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Big buy-out or small venture

Institutional investors are beginning to make their fund investments with a greater degree of care after many got their fingers burnt by the bursting of the technology bubble. David Leidl of the AVCJ discusses how investors are looking more at mid-market buy-outs, although most still maintain an interest in the venture sector.

As Paula Chester told the largely VC audience attending the recent AVF/Silicon Valley even when the big American investors are aware of Asia, because they are big, they ‘have a difficulty pulling the trigger.'

The former director of private equity for the New York State Common Retirement Fund ($16bn in the asset class) and panel moderator, Chester, and panelists Margo Wirth and Clinton Harris have the collective throw weight: Wirth is investment officer/alternative investment program for the enormous California State Teachers Retirement System (CalSTERS), Harris is the managing director for Grove Street Advisors and in effect the mahout for the even bigger California Public Employees Retirement System (CalPERS).

Buy-outs are better
Because they have relatively few staff and lots of capital to place, big institutional investors prefer to lay down big blocks of capital. However, they also like diversification, hence the rationale in the late 1990s to develop ‘captive' fund of funds where the II was the sole LP. Easy access is another requirement and, chides Chester, it's not easy to get a bulky beast into a top-tier, brand-name Silicon Valley VC fund, whereas the big buy-out funds are much more approachable. Historically, big buy-outs are perceived as less risky vis-à- vis venture capital investment, especially early-stage VC plays where ‘the hit' may be only one in ten with the rest of the roster ranging from so-so to oh-no!

‘Don't forget,' Chester warned. ‘Big funds are definitely long-term investors. They don't like to get in and get out of funds. They want to stay in them as long as they're performing well.' Aside from the VC happy days of 1998 to 2000, Chester believes as an asset class, buy-outs and their ilk have performed better than venture capital. (Clinton Harris disagrees.)

The post-2000 crunch
However, she also says there's always a need for a venture capital component and the ‘real interesting' events of 2000 proved it: the pension funds were having problems with their asset allocations, the denominator shrinking in tandem with the shrinking public markets. Three years in, the crunch continues. Of CalPERS's $175bn, $10bn was committed to private equity, virtually all of it buy-out. Harris says there's now a push to up the allocation to about $20bn and ‘over time' move 20 per cent to 30 per cent into the venture arena.

CalSTERS is a $90bn entity with about $5bn (market value) in alternative investments with about 55 per cent in buy-out, 25 per cent in venture, 15 per cent international and 5 per cent debt. Launched in 1988, the alternative investment program has an IRR of about 16 per cent since inception. Little of it was made in Asia. On the surface, anyway. Although CalSTERS's investment policy is restricted to funds focused on North America and Europe with the majority of the investment on businesses either registered in or primarily doing business in the United States, Wirth says ‘quite a few' of the US-focused stalwarts do significant business in Asia, especially via mid-market buy-out funds with distressed debt opportunities looking ever more appealing. Although Chester is no longer with the New York state retirement fund, she says its $16bn of committed capital was very interested in Asia.

So where's it all going? The ‘meltdown' has bred caution and sharpened due diligence. Wirth believes the fund-raising cycle is at a lull for now but it should pick up next year and with it, CalSTERS's investment pace; it has an allocation ceiling of eight per cent, it now sits at five per cent but ‘there's no push or expectation we'll get there anytime soon.'

Return to basics
Agreed, says Harris. The venture industry has gone through an unprecedented peak and valley, the IT industry was infused with $150bn of investment in a two-year period . . . investments which are now worth perhaps 50 cents on the dollar ‘and the industry has been reeling from the aftermath of that.' The industry isn't about to go back to the well and bucket out new fund money until next year. Which means investment officers tasked with placing money by year's end, don't have much to pick from: there has been ‘very, very few top-quality venture firms in the market in the last couple of years.'

With buy-outs, slow and very careful going means a return to the basics: build a great company, the good firms being those with the varied skill sets to work with that entrepreneur. Before that, there was the brief period in the late 1990s where getting into the top-quartile meant having an ‘outstanding visionary' at the helm and who cares if the engines need fixing? The implosion of April, 2000 brought such hubris to a ‘crashing stop' so now it's back to the basics.

To sleuth down the few good funds, Harris says expect to spend ‘a huge amount of time' on a deal-by-deal, company-by-company investigation. Understand the attribution, the reality behind the predictions, the team and whether it has the legs to carry it through.

Buy-outs receive attention
When considering funds, file the track records of the late 1990s. Bolstered by a bubble which likely won't return in our lifetimes, they're almost irrelevant and ‘quite suspect' warns Harris. Aside from being impossible to repeat, the folks that built those track records have mostly retired, booty in hand. Meanwhile, the teams which remain are fraught with internal cracks and stresses courtesy the aforementioned implosion.

‘Private equity is an industry where past performance has been the best indicator of future performance,' mused Harris. ‘I think that's going to be less true in both the venture and buy-out industry over this next cycle, than it has ever been in the past.'

A little no longer equals a lot. Back in the late 1980s even if a company posted zero change in sales and earnings, a half-decent purchase, leveraged well and fitted with good financial engineering, could yield returns in the ‘mid 40s' or top quartile, no problems. Today, says Harris, financial tinkering and leverage might pull in a ho-hum five per cent or less.

