Institutional investors get back into the driving seat

When it comes to fund raising European-based venture capitalists and buyout players pretty much fall into two camps at the moment. They are either concerned by what is universally described as a “difficult” fund raising market, or they fall into the group that is relieved to find itself with enough money in the current fund that they won’t need to fund raise for another couple of years. At which point it is assumed that either the stock markets will have recovered or limited partners (LPs) will have sufficiently adjusted asset allocations, or both.

With fewer institutional investors effectively in the market for private equity asset allocation at the current time venture capital and buyout players are finding they have to work hard to attract investors. And for their part investors are undoubtedly playing a cautious game, which can mean that the follow on fund of a good performing fund looks like a good bet whereas new funds may prove less attractive than they may have appeared some 18 months ago. Or do they?

Despite the cautious tone of the market, there appears to be considerable interest in next generation buyout funds, if the experience of Almeida Capital, a new entrant to the fund raising market, is anything to go by. Almeida Capital, set up earlier this year in London by Richard Sachar and Jamille Jinnah, has signed some 200 institutional investors onto its books and expects this number will soon rise – Sachar estimates there are some 2,000 active private equity institutional investors in the market globally.

While Almeida Capital expects to match institutional investors with venture capital and buyout funds it has also found that around a dozen of its institutional investor clients are interested specifically in investing in next generation funds. The interest is such that Sachar says: “We have about 12 institutions that are looking to cornerstone new or spin off funds. This [matching service] is likely to be a core part of our business going forward.”

These institutional investors interested in becoming cornerstone investors would consider taking a stake in the management company. The interest in spin off managers might be seen as a way to avoid being locked out of the future high performers some of which have become invitation only. Although in truth the invitation only phenomenon is much rarer than people would have you believe.

Sachar and Jinnah both spent time as institutional investors in their former careers. It is this experience that has led them to think there is room for an approach that differs to the way that a lot of placement agents operate: namely touting all of their funds to all their investor contacts. And so, Almeida Capital was conceived. All institutional investors using Almeida’s service have their investment preferences stored and when Almeida is bought into the fund raising process by a venture capital or buyout firm it will only introduce funds to those investors who match the fund’s profile. These include things such as geography, sector, and investment philosophy. Sachar is at pains to point out that Almeida doesn’t aim to replace any parts of the existing market rather to complement and add to it.

Now that there is skepticism about the ability of investments made at the top of the cycle to do what’s required of them in terms of performance and market confidence remains shaky, institutional investors are finding themselves in a better position to negotiate terms than they were during the technology and Internet boom. Things like carried interest leaping over the 20 per cent barrier and hurdle rates being lowered are oft cited complaints of US funds, (the latter is also true of European funds but less so) have grated with institutional investors. Whether investors succeed in imposing stricter discipline on fund managers will depend on that fund’s track record and the ease with which it can attract investors.

dotting i’s and crossing t’s

Christiian Marriott, investor relations director at Mezzanine Management, which last year closed its third fund at $500 million and this year is raising a E150 million mezzanine fund for investment in central Europe – the first of its kind -, notes that some of the detail requested in questionnaires or meetings with investors is complex. This in itself illustrates that at least some European investors in private equity are becoming more sophisticated.

“[Investors] are more sophisticated in terms of the information they are requiring before they come into a fund, even on a repeat. The questions they are asking are more sophisticated, more detailed and there are more of them. A number of [investors] are recruiting analysts to cut and dice all the numbers – that is the quarterly numbers as well as during the due diligence process,” says Nick Archer, director of fund administration at CVC Capital Partners, which this year closed its third fund at E4.65 billion. CVC originally started fund raising with a target of $3.5 billion (E4.1 billion.)

Marriott and others note that institutional investors increasingly want to see what side agreements other investors in the fund have asked for. “Institutional investors are increasingly conscious of what side agreements other investors in the fund have asked for. We always tell limited partners that we will disclose any side agreements to the other investors in the fund – it’s the only fair way to do it,” says Marriott. Given that most funds carry a clause permitting all investors equal treatment, should they request it, this sort of passing around other investors legal documentation is accepted practice.

Side agreements won’t inhibit the fund managers ability to make the best commercial decisions but include things like the right for institutional investors not to participate in tobacco investments. What’s clear is that these sort of extensions to the legal framework of the investment agreement are on the increase.” In addition to the basic core agreement we had 17 side letters averaging three to four pages for the first fund (in 1996) and for latest fund raising (closed earlier this year) we had in excess of 50 side letters and some of those run to 20 or 30 pages,” says Archer.

By the time institutional investors have got to the documentation stage the due diligence is done. John Snook of Close Brothers Private Equity says: “The due diligence process is not very intrusive. We don’t think people do excessive amounts of homework for amounts they commit. They take up references and look into the portfolio. A visit to our offices is the biggest intrusion, typically for half a day, although the longest has been for a day. But we see [this process] as a relationship building exercise.”

The styles and depth of due diligence employed by institutional investors go from requests to complete proforma questionnaires at one end of the spectrum to requests to visit portfolio companies, to find out if the VCs marketing story rings true, at the opposite end. “Some investors adopt the detailed questionnaire approach when it comes to due diligence. Others want to spend more time visiting us and seeing the deal teams. Some will also insist on visiting portfolio companies,” says Archer. This can be a double-edged sword given that fund managers would rather have their investee companies CEOs and CFOs getting on with the job in hand than acting as their PR.

CalPERS

The biggest problem for institutional investors, of course, is comparing funds. This isn’t made any easier by virtue of bad practice, such as excluding investments gone bad from a firm’s overall IRR figure or dropping old funds from the picture, which have not performed well as others. CalPERS embarrassed some and pleased other venture capital and buyout firms in July this year when it was discovered that its website contains a list of IRRs of all of its private equity fund investments – which run into billions of dollars – by fund vintage.

