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Institutional investor profile: Tim Cruttenden, Senior Investment Manager, VenCap International

Cruttenden on why US venture is an exciting area at the moment, on why Europe is coming of age, on why there is no substitute for experience in private equity and on why mentoring matters in private equity.

VenCap International is a fund of funds groups with over $1bn under management across ten funds. Formed in 1987, it is one of the longest established fund of funds in private equity. Based in Oxford, UK, and San Francisco, USA, the firm has investments in over 150 funds across the US and Europe. Cruttenden heads VenCap's fund investment team and has over eight years of private equity experience. Before joining the firm in 1994, he was an economist and statistician for the Association of British Insurers.

What type of investments do you look for?
‘We invest in both the US and Europe. In the US, we mainly focus on venture capital firms across all stages. We like venture because of the variation of return around the average, meaning that if you get the fund selection right, you can outperform the market significantly. In Europe, we invest in both venture capital funds and small to medium-sized buy-out funds. We like the MBO funds because they are very attractive if they have strong local networks. That allows them to have good proprietary deal flow. Most of them get to see virtually all the deals that fall within their universe of opportunities. We avoid the large buy-out funds. We think that is a very competitive arena and we also think that these funds are accessible to our investors directly. We want to be adding value to investors - if they want to invest in the larger funds, they can easily do that themselves. The value we provide is finding the smaller buy-out groups or the high quality venture groups.

‘We started out investing in the US and expanded into Europe. That reflects the way that the market has matured. We now invest 80 per cent in the US, 20 per cent in Europe. Of the US investments, 95 per cent is in venture. In Europe, we will continue to invest approximately 50-50 in venture and small buy-outs. I don't think that allocation will shift significantly in the future. We know the US venture market space very well and we remain attracted to the fact that we can outperform by investing in high quality venture groups.

‘We do not do any direct investments or co-investments because we think that is the job of our VCs. If a fund came to us with a co-investment opportunity, we would question whether the deal was of the highest quality, especially given our focus on venture. If a venture fund has a position left in a round of investing, they are better off getting in another quality venture fund or strategic investor They would be able to add far more value than we could. I think co-investment is more appropriate on the larger buy-outs where there is often more scope for passive co-investors.

‘We have done a number of secondary investments in the past, back in the late 1980s and early 1990s, and we continue to look at them opportunistically. Clearly, there are quite a few secondary positions on the market right now - we're hearing of a lot on the venture side. But we are very wary about them. You have to have the three elements of timing, pricing and quality for it to be successful. It's difficult to assess the timing at the moment because there is definitely some pain still to be felt and the markets are so volatile. On pricing, I think there are still a lot of people who haven't yet come to terms with what has happened to valuations. And on quality, not many people are selling their good funds. For secondaries to be really attractive to us, especially on the venture side, those three have to be in line and I don't think that is happening at the moment.'

What is your appetite for first-time funds?
‘We look at first-time funds. We are especially interested if they have come through our network. We try to be proactive when we are sourcing funds. We try to use our general partners or limited partners that we trust to find out about opportunities. If we hear about a first-time fund that way, we will take a serious look. It could be the first time that that fund has raised a fund from institutions, for example, or it may be a spin-off. Our usual disciplines still apply in that we want to see evidence of good experience and a demonstrable track record. It is also important for there to be one partner in a newer group with eight to ten years' private equity experience so that they can effectively act as a mentor for the less experienced people. And it's important to see whether that person has had a good mentor themselves. There needs to be a good chain of apprenticeship going through the group.'

What do you look for in a private equity manager?
‘We look at it this way -- venture capital is expensive for a small company. The entrepreneurs have to give up a large chunk of equity to have a venture capitalist invest in their company. The ability to add value and build a great company going forward is vital. You can add value in many ways, by providing great operational experience, with fantastic networks, greater recruiting ability, sound technical skills, good strategy, good discipline, etc. But we really need to understand that the venture funds we are investing in really can add value. If they can demonstrate value-add to an entrepreneur then they are far more likely to be able to get in to a deal at a good valuation and that helps them make great returns for us. Most of the successful VCs in the past have proved that they are not passive and they are not just lending their name, but that they are really getting involved and rolling up their sleeves and helping portfolio companies.

‘With buy-outs, it's slightly different. When we look at a buy-out fund, we are looking primarily for sourcing and , transaction skills. Investment experience is generally more important than operational experience. Experienced investors will structure transactions well and help make the company grow by working closely with management, often helping with further transactions to build the business.

Where are the most interesting areas going forward?
 ‘The first sector for us is the US venture sector. We believe that it looks very much like it did in the early 1990s. The venture investments that we made back then have proved to be very rewarding. The VC market is cyclical. Having a long-term and committed approach to investing in it is proving sensible. You really cannot time the market.

