value creation plans.

[00:35:31] Ross Butler: Now that we’ve seen those risks being borne out, are you more alert to them on the way into a company? You’re like, this company is too dependent on elongated supply chains. Or have things just opened up more? And that was a one off.

[00:35:45] Alejandro Alcalde Rasch: People have become more critical of what risks you are willing to undertake with a portfolio. You have learned from your past experience. It’s like every child, once you put your hand on the hot stove. On the hot stove, yeah. You will probably be more careful next time. And the same thing is here. So if you realize that there could be supply chain disruptions. Just because you are dependent on single source suppliers, you will focus more on, okay, what is dual sourcing, what is the lead time for a certain product? I think this kind of collective experience is important that you have that, and that’s also why it’s so important to have a team that has experience in what they do. Like I’m now 13 years in my role.

Many of my colleagues are 5678 years, ten years in the same role. So they have already gone through a number of challenging economical situations. So you learn from these things. If you’re in a world where everything has gone just into one direction, and all of a sudden you have to look into more challenging time, it’s the first time for you, and then you do not have that experience.

And having this experience doesn’t only show you, okay, what should I be doing in a specific situation? But it also tells you that, hey, I’ve gone through this already in the past, it’s going to be better a few months from now, potentially, and you just feel a little bit more relaxed about these things. You know, things can go sour, but you also see that things can actually also turn around pretty quickly.

[00:37:27] Ross Butler: So in practical terms, that means you’re not as likely to overreact to downturns.

[00:37:32] Alejandro Alcalde Rasch: Because it’s always difficult, particularly in supply chain. So the tendency that you overreact, you have too little stock, then you overbuy, then once you’re not able to supply your customers and six months later, you have an oversupply of raw materials and work in progress materials, and then your inventories will go up big time, and then you have another challenge.

These experiences, I think, matter a lot, and I think that’s why it’s also important to keep an experienced team and not to have too many changes.

You need to have stability in your portfolio support groups.

[00:38:16] Ross Butler: So there’s an inverse relationship between the general trading environment and your learning rate.

[00:38:21] Alejandro Alcalde Rasch: But you can also learn from good times.

[00:38:23] Ross Butler: Yeah, better that way. Buy and build has become, for quite a while, an increasingly important part of the upside in a private equity play.

That strikes me as kind of an investment side skill set. To what degree do the portfolio support group get involved in that?

[00:38:41] Alejandro Alcalde Rasch: Buy and build? It’s a lot about the capability of a company to be able to integrate the business that you have bought. It varies a little bit by sector, but if I look at the more industrial space where you have physical goods that you’re touching, you need to be able to integrate that company into your sales and operations planning process. You need to be able to integrate them into your ERP landscape. So there is a lot of institutional knowledge that you need to build up in order to be able to integrate those businesses quickly, because very often your buy and build will be also based on synergies that you can capture from these companies. And then it’s important that you can actually realize those synergies and that requires that you integrate them.

There are certainly areas in the tech space that work differently. I can only speak of, say, the industrial part. So it’s very important that you develop this capability as a company to be able to take a company, take your own processes and put those processes into that company that you acquired, the whole GNA space, sales and operations planning, production planning and so forth. That is something where I think where we can play an important role to be able to integrate those companies quicker.

[00:40:08] Ross Butler: Are those skills diffused across a company, generally speaking, or would you try and create a unit for integration and transformation within the portfolio company, or a bit of both?

[00:40:18] Alejandro Alcalde Rasch: We have some companies that have a more constant flow of stream of acquisitions, that have developed an M A team that has these strong deal capabilities, but who also have developed the capability to integrate those companies. So yes, wherever meaningful, you should have that as a dedicated team within the organization.

But it depends very much on the portfolio company and the value creation plan.

How important are Bolton acquisitions in order to deliver the entire VCP?

[00:40:59] Ross Butler: So it depends.

[00:41:01] Alejandro Alcalde Rasch: Yeah, it depends. Again, there is no silver bullet, unfortunately. So I’ve always tried to. Okay, what are the things that I have learned in this one company, and can I apply them one to one in the next one? It very rarely works.

[00:41:14] Ross Butler: Well, at least that means your job can’t be taken over by AI.

[00:41:18] Alejandro Alcalde Rasch: I don’t think so.

But AI is indeed, it’s one of the big disruptors, I think, that we’re currently seeing. So how can we optimize GNA processes using AI, which processes, sorry, GNA so general, and admin processes, so back office processes. It is a little bit of a mantra that has been constantly preached, but there is something, it is disruptive, I think I’ve also had to learn it over the last few months that you can completely change processes by applying AI in an intelligent way. It’s interactions with your suppliers, where you have an AI engine that is looking at data and even writing memos that you would send to your suppliers in an automatic fashion that you couldn’t just handle in the past. So it’s a lot of examples like this. So it’s something we need to seriously look into and we are looking into it.

[00:42:21] Speaker A: And presumably there’s quite a lot of scope for knowledge sharing as well for something that’s so emergent and generally applicable.

[00:42:27] Alejandro Alcalde Rasch: Yeah, that’s also why we have built up this digital muscle in the last 24 months, because that is something that is not sector specific. It’s a capability that you can easily transfer from one portfolio company to the next one, and where you also need to have enough knowledge, a lot of knowledge to be able to navigate in this ecosystem that is developing of different development firms, software companies and so forth. And that is nothing where I would feel very comfortable with navigating in. Yeah, so you need someone who really knows this stuff.

[00:43:02] Ross Butler: So as we move through the lifecycle of a deal and we get towards exit, generally speaking, would the portfolio support group have less and less to do with the deal because you’ve almost finished your.

[00:43:14] Alejandro Alcalde Rasch: Normally, I said we’re having twelve people in Europe, so we need to be careful as to where do we spend our time on. So we always want to be short on supply so that actually we don’t never come into a situation where we don’t know what to do with our time.

So we’re typically not supporting all of our portfolio companies because there may be some who are either from the beginning, they do not require a lot of handholding because the investment thesis is quite clear. Management teams knows their stuff and it’s relatively straightforward, still needs to be done, of course, but there may be other situations where the heavy lifting in the VCP has already been done and so we’re at a later stage and then it’s all about exit preparation. And then there are situations where we need to also prepare the company for exit, just spending more time on them, working on an additional new wave of VCP activities. It’s the exception, but it happens that we are also involved until we exit the company. But it’s few situations. I think the heavy lifting is the first one, two, three years.

[00:44:27] Ross Butler: But how do you feel when you say goodbye to a portfolio company, having worked with a bunch of people so.

[00:44:31] Alejandro Alcalde Rasch: Closely for you hope all the best for them, for the future that they continue to be successful. Hopefully we have made a great exit for ourselves, but hopefully, I always hope that it’s also a great investment for the next owner. Obviously I want to see that the management team continues, continues to develop and it’s not like you sell it and then you forget about it, you’re still interested. And also there are some sectors where you meet again, not necessarily because it becomes another deal like a second acquisition. But it could be that you may work with this company as a supplier or as a customer.

[00:45:17] Ross Butler: Right.

[00:45:17] Alejandro Alcalde Rasch: So if you’re in an industrial space, in chemicals, for example, it can happen that your pass portfolio company may become a supplier of a critical raw material three, four years down the road. So the better your relationship to them, the easier it may become to work with them again. Or it could be that individuals, you meet them again in a different role in a different company. So it’s not like fire and forget, it’s quite the opposite.

[00:45:47] Ross Butler: Yeah. So private equity is essentially, it’s an iterative game. And I think that’s what people who do not understand or are not involved in private equity. The general public perception of private equity can be very critical. We get it sometimes in our comments section. Yeah, some private equity people are nice, but mainly they just buy, leverage and sell. But what that misses is the integrated nature of business and also the fact that you’re not just doing one deal and then you’re done. Your reputation spreads across time and across deals and across sectors.

[00:46:20] Alejandro Alcalde Rasch: First of all, very practical things. You can only make a successful exit if that company has a brilliant future ahead, because otherwise, who would be buying that company?

I’m coming from Germany. So we had what we call the locusts debate a few years back, before 25 ish, where even the government was stating at some point that, yeah, private equity will come in and, like, locusts, will fall over the companies and they would leave nothing left behind. It’s a complete misperception of what we’re trying to do. We’re trying to create industry leaders and long term industry leaders and companies that are successful also for the next shareholder. Otherwise no one would be paying the premiums that we hope to get for those businesses. And then your reputation matters a lot in Germany. If you’re perceived as someone who treats the management teams and the employees badly, you will have a very hard time in getting your next deal.

So I think it’s quite important that you’re supporting, you’re creating great enterprises and you treat the companies fairly in that process, that you help them become stronger and that also the public perception is as such. But you’re always only as good as your last deal, actually.

