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Institutional investor profile, Jan Faber, Head of Fund Investments, Henderson Private Capital

Faber on entrepreneurial private equity groups, on why a downturn is the best time to spot the best managers, on the concentration of capital in a few large funds and on fighting yesterday's battles.

Henderson and its parent, the AMP group, started investing in direct private equity 30 years ago and together they have committed $1bn to 74 funds. The group centralised its third-party private equity investments in 1999 under the Henderson Private Capital umbrella with offices in London, New York, Singapore and Sydney. It had a first closing of its first fund of funds open to outside investors in November last year with $200m in commitments and is seeking to increase the fund size. Henderson has also recently announced plans to launch two funds of funds in conjunction with Feri Alternative Assets targeted at the German institutional market. Faber has over 12 years of private equity experience and was previously with the International Finance Corporation in Washington DC and FMO in The Netherlands.

What type of investments do you tend to look for?
‘I am a very strong believer in what I call the “entrepreneurial” private equity model. We like firms that have between five and ten partners who manage a reasonable amount of money - those that may seem from the outside to be over-resourced for the amount of capital raised. We invest in firms that have a strategy focusing on intensive care of their investments. We like hands-on managers who get involved in the strategy, recruitment and operations of their portfolio companies. They are business-builders, people who probably have an entrepreneurial background and have set up and grown their own businesses.

‘We often meet groups that have more of a relationship model who don't get involved with their companies so much and just attend board meetings. I don't think that is the right model in this market. Our experience has shown that it is usually the small, hands-on teams that make the most interesting opportunities.

‘Having said that, we don't ignore large funds. In Europe, especially, it is hard to find enough good smaller funds, so we do look at the larger players, too. You have to dig very deeply in Europe. You have to look hard at every market for the local teams. In each country, you will probably find one or two interesting teams, so that's not a very large supply. It means that you can't afford to focus solely on the smaller funds and you have to look at the more established players. I think this will change over the next five years or so as you continue to see more and more spin-outs from the larger groups. You have seen that a lot in the US, but Europe isn't there yet.

‘We have also been looking at the possibility of buying up a few secondaries positions. We wouldn't participate in auctions, though. We would prefer to find out about opportunities through our network, through general partners, and try and buy positions in firms that are on our watch-list. We haven't closed one yet, although we have looked at a couple.'

How do you put together your portfolio?
‘When we look at our portfolio we look at four points: geography, investment stage, fund size and life cycle. In terms of geography, we are a global fund of funds. We invest equally between the US and Europe, but we also invest in Asia. Many people overlook the region, but we think that it is an interesting market, provided that you don't focus too heavily on it. We are very selective there. Over the last three years or so, though, people have made quite a bit of money in the region. Korea, for example, has been a good market. We invest around ten per cent in Asia and the rest evenly spread between the US and Europe. We have set these allocation targets, but we can change them at any time because have a global mandate. What drives our allocations is the opportunity set, which is probably more in the US than in Europe, although Europe is becoming more and more attractive. We are opportunity-driven in terms of where the best management talent is.

‘As for investment stage, we try to have a balanced approach between buy-outs and venture. Our focus is very much on the smaller end of the buy-out market and on early-stage US venture capital. We almost ignore the large buy-out market and the later stage venture markets. The third point is the fund size - not the absolute amount, but rather the amount per partner. We try to have a good balance between the larger fund sizes and the smaller ones. Then, fourthly, we look at the lifecycle of the partnership. We don't want to have all our money invested in firms that are raising their seventh or eighth funds. We want to have a good amount of fresh blood in the portfolio. We like to have some exposure to emerging groups, some to groups that are managing their third or fourth funds and some to the very well established institutions.

Why do you not invest in buy-outs or later stage venture?
‘If you take the large buy-out market in the US, you have a large capital overhang that isn't going to disappear quickly. Competition as a result is huge right now. The market may improve over time, but not in the next three years. I don't think they are very good buying opportunities at the moment.

‘As for venture, we like groups that are very hands-on and that create value rather than, as is the case with many later stage managers, those that rely on arbitrage of the public markets - investing in later stage companies in the hope that you can then float them when the IPO market returns. We like managers who come into a business early on and build it to a certain size. That's where the value is really created. That's where you want to be. In the later stage venture space, you have a lot of players and they have raised huge funds, so there is a lot of competition.'

How do you tend to find out about good investment prospects?
‘The most important way of finding good managers is through referrals. We ask the general partners in our portfolio. We find out from them who they think are the smartest investors. That gives you pretty good advice. It's also worth finding out which firms your GPs have invested in with their personal wealth. We try to use our relationships with GPs to get new introductions. On top of that, we continuously conduct research. We have a watch-list of firms that we would like to back and we have compiled this over the years.

‘We try to build up relationships early on rather than just when they are in the marketplace because in the end, successful private equity investing is based on judging individuals. We have to see how well the team works together. I am always very uncomfortable if we have just six or eight weeks and two or three meetings in which to make a call on individuals. We prefer to have a number of meetings over a long period of time so we can check them out and really get to know them. We like to get inside the firm and also talk to the junior guys.'

What do you look for in a private equity manager?
‘We want them to be hands-on and entrepreneurial, as I have already described. But the most important thing is the team dynamics. We want to see how the team has addressed succession issues, how the carry is split and how team members are motivated. We don't like one-man shows in which there is just one person running the firm who has put his or her name on the door. What we want is balanced teams, cohesive teams. That's what we look for.

