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Institutional investor profile: Stefan Mårelid, Head of Private Equity, SEB Asset Management

Mårelid on the dangers of over-diversification, on the problem of staff retention among institutions, on why general partners should commit more of their own money to their funds and on the difficulty of investing with preferential terms.

Based in Stockholm, SEB Asset Management is a division of Swedish financial group SEB with E80bn under management. The firm has been investing in private equity since 1989 and spawned one of the best known European funds, Industri Kapital. It launched a private equity fund of funds in 1999 and has a private equity programme of around E1.5bn. SEB Asset Management invests in buy-out and venture capital funds in the US and Europe. Mårelid joined SEB in 1998 and was previously at McKinsey & Co.

What type of investments do you look for?
‘We focus entirely on private equity investments and by that I mean equity investments in privately held companies - basic buy-outs and venture capital. We do not currently invest in mezzanine, sub-debt, structured finance, real estate or distressed assets. First, we look for equity risk-return characteristics. Second, we believe that it is important to have deep insight into the area where we invest. Being a fixed-income investor is quite different from being an equity investor, and few people are good at both.

‘We look at private equity funds of all sizes, although I would say that there are some funds that are too small for us. That is a function of the amount of capital we have to invest. Our programme is worth around E1.5bn and so we have to deploy that capital efficiently. We don't like to take too large a share of any given fund and as a result, we tend not to invest in funds of much less than E400m, although there can always be exceptions to the rule.

‘We invest across Europe and the US, but our overall strategy is not to pick out specific markets. We rather look for look for teams that can add significant value post-investment.

‘Our strategy is to build relationships with a core of around 30 managers that we have identified as being good and that clearly add value to their portfolio companies. We believe that that is a manageable number and besides, we think that it is possible to over-diversify. If you spread your capital too thinly, you simply end up with an index of private equity fund investments and that can have an adverse impact on performance.'

How persistent do those 30 managers tend to be?
‘The 30 or so managers do not remain constant over time. One of the dangers in this industry is that, because it is a people business, it can be easy to have your decisions coloured by the relationships you have with managers. Some people have a tendency to continue to re-up regardless of a fund's performance and regardless of what might have changed in the firm. There may be succession issues, for example, or the fund size may have doubled or there may have been a strategic shift. We are very wary about simply re-upping because of our relationships. To prevent this, we monitor each fund's performance very closely and weed out the bottom performers in our portfolio - regardless of whether they are top quartile performers in the wider market. By doing this, we free space for new managers in our portfolio. We are very mindful of the fact that today's winners are not necessarily the winners of tomorrow.'

Do you invest directly?
‘We do invest directly, but only through co-investments with general partners that we know and trust. We are offered a lot of co-investment opportunities, but we review them on a case-by-case basis. We will only make a co-investment if we believe that it has the potential to outperform the overall portfolio and as a result we are very selective.

‘In this respect, we have a different approach from many funds of funds that co-invest. Most of them have different incentive structures for their direct investments than for their fund investments. It is often more lucrative for funds of funds to do co-investments. But we don't believe that you can justify higher charges for co-investments even if it is the market standard. The skills and the time that you need to do them are not so different from those required for fund investments.'

What is your appetite for first-time funds?
‘We see private equity as an apprentice business, where you learn the ropes by on-the-job training. We have invested in first-time funds and we no negative bias towards them, but we do have a negative bias towards first-time investors.'

How do you assess them?
‘Looking at a first-time fund is similar to assessing any type of investment. We go through exactly the same processes, although they will take a little longer. The typical type of first-time fund that we would look at would be spin-outs and with these, we would require a core team that has worked together and stuck together for five to six years before spinning out. Of course, the due diligence is a little more complicated than with more established teams because we have to spend longer assessing the chemistry between the team members, the deal attribution can be tricky and we have to spend more time making the reference checks. It's a bit of a double-edged sword. It takes a lot more work to assess newer teams, but they can represent some great opportunities. Spin-outs have everything to prove and will live or die by their first or second funds and so they tend to be rather hungrier than more established teams.'

Would you consider cornerstoning a fund?
‘We have been offered the opportunity to cornerstone a number of groups, but we have always categorically refused. By the same token, we would not invest in a fund that had been cornerstoned by someone else unless we were confident that that investor could add value in some respect.

‘I don't believe that it should be just about writing a large cheque. We are not seeking funds that will offer us preferential terms. We take the view that if the group is good, then it will be able to raise the money anyway. Why should a good team need to offer preferential terms?'

What do you look for in a good private equity manager?
‘We look primarily for good judgment. In order to make money in private equity you have to buy well, add value to the assets, and sell well. This requires good judgment. In addition, people with good judgment usually know what they know, and know what they don't know - that is important.

‘Working out who has good judgment is pretty hard and it is certainly more art than science. But we take a long look at the deals that a manager has done in the past. Did they pay a reasonable price? And you also have to examine the exits as well. Have they managed to exit at the right time? We simply have to drill down into every deal and from that we can also see how their strategy has developed over time. Have they, for example, gone into areas that they didn't know very well?

‘On a more general level, we also look for a compelling business model with a sustainable competitive advantage, a hungry and cohesive team with complementary skills that fit the chosen business model, a track record that proves that the business model is compelling, an investment process that can yield a sustainable competitive advantage and terms and conditions that ensure alignment of interest.'

