Fund of Funds Roundtable

Buyouts reporters Mark Cecil and Ari Nathanson recently sat down with a handful of top flight fund-of-funds experts to talk about a number of issues facing the limited partner community today. The following includes excerpts from the discussion. The participants were:

John Morris: Managing Director, HarbourVest Partners LLC

Carl Tippit: Managing Director, Peppertree Partners

Steve Costabile: Managing Director and Head of Private Equity Funds Group, AIG Global Investment Group

Tom Dorr: Chief Investment Officer, Morgan Stanley Alternative Investment Partners Private Markets program.

Maria Boyazny: Principal, Siguler Guff & Co.

Tim Kelly: Partner, Adams Street Partners

BUYOUTS: The Pension Protection Act of 2006 requires employers that offer traditional benefit plans to fully fund the plan and bring all plans up to fully-funded status within seven years. This change is likely to stimulate growth. What does it mean for private equity?

JM: It just means more money chasing deals and bidding up prices and more efficiency in the market, which is going to lead to lower returns.

TD: Shortage of capital doesn’t seem to be the problem. It seems to me there’s such a crushing weight of latent demand that’s going to try to find its way in over the next few years, its hard to see how anyone is going to have a hard time fundraising if they’ve got the three main events: track record, deep team with continuity and interest alignment.

TK: It’s a symptom of the real issue, which is substantially more capital flowing into a marketplace where you have arguably a finite number of potential transitions. Plus, the new players are another element of that. Traditional pensions understand the nature of our market and understand the idea of a J-curve. Where you have newer players coming in there’s a new dynamic that you have less informed investors going after the returns and not understanding the nature of the industry. That creates administrative strife because they don’t understand the nature of the returns…There might be a false sense of security that it’s an easy asset class when in fact it’s a very difficult, very complex asset class.

MB: I think it has the effect that it’s encouraging people to invest in alternative assets at exactly the wrong point of the cycle.

CT: It also has the effect that the lower-tier, mediocre funds tend to get funding when they probably shouldn’t be, just because there is lack of knowledge out there.

BUYOUTS: Maria, you mentioned earlier that we’re in the wrong point in the cycle to get in. Where are we in the cycle? What does the oft predicted default wave mean to buyout shops?

MB: I think we are at the peak of leverage, with a record [level] of high yield issues…In the first half of the year, there was $80 billion in high yield issues and if you look at the pipeline it is very strong. Recently, I think it has been skewed, with people looking to get financing in the leveraged loan market alone. Banks are no longer lenders. They are facilitators. Debt is now coming from two main places, CLOs and hedge funds…It’s creating extreme liquidity. The high yield market is over $1 trillion in size, the leveraged loan market is $1.1 trillion, plus you have over $2 trillion in low-quality issuance. Fifty five percent of all the credit issued on the leveraged loan side is B+ or lower….Given the sheer amount of issuance, there is going to be more defaults….Of course there are some really smart hedge funds that will figure out how to hold on to the paper, but I’m seeing multi-strategy hedge funds moving people from their risk/arb desk, who are new and don’t know the cycle.

SC: This is interesting. Everything we’re talking about is something everyone acknowledges, the GPs acknowledge it. Now, does every GP see it and think, “We are smarter than the masses,” or in fact are people saying that this isn’t a buyout bubble it’s a debt bubble?

JM: Look at the amount of capital raised over the last few years that’s waiting for this cycle to burst….Look at the size of Apollo and Ares and Oaktree, the number of distressed players that not only are coming back to market but raising substantially larger amounts of capital just waiting for this opportunity. I think it’s a place for the larger funds to take advantage in sell situations where it might be a fire sale…It could be a great opportunity for smart distressed players to take advantage of.

MB: It’s a case of everyone saying their houses will be bombed but it won’t be my house. I have a Persian friend who grew up during the Iran/Iraq war. She said that when Saddam Hussein first started sending the planes to bomb, everyone ran for the bomb shelter. Then in a week, people started to look out the windows and see the planes. In a month, when the planes were coming, people were running up to the roofs and taking pictures. My friend asked his father, “Why are we doing this?” The father said, “There are ten million people that live in the city, our chance of being hit is probably one in one hundred thousand. And if we are so unlucky to get hit, then we deserve to die.” [Laughter.]

