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Institutional investor profile: John Hess, Chief Executive Officer and Director, Altius Associates

Hess on why manager selection is not astrophysics, on the persistence of outperformance, on what it will take to drive the European secondaries market forward and on the difficulties of secondary buy-outs for investors.

Established in 1998 and based in London, Virginia and Copenhagen, Altius Associates is a private equity adviser. The firm currently manages and advises on E2.5bn for US and European institutional investors, including CalSTRS, Danish pension funds and UK institutions. Altius searches for opportunities in the US and Europe primarily in buy-out and venture capital funds. Hess is a founder of the firm and previously co-founded its sister company, placement agent Helix Associates.

Why did you set up Altius Associates?
‘It started becoming apparent in 1997 that European institutional investors were going to set up formal private equity programmes. This was coming from the US on the back of the success of quoted equity markets. Investors on both sides of the pond were increasing their allocations to private equity as they completed asset/liability studies. I was then working for our sister company Helix Associates and a few institutions, with whom we had established relationships, asked us if we were able to help them build private equity programmes and select managers.

‘We realised that we couldn't do that as a placement agent and thought long and hard about what we could do to set something up without there being a conflict of interest between the two businesses. We turned around their suggestion and asked the investors if they would help us set up a separate company, staffed by different people, with an independent investment committee.

‘When we started out, we were advising on around E100m and we now have around E2.5bn. We have a very small customer base and that is what we intend to carry on doing. We do not run a fund of funds product and have no intention of doing so in the foreseeable future. All our mandates are advisory, although with some we have de facto discretion. We hope to keep our relationships down to around ten to 12 so that we can provide tailored services to our clients and get to know them very well.'

What type of investments do you tend to look for?
‘We design the advice and the portfolios we build for our clients on a case-by-case basis. The portfolios of each of our clients will not be identical, although there is likely to be some crossover because there are limited good opportunities in the market.

‘We work in partnership with our clients to construct a portfolio that they are comfortable with and that produces diversification by stage, sector, vintage year and, where appropriate, geographical focus. But a rough guideline would be between 45 and 50 per cent to the US with around 60 per cent going into buy-outs there and 40 per cent to venture capital. We would allocate a similar amount in Europe, split 90 per cent buy-outs and ten per cent venture. The remainder we would reserve for more opportunistic prospects.

‘I would stress, though, that these are only rough guidelines and are by no means rigid. We will alter these according to the market and our clients' needs.'

What do you look for in a manager?
‘We look for all the usual characteristics. We don't feel that this is astrophysics - it is not a complicated business. We are looking for managers that can achieve consistent returns over a long period of time and that outperform the quoted benchmark by somewhere between 400 and 600 basis points. You'll note that I don't use the term upper quartile. The numbers in private equity are the easiest thing to do. We get these out of the way first, check the consistency of their performance, because the numbers are so easy to manipulate. So the quantitative element is really the first cut for us. If managers pass that particular hurdle, then we will look a little closer.

‘But I can't emphasise the consistency enough. Our clients really want a consistency of outperformance. The standard industry benchmark is a difficult one. It does not include the entire universe - far from it - and tends to be upwardly biased. As a result, we have started developing our own middle-market European benchmark that includes the universe of transactions.

‘We look for teams that do what they say the are going to do rather than having deviated from their stated investment strategy.'

How can you be sure that consistent outperformance will continue in the future?
‘You can never be certain. But you have to start somewhere and past performance is as good a start as any. But once you have analysed that, you have to look beyond the bare numbers. You have to look at the team that generated that performance. Will the team members be there in the future, for example? You quite often come across teams in which the founding partners are in their fifties or sixties and are getting ready to slow down a little. In that case, you have to look very closely at how they have built the successive team that will take over eventually. There is often a big gap between the older, experienced members of the team and the younger people. That would raise questions in our mind.

‘The other area that we are concerned about and that we look at closely is size escalation. Many firms have moved from an area and size of deal in which they did well to deals at the larger end. If a fund suddenly doubles in size, then there's a fair chance we won't do it - we are not as rigid as some advisers or investors and we may go for it, but we are increasingly concerned about this issue.

‘The other obvious area to look at in depth is the team dynamics - how decisions are made, whether the firm is a one-man show, etc.

‘On a more general level, we tend to be of the view that anything that takes a team into new, uncharted territory is a huge risk. All other things being equal, if a team has managed to create a consistent good performance then it has a strong likelihood of succeeding in the same area again. It will have a reputation and people like to go to successful people.'

Does that mean you avoid the mega-funds?
‘I wouldn't say that we actively avoid mega-funds. We have to take each opportunity on its merits for each of our clients. It also depends on the market you are investing in. The segmentation of the market in the US is very different from that in Europe. In the US, there is a handful of large players and then below that, everything is the mid-market. Our preference is probably for that mid-market segment - which runs from a fund size of around $100m to $200m right up to $2.5bn - with a preferred size of around $1bn. Venture capital is irrelevant for this conversation. That's because the players raised as much as they could and the market is now shrinking. If we can't get into a fund, then we won't just do anything for the sake of it. We take the view that if we can't get in to the quality funds then we won't do it.

‘In Europe, there are some groups that are clearly large buy-out groups, such as the large US players that have come over. There are also a few truly pan-European firms. But there are many that have raised large sums of capital over recent years and they still do everything. They will still do smaller mid-market transactions, for example, and they will do them successfully. We like to include some of those groups in our recommendations, but we will complement them with some of the smaller, regional teams where there are higher barriers to entry in markets such as Italy.'

