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Institutional investor profile: John Brakey, Head of Alternative Investments, Macquarie Bank

Brakey on the importance of vintage year diversification, on the peculiarities of the Australian private equity market, on why he steers clear of corporate investors and on the dangers of crossover funds.

Australia-based Macquarie Bank has been investing in private equity since 1995 on behalf of its balanced funds. With A$200m under management, it currently invests five per cent in private equity funds, but is able to commit up to ten per cent to the asset class. It also launched its first retail private equity fund of funds in 2000, which is open to retail superannuation investors. Brakey has worked on Macquarie's private equity fund investments for two years. Before that, he was an asset consultant looking at private equity fund of funds managers and fund managers at Towers Perrin.

What type of investments do you tend to look for?
‘We only invest in Australian private equity fund managers because that is the market that we know. It is a unique market in some ways. The Australian private equity market is much younger that that in the US or even Europe. We are just starting to see some of the managers specialise in the early-stage areas and we are just starting to specialise in buy-outs, but the vast majority of these managers have evolved from generalist expansion-stage funds. So as a result, we don't have specific allocations to the sub-sectors of private equity that you find in other more mature markets. We tend to focus on the generalist expansion managers and the buy-out managers as the core for our portfolios and we look to add early-stage managers around that.

‘Some of our Australian investors are looking for international exposure and we can get that for them through our joint venture partner Pacific Corporate Group. They can source opportunities for the international mandates. It would be hard for us to invest well outside our own market because of the access issues in, say, US funds and because we don't have the international reach required.

‘We do co-investments, but not direct investments. We do also have a direct investing team, but we have procedures in place to ensure that there are no conflicts of interest with them.

‘We look at secondaries, too - if we can find the right opportunities. Australia has a few issues as far as secondaries are concerned. One is that the market is reasonably thin at this stage. It's such a young market that there aren't that many opportunities around. The other is that the trust deeds with managers have pre-emptive rights for existing investors. That means that there is an additional level of complication that we have to go through to be able to buy secondary interests. The third issue is that there is a big push here at the moment about valuations in private equity funds. There is a move for the auditing profession to put pressure on managers to ensure than portfolio valuations are up to date. Investments that are held at cost for two years aren't regarded as being valid right now. Managers are being pressured to increase the value of their portfolio companies. That makes secondaries a less attractive proposition for buyers because they have to decide the price they are willing to pay for the deals in an uncertain market.'

How large is the Australian market?
‘There are approximately 140 funds based in Australia. Of those, we believe that there are between 50 and 60 that are institutional quality. That is a dramatic increase from the number in existence even five years ago. I think that we will see still more funds over the next few years, too.

‘There are currently a number of first-time managers in the Australian market, but there are also a lot that have gained their experience elsewhere (for example, in commerce) and have set up their own funds to take advantage of the opportunities that are springing up here. A number of managers have also had expatriate experience from funds in the US and Europe and have returned to Australia to establish their own private equity funds.  That is a very healthy state of affairs.

‘One of the most positive aspects of the private equity market is that the Australian government has been very supportive of early-stage funds. It has set up a variety of programmes that are aimed at helping early-stage technology companies. That will be important in developing a strong venture capital community for the future.'

What do you look for in a private equity manager?
‘Track record is absolutely critical. That almost goes without saying. Importantly,a s the market here develops we like to see a manager that can evolve with the market changes - I'm not talking about quantum shifts in strategy, more a gradual evolution. We also look at their ability to add value to their investee companies. And exit experience is key. I think that's one area that managers tend to overrate themselves. It's important to us to see that funds have exited deals. The industry is so immature that there are a lot of managers that have done a lot of deals but that haven't actually realised any of those investments yet. We place a premium on managers that have shown the ability to exit deals.

‘The other thing is to do with a firm's processes and structure. At the moment the managers here are still reasonably young, but we like to see willingness in a firm to institutionalise their business so that they are able to pass on ownership. Succession isn't an issue here as it is in other more mature markets, but we like to see evidence of firms thinking ahead about this.'