[00:47:55] Ross Butler: Right? Like Hollywood.

[00:47:56] Alejandro Alcalde Rasch: Yeah, it is like that. So the memory is also sometimes a bit short.

[00:48:03] Ross Butler: So you’ve done more than a dozen deals. Do you look back generally and think, this is a very worthwhile enterprise, created value and, yes, absolutely. Good for the world?

[00:48:12] Alejandro Alcalde Rasch: Absolutely. No, definitely. I mean, otherwise I wouldn’t feel happy with what I’m doing. First of all, I enjoy every day of this professional life because it’s so, or should I say it’s so diverse in terms of topics you have to deal with. That’s interesting. But then you’re also proud if you exit a company and you see it being successful a few years later.

[00:48:37] Ross Butler: Well, that’s a great point to close, but I actually have a bit of a cheeky question. Okay, so I was speaking to a chief investment officer the other day and we were talking about private equity firms themselves and how well run they are. And I made the observation that, well, you go in and support portfolio companies and make them better. So why isn’t it just standard procedure to always be introspective as well? And he made the valid point. He says, yes, but portfolio companies don’t do it to themselves. It’s actually quite difficult to make yourself better. It’s easier to make someone else better. Now you slightly separated from the main part of Advent’s investment side, and you’re always looking at how to improve companies. So just from your perspective, in terms of how private equity firms are run in general, perhaps, do you ever think that could be done better?

[00:49:27] Alejandro Alcalde Rasch: I’m sure we see this every week. There are things where we could think, okay, why are we doing it this way? Why aren’t we automating the way we are gathering information from the companies?

There is a lot of things, but I think we have a long history already. I think we were founded 1984 and since then the Advent has gone through tremendous growth, but also I think a lot of institutional learning. So I think we are very conscious about our own internal processes, how we develop people and so forth. And there is always things that you can do better. But I think the general direction has been very clear from at least since I am there. And I think yes, we can improve things, but we should not be trying to make an internal portfolio support group program just on ourselves. We have a number of things on the ESG side. We have done quite a lot. I think we have invested a lot of time and effort into becoming more diverse as an organization. I think we have done a lot of progress. We have made a lot of progress in the last years. So there’s always things where you can get better. So complacency is probably the biggest enemy of ourselves. And as long as we are critical with ourselves, as long as we try to improve things, I think it will go well.

[00:50:56] Ross Butler: Alejandros, thanks so much for sparing your time for fun Shack. It’s been a pleasure speaking with you.

[00:51:00] Alejandro Alcalde Rasch: Well, thank you very much for inviting me.

Harvard professor Josh Lerner explains the risks and requirements of public intervention in establishing a thriving venture capital and entrepreneurial ecosystem.

Professor Lerner tells Ross Butler that seeding a venture capital industry is a difficult and slow process – it’s not just the case of emulating Silicon Valley. With reference to his classic work, ‘Boulevard of Broken Dreams‘, Ross Butler asks for Josh’s key recommendations, and in particular whether increasing the supply of venture capital or the demand for it, is the more sensible route for policymakers.

With reference to the US, Japan, Australia, the EU and Great Britain, this wide-ranging conversation looks at where policymakers are going right – and wrong – when trying to promote entrepreneurial risk taking and institutional venture capital.

We close with a look at the importance of ethics when working at the cutting edge of scientific innovation.

[00:00:00] Ross Butler: You’re listening to Fund Shack. I’m Ross Butler and today I’m speaking with Josh Lerner professor of investment banking at Harvard. Professor Lerner teaches venture capital and private equity one of Harvard’s biggest elective courses. His research focuses on private capital and he has many published papers and books on the subject including The Money of Innovation, Patent Capital, the Commingled Code and Boulevard of Broken Dreams. He also founded and run as the not for profit Private Capital Research Institute. In this episode, among other things we will look at how to nurture a thriving entrepreneurial and venture capital ecosystem.

Professor. Welcome to Fund Shack. Just after the great financial crisis you published a book called Boulevard of Broken Dreams which I read at the time and it’s one of the more poetic titles, I’d say in the pantheon of venture capital literature. So well done on that. And in it you made a very nuanced argument, I thought for the necessity of state intervention of public sector support to at least kind of seed and nurture venture capital ecosystems in their formative years and decades. But you also equally, I think, put as much emphasis on the pitfalls and of not getting it wrong and hence the title of the book, I guess. So I’d like to look at both of those angles. I mean, I guess I’d start by saying do you still believe that state support is necessary? And if so, kind of why do you think that is?

[00:01:25] Josh Lerner: First of all, thanks so much for the chance to be here and it’s great to get a chance to talk about these really important issues. I think that the answer is yes. That the nature of venture ecosystems which in some sense are even more compelling today than was the case 15 years ago. Given the kind of growth we’ve seen in both new technologies like artificial intelligence but as well as just simply the creation of wealth associated with these new ventures with jobs and the like, that this is a tough process. We’d like to say it’s just a matter of sprinkling a little pixie dust and it takes care of itself. But it seems it’s a really slow process of trying to get a lot of things coming together and in a way there’s an instinct to look at Silicon Valley and say wow, that’s great. I can just clone this and carry it over and just get the right looking buildings, a fancy university, a few fancy professors and everything will take care of itself from there. And I think everything we’ve seen about creating these kinds of clusters suggests that it’s a much longer and much harder process than that where we have to get a bunch of things coming together.

Were we trying to put a label on it? We might say, increasing returns.

[00:02:57] Ross Butler: Right.

[00:02:57] Josh Lerner: That it’s really hard to be the first entrepreneur in a city in a category by the time there’s 100 people buzzing around doing stuff in that area, it’s much easier. But that process from going to one to 100 of really getting the plane off the runway is where the challenge really lies.

[00:03:15] Ross Butler: But do we not need to distinguish between kind of general entrepreneurialism and business creation and scale up and all of that stuff? And then a formal institutional venture capital can presumably, you can have a thriving innovation ecosystem without necessarily a venture capital ecosystem. Is that true?

[00:03:34] Josh Lerner: Absolutely. And certainly we can think about the history of much of Europe as saying that when we look at many of the really critical technologies, everything from Internet to biotech, european academics and researchers were right at the front lines. In many cases, they were there first. The challenge that I think is pretty well documented for much of Europe has been really that translation of the innovation of the researchers with great ideas into businesses and ultimately into prosperity. And it’s really that translational thing of going from the innovation to the ecosystem, all the stuff that goes with it, where the intermediaries play a critical role.

[00:04:28] Ross Butler: And you make the case for state intervention primarily, I think, by looking at historical case studies, silicon Valley being an important one. People tend to think of Silicon Valley as the cutting edge of free markets. But as you explained, it’s not that at all. And in fact, I think to a large degree, in the early years, it looked like the kind of the R D wing of the US. Military. And to some degree, it’s still very closely related to that. But I guess the difficulty is the very limited number of case studies there are with regards to successful venture ecosystems. And so my question really is, and you are very nuanced in the book about this but what’s your kind of confidence level that let’s say in the next 20 or 30 years there won’t spring up a vibrant venture ecosystem in an economy that currently doesn’t have one, where there was no proactive state support or intervention?

[00:05:28] Josh Lerner: Great question. So I think one observation I’d make is that when you look around the globe today, it seems like every corner you look at, governments are doing policies to do stuff right. Certainly you look at things as diverse as Australia and the Emirates and Brazil, and you see very active policies to try to nurture high potential entrepreneurs and the intermediaries that help make them succeed. I should say that’s more than venture capital, right, that we’ve seen, particularly in the last decade or so, a lot of interest in trying to boost angel investors as well. And I think there’s often a sense that the angels will will wander where the venture capitalists fear to tread, right? In terms of I mean, in a way, when you look at many angels, they’re bright, sophisticated, successful people, but they also are doing this not just simply to maximize their bottom line, right? They’re getting some real enjoyment out of working with entrepreneurs, trying to in many cases try to boost the economic development in their place and they can really play that bridge role in the early stages. So we are seeing a very significant uptick in terms of the kinds of interventions that are there. We recently completed a project where we just looked up to the time of COVID and tried to identify all the programs we could find around the globe that were aimed at boosting entrepreneurial finance or the intermediaries that provide that capital. And our compilation came up with somewhere in the order of 900 such programs in the last couple of decades. Pretty much everywhere in the planet you look except for a few corners of Africa and the like did you look.

[00:07:31] Ross Butler: At how many of them had been successful or in your own subjective view, where has this been done?

[00:07:37] Josh Lerner: Know, I think you came in at the beginning saying it’s a little qualitative.

[00:07:41] Ross Butler: Right.

