By Steven Leistner, HGGC
Amid a humbling market, as GPs and LPs search for stable footing, conventional wisdom suddenly appears less sturdy. Flexible investment strategies shine in these tough markets by adapting and performing despite the conditions.
Tried and true strategies can be challenged when the enabling macro backdrop is upended. Consider the proliferation of software buyouts or high-tech growth equity. Historically low interest rates, hot public markets, big LP inflows, and other dynamics fueled returns and popularized these approaches. As the enabling factors change, these specialized portfolios may encounter strong unforeseen headwinds that are difficult to mitigate.
Flexible strategies adapt to changing conditions. They invest across industries, employing creativity and rigor in sourcing, underwriting, structuring and value creation, all to succeed in a turbulent market like today.
Before executing this strategy, firms must communicate to LPs their vision and the value of a flexible approach early and often. This is essential to overcome inherent biases and build confidence and trust among all investors as the profile of the firm’s investments changes to match the market opportunity. While some LPs may be skeptical about this flexible approach, LPs who have heard the message will see a firm that is executing its stated strategy versus a firm without direction. To get true buy-in from LPs it is important to show the virtue of this dynamic approach across several aspects of the business.
Versatility & prioritization
Flexible strategies allow for an adaptive response to valuation conditions and the associated opportunity set. Asset prices in varying sectors and sub-sectors get overheated periodically, and a narrow mandate is a mandate to deploy regardless of the attractiveness of valuations in that area. Flexible managers are advantaged in their pursuit of excellent all-weather returns.
Further, lines are blurring between industries, and many opportunities benefit from a multi-disciplinary approach to underwriting and value creation. Understanding common characteristics of businesses across sectors can broaden the opportunity set.
Flexibility allows an investor to align a value creation thesis with both a relevant company and valuation conditions. The flexible investor can respond by prioritizing situations where there is opportunity to get paid for differentiated access, insights or capabilities.
Capital structure flexibility – specifically diversifying the risk of financial leverage – is similarly beneficial. Focused leveraged buyout strategies are often heavily exposed to rising costs of debt, which can depress both near-term cash flows and exit valuation multiples. Flexible strategies can feature a mix of low-leverage and un-leveraged investments where returns are driven by organic value creation that is less reliant on persistence of specific capital market conditions.
Shared control transactions done in partnership with a founder or another investor and minority investments – accompanied by an acceptable form of control and influence – are two additional tactics to broaden the opportunity set. The very best companies are often not “for sale.” Creative and flexible transaction structures can create access to those opportunities, sometimes at more attractive valuations.
The volatility of the public markets offers unique opportunity for flexible firms positioned to capitalize. PIPEs (private investment in public equity) enable investment into public companies that are not for sale and even at times where the public share price might be meaningfully disconnected from fundamental intrinsic business value. “Toe-hold” investments in private or public companies allow a deeper understanding of the business in advance of a buyout transaction. “Take private” transactions can catalyze change and value creation that was not possible under the short-term eye of the public markets.
Making it work
Executing the flexible strategy is difficult. A few specific requirements make it possible.
The first is culture. Intellectual honesty, humility, passion for investing and for learning, diversity of perspectives, teamwork and collaboration create the necessary conditions for exceptional investing through a flexible and dynamic approach. Organizational design and compensation need to mirror these values to bring them to life. A collaborative spirit in pursuit of excellence attracts exceptional people to build value together.
Second is talent. The best flexible investors combine rigorous “hard hat” diligence, creativity in problem solving, strong interpersonal skills and a nose for value. These professionals thrive with a flexible mandate in the right supportive culture, but are hard to identify, attract, train, and retain.
Third is rigor of underwriting and process. A creative and flexible approach demands the balance of rigorous underwriting and diligence. Culture and talent are the bedrock on which the underwriting machine is built.
While less commonplace, an opportunistic investment strategy predicated on flexibility, creativity and dynamic specialization, with the talent and vision to do things differently, can optimize capital deployment as economic conditions change. This approach acknowledges and respects the extreme uncertainty of our world, with the steadfast pursuit of exceptional returns through all seasons.
Steven Leistner is a partner and co-chief investment officer of HGGC