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Institutional Investor Profile: Graham McDonald, Head of Fund Investments, Bank of Scotland24/02/2006. Source: AltAssets. 
Graham McDonald on why Bank of Scotland is increasing its allocation to private equity investment and on why the bank prefers to significantly increase its average investment size rather than the number of funds in its portfolio.  Bank of Scotland invests in standard limited partnerships and also co-invests alongside private equity funds. The bank has been investing in private equity for some ten years. Currently committed capital across both fund investments and co-investments amounts to £1.2bn. The private equity team envisages taking this up to nearly £2bn over the next three years. Bank of Scotland currently makes all its private equity investments from its own balance sheet.
Graham McDonald's background is in structured finance. Prior to becoming head of fund investments at the beginning of 2005, he led one of the structured finance origination teams based in Edinburgh.
What type of investments do you look for?
'Our fund investment strategy is to invest in UK and pan-European buy-out funds. It may well be that certain fund managers in our portfolio will take us into new regions such as Central and Eastern Europe with their new funds.
Our portfolio consists of a small number of mainly UK-based funds and a few funds based on the Continent. Most of the funds in our portfolio are not industry sector-specific.
We are looking to invest sizable amounts with stellar performers in the buy-out sector. Our largest investments to date have been in the region of £100m. Our smallest commitments are around £20m. Currently we are in 81 funds, funds that vary in terms of size and type, across 46 different managers.
Bank of Scotland recently established the Private Equity Group, which encompasses our fund investment businesses, our structured products business, our origination businesses and our LBO portfolio, so that we have a measured view across all aspects of private equity. The main reason for setting up the Group was to enhance our capability in the private equity arena and to allow us to deliver transactional excellence, focused investment and asset management capability post transaction.
We want to make sure that our business overall is aligned to that of our clients in order to drive value for the respective parties. Fundamentally, we are a relationship bank and we are looking to establish long-term relationships which create and drive value for both parties.'
How do you conduct your due diligence?
'Almost all our due diligence is done in-house. We examine the track record of each firm and the track record of the people. We find out who was responsible for past performance, positive and negative, who originated the deals and who exactly created the value to date. Our team works in conjunction with our colleagues in structured finance and acquisition finance. Within the bank we have good intelligence on different funds and individuals. On occasion, we use external consultants to get an outside view on funds and people.
For re-investments, monitoring is a fundamental part of our due diligence process. As we are going through the life of a fund we build up a matrix in terms of the performance and the type of relationship we - that is the fund investment business and the structured finance/acquisition finance businesses - have with the team.
From our portfolio we expect a consistent flow of quality information. We look to align our business with that of our financial sponsors in order to drive significant value for both parties.
We meet up with funds in our portfolio at least once a quarter, and in the interim period there usually is a regular dialogue. Our jobs involve a fair bit of travelling because our fund investment team is primarily located in Edinburgh and London.'
What do you look for in a good private equity manager?
'We are looking for a combination of things: top quartile performance and a "meeting of minds" - these are two very important criteria. Ideally, we also look for an ongoing, in-depth relationship with Bank of Scotland Corporate so that we can work with our colleagues in structured and acquisition finance, and both the private equity house and the bank benefit from our investments.'
Are co-investments likely to become an increasingly important part of your strategy?
'Co-investment features prominently on our agenda at the moment. We see a fair number of opportunities and we see them as a key element of our strategy going forward. We are looking to significantly increase the amount invested in co-investments over the short term.
Across our business we completed 23 transactions in 2005 and this was spread across LP commitments to funds, co-investments and individual PEFS transactions. We are constantly on the look out for new opportunities although activity is driven by the fundraising cycle of funds.'
What is your appetite for first-time funds?
'We do invest in first-time funds. Our team would always examine their profile and their track record. It would be a significant advantage if we knew the team or at least some of the individuals in the team.'
From where you are sitting, what are the biggest issues in private equity at the moment?
'The market is currently very buoyant but also very challenging. You are seeing a significant extension of the LP base and there is a wall of capital coming into the asset class due to its recent performance. We are confident that there will be a continued professionalisation of the business and fund managers realise that value creation and the timing and the engineering of the exit have become crucial success factors. Houses have to work hard to maintain the levels of return. They cannot afford any underperformance at investee company level.'
What advice would you give to a new private equity investor?
'You have to be reasonably well diversified, do your homework and concentrate on quality and value. I think an investor first has to challenge some of the fundamentals and some of the assumptions and then build up in their own mind how they see the performance over a sustained period of time.
You also have to be sure on why you are investing. You really have to understand the markets in which the various funds are operating and if that accords with what you want to do then go for it.'
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