[00:07:42] Josh Lerner: And I agree with it know? Certainly when I feel when I’m asked, for instance, to give advice to a government or just give a talk, I always say a lot of what we’re doing here is not at the when we try to write an article, submit an article to the Journal of Finance, everything has to be at the 95% level of confidence right. With two stars and all the regressions. And they really like it when it’s 99% confidence. Right. Here we’re definitely in the realm where if we feel we’re 70% confident, we feel really happy that this is more often right than wrong. So there certainly is not real certainty on many of these things. But at the same time, when you look at data, you do see that some of the messages that I and others have been pushing that first of all, government intervention can make a positive difference at least in the right places at the right times. And secondly, that the provision of matching fund shack trying to get a signal from the market as to where the money should go is really important. Those two things are very much corroborated in the large sample studies as well.

[00:09:00] Ross Butler: Right, so I was going to ask you what are your key recommendations? Sorry, could you elaborate on those? So did you say you got to identify the need effectively? Was that your second point?

[00:09:11] Josh Lerner: Right, so I think certainly one of the challenges that public programs have faced has been this sense of saying let’s just go and do whatever the flavor of the moment is, right? That when you think about it, most politicians and most senior administrators are no doubt well intentioned but they’re not deep students of economics and economic development and even if you are a deep student in it, predicting what the future is is really hard right? So in a way to come in and say what so often happens is people look around at what other places are doing and just simply emulate what’s going on.

One example, of course, is biotech. I think an example I’ve used many times over the years is a paper by my friend Marianne Fieldman, where she documented that in the United States at the time she was looking, 49 out of the 50 states had programs encouraging biotech ventures, which were sort of predicated on the proposition that their state had some unique competitive advantage in biotechnology.

And the only one which didn’t was the Alaska, which had one where the former governor and former vice presidential candidate Sarah Palin abolished it on the grounds that it made no sense for Alaska in one of her few moments of really good public policy.

Right. When we look at that, you say that’s absurd.

[00:10:56] Speaker B: Because no doubt there are a number of places where having a biotech cluster makes sense, but 49 out of 50 is unlikely to be there.
And we’ve seen the same thing play out with clean tech and various other various other things as well.

[00:11:12] Josh Lerner: And when you ask the question of what’s right, it often is hard to say sitting in the ivory tower. But once you actually see it work in practice, it actually makes sense. So I remember one of the Australian states had put a big effort in terms of encouraging research in terms of life sciences. They had built all these fancy labs and he had a bunch of professors they had hired for big sums to come over and set up these facilities. But they were very frustrated because they were not getting the spin outs that were there. The spinouts that were coming out of those labs were either going to Sydney if they were good, and if they were really good, they were going to San Diego or San Francisco. And meanwhile, when you looked at saying, what are the startups that are doing really well and getting a lot of financing and market traction, it was things like using drones for low water agriculture software for the mining industry and stuff like that. In other words, companies that had some real rationale for being located there because of customer demand and being able to do really cutting edge applications. Right. And it’s hard to sit in the ivory tower and figure that out in advance, even if afterwards you say, AHA, that makes a lot of sense. And in a way that really sort of speaks to the power of market signals. In other words, saying, let’s see who’s sort of able to get traction there and then help those people get to the next level, rather than the more technocratic idea of saying, here’s our plan, and we say the answer is x. Right.

[00:13:12] Ross Butler: So the local dynamics is critical, but it’s very difficult even for politicians in that locality to know what they really are in advance. The lesson, therefore, presumably, is don’t be too specific with regards to your intervention and where you want the money to go and what you want it to specifically achieve. Is that fair enough?

[00:13:31] Josh Lerner: Absolutely. Right.

We just have thousands of examples of not just politicians who get it wrong, but even people who get it wrong about their own discoveries. We have across the way here the first programmable computer that was developed at Harvard during World War II. And there’s a famous quote from the professor who invented that like ten years later. They said, is this computer going to be useful for doing things like helping department stores send out bills? And he was like, if this computer, which we did to do calculations for developing the atom bomb differential equations ends up being useful for department stores, I’ll regard that as the biggest miracle in the history of humanity.

[00:14:21] Josh Lerner: So even there, the dude who had actually put this thing together, conceptualized this and put this thing together, couldn’t see around the next bend as to how It technology was really going to evolve. So in some sense to say to a public figure, oh, you figure out how all this sort of really complex stuff is going to bake out is.

[00:14:49] Ross Butler: That’s really the miracle of Silicon Valley, isn’t it? Because you made the point in your book and as I mentioned earlier, it’s very much one way or another, the military has either been a customer or a funder of ventures, but in another economy, that’s kind of where it would have begun and ended. But with Silicon Valley’s genius is to take whatever it is, global positioning systems and allow everyone to find their way, right? Yeah, go, absolutely.

[00:15:18] Josh Lerner: In a way that sort of serendipity or basically having just a ton of really bright people who aren’t afraid to fail and aren’t being punished for failing, being able to sort of play around in the sandbox and say, what is the next step that could be done with this? Fully cognizant of the fact that most of these ideas aren’t going to work out. But if one gets that right combination, it can be enormously powerful.

[00:15:50] Ross Butler: But I still come back to the point that it’s like there’s only one Silicon Valley and that’s true even in America. Like, if there were three or four Silicon Valleys, then maybe it would make sense for other countries to say we need one of these, but there’s one. It looks like a real anomaly. Maybe I’m being too cynical. Maybe there are other clusters that are smaller there and I don’t know, but from a layman’s perspective, it does look like a know, you’ve got America global power, you’ve got Silicon Valley, one cluster, end of story, and everything else is just miles behind. Is that unfair? I hope so.

[00:16:25] Josh Lerner: I think the answer is it is unfair. Right. If you looked at a chart of just a pie chart of venture capital and its allocation over the years exactly. If we took the snapshot as of 2001, and looked at it, basically the US. Would represent 85% of the pie. And once you added in the slices for UK, a little bit of France, Japan, Australia, Canada, right. You were basically at the mid 90s in terms of accounting for the accounting for the pie. And the whole rest of the world was just a tiny little sliver. Right. Today, when we look at it, or at least in 2022, what you see is the US. Is still the biggest piece. It’s probably 40 something percent in terms of the pie. But we’ve got any number of other slices of pie which are very significant. Obviously, China, the red slice, being quite big. But today India is representing close to 10% of the venture capital investment around the world. And we see significant clusters in a lot of other places as well, with a lot of the growth having taken place. Not so much in the again, when you look at relative growth because overall pie has grown, but the growth in the slice of the pie being most dramatic in the developing world in various places. So I think the view that this is just a game about the US. Or just a game that’s about Silicon Valley is mean. Certainly there’s still this sense of when you go within a particular country, when you go to Sweden and look around, right. The vast majority of the action is going to be in Stockholm.

[00:18:26] Josh Lerner: It’s still a game where there’s just a lot of what US nerds would call agglomeration effects, and we might just call lumpiness or stickiness, where people all want to be together with want to be together with each other. But when you look at the aggregate trend, it has really been to go from just one big lump to a series of lumps around the globe. Yeah.

[00:18:54] Ross Butler: Okay, well, that’s good news. So there is progress, and I’m being too cynical, and I’m glad to hear it.

So you could probably tell that I’ve recently reread your book because another point that you made, and you put this so brilliantly, and I hadn’t thought of it this way. It’s very simple. You basically say there’s a couple of ways that you can support venture capital. One is to create an environment whereby it thrives, and another is to increase the availability of capital, the equity gap type thing. And one, the former increases the demand for venture capital, as you say, and the latter increases the supply.

Which would you say is the most effective?

[00:19:31] Josh Lerner: Well, I think it’s certainly the case that you can’t have the one without the other. And in particular, I think there’s this sort of natural instinct that is, regardless of the political system, regardless of the culture or the religion, we see this natural inclination of political leaders to want to hand out big checks to people. Right. It’s just somehow, as a leader, that’s what gives you the warm and fuzzies in terms of saying I’m doing my job, I’m going to get lots of happiness and recognition for having done this. And one thing we can say with a lot of certainty is just that strategy of pill mill distributing funds without having done the hard work of setting the table, of making an environment that’s conducive to entrepreneurship is very unlikely to be successful. And yet we’ve seen this again and again. I think that there are any number of classic experiences along these lines. Probably with the Japanese being the most famous of policymakers who were bound and determined to create high potential venture VC ecosystem and said let’s just skip all the other stuff and go directly into dumping money into the entrepreneurial ecosystem. And as long as they were shoveling money into the system, there were people there willing to take it. But as soon as they had to because of financial pressures scale back the spigot, the venture industry just disappeared.

