David Carratt, a managing director in the London office of Kennet Partners, talks shop during one of the most exciting and challenging times for the technology sector. Among other topics, Carratt speaks of the virtues of investing in and exiting from bootstrapped businesses in a healthy and fast-paced technology market, why traditional buy-out funds are going 'down market', integrating new styles of value creation, and developing the fine art of hiring a CEO that can last the duration of an investment. Interview by Katherine Steiner-Dicks

In a matter of months, David Carratt and his colleagues on both sides of the Atlantic have experienced what could be described as good but challenging times. Good, in that Kennet has had a stream of exits with simultaneous access to healthy deal flow. The challenge has come with attracting experienced CEOs given the pace at which technology is developing. In the last tech boom Facebook founder Mark Zuckerberg was still a 'kid', therefore technology investors were not contending with the convergence of social media and customer-driven advertising analytics as they are today.

Combine these good and challenging factors with a major shift in value creation styles, without altering the industry's typical return target of 2.5 times, and the landscape is unique to any other investment period in private equity's history.

In October of last year, Kennet sold its European online fashion buying community site, BuyVIP.com, to Amazon.com. A month later, Kennet sold branded video distributor goviral to AOL Europe for $96.7m. Taking into account that Kennet invested €6.5m in goviral in March 2009, and was the company's only external shareholder, things seem to be going well on the exit front. Are there any particular market drivers that are connected to your recent stream of exits in the past three months?
Corporates have got a fair amount of cash on their balance sheets at the moment, so they are looking for a chance to buy higher growth businesses. Plus, the overhang of money in the private equity market is also driving deals. Currently, there is a high level of profitability in technology portfolio companies. Speaking to people at a recent conference, there was a common consensus that everyone is surprised at the level of good performance of their portfolio companies. Some are even thinking that things could be too good to be true and too good to last.

Plus, in the corporate sector profits are also high. This could be, in part, down to the cost cuttings that were made following the credit crisis. Corporates are experiencing those benefits now, thereby creating free cash for acquisitions and growth assets. This is in particular where there is a strong predictability in continuing growth.

Are you seeing a lot of secondary buy-out deals in the current market as well, taking into account some of the above mentioned market drivers?
Yes, I am. There are a growing number of cases where private equity buyers are outbidding trade buyers. That is probably due to the overhang of capital, generated from the capital that was originally earmarked for buy-out funds raised in the 2007 and 2008 vintage. At that time, funds were effectively raising equity capital on the assumption that they could use leverage. But now they are coming 'down market' to invest in deals with higher equity components and often outbidding trade buyers.

But how do trade and private equity buyers differ in terms of what they are looking for?
Trade buyers are usually prepared to buy on their own earnings multiple, but they are less inclined to pay up for growth. Private equity buyers, on the other hand, are more prepared to pay a more aggressive multiple, even higher than public market valuations, when they see a high growth opportunity.

Kennet positions itself as a growth equity investor that backs entrepreneurial technology businesses. What does it offer that other firms in this space do not or cannot in this climate?
We have been able to buy secondary positions in companies. So, instead of putting in a lot of working capital we have sometimes bought a position from a departed founder or an early fund investor who has gone with the business as far as they want to go. In the goviral case, we bought the position from a departed founder in a secondary purchase for €6.5m, but with zero working capital.

In the current environment many businesses are essentially running cash flow positive, so it is tough to invest a lot of working capital. It's not like the internet bubble, when companies were running with deep losses. The main advantage that we have over other potential investors is that we are prepared to do a flexible transaction that mixes secondary and working capital to get the shareholder base aligned with the same risk appetite for the next phase of development.

Are potential buyers looking for revenue or profitability models?
We are looking for buyers that are not buying on a profitability model. For example, when we sold BuyVIP.com to Amazon they bought our revenue model, and not our profitability model, because the company was in a dramatic growth phase. During the time we were shareholders, revenues went from something like €25m to €54m to €83m in successive years. And it will probably do €120 this year. Its market share in Germany is still relatively low so there is still a lot of developing the market position.

In the case of FRSGlobal [Wolters Kluwer Financial Services acquired FRSGlobal, a Brussels-based global financial regulatory reporting and risk management business, from The Carlyle Group and Kennet in September 2010], which was a bigger business than BuyVIP.com, it had an incumbent position in the North American market, namely Canada. It also had positions in Asia Pacific and Continental Europe, meaning it had less competition, making it possible to optimize profitability in the buyer.

Does being a technology investor in both North America and Europe provide you with access to trends and an early indication of where new opportunities will arise?
Yes. On the consumer and technology trends there is not a lot that is private about it since you can get a lot of information on the internet, so it doesn't matter if you are in California or Europe since you have access to the same data. But for investment trends, and what we are seeing in valuation trends or styles of business, it helps a lot being in the US market. I think there are things that happen in the US before happening in Europe and vice versa.

