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Institutional investor profile: Katja Salovaara, Portfolio Manager, Ilmarinen Mutual Pension Insurance Company

Salovaara on the dangers of buying macro stories, on why secondaries have been risky over the last couple of years, on the incompleteness of IRRs, and on why the private equity industry should be beyond inconveniencing its investors by now.

Based in Helsinki, Finland, Ilmarinen has been committing to private equity funds since 1994. It took on specialist staff in 2000 with the aim of investing up to five per cent of its E14bn assets in private equity funds, primarily in Europe. Ilmarinen commits mainly to buy-out funds, with some commitments to venture capital and secondaries. Salovaara has been with Ilmarinen since early 2000 and was previously with the Shell UK pension fund in London where she worked on its private equity fund investments. Before that, she was an investment analyst at Pantheon Ventures.

Why do you invest in private equity?
‘We are looking for higher returns than those we can achieve on the public markets. Diversification is not our main reason for investing. In terms of our return expectations for private equity, our target is to achieve a premium of at least 300 basis points above quoted market investments.'

What type of investments do you tend to look for?
‘We focus on areas where we think that private equity can add value and outperform public markets - for us that means buy-outs and venture capital. To date, we have focused on the European buy-out market because we think that it has very attractive opportunities. The corporate landscape in Europe is changing and restructuring. The spin-outs that result from this provide a wealth of opportunities for buy-out players - the US has already been through this and is a more mature market. This means that we believe that there are opportunities at all ends of the buy-out market. So we want to build a portfolio that has underlying investments in all sizes of company and that has a balance between pan-European funds and country-specific funds. Currency risk also drives our bias towards Europe. You can't really hedge cash flows on private equity funds. The last point to bear in mind is that diversification is not our main reason for investing in private equity and so it is more efficient to diversify our overall assets on the quoted side.

‘We don't have an index mentality to private equity investment. That means that we don't feel the need to invest in every sub-category or market in private equity and that we don't want to allocate to geography based on private equity dollars invested.  We do look at some of the more opportunistic types of private equity, such as mezzanine and secondaries, but buy-outs and venture capital are our core investment areas.

‘Currently, our commitments are 96 per cent to Europe, four per cent to the US. Within that, 74 per cent is committed to buy-outs including mezzanine, 18 per cent to venture capital and eight per cent to secondaries. Our buy-out and venture exposure would vary by region, so if we decided to invest more in the US, for example, we would target a higher venture exposure in the US than in Europe to reflect the relative skills bases in the two regions. In Europe, we also invest through funds and in the US, through funds of funds, because it is much harder for us here in Finland to assess the opportunities across the Atlantic.'

What is the outlook for fund opportunities over the coming year?
‘I think that times are currently tough for exiting private equity investments, but it should be a better time for making investments. We have a strong emphasis on making commitments on a consistent basis. We expect there to be some good opportunities over the coming year.'

How does your investment process work?
‘Our process starts with finding good investment opportunities. We have done a lot of research internally and we have built up extensive networks over the years. All the placement agents also approach us. In addition, we keep up to date with the trade press. So, based on all this and on our own research that we have conducted, we have whittled down the manager universe in Europe to 60 core buy-out managers and 20 venture groups that are most relevant to us and on whom we would like to spend most of our time investigating.

‘We regularly review the entire flow of investment opportunities. We decline many GPs pretty quickly because we want to spend most of our time on analysing the most relevant opportunities to us. We take the view that private equity is not easy or cheap to trade out of if you make mistakes and so we are very disciplined and selective in our processes.'

What criteria do you use to select managers?
‘We don't want to look at managers in isolation. We want to benchmark managers so that we can be sure that we are taking a best of breed approach. Many managers look good in isolation, but it doesn't make sense to invest in them in this market if they have competitors who are better positioned than they are. That's our first test.

‘In addition to this, the investment strategy has to make sense. What's important to us is the way in which managers create value in their portfolio companies. We are looking for managers that generate Alpha rather than high Beta bets. We find quite large differences between managers, for example, in the area of resources if they are trying to execute a particular strategy, ensure good quality deal flow, etc. Managers should lead deals. And for us, money multiples are more important than IRRs. Consistency and alignment of interests are extremely important for us. We also have a strong preference for independent firms over captives.'

What do you think are the most interesting countries or sectors going forward?
‘We want to manage our stage and geographic allocations very actively to ensure that we get diversification in our portfolio, but we recognise the limitations of a top-down approach. Unless you have a crystal ball, you can't tell for certain which areas are going to be the most promising. LPs also need to add value through manager selection - that's why we follow a bottom-up approach to investing in private equity.

‘I don't think that successful private equity investing is about chasing fashions or buying macro stories. It should not be used to take advantage of what you believe may be opportunities in the short term. It makes much more sense to call your broker and buy futures if you think there is a specific opportunity. Private equity funds take five years to invest and then at least another five years to divest, by which time anything could have happened. You need to take a long-term approach. That's one of the reasons why we find properly structured pan-European funds attractive. In these funds capital is mobile and managers are incentivised to allocate capital to opportunities with the best risk-return ratio.

‘Take Germany. A lot of people have pinned their hopes on Germany for a number of years. There is a great macro story there, but it still hasn't delivered on its promise. The potential for a big buy-out market in Japan is another such story. The problem is that we just don't know whether it will take five years or ten years to start taking off and, most crucially, it might not ever happen.'