What type of secondary opportunities do you look for?
‘We have recommended a few investments in secondaries funds to a couple of our clients - the market has improved substantially over recent years. There has been a substantial weight of money channelled in a few large players and these may do well at the larger end. On the whole, though, we prefer to source secondaries opportunities directly for our clients through our relationships with GPs.

‘It's a funny time for secondaries, though. There seem to be some deals out there but a lot of them have not been done. In Europe at least, many LPs appear to want to hold on to their interests if they are unable to get the price they want. That may change if the regulatory environment changes - the Basle II Accord, for example, may prompt more sales on the secondary market. A lot of the action so far, however, has come from the US.'

What is your appetite for first-time funds?
‘We have a fairly low appetite for first-time funds. We tend not to like them as much as more established players. For us to look at a first-time fund, it would have to be a true spin-out and have an intact, fully attributable track record. If the team does not have this, then we will tend to wait until the team is fundraising again in the future. Many of our customers have really only been investing in private equity for five years or so, which means their appetite for more risky areas of private equity tends to be quite low.'

Where are the most promising areas at the moment?
‘We don't try to find opportunities by region or stage. We do have to have a top-down view to some extent, however. We look at any environment in which private equity thrives and so you have to look at the country regulations, see whether the opportunities exist, etc. We like the less efficient markets in Europe and general partners focusing on medium-sized transactions.'

‘Our view is that we do not want to focus on the flavour of the month, we would rather build a portfolio. We like the idea of trying to build relationships with managers over time and work out how consistently they have performed over time. Having said that, every firm will have a bad fund at one point - that does not mean that the managers are bad.

‘There are some markets that we think are more promising than others and there are some that we think are inherently problematic. Part of the difficulty with making predictions about particular markets is the fact that there is a five-year investment period in private equity. What applies today may not necessarily apply tomorrow and almost certainly will not apply in five years' time. As a result, the quality of the team is the most important factor in any investment.'

What is the biggest lesson you have learned?
‘You have to trust people, but you can't trust everyone. This is a business in which success is based heavily on judgment. The mistakes that I have made have been down to lapses of judgment - something everyone is susceptible to at some point.'

What is the biggest issue in the market?
‘The private equity market as a whole is going through the down part of the cycle. There are a lot of parallels with the last downturn, although many of the economic conditions are very different. The risk of deflation is higher, for example. But most of the conditions faced by the private equity industry are the same. People will disappear from the market, funds will be harder to raise, asset prices will fall. The major challenge that anyone faces in this environment is maintaining discipline and remaining confident enough to stay in the market.

‘It doesn't help, of course, that the exit conditions are lousy. Exits are correlated to public markets and if the public markets are strong then that filters through to private market valuations. My big concern is about the prices paid over the last three to four years. Will that capital ever be recovered in the future? It has been a terrible two years on the quoted markets, but who's to say that they won't go up 50 per cent or more over the next two years.

‘Certain things always seem to happen at this point in the cycle - they happened last time. The large institutions decide to beat GPs down on fees and attempt to get huge concessions on terms and conditions. But it just doesn't happen. It won't happen this time, either. GPs may get a little more humble than they were over the last few years, but investors will always search for the managers that they believe will outperform and these will be able to earn robust but not outrageous fees.

‘For us, the main challenge in this type of market is to continue to work with existing customers to make sure that they don't lose heart when times are tough. We have to ensure they are convinced to invest through the difficult part of the cycle. Many of them are under various regulatory pressures but most of them, where they can, are continuing with their programmes.'

Do you think that secondary buy-outs are a viable exit for investors?
‘Secondary buy-outs are an interesting area. We look at them on their merits. Their increasing incidence does raise the question of where you want to be in the food chain. There have been examples in which everyone has been able to make money. But from an investor's perspective, you have to ask how many incentive fees you want to pay along the line. Too much is bad. The chain has to stop somewhere. You can't have a never-ending line of private equity firms buying and selling to each other. Someone is going to be left holding the baby until the M&A or quoted markets re-open to true exits.'

What is your view on the fees charged by private equity managers?
‘I'm not sure that this is an issue that will ever be changed. But fees are a concern to us because they eat up such a large chunk of our clients' returns. We make every effort that we can to reduce the fees charged by managers. The GPs' receptiveness to negotiation is in direct relation to the size of the hammer. If we represent an investor that is going to commit $300m as opposed to $10m, then we tend to get a better response. In general, GPs will get away with what they can, as long as it is not outrageous. If they perform well, it is not as big an issue. Fees seem to be less of an issue with investors when they see good returns.'

How will the market change in the future?
‘I don't think that the market will change much in the future. People will come and go, we'll see the emergence of new teams and deals, etc. But there will always be a ‘private' private equity market. We will never reach the situation where there is a perfectly efficient market, although you could question whether some of the very largest deals are approaching that point. But even there, you will find parts of the team spinning out to set up on their own and focus on another part of the market. There will always be opportunities, especially at the venture capital end of the market because that's the only way many of these companies can be financed. It is human nature to try and make everything public, but there will always be privacy in this industry - it's the way that it functions. This business is about as close as you can get to a real market in today's world - firms buy at one price and then sell on at a higher price.'

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