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Institutional investor profile: Richard Allanic, Investment Manager, 123Venture

Allanic on the attractions of the French market, on the value of the large buy-out funds for the private equity industry as a whole, on why the US venture capital market is not applicable to Europe and on the prospects for the buy-out arena.

Established in 2000, 123Venture was set up with the aim of providing French private individuals with access to the private equity asset class using a fund of funds. 123Venture raised its first fund of funds in 2001, and it is currently raising its second. The firm is also developing an advisory business for institutional investors - it already acts as a gatekeeper to two institutions. It invests across the range of stages in Western Europe and the US, with a particular emphasis on the French market. Allanic joined 123Venture in 2000 and was previously an auditor with accountancy firm Mazars & Guérard.

What type of investments do you look for?
‘We have built up a real expertise on the French market. We know pretty much all the players and they know us. As a result, the French market makes up a large proportion of our portfolio. We invest around 50 per cent in France, up to 30 per cent across the rest of Europe and 20 per cent in the US. We know the French market best, but we also recognise that there are a lot of opportunities elsewhere and we want to build a balanced portfolio.

‘By stage, we invest up to 70 per cent in buy-outs, with the rest going mainly to all stages of venture capital. That is how we allocated our first fund and it is likely to be the same in our second - unless, of course, we decide that prospects for venture capital are looking up.

‘We have a preference for smaller funds that have an original focus and strategy. Our view is that, as a fund of funds, we shouldn't be seeking out the pan-European funds, at least when they target the mid-market. We want to be in control of where our capital is allocated. That is not possible if you invest in a large pan-European fund. So we look for smaller funds that focus on one specific country or region. In that respect, the private equity market in Europe is quite different from that in the US. If you invest in the US, it doesn't matter so much whether the firm is based in Boston, California or New York. The market is relatively homogeneous. Companies across the US are subject to the same regulations, laws, culture and way of doing business. In Europe, all these factors vary according to whether you are in the UK, France, Spain Scandinavia, etc. It's far better to invest with teams that are native to the country in which they are operating. We believe that they are far more able to source, execute and exit deals than pan-European firms that are possibly less sensitive to local differences.

‘I do believe, however, that these large funds are good for private equity in general. They get a lot of exposure. If you look at France last year, there was a private equity story practically every day in the press - and that was down to the large players. All that helps us to explain to the wider world what private equity is. Private equity has become part of the business landscape as a result of these larger firms. This is especially true now that many large companies are burdened with debt and are looking to sell off their subsidiaries. The only people with money at the moment are the private equity players.'

How do you raise funds from the public?
‘We have managed to build a distribution network through independent financial advisers, online brokers and private banks. We launched our first fund in the autumn of 2001 - and it was tough. Aside from the political uncertainty being felt at the time, we also had the major job of educating people about private equity. Many of the people we spoke to didn't really understand the asset class and so it took us about a year to build our distribution network.

‘Marketing a fund of funds when you are dealing with private clients is totally different from raising money from institutions. Our clients usually don't have a lot of knowledge about private equity and that throws up different problems from those a more traditional fund of funds would come up against. I'm not saying that it's any more difficult or easier. It's just different.'

You also have a direct fund, don't you?
‘We do - although with a twist. One of the problems for venture capital firms in France is that it is now very hard for them to raise money. Since the introduction of the FCPI structure - which provides investors with certain tax advantages - VC firms have suffered. The problem with most traditional FCPI funds is that they have been set up by large financial institutions. These institutions have brought together brand new teams that usually haven't worked with each other before and the funds are usually structured in a way that means the carried interest flows straight to the parent organisation. Most FCPI teams are not properly incentivised, as they are in other funds.

‘So we decided to set up our own FCPI because we didn't think that this was a very healthy way of dealing with private clients. It is a multi-manager FCPI, which we think is quite original. The idea is to leverage our knowledge of private equity managers. So we have selected five different managers and each of these will co-invest their share of our FCPI alongside their fund commitments. We believe that this gives our clients a very good way of diversifying their portfolio. They invest in one FCPI - which by law is permitted only to invest in equities, not in funds - and they end up investing with five different managers.'

How does your investment process work?
‘There are three phases to our investment process. We start by reviewing the PPMs. We have developed a questionnaire on which there are about 150 points to check against the PPMs. From that we are able to rate each fund so that we can see, from these quantitative elements, whether they are of investment grade or not. The ratings are applied to aspects such as location, the team, the amount of money against the amount of people in the firm, the ratio of partners to other staff, the way that the carried interest is split, the strategy and track record. At that stage, we turn down 50 to 60 per cent of the PPMs that we receive.

‘We cross-check the ratings and the information we have against our database. We now have a mine of information on this and it allows us to check areas such as valuations. Very often we will have data on what valuation three or four different managers have placed on one portfolio company, for example. You will often see some stark differences in this. That can give us some very good insights into the way that funds operate.

‘The next stage is to meet the team. We have several face-to-face interviews with the partners so that they can articulate their strategy and the ways they differ from their competitors. That last point is essential: most PPMs look pretty much the same, even if the GPs try to show a real differentiation in their investment approach. We need to assess whether this edge can be confirmed or is just pure marketing. This will help us complete our original questionnaire.

