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Institutional Investor Profile: Rainer Busch, managing partner, Mercury Partners

Busch on transparency and valuation techniques, on why European venture has failed to set the world on fire, on avoiding over crowded markets, and on why the best opportunities in the secondaries market are now in the past.

What type of investments do you actually look for?
‘We have a very broad investment strategy. We look at direct investments, fund investments, secondaries investments and co-investments in many different geographies, sectors and stages. Historically we have focussed primarily on Europe and the US, but we have recently extended our scope to encompass the rest of the world.

‘Our objective is to invest in a manner where we can be quite opportunistic in terms of what we want to do and when we want to do it. I think it’s important as a fund of funds or as an advisor, to avoid the limitations that come with restricting yourself to a specific sector.’

How do you put a portfolio together?
‘We formulate our investment strategy and allocation model on an annual basis. Our approach may only change slightly year on year, or it may change quite dramatically. This year, for example, we changed our strategy quite markedly by expanding our focus to include markets outside of the US and Europe. We did this because we feel that there are areas outside of these traditional markets that offer superior risk adjusted returns.

‘Our portfolio construction process begins with this definition of strategy. We are then very active in identifying funds that will fit with this strategy. So for example, we have recently been extensively researching Eastern Europe and Russia for good fund opportunities. We are also looking carefully at Asia.

‘In terms of stage, we have a target allocation of approximately 30 to 40 per cent for venture investments, with the rest being allocated to buy-out and distressed situations. We are also highly diversified in terms of sector, although there are a number of areas in which we are particularly interested at the moment, most notably the energy market.’

What are your views on the venture market at the moment?
‘I definitely think that things are looking more positive. The confidence is certainly coming back into the market. Investors are more conservative than last time around, but that is definitely a good thing, as it is forcing investors to be far more selective and valuations have been restored to realistic levels. Exit opportunities are also opening up in the form of IPOs and trade sales.’

Does your optimism regarding the venture market extend to European venture?
‘I think European venture has been largely disappointing so far. The market has suffered a number of false starts over the last few decades and has yet to really leave the starting blocks. Every five years or so, Europe sets about trying to create a venture industry along the lines of what it sees in the US. The last attempt took place at the end of the 1990s. And as we all know, things went wrong. Just as in the US, Investors were hurt. They lost a lot of money. The difference is that European investors are inherently more cautious about venture than their US counterparts and the confidence is therefore taking longer to return.

‘But there are also other reasons why the European venture market has failed to set the world on fire. It is, quite simply, much more difficult to make money in the venture capital sector in Europe than in the US and that is predominantly because the US has a much longer history of operating in this asset class. In addition, the US has the advantage of being one large market, which shares the same language and the same legal system. It is much easier for a US company to sell its product to 80 million people than it is for a European company to grow to a similar level. Even though the European market is the same size as the US in terms of inhabitants and GDP, it is just too fragmented.’

Do you invest in country specific or pan European funds?
‘Our strategy is more focussed towards pan European funds than country specific funds at this stage. I think that pan European middle-market buy-out funds are a particularly exciting proposition at the moment. The rewards can be considerable, largely because it is a very difficult area to operate it.’

What size of investments do you typically make?
‘We generally make investments of between E500,000 and E5m.’

What are your views on the secondaries market at the moment?
‘I think the best opportunities in the secondaries market are now largely in the past. The reasons for this are two-fold. On the supply side, the majority of distressed investors that have been looking to liquidise their private equity assets in this way have now done so. Fund performance is improving and limited partners are starting to receive distributions, so this too will reduce the supply of private equity assets coming into the secondaries market.

‘On the demand side, there were a significant number of secondaries funds launched at the end of 2003 and beginning of 2004, including several mega funds, such as Coller Capital. This vast quantity of capital flowing into the market has destroyed a lot of the potential for outsized returns. The laws of supply and demand inevitably dictate that price expectations are on the rise and the potential for returns, therefore, on the decline.

‘Having said that, I do think that the secondaries market is a good thing in terms of providing liquidity for limited partners. In removing one of the asset class’s major obstacles, this should encourage more investors to take the plunge into private equity.’

How do you find our about good investment opportunities?
‘We tend to be aware of most of the funds that are being raised at any one time, either through our extensive network of contacts, placement agents or trade magazines and so on.’

What do you actually look for in a fund manager?
‘We like to see a team that has worked together for a long time. That team should have strong skill sets both in terms of financial expertise and operational know how. A good private equity manager needs to be equally adept at the hands on aspect of growing companies and understanding tax and legal issues. The team should have a deep understanding of the markets they invest in, and have a clear view on where those markets are heading and how best to extract value from that market evolution. A fund manager should also have the ability to build up its own team and to retain and develop the people it has hired.’

How do you conduct your due diligence?
‘Our first step is to hold in depth meetings with the whole management team. We also have a very detailed questionnaire that we ask managers to fill in. We then conduct comprehensive reference checks. We analyse the team’s track record, looking at the investments that succeeded and those that didn’t. We look carefully at the team’s strategy and consider whether it falls in line with our own view of what is happening in the market they are investing in. We also take a look at who the firm’s competitors are and how much money is potentially coming into that particular area of the market at that time. If we feel that a sector is likely to become over crowded we will turn down an investment proposition on the basis that expected returns will be lower.’

How would you describe your appetite for first time funds?
‘In general I would say that it is quite low. What we look for in a fund is a team that has worked well together, that has a common track record, and that has been able to make good collaborative investment decisions. So if this first fund is in fact more of a spin-off from an existing group, then that is something we may consider. But if it really is an emerging manager, whereby individuals with no shared investment experience come together, we feel that that represents a substantial additional risk that we would not be prepared to take.’

What advice would you give to a new investor in private equity?
‘In the first instance I would say that it is very important to have a good understanding of the mechanics of private equity, both in terms of its advantages and its constraints. I would also advise a new investor to be wary of jumping on bandwagons, because typically it will be too late. Just take the internet for example, by the time everyone was talking about it, it was time to sell and not to start investing.

‘One of the first decisions a new investor in private equity needs to make is to decide what proportion of their overall portfolio they are prepared to allocate to the asset class, which will leave them with an absolute figure available for investment. I would recommend that if this figure is above $50m, then the team should recruit an experienced individual or team, to take charge of their private equity operations. In this instance I would also add that a private equity portfolio should consist of a minimum of 15 investments in order to supply the necessary diversification.

‘If the investor has less than $25m I would strongly suggest that they invest in a vehicle that offers diversification rather than take it on themselves. Because if they do the chances that they will loose money will be very high indeed. There is clearly a grey area between $25m and $50m, where the investors needs to look very carefully at their own requirements and capabilities and decide accordingly.’

What do you think is the biggest issue in the private equity industry at the moment?
‘In the US, I would say that the biggest issue is that of transparency and valuation. I think that the combination of, on the one hand, having very limited transparency and, on the other hand, having inconsistent valuations, is something that, from the investors perspective certainly, needs to be resolved. I think that the issues facing Europe are somewhat different. The European market is still five to ten years behind the US, so it is still struggling with issues linked to taxes, for example, and the way that options are valued.

‘I also think that there are significant issues facing the venture market and the technology sector. Technology cycles are consistently getting shorter, but at the same time the funds that invest in these companies are still structured in a ten-year partnership. This is creating some difficulties for venture investors and may detract interest from the asset class in the long term.’

How do you expect the market to evolve going into the future?
‘The private equity industry is constantly maturing and as that continues to happen I would expect to see increased consolidation in the market place. We are in the midst of a transition from a market made up from smaller entrepreneurial groups, to something far more institutionalised and corporate.’

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