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How to build a successful private equity programme

To achieve long-term success in private equity investments, institutions need to take a structured approach. LGT Capital Partners provides an overview of the phases that investors should go through when programme-building at a time when the market is proving challenging.

Given that many institutions are currently beginning, or considering beginning, a private equity Programme it is important to revisit a few essentials for what can make this a successful endeavor over the long-term.

Any institutional investor considering these important Programme-building steps at the moment is doing so in a period where difficult and volatile capital market adjustments have made it more challenging than ever for those constructing a private equity Programme.

In this case we will explore the situation of an institutional investor willing to allocate at least €300 million to private equity and who wishes his or her team to become capable, over the long term, of gaining the access and experience necessary to be able to successfully manage their own Programme without outside help.

Complicating this goal is the closed and inefficient nature of the industry. This means that there is no organized market for distribution and access, no daily market pricing, no standard for managers to calculate and present performance, little published information or comparison of returns, no liquidity for ten years once committed, high investment minimums, little research available, emerging disclosure standards, no regulatory oversight, and the opportunity to invest often by invitation only. One approach to mitigate these systematic problems is to begin a Programme by working with people who have experience and to build up ones own expertise over time with them.

Phase I: Start-up. Investments made in the first years of the portfolio will have an important impact on overall portfolio performance and will be prominently visible in the first years. It is thus important to consider how to ensure that the portfolio does not run into difficulties with the first few investments, as it could be disastrous for the continued success of the private equity Programme. Mistakes create delays, loss of internal support, and errors are paid for in cash and opportunity cost. This is why it is crucial to climb the steep part of the first years' learning curve with professional advice. Two main routes have been tried and trod for obtaining professional advice, depending on Programme size: funds of funds or advisors. Whether one chooses to work through funds of funds, advisors, or both, their track record and experience should be key to an investor's choice. Investments conducted through the advisor or fund of funds can act as a core around which one can later add additional investments.

Once having chosen an allocation and risk/return target together with an advisor or fund of funds, the key steps in constructing a Programme are to:

• Understand the subtleties of the market, how it is organized, who are the best managers and why, and how to get access to these managers. (Having an appropriate fund of funds or advisor is critical at this stage for accelerating the learning process and helping one to avoid rookie mistakes.);
• Come to grips with the regulatory and tax issues involved with investing in the asset class ;
• Diversify from the outset amongst markets, types and stages of investing. Diversify between the two main sub-classes of private equity: venture capital and buyout and between Europe and the United States. A good balance between venture capital and buy-out is to be recommended, as they tend to be correlated against one another to only a low degree and a good balance between Europe and the United States provides obvious diversification benefits regarding currency and economic cycles;
• Use an often overlooked but critical factor for diversification, so-called vintage year diversification. Vintage year diversification involves spreading investment across time periods, and thus reflect different pricing and liquidity cycles of the private equity and exit markets. It involves purchasing portfolios, or parts of portfolios, from investors whom are readjusting their asset mix or looking to make new commitments to the asset class for strategic or other reasons . Benefits include not only the increased diversification of risk provided through the incorporation of a variety of vintage years into the portfolio but also through the greater speed at which positive cash flows and desired allocation levels become reality;
• Diversify amongst managers. According to common estimates of current market size, there are over 2,000 private equity fund managers worldwide with at least USD $50m of assets under management. To properly access and evaluate these funds, or even a good percentage of them, is a Herculean task. It is often also the case that one needs to make a minimum commitment of $5-10m to be able to invest into a fund - a situation that makes building a diversified portfolio extremely costly. Just as daunting is to get the critical, “behind-the-scenes” information that can only be obtained by those who are “in the know” and have been operating in the market for years; and
• Build internal systems to monitor fund cash flows, fees and valuations and establish a reporting and performance infrastructure to keep in close touch with the development of the portfolio.

Given the above challenges, it is strongly recommended, as mentioned, that an investor begin working with an experienced advisor or fund-of-funds. Such a partner should be able to ensure not only diversification along the axis mentioned above, but also access to the best funds and important market knowledge. As with all investment decisions, working with a couple of consultants and FOF managers - perhaps two to four in total, depending on the intended size of the Programme - should help ensure not only risk diversification and competition between managers, but also access to a variety of opinions and investment opportunities.

Investors who have no clear strategy, limited knowledge and understanding of the market, and who do not use professional partners to start their private equity portfolio take a lot of unnecessary risk. The 1998, 1999 and 2000 vintage years will be especially painful for investors who did not have a complete view of the market, or who did not have a clear strategy and finely-tuned processes in place.

Phase II: Development. This phase involves developing internal capabilities. The goal should be to build up a team which can give the institution those resources and relationships required to professionally carry out the vast amount of work required for investing effectively.

At this stage it can be seen if one has chosen wisely with regard to the advisor(s) or Fund of Funds provider(s) used in Phase I. Indeed, those service providers who truly have their client's interests at heart will assist with this process of team build-up and information transfer.

In this phase the investor should also be able to begin to measure the performance and quality of the investments completed in Phase I. While private equity returns are measured cash on cash over their life cycle (10 to 15 years), early indications of performance can be quite useful in assessing the quality and direction of the core portfolio.

Phase III: Expansion. At this stage, the investor is now ready to conduct fund investments alone and can increasingly extend its expertise into the realms of secondary transactions, specialty funds and co-investments. Indeed, funds in which investments were made in Phase I may now be coming back to the market with follow-on funds and the investor can now choose whether to phase out its collaboration with its advisor or fund of funds.

Following the above steps for investing into private equity will not guarantee success for every institution. Nevertheless, a well structured and rationally constructed Programme along the lines suggested should allow most institutions to profit from the extraordinary opportunities inherent in the asset class, regardless of the state of public equity markets. 

LGT Capital Partners is one of Europe's leading private equity and hedge fund investors and multi-manager Programme managers. LGT Capital Partners currently manages over EUR 1.7bn in private equity assets on a global basis and over EUR 800m in hedge funds.

LGT Capital Partners acts both as principal investor and investment manager, with clients investing on equal terms alongside its own capital. As a principal investor, LGT Capital Partners' primary objective is to achieve superior risk-adjusted returns by accessing and actively investing in the most promising private equity and hedge fund investment opportunities world-wide.

For more information: aim@lgt.com or telephone: +41 55 415 9 415