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Institutional investor profile: Lauge Sletting, Managing Director, Partner, Nordea Private Equity

Sletting on theme-based investing, on the dangers of timing private equity markets, on why mistakes turn out to be blessings in disguise, on the increasing length of time to exit and on the decreasing focus on the liquidity premium.

Set up in 2000, Nordea Private Equity is part of Nordea Investment Management, the asset management arm of the Nordea Group, which has E108bn under management. It has one fund of funds, launched in May 2001, and has just announced a final closing at E208m with contributions from 14 Nordic institutions. It also manages separate client accounts. Sletting joined Nordea in September 2000 from Danish early-stage venture fund Novi and before that was head of investments in PensionSelskaberne. He heads up Nordea Private Equity and is responsible for development of the private equity programme at Nordea Investment Management.

What type of investments do you tend to look for?
‘We have a global mandate. We anticipate investing 50 per cent into the US and 50 per cent into Europe, but we are able to allocate up to 20 per cent in the rest of the world. We have a range for Europe, from a minimum of 30 per cent to a maximum of 60 per cent. We won't go to the limits in the current environment, but we are able to do it. Our current allocation is 35 per cent in venture capital and 65 per cent in buy-outs and special situations. Our early-stage venture exposure is all in the US and our European exposure tends to be in pan-European groups rather than local teams.

‘Our fund is euro-denominated, but we have a global mandate. If we see that there are more opportunities in the US than in Europe in the coming years, then we will invest there. The highest we can go into the US is around 70 per cent.

‘We will also look at co-investments in the future, but from a separate co-investment fund, and we will be looking at secondaries - we have already done one secondary investment in our current fund of funds.'

How does your investment process work?
‘We have a very specific investment strategy - we use a thematic investment process. This allows us to pick those funds that we believe will be the out-performers among top quartile players. Out of more than 600 funds on the market we, together with our adviser Hamilton Lane, pre-qualified 100 good top quartile funds to be candidates to our fund. Out of these we picked 13 for our fund of funds to invest in and others will follow. The philosophy behind the process is to identify different trends, which we describe as themes. Our rationale is that we believe that you can be more confident about your manager's ability to buy well if his focus is within sectors that have not been fully appreciated by the different markets. You can also be more confident about your private equity manager's ability to sell well if the investments benefit from a trend rather than a cyclical movement in the economy.

‘We select the funds where we believe the managers are able to find companies that can capitalise on the themes we identify. But it is also important for us to select the right managers who can add value on a strategic level or add value through hands-on management.'

So would you say that you take a contrarian view of the market?
‘You could describe it as contrarian, but it is more a unique approach. We combine a top-down analysis of themes and a bottom-up analysis of funds and industry cash flows. We identify themes by looking at the long-term structural changes in the global economy. A theme is essentially a longer term trend that will drive cash flows. We then identify the sectors that are most likely to benefit from those themes. We select funds on their ability to exploit the opportunities offered by a given theme or themes.

‘It is important to stress that this process is based on a team effort with a disciplined and structured approach to dealing with the large amounts of macroeconomic, fund and portfolio company data involved. Our public and private equities teams work together - that's about 30 people with different skills and expertise - to develop different themes. And from those themes, the private equity teams try to identify the best private equity firms operating in those areas.'

How do you identify the themes?
‘To identify the investment themes we analyse the big-picture changes that are evolving at an increasing pace. For us, structural changes are the forces revolutionising corporations, sectors and whole economies. They are the forces transforming today's world into tomorrow's world. Historically, investment processes constructed to capture the implications of these great structural changes, in combination with strict risk control, have generated above-average rates of return on a risk-adjusted basis. Currently, we are using three structural changes as a framework for our process: demographic changes, technological changes and globalisation. One example is the demographic shift that is impacting the welfare state in the western world. An ageing population is putting significant pressure on the healthcare systems with increasing costs for healthcare, while the pension systems are under funded.'

‘The process of finding and identifying themes is complex. Essentially, we are attempting to identify, systematically, processes of change in the global economy that lead to new opportunities for investment and growth. This involves analysis of macroeconomic, structural and cultural factors. Examples of such themes are outsourcing, privatisation, deregulation and data communications. They are clearly visible, yet their effects are not limited to any individual sector. Hence, part of the process is to determine the consequences of a theme across a number of sectors. But simply identifying a theme isn't enough. We have to have confidence in the theme and we also examine the conditions that will mark the end of a theme's dominance.

‘Two or three years ago everyone was playing the data communication theme by investing in telecom capacity. Valuations were high and people were following each other into the market. If you had the best private equity managers in that space, you might be doing less badly than some others now that valuations have fallen. But if you had done this through a fund that had figured out that the sector might run into over-capacity and therefore focused on enabling technologies into communication and other areas, then you would have been doing much better now.'

How do you find out about good investments?
‘We screen the market and take a proactive approach. We want to see every fund that fits within our thematic investment process. We have joined forces with the adviser Hamilton Lane, which specialises in US and large European private equity funds. They can bring us opportunities in these areas. In return, we can bring them funds that we see in the Nordic and European market. This relationship means that we can exchange views on funds and their strategies. We bring the top-down approach, the thematic view; they recommend funds to us that we can then analyse to work out which ones will outperform. This way, we optimise our time and our skill sets.'

What do you look for in a private equity manager?
‘We look at the quality of the team, how well connected they are, the team track record and, importantly, individuals' track records. We focus heavily on a fund's deal origination capabilities and on its strategy. We want to see that a fund is able to source the best deals and invest in the best companies. So in a local fund, that would mean ensuring that the team has a good local network, that it has good relationships with local M&A advisers. We would also look at whether the larger financial institutions back them, so that in an auction the banks will be able to write them a cheque. There is no point going into an auction if the firm can't guarantee that the banks will act quickly on its behalf. That's important.

