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Institutional investor profile: Clint Harris, Managing Partner, Grove Street Advisors

Harris on the problem with traditional gatekeepers, on adding value to investors and private equity firms, on why today's leaders may not be the stars of tomorrow and on how the market has changed over recent years.

Set up in 1999 and based in Massachusetts, Grove Street Advisors is a gatekeeper with $3.2bn under management. It currently manages private equity fund investments for US giant CalPERS, for the State of Oregon fund and is about to sign up a major new European client. It invests across the full range of private equity sub-types, but an important part of its strategy is finding new and emerging teams. Before setting up Grove Street, Harris was a founder of Advent International and prior to that, was at Bain & Co.

Why did you set up Grove Street?
‘When I was at Advent, I was horrified by the way that gatekeepers did their business. If I was a major financial institution, I would not want to be represented the way that they represented their clients. I felt that the way that they ran their business almost prevented them for making good investment decisions. Grove Street was an experiment to see if we could re-engineer the way that gatekeepers ran their business. We spoke to CalPERS early on and discovered that they had the same issues with gatekeepers that we did. That's how we ended up with an initial $350m account with CalPERS and that's how Grove Street was launched.

‘The CalPERS relationship has grown very quickly, in part with the market and in part because we were able to gain access to a number of very high profile funds. We now manage $2.9bn for the fund through a number of different vehicles. Some of that is discretionary and some non-discretionary. Our second client is the State of Oregon pension fund, for whom we manage $250m. We are also about to sign on a third contract for to manage a portion of the US private equity investments of a European investor.'

What type of investments do you look for?
‘The concept of Grove Street is to work with relatively few, relatively large clients and do for them what they are unable or unwilling to do in-house. We don't set up funds of funds, we set up individual, dedicated accounts for each client and so the type of investments we look for vary according to each client's needs. In short, each client has a different hunting licence.

‘In the case of CalPERS, our initial role has been to help the fund get into venture capital. Until recently, it had pretty much all of its $10bn committed to private equity in buy-outs with very little venture capital exposure. It was almost a matter of pride among some of the best venture firms in the US that they would not take money from state pension funds. That was partly because of their reputation for being difficult and cumbersome to deal with, partly because of the gatekeepers they use and partly because investment decisions are generally taken by the investment boards, which are unable deal effectively with small investments. CalPERS, for example, had difficulty managing investments of less than $100m and it was almost impossible to get large allocations from the smaller, high quality venture firms.

‘Our initial mandate was to break into the high quality venture funds. In addition, we wanted to emulate the way in which the most successful venture investors - the endowments and foundations - gained their exposure. They managed it by investing with groups before they gained their excellent track records. So they would work with a relatively small team, write a relatively small cheque, but over time they would increase their exposure if those groups performed well. If you walk into a Kleiner Perkins, a Greylock or a Matrix, you find that those with the highest allocations are the long-term, loyal investors.

‘There is a pronounced life cycle in fund management teams - and we are seeing this right now. New teams come onto the market, they perform well, the partners get rich and the junior partners get frustrated. At some point something happens and the new teams spin out and form another new firm. There's a constant regeneration of teams in the market. So there was a two-pronged approach of investing in proven teams and investing in emerging teams.

‘The final piece of this is that within the new and emerging team business, there are two ways in which you can do that. One is to write small cheques to promising teams. The other is that, every now and again an A+ team comes along and you can, in effect, put them into business and write a large cheque. You can save them the agony of raising the first-time fund. In the process, you can make your initial investment on very favourable terms. To this point, we have done five of those investments with a total of $600m, such as the Audax Group, which spun out of Bain Capital, and New Mountain, which spun out of Forstmann Little.'

‘Today, we have got them into about 65 to 70 venture funds, of which half are proven, blue chip teams and half are in the new and emerging category. CalPERS' objective was to go from $10bn to $20bn in private equity and it knew that it would need to have $5bn to $6bn in venture capital. Our job was to build the platform to get the fund there - not to invest all that money, but to build the relationships it needed to do so.

‘That job was largely completed by 2001. CalPERS then changed the hunting licence so that now our job is to help initiate relationships, regardless of whether it is venture or buy-out. We're spending a lot of time looking at smaller European funds. CalPERS has a good representation among the larger high quality pan-European funds, but it hasn't invested in the smaller, local teams. We're looking across the entire range of private equity firms for CalPERS and we are continuing with the emerging firms strategy for venture. We are also actively beginning to apply that to the buy-out side. So our work for CalPERS means that we are looking at two-thirds venture and one-third buy-outs, with the majority in the US, but around 15 to 20 per cent overseas.

