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Institutional investor profile: Arianne Leuftink, managing director, Wilshire Associates

Wilshire Associates is a fund of funds manager with $2bn under management. In the private equity industry since 1984, the firm has 24 investment professionals in its private markets group. Wilshire is currently raising its fifth fund with a target of between $400m and $500m. The fund invests in the US and Europe and has offices in the US, Europe and Australia. Arianne Leuftink has 17 years of investment experience.

What type of investments do you look for?
‘We focus on return in all our investments. Our top-down assessments have provided strong sector views. For example, we invest in mid-sized buy-out funds and by that I mean those that make investments of between E25m and E250m. There have always been investment opportunities in this area and there will be in the foreseeable future.

‘We also believe in maintaining a balance between buy-out and venture and are continuing our commitments to venture funds, albeit at lower levels. Early-stage investments will remain the focus area as this is the phase where VCs can demonstrate their skills and build the company. There are great opportunities as current market conditions provide lower entry valuations. “Quick flip strategies” are over and ultimate returns will be lower and more return to the mean as a result of longer holding periods with exits through IPO and trade sales being very difficult right now. I wouldn't be surprised if it is shut until late 2003 or even 2004. We just have to be prepared for it.

‘Funds that specialise in distressed situations are also an interesting pitch for us now. There are a number of private equity funds that have demonstrated in previous downturns that they can manage them and produce superior returns from turnaround investments. Those are the funds that we invest in.

‘We invest in management teams that are driven by carried interest rather than those that rely on their management fee for remuneration. This alignment of interest is one of the reasons we are less focused on investing in large buy-out funds. It's also an issue of pricing. At the higher end of the market, pricing is too competitive and it is rapidly becoming an almost efficient market. I think that some people at large buy-out firms will step back to the mid-market by spinning out from their current firms. We've already seen a couple of these.'

How do you find out about good investments?
‘We identify private equity firms proactively. By that I mean that we establish and build relationships with firms especially when they are not fund raising. This provides a more objective view and often makes GPs talk more openly than when they are out in the market with a fund. We have a name in the marketplace and we have been around for over 15 years now so investment opportunities come our way. We think it's necessary to know all the firms that are around.

What do you look for in a private equity fund manager?
‘All investors look at pretty much the same determinants - strategy, people and track record. Of course we do all of this, but we also have our own way of assessing the investment proposal by using a more scientific approach. We look for teams and strategies that outperform public markets. As a supportive tool in our due diligence process we have developed a proprietary risk/return model to evaluate future performance of LBO firms based on historical statistics and proprietary information as well as independent assumptions. In this model we re-engineer common indices used in stock and bond markets. Using this as a benchmark or hurdle rate we assess each investment relative to its customised benchmark, much as companies look at corporate finance decisions. For example, we assess how much a partner can add through cash flow growth and its impact on future returns. We can work out how much a fund manager can add over GDP growth and how much it will generate in future returns. It's a useful tool and it supports our decisions of where to invest. It means that we are not just looking backwards at the track record, but ahead, too.

‘In terms of key skills within funds, we look for teams with a broad mix of experience. We're looking for both operational and financial skills, with more emphasis on the operational. We also look for general partners that have a strategy that makes sense, that have a proven success in their strategy that they will implement in their forthcoming fund. The sourcing process and structure is one of the key items in discussions and reference checks should confirm this. We need to be sure that the team has the right skills and experience mix to make that strategy work.'

How do you conduct your due diligence?
‘Most areas of due diligence are fairly obvious. From a quantitative perspective we differentiate through this risk model I mentioned earlier that we apply to buy-out funds. But there are some basic things that other investors don't do in the same rigorous way, for instance making reference calls - or at least up till now - they tend to take the matter less seriously - that's the feed back we get from references. Until about two months ago, people we called at banks (lenders), consulting firms and portfolio companies confirmed that we were really one of the few that checked references. Today, everyone seems to be doing them. I think people are now realising that they have to be more careful about where they invest their money and are checking much more thoroughly.

‘We have always carried out very thorough reference checks on investments that a fund has made in the past. So we will ring CEOs of portfolio companies to find out how much involvement GPs had, what the relationship is like, etc. Quite often you hear more interesting messages through CFOs, who are the forefront but sometimes don't get the credit for it.'

How do you put together a portfolio?
‘First of all we decide which broad sectors, such as early/late stage venture, buy-outs and/or distressed, we want to be in. Based on variables such as supply and demand of capital, valuations, exit opportunities, etc. lead to the sector decisions. And, because we build relationships with firms even when they are not raising funds, we are able to construct a forward calendar of groups that we expect to be in the market. We use that to see which firms should be fund raising. We are very selective in the sense that we make sure not to over-diversify: picking the “best of the best” rewards and the top-quartile performing universe is small. Many other fund of funds seek diversification, but we believe that that simply dilutes returns and diversifies the higher alpha. If you spread yourself too thinly, it's very hard to make superior returns, you just end up with average results.'

