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The best business in the world

How long have you been involved in the private equity arena?

I’m now in my 17th year: that’s a long time back then I had hair and was thin. I joined Stewart Ivory (then Stewart Fund Managers) straight from law school, and worked with John Murray, which taught me a lot. While acting as John’s bagman or gofer, I was looking after the private equity component of the Scottish American Investment Trust portfolio and BES funds. After four years I moved to Castleforth Fund Managers to open its Edinburgh office. While working alongside Chris Masterson and Donald Workman was great, I felt that Castleforth focused heavily on corporate finance and that private equity fund management was not necessarily getting the attention it deserved. At that point I left and joined Standard Life as a private equity investment analyst, the firm’s only full-time private equity executive.

In early 1993, I took over the running of the portfolio from my then boss and worked alone until 1997. That was hard work: Standard Life had a portfolio of more than 70 private equity positions, nearly half of which were direct deals. In 1997, we started to build a team and Standard Life now has seven professionals and two dedicated support staff in a A1 billion plus private equity operation.

And what are its attractions for you?

I love it it’s the best business in the world. You get involved in a myriad of different businesses, from distribution to biotech and from car parts to retailing. Private equity is an amazing industry to be in: you are (generally) surrounded by very clever, ambitious and enthusiastic people from a range of backgrounds.

But, it took me a long time to reconcile the fact that the commodity of private equity management is intellect and capital. As a grocer sells produce, so a private equity manager sells capital, so it’s worth bearing in mind that, if you are able to steal equity, that equity is probably not worth having.

Private equity is inherently a long-term play it is possible to make money both at the bottom and top of the cycle, depending on whether you are putting capital out or bringing it back in.

It does not follow, however, that you can’t buy well when times are good. Thinking like that helps to perpetuate the ongoing myth of “too much money chasing too few deals”, which has been playing like a cracked record since the early 1990s. And that is demonstrably not the case: returns from private equity have continued to rise as more money has flowed in.

Europe and the US have comparable populations and GDP but the European private equity industry is only around a third of the size of the US market. Given private equity’s history of outperformance, it would not be bold to suggest that outperformance is sustainable despite more capital deployment. My concern is that investors’ expectations of returns become unreasonable and while I believe outperformance will continue, it may be at lower levels in aggregate. Our job as a fund-of-funds manager is to ensure we select the best funds and direct deals to keep us consistently in the top quartile or higher.

Which periods or events have marked turning points in the industry’s development?

In the UK, the Inland Revenue’s acceptance of tax treatment of limited partnerships was a big turning point in that it gave everyone a degree of certainty and washed away a raft of tax inefficient structures. The Financial Services Act was another major event, which resulted in colossal changes. It’s easy for people to forget how things were before May 1987. The Financial Services Act brought an awful lot of regulation to a previously footloose business. I don’t know that it has actually given investors all that much protection, because risk is inherent in private equity, but it is a good thing to have the discipline of regulatory processes in place.

Later that year, the October 1987 crash taught us all a lot no one could presume that the cyclicality of the economy had been suspended and it provided a salutary lesson for a lot of people, who saw their assumptions on realisation time-scales and multiples blown out of the water. The recent bull run has been good for everyone but my regret is that there aren’t more people that remember a bear in the market.

Thatcher was responsible for many things, including much of the growth in acceptance of the capitalist approach during the 1980s: she fostered a spirit in the UK which saw making money as OK and maybe woke up the continent as well. Attitudes on the continent have certainly changed: people are no longer happy with a bigger BMW and pension they want equity ownership.

In the 1980s, high-tech which in effect boiled down to anything with a plug on it became flavour of the month. But when hardware suddenly became a commodity and the tech industry piled into software, a lot of people lost their shirts. Those people learned from their mistakes; the sad thing is that many of the institutions that funded that learning curve didn’t stick around to reap the fruits of the process. As time passed a seasoned group of managers emerged and we made a lot from supporting them over the longer term. All these factors have been important influences on the development of the private equity market. More recently, however, there has been a proliferation of private equity managers with limited experience, and that could give rise to the next turning point.

Why has Standard Life been such a consistent supporter of private equity?

Because overall it has delivered us superb returns! Naturally we have stuck with some managers and moved on from others but as an institution, over the years, we have built good relationships with some very talented groups.

Now, we have moved on from investing off only our own balance sheet and recently closed the A868 million European Strategic Partners fund-of-funds, which will split 60:40 between fund and direct investments. This allows third parties to invest alongside us and benefit from the advantages of our network and experience.

