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Institutional Investor Profile: Dr Hellmut Kirchner, Co-Founder and Managing Director, VCM Capital Management

Dr Hellmut Kirchner on due diligence, arrogant fund managers and on why VCM Capital Management started raising its second mezzanine fund of funds straight after closing the first.

VCM Capital Management is a fund of funds manager with $1.2bn under management. The firm is currently raising two funds of funds: VCM VI Institutional Private Equity will invest in US growth capital and US venture funds and Mezzanine Capital International II will invest in European and US mezzanine funds. The new growth/venture fund of funds has a target of $100m and is already 60 per cent pre-committed. It will close before the end of this year. The target for the new mezzanine fund of funds is $150m. VCM Capital management's investment size ranges from $5m to $10m in the venture and buy-out space and up to $20m in the mezzanine space.

Dr Kirchner started his private equity career in 1974 when he joined DEG (German Development Bank). He was part of a team that invested capital provided by the German government into companies in the emerging markets. Following a stint at Munich Re Dr Kirchner joined Munich-based Matuschka Group and built up their venture capital business. His team joined forces with US private equity firm TA Associates, which had the local knowledge and expertise to do successful venture capital investments in the US. The capital came mainly from high-net-worth individuals. When Matuschka Group, together with other blue-chip organisations, founded Techno Venture Management, Dr Kirchner was part of the founding team and for the first time invested on behalf of institutional rather than private investors. Before that he had recruited Thomas Schwartz to take over his role at Matuschka and to take care of the private clients.

In 2000 Dr Kirchner also got involved with the German Treuhand and later he started investing in East German companies, together with a group of other investors.

Why did you found VCM Capital Management?

'In 1991 Thomas Schwartz and Stefan Herzog - who Schwartz had recruited as part of the firm's expansion process - approached me to help them with their management buyout but the vendor, Matuschka Group, did not want to sell. We needed plan B, and in 1992 we founded our own business, VCM Capital Management. It was a bit more difficult than a buyout because we had to build the client base anew.'

What is your investment focus?

'VCM Capital Management targets investments in the US and Europe. In the US we invest about 60 per cent in venture capital funds, 30 per cent in growth plus buyout funds, and ten per cent in mezzanine funds.

In Europe we invest significantly less in venture because the venture capital market here is still in its infancy compared to the US. Therefore, our focus in Europe is on buy-outs and mezzanine. Our European portfolio consists of 35 per cent venture capital funds, 20 per cent growth plus buyout funds, and 45 per cent mezzanine funds.

Our allocation by geography currently is 65 per cent in the US, 30 per cent in Europe, and the remaining five per cent in Asia. The Asian percentage is shrinking because we no longer add to our Asian exposure. We sit on the sidelines and watch what is happening in Asia, particularly in India and also China. It is no secret, we have not made the best experiences with our Asian investments so far and we do not know of anyone who has made great experiences in the region. That is why we are careful.'

Why did you start a mezzanine fund of funds?

'If you compared our target allocation to venture and growth/buyout in Europe with our current allocation you would find that we have an overweight in venture capital and are underweighted in the growth and buyout segment. We want to change this and that is why we now have a mezzanine fund of funds.

Prior to launching our first mezzanine fund of funds we carried out extensive research. It involved screening 1,000 mezzanine transactions between 1986 and 2003, the year when we started our research. On this basis we simulated funds of funds and compared their results, including all the costs and all the carries. The results were just to good to be true and that was why, after 20 runs, we launched a more comprehensive research study. We asked Frankfurt University for help and a group of students formed 5,000 virtual mezzanine funds of funds with 100 virtual investments each. The outcome was what we were hoping for: the numbers were still excellent, and so VCM started to approach German institutions. The institutional investors we have been approaching since are insurance companies, pension funds and family foundations.

Some of our institutional clients had never made an investment in private equity, venture capital or mezzanine before. With investors new to the asset class it took quite a long time to convince them to come on board. Other investors had already done investments in buyout funds or funds of funds and regarded our mezzanine idea as and interesting opportunity and supplement to what they had already invested in. Mezzanine funds produce quicker returns than venture or private equity funds and that is what attracts investors.

Our mezzanine fund of funds recently closed on $200m, and some interested investors missed the final closing. We sensed such high demand that we started marketing our second mezzanine fund of funds straightaway. We expect it to close in summer 2006.'

How do you conduct your due diligence?

'Typically we research and get to know a team well before they are out fundraising for their next fund. Our approach is more of a 'movie' rather than a 'snap-shot approach'. We want to know what the GPs did 20, ten and five years ago. We spend a lot of time on understanding the human dynamics within a team. This includes an analysis of which deals are attributable to which person and who the best and worst performers are.

Through reference calls we find out what impact the general partners have had on portfolio companies. Of course, the problem with due diligence is that you can be wrong because you can only analyse the past and present, not the future - there is always an element of uncertainty.'

What is your expected allocation to funds this year?

'We think we have already done most of our investments for this year but we will probably allocate $50-100m more before the end of December. In total we will have committed between $150-200m in 2005.'

What would put you off investing in a certain fund?

'Unfunded arrogance. If you deal with the most successful investors, they should not be arrogant but if they are it is understandable in some ways. However, it is inappropriate if people who have only achieved one or two times the upper quartile are arrogant.

A demographic imbalance. We do not like it when there are only 30-year-olds and 60-year-olds at a firm.

True disputes. In about one out of three to four cases we experience a real dispute emerging among the people in front of our eyes. This can be an interesting show and you can tell whether it is a show dispute or a real dispute. Real disputes do worry us because how can a team come to conclusions if they do not fit together? It is also interesting to observe how a team gets through difficult times, whether they support or blame each other.'

What is your appetite for first-time funds?

'We do invest in first-time funds but try to avoid first-time teams. We like to see that at least two or three of the senior investment professionals have done a series of deals together. The main risk with a first-time fund is that the team may fall apart.'

Do you invest directly?

'We have done direct investments in the past. Direct investments are different from investments in funds. As a direct investor you have to spend a lot of time inside the portfolio company to support it.

However, I also believe that it is very important that as a fund of funds manager you do not lose contact with the way the funds' portfolio companies are operating. That is why from time to time we - that is Thomas Schwartz, Stefan Herzog and I - invest in companies directly, but only with our own rather than with our clients' money.

As a fund of funds manager with direct investment experience we can offer added value to our fund managers, especially when it comes to US fund managers discovering Europe.'

What advice would you give to an investor new to the asset class?

'Take a long-term approach and be patient. Do not invest all the capital that you have allocated to private equity and venture capital investing in one go, better build a diversified portfolio over time. Invest a third now, the second third in 18 months' time and the last third another 18 months later. Diversification in terms of geography, industry sectors, and development stage is also very important.'

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