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Institutional investor profile: James Pitt, Managing Director, Primary Fund of Funds, AXA Private Equity

Pitt on the attraction of small, regional funds, on the inherent inertia in private equity investing, on the living dead of the asset class and on faddish funds.

With a total of over E4bn under management, AXA Private Equity is made up of a direct investment business and a secondaries and primary fund of funds division. The firm also manages a number of AXA's balance sheet investments. Together, the secondary and primary funds of funds have over E1.7bn under management. The primary fund of funds invests in the US and Western Europe across all stages, although it has a preference for smaller, regional players. It has so far raised two generations of funds, both of which are split into euro and dollar-denominated funds, and is to start raising its third fund early this year. Pitt joined AXA's London office at the end of 2002 and was previously a Managing Director at private equity firm Whitney & Co.

What type of investments do you look for?
‘Our funds are split between euro and dollar-denominated funds, which means that we have a basic geographic division between the US and Western Europe. Within that, we commit across the main stages of investment. The actual percentages vary according to fund, but we invest predominantly in buy-outs, venture capital and growth capital. We do look at mezzanine, although today it is not a major proportion of our allocations.

‘From the very beginning, we have tried to build a very balanced portfolio between the geographic regions and stage'.

‘Beyond that, we very much like investing in specialised, regional funds. We do invest in some of the larger buy-out funds, although we spend a greater percentage of our time looking at the smaller funds that specialise in particular geographic regions both in the US and Europe. We are quite unusual for a fund of funds because we operate out of four offices - New York, London, Paris and Frankfurt. That means that we are close to the ground in our target geographic regions.'

What is your rationale for seeking out smaller regional players?
‘Part of the rationale for investing in smaller regional funds is portfolio-building. We want to have some element of regional control over our asset allocation. Some people are content to do that just at a pan-European level. But we are a European firm and we have a view on each of the markets and of how much capital we would like to allocate to them.

‘The other part is in seeking out superior performance. The pan-European market is pretty well known and well understood. There are some very good firms there. Hopefully they are not going to surprise their investors too much on the downside, but equally they are unlikely to surprise them too much on the upside, either. It's a heavily auctioned and intermediated market. With the smaller, regional firms - when I say regional, I don't necessarily mean country-specific, it may even mean firms that focus on, say, north-west Italy or south-east France - there are a lot of good managers with sub-territorial focuses. It comes down to the fact that we are looking for good teams with a unique focus. If you are another London-based team that is aiming to do mid-market deals in continental Europe, you are probably not very differentiated. But if you are a team based in the South of France and you have been working together for ten years and you have got a good track record, then you have something pretty unique. These teams are probably better placed to find and execute interesting deals.

‘It's just one of the ways that we aim to serve our investors by adding value.'

How does your investment process work?
‘Broadly, we use a six-step process. Our first consideration is whether the fund fits our investment mandate - is it the right vintage, stage, geography? When we meet the team, we have to establish whether the fund fits our criteria. Does the team have a good track record? Is the team stable? If it passes this stage, we would take the investment to the in-depth due diligence stage. The length of time this takes obviously varies according to how well we know a particular team. If we know them well it can be relatively quick. The next step is going through documentation and negotiation, after which the investment would go to our final committee to approve it. And then finally, importantly, we monitor each of our investments on an ongoing basis. The whole process, from meeting a new fund through to committing takes us between three and six months on average.'

What is your appetite for first-time funds?
‘Whether or not to invest in a first-time fund is always a harder decision to make than with an established group. But I think that if you just invested in established players, you would probably not achieve the best track record. You need to spread your nets wider than established teams - and we certainly do. By first-time funds, I'm talking about spin-outs and established teams in which at least some of the members have worked together before. We will make a small number of this type of investment this year. But like all investors, we are fairly risk-averse and so we do not want to have too many first-time funds in our portfolio - they are inherently more risky than the well established teams.'

What do you look for in a private equity fund manager?
‘We look for a wide variety of things in a fund manager. First of all, we need to like their strategy. It has to be unique and well suited to the environment and the team's capability and experience. We don't like me-too funds. We look for people that we will get on with and that get on with each other.

