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Institutional investor profile: Austin M Long III, Managing Partner, Alignment Capital Group

Long on the difference between a series of pleasant meetings and building a portfolio, on the persistence of performance among private equity managers, on faith in financial markets and on avoiding conflicts of interest.

Based in Austin, Texas, Alignment Capital Group is an alternative investment advisor. The group was set up in 2001 to provide portfolio construction, management, analysis and monitoring services to institutions that invest in private equity. It now manages, on a non-discretionary basis, the Targeted Opportunities Program for Colorado PERA and provides private equity benchmarking analysis for the Florida State Board of Administration. Long co-founded Alignment with Craig J Nickels and previously, they both managed the private investment portfolio for the University of Texas System.

Why did you decide to set up Alignment Capital Group?
‘We originally left the University of Texas System to set up a fund of funds in April 2000. Despite the fact that we had committed capital, we found that the time just wasn’t right and it was more complex than we had imagined. The crash of the Nasdaq also dissolved the capital that had been pledged to us. As a result, we had to downsize, close offices, etc. In short, we did all the things that we would expect entrepreneurs in a portfolio to do.

‘We then went back to the people who had agreed to back us in the first place and from these conversations, we realised that almost everyone we spoke to wanted a value-at-risk assessment. They wanted to know what their portfolio would do in the future, what the cash flows would be. So we set up a consultancy on the spot. Colorado PERA was our first client and we have since been appointed to manage a non-discretionary mandate for them to find funds of under $250m. This is the Targeted Opportunities Program (TOP). We are also strategic consultants to the Florida State Board of Administration and we have done a review assignment for the Kansas Public Employees Retirement System.

‘We don’t currently have any discretionary mandates, although it’s not something I’d rule out entirely. We do what our clients want us to do for them, but it has to be consistent with our philosophy that there should be no conflicts of interest involved.’

Do you have ambitions to raise a fund of funds in the future?
‘That would be dependent on whether we felt it was consistent with the advisory work we are already doing. We have seen a number of consultancies ending up managing discretionary funds and this can cause conflicts of interest.’

How focused will you remain on public pension plans going forward?
‘We will respond to trends in the market. Today, there are two main needs – one of these is consultancy for public pension plans. This is in part driven by the high staff turnover that many of these organisations have. And there is another need that we have addressed on a couple of occasions. Around the world, there are between ten and 15 large banks and insurance companies that, either through mergers or the passage of time, have collected private equity interests. These are legacy portfolios that are, in effect, orphans. Several of these financial institutions have been in discussions to undertake securitisations to get some cash from the portfolios without selling their positions. We have helped price the risk of the AAA tranche in two of the three that have gone ahead – AIG and Deutsche Bank.

‘So these are the two needs that we have identified in the market that we can work on. What these two areas have in common is the need for a quantitative approach.’

How would you describe your quantitative approach?
‘Without going into too much detail, what we do is based on a view of risk as outcomes over time. We have developed a mathematical theory to quantify that risk. The techniques that we have, three of which are patent-pending, enable us to diagnose the risk versus return of a private equity programme. We are able to calculate an internal and external correlation and we are able to form a view of the portfolio cash flow projected over the future.’

How do you source opportunities for your clients?
‘With the TOP programme, the sourcing in some senses was taken care of for us. The programme was announced at a time when fundraising was at its hardest. It didn’t take much effort to direct the attention of everyone in this tier to us. The Colorado PERA public relations people did an excellent job at getting the programme a huge amount of coverage in the media and so we have had a great response. In the last year or so, we have seen around 270 private placement memoranda and we’ve had excellent deal flow for that programme. That has enabled us to pick the very best in the sub-$250m bracket.’

