E288: Inside a PE Fund Ranked #1 in IRR, DPI, and TVPI

0:00You've raised$875 million in one of the most difficult fundraising markets in decades. How were you able to accomplish this? For us, it was a function of having the right time, the right strategy, and the right team. Our track record's been good. Leading up to the fundraise, we had been posting a lot of exits, a lot of very successful exits, and our DPI numbers had been great at a time when there isn't a lot of DPI. So the timing was really good. Our strategy resonated with investors as well. We focus on the lower middle market. We buy founder-owned businesses. We buy sub-10 million dollar EBITDA businesses.

0:30And we are a purchase price matters firm. And I think all of that story is resonating right now with LPs. We have a 45-person team, which is quite a large team relative to our fund size. And I think people love our team today. Every on-site diligence session that people do, we get complimented on the quality of our team. And I think it's a combination of those things, the time, the strategy, and the team that led to a great outcome. So Renovus, alongside being oversubscribed on$875 million, you're also ranked number one in terms of quantitative metrics like IRR, DPI, TVPI. What allows you to capture alpha in your fund?

1:02What's the secret sauce? It's a great question. Just a quick story. There was a morning in 2022 when we both woke up to having all these inbound emails from institutional investors, highly respected names from around the world who wanted to set up meetings with us. That's not what we normally wake up to. And we were wondering what was going on. And it turns out we had been named in one of these studies. This particular study, HEC Dow Jones Private Equity Report, is one that turns out to be very widely followed. You needed to have 10 years of track record in order to get into that study. Come 2022, we had built up 10 years of track record and have been in that study every year since then.

1:41So it's just been fantastic for us and helped to raise our brand and raise our profile, which has been great for fundraising. but it's also been great for recruiting executive talent to our portfolio companies, recruiting in young and very talented people who want to make their careers at Renovist. It's been an amazing momentum builder for us. But to answer your question, what is the secret sauce? You know, there's really no one thing in private equity. And we hear this all the time from founders considering selling their businesses. Every private equity firm looks the same. You know, we show up in our, you know, Patagonia vests and we look a certain way.

2:17and we're smart people, but from one firm to the next, are they different? And in some ways, we are like the others. We do LBOs. We do some business repositioning. We employ smart, competitive, driven people. So what is it that has enabled us to deliver the results that we've delivered for the investors? We actually, in last year's annual meeting for our investors, tried to answer this question for them in the course of our presentation. And what it really came down to was we put forward three questions for ourselves. What game are we playing, really? How good is our team? And do we have any special resource advantages?

2:52The game we're playing is about playing in the lower end of the lower middle market. Almost every deal we do is a sub $10 million without business. The number of at-bats that we see compared to an upmarket strategy, it is night and day different. We have so many more targets that we can pursue within our strategy. We are buying from founders. We're the first institutional investor. We're buying fundamentally solid businesses, but where there is so much value that an experienced institutional investor like us can have. So we're trying to play what we call the game on easy mode. I think that's been a big driver.

3:26In terms of the team, we have a big team. We mentioned that. 45 people. That is large, especially relative to the fund size that we have. One of those investments that we've made is we have a full-time director of people. That's become more and more popular in private equity. A lot of times, though, that people person focuses on portfolio companies. Our director of people spends all of her time recruiting, training, and ensuring that we're living out our cultural values and that people can make great careers at the firm. We also work with an executive coach. He works with the partners. He works at the levels beneath the partners.

3:59And so there's just a lot of investment when you add all that up and a lot of time and focus spent on building a truly world-class team. So I think the team is a special part of why we've been able to produce the numbers we've been able to produce. And we now have this kind of flywheel effect where we have stayed down market and focused on small businesses and have this vast network of people that are willing to talk to small business owners who are thinking about selling their business to private equity and can tell them, you should sell to these guys because if you roll a piece of your equity into the deal, it's going to do really well.

4:33look at how well it did for me. And so I think just the staying power that we have had in the market in doing this for 15 years and all the successes that we have has built a brand and a network of references that really is helping us to stand out relative to the company. Over those 15 years, what has compounded exponentially and what has compounded linearly? I won't be surprised to hear me say this. I'm so uber focused on talent. It's the part of the business that I like the most, I think that has really compounded exponentially for us. We have, we mentioned that we showed at our annual meeting, the series of slides about what makes us special and why we're able to produce great results.

