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Institutional investor profile: Richard Hotchkis, Cooperative Insurance Society

Hotchkis on what adding value really means, on why no-one has to be in private equity and on why the issue of management fees just won't go away.

The Cooperative Insurance Society has been investing in private equity since 1985. It currently has a commitment of 0.5 per cent of its total assets to private equity, with no plans to increase this for the foreseeable future.

What type of investments do you tend to look for?
‘We tend to invest either in technology venture capital funds predominantly in the US or in firms that specialise in restructurings. We go for opportunities where we believe that the general partner can add value. With venture capitalists, we know that they are creating new technology, from software to developments in life sciences and they have to work closely with the underlying companies to help them grow. We want the general partners to roll up their sleeves and get involved - they are adding value. I am a little suspicious of buy-out funds - they don't seem to do much with the companies they invest in and I think that you can get better results elsewhere.

‘We do also invest via funds of funds. There is no hard and fast rule about how we choose, but we tend to use funds of funds in instances where we have no direct expertise or where we have a long-standing relationship with a particular firm. For example, we have a small exposure to Asia via a fund of funds.

‘We have 70 per cent of our private equity allocation invested in the US, but that is slowly falling as we invest more in the UK and Europe. The US will always be where we invest most of our money, but we like the outlook for the UK and European markets and we are gradually building up our investments there. I think that you're finding greater professionalism in the UK and Europe and there is more restructuring going on.

‘We also invest quite a lot in secondaries - we have 20 per cent of our private equity allocation invested in that section of the market. In fact, we were one of the first people to invest in secondaries in 1990. The argument just seemed to make sense: you were buying into established venture capital funds at a sizeable discount and at a point that was closer to realisation. The industry has become much more competitive since then, but I still think that there are plenty of opportunities there.'

Do you ever do direct investments?
‘We don't do any investments directly into companies - we have nowhere near enough resources to do that. I'd never say that we won't do it, but at this stage, I think it is very unlikely that we'd invest directly.

How do you find out about good investment prospects?
‘It's a case of knowing what's going on in the industry first and foremost. As a long-standing private equity investor, we are reasonably well known and so we do have some groups coming to us, although I would have to say that that is not my favoured route. So it means networking, getting to know people in the industry. Many other institutions have large numbers of people solely dedicated to private equity, but we're not like that. It's really only me taking care of our private equity investments, alongside my other investment duties and responsibilities.'

What do you look for in a private equity fund manager?
‘We look for a long, established track record and with that, a good record of adding value. As we found out in the recent bull market, just because you are reporting excellent returns doesn't mean that you're actually adding value. It's a very serious issue - there is a big difference between pouring money into something and hoping that it is going to grow and investing money and working with a company to help it grow so that it is worth more than when you started out.

‘We also look for depth. By that I mean that we look at how much share of carry that senior general partners get and how that filters down towards the younger partners. The new blood needs to come through for a firm to continue to be successful.

‘We prefer to invest in general partners that entrepreneurs will actively seek out as an investor. This means GPs that have a reputation in the industry among entrepreneurs - it's the surest sign that they do actually add the value they claim to. We will also invest in firms where the GPs have, say, a sector theme and look for potential opportunities. But we would want them to provide strong evidence of a positive track record in this area.'

How do you assess general partners?
‘I try and spend as much time with them as possible. I talk to as many members of the team as possible. I like to get a feel for why they are doing what they are doing, why they work in a particular firm.

‘I also ask for a list of the other limited partners in the fund. I look out for the names of investors that I respect. I would never rely solely on this, but because of our limited resources, I find that it's a fairly good indication of a fund's quality. If a fund hadn't attracted any of the blue chip investors, for example, I would be wary about investing in it.'

Would you invest in a first-time fund?
‘We look at people's track record rather than the track record of an overall firm. We wouldn't have any objection in principle, as some investors do, to first-time funds as long as they were set up by experienced individuals. You just have to ensure that you are thorough in your reference checking to ensure that you a re backing good people. It's the same with any fund. I think that if we hadn't invested in first-time funds along the way, then we wouldn't have had access to their subsequent funds - some of which have turned out to be extremely good.'