To get significant returns today, you must get involved in the buy-out. Sure, that sounds obvious, says Harris, but it means invoking very different skill sets. Before, the key skills were access to transactions, proprietary deal flow, transaction skills. Today, the primary skill is knowing how to boost that particular company, in that particular market. Transition, operating, business analysis skills, people skills and the ability to mix it all together.

Big isn't necessarily better. Up until the last few years, it couldn't really be proved there was any correlation between fund size and performance. Call it self-fulfilling but the people that did best, the funds that did better in the past, tended to garner the attention and the investment money on the next round.

Bigger is better?
The huge funds that exist today - thanks to their franchise, skill sets and domain expertise - continue to do well. The returns might not be huge but like efficient hard-rock gold-mining operations, wealth isn't counted in nuggets but in the masses of efficient capital steadily grinding out profits. There's also the odd huge corporate divestiture, notes Wirth, mega-firms like Vivendi which need to raise money fast, the big buy-out funds circling around picking off ‘some very, very attractive buys.' But, she's quick to add, that's not the norm. ‘A lot of it is pretty scary, how much competition there is and how the returns would seem to be . . . are going to be driven very low.'

However, says Harris, in the buy-out industry and over the longer-term, there is evidence the small funds are outperforming the big guys. Credit it to simple math. It's much easier to double the performance of a $50m company than do the same to a $1bn company. In relative terms, seedlings grow much faster than mature oaks. Of course, seedlings do get eaten, squashed or parched quicker but if it's performance you seek, look to the middle and micro-markets.

‘It's easy to write those big cheques to these multi-billion- dollar buy-out firms but they may, over the long term, be the hardest place to get exceptional returns,' says Harris. So, where go Grove Street Advisors? Towards the small, says Harris. ‘We're focusing on micro-caps and small buy-outs and we're continuing to back the venture industry.'

Specifically, that means working with ‘new and emerging' managers a.k.a. first-time funds where the fund has a proven cash and cash-track record. ‘In terms of ‘bite size' we're a bit schizophrenic,' says Harris. ‘We'd rather do more of those with very small bite-sizes and work closely with those groups. It's relatively inefficient when you start but over time, you start doubling up on your bets that are performing well and over three or four cycles, this is what Harvard and Yale and MIT have been doing for the last 30 years and how they built their portfolios. It's not rocket science.'

But prototype rockets do blow up, warns Chester. Micro-caps? ‘I'm not too sure it's necessarily the right place to go either; so where the hell do you go?' One major problem is the general partners. Big firms have the ‘financial partner' mindset where cash flow is top priority, whereas small firms need ‘operating type' partners if they're to achieve their potential. As well, the small guys generally have less-evolved management talent, dicey margins which rely too much on one supplier, one customer.

And Asia?
Maybe, soon, but not quite yet. Or as Wirth mused vis-à-vis launching an Asian-focused fund: ‘I think we're quite a way from doing that. We do have tremendous interest in Asia because of the great potential but [our interest] is more indirect.' As in piggyback along on US-based GPs and investments which are putting a toe, a foot, or a leg into Asia via the relocation of manufacturing facilities and the like.

But it's a qualified piggyback ride. Due diligence is exactly that, warns Wirth, the criteria used to test European and American investment candidates applies to Asia and Asia doesn't compare well. ‘Our perception is that nothing in Asia would really meet the standards we have for those investments. That's why we're not anticipating anything direct, like an Asia-focused fund, in the near future.'

Thanks to his professional life prior to Grove Street, Harris knows his way around Asia. But, as he cautions, others do not and those who move into a market too early, the pioneers, ‘you typically do not do well financially.' Being no fools, institutional investors require a big comfort level and assurances of liquidity before commitment. It's one thing for, say, a big manufacturer like General Motors to make a strategic play and sink cash in, say China, and prepare for the long haul. Speaking for his clients, Harris says it's different for us. ‘We have to get our money out each cycle, we have to be able to get the liquidity.'

Returns, returns
They also want to see a competitive edge and returns comparable - if not better - than the European and/or American deals out there and the smarts behind them. ‘We don't want to go into a market where there's only one good performing team; you're compounding the market risk with the single-team risk. I want to be able to diversify across at least a couple of teams.' These teams must also demonstrate via ‘reasonable evidence' that they have the longevity, a longevity tested and proven at someone else's risk and expense.

‘The state pension and public pension funds we've looked at, have been very cautious with Asia because they haven't seen the proven track records of the teams,' Harris told the somewhat subdued audience. ‘Until you see those proven track records, it's not appropriate for the public pension funds to be the pioneers. Now, that's a pretty controversial statement, but that's how we feel about it.'

And, like it or not, when the money talks, you listen.

Copyright © 2003 AVCJ

David Leidl is a senior writer at the AVCJ.

This article first appeared in the Asian Venture Capital Journal in July 2003.

The Asian Venture Capital Journal is the region's leading publication on private equity and venture capital. With readers worldwide, AVCJ provides monthly coverage of fund raising, investments, exits and the people behind them. For more information please visit www.asianfn.com