What makes a good private equity manager?
‘Those stories are as individual as the managers that run the funds. There are, however, some common threads that it is possible to observe and there are also some that are less tangible. But our process initially revolves around revolves quantitative screening. Out of the 270 managers that we have taken an initial look at, for example, we have had interviews with 17. Those managers have one thing in common that it is possible to quantify – a long and distinguished track record of doing what it is that they propose to do. One of our mantras here is that there is a learning curve to everything. We want to see people who have already spent someone else’s money, either their own or that of other institutions. We want to see that they have climbed to the top of the learning curve already. That is the only protection we have. All that we can be certain about in this market or any other is proof of past performance.’

How much of an indicator do you think past performance can really be?
‘I think that it is more of an indicator in private equity than it is in other asset classes. One of the calculations that we do routinely is whether the performance of particular managers over a given period of time is statistically significantly different from the index over a period of time. When you apply that to public equities fund managers, you find that it is extremely rare for managers to outperform an index such as the S&P500 over a decent amount of time. Yet in private equity, the situation is somewhat different. Every one of those 17 that we have spoken to is statistically significantly different – every single one of them. That is proof of the inefficiency of the private equity market.’

But presumably you believe that the sub-$250m area of the market is more inefficient than others…
‘That is absolutely true. Our feeling is that, when people raise extremely substantial sums, are involved in the New York investment banking scene, are paying those fees and are competing against one another in that segment of the market, it is vastly different in terms of efficiency than the market we are researching. When we see people who say they have a privately negotiated deal, we can trace through the origination and audit the files and in the sub-$250m space, we’ll often find that there is no other buyer in the negotiations.’

Would you consider expanding your focus outside North America?
‘We are open to whatever our clients need us to do. But I would say one thing as a caveat. The European market is not just the US on the other side of the water. It’s a different place: the people and the history are different, as are the capabilities. The deal flow arrives in a different way. By and large, the industry there is much less mature than it is here in the US. It’s extremely hard to find groups with a round-trip track record in Europe – by that I mean that there aren’t many managers that have sold as well as bought companies. In the US, a round-trip track record would date back to the late 1960s in some cases. It’s very hard to find a track record that lengthy in Europe. It isn’t that you can’t; it’s just that there are so few of them.

'All that makes it very difficult to do exactly what we do in Europe. I frequently hear the criticism that it’s unfair to insist on a track record that is that lengthy. I concede that point. It isn’t fair because it means that people who are just starting out and who may be brilliant won’t be considered. But if we believe in the mathematics of what we are doing, we have to realise that we have no principled, disciplined way of understanding very short track records. If we were to look at more recent arrivals, then we’d have to go entirely on feel. We have a good record of having done that in that past, but we now have fiduciary duties to our clients.’

Would you not agree that at least part of the decision to back a group is down to ‘feel’?
‘Absolutely. In fact, some people pass our quantitative screens and then fail on feel. Some of them will fail the file tests because they don’t actually make decisions the way they say they do or they don’t have any verifiable way of reaching those decisions. In the end, we are in the business of making this process as disciplined as we possibly can. There are means of making the feel element disciplined. Only if we do that can we have a truly rigorous process. If you lack either the quantitative the feel element, then it is not a complete decision-making process.’

So do you look at individual or fund track records?
‘We would rather see fund track records. By that I mean we like to see the same people, at the same shop, doing the same thing for a meaningful amount of time. On occasion, you do see individuals that have been in private equity for a long time in different firms and who come together. In those, instances, I’d say that feel becomes paramount. You are trying to understand along which fault lines the group will crack under pressure. There is extreme pressure in this industry.

‘The problem is this: there have been studies done on indices of public markets versus the people buying stocks. What people tend to do when buying individual stocks is that they buy stories. They tend to explain things to themselves in a way that seems logical to them. They will usually assemble a portfolio, not based on the merits of that portfolio, but on a feel for each constituent part of the portfolio. That way lies madness. We take the position that the only way to control risk is to assemble a portfolio of parts that are designed to be counter-cyclical to each other. So, for example, we would never buy everything in one sector or in one stage of development. The reason we are so militant about the statistics is that, unless you are quantitatively rigorous about putting together your portfolio, it tends to become a series of stories and pleasant meetings. Pleasant meetings are great – I like them as much as the next person – but they don’t make a portfolio.

