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Institutional investor profile: Scott Delman, President, Capital Z Investment Partners

Delman on being a value-added investor, on succession problems, on why we'll see no more mega-funds, on the fragility of limited partnerships, on managing expectations and on the importance of secondaries.

Set up in 1998 and with offices in New York, London and Hong Kong, Capital Z is a global alternative asset manager. Its aim is to build a diversified alternative investments portfolio on behalf of Zurich Financial Services and to act as a strategic partner alongside emerging teams. It initially received $1.5bn from Zurich in 1998, which is fully committed, and now has a further $1.5bn from its parent to invest in private equity and hedge funds. Delman co-founded Capital Z and before that, was an executive director at Foreign & Colonial Emerging Markets in London.

What type of investments do you tend to make?
‘We have focused largely on funds that provide expansion capital or that undertake buy-outs. We took a long, hard look at the venture capital space when we set up in 1998 and made a conscious decision then that we did not want to allocate any capital to VC firms either in the US or in Europe. We felt that valuations were unsustainable. We thought that it was a terrific time for a general partner to be raising money, but we didn't think that it was an opportune time to have that capital invested.

‘As a result of that decision, our portfolio is currently more skewed towards buy-outs than you might expect to see with a more traditional private equity investor.

‘We have one venture capital fund investment in our portfolio. That has a focus on the Indian market - it is Westbridge Capital Partners and raised approximately $145m. But we have not made any commitments to European or US groups.

‘As for the future, we've been watching the technology correction that has been taking place. We are looking more actively at venture groups than we have in the past few years. We are a little unclear, however, as to how the venture capital market is going to evolve over the next few years. Industry observers are projecting a very significant contraction of the established private equity groups already in the market place, so it is unclear to me what room may exist for new partnership vehicles.

‘Having said that, we are in discussion with some venture groups in Europe and the US. We would be open to a commitment if we identify an opportunity that we are comfortable with.

‘From a geographic viewpoint, the majority of our unfunded exposure today is 40 per cent in Europe and the balance is split 31 per cent and 29 per cent between the US and Asia. Again, going back to 1998, we spent a lot of time analysing the Asian market after the financial crisis. We reached the conclusion that Asia would recover from the crisis and that the existing private equity community in that part of the world had been decimated by that crisis. These circumstances meant that the region offered a one-time opportunity for a few select private equity groups to build businesses from scratch that would become leading franchises in that part of the world. We took a highly calculated bet on this. We were in very good company - JP Morgan Chase, Carlyle and CVC all either established or expanded their Asian businesses at the same time.

‘In the US, most of the activity up to 2000 was in venture. So by virtue of having decided that we weren't going to commit to US venture capital, it was inevitable that there would be very few opportunities open to us there then.'

How will your geographic balance change in the future?
‘We will not make commitments to new private equity groups in Asia, with the potential exception of Japan, although we currently believe that it is premature to make a significant commitment to that market. We will continue to support the existing stable of managers that we have in our portfolio in Asia, but we do not expect them to be raising their next round of capital until late 2003 at the earliest.

‘We continue to be very positive about the private equity environment in Europe. So we expect to continue to make commitments there. We would also anticipate an acceleration of our private equity commitments to the US over the next 18 to 24 months.'

What is your rationale behind investing in management companies?
‘There are a number of terrific private equity investors out there who have terrific experience in making successful investments, but who have never run their own business at the management company level. We work very actively with our managers to help them with the institutionalisation of their business. That can be anything from their capital-raising efforts to developing their financial reporting systems to developing their investor relations and communications strategies and establishing their internal compensation programmes and succession plans. We believe that it is important for us to be a shareholder in the management company in order to be a value-added investor.

‘Zurich made a very substantial commitment to us. I can think of very few private equity groups that have received a comparable commitment from a single institution. As a result, we feel a very considerable fiduciary responsibility to look after Zurich's interests. We understand that private equity managers sometimes lose money on their investments and occasionally on the fund level. We don't like that and it's highly regrettable, but we have to accept that it's part of the risk inherent in this business. We have less patience with a manager who goes off strategy, or one who takes advantage of latitude in a limited partnership agreement to do things that vary considerably from the representations that they originally made to investors when they committed capital to the fund. We feel that, particularly with emerging groups, it is important to ensure that managers stick by their promises and focus on their core strategy.

‘If we are successful at helping these managers build an institutionalised business, then we'd like to be able to participate financially in the growth of that company.'