‘The situation with Oregon is very different. It has invested in private equity since the 1980s but it has a very small internal staff. It needed to find an effective vehicle to invest in some of the smaller private equity funds, but didn't have the manpower to do so. Oregon split a $500m programme between Grove Street and Pathway to invest in smaller firms under $400m.

‘The new relationship is working with the US office of a major European investor to help it put in place a new and emerging venture capital portfolio. This programme is designed to invest around $100m a year primarily targeting North American venture capital funds, new and emerging funds in particular.'

How are you different from other gatekeepers?
‘In my mind, our job is to add value to our clients and to complement rather than compete with their in-house staff. In order for us to have a sustainable relationship with our clients, we have to do the hard part of private equity investing.

‘We are working with the most sophisticated of the major institutions. Our clients have high quality staff, but there are areas that they find particularly difficult to cover for various reasons. If I am going to be valuable to my clients, I have to concentrate on those areas.

‘The second issue is this. The gatekeeper is in the middle of the food chain. We are in between the fund managers and the investors. In reality, we exist because the major institutions need someone to give them the expertise they need in private equity because it is so different from other asset classes. It's very hard to invest effectively in private equity in-house and it's very difficult to retain staff. And yet the fund managers dislike the gatekeepers on the whole. They want to have a direct relationship with their investors and so they see gatekeepers as a problem and a barrier rather than as a solution. This means that the very good fund managers can choose not to take money from gatekeepers because they can pick their investors. So as well as adding value upwards, a critical element of what gatekeepers can do is to be able to add value to the teams they invest with. You need to run your processes in a way that respects what they do. As a gatekeeper, you shouldn't be wasting their time or getting in the way.

‘Another thing that we can do to add value is help funds with their deal flow. We help them with their staffing and with best practice. We can add a lot of value this way, particularly to the newer teams. We see around 500 funds a year, which means that we know their processes.

‘Traditionally, investors have fallen into two camps: high net worth investors who can add a lot of value to a fund but who don't write big cheques; and institutional investors who were reliable in terms of financing a fund, but who couldn't add much value. We have positioned Grove Street somewhere in the middle. We can be reliable about writing cheques, provided that a firm performs well and we can add some value to a fund. The concept has been to become an investor of choice. That doesn't mean that we can forego our due diligence. But the first rule of venture is don't lose access to the deals that you want to do because of the way you run your processes. Run your processes in a way that allows you access to the kind of deals that you want to do and then figure out which deals you want to invest in.'

What do you look for in a private equity manager?
‘We look for teams that have a clear strategy for how they think they can make money going forward. It has to be a strategy that we are comfortable makes sense. We want to identify teams that will outperform the market significantly going forward.

‘We focus our due diligence questions on a number of things. First, we need to be sure that they have the resources in place and the organisation in place to ensure that they can effect the strategy. Do they have the track record to demonstrate that they can make money following their stated strategy? One of the issues when you are looking at track record is repeatability. If a team that has impressive numbers, but the environment has changed and the way in which they have made money in the past will no longer work, then that is highly suspect. Again, if a team has a great track record, but it was generated by one deal, we often find when we do that attribution analysis that that the success of that deal was largely down to luck.

‘The bottom line is that we have a very broad definition of the ways in which firms can be successful. In fact, we like investing with firms that have a differentiated approach to the business. We're not looking for the cookie-cutter approach. On the other hand, we are very careful to make sure that, if it's a new and emerging team, they have to have the skill sets and track record in place to make us comfortable backing them and if it's an established team, they have to prove that their strategy is working. It takes a lot of deal by deal due diligence, particularly on the more recent deals that have not yet been realised.'

How do you conduct your due diligence?
‘We have set up our evaluation process so that it is similar in style and substance to that of a first-class private equity firm. We believe the skill sets that you need to do due diligence are very different from those you would normally find in a traditional gatekeeper. If you go to a venture firm today that, say, invests in telecoms, you will find people in-house that have operating experience of the telecoms industry. The venture industry clearly believes that it makes no sense to try and do deals in a leading edge technology industry when you don't have any expertise in that field.

‘However, if you look at traditional gatekeepers, virtually none of them have operating experience in the venture industry. They are investing in funds and making judgments on people when they themselves have never worked inside a venture capital firm. Grove Street has been built by people who came up from the operating side of the venture capital business. Our partners have more than 80 years of operating experience, leading investments, sitting on boards, raising funds and building and managing teams of VC professionals.