JM: Well, it’s an interesting observation. I think the pain is going to be felt most acutely by the lenders and not the equity holders. [Nods of agreement.] The oddest thing about the industry today, and it’s often talked about but the scale of it is phenomenal, is the credit bubble. You have such an imbalanced global economy and there are going to be winners and losers. As an equity holder, you can have winners and losers and still do OK. As a lender, you can’t. A lot of the economic carnage, it could hit equity, but I think the people who are really going to get hurt are on the lending side. What this equity wave is taking advantage of is amazingly cheap credit that they are able to extract value out of. I’d much rather be an equity holder than a credit holder.

BUYOUTS: So even when the distressed trough does hit, perhaps it won’t be that bad for private equity firm?

TK: One of the things that might be different in the next cycle is the globalization of this business. I know we all talk about globalization, but when you think about the domestic partnership we have exposure to, while they might have been more susceptible to a credit cycle change a decade or a half decade ago, they now have revenue streams coming from a myriad of companies around the world, so it might not be as cataclysmic as we think since they do have earnings potential far broader than the borders that they used to.

BUYOUTS: Do you allocate your funds or pick GPs based on where we are in the cycle?

SC: About cycles, there’s no doubt that our business has cycles, but when you can’t even time the public equity markets, when all the information is transparent, you can’t time the private equity market. You only know in retrospect what the cycle looked like. I think by trying to build portfolios to anticipate a cycle, you end up being suboptimal. Our job as fund-of-funds managers is to select managers who understand they are a creature of the time they are in, and know how to allocate that capital correctly. To say we have to anticipate a bad cycle….if anyone of us could time cycles we’d probably be in a different business.

JM: We have been talking about this credit cycle for three years. If we had jumped out and sold all our limited partnerships three years ago into the secondary market, we would have missed some of the best returns the buyout industry has generated. [Nods of agreement from all.]

MB: As an institutional investor, maybe you can not completely withdraw from a certain space, but you can regulate your allocation. The best returns in buyouts are those that were invested in trough periods.

SC: But you only know in retrospect it was a trough period. I had guys coming to me in 2001 and 2002 saying, “What are you crazy? You’re doing buyouts? Things are horrible out there, those companies are going to be suboptimal.” I said, “You know what? These are great managers. I don’t know about cycles but I know that this manager is open and I want to be a part of that.”

CT: What we try to do is see the managers that have been able to manage through cycles, who manage in good cycles and in bad cycles.

TD: It’s easy to invest in hindsight. I think in 1999 and 2000 that was fundamentally a bad time to be making venture capital fund investments. And actually I don’t think that was unforeseeable at the time. I do think you can say today that pricing is at a peak level, not at a trough. It seems inconceivable to me now that multiples could expand any further….From an earnings standpoint and a multiples standpoint it’s about as good as it gets.

BUYOUTS: So if we are at a peak, then you don’t invest in buyout funds?

SC: You hope that these guys realize that the way you make money over the last few years is not the way you’re going to make it over the next four. But you still have to get deals done. I mean, we talked about 2000 in retrospect as a bad time to put venture capital to work, but let me ask you, if Kleiner Perkins [Caulfield & Byers] is raising a venture fund in 2000, do you say to Kleiner Perkins, I don’t like this cycle, I’m not going to do your fund? [Everyone a the table quickly said “No” to this.] Maybe instead of giving them $25 million, you give them $12.5 million.

TD: I’d give them everything they would take. [Laughter.]

JM: I’d say you back them, and Carl as you were saying, you back managers who have managed through cycles.

TK: I wish managers would evolve to a point where, if the cycle is bad and they know they are not going to put out money, they would say, “I’m not going to raise a fund right now. I’m gonna wait a year.” But no, what they do is, regardless of the cycle, they raise a fund anyway and sit on it. Maybe that’s not optimal for me.

MB: Smartness is not doing half the things you’re asked to do. Brilliance is knowing which half. If you look at the managers that are oversubscribed, the ones that you really trust to allocate less capital when you are at a peak and more when there is a trough, there’s really not that many that do that. You can count how many that are really like that within each sector and that really deserve a constant allocation. I don’t think it’s just about a constant allocation to the best people. If it is like that, it is only for a small group of people.