Do you make direct investments?
‘No. We think that it creates a conflict of interest and it's really our objective to be the best partnership investor.  If you co-invest alongside private equity firms, the tendency will be to stick with those groups that offer you co-investment opportunities even if they are not necessarily the ones that are going to perform the best. You also become much more involved with individual firms. You end up being not only on their advisory boards but also on investment committees. You may not select the best of the best performing top-quartile funds but the ones that are prepared to share deals with you.'

Which areas do you think are the most exciting at the moment?
‘To decide that, we look at the macro-economic factors, and most importantly, valuations. From looking at these factors, we can then make our sector selection. To give you an example, distressed and turn-around situations offer great opportunities at this point in the economic cycle. In Europe, the corporate restructuring process as a result of shareholder value focus and industry de-fragmentation will continue. This will create good deal flow for GPs and they are companies that will still benefit from growth and restructuring.. Quality venture investments that can be made today provide a lot of opportunity with valuations being a fraction of what they used to be two years ago.

‘In general terms, we still think that the best value is to be found in established markets, so the US, UK, France, Germany and the Nordic regions. We have an open mind for investments outside these countries but we closely monitor all different macro factors and other mechanisms that influence private equity investments. The infrastructure just isn't always there yet to generate excellent returns.'

What advice would you give to an investor new to private equity?
‘The first thing I'd say is that they need to acknowledge that private equity doesn't just add alpha to their portfolios but also broadens the general knowledge level with respect to other asset classes:: private investments add substantially to public investments. Again, only top-quartile performance is rewarding and the issue here is whether they can gain access to the top-tier funds. Bear in mind that building a private equity programme takes a lot of energy and resources. You need to invest a lot of time if you want to set up a private equity effort, so, probably unsurprisingly, my advice would be to invest through a fund of funds to begin with, at least. That way, investors can grow into the asset class. If you can build a good relationship with a fund of funds or a few fund of funds, then you can team up with them. You can use them as a sounding board and learn from them. I would suggest that only once you've been through this process and built up your knowledge base should you invest in fund managers directly.

‘My concern with new investors - and I've seen this happen - is that when starting, they tend to invest in their own backyard. They invest in domestic funds only because they may be more familiar with them. These funds may have the same glossy presentations as anybody else, but some of them lack the knowledge and experience of how to make good private equity investments. Critical knowledge of the market is key since once you have invested in a fund, it is too late to back out if you subsequently decide that it was a poor decision. You have to live with a fund for ten years, so it had better be a good decision. I know from experience that it is terrible to have to deal with a problem fund. You spend so much time and energy on it.'

What is the biggest mistake you have ever made?
This was before I joined Wilshire and worked with the IBM Pension Fund in The Netherlands. It was about ten years ago when there were still countries without stock exchanges and we couldn't cover these countries though our public market exposure. As we saw good opportunities in some areas we decided to invest in private equity funds active there. Only when deregulation really happens there I would reconsider such investments. Some of them were in the Far East, for example, and at the time their legal and accounting systems were still in their infancy. It meant that the investors had very little control of the companies and weren't able to identify problems early on. The infrastructure just wasn't in place and, because there were no stock markets, exits were extremely difficult.

‘I'd like to emphasise, though, that IBM over recent years has been one of the top performing pension funds and a great deal came from private equity investments. I think it serves as an example for investors considering investing in the asset class. You just have to make sure that you invest in private equity in the right way and understand the risks involved and the special characteristics it has compared with other types of investment.'

What do you think is the biggest issue for the private equity industry?
‘At the moment, I'd say that the biggest issue is the capital overhang that exists at the moment. We foresee continuing demand for private equity from an LP base as well as from companies that feel comfortable being backed by financial investors. But there is a lot of money washing around the system that still needs to be invested. It comes more than ever down to making the right investment decisions. Huge funds have been raised here in Europe as well And this is probably the last mega-billion round that we can expect. Private equity firms will be become factories in the end with management fee as the major incentive and this doesn't reflect alignment of interests. I don't think that is right. In my view, groups that are unable to invest all their money should hand it back to investors. This is specifically an issue now with some venture funds that are just too large. I know there are some groups that have talked about doing this, but up till now only Softbank has handed back money to investors and discussions are going on about other funds.'
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How do you think the market will change over the next few years?
‘I think that we will see continuing demand in Europe, as the early-stage market develops and the opportunities from corporate restructuring continue to feed through the system. I would expect to see many more groups adopting specialist strategies, such as turnaround funds. At the same time, though, I think we'll see widening strategies. So we'll see many more venture capital firms operating global strategies and investors should be more flexible in their geographical allocation.

‘I also think that there will be many more spin-off firms. Succession is a major issue at the moment and it's something that we look at very closely in our due diligence process. We don't want to invest in a fund and then find that the key people managing it walk away after four years. In a way, spin-offs are just part of the natural cycle in private equity, as many venture capitalists are entrepreneurial types. They believe that they can make more money and get more out of spinning out and setting up a new firm. In many large firms, there is a layer of people just below senior level who have seen their share of carried interest gradually decrease as the firms have increased in size and the carried interest pot is not the same anymore as opposed to a year ago - these are the people who will spin out. These investment people think there is much better value to be found in the mid-market and prefer to stick to their knitting. We have experienced a similar phenomenon happening in the US in the mid-nineties and will see this also occurring in Europe within the next two to three years.'