PRINT THIS PAGE

Institutional investor profile: Rod Selkirk, Head of Private Equity, Hermes Pensions Management

Selkirk on the hazards of relying too much on past performance, on the attractions of spin-out groups, on the prospects for exits and on what it will take to change management fee structures in private equity.

Hermes Pensions Management is the investment manager for the pension schemes of British Telecommunications and Royal Mail (formerly the British Post Office) and manages assets in excess of E50bn. Hermes has been investing in private equity funds for over 15 years and in addition to its pension fund mandates it manages the Hermes UOB European Private Equity Fund, a European fund of funds. Hermes looks for buy-out and venture capital opportunities in the US, Europe and Asia. It currently has over E1.5bn committed to private equity and has recently announced the launch of a direct private equity fund. Selkirk joined Hermes last year and had previously been at Bridgepoint Capital since 1990.

How has Hermes' approach to private equity changed since you joined?
‘We are owned by the BT pension fund and as a result, the investments we have historically made have been done in the way you would expect a pension fund as asset manager to invest in private equity. That is, we have treated it as an asset class to invest in rather than a business activity to develop. We invest in a diversified portfolio of funds and we have an allocation for the US, Europe and Asia and for venture capital and buy-out. This gives us a diversified exposure to the asset class. We have done this historically and will continue to do this. In fact, we have recently hired someone to head up the fund investment side of our business. They will be starting in April.

‘In addition to this, Hermes has always had an objective of making direct investments either through co-investments or through some pure direct deals. Now that I have joined, there will be an increased emphasis on this area. We have created a £200m fund for new direct investments, using traditional private equity architecture, such as the traditional limited partnership structure, in which BTPS is the sole investor. Doing direct deals is entirely consistent with being an asset manager. In the medium term, the intention is to build the direct investment business and start attracting external capital.'

How do you expect your allocation to private equity funds to change?
‘We haven't made any significant changes to our allocations across regions or stages recently. It may be something that we will change in the next few months. What I would stress, though, is that it is a framework rather than a rigid allocation. We would never invest in sub-standard funds simply because our asset allocation model dictated that we had to have a certain amount committed to a particular type of fund.'

What is your rationale for setting up a direct investment fund?
‘On the face of it, when pension funds look at investing in private equity funds, the in-house activity looks like quite a low-cost operation. But of course, those private equity firms charge management fees and carried interest. The rationale for setting up an operation in-house is partly because it makes sense because we're an asset management company and partly because it is lower cost. We share the carried interest from the fund between the team and the house. Bringing the direct investments in-house also brings a greater degree of visibility and control over individual investment decisions. If you then build that business and attract external capital, then the direct investment arm becomes a profitable fund management activity. All these reasons have proved to be attractive to the pension fund trustees.'

How does the incentive structure work?
‘We have set up the same type of structure as any other private equity firm would have - managers receive carried interest for outstanding performance. It is what you would expect from a captive or semi-captive organisation. It was very important for the trustees to see that our proposals were consistent with market practice.'

What will the fund's focus be?
‘The amount we have to invest - £200m - puts us squarely in the middle market. The focus for the fund will be UK companies, unless we are investing alongside local groups in Europe. I can't see us leading deals in continental Europe, but we may well work with local teams as a partner. If we see a French deal, for example, we will give it to a local player with whom we have a relationship to look at and if they then need a partner in the investment, then we can potentially be that partner.

‘The main focus of our activity will be on UK buy-outs. One of the areas we will be interested in is secondary buy-outs where the opportunity is huge. Just look at the number of companies that are under private equity ownership. The firms that have invested in these companies need to exit and realise their investments. Increasingly, they are choosing to sell to other private equity houses.

