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Institutional investor profile: Charles Froland, Managing Director, General Motors Investment Management Corporation

Froland on going beyond arbitrage opportunities, on improving the top line as well as the bottom line, on empire builders, on why taking a conservative approach will not serve most LPs and on investors and their comfort food.

Headquartered in New York, General Motors Investment Management Corporation (GMIM) is a subsidiary of General Motors Asset Management, which manages assets on behalf of parent company General Motors as well as offering services to institutional clients. The company has been investing in private equity for over 20 years and currently has in the region of $5bn invested in the asset class, both directly and in funds. Of this, $1bn has been raised externally and is invested via funds of funds or is co-invested alongside the firm's direct investment programme. GMIM invests across the spectrum of private equity, from venture capital through to buy-outs and mezzanine and has commitments across the globe. Froland joined General Motors in 1995 to manage a variety of asset classes and he moved into the private markets division in 1998 to build and manage a team dedicated to the area. He was previously managing director at Stanford Investment Management Company.

What is your allocation to private equity?
‘We don't have a specific target to private equity. We take an opportunistic approach to investing in private equity because our aim is to seek an optimal premium over what we believe we will be able to earn from the public markets. We have $5bn invested in private equity and that amount hasn't changed that much over recent years. The actual percentage does change, however, because it is dependent on the levels of our overall portfolio, so it tends to be anywhere between five and seven per cent.'

Do you see private equity as a diversifier as well as a returns enhancer?
‘It is possible to argue that private equity can provide some level of diversification to a portfolio, but that is not why we invest in it. If you think about this from an asset allocation perspective within the broader plan, you find that private equity has the highest risk and the highest return potential compared to other types of investments. An optimiser will suggest that you invest in private equity, primarily because it's the only way that it can find to increase your returns. That is the way that we view private equity - we don't think that it can diversify your risks. You can have discussions about how much risk you are prepared to take on, but the fact of the matter is that if you are in the business of making money, you have to take on a certain amount of risk while being confident that you can earn adequate returns to compensate for that risk. We believe that private equity can do this.'

What type of investments do you make?
‘We have a broadly diversified portfolio that spans the private equity spectrum. We invest on the venture side all the way through to bankruptcies and special situations as well as investing in buy-outs. We also invest internationally and so we have commitments in the US, Europe and some of the emerging markets.'

What is the broad split of your portfolio?
‘We have a basic split of 80:20 equity to debt in our portfolio. On the equity side, we have roughly 20 per cent allocated to international direct investments, primarily in Europe. We have a further five to ten per cent exposure to buy-out funds in Europe through investments made by US funds. On the domestic side, we have about 25 to 30 per cent in venture capital, the balance in buy-outs. On the debt side, the split is roughly 60:40 between distressed, bankruptcy-type transactions and mezzanine.'

Why did GM create a separate private markets division?
‘General Motors had been investing in private equity for around 15 years, but it was spread between three separate areas: domestic equities, international equities and global debt. We felt that, because of the characteristics of private equity, we needed a professional team dedicated to the asset class. So in 1998, the private markets division was created and we expanded the team dramatically. We hired people with direct investing experience, both because of our direct investment programme, but also because we felt that they had the knowledge and the networks to source fund investment opportunities. They also understand the pressures faced by GPs and their motivations. We now have ten investment professionals in place in New York and London, plus a significant back office.

‘But we also understood that if we were to attract and maintain a professional level of staff that we had to have the right structures in place, both in terms of remuneration and development. Also, in order to further the franchise, we decided that we wanted to be working with a diversified base of capital and I think that GPs are keen to understand the strength and stability of the capital that an LP can provide them with. I think the fact that we have a dedicated team in place helps us access some of the best opportunities.'

How much of a problem do you think that staff retention is for institutions?
‘Working for a private equity firm is clearly an attractive option for those investors with talent. I think that this has been a problem for some institutions and they have suffered from a certain amount of instability as a result. It can be frustrating because you spend a lot of time, effort and money training people and developing that talent and the last thing that you want is for it to walk out the door. We took the view that as an institution, we didn't just want to be a training ground for private equity firms, and that is why we have been very careful to ensure that the right structures are in place to attract and retain the best people.'

