Before we begin, it is useful to briefly recap the conclusions reached in previous publications: i) The difference between the supply of SMEs and the demand from private equity in the lower mid-market (“LMM” or “Lower Mid-Market”) makes their risk-return equation more attractive than larger segments. ii) In the LMM, specialist funds generally offer better returns than generalists because they are industry experts and have access to better opportunities. iii) Regional funds tend to perform better than pan-European funds in the LMM as they have a deeper understanding of the region they invest in and enjoy a local advantage in accessing the best opportunities compared to pan-European institutional investors. iv) Emerging managers (novice fund managers with only one previous fund and few exits) often possess characteristics that drive them to achieve above-average results. v) Not all investment strategies work in all countries, so investors must have a good understanding of the context in each region to select funds with strategies that align with structural tailwinds and reflect the country’s macroeconomic reality.
Building upon these conclusions, which are supported by historical data but not absolute rules, we will focus on the last one and move on to analyze how we could select a good fund if we wanted to invest in France. We should start by narrowing down the options from all funds investing in the country to those that are regional, French, and operate in the LMM. Next, it would be advisable to analyze the context of the French market to identify structural trends and select specialist funds in those areas. Among these funds, we will analyze their historical performance, as well as various relevant metrics such as fund size, value generation levers in their strategy, and past transaction configurations. If there are interesting emerging managers, we need to assess whether they inspire enough confidence to invest in them by studying their previous experience.
Analyzing potential structural trends in France, policies aimed at protecting troubled national SMEs through institutions like CIRI ((Comité Interministériel de Restructuration Industrielle), appear particularly relevant. Established 40 años years ago, CIRI’s mission is to help companies with over 400 employees facing difficulties to develop and implement solutions ensuring their sustainability and growth. While this institution operates at the national level, there is also CODEFI, which operates locally and provides assistance to companies with less than 400 employees. Both institutions played a crucial role during the 2008 crisis. Additionally, the service sector holds the greatest weight in the economy, although the country remains a leader in other industries and sectors such as cosmetics, luxury goods, aerospace, and automotive manufacturing.
These two institutions that provide assistance to SMEs not only suggest that the government is likely to take measures to benefit or support companies facing difficulties, but also indicate that the number of such companies may be higher than in other countries. Therefore, a strategy of investing in special situations where assets and transactions have a higher level of complexity could work well in France.
It is considered a special situation when a company is being sold while experiencing some form of difficulty. This could be due to business model challenges (turnaround), inefficient management (underperforming), the risk of bankruptcy due to capital structure issues (distressed) , or simply when a part of a larger company has grown too much and its core activity no longer aligns with that of the parent company, leading to a decision to sell to a third party that is a natural owner of the asset (carve-outs).. Many transactions are also considered special when there are succession issues in a family-owned company that is not facing performance difficulties but heavily relies on a retiring founder and needs someone to assume management.
As we can see, each special situation is unique, which prevents the use of a generic strategy to address all of them. It first requires developing different strategies based on the type of situation and then adapting them to the specific circumstances of the company. While it is more challenging to define a specific management style for turnarounds, underperforming companies usually focus on increasing operational efficiency by streamlining production processes, avoiding redundancies in staffing, improving distribution channels, or, if possible, adjusting pricing strategies and renegotiating with suppliers to charge more and pay less or later. It is also common to replace the company’s management team with individuals who have prior industry experience and a good understanding of market dynamics. These strategies are typically employed regardless of whether the company is in a special situation or not because improving operational efficiency is a direct and clear way to generate value.
In the case of distressed companies, typical techniques involve implementing restructuring measures to ensure the long-term viability of the entity. This could include deferring debt payments, selling non-productive assets to repay part of the debt, or improving the company’s credit quality through capital injections. Finally, in carve-outs, if the existing management team does not continue because they remain with the parent company, a new team needs to be appointed. In such cases, the goal is to ensure a smooth and natural transition to independence. Often, companies decide to internationalize or, in fragmented industries, create value through inorganic growth by consolidating the market through mergers and acquisitions (M&A). The challenge with carve-outs lies in establishing a distinct culture for the entity that is completely separate from the one it had as part of the parent company.
Having identified what could be a structural advantage in the French market, the next step is to filter among the regional funds operating in the LMM and focus on those specialized in special situations, as they will benefit the most from this trend. In this case, the fund manager will not specialize in a particular sector, as mentioned in previous newsletters when referring to this type of manager. Instead, their expertise lies in a strategy: capitalizing on the special situations companies face to generate value, whether it involves changing the business model in a turnaround, implementing operational improvements in an underperforming opportunity, restructuring the company in a distressed situation,or facilitating the divestment transition in the case of a carve-out..
Special situations funds typically focus on specific types of situations, so the next step would be to filter and select those funds that focus on opportunities with a favorable risk-return profile. Additionally, it is important to consider that in this type of fund, the most crucial factor is the capability and experience of the senior team, who will likely be responsible for implementing the necessary changes to generate value. For example, an emerging manager who seeks to invest in distressed companies and has been founded by partners with prior experience in restructurings or distressed debt investments would be of interest.
In our case, after applying the filter, we found a regional and emerging manager who was launching their second fund with the intention of investing in fundamentally sound companies facing some form of difficulty. The manager would maintain the same strategy as its first fund, targeting underperforming opportunities, carve-outs, distressed situations, and consolidation plays – companies requiring market repositioning where the strategy involves acquiring small companies in a sector to consolidate them while increasing the size of the company. It is evident that special situations tend to have lower valuations than the market average, but this manager not only offered valuations below the market average but also below the average paid by comparable funds in this strategy, while utilizing lower leverage in its acquisitions. In other words, this manager maximizes a value lever characteristic of its operating segment, such as multiple arbitrage, while minimizing risk by using less debt.
Figure 1: Value waterfall of the manager’s Fund I (realized fund).
As observed, the value generated in the manager’s first fund was primarily driven by operational improvements. This is because the manager has a senior team that is highly familiar with special situations and adopts an approach that sets them apart from competitors. They directly manage the companies they acquire, as opposed to appointing separate management teams for each company or special situation. It is precisely this hands-on approach that is the main reason behind their ability to generate significant value and why Qualitas might have confidence in them.
Upon analyzing the manager, we can identify the following characteristics: i) they are a regional manager focused on the ii) LMM francés market, iii) they are an emerging manager, but with an experienced team that has demonstrated strong management capabilities, and iv) they specialize in a strategy that appears to benefit from structural tailwinds, such as government support through assistance programs that facilitate the management of companies in special situations. Therefore, it seems reasonable to consider this manager as a good candidate if seeking to invest in France.