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Institutional investor profile: Giuseppe Campanella, Chief Investment Officer, Mediolanum State Street

Campanella on the difficulties of co-investing, on the Italian market's potential, on why general partners are storing up trouble for the future and on the need for education among limited partners.

Based in Italy, Mediolanum State Street was created in 1998 to provide asset management services to the institutional market. It currently runs one private equity fund of funds - Italy's first - named Fondamenta, which closed at E160m in March 2001. Fondamenta invests in Italian funds across the range of private equity sectors as well as making substantial co-investments. Campanella joined Mediolanum State Street in 2000 following a management career in several medium-sized Italian industrial companies, including chemicals company ALPA. Immediately before joining Mediolanum, he was Chief Operating Officer of the Angelucci-Gabrielli syndicate during its acquisition of Cofiri.

What was the rationale for setting up Fondamenta?
‘The rationale for Fondamenta was part of a wider project, which aimed to provide asset management services to the newly established private pension funds in Italy. This project started offering services for the traditional asset classes and then moved towards alternatives. When Mediolanum State Street decided to set up Fondamenta, there were no funds of funds in the Italian market and yet there was a growing institutional appetite for private equity. The idea was to attract a limited number of investors - we have only five - but we initially wanted those that understood the asset class well. Since we established Fondamenta, we have seen that there is further potential for alternative products in Italy in areas such as hedge funds and real estate.'

What type of investments do you look for?
‘We invest only in Italy. Part of the reason for this is our investor base. Two of our major investors are bank foundations that have the set objective of contributing to the development of the Italian economy.

‘Our investments are split between funds and co-investments. Our limited partnership agreement stipulates that we can invest no less than 50 per cent in funds and no more than 50 per cent in co-investments. We have, however, found that a 65 per cent fund investments and a 35 per cent co-investments split is more realistic. It is quite difficult to make co-investments. There are few deals in the market anyway and we have found that few funds will offer their investors the best deals. Fund managers tend to present the larger deals that they are unable to finance alone or the ones that they view as being more risky - that's not particularly attractive to us. I don't think this problem is unique to the Italian market. But we only want to do good quality deals and so we have had to revise our expectations about the amount of co-investments that we will be able to make from this fund.

‘The next time we raise a fund of funds, we would like to raise more capital. That would allow us to make larger commitments to individual funds and to negotiate better co-investment agreements. We believe that if we can find the right co-investment deals, we can boost the overall return of the fund because we don't have to pay management fees or carried interest.

‘Within both our fund and co-investment strategies, we invest across the range of stages from start-ups through to mature companies, but our main focus is on investments - either via funds or directly - in medium-sized Italian companies operating in industries with strong growth prospects.'

What irritates you about private equity?
‘I am not particularly happy with the private equity market as it stands. I don't think that the interests between investors and fund managers are well balanced. The basic concept of private equity is that investors provide capital to fund managers and we share the risks and profits. The deal should be that fund managers are incentivised to perform well by earning carried interest - not by simply collecting an annual management fee. If you look around, almost all - but especially large funds - are making money from their management fee. This is immoral. It is very similar to what happened in the brokerage industry in which firms made a lot of money, but without taking any risk.

‘I think this is storing up a problem for the future. Of course, you can't regulate the private equity industry to stop this happening. But if it doesn't impose self-regulation on the issue of management fees, there will be trouble. If the funds raised over the last few years do not return money to the investors that have paid these excessive fees, private equity's reputation will suffer some significant damage.'

How likely do you think it is that the industry will change in this respect?
‘I don't think that it is very likely. The problem is that private equity is not very competitive and many limited partners are simply prepared to accept the terms offered to them by fund managers. This is the reason that I would like to be in a position to negotiate in the future and to get better terms in the future - and we can only do that if we are able to raise a larger fund.

‘Limited partners are unable to put pressure on general partners. I don't see why a two per cent management fee, for example, should be a market standard. That level of fees may be appropriate for some funds, but not all. Private equity funds do not need to charge a percentage. The logical evolution of this industry would be for investors to pay for the running costs of the management company, which would be a set amount each year. The only reason that two per cent has become a standard is because limited partners are prepared to pay it. And the reason they are prepared to pay it is because limited partners don't get together to discuss the problem and work in concert.'

What do you look for in a fund manager?
‘We look for a number of things, but remember that until recently there was only a handful of firms operating here. Over the last two years, we have looked closely at 45 funds, which shows how much the market has grown. There is a lot of activity, there are initiatives being put in place and there are new teams exploring new areas.

