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Institutional investor profile: Donald Kendall, Managing Director and CEO, K2 Capital

Kendall on the market's return to normality, on misleading performance information, on cycles of success, on limited partner revolts and on why they won't happen.

K2 Capital is a private equity fund of funds manager. Evolved out of a family office, the firm manages money for wealthy individuals and small institutions and has approximately $100m under management in its first fund of funds. It is currently looking at raising a second fund of funds and expects to raise over $100m, but has no specific target. Kendall, founder of K2, previously founded Palmetto Partners, a family office and investment management company, and has been involved in private equity programmes at Morgan Stanley, Drexel Burnham and First Boston.

What type of investments do you tend to look for?
‘We invest predominantly in the buy-out sector, but we also have a reasonable amount of venture in our portfolio, plus a lesser amount of mezzanine, distressed and special situations. In our first fund, which is close to being fully committed, we have invested around 50 per cent in the buy-out area, 35 to 40 per cent in venture and the rest is in mezzanine and distressed.

‘Geographically, we have looked globally, but for the first fund, we have invested predominantly in the US. That is mainly because that is what our customers wanted. We do have some international exposure and we may well have more in our second fund of funds, but I think that, because of the nature of our investors - small endowments and foundations, local pension funds and wealthy individuals - we are likely to continue having a heavy weighting towards the US.

‘We invest across industry sectors. There may be some funds in our portfolio that have a sector focus, but others will have a broader focus. We are not industry-specific.

‘We also invest in secondaries. Given our size, we go for individual interests in limited partnerships. We are seeing a lot of those around at the moment. There are a lot of people who have seen their circumstances change and many have found that they are now over-exposed to private equity. But they are even harder to evaluate than they ever have been. On the buy-out side, you can generally get enough information to get your arms around it however the valuations may not reflect the portfolio's real value. On the venture side, it's much worse, it's more complex trying to come up with what the net asset value of a portfolio really is.'

Do you invest in first-time funds?
‘Yes, but we don't do first-time investors - we want to see some real private equity investing experience. It's not like investment banking, for example, and I should know because I used to be that area. The type of first-time fund we like are the ones that consist of people who have been in an excellent private equity firm. The group has been together for five or so years and they may be just below partner level, but they have been the ones doing all the deals. It's difficult getting due diligence from the firm they were at, but you can get it from the lenders to portfolio companies and the management teams.

‘Part of the logic with first-time funds is that they are hungrier. If a firm is raising its fifth fund, the people have already made a lot of money, there are always questions about their motivation and the size of fund. With a new group, they feel much more incentivised to be successful - that isn't a guarantee, but historically a firm's second and third funds are the best performers.'

Where are the most interesting opportunities at the moment?
‘The most interesting opportunities at the moment are clearly not in venture capital. I would say that mezzanine and distressed are much, much more interesting now than most things in venture capital and probably many things in buy-outs. We're looking at those very carefully.

‘In buy-outs, the most interesting opportunities for us are probably industry-specific or regional funds. We see less competition and more value-added in these areas. I'd also say that most people's view today is that there are more opportunities in European buy-outs than in the US.

‘I think that we will focus more attention for our second fund than we have to date on the international scene. We do have some exposure to Asia now and we will look there cautiously. The problem is that it is tough to call Asia one market - Japan is very different from Korea, which is very different from China, etc. It's not homogenous and there are certain countries that we are more comfortable with, others that we are less comfortable with. No-one has a pan-Asian approach and so you have to look very carefully at what is happening in each individual country. If you're backing an Asian fund, you have to make a really tough decision not only on whether the managers are good or not, but also on the country itself.'

What advice would you give to an investor who is new to private equity?
‘It does depend on size, but I would say that they should invest via funds of funds - but I would say that, wouldn't I? But actually, I do believe that it is a much better way of accessing the market, you don't have to build up all the relationships yourself and if you're looking for US exposure as a European investor, it's hard. The big funds will go to Europe, but many of the better smaller and mid-sized funds don't have to.

‘I don't think that you can time the market in private equity. But I think that if you look back, you'll see that when you're just coming out of a difficult environment - which is what's happening now - you tend to see some of the best performances. I don't know whether we are at the bottom, but I think that we're close enough to believe that the timing for commitments to private equity is ideal. Valuations have come down across the board. The exits may take longer, but if you're investing in private equity, you should only do so across a long time horizon. The IPO market will come back and strategic and trade buyers will return - you just have to be patient. I do think it is a very appropriate time right now to be making private equity commitments. Do it in a diversified fashion - I wouldn't advise investing in venture only, for example, because even if the valuations are low, there is so much haemorrhaging with existing funds, there is such a large overhang of capital, that I'd be very cautious still.'