JM: That goes back to the supply-demand issue. There is just a crushing weight of capital wanting to get to work in private equity, so it’s good to be a GP today.

SC: I think the philosophy at AIG has always been let the capital flow to the best use. We don’t say we want a higher buyout exposure or a lower venture capital exposure. At the end of the day it’s about the manager. At any give time period, if you have institutional quality managers coming to market, that’s what you want to capture. In one given time period, if more institutional quality managers on the venture side become available, you want to capture that. Maybe your base on allocation was 20% in venture, and maybe you’ll do 25% or 30%. Why? Because this manager is available now. To be tied to a defined allocation is not as optimal as allowing the capital go to where the manager is.

TK: I think the key word you used was institutional quality.

BUYOUTS: With all this demand on private equity from LPs, have there been any changes in terms or fees? What have the GPs been able to get away with?

SC: Across the board we’re seeing an increase in carry and/or the way the clawbacks are calculated, some funds raising their percent of carry or management fee. It’s simply a function of what the market will bear.

MB: In some of the early documents about the 20% carry, the paragraphs are still intact. And that is absolutely amazing. In any other asset classes you have an inverse relationship between the maturity of the industry and the profits in the industry

BUYOUTS: When you can’t get into the institutional quality funds, though, you have to look elsewhere. How do you keep track of new GPs?

JM: We try to meet with everyone in the marketplace and over 90% of them we will not invest capital with. But we are trying to create relationships, understanding what’s going on in the marketplace. We may meet with a group over a ten-year period and not invest with them over that decade but ask for them to stop by in Boston and we track them. It’s rare we invest in an emerging manager, but we start the relationship early on and let them prove themselves with other people’s capital. Some of the best emerging managers we have backed were organizations formed out of GP relationships we already had backed for a number of cycles. For sure they are proven managers.

CT: You don’t want to try to be opportunistic… [It’s about] making the relationship and watching them and listening to their strategy. What are they starting out with and are they still executing that? Eight years and two funds later are they still executing the same strategy that they started with?

TK: “Relationship” is a word that’s used a lot, but it’s critical. You’ve got to build the relationship so you can say “No” on the first fund, maybe even the second fund, because they’re still a little too unproven…If you’re honest with the GPs and you build the relationship in the right way, hopefully you can still get the toe in the door.

CT: If you’re going to get turned down after investing that amount of time and really helping them along and telling them what you’re looking for, it’s probably not what you want to invest in anyway.

TD: We do a lot of fund-ones and fund twos, probably a disproportionate amount. I think there’s no substitute for being proactive and surveying who’s in the market. Nowadays there can be a little bit of a definition problem with “fund one” and “fund two,” since so many new funds are spinning out from captive situations. I think what any institutional investor is looking for is an experienced manager, but new situations can be very interesting and some of the most exciting stuff in private equity.

MB: It’s like a college application process where all of us are trying to get in the best school.

JM: And all of us have above average GPAs. [Laughter.]

BUYOUTS: How proactive are you in seeking out Asian GPs, or U.S.-based GPs focused on Asia?

TK: We hear a lot of LPs that say, “Asia is really hot, we need to make an investment.” They get the first OM across their desk and it looks attractive. Unless you really know what the strategies are of the other dozen players in that market, to make the ultimate best selection….reminds me of the old adage, “The early bird gets the worm, but often the second-smarter mouse gets the cheese.” It makes sense sometimes to sit back and analyze the players.

SC: We’ve been seeing growth rates in China and India over the last decade are phenomenal. But I’m no so sure that if an investor had a desire for a diversified allocation to private equity managers in India, in China would have done better than someone invested in the U.S. or western Europe over the last ten years.

JM: A great macro story doesn’t translate into a great private equity story.

SC: To a certain degree, though, if we’re building portfolios in the U.S. and doing midmarket buyouts in the U.S. you are de facto investing in China and India right now. I can’t tell you how many midmarket buyout guys either have an office in Shanghai now or have relationships there because they’re doing sourcing or moving operations offshore, so there is more of a global connection.