[00:21:18] Josh Lerner: And in a way it was an artificial industry that was being propped up by the public funds. And you say why was that? Are Japanese people not entrepreneurial? Are they not smart? Are they very smart? And certainly you walk around downtown Tokyo and you see big signs saying Toyota and stuff like that and these were real entrepreneurs who created companies out of nothing and created tremendous wealth from it. But that being said, for much of the period the government was trying to do this boosting of the venture sector. It was an environment which was really stacked against the entrepreneurs. First of all, of course the labor market. You could quit your job at Mitsubishi, but once you quit there was no way back in, right? Which really raised the barriers to going and starting something. You were definitely burning your bridges behind you. The tax laws, the labor laws, a 1001 other things were sort of rigged in a way that really made it unfriendly to be an entrepreneur and where it was a real struggle as a result. And I think again, why didn’t the government address that? Well, a lot of that was really hard, right? We know that anytime you sort of have regulatory or policy reform there’s lots of vested interests yelling and pushing in a bunch of different ways. In some sense it’s a lot easier to say we’re just going to go hand out funds. But I think that really has to be the first step.

[00:23:00] Ross Butler: Do you have a view on what’s going on in Europe and the EU’s initiatives to support venture capital?

[00:23:06] Josh Lerner: There’s certainly been a lot of money handed out by European Investment Fund and others and certainly there’s been some significant changes, positive changes in terms of some of the table setting kind of stuff, right. So if you think about a couple of decades ago in a place like not just Italy, but even Switzerland, you had this sort of extremely unforgiving regime in terms of treatment of failure. Right? As I understand it, the extreme form of that was not only were as an entrepreneur, if you were an officer of a company which failed, were you banned from being an officer of another company, but even as a board member you basically were hexed from doing that, right? Which of course, no doubt if you were sitting at the Swiss Business School and some student came to you saying will you be on the board of my startup?

Your answer would be no.

So, you know, there’s certainly been some positive changes in terms of some of these areas. And certainly you look at many corners of Europe. We talked about Stockholm already, right, where you do see a lot of this sort of virtuous cycle. And I think we could put London in the same category, where you do see just much more development of an entrepreneurial culture and process. I think on the other side you could certainly ask an impolite question which is given the massive investment of public funds, has the return on investment been as high as it ought to have been? And I think there my answer would probably be no. And if I was to highlight one issue or one problem, it seems like in many cases they’re starting off with a big lump of butter and then spreading it super thinly over I don’t know what the number is now 28 or 27 pieces of toast. And even on each piece of toast they want to put some money up in northern Lapland and some money out in the extreme western end of a country and so forth, right?

Even at a country level, rather than putting one pat, there’s this tendency to want to spread it out extremely broadly and in some sense that’s appealing, right? It’s sort of fair. That why let one place get all the goodies and other places not get the goodies, right? And in particular, you might argue the need for economic development is probably way higher up in northern Lapland than it is in Stockholm, where people are pretty prosperous and happy. But it ends up being really counterproductive because once you get that 1000th of a millimeter layer of butter spread all across the board, you can’t taste it and it doesn’t have any kind of real positive effect.

[00:26:21] Ross Butler: Right.

[00:26:21] Josh Lerner: It basically ends up ignoring the lumpy nature of this process. And I think that’s to some extent cut against the efficiency with which money has been spent.

[00:26:35] Ross Butler: So just as an aside, back in 2010 I was working actually at the European Private Equity and Venture Capital Association, which is now called Invest Europe. At the time we put out a venture capital white paper so we all read your book and we had a chap on to comment from the EIF called Thomas Mayer. And so the conclusion that Thomas and we came to was kind of precisely what you just said. And the solution that one of the solutions we put forward in the White paper was it was mainly focused on what you’re saying, increasing the conditions to increase the demand for venture capital, but also to try and take the source of public funds one step removed from the EIF. So you create a kind of a fund of funds and that allows the market to allocate to pick the winners rather than it was still online if anyone’s interested in reading it, but that was where we got to. But obviously Europe’s difficult because it is.

[00:27:27] Josh Lerner: Intensely political, obviously, but certainly I’m very sympathetic with this notion of saying to put as much distance between the politicians on the one hand and the entrepreneurs on the other is, I think, a great guiding principle. You know, when you think about some of the efforts that have been successful, albeit at a sort of smaller scale, so you can think about something like New Zealand Venture Investment Fund. They tried to create a body to take the public funds and allocate. It where they put a real moat around it to influence the process of somebody from Parliament calling up and saying my brother is trying to launch a fund and can you talk to him? And all that kind of shenanigans that we know is all too often the part and parcel of the process. I mean, this is not a popular message pretty much anywhere in the globe. I remember once testifying before some Senate committee and some very distinguished and reputable senator from somewhat far corner of the Wild West said this is just a sign that you’re a Harvard elitist who just wants you kind of people on the coast to do really better and don’t care about us. And with that kind of framing, you knew the conversation was not going to go terribly well.

[00:28:48] Ross Butler: Well, good for you for putting out unpopular messages because someone’s got to do it.

Have you been following so I’m currently in London, just had something called the Mansion House reforms where our government has encouraged British pension funds to allocate significantly from a very, very low base anyway to private capital in general. And obviously the press release focuses on venture capital. Have you any thoughts on that kind of corralling of local institutional investment vehicles into the sector?

[00:29:18] Josh Lerner: I must admit I’ve got a fair degree of caution there and again, you can say this is simply anecdote, but we have had a number of experiences in the past. I think one of the great case studies was that of the experience in Australia in the early 2000s where there was a real effort on the part of the government that was in charge then to strong arm the super funds. Basically the pension funds, which are massive due to the mandatory savings that they have in Australia to put money into local venture funds. And again, it was well intentioned in terms of what they were trying to do, but it was a situation where the industry itself was extremely young in many cases. Not that the people running the funds were not that good and where certainly it couldn’t accommodate the kinds of funds that the super funds were being asked to put into it. And the results were bad in the short run, which is to say a lot of money got put into these nascent venture funds which weren’t able to wisely invest it and ended up with basically a lot of money being wasted. But the real consequences were in not just the few years afterwards but really the decades afterwards. It just created this extremely bad taste in the mouth of the super funds around doing venture type investments, particularly locally. And they were like maybe we’ll give a little money to Carlisle or KKR but we’re certainly not going to put any money into any aussie bloke who shows up here talking about doing venture capital here.

[00:31:08] Josh Lerner: And it became counterproductive right? In the sense that they were so negative on this that it almost became an active aversion to doing venture investing and unwillingness to say the market is very different today than it was 15 years ago. That’s sort of gradually changing but it really had an unintended consequence and a very long hangover associated with it.

And I worry a little bit that I think it’s often very tempting on the part of policymakers to look around and say here’s a big pot of money, let me just solve my problem by reaching into it and using it over here. But I think that without really making sure that there’s an attractive set of ventures out there, it can be pretty problematic.

[00:32:04] Ross Butler: It’s not just tempting for the politicians, it’s also, I think, tempting for the industry itself, of which I kind of count myself as part. And with these Mansion House reforms people have been going around giving each other high fives. There’s this massive rush of capital coming into the industry. That’s got to be good news. I’m a big believer in the power of private equity. But I’m asking you this line of questioning because, of course, there is another side to it which is a little bit more concerning, which is maybe long term this is a risk. And that the press release that the government put out put some really was very specific about how it was going to improve the performance of British pension funds. Governments can say that kind of thing, private sector institutions can’t. But it’s certainly I think it is a bit of a concern. But you can understand that the industry is all for it because they can’t change the wider environment. One thing they can do is change that. They can lobby very narrowly for more funds for themselves. And so there aren’t that many people kind of sitting on the sidelines calling for kind of the bigger picture and a little bit of caution.

[00:33:10] Josh Lerner: Certainly this is a chicken. And egg problem and anything that can sort of shortcut that conundrum is obviously appealing. But I think one ends up being keenly sensitive after looking at enough cases to this sort of law of unintended consequences and how things that seem appealing end up can come back to bite one.

[00:33:33] Ross Butler: What about patents? I see you’ve done quite a lot of extensive work on the importance of patent regimes in order to spur innovation. What’s the situation there in the US and elsewhere?

[00:33:46] Josh Lerner: The good news with patents is that they really do allow one as an entrepreneur, or even a proto entrepreneur, to get protection for one’s idea and be able to use that protection to more confidently go and approach corporates for strategic alliances, potential investors and the like. And there was a very intriguing paper by some academics here in the States as well as in Sweden, where they looked at entrepreneurs who got slightly bigger, broader patents and slightly narrower ones, but where it was really much more a function of which patent examiner was doing the review of the patent more than anything else. And what they showed is that those entrepreneurs or those proto entrepreneurs who got the broader patents ended up being more successful subsequently, really, again suggesting that patents can be a really positive thing for entrepreneurship, given just how challenging the position you are starting off is.

