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Institutional Investor Profile: Dr Hosein Khajeh-Hosseiny, Managing Director and Head of Global Private Equity Investments, Northgate Capital

Dr Hosein Khajeh-Hosseiny speaks about his firm's strategy and describes his views on how fund of funds investment will evolve. Northgate Capital's goal is to provide institutional and family investors with identification of and global access to a select group of alternative investment opportunities. Northgate now has over $600m in assets under management and a strong, growing group of top institutional and family investors. The firm has offices in the United States and the United Kingdom.

Dr Khajeh-Hosseiny joined Northgate as managing director and head of global private equity investments in October 2004. Prior to Northgate, he served as head of global private equity investments at the McKinsey Investment Office, a wholly owned subsidiary of McKinsey & Company.

What is Northgate's strategy?

'Northgate invests in both private equity and venture capital. We have not done any other investments in the alternative asset class and are not planning to do so in the near term.

We are building a portfolio of 18-20 funds with our current fund, and our typical investment size is $15-30m per fund. Therefore, we are looking for funds with the greatest likelihood of delivering top risk and liquidity adjusted returns. A small number of them will be funds above $1bn and below $5bn in fund size, but the majority will be below the $1bn mark.

We see the strengths of our strategy in 1) our primary focus on two key developed markets, the US and Western Europe where corporate transformation is amply rewarded in a relatively stable and well understood financial environment; 2) our fund size. Our fund is capped at $500m instead of a higher figure which helps us avoid having to fill up the portfolio with funds that may have less attractive risk-adjusted returns; 3) having a strong relationship with some of the best funds in our targeted markets; 4) a comprehensive forward calendar; 5) the distinctive capabilities we have acquired both individually and collectively over the years as well as those afforded to us by some of our key LPs in the form of sector and functional insights. These help us measure the true capabilities of a fund to deliver top returns by transforming its portfolio companies.'

How much should a programme allocate to private equity and venture capital?

'Allocation to private equity and venture capital should be influenced by two key factors: 1. one's liquidity requirements; 2. the strength of one's objective belief regarding the risk-adjusted excess returns one can obtain from private equity investing relative to public equity investing. This in turn reflects one's ability to control the risk and raise the return profile of the private equity portfolio. Each investor though has different performance objectives, liquidity constraints and different access levels to funds or funds of funds with high information ratios, so it is difficult to generalise what percentage of assets an investor should allocate to the asset class. We leave that decision to our investors and their advisors, but typically institutions invest between five and 25 per cent of their total assets in private equity and venture capital.

As far as venture capital is concerned, our proposed VC allocation as a percentage of private market's (private equity and venture capital) allocation, does not exceed 30 per cent. The key problem with venture capital is the scarcity of access to top decile funds. We are in a unique position in that our venture capital access is very good; we invest in top decile funds and a handful of compelling emerging funds operating in the top decile funds' ecosystem.'

Do you do first-time funds?

'Absolutely. Having the full spectrum of capabilities for evaluating, structuring and governing investments in first-time funds or to seed one or two first-time funds a year is an essential prerequisite for delivering top returns. First-time funds allow us to tap into the tremendous energies of a new determined team which has two or three potential deals in their hands. They also help us negotiate better economics for our limited partners.'

How do you assess first time funds?

'I want to begin by saying that we are constructively prudent. Looking at the history of the private equity industry in the US and Europe and studying over 400 quality institutional funds, we do pull in significant expertise to ensure that we are not associated with underperforming small or first-time funds. Our distinctive sector and functional insights and backgrounds as well as our focus and tenacity as a firm to deliver top returns drive our due diligence process. Moreover, our network of relationships with senior executives and having seasoned high quality LPs from across particularly the US and Europe are important components of our capability platform.'

Do you invest directly?

'In addition to fund investing, we do a small number of co-investments. For us, the economics of co-investing and fund investing and, indeed, also secondary investing are the same.'

We do not charge carry or a special fee for co-investments because we want to be free to decide between co-investments and fund investments and go with whatever the best opportunities are. This does not mean that we do not gain from the added capability we bring to bear with co-investments because in maximising our LPs' returns, we maximise returns to our own investments too.'

Why do you co-invest?

'For us, with our backgrounds in helping the establishment of private equity firms from scratch, conducting due diligence, advising and designing corporate transformation programmes, and with our access to functional, sector and geographic insights, as well as utilising the due diligence of the best funds in the developed world, it is one of the most secure ways of boosting our fund returns.

The economics of co-investing and fund investing and, indeed, also secondary investing are all the same for us.'

Do you have a particular focus on Europe?