As long as we can continue to generate returns and deploy capital successfully, we will continue to look at all private equity spheres and possibly at broadening our reach beyond Europe.

Our performance over the last seven years has been stunning; there are times when I’d love to have an “open book” debate with our competitors to truly establish who is upper quartile in performance terms. The cynic might suggest the upper quartile is the most crowded sector in the game…everyone is allegedly in it.

What prompted Standard Life to move into the third-party funds market?

We have a skill base here that is unique within the European institutional arena, in that all bar one of our seven professionals have prior direct deal experience. As well as having spent years putting together systems and processes for buying into funds, we have all led and syndicated deals ourselves. This means we come to the assessment of fund managers with a different perspective from most other groups.

We also benefit from the huge Standard Life Investment information machine, which gives us a due diligence capability most fund managers can only dream of. These factors, together with Standard Life’s historic track record in private equity, convinced us that we could do a better job managing a fund-of-funds than most of the competition.

Do you think the role of funds-of-funds is changing?

Yes, it is changing as more institutions recognise private equity as an asset class. Fund-of-funds are providing more bespoke services to institutions wanting to deploy capital, and single client fund-of-funds are playing an increasing role. Retail funds-of-funds have yet to come into their own. Although there are a few European retail funds-of-fund offerings, for the most part their terms are fairly outrageous. The costs of participating for retail investors are such that the returns won’t be commensurate with the risks taken.

Conventional funds-of-funds are still very influential, setting the pace in fund design and structure. But, when surveying the variety of funds-of-funds global, regional, incorporating secondary or direct elements and so on, institutions need to ask themselves whether the players in question have the core competencies they claim. Does the manager have a credible, long-term track record or is the offering just an opportunistic fund raising event because of perceived demand? Offering direct co-investment doesn’t necessarily mean the managers have the ability to assess direct opportunities. We include it because we have over 70 years of experience in direct transactions within the team.

Everyone claims to “add value”. At Standard Life we believe that assertion has credibility, by virtue of the volume of information we have access to. For instance, we have immediate access to over 150 other investment managers from our quoted fund management team on the same floor in the same building who can identify the top analyst in any given country and in any particular sector and within an hour have him on the phone to one of our GPs as part of the due diligence process: not many funds-of-funds have that reach. Having over GBP78 billion under management, all locally, gives us great reach. Meanwhile, many of our competitors among the large financial institutions are such huge organisations that their information networks are inevitably less cohesive than ours.

I think the role of funds-of-funds will continue to change: as more players come into the market they will act more as advisory organisations both for GPs and for investing institutions. My biggest worry is that a lot of groups, some with good brands, are now setting up funds-of-funds with no experience whatsoever and their investors may make less money than they thought and if these investors lose money, they may quit the market for a long time.

What do you think of the quality of fund deal flow at present?

In terms of quality, the market has just gone through the best phases in the calendar ever. The funds available during the last 18 months have been extraordinarily good and I expect high calibre deal flow to continue through the first quarter of next year. Thereafter, things will very much depend on who comes back to the market and when, so we may find ourselves treading water for a while.

But, while the market has been awash with good offerings lately, it has been flooded with some astonishingly bad venture capital offerings from me-too’ fund managers jumping on a trendy bandwagon. Inexperienced venture capitalists are being supported by investors with even less experience. It would give me no satisfaction to see them lose money, because that does not benefit anyone, but I am concerned that they might.

Does the UK institutional market understand venture capital and private equity?

A top league of UK institutions clearly does understand the opportunities in the market. Investors in this group have taken the time and committed the resources to do the necessary research and have been conspicuous in their consistent support for the venture and private equity markets.

But, overall, UK institutional investors think they understand the private equity market but are less well informed than they believe themselves to be. GPs are capable of creating an immense degree of obfuscation, and institutions need experienced managers who can refer to history to properly assess investment propositions.

I think institutions genuinely have a wish to understand the asset class, having recognised it as a very exciting sector of the fund management industry, but they are both curious and naive about how to access private equity. Taking the route of setting up their own private equity operation and giving it money to get on with might be unwise. Institutions would be well advised to balance the cost of professional advice against the potentially far greater cost of bad investment decisions.

