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Institutional investor profile: Thomas Dorr, Managing Director, Morgan Stanley Alternative Investment Partners

Dorr on the attractions of entrepreneurial firms, on the importance of judgment in private equity, on the herd mentality, on the irrelevance of since inception IRRs and on the difficult exit environment.

Based in Pennsylvania, Morgan Stanley Alternative Investment Partners was set up in 2000. To establish the alternative investment programme, Morgan Stanley brought in the team from the Weyerhaeuser Pension Fund, which had been investing in private equity since 1990. The firm manages a programme of special accounts plus the capital raised in a fund of funds that closed in 2001. Its total commitments currently stand at $4 bn. Morgan Stanley invests in the whole spectrum of private equity, with a particular emphasis on smaller to mid-sized buy-outs, distressed funds and co-investments across the US and Europe. Dorr joined Morgan Stanley in 2000 after 14 years at Weyerhaeuser.

What was the rationale behind the Weyerhaeuser move to Morgan Stanley?
‘The rationale was based on mutual interest between the two parties. Morgan Stanley has a very large and successful investment management business, which offers the whole range of investment products to its clients. For alternative asset categories, it  had direct investment arms, but it didn't have a fund of funds offering that provided its clients diversified access to the full range of private equity and hedge funds opportunities. It had been looking for a number of years to either build, or bring in, a team to provide this offering.

‘At the same time, Weyerhaeuser had a long established track record of success in this business, but the pension fund was fairly mature. It certainly had an opportunity set in front of it in terms of investments that outstripped its ability to commit. It felt that under this arrangement, it could leverage this infrastructure across a larger capital base.'

What type of investments do you tend to look for?
‘First of all, we begin with a very broad scope. We have experience and resources focused on virtually all strategies and geographies with developed private equity markets. This broad scope is important given the herd mentality of private equity.  It is beneficial to not be locked into a narrow scope that can be overrun with capital.

‘We look for a tangible rationale for superior returns. This leads us to focus on funds targeting less efficient market segments and with differentiated skill sets that can drive value enhancement in portfolio companies. These opportunities are harder to identify and require more resources to diligence than the brand name funds. But extra effort is required to build a portfolio with an expectation of outperformance to industry averages. This approach results in an emphasis on small to mid-cap buy-out funds and specialist funds. Examples of specialist funds popular in today's market are distressed and turnaround funds.

‘As the market matures, we will see an increasing segmentation in the market. There is a institutionalised segment of very large funds with strong brands, operating in a fairly efficient market for larger deals. These groups should be able to provide respectable returns to compensate for the lack of liquidity in private equity. They also provide investors with the opportunity to put large chunks of capital to work. Their logical customer base is investors who need to deploy large amounts of capital into single funds.

‘Underneath this institutional segment is a market that tends to be more entrepreneurial in its outlook and approach. An active, opportunistic programme with the right resources targeting this segment can provide outsized returns. That's where our focus tends to be. Unconstrained capital availability (in the institutional segment) is inconsistent with superior performance expectations.'

Do you look outside the US and Europe?
‘We do look outside the US and Europe. We have past investments in Asia and Latin America. These areas have always been a small part of our investment programme and they will remain so. We think that it is important to monitor these markets as they evolve because they will present attractive opportunities. You just have to be quite careful about how and when you participate.

‘As we sit here today, Asia remains an area in which we will evaluate opportunities on a consistent basis. Latin America is a little more uncertain.'

How are your investments split between the US and Europe?
‘We don't have specific allocations to regions. There are two things that you need to do to build an attractive private equity portfolio. The reason to be in private equity is for superior returns relative to public markets. It is a return-driven investment. But at the same time, you also have to have a highly diversified programme. You have to meet these two objectives but the need to be diversified is not very constraining. Private equity has a very broad landscape that allows you to achieve diversification quite readily while at the same time taking a flexible approach to emphasise where you see opportunities and de-emphasise areas that you believe to be over-capitalised. We cherish that flexibility. That said, at any given point in time, we can ask where we should be focusing our energies, where we believe the majority of our investments should be. We can give a pro forma sense as to what we feel the mix should be. In the near term and in the recent past, that split has been roughly 40 per cent Europe, 50 per cent US, with the remaining capital going to other regions.'

What is your appetite for first-time funds?
‘First-time funds is a widely used term and I think that it's helpful to define what we actually mean by that. At one end of the continuum, you have an intact, established team with many years of experience that is simply changing its ownership or spinning out of a parent organization. We certainly have an appetite for those types of funds and we don't really classify them as first-time funds. They are newly independent funds and that often provides a more intense interest alignment between GP and LP than existed before.

