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Institutional investor profile: Sam Armstrong, Managing Partner, Quay Partners

Armstrong on the challenges of servicing the appetite for private equity among Australian institutions, on the latent promise of early-stage venture capital in Australia, on fund of fund innovation and on never saying never.

Based in Sydney and established in 2000, Quay Partners is Australia's first independently owned private equity fund of funds manager. The firm was set up by Armstrong, Stephen White and Geoff Norman to provide Australia-based institutions with access to private equity investment. It currently has A$210m under management across three funds and is in the process of launching its fourth, Quay Partners II, with a target of between A$150m and A$200m. Quay Partners invests across the private equity spectrum, including secondary transactions and co-investments. Armstrong was previously at Macquarie Bank, where he and White set up its fund of funds operation.

Why did you decide to set up Quay Partners?
‘We set up the firm because we felt that there was a good business opportunity to provide a service to Australia-based clients that we felt many of the mainstream, international funds of funds were not providing. There are a number of issues that are germane to Australian investment institutions and we felt that we had a good understanding of these. There were also more personal reasons - we get on very well together and we all wanted to run our own firm. We had all worked in the fund of funds industry for a number of years - Stephen White and I had set up the fund of funds operation at Macquarie Bank and Geoff Norman had built the Asian business for Pantheon.'

What are the issues that Australian institutions face?
‘Most Australian pension funds are defined contribution and they are growing rapidly. That means that typically, they need to run high over-commitment strategies. There are certain implementation issues that arise from that - they are keen to have capital deployed more quickly than other institutions elsewhere. The second major issue for them is currency risk. And lastly, there are certain tax issues for outbound investment in particular. These need to be thought through very carefully. These are all reasons why Australian institutions need an investment approach that is tailored to suit their needs.'

How do you deal with the difficulties associated with defined contribution schemes investing in private equity?
‘No-one has yet come up with the magic solution to the problems that can arise from defined contribution schemes committing to private equity. One of the issues that defined contribution schemes face is portability. Individual members can easily leave one scheme and move to another. Most funds therefore have a very high liquidity requirement. That poses a particular problem for private equity because it is an illiquid investment. Ultimately, it puts a ceiling on the amount of exposure that these funds can have to illiquid asset classes.

‘But the market is maturing. By that I mean that people are beginning to reassess what constitutes liquidity - they are beginning to realise that just because something is listed or because an asset has a quoted price, it doesn't mean that it is necessarily liquid. With the downturn in the listed markets, I think people are beginning to consider that investing in an asset class that provides a liquidity premium is worthwhile in its own right anyway.

‘I also think that the market will respond with a variety of innovations to address the needs of defined contribution funds. A pre-seeded fund of funds is one idea that I think will make a difference - this would be a fund in which the opportunities have already been identified and selected before investors commit. That will help to truncate the whole investment process and potentially shorten the life of the fund of funds. In fact, we would like to provide institutions with funds that are pre-seeded and that are offered over a regular, short cycle, say, every 18 months. That will allow fast-growing defined contribution schemes to invest over a predictable cycle in a fund that offers some kind of transparency in terms of what the underlying investments will be.'

What type of investments do you tend to look for?
‘We have four funds under management. These are: Quay Australia I, which invests in Australian and New Zealand private equity funds; Quay International, which focuses on international investments; Quay Secondaries I; and we are in the process of launching Quay Australia II.

‘Our approach is to get a very balanced outcome. We have roughly a third invested in venture capital, a third in expansion capital and a third in buy-outs. That's how we like to see all our portfolios weighted, except for the secondaries fund, which is rather harder to balance. We are an active secondaries player, but we operate mainly in Australia. We also make some co-investments from our other funds.'

What is your appetite for first-time funds?
‘We do invest in first-time funds. We have one rule: never say always and never say never. Particularly in a relatively young market like Australia, there are some very good opportunities offered by first-time managers that don't have a long history. Obviously, these managers have to clear higher hurdles than more established players before we would invest with them.'