Do you think that we have returned to normality as far as exits are concerned?
‘We clearly had craziness in 1999 and 2000. A lot of companies that should never have gone public went public. There was very easy access to capital and there was a very quick turnaround. That wasn't normal. It shouldn't have happened, but it will probably happen again. Today, I'd say that we are on the other end of the pendulum swing, especially as far as IPOs are concerned. And yet there is still a small handful of very good deals being done in specific industries - defence being one. I don't think that this is normality, but it's not the worst we've ever seen. And there are still opportunities to exit to trade and strategic buyers. Now may not be a good time to sell and some smart investors may want to hang on for a while, but I know of a couple of companies that have attractive offers in front of them right now.'

What's your biggest mistake?
‘I'm sure there are others, but one thing that we didn't quite appreciate was how hard it is to raise a fund. We felt that if we built the right team, fund-raising would be easy. I think that we are in an environment in which it is important to build up your fund-raising team as well. We are an independent firm with no affiliation to an investment bank or other financial institution and fund-raising is tough for everyone, so I think we need to work very hard on this area.'

What irritates you about private equity?
‘We'd like to see more transparency so that we can do our job better. But I suppose that that is an opportunity for us because we will always stick to our core philosophy. I liken private equity to a bell curve in which you see the bad funds at one end of the tail and the excellent funds at the other end of the tail and many good to medium funds in the middle. What we want to do is avoid everything in the bad tail. We want only to be in the good tail, but that is extremely difficult for anyone to do consistently - remember that some funds only ever appear in there once. That's why we seek consistency. People have different ways of presenting the numbers, so it's awful difficult to do the due diligence. I've seen placement memorandums for groups that make out that everyone there has been there for 15 or 20 years yet - and this is a real example in an investment bank - when we dug into it we found that the main investment team had left to form their own fund and they had just shifted people from the investment bank over into private equity. You would never have known from the PPM. You really have to look at the numbers you are given, too, because many groups present their performance in a way that is misleading. But overall, the people in this business are sharp and fun to work with.'

How can you ensure that you miss the bad funds?
‘You can never guarantee that you won't be in bad fund and you can't guarantee that you will always be in the top funds. But in this asset class more than any other, history is a good indicator. If you see a fund that done very badly for three funds, then you can assume that that is not a good place for your money. That's easy to avoid. The tougher one is the firm that has had three great funds in a row. Will it have another great fund. In private equity in particular, I think there is a cycle of success. The better funds keep getting better. If they have great deals, then entrepreneurs or sellers will flock to them and want to work with them. They will see deals earlier and will have opportunities that other funds won't have. So the better do tend to get better.

‘Yet there is another issue, which is very tough to predict, and that is the paradox of investing. Good or excellent investors naturally attract more money. As funds attract money, that shifts people out of the areas they have succeeded in and that usually leads to poor performance. If a fund has done a great job at $250m and then decides to raise $1.5bn because it can, I'm not sure it has the right expertise.'

How do you think the market will change in the future?
‘I think there will be a lot of interesting changes. It's going to be a fun industry to watch. Eventually, we will get more transparency and I think that will create a more active secondary market. If you take the public markets, if you feel that you are over-exposed to telecoms or whatever sector, then you pick up the phone and you shift your allocation. In private equity - they might not like the price they get - but there may be certain investors that decide they want to reduce their venture exposure and take on, say, some mezzanine. Today if they are at their limits for new commitments, then there's very little flexibility for them to rebalance their portfolios. You will end up seeing a lot more ways of allowing investors to treat this asset class in the same way they would a more liquid asset class.

‘There should also be a lot more LP revolts, but many are too afraid of not being allowed into the next fund. If things get much, much worse, then that might change, but otherwise, I don't see that happening.

‘There is another change and it's just starting to happen. We're just seeing the early, well established funds have their founders reach retirement age. I will be interested to see the generational changes. The question is: are these businesses that can stand the retirement of the key people, or were they businesses dependent on a few key people to create value? There are a couple of groups starting that shift, but it's early days yet. Some will accomplish part of the generational shift by selling a share of the management company to pension plans, etc because the intermediate partners can't afford to buy out the senior people. It's a way of providing liquidity to the senior people to allow them to exit. But there are others that will just fall by the wayside.'

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