Essentials of success
As many European institutions are beginning, or considering beginning, a private equity programme, it is important to revisit a few essentials for what can make this a successful endeavour over the long-term.
Any asset manager considering these important programme-building steps at the moment is, of course, doing so in a period where challenging public market adjustments have made it more difficult for venture capital firms to see their portfolio companies successfully floated. At the same time some buyout firms are still holding investments entered into at much higher acquisition multiples compared to ones currently prevailing in the market. These situations, compounded by continuing turbulence in public markets, can make it seem an overly challenging environment for those who must now attempt to construct a private equity programme. That is why it is, perhaps now more than ever, especially important to consider how an institution can, on a systematic basis, go about building a superior private equity programme, even in tough public market conditions.
As, first and foremost, a principal investor1, LGT Capital Management has successfully navigated the very process through which these other groups must now pass. A key factor in LGT Capital Management’s original decision and continued enthusiasm for committing substantially to the asset class is the fact that, regardless of temporary fluctuations in public market valuations, investing in private equity can provide superior returns over the long run. Indeed, as a long-term independent investor with no pressing need for liquidity, LGT Capital Management can profit from making well-informed investment allocation judgements through any market conditions. Market timing of allocations is less important than investing with the best private equity fund managers, whose experience and discipline allows them to outperform over the long haul. Indeed, LGT Capital Management’s belief in the validity of this approach is demonstrated by the fact that LGT Capital Management has one of the largest allocations to alternative assets in Europe, with 20% of the main shareholder’s investable portfolio in private equity and 20% in hedge funds.
While LGT Capital Management believes such allocations to be absolutely appropriate for long-term investors with low liquidity needs, it is a fact that, despite their long-term investment horizon, pension and insurance groups are still prevented by regulatory and other concerns from allocating such high percentages of their assets to the alternative sector.2 Indeed, obtaining an understanding of the regulatory and tax issues involved with investing in the asset class is clearly the first step an institutional investor must take3. While fairly straightforward in the UK and the Netherlands, these considerations become much more critical in markets such as Germany, France and Italy. For groups in these countries in particular, it is important to find a consultant with continental reach and expertise or, indeed, to team up first with experienced local tax and legal counsel who can orient the structuring of the programme. There would be nothing worse than to have a private equity programme fail not from the choice of investments but rather from incorrectly structuring the vehicle into which these are placed.
The next important step is to consider how to ensure that the portfolio does not run into difficulties with the first few investments, a situation which could also be disastrous for the continued success of a private equity programme. Such an imperative implies, of course, that initial investments should be well diversified from the outset. One should diversify among markets, types and stages of investing as well as managers. In terms of market diversification, for European institutions with financial liabilities in Europe, it certainly makes great sense to have a significant portion of their investments in Europe. That notwithstanding, the deepest, broadest and most profitable private equity market continues to be that of the US. Over 70% of private equity capital raised in 1999 (and another vast majority in 2000) came from the US, with most of that invested into US funds.4 For years it has been said that the US market has been over-capitalised and too competitive, and yet average returns have maintained an impressive edge over those found in Europe.5 While a few European funds now have attained levels of experience comparable to leading US funds, it is still true that the US market provides more opportunities to invest with seasoned professionals.
In addition to ensuring this important cross-Atlantic balance, new investors to the asset class should also strive to diversify between the two main sub-classes of private equity: venture capital and buyout. A good allocation to both sub-classes can help dampen variations in return patterns that can be linked to public markets. While it is true that both venture and buyout firms can benefit from periods of lower public market valuations to enable them to load up on better value investments, it is also often the case that many venture capital firms rely more on public markets6 for exit opportunities. Returns in venture capital can, on the other hand, also be significantly higher than in the buyout business, especially when public markets are buoyant. In any case, a balance between the two main sub-classes is to be recommended, as they tend to be correlated against one another to only a low degree.