‘In Europe, VC is coming of age. There was a lot of excitement in 1999 and 2000 when the exit markets were hot and European VCs looked as though they were doing fantastically well. But the people that we at VenCap look to back in venture capital in Europe are the people who have been around a long time - the ten to 12-year veterans, of which there are not that many. But overall, VC in Europe is becoming more attractive. The entrepreneurs are returning from the US, the tax laws are getting better Europe-wide. We are believers that the market will prove to be a good one.'

What are the main barriers to private equity investing?
‘The inefficiencies and the lack of transparency in the market cause a lot of problems for investors. To be successful in this market, you really do need to understand what you are doing before you have any success that is based on sound judgment, as opposed to pure luck. There is no substitute for experience. The good funds are hard to find and access.

‘A lack of knowledge and understanding is dangerous. If you have some lucky early successes you perhaps believe that you have the Midas touch and this can lead to some irrational decisions. We have seen this happen especially with the technology sector in recent years. A lot of people were attracted to the market because of its high returns and those that got in around 1998 had some early successes. They continued to put a lot into the market, thinking that it was just going to go up and up. Now, people with 1999 and 2000 portfolios are feeling a lot of pain.'

What has been your biggest mistake?
 ‘I don't think that we regret anything that we've done in that we are bound to make some mistakes. What's important is that we have learnt from these and become better investors for it. One piece of advice I would give to people is to make sure that the team needed to invest the money is already in place - that one or two partners are not going to be added at final closing. This is a particular problem with funds managed by two people who say they are going to move up to three. That is probably the hardest recruit you can do. You are adding 50 per cent to your staff. You are adding someone to a team that has probably been working together for five or six years. It is a difficult decision for people to make to bring on a third person and so sometimes it doesn't happen or, even worse, they bring on the wrong person, and that can have a really detrimental effect on the fund.'

What advice would you offer to investors who are new to the asset class?
‘Make sure you take the time to understand what you are investing in. This is a long-term business and consequently, the rewards are long-term. Do not jump in and out of the market - that's the surest way to have a bad experience. On the other hand, it's a very difficult business to get to know and so experience counts for an awful lot. That is particularly true of the venture side because of the dispersion of returns. This means that if you make the right decision it's very rewarding, but the wrong one can be very costly. So my basic advice is to make sure you know what you are getting into.'

Are you seeing many new investors coming into the market?
‘Yes, certainly the UK. We are hearing of a lot of pension funds, especially the local authority ones, coming to the market. Europe-wide it has been happening for a little longer. I suppose the question is: ‘Can the industry cope with significant amounts of additional capital?' Is it an industry that thrives on a relatively small amount of capital or can it continue to outperform with these larger pools? Time will tell.'

What irritates you about the industry?
‘One thing that irritates me is hearing investors say, given the current correction in technology, that they're glad they don't invest in technology. I hear that quite a lot. We've been investing in technology for many years and we have made significant returns for our long-term investors - this downturn effectively means a portion of that profit is being taken back. So it's a bit like looking in the rear-view mirror and saying, “Oh, I'm glad I missed that”, when if you had been in long-term you would have done very well. I find that a bit irritating.'

What's your view on what is likely to happen in the tech-sector?
‘I think that technology will continue to drive innovation. The private market in the US and Europe is attractive right now in terms of valuation. Also the VCs are getting time to look at deals, structure the transactions properly and help to build good companies. There is a much better selection process, the quality of deal flow is generally much higher, business plans are more sensible and entrepreneurs and investors are more realistic. It will take time but then that's normal. I think liquidity will be a number of years out rather than a number of months out. But innovation doesn't stop just because the markets are being hit.

‘Just look at what is happening with the convergence of tech and life sciences. You've got companies developing technology that could take years off the front end of drug discovery. And life science in itself, as a technology, is very exciting. The developments in genomics were perhaps overblown from a market valuation standpoint, but long-term these developments make the sector an attractive bet.  The semiconductor market also appears attractive, with significant opportunities for disruptive technology to make a real difference.

What is the biggest issue in private equity at the moment?
‘Liquidity is the biggest issue. That basically implies that investors have to be patient. Some will be and some won't. It also means that funds need to work out how to get some kind of turnover in their portfolio. How do they exit companies? How can they make new investments and keep their capacity at manageable levels? In venture, follow-on financings are quite a big issue. Some worthy companies are not getting follow-on financing and are going out of business. A lot of other companies are getting “inside only” funding.'

How do you think the industry will change in the future?
‘Consolidation is probably the main factor. We are seeing a lot of venture capital-backed companies going out of business. We are starting to see some of the funds disappear and I think we will see quite a few of the fund of funds disappear. For us, our overall impression is that this is a good thing. The fittest and strongest will come through. It will rationalise the market and we'll come out the other side with a stronger environment. There could also be a changing of the guard for the top-tier venture groups, especially in the US. Investors in that area really do have to work hard to identify the future stars. Some of the groups that have been around for 15 or 20 years and have done very well will continue to do very well because they've had very good mentoring and apprenticeship models in place. Those that started up very rapidly and didn't really bear the apprenticeship/mentoring model in mind are going to find it much harder.'

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