For example, the private fashion buying club category really came out of France with Vente-privee. The view we therefore had in making the investment in BuyVIP.com was that, in the US, e-commerce is very mature, but in some parts of continental Europe it is very immature.

Take Italy for example. There is no tradition of mail order in the country. So the whole idea of buying a product online and having it shipped to you is very odd to an Italian consumer. On the other hand, Germany is a very mature e-commerce market. They are very sophisticated about their buying. German consumers will often order one item in three different colour ways or sizes if you let them. This means that German consumers return 30% of products they order.

Is it safe to say that you have to factor in consumer behaviour and expectations when investing in European e-commerce?
Yes, you have to price in the level of returns and scrap, especially in Germany. But, going back to the example of Italy, since the market is immature, there isn't much infrastructure to do returns there. People have to go to their local post office to arrange the return, which is fairly inconvenient. So we have seen that, instead of returning an unwanted product, the Italian consumer tends to give it to a family member or a workmate instead of going through the hassle of returning it.

What else are you seeing in the US that has yet to be seen in Europe?
We have had good discussions with the US and European teams on areas such as website customer re-targeting, which is connecting businesses with their past website visitors to increase the likelihood of a completed transaction. There are no businesses of this kind in Europe.

RadiumOne is an example of the next generation of analytical advertising that takes the network of social connections through Facebook and LinkedIn and from there uses analytics to gather data to see what your friends are likely to buy. It produces a more effective advertising network than just looking at individual consumer behaviour. It can not only predict what a consumer will buy, but which advertising method will be best utilized.

That is an idea for a business opportunity that we will be looking out for now in Europe. It's not the one way street that people think it is. It's a dialogue.

Most of the Kennet team has enjoyed long and successful corporate and entrepreneurial careers before becoming involved in technology investment. What are some of the entrepreneurial elements that you can provide when it comes to evaluating exit opportunities or taking a business to the next level of growth?
In the BuyVIP.com case, some of my corporate background enabled me to contribute to the organisational design for international expansion. If you are going to expand to a pan European business you have to decide which parts of the business are best run in, say, Madrid, Milan or Frankfurt.

In the case of FRSGlobal, we needed to work with the bank in Montreal, but the business expertise and analysis were carried out in Brussels and the software engineering in India. Trying to glue all of that is a big organisational design challenge. I worked with an ex-colleague of mine from Sybase to help the new chief exec determine which functions to treat as global and which as local.

Sometimes it's a matter of recruitment. For example, one of the key decisions for goviral was hiring CEO René Rechtman, a decision made before we became shareholders.

How do you think value creation models have changed?
There is a very strong argument that you need to be focused on operational improvement in portfolio companies in the current market. We did some analysis that looked at the contribution of different types of value creation to the total return. So if you took the return at 2.5 times multiple of money invested before the debt crisis, the contribution of operational improvements was probably around 0.8 times. So if you entered at €100m you create €80 million through the business growing and through operational changes. After the debt crisis, assuming you still want 2.5 times return, the contribution from operational performance improvement needs to be 1.4 times.

Roughly, it now contributes more than half of returns where before it contributed less than a third. The challenge is to make those interventions more focused and have bigger outcomes. 3i, for example, has a focused programme for doing that. All of us have now had to work harder at that.

Have you ever had to bring in interim managers in any of your businesses?
Yes, we have. The interim market is usually aimed at bringing in a head of function type of person. But, very often, what we are really looking for is an executive to come in prior to the investment, to do the due diligence on the opportunity and create the 90 day plan for the business.

In the FRSGlobal case, we brought on Steve Husk as a consultant before we did the deal to help build the business plan that we invested against. Then he became the chairman at the time of investment. In our minds he was an insurance policy on the incumbent chief executive working out and, as it happens, the incumbent chief exec didn't work out and Husk ended up being the full time chief executive.

What are your thoughts on the calibre of interim talent out there, especially for the technology sector?
I think there is a wide range of quality in terms of interim people available. On one hand there are people that are incredibly experienced and very skilled change managers that just like working on sequential projects in an interim way or have experience with private equity. On that level they are just as experienced as any one of us are.

There are also people that may not have a lot of operational experience, but they have the benefit of time on their hands. I am constrained in my situation to be a sort of butterfly on many companies. You can come into a company and initiate some change, but do not have the time to follow it through deeply. This is where an interim can pick up on your ideas and analyse the situation and agree on what needs to be done. They are often interested in seeing the changes through anywhere from a six month to two year period. At that end of the market there is a valuable service.

