Click here for printer friendly page

Institutional investor profile: Hermes Investment Management

Where does one of the UK's best known private equity fund investors place its money? And what does the stock market downturn mean for venture capital firms? We asked Hermes' Guy Eastman.

What kind of investments are you looking at?
‘We're seeking to build a balanced portfolio of private equity fund groups, focused mainly on Europe and to a small extent in the US and Asia. The fund of funds we're managing is purely a European product. The British Telecom Pension Scheme has also allocated capital to private equity - three per cent of its equities - equivalent to roughly £700m. Of that, roughly 60 per cent will go into fund investments (£400m) and the balance will go into co-investment opportunities/direct investments.

‘The area that I'm spending most of my time on is the £400m fund investments programme. Of that, 60 per cent goes into Europe about 25 per cent into the US and 15 per cent into Asia. You might say that the US is a small element, but there's a strong argument to say that Europe has a lot of potential now, whereas the US is already a heavily funded market.

‘We're investing in between 15 and 20 separate funds across Europe. Maybe four of those will be large pan-European buy-out funds, which will form around 35 per cent of the capital. At the other end of the scale, we'll invest roughly 15 per cent in early-stage venture firms. The balance will go into mid-market development capital and buy-out funds.'

Which countries in Europe are you focusing on?
‘We're focusing mainly on western Europe. If you look at Spain, Italy and Germany, the amount of private equity in their economies compared to their GDP is really quite small and they're all strong manufacturing economies. The north-eastern area of Italy is said to have more small manufacturing enterprises than any other part of the developed world, but the private equity market there is still relatively underdeveloped. There are a lot of opportunities to invest in groups that will target those types of business.'

‘For the last ten years, people have been saying that the German market is really set to take off. But even now, it's quite hard to find deal flow. I've heard that there are as many private equity firms in Germany trying to do deals as there were deals done last year. This suggests that there are either too many people in the marketplace or that there is the right number, but that deal flow hasn't developed. So Germany is on our radar screen, but it's still got a long way to go.

‘One of the issues with France is that a lot of deals have been done over the last ten or 15 years, but many of them haven't yet been exited. There are a lot of unrealised companies sitting in firms' portfolios. It's also quite difficult for non-French teams to make headway in France although one or two are starting to achieve success. But France is high on our list, as is Spain.

‘We want to find at least one good country-specific group in each of the major western European economies from Scandinavia all the way down to Spain. These will need to possess good contacts, knowledge and deal flow.'

What do you think about the central and eastern European markets?
‘In our fund of funds, we're planning to do one central European investment and we're quite close to selecting one there. But that's probably all we'll do because we need to convince ourselves that it is possible to get strong exits. The quality of the management teams in some of these firms is high. There's a lot of private equity intelligence in central Europe and we're impressed with some of the managers there. I just think that getting exits may take a little longer. On the other hand, there's less competition and entry prices are lower. So one of the arguments for going to central Europe is that you pay a low entry price with a view to building up a business that one of the western companies would then want to acquire at a high exit price.

‘But we're being careful about which countries we're looking at - it's really only Poland, Hungary and the Czech Republic. Many other eastern European countries are still too risky. We're quite conservative investors. Private equity has an inherent risk without adding very heavy country risk as well. So you have to be satisfied that the country you're investing in has a stable economy. One of our American investors told me that you should never invest capital in a country that you don't like visiting. If you don't feel at ease, then you shouldn't invest there. I think that's quite a good general rule.'

What do you look for in a management team?
‘People always talk about track record without analysing in detail what's involved. Firms will just throw out statements like, “Oh we have a 40 per cent track record”. But analysing how a track record has come about is what's important. You need to have a balanced portfolio, so you'll want a number of successes, one or two failures and the rest somewhere in the middle. But just saying it's a 40 per cent IRR doesn't tell you the spread.  You need to dig into each line of the investment spreadsheet.

‘You also need to work out who in the team actually did the deal and to be sure that that person is still there, that a firm isn't selling a fund on a team of deal doers who have now gone elsewhere.  A team's ability to stick together is very important. So if you back a fund, you need some confidence that five years later the people who made the initial investments will still be there.