Where are the most interesting opportunities going forward?
‘I think that potentially, the most interesting place could be Japan. I stress the word could. Even our Asian fund of funds is taking a pretty cautious view of the private equity market in Japan. If it was ever to move wholeheartedly towards restructuring, then there would be tremendous opportunities for growth. No-one has yet come up with the right model for private equity in Japan. But it's definitely one to watch.'

What advice would you give to an investor who is new to private equity?
‘Take your time. Do not be seduced by ratios of five per cent of assets. Start with a low allocation and don't increase it unless you're sure it's going to reap the rewards you want. Experience in this asset class, possibly more than any other, comes with time. People who rush into investing in private equity are likely to end up disappointed with the returns that they achieve.

‘We have always taken the view that we do not have to be in private equity and I think that that is a fairly sensible place to start. Make sure that you have a good case for investing. And don't think that you can enhance your returns overnight. If you take the people who have made a lot of money out of private equity, the US endowments, for example, they have been investing in private equity for years and they quite rightly made a lot of money. You have to be there before the beginning of the bull market - in some cases you're there ten years before the beginning of the bull market.

‘The other thing I'd say is to get fully familiar with internal rates of return and multiples. If you make twice your money on your investments, there is obviously a world of difference between making it over four years and making it over eight years.

‘Lastly, I would recommend that new investors get exposure to secondaries funds early on. They tend to start distributing cash to investors almost immediately, which can be tremendously helpful for an investor's cash flow.'

What is the biggest mistake that you've made?
‘I like to think that we haven't made that many over the years that we have been investing in private equity. We made one disastrous one in Eastern Europe and we will be lucky to receive back even 50 per cent of our original commitment. I suspect some of our investments in the 1999 and 2000 vintage years will not prove to be good investments, so that I and some other investors will be regretting a few of our decisions.

‘It is of course possible that our biggest mistake will be to be a too cautious approach to the asset class. We have 0.5 per cent of our assets committed to private equity and we have decided that we will not be increasing that for at least the next 12 months. But I doubt it.'

What is the biggest issue facing the private equity industry?
‘The size of the market has increased almost beyond recognition from when we first started investing in private equity. Investors' expectations of the type of returns that can be achieved has also grown - to unrealistic levels. I'd even say that there was too much capital in private equity now. Most institutions these days have a commitment to private equity. Too many of them have excessive expectations of the type of return that they can achieve in private equity - especially the ones who have only recently started committing to the asset class.

‘I remain nervous of the IRRs that funds are going to achieve over the next few years. Exits are clearly difficult at the moment and will remain so for the foreseeable future and the longer that firms have to hold onto their investments, the lower their IRRs will be. So if you're an investor expecting the type of returns that we saw in the late 1990s, I think that you're going to be sorely disappointed. I think you have to compare this to previous cycles. In the late 1980s, returns from private equity were very low on average and I think there is a danger that this time around it could be even worse. The effects of this will be felt much more widely than previously because there is so much more money in the industry these days.

‘I think that terms and conditions have been an issue for a while now and will be more so in the future. As investors start seeing their fund returns start dropping, there will be more pressure on the two plus per cent management fee as standard. That two per cent may have made sense earlier on in the history of private equity, when fund sizes were much smaller. These days, now that fund sizes are in the billions, there are some firms making rather a lot of money even before they have invested a single penny. Add to that the fact that most of these firms have more than one fund, it soon looks as though GPs can get very rich on the management fee and the carry bears little weight when it comes to incentivising people. This is especially true when you're looking at some of the ailing funds. If a GP has no hope of achieving carry on a fund, there is little incentive for them to do the best they can for their investors.'

How do you think that the market will change in the future?
‘I think that it will become much more institutionalised. There is a lot of similarity between the leading venture capital firms now and the merchant banks of 20 years ago. Back then, the merchant banks were boutique-style partnerships. Over the years, they have been absorbed into large institutions. I think that something similar will happen with many of the larger VC firms.

‘I think that terms and conditions will be a source of potential conflict. Limited partners will be able to extract better terms from their general partners. We have already noticed that there is already a creeping standardisation in terms and conditions, and that isn't such a bad thing.'

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