‘This is a great time to test good and bad managers. You see a lot of managers now, for example, who have raised a lot of money and they are just not investing. They say that the debt markets aren't there and so they aren't doing anything - they are held hostage by the debt markets. On the other hand, there are a lot of other managers, particularly the smaller ones, who are very actively investing and divesting. These are the managers who take advantage of the value opportunities available. You can really see who the creative, smart investors are at a time like this.'

Where are the most promising areas at the moment?
‘That is a very difficult question. I'm not a believer in deciding that now is the time to invest in, say, mezzanine or biotech. I think that is very difficult. I met a fund manager yesterday who said: “Investors are always fighting yesterday's battles.” I think that is pretty accurate. I don't think that the opportunities lie in certain sectors or in certain countries; I think the opportunities lie in backing the best managers - and they can be in any area. I look for great teams with a great strategy and a great formula. We don't put bets on the market by moving into particular areas because everyone is saying they're hot. I think you end up being two or three years too late if you follow that. As soon as people are on to that type of opportunity, it's too late.'

What advice would you offer to an investor new to private equity?
‘If you decide to invest in private equity, don't wait. Start now, but be sensible. Don't put everything in one fund. Build a network of smart investors who can really advise you and give an insight into the market, give you gossip and help you work out what's going on. I would spend a lot of time doing that in the first instance. Get your network and your information sources right. Don't just rely on placement agents. Talk to other smart investors who can give you independent assessments.

‘If you want to go via a fund of funds, spend some time working out what you really want. Do you want an indexed fund of funds that writes large cheques to funds? Or do you want a fund of funds that is more balanced and can really help you outperform the market?'

What is the biggest issue in the private equity market?
‘I think there are two. One is the issue of partnership risk and succession. That is a big issue. The second issue is the concentration of capital. You are starting to see the emergence of huge funds of funds and gatekeepers that are directing a lot of money. The good thing is that they are being run by smart people. But I think that a concentration of capital is never a good thing. It's not good for the fund managers because they have few capital sources - if one large fund of funds says no to them, then it is almost impossible to raise a fund. It's not good for investors, such as the newer pension funds wanting to invest in private equity. Their consultants are often recommending one, two or three large funds of funds. I think they are missing out on a lot of opportunities. If this trend continues as it has been going for the last five years, it could become a major problem.

‘I would like to see more players in the market and not so many dominant players. In the end, the markets will decide because investors will look at performance - they will be able to weigh up whether they want to go for one of the large funds or invest in the more specialised fund of funds. The problem is, much of that performance information will take a long time to come out.

‘There have a been a lot of new players entering the market over the last few years and that is positive for both fund managers and for investors, but only provided that they are good quality. You might expect that, since there are so many now, there will be some form of consolidation. Many funds of funds are offering “me-too” products and have not differentiated themselves much. People will disappear and we will start seeing more differentiation in the market. You will see people focusing on niches or themes.'

Do you think that we will see an emergence of specialist funds of funds?
‘I have met some funds of funds that only do emerging managers or start-up managers. I think that is an interesting differentiator. But I have also come across Australian funds of funds that only do Australian investments. That doesn't make sense to me. I think that you have to specialise in an area in which you will have a lot of choice in terms of quality teams.

‘It could become more of a feature of the market, but not for a long time. I don't think that investors are ready for it yet. If you look at many investors in Europe using funds of funds, they tend to be new investors, just starting out or who have a small allocation to private equity. Many of them are looking for diversification in their portfolios, so they are unlikely to be tempted by specialisation.'

What is your biggest mistake?
In a previous role, I was investing in emerging markets in the early-1990s. From that I have learned that if you go to markets too early, the returns you receive are not going to compensate you for the macro-economic risks, for the currency risks you are exposed to or for the lack of capital markets. You have to be very careful if you go to a new market. For example, there is a lot of debate surrounding Japan at the moment. I would first want to see evidence that deals can be done and exited before I would feel comfortable about investing there. I don't think that it helps even to team up with a brand name from the US or the UK. We have some investments in our old portfolio that are examples of this - US or UK groups going into Continental European countries and they haven't been that successful. You have to look at this type of proposition as a first-time fund irrespective of the past successful track record since it's not one based on investing in the new market. I've learnt this the hard way.'

How do you think that the market will change in the future?
‘I think that we will see a lot of dynamics in terms of spin-outs over the next five years. Many captives are becoming independent - some very solid groups - and they will spin out younger teams. This is a good thing. You always need to have the large, established players, but you need to have new groups coming to the market. It makes it more competitive. If you're backing a new group, partnership risk is pretty high, but if you get it right, you can really outperform the market. If you do an analysis of many of the established groups to see where they have made their money, it's very often the case that they have done it in funds one and two. For an investor, the trick is to identify these managers early on in their lifecycle. The challenge for a smart fund of funds player is to get that right.

‘You will end up with large powerhouses that will continue to grow, too. In five years' time, you will have a handful of huge firms. Some of them are well positioned to go that way - Apax is one, Warburg Pincus is another. These firms will become large institutions, almost like asset management businesses, and I wouldn't be surprised if they opened themselves up to the retail market. At the other end, will be the smaller, vibrant firms. They will come and go - the good, solid ones will stay, but there will be many that fall by the wayside.

‘Private equity is going to grow. It will become a mainstream asset class. The word “alternative” will disappear. I don't know what the exact timeframe will be, but it will happen. At that point, private equity will start to compete with listed securities for capital.'

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