The lower middle market in the United States has long been a fertile hunting ground for private equity investments. AlphaWeek’s Greg Winterton sat down with David Fershteyn, CEO of Atlanta, Georgia-based Altera Private to learn more about his company and its activities in the space.

GW: David, tell us what’s in 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 get there? Our journey to focus solely on the lower middle market began with us deciding what “game” we wanted to play, and then ensuring that our game had an increased likelihood of investment success. The most important factor for us in this decision was trying to identify where the market inefficiency is and why. The number of publicly traded companies has fallen to around 4,0001, while assets held by public equity funds have steadily increased. Billions of dollars chasing a narrow universe of opportunity (where there’s a lot more transparency and analyst coverage) didn’t seem like the best chance of generating alpha for our investors.

At the other end of the spectrum are illiquid private investments in the lower middle market – a less transparent market and a market in which large capital allocators are structurally unable to participate. It doesn’t make sense for a $2 billion fund, incentivized to deploy capital as efficiently as possible, to make a “small” investment of $20 million. 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 find an exclusive deal that is not sought by an investment bank in a formal auction process. In lower markets, having a strong relationship with a seller can translate into a significant value generation opportunity for a buyer. For larger assets, although the buyer and seller may have a relationship, the buyer will likely need to negotiate with a formal board or management team that has a fiduciary duty to maximize shareholder value. This often results in more attractive buying 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 withstand to different macroeconomic environments.

Once an investor finds a suitable opportunity, they can often immediately add value by taking care of the “low hanging fruit” such as implementing institutional best practices, creating a thoughtful budget, l adjusting prices to the market, hiring experienced managers, etc. Operational improvements like these can generally be executed regardless of the market environment. For larger, more mature companies (over $100 million in revenue), there is no “low hanging fruit” – i.e. operational improvements have already been made and incorporated into the value of the asset. For these more mature institutional businesses, creating continued value requires much more complex strategies. And while this is certainly doable, we prefer to execute 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 due to the sheer size of the assets being sold. Contrast this with lower market fund sponsors – they usually have plenty of exit opportunities to a wider universe of financial buyers and strategies for their assets. Upon release, sophisticated lower-middle-market sponsors will run a true auction process and can tap into a vast universe of potential buyers. These buyers, as mentioned above, have an incentive to deploy capital and often have a lower required cost of capital. This often results in multiple expansion (or cap rate compression) on exit, which can create additional returns.

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

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

DF: The demand for private investments from high net worth individuals and family offices has always been there. Investors understand that private markets can offer enhanced returns, greater diversification and increased returns. Additionally, while illiquidity can certainly pose a risk to a portfolio, it is also difficult for investors to make market-timing decisions that are often driven by emotional reactions. As Charlie Munger said, “The first rule of capitalization: never interrupt it unnecessarily.”

David Fershteyn

So while the demand has been there, the issue for this cohort of investors has always been around access (or quality of access). Often, private market funds have high minimums ($1m – $10m) that make it difficult to participate and/or build a diversified private portfolio. But even if the funds lowered their minimums, wealthy investors would still face additional hurdles. To effectively underwrite an opportunity and understand the risks, an investor would need to spend months talking to managers, doing benchmarking, performing legal reviews, background checks, and more. These are costly and time-consuming activities that would not make sense for a “small business”. “Investment of $250,000. Because Altera acts in part as a capital aggregator, the costs of our due diligence are spread across the entire investment vehicle, making commitments of $100,000 to $500,000 not only feasible, but more economic for investors. Investors who work with Altera can build a robust portfolio of 5-15 private equity investments with $1-10 million in private equity, real assets and private credit.

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

DF: The main determining factor in whether we launch a single or multi-manager strategy is determined by the type of investment exposure we seek to create for our investors. What risk and return profile makes sense for us and our investors? There are times when we may want concentrated exposure to a single fund manager running a discrete strategy, and we don’t want to lose the benefits of that specific exposure by diversifying further. Other times, we may wish to improve the diversification of an investment strategy and spread capital across multiple management teams and/or create co-investment exposure. It is important to note that our multi-manager strategies do not cross-pollinate various asset classes (for example, an Altera multi-manager private equity strategy will not contain real asset or private credit strategies) . This origination flexibility allows us to generate differentiated sources of returns and execute unique investment ideas.

GW: Altera also has a GP holdings business; it is a sector of the investment industry that has experienced significant growth in recent years. What is Altera looking for in these situations?

DF: Our GP solutions have primarily revolved around Co-GP investment strategies. Due to Altera’s ability to anchor or be a significant LP in the fund or direct deal of an emerging manager (in addition to providing advice on reporting, legal structuring or backstop support -office), we can often negotiate to receive a portion of the interest carried – 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 holdings have recently garnered wider interest. Many general partners have created significant personal wealth, so it is not surprising that their businesses, the private asset management companies themselves, are attractive and profitable businesses – they are assets with contractual revenue streams (management fees) with additional upside potential (deferred interest). Most of the investment in this space has been led by big players like Dyal and Petershill, who are taking ownership of established fund managers. We see a tremendous opportunity to invest in smaller, emerging private asset companies.

From an underwriting perspective, the first stage of a GP Stake investment is very similar to an investment in a main fund. We want to understand the motivation and alignment of the GP, its competitive advantage, the sustainability of its strategy, etc. An additional step that requires further consideration relates to the manager’s strategic plans beyond their first or second fund – understanding if the manager really wants to build a franchise, what hires will be needed to support growth, launching potential new strategies , etc. Winners in this space will be those who can build strong, mutually beneficial relationships with emerging GPs, create structures that ensure alignment, and be a value-added partner from a capital and strategy perspective.

GW: Finally, David, Altera recently secured its own growth capital. What is the plan to deploy this capital and how does the next 12-18 months look for Altera?

DF: Yes, we recently raised a strategic financing round for the company that will allow us to expand our operational capabilities through new hires in our investor relations and accounting teams, improve our ability to launch new private market investment strategies and further strengthen our business. balance sheet to enable the company to pursue its strategic growth initiatives. Over the next 18 months, we plan to invest an additional $250 million in lower-middle market strategies, manage our current portfolio, and continue to deliver differentiated sources of return to our limited partners. We will also probably be moving offices as our team is growing and we need more space!

David Fershteyn is CEO at Altera Private