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Institutional investor profile: Thomas Kohlmeyer, Partner, Extorel Private Equity Advisers

Kohlmeyer on the gap between logic and the actions taken by some investors, on the limited scalability of private equity, on the frustrations of the German tax and legal situation and on what the future holds for the fund of funds market.

Extorel Private Equity Advisers is an independent private equity adviser based in Munich, Germany. It was originally founded as a family office vehicle for the Technologieholding Managing Partner Falk F Strascheg. In 1998, the firm enlarged its business scope by launching a fund of funds for high net worth individuals and now manages approximately E500m for a number of clients comprising families, institutions and high net worth individuals. Kohlmeyer joined Extorel in 2000. Before that, he had been working as a fund of funds manager for the European Investment Fund in Luxembourg. He joined the EIF from Dresdner Kleinwort Benson in Frankfurt, where he was responsible for German direct investments.

What type of investments do you tend to invest in?
‘Our key philosophy is that private equity is only scalable to a very limited extent. We therefore target clearly focused quality teams, with a mixture of entrepreneurial, industrial and private equity background who are still eager to perform. These can be brand names who kept their feet on the ground over the recent hype years as well as promising spin-outs of existing teams - a phenomenon that we think we will be seeing more often over the next years.

‘From a historic point of view, we are a European player as we know this market best. In addition, we have long standing relations with some leading US private equity firms through our family office activity. We are not as familiar with the Asian or Central andEastern European markets so these regions tend not to be our prime focus.

‘When we define an investment strategy for a client, we consider their requirements for diversification, portfolio composition and risk/return profile expectations. For some we would only invest in Europe, for others we would build a mixed portfolio to varying degrees depending on their individual allocation needs. We tend to recommend a certain bandwidth within the set allocations targets. Quality of the underlying investment opportunities rather than pure overall allocation targets should be the overriding principle governing the way in which you invest.

‘Within these parameters, we take a bottom-up rather than top-down approach. Our team consists of people who have either been entrepreneurs or who have done direct investments themselves. In selecting good fund managers it is very important to be able to ask the right questions, judge the answers and focus on the essential areas during due diligence in order to identify the strengths and weaknesses of a team. We believe that you can only assess these points effectively if you have had hands-on experience of doing these things yourself.

'We choose teams with a mix of skills that fit their investment strategy and a clear emphasis on entrepreneurial and/or industrial experience - that applies to both venture capital and mid-market buy-out funds. The teams must have the potential to create value by leveraging the experience of their individual careers into the portfolio companies. At the larger end of the buy-out market, operational and entrepreneurial skills are not as important because the upside relies much more on efficient financial engineering. We could invest in large buy-out funds, but in our opinion we can add much more value for our clients by sourcing and managing investments in small and mid-sized venture capital and mid-market buy-out funds.'

What size investments do you tend to make?
‘It depends on the programme we manage, but our normal bite size ranges from anything between E2m and E15m. The investment size goes back to what I was saying about our preference for smaller and mid-sized funds. Unlike some investors, we have no problem investing in funds that are significantly smaller than E100m. Our experience has been that the small to mid-sized funds have tended to do extremely well - the returns they have yielded in terms of cash multiples have been comparatively better than some of their larger competitors. They tend to be more hungry than large teams since carried interest - and not the management fee - is still the driving force. This is not a matter of size as a dogma, rather the balance between deal flow, resources and investment strategy.'

How do you find out about investment prospects?
‘Our team has various personal networks through which we source opportunities. Often we find that the most interesting prospects are the ones that we learn about before they come to the market. We are quite proactive in our approach as we are known to serve GPs also as a sounding board in the early stages of their fund raising process.

'We also have a number of funds on our radar screen that we track through their funding and investment cycles and if we are particularly interested, we contact them before they go out fundraising. We also do re-ups with existing funds if we are satisfied with their performance. Entrepreneurs are another source. They often recommend teams to us. They are a very good source for finding out about the myths and reality of a fund manager's activities. They often have a very clear view on which GPs are able to add real value and for what reasons - after all, they are the end-user.'

Which opportunities would you like to see develop?
‘We would like to see an improvement in the German legal and fiscal environment. We would welcome a more considerate policy on tax and legislation so that the private equity industry can operate in a more stable and predictable environment. After all, private equity investors take an entrepreneurial risk from which the economy as a whole benefits. Innovation and growth is fuelled by entrepreneurs that are willing and able to take their ideas into the market. These entrepreneurs need investors who are able and prepared to back them and share the risk. If an investment in Germany is done under certain assumptions, the investor needs to have confidence that these will remain valid for more than a year or two. Many investors in Germany are currently holding back on investing because of the prevailing uncertainty. The government needs to be more precise about its private equity policies - after all, politicians are happy to benefit from the economic impacts, such as jobs and wealth creation, but they seem unable to see that investors should be fairly rewarded for taking the risk associated with creating these benefits.

‘I would also like to see a standardised European private equity fund structure with the same taxation and transparency implications in the different European jurisdictions. It currently takes a lot of time and resources to structure a fund so that it is tax-efficient. We would rather use this time for sourcing and investing in the best opportunities.'

What do you look for in a private equity manager?
‘We look for good quality teams with sound proprietary deal flow at appropriate risk-reward profiles. Overall, though, it depends on the strategy of the portfolio we are managing and the risk appetite and needs of any given client. So, first we check whether an investment opportunity fits with any of the given strategies we have under management, then we go in more depth to assess it.

‘Quality of the team is the overriding factor in all of this. This means that the team has to have an attributable private equity track record. Often in these types of investments, the good quality teams have more operational than asset management experience. We are searching for a good mix of skills - a mix that has been there for a long time so that we know that the various team members can work well together.'

