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Institutional investor profile, Simon Thornton, Landmark Partners Europe

Landmark Partners is a US-based firm with $3.5bn under management, of which 75 per cent is dedicated to private equity. The remainder is invested in real estate. Established in 1984, the firm specialises in secondaries investments, but also commits capital to first-time funds. Landmark Partners Europe, which is headed by Simon Thornton, advises Landmark on European and Middle Eastern activities.

Where do you invest?
‘The secondary funds are the core part of the business and we have a global mandate. Some players in the secondary market raise funds for venture funds, for mezz funds, for buy-outs, for Europe and for the US. But we have taken the view that it is better to have global funds with no particular focus, simply because if you look at a portfolio, it may purport to be a pure US venture portfolio, for example, but you'll often find some US buy-out or development capital investments within that, plus maybe some Latin America etc. Closing a secondaries investment is complex enough without having to divide up a portfolio between different funds that you run.

‘We have taken the view over the last five years that we will run global funds. Within that, there is no fixed allocation between international and US. Traditionally, around 85 to 95 per cent has gone to the US, but that is more an indication of the relative sizes of private equity markets globally. We are a team of 35, based in Connecticut. We set up a London office four years ago, focused partly on fundraising and investor relations in Europe and the Middle East and partly on transaction sourcing for the secondaries side. We also source the primary funds activity as well as conducting early appraisals of potential investment opportunities. We have such great expertise in evaluating and executing secondaries and next generation primary funds sitting in Connecticut, it wasn't going to be possible to replicate that in London. You can't find people with that experience in Europe, and the market is still too small to justify that scale of team. So, once we have identified a potential investment opportunity that looks interesting, we can get someone on the plane from Boston to come over here.'

What type of investments do you look for?
‘As a secondary player, you have to be very opportunistic. One year, you may see a very good deal flow of well priced buy-out assets, the next, you might find venture assets are more attractive. We tend to focus on small and medium-sizedsecondaries investments, smaller privately negotiated transactions. Those have historically tended to involve venture assets because the investors in big buy-out funds have generally been the big state and corporate pension plans. When they have sold, they have tended to go down the auction route. We do smaller deals from individual sellers with maybe a few venture capital fund interests in the $5m to $30m range. At that sort of size, it's not feasible to conduct an auction process.

‘But, during 2000, the fund that we invested was far more heavily weighted towards buy-outs because we weren't comfortable with the pricing or the quality of the venture assets that were for sale. We will look at any asset that we believe will generate a good return for our investors. Having said that, within the overall context of our portfolio, we will always have an eye on our exposure to particular countries or particular fund managers, or particular sectors. We wouldn't create a fund that was 60 per cent with one fund manager or 40 per cent within biotechnology. We want diversification.

‘We will invest in any group from the very best of the best US venture capital funds to, in some cases, the worst of the worst. Actually, if you look at some of our early returns –we were around in the early 1990s downturn in the US venture market - some of the funds then that generated very good returns for us generated some very poor returns to their original investors. Take a fund that makes 20 investments, writes off 15 of them, writes down the remaining five. We buy at a discount on the written down value on the remaining five. For the original investor, it will be a very painful experience, but for us, if one of those investments then comes good, we can do very well out of it. We obviously take into account the quality of the general partner when we are appraising the value that we expect to come out of a portfolio. But at the right price, we can make the same return from a weak general partner as from a good one.'

How do you find out about investments?
‘We spend a lot of time on the road, both in Europe and the US, with limited partners, general partners, advisors to the GPs and LPs, consultants, we spend a lot of time attending and speaking at conferences to make sure that as many people are aware of us as possible. So deals tend to come to us because we have spent a lot of time on the road. We do identify potential opportunities - we target particular groups because we know what is happening in a given market. But generally, we are well enough known for people to come to us. We make sure that we are well enough known.'

What would you say makes a good general partner?
‘We're looking for the ability to work with a portfolio company, to ensure that the investment stays on track and to exit the company successfully. We have no influence on the way that the partnership is run. We rely on the GP to get our money back and to get a good return for us.

