All roads lead to Rome

Date: 10 Mar 2020

Citywealth

The internet may have driven global connectivity and sped up economic development, but these worldwide links have a downside too. As investors in Kyoto read the same research as those in Manchester, there is a danger that too many roads lead us in the same direction: private equity.

Once a truly ‘private’ asset class with limited general press coverage, private equity has now fully graduated into a mainstream component of investment portfolios. It is important to recognise that private equity today is a fundamentally different asset class, and investors and trustees need to adapt their decision-making process accordingly, especially given the significant amounts of capital raised in recent years.

Wheat and chaff

Given the illiquid nature of private equity, it has always taken a discerning eye to identify genuine and sustainable manager skill. However, what had been a relatively opaque asset class is now a well-oiled fundraising system, with several ‘bulge bracket’ platforms now able to raise hundreds of millions (if not billions) of dollars in a short time frame.

Trustees can be presented with many opportunities to assess; below are a few pointers to sort the wheat from the chaff.

The right team

Management is key and you will need to look for genuine competitive edge. Some teams have an entrenched and sustainable advantage, and you will need to find evidence of that before deciding to invest. Teams should also show stability and an appropriate level of humility; management needs to be confident, but also cognisant, that the market can change quickly and not always for the better.

Any battle scars should be worn with pride. Management needs to be well equipped to cope with any risks or challenges, and they should be able to discuss case studies across different phases of the market cycle. Ask for examples of the team doing the right thing for investors, even if it makes it harder for them to hit their carried interest targets. It’s also a good sign if the team is economically aligned with investors through a meaningful commitment to the fund.

Make sure that the fund fees are commercially reasonable. A large manager with many lines of business would be expected to pass on the benefits of scale to their clients through a lower fee; however, the industry has not passed on these efficiencies to limited partners to the same extent that we have seen in liquid markets and hedge funds.

Conversely, if we use a high-conviction approach, we would accede to market standard rates for an emerging manager. The idea of ‘starving’ a management team in their early years is counterproductive in terms of alignment. If a general partner does not have the wherewithal to execute its investment strategy and fund its operations (including risk functions), the potential downside, in terms of performance, is far larger than the likely fee savings.

Take a thorough look at the financial statements of previous funds to ensure that valuation policies have been conservative and that there are satisfactory reports from the auditor; make sure the manager isn’t baking in unduly rosy exit price or timing assumptions. Finally, repeat custom is generally a good sign, so look for a reasonable commitment rate from existing investors.

The wrong team

As private funds are illiquid, underwriting a commitment in this sector is as much about assessing the governance of the fund and general partner as the investment thesis itself. This is especially important where a fund team is a subsidiary of a broader asset manager undertaking other (potentially conflicting) activities, such as other funds (hedge funds, credit funds, real estate funds, etc.) or even other businesses, such as corporate finance advice and broking.

When it comes to the team, there are some immediate negatives to look out for. Stay away from unstable management where staff turnover is high, along with a poor corporate culture, negative body language dynamics in meetings and look for a sensible team compensation approach. Complex ownership structures and negative reference checks are naturally red flags too.

Some managers have a proliferation of new general partners, which creates confusion in performance track records. When a team leaves to start their own firm, ask yourself how much of the ‘special sauce’ is theirs or their former employers?

The general partner should be setting a clear rationale, so look for signs of a significant drift in strategy, whether by country, sector or asset type.

Look closely at fund governance too, as you’ll need to get comfortable that there are senior risk staff with enough organisational power to reign in ‘star’ portfolio managers. Historic performance data should be readily available, up-to-date and, ideally, calculated in line with industry best practice rather than the manager’s internal assumptions. Some managers have limited and stale performance data and those are ones to stay away from.

Finally, consider the quality of the peer group. More liquid strategies and hedge funds may have widely divergent managers but are still lumped into the same peer group (e.g. ‘value’ equity), and the same issue happens in private capital, for example ‘European buyouts’. One has to invest time and expense to understand each team as quartile rankings are easily skewed.

As the capital continues to flow to this asset class, trustees are increasingly involved in understanding how it works. It is an exciting part of the investment industry, with its own positives and pitfalls.

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