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Institutional investor profile: Christopher S Bödtker, Principal and Head of Private Equity, Lombard Odier Darier Hentsch & Cie

Bödtker on the attractions of the mid market in Europe, on firms that raise too much money, on looking beyond IRRs, on increasing self-awareness among managers and on firms that aren't meant to outlive their founders.

Based in Zurich, LODH Private Equity is the private equity arm of Swiss private bank Lombard Odier Darier Hentsch & Cie. The bank has been investing in private equity funds for decades, but decided to formalised its approach in 1998 when it set up a unit to manage fund of funds operations and direct investing. LODH also manages funds that make direct private equity investments in the life sciences space. These are advised by Ultreia Capital, which is owned by former members of the firm. The private equity operation has over E500m under management. It is currently raising its second European mid market fund of funds programme, which is targeted at between E200m and E250m and scheduled for a final close at the end of 2003 or early in 2004. Bödtker joined LODH in 1998 to set up the private equity operation and was previously a Managing Director with UBS.

What type of investments do you look for?
‘We take a thematic approach to private equity investing. Our primary focus is on mid-sized companies in Europe. To give our investors access to this important segment of the market through one sufficiently diversified product, we have split our allocation 70 per cent to funds and 30 per cent directly in companies - some of which goes to co-investments.

‘We decided early on to invest in the mid-market segment because we felt strongly that the risk/return opportunities would remain the most favourable. We have known for a number of years that buy-out funds in Europe tend to fall into two categories with distinct different profiles. First, you have the larger funds that focus on pan-European deal flow, mainly at the larger end. Most of these have strong London connections. Second, you have funds that focus on national or regional deal flow and target companies with an enterprise value of between E50m and E300m. It's managers in this second group that we seek to back. We believe that you have to have a strong local presence to do good mid-market deals. Our investors - who share this view - have a strong preference for being invested in one or two of the best funds in each country or region.

‘We feel that our approach gives investors the optimal mix in a mid-market portfolio - you get the effect of industry and country blends and you get good manager and vintage year diversification. Fund managers' style and level of involvement with their portfolio companies varies quite widely from market to market and sector to sector so you also get different levels of leverage and a use of different drivers to create value. In almost every dimension, this strategy gives a different real diversification.

‘We don't invest in venture capital in our fund of funds. That's not to say that you can't get good returns from venture - we believe that you can. We do however believe that it can be hit and miss and that the risk/return characteristics of European venture capital fund investing are less attractive in comparison to the mid-market. We also believe European venture capital managers to be much less seasoned than their US counterparts. Plus, commercialisation of products happens faster in the US as it is one market. All this contributed to our feeling that, from an allocation point of view that it did not make sense to invest in venture capital funds. Additionally, we believe investing in venture capital funds requires dedicated US focused resources.'

Would you look to expand into the US in the future?
‘The view we take is that we wouldn't invest in the US unless we were prepared to put resources in place for this and then likely on the ground. At this point in time, it is not a priority for us to do that. Our primary focus is to exploit the resources and expertise we have in Europe. We have a lot of experience in Europe and we have access to the best funds here.'

What is your appetite for first-time managers?
‘Our rule tends to be that we will not invest in unproven teams. We will qualify someone as proven if we can demonstrate to ourselves that the managers have already worked together in some way and invested together. So we will look at creation of groups that have joint track-record or spin-out teams, etc. These are very interesting groups for us. We want to back proven investors and partnerships that have proven their stability. This is important irrespective of a manager being a spin-out or fund V. We go to quite some length to review this latter point - it's very much an issue of data gathering and forensic work that ultimately results in a well founded qualitative judgment.'

How much do you rely on track record when you assess funds?
‘We do a lot of assessment of a fund's track record, but we break it down and analyse each individual investment that has been made. We have a very resource-intense bottom-up approach to our due diligence and we have become known for that. But we believe that you can only really judge a fund's track record by analysing each individual deal in detail and double-checking all our findings with numerous reference calls. We want to understand how a manager derived the returns in an investment and what the common threads across a portfolio are. We need to be able to compare the analytical conclusions of this process with the strategy, set-up, size, resources, etc that are being proposed in a next fund. This approach helps us judge whether the drivers for success in a previous fund are applicable to the future. The new fund of course also needs to be compared with the changes that have occurred in the environment and the space a manger operates within. In a sense, that's our ultimate aim when we are conducting our due diligence.

‘One of the most important aspects of our due diligence is the reference checking - on the team as well as on the transactions. We have designed the process so that we can let the market tell us more information, whether or not we have the right details and whether we have come to the right conclusions. That is an extremely time-intensive process, but one that pays off.'

