Example of an investment in the Nordics

Funds of Funds Experts
Lower Mid-Market Experts

As we have seen in previous editions of the newsletter, in the Lower-Mid Market (“LMM”) segment of the private equity market, managers’ performance is often heavily influenced by whether their strategy is appropriate within the macroeconomic context of the country in which they invest. This is explained by the strong link to the real economy of those countries, as these managers are investing in SMEs, inherently more representative of the country’s economy.

Consequently, in order to choose those managers with the best strategies in their respective geographies, investors should have a good understanding of the structural situation in these countries, understanding in which direction their economies are heading and where the maximum value can be created with the least possible risk thanks to structural tailwinds.

Thus, to invest in a region such as the Nordic countries, it is important to understand the context of the economies of the countries in the region in order to find and select those managers whose strategies best fit that environment. For example, in Sweden, the government has decided to invest heavily in technology, not only by investing directly in the sector fostering its emerging companies, but also by creating an environment that values and encourages the development of companies. Therefore, if an investor is looking at funds in Sweden, it would make sense to look for managers who plan to exploit this situation to benefit from the tailwinds that promote industry growth while reducing investment risk with government support.

Clearly there are many funds that invest or plan to invest in technology, so the next step would be to narrow down the options and aim at specialist managers, i.e. managers that invest only in companies in the technology sector and therefore are immersed in the sector and prepared to benefit fully from the sector’s tailwinds. These specialists are better positioned than generalist funds that also benefit from the structural tailwinds in the tech sector, albeit only partially because not 100% of their portfolio is invested in technology companies.

In addition, within the funds specialising in the Swedish technology sector, it would be appropriate to narrow the search even further to those operating in the LMM, a segment with a better risk-return trade-off as a result of the structural mismatch between the large number of SMEs and the small number of managers competing for them. This lack of supply and demand equilibrium makes it easier to buy at more reasonable prices and favours good results without the need to use debt as a lever of value, further reducing the risk of operations compared to the higher segments of the market.

Finally, to finish narrowing down the universe of those who could be the best candidates for investing in Sweden, the ideal would be to reduce the search to those managers who, fulfilling the above characteristics, are regional, i.e. local, as these are usually those who i) know the country’s macroeconomic context best and ii) with whom SME sellers empathise and identify the most, who, being mostly individuals or groups of individuals, tend to trust local players more than large institutional investors.

At this point all that remains is to compare the funds in this universe and decide which, if any, are good enough to invest in. In our case, among the funds that met the above requirements there was one that caught our eye, a specialist manager with more than a decade of experience and four funds in the e-commerce & software sector in Sweden.

Having kept virtually the same senior team since the first fund, the manager intended to continue doing what had worked so well for them so far, investing in Swedish companies in the e-commerce & software sector that had high levels of growth and, preferably, a positive operating margin. Their strategy was simple, drive the company’s sales growth and, at the same time, implement operational improvements that would further boost the company’s EBITDA.

Figure 1: Value creation bridge for the manager’s Fund IV (its previous fund).

Having achieved an 86% proprietary sourcing, buying without competition and avoiding auctions, this is a regional manager that took advantage of its local character to access unique opportunities. Furthermore, analysing the manager’s sources of value generation we can clearly see how he sought to benefit from the particularities of the LMM, maximising the multiple arbitrage by buying at a discount to the average transaction in the sector and minimising the risk of the operation by taking minority positions in the companies without using debt, but guaranteeing control over the companies. In fact, as can be seen in the graph, instead of leveraging the company in the purchase to generate value by repaying it, this particular manager prefers to lever the company once things are going well to further boost its growth. As a result, this leverage may even have a negative effect on value creation.

Figure 2: Manager’s entry multiples benchmarked against its peer group of Qualitas Funds investments.

The process of filtering and selecting the best funds is not in itself too complicated for investors with a dedicated team. The complexity increases at the last step, where you have to go into a thorough comparison of funds and make the best decisions at the portfolio level. This is a time-consuming process and requires in-depth knowledge of the global private equity market as well as detailed knowledge of each market and its regional particularities.