What puts you off an investment?
‘One thing that sets off alarm bells is a fund that has done a lot of quick flip deals. That's always a concern because it means that the fund manager has done nothing to add value to a company. Another key area of concern is where the alignment of interest between us and the manager isn't what we regard as correct. That would put us off. We like to see funds in which the managers are incentivised to do the best for their investors.

‘We also tend to steer clear of funds that attract a lot of corporate investors looking for strategic deals. We don't believe that those types of fund are necessarily financially motivated. We always apply the “like-minded investor” test.'

What advice would you offer to investors new to private equity?
‘The biggest issue that we have in Australia is that investors started getting into private equity in 1998 and 1999 - right at the top of the private equity boom. They invested large amounts and have little of their allocations left to invest now that things have calmed down. Some are even trying to pull out of the market. You cannot overstate the importance of vintage year diversification. If you are putting together a private equity programme today, think about it over the long-term. Don't just try and get everything out of the door today. That is the lesson that we need to learn in Australia today.

‘There will be a lot of investors that have had their fingers burned as a result of all this. But we are quite lucky because the largest private equity investors in Australia, the Industry Funds, have been investing since the early 1990s. They did make large allocations in the late 1990s when private equity was starting to run, but they do have a history of private equity investing over a number of years. Hopefully, they will continue to invest in the asset class in the future. We did see some opportunists come into the market in 1999 and they will have a bad experience unless they continue to invest through the whole cycle and for the long-term. Only then will they start seeing the good returns come through.'

What is the biggest mistake you have ever made?
‘The biggest mistake I have ever made was investing in a manager that made significant crossover investments - they invested a large amount of capital between funds. Fund I was a reasonable size, whereas fund II was too large, so as a result, they did some follow-on deals from fund I. That makes it incredibly difficult to judge how a manager is going to perform over the long term as the manager has jeopardised the performance of two funds rather than one. How do you extract out the manager's performance from that?'

What irritates you about private equity?
‘Investors (and their advisors) that have not thought about investing across vintage year irritate me. They will put all their money to work over one or two years and then wonder why they don't get the returns they were expecting. Private equity is a long-term asset and you need to be thinking long-term to make it successful.'

What is the biggest issue in the market?
‘The biggest issue at the moment is valuations. Here in Australia it's an issue because of the changes that are happening in the pensions system. There is a huge shift towards what we call member investment choice. That allows members to swap from one investment option to another investment option and, perhaps more importantly, from one pension fund to another. Under that scenario, valuations are critically important as equity between members in the pension plans is at stake. So the way in which the private equity industry goes about the valuation process is one of the most important issues in the Australian market at the moment. There are guidelines on this in place that have been drawn up by the Australian Venture Capital Association. But some investors are forcing funds to diverge from those guidelines to ensure that they revalue their investee companies more frequently. There is a real issue between the requirements of investors within a framework of choice and the long-term investment and valuation approach of private equity. It looks at the moment as though the battle may be won by the investors. I think there will be a move towards private equity firms making their valuations more frequent than is currently the case. Only time will tell whether that is good or bad, although I do think you need to be patient in private equity.'

How do you think that the market is likely to change in the future?
‘I think we'll see more specialisation in the Australian market. As it grows, it will become more sophisticated. The one area in Australia that will become more important is buy-outs. If the buy-out area is successful, I think that will provide an impetus for the other types of private equity in this market. Buy-outs are the area where investors can get good risk-return trade-offs.

‘The other thing is that we need to ensure that we have a consistent investor base. At the moment we're seeing superannuation funds that have made commitments to the asset class withdrawing from the market. That is damaging. They need to understand that this is a long-term asset class, you need vintage year diversification and you need to build programmes over time. When that happens, I think that we'll end up with a more mature, successful and sophisticated private equity market.'

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