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Institutional investor profile: Varun Sood, Founder and Managing General Partner, Capvent

Sood on offering a service rather than a product, on the dangers of relationships in private equity, on why the principle of adverse selection applies to the asset class and on being exceptionally critical.

Capvent (Capital Venture Partners) is a fund of funds based in Zurich. Set up in 1999, the fund has $425m under management. Capvent invests in US and European buy-out and venture funds, but sees itself more as a ‘contrarian' investor, allocating its capital according to areas it considers to offer the best opportunities available at any one time. Before setting up Capvent, Sood headed up the European leveraged buy-out group for SG Cowen in London and before that was at ABN AMRO Rothschild. He has ten years' private equity experience.

Why did you set up Capvent?
‘We were one of the latest starters. We looked around in the late nineties and saw that things in the private equity market were getting out of hand. We realised that a more rational approach would be appreciated by investors.

‘Our team members have hands-on experience in the business. I was running the European leveraged buy-out group for SocGen. I had also previously been involved in financing a big start-up telecoms business, so I'd seen the TMT craze from the beginning. I had been doing deals and I was working with our other founder Tom Clausen at SocGen (he had previously been at CSFB doing deals in Silicon Valley). The key thing for us was to focus on the most sophisticated investors. They may not necessarily need funds of funds or advisors for expertise, but they need a consistent strategy towards private equity. This isn't an investment in which you can take a switch-on, switch-off approach. You have to be committed. So either you have your own team that looks at the sector every day of every year, or you work with someone from outside such as a fund of funds that can do it for you.

‘We take a different view from other funds of funds. We consider this as a service business rather than an asset management business. Our clients don't need asset management; they need a specialist service. We believe that because it's a specialist business, it's a business with information asymmetry, you've got to be dedicated to it 100 per cent of the time. Otherwise, you will get hurt.

‘We focus on highly specialist products. We work on long-term maturities based on very sophisticated modelling and planning. We are launching a new product that will guarantee the capital and uses derivatives to do that. It's the first time such a product has ever been launched.'

What type of investments do you look for?
‘We invest in Europe and the US across both venture and buy-out. We don't stray out of those geographic regions because we only know those markets. But within the buy-out and venture capital sectors, we go into a great amount of detail to look for the best opportunities for the moment. We are contrarian and we believe that you have to adjust your investment style according to the opportunities available in private equity. At the moment, we are looking at investments that will bring equity-like returns and debt-like protection. That means we have solid down-side protection in today's market. We go a few levels deeper than just saying that we invest in buy-outs and venture. We know how to do this because we have a buy-out background.

‘We try to add value by investing in areas that are ahead of the curve, so we don't have specific allocations to buy-out or venture, for example. Instead, we look for areas before people start talking about them because when that happens, it's already too late. We started investing in turnaround funds about two years ago, for example, and it's only now that people are looking at this area.

‘We are contrarian in many ways. We don't talk about this business in terms of relationships as other funds of funds do. We are much more objective in our approach. It's the relationships that have harmed investors. If people hadn't re-upped in 1998, 1999 or 2000 at four times the amount they put in in 1995, for example, they wouldn't be in such a mess. You have to question the received wisdom that private equity is about relationships. There is no such thing in this business. It's exactly the same as if you were buying a publicly quoted stock. It's an investment. It's not a relationship. So that's the philosophy that drives us. We work for our masters.

‘We focus on the smaller and medium-sized funds. We take the view that private equity is just like any other market with asymmetrical information. You get the same problems in private equity as you do in the used car markets. You get adverse selection - the bad guys come forward with the bad cars. We take everything with a pinch of salt. When funds say that they look through thousands of investment proposals to find the right opportunities, we know the types of investment proposals they actually get - many of them are just ludicrous. This phenomenon is typical adverse selection. People will try to pull the wool over your eyes - whether it's in a sophisticated manner, because they have a relationship with you, or however. It's an economic problem.

What type of investments do you avoid?
‘We have totally avoided Silicon Valley venture capitalists. People are only now starting to admit that supply of capital is an issue in private equity. But it has been an issue, especially with those Silicon Valley funds, since 1999. Some areas have been oversupplied with capital. Those are the areas we avoid. Instead, we will look at areas that other investors are ignoring. We have invested in venture capital funds in the Texas area, for example, because we believed it was a healthier market that wasn't awash with cash. These investments have done extremely well for us. Don't bring us Silicon Valley investments - we won't do them and they don't need our money.

‘We are also seeing a generational change in private equity. The older generation is being pushed out. So we avoid the larger funds. We are moving into the second phase of risk - if it is in your interest to stray and do something for yourself because you think the investor is not watching, then you will do it. So you are seeing the larger funds with all that capital to invest either deciding that they are making money by not investing and therefore sitting on the cash or they are trying to deploy their capital in areas they know nothing about. For instance, people think that there are opportunities in the US turnaround sector and they are jumping in, even if they know nothing about it. And yet it's a very complex sector. And look at what happened to the power sector, where some larger US buy-out funds are considering investing – the government basically allowed the two Californian utilities collapse. That had never happened before. This area is a tricky quagmire. You need experience to do it well.

