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Institutional Investor Profile: Frank Brenninkmeyer, Principal, Performance Equity Management30/11/2006. Source: AltAssets. 
Frank Brenninkmeyer on fund selection criteria, on the qualities his team seeks in a good GP, and on portfolio construction issues.  Greenwich, Connecticut-based Performance Equity Management is a global private equity investment firm providing partnership and direct investment services to institutional clients. Performance Equity is a registered investment advisor and is an affiliate of General Motors Investment Management Corporation. PEM invests broadly across what the firm defines as 'private markets'. It comprises investments in all types of private equity and private debt, including buy-outs, venture capital, growth equity, mezzanine and distressed debt. The firm makes both fund and direct investments.
What size of investments do you make?
'There are no hard and fast rules but we do have "ranges" that we can talk about with respect to size of investments. On the fund side, our investments range from about $20m to $100m. On the direct buy-out investments side, our sweet spot is anywhere from $15m to $50m, but our appetite is increasing and we have now offered to put up to $100m into several very compelling opportunities. On the venture side, we participate in later rounds of financing investing anywhere from $5m to $20m.'
How does your investment process work?
'PEM has a very team-oriented approach to investing and an iterative investment process. After an initial screening of a manager or direct investment opportunity to evaluate whether several high-level criteria are met, a team consisting of two to three people will begin a rigorous due diligence process. Throughout the process, the team will present its findings to the broader group for review and to gather questions requiring further diligence. At any point the team in conjunction with the broader group may decide to cease further diligence. When an investment meets all of PEM's criteria, the deal team presents a detailed investment memorandum to the appropriate investment committee.'
How many investments do you intend to make over the next year?
'We do not set targets on either the number of investments or the dollar amounts that need to be invested in any given year. Rather, we look at each investment on the basis of its merits and its impact on the overall portfolio. We do make the calculations of how much we theoretically need to deploy to maintain certain allocations, but we use those calculations more as guidelines rather than as hard targets.'
How do you find out about good investments?
'Given our long history in private equity (Our clients have been investing in private equity since 1981.), we are very well-known in the community of fund sponsors and other principal investors. Over the past 20 years we have developed a mature portfolio of long-standing partners that bring us a steady stream of high quality investment opportunities. Having executed many of these transactions, we have developed a reputation in the market for being able to bring both the resources and the capital to bear on new investment opportunities in a timely fashion. In addition, as a result of this successful investing history, we have developed a broad network of key executives and entrepreneurs through whom we also source new deals.'
Do you invest directly?
'Yes, the senior investment professionals at PEM have a long history of direct investing in both the buy-out space and in venture. We actively seek out co-investment opportunities from our buy-out relationships, and we proactively lead or co-lead rounds of financing in late stage venture companies where our current GPs are investors, where the company has evolved passed the technology risk stage of development, and where it has demonstrated the ability to attract meaningful customer traction.'
What is your appetite for first-time funds?
'We will consider first-time funds if they involve highly experienced people who have worked together in the past and are spinning out of larger organisations. We consider funds of this nature to be a source of capable mid-market managers. On the other hand, we do not typically back young teams that have yet to fully demonstrate their ability to select appropriate investment opportunities.'
Would you consider acquiring an LP stake in a fund from a fellow LP?
'PEM is an active player in the secondary market for LP interests. We have seen and executed many excellent secondary opportunities, and believe that we have a number of important advantages in completing a secondary transaction. Often we will already be investors in the fund for sale and thus be very familiar with the portfolio on offer. This familiarity allows us to determine the value of the portfolio with a high degree of confidence. In addition, the GP community sees us as a group that can act quickly, quietly and decisively, and so we are a logical choice for a GP that is looking to help another LP out of their position.'
How do you conduct your due diligence?
