Click here for printer friendly page

Investor profiles 2003: a review

Alignment of interest, growing concern about secondary buy-outs and investors’ roles in the creation of the boom-bust private equity cycle. These are just some of the issues that preoccupied our institutional investor profile interviewees this year.

Those familiar with the AltAssets web site will know our institutional investor profile slot well. Every week, we talk to some of the world’s leading investors in private equity funds to discover their appetites and their views on the current state of the market, plus what the future holds for it. As usual, this year we have spoken to a huge variety of investors, such as pension funds, insurance companies, family offices, asset managers and funds of funds, from North America and Western Europe to Australia. The format of the resultant articles remains pretty standard throughout and as a result, when taken together the interviews form an insightful profile of investor sentiment across the spectrum of institution type. And, as 2003 draws to a close, it seems appropriate to look back and identify some of the themes touched on in the interviews and take stock of the concerns occupying investors about this asset class.

The year started on a note of great uncertainty as a potential war in Iraq loomed. Investors of all types in all asset classes held back to wait and see the outcome of a conflict that appeared inevitable. In the end, the war was over rather more quickly than many had anticipated, notwithstanding the continuing difficulties faced by troops out in Iraq. As a result, the main stock markets saw something of a rally and with that returned some of the confidence that had been lacking in the previous couple of years.

But it still hasn’t been an easy year for the financial community. Many insurance companies and banks are facing a tough time, with the result that they have been looking carefully at the investments they have made in the past and those they will make in the future. The intended withdrawal or scaling back of private equity investments among these institutions started to materialise this year with a number of secondary sales taking place. One notable example was the massive Deutsche Bank transaction. In two separate deals, the bank sold the more mature portion of Morgan Grenfell Private Equity’s portfolio to Vision Capital for around $100m as well as a E1.5bn mega-deal to dispose of its late-stage direct private equity investments through a management buy-out vehicle called MidOcean Partners. And more recently, UBS acted on its stated intention of scaling back its private equity investments through a $1.5bn secondary sale of its fund investments to HarbourVest.

Consolidation in the fund of funds market has also started – a trend identified by many of our interviewees last year. Earlier this year, we saw Lehman Brothers snap up US fund of funds Crossroads Group. More recently, CAM Private Equity and the fund of funds arm of Sal Oppenheim announced a merger. And we’re likely to see many more examples of this in the months to come.

At the general partner level, this year has seen some good news. The indications are that 2003 will see an increase in investment pace for the first time in three years. Preliminary figures show that $57bn was invested in the first half of this year across the world, according to 3i and PricewaterhouseCoopers. This compares with a total of $102bn and $103bn for the whole of 2002 and 2001 respectively. But despite this pick-up in investment activity, investors still remain concerned about the low level of distributions they are seeing from their fund investments. Candover’s recent sale of Pandrol to French firm Delachaux provides some hope that trade buyers are starting to return to the market, but the fact is that this type of exit remains scarce.

So all in all, it’s been another eventful year for private equity. But the investors we spoke to – almost without exception – continue to see the attraction of private equity as an asset class. They may have gripes about particular characteristics of the market, but they generally believe that, provided they choose their fund investments wisely, private equity will provide them with attractive returns.

Each of the investors we spoke to naturally had their individual take on the market. There are, however, some main themes that emerge from this year’s selection.

Investors are as much to blame for the boom-bust cycle as fund managers. This change of heart has been interesting to observe. Last year, many investors were still so shell-shocked by the poor performance of their portfolios that they were seeking to place the blame with general partners. But now that institutions have come to terms with the losses they may have made and they have had time to reflect on the hey-days of the late 1990s and 2000, there appears to be a more balanced attitude to what happened (although none of them admit to being at fault themselves, of course).

Many investors – funds of funds in particular – are now critical of the short-term perspective inherent in many institutions, as exemplified by Fort Washington’s Gus Long. ‘I get particularly frustrated by the general tendency of people to follow the crowd and then get cold feet exactly at the time they ought to be continuing to invest. What drives success? In any asset class, those who have been successful have been those who have not become enamoured with particular areas and who have recognised that the key is a steady investment pace over a long period of time. People who put a lot of money to work during the bubble, but who are shying away from investing today have violated that principle.’

