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Institutional investor profile: Michael Taylor, director of finance, Surrey County Council

Surrey County Council pension fund has been investing in private equity since 1986, allocating around one per cent to the asset class. It has recently decided to increase its allocation to between three and five per cent. We talked to Michael Taylor about why the fund wanted to put more in private equity and how it went about the process.

Why did you decide to increase you allocation to private equity?
‘We're a county council pension fund with a market value of about $1bn as of this summer. We've been in private equity for quite some time - since 1986. Our exposure was fairly limited in that it was about one per cent of the fund. Then, 18 months ago, we decided to do an asset and liability modelling study of the fund and from that we decided that within our risk tolerance we could put more money into alternative assets. We'd had a good track record with private equity to date and so we decided to increase our allocation to between three and five per cent, so about £30m to £50m from the £10m it was at the time.

‘We're increasing the allocation because when our advisers were matching our assets and liabilities, they felt it was a sensible thing to do and was more likely to increase the value of the fund, lower downside risk. My trustees were also keen to be investing more in the asset class.'

How were your investments structured before your decision to increase the allocation?
‘From 1986, we'd been doing direct investments in private companies on advice from the manager. Then in about 1998, we decided to move away from direct investments towards investing through limited partnerships, primarily because we felt that the overheads on the direct investment were too big. Direct investments are too time-consuming. I think you get a better spread of risk if you go through a fund. The fees are slightly higher, but that is balanced out by the risk. Also, if you're trying to approve individual investments, it's a lengthy process.

‘So, we wanted a better spread of risk, which a limited partnership investment gives us. We decided it would be better to extend our exposure beyond a single manager to global, European and more widespread investments. We were pretty much limited to small and medium-sized buy-outs before, but to get a better spread, we decided to invest in a fund of funds as well. We are prepared to look at anything from start-ups to large buy-outs, but we can only have that spread through a fund of funds because the amounts that we are investing are relatively small.

‘So, about 25 per cent will go to fund of funds and 75 per cent will go to direct fund investments. It's not firm at this point in time. The difficulty is that it's easy to commit to private equity, it's much harder to spend the money. It's a function of what's going on at the time. We don't want to be too precise on this. We've got a ceiling of £50m and we'll get to that over three years, and I'll take decisions en route as and when opportunities arise.

‘So far, we've done two fund of funds - Goldman Sachs and Merrill Lynch - and we've committed up to £10m to Friends Ivory & Sime Private Equity. So I've got about £20m committed and we'll build it up by around £10m a year over the next two or three years. I intend to invest in a European fund of funds and also in a UK fund of funds that focuses on a different end of the market to the FISPE fund.'

How do you decide who to invest with?
‘The trustees have delegated the decision to me to take in conjunction with our specialist advisers. I do a lot of research myself and then I share my conclusions with the adviser.

‘The decisions on where to invest the fund are more pragmatic than anything else. Private equity isn't about saying right I'm going to do this and I'm going to do it now. You have to have funds that are open, you have to have the right funds open and they have to want you to a certain extent. It's quite easy for us because we're a blue chip client. A lot of funds like to have the Surrey County Council name in there because it does them some good as well when they're fundraising. They also know I'm not going to give them a lot of hassle because they know that we are relatively mature investors.'

What are your trustees' views on private equity?
‘I've been doing what Myners recommended a few years ago, which was to train them, take them on training days to ensure that they understood the whole investment process and get them so that they feel comfortable with the kind of decisions that we were recommending to them. We also made sure that they were able to maintain constant contact with the private equity manager that we had. Most politicians - our trustees are council-elected members - don't go onto their county council or their local council to look after the pension fund, they go to do their area some good. So I had to make it interesting for them. They have found private equity one of the most interesting areas of investment. Ideally, they would like to think that they are investing in their local economy. Now, that isn't the necessarily the right thing to do. But they think it's a good thing to be investing in small-scale companies either in the UK or worldwide.'

