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Institutional investor profile: Paul Rice, Senior Managing Director, Private Equity, Mesirow Financial

Rice on the amount of dollars flowing into private equity and how that will affect returns, on judging teams with a problem fund, on the importance of people and on what proprietary deal flow really means.

Established in 1937, Mesirow Financial is a financial services firm headquartered in Chicago. It began investing directly in private equity in 1982 and set up a fund of funds operation in 1999. It has since raised two funds of funds with a total of $522m under management and is considering launching a third over the next year or so. Mesirow invests across the full spectrum of private equity funds in North America and Europe as well as running a separate direct private equity investment arm. Rice joined Mesirow in 1999 to set up the fund investment business and previously spent 14 years managing the alternative investment programme for the State of Michigan Retirement System.

What type of investments do you look for?
‘Our aim is to create a diversified portfolio for our clients. We invest around 33 per cent of our capital in venture capital funds, 40 per cent in buy-out funds, 25 per cent in special situation partnerships and we have a small amount reserved. By special situations, we mean European partnerships, primarily, in the developed economies as well as industry-specific funds and mezzanine. None of these allocations are carved in stone, but they act as a framework for us to build a portfolio.’

Do you make co-investments and secondary investments?
‘We do make co-investments alongside the partnerships that we back and these have worked quite well for us.’

‘We are also able to make secondary investments. We wouldn’t necessarily invest in a secondaries fund, but would rather buy up secondary positions in partnerships. We haven’t done any to date because our policy is only to invest in funds that we know very well, most likely funds that we have already made commitments to and those kinds of opportunities have not presented themselves to us at a price that we would be willing to pay.’

What is your appetite for first-time funds?
‘We have a small appetite for emerging groups. But first let me define what we mean by emerging. We don’t mean two strangers that meet one night and decide that it would be a good thing to set up a private equity fund. We are talking about groups or individuals that may be raising their first institutional round, but that have funds already in existence. We also mean people that we know who have spun out of groups that we also know and have performed very well through their first partnerships. We are seeing a lot of these types of opportunities, but first-time funds are not a large part of our overall portfolio. We are primarily focused on groups that are difficult to gain access to. We can do this because of the relationships built through Mesirow and through my time at Michigan. That is the core of our portfolio.’

What do you look for in a private equity group?
‘The number one thing that we look at is the people managing the fund. Private equity is, first and foremost, a people investment business. We spend our time analysing the team, the people involved in managing our money. We don’t just check references and how much time they spend with their portfolio companies. It’s more than that. We look very carefully at the relationship between the managers themselves and how they communicate. We also look at who makes the decisions. Pretty much every partnership that walks through the doors tells you that they all make decisions together and that they are all equal in the partnership. That is fine if that is true. But in my years of being in this business, I’ve found many examples where that hasn’t been true. That doesn’t mean that it’s a bad thing. But it is bad if all the partners are not in agreement.

‘We also spend a lot of time analysing the returns that are presented to us. We want to see the returns broken down so that we can analyse them and come up with our own verification. We take a lot of time focusing on the area that the group has been working on to ascertain whether there has been any strategy shift. That doesn’t mean that a change is necessarily bad – we just have to be convinced that the change has been for the good and for the right reasons. We want to make sure that the team has the expertise and knowledge of the area that they are working in. We also talk to a lot of other people who are in the business to get their views, we look at other opportunities in the market and what is coming to market. Only that way can we select the best possible opportunities for our investors.

‘Of course, we do all the other things necessary to complete due diligence on a fund, such as negotiating terms. We want to make sure that the terms are as they should be, from fee structures through to clawbacks and the way in which fees are shared between GPs and LPs. The other key area, of course, is communication. We have to be satisfied that a group will communicate effectively and frequently with its LPs and that we are able to access information as and when needed.’

How have these criteria changed over the years?
‘They have changed quite a lot. The number of partnerships under management has increased substantially over the years. The last figures I have are for 2002. In that year, there were 292 venture capital firms in the US and 546 buy-out firms. There has been a large influx of new entrants to the market over recent years and as a result, we spend more time looking at track records and management teams than I ever have done in the past.’

How do you judge the track record of a team, bearing in mind that some recent vintages will be very poor?
‘It really depends on how established the team is. If it’s a new team that has a track record that is shot to pieces, then we just won’t consider them. We just don’t have any evidence that they are able to produce decent returns. If, however, you are talking about a fund with a long and successful track record and they have a fund that has slipped a little, we’ll look closer. We’ll look at why the performance on that fund wasn’t great, at whether the motivation is still present in the team, and at whether they have regained their focus. We may, indeed, support a well established, successful group that has had a problem fund as long as the team is continuing to hold together and is willing to work hard with the next fund.’

What’s the biggest lesson that you’ve learned?
‘The most important lesson I have learned is never to forget that we are investing in people. I have learned that you cannot stray from that. If a management team appears to be loose or not cohesive, then move on. Don’t spend the time with groups that show any indication that they can’t work together.

‘A lot of the newer investors need to focus more on this. Those that are just getting started on partnership, or even direct, investments need to remember that this is a people business. They need to identify groups that have made successful investments in the past and that are going to continue doing so. That is down to the quality of the team.’

What advice would you offer to these newer investors about judging the quality of a team?
‘Part of it is down to gut feel. But there are more concrete ways of identifying the highest quality teams. It is analysing track record, it is determining whether or not they are adequately capitalised to accomplish the plan in the way they have set it out. You have to determine whether they really have the deal flow they are claiming. Of course, everyone has “proprietary” deal flow. But real deal flow comes from having made investments and having people you have invested with coming back to you or bringing transactions to you. You also have to look at whether a group has good accounting and reporting procedures. All these are even more important when you are looking at first-time funds.’

What frustrates you about the private equity market?
‘I get frustrated by the amount of dollars being thrown at private equity. I’m not talking about the overhang of capital that has to be invested over the next few years. I’m more concerned about the amount of money coming into the industry now and that is slated to come in the future. When I look at the industry’s returns and its ability to absorb all these extra dollars, I am not sure I like what I see. It looks to me as if the industry can take around $80bn, but there is a lot more flowing in. There are also a lot of people poised to enter the market, from small pension funds to endowments and foundations, and even the larger pension funds are looking to increase their allocations. I question whether, given the industry’s current structure, it will be able to deploy sensibly the amount of money coming into the market. We need to sit down and think about this. I recognise that some of that money will go to other private equity markets, such as Europe, but I think we should start being concerned about how it will affect returns. Where is it all going to go?

'All this makes it very important for investors to find fund or fund of funds managers that actually have access to the best quality private equity product. There are a lot of funds out there now that claim to be able to give investors access to great emerging manager teams, for example. That’s fine if they have a track record of doing so. Most of them don’t.

‘The number of dollars in the market and that are poised to enter it is the biggest issue that this market faces. If it doesn’t handle this correctly, it could cause great and lasting damage to the industry.’

How do you see the market changing in the future?
‘I think the main change will be a bifurcation of the industry if we continue to see a large amount of money pouring into it. Certain investors will be able to commit to the top performers; others will be forced into the second-tier groups where there is a higher risk and greater opportunity for failure.’

Do you believe that this bifurcation may be aggravated by the disclosure of performance by public pension funds?
‘There will be a certain number of public pension funds that, because of their strict adherence to the freedom of information laws, will be forced either to stop investing in private equity or to invest in funds that may not be today’s top performers.’

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