The Importance Of Private Equity Manager Selection
By: Helen Steer
Although private equity is an interesting asset class, investors are also aware that there are several challenges associated with investing in this asset class. Helen Steers, of Pantheon Ventures Limited, examines the critical areas of selecting a private equity manager
Private equity is an interesting, exciting, and potentially rewarding asset class for institutional investors to consider. Over the long term, private equity has outperformed public equities and has become increasingly accepted as a mainstream part of pension plan sponsors’ investment strategy.
The biennial Report on Alternative Investing by Tax-Exempt Organizations, produced by Russell Investment Group and Goldman Sachs, shows that pension plan sponsors in North America, Europe, and Asia have consistently increased their allocations over the past few years. In the latest edition of the report, published in November 2003, North American institutions reported an average strategic allocation to private equity of 7.5 per cent of total plan assets. The same institutions forecast that their average strategic allocation in 2005 will be 8.1 per cent.
Although institutions generally agree that private equity is an interesting asset class, they are also aware that there are several challenges associated with investing in private equity, including the selection of a private equity manager.
Breaking Up Is Hard To Do!
Wouldn’t it be convenient if private equity managers could be assessed and rated in the same way that public equity managers are ranked? If a foolproof method of classifying private equity managers in the same way as their public brethren has yet to be created, it is not for lack of trying. However, since there are many common investment principles and techniques that can be applied to manager selection in both the public and private worlds, investors have to be aware of the significant differences between the two universes.
Of course, extensive research and astute investment judgment are key in selecting both public and private managers. Experience in the various sub-asset classes is crucial and institutional investors generally require professional assistance to achieve expert manager selection. The selection decision hinges on an assessment of the same five fundamental criteria in both the private and the public markets:
- Portfolio Fit
The investor must find a method of ranking different managers against these key criteria using a consistent rating system that can be made as objective as possible. It is always important to compare both public and private managers across their peer groups and to ensure that the entire universe of fund managers in each sub-asset category is examined. In addition, diversification by style, by sub-asset category, and by manager is essential in all investment portfolios, both public and private.
However, unlike in the ‘hire and fire’ world of public manager selection, the choice of a private equity fund manager is an investment decision that will endure for 10 years or even longer. Much more is at stake in the initial manager selection decision in private equity, hence the importance of getting it right the first time. Moreover, the consequences of ‘getting it wrong’ in private equity are much more serious than in the public markets. Dispersion in performance between private equity fund managers is significantly greater than between public equity managers. In fact, the dispersion between the top performing U.S. private equity managers and the worst performers can be more than 80 per cent compared with less than eight per cent for the U.S. small cap money manager universe (See Chart 1).
Another vast difference between the public and private worlds is that there is much less publicly available data to assist in private equity manager selection. Generally, the investor either has to build his own database or rely on outside sources that may be limited in nature.
The investor has to ask for detailed information on each fund he conducts due diligence on – there are no rating agencies to help, no standard documentation, and no standard methods of measuring private equity fund performance. The investor also finds that there is less quantitative data available than in public manager selection – hence the importance of qualitative methods and ‘informal networks’ in assessing private managers (for example, reference checking is of even greater significance in private equity).
The process of winnowing down the investment opportunities is further complicated by the fact that there are restricted ‘open to buy’ periods with private equity funds and accessing the best funds can be difficult or impossible. Investors must compare a private equity fund offering not only with other, similar funds currently open for investment, but also with funds that may be organized in the future by comparable managers, some of which may be impossible to access. This is clearly not the case in the public equity world.
Although standards and guidelines for private equity fund manager selection can be set, these have to be viewed as a basket of criteria involving a large degree of subjective assessment. Typically criteria such as people – organization, individual team member experience, and compensation; and investment process – deal sourcing, due diligence, monitoring, and exiting are evaluated and assigned a weighting within the final investment decision.
Chart 2 illustrates the typical stages in a private equity fund investment process. Every private equity investor has their own method of reducing the roughly 500 funds on offer every year down to the dozen or so they may commit to in any one year.
However, fund manager due diligence should include steps such as:
- Multiple face-to-face meetings, including visits to the fund manager’s offices
- Organizational analysis
- Detailed reference checks with portfolio company management, other private equity professionals, bankers, accountants, lawyers, investors, and previous colleagues
- Review of the fund manager’s previous due diligence work
- Evaluation, verification, and performance attribution analysis of the fund manager’s track record
- Comparison of strategy and competitive positioning with respect to those of other private equity funds targeting the same or similar markets (whether or not they are currently in the market with a new fund)
- Analysis of trends and segments in previous portfolios of the fund manager
- Portfolio company visits
- Legal document review
So much upfront work is involved for both the investor (in assessing the fund) and the manager (in working through the investor’s due diligence process) that investors and managers try to build long-term relationships that will last for a series of funds.
This is probably the final comparison that should be drawn between the public and private worlds – the importance of the time horizon. In the fickle world of the public markets, managers are assessed on a day-by-day, trade-by-trade basis. Because of the timing lags involved in private equity, and the long-term nature of the asset class, investors are compelled to have an extended time frame and live with the consequences of their manager selection decisions for much longer … ‘breaking up is hard to do’ for a private equity investor!
Given the importance of private equity fund manager selection and the significant challenges involved, most institutions seek expert advice in building their private equity program. Many institutional investors opt to hire an adviser, or outsource their private equity investment strategy, to a fund of funds provider. The latter solution has the advantage of providing institutional investors with a ‘one-stop shop as fund of funds managers take care of not only identifying, accessing, and investing with the leading global private equity firms, but also managing the review and monitoring of private equity portfolios.
Helen Steers is a partner at Pantheon Ventures Limited.
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