What do you look for in a private equity manager?
‘First and foremost, we are looking for strategies that, from an asset allocation standpoint, we feel comfortable committing capital to. We also look to put capital behind management teams rather than individual managers. We've often been approached by very talented managers looking for sponsorship, but they are sole practitioners. We encourage them to identify and recruit other partners before approaching us again. In the light of the ongoing consolidation within the financial services industry and the increasing transition from captive private equity shops to independent houses, we are increasingly seeing fully formed teams spin out of established organisations. We look at those as being very attractive opportunities.

‘We look for managers that not only have a proven track record of making money for their investors, but who can also demonstrate to us a proprietary value-added that leads us to believe that they will continue to make money for their investors going forward.

‘We are very concerned about alignment of interests within private equity organisations. One of the issues we feel that more established partnerships face is that the senior or named partners are no longer the principal deal-doers and so the economic returns are not flowing to the individuals that are doing the work. Key man provisions in the terms and conditions do not protect investors against the departure of the most critical players within the organisation. Instead, they tend to focus on the founder. If we felt that there was not an equitable carry arrangement among the team when we met them, for example, we would certainly want there to be an equitable arrangement before we decided to commit.'

Why do you think that succession has become such an issue?
‘You have a situation today in which the founders of established private equity businesses are still in their forties or fifties in most cases. They are not ready to give up substantial ownership or leadership of their fund, in large part because most private equity groups are not able to sell ownership interests in their business to third parties. Only a very small group of general partners has ever managed to sell their stakes in their business. In the absence of a founder having some avenue for liquidity in their business, it becomes more difficult for them to contemplate simply giving those economics to the next generation.

‘Historically, vesting arrangements associated with carried interest have served as a form of golden handcuff on junior partners. But as private equity returns have declined and as carry has become less valuable, those handcuffs have become much looser.'

What is the biggest issue in the private equity industry?
‘The single biggest issue is the management of expectations among both general and limited partners regarding the level of returns that people should expect through investment in this asset class.

‘The second would be that these partnerships are fragile human institutions and limited partners probably do not spend enough time understanding both the personalities and the structural mechanisms that exist at the GP and management company levels. I'm talking here about the key man provision, about carried interest structures, about how much capital the general partners are committing to a fund. I recently saw a fund in which the GP sold themselves to a large financial institution. As part of that transaction, they sold their entire personal financial commitment to the fund that they were managing. That commitment was taken over by the financial institution. The general partners as individuals no longer had any personal capital invested in the fund. There was nothing in the partnership agreement that explicitly precluded them from doing that. Limited partners just need to be aware of some of the pitfalls. People haven't historically spent enough time looking at those limited partnership agreements and understanding what could go wrong and ensuring that if anything did go wrong, that their rights and interests would be protected.'

What is the biggest mistake that you have made?
‘Our biggest mistake has been committing capital to a fund comprising a sole partner who we had known for many years. We relied on his ability to bring together the balance of his management team, which ultimately did not materialise. In the end, we were unable to go forward with it. We learned a lesson from that and have incorporated it into our investment process.'

What irritates you about private equity?
‘What irritates me most is the creation of mega-funds. If you have a vehicle where a management team is earning $50m to $100m just in management fees while also earning additional money from predecessor funds that still have invested capital, you have general partners being paid at a current compensation level where their carried interest amounts to nothing more than a free option. I anticipate that, as the balance of power has shifted in the last 12 months from GPs to LPs, LPs will take up the cudgels on this issue. I'm not sure, however, that the established mega-funds will need to cut their fund size in the future. My sense is that the institutions that are allocating capital to those organisations are ones that seek to put out large allocations to a limited group of funds. However, I think that it will be less feasible for the tier two funds - in terms of size - to move up to the mega-fund level.'

How do you think that the market is likely to change in future?
‘The great unknown in the market today is the pace and development of the secondary market. Clearly, if a vital and vigorous secondary market develops where institutions are able to rebalance their portfolios, that would be a very positive development for the private equity market. It would allow institutions to take money off the table for whatever reason and reallocate it to new funds in which they see opportunities.

‘If the secondary market doesn't accelerate considerably, the private equity market should prepare itself for several fallow fundraising years. Institutions in the US are over-allocated to private equity because of the decline in the public equity markets. They will continue to be over-allocated for some time. Their European brethren are joining them.

‘There are many people predicting increasing allocations to private equity among European institutions. That is the great white hope in the market. But I daresay that if you were to visit the third-party capital raisers in Europe today, they would be very discouraging about their ability to raise capital over the coming six to 12 months.'

Copyright 2002 AltAssets