BUYOUTS: We’ve heard that financial services could be a big area of interest in Europe…

TK: Leverage at the consumer level is a new phenomenon in many Central and Eastern European countries. We just invested in one fund that is targeting financial service opportunities and building mortgage lending and auto lending types of platforms throughout Eastern and Central Europe. Five years ago people thought you could only buy a car with cash. That’s what their parents did and their parents’ parents.

MB: I think financial services in emerging markets is a very interesting opportunity. I was in China a few months ago and I met with ten different banks, and I can tell you, there are two main areas for growth, credit cards and wealth management. In China there are five million credit cards for a jillion people.

BUYOUTS: Now for a stock question. There has been a lot of capital raised. Is it too much? How will it get deployed?

SC: Let me ask you, when you say “a lot,” what does that mean? Relative to what? In 1996, back in the old days I remember [pundits saying], “We’re at a breaking point, where is this money gong to go?” Especially on the buyouts side, the capital raised creates the opportunity. You form the capital and create transactions that otherwise would not have been created without that capital being there. I think on the venture side that’s where we run into problem. But on the buyout side, the buyouts market has never been more than 2% of the Wilshire 5000.

JM: It’s a good indicator. It’s almost de minumus what has been raised in the private equity world.

TD: With one caveat. I think for all this money to get to work productively, increasingly it’s going to get to work through public-to-privates. That is increasingly going to be the hunting ground for these larger and larger funds.

SC: That’s a great observation. You talk to Steve Schwarzman and he’ll tell you that Sarbanes-Oxley has been this fabulous, fabulous phenomenon.

JM: The reality is even these $15 billion funds are only allowed to buy mid market New York Stock Exchange companies, so there is a tremendous amount of the economy that they are still too small to be able to reach. So that would tell you there is tremendous amount of headroom for private equity to grow into. I’ve been doing this for 15 years or so, and the day I started people were saying there’s too much money in it. [Laughter.] Returns were going down, returns were going away, and it was a business that was becoming too efficient.

CT: Some of you guys were probably at the Bain [Capital] annual meeting. Bain admitted that they had to go to bigger deals because the Bain model, which is throwing X amount of people at a deal and learning all about the company inside and out, more than the company knows about itself, doesn’t work at the smaller levels anymore because you’ve got 25 other guys throwing a term sheet at it. And we [Bain] can’t invest that kind of human capital into a deal anymore so we’re going to a higher level.

TK: I agree—the number of firms throwing term sheets at these small mom-and-pop operations has grown dramatically. But there are still a lot of orphaned divisions sitting out there in the big conglomerates that are ripe for private equity opportunities.

JM: Warner Music is a perfect example. Everyone said, “Why do you want to buy this company? The recording industry is a declining industry, it’s part of Time Warner, it must be run well.” But look at what Providence [Equity Partners] and Tom Lee have been able to do with that company. It was a terrific return for their investors. It was an over-bloated cost structure they were able to rationalize.

BUYOUTS: How do you guys feel about hedge funds? Are they good or bad for private equity?

JM: There is no question about it, that hedge funds have been much more of facilitator to buyout funds than their competition, whether it be through agitation or through providing second lien debt. There was a lot of beating of the drums about what hedge funds will do to the private equity markets, but I think it’s only helped their returns ultimately.

MB: I think you have a huge part of the capital structure that hasn’t been tested—second liens. There have only been a few cases where you see how that plays out. And what hasn’t been tested is the behaviors or those investors.

SC: What I wonder is how much distressed capital is out there that hasn’t been labeled “distressed capital,” that’s going to be playing in distressed—whether it’s hedge funds or [other funds]. People who are going to say, “Before we didn’t play in distressed, but now we understand it and we’re going to be doing that.” I think there’ s even more capital waiting for that first fallout.

MB: There is also acquiring through the debt to create a cheap LBO. That market has more barriers to entry. For that you need two skill sets, you need to know how to take a company through bankruptcy and you also need to be a private equity guy. What increasingly will happens is buyout guys teaming up with distressed guys who can do it.

SC: As an investor you then might get more of that exposure than you otherwise thought because these firms are not defined anymore. You’re going to get exposure, from your distressed side and from your regular side. I think you’re going to see a lot of traditional PE guys say we understand this let’s do this deal together.