What advice would you offer to new private equity investors?
‘Be patient. Take time to build a private equity portfolio. It takes a long time to find the right funds with which to invest, but it's important to diversify over time. Consider investing in secondaries because they have the potential for early cash flows. Build up contacts proactively within the industry before investing. This is a knowledge industry in which you really have to go looking for information. And most of all, be aware that the industry suffers from the problem of adverse selection - the funds that come knocking on your door may not necessarily be the ones that you should be investing with.'

There is some concern about the secondaries market overheating at the moment. What's your view?
‘The secondary market has a lot of potential, but you really have to think in terms of five years - the investment period of funds that are being raised now - rather than what will happen over the next quarter. It has a lot of potential over the medium term, but I also think that it has been a very risky place to be over the past two years because of falling asset prices. We have been targeting funds that have been exercising a disciplined approach of buying up positions that are mature - that's where the potential lies.'

What is the biggest mistake that you have ever made?
‘I think my biggest mistake was approving a partial change in investment strategy for a fund. In this sort of situtation it would be nice to have the option to sell but it is very difficult if the fund has invested very little. So with no option of selling you can either try to influence the manager to change his mind, try to block it or at least keep the requested special allocation to a minimum, which we managed to do in this case.'

What irritates you about private equity?
‘One issue that irritates me is the rise in agency costs. GP compensation is shifting towards fixed remuneration rather than performance-based rewards. The more visible examples tend to be in the larger funds, the mega-funds. But I think that, in general, private equity managers are becoming more experienced and yet the risk/reward profile is changing not just in the larger funds, but in many smaller funds, too. In all these instances, the resource base is not being expanded in step with the increase in assets under management. It is an issue when managers can become fairly wealthy through the management fee and don't really have to try very hard to optimise fund performance. LPs would like GPs to invest more of their own money in their funds and for management fees to come down. I think that's the solution to this.

‘The other thing that irritates me is a lack of discipline in marketing among GPs. Private equity can be marketed to investors in a very misleading way. There are so many ways for a GP to calculate and present their performance - granted, past performance isn't necessarily the best indication of future performance, but it is very irritating to be shown exaggerated numbers. You have to live with this because it is a feature of the market. But I don't see why managers continue doing this. If I have to take half off the performance figure that a GP has presented me with, I don't think that that is a very good start to a ten-year relationship. I don't see why they bother with this smoke-screen. It's like a marriage - cooking lasts longer than looks. The real issue is if funds are marketing to private individuals - that's when there should be more discipline in the marketing.'

What's your view on the current transparency debate?
‘I don't think that a few public pension funds publishing IRRs on their web site is going to drive transparency. That's not going to help anyone. You can't assess performance on a short-term basis. It's not helpful to look at IRRs without knowing whether a fund is two or eight years' old, whether it is 20 per cent or fully invested, and without knowing what the underlying company investments are and how they are valued. There is a danger that publishing IRRs could also lead to more optimistic and aggressive valuations of unrealised investments.

‘What it might do, though, is put pressure on the industry to achieve certain things that have so far been slow to materialise, such as global, uniform valuation standards. Even if that were to happen, it would not remove the substantial uncertainty about the fair value of an asset that is not traded, but an agreed framework is a necessary starting point. Valuations are unavoidably and necessarily subjective - that is a feature of the market. What value do you ascribe to an asset at a given point in time that is not traded?

‘I think that what matters, more than interim valuations, is cash-to-cash returns. That's what people should focus on. You have to recognise, though, that there is a very real need for interim valuations - in the quoted vehicles, in the secondaries market and so that investors can measure their performance periodically. But a set of global standards is not going to provide an instant fix to benchmark against. Pure numbers don't tell you what you need to know.'

What do you think is the biggest issue in the market at the moment?
‘I think that the biggest issue that the industry is facing is the increased time to exit and its impact on returns. That is so tied in with what is happening in public markets that I'd rather talk about something that is within the industry's control. The industry needs to be truly institutionalised. If you think of the scale of the industry now, it is incredible that it lacks standards. Investors are prepared to put up with a lot of inconvenience in return for a really ground-breaking product. But it's not ground-breaking any longer and so the industry needs to be prepared to standardise much more and become more investor-friendly. LPs want more convenient admin, they want to be able to automate their processes, they want a standard format for quarterly reports, cash calls and distributions - all of this should be achievable. Some of the problems, such as the subjective nature of valuations won't go away, but it would help at least if everyone was using the same framework.

‘There is also a need for better benchmarks. There needs to be much more academic research into this area.'

How do you think that the market will change in the future?
‘Private equity is not a single market, but I think that a common theme that runs through both the venture capital and buy-out markets is an ever increasing pressure to add value as markets develop and mature. This has organisational implications - firms will need to specialise and grow their organisations or become niche players.

‘There is clearly a need for consolidation among firms. To what degree that will actually happen, I'm really not sure. It will take a long time because everything takes that much longer in private equity. Many firms will linger on, even if they can't raise a successor fund, because they will be able to live off their old management fees.

‘Over the longer term, I would expect institutions' allocation to private equity to increase as they search for higher returns and they gain increasing experience in this asset class.'

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