Long is not alone. ‘I get frustrated by the gap between logic and the actions taken by some investors,’ said Thomas Kohlmeyer of Extorel. ‘If you talk to investors about private equity and the fact that it is a long-term activity, that it is damaging to dip in and out of it, while at the same time it is anti-cyclical, they will understand. What I just don’t get is that many investors yet don’t abide by this logic. Investors coming in and out of private equity over short periods only serve to distort the market – and that can be harmful not only to themselves, but also to other investors and to funds and eventually portfolio companies.’

And it’s a view shared by Morgan Stanley’s Thomas Dorr, among others: ‘What amazes me most is the lack of critical independent thought among investors – the herd mentality. Money flows in excess to yesterday’s good idea, making it tomorrow’s underperformer. Because current performance is opaque, investors rely too much on stale realised returns.’

Increased secondary buy-out activity alarms many investors. With a scarcity of trade buyers and the closure of the IPO window, firms have increasingly been looking to other financial buyers as an exit route. The latest UK figures from the Centre for Management Buy-Out Research bear this out. In 2000, secondary buy-outs accounted for just ten per cent of all exits; so far this year, they have made up a quarter of realisations. It’s a trend that concerns many investors. ‘The problem with secondary buy-outs is that you can end up being a limited partner in both the selling fund and the one that is buying,’ said Winterthur’s Chris Manser. ‘In that instance, you haven’t got an exit, but simply a transfer of assets. That is not good for investors. As a result, I sincerely hope that trade sales remain the most important way of exiting and that they pick up once the general economy starts looking more healthy.’

Investor concerns also centre on how much value a succession of funds can extract out of one company. This point relates to the fact that most investors believe that future returns are dependent on the value-added capabilities of a firm, rather than on financial engineering as in the past. ‘The level of secondary buy-out 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,’ said Pilotto. ‘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?’

Alignment of interest between limited and general partners remains a concern. Last year, investors focused heavily on the management fees earned by general partners, particularly those running large funds. They felt that the traditional 1.5 to two percent fee was no longer appropriate for mega-funds as fund managers were being well remunerated even if they performed poorly. Management fees were cited as an irritation by many of our interviewees this year, too. But there appears to be an increased recognition that management fees are only part of the overall picture. This has led to increased talk of alignment of interest. In addition to the level of management fee charged, this includes other fees charged to limited partners and portfolio companies, such as directors’ fees and transaction fees, as well as the amount of commitment to a fund made by general partners. The views of PPM Ventures’ Roberto Pilotto were representative: ‘We don’t like to see fund managers making huge profits from directors’ fees, arrangement and transaction fees, etc, or cashing in early due to aggressive distribution patterns. The fund manager’s cash flows should be the same as those of the investors – that’s our basic premise for ensuring there is an alignment of interest between the two parties.’

The difficulty many investors have is that funds are able to become profit centres in their own right. You still see situations in which limited partners lose money while GPs still do OK,’ said Kevin Kester of Colorado PERA. ‘If you look at a typical limited partnership agreement today, in which the GP contributes one per cent of capital, and you look at the fees, including deal fees, etc it’s easy to see that there is a certain amount of profit that can be generated from those fees. If you start to add it all up, you are likely to start asking the question: is the general partner taking any risk?’

Harold Weiss of Swiss Re summed up investors’ concerns. ‘Fund managers should be rewarded through the returns they generate for their investors. Otherwise, private equity professionals’ remuneration is not aligned with the risks that investors take. Clearly, the issue of alignment between LPs and GPs must be dealt with if the industry is to continue to develop.’

The development of the secondary market is warmly welcomed. The last couple of years has seen an explosion in fundraising for secondary funds. The most obvious example was Coller Capital’s record $2.5bn close on its fourth fund last year, but there have been other significant closes, such as Pomona Capital’s $582m fund (well above its $400m target) and Lexington Partners’ $2bn close earlier this year. Judging by these figures, it’s clear that there is strong institutional appetite for this area of the market.