What do you look for specifically in a first-time manager?
‘We need to be convinced of a team's stability. We need to reach a comfort level that the team will stay the distance. The team is vital in a private equity fund and so we want to see some evidence that it will hang together and that it is operating in an area in which they have a track record or have demonstrable experience from a previous career.'

Where are the most promising areas?
‘In Australia, buy-outs have delivered great returns over the last couple of years. Banks have been willing to support these transactions with decent levels of debt. This looks as though it is set to continue. There are a lot of corporates and government organisations still looking to spin out non-core operations. There is also some movement in areas such as public-to-private transactions and in secondary buy-outs - these areas may seem pretty passé in more developed markets, but we are just starting to see their emergence here in Australia.

‘On the other hand, the early-stage venture capital market has yet to take off in Australia. Globally, however, I remain confident that venture capital will continue to provide good returns. The biotech industry may be in the doldrums at the moment, but the signs are there to suggest that it will do well over the longer term. Overall, I haven't lost faith in the venture capital market - I think a lot of the capital overhang that existed a couple of years ago is being worked through, players that will stay the distance remain in existence and we are getting back to something approaching normality as managers start looking to occupy themselves with something beyond nursing the living dead. I have every reason to believe that VCs will again be commercialising the next wave of new generation technology.'

What will it take to boost early-stage venture capital in Australia?
‘Successful early-stage venture capital markets are built on foundations composed of a variety of different factors - all of which need to be lining up for you. You need money, good managers with previous experience, good mentors and entrepreneurs who have done it before, good paths to exit, good science and good IT professionals to provide the commercialisation opportunities.

‘I would say that in Australia, we now have half a dozen venture capital firms that have managed more than, say, two funds. They have adopted the world best practice VC model. We've had a number of notable successes that have made returns in the tens or even hundreds of multiples. So there's reason to be confident. But there is still a question mark over whether Australia as a remote country can generate internationally competitive deals consistently and on a repeat basis. Could we become another Israel? That's the hope of the government and there are certainly initiatives at state, federal and local level to try and achieve this. The research and educational institutions are all much more aligned now with the venture model and I do think there are going to be a lot of very interesting developments over the next few years.

‘The one thing that will give the market a boost is the introduction of the Australian limited partnership - for the first time, offshore investors are able to take advantage of an international-type vehicle. That will enable Australian VCs to attract overseas investors and they will be able to forge relationships with VCs in other countries, allowing a transfer of knowledge and of best practice. But a lot more still needs to happen before we can get too excited yet.'

What is the biggest mistake you have ever made?
‘I think our biggest mistake has been to follow managers who have been successful in a particular area into a larger fund or an area in which they have proven themselves. So we have seen managers move from being excellent expansion managers, for example, to working on some of the larger buy-outs. Those that shift strategy tend not to be so successful in follow-on funds.'

What is the biggest issue in the market?
‘The biggest issue as I see it is a local one, although I think it probably applies globally. The market is developing into different strands - the boutique firms, the institutional firms and the hybrids. There has been a major reversion among investors to the boutique approach that follows a model I would describe as craftsman-like. In this type of fund, the principals own the firm and the second generation of managers are apprentices to the founders. There is a general recognition that alignment of interest between GPs and LPs is much greater in these funds. Private equity is a long game of football and the natural time horizon of an institution is different from that of a partnership that owns its own business.'

How do you think the market will change in the future?
‘I think the fund of funds market is going to go through a significant amount of change. There will be a tremendous amount of innovation in this area of private equity as funds of funds seek to cater for the needs of their clients. There will always be a role for the one-size-fits-all type of fund of funds as a core product for institutions. But overall, they will start offering new features, such as line of credit facilities, over-commitment strategies, listed funds of funds, pre-seeded funds, niche market funds, etc. We're already seeing next generation-type funds of funds, but there could be a place for biotech-only funds of funds, for example, or other sector-specialist offerings. There will be a plethora of that type of activity in the market.'

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