Is the lower middle market the key to private assets alpha?

Nitin Gupta, Managing Partner and Co-CIO of Flexstone, believes that every investor in private assets should have an allocation to the lower middle market as it drives both portfolio diversification and alpha. He says that this lower middle-market focus, along with Flexstone’s relationships and access, due diligence and investment process and strategy all combine to give Flexstone its enviable track record of never losing money on any of its funds, over its nearly 20-year track record.

Nitin has been working in private markets for nearly 30 years, 16 of these at Flexstone, and in this wide-ranging podcast he talks to Louise Watson from Natixis Investment Managers about:

• How he first started in investing and why he chose private markets and Flexstone (3min 12sec)
  
• Flexstone’s focus on the lower middle market and its investing ‘special sauce’ (7min 2sec)
  
• The best and worst investments in his career and what he learned from them (10min 30sec)
  
• The growth of private assets and whether there is a bubble (17min 24sec)
  
• Why Flexstone invests in everyday, ‘boring’ businesses (19min 48sec)
  
• How Flexstone adds value to the businesses it invests in (22min 50sec)

This podcast was recorded in December 2024.

Lightly edited transcript

Louise Watson: Hello and welcome to Navigating the Noise, a podcast by Natixis Investment Managers, where we bring you insights from our global collective of experts to help you make better investment decisions. I'm Louise Watson, and today I'm joined by Nitin Gupta from Flexstone Partners.

Nitin is one of the managing partners at Flexstone and is also the Co-CIO. He's based in New York and leads Flexstone's US investments while also sitting on Flexstone's Global Advisory Investment Committee, working closely with the Flexstone teams around the world. Nitin and Flexstone are private markets specialists—an asset class that has been growing very quickly and taking up a greater share of many investment portfolios.

I'll stop there and bring in Nitin now, as I know he has a wonderful ability to explain complex subjects simply, which I think is often the mark of a true expert. So, Nitin, it's great to have you on the podcast. Welcome.

Nitin Gupta: Thank you, Louise, and thank you very much for the kind words.

Louise: I always like to start these podcasts uncovering a personal element about our speakers. When I was in your office recently, I learned that you are a lifelong Yankees fan and a huge baseball fan. You’ve got some really interesting quotes up on the wall in your office from the likes of Babe Ruth and Mickey Mantle. I thought you could share one of those with us before we get started.

Nitin: Absolutely, you're right, Louise. I do love baseball and the Yankees a lot, although I’ve got to say this year, you know, while they got to the World Series, they played absolutely terribly and gave the Dodgers a lot of extra outs, which, you know, when you play a great team like the Dodgers, you just can’t do that. Unfortunately, they just didn’t play crisp baseball and lost. So hopefully next year is better.

But you know, you asked for a quote, and actually, I have a quote from Yogi Berra. He was amazing in his own right, but he was often overshadowed by the likes of Babe Ruth and Mickey Mantle and DiMaggio. If you look at his own stats, he was really just an incredibly gifted player. He’s a Hall of Famer, and one of his quotes that I love is, “Baseball is 90% mental, and the other half is physical.”

It’s just incredible because, you know, you always talk about baseball and sports in general, kind of the bigger you are, the better you are at something. Whereas, you know, it’s comedy. It’s a typical Yogi Berra quote, right? 

Louise: It's such a great lesson to apply to this asset class, isn’t it?

Nitin: Absolutely. I mean, I think, you know, we're always learning from our investments, but it really is about how you approach investing and how consistent you are, which is what Yogi Berra was throughout his career.

Why Nitin first started investing and chose private markets and Flexstone

Louise: That's great. Thanks for sharing that, Nitin. Why did you first become interested in investing, and why did you join Flexstone?

Nitin: So, you know, to be honest with you, when I was at university doing my bachelor's, I didn’t know what private equity was. I liked finance and accounting, so I ended up majoring in it when I was at NYU Stern. Being in New York and being at Stern Business School on the undergrad side, you know, you become very exposed to financial markets generally.

After graduation, I started off my career in the M&A group at Merrill Lynch, where we were advising Fortune 500 companies on M&A transactions. That’s when I first got exposed to private equity because I was working on various projects and pitches where we were working on M&A ideas for the likes of Clayton, Dubilier & Rice, JLL, Joseph Littlejohn & Levy, and some of these were larger firms. We were always pitching ideas to them, and that’s when I started to learn about private equity and what they do.

After I finished my analyst program at Merrill Lynch, I joined a private equity fund in 1997 called McCown De Leeuw, which was a middle-market buyout fund that was started all the way back in 1984. They were one of the first to actually incorporate the operating partner model back in the 80s and 90s, whereas now it’s become much more commonplace where every private equity fund has something similar to that. We were really at the forefront of that.