‘More specifically, we look for teams that are able to articulate their strategy clearly and are able to demonstrate a consistency of investment style throughout their investments. Consistency within the team members is also key for us, as is relevance of experience to the strategy. I see so many mangers that claim to have the right credentials for private equity investment, but when you delve a little deeper, you find that they have never really spent time in a company. We want to back people who understand business. Operational experience is essential for those who are doing the larger deals. The larger firms have some extremely clever people on board and have partners who have worked for many years with large corporations to gain strategic and financial skills. They can sit on the board of a company and make decisions in the knowledge that there are people in the company who can implement them. But if you are talking about the Italian market, which consists of much, much smaller companies, you need a totally different skill set - and that's what we look for. If you are investing in companies with a turnover of E75m or less, you have to be able to relate to people on the factory floor as well as the management team. You have to be ready to get your hands dirty. Private equity investment in Italy is not about ideas and strategy, it's about the detail of the business. That is where the opportunities lie and those are the types of skill we look for.'

What is the biggest issue in the market?
‘I think that one of the biggest issues in the market is the limited amount of attention that many LPs pay to their private equity portfolios. Only a tiny percentage really monitors what is happening in their investments. They are too blinded by the promise of stellar returns. I think that many of them are in for a shock because their returns are unlikely to be stellar - they will certainly be lower than many are expecting. When investors realise how little they will receive from their investments, there will be a backlash - and that's what I fear. The media will report on it as a scandal and that will do the private equity industry untold damage.'

So you don't have a very optimistic view of the market?
‘Over the short term, my view is pessimistic; over the medium term, I am more optimistic. I believe that demand for alternative products will grow in the Italian market - that is the market I know. I think the problems that we are seeing now and will see in the short term will lead to a shake-out in the market and that will be a good thing. The problem is that the shake-out will be slow. If an investor commits in one year, they will not know for at least five or six years how the fund is doing. In the meantime the fund, however good or bad, is able to remain in the market and can survive. My fear is that when investor interest grows in the future, it will unfortunately coincide with the time when the poor performance of many private equity funds comes to light. The behaviour of some of these players will ruin the image of the asset class and will delay further the development of private equity. I hope this doesn't happen, but I fear that it will.'

Do you think that the publication of performance figures will help to dampen investors' unrealistically high expectations?
‘I think that the problems I have described have been caused by a lack of transparency in the industry. I have been encouraged by the moves in the US by public pension plans to make their private equity fund performance public. This is a good thing. I can see no reason why this information should be kept secret.

‘I believe that this is beneficial to the industry. Without it, new investors have no means of benchmarking the claims of the teams they meet against the actual returns seen in the industry.

‘But I think that what could be more beneficial is an association of limited partners in Italy. That way, we can share information, performance and experience. That should help fill some of the information gaps we currently have to deal with as investors in private equity funds.'

How would you characterise appetite for private equity among Italian investors?
‘There is a growing interest in private equity among Italian investors. I think that the market has the potential to be ten times the size of that today. The average allocation of institutions is currently well below one per cent. It will take a while before they reach similar levels to those seen in the UK, for example.

‘Historically, firms have raised money through two main ways. The first of these is by targeting the retail market. I'm not sure that there is much future in this because firms are asking people to buy into something that they don't understand very well. The second is what I would call the “friendship” approach. In this, money is raised through relationships. Whether they are conscious of it or not, investors haven't always committed because they believe in an investment's prospects, but because they have a good relationship with the managers. That has been true of large banks and also to a certain extent of pension funds. This is done in good faith, but I don't believe that there is a good case for making investments on this basis.

‘But there is another type of private equity investment. It takes a more professional approach and I would call this “conscious” investing. This consists of money raised by firms that have been investing for a number of years through several funds and that have had a reasonable level of success. The limited partners in these funds have tended to re-up with each successor fund and so their investor base is fairly constant. This makes up no more than 30 per cent of the market, however - the bulk of the money raised elsewhere in Italy is from investors that are not really conscious of where their capital is being invested.

‘As a result, I feel that there is a need for much more education among limited partners. There are several positive signs of increased investor appetite, but there is a lack of competitive attitude among financial institutions - and I don't think that is necessarily particular to private equity. Manufacturing is totally different in this respect. In industry, people are prepared to compete heavily on price or quality. In the end, the customer knows exactly what they are buying because the process is that much more transparent. That is not apparent in most activities of the institutional investment community.'

How will the market change in the future?
‘Private equity will become as complex a market as public equities. There will be a growing stratification of private equity. At the lower levels, you will find very specialist funds emerging that invest in particular industry sectors at particular stages. Then you will find specialist funds of funds and more mezzanine players. And at the top, there will be publicly traded synthetic vehicles that package investments in the layers below. This will cater for the liquidity needs and appetite for risk among investors.

‘So all in all, I think that the industry has a big future and has a lot of scope for growth and development.'

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