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Institutional investor profile: Tom Thompson, Director, Private Equity Group, WestAM

Thompson on the dangers of style drift, on the importance of strong deal flow, on the return to fundamentals in private equity, on the lack of operational capability among many fund managers and on the opportunities stemming from the succession issue.

Based in Chicago, WestAM's private equity group was formed in 1997. It offers separate accounts and funds of funds and has approximately $2.5bn in private equity investments. It currently has two funds of funds and is planning to launch a third imminently with a target of $300m. WestAM invests globally across private equity stages, with a specific focus on smaller funds. Thompson joined the firm in 1997 and previously ran a private equity consulting firm.

What type of investments do you look for?
‘We focus our efforts on offering our clients access to areas that they find hard to enter. That tends to be in the smaller and middle markets - and these are areas in which we have historically seen higher returns than have been generated in other markets.

‘We offer two private equity funds of funds. One of which, Special Private Equity Partners, focuses on the smaller end of the private equity marketplace. It invests in funds that are under $350m in size. It can include, on a very selective basis, first-time institutional funds. In addition to Special Private Equity Partners, we also offer another fund of funds, COREplus Private Equity Partners, which has a broader focus with an emphasis on the middle markets.

‘The smaller private equity groups constitute a major component of the overall private equity market. As a result, our target area is not limited in scope, but it is difficult for many investors to access. Larger investors spend a lot of time looking at fund investments and they can often find it difficult to channel a significant amount of capital into smaller funds - it takes as much time to conduct due diligence as with a larger fund and as much ongoing effort to monitor. As a result, we think that we can add value to our investors. In addition, for our investors outside the US, we can find locate funds that they would never even see because most of these firms do not fundraise outside the US. Overall, the rationale for our fund of funds is that we can find opportunities that investors should have as part of a diversified strategy but that are too difficult, time-consuming and impractical for them to invest in themselves. It may be that our investors choose to invest directly in these funds in the future - we are happy to introduce managers to our investors.

‘But despite our focus on smaller and mid-sized funds, diversification is key to our game plan for both funds. We have seen over many cycles that diversification is absolutely essential to success in private equity. As a result, both our funds of funds invest in a cross section of buy-out and venture capital funds. There may be a bias towards one strategy over another, but under no circumstances is there a focus on a single sector or stage.

‘We are just about to launch a new fund of funds, Special Private Equity Partners II, with a target of $300m. This will offer limited partners the ability to weight more heavily buy-out or venture capital outside of our own target portfolio mix. This allows us to customise the product to investors' individual return strategies. As a rule, however, we believe that diversification is essential to a long-term investment strategy. There are too many things that you have no control over - witness the current economic conditions. The various types of private equity investments can react more or less favourably to different economic climates.

‘One of the things that we do in terms of our portfolio strategy is to look at private equity using efficient frontier modelling. We look back over the history of the asset class and examine how different types of private equity investments have performed. We can then make a risk assessment of each type of private equity investment and use efficient frontier characteristics to create a model portfolio strategy. There has been a lot more capital going into private markets over recent years than historically, so that type of modelling is much more valid than it might have been 15 years ago when the total amount of capital committed to the industry was relatively thin and so any blip or movement in the industry could reflect a distortion. The more data there is, the greater confidence we have in using it as part of our portfolio strategy planning. But that is only part of our planning - our own experience is also vital in setting our investment strategy.'

What is the geographic spread of your investments?
‘On an overall basis, around 20 per cent of our investments would be non-dollar, but that varies from client to client and from fund to fund. Of that, we are more heavily weighted to the European than the Asian market.'

Why do you make co-investments?
‘Co-investments are an important part of our strategy. Typically, our portfolio strategies will include a reserve of ten per cent to be allocated to co-investments. When you consider that a large portion of our capital goes to smaller and mid-sized funds, then it makes sense that we co-invest - these are the firms that are most likely to need co-investors and they will offer you good opportunities. This makes a very comfortable marriage.

‘We have found that co-investments can provide an enhanced return as well as an opportunity to diversify the portfolio with emphasis on types of investment or industry sectors. Two of our partners are devoted to making co-investments. They spend their whole time doing co-investments - that is a little unusual among funds of funds, but we believe that it is appropriate. Co-investing is not an identical process to fund investing. It also requires a relatively rapid response time to any given opportunity and having two people working solely on co-investments provides a certain comfort level to GPs that we will be able to act quickly.'

What do you look for in a fund manager?
‘In some ways, the business hasn't changed in 20 years and the qualities that you looked for back then are the same as they are today. Private equity revolves around subjective decisions as to the capabilities and experience of the people you are examining. Of course, if you are looking at a newer fund, there are additional issues to consider - the track record, in many instances, is an individual's track record that has been carried forward into the new fund's strategy. You're looking not only at the individuals separately, but also as a group coming together possibly for the first time. You have to judge how an individual's experience will complement the experience of the group as a whole. The combination of the whole group's experience should provide a two plus two equals five result. We like investment teams that operate as a team and that bring applicable diverse backgrounds together.