In addition to balance in geography and private equity sub-class, an often overlooked but critical factor for diversification – and in particular for new investors – is so-called vintage year diversification. Vintage year diversification involves spreading investment through time, ie, investing into funds which have closed (and begun investing) during various calendar years, and thus reflect different pricing and liquidity cycles of the private equity and exit markets. For new investors who do not wish to see their programmes come under fire from beginning investment in or ahead of more difficult market conditions – where it takes more time to start seeing good returns – investing in secondary transactions is the most sensible way to gain exposure to earlier vintage years. Secondary transactions involve purchasing portfolios, or parts of portfolios, from investors whom are readjusting their asset mix or looking to make new commitments to the asset class for strategic or other reasons. Gaining access to these portfolios – which are often sold off quietly – and paying a price that allows one to still attain returns significantly above public equity markets pose significant challenges for private equity investors, and indeed especially for institutions entering the market without established relationships and prior experience. Nevertheless, and despite the difficulty involved, successful secondary investing can provide important elements of a private equity programme’s success. This is due to not only the increased diversification of risk provided through the incorporation of a variety of vintage years into the portfolio but also through the greater speed at which positive cash flows and desired allocation levels become reality.
Lastly, and most importantly, one should diversify amongst managers. To diversify amongst managers is not, however, as simple as choosing, say, a percentage allocation between the US and Europe or between venture capital and buyout funds. According to common estimates of current market size, there are over 2,000 private equity fund managers worldwide with at least $50m of assets under management. To properly access and evaluate these funds, or even a good percentage of them, is a herculean task. In addition, private equity is an inefficient market wherein there is no organised market for distribution and access, no daily market pricing, no standard for managers to calculate and present performance, limited liquidity for 10 years once committed, no disclosure standards, and no regulatory oversight. It is often also the case that one needs to make a minimum commitment of $5m–10m to be able to invest into a fund – a situation which makes building a diversified portfolio extremely costly. Just as daunting is that the critical, ‘behind-the-scenes’ information can only be obtained by those who are ‘in the know’ and have been operating in the market for years. Indeed, many of the best and most established funds are closed to new investors. Increasingly, it has been the case that the ability to invest in top quartile funds has been on invitation only.
Given the above challenges confronting an investor seeking to build a private equity programme, one can only recommend that – after determining the appropriate structure and investment policy for the investments – an investor begin manager selection by working with either an experienced advisor or private equity fund of funds (FOF). Such a partner should be able to ensure not only diversification along the axis mentioned above, but also access to the best funds and important market knowledge. As with all investment decisions, however, FOF or adviser choices should also consider risk diversification and look to – depending on the intended size of the programme – work with a variety of consultants and FOF managers, perhaps two to four in total. This should help ensure not only competition between managers but also access to a variety of opinions and investment opportunities.
When choosing a FOF manager or adviser it is, again, important to ascertain if the particular party in question has, in fact, the access to top funds and resulting top quartile performance track record. This is the cornerstone of a successful private equity programme. In this regard, many low performing or inexperienced FOF managers or advisors will be unwilling or unable to show complete and audited numbers for their own track records of investments or documented investment recommendations. It is wise to be extremely cautious in such cases, as it is a clear indication that the FOF manager or advisor has either poor investment judgement or a lack of experience and – most likely – concomitant lack of important relationships and access. Other areas of important due diligence should involve having the FOF manager or adviser prove how its firm can successfully access and evaluate secondary transactions (something virtually impossible for advisers with no balance sheet resources to make them credible secondary purchasers in the eyes of sellers) and the alignment of interest between FOF manager or adviser and the institution building the programme. Many FOF managers or advisers are primarily compensated through an increase in assets under management. This does not necessarily make these groups as concerned as they should be to assist in achieving the excellent, above public equity market, returns that a properly invested top-quartile private equity portfolio should produce.