‘They have to be able to manage the whole lifecycle. For instance, one of the issues now is that if you're buying a partially funded venture capital fund, say 40 to 50 per cent drawn, you have to form a view on what the GP is going to do with the outstanding 50 to 60 per cent. If you have ten companies in that portfolio and the GP is going to use the remaining capital to nurture the two really great businesses through to becoming very profitable investments, that is one thing. If they are not going to have the discipline to pull the plug on the bad companies and they continue to drip-feed your capital into loss-making businesses, you don't want to be in that situation. That is partly a question of experience and it's partly a question of discipline.

‘As a VC, if you don't back and build good companies, you won't make great returns. They may be able to take advantage of a short-term anomaly in the public markets, but as we've seen over the last year, that anomaly won't last.'

It must be an interesting time to be a secondaries player right now…
‘It is a very interesting time to be a secondaries player at the moment. There is a huge opportunity to buy assets. But there are also very big dangers at the moment. General partner valuations have been slow to adjust to reflect the real situation in the underlying portfolio companies in many cases. We have seen a lag of two to three quarters in venture capital valuations for assets coming into the market now. A very good example of this is that the returns for venture capital were around minus nine per cent in 2000; on Nasdaq, the returns were minus 40 or 50 per cent. If Nasdaq comes down by that much, venture capital should come down more than a few negative percentage points. This is because the valuations haven't come down to reflect public markets.'

‘As an experienced secondaries buyer, you never simply look at GP valuations, you form your own opinion of the real value of each underlying company. That always has been true in the secondary business, but it is even more crucial at the moment. It has been hard to call the bottom in technology downturn, but it isn't only hard for secondary buyers, it's also hard for venture capitalists and for public technology equities buyers as well.

‘There are funds out there that we would not be given right now. If they have a significant amount of uncalled capital, you can get their existing investments for free and still believe that the downside on the uncalled capital is greater than the upside on the existing investments. There are funds out there that have already lost 95 per cent of their committed capital. If you're looking at a fund that is relatively new and run by a relatively inexperienced team, you have to ask yourself what they are going to do with the remainder of that capital. This is particularly true of the very new funds that have raised capital during the internet boom, made good money very quickly, but the individuals have never seen a VC downturn or a public markets downturn. Many of them will lack the discipline to invest well during this cycle.'

That would imply that there will be huge consolidation…
‘People are saying in the US at the moment that up to half of the current venture capital players could disappear over the next cycle. But there has been a vast growth. You will see some of the new entrants disappear. And I think that you will see some of the very established players close shop over the next five to ten years. This is either because, while they are well established and have a good track record, they have made some very bad investments over the last few years and this will show through in poor performance. Or it is because you will see the situation where the senior partners decide to retire leaving the junior partners, who are meant to be locked in by the carry from a 1998 or 1999 fund that has lost 35 to 40 per cent of its capital. They won't raise a new fund until 2003 or 2004. Are they going to spend their time fire-fighting a portfolio that they know will never generate any carry? If they're good, they will go to another firm that has done better through this cycle. So you may see firms dissolve.

‘That will be a huge opportunity for the secondaries market because somebody is going to have to come in and re-organise those funds and find people to come in and manage out the assets. I think secondary investors are in a very good position to help do that. We've done that before. Part of the secondaries market is the very traditional business of buying the private equity fund interests from institutions. But actually, over time, we have seen the business become more complex to include limited partner interests, plus a couple of co-investments, then you have partnership, plus co-invests, plus a few directs. In each situation you have to work out how to put the right people in place to manage out those assets. If you have direct investments, you need to find someone to take over the management of the assets.

‘Over the last few years, we have done a couple of transactions in which we have spun out teams and portfolios of direct investments from captive institutions or from funds that have decided to change strategy or narrow their strategy. That is a far more complex and interesting process. In some cases, you have to bring together the remaining limited partners in the fund you are trying to buy, the general partner of those funds and the group that you want to manage the assets once they have been spun out. So it not just a buyer-seller negotiation, it's a four-way negotiation with some potentially very conflicting interests. That is fascinating work and it's where we can add a lot more value because we have experience of structuring that sort of situation and because we have the capital to back the decisions that we're taking. I'm sure that we will see much more of this type of work over the next few years because of this huge restructuring of the US industry and in Europe as well.'