‘There is also a huge amount of judgment involved in the evaluation of a team. Recent track record is still unproven because the deals are still unrealised. You have to assess how a team will do over the next five years based on hard data that is more than five years' old. You need the ability to assess the performance of their more recent investments. Our operating experience is invaluable here. We can come to a reasonable judgment on the value of unrealised investments.

‘We can also leverage off the relationships we have with executive search firms. Part of the reason for this is that investing in a firm is an awful lot like hiring someone. You are making a permanent commitment with someone and you are stuck with them for a long time. Also on our team as a founding partners is Dave Mazza, who was one of the most successful headhunters in the venture capital industry. He placed more than 60 general partners in his career formerly and helped another 60 find their positions informally. He has expertise in terms of contacts in the industry, in terms of the amount of time he spent working with teams to ensure the right fit, in terms of structuring compensation to retain the younger partners. That is invaluable to us when we're looking at an investment.

‘Dave will also have an insight into things like whether the junior team members in a fund are talking to headhunters because of his contacts. If they are responding to calls, then you know there is something wrong. Again, because of his contacts, he can make five phone calls and he will get an honest answer very quickly as to what people think of a deal, what people think of an individual, etc. There have been some funds raised that we would not have touched as a result of a very clear negative answer in response to our five phone calls, whereas the superficial phone calls came back fine.

‘One example was of a fund set up by a number individuals who had worked at other high quality firms. The superficial due diligence on these individuals resulted in positive reference check from their prior firms. But when we really dug in and got the true, off the record evaluation, it turned out that several of these individuals had been pushed out of their firm and the actual reference check came out quite negative. When we did the attribution analysis, a lot of their track record also melted away. It became very clear that these guys were not the stars they made themselves out to be. It was a very easy negative decision for us, yet when you looked at their investors, you would have been very impressed by many of the names.'

What's the biggest mistake you have ever made?
‘It may turn out to be starting our firm in 1999, which looks as though it is going to be one of the worst vintage years on record. But I should add that we only have around five per cent of our investments in funds that were raised during the bubble, so we should not be badly affected.'

What is the biggest issue in the private equity market?
‘The rules have changed substantially over recent years and that has implications for how you can become a successful investor in private equity. Track records from the late 1990s are not that relevant to today's environment.

‘In the buy-out area you used to be able to make your money purely through financial engineering. You needed pure transaction skills. Today, you still have to buy well, but the most important thing is to be able to add value to the companies that you invest in. In the 1980s, the company could go sideways, you could have no change in value of the company you bought and still generate top quartile returns based on leverage.

‘In the venture industry, you could argue that it has reverted to the way it was in the late 1980s and early 1990s. The only way that venture firms are going to make money these days is to build viable, long-term, successful companies. Venture capitalists have to be hands-on. There is no room for the quick flips we saw in the late 1990s. You still have to be careful to catch the new waves and you have to think outside the box. You don't want to be invested in the 355th optical networking company. But it is not a momentum game. You had some very successful funds at the end of the 1990s whose strategy was momentum investing. Today, a fund has to have a lot of operating experience and a lot of domain expertise. Five or ten years ago, an individual general partner could be a generalist venture capitalist and do very well. Those days are over.

‘So the issue today is that investors need to be wary of track records. They need to pick them apart and work out how relevant they are to today's market. The market will continue to evolve and investors need to adapt accordingly. What worked yesterday may not necessarily work today.

‘The second is that the established venture firms are going through a change in leadership as the senior partners come to the end of their working lives. You will also find that there will be a lot of change as to which firms are the leaders. That is partly because the environment has changed in such a way that firms cannot make money in the way they used to. It's also because a lot of funds have generated great wealth for their founders and many of these firms are struggling with succession. In some of the cases the senior partners do not want to retire, but do not want to make room for the rising stars. In other cases the senior partners have not built the framework to let other people take over.'

How will the market change in the future?
‘The succession issues I just mentioned will play out over the future and some firms will eventually disappear as a result.

‘Another change is that we have just experienced a one-time event in terms of returns. We will not see that happen again. Firms and investors must be prepared for that.

‘The other thing is that the environment for investing right now is a very positive one. A lot of people are worried about the capital overhang that exists in the industry, but I don't think that's a problem. Some firms are handing money back to investors, which will help, but the important thing is that venture firms are investing their money slowly now. That creates an environment in which entrepreneurs think that financing is scarce - that is the best environment in which to be investing because you can go in a low valuations.

‘I also think that now is the best time to be investing in smaller deals in the buy-out industry. I still am very sceptical about larger deals. It's relatively easy to add value to smaller companies; it's exceptionally hard to turn around large companies. I think there is a large question mark hovering over how you can actually make money out of the mega-deals.'

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