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Institutional investor profile: Roberto Pilotto, Funds Director, PPM Ventures

Pilotto on the attraction of mid-market country-specific funds, on adding value as an investor, on the changing nature of competition in private equity, and on what terms can tell you about a manager's motivations.

PPM Ventures is the private equity investment arm of UK insurance group Prudential Plc, which has been investing in the asset class for over 20 years. In 2000, Prudential decided to increase its allocation to private equity. PPM now has access to over E2bn, of which about E400m is dedicated to its fund investment programme to invest in European and Asian opportunities and the remainder is managed by the direct investment side of the firm. In Europe PPM invests mainly in mid-market buy-out funds and has a small portfolio of venture capital funds. Pilotto joined PPM in 2002 to head up the European fund investment programme from the European Bank for Reconstruction and Development, where he managed the expansion of its $1bn Central and Eastern European private equity fund programme.

What type of investments do you look for?
‘We invest in Europe and Asia (a separate arm deals with US investments). So far, we have around 55 per cent of our allocation committed and of that, about 70 per cent has been committed in Europe and 30 per cent in Asia. That may change over time, but that is how we stand at the moment.

‘We invest mainly in mid-market buy-out funds and we have a particular preference for country-focused funds. Typically, the fund size we like to commit to will be between E150m and E600m. When possible we try to seek a seat on the advisory board.

‘We also make some venture capital investments. We currently have a couple of commitments to venture funds in Europe and also in Asia. Overall, these do not represent more than 15 per cent of our exposure and we do not expect to increase that, at least over the short term.'

Why do you focus so heavily on mid-market country-specific funds?
‘We focus on this area of the market for two main reasons. The first is that, if you take the allocation of Prudential as a whole, it wouldn't make sense for us to duplicate the investments that the direct side of PPM already makes. So we don't tend to commit to large pan-European funds, for example, because our direct team is already investing in the type of companies that these funds invest in. The second is that we believe that if there is space for a new entrant and room for growth in an area of private equity, then that area is on the country-specific funds side. If it is true that the economy is becoming more pan-European, then it is also true that local players are becoming more interesting in terms of the opportunities they have access to and in terms of the returns they are able to generate. We like independent, country teams that we can build good relationships with.'

How does your fund investment side fit with your direct arm?
‘We feel that the fit between the two activities makes us a strong player and differentiates us from other investors in a number of ways.

‘The first thing to bear in mind is that we are not an asset management company or similar institution. These types of investor tend to look at diversifying through investing in private equity via funds and then move slowly into co-investments and sometimes even direct investments. We are doing this the other way around - we were direct investors for many years before we became fund investors. That means we have an understanding of multiples, valuations, of which sectors are hot at particular times, of the hurdles that private equity teams face in different parts of the cycle and so on. This knowledge automatically allows us to have a closer relationship with the teams that we back. We can help them on occasion and exchange information with them.

‘Additionally we can co-invest in much the same way that any other investor can. If you take a typical fund of funds, they sometimes have a separate direct investment team and sometimes it's the same people making fund and direct investments. But they are generally not experts in direct investing. They basically piggy-back off the fund manager originating the deal - they passively use their due diligence and make their decisions on that basis. But we have an intelligence and experience that we wouldn't have if it weren't for our direct team. That enables us to be much more proactive than other investors and allows us to respond much more quickly to a call from the fund manager. As a result, we can be valuable investors - we can add more than simply capital.

‘The other important thing is that as Europe becomes closer, the more we find that we can help source deals for our funds. This is because you are increasingly finding that, say, Swedish deals can have an Italian side or UK deals can have a Spanish side and so on. We are seeing a few cases where deals considered by our direct arm have an important element in the countries in which we have invested and we have been able to pass them on to our funds' GPs for them to consider.

‘I think that these factors are very well appreciated by the teams we are invested with, especially in an environment like today's. I talk to them on a daily basis - they call us for advice and knowledge and we call them too.

‘The real issue for us is to be an important investor - I'm not talking about being a sponsor or anything like that. We like to sit on advisory boards so that we can have some influence and provide the value added I mentioned before.'

Do any of these funds view you as competition?
‘We try to avoid the issue of competition. We see our direct arm and the expertise it has as more of an opportunity than competition to the funds we invest with, which tend to be in areas where we don't have the in-house skills.

‘In any case the market is changing - funds are no longer only competitors to each other. They can be buyers, sellers, co-investors. Furthermore, if you took the traditional view of the market, even certain funds of funds could be viewed as potential competitors for deals. You have to look at the market in a different way.'

How many co-investments have you made?
‘First let me say that we don't invest in funds because of the co-investment opportunities that they are going to offer us; we want to invest in them because we believe they will deliver the best returns for our client.