‘We examine their deal flow to see whether they can generate true proprietary deal flow or whether they are deals won through a series of auctions. This is not a trivial question. A lot of firms struggle to generate sufficient deal flow.

‘We also look at a team's exit record. Many teams are able to execute good deals but are not great at exiting their investments - a vital point for investors. It's obviously been a tough environment for exits recently, but some firms have managed to realise investments. The returns haven't been as good as they have been historically, but they are at least making distributions to investors. It's quite a good time to be an investor now because the current environment has really showed up those teams that have thought carefully about their exits and those who simply relied on the IPO market. I'd say that times have been less hard for the smaller end of the market. These firms tend to have thought more about exits because they have traditionally been more involved in M&A activity than IPOs.

‘Clearly, we look for a good track record and the way in which that has been built. We'll look at the success ratio because it's obviously risky to go with teams that have an excellent track record that is based just on one or two good investments.

‘We look for disciplined and rigorous teams. But we also look at whether a fund is a prudent size. Many smaller firms have invested very successfully, but they now want to step up in size considerably. You have to ask whether their success is likely to continue with a larger fund. Many of them attempt to deal with this by hiring in a lot of new people - the question is whether the firm can accommodate that.

‘And lastly, we look at the terms of the deal and whether the interests of the LPs and GPs are aligned.'

What puts you off investing in a fund?
‘We are put off by funds that are faddish. We have come across a number of people who are clearly straying away from the areas that they know. We are seeing this particularly in the mid-market. There are quite a few managers out there who are attempting to construct a fund based on investors' criteria rather than on their own skill set and experience. It's normally pretty obvious when they do that, but it can be frustrating. We would rather that they stuck to what they were good at.'

What is the biggest mistake that you've ever made?
‘Probably the one that we don't yet know about.'

What irritates you about private equity?
‘One of the most irritating features of the market is conflicting market statistics. It's always a tricky exercise trying to reconcile all the different sources of private equity market information.'

What is the biggest issue in the market?
‘There is still too much venture capital around. Too many 1999/2000 funds are still charging full fee levels even though they will never make any returns - many of them will return only a fraction of their investors' original capital. These funds are reducing the size of their teams to the bare minimum and then living off the management fee. They will never raise another fund and are the living dead of private equity.

‘There is a lot of inertia in private equity because it takes a long time for things to happen. Fund structures are designed to be long-term vehicles in which GPs have a lot of control and so it is very time-consuming to effect change. It will happen, but in the meantime, a lot of money is being burned - and that is money on which there will never be a return.

‘Investors are becoming increasingly active, but the practical problem is that there are a lot of limited partners in each fund. Getting 40 investors to act in concert is extremely difficult. So you have the inertia on the GP side because change isn't in their interest and you have the inertia on the LP side because it is so hard to organise such a fragmented group.

‘Fund reductions are happening, but not at the rate they should be nor of the magnitude they should be. That is a result of funds that are upfront and honest about the environment in which they are operating. But equally, there are a lot of funds that are less willing to be upfront. When we look through their portfolios - we spend a lot of time looking through and valuing portfolios - many of our professionals have prior direct investing experience - we find that we would value them at a small fraction of the amount they have reported. We have a very good idea of what these assets are worth because AXA Private Equity is also a large secondaries player. That gives us a good view of what the market is prepared to pay for those assets. Managers just need to be a bit more honest and upfront going forward.'

How do you think that the market will change in the future?
‘If we were to look forward five years, I think that there would be a far smaller number of players in the market. There is currently a long tail of small and mid-sized firms that will not raise another fund, a particularly acute situation in the US. I think there will be a cleaning up of these funds - that hasn't really started yet. A lot of people have talked about wholesale mergers, but I don't see that happening. Rather, firms will quietly go away. The pressures are starting to build. Investors who up until now have been waiting for an act of God, are starting to realise that there are firms out there that will never make them any money. They will start to act.

‘As a result of this clean-up, I think you will see a concentration at the large end of the market, but at the same time there will be a substantial number of interesting smaller players working in niche areas.'

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