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Institutional Investor Profile: Brian D. Isroff, Senior Managing Director, Sterling Private Investments, Inc.

Isroff on the need for realistic returns expectations, on searching for managers with the X-factor, on the difficulties of pricing secondaries transactions in an increasingly competitive market and on only taking on a level risk that will allow you to sleep at night.

Why does Sterling invest in private equity?

‘Above all, we invest in private equity to provide diversification for our investors. We like the fact that this is an asset class that is not highly correlated to traditional investments and we believe that including private equity in a portfolio is a great way to enhance qualified investors’ risk adjusted returns.

‘It is no secret that the best performing asset classes tend to vary significantly over time. One year the S&P 500 may be the best place to be invested, another year it will be bonds or perhaps private equity. So our advice to investors is to broaden their allocation model as much as possible. I am a firm believer in diversification as a means of smoothing out overall portfolio returns and reducing portfolio risk.

‘I often remind investors that they should invest in such a manner that they are able to sleep at night. Never take on a level of risk that will keep you awake. The added diversification provided by adding private equity to an otherwise well allocated portfolio helps me rest easy in the knowledge that I am doing my best to maximise risk-adjusted performance.

‘In addition to the benefits of diversification, we also invest in private equity because of the depth of management skill that we believe can be found in some general partner teams. We believe that top tier private equity managers really have shown an ability to generate significant alpha.’

What type of investments do you look for?

‘So far we have invested in 23 different private equity funds formed by 17 different underlying managers. We try to diversify across both geography and stage. We will at times commit a modest amount of money to early-stage managers and we also invest in some large buy-out funds and some mezzanine vehicles. However, middle-market buy-out shops tend to be our sweet spot. We believe that there are more opportunities in this area. The growth prospects and exit opportunities are greater than at the top end of the market, and yet you are avoiding some of the risks that are inherent with early-stage investing.

‘We invest primarily in the US, but not exclusively. Most of our managers are broadly diversified across geographic regions in the US, and sometimes beyond. The funds we invest in are also often generalists in terms of their industry focus, although we do invest in a few sector specialists.

What sectors or geographies do you think are particularly exciting at the moment?

‘I think that there are still a lot of opportunities in the US and we do tend to favour managers that deploy the majority of their capital here. But we also like our managers to be opportunistic when the need arises and clearly there are exciting possibilities overseas. A lot of firms are increasingly either looking to invest in foreign companies, or are making use of international outsourcing opportunities. Private equity managers certainly have more of a global outlook than they ever have had before.’

Do you make secondary investments?

‘No. We don’t invest in secondary opportunities. I think these types of transactions are simply too difficult to price. There are a growing number of firms that are specializing in that area of the business and we prefer to leave it to them.’

What size of investment do you typically make?

‘Our bite size can vary considerably. Our investments can be as small as $250,000 or as large as $10m.’

How do you go about putting a portfolio together?

‘We tend to have Anywhere between five and ten managers in a given portfolio. But beyond that it is simply a case of trying to achieve the most diversified offering that we can among quality managers. We like to include fund managers with a variety of investment approaches, as well as diversifying across geography, sector and stage.’

How do you find out about good investment opportunities?

‘We are particularly fortunate in that we have an affiliation with a group called National City Equity Partners, which is the venture capital and buy-out arm of National City. National City Equity Partners has committed over $1bn of National City’s own money to private equity and our affiliation with such a large and experienced investor allows us to ride on their coat tails to a certain extent and at times enables us to gain access to some funds where we might not otherwise get in.

‘We also get solicited by private equity firms all the time and we therefore have to be highly selective. We do tend to favour managers with whom either Sterling Private Investments or National City Equity Partners have had a successful investing relationship with in the past.’

What do you look for in an investment management team?

‘We like to see a very defined investment philosophy and strategy where the size of the fund being raised is clearly consistent with the team’s ability to implement that strategy. If a firm that had previously raised $100m or $200m funds suddenly announced they wanted to raise $1bn, that would be a negative for us and would dissuade us from investing.

‘Obviously we look for a track record of successful investments and exits. But we also look for some differentiating factor. We like to see something unique and that can manifest itself in a wide variety of ways such as the ability to source deals, a specialty niche, or the people they have on the team. We also consider a fund’s legal documentation and we are obviously looking for reasonable market terms. Finally, a positive experience by National City or another strong referral source is always helpful.’

How do you conduct your due diligence?

‘We evaluate potential managers against a variety of quantitative and qualitative criteria and then we supplement that by talking to others in the industry. We look at what the firm’s portfolio companies have achieved and we analyse their returns. We obviously spend a great deal of time getting to know the managers themselves and we also sometimes talk to previous investors in their funds.’

How would you describe your appetite for first time funds?

‘I would have to say that it is very low indeed.’

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

‘I think you have to be very careful. There are an awful lot of private equity fund managers out there at the moment, and not all of them are worth investing in. You have to be very selective.

‘Private equity is a very difficult industry to allocate capital to if you don’t have access to the best managers. Most of the empirical data out there suggests that the disparity between top tier managers and the also-rans is far greater than in other assets classes. That means there is a premium on finding top quality managers. In fact it is essential.

‘If you are not allocating a great deal of capital to the industry it can make the job even harder. Many managers have a minimum commitment threshold of around $3 - $10m. As I mentioned before, this is one area where our affiliation with National City really helps us out. We may be able to access such a fund with a $1 - $2m commitment and that can be very helpful for us as we are not a very large group. We cater to the needs of about 400 individual and quasi-institutional investors and we need to have the leg up that National City Equity Partners provides us in order to compete effectively in this space.’

What would you say is the biggest issue in the market at the moment?

‘I think the fact that there is so money flowing into the industry at the moment makes it much harder for private equity managers to find entry valuations that allow them to generate the types of returns that they have generated in the past. The amount of capital that needs to be deployed inevitably increases the price of deals and reduces long term IRRs.

‘I think it is important that people are cautious and realistic. Expectations have to be tempered. Even if you are investing with a manager that has produced a 40 percent IRR in the past, I think it would be very unwise to expect anything close to that in today’s market.’

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