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Private equity is one of the few asset classes that’s been able to outperform even public equities during the bull market.

And the sector is reaping the benefits of that outperformance with 529 firms in the space raising an aggregate equity volume of $1.4 trillion over a 10-year period, according to the 2020 annual HEC-Dow Jones Private Equity Performance Ranking.

Dipanjan ‘DJ’ Deb is the co-founder and CEO of Francisco Partners, the top performing individual firm in that annual ranking. Deb sat down in an interview for the Delivering Alpha newsletter and revealed what keeps him up at night, despite the firm’s outperformance. The CEO also reviewed where the firm sees the most opportunity.

 (The below has been edited for length and clarity.)

Leslie Picker: I know you’re not able to discuss performance specifically, but what do you think was responsible for this outperformance? What’s the secret sauce here? 

DJ Deb: Of course, we’ve all benefited from a buoyant market and the tech markets where we spend a preponderance of our time. But I’d say we probably have done three things that hopefully has helped us differentiate us in the past and will continue to do so in the future. One is a focus within technology of sub-sectors. So we have 10 different vertical markets we pursue, whether it’s consumer internet, or healthcare IT, or network security, or cybersecurity, or FinTech, or education technology. So we have partners who specialize in each of those areas. And we believe that sub-specialization is the key to success. 

Second is we have an operating team of 35 people going to almost 50 to 60. These are people we can try to help with each company, both in terms of optimizing a company’s operations, but also getting best performance cost portfolio. And third is our culture, which is kind of a relentless focus on perfection. Of course, you never achieve that, but every day we wake up and say, “What are the 10 things we’re doing wrong?” We just had our annual meeting a couple weeks ago and the first slide we put up was, “Here’s the year-in-review.” The second slide was “Here’s the 10 things we’re doing wrong,” and I think you kind of need that focus to stay ahead. 

Picker: What do you think you are doing wrong? What is it that you need to improve on? 

Deb: As I reflect on the last decade, probably the biggest mistakes we’ve made is all the deals we didn’t do it. So it’s almost an anti-portfolio as it were. So we never thought that interest rates would go down and the stock market would come up the way it did. We also never thought leveraged markets would reach the levels they have today. I would say we were wrong in terms of software re-rating, software companies that used to trade at 8x or 10x EBITDA trade at 25x to 30x EBITDA. So we missed out on all those. 

Today I think one of the great things, as I said, is our focus on specialization. I think sometimes what that leads to is people get in their swim lanes and sometimes we need to take that more expansive view on things that don’t fit neatly into swim lanes but they still may be great investments. There are people in our firm who are better sources, and better portfolio managers. I think we need to constantly focus on putting people in positions to succeed. And so the same people may not be the best person to go soup to nuts. 

Picker: Right and and obviously, you know that’s the saying goes in finance, “Past performance is not always indicative of future performance,” so where do you think things go from here?

Deb: At a high level. I think we’re big believers in the long term dislocation of tech. I say to all of our investors is that tech is no longer a vertical, it’s a horizontal, it’s ubiquitous. It’s disrupting every sector, every part of society. So if you look at whether it’s within financial services, in healthcare, in consumer internet, it’s literally disrupting every part of society. I mean, you know, I have three teenage daughters. They don’t they don’t know what a physical check is. Everything is made through payments on their phone, whether it’s Venmo or Splitwise and things like that. So that’s just a small token. You know, when we’re watching TV in a hotel room, they’re like, “Where’s the DVR?” And like, when I was growing up, there was no DVR. 

So those are just things we see that we take for granted today that have only come to fruition over — streaming television, everyone, whether it’s Netflix, or Amazon Prime, or Hulu — that didn’t exist even five years ago. Technology literally is eating the world. So we’re big believers in long term tech. You have to be careful. The markets are reasonably frothy today, so you need to pick and choose. But long term, I think the trends are inexorable. There’s only been four down years in technology in the last 50. That’s grown at double the rate of GDP.

Picker: Can you extrapolate on that a bit more this idea that you believe the markets are frothy? Because I feel like I’ve heard that in the tech world, you know, at least pockets of the tech world, for the last 10 years or so and yet trajectory-wise, things continue to go up. And as you mentioned, tech just becomes increasingly pervasive. So how does this kind of look? Is there ever some sort of reckoning that that we see on a large scale?

Deb: It’s something we think a lot a lot about. But it doesn’t impact our day to day that much in the sense that we’re long term investors, we’re buying companies. Typically we’re control investors. Almost 80% of what we do is control investing and 20% is minority investing where we’re a large outside shareholder. We’ve been wrong for five years. We’ve thought that the markets would have a dislocation. We think there’s probably two areas of irrational exuberance, to use Chairman Greenspan’s terms from years ago. 

One is in late stage growth equity, where many of the unicorns today are actually disrupting the world and deserve their valuations. But probably 70-80% of them will have some sort of day of reckoning. They’re not all going to disrupt the world and people are conflating growth and quality in late stages of a bull market. And perhaps we’re in the late stages of a bull market – the growth and quality became conflated. And so I think that actually creates opportunities for us down the line when some of those companies have pullbacks in their valuation. 

Picker: You also mentioned a second pocket that you see frothiness right now?

Deb: Yeah the second pocket is just in software buyouts, particularly larger-scale software buyouts, where I think the wisdom now is, “You can’t lose money in software.” And by the way, software companies are amazing companies, they have great retention rates and I think software is eating the world, as many people in our industry have talked about. But that doesn’t mean that valuations don’t matter. If you buy something at 30x and lever it 11x, if terminal multiples compressed because interest rates rise, you could lose money. And so I think we’re being careful. 

We invest in what we call a barbell approach. On the right hand side of the barbell, we’re buying companies that are disrupting existing markets that we think could be optimized. So we just bought Boomi, from Dell Software, for instance. So that’s on the dislocating side. On the left hand side of the barbell, we’re buying companies that we think, again, under a different ownership, could be transformed. We just bought a division out of Raytheon called Force Point. So we’re pursuing it on both sides.

Picker: Where are the opportunities that you are most excited about right now?

Deb: I would say that, probably the two areas — and these are more or less industry-specific areas — which is mostly division carve-outs and founder-backed companies. So almost half of what we do is partnering with founders. And in many cases, the founder grows a company to a certain level and then they decide that for their own life reason, they want to monetize most of their business or 60%-70% of their business and they want us to try to help the company, take it to the next level.

So that tends to be still 50% of what we do. Another 25%-30% is 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 kind of a tail on the tip of the dog and doesn’t meet the corporate profile. What we say to the parent is it’s addition by subtraction. If you get rid of this division that’s either growing slower or is more margin dilutive than your core business, your terminal multiple will increase if you divest out to us. And that’s a speech we make over and over to many, many corporates. I think it resonates. It particularly resonates in a market like today where people are more focused on revenue growth versus rule-of and most of the companies we’re running are rule-of. 

— Ritika Shah, producer at CNBC, contributed to this article.