PRINT THIS PAGE

Institutional investor profile: Gordon Hargraves, Vice President, Rho Fund Investors

Hargraves on the attractiveness of the Japanese market, on the unattractiveness of emerging markets, on the push for disclosure and on why that's a good – and a bad – development for GPs and LPs.

Based in New York and London, Rho Fund Investors started out as a family office 20 years ago and now manages the private equity allocation of a number of wealthy individuals across the globe. With $1bn under management, the firm is looking at the possibility of raising institutional money in the future. It invests mainly in seed and early-stage venture capital funds and in smaller to mid-sized buy-out funds across the US and Europe. Rho Fund Investors is part of Rho Capital Partners, which also includes a direct investment arm, Rho Ventures. Hargraves joined Rho in 1999 and was previously responsible for the National Bank of Kuwait's private equity investments and before that, worked for GCC Investments and Donaldson, Lufkin & Jenrette.

What type of investments do you tend to look for?
‘We invest about half our allocation in venture capital and half in buy-outs. On the venture side, we look at seed and very early-stage funds that have a strong technology focus. These funds are managed by people who have an industry background rather than a financial background. On the buy-out side, we look for funds that are value creators. By that I mean that they are run in a similar way to venture capital funds - the managers are extremely active with their portfolio companies to ensure that they create value in their portfolio. This means that we tend to focus on the smaller and middle-market buy-out funds. It's very hard to create value if you're a large fund investing in large companies - it's already a pretty efficient market. We're looking for managers that have the operational experience to create cash flow in their investee companies.

‘We have made some investments in the emerging markets in the past, but for the last five years, our focus has been very heavily on US and Western European teams. Within European buy-outs, our focus is away from the pan-European buy-out teams, but towards the smaller regional players. If you go much larger than this, then you end up in funds that participate in auctions. We don't believe that that is where the strongest returns are to be found.

‘Unlike many investors, we do not look for co-investment opportunities. We're just not structured in that way. A lot of people want co-investment rights, but to do that successfully, you need a whole team, a structure and a process in place. We don't have that.'

What is your appetite for first-time funds?
‘We have invested in a lot of first-time funds - and quite often we have seeded them. It's not an explicit part of our investment strategy, but rather a function of the fact that we look for smaller teams anyway. It's also a result of our belief that first-time funds are incented to do well by making good investments rather than by generating a large management fee. In addition, you can often secure better terms by seeding emerging managers.'

What type of fund are you specifically targeting at the moment?
‘We are constantly searching for funds that fit our criteria. But there is one area in which we would like to see more funds and that is the smaller, regional European buy-out funds with experienced teams and excellent, proven track records. There aren't actually that many out there.'

How does your investment process work?
‘We start off by taking a top-down approach to our allocation. We analyse where capital has been raised, the M&A capital multiples, where people have been investing, where returns have been generated, etc. So we take that top-down approach as a starting point and review that regularly. I will say, though, that our strategy hasn't changed as a result of that exercise for three years - we continue to go for smaller, hands-on buy-out funds and very early-stage ventures funds, both of which can generate some real value for their investors.

‘But we also take a bottom-up approach in that we do very extensive due diligence to find the best managers available within the space that we invest. That is one of the reasons that we have anchored a number of first-time funds. We have an open-door policy to ensure that we are seeing every fund possible that fits our criteria. The way that we think of it is that we have a wide funnel, but a very narrow focus.

‘The focus of the due diligence is very much on the people and what their industry expertise is. We also look closely at whether their strategy fits with where we want to invest. The process for doing that is fairly standard, but we do have the added advantage of having our direct investment arm. That means that we can spend a lot of time accessing non-traditional reference sources, such as other investors or bankers (both commercial and investment) who may have participated in the deal, sellers or acquirers, management, customers and suppliers, etc.

‘The investment process can take anything between one month and 12 months, depending on the amount of information available on the team and whether the team is well established or not. I would say that the average is about two months.'

What puts you off investing in a fund?
‘There is no specific thing that would always cause us to say no - it's usually a combination of a number of factors. But there are certain things that would cause alarm bells to ring: a high staff turnover in the partnership, a lot of write-offs in a portfolio, a lot of unrealised investments in a portfolio, unrealistic valuations, terms and conditions that are outside the market standard, a lack of team cohesion and a low level of experience or the wrong kind of experience among the team members. Those are the most common reasons for us not to invest.'