How does your investment process work?
‘The first stage for us is to assess on paper whether the fund is interesting for us in principle. Unless the fund is completely outside our investment scope, we have a meeting with the manager to get an initial personal impression of the team. The next stage is to do reference calls to complete our first impressions. At the same time we carry out desk research and due diligence. We check track records, taking further in-depth references, from our own contacts as well as those on the list. Based on that, we are able to identify or define areas in which we would like to dig deeper.

‘We then like to spend several days at the firm's office interviewing the entire team -from the managing partner to the support staff. We also talk to many portfolio companies, competitors and other LPs. We try to accumulate as much data as possible to get a realistic view of how the team operates and how well they fit our criteria. During the entire process, we look for an open and honest discussion with the team. There is no such thing as a perfect manager. You simply have to be able to identify and weigh up the risks against the potential upside. Some of those risks you can address with an appropriate structure, others you can avoid, but there will always be risks left, so the management team has to convince you that they are able to handle them appropriately.

‘At the end of the day, it's mainly about management. The fundamentals have to be there, but you have to be able to judge whether a team will be able to create value and to weather the storm, because storms will inevitably come at some point.'

You talk about looking for hands-on managers. How hands-on are you as an investor?
‘As investors, we are as hands-on as necessary and as wanted. We like to have a seat on advisory boards, but we also tend to have an informal dialogue with fund managers on an on-going basis. It's important and it is part of a GP's due diligence to stress what we do and where we could add value. But we never forget that we have backed the GP's judgement. We pay the fund manager to take responsibility for and execute the investment strategy and so we usually don't want to second-guess the fund manager's judgment. Obviously, it is a different matter if the fund is not running in the direction we expected. Then we will seek a way to improve the situation - either constructively or, if necessary, more forcefully. A fund of funds manager can add value beyond fund sourcing, selecting and managing - he should be able to negotiate terms and structures that enable him to take some kind of action if things aren't going according to plan.'

What is the biggest mistake that you've ever made?
‘I think that looking back, you always get smarter over time. But there have been occasions when we feared that things haven't been going too smoothly for a fund. We have given the GPs signals to resolve the situation, but they haven't always reacted as we would have liked. It's hard because you have to find the right balance between giving the GPs the chance to take their own initiative to improve matters and attempting to enforce change. Private equity investing is all about being part of the same team. Both GPs and LPs live or die by the same sword. However, sometimes you have to acknowledge that you can't trust the cat to save the cream. You can waste valuable time, if the cat turns out not to be suitable for the job.'

What irritates you about private equity?
‘I get frustrated by the gap between logic and the actions taken of some investors. If you talk to investors about private equity and the fact that it is a long-term activity, that it is damaging to dip in and out of it, while at the same time it is anti-cyclical, they will understand. What I just don't get is that many investors yet don't abide by this logic. They are trying to get the full upside with full downside protection, total liquidity and build a portfolio from scratch in one year. That's not the way it works. Investors coming in and out of private equity over short periods only serve to distort the market - and that can be harmful not only to themselves, but also to other investors and to funds and eventually portfolio companies. I sometimes get irritated by this lack of long-term discipline.'

What is the biggest issue in the market?
‘I think that it depends on which part of the market you are talking to, but clearly one of the biggest issues in the market currently is the interruption in the cycle. The capital markets are not functioning well and they are not taking up private equity-backed companies. That is a serious issue for both funds and investors because realisations are very difficult.

‘Institutional investors are clearly struggling in other areas with their portfolios and that means that private equity is currently low down on their list of priorities - they are far too busy putting out other fires for them to devote much time to private equity.

‘Reporting and transparency are obviously a talking point at the moment. But I'm not convinced that it will be possible to make the market absolutely transparent to everyone for various reasons. After all, a substantial part of the upside in private equity results from using inefficiencies in the market effectively. However, in terms of reporting I think GPs can never do enough to provide their investors good quality, clear information on their portfolios - the key data. On the other hand, they also need to make it clear that the reports they receive are based on interim valuations and that at the end of the day the golden rule of buy low sell high applies. Only after you have received the cash distribution are you 100 per cent certain about the value of your portfolio.'

How do you think that the market will change in the future?
‘I think that we will see consolidation at all levels. We will see portfolio companies disappear, many fund managers won't raise another fund and the same goes for funds of funds. Limited partners too, will undergo some form of consolidation - you only have to look at some of the insurance companies that are facing major difficulties. In my opinion this also offers opportunities for the private equity market. The competition is fierce between institutional investors. They need to manage their portfolios more efficiently in order to outperform their competitors. This means that they have to invest in alternative assets to get that extra edge of returns. If they stick to the more traditional asset classes, their returns will only be mediocre. Private equity can help boost their overall returns. In Europe we see a good potential with institutional investors who have to increase their level of alternative assets.

‘In terms of the advisers, I think there will be a bifurcation of the market between the large asset managers and the specialist boutiques. For the small and medium-sized institutions, in particular, these boutiques will be able to offer tailor-made private equity programmes to accommodate their individual needs. They will get a lot of value out of that in terms of access, investment experience and helping them along the learning curve. The larger groups may be able to help out those institutions with a large allocation. But the question is whether the market has the capacity to soak up that capital. In addition, the amounts that they will need to put to work in each commitment could preclude them from participating in many smaller to mid-sized funds.

‘Overall we feel that private equity as an asset class is still comparatively young in Europe. Based on the currently prevailing quota of private equity allocation by institutions, there is still plenty of potential. Finally, innovation, technology and changing environments will always be the driver of modern economies.'

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