Private Equity: Responding Tactically, Changing Strategically

The current year has seen an enormous amount of change packed into a few months: breakout inflation, rising interest rates, war in Ukraine, COVID mutations and stubborn supply chain problems. We know how the public equity markets have reacted. But what about the private side? At Commonfund Forum 2022 a panel of private equity experts probed this question.

The panelists were Adam Feinstein, Managing Partner, Vesey Street Capital Partners; Miriam Schmitter, Managing Director, Commonfund Capital; and Gero Wittemann, Partner, Hg, a leading software and services investor. The panel was moderated by Peter Burns, President and Chief Executive Officer, Commonfund Capital. Excerpts of their discussion follow, organized around the central themes to emerge during the discussion.


Peter Burns: For years, people have been saying private equity returns are going to come down. Typically, the illiquidity premium has been in the range of 300 to 500 basis points over the S&P 500. Is this holding up or are we seeing it shrink?

Miriam Schmitter: You can look at it as return relative to public equities or simply absolute return. We have seen both hold up very well despite growth in the market and more competition. One reason is that innovation has kept pace. There may be years when the public markets outperform, but looking at three-, five- or 10-year averages we have seen private equity outperform and deliver strong absolute returns.


Burns: Gero and Adam, what are the opportunities in markets where you focus?

Gero Wittemann: We are sector specialists focused on mission-critical, business-to-business software, an area where revenues are stable and predictable because our portfolio companies have revenue subscription models. We price risk-adjusted returns of about 20 percent. But returns are often higher because we invest in innovation and support M&A. As a result, we generate returns that go beyond this baseline, typically to around 3x invested capital.

Adam Feinstein: Our strategy is to make three times our invested capital over a five-year period. We have a strategy that is focused on lower and middle market healthcare services. We do not maximize leverage—we are looking to grow portfolio companies rather than layer them with debt. We constantly think about risk. In the healthcare world, where so much is mandated by the government, one way we try to mitigate risk is by investing in businesses that do not depend on government reimbursement.


Burns: Miriam, 20 years ago most firms were generalists. What’s your view of generalists versus specialists?

Schmitter: Sector specialization started in the U.S. because it’s the most mature private equity market as well as a large and deep economy. Now in Europe, as well as some smaller Asian markets, we have seen the trend expand. In emerging markets, for instance, healthcare is a sector that has seen a lot of specialization. Typically, at Commonfund Capital we invest with managers that are either industry focused, country specialists or have a particular skill set, such as distressed buyouts.

Feinstein: Within the broad healthcare market, we look at growth companies that provide services that benefit either hospitals, doctors, insurance plans, drug companies or consumers. These companies help reduce costs, raise quality or improve the patient experience. We don’t buy hospitals, for example, we buy companies that make hospitals more efficient.

Wittemann: We are a kind of specialist of specialists in that we don’t look at vertical markets in the software industry … in other words, we are experts in software, but also in the end markets the software is applied in to perform essential tasks in ways customers couldn’t do otherwise. This could be companies in financial technology, healthcare IT or tax and accounting, for example. We are active in these sectors consistently, which builds quasi-strategic insights and scale (by investing consistently).


Burns: Miriam, what about continuation funds? What are they and why the interest?

Schmitter: In this case, the general partner (GP) typically transfers one or several owned assets where the growth trajectory is not finished and thus the GP does not want to sell. The GP retains management of the asset but sets up a new vehicle open to new investors or gives the existing limited partners (LPs) the opportunity to cash out or maintain ownership of the asset. It’s positive for the GPs because they are able to keep growing the value of an asset they know inside and out. It’s positive for the LPs because it creates option value—they can sell if they want the distribution or if they like the company they can continue to hold. On the downside, there could be potential conflicts of interest because GPs essentially sell to themselves, although they are not the direct owner, making the involvement of the advisory board a key factor when it comes to monitoring how the process is conducted. And, typically, there is also an external price-setter so the GP does not necessarily set the price.


Burns: Adam and Gero, are you seeing inflation impact the way you do business?

Friedman: Inflation goes hand-in-hand with labor. We’re in a tight labor market and our companies have to pay more to keep their people. We have found that customers are receptive to price increases because without the services our companies provide they would have to provide them on their own and, most likely, need to hire more people.

Wittemann: Businesses are looking to protect profits against inflation. The more obvious short-term adjustment is increasing prices to pass on higher costs. Longer term, businesses are to going to seek to increase efficiency. That’s where technology comes in: demand for software increases because it is part of the solution to achieve this objective.


Burns: What about diversity in the private equity industry? What are we seeing?

Schmitter: Among GPs, there’s a definite focus on diversity and a concerted effort to bring in more diverse talent. It may take a while to reach parity but everyone is making an effort.

Wittemann: Two thoughts: It has been a real difference maker for us … we have committed as an institution to the idea that a diverse set of people will solve problems better. In 2021 we proudly onboarded one of Europe’s largest Analyst & Associate cohorts in PE, which is the most diverse we have had at Hg to date; consisting of 54% women and 54% ethnic minorities. Second, we have also established The Hg Foundation and are funding it with a percentage of our profits. The mission is to systematically allocate to causes that help underprivileged minorities acquire the skills to get into information technology and contribute to improved, quality employment opportunities.

Feinstein: It’s something that’s extremely important to us. It’s about casting a wider net than just those people that have exposure to banking, finance and private equity. We try to attract candidates who are not just from traditional core schools, and this includes internships, so they start thinking earlier about careers in these fields. We have also created the Vesey Street Partners Foundation that, because of our focus on healthcare, seeks to broaden access to healthcare among diverse groups of people.

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