Business development, buyouts, and private wealth in the US middle market

^{Tharald Fongaard, Founding Partner, Norlantic Capital}

Tharald Fongaard is Founding Partner of Norlantic Capital, a new fund-of-funds manager focused on the US middle market. Prior to setting up the firm, he worked at Parthenon Capital and Strategy&, having graduated from Princeton with a degree in Operations Research and Financial Engineering. 
 
As part of our series of Q&As about emerging managers, Tharald spoke with Shaun Beaney, Editor of Preqin First Close, about the power of the middle market, meeting investors, and demystifying private equity.

What inspired you to set up Norlantic Capital?

My experience of the US middle market began at Parthenon Capital, a private equity manager with offices in Boston, San Francisco, and Austin. I was able to work closely with the partners who founded Parthenon and learn a lot about the market. My experience there brought me close to the tight-knit system of super-high-performing managers in the US middle market.  
 
One thing that really stood out when I looked at the LP lists of these different funds was that the majority of the capital came from large US-based institutional investors. Very few investors from outside of the US tended to be invested in these funds. That left many high-quality but smaller investors out of that segment.  
 
I founded Norlantic as an interesting product-market fit, where we could provide access to these high-performing private equity strategies in the US and give investors access to top-tier, mid-market private equity. That comes with a huge benefit of the tax efficiency. It also comes with a diversified entry point.

Why a fund of funds?

It allows us to offer investors a more flexible mandate to pursue strategies that are valuable to them. Some investors need very diversified, low-risk, traditional, primary-type fund structures. Some want direct exposure to specific industries through co-investments. Others want short-duration, high-return, secondary-type opportunities.

In general, we skew toward smaller, mid-size managers, and toward industries and sectors I have familiarity with and that are resilient and able to withstand market forces in corrective territory. That’s in business services, B2B services in healthcare, B2B in financial services, or technology-enabled services. The contracts tend to be long-dated and ingrained in deep processes. Overall returns from those deals tend to come more from organic growth rather than leverage. 

Tell us about your partners, such as investment firm Ness, Risan & Partners. 

Ness, Risan & Partners has decades of experience in alternative investments, so it helps by bringing strategic capital to the table, by finding and navigating Europe’s regulatory market, understanding alternative investments, and being a value-add to Norlantic. 

It’s still very early days for you, but what’s been the best thing so far about setting up your own firm?

The most rewarding thing is controlling and shaping every aspect of what the business looks like – strategies, structure, the people we work with – and prioritizing long-term alignment with our investors. Meeting investors, talking to them, and solving real challenges for them has been great. Building deep relationships has been very rewarding. 

What’s been the most difficult thing?

I am originally European, and I support certain types of democratic processes and regulation. But I really underestimated the complexities of navigating the EU’s AIFMD regulations, and especially how they apply across multiple jurisdictions in the European Economic Area, as well as the UK and Switzerland. I've spent my entire professional career in the US, where I've become accustomed to the relatively predictable and streamlined regulatory environment from the SEC.

Where have you looked for investors?

Our original fundraising market has been where I'm from, and where I have deep relationships – Norway and the US. High-net-worth individuals, family offices, wealth managers, and to some extent, endowments and smaller institutional investors, are all increasingly looking to allocate to private-market strategies, and they’re under-allocated compared with larger, long-dated investments. As we’ve started to expand our fundraising outside of the Nordics, we’ve seen a similar response from LPs.

Some investors are unfamiliar with the asset class. Are they concerned about the risk/return profile?

A big selling point for North European investors is that they might be familiar with alternative investing, or maybe they've done some angel investing or direct private equity-type investments in their own market. The returns they’ve achieved over long periods in those segments have been several percentage points lower than in the US, so they all want to be able to allocate to the US. But it seems too far away, too complex, or it’s not the right fit, or the timing doesn't work. We’re demystifying the asset class to give them a flexible mandate.

The other side of the coin is investors who have not allocated much to private equity and don't really understand it, think the fees are too high, or think the time schedule is too long and drawdowns too complex. This is also about demystifying the asset class and showing them exactly how value is created in this market, and how it’s very different when you look at US mid-market strategies versus large cap.

What’s the potential in the US middle market?

The way we found to define it is for companies in the EBITDA range of $5–100mn. The biggest part of that bucket is $5–50mn. The middle market is the powerhouse of America’s economy. It's the most diversified and fast-growing segment. Only 5% of over 200,000 mid-market private companies have private equity backing.

We track around 800 funds in that space. And I would say there are probably around 300 that are interesting at any given time, so we keep a very active pipeline. Every quarter, we're probably looking at 10–15 funds. It's a big space. You can find specialist investors that invest in only one asset class, strategy, or sector, and have done so for many years with a proven a track record.

What’s the historical investment performance been like?

We did a study with Bain & Company where we pulled the returns for almost 1,300 funds in the US middle market for the last 25 years. We found that the average net IRR – that's after fees and carry – is 22%. So, that's 22% across five presidencies and three market corrections. For large-cap funds, the average net IRR was 14%.  
 
At the top-quartile level, the spread is even more compelling, with 33% in the middle market and 26% on the large-cap side. When you look at money on invested capital, the average MOIC is 3.2 against 2.4 for large caps. I don't think I've seen anything in the whole alternative assets space that has anything even close to that in terms of risk/reward.

Shaun Beaney is Editor of Preqin First Close. It’s quick, easy, and free to subscribe here. 

Preqin, a part of BlackRock, offers one of the world's most extensive selections of alternatives benchmarks, including more than 150,000 available that span 50-plus years of performance data, helping investors make confident decisions when identifying and evaluating new opportunities. 

Special thanks to Leni Merriam at Norlantic Capital and Jack Shortell at BlackRock.

_{The opinions and facts included in the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin accepts no liability for any decisions taken in relation to the above.}