BUYOUTS: As limited partners, what are your feelings on consortium deals?

SC: Everyone at this table—if they’re earning their money—should have an estimate of the risk of overlap among the people they select. Past is not necessarily prologue, but you ought to know if any firm has a history of doing deals with another firm, who has a comfort level with who, and if you’re committing to funds that have historically done deals together, you know you’re going to have a high degree of overlap and syndication. Even though the returns in those deals have been great, I think it’s our job as fund-of-funds managers to mitigate that risk. We try to do it in below 5% of the portfolio.

TK: The good side of consortiums would be what I would call the “yesterday story,” where the funds were not large enough to buy the company themselves so they form a consortium. Hopefully they are each bringing a different skill set to the table that will accentuate value at that company. And if they are minimizing the amount of competition, hopefully they are buying a company at a better price. The “tomorrow story” is that the funds are so large today, the very same GPs are saying we need a bigger fund so we can minimize the clubs. That is contradictory because if you’re buying it all yourself, doesn’t that suddenly mean you are paying more for it? I think the next thing that’s going to occur, when the cycle hits, all of a sudden they are going to be sitting around a table squabbling with one another.

JM: And typically when one company is blowing up, other companies in the portfolio are blowing up as well, so getting GP management teams’ attention and trying to get together around a table like this, that’s going to be a very challenging time period and I hope it doesn’t happen.

TK: It’s like the marriages are going through a honeymoon right now. Let’s wait and see.

CT: From an LP standpoint, when you’ve got three or four firms buying a company the question is who’s got the better terms? In other words, are we 2% and 20% on this group and 50%/50% on the sharing, or are we 2.5% and 30 percent? I’d rather be in the lowest cost one.

BUYOUTS: We just had the HCA deal beat out RJR for the largest-ever PE-backed deal. What is the ceiling for LBO deal size?

SC: We’re way behind RJR, on an inflation adjusted basis, we need to do $60 billion. [Laughter.]

JM: I think it really depends on the depth of the debt markets. I think that is the only thing that’s gating the size of any LBO that’s available… And there really has been a change in the number of providers of debt capital. If the second lien market, CDOs, CLOs and all of those things are here to stay, and fixed income mutual funds that increase liquidity in the marketplace, then we’re going to see larger and larger LBOs done.

BUYOUTS: Looking into the future, where are your allocations going?

MB: I think you are going to see more venture capital in emerging markets. When you travel to these countries you see the drive and the hard work that you don’t see, unfortunately, in the more developed countries. What you’re going to see from those countries is innovation and they will have the advantage of seeing how we did things over the last 25 years, and they’ll leap frog the technology.

CT: But even if generationally, the first group of VC investors has moved on, those kids who got out of college ten years ago are going to be 30 to 50 years old ten years from now. They all grew up on video games and cell phones. I don’t think they’re going to leap frog us in another country. I think on an educational basis the foundation is there for these kids to be the next wave of real strong entrepreneurs. I think there is going to opportunity in venture capital again.

SC: I’d say we’d only increase our venture capital allocation if the institutional managers present themselves. I wouldn’t have the ability to say in the next cycle I’m increasing my venture allocation because quite frankly, I don’t know if there will be the institutional managers of the quality we want to invest in.

TD: In spirit I support the notion about leaning away from buyouts…. In our case, it takes the form not so much of moving into venture capital, but more into special opportunity investing. That includes distressed opportunities, hard core turnaround funds, restructuring funds, structured finance, aircraft trading funds. There’s a plethora of specialized situations opportunities, and even within the buyout set, there is an increasing specialization within different types of buyout funds, whether it’s by industry specialization or a hybrid skill set, by marrying infrastructure with a buyout mindset [for example]. I think increasingly why private equity is an exciting place to be is that it’s an innovative community. These people are highly motivated, and I think with respect to buyouts it pays to look to the place where more innovation is happening and move into more specialized areas.

CORRECTION: This article originally appeared with two quotes wrongly attributed to Tim Kelly of Adams Street. The quotes attributed to Kelly said that Adams Street does not have a presence in China, when in fact it has an office in Singapore and has already invested in China-focussed funds. The passage has been removed.