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Institutional Investor Profile: Thomas Kubr, CEO, Capital Dynamics

Kubr on the difficulties for non-US investors of committing to private equity, on why the industry is suffering from unjustified fright, on why secondaries trading will never be vibrant and on why private equity is all about successful selling.

Founded in 1999, Capital Dynamics is primarily known for its PrimeEdge structured private equity product, which it closed in February 2002 at E175m. The firm's stated aim is to bridge the gap between private equity and the investor by creating vehicles that are not subject to the tax and legal hurdles and to the illiquidity present in traditional limited partnerships. Capital Dynamics is headquartered in Zug, Switzerland, and New York. Kubr is a co-founder of the firm and was previously with Partners Group. He has also been an aerospace engineer.

What type of investments do you tend to look for?
‘On the investments side, we look for to have well diversified portfolios and to ensure we achieve this diversification on a high quality level. So, for our basic investor portfolio we would not suggest going with one or two funds, we would always suggest investing with a group of funds, maybe as few as ten, or maybe 30 or 40. In each case you must select very carefully every single one of these funds.'

How are those investments split?
‘It varies according to client, but let's say we were putting together a portfolio for a classic client. The first thing a client must decide is what basic currency or geography they want to invest in. We find that that decision is driven mostly by their liabilities and their own overall portfolio decisions. I don't think there is a magic mix between US and European private equity. On the whole, we think that an ideal portfolio has anywhere from 20 to 25 per cent in venture, somewhere between 50 and 65 per cent in buy-outs and then up to 15 per cent in other investments such as mezzanine, secondary funds and special situations. These are ranges, but there is no hard and fast rule. We have done a lot of research to understand what an optimal portfolio mix would be, but there is no obvious peak. As long as you are within these ranges, you will be fine and you don't have to worry about being way off the mark. On the other hand, if you attempted a portfolio with 70 per cent venture, this would be less optimal.'

Why do you create structured funds of funds?
‘The vast majority of vehicles in private equity are limited partnerships. There are perennial attempts to do it differently but people will always come back to the limited partnership structure. It is a proven model. It works well and has been tested. The trouble with the partnership model, though, is that few institutions and investors actually like limited partnerships. They would much rather hold a bond or a share.

‘With partnerships, there tend to be a lot of legal and tax issues that can be challenging for people to invest in them. As a result a majority of the money comes from very large institutional investors who are mostly from the US and UK. Our business concept is to create structures that make us look like any other institutional investor for the private equity industry. We are just like any other limited partner in our investments. We play by the rules. We do not expect anything outrageous from the GPs when we want to invest in them. However, we then turn around and deliver that private equity exposure in a format and structure that fits certain groups of investors. There is no golden product that fits everybody's needs, so you also have to find the pockets of common features that allow you to put together a large enough investment pool. We can create products that come in the shape and form of a share, a bond, a convertible or simply a limited partnership, if that is what you want. You can also change certain features of private equity - maybe you want to change the liquidity, the risk, or maybe some tax features. We can do that for our investors.

‘Capital Dynamics is in its basic form two firms. On the one hand, we are an asset manager of private equity assets and on the other, we are a structuring group that creates bridges for investors. We can provide solutions. If a client has a problem, we can take care of it from A to Z - everything.'

What do you look for in a private equity manager?
‘Quality. There are a couple ways of looking at this. I think track record is only one of these many details that you need to look at. Most importantly, it is a combination of the fund strategy and the market in which that fund intends to invest. We wouldn't, for example invest in a biotech fund managed by a great team of venture capitalists and scientists that invested in Sicily. Neither would we back a team of investment bankers who have never invested in private equity before. You need to find the right combination of these elements to build a successful product. Experienced managers, experience in a wide range of activities, not only in purchasing companies, in creating companies, but also in selling them. Private equity is not about buying, it's about successful selling. I think that has been forgotten over the last couple of years. Another feature we look for is honest, open communication. Integrity is very important. Why would you catch a ride on a journey that may last 15-16 years if you do not have complete trust in what the managers do?

‘On the whole, though, I would say that one thing that fascinates me about this industry is that the really successful guys are ones that have no problems with talking about themselves, talking about their failures, talking about their mistakes and are completely and utterly open with what happens. I think that it is one of the great strengths of that private equity industry that we are blessed with this culture that has been nurtured for the last 20 years. Having said that, you do see some interesting attempts to try and raise money.'

How does your investment process work?
‘We have a structured process that goes through several stages. The purpose of that structured, regimented approach is to have a repeatable process that should have a degree of reliability so that we can dig out issues. We couple that with some very intelligent, experienced high-powered people that examine these issues, question the numbers to understand what is going on and attempt to pick the best managers going forward. We look at it this way: our role is not so much one of investing as it is of hiring good people. That focuses discussion away from the raw numbers and much more towards the ability of the people and our belief in their future capability. The historical performance of numbers are notoriously poor guides for the future performance.'