'Our due diligence process is organised to cover all aspects of risk. We conduct a rigorous examination of the elements that drive success, and continually ask ourselves, "What are we required to believe to go forward?" For every investment opportunity we create a focused deal team that reviews the team, its strategy, its portfolio composition and its results. This will include several meetings with the team, a review of each portfolio company, discussions with references provided by the team, as well as with our well-developed network of industry contacts, and if needed a revaluation of the portfolio.
Regarding the team, our approach looks at maturity, cohesion, turnover and incentive fairness.
Reviews of portfolio companies will include a look at the investment thesis, fit with strategy and team strengths, sourcing, and the key components of value generation.'
What do you look for in a good private equity manager?
'Our assessment of managers begins with a careful review of their stated strategy and the skills and resources they bring to bear to carry it out. It is critical for us that a fund has a clearly articulated strategy detailing the types of businesses that will be pursued, the sectors where the fund has a unique advantage or deep domain experience, the deal sourcing methods to be employed and the nature of the operational improvements utilised to transform the business.
Equally important is the quality of the team. The GPs must have a broad set of diverse skills that are germane to the stated strategy and have exhibited a long history of successfully working together. In particular, we look for teams that have a demonstrable edge, whether it is a special understanding of a sector, an advantaged deal-selection methodology, a proven restructuring capacity, a clear deal-sourcing strength, or some combination thereof. We further evaluate the myriad resources that a group brings, including operational advisors or partners, industry connections, understanding of government regulations, and right-sized teams with talent at all levels. That said, we do not have a mould that GPs must fit; we believe there is more than one way to make money and that many approaches to private equity can be successful.'
How do you put together a new portfolio?
'Every new portfolio must begin with an assessment of the client's return expectations, liquidity needs and risk tolerances. In creating a new portfolio it is also important to determine how success will be measured and against what benchmarks. Once these have been identified a new portfolio can begin to be formed.
Diversification is important and should lead to the careful balancing of strategies, taking into account the underlying cycles, levels of risk, and liquidity that they are subject to.
Time diversification is also a critical component of any well-balanced portfolio. Investments, especially venture capital investments which follow a more pronounced cycle, need to be staged such that the weight of money in any given period does not overwhelm that of other periods to the detriment of portfolio return. Our analyses show that vintage year is an important component of overall portfolio return, and that vintage concentration can be a source of significant unsystematic risk. At a very high level we believe that the split between buy-out and venture in a mature portfolio should be approximately 70 per cent buy-out/30 per cent venture capital and growth equity. Furthermore, we believe that a mature portfolio should have at least 20-25 per cent of broad international exposure. With respect to sector diversification, we believe that a portfolio composed largely of "generalists" will have ample diversification with respect to sector, and that therefore it is unnecessary to have a high number of relationships that are sector specific.'
What are the most interesting countries/sectors going forward?
'We believe that the "rule of law" is one of the most fundamentally important criteria for a strong, consistently profitable private equity market. We see a strong legal system built upon long-standing traditions of enforceable shareholder rights and fair competition as the bedrock upon which good returns are built. Many of the much-hyped emerging economies fail to pass this fundamental test. As we look East, we see Japan as not only having the necessary legal foundation, but also an economy with the scale and breadth to make it a compelling private equity market. By now most people are aware that Japan is experiencing an economic revival driven by structural reforms, regulatory changes and changing business practices. However, private equity is still relatively young and underdeveloped in Japan, making it an exciting opportunity for a long time to come.
Other areas of opportunity are the venture industry which itself is poised for renewed growth driven by steadily increasing IT spending and renewed interest by strategics in making acquisitions.
Finally, we are monitoring closely the distressed area, where undoubtedly in the future there will be substantial opportunities.'
What advice would you give to a new private equity investor?
'New private equity investors have two options: they can form a dedicated internal team or outsource the creation and management of their portfolio to a private equity investment firm. If an investor chooses the first option, we would recommend they hire a small team with a deep understanding of the asset class and the relevant networks and skills to develop a sound portfolio. While assembling such a team is no small task, it is critical that the proper organisation be established with the resources necessary to provide execution and provide stability.