For those institutions whose long-term goal is to participate more directly in the private equity market, it is important to ensure that the chosen FOFs and advisers have a real commitment to ensuring information sharing and the relationships within the closed private equity world. An institution intending to build its own capabilities over time should ensure that their choices of FOFs or advisers commit in detail, and in writing, to how they will facilitate the investors’ attainment of knowledge and relationships. Professional reporting is an important element in this regard, but far more important is the open spirit and philosophy of the FOF team or adviser in question. If an institution is one of only a few clients for the FOF team or adviser, an institution must also clearly consider whether the FOF team or adviser is really sincerely committed to a ‘if you love someone set them free – if they come back to you they are yours’ philosophy which, in the long term, is the only way of building the trust and information sharing so critical for success in private equity investing.
When such FOF or adviser counterparts are committed to the growth of the programme-building institution’s capabilities, the institution can expect to successfully develop its own capabilities over time. These attained capabilities should include an ability to proactively search out (and be accepted to invest in) appropriate and high-performing funds. It is also important as an institution to develop enough attributes of being a value-added investor – ie, sending reverse deal flow to funds, helping funds network into new markets, etc – to become oneself an investor actually sought out by the high-performing funds. A good measure of whether this has been accomplished (and this applies also to FOFs and adviser) is what percentage of fund investments is made directly and not through the help of placement agents.
Critical to developing the above capabilities is, of course, building up an effective team which can give an institution those resources and relationships required for professionally carrying out such a vast amount of work. A key component in constructing a good team is to ensure that the members are capable of doing effective due diligence manager and company visits and reference calls in the markets that an institution wishes to target. This may mean being able to conduct due diligence calls in subtle French or with sensitivities to Asian culture or an appreciation of a straightforward ‘what have you done for me lately’ American attitude. People, language and cultural skills are absolutely critical in conducting thorough due diligence in what is, essentially, a people business that requires a lot of judgement and ability to understand and put into context those things said between the lines.
This contextual work continues into the next critical phase of private equity programme building – critically and constructively monitoring and adding value to a portfolio of complex international investments. This must be done with keen regard to any changes that may occur in fund investment strategy. An institution must be active and alert to timely pruning of investment in those funds that develop mismatches between strategy and resources – replacing those funds that fall out of step with new funds possessing strategies that more appropriately match resources. As final steps in building a complete and successful programme, more work-intensive investments, such as those involving specialty funds and co-investments can be undertaken once the team and the cornerstones of the programme have been put firmly into place.
Following the above steps for investing into private equity will not guarantee success for every institution. Nevertheless, a well structured and rationally constructed programme along the lines suggested should allow most institutions to profit from the extraordinary opportunities inherent in the asset class, and that regardless of the state of the public equity markets.
Graeme Scott Johnson is an adviser to the executive board of LGT Capital Management, where he is responsible for business development in the alternative investments area and is a member of the private equity investment team
1 Over one-third of the money invested in alternative assets by LGT Capital Management belongs to either the investment team or the foundation of the main shareholder, the Princely Family of Liechtenstein.
2 Institutional investors’ allocations to alternative assets are forecast to be 8% in the US against 2.9% for Europe in 2001. Source: Russell/GS AA Survey 1999.
3 Members of the LGT team have extensive experience in this regard, having advised institutions such as Calpers, the World Bank, the State of Oregon and numerous European institutional investors.
4 Private equity fund-raising in the US totalled $97.3bn for 1999 and $153.9bl for 2000 (Source: Private Equity Analyst, January 2001, p72); Private equity fund-raising in Europe totaled e25.4bn for 1999 (Source: European Private Equity Survey, PricewaterhouseCoopers, 2000, p2).
5 In 1999, average returns in the US were 63.6% versus 48.3% in Europe, respectively. Source: Venture Economics. (2000 figures are still not complete.)
6 An important element of due diligence with regard to any private equity fund remains ensuring that they have good experience in exiting investments, not only through public markets but also through trade sales and strategic combinations.