But at the other end of the market you have people who have just been made redundant in a situation and have found themselves in an interim position because they really do not know what they are going to do next. They are tapping into opportunities that will help them fall back into permanent employment. They are generally less skilled people, I would say, while useful for some roles, such as a CIO in a geographic market where it is hard to place someone, perhaps.

One challenge we face specific to the technology industry is that, quite often, the technology originates in places where there isn't a huge amount of management talent.

Is that the biggest interim management challenge you face as a technology investor?
An even bigger issue for us is CEO recruitment. We are backing companies that are growing quickly. If we invest in the business and the chief exec isn't growing the business then that is a problem and we need to replace him.

On the other hand, if the business is successful and growing we may need to replace someone because he is used to managing, say, 50 people and can't scale up to managing 400. Either way, we end up with a lot of chief exec recruitment.

Our experience is we get it right one time in every two, which is not a great track record. It basically means that every time you recruit a new chief exec it's costing the company anywhere between six and twelve months of development. If you are in a really fast moving sector that could be the difference between another firm that was once uncompetitive becoming competitive to your investment.

In tech, you are often looking at growth levels of between 70% and 100% per year. Our thinking has tended to be that we will happily provide mentoring to a good chief exec. We feel its better to extend someone's performance for longer, rather than make a change.

Backing technology entrepreneurs must certainly bring different challenges. For example, how do you surround someone with a good idea with people who are good at exploiting routes to market?
Yes, you need to surround them with people who have experience delivering these kinds of growth rates on a continuous basis. While there are a lot of people who can do that, the challenge is to find people who have what I would call balanced judgement to think about the downside case scenario.

Ideally, you want someone who has growth experience and use of external capital so they can understand the advantages and disadvantages of raising external capital at particular stages of the business. It is easy enough to say let's raise more capital, but unless that capital creates value, a chief exec will find out that instead of owning 50% they own 5%. You have to make sure that the entrepreneurs are getting value from every dollar of capital they use.

How does Kennet measure its value creation these days?
One particular aspect that we focus on is bootstrapped entrepreneurs, especially in the US. We invest in companies that look at their customers to generate cash rather than their shareholders.

You create a healthier business if you learn from the market: learn what customers will buy at what price, generate cash from your initial customer contracts and then raise capital for full blown sales and advertising expansion once you learn what the sales equation is. The metric we look at is gross margin contribution from an incremental sales team net of total sales costs. How much incremental cash per year does a new sales team contribute? That's the real measure on how capital can create value.

There appear to be many good technology opportunities in Asia. Does the current team collaborate at all on possible opportunities or is that simply going against your US-European investment remit?
It doesn't fit with our investment remit. Investing is incredibly culture specific, I think. To be successful in Asia you have to have a very close relationship with the chief executive and the management team that you are investing in. It's not like a banking transaction.

Our view would be that you would need to have people on the ground over there and be able to build relationships amongst the relevant cultures. To be an early-stage investor in China would be very hard.

It may be possible for us to be an investor in the expansion of an Indian business to the US, for example. Plus, a lot of our businesses are selling to Asia Pacific or India. Some day we may be looking to China, as we have considered some opportunities in the past, but not just yet. It's a bit like the public equities argument that says that you can have lot of exposure to China without needing to buy a Chinese company. Every major US or European company has some initiative going on in China.

When do you think the market will be primed to invest?
At the moment China is not on our radar screen since we see opportunities in our existing remit markets. For example, we see a lot of opportunities on the East Coast of the US, which we would like to address.

We are not short of opportunities, with the combination of US and Europe. We can get exposure to end consumers in China and India through selling channels incorporated just outside of those regions. We would take a 10 to 20 year view of China rather than a five year view.

What is the LP attitude to investing in China?
The general LP attitude is that they do the geographic allocation. This is particularly the case in the early stage investment space where LPs want local GP groups focusing on local opportunities.

Do you agree with that line of thinking?
It's very annoying in tech because technology opportunities are intrinsically global. Europe and the US do not have a monopoly on smart technology guys. In fact, the tech industry often sees a bunch of smart Chinese or Indian tech guys who get educated in the US, such as at MIT, and then go back home to start-up interesting companies that have a level of aggression and ambition that doesn't exist in the West. We are getting more comfortable all the time in the West, where China is very hungry.

How would you sum up prospects for investing in the technology sector?
I think it is a pretty optimistic time for technology despite the gloom of the debt crisis. The sector is generally not leveraged and has no issues with debt overhang. Availability of capital and talent is good. China and India are driving capital investment on new business processes, which drives requirements for IT systems and broadband penetration, so opportunity for internet is still very good.

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