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Institutional investor profile: Tom Danis, Managing Principal, RCP Advisors

Danis on the importance of integrity in a fund manager, on the increasing difficulties involved in gaining access to the best performing funds, on the potential dangers lurking in limited partnership terms and conditions and on the rigours of thorough due diligence.

RCP Advisors is a private equity fund of funds focussed exclusively on the US small to mid-cap buy-out market. The firm was founded in July 2001 and closed its first fund last year. It has five investment principals with offices in Chicago and California. RCP Advisors currently manages in excess of $100m on behalf of institutional investors and high-net-worth individuals. Prior to joining RCP Advisors Danis was a director of Aon’s mergers and acquisitions group and was responsible for the firm’s Midwest private equity practice.

What type of investments do you look for?

‘The charge of RCP’s fund is to use our relationship building skills and due diligence expertise to gain access to the very best small and mid-market US buy-out funds. There are approximately 400 of these funds operating in the US and at any one time over an 18-month period you might have 100 to 150 out there raising money. We look to invest in 12 to 13 of the top performers while also diversifying our investments by industrial focus, geographical reach and certainly by fund manager experience.

‘But despite our desire for diversification, we are not of the opinion that you have to work entirely with specialists. There are some tremendous generalist funds out there and one of the best performing funds that we are currently invested in happens to be such a fund. Having said that, we do also like funds that have focus on a particular industry, or on a particular region of the country, if we think that there are potentially rewarding inefficiencies to be found.

‘As long as a fund fits our mandate and invests at least 80 per cent of its capital in controlling positions in US companies with enterprise values of between $50m and $500m, adding value to those companies and for our investors, we consider it a valid investment proposition. Regardless of the focus of a fund, what we are really looking for are the funds that perform the best.’

How would you describe your appetite for first time funds?

‘We actually allocate up to 20 per cent of our fund to emerging managers and first time funds, although many of the managers we partner with are a lot more experienced and on average are investing from their third fund.’

What size of investment do you typically make?

‘So far our typical investments have been between $5m and $10m.’

How would you describe your investment process?

‘We have a very rigorous and disciplined investment process because in today’s environment there is no alternative if you wish to identify and invest in the best performing funds. The US small to mid-cap market is becoming an increasingly competitive place to be for an investor. Heavy weight limited partners are taking large anchor positions in the best funds and that is making it increasingly difficult for smaller investors to gain access to quality investment opportunities.

‘There is a real gap in the fundraising world between those funds that are top decile and the rest. The other 90 per cent are having a hard time raising money, while the best funds can pick and choose their limited partners. What we try to do is to get out in front of fund managers two to three years before they are even out raising money. The most popular funds often raise their funds extremely quickly and that doesn’t lend itself to a thorough due diligence process if you are late to the party. We like and need to be ahead of the game.

‘One of the strengths of our organisation is our relationship building skills, whether it is in our own fundraising, or more importantly in forming relationships with general partners. We have a very rigorous and disciplined process when we get to know a firm. Our approach is both quantitative and qualitative. We spend a great deal of time looking through firms’ track records. We rebuild their track records from the ground up and pay particular attention to consistency. We analyse every realised and unrealised investment and confirm that the returns and valuations are accurate in order to ensure that we have a picture that we can really believe in.

‘We focus strongly on whether a firm is buying its portfolio companies in an efficient fashion. We look to see if they are paying multiples of cash flow that are below market rates. If so, that generally means that they are either buying bad companies and buying them cheaply, and that isn’t that hard to do, or they are using a sourcing advantage to buy good companies at the right price. A sourcing advantage is absolutely crucial. What people pay for fundamentally good companies is probably the single most important determiner of ultimate returns.

‘On the qualitative side it is all about an obscene amount of reference checks. We check the fund managers themselves, their backgrounds, their relationships with their underlying portfolio companies’ management, their relationships with their limited partners, their relationships with their financing sources, their relationships with their professional service providers and their relationships internally. We look at how stable their organisation is, and since this is a ten-year partnership, we look at whether they are going to evolve in a way that will stand the test of time.