What do you look for in a fund manager?
‘The simple answer to what we're looking for is talent. The harder answer is actually defining what that means and working out how that talent fits with what the firm is actually trying to achieve. One of the most important aspects for us is to understand how the talent in an organisation will stay the course. That is partly to do with the ways in which the people are incentivised - something we look at very closely in our own organisation, as I've already described - but it's also to do with how that talent applies to the model that the firm has and the strategy it has defined for its success in the market.

‘We look at this talent on a variety of levels. The first of these is how a fund will select proper and appropriate deals. I'm not talking here about deal sourcing. It's easy enough to see what deals are available, especially in the areas of the market that are driven by the auction process. By sourcing deals, I mean that we look at how a firm will analyse the deals they see and how they reach their decisions as to which opportunities justify them getting out their cheque books. It's possible to make money by buying cheap assets, for example, but that's far from the end of the story. We look for firms that really understand which companies are the ones that the wider market will find interesting and that will ultimately make a good exit. Private equity should be about far more than taking advantage of arbitrage opportunities. Just because a company is cheap does not mean that it's a great deal. So we look for people who have a well thought out strategy for deciding which deals to do and who have a good eye for what makes a great deal and what will make a great exit.

‘Moving on from that, we look at the skill set and balance within the team. Of course, you have the investment banking bag of tricks that include deal structuring and execution and negotiating throughout the deal process. There is scope for adding value through this. Then there are the operational capabilities that a firm has. These can either be in-house or they can be capabilities that a GP can call on externally through its networks so they can access management talent that is appropriate to a variety of situations. We look for teams that are able to monitor their investments actively and that are able to spot potential problems and work through them before they become a major issue. They need to have the ability to work out whether they should, for example, reposition a particular company, access new markets, change the marketing strategy, etc. We are looking for people who are really able to enhance the top line as well as the bottom line.

‘And finally, we look at how a firm works towards exiting their portfolio companies. It's not just a matter of hiring a group of investment bankers and doing an IPO. There is a lot of scope for finding the right buyers through marketing the asset or telling the story in a compelling manner that convinces people that the company has really got some legs. If you look at some of the most successful deals that have been done, there is typically evidence that the market believed the company had a solid story. Part of that is unique to the company, but part of it is to do with the way in which the company has been positioned to be as attractive to the market as possible.

‘These are the key skill sets that we are looking for, but we also have to be sure that the talent is stable and has a reason to stick around. That means ensuring that the infrastructure is in place to support the team members and that the people are fairly and correctly remunerated, from the investment professionals, right through to the support staff.'

Would you therefore characterise your process as more qualitative than quantitative?
‘These are the broad questions that we seek to answer, and they are qualitative. But there is a lot of quantitative analysis that goes into answering the questions. We don't just look at the headlines of the firm's current track record, we drill down internally into what went on with each of the portfolio companies. The best way of thinking about these questions is that they are the tracks in the sand, it's up to us to quantify them and understand where they lead.'

How exit-focused do you believe that most firms are?
‘I think that the vast majority of firms do not place enough emphasis on exiting their portfolio companies. A lot of them are driven by an operating philosophy, so they will pay a lot of attention to the bottom line and making operational improvements and cost-cutting and so on. But I don't think there is generally enough true understanding of how to really improve a business. As I said, you need to focus on the top line as much as on the bottom line. You need to have the ability to transform a company in order to position it for a successful exit. But I think a lot of it comes down to the initial selection of the deals. Most firms do not have a well planned approach to this. There is very little thoughtful strategic work done on how to select deals. Firms tend to put too much emphasis on deal sourcing instead - it's not the same thing.'

Why do you think this is?
‘I think that it is partly because of the history of the industry. A lot of the people in this business come from investment banking backgrounds and so they are naturally transaction-driven. If you look at what happens in public markets, most of the investment process is about selection. They spend a lot of time selecting their investments - they understand the context in which they are working, they understand the alternative methods that can be used and they can see the implications of different methods of selection. That level of discussion is completely absent in private equity. Virtually no-one has a thoughtful understanding of the context in which they operate and it's because they have never had to - for that matter, you can actually be quite successful without that. But if you do have that, then it is another factor that can contribute to your success. There are one or two that do have this thoughtful approach to selection and it shows. There are others who pride themselves on their operational capabilities and their ethos is that they build companies. That is very laudable. But there is a danger that they are promising to do everything.

