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Institutional investor profile: Brad Heppner, Chairman and CEO, The Crossroads Group

Heppner on the opportunities presented by the recent US tax changes, on the optimism creeping into the market, on the lack of exit focus among many firms, on the public disclosure of private equity numbers and on deliberate defaulting by institutions.

Established in 1981, The Crossroads Group is one of the oldest funds of funds in the private equity industry. The firm is based in Dallas, Texas, and has $2.1bn committed to private equity funds. It manages eight funds of funds, each of which represent a particular strategy, from co-investments and secondaries, through to US and international portfolios. Through these vehicles, Crossroads invests across the spectrum of private equity on behalf of its 100-strong investor base. Heppner joined The Crossroads Group in 1996 and was previously a consultant at Bain & Co and before that, was responsible for public and private market investments at the John D and Catherine T MacArthur Foundation.

What type of investments do you tend to look for?
‘We invest across the whole range of private equity types through what we call our eight composites. Each of our funds has a particular theme and together they make up our family of funds. These are: the private equity asset allocation composite, diversified venture capital, mid-cap buy-out, diversified private buy-outs, international diversified private equity, private equity opportunity, global secondary acquisitions and global direct/co-investment. We offer three of these composites to our investors each year. We feel that this is the best way to cater for the different appetites of our investors, of which we have around 100.'

Bearing in mind that you look across the market, where are you seeing the most promising opportunities?
‘I would say that the opportunistic and contrarian investors are looking very closely at mid-cap buy-outs and at venture capital at the moment. Venture capital has had a rough few years as valuations have soared and then plummeted and the IPO market has dried up. But the recent tax changes announced by the Bush administration in the US should be favourable to the market. Companies have been cutting back their budgets for a few years now, but the tax changes, which provide a type of tax relief to businesses' IT spend, should provide a boost to the market - technology venture capital is highly correlated with levels of IT spending among companies. The other area, mid-cap buy-outs, we are finding more interesting than larger buy-outs right now. There is less competition for the deals and the numbers have historically been better than at the larger end. I also think that there are parts of the president's new tax plan that will help this area of the market, too.'

What is your appetite for first-time funds?
‘Our firm was founded on the basis of supporting first-time funds, the reason being that when we started in 1981, there were very few institutional funds in existence. Many of the first-time groups we backed in our early years have gone on to become some of the best known names and best performers in the industry, so we are keen to continue backing new talent. I would say that we have a preference for backing principals that we already know well who decide to set up their own firm. That way, there is a complete track record that we can analyse and verify - quite often with help from our own database. Our other focus in the area of first-time funds is spin-out groups from larger organisations. Again, this is because we can get the complete and verifiable track record information we need to ensure that we are backing the right team.'

What do you look for in a fund manager?
‘We want to back teams that can clearly demonstrate previous successes and for which we can have a thorough understanding of their history. We want to see that the team is cohesive and can work well together. We look for teams that can source the best opportunities in their space and that have the right skills and capabilities to work with and exploit those opportunities. We verify the integrity of the managers. We also have to be convinced that the team has positioned itself well and is working in a space that we believe makes sense for now and for the next few years. That is for the primary fund investments that we make. In our secondaries investments, we look very closely at the ability of the managers and the investments they have in their portfolio. We want to ascertain whether the portfolio has legs and whether managers have the capability to manage out the assets to the best of their potential. In all of this, of course, we analyse the exits that a team has made, how they planned for and executed them and how much emphasis is placed on the exit throughout the investment process.'

How much emphasis do you think firms place on exits?
‘I don't think that most firms focus enough on exits. This is evidenced by the fact that this usually the area on which we receive the least information from firms when we are conducting our due diligence - whereas in fact, it should be one of the most important fields for firms to show their expertise. We look very closely into a firm's exit capability. It's all very well to show the IRRs and performance, but we need to drill down and see whether the exits a fund has achieved have been down to pure luck or whether the team has had a clear vision about where they were going to achieve realisations. From this exploratory work, I would have to say that we have encountered very few that have a real and clear exit strategy and that have the ability to exit in the best possible way.

‘The problem is that if an exit is done poorly, you can really lose any value created in a portfolio company. So we get down to the detail of who in the firm has the skill set to pick the best exit strategy for each deal and to negotiate the best terms for the fund. When we look at a firm, we analyse their decision-making process in the exits they have executed and work out how they have arrived at the conclusion. We want to back teams that know themselves what the best path will be - far too many simply rely on investment bankers and advisors for sourcing exit opportunities.'

What are the main trends that you are seeing in the market at the moment?
‘I think that the new tax plan that I have already mentioned will have a significant impact on venture capital. The plan was announced just about a month ago and people are still working through what it means for them, but when they do, I think we'll see an acceleration of companies' IT spending. I've already seen this to some extent in my own local area here. CEOs I talk to, who have previously cut back expenditure on new technology, are now starting to implement new technologies in their companies. It has been so long since they spent any money on this area, that there is now a pent-up demand for various technology-type products. I have also seen the capital calls from our GPs start to pick up recently. There is still caution in the market, but there is a little more optimism about the future. I think that the security and disaster recovery areas are particularly interesting at the moment.