How do you ensure that your interests are aligned?
‘Obviously the level of fees plays a part, but one of the most important aspects of alignment of interest is the amount of money put in by the general partners themselves. The actual amount should vary according to a number of factors, such as where the GP is in his life, how much he has earned in the past, etc. But it should be something that would hurt them to lose. The most common level tends to be one per cent of the fund size. That is usually sufficient for managers that are just starting out, but the more established funds should put in more. I think five per cent would be better in those cases. It's just one more way of ensuring that the team is hungry.'

What is your view on the venture capital opportunities available in Europe?
‘Our view is that the European venture capital market is not as concentrated at the US VC market, where you tend to have clusters of activity in areas such as Boston and Silicon Valley. The European scene is far more fragmented, however, and does not have the same critical mass or knowledge transfer. As a result, we are bullish about US venture capital, but less so about the European market. We have done some VC investment here, but not much so far.

‘I think that one of our concerns about the venture capital market overall is the life sciences sector. We have seen so many people flooding into the market - and when people do that, we are always wary. Why would you want to be where everyone else is?'

Does that mean you have avoided secondaries lately?
‘We have looked at a lot of secondaries prospects. But if you look at the larger end of the secondaries market there is a lot of competition for the deals. A lot of money has gone into secondaries funds over recent months and that is now having an effect. There are some more attractive deals at the smaller end of the scale, but I take the view that it is a very different business from fund investing and you need to have the skills and the time to be able to do it well. This is a pretty specialist area of the market and so we have tended to avoid investing in them. And, while they tend to be attractive to newer investors, we don't need the diversification that they can offer.'

How do you conduct due diligence?
‘That is a trade secret. In general, there is a lot of leg work, interviewing all the partners, going through the data room, portfolio company visits, doing 360-degree reference calls, etc. The key thing with due diligence is to develop a number of hypotheses of key issues, that can be tested throughout the entire due diligence process in a structured and consistent way.

‘The hypotheses that we tend to develop are based around what we believe the key points are. This could be anything from succession issues, to team stability, etc. A lot of people have a very formulaic, box-ticking approach to private equity. We try and avoid this partly by using our networks within the industry. We talk to fellow limited partners, for example, to bounce ideas off each other. In an industry in which transparency is lacking, you have to rely quite heavily on personal networks to understand what the motivations of individual managers are. You can't just take the information that you gather at face value. You have to be able to read through the lines.'

What advice would you give to a new private equity investor?
‘Do not put any money down until you have climbed the learning curve. Spend a lot of time building and nourishing a network of contacts who can help you look underneath the hood. When I first started, I mapped out the entire industry, got in contact with investment bankers, etc. Never invest in a fund without having spoken to the other players in the same market.

‘Also, think diversification, but don't over-diversify. Even though your primary role is to pick the top decile performers, they don't always pan out that way. Spread your investments over time, over funds, across geographies and sectors. However, if feasible, stay with 20-30 core relationships. Over-diversification can lead to returns approaching the mean and that is not necessarily a good thing.'

What is the biggest mistake you have ever made?
‘Becoming a limited partner rather than a general partner. Direct asset investments are clearly more intellectually rewarding and challenging than blind pool investments. I did actually consider going into direct investment, but realised that I needed to get more experience to do so.'

What are the main risks involved in private equity investing?
‘The main risks for investors are loss of capital and, in fact, loss of talented professionals. Many institutions do not have the incentive structures in place to retain their best staff. If people are good, they often end up being lured away by the funds themselves. As I've already said, it takes a lot of time to develop the intellectual capital in-house and it is a real waste to lose that. It also ends up in a situation in which many LPs just aren't very experienced and that can cause the kinds of market distortions that we have seen over the last few years. LPs are very quick to blame managers for having been greedy, raising too much money and investing it unwisely, but this is a free market. Who chose to place their money with those managers in the first place?

‘So I think that that brain drain can be dangerous. There are some structural issues to be addressed here among institutions.'

What irritates you about private equity?
‘Fee structures that undermine the fundamental pillar of private equity - alignment of interest - irritate me. We might be digging our own grave with these structures. And I put equal blame on limited partners that blindly pile into these funds and accept structures without alignment of interest. Having said that, I can't see the level of fees charged coming down. We've seen the disappearance, thankfully, of the 30 per cent carry, but that should never have been there in the first place. The fee levels should change, but the LP community is too fragmented for that to happen.

‘Another irritating thing about private equity is the lack of transparency in reporting and legal documents. It is amazing how difficult it seems to be to provide basic facts regarding acquisition costs, valuations, exits, fees and returns for the individual limited partner.'

How do you think the market will change in the future?
‘I have a fundamentally positive view about the private equity model. In principle, for most companies the private equity market is a much better source of finance than the public market. The public market is in many cases a necessary evil for companies that need access to more capital in order to grow - with it comes irrational volatility, short-term focus on quarterly earnings, weak owners, and a management team that have to spend a substantial part of their work hours communicating with the market rather than managing their assets. The private equity model done correctly has superior corporate governance, focus on long-term goals, strong owners, aligned interest and a management team that can focus all their time on managing their assets.

‘Thus I believe that the private equity market will continue to grow and take a relatively larger share of the global financial markets. I think the market will continue to bifurcate into large asset management firms that steal market share from the public market, and the more traditional principal investment firms from which the industry originated. The two will have quite different risk-return characteristics.'

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