Where do you think that the most interesting opportunities lie at the moment?
‘We've been looking very much into Japan recently. There is clearly a lot of opportunity there now with all the corporate restructuring that needs to happen - there will be a lot of spin-off businesses that need financing. Despite the problems that the economy is facing, the market is very liquid compared with the US and Europe at the moment.

‘So the opportunities are there. The problem is finding the right teams that have the right expertise and that can take the best advantage of those opportunities. Historically, it's not been that easy to find those teams, but that has been because the market is so young. I think those teams are starting to emerge now, though. We have invested in one Japanese fund and we are looking at investing in another.'

What advice would you offer to an investor new to private equity?
‘I think the best advice I can offer is that investors should realise from the outset that private equity is a long-term highly illiquid asset class. Investors should look very carefully at why they want to commit to it and how they are going to do it. It's not a decision to take lightly.

‘One thing that really annoys me is private equity tourists. If you look at the last few years, the growth of not just dollars invested in private equity but also new investors getting into the asset class has been phenomenal. The problem is that most of them got in at the peak of the venture bubble. That was absolutely the wrong time to invest - and it harmed not just their prospects, but those of other, more loyal investors, by flooding the market with money. Those tourists are now leaving the market right at the time they should be committing to it. There are far more interesting opportunities in the market now than there were three years ago. Valuations are back to the levels they were before the bubble and there is much more time available to scrutinise investments. Investors have to understand that private equity is the most punishing investment there is to hop in and out of.'

What can be done to educate investors?
‘I think investors need to be educated to either commit to the asset class or steer clear of it. The national associations are doing a good job at getting the GPs and LPs to work together to ensure that there is clear communication between the two. I think that the incorporation of the International Limited Partner Association is also an interesting development.

‘These developments are also helping the move towards a commonality of approach among GPs to make the lives of LPs easier. I think that as a result we'll see an increased standardisation of documentation and procedures. That can only be helpful. This is now a very institutionalised asset class. You see several articles a day in the generalist press on venture capital. That didn't happen even five years ago. You're also seeing the very large asset management shops starting to acquire an interest in private equity. I think that is creating pressure for much more uniform disclosure. The increase in the number of professional private equity investors is also a driver for change. The industry cannot expect to grow without resolving some of the issues we see at the moment.'

What's your view on the current push for disclosure among public pension funds?
‘I'm not against disclosure, but I think that what is needed is a consistent, standardised metric for portfolio valuation. Until you have that, publishing figures simply creates confusion in the market. The push we are seeing here for public pension funds to provide performance data on their private equity investments is potentially damaging for both GPs and LPs. If the published data is not put into context, then it's misleading. Very few people outside the industry understand the J-curve effect and they are so used to looking at performance in the short-term (as they generally do with publicly quoted investments) that they are liable to come to the wrong conclusions.

‘State pension plans are a very important source of capital for the private equity industry - GPs can't simply ignore them. So I think that there will be pressure for standardised reporting as the pressure for disclosure in the market continues.'

What is your biggest mistake?
‘I would say that our biggest mistake was investing in emerging markets. We thankfully haven't had any disasters and we have been in the top quartile funds for the region. But even so, the returns we have received haven't been anywhere near sufficient to compensate for the political and economic risks apparent in these markets. We have come to the conclusion that we won't be investing in these regions again for some time to come - they are just too volatile. I'm not sure if we invested in these regions too early, but you need a stable environment in which contract law is established and respected if you are to be successful in private equity fund investing. Either that, or you need to be able to generate extremely good returns to compensate you for the risk you are taking. In our experience, none of this is true for emerging markets.'

How do you think that the market will change in the future?
‘The industry will continue to institutionalise, but I think that it will diverge between the larger and smaller players. On one hand, you'll increasingly see the emergence of large players that raise large funds and employ hundreds of professionals. These firms will provide investors with a one-stop investment shop. You are already seeing the large players raise CLO and CDO funds. We haven't seen that last of this and there will undoubtedly be further products and offerings that these funds will develop. At the other end of the spectrum, you will see the continuation of many of the smaller, niche players, some of which will have spun out from the large institutional groups. These firms will be more specialised and will provide a different offering to investors in terms of returns and type of investment. So I think like any mature industry, you will see some firms go for scale, ie one stop shopping, while others will become even more specialised and focus on very specific niches.'

Copyright © 2002 AltAssets