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Institutional investor profile: Gunther Pamberg, president, Alcyon

Pamberg on borrowed track records, on the unrealistic sales pitch of the self-funded private equity investment, on where IRRs are heading and on the industry's walking dead.

An investor in private equity funds since 1985, Alcyon is a Switzerland-based family office with CHF100m under management.

What type of investments do you look for?
‘Our preference is for well established venture capital firms in well developed private equity markets. We invest around 75 per cent of our private equity allocation to venture and 20 to 25 per cent to buy-outs. We prefer venture because it has historically performed much better than buy-outs and the returns are diverging further between the two sectors.

‘We invest mainly in North America because the market there is much more mature and professional than elsewhere. We like to commit to venture groups that are raising fund four or five - you can only really find these in the US. But we do also invest in Europe - and that's where most of our buy-out fund investments are. It's very hard to find experienced venture teams in Europe. The market is still too young.

‘We prefer to invest in funds directly. That way we have direct access to general partners and it's also a great way of learning about the industry. However, we do invest in a couple of funds of funds. We find them useful as a window for benchmarking returns against our own direct investments.

‘We also have commitments to three secondaries players. To be successful in private equity investing, you need to have a good spread of commitments by vintage year to smooth out the inevitable ups and downs. Investing in the secondaries market gives you instant diversification by year, so it makes a lot of sense to us to do this.'

How do you find out about good investments?
‘We have been investing in private equity for 17 years now, so we have a pretty good idea of who is out there. This is very much a people business, so you really have to get to know the fund managers. We spend a lot of our time networking. Plus, we only invest from fund four or five, which means that if they are any good, we will have known about them for some time before we decide to commit.'

What do you look for in a private equity fund manager?
‘We look for an excellent track record and, importantly, a demonstrated capacity to manage exits. But what is vital to us is the quality of a fund's reporting system. We believe that this bears a direct relationship to the quality and performance of a fund. If a fund cannot provide good quality reporting in a timely fashion, it's an indication that it either has something to hide or that it doesn't have its processes in order.

‘The other thing that we look at is team stability. Where are these people in their life cycle? What is the age structure of the firm? This is an important issue. Private equity fund vehicles may officially last for ten years, but they are rarely wound up then. We have been investing in the asset class for 17 years and we still have a few investments dating back to when we first started. It creates a huge problem of bureaucracy if you're having to maintain active funds going back that far. So it's essential that the main core of the team that you originally invested in is there to manage all the investments right through to exit. You really want to invest in people who are going to be around for a while.'

Would you ever invest in a first-time fund?
‘No. We would certainly never invest in first-time investors, and we avoid first-time funds - the type run by people who have spun out of captive or larger organisations. I don't see why we should take the risk when we can invest in a firm's fourth or fifth fund onwards. There are a lot of people out there trying to capitalise on the fact that they have worked in a successful group that has a good track record. They are trying to bring that track record with them - I don't trust that. The track record belongs to the group rather than the individual. And I have seen a number of individuals trying to claim a track record that is not their own.'

What do you think are the most promising areas going forward?
‘I think that all markets are looking pretty tough everywhere at the moment. Some people seem to think that biotechnology is a good place to be and there is a lot of money going into that sector right now. But I am afraid that it is being used as a diversion away from the problems that we've seen in technology. There are a lot of venture capitalists going into biotechnology who do not have any expertise in the area and that is dangerous. Sure, they are using advisers and consultants who do have industry knowledge, but that's no substitute for the one or more of the team members having a background in biotechnology. I am very sceptical of this - it's a new fashion that to some seems plausible, but I see it more as a diversionary move from technology.'

What's the biggest mistake that you've made?
‘I think that it would be getting caught up in the general euphoria in the late 1990s - and I'm sure that I won't be the only one regretting some of the investment decisions we've made.