‘We will also look at recapitalisations where there is a great opportunity. When private equity firms manage their portfolio, not only do they have to manage the individual company performance and exit, they also have to manage the performance of their whole fund. One of the elements of this is returning cash to limited partners. This can create a pressure on firms to churn investments too quickly. Our strategy is to get to know some of the best portfolio companies around. If their investors are groups that we have a lot of respect for, then we will be more than happy to lead a recapitalisation of their portfolio company to provide a partial exit for the private equity firm. The attraction for us is that we will be working with groups that we respect and we are investing in companies for which there is a medium-term exit strategy. That is something that very few, if any, other private equity firms are in a position to do. Their limited partners would hate it. But because we are backed by BTPS, who are supportive of what we are doing, we are able to follow that strategy.'

Has your view of limited partners changed since you have become one?
‘I don't think my view has changed substantially. Prior to joining Hermes I was heavily involved in fundraising and so I have a very clear view of what investor expectations are. I may not have agreed with them all, but my view as a limited partner hasn't changed. One advantage of having been on the other side, though, is that I can spot when I'm being sold to in an instant.'

How do your expectations as an LP differ?
‘I think that some LPs look back too much purely at historic track record. When you are making a fund commitment, you are investing in a ten-year partnership. You want the people you back to be the ones who are investing, driving value and exiting.

‘As a direct investor, we back management teams. We would never expect those teams to have been through at least two buy-outs, to have been in the same jobs for the last ten years, to have pursued exactly the same strategy. We wouldn't necessarily be interested in a team that is already fabulously wealthy because they have been successful in the past. To my mind, that's not what makes a great investment. I go into opportunities looking to back tomorrow's management, tomorrow's business run by a team that can demonstrate a good track record, but that is still very motivated. I don't think that anyone would disagree with that. But that kind of thinking is often not reflected in LP expectations.

‘I think that one of the best types of team to back would be a spin-out group from an existing private equity group. You have the same dynamics as you have in a management buy-out. The team is motivated, it has a new-found freedom and it has everything to prove. As long as you think they have the credibility and the experience, I would say that is one of the best teams to back. If you have a group of individuals coming together to form a new fund, you have team chemistry risk, but again, I think that it is often a risk you can afford to take on board. I don't think that risk is any greater than investing in an established group where they have done well in the past but they might not be quite so motivated to do well in the future.'

So how would you judge the merits of a newer group?
‘The ideal would be a spin-out group and so you are able to look at individual track records. There are usually some issues as to whether the organisation they are spinning out from allow them to use the data, but you can generally get the information you need. You can get references on them and find out what they have done and how they have done it in the past. The information you need to assess a newer group might not be as neatly packaged as the information you'd get from a more established group, but you don't back a group because their realised IRR is 35 per cent as opposed to 30 per cent.'

Are firms doing enough to address the succession issue?
‘I think that firms can't ignore succession - it is one of the hottest topics for LPs. But if we go back a little, I think that private equity firms need to decide what their business model is going to be. Do they want to raise one, two or three funds and then end the story there? It would be perfectly valid for a buy-out firm that has been successful to turn around and say: “We've had tremendous fun doing this, but this will be our last fund. These people will get a share of carried interest. We will work through the fund and then we'll exit the stage.” But if a firm decides it wants to build the business, then it has to deal with succession. They have to focus not just on the deal-doers but also on the people who are able to manage the firm as a business. Very few private equity firms develop people who are business managers - they concentrate instead on the deal-doers - and yet they need proper management if the firm is to develop.'

What is the biggest issue in the private equity industry?
‘Fees. Management fees. The 1.5 to two per cent management fee may be entirely appropriate for a fund that is measured in hundreds of millions of euros, but you have to question whether a multi-billion euro fund really needs to charge that amount. You certainly have to question the management fee on a fund that closed way in excess of its target. If a fund sets out to raise a certain amount of money, the managers of that fund will have set their budgets around the original target. If it then raises twice as much, it doesn't then double the overhead of the firm. Where does it go? It is a pre-payment to the partners before they earn carried interest.'

