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Institutional investor profile: Sara McMahon and Trey Thompson, co-managing directors, UTIMCO

McMahon and Thompson on the importance of investing with hungry private equity managers, on avoiding the herd mentality, on being tough on terms and on how to live with disclosure.

The University of Texas Investment Management Company (UTIMCO) was established in 1996 when it span-out from the university to become the first private investment firm to manage a public university endowment. UTIMCO currently allocates 15 per cent of its overall portfolio to private equity and invests across a wide range of sectors, geographies and stages. The organisation also makes some direct investments. UTIMCO has three professionals dedicated to private equity in addition to its chief investment officer. Thompson and McMahon both joined UTIMCO from the asset management arm of Prudential Capital.

Why do you invest in private equity?
McMahon: 'UTIMCO invests in private equity for two reasons. Firstly, it has been one of the best performing asset classes for us over the last 20 years and a very strong return driver for the endowment, and secondly, we invest in private equity for diversification.'

Thompson: 'We have a fairly robust asset allocation for our overall portfolio and we review this allocation every two years. At the moment we feel that private equity offers great diversification and is also relatively uncorrelated to the other asset classes.'

What type of investments do you look for?
Thompson: 'We are fairly well diversified because we have been in private equity for a relatively long time. We have exposure to everything from venture capital, to distressed debt, to European buy-outs. So while we are looking opportunistically at new areas we don't feel the need to actively target any particular industry. We are simply trying to find the best managers at any given point in time rather than focus on the specifics of sector or geography.'

What areas do you think are particularly exciting at the moment?
Thompson: 'We are looking carefully at venture although on a highly selective basis. We think there is a great valuation environment at the moment. We are remaining cautious because we still have a concern regarding the overhang of capital that's been committed to the asset class. But we are certainly hoping that the industry won't become flooded again and that investors like ourselves will remain prudent in how we allocate capital to funds so that we don't find ourselves in another valuation bubble.

'In our most recent review of UTIMCO's overall portfolio allocation we determined that we would like to increase our venture capital funding from roughly 2 per cent of the total endowment to up to six per cent over the next five years.'

McMahon: 'While we are approaching the market cautiously we are really excited about the opportunities emerging with top tier venture capital groups. We have been working hard to meet new teams and hopefully add some strong relationships to the portfolio.'

What size of investments do you typically make?
McMahon: 'The size of our commitments varies significantly. In general we will invest between $25m and $50m in a later-stage fund. On the venture side, while we would like to gain as much exposure as possible to the top tier firms that we invest with, we are cognitive that fund sizes are reducing. So although we would like to invest between $25m and $50m in venture funds as well, we normally invest between $10m and $15m.'

How does your allocation model work?
McMahon: 'As we already have such a diversified portfolio we tend now to be more opportunistic about the investments we make. We do try to be tactical in identifying the right segments to be investing in at any given time but we are not restricted by any asset allocation tool.'

How do you find out about good investment opportunities?
Thompson: 'Because we have been involved in the asset class for 20 years we are the beneficiaries of deal flow activity. Opportunities are brought to us because we have been active for so long. But we try not to rest on those laurels. We try to be proactive in meeting new groups. We network with other limited partners in order to learn about opportunities in the market so that we can broaden our deal flow pipeline.'

McMahon: 'We also try to leverage our relationships with our general partners as they obviously have a good insight into the market. We use them for relationship building, introductions and in routes. Trey and I sit on 55 advisory boards between us, and that gives us a lot of time to spend with the general partners and the other limited partners on the boards. We get a lot of benefit from it.'

How does your due diligence process actually work?
McMahon: 'We have a fairly structured due diligence process. We meet with new groups on a regular basis. We then narrow down the groups that we want to spend more time with and assign a person on our team to run the due diligence process from that point. The due diligence itself involves lots of time spent with the general partners, reference checks, analysis of track record, attribution analysis, etc. That process varies in time anywhere from a month to four or five months depending on how complex the investment is. The next stage is to take the investment proposal to our chief investment officer who must approve the investment. Finally, we take the formal investment memorandum to our board. The board do not necessarily have to approve the investment but it is simply important that we make then aware of the investments that we are making.'

What do you look for in a private equity manager?
Thompson: 'We look for two main things in a private equity manager, a great team and a great market opportunity. It doesn't matter how good a team is if that team is going to be investing into a bad market. So we try to focus our due diligence on balancing those two elements.'

