Institutional Investors – Working through the corporate maze

Good news for institutional investors in European private equity: the latest figures show strong returns in all investment stages with results showing a 30 percent top quarter* internal rate of return (IRR) from inception. These preliminary figures were released towards the close of March at European Venture Capital Association’s (EVCA) Geneva conference for institutional investors. The report, which analyses data through to the end of December 1999, produced by Venture Economics and Bannock Consulting in conjunction with the EVCA is titled 2000 Investment Benchmarks Report on European private equity. The full version of the report will be published later in April.

Since the indicated return of 30 percent top quarter IRR from inception is across all investment stages, this report makes good marketing material for those in the industry whose job it is to grow its investor base. (See boxed item.) EVCA is one such body and it engages in a number of other activities on an annual basis that serve to make the private equity industry more transparent with the aim of encouraging more participation at all levels.

As well as the release of the latest Investment Benchmark Report in Geneva last month, EVCA also unveiled new reporting guidelines through which it aims to homogenise European private equity reporting and so increase transparency for investors, according to an EVCA spokesperson. The move is an acknowledgement that statutory accounts governed by the law of the jurisdiction in which the investment company or fund is established, together with the investment agreement or constitutional documentation of the fund, do little to enable investors to draw performance, and other, comparisons. A task force made up of EVCA and industry members worked on getting these guidelines to print over the last year.

The EVCA also engages in a private equity updates three times a year, the results of which are posted on its website and it produces a yearbook, which contains comprehensive country data and year on year comparisons, that is released each year at its annual symposium in June. It also gets involved in ad hoc studies such as that recently undertaken by the London Business School (LBS). The study, according to a National Association of Pension Funds (NAPF) spokesperson, was originally mooted by that UK organisation. NAPF has felt pressure from the UK government following calls last year made by British Prime Minister Tony Blair for the domestic pensions industry to increase its support for the venture capital industry.

The resulting report from LBS is called UK Venture Capital and Private Equity as an Asset Class for Institutional Investors. (See March EVCJ page 4 for details.) Importantly the Minimum Funding Requirement (MFR) introduced by the previous Conservative administration in the wake of the Maxwell pension scandal was examined and found to “present more of a psychological barrier to trustees… than actual significant depletion in a fund’s liquidity.” A private equity investment will have a small adverse impact on a pension fund’s MFR position but the report notes this is only experienced by first time investors. However the report went on to call for a review of MFR. This is now in train following a request to Paul Myners, as part of UK Chancellor of the Exchequer Gordon Brown’s March 2000 budget, to undertake a root and branch review of the UK fund management industry.

A review on this scale however effectively puts the issue on hold for a year or so until the report is delivered. However at the very least it’s an admission by the current administration that calling for increased support of venture capital is not sufficient to galvanize institutional investors into action. William Hague, the Conservative leader, promised the BVCA annual lunch at the Savoy earlier this year that there is an ongoing review in the Shadow government to look at promotion of venture capital investing and the MFR issue.

In the meantime, in response to the LBS’s offering, the National Association of Pension Funds (NAPF) has produced its own 12-page report for pension fund trustees titled Private equity and venture capital made simple. It’s a condensed version of LBS’ near 100 page report, which on reading strikes that it could have been titled Private equity and venture capital for the simple. Consequentl, the NAPF document begs the question that, if that is really what is required by trustees, should fundraisers skip the heartache and give the UK institutional scene a miss?

Of course that’s being fatuous and, worse, overlooking UK pioneers like Johnny Maxwell at Standard Life who has been investing in private equity transactions across Europe for 15 years. To redress the imbalance between those that are sophisticated and those that are not, the education process has to continue for the knowledge gap to shrink. This will eventually pay a dividend in the form of a developed private equity and venture capital UK institutional investor base that commits to the asset class.

The knocking of UK institutional investors, particularly the UK pension funds, for failing to support private equity and venture capital is perhaps keener than it might otherwise have been if the UK had not led the way in European private equity activity. The Netherlands scores that prize for venture capital. For now the northern European countries, Scandinavia and the Netherlands provide much of Europe’s institutional private equity investment. Thankfully, US investors remain committed to Europe.

Without US investors the industry would certainly fall a bit flat in volume terms in Europe. However, that is not to underestimate the European institutional investor base that is evolving and growing all the time. One institutional investor termed a sophisticate in the asset class is Standard Life’s Johnny Maxwell. His understanding of the asset class and the dynamics of the market and its players is evident: he talks in terms of interest in specific sector-based funds that are coming to market at various points in the year. Standard Life’s asset allocation to private equity is 60 percent funds and 40 percent direct investments throughout Europe.

Crudely, there are three main routes for institutions looking to invest in European private equity: through a fund, a fund-of-funds or directly. The direct route tends to arise for investors as a co-investment rights deal through a fund investment and – to generalise – is likely to be embraced by the more experienced institutional private equity investors. The fund-of-funds route – a bit like investing in a unit trust – achieves diversification. However, investors are one step further removed from the investment and as a consequence are paying both the fund of funds’ management fee on invested capital fee and that of the underlying investee fund – around 1.5 per cent to 2.5 per cent in total.

