L-R: Nitin Gupta and Eric Deram

This article was produced in partnership with Flexstone Partners.

Few private equity players say they actively avoid hot sectors, but Flexstone Partners is of the view that PE investment is not about “hitting a home run every time” but securing doubles and triples every time it steps up to bat.

The Natixis-affiliate private asset manager and self-described “boring company lover” boasts a low-risk, low-loss ratio investment strategy that focuses on low to middle markets in the most traditional sense – less than US$500 million ($776 million) in enterprise value.

That’s for direct investments; for a fund-of-funds investment, the middle market ceiling is US$2 billion.

“Most larger private equity funds all say they do middle market, but they define it as between the US$1 to US$5 billion range. But because we’ve been doing private equity since the mid 90s, our definition of middle market is a bit old fashioned,” Nitin Gupta, Flexstone’s New York-based managing partner tells Investment Magazine.

“The opportunity set is so much broader on the lower end. You get better valuation, lower leverage, better returns and more of the actual value creation. Whereas on the larger end, those companies tend to be already very professionalised, and there’s fewer growth levers there.”

While these companies might be less exciting than a tech unicorn, Gupta says they are in no way less essential. In fact, they are often “mission-critical” for certain industries, such as the bottle cap manufacturer, the vegetation management service, and the hospice company Flexstone invests in.

There are also incredible nuances within these companies’ products. For example, the seemingly unassuming bottle caps of expensive wines and perfumes can have wireless chip implants for tracking and authentication purposes.

“We like that [bottle cap company] example because, with pun intended, if you screw up the quality of your cap, you basically destroyed the entire product,” says Eric Deram, Flexstone’s Geneva-based managing partner.

“The value of the cap is tiny compared to the value of the entire product, but it’s essential in terms of maintaining the overall quality.

“This type of company – even though they’re not called Apple – they have fantastic pricing power.”

The firm doesn’t dabble in venture capital but focuses on cash flow and EBITDA-positive, traditional businesses that people can “touch and feel”, says Gupta. More often than not, these businesses are led by founders and management who have skin in the game. The asset manager is looking to lock in two deals in the coming weeks whose founders are rolling over 35 per cent of their equity into the transaction.

“Most of them [founders] like to roll because they know they’ll make more that way then exiting fully. We like that too because there’s better alignment of interest,” Gupta says.

“These are all good businesses, they’re not turnarounds. And when the first institutional capital comes in … they can help to invest in ways maybe founders didn’t have the capital to or were less inclined to by expanding product line, geographic reach or doing M&A.”

Strong appetite

At the end of 2023, global private equity dry powder had jumped to an all-time high of US$2.59 trillion, according to data from S&P Global Market Intelligence and Preqin. But with more certainty around interest rates ahead, Gupta says the appetite for private equity deals has come back strongly.

Considering a typical investment period of five years, the fact that most dry powder continues to sit in 2021-23 vintage funds means many private equity funds are starting to be impatient about sitting out of the market, he says.

“They’re charging management fees, but they are not currently doing deals,” Gupta says.

“There’s some retrenchment from the sellers as well in terms of the expectations they had, so I think there’s a better connection now between valuations.”

Separately, Deram also points to an attractive secondary market where he says some good quality assets are available at double-digit discounts. The firm is looking for 15 to 20 per cent net internal rate of return (IRR) on an unlevered basis and a 1.5 to 1.8 money multiple in this space.

He says the typical perception that “sellers will try to sell junk” is not the case here.

“The reality is a seller is not necessarily a willing seller, because when you invest in private equity, you invest for value creation which takes time, this is the thing you plan for,” Deram says.

“But selling for reasons of liquidity – you don’t plan for things like that.

“So if you are a reluctant seller, and you sell the worst part of the portfolio, you’re going to have a huge discount that really hurts.”

Playing it safe

With around 50 investment professionals in offices across four countries, Flexstone has local mandates with profit-to-member funds Hostplus and AvSuper. The latter is in the process of merging with the $280 billion Australian Retirement Trust.

Flexstone has a four per cent selection rate after the deals are funneled through by the funds it invests in, and the firm’s own due diligence. Through its fund-of-funds strategy, Flexstone leans on its relationships with other asset managers to tap into global deal flows.

“It’s a highly selective process,” says Gupta. “It’s not about hitting home runs every time. This is about hitting doubles and triples every turn.”

Geographically, while the US and Europe remain the biggest PE markets (claiming about 60 per cent and 35 per cent of the deals each), Deram says the firm is quite bullish on Asia.

“One market that has been pretty dormant over the last 20 years or so, but we think has become very attractive is Japan,” he says.

“Japan is an interesting market not only for the macroeconomic factors… but also that there’s a lot of SMEs in Japan, which have been passed on from generation to generation and not to professional financial investors.

“That is starting to change a little bit, but private equity penetration of in Japan is very low compared to the US, for instance, or to the UK, so there’s quite a big potential there.”

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