Do you not think that there is some degree of performance consistency?
‘I think that past performance is a good indicator that people have done something right. On the other hand, good past performance is no guarantee of good future performance. Top quartile returns aren't as repeatable as people think - it is pretty challenging to have top performing funds. We have clearly seen that the “luck factor” in historical performance is extremely important. Very often a fund's good past performance can hinge on a single investment; just as often poor performance can hinge on one write-off that had little to do with the ability of the managers. I would say that investing in lucky managers may not be the best idea. Of course, you make your own luck to a large degree and it all goes back to taking the numbers with a grain of salt and determining what their future potential is.'

What is the biggest mistake you have made?
‘Timing. I should have started two years earlier. When we came up with our first product PrimeEdge, we marketed that in the first quarter of 2001. That was tough. We unfortunately just missed the big run in this industry and we had to build our firm in the trough of the private equity market. So it would have been nice to start earlier.'

What are the main barriers to investing in private equity?
‘It depends on which geographies and segments you are in. Effectively, your troubles start if you are not a North American tax-exempt institution. The industry has really been shaped by US-based pension funds, which is great for the industry. But again the limited partnership structure makes life difficult for other people. Famous examples in Europe are the German laws that make it challenging for institutions to invest directly into limited partnerships. Another issue that private equity very often brings with it is tax. Although the activity is fundamentally a capital gains investment strategy, many jurisdictions cannot find a natural home for limited partnerships and tend to tax them as active investment vehicles. That way you end up paying income tax, which is generally higher than capital gains.

‘Other issues that you have are inherent to the asset class. Historically, the only way to invest in private equity has been over the long term. You put your money in and you are in for the ride - you have no liquidity. There are some secondary plays out there, but that's not really what you'd call liquidity.

‘And, of course, one of the things we have demonstrated with our Prime Edge product is the ability to really turn the risk-return wheel. We have given investors the option of taking private equity exposure straight up, or concentrating it with leverage, while allowing people to principle protect their investment. It is really the first time that this fixed risk-return feature of private equity has been broken.

‘Liquidity is another issue. Offering investors liquidity options can be very important. Allowing investors exits without having to eat discounts that may not be very attractive at that time removes a major hurdle to investing in the asset class.'

What do you think is the biggest issue in the private equity market?
‘Fright. Unjustified fright. The industry has gone through an unprecedented growth spurt in the late 1990s, fuelled by all the wrong factors. We are seeing the backlash right now. Dot.com has very little to do with the private equity model and yet the industry is getting hit on the head right now by that issue. But the smart investor is investing in private equity because there has not been as a good a general market for new investment in private equity since the early 1990s as right now.

What do you think will need to happen to alleviate some of that fright?
‘Time. Unfortunately I do not think that there is anything that can be done about that. We'll still be reading negative news about private equity until the autumn of 2003. The last bad news at a company level will happen this year; those write-offs will have to be taken. But it won't all be percolated through the system until summer or autumn next year. The good managers took the write-offs some time ago, but a lot of the pain, especially among new managers, has not been taken and that will show up in the news. And then it will take time for people to realise the private equity model is a strong, solid performing asset. I would not predict a significant change in the fundraising environment until after 2004.'

What advice would you offer a new investor?
‘Get yourself a good advisor or invest with a structured approach. This is an industry that is very easy to understand intellectually but requires a lot of work and experience to figure out what to do with the money. It's not enough to start with a blank sheet of paper, hire some smart guys and go off. You can always invest money like that but with the private equity industry cycle as it is, you won't know for five to ten years whether you have done it right or wrong. You can purchase “know-how” from experienced players.'

How do you see the market changing in the future?
In general, I would say that the partnership structure will stay with us. I can't for the life of me see why the industry as a whole would move away. I don't believe that calls for increased transparency will result in any changes. The industry is transparent enough for investors that devote time to it and I think it would be detrimental to the industry to become more transparent than it is today.

‘In terms of market size, the industry is, on a global basis, good for $300 to 400bn a year in new commitments. It will be a while before we get to the growth stage again, but the current private equity market is puny compared to its potential market. In any country in the industrialised world only a small fraction of the actual privately held industry is cornered by the private equity market.

‘A lot of people are predicting a massive upturn in secondaries. I don't agree. I do not believe that we will see vibrant secondary trading out there. The pieces are too difficult to trade; there is no standard documentation, no standard material required for active trading. Secondly, there are also some pretty good regulatory reasons why this could never happen. Let's say somebody comes up with a concept that will generate the transparency and standardisation necessary to generate active trading. Such a concept will effectively shut down the regulatory protection that the industry enjoys at this stage. There is a reason why this asset class is called “private” as opposed to “public”.'

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