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Institutional investor profile: Marc der Kinderen, Managing Partner, 747 Capital

Der Kinderen on the hunger of smaller funds, on finding teams with an ‘edge', on the pitfalls of cornerstone investors, on investors who blame the industry for their own mistakes and on not following the herd.

Based in New York, 747 Capital was established in 2000 as a result of a buy-out of the US operations of Greenfield Capital Partners. With $50m under management, the fund of funds has a number of European high net worth individuals and smaller institutions as clients. It has also built relationships with large European institutions for which the firm acts as an advisor. 747 Capital invests solely in the US with a spread across venture capital, buy-out and mezzanine markets. Der Kinderen was one of the founding members of Greenfield Capital Partners when it set up operations in the US in 1994.

What type of investments do you tend to look for?
‘We only invest in the US. Our remit is to provide our clients and limited partners with a gateway to US funds. Our philosophy is not to time the market in terms of investing by industry. If you make investments in technology today, for example, you cannot predict what the environment will be like in five to seven years from now when you start harvesting them. Our belief is that you should invest consistently across the whole market and focus on selecting teams that are well positioned for success rather than to try and time an industry allocation.

‘Our specific focus is on the smaller funds - those of between $100m and $400m. If you are in private equity, which is an illiquid asset class, you should demand a higher return than when you participate in public equities. We believe that the inefficient market that the smaller funds are operating in provides greater opportunities to achieve higher returns. Private equity manager selection in this part of the market is particularly key, of course. It's easier to make mistakes with smaller funds, but our job is to select the best positioned teams for our clients.

‘We build an “enhanced” index of private equity funds that does not include any of the larger funds - some of these larger funds are a good addition to a private equity portfolio, but that isn't an area we invest in. Within our segment, we are pretty equally split between venture capital and buy-outs and we occasionally also invest in mezzanine. In our venture capital investments, we have about 30 per cent committed to healthcare and the rest to other types of technology.

‘We do not do secondary investments. We feel that you need specialist expertise to invest in this market successfully. We expect our limited partners to do the same analysis on us as we would do on a general partner. We would not be very happy if, for example, we were looking at a GP that had two very separate areas of expertise and focus. Equally, it makes no sense for us to do that.

‘We have done some co-investments. Some of them worked out very well; others fared less well. If we decide to do further co-investments in the future, we will go for those in which we are able to add some value, primarily by being trans-Atlantic. I imagine that those opportunities are likely to be more in later stage transactions than those in early stage. You cannot build up a well diversified portfolio of early-stage co-investments and so it is less risky to opt for later stage companies.'

What is your appetite for first-time funds?
‘We invest in first-time funds if the team has worked together before. Our rationale for doing this comes down to our overall philosophy: that investing in private equity should provide investors with enhanced returns because it is such an illiquid asset class. As I've said, we believe that the inefficiencies in the smaller segment of the private equity market are higher than those at the larger end. A significant share of those smaller funds are run by emerging managers because of spin-out teams, etc. These managers are likely to be in an inefficient market and are often much more hungry to fight for each deal. We believe that if we combine the inefficiency with the hunger, you will end up in fund sizes of between $100m and $300m and many of those will be, almost by default, emerging managers.'

And what is your view if they increase their size in subsequent funds?
‘If they increase their fund size significantly, then we have to consider very seriously whether we want to participate in the future. That does not mean those funds are not attractive - their teams may have grown and their new approach may have merit. We look at each fund separately each time but you also have to consider our clients. They will have programmes that include much larger funds than the ones we invest in. They use us as their team on the ground in the US for the smaller US funds. If they want to invest in a fund that has grown outside our sweet spot, that's fine, but it's not for us to do that.'

How does your investment process work?
‘We have been in the US for over ten years in the fund of funds business, and so we have built a very large network. Most of the funds that we see come through this network - we either know them already or they hear about us through their own network. We also actively manage our network to get new deals. We talk to our general partners - that is usually a great source of new opportunities for us. Of course we also research the industry's literature and cold call on teams when we are travelling. We cover our segment of the market pretty well.

‘The first part of the process is to prepare well by reading the PPM and to have an initial meeting during which two of us assess quickly whether we can positively relate to the team in terms of their experience, personality and ethics. We also quickly zoom in on their pitch on having a differentiating approach to investing.

‘So, in this first meeting, we hear the pitch, get a feel for the team and work out whether we believe in their investment philosophy. Then we go out and we talk to people that are in similar spaces - often, that means talking to our network of GPs. We ask them what they think of the team and the opportunity they are pursuing. From this we can build up in our team a feeling of consensus as to whether the team has an edge, whether the market is truly there and whether the team can really execute their strategy.

‘If we have a good feeling about it, we will visit the team's offices. They always want to kick the tyres when they look at a deal and we want to do the same. We spend a couple of days there, talk to them, go to dinner with them to get a really good feel for them. We also talk to various of their portfolio companies. We pick between five and ten deals, find out how they were sourced, who sourced them, talk to the management team to find out how the firm negotiated, added value, etc. We will also normally know various of their co-investors in deals who we can contact to assess how the team performs. We will then work all the way through to the exit. We want to get a feel for how the deals were put together both on paper and in reality and so we'll talk to the deal source, maybe a broker, all the way through to, say, the investment bank that took the company public. When we have followed that through on up to ten companies, we have a very good idea of how well a team is able to execute a particular strategy.

‘Then, of course, comes the due diligence in terms of background checks, legal review and term analysis, etc. After all that, we are able to say either yes or no.'