On the other hand, and sadly, there always is another hand, right? We’ve also seen some real abuses in the US system, right? And this has been much we’re at the extreme end here, but the sort of patent gamesmanship of people basically often self styled entrepreneurs, but who are basically doing nothing besides litigating patents. And if you’re an entrepreneur trying to build a real company and you get a letter from one of these persons, it basically is framed as give me $50,000 or I’m going to sue you. Right? And in most cases, picking up the phone and calling a fancy patent attorney, the first click on the taxi is basically $50,000, right? So they’ve configured it in a way that it’s often considerably cheaper to just give them the money and have them go away rather than fight this thing. But the consequence is, of course, that it becomes a self perpetuating kind of thing, almost an innovation tax. So there really is both this bright side and this dark side. There and again was American public policy. A little bit more together, we would have figured out ways to try to accent the positive and downplay the negative.

[00:36:24] Ross Butler: So there’s no easy answer with regards to kind of IP law. And there’s nowhere in the world that you think are particularly kind of a good case model.

[00:36:32] Josh Lerner: I think Europe is better, if only because I think the quality of the examination system I think one of the big issues here is that not only are patent examiners not paid very much, but they’re under tremendous pressure in terms of quotas to get throughput in terms of this. So even if you get a patent, you sort of think it’s wrong or problematic, so forth. You’ve got your boss looking at your computer output and saying you’re not moving fast enough here, right? Even if ultimately that patent ends up doing hundreds of millions or billions of dollars of distortions to the economy, you’re under your pressure to do your 8 hours in that patent and go on to the next one and the next one and the next one. So it’s certainly a system that is ripe for a little bit of improvement.

[00:37:24] Ross Butler: So I noticed from your bio that you graduated from Yale and you looked at physics and the history of technology and the reason I bring that up is that, well, I’ve been thinking rather a lot recently about the scientific endeavor for good and for bad. And there’s the new movie out, isn’t there? The Robert Oppenheimer movie, which I haven’t actually seen. There was this phrase, not so common now, but a few years ago in Silicon Valley about move fast and break things and it’s know, just innovate, innovate, innovate and something good will come of it. And I just wonder if you’ve got any views on that and on the scientific endeavor and its dangers and our ability to, I don’t know, apply I’m a venture capital to apply kind of an ethical caution to innovation.

[00:38:15] Josh Lerner: It’s a great question. I teach a class for undergraduates over in the engineering school and certainly I’m surrounded by youthful founders who are not spending deep amounts of time contemplating the implications of what they’re doing, right? But I think when we sort of step back and say how do people get into trouble? Right? In particular, when we look at many of the boneheaded moves made by some of the most successful entrepreneurs, at least in our country, you say, how is it they were so blind and not thinking through the broader picture? And a lot of it is because a they probably just studied technology and we’re like, we’re not going to bother with those sort of soft kind of classes where these painful, complicated questions that can’t be resolved with a few equations lurk, right? And B they’re under whether self inflicted or inflicted by the outside pressures. They’re under so much time pressure that they’re never stopping to sort of step back and think what is this? What can go wrong? And so forth. And in some sense, clearly you’re never going to have a situation where you have entrepreneurial venture as a think tank where everyone’s spending months and years contemplating every ethical application of these things, right? There’s always going to be an element of experimenting just simply because by the time you know the answer, the opportunity is too late. But at the same time I think that it’s absolutely essential to have some of that awareness and this willingness to question baked into the entrepreneurial system. And I think those who have neglected know in many cases it’s ended up coming back to haunt them at some later point.

[00:40:27] Ross Butler: I heard this really scary story about I think it was in Princeton and there was an experiment going on with regards to gene editing, and I think it was CRISPR technology. And it was only by accident that one of the students came in over the weekend and realized that it was turning everything to slime. And the professor was reported as saying that if it had leaked out, it may have ended terrestrial life on Earth, all green life. And it’s like, oh, well, that sounds dangerous.

So great. Look, professor, thanks so much for sparing your thoughts and maybe you come to London next year and we’ll kind of pick up where we left off because there’s lots more to talk about.

[00:41:07] Josh Lerner: Absolutely. I’m really looking forward to act two. Thank you so much for the invitation to talk about all this stuff.

Andros Payne talks to Ross Butler about the holy grail of private equity value creation: a systematic, quantitative approach to cultural and behavioural change.

What makes businesses work well? Andros Payne is an engineer and entrepreneur who has spent two decades codifying and benchmarking the behaviours of senior and middle managers that are proven to drive growth and underpin cohesive and healthy cultures.

His firm, Humatica, has worked with some of the leading private equity firms in applying the methodology to their portfolio companies.

In this Fund Shack podcast, he explains how he has managed to make objective and transparent a conundrum that was long thought to be hopelessly subjective.

Reynir Indahl tells Ross Butler why he left the world of mainstream Nordic buyouts after the global financial crisis to pursue philanthropy and then on to re-imagine his role in investment.

In 2016 he founded Summa Equity, which currently manages Europe’s largest Impact fund.

As explains, the difference between Impact funds and mainstream buyout funds is more philosophical than technical. In fact, he expects the term to have a finite life as all funds effectively becoming more Impact oriented.

However, the firm requires a significant philanthropic sacrifice by its employees and Reynir has worked closely with his alma mater, Harvard, to develop a robust methodological approach to measuring the non-financial side of Summa’s investment activities.

This episode of the Fund Shack private capital podcast deliver the kind of serious, senior insight that money can’t buy. So make sure you follow us, leave copious likes and please rate us on your podcast platform of choice.

What’s going on with private capital fundraising? To find out, Ross Butler of Linear B Group asks Warren Hibbert, founder of Asante Capital Group.

After a splurge by institutional investors during 2021-2022, and a correction in public market valuations creating a ‘denominator effect’, fundraising sources have all but dried up – even for some big name private equity managers.

There is a lot at stake, and while it’s difficult to ‘kill’ a GP, even one poorer vintage can put a manager on the sidelines for a decade.

Warren explains what it all means for managers, when they should get on the road, and what to expect.

Transcript:

[00:00:00] Ross: You’re listening to fund Shack. I’m Ross Butler and today I’m speaking with Warren Hibbert, founder and managing partner of Asante Capital Group. Warren manages global fundraisings for private capital managers, so he maintains relationships with institutional investors across Europe, North America, Middle east and Asia. In this episode, we discuss the difficult states of the private equity fundraising market in 2023, the outlook for the fourth quarter and for 2024, and some top tips for managers going on the road. Enjoy.

Warren, welcome to Fund Shack. We’re approaching the fourth quarter of 2023. I wanted to ask you what the market for private equity fundraising was looking like.

[00:00:42] Warren: I think it’s getting better.

Everything’s relative in this industry, and I’ll explain why I think it’s getting better, but it’s probably easiest to contextualize that in terms of what we’ve seen over the last three years.

So if we dial back to actually 1920, it was a very strange time. Obviously, you had COVID. You had a very poor, a relatively poor fundraising year in 2020.

[00:01:06] Ross: Yeah, there wasn’t much fundraising in 2020, but there wasn’t much capital deployment, I.

[00:01:09] Warren: Seem to remember well, in fact, if you go back to 2008, so if we really look at the broader perspective, the peak, which was back 2007 eight, was about 650,000,000,000 raised. That was eclipsed in 2014. And then you had a record in 2019, well north of a trillion, just under 1.3.

2020 was over a trillion. So it was a good fundraising year, relatively speaking. But it was a down year and it was a very funny time for a relatively brief period post which markets really just took off whilst everyone worked from home, invested from home, et cetera.

And I think it’s a case of no one really knew at that time which way was up. Markets were going crazy, everyone was working from home, you know the story, and we didn’t really know what the outcome would be. In fact, everybody in our industry were pleasantly surprised, regardless of what you were doing and what your role was at how things had gone crazy virtually, and everything was working and it was driving huge efficiencies, right? Yes, on the fundraising side, but across the spectrum, what you had with that was this huge leap in valuations in the market performance and valuations of tech stocks mainly. Tech stocks predominantly. And this is largely a tech story, really. And so what you had, so you had the very few large players who were in the right place, right time from a technology perspective, and the mega caps who were just there now, really asset managers being able to raise incredible amounts of capital off the back of amazing valuations and performance delivery, both in terms of realized and unrealized. And what happened in addition to that is the deployment pace picked up fantastically. And with that increased deployment pace, so the fundraising pace followed very quickly. And so what you had is, instead of funds, generally speaking, going out to market every two to three years, which is a pretty good pace, they were now coming out to market every nine to 14 months.