‘We don't just look at the usual fund analysis concerns and issues, we also look at some of the underpinnings of the individual investments and how they have performed. We are able to do that because our team has considerable M&A and operational experience. We try to look under the hood and get our hands dirty rather than simply kicking the tyres of an investment opportunity. So we look at whether a firm's plan at the time of the deal was actually executed. If a deal failed we want to know whether the firm was unlucky or whether it was the firm's fault for some reason.

‘As a result, one of the most important things we look for today is operational capability - this is more important than previously. The industry has always been cyclical and downturns have always required an additional operational capacity in firms. But private equity's cyclicality has never been quite as apparent as it is today because of the industry's size. GPs really need to be able to understand issues at the operational level and offer assistance that portfolio companies may need and that is currently proving to be beyond many fund managers' capabilities. They don't have the right experience. I think that in many instances, the mix of skills among fund managers hasn't reflected this need. But I think that it's also because they haven't been through the down part of a cycle before. They simply haven't been pushed into situations in which they have to address companies' needs in a bear market. In many instances it's a novelty - and not a very welcome one.'

What puts you off an investment?
‘We are very alert to funds in which we have seen style drift. There are two reasons for this. The first is that the fund manager may not have the experience necessary to execute a new strategy or investment style. The second - and possibly most important - is that the necessary deal flow in the new area will be missing. Over the years, we have seen that deal flow is crucial to getting the best selection of opportunities and therefore to producing the level of returns we would expect as an investor. We have seen very frequently that, when a manager changes its focus, even in the type of environment we are seeing today when companies are crying out for capital, deal flow quality and quantity for that matter, will be substantially lower than for others executing a similar established strategy.'

To what extent do you see style drift as an issue in today's market?
‘We are still seeing this happen. We are seeing new targets and strategies from GPs. These may be literally new or they may be an attempt to refocus an existing strategy and I think you will continue to see this happen, certainly in the near term. There are large numbers of funds at the moment, for example, that are highlighting distressed opportunities as part of their strategy. In some instances, funds that have been managed historically under buy-out strategies are now offering strategies that look very much like distressed investments.'

What is the biggest mistake you have made?
‘I don't think this is specific to us, but it is widespread in the industry: one of the things that may still unfold - although it's not clear yet - is that some of the investments with established, premier names may not be as reliable as we would have expected. A lot of that is attributable to the time frame of the industry. We are witnessing a transition period in which firms are facing succession issues and are relying on members of the team that may not have the wealth of experience of their more senior partners. In many cases, they have not been through the different cycles of the private markets. Many institutional investors will unfortunately be very disappointed with the results of some of the premier funds in the current cycle.'

How do you see the succession issue playing out?
‘It would seem to be an anomaly that people who look at businesses day in day out don't look at their own businesses in the same way. I think that general partners can get so consumed with their investments that they simply don't focus on their future operations at all or to the level necessary to deal with succession. Sometimes it is the result of the way that a firm is managed or with the way that ownership issues are held. Either way, I can't see that changing much. Some firms just aren't set up to be perpetuated by future generations; others are. But one thing is certain and that is that we will continue to see more spin-outs from established, well known firms. It is simply part of the industry's evolution. It is also a reflection of the type of people who succeed in private equity, many of whom are not exactly shrinking violets and who are highly motivated to set up their own firm.'

What is the biggest issue in the market?
‘The issues in the market are often based on misconceptions. There are frequently discussions about capital overhang in the marketplace, for example. That may certainly be accurate in some parts of private equity, but by no means all. There is a perception that this overhang will preclude good investments. I think this is misleading. In fact, in the experience of many in the private equity industry, today's investments may offer the best opportunities for the upcoming years.

‘I think that many of the supposed issues we are seeing today are the result of the industry having oversold itself to investors in the past. Many newer investors simply misunderstand what private equity can and should provide as part of an overall portfolio.'

How do you think the market will change in the future?
‘I think that the main trend we are seeing is that the private equity market is reverting to the way it was before the bubble. That is a good thing. I think it's also clear that the market has become global. As a result, companies looking to expand their business beyond their domestic markets are now able to do so much more quickly and much more cheaply than previously. A lot of that has to do with technological developments. Exit markets have been difficult over recent years, but cross-border exit opportunities have increased and will continue to do so. Again, that is a welcome development.

‘So overall, I think that while we are returning to the mentality and size we saw in private equity in the mid-1990s, the opportunities for the industry have broadened over recent years. Private equity has become more sophisticated - both in terms of general partner capabilities and in terms of limited partner understanding of the market.'

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