5:12One of those things was all the boomeranging talent that we've had at the portfolio level. We had a page that was just focused on CEOs and founders who have done business with us on a repeat basis. And we have people on there that hadn't just done like two deals with us. They had done three deals with us and they'd all been successful. And I think when you're able to build that network of really good people who want to keep coming back into the Renovas ecosystem, and they happen to be friends and connected with really good and really talented people, and they're pulling their people in, I think that network effect is really special in Compounce.

5:42There are so many thoughts that come to me. One of those is our own evolution. When we started the business, we were really deal guys and had really good training and experience putting deals together. Over the last 15 years, we've elevated our role from just deal leaders to fund managers and from there to firm owners. And what that means is that as we've studied different models, we have become good at not just doing a great deal at the deal level, but delivering great fund products to the LPs where we are generating not just good deal returns, but good gross returns. And most importantly, great net LP returns by recycling capital, by using really innovative financial capitalization at the fund level.

6:35So those things have resulted in very significant growth in terms of the results that we've been able to produce. So that evolution obviously continues. And brand is something else that has had a pretty significant impact that 15 years ago, nobody knew who we were today. Thanks to all the transparency that third parties are bringing to our end of the market through rankings and through a lot of benchmarking, a lot of investors, not just here in the U.S., but globally, are able to find us. And raising capital has become a lot easier than it was 15 years ago. One of the hardest things of investing is seeing what's shifting before everyone else does.

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8:37So you have three main co-founders, Jesse, Autif, Brad. If I gave you 100 points in terms of what drives the company, how much comes from the three of you versus your hires and this machine that you built in terms of talent? That's a great question. For the first fund, it was really the three of us that did everything. We raised the fund. We sourced all of the deals, executed, did the portfolio management work ourselves. And so certainly all 100 for fund one. And the goal has been to shift that down over time. And we have been very successful in doing that. Now we think of ourselves, really, we've gone away from being players.

9:12We're still playing, but we're playing player coaches. And we've organized the firm with the specific intention of enabling really good and talented people, coaching them up, working with them, developing them, and seeing them spread their wings and being really successful. And now we're at a point of our own individual careers where nothing makes us happier than seeing people get it. I was saying just as we were kicking off the podcast that we just completed an internal call where we announced all of our internal promotions for the year. I mean, it was kind of an emotional event for many of us.

9:44Like there is great pride in seeing the people beneath us succeed. Was that something that was difficult to cultivate? There's a lot of learning that goes as you build a firm. As investors, you take a lot of pride in putting together the best deal possible, the best financial structure, the best executive team, and doing both financial and operational engineering to get to a great outcome for the investors. This is something we take so much pride in and that becomes a DNA. But when you are building a firm, it's not about the best deals you do. It's, again, delivering a great fund for the investors.

10:23And that means not just doing your job well, but creating an environment for your team members. Fund one, as I mentioned, it was just the three of us doing the entire thing. And that was a function of starting in 2010, it took us two solid years just to get into business, no paycheck. And so we were really careful with our management fee dollars in the early years of the fund. fund two comes along, we start bringing in some institutional investors. In fact, our largest institutional investor in fund two is still our largest institutional investor today. And they asked us a really simple question, when are you guys going to start building the team?

10:58And they were walking us through about like why we should do this, giving us comfort. Hey, you're going to be around for a while. And Atif says this sometimes, some of these institutional investors, they believed in us more than we believed in ourselves. And that helped get us started on really investing and thinking about Renovus as an enterprise. And we have so fully embraced that, you know, 10 years later, after our second fund was raised, that today, this is what we have. We have a large team. We have a director of people. We work with an executive coach. And so it has been a gradual thing, but we've gotten some great advice that's helped us, you know, make that transformation that we very much needed to make.

11:35That's my heuristic for who you want to surround yourself with people, people that see more new than you see yourself. And similarly to that, I look at the heuristic of who you want to hire is somebody that is going to do things that you never even imagined. So you bring somebody in, not only do things as good as you or even better than you, but come up with things that you didn't even think about. Absolutely. This concept, I think like Netflix popularized it of talent density. You have a talent dense organization that just raises everyone's game. I think our people, our best people. They're raising his game.

12:06They're raising my game. It is awesome to have people around us, even if they're less experienced, but you just see their passion and competence. That makes everyone better, including us. Talent that we are hiring, they have a lot of new ideas, new competencies. They're better at AI than we would have ever been. So we've learned so much about AI adoption within our firm and how we can push that out to a portfolio companies from one of our associates. So yes, there is this flywheel effect that Jesse was talking about. You learn from your junior people. They learn from you. And in a way, what we talked to them about is that we are looking to bring in more entrepreneurs in the firm, not more managers.