We would advise a client without such a team setting the long-term strategy and acting with discipline, that the portfolio be outsourced. The ideal firm would be one with a long, successful track record whose team's deep industry knowledge and long-standing relationships in the market could be leveraged.
As for portfolio construction, we would recommend that new investors enter the private equity market slowly. Given the closed-end nature of funds and the long investment period, it will take several years for the net asset value to reach a targeted allocation level. Time diversification remains important, and a hasty entry could leave an investor overly concentrated in just a few vintages.
Furthermore, we would recommend that investors initially concentrate on building a portfolio of traditional private equity and private debt. After this portfolio emerges from the J-Curve and begins to deliver positive results, we would recommend that a venture capital component be slowly added. Venture capital is by nature more cyclical and the deals have inherently less down-side protections. Therefore, introducing venture capital too early in the development of a broad private equity portfolio could lead to undesirable short-term volatility, and if early results are poor, build a negative bias towards venture capital by an approval committee.'
What irritates you about private equity?
'Misunderstanding about what private equity is, especially by lawmakers and regulators, is the biggest problem for all of the participants in the industry. Take, for example, the German Minister Müntefering, who described private equity houses as "locusts". Our industry needs to better communicate what private equity is and what the benefits of a private equity industry are. Break-up LBOs where assets are rapidly liquidated to pay off heavy debt loads and where the headcounts are severely reduced are largely a thing of the past, and constitute a very small percentage of the private equity market. Rather, private equity today is as likely to be involved with growing a firm's topline through new product introductions and expansion into new markets, as it is with finding consolidation opportunities and synergies. In aggregate, across all their portfolio companies, many private equity firms will actually be responsible for net job creation.'
What is the biggest issue in the private equity industry?
'An abundance of debt and a correspondingly higher degree of leverage on deals are often mooted as some of the biggest issues facing the industry. We believe that there are two components to this issue, 1) the impact of leverage on the company's day-to-day operations, and 2) the impact on the ability of the owners to exit the deal profitably. The high degree of liquidity in the market has resulted in a decline in the equity contribution and increased the leverage in deals. However, the cost of debt has declined significantly over the past few years and the terms have become more favourable. This has largely kept interest coverage ratios at reasonable levels and made tripping covenants harder to do. So while the debt load may be higher than in the recent past, the cost and risk of carrying this extra debt has diminished. If interest payments are properly hedged, this increase in debt availability poses less of a threat than it did in the past. However, we do see a risk to exits should the debt markets pull back from current levels. Multiples would contract and prices would fall if and when the tightening occurs.'
How do you think the market will change in the future?
'The private equity industry is growing rapidly, as more and more dollars are rushing into it. Allocations at state and corporate pensions are growing as the effort to find alpha in a low-return environment becomes of paramount importance. As a result, fund sizes at the most successful firms keep increasing, and the types of deals getting done are necessarily changing. As many times before, the industry is moving into uncharted territory. Public-to-privates will continue to grow in importance as these larger and larger funds seek homes for the massive pools of capital they have raised. Given that we expect many private equity firms will continue to drive excellent returns from restructuring and/or growing these businesses, and provide handsome reward to the managers who help them accomplish this task, the business community may increasingly wonder why it is that public company shareholders should not benefit from these reforms, and question how management teams can both fulfil their fiduciary responsibilities to their current shareholders while simultaneously participating in the leveraged buy-outs of their firms.
We also expect that hedge funds and publicly traded private equity vehicles will play an increasingly important role in the financing of private equity deals which will have an impact on the limited partner community.'
How would you describe the market environment in which you are operating?
'The market we are operating in has been and continues to be very benign. The world has been experiencing a long period of healthy economic growth, providing strong winds for the private equity world's sails. On the legal front, the advent of Sarbanes Oxley and the recent changes in pension legislation have been net positive events for the private equity industry by making more and more companies eschew the heavy cost of being public and seeking out the relative freedom to pursue strategies unencumbered the short-termism resulting from quarterly earnings pressures.'
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