I did that, and then I got my MBA at Harvard Business School and joined another middle-market buyout fund, Saunders, Karp & Megrue, which then merged with APAX Partners out of Europe. I joined Flexstone about 16 years ago. What attracted me the most about Flexstone was this philosophy of the firm around lower middle market, which is where I’ve spent all of my career in private equity. While we’re part of a much larger institution in terms of Natixis, the firm still maintains that partnership model and feels very entrepreneurial and independent. The quality of the team, I would say, here is tremendous, and throughout my career, I’ve never seen the level of diversity that we have at any other private equity fund.

Louise: It's an amazing career journey, Nitin, and so interesting, the level of expertise that you've managed to uncover throughout that long career, and now that you're at Flexstone - another great company. For those of our listeners that don't know Flexstone very well, what is it that you do?

Nitin: At the heart of it, we create customised solutions in the lower middle market for our clients. We provide them with customised access to private equity funds. We raise co-investment funds and we raise secondary funds. Now, our clients can access the larger funds themselves. So if you wanted to invest in any of the mega funds, you could probably do it yourself.

But the lower middle market is very different in the sense that there are thousands of smaller funds, and those funds aren’t travelling globally to raise capital. Whereas if you look at the number of mega funds, it’s a bit more limited, and they’re global.

Flexstone's investing 'special sauce'

Louise: And what's the special sauce at Flexstone? The thing that you're most known for?

Nitin: So, you know, I would say in terms of special sauce, it’s just not one thing that makes it special; there are a number of things, right?

• One is really our global lower middle market focus. You hear a lot of firms talk about investments in the lower middle market, but it really depends on how you classify them, right?
  
  So when we invest in funds on our SMA side, we would classify funds that are about a billion and a half or less as lower middle market, whereas many of our competitors would classify funds that are 1 to 5 billion as middle market. Similarly, when we talk about co-investments, approximately 97% of our investments are actually less than a billion and a half in enterprise value, and within this, the vast majority are less than 500 million.
  
  So I think this definition is really important when investors talk to different private equity funds and they say they do middle market. So that’s really your special sauce: how we define it. This really goes back to the fact that the principals here at Flexstone, all of our partners, have a long-term history in private equity. So we’ve sort of stuck to this old definition of private equity and middle market rather than just grow with the market where now large funds are classified as middle market by our competitors. So that’s sort of one.
  
  
• Two, I would say, is our relationships and access to top funds and co-investments in the lower middle market. Again, these funds aren’t out there raising billions of dollars, so access is really important.
  
  
• Three, I would say, is our diligence process that has allowed us to not only deliver consistent top returns but also do that at a very low loss ratio, which is a third of what the industry loss ratio is in private equity. That process that we have is very consistent across geography, and we follow the same process going back to the history of the firm.
  
  
• Four, I would say, is that it’s not that we’re trying to hit home runs and have a bunch of strikeouts. You may win some games that way, but to consistently win, you really need to hit singles, doubles, and triples. We saw that in the World Series also, where the Yankees were often looking at hitting home runs, and they just couldn’t do that. Now, comparing it to our funds, you know we target 2X type returns across our funds with low volatility. So what we are doing is really creating a fund and creating a strategy where we give our investors consistent returns fund after fund in a market where the persistency of returns is actually decreasing. We’ve been able to consistently do this fund after fund.
  

And I would say lastly, since we started the firm, we’ve never lost money on any of our funds throughout various market cycles and various geopolitical headwinds. I would say that’s really driven by how we approach investing in private equity, and that’s been our special sauce since we started the firm.

Nitin’s best and worst investments and what he learned from them

Louise: You mentioned the long history of the firm. I'm interested in how you've changed over the years. What have you learned? Can you tell us about one of your best investments and one of your worst investments? What have you learned from those?

Nitin: So we are always learning. Definitely Louise, that’s part of the fun of the job, because every investment is different, and every company is different.

At our core, we’re still making the same types of investments that we made when we started the firm. Now we’ve seen many private equity funds grow much larger over the years and drift away from their core strategy and what made them successful because they were simply out there chasing larger funds and larger fees, whereas at Flexstone, we’ve really stuck to our lower middle market focus throughout with no strategy or style drift.

You asked me about our best investment and our worst. I would say our best investment was in a company in the US that was a research site focusing on Phase 2, 3, and 4 clinical studies for pharmaceutical companies. During our investment period, the company’s EBITDA grew threefold, mostly organically and through some small add-on acquisitions.

It was a typical Flexstone thesis of investing in mission-critical businesses. Clinical sites are extremely critical for pharmaceutical companies in order to validate new products and new drugs. We did add-ons, which is again a big part of what we do—buy and build. We exited it to a larger private equity fund, which again is core of what we do. Most of our companies are sold to larger private equity funds or to strategic investors, not really through the IPO market. This was a great investment where we made over six times our money. But that doesn’t mean every investment is like that.