'We are slightly biased towards Europe. However, we are a bottom-up instead of a top-down manager and that means, the strength and distinctiveness of particular funds are the key criteria for capital allocation, and not the geographical focus of a fund. One of the reasons for our slight bias towards Europe is that there are fewer opportunities to buy unrelated, potentially undervalued businesses from major companies in the US. Another reason is that currently US valuations are high, making it a good time to realise exits and deliver returns to investors, but difficult to buy US companies at attractive valuations compared to European companies. Moreover, the US economy is generally expected to decelerate slightly, creating valuation uncertainties for all deal sizes.

Our observations show that European private equity firms are benefiting from the delayed process of deconglomeritisation and corporate divestitures and the advancement of a single borderless market across Europe. There has been an increasing number of positive steps by the European Commission and individual European states to establish a more competitive and innovative environment capable of winning in an increasingly integrated global economy.

However, the European Commission and the member states must continue to push further, particularly regarding labour laws and regulations. Luckily, all large and small European countries are embracing the need for reviving productivity and increasing wealth generation.

In the late 1990s - for the first time since the 1950s - Germany and France saw their productivity gap with the United States widen, and this needs to be reversed. To do so Germany and France need to more vigorously dismantle regulations that not only hinder the adoption and spread of innovation but also support fragmented industries.

From our experience with private equity in Germany, the "Mittelstand", which employs 75 per cent of the German work force, continues to provide opportunities as well as challenges. The main challenge of the "Mittelstand" for private equity firms is educating and reaching alignment with the owners of the many medium-sized companies who remain somewhat suspicious of private equity firms.'

What do your activities in Japan involve?

'We are cautiously positive about Japan. Japan has a tremendous amount of talent, energy and culture. However, most of the companies are still small, overstaffed and inefficient. The necessity of corporate restructuring, the increasing flow of entrepreneurship, the continuation of positive steps by the government as well as attractive valuations are spurring significant private equity opportunities for able private equity firms, but there are not many of them around. So far, we have identified only two interesting funds.

Previously at MIO, we derived significant returns from investing in US head-quartered firms investing in Japan. Today, the environment has changed. Going forward, our focus is on domestic Japanese firms and we hope that over the next few years, the private equity industry will generate a stronger pool of private equity firms, providing us with greater choice.'

Going forward, what are the key challenges for top performing private equity funds of funds?

'It is interesting to note that last year, globally, $144bn of private equity was raised. If we leverage this at a conservative 2.5x, we have over $360bn of investable assets, by far an unprecedented amount.

As a result of the growing flow of capital to the private equity industry and the increasing number of firms, the private equity market in general has become more efficient, especially in the US and to a gradually increasing extent in Europe. The private equity firms' personal networks no longer give them adequate access to exclusive deals, and creative-financing models have become commonplace. Consequently, new approaches are necessary, including a focus on fewer sectors or on specific types of deals.

Fundamental fund performance improvement via operational transformation, commercial transformation or corporate repositioning are key requirements for delivering top returns. However, very few private equity firms possess these capabilities in the necessary doses. At the same time, we are witnessing a regeneration of vigour and capability in publicly quoted firms making them more challenging to deal with either as sellers of subsidiaries or as buyers of portfolio companies.

As an inevitable consequence of the evolution of the industry, private equity deals have become increasingly risky. Although good risk management can confer a competitive advantage to a private equity firm, enabling it to be more innovative, entrepreneurial, enjoying a responsible risk culture and making it more successful in generating top returns with low volatility, few do it well.

At Northgate we look for funds that clearly articulate and evidence a well thought through and realistic value creation strategy with corresponding capabilities, risk management strategies and methodologies.

Our insights into potential opportunities and threats that are present in various industrial sectors and endogenous to alternative value creation strategies, and best practice functional skills - such as M&A, accelerated post merger management, product development, business repositioning - give us the necessary prerequisites for rigorously evaluating the opportunities presented by private equity funds.

We also seek funds which have already gone through a comprehensive introspection, evaluating themselves on whether they have the necessary competences for delivering top returns; whether they have the right senior and junior people; whether they have been consistent and diligent across all their portfolio companies, etc.

To us, a private equity firm's ability and determination for consistently applying best practice corporate transformation programmes, actively governing portfolio companies, investing time on a rigorous high quality first-100-days programme and a medium-term portfolio of initiatives and changing management teams early when necessary are key requirements for ensuring portfolio companies do outperform their industry peers and that we do receive top returns. Clearly, a great performance transformation programme can easily fail if the underlying initiatives are overscoped or if they are overambitous or they suffer from weak execution.'

How will some of tomorrow's successful PE funds deliver returns?

