Today’s post features a not-to-be-missed opportunity to hear from Neetesh Kumar, Partner at Spruceview Capital Partners, a fund of funds investing in low and mid-market buyout fund opportunities focused in the US. He takes us through Spruceview’s specific investment methodology and shares some compelling real-life examples that illustrate their success in pinpointing valuable opportunities in the space.
Neetesh Kumar has over 25 years experience investing in Private Equity and has been a Partner at Spruceview Capital Partners since 2014. Prior to that, he was an MD at JPMorgan’s Retirement Plan Investment Group, responsible for the $2.5 billion in global private equity portfolios. Listen to the conversation on Apple Podcast or Spotify.
Investing in low and mid-markets
Neetesh Kumar: “Low and mid-markets have been an area of focus for us for over two decades, and we have consistently seen it deliver returns across economic cycles. When we think of low and middle markets, we think of companies with an EBITDA of less than 25-30 million dollars. These are growth companies that have organic growth opportunities as well as opportunities to make add-on acquisitions. The reason low & mid-markets has been a segment of interest to us as well as to some other investors is: it is an inefficient place, it has a large number of target companies. You can find value here where valuations are well below the industry average. These companies require operational improvements or growth to optimize their cost structure. And usually, the leverage is less in these companies. They are less dependent on debt happening in the capital markets and the vagueries of exits that come through that. So basically, focusing on the fundamental improvements of the companies where you are able to add value and generate returns.
Also, there is an important aspect in the low and mid-markets because there is a lot of capital chasing these deals in the larger end. There are capital tools that have raised 10 billion, 12 billion dollars who are looking to acquire companies from low and mid-market buyout investors who are willing to pay a high premium for good quality companies that have already achieved operational improvements. This leads to opportunities of generating outsized returns of over 3x for operationally improved strategies and to deliver returns with the illiquidity premiums that you could expect in the PE space. So that is the segment of low and mid-markets that gives us the excitement as well as provides a role in our portfolio.”
Specific segments of interest in low and mid-markets
NK: “There are sectors of growth in the US economy like healthcare, technology, parts of industrial manufacturing… These sectors represent a large portion of the US economy and they are the right set of sectors for investments in the low and mid-markets buyout space. So defensive sectors provide an opportunity with downside protection and a tail win for growth. For instance, in healthcare, there are opportunities in the services segment, products and distribution segments, specialty form, and consumer segments. There are specific growth trends — like shifting demographics that are contributing to higher adoption of new products in wellness and preventive segments. There are cost-reduction sectors leading to more demand for efficient delivery of healthcare services or increased regulatory pressures and compliance as well as administrative requirements creating an opportunity for innovative business models. Those are specific to healthcare, but you could see the same in technology: with using softwares as a service, cybersecurity systems… In manufacturing, supply chains are moving to the US given the trade-tariff dynamic. Also, high-end manufacturing with high margins continues to be a part of the US manufacturing sector and we are witnessing interesting opportunities with very attractive entry valuations. Consumer as a segment has driven the economy as more people are spending more time at home.
So those are the main sectors where we see opportunities. But we even have sub-sectors in these that present more opportunities to focus on. And that sub-sector analysis is an important one that gives us a roadmap and a vision for growth and creates a framework to make sure there is adequate tailwind.”
Example of investment in low and mid-markets
NK: “Within healthcare, one of the teams that we identified back in 2014 was in the veterinary clinics in the US. This space did not have any reimbursement risk. Anyone who has a pet knows that we take care of them a lot and that they matter a lot more to us than some other things in our lives. In fact, our industry refers to it as the humanization of pets. When we did the top-down thematic analysis, we came across the data that there are over 28 thousand veterinary clinics in the US. And we believe that there will be an opportunity to buy and build, to grow into larger companies. The growth rate that we expected was around 4.2 to 4.5% range over the next to 5 to 7 years — this segment of the market being one of the least impacted by the economic crisis of 2008. And we believe that this segment is also a recession-resistant segment. The key to success in the industry was to have high-quality management teams that had an eye towards Business Development – to acquire the right targets. An important element of that was not to dilute the local brands of the clients as it is a very local business.
We looked at 17 different companies in the space over the span of 3 to 4 years. One of the companies that we ultimately ended up investing in grew from 2 clinics to 49 clinics alongside one of our trusted managers. When the company needed additional capital for growth, we stepped up in May of 2018 to invest in the company with the expectation of delivering 5x returns over 5 years. That was the underwriting that we did. During Covid, the company continued to outperform and has grown their revenues to about 4.5 times the revenues we had in May of 2018. It has already achieved the assumption for over 5x return and it is still continuing to grow as we continue to own the company. Not all companies will have this trajectory of growth but the steps that we followed to make an investment systematically go through: looking at the industry, the management teams, the companies and then investing in a company. That’s the kind of efforts it takes to find an outsized return deal along with a trusted manager.”