What will it take to force a change in fee structures?
‘To enforce change in this area, it will require a concerted and powerful limited partner lobby to make any kind of progress. This will need to be led by the largest investors in the industry, perhaps the US pension funds.

‘The difficulty they face is that the fundraising process tends to be carried out on an investor-by-investor basis. It would be quite brave for an LP that likes a group to turn around and start negotiating the management fee. That will marginalise them as an investor. It will not be easy. But investors should be asking certain questions. They should be looking them in the eye and ask: “Do you want to get wealthy on the management fee or do you intend to make your money from the value that you create?” Without exception, GPs will turn around and say they want to be rewarded for the value they create and that the management fees are there to cover the costs of running the business. The next question should be: “Well, what are those costs and can we agree them?” That will be when you encounter resistance - and that is wrong.

‘Fund management should be a profitable activity and you should be rewarding good people for good performance. And to a certain extent you also have to be able to reward people - particularly younger people who may not yet have received any carried interest distributions - ahead of good investment returns because they need to be motivated to do the best deals. Fund as a whole carry is a very long-term incentive - it will be six or seven years before you start seeing any rewards. I have no problem with people being well remunerated if they are doing a good job. But there has to come a point where you draw the line.

‘I'm not just moaning about fees for the sake of it. My concern is that you will get funds that under-perform - there will be a lot that do - and then you will see an LP backlash. They will have seen a huge distribution to managers from fees and yet the LPs may not be making the returns they anticipated. That is a threat to the future of the industry.'

How will the industry change in the future?
‘Market conditions are tough right now. Many of the buy-out funds raised in the late 1990s and 2000 will find that their performance is down. Some funds may not get into carry and that is where you'll see the greatest problems. These firms will be in danger of disintegration because staff retention, particularly among the more junior staff, becomes very difficult. But out of that, I think we'll see a lot more new groups spinning out. People talk a lot about consolidation in the industry. I don't see wide-scale mergers happening, but I do see some firms imploding and new groups emerging from the ashes.

‘There is also a lot of talk about secondaries at the moment. There are many impatient LPs waiting to get out of funds. That market has a huge potential. The majority of the deal flow for the secondaries players will come from the same sources as we've seen in the past - the smaller LPs, for example - but I think we'll also see a lot of deals coming from the financial institutions that are looking to reduce their exposure to the asset class. For the smaller LPs, the biggest problem at the moment is funding their unfunded commitments. Those types of deals are interesting because they are not necessarily ones that the larger secondaries players are interested in. So there will be a lot of more informal activity in the market that doesn't become public knowledge.

‘At the company level, there will be more secondary buy-outs and recapitalisations. That is driven by a need for private equity firms to return money to their investors and by the desire of management, who have implemented the business plan, to sell up. If you look at buy-outs from the outside, we are simply part of the mainstream M&A market. There are more companies backed by private equity money these days than ever before and therefore it is only natural that there will be more secondary buy-outs.'

How do you think an improvement in exit conditions will affect secondary buy-out levels?
‘I'm not prepared to concede that exit conditions are that bad. There is no IPO market at the moment and I wouldn't bank on it coming back any time soon because of the shift away from small-cap stocks. And anyway, when you think about it, the market has changed so much and an IPO does not provide firms with an exit these days. Ten years ago, a £50m deal would have been syndicated between two or three players and when it came to flotation, they would think about how much they wanted to sell at the IPO. Now, a single private equity firm could own 80 to 90 per cent of a business, even if it manages an IPO, it is not an exit. An IPO will allow that firm to get only a very small amount of cash back, but it will leave them with a large holding in a public company, with all the public company rules attached, and the firm has to then trade out of the investment over the medium term without having insider information.

‘There is no doubt that the exit market is tougher now, but I think it would be better to assume that this is what it is going to be like in the future. If it loosens up, you can take advantage of it, but still treat it as an abnormality.'

Copyright © 2003 AltAssets