Private Equity Q&A: David Fershteyn, Altera Private

The lower middle market in the United States has long been a fertile hunting ground for private equity investing. AlphaWeek’s Greg Winterton spoke to David Fershteyn, CEO at Atlanta, GA-based Altera Private, to learn more about his firm and its activities in the space.

GW: David, tell us what it is about the lower middle market that Altera finds particularly appealing.

DF: Like most professional investors, we are hyper focused on generating attractive risk-adjusted returns for our limited partners – the question is how do we achieve this? Our journey to focusing solely on the lower middle market started with us deciding what “game” we wanted to play, and then making sure our game had an increased probability of investment success. The most important factor for us in this decision was trying to identify where there is market inefficiency and why. The number of publicly traded companies has declined to ~4,000, while assets held by public equity funds have steadily increased. Billions of dollars chasing a shrinking, limited universe of opportunities (where there is much more transparency and analyst coverage) didn’t seem like the best chance of generating alpha for our investors.

On the other end of the spectrum are illiquid, private investments in the lower middle market – a market that is less transparent and a market where large capital allocators are structurally unable to participate. It doesn’t make sense for a $2bn fund, incentivized to deploy capital as efficiently as possible, to make a “small” $20mn investment. In addition to the supply/demand imbalance on the capital side, we found that return drivers in this part of the market were less correlated to large cap private and public investment strategies and less reliant on financial engineering.

Diligent lower market investors can still source a proprietary deal that isn’t being shopped around by an investment bank in a formal auction process. In the lower markets, having a strong relationship with a seller can translate into a meaningful value generation opportunity for a buyer. For larger assets, although the buyer and seller may have a relationship, the buyer will likely have to negotiate with an official board or executive team that has a fiduciary duty to maximize shareholder value. This often translates to more attractive purchase prices (likely requiring less leverage) in the lower middle market, which can generally increase the buyer’s margin of safety and the asset’s ability to weather different macroeconomic environments.

Once an investor finds a suitable opportunity, they can often immediately add value by taking care of “low hanging fruit” like implementing institutional best practices, creating a thoughtful budget, adjusting prices to market, hiring experienced executives, etc. Operational improvements like these can usually be executed regardless of the market environment. For larger and more mature companies ($100M+ in revenue), there is no “low hanging fruit” – i.e., the operational improvements have already been made and priced into the value of the asset. For these more mature, institutional companies, continued value creation requires much more complex strategies. And while it's certainly achievable, we prefer to execute on simpler strategies.

When large cap fund managers like KKR and Blackstone sell their assets, they typically have a smaller and limited universe of potential buyers to sell to due to the sheer size of the assets being sold. Contrast that with lower market fund sponsors – they typically have many exit opportunities to a larger universe of financial buyers and strategics for their assets. At exit, sophisticated lower middle market sponsors will run a true auction process and can tap into a large universe of potential buyers. These buyers, as mentioned above, are incentivized to deploy capital and often times have a lower cost of capital requirement. This often results in multiple expansion (or cap rate compression) at exit which can create additional returns.

We believe that investing alongside private lower middle market sponsors with the ability to access proprietary deals, obtain attractive valuations, create immediate value through simple operational improvements, and seek multiple expansion at exit is a prudent investment strategy. By focusing here, we can create differentiated sources of return for us and our investors.

GW: Altera’s clients are primarily high net worth individuals and family offices. What’s driving the demand for private equity opportunities for this cohort of investors?

DF: The demand for private investments among high net worth individuals and family offices has always been there. Investors understand that private markets can offer enhanced returns, greater diversification, and increased yields. Additionally, while illiquidity can certainly pose risk to a portfolio, it also makes it difficult for investors to make market timing decisions that are often driven by emotional responses. As Charlie Munger put it, "The first rule of compounding: Never interrupt it unnecessarily."

So, while the demand has been there, the issue for this investor cohort has historically been around access (or quality access). Often, private market funds have large minimums ($1mn - $10mn) that make it difficult to participate and/or build a diversified private portfolio. But even if funds lowered their minimums, high net worth investors would still be faced with additional roadblocks. To effectively underwrite an opportunity and understand the risks, an investor would need to spend months talking with the managers, benchmarking, doing legal reviews, background checks, etc. These are costly and time-consuming activities that would not make sense for a “small” $250k investment. Because Altera partly acts as a capital aggregator, the costs of our diligence are spread across the entire investment vehicle – making $100k - $500k commitments not only attainable, but more economical for investors. Investors who work with Altera can build a robust portfolio of 5 to 15 private holdings with $1mn to $10mn across private equity, real assets, and private credit.

GW: Your primary funds program allocates capital to both single and multi-manager funds in the lower middle market. What determines when you go the single manager vs multi manager route?

DF: The primary factor for whether we launch a single or multi-manager strategy is determined by the type of investment exposure we are seeking to create for our investors. What risk and return profile makes sense for our us and our investors? There are times where we may want concentrated exposure to a single fund manager that is executing an under-the-radar strategy, and we do not want to lose the benefits of this specific exposure by further diversifying. Other times, we may want to enhance the diversification of an investment strategy and allocate capital amongst multiple management teams and/or build in co-investment exposure. It’s important to note that our multi-manager strategies do not cross-pollinate various asset classes (e.g. an Altera multi-manager private equity strategy will not contain real asset or private credit strategies within it). This origination flexibility allows us to generate differentiated sources of returns and execute on unique investment ideas.

GW: Altera also has a GP stakes business; it’s a sector of the investment industry that’s seen significant growth in the past few years. What does Altera look for in these situations?

DF: Our GP solutions have primarily revolved around Co-GP’ing investment strategies. Because of Altera’s ability to anchor or be a meaningful LP in an emerging manager’s fund or direct deal (in addition to providing guidance around reporting, legal structuring, or back-office support), we can oftentimes negotiate to receive a portion of the carried interest – a benefit that we ultimately pass on to Altera LPs. We believe that by providing these solutions, we can create a more complete private market ecosystem.

We agree that GP stakes have recently gained broader interest. Many general partners have created significant amounts of personal wealth, so it’s no surprise that their businesses, the private asset management firms themselves, are attractive and profitable businesses – these are assets with contractual revenue streams (management fees) with additional upside potential (carried interest). Most of the investments in this space have been driven by the large players like Dyal and Petershill, who take ownership in established fund managers. We see tremendous opportunity to invest in smaller, emerging private asset firms.

From an underwriting perspective, the first step in a GP Stake investment looks very similar to a primary fund investment. We want to understand the motivation and alignment of the GP, their competitive edge, the sustainability of their strategy, etc. An additional step that requires more scrutiny revolves arounds the strategic plans for the manager beyond their first or second fund – understanding whether the manager truly wants to build a franchise, what hires will be needed to support the growth, the launch of potential new strategies, etc. The winners in this space will be those who can build strong, mutually beneficial relationships with emerging GPs, craft unique, creative structures that ensure alignment, and be a value-add partner from both a capital and strategy perspective.

GW: Finally, David, Altera has recently secured some growth capital of its own. What’s the plan for deploying that capital and how does the next 12-18 months look for Altera?

DF: Yes, we recently raised a strategic financing round for the business that will allow us to expand our operational capabilities through new hires on our investor relations and accounting teams, enhance our ability to launch new private market investment strategies, and further strengthen our corporate balance sheet to allow the firm to pursue strategic growth initiatives. Over the next 18 months, we plan on investing an additional $250mn in lower middle market strategies, managing our current portfolio, and continuing to deliver differentiated sources of return to our limited partners. We will also likely move offices as our team is growing and we need more space!

David Fershteyn is CEO at Altera Private