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Institutional investor profile: Daniel Keller, Director, LUMA Capital

Keller on the attraction of fund innovations, on the difficulties of co-investing as a small investor, on why he's optimistic about the US venture capital market, and on the over-dependency of private equity on institutional money.

Based in Naples, Florida, LUMA Capital is an investment company that manages the wealth of high net worth investors. It has advised clients on over $100m in private equity and invests both directly and via funds. LUMA invests predominantly in the US but will also consider Europe and takes an opportunistic approach to the market. Keller is an accountant by training and has an MBA from the University of Chicago. He spent 13 years in Europe managing assets in public securities and private equity before setting up LUMA Capital.

What type of investments do you look for?
‘We invest in public markets as well as other alternative assets, but we make a lot of commitments to the private equity asset class. That's partly a function of my background and because a lot of my clients created their wealth through either family businesses or entrepreneurship.

‘We are opportunistic in our approach to private equity. If we think that a particular region or sector is going to do well over a period of time, then we will identify ways in which we can gain exposure to it. We are looking for areas or managers where there is a macro or fund manager reason to invest and where we can see the value proposition. Since we are opportunistic, there will be times when we invest more in mid-market buy-out funds than other types and there will be other times when we're looking at other areas. We are fairly loyal to funds that we like and that have done well for us in the past.

‘As a result, we don't have target allocations or weightings to particular types of investments. We are not capital constrained and so when we see a fund we like, then we will deploy capital. Having said that, we do pay attention to where we are investing our money and we will address the balance if we feel that we are over-allocated to a particular area. There was a point in time when we may have been over-committed to venture capital, for example. But now that valuations have come down, the imbalance has been corrected.

‘We invest predominantly in the US, but we do also make some select investments in Europe. I travel a lot to Europe - about six or seven times a year - and I try and see managers that I like the look of when I'm over there. We are looking to make a few more investments there.'

How does your direct investment programme work?
‘We look at a lot of direct investments and would like to do more. My background of doing due diligence for clients on direct deals makes me comfortable in analysing them. Also, about two years ago, my partner Richard Molloy and I started talking about the opportunities we thought we would see on the smaller company side. He has a very complementary skill set to mine, with a background as a management consultant at Booz Allen and prior to that as an officer in the British Army. We felt there was an opportunity for us to do smaller, direct deals as well as potentially investing in some larger co-investment deals. As well as looking at local deals, we have a good international perspective. I am a Swiss-American, he is British and we have worked in Europe, the US and Latin America.

‘But as for co-investments, my experience is that, as a small investor, we tend not to see that many opportunities. Those we do see may not be of the best quality. We would love to co-invest alongside GPs, but they prefer to put their best deals in front of their largest investors which makes perfect sense. Instead, we tend to do this: if we find a deal that we like, but that we don't have the right experience for or it is too large for us, we'll take it to someone who does and then make a small co-investment alongside them.  Sometimes we have deals referred to us from mid market funds - deals which are too small for them to do. This is something we really appreciate.'

What do you look for in a fund manager?
‘I want to see funds that have something unique about them. Something that makes them stand out from their peers or something about their understanding and knowledge of a specific market.

‘Generally, I don't like large funds. I'm not saying that they can't do well - I just think that there is a potential misalignment of interest between GPs and LPs there. I'd much rather see a smaller, dedicated fund with a better alignment of incentives.

‘I also like to see an overlay of skills. So, in a mid-market fund, for example, we like to see a good mixture of operational and financial engineering skills. On the VC side, I think the most important factors are the operational skills and people with solid networks, people who understand how to get a company onto the path to profitability.

‘Decent return figures are fine, but that's only part of the story. At best, IRR numbers are a beginning screening mechanism. I pay a lot of attention to unrealised versus realised gains. I also want to compare their numbers with what was happening in their specific market niche as well as what was happening in a comparable public market security/industry.'

What's your appetite for first-time funds?
‘I like first-time funds a lot. I think that many private equity firms make their best returns in the first few years of their existence. The partners are hungry and lean. I do find that some first-time funds that are spin-outs of larger private equity firms are sometimes too large. I'm not against spin-outs, but I like to see funds that start out small and that have an incentive to grow. I also want to understand why a team is spinning out.