McMahon: 'When we look at a team we naturally want to see that they have demonstrated that they can make profitable investments. But at the same time we also have to consider whether or not they have the incentives necessary to invest our dollars in a manner that can generate great returns for us. We regularly come across groups that have profited from prior funds and are therefore not as incentivised to work hard in the future. It is a delicate balancing act. We want to make sure that our GPs have got great experience but that they have not yet grown too complacent. There must be a genuine alignment of interest between the LPs and the GPs.'

What advice would you give to a new investor in private equity?
Thompson: 'My advice would be to take your time. There are a lot of new investors in the US, Europe and Asia that have added private equity to their asset allocation over recent years. It might only be two or three per cent but that is still a lot of dollars. I think it is best not only for their own returns but also for the industry as a whole for them to be very selective in committing capital to the asset class. Investors should not just commit for the sake of reaching target allocations.'

McMahon: 'I would also say to avoid the herd mentality. I think that LPs have a tendency to move together and focus on the current hot opportunity. We are constantly trying to focus on what everyone is not focusing on and that is where the returns are to be made.'

What is your appetite for first time funds?
Thompson: 'We have invested in first time funds but we don't have an official programme where we set aside a specific number of dollars for emerging teams as some other institutions do. We have invested in three first time funds in the last year.'

What would you say is the biggest mistake you have made as an investor?
Thompson: 'From an institutional standpoint, UTIMCO left the asset class entirely in 1993 for almost a 24 month period. This decision was made on the basis of some short term under performance from the asset class. As a result the endowment missed out on two very good vintages. Had we had a more long-term approach our returns would have been much higher.

'From a personal point of view, I may have contributed capital to funds where I wasn't as tough on terms as I could have been in retrospect. I think it is important to maintain a high bar and ensure that our interests are aligned in terms of management fee and carried interest. I probably made that herd mentality mistake. I wanted to be gain exposure to a particular fund and as a result I let myself be swayed on terms.'

What are your views on the disclosure debate?
Thompson: 'UTIMCO discloses internal rates of return and some other high-level fund data. Initially it caused us a little bit of heartburn and certainly caused our general partners a little bit of heartburn. But from our perspective the disclosure debate has pretty much worked itself out. By making it clear that we are not going to be disclosing portfolio company information our lives have been made a lot easier and firms are generally a lot happier to work with us.'

McMahon: 'I think its important for everybody in the industry to get comfortable with the fact that portfolio company information is not going to be revealed. We have no interest in releasing that kind of information. Various attorney generals and other officials responsible for interpreting the law have been consistent in saying that portfolio company information is sensitive and does not have to be released to the public. Now that we have that guidance I think that everybody is a lot more comfortable. We are happy with the level of disclosure we have and we are pleased that we now have that additional clarity provided by the various officials around the country that have drawn that line for us.'

Have you experienced any problems accessing funds as a result of your disclosure?
Thompson: 'I don't think we could say with a straight face that we hadn't encountered any problems. But by and large I think that we have been fairly surprised at our ability to access the funds that we really want to access. The fact that we have managed to convey that we will not be revealing portfolio company information has helped us, but the fact that we have been investing in the asset class for a long time and that we write fairly large cheques has been even more significant. We are supportive of our general partners and it is well known that we like to develop long-term relationships with them. These kinds of qualities go along way in private equity and have helped us to overcome any challenges that we may have faced as a result of the Freedom of Information laws. Our jobs have certainly been made a little harder over the last couple of years but I think that it is paying dividends at this point.'

What would say is the biggest issue in the private equity industry at the moment?
McMahon: 'I would say that the amount of capital going into the asset class is the biggest concern going forward. There is a very real danger that too many private equity firms will get funded simply because of allocation driven motives. This reckless type of investing has the potential to drive the efficiency out of the market. But I think that as long as investors are cautious about where they are putting there capital the industry will remain a very attractive place to invest.'

How do you think the market will evolve?
Thompson: 'I do think that things are going to become more efficient in terms of pricing due to the volume of capital available in private equity funds. I think that existing inefficiencies are already being wrung out of the market and I think that return expectations are going to have to come down as a result.'

McMahon: 'As a consequence I think you are going to see an increased specialisation among private equity groups. Firms will be forced to search out areas of the market where there may be inefficiencies remaining.'

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