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Institutional Profile: Tom Kennedy, founder and managing director, Kensington Capital Partners

Kennedy on where Canadian private equity steals a lead from the US, on the ability to succeed regardless of market conditions, on vintage as the key diversifier and on doing your research on management.

Kensington Capital Partners is a Canadian merchant banking and private investment firm with a specific emphasis on private equity. The organisation manages the $100m Kensington Fund of Funds and the $100m Kensington Co-Investment Fund in which the Canada Pension Plan Investment Board is the sole limited partner. The firm is mandated to participate in Canada-based private equity buy-out funds focused on investing primarily in North American opportunities on behalf of the pension group. Kensington Capital Partners is also currently raising a second fund of funds with commitments from outside investors. Tom Kennedy founded Kensington Capital Partners in 1996.

What is Kensington Capital Partners’ background with regards to private equity investing?

'We initially invested the firm’s own money in direct investments. But around three years ago we were awarded a mandate from the Canadian Pension Plan Investment Board to manage a fund of funds programme on its behalf. In order to not be in conflict with the funds we are now investing in, we are in the process of selling off the last of our direct investments. This aligns our interests with those of our LP and ensures that we are not in competition with our fund managers.

'We have also recently announced the first closing of our second fund of funds. Fund II is open to outside investors and we have already received commitments from institutional investors and high-net-worth individuals.'

What types of investments do you look for?

'We invest purely in Canada-based buy-out funds, principally those investing in North America. Despite this relatively narrow focus we have tried to build a well-diversified portfolio. I believe that vintage is probably the best diversifier of all, but we also look for some geographic diversification.

'We are very interested in the geographical disparities that exist in North America. The level of private equity competition tends to be fairly high in the major financial centres and valuations are therefore fairly robust. But there are also some regionally interesting businesses that trade at much lower multiples. Areas such as the Canadian East Coast, or the US Mid West, are comparatively underserved by the private equity industry and there are some very interesting opportunities to be found there as a result.

'It is difficult to achieve industrial diversification in the Canadian market because it is simply too small to accommodate many specialist funds. Of the nine funds that we are currently invested in, eight are what I would call generalist funds. But we are currently looking at two industry specialists, one in the oil and gas industry and the other focussed on the aerospace industry.

'The final level of diversification that we focus on is diversification of investment style. We invest in funds with a range of different approaches to making businesses grow.'

What are your views on the Canadian private equity market and how does it differ from the US?

'I think the Canadian market in general is underserved with capital and our companies are less expensive than those in the US. This works very much to our advantage. The US is Canada’s biggest trading partner and there are very real opportunities for successful Canadian companies to expand south of the border. There have been numerous examples of Canadian businesses growing into the US market and seeing their valuations escalate in line with US norms, generating very handsome returns for investors. So I think there is an interesting arbitrage between Canada and the US.'

What size of investment do you typically make?

'Our commitments to funds so far have been in the order of $10m. We do expect this to grow over time although we currently have a limit of $20m or 20 per cent of capital under management. Having said that, we have indicated interests of in the order of $50m for the successor funds of two general partner’s that we are already invested with. So, depending on the performance of a firm, our level of commitment could grow quite substantially from the initial $10m that we invest.'

On what basis do you make the decision of whether to co-invest along side a fund?

'We spend a tremendous amount of time assessing and selecting our fund managers. It is therefore our philosophy not to try and second guess them at the direct investment stage. Our co-investments are really intended as a tool to assist the fund managers in the execution of transactions. We basically piggy back on their due diligence and try not to get in the way. If the fund management is enthusiastic about an opportunity and we consider that opportunity to be a good fit for the fund’s strategy, then we are generally happy to co-invest.'

How do you find out about good fund opportunities?

'The Canadian Pension Plan Investment Board is responsible for a very sizeable pool of capital and so anybody raising a fund tends to knock on their door. Any fund opportunities that fit our mandate are then deflected to us and this gives us exposure to the vast majority of Canadian buy-out funds. In addition to that, I have been in the private equity industry in Canada for 20 years and I therefore know a great many players in this area of the market. I think it would be very rare for us to miss out on any opportunity.'

What do you actually look for in a good fund manager?

'I think our number one criteria is a team’s depth of experience in private equity investing and their success rate in finding exits in just about any part of the economic cycle. The innovative ability to take advantage of market conditions, no matter what they are, and to make money on an investment is pretty critical to us.'

How do you go about conducting due diligence?

'We spend a great deal of time assessing the integrity and the thoroughness of fund managers in their approach to business, conducting in the region of 50 to 60 reference check interviews on each individual. The quality of the individuals and the durability of the team is extremely important to us.

'If we are comfortable with the individuals themselves, we then overlay the fund on our portfolio to make sure we are not duplicating an area in which we are already invested. In order to create a healthy portfolio it is important to maintain that sense of balance.'

What advice would you give to a new investor in private equity?

'I may be a bit biased here, but I think that unless you have a great deal of capital allocated to private equity and can therefore afford internal resources for the necessary in depth due diligence and detailed monitoring of your investments, LPs should seriously consider the fund of funds approach. I certainly think that investing in a fund of funds can be the most cost effective way of getting an experienced team to do the work for you. The economies of scale created by having a small team of people doing all the homework for you is pretty impressive.'

What would you say is the biggest mistake that you have ever made as an investor in private equity?

'As a direct investor I would have to say that my biggest mistakes came about from inadequate homework on management. Somebody once told me that a bad investment is its own punishment. When an investment goes bad it chews up not only your capital, but a tremendous amount of time is invested in trying to make it right before you finally realise that you can’t. I would say that is probably why we place so much emphasis on fund manager selection in our fund of funds operations. It is the result of bitter lessons learnt in the past. You have to get it right.'

What would you say is the biggest issue in the private equity industry at the moment?

'I think that the biggest issue in the Canadian private equity industry is the very slow pace at which Canadian LPs are waking up to the opportunities in this asset class. There is a commonly held belief that there is too much capital chasing too few deals but I quite simply don’t share that view. The Canadian market is opening up very nicely at the moment and opportunities are expanding all the time. Ultimately, this development may be hampered by the slow pace at which Canadian LPs are committing capital, but at the moment this creates great opportunities for those investors that do recognise the benefits of private equity investing.'

So LPs are not faced with difficulties in accessing the best Canadian funds as they are in the US?

'We certainly don’t have any of the problems that face LPs in the US with regards gaining access to funds. The industry is too new here. No doubt there will be a point in time when fund managers are limiting their dollar volume raised and can therefore pick and choose their limited partners, but we are a couple of fundraising cycles away from that risk now. I think we have seen just about every private equity fund that has been being raised since we have been in this business and we have certainly not had any feed back from any of the managers indicating that they are topped up and turning investors away.'

How do you think the market will evolve going into the future?

'I think that there will be a heightened stratification of fund managers in Canada. There will be a few very high quality general partner teams that have no problem raising money at all, and then there will be a very large number of fund managers that are constantly struggling to raise capital. It takes a long time to die in this business because your performance takes a long time to prove itself. But I think that within five to ten years we will have seen the same type of stratification develop that is currently to be found in the US and Europe. But there is still a way to go.'

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