Spruceview’s team members and their backgrounds
NK: “We have over 25 years of experience investing in PE strategies across economic cycles. We have built relationships with GPs by virtue of the positions that our team members have held in the past – whether it was head of PE for endowment, or most recently at JP Morgan… We have carried on these long-lasting relationships. These relationships that we have built are hard to cultivate today because some are very hard to access. In addition, we are trying to use our experience and patterns of success we have seen succeed in the past to identify investment opportunities. Whether it is for investing in new managers or companies, we are trying to now build some new relationships. One of the things that we have seen based on our experience and having come from our operations in direct-investing background is: operational improvement of portfolio companies and not financial engineering is the recipe for success across economic cycles. We believe that one common factor of rolling up the sleeves, working closely with the management teams to help identify and implement top-line growth strategies along with steps for operational and cost-structure improvement is what you need to focus on.
We want to have lower entry valuations. One of the biggest challenges in PE at the moment is the valuations of very, very high at the larger end of the market. If you can find good attractive deals at a modest valuation and with low leverage, you are creating value on the buy. Those kinds of background give us the perspective not to shift our strategy, not to move upmarket and to keep our focus on what we know best.”
Spruceview’s strategy for co-investments
NK: “One of the things that we have been doing over the past 25 years is maintaining relationships and access that we have built. We have spent the time to cultivate these relationships and that helps us get to what we think are the best managers and the best deal flow opportunities. We source deals proactively by looking at a specific segment and approaching the GPs. But we also source deals that come to us on a first-call basis.
The processes that we have built helps us to quickly analyze and see if a deal is a fit to the specific criteria we have outlined. This is an important step for us: when we look at a deal, we know if it’s interesting to us and we get back to GPs quickly. We have a disciplined process that allows us to evaluate if the company has a good offer of products and services, we would know about the sectors, we do the top-down thematic analysis and then we evaluate what are the mechanics and the structure of a deal. It is a high probability that if you are looking at a deal, we have already seen at least 4 or 5 other deals in the same space if we have done the thematic analysis. That gives us an advantage to evaluate rather quickly, get back to GPs quickly… We always share our views with the managers and that gives us a leg up in comparison to a lot of other folks.
When we say no to a deal, it’s an interesting challenge. It usually is a good deal, simply not a good fit for us. The deals that come to us are in high-demand, and when we say no its because it is not a fit. And that allows us to maintain a strong relationship with fund managers, even if we decide not to invest in them.”
Co-investing with managers you are not already invested with
NK: “We receive a significant amount of deal flow that comes to us from our existing manager relationships, some past managers relationships, new managers, fundless sponsors… And we are also proactively sourcing for investments. But we do favor co-investment opportunities where we have a strong conviction on the manager’s ability to make significant improvements and have the expertise to work closely with the company.
We have seen that usually the companies we invest with are alongside managers that we are already invested with or will be looking to invest with. And we recognize that it is a privilege that we have. But that has been our bias. If we receive a deal from a manager that we don’t have a relationship with but that we really like the managers’ skillset to add value in a portfolio company, we put them in our bucket list and try to build a relationship with them.”
Building relationships with managers
NK: “Some of our relationships go back 20 years whilst others are more recent. We build relationships today based on the opportunity set. We are noticing a lot of experienced PE people that are leaving their firms and starting their own funds. We work with them and often receive their calls. Our older relationships have usually stayed consistent and true to their strategy. One of the biggest challenges in PE is when a fund manager’s performance is halfway decent, they would then like to raise a 5 billion dollars fund and they suddenly go upmarket very quickly. There are a handful of managers that have stayed consistent with their strategy and their focus on the low and mid-markets. Fortunately, a lot of these are our existing relationships and our preferred relationships to source deals.”
NK: “It depends on the portfolio and the strategy. For low and mid-market across the four sectors we favor, we would have fostered 5 to 6 key relationships in each of these segments. Although our database has got over 400 names and that we have been keeping track of each of their companies. But it is very targeted. We are also focused on diversification across vintage years. We try to keep 2 to 3 years of diversification whether we are investing with the managers or doing co-investments. In addition, when we look at the type of companies, we want to make sure we are complementary across subsegments. We don’t want our portfolio companies to be competing against one another. So, we monitor those considerations, we size our investments accordingly. We have been doing it for 25 years so we know the approach that works for us and this is what we do of the portfolios that we construct.”
Personal experience and view on PE’s evolution
NK: “PE has matured a lot. Twenty years ago, I remember when someone would raise a billion-dollar fund, everyone would think it is too much money and whether they would be able to find deals. Now it is considered to be a mid-market buyout strategy. So, things have changed.
The guys that are raising big money, that space is becoming commoditized. Multi-manager and fund of funds are facing strong pricing pressure and they are not really able to adding value to the investor. Also, we have noticed as the size increases and we go for larger companies, they become more efficient. It is much harder to do a 2x or 3x when you invest in those larger companies, but the advantage is you can put 500 million dollars to work very quickly with a megafund.
The consistency of return is another fact that we have seen through a study that said only 34% of PE fund managers were top-quartile in their subsequent funds. So, there is a need to be consistently evaluating the investment thesis and be selective in the manager selection process. So, the potential for outsized returns is what we are all focused on and one of the places we have identified to that effect is the low and mid-market buyout funds — that kind of go back to the fundamentals of PE by being disciplined on the fund’s side of strategies and operational improvements.
The challenge as a PE investor is to know who the best managers are and how to access them.”