‘In the area of secondaries, we are seeing a lot of deal flow. Banks and insurance companies are selling their exposure to private equity. We have seen a few large deals hit the headlines, but there are many other deals in the market that don't make it to the public's attention. In fact, there are very few entire portfolios up for sale, most of them are being divided up and sold in parts now. For example, we purchased the entire EDS portfolio a little while ago, but now what we're seeing is parts of portfolios for sale. We're also seeing quite a few positions originally taken by high net worth individuals who now find themselves unable to meet their capital calls. These are people who waded into the market when times were good and they had made money on the booming stock markets. They have now lost large portions of that money and are coming to people such as us to buy them out of their private equity partnership investments.'

Have you seen many defaults on the part of institutions?
‘I haven't seen many actual defaults, but I have seen some intentional ones on the part of institutional investors. These have been intentional in that institutions have used them as a means to resolve a situation that they were unhappy about. In the cases I have seen, it's a strategy that has worked. They have managed to get the result from the GP that they were seeking - the defaults have forced GPs back onto the right path. We have only been invested in one fund in which this has happened and we saw that the voice of the defaulting LP was clearly heard by the GP.'

What irritates you about private equity?
‘There are a couple of sources of irritation for me. The first of these is the issue of valuations. There is not a good understanding among many people - some LPs included - about how meaningless interim valuations can be. Investors and others involved have to be comfortable to look beyond the interim figures. They have to let the GP work through to the finish line. They have to be patient. If investors are prepared to wait, they will find that their private equity investments will add Alpha to their portfolios. It's often the case that it's only in the later stages of a fund's life that you get good returns.

‘The other area is the issue surrounding the Freedom of Information Act that we're seeing played out here in the US. This is something that has been led by the public institutions but that is extremely unfair to other private equity investors. Private equity is attractive to investors because it has the potential to make high returns based on certain inefficiencies in the market, including in the area of valuations. Publishing a set of figures on a publicly accessible web site has the potential of eroding those returns.

‘The drivers for this development are two-fold. The first is that, having seen the value of their pension plans decline over recent years, some people are looking to point the finger. They are seeking proof of ways in which public institutions may have misappropriated money. Sure, that is in their interest, but this puts into question the role of public institutions in the private equity market. The obligations they have to their plan holders have the potential to spoil the market for other investors. The other driver is an attempt by people to look at opportunities before a venture capitalist has had the chance to fully exploit their investments. This I find very discouraging. VCs spend a huge amount of time, effort and resource sourcing investment prospects - why should their work be compromised by those with a commercial objective taking advantage of a law that wasn't intended to have these consequences? I have also been very discouraged by the fact that the public pension plans took action before consulting the industry and before a proper solution to the problem could be found.

‘The industry needs to have a debate about the implications of the FOIA and the role of public money in private equity. The industry needs to work to see what information it can make available without prejudicing the interests of both LPs and GPs. We have to work towards a solution.'

What do you think the solution should be?
‘I think the answer lies in some form of indexing. Investors are able to index their performance without actually putting figures against fund names. They could provide information on each of the sectors or sub-asset classes and provide a good picture of performance and they can list the names of the funds they have commitments to. That seems to me to be a sensible way of providing retirees with the information they need as to how their plan is doing but without compromising the private equity industry.'

How do you see the market changing in the future?
‘Well, if we start off in the present, I am feeling broadly optimistic - at last. We have been through a long period of adjustment over the last few years and that has been a difficult time. But valuations have come down and the number of capital calls from our GPs has increased recently. It's starting to feel a little more like 1994 and 1995 - that's a good thing and I'm encouraged by that. I'm disappointed that the adjustment took so long, but I'm glad that things are finally beginning to pick up.

‘Looking further ahead to the future, I think that we are going to see smaller funds than those we have become used to over recent times. This is especially true of the venture capital space. In fact, we have already seen the best performers scale back to fund sizes more reminiscent of the mid 1990s. Again, I am encouraged by that.

‘I also think that succession will be a major issue for many of the smaller funds. I have seen instances in which founding partners who had left the firm actually go back in to reposition it and regain the focus that had been lost over the last few years. They are stepping back in to protect their legacy. I have a lot of respect for that.

‘One of the things that I think is often forgotten when people talk about succession is the fact that the older GPs still have an interest in ensuring the best for their firms. If you think about it, some funds go on for ever. We still have investments in some funds that we committed to way back in the mid-1980s - they have still not been wound up. The older GPs, even if they have now retired, still have carried interest owed to them from these funds. They will ensure that the best people take over from them to maximise the value that they get out of the portfolios.

‘On balance, I think that the main, old-line firms have done a superior job in managing succession. They have made it part of their focus. Some of them may have made a few mistakes, but they are now stepping back into the firms to correct those mistakes. That is very positive.'

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