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Institutional investor profile: Roger Wilkins, Private Equity Manager, Morley Fund Management

Wilkins on why investors should not be lowering their return expectations, on the increasing power of limited partners, on the attractions of France versus Germany and on investors that dip in an out of the market.

Based in London, Morley Fund Management has been investing in private equity since the 1980s. The firm was established under the Morley brand to manage the investment business of insurance company Aviva following a series of mergers involving Commercial Union, General Accident and Norwich Union. The Aviva Life Insurance Company has recently increased its allocation to private equity from one per cent to two per cent. It currently has £650m invested in the asset class and is seeking to build up to around £1bn, with the majority likely to go to UK and European buy-out funds. Wilkins has been in private equity with Morley since 1989 and was previously with Plessey in corporate finance.

Why do you invest in private equity?
‘We invest in private equity partly because it is another asset class with a different set of characteristics from public equities or fixed income. It adds a certain amount of variety to our overall portfolio. A two per cent allocation may sound quite small, but the actual amount - £1bn - is a pretty significant amount of capital to have earmarked for private equity. We also invest to boost our overall returns. The target we are mandated to achieve is to outperform the FTSE All-Share index by at least two per cent over a five-year period. We are currently achieving this and I see no reason to believe that we will not continue to do so.'

What type of investments do you look for?
‘Our private equity investments are primarily in limited partnership funds, although we do have a smaller portfolio of co-investments as well. These are nearly all made alongside funds that we have already committed to, although some are with funds that we would like to invest with in the future. The amount of co-investments we have in our portfolio obviously varies form time to time, but over the last 12 years we have been involved in around 35 deals. They have generally been very successful and have helped boost our private equity returns.

‘The bulk of our private equity portfolio, however, is private equity funds. Our focus is almost entirely on the UK and Western Europe. We have little US exposure because we feel that we do not have sufficient resources to cover the market effectively. When we started a more formal approach to private equity investing in the early 1990s, the UK market was showing promise and the Western European market was just beginning to develop. Many of the UK funds that we started out investing with have since become pan-European players and that, alongside our investments in local European teams, has given us a good coverage of the region. This has evolved gently over the last ten years or so and the development of the market has provided us with a natural progression into Western Europe. Moving into the US, however, would be a much harder step and would require a significant increase in our resources. We have thought about investing in the US and we do have an allocation for that market, but there is no pressure to do so. Besides, the returns that we have been achieving from the European market have been very good.

‘We have very little venture capital in our portfolio. We rode the wave of the larger buy-out funds in the mid to late-1990s and have achieved some good returns from that part of the market. But we have always invested across the range of mid-market funds as well. I anticipate that we will maintain that mix going forward.

‘We have never gone heavily into venture capital and in hindsight, this appears to have been a very sensible decision. We completely avoided the TMT bubble, for example. This was down to judgment and because of our experience - we saw what happened with the technology bubble in the early 1990s and we felt that the atmosphere in the late 1990s was very similar. But it's more than the inherent cyclicality of the VC market that put me off. I have always preferred to invest in companies that have cash flows. I understand these types of business better. It's possible to put valuations to them much more easily. I always think that venture capital valuations are somewhat nebulous and I never feel very convinced by them.'

How do you put together your portfolio?
‘We take a bottom-up approach to private equity investing. It's almost opposite to a fund of funds in that we don't have a variety of boxes that we need to fill according to geography or sector. We approach private equity by getting into the best funds that are around at any one time regardless of their focus, but always with a view that we don't want to have too many funds in our portfolio that compete with each other.'

What appears to be the most popular area for fundraising at the moment?
‘We see nearly all the fund offerings in Europe and we've noticed that the types of funds on the market tend to go in phases. A couple of years ago, for example, we saw a lot of funds from Germany. But this last 12 months, we have seen very little from there and instead, many of the funds that we are seeing are from France, especially in the mid-market. The quality of funds from France appears to be much higher than those we saw in Germany. French teams in general have a much greater depth of experience - we are able to examine their track records. We didn't invest in any of the German funds, but we have already committed to a couple of French funds.'

How does your investment process work?
‘We start off by examining the fund documents. If they are of interest, we will meet the management team in our offices in London. The next stage is to go into detailed due diligence. This involves looking at a wide variety of things. We will meet the team at their offices, take references from deal providers, intermediaries, personal references from ex-colleagues, previous investors. We look to understand the deals that they have done in the past and talk to portfolio companies both past and present. During this part of the process, we attempt to understand how the fund's track record has been achieved. Has it been through growing the profits of the company? Has it been through financial engineering? Or has it been through taking advantage of a p/e ratio uplift?

‘We want to know that a fund has a significant proprietary source of deal flow. Most teams will see many of the same deals, but there are some that have the right contacts or who have carved out a niche for themselves. We don't want to invest in firms that source their deals entirely through the auction process. One of the ways of finding this out is talking to intermediaries and asking them who they rate highly and who they would take potential deals to. We also look at a firm's position in the marketplace, who their competitors are, how they are differentiated.

‘Terms and conditions are important, too. We want to know that they do not contain anything outrageously out of the ordinary. To be fair, few of them are. But I think that we are now reaching a point where there is scope to negotiate terms more in favour of limited partners. We are finding this particularly with new groups, especially those who are looking for cornerstone investors. You can also see that in the US, investors are starting to apply pressure to GPs over terms and conditions. That is likely to spread over to here in Europe. I imagine that the areas that will be negotiated in the future will be deal costs and carried interest - there may be a move towards tiered carried interest according to performance rather than a blanket across-the-board percentage. Another area under pressure will be the requirement for 75 per cent of LPs to have to agree on a course of action if things aren't going according to plan. It can be difficult to get that 75 per cent and so I think that may come down to two thirds. We don't tend just to accept the standard terms and conditions.