‘I think that we will come to regret being rather more lax in the criteria we used to select which funds to invest in. We, along with other people, ended up committing more than we normally would at one time. As I said earlier, diversification by vintage year is key to success. But we over-committed in the expectation that exits would come thick and fast and that we could then re-invest that money. Remember that at that time, liquidity events were happening weekly.'

What advice would you give to an investor who is new to private equity?
‘Don't plunge into it head-first. By that I mean decide how much you want to allocate to the asset class, but don't commit it all in one go. Private equity is a long-term asset class therefore you will get the best results if you invest that allocation over several vintage years. Again, it's to do with smoothing out the ups and downs. Be aware that there are cycles in private equity investing, just as there are in other asset classes.

‘Many of the investors that are having problems with their private equity portfolios now are new to the asset class and committed all their allocation between 1998 and 2000. Those people will have had a high exposure to technology and the internet and will now be suffering the consequences. To really make any money in these areas, you had to be in them back in 1993. Only by diversifying by time can you avoid some of the extremes.'

What is the biggest issue for the private equity industry at the moment?
‘Damage limitation. Many limited partners are very unhappy with their private equity investments right now. They haven't seen any distributions for a long time - liquidity has virtually disappeared over the last 12 months. It wouldn't be so bad, but general partners sold their funds to investors on the basis that they would be pretty much self-funding because they could re-invest the distributions. That argument is looking pretty weak now.

‘Internal rates of return are a big issue. The exit market is almost non-existent at the moment and so firms are going to have to hold on to their investments for much longer than they had anticipated. That kills IRRs. And low IRRs will give the industry a bad image. It may take a while, but I think we'll see those low returns discouraging new investors from going in to private equity.

‘Some LPs are concerned about management fees and paying their fund managers even when they are not investing. I am less concerned about that. I would rather see general partners wait for quality deal flow to come through than for them to invest just because they feel that they need to justify their management fees.'

How do you think that the market will change in the future?
‘I think we'll see a very substantial cleaning out of the marginal players - and in the short term, a lot of damage to the industry's reputation.

‘There will be many firms unable to raise successor funds. I think this clean-out will be worse in Europe than in the US because it will be the less experienced players that suffer the most. The industry is new over here, especially in Continental Europe and almost the maximum track record here is five years. That doesn't go back far enough to prove that managers are capable of surviving through a downturn.

‘Many firms with problem portfolios will be in for trouble, too. General partners are counting not only on their management fee, but also on their carried interest. Younger partners are not going to hang around tending to sick portfolio companies if there is no hope of any carry at the end of it. If they aren't locked in by carried interest, they are mobile and they will leave.

‘There will be a lot of walking dead in the industry for a while as all this plays out - and it may take a while because of the long-term nature of private equity.'

‘But many will survive, and they will be the firms that can demonstrate good cash returns - I don't mean IRRs, I mean actual distributions to limited partners.'

What is the most important thing for investors to be thinking about at the moment?
‘In the current environment, I think it is essential for investors to understand that the critical drivers for long-term private equity performance are different from other, more traditional asset classes.'

So what kind of returns should they be expecting?
‘They should expect a premium for a number of reasons. The market is illiquid and an investor's commitments can be locked in for the whole life of the fund. Capital calls are unpredictable. GPs can call funds at just seven days' notice, which means that he can work the fund with virtually zero liquidity and leverage his operations from the LPs' balance sheets. Private equity is not a transparent market. Funds are unregulated, are not subject to any formal corporate governance codes, they have advisory boards consisting of institutional investors who have their own agenda, the fair market valuations in quarterly and annual reports are fairly arbitrary, and smaller LPs can have little influence over a fund once they have signed the agreement, other than to deny the firm capital at its next fund-raising round. Private equity is also subject to the same type of cycles as the public market - even if it is meant to have little correlation with it - as we have seen from the bubble returns of the nineties.

‘All this means that long-term private equity returns for the top quartile funds should be measured as a positive spread over long-term equity returns. I use the MSCI plus 600 basis points as my benchmark - which means that after the bubble returns of the late nineties, we have pretty modest expectations.'

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