Many good performing funds were either pleased to see their names in the top quartile of performers or, if they weren’t actually named, they were glad of the opportunity to benchmark their performance against that of their peers. However, Christian Dummett, head of private equity at Abbey National Treasury Services, makes a valid point: namely these figures CalPERS has published may not correspond with figures experienced by other LPs in the same fund given the variables of exchange rates and date of entry into a fund, for example.

While this sort of transparency in comparability is probably not quite what the industry had in mind the BVCA and EVCA have both got the bit between their teeth this year in promoting a common valuation methodology to better assist institutional investors in making investment decisions. Many in the industry feel the problem lies more with venture funds that have revised valuations upwards at each new financing round and have been slow to down value. And people are, naturally, slow to value investments below cost where the investment was made at the top of the cycle. Whereas buyout funds tend to hold investments at cost throughout their life unless a subsequent acquisition or investment necessitates a revaluation of the company.

Regardless of the desire for homogeneity it’s not always a simple proposition. Nick Archer notes that CVC, which was originally founded in the US, was advised by its auditors a couple of years ago that US GAAP requirements meant it would have to move to fair value reporting. As a consequence CVC now produces cost, fair and gross value reporting, although cost and gross are produced as memoranda adjustments rather than full reports as is required for the fair value report. “We put lot of emphasis on the quality of our reporting, in part because it’s the visible face of CVC. While we have a regular dialogue with most of our investors there are some that we do not get to see on a regular basis simply due to the diversity of their locations. Quality reporting is therefore an essential aid to communicating with these investors,” says Archer.

This emphasis on communication with institutional investors is clearly warranted. “One or two funds have been particularly lax: we don’t view the odd call as sufficient. We will take into consideration the relationship as well as the returns when a firm comes to raising a successor fund,” says Dummett.

Aside from transparency, accessibility can also be an issue for limited partners. Dummett at Abbey National Treasury Services, who started investing in private equity when he joined the firm in early 1998 (Abbey National Treasury Services had started investing in the asset class in late 1997), makes some interesting observations. “When we started out fund marketing was fairly unprofessional by which I mean it was difficult for us as new entrants to the market to find the appropriate people to talk to. We had to overcome this by constant networking. We attended many conferences and we did a lot of cold calling, although a lot of funds just did not return our calls,” says Dummett.

Four years on the picture is obviously very different at Abbey National Treasury Services – the LP’s appetite for private equity is known and it does a significant amount of co-investing and equity underwriting with some of the general partners (GPs) with which it has relationships. For an institutional investor cold calling a VC who to talk to, especially if the firm is not in fund raising mode, can be problematic. “Most of our relationships are with the investing professionals, although an investor relations person is extremely useful for things that you don’t need to bother the GP with. However, in some businesses the marketing people have tried to become a bit too slick and can end up just throwing cliches at you,” says Dummett.

Placement agents can provide a good entree into the market. “Generally [placement agents] do play a useful part in sorting the wheat from the chaff but that does not mean that the wheat is necessarily a good fund. [Placement agents] are not a substitute for due diligence,” says Christian Dummett. He goes on to say: “We frequently ask placement agents to show us a track record of performance of the funds they have helped raise. None, so far, have done this.”

It’s fair to say that while institutional investors and limited partners alike can balk at the fees charged by placement agents, both camps appreciate their potential value. “We are often asked by LPs if we use a placement agent and when you say no it’s generally well received. Having said that there can be a role for the placement agent particularly in the context of expanding the investor base and accessing previously untapped markets,” says Archer.

John Snook, who used a placement agent for Close Brothers Private Equity’s recent fund raising, says he did not detect any negativity on the part of institutional investors regarding the presence of a placement agent on his fund raising. No one denies that fund raising is a time consuming process, some describe it as a chore, and there is the added pressure of perception. “A fund is stale by older than 12 months into its fund raising,” says John Snook.

Part of the effort of fund raising is the two or three month, or longer, relationships built between VC and investor. Steven Scott, a partner at Penta Capital and a member of the British Venture Capital Association’s (BVCA) investor relations committee, says of raising Penta’s first fund: “We didn’t get any meaningful rejections from investors. No one ever actually said no, they just asked us to keep in touch. David [Calder] and I would turn to each other after such a meeting and say well, I guess that was a no then’,” says Scott. Scott and Calder experience is not typical to first time funds – firms raising their second, third and fourth funds.

Some put these relationships that seemingly head nowhere down to fact finding missions on the part of the institutional investors and others move on hoping to rekindle the relationship next time around. Institutional investors can be pretty candid at times, however. “We have been told by number of institutions that they are going to down size the number of their private equity relationships. [LPs] find that actively managing these relationships is very time consuming and so it’s seen as more cost effective moving forward to look at larger commitments to a smaller number of funds. Some investors are tiering fund manager relationships according to quality and allocating larger commitments to the core relationships. We were hearing about this move as long as two or three years ago in the US when we were raising our second fund,” says Archer.

From his work at the BVCA Scott has learned that for institutional investors the issues that continue to dominate the agenda in terms of investing in private equity are: fee levels (management fees and carry); standardisation of LP agreements, and transparency. The fees for private equity are the most expensive in the fund management industry but are argued to be warranted because of the higher returns on offer. But without transparency tracking these returns and where they are likely to be is hard. Scott believes the profile of various quoted private equity investment trusts will aid transparency and that the exploding fund-of-funds industry may follow CalPERS example.

Give that the fund-of-funds managers value is in picking the next hit it’s arguable that they won’t mind giving existing performance information away – especially until now (i.e. pre-explosion) the fund-of-funds industry has consistently posted above average returns. We’ll see.