12:49And we're also constantly screening people, not just for their pedigree and resume, but for their potential. How do you do that? How does a fund manager go about sussing out, I guess somebody's soft skills or somebody's future talent versus their track record of completing tasks. This is spending time with them and having a good sense of who you want to bring into the firm and who you do not. Jesse was mentioning to you our chief people's officer. She's someone who had never done any HR work. Jesse got to know her through his time with his local church. And she had such amazing people skills that Jesse kept talking to me that we need to bring her on.

13:30And when Jesse approached her a couple of times, she said, no, the person who was running our IR was actually an asset manager at Vanguard. But we saw in her the passion, the detailed orientation, which many times you don't see in other IR people. So we are really screening for attributes, not for people's backgrounds. And when we are hiring our people, we tell them the first couple of years are on us. Even when we are hiring who you may consider plug and play investor who comes from a brand name private equity firm, we say to them, look, we do things slightly differently. We pursue the same kind of deals that you may have been at your firm, but we are operating at the lower end of the market.

14:13We have more of a valuation discipline that you may have seen at your firm. We are willing to do more volume that you may have seen at your firm. So it is, and it takes them at least a year, but once they get it right, they really start to perform and become believers in that model. When you want more, you start your business with Northwest Registered Agent. They give you access to thousands of free guides, tools, and legal forms to help you launch and protect your business all in one place. With Northwest, you're not just forming an LLC, you're building your complete business identity. From what customers see to what they don't see, like operating agreements, meeting minutes, and compliance paperwork, you get more privacy, more guidance, and more free resources to grow the right way.

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15:27And with Northwest, privacy is automatic. They never sell your data because privacy by default is their pledge. Don't pay hundreds or thousands of dollars for what you could get from Northwest for free. Visit northwestregisteredagent.com slash invest free and start using free resources to build something amazing. Get more with Northwest Registered Agent at northwestresortatoragent.com slash investfree. And I want to get into your portfolio construction later, which I think is fascinating. But on the LP mix, you mentioned that that institutional investor came in fund two, and now they're one of the larger investors.

15:59How has your LP mix evolved from fund two to fund four? When we started in 2010, it was right in the midst of GFC, and there wasn't any capital available for first-time managers looking to start a blind pool of capital. So through Jesse's research, we stumbled upon this program run by the U.S. Small Business Administration called the SBIC program, except that that program was really for mezzanine investors and for people who had a lot more deals on their track record as we did. But the best thing about that program was for every dollar of capital you would raise from third parties, the program would give you two additional dollars of capital.

16:42So essentially, the U.S. Small Business Administration became our largest LP in our fund fund with 67 % of capital coming from them, and the rest primarily coming from family offices and high net worth. So fund two is really when we made the transition, not complete, but beginning to make transition from that investor base to bringing in a large university endowment, insurance companies and start building that base. To our last fund, Fund 4, where instead of the SBA being 67 % of our capital is less than 20, we've been able to retain all our large accounts and really proud of the 130 % re-up rate from our existence.

17:28meaning investors who gave us$500 million in Fund 3, not only they've kept that investment with us, but on top of that, they've given us another$650 million. So we've been able to keep our existing, but expand the LP base and over time diversify a base from the capital that we've been receiving from the SBA. As I mentioned, you were overscribed. There's a lot of demand. How did you pick and choose which LPs you wanted to add to Fund 4? So how did we select our LPs? So I would say it's a matchmaking process. Obviously, our existings are the ones who know us best, and they always have the first tips at the available capital that we're looking to raise, and they came in very, very strongly.

18:12So they filled up most of the capital need that we had. And beyond that, we've been very strategic. There are certain areas and certain types of capital that we think could be a base for our long-term success and growth. So we brought in one large state program, and we feel that could be a way for us to build that type of investor base. For the first time, we went outside the U.S. and got a number of high-profile institutions and family offices in Europe and the Middle East. We think that we can significantly expand that. So while availability was limited, we used those limited slots to bring in what I would consider strategic investors who can really help us grow our capital base.

19:00And that's just geographic diversification. The new investors, largely people, like we're very confident that the capital base is going to be stable over a long period of time. And to your point, it's not just the relationship with the person, it's also the quality. I just interviewed the former CIO of UTEMCO, the second largest endowment in the world. And I learned they're going to be the number one largest endowment in the next 10 years because they get one and a half,$2 billion from the state of Texas from oil reserves every year. So kind of knowing where what's going on with the underlying capital base is also really valuable versus a pension fund that might be overfunded or other pools of capital, otherwise great relationships, but they might be in a difficult situation from capital base.