Have you ever looked at regional funds?
‘Not to any great extent because I don't believe we should be investing our pension fund into our own economy. That's a difference of opinion that I would have with some of my colleagues elsewhere in the country. The Surrey economy is very strong and booming, so you could argue that we should be investing there. On the other hand, I think that I have a fiduciary duty to the pensioners and my only reason for being part of the trustee group is to ensure that their pension is paid. Therefore, you have to go for the best return.'

What do you look for in a private equity manager?
‘I'm looking for a track record and confidence in the investor. They are the most important things. I also need confirmation from my advisers that these people know what they're doing. I'm also trying to spread my risk as far as I can. With a fund of funds, by its very nature, you're spreading risk. But you do need to ensure that you have a good spread by manager, by investment stage, by sector, by geography, by vintage. I'm looking for that as well, but I'm also looking for the top quality names and the confidence that I'll get excellent returns as well.'

What gives you that confidence?
‘Reading the prospectuses, meeting the people involved, understanding their processes, looking them in the eye when they're telling me about their process and then checking out with the real experts, such as my professional adviser.'

Are you interested in any particular countries or sectors?
‘There is a lot that I'm not interested in. As with most UK pension funds, the majority of our money is in the UK. But I'm also interested in Europe and the US. If you do the research on where money is invested, then it's US, Europe and the UK. Those are the areas that we're concentrating on. There will be a very small amount of money invested in the global fund of funds that will go to Asia and other places, but that will be minimal. I'm more interested in the more mature economies where private equity is understood and the accounting regimes and regulatory environment can be relied on. I wouldn't accept that private equity is a particularly risky asset class - as many people think it is - but I wouldn't do things in private equity that I would do in public equity in terms of countries or weighting towards geographic regions.'

What advice would you give to a new investor?
‘Start small and make sure you understand what the process and procedures are of the people that you're dealing with. That's very important to get confidence at an early stage. It's almost sod's law that the first thing that your manager will invest in will probably blow up. But you don't stop after one investment. You have got to be sure that you have made the right decision and stick with it for a period of time. Don't lose your bottle at an early stage. Always remember the J-curve of returns. You're not going to start seeing a positive return until after at least a year or two. Our returns pattern has gone up and down. We didn't actually start seeing very good returns until after quite a few years. Now, with the investments that we've been making more recently - the ones at the mid-stage - we've got slightly less tolerance of the ones that bomb out completely. And we'll only get a handful of investments that really take off.

‘It's thinking about investment over the long term. Pension fund investment is long term. It's pointless changing your strategy because of something that happened last week. That's a slight problem when you're talking trustees. They meet quarterly and they see the quarterly returns and think that we should be reacting straight away.'

‘One of the key things to understand is the exit strategy. At times, I ensure that I focus purely on the exit strategy so that the investor is, too. We would like to see an exit within three to four years. If it takes off, you want to be doing it within six months or 18 months.  But you don't necessarily want something that five years later is still not ready for exit. The target IRR should be around the 30 per cent mark. Our target is FTSE plus five per cent.'

What would you say is the biggest issue for the private equity industry?
‘Convincing people that it isn't necessarily risky. There are good returns to be had, there is generally a breakdown and correlation to the quoted market, so you have to look cyclically to some extent. Convincing the consultants that private equity has a place in asset-liability structures, so that you have this opportunity for higher returns if you're prepared to take that risk.'

What are the issues for investors in private equity?
‘The main issue is convincing trustees that private equity is not simply a fad. It's not something to get into simply because Paul Myners has suggested it. If Myners has said it, then perhaps Gordon Brown is pushing it and why is Gordon Brown pushing it? There are some political issues there that you have to look through. Private equity isn't for every pension fund. We are a cash-positive pension fund, we will probably not be a mature fund in the sense that the outgoings will match the income for ten years hence. We're not in the Boot's situation where we're a closed fund and can go entirely into bonds.

‘The local authority pension market is worth around £90bn. Every local authority treasurer will have done a report on Myners and its implications. Therefore, you have to address whether or not you want to invest in private equity. But it has to be part of asset and liability modelling to ensure that, at the end of the day, the pensioners get paid. If you forget that, then you've lost the plot.'

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