[00:03:24] Ross: So I am out of date because I was thinking it was. It was more like four to five years, they might go to a mid market manager. So they’re pretty much constantly on the road.

[00:03:33] Warren: It’s a perpetual exercise of fundraising.

[00:03:35] Ross: I mean, they’ve always said that, but now it really is.

[00:03:37] Warren: Right? It really is. It really is. Largely because you’ve always got a product in the market if you’re an asset.

But going back to this period, which was really the 2020, 2021, you had these very large managers raising at a cadence that the market had never seen before. The flip switch that would have put that all to bed was the LPS going, look, we’re just out of capital.

But there was huge fear of missing out syndrome taking place, because those large tech stocks, tech stocks, tech GPS, if you take the top seven, their performance the beginning of 2021 back end of 20, was between four and nine times, net.

So you couldn’t. But you’re going to lose your spot. You had to re up.

[00:04:28] Ross: Were you talking global GPs who have a significant proportion in tech or something?

[00:04:31] Who are predominantly tech

[00:04:32] Warren: Yeah, predominantly tech.

[00:04:33] Ross: Okay. Who were all raising at the time in the sort of low teens to low 20s.

[00:04:37] Warren: Right.

Ross: So it’s not the redistribute distributions are increasing, it’s the fear of missing out that’s driving this.

[00:04:42] Warren: Correct. Allocate. Right, correct. During that period. Yeah. And there were distributions happening.

[00:04:45] Ross: Sure.

[00:04:45] Warren: But, yes, most of it was on paper in terms of the valuation uplift. So what you then had was these managers raising at an incredible cadence, LPS not being able to say no, and particularly the US state pension plan market, which is the largest pool of capital to privates, going, we’ve got to sort of double down. But effectively, we’re having to borrow allocation forward. So they’re committing future years allocation as.

[00:05:10] Ross: They’re eating into 2023.

[00:05:11] Warren: Exactly.

[00:05:12] Ross: Right.

[00:05:12] Warren: So what we saw in 21, and this was around October 21, and it was one specific USA pension we were speaking to at the time. They said, look, we think we’re done for 22.

And we sort of scratched our heads and said, well, hang on a second, you mean you’re done for 21? It’s October 21. No, we’re done for 22. They had effectively pre allocated all of their allocation to their respective managers, existing managers, to the end of 22, so over a year in advance. And that took everyone by surprise. But, whoa, what’s just happened here? Because no one had seen this forward committing, an extent to which it was.

[00:05:50] Ross: Happening, and it’s not a technical thing, it’s like a hype thing.

[00:05:53] Warren: Yeah, completely.

[00:05:54] Ross: My, I didn’t realize this.

[00:05:55] Warren: Okay. And so if you follow that through, and the same again happened in 22, where 23 was pretty much done back end of 22, as far as those managers were concerned, the LPS, what you then had is the correction with that. The LPS had really maxed out to the best extent possible, predominantly into tech, their allocations to the private markets. You had this drop off in public’s massive denominator effect. The distribution started to fall and it was the perfect storm.

And this was all leading into 23. So 22 was a down year, still a pretty good year if you take it in the context of the last decade.

But the first half of 23 actually was the epicenter. So LPs really sitting on their hands, having committed to their existing. Getting a new GP into your portfolio was almost impossible from an LP perspective. And again, I’m talking largely at the large end.

And so just a very difficult time, incredibly difficult fundraising time, because if you’re in our position, raising new capital into funds established or new first time funds, it was now impossible. And we’ll come to how we’ve managed to achieve what we’ve achieved. But it was very, very difficult. And in fact, we just completely put a line through first time funds for some time, which has been reflected in the market stats as well.

[00:07:25] Ross: Well, I have heard even very established brand name mid market managers been on the road for ages now and really surprised me because it’s like, okay, so maybe some of the big California state pension funds overallocated and got caught up in the hype, but we’re talking about global capital pools. You’d think that really good, well known managers that used to have a queue of people lining up, they’re on the road. Is that your experience as well? That there are some really good names still waiting?

[00:07:54] Warren: It’s a big reset for the market and it hasn’t quite played out entirely.

So the market, as you’ve heard and everyone’s heard many times before, invests by looking in the revenue mirror, as they say. So the performance of your 2017, 18, 19 funds is what’s relevant today. What’s happened in 20, 21, 23, it’s largely relevant. That’s money that’s being put into the ground, but you’ve sort of got a stay of execution. It’s really what have you delivered prior?

And everyone’s up against this new benchmark, which is the performance that was generated through 2020, 2021, through these incredibly periods of massive valuations. And there were significant distributions as well. So it wasn’t all on papeR. The VC market has had a very big correction, relatively speaking, not as big as the public’s, but there hasn’t been a significant adjustment on the buyout side in terms of valuations.

It’s just a very challenging time for many, because whilst you’ve been very consistent and generated net, 1.71.82, that doesn’t really stack up to this new paradigm. The new benchmarks that have been created, again, largely tech skewed. Hugely, hugely tech skewed in a way.

[00:09:15] Ross: But does that make sense?

Because the new benchmarks may just be Anomalous and this is one of the issues with the industry, is how do you decide who you’re going to re up with, commit to or in terms of new GPS or otherwise?

Warren: There is a multitude of different factors and performance is one of them.

Team is probably the most significant one. And then it’s a case of what’s the future play? Why is this going to be so interesting going forward?

And I think there are many investors, many GPs out there, who have had to really sharpen their tools and go, okay, we need to up our game. So the performance has been generated fine, that’s an anomaly. And that’s certainly what they’re telling investors. And there’s a premium for consistency. So if we, the GP, have performed consistently through cycle, that gets us lots of points, and it does, but your performance needs to be north of two X net.

[00:10:13] Ross: When you say sharpen their tools, you’re talking about value creation and just.

[00:10:15] Warren: Yeah, how do we show that we’re really cutting edge? Because along with this technology hype and valuation has come technology itself, right? This huge creative of efficiencies and new means of driving value, new means of doing pretty much everything, and those taking advantage of it are at the forefront of technology. So the tech GPs have benefited massively because if they really have domain expertise, they’re going deeper and deeper every day, whereas the more generalist or others that are focused on multiple sectors have been content to just continue on doing what they’re doing with the brand above them that drives these raised funds every vintage, not sort of reflecting on whether their model is world class and relevant. Yeah. And I think relevance probably a bit extreme, but really, is it world class? And I think that’s what’s really interesting because we see it with groups. Groups we meet. So many very well known, have been around forever GPs who really haven’t got the perspective of how the market has moved and how it is moving. It’s a very real time thing.

[00:11:33] Ross: So this really is. It’s all about tech. But I mean, there are large managers who are generalists, but that can really go deeper, can tell their portfolio teams, everyone, invest in AI and see what comes of it or something like that. That must be the case that there are some. Sure, you don’t have to be a.

[00:11:49] Warren: Tech specialist, you don’t have to be a tech specialist, but you do need to reflect on your business model and try and figure out what is the best means of getting to the top of the league table effectively.

[00:12:01] Ross: You said earlier, I think performance is key, but actually team is potentially even more important. What do you mean by team?

[00:12:08] Warren: When an LP goes in to assess a GP, the performance is obviously very important, but performance to an extent can be manipulated, whether it’s valuations, IRR in particular. Right.

As I say, you can’t eat IRR, but that is how many LPs are immunerated today? The majority of them. So it is a huge driver and that can be manipulated to an extent. So what you’re effectively backing is the team who are going to be deploying your capital in the next blind pool that you’re providing for them for the next decade plus.

And you have to have absolute confidence and excitement and conviction that this team, as calibrated, can deliver that.

And so the numbers are really important, but if the team is not fit for purpose or you have question marks over it, it really doesn’t matter what the prior performance was. Yes, and that’s why it is so, so important, particularly where there’s team change or evolution, succession, et cetera.

[00:13:13] Ross: Presumably when you talk about team, then it’s about assessing the individuals, but it’s also assessing the cohesiveness of those individuals working together and the organizational structure and whether that’s credible and all of that.

[00:13:23] Warren: Correct. And the alignment. Can I quite easily figure out what this team is going to look like in the next decade?

It’s not next year or even the next fund, but it’s the next two funds.

[00:13:34] Ross: You mentioned the market’s bifurcated and always has been, but presumably that becomes ever more polarized, the tougher the conditions get. Are there people that can still go out and just raise at the snap of the fingers or not?

[00:13:47] Warren: Yes, there are, but it’s the very few. So roughly today, if you assume that a trillion just over is raised every year up here or down year, I think this year would be just over a trillion. Still, although it’s a down year, the top ten managers take roughly 30% of that. That’s the top ten. The top 10% take north of 80%. So it’s massive bifurcation. So we saw this really become a significant thing post 2008.