What do you look for in a private equity manager?
‘We look for a solid team that has identified the right opportunity for them - you need both elements to be successful. You can have a great team, but if it doesn't have good opportunities, then it's not going to work. When you look at the team, you want to make sure that the members have joint transaction track records - that they have worked together on deals and that you can go back and trace them. That doesn't mean that they have to be raising fund four or five; we will invest in first-time funds. But they must have worked together as a team before and we must be able to go back and verify that they did a good job.

‘The team also needs to be hungry and enthusiastic. They have to have the right entrepreneurial, keen attitude and want to build a quality firm with a long-term view on partnerships and investing. We're not looking for corporate finance professionals who are after the next big deal. Obviously, they also have to be very honest and they need to have a very deep knowledge of the area they are investing in - that goes without saying.

‘But we also look for something else. We look for teams with an edge. They have to have a competitive advantage over people in the same space. Many funds come and tell us that they are great at early-stage technology, for example, that they have deep domain knowledge, that they have worked together for a long time, etc. When we turn around and ask them what makes them different from their competitors, they are often unable to tell us. For them, it's enough that they are good at what they do. But we believe that, to achieve higher returns in private equity, you have to have an edge.'

How would you define an ‘edge'?
‘It depends on what stage of private equity you are talking about. It can be very different in venture capital, for example, from that in buy-outs. By way of example, we looked at a mezzanine fund recently. Mezzanine funds generally use large buy-out firms as a deal source and the only way that they can really compete is by having a good relationship with those buy-out funds or by being cheaper. As an investor, you don't want to be in something that's cheaper. The one that we met is a true one-stop shop. It delivers mezzanine as well as equity and it goes into deals in stand-alone, non-sponsored transactions. It gets its deal flow in a similar way that a buy-out firm would, rather than relying on the buy-out shops. So, here is a mezzanine firm that sources its own deals and competes with buy-out funds. You may disagree with the strategy, but that firm has an edge. If a fund doesn't have an edge, we won't invest in it. We are in the market for inefficiencies, not for auctions.'

What's your view on investing in funds with a significant cornerstone commitment?
‘If we are looking at a fund that has a cornerstone investor, we really want to be able to understand how the deal works. We need to be sure that there are no material conflicts of interest. We need to know every single detail of the arrangement. If there are no problems with it, we are happy to invest. But in some cases, we find that a large cornerstone investor is taking part of the carried interest. That may be fine for the first fund, but if it carries through to subsequent funds, you have to wonder how motivated the team is going to be - there may be fights, people leaving, etc because they are not getting the full benefit of the carried interest. In that case they may have made a pact with the devil. In some ways, it's like looking at a team that is part of larger institution, and that is something that we are not likely to consider.'

What advice would you offer to a new private equity investor?
‘The best advice that I can give is to take your time to build a diversified and solid portfolio. Don't follow all the other limited partners with the newest trends. You are in this asset class to make an enhanced return. You can't do that very well in an efficient market so look for experienced teams with unique approaches to investing, not just a good historic return. Private equity teams must have an edge, either on deal sourcing, portfolio management or in generating exits. Build your own vision of where you should be in terms of portfolio allocation - maybe with the help of advisors - and then execute that strategy. It may take a while to form a view, but don't just follow other people because the difference between good and average is very large in this asset class.'

What is the biggest mistake that you have ever made?
‘The biggest mistake I have ever made was participating in a venture capital fund that was part of a large, reputable bank and believing that being part of that bank was the fund's edge in terms of deal flow. I was totally wrong about that. The political scene in the bank - people getting fired, people leaving, deals being done for the wrong reasons, conflicts of interest - caused problems. So my mistake was thinking that a fund being part of an investment bank was an edge. I now know that it can't be.

‘Don't get me wrong. Some of the teams in these captives are great; their association with their parent company isn't. If the team spins out from the organisation, then that's a different matter. We're more than happy to see them then.'

What irritates you about private equity?
‘I get annoyed by the fact that so many people who invest in private equity still have inappropriate risk/return expectations. You have to understand what you're participating in. If you want to invest in venture capital, the rough times we have had over the last couple of years are a part of that. If you build a well diversified portfolio, you can mitigate that risk. But we have spoken to so many people who started investing in venture capital in 1999, put all of their money in three or four technology funds and who are now complaining about the asset class. That irritates me. If you participate in a consistent and diversified fashion, if you do your homework and if you select the right manager, you are going to outperform any other asset class. But do not jump in, pick one or two managers because you like them and then be surprised when you lose 70 per cent of your investment. If you did that, you made a mistake - don't blame the industry.'

What is the biggest issue in the industry?
‘The biggest issue is that there is significant capital out there with the larger funds, while there still not enough capital available for the smaller funds. There is a huge discrepancy between the two. We are now seeing the larger funds trying to move into the opportunities at the smaller end, but that isn't their historic background and so they are unlikely to do a very good job.

‘I think that the initiative being taken by some of the larger funds to release their limited partners from part of their commitment will help in this respect. It shows that some of them recognise that they can't play in all sectors of the market. If you have a billion-dollar fund, it makes no sense to invest in a $5m start-up. Throwing $50m at it is not going to make it any more successful. I think we will see more of these firms handing money back.

‘I also think that the secondary market is positive. Providing a route to liquidity for limited partners for whatever reason - strategic, financial, whatever - that is positive. It also takes a lot of the burden away for the general partner. They need to worry less about their limited partners' financial health if there is an active secondary market.'

How do you think that the market will change?
‘The market will become better understood. That will, in turn, mean that it will become more professional. It will also become much more transparent with more benchmarking - you will be able to compare track records of different funds. However, I think that the underlying premise of private equity will never change: you have to have the right team in place working in an inefficient market to take advantage of opportunities that no-one else has exploited. That means helping small businesses with great potential to build larger, successful companies. That market will always remain inefficient and will not change.'

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