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Institutional investor profile: Harold Weiss, Head of Private Equity Fund of Funds Unit, Swiss Re

Weiss on the increased need for operational skills in private equity, on wishful thinking among general partners, on the unfairness of deal-by-deal carried interest and on sticking to the areas you know best.

Established in 1863, Swiss Re is a global reinsurance company with approximately CHF137bn of assets under management including approximately CHF54bn from third parties. It has invested in private equity  in a systematic way since 1995 and in 2002 decided to offer products and services to third party clients via funds of funds and separate accounts. Swiss Re is currently raising  its first fund of funds involving third party assets. Currently, Swiss Re manages commitments to over 90 private equity funds and invests across the whole private equity spectrum in the US and Western Europe. Swiss Re has also underwritten securitised private equity portfolios and makes direct investments in the insurance space. Weiss joined Swiss Re in 1998 and previously worked for a number of Swiss commercial and private banks serving and advising  institutional clients and corporates on the public markets side.

What type of investments do you look for?
‘We invest across all types of private equity, including all stages of venture capital, buy-outs, mezzanine, secondaries, etc. Geographically, we concentrate on the US and Western Europe.'

Do you make co-investments?
‘We have made some co-investments in the past. We made these alongside groups that we knew well. But we have come to the decision that we should devote all of our resources to our core area of expertise - investing in private equity funds. Co-investments are more time-consuming and so we expect to make them only occasionally in future.'

How do you put together a portfolio?
‘We take a mixture of top-down and bottom-up approaches to portfolio construction. We begin by understanding the risk appetite and liquidity preference for the capital that comes from our own balance sheet and from third parties. Once we have a feel for that, we can work out the correct allocations with the help of applying our proprietary modelling tool to designing the portfolio. While doing so, we are very conscious of having a diversified spread within the portfolio. We do not want to time the market in any way and so we look to diversify by vintage year, but as well by financing stages, by different business sectors and by geography ie, US and Western Europe. We have invested in other regions previously, but we have decided to focus on these two more developed regions.'

What is your appetite for first-time funds?
‘We consider first-time funds if we are able to apply rigorous criteria to them during due diligence. The main points we look at are whether the core team has a number of years in private equity, whether the fund is offering some kind of specialisation and whether that strategy fits with the managers' experience. But I would have to add that first-time funds are not a large percentage of our portfolio and we are no longer looking to sponsor emerging managers - something we have occasionally done in the past.'

What do you look for in a fund manager?
‘The team is key to successful private equity investing. We look for a good fit between the proposed strategy and the skill set of the team. We think that the skill set necessary for success has changed over recent years. Investment banking or consulting experience is clearly no longer sufficient. Fund managers really need to be able to add value to their portfolio companies and so we look for relevant operational experience in the team. By relevant, I don't necessarily mean experience gained in a large corporation. In venture capital in particular, we look for people who have really been involved in creating and building companies from the start right through to the exit. So the team has to show us they have domain and industry expertise - they have to know the sector they invest in. This is very important to us. We also take references on the team's integrity.

‘We look for teams that have the right incentive structures in place. Carried interest must be distributed in a fair and sensible manner to ensure that the general partners remain at the firm for the foreseeable future. We find that the founders of some firms are not willing to share carried interest with the rest of the team or do not share it out fairly. That can cause problems with staff retention and can create friction in what is meant to be a team effort.'

Why do you place so much emphasis on adding value?
‘Venture and, more recently, buy-out teams have to add value to a certain extent, but in a low-growth, low-inflation environment, such as we are experiencing now, it becomes even more important that a private equity investor provides a portfolio company with more than just capital.

‘Adding value has also become more important for buy-out firms over recent years. Buy-out players are now finding it increasingly difficult to make good returns from deal structuring and leverage alone and from multiple expansion strategies. In today's world, the key question is: how can you grow EBITDA? Firms have to have some kind of sector expertise, they have to work with the board and management of each company. It's no longer adequate simply to provide risk capital to portfolio companies.'

How well do you think buy-out funds are adjusting to this new environment?
‘In the US, I see more and more buy-out groups that have relevant operational people on board. A number of smaller and mid-sized buy-out teams are now selling their funds on the back of this expertise, although larger buy-out houses have not moved as much towards this model.

‘In Europe, this should be the name of the game over the next few years. Until recently, European firms were able to apply leverage, but this will not be the case in the future. They will have to adjust and bring on new people with the right experience. This is just starting to happen, but we will not see a wide-scale shift until five to ten years from now.'

What puts you off a fund?
‘We tend to be more cautious of firms with an institutional business model, particularly if it comes to venture investing. We normally prefer to invest in funds in which a number of partners share in the rewards and the risks. We also avoid GPs in which there is not a good mix of age groups, in which either all of the partners are approaching retirement or half in their mid fifties and the other half in their late twenties. There needs to be some evidence of continuity and opportunities for investment professionals to grow within the organisation. In addition, we do not generally like groups that are dominated by one very strong personality. We try and avoid these because if something happened to that person, you have no assurance that the group would still be able to function successfully.'

What is the biggest mistake you have ever made?
‘Our biggest mistake was to allocate a small amount of capital to the “rest of the world” - ie, Asia and South America. The problem was that these regions face unique challenges due to their macroeconomic situations.  We did not know these markets as well as the United States and Western Europe and so we had mixed results from these investments. It has taught us a valuable lesson - that we should stick to the areas we know best.'