‘You have to ensure that investments are being realised, too. If you see a fund that has made ten investments and six years on only two have been sold and the rest are at valuation, then that should cause some suspicion.'

How would you react if one of the team members left?
‘If there was a team of, say, four key players and one of them left, we would probably live with that. We'd like to know why, though. We like the core team to stay together, especially during a fund's investment period. It's not a great sign to your existing investors if one of the people who raised the fund then leaves halfway through the fund's life. The sort of question raised is whether they'd do that again. We also like the more junior members of the team to stick together and move up the organisation. If they don't, then it's a sign that the rewards system is not filtering down. All private equity firms need a succeeding generation to come up through the firm. You need to be sure that they're grooming people to take over.'

Would you ever consider first-time funds?
‘We would look at a first-time fund where at least two members of the team had been together before and had made investments together. What we wouldn't do is back a group of consultants who thought they knew something about early-stage investment and wanted to raise an IT fund on the back of their consultancy expertise. One of the key things about early stage is that businesses go through a series of rounds of funding and if you've funded a company from the start and they're on their second or third round of funding, you have to make a choice about whether to continue to the next round or not. A consultant may know everything about how the technology works, but does he have the judgment to decide whether to continue backing a company that isn't performing as he might have hoped originally? That kind of judgment comes from investment experience and from making a few mistakes, hopefully with someone else's money.'

What's the big issue for private equity investments in the coming 12 to 18 months?
‘The big issue is that stock market exits are going to become much tougher. Just where are those exits going to come from? What we're now seeing is only the beginning. People are just waking up to this and asking: “How are we going to deliver shareholder value?” Every day it's becoming tougher. Flotations are harder to do and M&A is slowing. There's no question that one of the reasons private equity has done so well over recent years is because of booming stock markets, especially the emerging stock markets in Europe for technology companies. This has driven the whole cycle of investment. If that dries up, then the industry will feel it because firms will not be able to realise as much, there won't be as much money making its way back into institutional coffers and that means there will be less to invest.'

Does that mean you'll be investing less in private equity?
‘We're not stopping our investment policy simply because times have become tougher. One needs to invest through cycles rather than try to predict them. Generally, the buying phase is better when the economy gets tighter because entry prices are more attractive. Shrewd investors should be able to make their capital go further than two or three years ago, when equity prices were much higher. Our view is to stick to a group that knows what it is doing, one that's been through a cycle before. A lot of people who started up in 1998 and 1999 will only have experienced the good times. The more seasoned players that have been around since 1988 or before will know the hard times.

‘Most of our investment teams will have a long record of investment. If you look at people such as Apax or BC Partners, these teams have been around since at least the late eighties and have raised a number of pools of capital. They have stable teams that know what they're doing and this gives investors confidence that they can work through a tougher economic climate and get the best transactions. So we're trying to choose the best 18 funds out of a universe of 500, by being fairly conservative and working with people who've been through an economic cycle of two. I'm a bit wary of the PPM that comes through for a second fund for a team that came together in 1998. They've invested their first fund pretty quickly and don't have many divestments or if they do, they're on the back of a booming stock market. The danger is that if you're a less experienced investor you might get sucked in because they'll tell you a very good story or give a very good presentation.'

What advice would you offer to a new private equity investor?
‘Choose established names and don't skimp on the due diligence - you must really dig deep. And avoid fancy presentations and IRR numbers where everything's tied to valuation, because things could turn negative soon after you have invested. It's a ten-year commitment and it's very tricky to get out early, even via the secondaries market.'

Guy Eastman is a director of Hermes Private Equity Management. He was formerly a director of Greenoak Capital Management, a member of the Granville group, which in 1999 became a member of the Granville Baird group. Immediately before joining Hermes, he was a member of eight fund advisory boards. He is a chartered accountant and gained his qualification at Arthur Andersen.

Hermes Investment Management is the principal investment manager of the pension schemes of British Telecommunications plc and Consignia (formerly the British Post Office) and manages assets in excess of £49bn. Hermes has a long-established history of private equity investment and has been investing in private equity funds for over 15 years. It has recently been granted a mandate on behalf of the BT Pension Scheme to increase its private equity investments to £700m and is the manager of the Hermes UOB European Private Equity Fund, a European fund of funds.

Copyright © 2001 AltAssets