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Private equity is one of the few asset classes that even outperformed public stocks during the bull market.
And the sector benefits from this outperformance, as 529 companies in this area raise total capital of 1.4 trillion US dollars over a period of 10 years, according to the annual HEC-Dow Jones Private Equity Performance Ranking 2020.
Dipanjan ‘DJ’ Deb is co-founder and CEO of Francisco Partners, the top performing sole proprietorship in this annual ranking. Deb sat down in an interview for the Delivering Alpha newsletter and revealed what keeps him up at night despite the company’s outperformance. The CEO also looked at where the company sees the most opportunities.
(The following has been edited for length and clarity.)
Leslie Picker: I know you can’t specifically discuss performance, but what do you think was responsible for this outperformance? What’s the secret sauce here?
DJ Deb: Of course, we have all benefited from a buoyant market and the technology markets in which we spend much of our time. But I would say we probably did three things that hopefully have helped us differentiate ourselves in the past and will continue to do so in the future. One is a focus within subsector technology. So we have 10 different vertical markets that we are pursuing, be it consumer internet, healthcare IT, network security or cybersecurity, FinTech or education technology. That is why we have partners who specialize in each of these areas. And we believe that sub-specialization is the key to success.
Second, we have an operations team of 35 people, almost 50 to 60 people. These are people we can try to help with any business, both in terms of optimizing a company’s operations and finding the best service cost portfolio. And third, our culture is a kind of relentless focus on perfection. Of course you never get there, but every day we wake up and say, “What are the 10 things we’re doing wrong?” We just had our annual meeting a few weeks ago and the first slide we uploaded was, “Here’s the year in review.” The second slide was “Here are the 10 things we do wrong,” and I think you need that focus to stay up front.
Picker: What do you think you are doing wrong What do you need to improve?
Deb: When I think about the past decade, probably the biggest mistakes we’ve made are all the deals we haven’t made. So it’s kind of an anti-portfolio. So we never thought that interest rates would go down and the stock market would go up like that. We also never thought that leveraged markets would reach the levels they are today. I would say we were wrong about software re-evaluations, software companies that used to trade at 8 or 10 times EBITDA are trading at 25 to 30 times EBITDA. So we missed all of that.
Today I think like I said, our focus on specialization is one of the great things. I think that sometimes leads to people getting into their swim lanes, and sometimes we need to take this broader view of things that don’t fit neatly into their swim lanes but can still be great investments. There are people in our company who are better sources and better portfolio managers. I think we have to constantly focus on getting people into positions to be successful. And so, the same people may not be the best person to make nuts into soup.
Picker: Right, and of course you know the saying in finance goes, “Past performance isn’t always an indication of future performance,” so where do you think what’s next?
Deb: On a high level. I think we strongly believe in the long term shift in technology. I tell all of our investors that technology is no longer vertical, but horizontal, it is ubiquitous. It’s changing every sector, every part of society. So when you look at whether it’s financial services, healthcare, or the consumer internet, it’s literally changing every part of society. I mean, you know, I have three teenage daughters. They don’t know what a physical check is. Everything is handled through payments on their phone, be it Venmo or Splitwise and the like. So that’s just a small sign. You know, when we watch TV in a hotel room, they ask, “Where’s the DVR?” And when I was growing up there was no DVR.
So these are just things that we take for granted today and that were only realized through streaming television, all of them, whether Netflix, Amazon Prime or Hulu, that didn’t exist five years ago. Technology literally eats the world. So we firmly believe in long term technology. You have to be careful. The markets are pretty frothy today so you have to choose. But in the long run, I think the trends are unstoppable. In the past 50 years, there has been only four fewer years in technology. That grew twice as fast as GDP.
Picker: Can you take the idea that you think the markets are frothy? Because I feel like things in the tech world, at least in parts of the tech world, have been going up for the past 10 years or so and yet in terms of evolution. And as you mentioned earlier, technology is becoming more and more ubiquitous. What does a species look like? Is there ever some type of reckoning that we see on a large scale?
Deb: It’s something we think about a lot. But it doesn’t affect our everyday lives so much in the sense that we are long-term investors, we buy companies. Usually we are control investors. Almost 80% of our activities are control investments and 20% are minority investments in which we are a large external shareholder. We’ve been wrong for five years. We thought the markets would have a fault. We think there are probably two areas of irrational exuberance, to use Chairman Greenspan years ago.
One of them is the late-stage growth stock where many of today’s unicorns are actually shaking the world up and earning their ratings. But probably 70-80% of them will have some sort of payroll day. They’re not all going to shake up the world, and people bring growth and quality together in the late stages of a bull market. And maybe we are in the final stages of a bull market – growth and quality merged. And so I think this actually presents opportunities for us down the line when some of these companies have declines in their valuation.
Picker: You also mentioned a second bag that you are currently seeing frothy?
Deb: Yes, the second bag is just software buyouts, especially large-scale software buyouts where I think the wisdom now is, “You can’t lose money on software.” By the way, software companies are amazing companies, they have a great retention rate and I think software is eating up the world as many people in our industry have said. But that doesn’t mean that ratings don’t matter. If you buy something 30x and leverage it 11x, you can lose money when the terminal multiples compress due to rising interest rates. And I think we are careful.
We are investing in what is known as a barbell approach. On the right side of the barbell, we buy companies that disrupt existing markets that we believe could be optimized. So we just bought Boomi, for example from Dell Software. So that’s on the dislocating side. On the left side of the barbell, we buy companies that we believe could in turn be converted under a different owner. We just bought a division from Raytheon called Force Point. So we’re following it on both sides.
Picker: What opportunities are you looking forward to the most at the moment?
Deb: I would say probably the two areas – and these are more or less industry-specific areas – these are mostly division carve-outs and founder-supported companies. Almost half of our work consists of working with founders. And in many cases the founder lets a business grow to a certain level and then decides in his own life that he wants to monetize most of his business or 60% -70% of his business and he wants us to try to help the company , take it to the next level.
That’s usually still 50% of what we do. Another 25-30% are division carve-outs like the Dell example I gave, the Raytheon example I gave. By the way, these are well-run companies, but the division is a kind of tail on the tip of the dog and does not correspond to the company profile. What we tell parents is addition by subtraction. If you part with this department, which is either growing more slowly or diluting the margin more than your core business, your terminal multiple will increase if you sell yourself to us. And that’s a speech we keep giving to many, many companies. I think it resonates. This is especially popular in a market like today, where people are more focused on sales growth than regularity, and most of the companies we run are focused on regularity.
– Ritika Shah, Producer at CNBC, contributed to this article.