‘We have completed one co-investment in Asia and in Europe we are looking at a couple of potential opportunities right now. This is because in Europe our programme is fairly new and so far we have been concentrating on building relationships and knowing our fund managers. But we are happy with the co-investment deal flow that is gradually emerging. We have looked at a number of co-investment opportunities but they haven't materialised for different reasons. We don't want to rush into deals because we don't feel that is the right way to approach them. We have rejected some co-investment opportunities on the grounds of pricing and quality, but also because in some cases we have found that we didn't have a specific role in the deal. We like being able to add value in any co-investment we proceed with and that will normally happen when we know or understand the sector, have access to management expertise that can be helpful to the deal.'

Do you have plans to raise third-party money?
‘We have to establish a track record in our fund investment programme and it will take another two or so years for us to build up our resources, knowledge and expertise. So in the short term, it's not something that we are looking at doing. In the long term, however, we may consider raising third-party money.'

How does your investment process work?
‘We do a lot of screening before funds actually come to market. We try to get a view on teams before they hit fundraising mode. In conjunction with this, we take a top-down view of where the next opportunities will be and where the competition for deals is increasing. We have seen a lot of teams raising in France and targeting the same type of deals, for example. That's not to say there aren't enough opportunities there, but it does make us more cautious. On the whole, we are of the view that top team selection is more important than diversification and we are driven by trying to identify those that will be the best performing teams of tomorrow.'

How do you judge that?
‘We don't focus too heavily on the track record of a team - that's a prerequisite and it doesn't tell you much about future performance. We look at the skills of the team, the attractiveness of the market, investment strategy and the life cycle stage the team is at in terms of its own development. That last point brings into play issues such as motivation, cohesion and team balance. There are teams out there that have delivered excellent returns and in theory they should be very good teams. But you have to question whether they still have the strength and the hunger to fight for their deals. On the other hand, there are teams that may have made some mistakes in the past, but they have now climbed their learning curve and it may be their moment to do very well.'

What's your appetite for first-time funds?
‘We look at first-time funds and have committed to a couple of them. But they must be run by people with a good track record who can demonstrate to us that they can work together. You face certain risks when you invest in a first-time fund, such as partnership risk, but you also invest with people who have a tremendous drive to succeed and to provide excellent returns - that's something you don't always find with teams that have been successful in the past. They also do not have portfolio issues from their previous funds.'

What puts you off investing in a fund?
‘In Europe we have noticed that, very often, funds IV and V are not as good as funds II and III. Motivated by high management fees, there is a temptation among many funds to continue increasing the size of their funds and the number of people in their team and that can have an impact on quality of deal selection and returns. It's just the same as a small company that grows too quickly - it's difficult to control the organisation, to delegate enough and develop internal systems to cope. And so these are the types of fundthat we would evaluate carefully.

‘Terms, too, can put us off, but not just because of the terms themselves. A lot of people believe that if you have the right team, terms don't matter. Our view is a little different in that the terms can often tell you the team's real objective - sometimes they can be so excessive, they betray a short-term attitude among the managers. That can be a signal to us that something is not right.'

What is the biggest mistake that you have ever made?
‘I think that the mistakes I have made have come when I have misjudged people in evaluating their motivation at particular moments in time. That is on a personal level. It's actually too early to tell what the mistakes will be for PPM. I think that maybe we should have negotiated harder on some terms, for example, at the very beginning, but I doubt that will have a material impact on our overall performance in the long term.'

What do you think is the biggest issue in the market?
‘I think that serial secondary buy-outs could start becoming an issue for performance. The level of activity we are seeing at the moment is not too problematic, but I think it becomes an issue when a company is bought for the third or fourth time by a private equity house. You really have to start wondering how much value you can get out of these companies. The first fund may have bought the company at 4x EBITDA, the second one 8x and the third 10x. How much can you squeeze from the same orange? How much faith can the company's management and other stakeholders have as they see a stream of private equity investors coming in and then cashing out? If this process continues, I wonder what kind of returns these funds will be able to deliver and in general as a limited partner I would not like that the funds we have invested in do too many of those or count on secondary buy-outs for their exits.

‘Many people talk about how you verify fund performance and how difficult it can be. To me, that is going to be of less importance in the future. It is clear that the market is leaning towards increased transparency. The whole industry is becoming more professional as investors, funds of funds, placement agents, lawyers, etc proceed on the learning curve, and that will have an impact on transparency. Funds will be under pressure to disclose everything and their story will be more verifiable. We have reached a point in the market where good placement agents are starting to refuse to represent clients unless they can do detailed due diligence on their performance, for example, because their reputation is also at stake.'

How do you think that the market will develop?
‘There will certainly be a lot more money for private equity from European investors. The continental institutions are now discovering private equity. Some may be put off by poor returns experienced in boom-bust cycles, but overall I believe they will stay the course. I think that may also encourage new local teams to spring up. These will be set up by talented individuals that might otherwise be part of a pan-European firm, but that recognise that they can tap local capital sources and set up their own country fund. If you look at Scandinavia, the reason you have a large number of strong local fund managers is because you have good sources of capital locally. That could easily happen in the next years in countries like Spain or Italy.

‘Everyone seems to be predicting a shake-out in the industry and I believe it will happen, but perhaps not as severely as some people think. I think the increasing flow of capital from Europe's investors will ensure that a lot of teams survive.'

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