Equally, if the private equity industry were able to explain itself better and to demonstrate performance in a more accessible format, it would benefit everyone on both sides of the market. Performance figures have not caught up with capital deployed larger MBOs’, for instance, have historically been categorised as deals of more than GBP10 million, but today that would constitute a small buyout. Going on the fund categorisations used, just about everyone has a larger buyout’ fund now, yet people are still saying larger buyouts outperform’.

I genuinely believe that funds-of-funds provide a good service for investors, particularly those who do not want the expense of an in-house team or for those smart enough to know they are inexperienced in private equity. They provide a great deal of expertise for a small incremental cost. And, for the naive investor, the cost of getting it wrong can be huge.

What should institutions be doing differently? And the venture industry?

Institutional investors owe it to themselves to take a more informed and detailed look at performance measurement. They also need to identify mechanisms to secure exposure where returns can still be generated and to be more open-minded.

For its part, the private equity industry needs to give clear indications to trustees that it is less illiquid, less risky and less frontier’ or loony tunes’ than some institutions believe. The industry now has a large number of experienced professional managers who have made money for their investors. In the UK, these groups should be pressing the government regarding the Minimum Funding Requirement, to make it easier for institutions to invest in private equity.

Across Europe, the private equity industry needs to ensure that its representative bodies do not turn merely into self-serving quangos. And, as I already mentioned, the venture industry could explain its performance a great deal better than it does, and in general could present a more friendly face.

Institutions should accept that unlisted does not automatically mean illiquid. There is a great deal of liquidity in the secondary market for private equity funds some commentators expect over $4 billion of secondaries to change hands this year. But, because it is easier for regulatory purposes to value a listed stock than an unquoted holding, the notion of illiquidity persists. It would benefit both the venture industry and investing institutions to dispose of the idea that a quotation automatically equates to liquidity.

The private equity industry would also do well to stop consuming itself with the notion that bigger is always better, that if a fund manager raised GBP1 billion last time, it should go for GBP2 billion the next. Institutions are already waking up to that.

I hope that institutions will also not get hung up on brands and be captivated by private equity supermarkets’. Such supermarkets’, when they offer everything from buyouts to biotech, are inevitably not playing to their main strengths and skills across the entire range of their offerings.

What worries you most about the European venture/private equity market at present?

There are people managing money in private equity who have less experience than the institutions who are funding their learning curve might have hoped. Ultimately, those institutions will find that they could have bought more experience, more cheaply, elsewhere. There are some me-too’ managers in the fund-of-funds market but perhaps fewer than in other sectors of the market.

There are also lots of groups sticking their flags in the sand, appointing private equity managers and saying they are going into the market. Naive investors supporting poor teams may well get burnt, and the pity of it is that these are the candidates that should be buying product or advice from experienced fund-of-funds managers.

There are certain things each of us is happy to pay advice for, and institutional investors are recognising that. Where they do not have the appropriate skills set, it is smarter to subcontract.

I’m also worried about an overpopulation of fund-of-fund managers from groups that have strong distribution capacity but lack the appropriate skills set or experience on the investment side.

What are the prospects for new fund raising in the short to medium term?

Fund raising is set to become more difficult, particularly for the very large funds. I have often suggested at conferences that the wall of money from US institutions would dry up in the wake of a major market correction. In the context of rising markets and quick returns from venture funds, institutions have over-allocated significantly to ensure appropriate levels of capital deployment. Now, following a market correction, which has trimmed their absolute levels of assets and has slowed flows of capital back from venture funds, these institutions find they have inappropriately high exposure to venture and private equity funds and are likely to reduce allocations going forward.

Funds being harder to raise will not necessarily be a bad thing, particularly for the venture business in the US, where a lot of people apparently believed that markets could move only one way. Many have made a lot of money, but some of the investors who took the venture capital trip all the way up and then down again have found their net positions rather less attractive than anticipated. But that is inevitable when valuations lose their ability to sustain gravity.

Among European institutions, I think prospects for fund-raising are better in the short to medium term which is why US players that were previously happy to exist purely on domestic capital have been working to diversify their investor bases.

A lot of European institutions now recognise the need for the kind of incremental outperformance that can be gained from private equity exposure. Some European institutions’ historic performance has been constrained by regulatory requirements. They now realise that they cannot meet their future liabilities through the structures they have been working with to date, which have had insufficient equity exposure. Such groups are likely to turn to private equity.

But prudence must be maintained a headlong charge into the private equity market would be in no one’s interest. A considered, informed and balanced approach will ensure better returns over the longer term.