Rising interest rates and the demise of Silicon Valley Bank and Credit Suisse have led to a paradigm shift in private equity and venture capital. Reji Vettasseri, lead portfolio manager at Swiss private finance group Decalia, believes investors now need to to be innovative with emerging strategies, carefully selecting ‘small cap’ firms to invest in instead of fleeing to the safety of larger ventures.
In this IO Talks podcast interview, Vettasseri discusses venture funding and private investments in the wake of SVB, the democratisation of private equity and the increasing importance of Luxembourg as a financial centre, also for Decalia.
The Swiss group was founded in 2014 and holds about 5 billion Swiss francs in assets under management. Through Luxembourg, it runs ten CSSF-registered sub-funds under a single Sicav, a dozen SCSp’s and a Raif fund. “The most important thing for Luxembourg to do in order to maintain what is its clear leadership now is to be efficient,” he said.
For investors, the recent shift in market conditions requires a new approach. In the higher interest environment, private equity investors are advised to consider investing in smaller companies which can be nimble and flexible, instead of the larger cap firms that provided spectacular returns during the era of low interest rates.
‘Smaller firms outperform where leverage is harder’
“When you go into an environment where leverage is harder, where some of the big deals dry up, the smaller firms actually tend to outperform, not just by their historic norm before the ultra low leverage years, but also even disproportionately relative to a normalised set of conditions, because they tend to have the ability to be more nimble.”
Vettasseri noted that larger cap investments are often used as a “flight to safety”, and noted that smaller firms find it far more difficult to attract funding than more established firms as they have a smaller investor base.
“Some of the best investors out there are actually taking exactly the opposite view from what perhaps is a trend in the market and saying, actually, this is the moment when I need to think, what is different about the world?” he said. “Where are the new opportunities as the world has changed? Where can I get real benefit from buying well from operational improvement, and not just from leverage? And that often points you towards smaller managers, and be people with innovative emerging strategies fit for the new paradigm we’re in.”
‘Market has not stopped’
The March 2023 turbulence in global financial markets triggered by the banking crisis has not brought the market to a halt, but it has made investors and financiers more cautious. “We need to be clear that the market has not stopped. This is not a financial style crisis, where it’s impossible for good companies to get funding. It’s just an extra level of caution beyond what went before.”
In venture capital and private equity, companies looking for funding were already pushing harder towards profitability as funding became more expensive due to rising interest rates. “The reality is that there is still some level of capital to go around. There are still investors who are out there wanting to take advantage of the lower prices. Just they need those terms to be different from where they were two years ago.”
The banking crisis has repercussions on a number of levels, he said. “We were saved from the worst of the damage, by the way that that was put into an orderly transition, particularly in Europe. And a lot of the companies who, frankly, at the time at that weekend, when everyone was uncertain whether the deposits would be saved, were in a real panic mode have now gone into a mode where they can breathe just a small sigh of relief.”
“But the reality is that you have plugged an important source of funding for the venture industry. And that is going to have some ramifications. First of all, it’s going to mean that people are just going to be more nervous about their ability to continue to raise capital.”
Highly-leveraged structures now harder
As for second round effects, it’s clear that the banking crisis has led to a pull-back in bank risk appetite. “That’s going to mean for the private equity industry, as has already been the case when interest rates went up, that the ability to do highly levered structures will be reduced before and people will need to focus more on buying well, operational improvement.”
In private debt, Vettasseri sees an opportunity to replace bank capital. “The same dynamic you had immediately after the financial crisis, which people talked about at the top of the cycle, but frankly, had petered off a little bit. It is now back, again, there’s a real need for that private capital to replace the banks.”
Vettasseri is upbeat about the democratisation of finance, making clear that this is about opening the doors to private investment opportunities for high net worth individuals, and not about mass markets. “What is actually going on in the democratisation of finance theme is that we are expanding private markets access to wealthy, sophisticated investors in a way that is safe and designed specifically to meet their needs,” he said.
Luxembourg is keen to play its role in this market now that the EU has upgraded its regulation for European long-term investment funds, known as Eltifs. Vettasseri believes that this new private market segment could reach 20 or 30 percent of overall assets under management within ten years.
‘Not really fair’
“Within that segment, absolutely, there is an enormous amount of growth, because a lot of people have been starved of this opportunity for a long time. It’s not really been fair. In the old days, you could get access to most of the economy through the stock markets. But increasingly larger portions of the world economy and including some of their best opportunities, particularly in the high-growth space have not been available to ordinary investors, has been a truly unfair thing.”
“That alpha has been something that’s only been available to a privileged set of institutional investors. It’s great that we’re opening up that and lots of retail investors want that type of product,” he said.
Luxembourg needs to make sure it can stay in the lead
Luxembourg has become a dominant place in European private equity markets, Vettasseri said. It needs to make sure it can retain that dominance by focusing on being innovative, efficient and easy to work with.
“Luxembourg is the location where all of the funds that we manage internally are based, and increasingly has a larger market share within the parties that we work with. Clearly it has benefited from the fact that certain jurisdictions have fallen out of favour. Obviously the UK, but also tax haven-style jurisdictions have also become more problematic over recent years.”
Swiss-based Decalia runs ten sub-funds under the Decalia Sicav umbrella, which held some 535 million euro in assets at the end of 2021, according to a filing. The firm also has registered about a dozen other funds, as SCSp’s and one as a Reserved Alternative Investment Fund, the Decalia Private Credit Strategies, which had some 45 million in assets at the end of 2021.
‘Be efficient’
“The most important thing for Luxembourg to do in order to maintain what is its clear leadership now is to be efficient. Clearly, the burden of regulation across the world is increasing. And we need that regulation for some of the reasons we talked about.”
“But we also need to make sure that when you have that regulation in place, it is being executed in the most efficient way. So Luxembourg is the dominant place in Europe for these types of services. To retain that dominance, it needs to rely not just on the fact that it isn’t other places, but on the fact that it can continue to be extremely innovative, efficient and easy to work with in the industry.”