What is the biggest issue in the market?
‘One of the biggest issues in the industry is the impact on returns of increased competition among private equity firms for deals. Private equity has become more accepted as an asset class, which has increased the capital available to it. This, together with the fact that we are in a low-growth environment, means that we are likely to have to expect lower returns from both public and private equity investments. The question is whether private equity will be able to outperform other asset classes sufficiently to make it worthwhile over the longer term for investors.

‘We are also going through a phase in private equity in which there are a lot of generational changes occurring. Limited partners don't necessarily know what the outcome of these changes will be. This is still a fairly close community, particularly on the venture capital side. Just look at Silicon Valley and the East Coast. Many of the deals done there are syndicated and those types of deal are reliant on relationships spanning many years. What happens when people retire? As a limited partner, you have to have your ear to the ground to understand what is going on. If you don't, you may be in for a nasty surprise. The well known and successful partnerships of today may not be the winners of tomorrow.

‘Clearly, the type of boom and then bust that we have just been through has created the impetus for many of these changes - and I don't think we've seen the end of it yet. Too much money was raised in too short a period of time. We are still digesting this. The good thing is that valuations are more reasonable these days and, if you had to time the market, now would be a good time to invest, especially in venture.'

How do you think that the capital overhang will play out?
‘We have seen a number of venture firms reducing the size of their funds - three times in some instances. This will continue to play out over this year. But as an industry we are often guilty of looking just at the numbers and not the wider environment. Yes, the numbers suggest that there is a lot of capital in the market at the moment, but bear in mind, too, that private equity firms are facing far less competition from other types of investor. Investment banks are out of the market, as well as corporates and angel investors. Consider also the fact that fundraising figures have adjusted sharply downwards over recent years, while deal activity has continued, albeit at subdued levels.

What irritates you about the private equity market?
‘I get irritated by the fact that some general partners are able to make money without even making any investments or working hard with the portfolio companies. Some groups have managed to raise such large funds that they are able to make a decent living from their management fees alone. Some participants in the market are becoming asset management houses that are sustainable through charging a management fee.

‘But private equity should rather be a partnership model. Fund managers should be rewarded through the returns they generate for their investors. Otherwise, private equity professionals' remuneration is not aligned with the risks that investors take.'

‘Another problem is that some areas of the industry still hope that we will see a return to the good times of 1990s and that is dangerous. If we see a pick-up in activity, I fear that many will think that it's the start of another boom. There is a certain amount of competition out there among firms with dry powder. My worry is that valuations start creeping up again as a result of this capital overhang, as firms push to do deals believing that an exit could be just two or three years from now. That is unrealistic. The industry has to accept that we will not see a return to the late 1990s for the foreseeable future. The mindset has not yet adjusted to the changed financial markets.'

How much scope for change is there in the area of fees?
‘This has to do with the size of the fund and how that relates to number of professionals and the investment strategy. I recognise the fact that less established or smaller funds will need to charge relatively high management fees - in the region of two per cent. They have to be able to pay competitive salaries to attract capable people. But a similar - or even slightly lower - level of fees charged by the mega-funds is no longer justified.

‘The only way this is likely to change is if limited partners are more stringent on terms and conditions. Fortunately, we are in a time when the pendulum has swung in the LPs' favour and negotiations on these types of issue are possible and they are happening. Clearly, LPs have succeeded in negotiating with firms in the recent past - we have seen a wave of fund size reductions, for example, and these firms have returned or reduced management fees. This confirms my belief that a good GP really cares about their investor base and wants to be in the business over the long term rather than simply trying to maximise its short-term benefits.

‘I think that, overall, we are starting to see a rebalancing of terms and conditions to take account of the rather more normal environment we are currently in. Many firms that increased the percentage of their carry to 25 or even 30 per cent, for example, have now reduced it back to 20 or 25 per cent.'

What other areas of typical terms and conditions concern you?
‘We are seeing a lot of firms struggling with clawbacks. I know a number of GPs that had a few early home runs and that took carried interest on those deals. Now, they are finding that they are not going to make money from the entire portfolio and they are having difficulty repaying the capital they paid themselves.

‘I think that this should teach the industry a lesson. I don't think that firms should take carry on a deal-by-deal basis - they should only start rewarding themselves once they have returned investors' capital, the management fee and once they have reached the hurdle rate. Anything less than that is simply not acceptable to me. Unless these conditions are met, I don't see it as a partnership in which our interests and those of the GP are aligned.'

How do you think that the industry will change in the future?
‘Clearly, the issue of alignment between LPs and GPs must be dealt with if the industry is to continue to develop.

‘Another change will be in communication between LPs and GPs and in transparency. Investors will no longer commit blindly to private equity funds. Limited partners now understand private equity better and are much more professionally organised and are asking for better quality information from their GPs. Firms will need to be more open and frank with their investors. They will need to be more proactive in alerting their investors in advance of what they should expect in portfolio company valuations. Firms need to be as open about their failures as they are in trumpeting their successes. Only then will they gain the trust of their investors. No-one likes surprises and so GPs have to think about their long-term communication strategy to ensure that LPs know precisely what to expect from their investments. There will be good and bad times and investors understand this. The best groups will always inform their investors of when things are not going according to plan.'

‘The partnership model is also changing to take into account the wider economic reality of lower growth and lower inflation for the foreseeable future. GPs are moving from being financial engineers to having a more operational and execution mindset. They will be working much more closely with their portfolio companies in the future to institute real change and growth rather than relying on buoyant markets to increase the value of their investments.'

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