How do you conduct your due diligence?

'Our due diligence has two overarching features: the first one is our effort at adhering to the highest levels of integrity and respect for the private equity firm because this is the only right way and because they may become our general partners, working with us to advance our investors' wealth in a highly competitive arena. The second overriding feature is applying all the energy, capability and rigor we can muster to understanding the details of an opportunity and measuring both the strengths and the weaknesses of the fund. After all this is a 12-year relationship.

Our due diligence toolbox leverages quantitative and qualitative analytical frameworks. We find that pruning our forward calendar from around 600 funds to 60 is relatively easy but pruning it below that requires a substantial amount of work.

Through our quantitative tools we try to understand how much of the return generated by each portfolio company was due simply to the market doing well, the sector doing well, leverage, improving the firm's multiple above the sector's and improving earnings. Through this exercise we also try to identify the firm's investment style and evaluate the risks and returns associated with that. We then compare the firm with a database of other similar funds to conduct a relative analysis.

Our qualitative analysis is a structured exercise, utilising our functional and sector insights as well as our capability diagnostic questionnaires. These enable us to measure a firm's value innovation IQ and its innovation compass, its organisational health and the overall robustness of a firm's capability platform to deliver top risk-adjusted returns.

In evaluating the organisational health of a firm, we consider and measure in what we think is a distinctive and proprietary fashion. We explore such issues as the degree of alignment between investment professionals, control and coordination mechanisms and processes, performance measurement and consequence management, staffing levels and skills, as well as gauging the collective behaviours, beliefs and understanding of the people of the firm.

In addition to understanding the organisational health of a firm and their competitive posture in their respective geography or niche, we also like to get to know the details of a firm's mindset and way of thinking. As a result we spend time with them to discuss individual deals, not only their operating metrics but also their due diligence, strategy formulation and their approach for executing the plan.

This does not mean that in the first meetings we immediately ask for and go through portfolio company due diligence folders but we start by first having a dialogue on some basic issues surrounding some of the portfolio companies. If a fund may have acquired not a market leader but a challenger, we start by getting their impressions on some of the basic issues relevant to the deal. Example of questions are: How do product customisation, customer size, scale economies, and patents affect the dominance of the market leaders? Do market leaders change price when faced with new competition? How do R&D, product innovations, higher quality, lower prices and larger marketing expenditures translate into market share and profitability? How can challengers capitalise on the leaders' weaknesses? What were the key issues for the first 100-days programme?

In the first meetings listening to the way they answer basic questions helps us arrive at a hypothesis regarding the firm's value creation IQ which then help us to swiftly move the fund forward to the next stage or provisionally pass on it.

Overall we look for a firm whose internal capabilities and organisational health are fully aligned with the key success factors associated with its chosen strategy; a firm that is consistent in its approach to value creation; a firm that cherishes a high performance culture able to attract, retain and develop top talent.

Why are sector insights so useful?

They are critical not only for larger funds but very importantly for small and mid-cap funds. They allow us to gauge the prospective risk-return profile of a fund by helping us to effectively measure the sophistication and distinctiveness of a private equity firm's thinking, strategy, team, network and due diligence. The latter is important because most mid-cap funds have limited due diligence budgets and capabilities.

For consumer packaged goods, it is extremely useful to have initial hypothesis regarding, for instance: critical profit levers; the state of CPG innovation today, including the high failure rate of new products and the industry's emphasis on incremental rather than substantial innovations and transformations; factors within the industry that hinder such transformations; external factors that undermine them, including the power of retailers and the behaviour of capital markets; and the potentials and limitations of alternative business models including alliances.'

What are some of the key pillars of successful investing?

'Four immediately come to mind: 1. a robust investment strategy; 2. rigorous execution and performance management; 3. strong talent management; 4. establishing a top learning organisation with the prerequisite knowledge management processes.'

How do you think the private equity fund of funds industry will evolve?

'Over the medium to long term it is likely that only two types of fund of funds will survive: the mega funds which buy the market and deliver average returns - as sought by some institutions; and focused, robust top-performing funds which enjoy two key features. The first of these is that they possess distinctive functional, sector and geographic insights; such functional insights as rapid operational transformation, rapid commercial transformation, rapid cultural transformation, rapid growth platform building; and doing it all under control. By sector insights we mean insights into the dynamics of the types of economic rents and PE plays available at any point in time within a particular industry and geography. The second is that they target, access and diversify across only a handful of top funds, selected from across the developed markets such that they are able to focus on gaining from a diversified pool of capabilities operating in differing macro-economic business cycles, industrial environments and market systems.

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