How do you conduct your due diligence on investments?
‘It is a potentially hugely complicated process because you may buy a large number of funds and an even bigger number of portfolio companies in a single transaction. The way we approach our due diligence depends to a certain extent on what we're buying. If it's a portfolio of fund interests that we know very well because we already have a commitment to it, then we can often work largely with the GP. If we're buying a portfolio that involves direct investments, or a portfolio where there are some very significant individual investments through a concentrated partnership, then we would want to go down to company level, meet with CEOs, etc. So it really depends.'

What advice would you give to an investor new to private equity?
‘Investors new to private equity should think first about how much they are committing to the asset class. The amount that they are committing to the asset class has to determine the strategy. If you are a E1bn pension fund aiming to make a one per cent allocation to private equity, you can't do it directly into partnerships. If you are a E50bn fund aiming to commit five per cent with the ability to deploy the human resource, evaluate the funds on the market, spend time getting to know them, spend time after you have invested to manage those investments, go directly into funds. Maybe start with a fund of funds or a secondary fund to give you initial exposure to the asset class. Again, depending on where you are, adapt your strategy accordingly. If you are a European investor, you might decide to invest directly in Europe and use fund of funds or a consultant in the US.

‘If you're investing for the first time, you are probably coming to the market at a great time. Over the next three or four years, you will probably be able to get into the best funds - ones that a couple of years ago you wouldn't have had access to. You will also be able to see how managers have performed in a downturn. During the 1990s, it was very easy to make money both in venture capital and in the buy-out space. Frankly, if you were trying to decide then whether a manager who has produced 170 per cent IRR was better or worse than a manager who produced 233 per cent IRR, you would have had a job on your hands. Both were meaningless numbers. Now, you know that if a manager who raised a 1999 fund has a positive IRR, it has exercised discipline in an excessive market. If you look at the 1999 funds, you will find that they vary between those who invested all their capital very quickly and those who invested between ten and 20 per cent of capital during 2000 and took a very cautious approach. My view is that they are probably the ones that you want to back over the long term.'

What is the biggest issue for the private equity industry?
‘The key problem today - and probably for the next two or so years - is what to do with existing portfolio companies that aren't fully funded to execute their business plans. There are some great venture-backed companies out there and it is going to be very hard to raise capital for them. It's going to be a number of years before the IPO window opens again. The difference between this downturn and the one in the late 1980s is that when public markets fell away, corporations stepped in and bought many of the best companies, giving VCs an exit route and ensuring that the value was captured. The problem now is that corporates were incredibly active in the venture capital market in the late 1990s. Many of them have been badly burnt and they are not going to be big acquirers for the next couple of years.

‘That exit route is going to be quite difficult. If you are someone who invested their capital very quickly on the assumption that the company wouldn't need follow-on financing, you haven't got the capital in that fund. Even if you raise new capital, it is very hard to invest that money in existing portfolio companies.

‘This downturn will dent industry confidence badly. It will come back, but I think it will take a few years.'

How do you think that the market will change in the future?
‘The industry will get smaller. There will be a real shift back to fundamentals. Investors will focus on what they do well. So you won't see the situation of buy-out funds investing significant chunks of capital in venture capital deals. I'm sure that the pendulum will swing too far the other way. You will see really good private equity fund management teams unable to raise capital even though they deserve to.

‘The institutions that have been in private equity over the long term are likely to stay in the asset class. But if you're a pension fund that started making commitments between 1996 and 1999, you're probably looking at a difficult couple of years. Industry returns over the next few years are going to look terrible and when that happens, why on earth would new institutions want to invest?

‘The statistics that the venture capital industry compiles are complex. It's an asset class that you need to measure in different ways from public equities, for example, if for no other reason than the valuation issue. I am convinced that there will be some fantastic opportunities over the next few years. But if you look at performance up to 2001 and base your decision on that, you probably wouldn't do it.'