The bifurcation didn’t exist to the same extent prior to that. And in fact, we saw that day to day. So raising funds pre 2000 and eight’s correction, everyone raised. Everyone raised. If you were out of investment bank or you were out of a consultant and you decided, I’ve got this thing and I’m going to focus on this region doing this, even if it was generalist, you were always going to raise how quickly you’d raise question mark, whether it hit your hard cap question mark. But you’d get into business. Yeah, post 2008, that’s not the case.

And so there’s massive survivorship bias in all the numbers post that period, to a far greater extent than pre. And then post 2020, albeit not a financial crisis, you had the same. So it’s the sort of rush to safe harbor, which is the megacap asset managers in a way. And so they’ve been able to really get a leap on. They’ve also been way ahead of the curve in terms of applying technology and thinking about their business.

And that’s an all too obvious but very interesting way of looking at things. You’ve got these groups called GPS, general partners who go around buying up businesses to create a portfolio and driving huge value by creating better businesses, looking at all different elements of the stack and going, how do we make this much, much better, bigger, more global, whatever the case may be, very few put a mirror up and go, let’s have a look at our own firm. And that’s kind of what I’m talking about is there are many groups and there are many GPs out there with a fantastic value creation stack with great means of driving huge value that still aren’t looking at themselves.

The management company is something you sort of drag along whilst you’re investing in these businesses, but their businesses have become significant businesses and there’s a lot you can do with them and you really have to be ambitious and work out where are you going in the next 1020 years relative to your peers, because it is such a fast moving market.

[00:16:33] Ross: So that matters when you’re actually raising a fund. LPs want to know that you’ve got a plan for your own money, because to some degree, I’ve got sympathy with the idea that let’s not focus, let’s not be too introspective, let’s just make money, let’s just create value in the portfolio companies, and let’s not worry too much about how things land internally.

[00:16:55] Warren: If you do that very successfully, and you usually find they go hand in hand, the introspection, and focus on your portfolio. But if you do that very, very successfully, those types of individuals and teams will be doing it on their own business inherently. That’s my view. And as a result, if you’re generating fantastic performance, so raising capital is fairly easy, and that’s the key element to growth, is primary capital raising. There’s a multitude of other things more on the secondary side that has been built in to augment that. But really, raising primary capital is the game.

Now, not everyone has a perfect vintage every time. From a performance perspective. There are some that are super consistent and very, very good, but we’re really getting to the top echelon 1%.

Everyone else is going to have a tough portfolio company and or even a tough vintage. And those can put you back on the sidelines for a decade plus, because it’s a very long term game. And whilst it’s very difficult to kill a GP who perhaps shouldn’t be around, it’s also very difficult for those GPs, particularly of even relative scale, to shift the direction of the tanker.

[00:18:10] Ross: So we’ve been talking about the extremes to some degree. We’ve been talking about the people that can raise really quickly, and we’ve been talking about the fact that not everyone will raise, actually, but the vast majority of people presumably are in the middle. They’re decent enough and they deserve to survive, but it’s a really tough market.

What should they be thinking?

Should they be conceding things? And are terms changing? And what’s happening in the mass middle?

[00:18:36] Warren: Terms aren’t changing massively. It’s always been a topic where, particularly through crisis, everyone switches to, well, the terms are now going to change.

Terms adjust relative to supply and demand, relative to each GP specifically. So there’s still GPS out there attracting premium terms through cycle.

Again, we’re talking back to the top 1%, everyone else, it evolves. So as you grow your Aum, as you get to a billion plus in terms of fund size, so you’re not getting 2% on your money anymore, but the 20% is rock solid. And then you now have continuation vehicles as well, upon which they’re earning economics.

And you can get quite creative on that front in terms of the degree of carry, in terms of ratcheting it.

[00:19:22] Ross: Up and down, because that’s newer, so they can play around with them.

[00:19:25] Warren: Exactly right. It’s less set in stone, but by and large you’re finding that GPs will continue to exist and raise capital. And even through crisis, they’re not conceding too much.

It’s more a question of how much can you raise? It really comes down to that you’re never going to go out and there isn’t a market clearing price per GPS, so you can’t go out and say, well, we’re not great or we’ve just had a rough ride. But inherently we think we’ve got a really good toolkit and we can drive value in the next vintage because we’ve learned from our mistakes, which all genuinely is pretty good. But the market will decide effectively how much you can raise, and that’s it. At set terms, you can’t sort of go, well, okay, we’re going to charge 5% carry and we’ll charge a few basis points of management fee and we’ll just suck it up for the next vintage because you won’t get anything at that point because the writing is on the wall.

[00:20:27] Ross: Cheeky question, but what kind of proportion difference does having a good placement agent make?

[00:20:33] Warren: Everything.

I think it depends on your scale. You take the host of child in Europe being EQT, who have one of the largest placement agents in the world, effectively in house.

They’ve got over 100 people focused on building out their AUM, and they do it very, very effectively.

You need a group focused on driving value in the area of capital raising at that scale, but ideally all the time. In the same way that you’d have a group focused on driving operational value within your portfolio companies, you need someone to be working on. How do you grow your business from an AUM perspective? And I think that’s something that many GPs haven’t quite got yet, which presumably.

[00:21:21] Ross: You need economies of scale in order.

[00:21:23] Warren: To you do in house or externally?

[00:21:26] Ross: Yes, one way or another.

[00:21:28] Warren: One way or another. One way or another, you need it.

And most importantly, it’s recognizing, and we can debate whether it’s 50 50, but I would certainly argue that 50% of your business is raising capital, at least 50%, whereas many believe that we’re out there to go do deals. We’re out there to go do deals, drive value and generate returns for our investors. And every couple of years, and amazingly, it shouldn’t be the case. But many still believe this, every couple of years, we’ll hit the light switch and raise more money. And those in that camp probably not going to raise again unless their performance has just been amazing. And if your performance is consistently fantastic, you raise yourself. That’s fine, that’s easy. And you probably need one IR person, really, just to make sure that everything’s running smoothly. But investors are marching to your steps, so that’s fairly straightforward. But again, it’s kind of irrelevant to discussion because there’s so few in that zone. So having a party, internal or external, who has a perspective and day to day, is watching what LPs are doing, particularly in today’s markets, where I still believe no one knows which way is up, is critical.

[00:22:40] Ross: Yeah.

Are there any differences between the North American fundraising market and Europe at the moment?

[00:22:46] Warren: Sure have been for a long, long time, simply because the largest pool of capital, privates, is in the US and will be for some time to come. It’s moving slowly only because the US is a very mature market. And so the element that is the largest, which is the US state pension plan market, is sort of tapping out at its maximum allocation to private equity. So that’ll continue to move ahead, but the growth is getting to the point where it’s going to be ceded to other groups, sovereign wealth, other large pensions, less so Europe and more Asia, and to the extent, the Middle East. So that’s quite interesting.

But you’re finding that really, the US has been such a strong market and the predominance of capital has been so favored towards North America, that in tandem with the fact that it’s the oldest, so they’ve learnt more, it’s a far more developed market. The returns have been better.

Getting in your car and driving down the road to your investor is very easy. And from the investor’s perspective, investing in your backyard, from a currency perspective, et cetera, has been pretty easy. So it’s been self fulfilling to a large extent, and has remained that way for a while. It’s been more a question from that market question for the US market as to how they diversify and whether they even need to.

And for quite a period post 2008, there was a retrenching back to, let’s just do it in our backyard.

Then only in 20, 16, 17 did we start to see them really going, we need to rebalance into Europe. Not 50 50, but we need to put more into Europe.

And that pulled back again post 2020, but is now starting off. It’s kicking off again. But Europe is a market where there have always been many questions around. To what extent do you need to be in Europe if you’re getting the returns and the diversity in terms of type of manager in our backyard in North America, predominantly the US.

And the only other real question was, okay, so how exposed do we want to be to Asia? Because Asia is moving really quickly. China is super interesting and we’ve got to be there until they can’t be there. And so that is a change now that we’re seeing where that may actually favor Europe.

[00:25:10] Ross: Right.

[00:25:11] Warren: Because that capital will shift across.

[00:25:13] Ross: So the domestic pools of capital, what kind of proportion, in terms of European GPs looking to raise money?

North America, obviously hugely important, but there are domestic sources of are.

[00:25:25] Warren: But the European market is a much smaller market. But yes, and just as a general rule, your local investors are going to be the ones that know you best, know you personally as a GP, because you dine at the same restaurants, whatever the case may be. And you always see that natural affinities, where, in fact, if your local pensions are not invested in you, investors outside your region start to go, well, how good are you?