To your question about our worst investment: our worst investment was in a pizza franchise business that had been around for a long time and focused on a low-cost, all-you-can-eat pizza buffet concept. What we liked about the business was that more than 80% of the business, about 85%, came from dine-in sales. As a result, the company wasn’t impacted by lower price delivery models like Domino’s or Pizza Hut in the US. The business had a really long history and had gone through the 2001 recession and the 2008 global financial crisis, and each time it came out of it pretty well in terms of having more or less flat EBITDA during those years because of its low-price buffet concept. We were investing in the company with a private equity fund that had particular expertise in the food side, especially in investing with franchise businesses, which is what this company was. So again, this was within the sweet spot of that GP.

However, what the business never experienced—and we never considered during our diligence—was a pandemic. The same strength of the business, which was their dine-in sales, turned out to be a curse during the pandemic as they had to essentially completely pivot their business model from dine-in to delivery. Unfortunately, the business was unsuccessful in transitioning quickly enough, and we lost the company.

Louise: The pandemic was littered with those sorts of examples, Nitin, and it’s terrible to see the outcome of some of those businesses, but what were the key learnings from that example?

Nitin: Yeah. So, you know, I would say we also have another restaurant business which has been largely flat since the time we made the investment. 

Louise: We’re thrilled to again welcome you back to Australia in 2025, but it’s not your first time in Australia. Can you tell us about Flexstone’s history in Australia and the types of clients that you have here?

Nitin: It’s great coming back to Australia; we’ve really enjoyed our time here. In fact, the last time I was here with my partner, we went to the Barossa Valley for wine tasting. It was absolutely beautiful in Adelaide, and we’ve also been to other regions within Australia. Everywhere you go, the people are incredible, and it’s just such a beautiful place.

Flexstone has over a 10-year history in Australia, and I’m proud to say we’re very thankful for the partners we have in the region and how supportive they’ve been of the Flexstone strategy. They’ve trusted us with a lot of their capital. We have great partners in Hostplus and their consultant, JANA, and they really view Flexstone as an important partner to drive not only strong returns in their portfolio but also to get exposure to the lower middle market.

Louise: Yeah, that’s fantastic, and it’s great to see some of the asset consultants here as well getting behind Flexstone and doing due diligence. We’ve seen that evolve over the years as well, which has been a great thing to see. Another thing that’s developed in our market is that private markets investing has grown significantly here in recent years. Why do you think this is? Has Flexstone also experienced this strong growth alongside this trend?

Nitin: You’re right, Louise. Private markets have grown significantly, and we have as well. I mean, Flexstone has grown to over US$10 billion in AUM since our founding back in 2005, and we provide access to private equity now across the US, Europe, and Asia.

Within private markets, private equity is really an attractive asset class, right? This growth is really driven by the fact that if you look at any dataset over a 5, 10, or 15-year timeframe, you can see time and time again that private equity outperforms other asset classes, which is why now it’s become a key part of the asset allocation strategy for institutional investors, for family offices, and now slowly for retail investors as well.

Is there a private assets ‘bubble’?

Louise: Yeah, the growth story in private markets has prompted some speculation that a bubble has developed, but bubbles are notoriously hard to spot, even in public markets, where they’re more transparent. Do you think there’s a bubble in some areas of private equity? And how do you ensure that the valuations you place on your investments are accurate?

Nitin: Right. I mean, bubbles are very hard to spot. We don’t try to, you know, time the markets or sectors. I’ve been in this industry now for close to 30 years, and I can tell you that market timing just doesn’t work. It doesn’t work in public markets, and it certainly doesn’t work in a long-term asset class like private equity.

We always recommend to our investors that they maintain a consistent and diversified allocation to private equity year after year. The way we build our funds is not to chase hot ideas or sectors from one year to the next, but rather to build very well-diversified portfolios across traditional sectors like healthcare, business services, industrials, and consumer, targeting companies that have a proven business model that have shown the ability to sustain macroeconomic cycles. So we’re not chasing the unicorns.

Louise: In terms of accessibility, private assets have traditionally only been available to very large, sophisticated investors, usually institutional investors. However, there’s now a push to open up private markets to wholesale and retail investors, essentially to democratise private assets. Is this movement something that you’ve been involved in, and are you also opening up opportunities for these kinds of investors?

Nitin: Right. I mean, we are definitely focused on this, and we believe opening up private equity to retail investors is really a great equaliser in terms of providing individual investors an opportunity to access private equity, which was historically reserved for institutional investors and the like. So, we have been approved to launch a product in the French market that will start before year-end. That’s really catering to the retail market. So, we’ll start that in France before the end of the year but hope to bring that out to other geographies over time.