‘Then, of course, we look at a fund's value-added strategy, how the team makes operational improvements to portfolio companies. We will look at how much the portfolio company's increase in value has been down to the wider business cycle and how much to the real improvements that a fund has made.

‘We spend a lot of time interviewing private equity managers. We ask them about their strategy, why they have invested in particular companies, what the rationale is for their strategy, what their views on certain themes and trends are. That gives us a feeling about whether they are on the right track. We can tell from these conversations whether they are trend-setters or trend-followers. We have been very well received by funds because we have given them the opportunity to explain their strategy. We say to general partners: show us your portfolio and then we can talk strategy.'

‘We want to back managers that really understand the sectors and the companies they are investing in. To get a feeling for this, we are able to bring in our own specialists from the public equities side. We get them to talk to the managers about their strategy, and to test their skills and abilities. We like to get under the skins of the management team to see how much they have faith in their own strategy. If we find that they are too opportunistic in their approach, then we won't invest because we believe that they are likely to stray from their strategy. Of course, they should occasionally be opportunistic, but we look for highly focused funds that can grow and continue to be great at what they are good at.

‘And, importantly, we look at their ability to exit. We find out what their exit strategies are, whether they partner with other venture groups etc.'

What advice would you offer to an investor new to private equity?
‘We would advise new investors to invest on a continuous basis. Don't just go into the market in one year, but have a long-term investment plan. Commit capital over the years. Don't believe that you can time the market in private equity. It is cyclical, but you have to be invested for a long time before you see great returns. You also have to be invested on a global basis and have a clear diversification strategy. Investing via funds of funds can help you do that. If you have a large amount to invest, you might also want to consider investing via a separate client account to ensure that you get a precise mix that is right for your portfolio. If you do invest via funds of funds, try to find those that add value to the process by following a specific strategy. Otherwise, you end up with a large number of underlying portfolio companies that simply make up what amounts to an index.'

What would you say is the most exciting area at the moment?
‘It's impossible to pin-point just one theme. But the most exciting thing for us is if we can add themes on themes. So, for example, you could have a sector that is benefiting particularly from a demographic driver such as the healthcare sector, but also benefiting from deregulation and outsourcing services from governmental institutions. The best opportunities for us are where we can take advantage of more than one of our 13 identified themes in an investment.'

What is the biggest mistake you've ever made?
‘My biggest mistake so far was probably when I was a venture manager and investing directly into companies. This particular incident occurred in 1996. We invested in a dot.com company and then sold it seven months later at an IRR of 200 per cent. At the time, we thought that was an excellent IRR to achieve and that it was a really good deal. Three years later, the company raised new capital in a third round and had we waited to sell at this point, we would have achieved an IRR of 5,000.

‘It turned out not to be a very big mistake, though. One year later, the bubble burst and only one investor, one of the founders, managed to get out with any money.

‘I think that with private equity, something that you may think is a huge mistake at the time often turns out not to be. Timing is, of course, crucial, but it's impossible to time things perfectly in every instance. So there were two lessons learned from that episode.'

What is the biggest issue in the private equity industry?
‘The biggest issue is returns. We have to show investors that we can return money. We have to demonstrate to them that we can grow the value of their investments.

‘Returns are related to the IPO market to a high degree. The focus now is on how well priced large cap companies controlled by the larger MBO funds can be launched on the stock market and how much money they can return. I think that we will see more IPOs over the next year for raising extra finance rather than for straight exits. This means that we should see increasing valuations, although we will have to wait for a while after IPO until we see our returns.

‘The average age of a company conducting an IPO on the US market has gone up from four years in 1999 to 12 years in 2001. And the percentage of IPOs with negative earnings per share has declined from 79 per cent in 1999 and 2000, to 49 per cent in 2001. This indicates a much more conservative IPO market and the latest developments in the stock market indicate that it will take many years before the market is open for venture exits again. The last time the average age of companies going for IPO was so high was in 1992. It took seven years before it came down to four years.'

How do you think the market will change in the future?
‘I think we will see consolidation in the venture market and from that I think that some really good groups will emerge. There are good entrepreneurs out there and there are good technologies, creating new products. But the process of transforming them into businesses is rather easier in the US. I think that one of the issues is that Europe is going through a transition period for venture. The process of attracting the best and most experienced management teams to grow companies is a slow process. That is a large problem for early-stage groups in Europe and only a consolidation can solve this problem.

‘European institutional investors will invest more in private equity as a way of diversifying their portfolios. In the Nordic region we expect the allocation to go up to ten per cent in the next five to ten years. If institutions invest only in public equities, they are missing out on excellent opportunities in, say, technology. Many of the best companies with the best technologies will be sold to strategic buyers. Those with just public equity exposure will only be able to access these companies by buying into the large corporations that buy them. They will be paying a high price for that upside. Investors will need to get in early, and that means investing in private equity.

‘I also think that institutions have learnt a valuable lesson over the last few years. Private equity is not a liquid investment, but then neither is a large part of the public markets when they are in crisis. Investors cannot sell on their public shares when the market is plummeting and they need to lower their exposure - only big companies can be sold. As a result, I think that the focus on the liquidity premium will decrease. Of course, for a large part of their portfolio, institutions need to be liquid, but we expect to see an increase in private equity investments, taking market share from the small cap and emerging markets.'

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