Q&A with Lee Gardella of Schroders Capital

Quality managers earn a 'complexity premium' by building better companies.

Lee Gardella is Schroders Capital’s head of private equity, North America. Buyouts sat down with Gardella to chat about the state of the fundraising environment, the increased focus on the lower mid-market and continuation vehicles, how Schroders selects managers and why early-seed venture may be having its moment.

Now that we’re a few months into 2024, what does fundraising look like? Are we out of the doldrums?

It’s definitely picked up from the depths of 2022 and early 2023. I think investors have mostly worked through their denominator effect issues. They’re now rethinking how they want to go about private equity in the context of a world that has changed quite a bit over the past few years. There are higher interest rates. Inflation came and went, but it’s still hanging around. And the financing environment is a different place than it was back in 2021. But the positive thing is that the economy showed far more robustness than I think people gave it credit for, and it’s continued to hold up quite well.

How have you weathered the storm of the past two years?

We had some downturns in valuations, particularly amongst our smaller companies. But what saved us was our ability to acquire growth, either through organic growth or through acquisitions. As the markets are turning back up, we’re quite excited about the return profile of our existing portfolios given the robustness of those businesses. I think that all things equal, managers who have that type of growth in their portfolio are going to come out looking quite nicely. If you take the nature of the actual economy and put some skill behind it, you should be able to outperform public markets.

Lower mid-market funds seem to be having their moment – especially from larger LPs who usually focus on the bigger end of the market. What are your thoughts on the smaller end of the buyouts market?

Schroders Capital is the poster child for this segment of the private equity universe. We live in the lower mid-market and most of the funds we invest in are less than $1 billion in size. The average size of companies in our direct co-investments ranges between $300 million and $500 million in enterprise value. If you look into our portfolio, you can actually see growth rates occurring at both the top line as well as the profit line. This is happening with reasonable valuations and leverage. Our returns are coming by backing managers who help turn a portfolio company into a better company in a few years.

How do you go about selecting managers?

It begins with the team. That’s by far the most important element – their experience and their skill. We like to find managers that have very specialized strategies and are really focused in on a particular formula for creating value. We like to know that they have the talent to make this happen. If you’re able to build a portfolio with managers with these unique skill sets, you create a powerful risk-return reward profile. But you’ve also earned a “complexity premium” where you’re able to figure out how to make a company better. That’s where the attractive returns in private equity come from.

Interest in continuation vehicles and GP-led secondaries has continued to grow , even as many large institutional investors aren’t able to participate due to governance issues. How does Schroders approach continuation funds?

We’re probably one of the more active players in the continuation [fund] marketplace out there on a global scale. We’re also focused on CVs on the lower end of the marketplace. It has been very productive for us from a return standpoint.

What do you consider when entering into a continuation vehicle instead of taking a distribution?

There’s three things. First is the quality of the business. We’ve been underwriting those individual companies and have been finding conviction on the return profile. Second is the alignment of interest with the sponsor. We want to make sure there’s an alignment of interest and it is reasonable for us. Lastly, it’s the sponsor itself. This seems obvious, but at the end of the day, one of the key decisions is to make sure you’re working with a quality organization who can take that company to the next level and continue its growth path. Having those relationships in the lower mid-market really drives that type of deal flow for us.

What’s one corner of the private fund universe that you’re bullish on besides the lower mid-market?

The seed and early-stage segment of venture capital is an area that we’re bullish on, and have been for some time. It’s been a very important return driver for our overall business. Success in seed and early-stage venture is all about having access and relationships, along with finding placement capacity with the better venture managers out there. You’re not investing in late-stage unicorns at the outset, but earlier in the life of future unicorns.