‘The luxury we have on our side of the table is that we can form a diverse view from looking at a variety of groups who approach private equity from a lot of different ways. We can recognise that all these skills sets can be brought to bear. If they are missing one or other of these skills, it doesn't mean that they are not going to make returns, but they are still missing something. It pays to bring as much as you can to the table.'

What are the most common deal-killers for you?
‘Success based on a very limited scope, not having a thoughtful strategy, straying from strategy. Other areas are having process or incentive structures that don't look stable, having generational issues, or having groups that look as though they are running an asset gathering institution as opposed to a return-driven and LP-driven organisation. There are a lot of empire builders out there. In a way you can understand why some groups are attempting to gain stable revenues from fees rather than relying on the less predictable income source of carried interest, but I'm not sure that that kind of model is one that pushes for the highest possible returns.'

Do you think it's likely that we will see some downward pressure on fees among those considered to be ‘asset-gatherers'?
‘I'm not sure that we will. Investors are being increasingly selective about which firms they invest with and we are seeing what's widely being dubbed a “flight to quality”. At the same time, I don't see any evidence of a diminution of appetite among most investors. There may be certain banks and other financial institutions that are withdrawing, but the appetite among endowments, pension funds, foundations, etc is, if anything, stronger than it has been in the past. These investors have seen a dip in the performance of other asset classes. They are increasingly looking to areas such as private equity as a means of boosting their returns.

‘The question is: how will all this money be put to work? The answer appears to be that large amounts of the capital will go to the higher quality groups and those that have been effective at building brands independent of any stellar performance. People are cautious at the moment and so they will seek refuge in brands and well known players. As long as there are investors committing to these funds, then I can't see that there will be downward pressure on the asset gatherers of the industry.

‘The real challenge for those in our shoes is to find groups that are properly incented and run by talented people. Not going with the asset gatherers makes our job harder, but ultimately more rewarding.'

What is the biggest mistake that you have ever made?
‘I think mistakes generally come when you don't pay sufficient attention to long-term investment disciplines. I think it's dangerous to suspend your usual long-term perspective because you think that the market has changed for good and you feel that you have to reach out to a particular type of investment. I think one of the most valuable lessons we have learnt over recent years is that you have to choose your approach and your discipline and you have to stick with it - that's true of any asset class, but particularly true of private equity.

‘I think we're seeing an illustration of this mistake at the moment in the venture capital market. There are so many people in shock about what has happened over the last few years that they are going to the other extreme and withdrawing from the market entirely. I would argue that you cannot make up for the money that you have lost in the past by taking a conservative approach to investing today. You have to stay the course.'

How do you think the market will change over the future?
‘The underlying markets and the opportunities that present themselves to private equity are unlikely to change. But what does need to change is that, as markets become more efficient, firms will have to be more sophisticated about how they extract value from those opportunities.

‘But perhaps more interesting is the evolution of the management side of the business. You have seen huge growth in the market, followed by some retrenchment and distraction from the bubble. But if you take a lesson from the public markets, you will see that there will always be new firms setting up. There is a lot of talk about consolidation in the private equity industry and while some groups may disappear, there will always be new ones on the horizon. In many ways it looks as though the large funds and the brand names are winning out - a lot of institutional capital is being channelled their way and it is hard to set up a new firm in today's difficult environment. But I firmly believe that we are currently going through a transition period during which the seed bed for new organisations is being planted. The difficulty for investors is understanding which groups will become the next wave of talent. If you looked at the US real estate market in the early 1980s, you had about half a dozen dominant players. Today, only about two of those exist and a whole new crop have come in to dominate the market. If you look at private equity 20 years from now, my guess is that you will see the same thing. The task for LPs is to figure out how to access the new guys. Will they give up the comfort food that they have been eating? That is the big issue for LPs.

‘The other point is that people generally believe that there is a fixed set of opportunities open to the venture capital market. They have seen that when they give the venture industry a lot of money, it cannot invest it well and returns go down and so venture funds should revert to being $200m in size as they were in the mid-1980s. I would ask, with the economy having grown so strongly, with higher valuations, with new markets having opened up, why should there be a fixed capacity? There is the potential for growth in the market. It may happen through fits and starts, but I believe that the venture capital and the buy-out markets have room for further growth and you will end up with a multi-tiered, sophisticated private equity market, much as you have seen in other asset classes.'

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