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The quality of the fund manager is crucial in private equity investments

There are over 1000 private equity fund managers active today in Europe alone. Permanent monitoring and the search for the best teams is a laborious process but is absolutely essential to successful private equity investing, according to Bruno Raschle and André Jaeggi of Adveq Management.

The success or failure of private equity fund-of-funds providers is determined by the selection of the fund managers in whose funds investments are made. They all promise high returns, but only few actually fulfill their promises. Finding the best manager is much like looking for a needle in the haystack. It therefore pays off to track and rate the performance of fund managers on a continuous and systematic basis.

The qualified investor takes advantage of the long-term nature of the private equity business. Regardless of the selection of certain market segments or the focus on certain development stages of companies, the proper choice of the fund manager becomes apparent at a relatively early stage if suitable monitoring and management systems are in place. This is why the fund manager is so significant. On the basis of the defined strategy, he decides for his fund whether investments are to be made in an unlisted enterprise or a business development project. This places high demands on his knowledge, experience and the assessment of his own executive power. His appetite to take risks and at the same time to manage the exposures to risk must continuously be addressed.

What do successful fund managers have in common

The most successful managers grasp situations quickly and have a keen sense of judgment. But they also share another skill: Time and again, they succeed in developing the companies in their fund portfolios into the leading players of their respective fields. Their marked ability to initiate, generate and realize values enables good fund managers to achieve excellent returns even in difficult economic times.

Thus, for example, the private equity provider Sequoia Capital, Menlo Park (U.S.A.) was repeatedly involved in the successful development of market leaders, a fact amply borne out by such examples as 3Com, Apple, PayPal, Google, Yahoo! or Cisco Systems. The success of these investments is attributable to more than the correct selection of technologies, market segments and market positioning or the above-average performance of the management crew. Just as much, success was due to the choice of the right financing models and partners; the fast recruitment of the best management staff thanks to the Sequoia brand and its direct network; the identification and integration of cooperation partners; and the joint financial clout and staying power of the investors. But many idea would never have received funding without Sequoia's entrepreneurial determination to generate an as yet non-existent, significant market service meeting future needs by a state-of-the-art company still to be established.

Knowing and measuring managers

For fund-of-funds investments, precise knowledge of potential and current investment objects is important in order to assess the possible value development of the funds. But much more important are the measurement and rating of the fund managers' activity and performance. Fund-of-funds investment providers need rating criteria to measure the actual performance of managers. This gives the fund-of-funds an early indicator as to whether an investment relationship is worthwhile. Much of the knowledge about a fund manager is obtained by careful observation and analysis of his work with each individual company financed. This may be an extremely labor-intensive process: Adveq, for instance, is involved indirectly in about 2000 companies through five fund-of-funds.

Clear criteria for assessing the quality of fund managers are necessary both for the historically most successful managers and the many others. Even the most seasoned fund managers allowed themselves to be driven to sometimes-questionable investments during the bubble in the nineties. Their otherwise excellent track records are today blemished by one or two fund years with poor returns. Today, the clear identification of fund managers with a high return potential is only possible by "standardized and automated" monitoring of the overall market, which is repeatedly tested and applied during an extended period of time.

It is generally assumed today that the fund managers with a good track record are those who will also deliver good results in the future. This approach may lead to success in a stable or continuously developing environment. For example, many of the buyout investments made in the nineties yielded profits without any fundamental strategic or executive improvements having been made in the companies concerned, but merely thanks to the skyrocketing capital market. After times of discontinuity, and especially when the general economic environment has undergone fundamental changes, this practice becomes mere speculation. This is all the more so when good entrepreneurial performance leads to a good track record, and not the other way round as is occasionally assumed. Other rating models, or models based on a systematic approach, have to date rarely been published in the literature or practiced in the private equity industry.

Systematic and permanent monitoring

A systematic approach has proven its worth for assessing the quality of fund managers on a permanent and universally comparable basis. It is based especially on two aspects: "Factors for maximizing returns" and "Factors for managing permanent risk assumption".

With regard to return expectations, the quality of the sub-results achieved to date in the individual development steps of investments is measured and rated. For this purpose, a check is made to determine how and with what success investments can be shed, and how the individual fund managers have succeeded by their personal contribution to generate value for the portfolio company. The financial structure and aspects of the financial power of the investing fund are taken into account. The strategic positioning of the fund and its maintenance by the fund manager is then given consideration during the subsequent evaluation for portfolio modeling at the fund-of-funds level.

Since a fund manager normally invests the money of "other people", his skills in assuming risks in a targeted and controlled manner at a personal and at a company level are crucial. The executive risks and the dynamism of the team are especially important for the fund manager. Also the risks resulting from the specific investment strategy of the fund are assessed. Macropolitical and structural and economic risks must be taken into account in portfolio modeling. Practice has shown that the effects of the continuous ups and downs of the financial markets have had an impact on the short-term behavior of fund managers. The model must therefore be designed so that the long-term nature of the private equity business mentioned above will offer the investor the value-added he expects.

The effort pays off in the long run

Permanent monitoring and the search for the best fund manager for a given case resembles time-consuming cherry-picking. This is especially true if we consider the fact that over 1000 private equity fund managers are active today in Europe alone, who in turn invest in dozens of companies. But such an effort pays off, for only those fund-of-funds providers can be successful who have a clear basis for making their investment decisions and who are able to state the reasons for their decisions.

This includes the ability to permanently be in the picture about the progress of individual investments and to know how fund managers' capabilities are developing. As a consequence, fund-of-funds will know at all times whether and why a fund manager is or can be successful. It is not the historically outstanding returns that characterize a good fund manager. It is his current creative power that allows future high returns to be expected. And this is precisely the philosophy that must govern the long-term orientation of the "private equity" form of investment and guide the committed and qualified investors involved in it. This approach will also produce sufficient qualitative arguments which can then be quantitatively evaluated, allowing the fund-of-funds manager or institutional investor to somewhat reduce their prejudice or to underpin their confidence in a fund manager with hard-and-fast facts.

Adveq Management offers expert management in private equity fund of funds to provide for start-up, expansion, buyout and development financing. For more information, please visit www.adveq.com