‘At the other end of the spectrum, you have brand new teams forming with professionals who do not have their own track records and who are truly green. Those we won't consider.

‘Somewhere in the middle lie the teams that have been formed by perhaps a couple of experienced people spinning out of an established fund manager and bringing on board a few people they have worked with in the past. These teams tend to have good experience, but they are a first-time fund because they have not worked together as a team before. They can sometimes show impressive skill sets and personal track records. We find these quite interesting and we do participate in those. The due diligence on these funds is more resource intensive and requires a network of independent references to address completeness of record, deal attribution, team skills and stability.'

What size investments do you tend to make?
‘We are flexible on the size of our investments. We don't have a firm lower limit, because good things can sometimes come in small packages. To build the type of portfolio that we want to build to generate the type of returns that we are targeting, we have to consider small bite sizes. In any event, a general range for direct co-investments would be $5m to $15m, for direct secondary purchases $5m to $30m, although we could certainly go above that, and for fund investments $10m to $40m.'

Where do you see the best opportunities for secondaries?
‘The best opportunities for us lie outside the focus of dedicated secondaries funds. We don't have a dedicated fund for secondaries. We look for smaller, less liquid interests in which we have direct knowledge of or direct experience with the manager and the existing portfolio. We are a very logical buyer in these types of deals and we can proceed quickly and discreetly. It may be a relatively unseasoned secondary, for example, that doesn't have much capital drawn down or it may be a smaller interest and these are deals that a traditional secondaries player would not generally be interested in.'

What makes a good private equity fund manager?
‘The first phase of assessment is whether the manager is conceptually interesting- that is, does the strategy have merit in today's market and does the team have a differential and relevant skill set? If we can articulate the “technical right to outperformance” we invest in due diligence to validate the opportunity. We then assess the teams' skills, experience together, cohesion and alignment of interest with us. We evaluate the track record for consistency, fit with strategy and source of returns.

‘It is important to be proactive in identifying the best opportunities as they may have limited or no formal fundraising process. We take advantage of our long-established network of GP relationships together with Morgan Stanley's reach in the market. We try to identify in advance where the interesting opportunities are, spend time in those markets and have a perspective on those prospects before they come to the market.

‘Beyond that, choosing the right fund managers is very much down to judgment. There are certain things that will drive private equity returns going forward - a differentiated skill set, the ability create value post-acquisition and, in the smaller end of the market, sourcing capabilities. We involve two senior people in every step of the evaluation process. It's a judgment-intensive business as opposed to an analytic-intensive one and so it makes sense to have two pairs of experienced eyes examining each prospective fund.'

What is the biggest lesson that you have learned?
‘One important lesson is that good team decision-making is superior to individual decision-making in this business. At the end of the day, it is judgment not analytics that counts. You need to bring to bear a team with a complementary skill set to reach a sound judgment. The appropriate skill set today needs to be broader than in the past given the importance of adding value to driving returns.'

What frustrates you about private equity?
What amazes me most is that lack of critical independent thought - the herd mentality. Money flows in excess to yesterday's good idea, making it tomorrow's underperformer. Because current performance is opaque, investors rely too much on stale realised returns. Those returns often apply to when the fund manager operated at a very different scale and scope. They may also apply to a strategy or skill set that is no longer differentially advantaged. The maths of since inception IRRs gives outsized importance to early winds not current performance. There is no substitute for the hard work and judgment that goes into properly assessing the unrealised portfolio as the best indication of the managers likely success in current circumstances. Otherwise, you rely on the easy to measure but irrelevant rather than the hard to measure but relevant.'

What is the biggest issue in the market?
More than the overhang of uninvested capital, I worry about the overhang of unrealised deals. The annual divestment pace for the industry for the last three years is about one tenth of the stock of unrealised investments. It is also well below the pace of new investments. We need a strong rebound in corporate M&A and the IPO market to work this off. This will happen eventually, but who knows when? The longer holding periods will dampen IRRs and stretch the resources of private equity firms.

‘We have seen an increase in the incidence of secondary buy-outs. I see it as a rational trend for the time we are going through. If the only people with money now are financial buyers, then they will be the natural choice for firms looking for liquidity. They are not high quality exits, but they do at least provide some liquidity.'

How do you think that the market will change in the future?
‘The market will continue to mature. This will lead to increased specialisation in skill sets and a focus on cost control. Both of these are important in the institutional end of the market. The entrepreneurial end of the market will always be evolving and the landscape of opportunities will continually change.

‘If you look over the horizon - and this may be wishful thinking - Germany and Japan will offer deep opportunities. Private equity should have a very constructive role to play in those economies. I just wouldn't want to predict when that will happen.'

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