This dual pricing puts some investors off: Michael Taylor at the UK’s Surrey Country Council being one. Surrey County Council’s pension fund’s allocation to private equity as an asset class is around GBP5 million. This allocation was made when the fund, which is presently worth just short of GBP1 billion, was worth around GBP200 million. Taylor is looking to increase the allocation to private equity to two per cent to four per cent of the portfolio while maintaining diversity. “I am exploring how I can spread risk around stage of start up, diversity of manager, sector, size and geographical spread,” he says. This list of requirements m erits careful consideration given that Taylor has a remit to invest only in funds investing in UK private equity, and that he is not initially attracted to a fund-of-funds due to the double fee payment.

On the other hand you pay for what you get and with a fund of funds that should be diversification and experienced fund managers. Diversification, as with listed equity and other asset types, is the key to creating healthy returns and thus reducing the risk profile – this was the key finding of the LBS report mentioned earlier. Experience comes in a variety of forms such as knowing who really knows what they are doing – i.e. the good technology teams – and being able to get the best deal. George Anson from HarbourVest, who describes the firm as the largest third party provider (i.e. fund-of-funds manager) in Europe, notes: “Being the first money into a fund and, say, the top five investors, gives you a reasonable but significant influence about how the fund is put together.”

Anson has clear views on what’s happening and what to look for as an investor in Europe. Anson prefers to invest with independent groups – described by John McCrory at Westport Private Equity at the classic four senior partners and four or five associates – this is by Anson’s admission partly through personal experience of the compromises semi-captives may be required to make. HarbourVest was, before becoming independent, part of John Hancock Mutual Life. MrCrory, on the other hand, simply says of the independents: “We have done better with these types of groups.”

This leads to the issue of personnel which is a big one across the spectrum for an industry that thrives on relationship building. Placement agents such as Campbell Lutyens & Co note this can be an issue when fund raising with institutional investors, as do fund of funds managers, such as HarbourVest and Westport Private Equity. Placement agents also have institutional investor client relationships to protect in this regard and must carry out due diligence to the level that satisfies. They would after all find it difficult to approach the same institutional investor contacts a second time if they had marketed a less than satisfactory fund to that investor in the past.

And from the investor side, a change of personnel in a small venture capital firm definitely can affect the decision to invest. This is evidenced by the number of interviewees that were saving allocations for specific funds they knew would be coming to market in the near future and those that had clearly identified teams with which they were keen and prepared to invest. This particularly came through with biotechnology and high-tech investments where the general impression created was that only a handful of teams in continental Europe were to be rated.

Given that the private equity industry and all its components feed off one another, no one can afford to bite the hand that feeds them. Facilitation by organisations like the EVCA and other research points such as KPMG, PricewaterhouseCoopers, and Venture Economics and Bannock Consulting are welcomed to ease the passage. However, these can get mixed reactions.

Johnny Maxwell at Standard Life’s bugbear is the classification of types of investment within the private equity asset class. The complaint rests largely with the classification of larger buyouts being those over GBP10 million. This is a classification used by the BVCA and KPMG in its half yearly surveys. (KMPG confirmed that this threshold has not changed since around the mid 1980s.) According to BVCA figures for 1998 small and mid sized management buyouts are those that receive less than GBP10 million of venture capital funding. “You are not comparing like with like and it might be confusing to investors new to the asset class,” he says.

British Venture Capital Association (BVCA) figures show that three quarters of MBOs and 86 per cent of MBI’s are accounted for by the small and mid size MBO category in 1998. And average deal size in 1998 in the small and mid sized market segment was GBP855,000. Of the total number of companies backed 86 per cent fell under the GBP5 million threshold.

It is well to remember that the UK figures may be distorting the perspective relative to what is happening in the rest of Europe – the geographic area to which Maxwell is referring. The EVCA’s 1999 Yearbook that publishes comprehensive data for the year to 1998 notes: “In 1998, organisations surveyed were asked what per centage of funds raised they expect to invest in certain stages of investment. Overall, 59 per cent of funds raised were expected to be invested in management buyouts and buy-ins versus 33 per cent in venture capital.” Whereas by country break down the UK was looking for an 88 per cent buyout contribution and just 8.5 per cent to venture capital. Figures for the rest of Europe favoured venture capital with 37 per cent heading for buyouts and 61 per cent to venture capital.

2000 Investment Benchmarks Report: European private equity

The top quarter return results show strong figures for venture, buyout and generalist vehicles, including fixed-life and evergreen funds, with a 30.6 percent pooled* IRR from inception, 39.3 percent for the five-year IRR, and 26.4 percent measured over ten years.

Venture and buyout funds delivered net returns to investors of 29.5 percent and 39.5 percent, respectively. Overall performance for all funds included for year ending December 1999 show a pooled IRR of 13.6 percent, a three-year return of 23.1 percent and a five-year figure of 21.3 percent, respectively.

This latest report is expected out in full in April.

Source: 2000 Investment Benchmarks Report by Venture Economics and Bannock Consulting. (Venture Economics and EVCJ are owned by Thomson Financial.)

The pooled IRR is obtained by taking cash flows from the funds since inception and residual valuations for each fund and aggregating them into a pool as if they were a single fund