Why Flexstone invests in everyday, ‘boring’ businesses

Louise: Let’s take a step back and look at some of those companies that you invest in because I find this really fascinating. You talked about mission-critical businesses, and you have a focus on smaller companies in the lower middle market or Main Street companies. I find it fascinating that many of these businesses are essentially family-owned, and over the 10-year holding period that you expect these companies to grow significantly. What are the different ways that you work with these companies to add value? Can you give us some examples?

Nitin: Sure. First of all, you know, as I’ve said in the past, we love to invest in everyday, boring companies. Now, why is that? Well, it’s because many of them have been around for a long time. They have a proven business model, and these are old economy businesses that you can touch and feel. We see them, we might know their products, we might have seen their ads, and we might have experienced the services that they provide.

These companies, as I mentioned, are not chasing some hot trend that’s great one day and gone the next. 

Many of them have been owned by families, as you mentioned, or individuals that have done an excellent job of growing the business to date, but they realise that they need help to professionalise the business and take it to the next level. They want to partner with someone who will do right by the business that these families have built and preserve their legacy, take care of the employees while allowing them the opportunity to take some money off the table and help grow the business. 

While we’re very focused on building a well-diversified portfolio by end market, as you mentioned, we invest really around three key themes:

• One is investing in businesses that are mission-critical and have a low-cost value they provide. This gives the company a lot of pricing power because it’s mission-critical, as well as the ability to sustain market downturns.
  

• Secondly, we invest in companies that are in markets that are highly fragmented, which presents us the opportunity to consolidate the industry and execute on a buy-and-build strategy that allows for two things: one, it allows us to average down our going-in multiple, and two, it also allows us to realise synergies as we integrate and scale these businesses.

• Thirdly, we like to invest in companies or industries where we can help digitisation trends grow further. This is basically not investing in some VC growth tech stuff, but it’s investing in companies that are using technology to improve the end customer’s business model or provide more efficiency to them.

How Flexstone adds value to the businesses it invests in

Now, you also asked about different ways to add value. Here, the beauty of investing in the lower middle market and in family-owned businesses is that there are many levers for us to improve performance, right? It’s not just about buying it at X multiple and selling it at a higher multiple down the road; it’s really about growing EBITDA and growing businesses. That’s essentially why the families trusted us with their business in the first place: to grow it.

So there are various ways to do it. On the top line, you work with companies to better understand both the product they’re selling and the service they’re providing to their customers. Many small companies haven’t truly understood their customers or their market share with customers or why customers buy their products. So the pricing, as a result, is not optimised, and they may not have invested in new product development. You try to work on improving pricing, capturing greater wallet share, and better understanding the customer and putting KPIs around it.

Many of these small businesses have grown nicely, but they’ve got very dispersed suppliers. If you consolidate them, you can get scale synergies—scale pricing. In terms of operations in manufacturing companies, this would entail walking around the shop floor and seeing where you can possibly improve operations. You know, bringing in a professional COO, for instance, who has seen other companies can bring best practices to this business. If you’re looking at a services business, you can look and see what things can be possibly outsourced versus doing them in-house, all in the spirit of improving margins. There are also other vendor cost savings, such as freight cost savings by consolidating freight with certain vendors and insurance savings.

Then, on the management infrastructure side, you bring in more experienced leadership into these businesses, and many times there are just gaps in the team. For instance, many of the companies we invest in don’t have a sales team, or if they do, it’s only one or two people. So now that’s a big opportunity to improve and build a sales team and really drive the top line. Another big investment on the infrastructure side that we do—again, I say we, but it’s really through our partners who lead these companies—we’re co-investing with them. It’s really installing an ERP system. Many companies don’t understand their customer because they don’t have enough data to understand them. By installing an ERP (Enterprise Resource Planning) system, you can now capture data and better KPIs around the business performance of these companies and just be able to make better-informed decisions and, as a result, better manage the working capital and the cash in the business.

And then obviously, outside of the company itself. There’s also consolidation. As I mentioned, pursuing add-on acquisitions allows us to scale the business. So it’s both organic growth as well as inorganic or add-on acquisitions that we’re really focused on. All of these initiatives lead to smaller and middle-market businesses deriving, during our hold period, most of their exit value from EBITDA growth versus financial engineering. If you’re able to drive EBITDA growth, it’s not surprising that you will likely sell these companies for a higher multiple than what you purchased them at. But of course, that’s not something we underwrite at the time of our investment.

Louise: Thank you so much, Nitin, for taking the time to be on our podcast. We look forward to seeing you in 2025, and I’d like to finish with my own quote from Theodore Roosevelt on baseball: “You can’t hit a home run unless you step up to the plate.”

We look forward to stepping up to the plate alongside you, Nitin, in 2025. It’s been great to chat with you and understand more about private markets investing and Flexstone Partners.

If you enjoyed the episode, please click follow on your favourite podcast platform to be notified of future episodes, and tune in again to hear more from our global collective of experts.