‘We also spend a great deal of time looking at a management team’s strategy and the extent to which they have adhered to that strategy in the past. We ask ourselves whether that strategy is replicable given the macro economic trends that a team is going to be faced with and the obstacles that that is going to create for them.

How much importance do you place on a fund’s terms and conditions?

‘Obviously the terms and conditions are a big issue. So much of a fund’s terms are superficially very standard. But the devil is in the details and our past backgrounds, working as advisors to these funds, have taught us that time and time again. You cannot pay enough attention to these things if you are going to make sure that you give your limited partners the best advantage.

What are the most important things that you look for in a private equity manager?

‘I would have to say that a deal sourcing advantage is an absolute must. Secondly, a consistent and replicable track record is very important. But above all we are looking for managers that conduct themselves with integrity in all their dealings. We cannot go forward unless we are absolutely convinced that that is the case.’

What would put you off investing in a fund?

‘A great deal of organisational turnover would certainly put us off investing in a fund. A lack of differentiation in approach would also be a warning sign. There is a lot of window dressing out there about operational value add or industry expertise, but too often when you dig deep, you discover that there is very little to substantiate a firm’s claims. We also certainly wouldn’t invest with a management team that has not stayed on strategy. If a firm has not done what they said they were going to do then that is a really a problem for us.

But you have to remember that it’s a two way process. We also have to make sure that a management team is comfortable with us. We need to know that we are going to be bringing a little bit more than capital to a fund and that the paths of communication are good. It’s a balancing act. You’ve got make sure you get the best terms and conditions for your LPs but you also have to make sure you are an attractive LP yourself in order to gain access to the right funds. Everybody always talks about the difficulties involved in gaining access to the top venture capital funds such as Sequoia and Kleiner Perkins, and there is no doubt that that’s a very difficult proposition, but nowadays getting access to middle-market funds like HIG and Endeavour is getting to be almost as hard. There are funds out there that simply don’t need your money and you have to build a relationship with them.’

What sectors or regions do you think are particularly attractive right now?

‘I would say that while we try not to build up too much concentration in any given sector we are not, in general, industry pickers. That said, there are a number of extremely compelling healthcare funds in the market at the moment, far more so than in the past. I think that the toughest job we have is figuring out which are going to be the most successful because we don’t want to become over allocated.

‘Conversely, the one sector where we see real challenges at the moment is manufacturing. But where there are challenges there are opportunities. There are going to be fund managers who know how to take advantage of the challenges out there and there are going to be fund managers that get caught like dear in the headlights. Our task is to choose the right ones.’

What advice would you give to a new investor in private equity?

‘I would say that diversification is key. Diversify by investment style, vintage year and also by size focus. Some of the oldest and largest fund of funds managers have built tremendous and enviable franchises and they do a great job. But because of the amount of capital they have to put to work, it can make it difficult for them to really get exposed to small and middle-market funds. You can’t ignore that part of the market. I’m not suggesting that large funds are not a place to be, but you really want to be exposed to the smaller players as well. Don’t think by getting into one high profile broad based fund of funds that you are getting all the diversification that you need.

‘I would also say that we are in a very difficult part of the cycle and there are a lot of heavily unrealised track records out there. There is a lot of carnage in a lot of people’s portfolios and you have to really dig deep to find out who did a good job. I also think that like any asset class that produces outsized returns, money has flooded the US mid-market and you have more competition out there than you have ever had before. With that many opportunities out there, thorough due diligence is imperative if you are to find the best funds.’

How do you think the private equity industry will evolve in the future?

‘I believe that the gap between the really top tier funds and the also rans will continue to widen. You are going to see a lot of so-so managers fail in the fund raising arena because their returns simply didn’t make the grade. I really think we are going to see a major shake-out in the industry. I’m not the first person to say that and I don’t think it’s particularly profound, but I do think it’s very real.’

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