But investors are also interested in the secondary market from a different perspective. Many see the increased liquidity that it represents as a positive development. ‘There are many impatient LPs waiting to get out of funds,’ said Rod Selkirk of Hermes. ‘That market has a huge potential. The majority of the deal flow for the secondaries players will come from the same sources as we've seen in the past - the smaller LPs, for example - but I think we'll also see a lot of deals coming from the financial institutions that are looking to reduce their exposure to the asset class. For the smaller LPs, the biggest problem at the moment is funding their unfunded commitments. Those types of deals are interesting because they are not necessarily ones that the larger secondaries players are interested in. So there will be a lot of more informal activity in the market that doesn't become public knowledge.’

This suggests that there are plenty of LPs that are interested from a buyer’s perspective at this smaller end, too. That has certainly been reflected in the comments made by investor profile interviewees. Hans van Swaay of Pictet & Cie was one: ‘We have been investing more in secondaries recently. Some of the opportunities that we have seen have simply been too good to pass up. We tend to look at smaller ones, the situations in which the seller wants a discreet sale. We’re not competing in the $20m-plus league – there are plenty of other people out there doing that already.’

The market will be split between the large and boutique houses. There is an increasing feeling among investors that as the private equity industry matures, we will see a bifurcation of the market. On one side will be the mega-funds; on the other will be the small specialist boutique private equity firms. The risk/return characteristics of the two types of firm will also diverge. ‘I think that you will have a group of large firms that are very successful at fundraising, and they will tend to deliver consistent, lower returns. It is inevitable because of the volume of money they will be managing,’ said Allianz Private Equity Partners’ Wanching Ang. ‘But at the same time, you will also have smaller firms that are more capital gains-focused. These firms will have an opportunity to deliver higher returns, but the dispersion of those returns will be greater across managers.’

Dorr agreed: ‘As the market matures, we will see an increasing segmentation in the market. There is an institutionalised segment of very large funds with strong brands, operating in a fairly efficient market for larger deals. These groups should be able to provide respectable returns to compensate for the lack of liquidity in private equity. They also provide investors with the opportunity to put large chunks of capital to work. Underneath this institutional segment is a market that tends to be more entrepreneurial in its outlook and approach. An active, opportunistic programme with the right resources targeting this segment can provide outsized returns.’

Allocations to private equity will increase over the longer term. There is no doubt that fundraising has been difficult of late. But there is evidence to suggest that the future is a little brighter. Regulatory changes, such as the Basel II accord, may make it harder for some investors to commit to private equity, but the overall trend is for increased capital flows into the market as institutions look for ways to boost their overall returns. The recent Goldman Sachs/Russell Global Report on Alternative Investing by Institutions suggested that allocations to private equity would creep northwards over the next few years. The current average in the US is 7.5 per cent and this, the report says, is anticipated to increase to 8.2 per cent by 2005. In Europe, the figure is 4.2 per cent, with an expected increase to 4.8 per cent over the next two years. This sentiment was echoed, unsurprisingly, by Russell’s Helen Steers. ‘More and more institutions in the US are investing in private equity and we will see the same in Europe. Investors are looking for good returns. We are moving into a low inflation, low interest rate, low return environment and so people are looking to try and get Alpha. Private equity is probably the ultimate active management strategy.’

But there are some reservations. Some investors are sceptical about predictions of institutions flooding the market with capital any time soon. Manser was one of the sceptics. ‘Over the medium term, an increase in capital flows will really depend on whether private equity can get itself back on a more positive track,’ he said. ‘Investors need to see some realisations and some positive news. They need to get a lot more money back from their investments at high multiples before they will commit further to private equity. Recently, we have only seen bad news emanate from the industry and investors are aware that it is suffering from substantial problems. As long as this remains the case, then they will stay cautious and will continue to assess the industry with a critical eye.’

However, despite these reservations and some of the other concerns listed above, there is encouraging news for the industry. The vast majority of investors we spoke to are committed to the asset class over the long term. The reason? They remain convinced that private equity will continue to outperform other asset classes and provide them with the opportunity to boost their overall returns. The challenge for the industry will be to live up to these expectations.

Copyright © 2003 AltAssets