‘We don't do co-investments ourselves, but we do offer them to our investors.'

How do you identify the best opportunities?
‘We go looking for them. We spend a lot of time travelling to find the less obvious funds. There are people who come knocking on your door - there is no shortage of them. But you need to be out there sourcing firms proactively and going to meet them on their own turf. It wouldn't be worth it for the type of funds that we invest in to come knocking on the door of European investors because they are just not open to those types of opportunities yet. The Texan fund that we invested in, for example, had no other European limited partners.

‘We do also appreciate placement agents bringing us good funds and we do find opportunities that way.'

What is your appetite for first-time funds?
‘We are open to the idea of first-time funds. Everyone has to start somewhere. But the whole concept of first-time funds is bizarre. You never used to get $200m first-time funds before. If you look at all the large funds and the funds that have done extremely well, they didn't start out with a PPM, pitching to investors. They started out raising from friends and family or however they could raise the capital. They somehow struggled through. I appreciate those types of group a lot more because when they do enter the institutional market, they can show that they have done something. It shows they have a commitment to what they are doing. So in my opinion, the funds that do well tend to start out in a more modest way. We like modest beginnings. We believe that that is the way you have to start, rather than being able to be wealthy from a management fee from day one.

‘The other thing is that track records are sometimes suspect with spin-off funds. I have seen examples in which about four spin-offs tried to claim they worked on exactly the same deal. Who do you want to believe?'

What do you look for in a private equity manager?
‘This isn't a people thing. We don't look at whether we are going to get on with a team. Our main focus is on whether a team will make us the best returns for our investors. First and foremost their strategy has to fit well within our portfolio. If a fund's strategy doesn't offer downside protection, and that's what we're looking for in the current market, we won't invest - even if they are good managers. We don't try and time the market, but we look forward to take account of the economic climate.

‘But beyond that, we look for a real commitment to the business. What really matters is people's motivation. There have been a lot of teams that have raised funds simply because they wanted to close before the markets became tough. That shows a commitment to having a fund; it doesn't show a commitment to making the best returns for investors. We like managers who really live for their businesses.

‘Integrity is extremely important. Funds need to show to us that the risk of moral hazard is very low.

‘We also tend to evaluate teams on a comparative not an absolute basis. If you look on an absolute basis, you would come away thinking that every fund looked good. Instead, you should be looking at funds in the context of their competitors. They have got to be better than the other funds we have seen in the same space. Why would I invest in a fund if it has a competitor that is better than them.'

What puts you off an investment?
‘There are lots of things because we are quite critical. But one of the main things we don't like is people wasting our time. We don't like people trying to pull the wool over our eyes. We are not stupid. We do our due diligence very thoroughly.

‘We are also unconvinced by the argument that because managers have made mistakes in the past that they have learned from them. That comes up time and time again in due diligence. They will tell you that they have made their mistakes and they are back to square one now. I tend to believe that's a bit of a sham.'

What is the biggest mistake you have ever made?
‘Our skill is in spotting trends ahead of time. That's what we are paid to do and that's why we do what we do. Whenever we have missed trends, that's when I think we have made mistakes.

‘I also think that we may have made a mistake at the beginning of this business. When we first started, we believed that it was a financial product. But we soon realised that we provide a service, not a product. So we probably spent a little too much time at the beginning working on the basis that this was a financial product that people needed in their portfolios. Investors don't really need a financial product, they need a service.'

What is the biggest issue in the private equity market?
‘The fact that there is a multitude of firms out there struggling to raise money is not a problem - that shows an element of motivation. The problem is that 80 per cent of the money lies with 20 per cent of the funds.'

How do you think that the market will change in the future?
‘We are seeing a generational change. You will see a complete shift in the way that people are investing, looking at groups, etc. That is a good thing because I think it will bring greater rigour to the market and it will bring new blood.

‘But I think there is high risk in the market because there is still a lot of money poised to come into the sector. There is a lot of talk about the large European pension funds committing to private equity. That will probably spoil things. I'm a strong believer in the effects of supply and demand. If you get just a couple of big pension funds coming into the market, they could commit as much as $3bn. That's an issue because private equity will become awash with money that it doesn't need. Where is that money going to go? There is more than enough for the big guys. And you find that a lot of newer investors want to invest in the same funds, so the big guys just end up getting bigger. These investors will spoil it for themselves.

‘But despite this pessimism, I do believe that private equity has a very good future as long as investors have a differentiated strategy. Don't just go for the obvious funds.'

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