‘If you put this into the context of private equity, over long periods of time buy-outs and venture capital tend to be somewhat counter-cyclical. They are not entirely counter-cyclical statistically speaking, but the difference in cycles is pronounced. As a result, we believe that it is important to assemble a portfolio consisting of both. The other point to bear in mind is that the dispersion of returns among venture funds is much higher than that for buy-outs. So we wouldn’t advocate an exact 50-50 split. Instead, we’d suggest a larger allocation to buy-outs in a smaller number of funds and a smaller allocation to venture spread across a larger number of funds.’

What irritates you about private equity?
‘A major irritation for me is that there is a tendency on the part of the entire LP class to consent to almost any behaviour on the part of the GP class. There are many complaints about GP behaviour and yet the very same legal and financial incentives remain in place and the same funds get funded even when they do not deserve it.’

What changes would you like to see in the industry?
‘If I had to ask for just one thing, it would be for people to follow the mathematical logic of what they can prove. They don’t seem to be doing that. Portfolios couldn’t be composed almost entirely of major buy-out funds if they did that. People would not be investing in multi-billion dollar venture funds either. I am only aware of one mega venture fund that has a long track record of managing a large amount of money. Everything about that firm is geared to deploying and managing that amount of capital. Everyone else is climbing a learning curve. That tends to be expensive.’

Do you not see the trend for larger venture funds reversing?
‘It’s happening excruciatingly slowly if it’s happening at all. Sure, many groups are raising smaller funds, but they are not that much smaller. It is one thing to manage a $150m venture fund; it is quite another to manage $1.5bn. Even if you reduce that to $900m, it’s still a whole lot more than $150m or even $400m, which is what I’d consider the northern limits of what is advisable.

‘When the market reaches a point of enthusiasm, which it always does, it is inevitable that many people cash cheques just because they can.’

What is the biggest issue facing the industry?
‘I think the biggest issue comes and goes. It’s the perception of risk. In our experience, everyone pontificates about risk and very few people actually measure it. You cannot manage what you are not measuring.

‘The problem that this industry has is born out of the fact that it is put together out of stories and pleasant meetings. When something hits the press that challenges the good stories and the meetings turn unpleasant, the industry as a whole is poised on the knife point of losing credibility. It’s vital to remember that everything that happens in the financial markets is based on faith. There is nothing more damaging than when people lose faith.

‘I think the industry has to marshal the evidence that is in front of it. It has a particular risk/return profile, it works in a specific way to fund liabilities in the future. There is no other reason for being in private equity.’

How will the market change in the future?
‘My feeling is that the advent of securitisation will bring on the advent of the quantification of the asset class. The industry will become more disciplined and more amenable to mathematical description than it has been in the past. It will become less a series of pleasant meetings and more an exercise in portfolio management.’

Do you believe that that is part and parcel of a maturing asset class?
‘I think it’s an inevitable step in a maturing asset class. When you consider the staggering amounts of money being invested in this asset class, the industry will have to become more quantifiable and it will have to have a position in a portfolio that can be optimised.’

Do you believe that the market is capable of absorbing the amount of money that is going into it?
‘I believe that it can in its current state. Fundraising has moderated sensibly over recent times. I don’t have the answer to this, but I think it’s important to remember that pricing and value in the market is set at the margin. At some juncture, an additional amount of money will have an effect. We are not there now, but it is mathematically inevitable that we will eventually reach that point if fundraising statistics increase again.

‘There are two aspects to this: the amount of money in the private market, relative to the amount in public markets; and the amount of money in the private market, relative the number of opportunities available. Here’s an example that we saw in the not too distant past. There was a consortium of three different bidders for a major buy-out purchase. We knew of investors that had interests in all three. They were bidding the price up for their own money. I would suggest that that is perilously close to calling into question fiduciary obligations. One of the litmus tests that we have in our portfolios is that none of the GPs competes in the same space as another.’

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