The largest risk in Private Equity

Louis Flamand: The biggest risk is clearly team risk. According to the Private Equity database, the worst vintage in LBO history is 2005 or 2006, because these funds were typically invested before the great financial crisis that followed the collapse of Lehman Brothers. In short, the entire portfolios of these funds were invested 1. at high valuations, 2. highly leveraged and 3. Often in cyclical sectors, and their entire portfolios then suffered the full brunt of the crisis. Nevertheless, it's worth noting that this vintage's performance is in the 8% range of net IRR. This means that no vintage has generated median returns that are negative or even below 8% net. But this obviously doesn't mean that you can't lose money investing in a Private Equity fund, because the figure I've just given is just a median. The most frequent reason for a negative return is a serious team problem. When I started in fund-of-funds in 2007, the performance of small funds in the Lower Middle Market in Southern Europe was excellent. We had just gone through a buoyant economic cycle, with a lot of capital transfer from northern to southern Europe following the creation of the euro. Many investors were fighting for an allocation to the best LBO funds in the Italian and Spanish Middle Markets. When the financial crisis hit, followed by Europe's sovereign debt crisis, the existing portfolios of some of these funds were hard hit.

Louis Flamand: These kinds of difficulties automatically create tensions within the teams of these managers, and in some cases, these tensions lead to the departure of key men. If you're an independent team of just ten investment professionals managing a small fund, and one or two key partners leave, it can really literally blow the team apart. This is what really happened to a number of funds during the crisis. And in that case, the risk of capital loss becomes very high. That's why our strategy at Altaroc is to minimize this risk as much as possible. As I've already explained, we only target funds over 1 billion in size, managed by solid, institutionalized organizations, with large teams of at least 50 professionals who have to survive the departure of one or two key men. However, this does not prevent us from covering the lower end of the Mid Market, which is often covered by smaller funds managed by smaller teams. In particular, we cover it via Lower Middle Market funds that are part of large Private Equity platforms. For example, Altaroc Odyssey 2022 is an investor in the LBO funds HG Saturn 3 and HG Genesis 10 managed by HG Capital, and Altalife is an investor in the smaller HG Mercury 4 fund. This Lower Middle Market fund has a much lower risk as part of the HG platform than if it were totally independent.

Louis Flamand: Indeed, if one or two key partners were to leave this fund, the manager could transfer resources from these larger funds to this smaller one, thus solving the team problem. These funds therefore have a much lower risk profile than an equivalent totally independent fund, and also offer a better return profile, as the team benefits from the established processes, sector and operational expertise of the large Private Equity platform of which it is a part. Our due diligence is also obviously aimed at minimizing this team risk, by meeting all senior members of team 2, validating the cohesion and good understanding between members of team 3, ensuring that there is a shared vision of the firm's strategy and that the management company's carried interest and shareholding are shared fairly and transparently between those who generate the most value in the firm, and finally by making sure that we fully understand the reasons for any departures of good performers, that we fully understand the firm's recruitment strategy and integration strategy, by measuring the job satisfaction of key members of the firm, by validating the reputation of each key member of the firm, by ensuring that the younger generations are happy, with real prospects, and finally by ensuring that the key men of the firm invest significant amounts of money alongside us.

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