‘The exciting thing about newer funds is that they are often innovators. I'd love to see funds that have new twists in their fund structures, etc, to cater for investors' needs. I think a smart person will eventually come up with a fund structure that aligns the costs and returns to investors a little better.'

What type of innovations would you like to see?
‘This is a question that I ask institutional investors quite a lot. Many of them complain about particular terms, etc, but I don't think that anyone has stepped up to the plate in terms of suggesting and negotiating the types of conditions they would like to see. There is definitely room for improvement and there should be an impetus for this, especially as returns have been relatively low in recent years. Why do you have to stick with the so-called standard terms?

‘I think you are starting to see some changes - I recently saw a fund that offered investors a choice of terms and fee structures. I thought it was a great idea. You could draw your own return scenario as to how you thought that fund would do and see what the implications of each structure would have on your investment. I think good funds will start coming up with this kind of innovation. At the end of the day, if they are in it for the long term, they shouldn't worry so much about short-term returns.'

What is the biggest mistake that you have ever made?
‘Hindsight is a wonderful thing. We do a lot of analysis on the public markets and probably the biggest mistake was not hedging the public markets against our private equity investments. Not just on actual individual stocks but also on baskets of securities that would have correlated with the underlying PE holdings.

‘We also had a loss on an incubator in mid-1999. It was a very small investment for us where we wanted exposure to what was happening in that space. It would be very easy now to say that I shouldn't have invested in it but at the time the team was very solid, had good capital markets experience and had vision about what they were going to do. Unfortunately, they didn't execute to plan and strayed from their normal valuation judgments.'

What's your view on the current state of the US venture capital market?
‘We are quite optimistic. On the direct side, for example, we are seeing some great companies. At a fund level, there are more opportunities as valuations have come down, and trade sales are starting to pick up. The problem is the over-capacity issue. Everyone is supporting their own portfolio companies and the question is how long funds can continue to hold out a lifeline to companies rather than just letting them die. I think new money going in now is getting invested at a good valuation.

‘One thing you have to do is compare the opportunities in the private markets with what is happening and with those opportunities in the public markets - especially in light of the correction and then rebound in the public markets. You have to balance the valuations, opportunity, liquidity and fees of the two markets. For example, at the end of last year there were quite a few public companies that were really beaten down and yet they had VC-type growth prospects, decent balance sheets and liquidity.'

What irritates you about private equity?
‘Fees, fees and fees. In particular, the fees on capital not deployed. The patience required is another irritant but that's part of the asset class. Also there is clearly a lot of spin involved before you invest and there are a lot of stories after you invest. You have to look through this.'

What is the biggest issue in the market at the moment?
‘I think the biggest issue is the GP-LP relationship. That is under quite a lot of strain at the moment. GPs have a lot of work to do to get investors confident in the asset class again. You also have the disclosure issue with the public LPs.

‘The other thing is that private equity has traditionally had a lot of endowment and pension money and in some respects I think that it has become too dependent on it. I'm not sure that's a good thing. The capital source has become too institutionalised. If you ran a mid-market buy-out fund, say, based in the Southwest of the United States, I would say that it is probably better for about 25 per cent of your money to come from CFOs and CEOs, etc of operating companies instead of having five or six large pension funds. I understand the advantages of having a stable base of investors but I think potential deal source is more important. It doesn't hurt to have a diversified investor base as long as the fund isn't taking credit risk.'

How do you think that the market will change?
‘I think that the market will continue to evolve. I think that developments in securitising portfolios will continue. If you can separate the cash flows and risks, more investors will become interested in private equity. People can build some fascinating products around that.

‘Given my background, I'd also like to see a much more active and evolving derivative market around the asset class. With all the data on past performance that's out there, it would be nice to see the evolution of an options market for speculation and hedging.

‘The development of the secondary market is a very interesting feature, too. It changes the nature of the private equity market as a whole. It's a very positive thing for both buyers and sellers. However, there's still a lot to be done about transparency and ease of transfer.'

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