What irritates you about private equity?
‘I get irritated by the vast amount of money that gets thrown at some funds. Many investors do not take the time or make the effort to analyse the amount of money offered to a fund against the number of managers, the strategy or the target market. Instead, they analyse it against the background of a manager's success by looking at previous IRRs. In turn, good managers are flattered by the amount of money they are being offered and they accept it. Investors should be matching the level of capital they put into a fund with the managers' strengths and to the market in which they intend to deploy it. We prefer managers to get a roll over from early returns for example, rather than have them raise a fund that is too big for their needs, skills or for the demand for capital in the market.

‘When they raise too much money, good managers often fall into the trap of building too large a portfolio. This is probably one of the biggest threats to the market although it will eventually assist a shake-out. We also hate to see managers that have raised too much money start lowering the quality of investments that they make - that can only have a negative impact on returns.'

Is that one of the reasons why you tend not to invest in larger funds?
‘Yes, it is one of the reasons. But there are other factors. One of these is that our analysis shows us that at the larger end, funds tend to pay high prices. Another is that large funds tend to buy market leaders. For a company as a market leader, it's almost impossible to grow at a multiple rate to that at which the sector is growing. It's very hard to grow at seven, eight or ten per cent per annum if the market is growing at two or three per cent. In a smaller niche that has a driver in another market or in an unconsolidated market, however, you can expand quite quickly and you are not stealing market share in a too obvious way.  So the combination of paying full price and the lower growth opportunities have meant that we have shied away from the larger end of the market.'

What is the biggest mistake that you have ever made?
‘Our mistakes have come when we haven't been vigilant enough about the purchase price of an asset and paid for more than we really got. This is very hard to get out of later. On the fund investment side, some mistakes have been made through believing that a partnership is more stable than it actually was. A mistake in these areas can lead to some serious problems requiring enormous resources to fix. The old axiom in merchant banking, that a work-out transaction takes ten or more times the resources of an average deal, seems to always hold true. As an investor, if you have a partnership that is no longer cohesive, for example, it doesn't take long for a portfolio to sink from a reasonable value to only just getting your money back.'

Do you think there is sufficient redress built into partnerships for you to deal with this type of situation?
‘There certainly should be more. We work very hard on areas such as the key man clauses, no fault divorce clauses and escrow of carried interest in the terms and conditions. We like to have an advisory board seat so that we get an early warning if things are going wrong. We also like to have some teeth in the clauses so that we are able to do something about it. Having said that, we don't want to be back seat drivers. We like to have our noses in it, but be hands off - unless something happens.

‘Our bottom up approach and reference checks that we do for our due diligence help inform us for the terms and conditions negotiation. During our reference checks, for example, we are able to identify who the lead players are in each deal. That helps us negotiate who should be included in the key man clauses and in what way. If one of the key people leaves or is incapacitated for whatever reason, then it doesn't mean that the whole thing comes to a grinding halt and is liquidated. This is usually in nobody's interest. It just means that we will have to talk seriously with the firm to work out a solution.

‘We think that it's important to have an advisory board seat because it keeps us in close contact with the managers. I realise that not all investors have the resources or the set-up to manage this, but for us it is vital. It's not just to keep an eye on what is going on; it's also because, by being there, we can identify areas in which we are able to help in some way. We can put LODH, the largest Swiss private bank, at their disposal and that can be very powerful. That could be helpful in deal origination and in clinching a deal. It can also help for exits and other areas of managing investments. Partnerships really appreciate the contacts that we can bring to the table.'

How do you think the market will change in the future?
‘I think we are entering an interesting time with much change ahead. There will be a realisation in the industry and among investors that too much money has been thrown around, although the realisation will come too late.

‘I also believe that managers will become much more self-aware. They are now starting to spend time working out what skills they really have and play to those skills. Good managers will become very cognisant of their strengths and they will work hard to exploit them. That has happened in the US and I am confident that it will happen in Europe. Allied to this, I also think that some managers will start realising that carried interest on a smaller amount, but on a much higher IRR, is more powerful than a linear return by getting more management fees. Managers that have accepted too much money, or that have changed their strategy, will find themselves punished severely by investors in the future - investors will no longer re-up on funds that produce mediocre or poor returns.

‘There will be a much clearer segmentation in the market. You will see a large, institutionalised area of the market, but you will also see more of the smaller specialised managers. The high returns will be with the specialists while the institutional end will continue to fight fee pressure from investors and become a benchmark return provider. They will provide lower IRRs, and will constantly have to justify that they produce an acceptable premium over public market assets to stay in the game.

‘European managers and investors will also start realising what the impact of generational changes among fund managers will be. Again, this has already started to happen in the US, but it is only just beginning in Europe. Investors should start to think about what happens when the founder and managing partner is not there for fund VI (and for fund V, he'll only be there as chairman rather than managing partner). That is a tricky situation to be invested in. There are some firms that just aren't meant to outlive their founding partners and there are some that won't survive because the market they have been successful in no longer exists. As institutionalisation is somewhat of an oxymoron in the mid-market, the true survivors will be few.'

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