‘Once we are satisfied that the fund meets our criteria and we are convinced that we would like to commit to it, it goes to the investment committee.

‘The timeframe for the whole process varies quite significantly. If we are looking at a totally new fund, then it will take us rather longer than if we are examining a fund that we know and have invested with before. But on the whole, I'd say the typical amount of time we take over the whole process can be between three and six months.'

What do you look for in a good fund manager?
‘We look for a team that really gels and that has worked together for a good length of time so that everyone knows each other very well. We like to meet teams a number of times before we invest in both formal and informal settings so that we can gauge how they interact with each other. They need to have complementary skills. We like teams that have people with some operational and/or consultancy skills, rather than just ex-investment bankers. I think that is becoming more and more important as the market develops. If firms are going to achieve good returns, then they will need to have the skills to transform businesses in some way.

‘We look for teams with attributable track records that are spread among the managers - we are not interested in groups that have relied on the performance of one or two individuals. Allied to that is the issue of succession. We'd like to see that this has been addressed and that the next generation of managers is being groomed. This is becoming increasingly important as many of the veterans are reaching retirement age or can become less hungry. So the carried interest needs to be fairly split between the team rather than weighted towards particular individuals. We like to know about the people who have left and why.'

What is the biggest mistake that you have made?
‘I think my biggest mistake was not promoting private equity as an asset class more heavily to the Morley board. I think we could have attempted to get more capital to manage earlier on. However, looking back it was hard to do because of the mergers of our parent company and continuous changing of reporting lines, but I wish we had done that. That doesn't mean that I'm not satisfied with what we have achieved, though.'

What is the biggest issue in the market?
‘I think the biggest issue is that the industry is moving away from one of its key tenets: alignment of interest between GPs and LPs. Many of the large funds are raising large amounts of money and are charging the same percentage of fees as when they were much smaller even though their headcount hasn't risen substantially. They are able to make themselves very wealthy without achieving outperformance. I don't think these instances portray an industry that remunerates its people for performance. They don't have to be successful to get rich. I think that will have an impact and may well be reflected in mediocre or poor returns. These funds tell us that they don't make any money out of the fees, but I remain sceptical.'

What would it take to enforce change in the area of fees?
‘I think that the move has to come from investors. If a fund went out marketing itself as having lower than average fees, then that could damage its reputation - investors and other funds would think they were desperate. But the problem is that, even with the application of investor pressure, good funds with good performance still call the tune.

‘I do think, though, that GPs should open up their books of accounts - only then would I believe that they are not making money out of their management fees. I can't see that happening, though.'

How will the market change in the future?
‘We are already seeing some changes in the types of deals being done. The environment is much more competitive than it used to be. The easy deals have already been done in the past and so private equity firms will need to work on their deals much harder than they have historically. The privatisation wave has already passed and vendors are now much more savvy than they used to be.

‘I think we'll see a lot more secondary buy-outs. This is a trend that is already being played out. In many cases much of the value to be gained from an investment such as cost savings may already have been squeezed out. That means private equity firms will have to work much harder at finding growth areas to make these deals work. That is one of the reasons why firms will need operational skills in addition to their deal transaction skills. Allied to this is the fact that it will take them longer to achieve their targets. Whereas it may have been possible to sell a portfolio company within two or three years in the past, it is more likely to take four to five in the future.

‘There will be more new entrants to the market, while at the same time other groups will fall by the wayside - particularly in venture capital. You will see more new teams, through individuals spinning out from larger funds. This will give investors a much wider choice as many of these teams find a niche to specialise in.

‘From an LP perspective, I can't see much changing. The longer term investors, such as ourselves, will continue to commit to the industry. But there have been and there always will be other LPs that come and go. That will still happen. The problem is that these LPs always seem to come in at exactly the wrong time - ie, when markets are booming - and then retrench when things turn sour. It often seems to be the same people who do this. I'm pleased to be able to represent my institution because we have been very consistent investors over the long term.

‘I think the secondary market will continue to develop. It serves many investors very well in terms of offering some liquidity and others a rapid diversification. It can provide a good entrée for newer investors because they gain fast exposure to the industry and an understanding of private equity. They don't need to spend years developing a private equity programme and they get returns reasonably quickly. We don't invest in secondary funds because we have invested through the cycles over the last ten to 12 years and we have exposure to every single vintage over that period and are already well up the J curve. In fact, in 2002 we were in the favourable position of receiving more distributions than draw-downs. That is extremely rare at the moment, especially when you consider that we are attempting to build up our portfolio, but is also a testament to some excellent investment decisions in recent years.

‘I also think that the industry is doing its best to lower investors' expectations. Traditionally, firms have marketed themselves by projecting returns of 25 to 30 per cent over the long term. That was their target. But, now that the market is more competitive, I suspect that many deals are being priced at the lower end of the scale to achieve only around 20 per cent gross IRR. This is being done to get deals done and to get the larger funds invested. So I do believe that there is a certain amount of massaging of investor expectations going on. Our stance, however, is that our return expectations remain the same as they have always been. We didn't raise them when the markets were booming and we don't see why we should revise them downwards now. Private equity is a long-term asset class. If you look at it over ten years, then the peaks and troughs get smoothed out over time. As a result, we favour funds that are consistent in their approach.'

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