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Institutional investor profile: Stefan Herzog, Managing Director, VCM

Herzog on the dangers of subjectivity in the fund selection process, on why private equity is not scaleable, on why there will be a wholesale market correction and on why capital overhang is one of the industry's biggest issues.

VCM is an independent private equity advisory firm, which spun out of the Matuschka Group in 1991. It now has eight investment professionals based in Munich and five professionals at its US joint venture VCM Shott Private Equity Advisors in Boston and San Francisco. To date, the firm has committed more than $750m to private equity funds in Europe, the US and Asia. Stefan Herzog is a co-founder of VCM and has 12 years' experience of private equity.

What type of investments do you tend to look for?
‘Since we spun out of the Matuschka Group, we have mainly been looking at venture capital in the US - everything from seed-stage to late-stage and growth capital. Over the last five years, we have expanded our focus to cover mid-market buy-outs as well, in the US and in Europe. We have also been expanding our VC focus to Europe.

‘We are still 80 per cent invested in venture and 20 per cent in buy-outs and special situations. We extended our focus in order to cater to clients needs and to balance some of the risk present in VC funds with some buy-out exposure. Looking back, that was a helpful move.

‘We have between 75 and 80 per cent invested in the US. The reason for this is that our investors don't like promises. They like hard track records when they invest in a pool of funds. The US is really the only place in the world where you can find this on a larger scale. Our investors also like to have an understanding of what they are investing in. Therefore, when we set up a product, it is not a blind pool but we tell our investors who the managers in each fund are and what they have done before.

‘We don't do any direct investments. We did them in the early 1990s because all our partners had been in the direct investment business before. But when the fund sizes grew over the 1990s and the investments became more and more specialised, we looked back at the results from our direct portfolio and saw that the results were no better than those from our fund investments. We decided that, if we were to continue, we had to build a much bigger firm because direct investing is a totally different discipline from fund investing. So we decided that we should focus on the funds of funds. We are also unlikely to do co-investments because it means that you end up having to be smarter than the GPs - if the investment prospect they were bringing to you was so great, then they would find a way to put more money into it themselves.

‘Overall, whether it is VC or mid-market buyouts, our main focus is on growth. That means we are not in the business of optimising IRRs in the short term, but we look at long-term multiples on our invested capital.'

What do you look for in a private equity manager?
‘We want proven and realised success - now more than ever. Book values don't mean much. We look for experience in both venture capital and industry - that's vital for VC investments. We like general partners who have been entrepreneurs themselves, especially serial entrepreneurs, because they can really help their portfolio companies come up with business concepts and grow the business.

‘Another thing that's important to us is long-term commitment, particularly with some of the firms that we are looking at. Some of the partners are extremely wealthy and we need to be sure that they are still motivated. We are looking at that a lot. Even if the key partners don't visit every company any more, we look for signs of clear leadership. I think that honesty and modesty are also very important.

‘These things can be very subjective and one of the dangers that we have identified in our business is that if you have known people for a very long time as we have, it becomes harder to remain objective in your judgment. As a result, we have set up a rating system that is an integral part of our due diligence process. We see the rating as a way of adding in an element of objectivity. You can't use ratings for the entire process because it's not completely quantitative, it's to a large part qualitative and relies on judgment. But as an add-on, it helps.'

What is your appetite for first-time funds?
‘We tend not to invest in first-time funds, although we have done a few in the past and in those cases it has been with very experienced individuals. But even then, you still have a number of issues, such as team risk. Another issue is that if you have four or five different track records in one firm, it's extremely tough to ascertain whether a particular track record is attributable to one person. You often find that there are three different teams running around with the same track record. So trying to work out who did the negotiation, who had which role in the management of the deal is always very difficult.

‘We have also done one investment with someone who had no experience, but the area was so niche that it couldn't have been done any other way. It was a fund run by two entrepreneurs who knew their industry inside out. In that case, we installed a GP that we had known for a very long time as a coach. The investment was very small and has worked out better than some of the larger funds - so far.'

What are the main barriers to private equity investors?
‘I think the main barrier now is the same it has always been and that is access to the top league funds. It did look as though this was going to ease at the end of the 1990s when the funds were increasing in size and a lot of new investors were able to commit to those funds. But today, those funds are not growing any more - they are shrinking substantially. They still have a large group of followers even though there are some large US institutions that will be lowering their allocation to the asset class. Rather than lowering their allocation on average, they tend to shift their focus to those groups that they really trust and that have achieved the best returns. So I think that it will be incredibly difficult for new investors to get into these funds.

