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Institutional investor profile: Daniel Barr, chief analyst, AP7

Barr on consistency of performance, on why private equity doesn't offer you the diversification many people have claimed, on the benefits of diversification and on why general partners won't be able to continue charging higher fees than is the standard in other asset classes.

AP7 is one of Sweden's state pension funds acting as the default fund in the newly formed premium pension system. Set up two years ago, the fund has E2.5bn under management and is heavily biased towards equities, with 90 per cent invested there. It has recently announced that it is to invest four per cent into hedge funds and four per cent into private equity.

Why did you decide to invest in private equity?
‘We carried out an asset liability modelling study. From that, we came to the conclusion that the fund could benefit from investing in alternative assets. We had to decide on the allocation levels, but we also had to bear in mind that legally, we cannot invest more than ten per cent in alternatives. The ALM study indicated that by investing four per cent each in hedge funds and private equity, we could raise our expected return without increasing our risk profile substantially.'

What type of investments do you look for?
‘We have a very lean organisation - we have just 12 people. Most of the management is outsourced and we have taken the same approach with our alternative asset allocations. So we will invest purely in fund of funds rather than directly in private equity funds and I do not forsee that changing in the future.

‘We have been looking for a broad diversified exposure to private equity with investments across buy-outs and venture capital with two-thirds dedicated to the US and one-third to Europe, broadly split 50-50 between venture and buy-out, although we can be fairly flexible on this.

‘The ten per cent maximum limit relates to committed rather than invested capital. We will therefore invest in some listed funds of funds to ensure that we reach our target allocation of four per cent. The listed vehicles will also act as a liquidity cushion for rebalancing purposes.

‘The investments in listed funds of funds will give us a vintage year diversification from the start. Moreover, some of the funds of funds will invest in secondaries on our behalf. That is good for us as we aim to reach our target allocation pretty quickly. Our fund is in the position of expecting a large inflow of capital over the coming years because we are still very new and immature. Even if we commit our four per cent straight away, we will need to commit further substantial amounts in the future to keep the allocation at the target set.'
 
What do you look for in a private equity manager?
‘We look for experienced and stable teams. We also look at the firm's investment process and its due diligence processes. These are very important to us. And price is another issue because the fees in private equity are so much higher than in other asset classes.

‘But we also have some specific requirements. One of these relates to transferability. By this I mean that we have to have the ability to sell. We cannot legally invest unless we have prior consent from the general partners that they will allow us to sell our interest should we need to. We also insist that the funds are onshore rather than offshore.

‘There were a few other conditions that had to be met before we could invest. One was to do with transparency. We had to be able to publish the names of the underlying funds that the funds of funds had invested in. We are a public pension fund, which means that we have to be transparent to our members. We asked general partners to produce quarterly net asset value figures with monthly updates for us. This is because we have to value our fund every day and we want to avoid the kind of volatility we'd see if funds were reporting to us on a six-monthly or annual basis.

‘We also have an ethical policy that we apply to all of our investments, including those in private equity. The general partners of the funds with whom we invest have to make a best effort commitment to us that they will adhere to our ethical guidelines.'

That is quite an unusual list. How have general partners reacted to your requirements?
‘Most of them were fairly flexible. This is partly because several them had seen similar requests before, with Middle Eastern investors or trade union-related funds, for example.'

What are the specific qualities you look for in a fund manager?
‘We have in our first investments specifically ruled out any funds of funds that have less than a five-year track record. Of those remaining, we are looking for consistent performance and obviously, preferably in the top quartile.

‘The quality of the team is key. We look for experienced investment professionals, people who have excellent track records and who are going to stay with the organisation. We want to avoid key man risks, so we look for firms with somewhat larger teams that have a proper incentive structure. We would also like to be sure that their interests are aligned with ours.'

What advice would you give to other investors that are new to private equity?
‘I suppose one lesson that many investors have learned the hard way is that private equity moves with the public markets. Granted, private equity doesn't follow the exact pattern, but they are very highly correlated as we've seen over the last few years. It's an asset class that offers you some diversification from public equities but not nearly as much as some have claimed in the past.

‘Another lesson is that investors need to be highly diversified within private equity. Get a good spread of investments across buy-outs and venture capital, a good geographical spread and, of course, a good variety of vintage years. Diversification is absolutely crucial.

‘Always look for experienced groups. In this asset class, more than any other, there seems to be a persistence of performance. The best funds in the past are likely to be the best ones in the future unless, of course, key managers leave or something else happens of significance.

'I would also advise doing what we have done. We took the unusual step of going through public procurement procedures using experts and consultants. It has been a very useful exercise and we have learned a lot doing it this way. The consultants brought expertise with them and because we did this publicly, the programme received a lot of attention and we had a lot of fund managers presenting to us. It meant that we had a much larger universe of funds to choose from than if we had done this more privately. We had nearly 130 firms tendering for our investment business in both hedge funds and private equity funds.'

What would you say is the biggest issue for the private equity industry at the moment?
‘Fees. They are a big issue for investors. The fees in private equity are way higher than in any other asset class. In the long run, this disparity will have to be fixed. Private equity fees will have to come down. Otherwise, firms will find it very difficult to attract new investors to the market.

‘The complicated legal structures are also an issue. There is plenty of room for innovations here. I think that the emergence of listed private equity vehicles is an interesting route for us and other investors because they provide us with some benefits that limited partnerships can't, such as liquidity.'

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