19:37Absolutely. So one of the most interesting parts about your fund is your portfolio construction. Tell me about your portfolio construction and how did you come about with this unique structure? Our portfolio construction has a number of attributes. First, we believe in starting out small and over time building our position. So if we are looking to invest$100 particular business, we must start out at 50 or less. And over time, as we professionalize the business and we scale the business through acquisitions, we put in more capital. So building position over time is the first thing that we think about.

20:17Secondly, because we operate not just in the market, but at the smaller end of the market, we look to create a diversified portfolio for every fund. And so we have typically around 15 or so active positions per fund. If we have early wins, we give the profits to our investors, recycle the cost basis, so have some of our capital make return more than once. And through that, we end up investing on average 120 % of the LP capital. And for that capital to have a compounding effect on the overall net returns of the fund, This helps us keep the spread between growth to net return for investors low and overall deliver a really good fund product for the investors.

21:08You guys have figured out what private equity has taken a long time to figure out, which is if you have a great company, why are you selling it four or five years later to your competitor? We're going to keep on investing and helping that company grow. I'd like to say that we figured it out right away, but it actually is a learning of ours. Autif talks, likes to talk about our both our worst deal and our best deal we ever did. It was in a company called Red Nucleus. And this was done out of our second fund, which is a great fund. But it was a business that we bought with$4 million of EBITDA. We took it to$12 million of EBITDA and sold it, did very well for our investors.

21:37And then that company continued to grow significantly after we exited with the team that we had put together, with the strategy that we had been executing. As we've grown our knowledge and grown our confidence by observing what upmarket GPs are doing, we've realized that we're able to do this. And so now there's no kind of dogmatic approach on our part that says, OK, when you double the EBITDA, now it's time to exit. And as a result, we have a business that started with four of EBITDA and today is 50. We have another one that started at three and today is 90 of EBITDA. So I think that's actually a practice that we're proud of today and we think makes a lot of sense.

22:13But it's one that has been a learning of ours over time. But in these investments, not only that we're growing our EBITDA, we're improving the quality of our businesses. So we make as much money from growing the EBITDA multiple. So we, on average, have been able to buy these smaller businesses for mid-single-digit EBITDA multiples, and we sell them at teens of multiples. So that has a compounding effect. Family offices have been doing this for decades. I spoke to Sam Zell's partner, Mark Sauter, who continues to run his foundation's family office. also Brent Bishore, he's in the Midwest, he has a 30 year fund where they figured out that a, first of all, if you make a fund that lasts longer, you're making decisions over a longer time horizon, you actually build healthier businesses.

22:56If I asked you guys to flip something in three years versus holding it for 10 years, regardless of, you know, how good of a guys you are, or your incentive is just going to be to build a fundamentally different business. What's corrupted that process historically is these two to three year fund cycles, You always want to be showing momentum. So everybody ends up owning slightly worse versions of the business downstream because of these like short term over optimizations. There's a lot we could talk about here. I think a lot of private equity has become what we say internally as investment banking.

23:27Plus, there's a very short term orientation that's kind of crept into the industry. And it's not just among the GPs, managers, the executives, the C-suite executives, you know, throughout the economy. I mean, they're now all trained to think this way. It's like, okay, I'm going to get hired. I'm going to exit in two years. And then I'm going to be on to my next private equity thing. The next thing I find. And I actually do think that if you can get your LPs to support this and you yourself can think differently, there's a great opportunity if you can be a little bit more long-term. Why do founders lower their valuation in order to partner with you?

23:57So selling a business by a founder is perhaps the most difficult decision they ever have to make at a professional level. It is an emotional decision. It is a game changer financially for them. So they are very diligent about it. They look for a number of things and price is just one of those things that they look for. First of all, they look for a counterparty, meaning a private equity firm like us, that is transaction worthy, an entity that understands that business has sector expertise, that has a really high close rate that once we sign on a piece of paper that we are interested in the deal, that we would get to a closing of the transaction.

24:42So they care deeply about those things that the counterparty they are dealing with is transaction worthy. And that is one area where as of late, private equity has gotten the bad rep, justifiably or unjustifiably. So we position ourselves as not just another New York-based LBO shop, but rather a founder-owned, founder-led firm that is based in Philadelphia and on location. We use it as a strategic advantage to give the message that we are a different type of a firm and we understand what it is to run a small business that's looking to become a mid-sized business. Beyond that, they do care about price.