[00:25:51] Ross: Yes, proximity matters, doesn’t it? And then there’s the kind of cultural things. And the topic of ESG feeds into this to some degree, because that’s become kind of a polarized issue in the US itself, but also between North America and Europe. And Europe is very much pro and not all of North America is. And so a topic like mean, that’s a delicate one to tread through.

[00:26:16] Warren: Is it? It’s a complicated one because it’s a question, I think, in many minds, as to what extent it’s window dressing versus genuine impact. And there’s ESG, but there’s impact, and there’s a ton of ways to describe what GPs are trying to do. Many with the right intent, some with a question of trying to attract capital from those LPs that are just focused on impact or ESG. And when you distill it, the reality is investors that are focused on impact and ESG is a significant proportion of investors. It doesn’t mean they’re impact and ESG investors. It doesn’t mean if you label your product ESG that you’re immediately going to raise capital from those investors.

Investors are still looking for the same simple things, strong team, great track record, and if you’re doing the right things for the society and the world, which most the best GPs are anyway. They’ve just rebranded as ESG and impact. Fantastic. You tick the boxes and you raise money, but not the other way around.

[00:27:21] Ross: Yeah. So maybe the lesson there is not to get too obsessed with the labeling and actually just do the.

[00:27:27] Warren: Do it properly. It’s one of those things. The understatement works if you do it well. And we’ve actually had this with a GP recently where we’ve had investors go, actually, we’re going to put you in our impact bucket. But they’re not an impact GP.

But the reporting is phenomenal and they really care about it and they do a lot of it, but that wasn’t the reason they got into business.

[00:27:49] Ross: We’ve relatively recently seen the rise of private credit funds as well. How’s that affecting, let’s say, the overall balance of the opportunity set if you’re a fundraising as a private markets manager, is that eating up some of the private equity allocation?

[00:28:04] Warren: No. So separate, separately separate in many instances, separate teams on the LP side reviewing the propositions.

A lot of that capital has come out of the fixed income buckets and that entire market has come to be what it is today, which is this juggernaut post 2008 as well. So you had the global financial crisis happen. Investors were desperate for yield for just some degree of cash back because it was pretty barren, it was just desert. Were you ever going to get your capital back, regardless of what strategy you were investing in?

And on top of that, very obviously, the banks were in a tough position, to say the least. So this credit fund market came to be and has grown incredibly since. But a significant portion of that has come out of the allocation to fixed income. What’s going to be interesting going forward, and it’s here to stay, there’s no question the banks are going to be in, are going to have ups and downs at infinitum, in my view, but they certainly have a bit of a tough time now, and that’ll happen through crisis, because we push the limits in the industry all the time and the credit funds are better able and aligned to fix things versus try and take the keys, which actually makes it a bit of a smoother landing when you do go through the downs and more attractive to GPs and more attractive to GPs and they’re able to take more risk, et cetera, they understand the assets better. Their approach is from the inside, as opposed to from a sort of banking perspective, where you’re just a line item of thousands.

That said, what is going to be interesting is the extent to which that capital starts to flow back to fixed income now that you have a pretty attractive yield coming through and how that starts to now compete with fixed income, which was zero. Therefore, of course, you moved it across and that’s massive. I mean, the fixed income market is larger than the public equity markets. The fixed income market is so large, it’s circa 130,000,000,000,000 that a very small proportion was shifted across into privates. It’s not all going to shift back. Sort of. No one’s really noticed, is my view.

[00:30:26] Ross: Yeah. It might just be worth keeping your hand in as a large institutional investor into the private credit market, just completely.

What’s your view on private credit? Because in terms of we got a rising rate environment and let’s say it plateaus here, or slightly higher, does it grow over the medium term in that environment, or does it require a low interest rate environment to become, to grow in the way that private equity has grown in the last decade?

[00:30:53] Warren: I don’t think it’s going to grow to the same extent it has over the last decade plus because it’s really gone from zero to hero quite quickly because your competitor was your competition, being largely the fixed income bond market, was at basis points, and you could deliver net sort of six to early teens, even on the senior secured side. So that’s very, very interesting. But you had no competition. You now effectively have competition for capital. And that, I think, is going to mean that they’ve got to fight a bit harder. But you’re also going to have this and you really have that. This bifurcation is going to become even more extreme. So it’s going to be those that are quasi banks who can really provide any financial solution for you.

[00:31:45] Ross: And what’s your kind of medium term outlook on the private equity fundraising market as a whole? You started by saying, by being kind of cautiously optimistic.

[00:31:58] Warren: Back to that discussion around where the market is and why 2022 and 23 are going to be tough fundraising years. Our view is 24 will look a bit like 22, and so we’re potentially back to a steady fundraising environment in 25. That’s our view anyway.

But the epicenter was the first half of this year and you can see the sentiment marginally improving, which is why I emphasized relative, it’s marginally improving. Investors are starting to get a little bit excited about what is to come in 24, where we haven’t seen that for quite some time now, which is great, and there’s capital out there. As I said, if you look at the fundraising statistics year on year, we’re in a period that’s way up on where it was a decade ago. You’re having up and down years for sure, but it’s still in the trillion plus, and I don’t see it changing dramatically. It’s just where that’s going.

Everyone sort of thinks on it as a very big market, which it is, and there’s plenty of capital out there if you’re, if you’re raising roughly a trillion two every year.

But if that’s only going to a handful of managers, for the most part, how do I, as one of those marginal managers, raise money? That’s, that’s the big thing. And that comes back to your point, around some very established groups who will raise, but are going to miss their targets, in some cases dramatically. They will continue on, but that’s going to be the story to watch is to what extent do they walk away and go, okay, well, we’re still around, we’ve raised money, we might not be able to do as many deals. It might be a slightly more concentrated portfolio stroke. We may take advantage of a lot more co invest. Not a bad thing for LPs to deploy into our assets and build up again. But what do we need to change such that that never happens again?

If you go on as well, it was just a tough environment.

When we raise our next fund in 26, everything will be fine again. You’re in trouble.

[00:34:03] Ross: Yeah. What’s your top tip? In the heat of the moment, you’ve got a fund to raise your top tip to a GP. What’s the common mistake that you’d watch out for something like that?

[00:34:12] Warren: Yeah, there’s one. So we have a diligence questionnaire where GPS always list out their common most or their key lessons learned. And the most common lesson learned is we didn’t replace management quick enough. Every GP’s got that lesson learned. If you would apply that to fundraising, it’s. We went out too early.

So that’s my piece of advice, is if you’re going to, before you plan to go out, you need to have a pretty good sense on what your fundraising is going to look like before you launch. You’ve got to have a very good sense on at least 50% of your capital that you want to raise and when that’s going to come and from whom before you launch.

And as you mentioned earlier, it is a perpetual exercise. So you’re always fundraising, even if you’ve only got one product, you should be speaking to your investors and spending a lot of time with them such that you can get the answers from them around. Are you there to support me and for how much? WheN I launch the next fund, that’s your existing investors, then you’ve got to do the same for new.

You should have a far greater degree of certainty around your existings, obviously, than your new. But I say obviously, actually not in today’s environment. So many investors, certainly through the last two vintages, have switched out of existing managers into new, or have had the problem of not being able to re up with all their existings simply because they didn’t have the allocation and the capital. So it’s been tough and you’ve got to have that perspective, which means you really need to make sure that you’ve actually mined the markets in your pre marketing exercise very, very carefully. Right.

[00:35:50] Ross: The readiness is all?

[00:35:51] Warren: Yeah.

[00:35:51] Ross: How long have you been doing this?

[00:35:53] Warren: Roughly 20 years.

[00:35:55] Ross: Right. And you set up your firm?

[00:35:58] Warren: Yes.

[00:35:58] Ross How’s that?

[00:35:59] Warren: 13 years ago. Fantastic.

Really good. It’s never a straight line, like most things in life, but ours has been a pretty extreme curve through the last 13.

It’s just a lot of fun, and that sounds fairly fluffy. But the most important thing to us, as we keep on saying, is the culture of the firm. And if you’re having fun, that’s everything, because everything comes with that. If you’ve got a team that are motivated, aligned and having fun, it’s like having a boat with four big engines.

And a lot of the good things come from that. It’s become more challenging as we’ve grown, obviously, as it does, particularly when everyone’s not under one roof.

So we’ve got five offices around the world, 74 people, and it’s maintaining a singular culture and that drive, passion and energy, that is something we spend a lot of time on every day doing.

[00:37:02] Ross: Sounds like a good culture and philosophy.
Well, thanks for coming on the show, Orange. Lovely speaking with you.

[00:37:06] Warren: Thanks for having me. Lots of fun.

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