What is the biggest issue in the private equity industry?
‘I think that the biggest issue is that there is too much capital in the market - that's true for venture, but I suspect that it is even worse for buy-outs. The major mistake that investors and general partners made was to think that the asset class was scaleable. It isn't. There are only so many deals that private equity firms can do and there's only so much capital that you can deploy sensibly. We'll see how this overhang gets spent over the next few years, but I think that there is still too much money flowing into the industry, even now. The amount being raised at the moment is still more than that in 1998 and that was pretty near the top. If you look at the amount of capital raised in the early 1990s, when returns were extremely good, it was a fraction of what we're seeing today. That is clearly a risk that you have to factor in and as long as this over-funding continues, you won't see such great returns as we have seen in the past.'

What's your view on GPs releasing their investors from their commitments?
‘I think that it makes sense - and we have been released from commitments by many of the funds that we have invested in. They were the funds that everyone wanted to get into. They could have raised any amount they wanted in the late 1990s, but clearly, they need much less money today to follow their investment strategies. It makes sense for both LPs and GPs because I don't think that they are out just to make money on fees - they want to make money from carried interest. It's a good move for the industry because it's a good way of helping to reduce the capital overhang in the industry.'

Where do you think that the initiative is coming from - GPs or LPs?
‘The funds had a hard time accepting this last year when these discussions started. I think that they found it difficult to face up to the overall situation. The general partners have, meanwhile, become more open to discussing these issues. That is a reflection of the realignment of power between LPs and GPs and that balance is good for everyone. I also think that this will move upstream to start affecting the funds of funds. We will see some fund of funds releasing their investors from part of their commitment. There's a significant capital overhang in this area, too. It's the same rationale - there are fewer targets and smaller funds now than there were when many fund of funds last raised. It's like a food chain and it's bound to work its way up to the institutional investor.'

Where are the most promising areas for the future?
‘We are looking at three areas at the moment - and these have to do with whether there is too much money and competition. We are looking at very early-stage funds. There are fewer investors in this area because many funds are unable to finance these ventures to exit as it's likely to take so much time. It's also the case that you really have to know what you are doing in this area. You have to have the technical expertise in the fund. I think that in general the appetite for risk is far less today in the industry than it has been in the past. So the fewer people are looking at this, the better its prospects are.

‘The second area is the whole wash-out re-cap area. By this I mean that we are looking at funds investing in established companies with a proven management team, a product and little technical risk but that need another round to become profitable. Given the size and burn rates of these companies as well as the very limited visibility on when customers will buy again, the odds are that one has to put more money on the table to see them through to exit than the current investor groups can or are willing to bear in today's much lower exit valuations. As a consequence, pre-money valuations for these rounds, if they happen at all, are often extremely low. However, if there are further delays for whatever reason, you may well move into difficulties with this type of investment as well. Some re-caps that made a lot of sense have failed because of this. But generally we think that the idea of leveraging the money that other people have put in before, buying companies cheaply and replacing investors that don't have high value-added any more, makes sense.

‘The third is secondaries, although a lot of money has gone into this area. Here, our approach is slightly different. We are not in the business of trying to understand or calculate the price of a secondary portfolio using sophisticated financial models, we are more or less focusing on funds that we know and have been following over the years - often they will be funds that we have already invested in. The disadvantage of this, of course, is that you end up with very small pieces. The advantage is that these pieces are off the radar screen of 99 per cent of the secondaries players, resulting in much less competition and thus lower entry valuations.'

What is the biggest mistake you have made?
‘One of the biggest mistakes was going into some areas in Asia. I think it has taught us some valuable lessons: don't invest in a country where you cannot enforce your rights. If you can't sue crooked entrepreneurs or jail them, then there's nothing stopping them from ripping you off. We had some very good investments there, but in some instances, we were cheated and there was nothing we could do. I think that situation is still true of some of the places considered to be the hotter destinations for private equity capital. We will be abstaining from that area for the time being - and I don't think that we will be the only ones.'

What irritates you about private equity?
‘What I find irritating is when people don't learn. You see this on the GP side in terms of the herd mentality. One VC sees an area they think is promising and suddenly you have hordes of people getting into the space and funding lots of portfolio companies with tons of money. You'd think that had changed after the experience of the last few years. But if you look today, you'd see that it's not that different - it's just that the money going in is less. The pattern is just the same.

‘It's also irritating to see so much money flowing into the industry. And another thing that is more surprising than irritating and that's the volatility that we have seen over the last few years. In the mid 1990s, a lot of groups tried to convince investors that private and public equities are not at all correlated. But history has shown that this is really not the case. The industry has participated in all the market hype, just as the public markets did. What is surprising is the extent to which private equity tracked the public markets.

How do you think that the market will change in the future?
‘I think the market will be quieter, we will see a shake-out on all levels - investee companies, funds, funds of funds and investors. There will be a major market correction.'

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