‘If we wish to go further with an investment, we then move into the due diligence phase. We meet the whole team, from the partners, to analysts and back office staff. We believe that the financial controls and the back office functions are extremely important for limited partners. Sure, meeting the partners is key, but once you have invested in the fund, the people that you deal with on a day-to-day basis will be the staff that take care of the reporting. We need to be sure that the reporting will suit our needs.

‘The due diligence also involves talking to past and present portfolio companies to understand how the relationships have worked. It's always important to find out how managers behaved when a company has been successfully exited, but it is equally important to assess what has happened when things haven't run so smoothly. Most managers will look the same when you're examining the successes; they look very different from each other when they are faced with problems. Some just don't know how to cope or manage through the difficult times - and that is more evident now than it has been for a very long time.

‘We also look at the usual issues such as team cohesion and carry split. These are both extremely important points for us. We want to see how the junior staff, for example, will be compensated for their work.'

‘Once we have completed the due diligence process and revealed all the terms of the partnership agreement, we compose an investment memo. We then present this to our advisory board for final agreement.'

What do you look for in a management team?
‘We look for an entrepreneurial spirit. We like managers who are independent. We believe that private equity is a craft and that private equity managers are craftsmen. You do need the skills of a financier, but you also have to think and act like an entrepreneur. Successful private equity investing is more than financial engineering, it is dependent on the managers being hands-on. We look for a balance of skills and experience within the team. By that I mean that there should be the right ratio between partners and analysts so that the firm is running efficiently. We think that this type of structure also helps groom future partners to ensure that succession issues are taken care of.'

What is the biggest issue in the market today?
‘I think that transparency is the biggest issue in the market now. The industry has grown so much over recent years and that is creating pressure for it to become more transparent. Too many managers are still very secretive about who they are, the way they work and how they have performed. There is no evidence to suggest that this type of secrecy gives these funds any kind of edge. I just don't believe that it has any positive effect on their performance. I'm not advocating that every single aspect of a manager's investments should be disclosed, but I do believe that fee levels and carried interest, for example, should be out in the open. Areas such as this are so standard in the industry, I can't see that funds have anything to hide.

‘The really big issue in this is obviously performance figures. I'm not sure that there is much value in disclosing information about a fund's current portfolio. I don't think that it is helpful and it can cause difficulties. We know of some instances in which the valuations of private companies had to be disclosed. Some of these companies were due to go public or receive a further round of financing, but had been valued very conservatively. The disclosure obviously affected the valuations placed on the company by the subsequent investors. So I don't think that disclosing company valuations is of any interest to the public and it causes problems for the industry. That's not good for the portfolio company managers, private equity firms or, ultimately, their investors.

‘On the other hand, I can't see any problem with disclosing a fund's past performance. I think that the private equity market will have to take a leaf out of the public market's book. You can judge mutual funds by their past performance. I don't see why you can't do that with a private equity fund. The onus will fall on managers to prove that they are good not by virtue of the fact that they have been in the market for 20 years, but because they have been good investors.'

How will the market change in the future?
‘I think that this depends on which areas you are looking at. On the venture side, we have clearly seen a bubble over the last few years. This has shown that some strategies that were imported from the US are not necessarily relevant to Europe. You can't simply take the US model of venture capital and apply it wholesale to Europe. They are two distinct markets. One example would be the US propensity for having very complex shareholder agreements for young companies. All that means is that you need to hire some of the most highly paid lawyers to draft these agreements. You then have to live with that because if you need to make some kind of change, it is a complex and expensive process. Another example is the idea that you have to find a high-profile and expensive senior executive in charge of the company. You need to hire headhunters to do this and they are even more expensive than lawyers. You then have to pay these executives an inflated salary, and yet quite often they have no experience of running a smaller, growing company. The VCs that followed this model will have found to their cost that the cash burn in these companies is horrendous and they will be suffering now.

‘The most successful VCs will be those that have kept a low profile and have remained smaller. They will have kept some money back to provide follow-on financing for the businesses that are worth saving. There will be a lot of fall-out in the venture capital industry, but those that remain will be the ones that had a modest approach to investing or the ones that have been around for a long time.

‘I also think that venture funds tied to corporations or financial institutions will fall by the wayside. I can't think of many very successful corporate venturing programmes. Venture capital funds have to be independent and they have to be able to incentivise their people correctly. Investors are much more interested in funds that are managed by their people. Managers are much more committed when they are managing their own company - it is their money, not just capital from the organisation's balance sheet. For that reason, I think that we will see a lot more spin-outs.

‘On the buy-out front, things are looking more positive. I think that the next few years should be very good vintages for this type of investment: the economic environment is creating tremendous market opportunities, either for the large buy-out funds or for the mid-market. Mentalities have evolved during the 1990s (among governments, Managers, bankers, politicians...) and buy-outs are now considered as a useful solution for helping companies to evolve more efficiently through for restructuring, spin-offs, transactions and to solve succession issues.'

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