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Institutional investor profile: Terry Sullivan, managing director, Paragon Advisors

Sullivan on the importance of good chemistry in an LP/GP relationship, on the value of operational experience in a management team, on the rise of BDCs and the arrival of private equity in the retail market and on how egocentric GPs can deter potential investors.

US Paragon Advisors is a multi-family office based in Shaker Heights, Ohio. Founded in 1996, the firm provides a wide range of services to 45 families with combined assets of around $1.8bn. These services include the implementation of a broad investment strategy for each family, including a sizeable allocation to a wide range of alternative assets. The firm’s approximate allocation to private equity is currently in the region of seven to ten percent of total assets under management. Sullivan’s background, and that of the entire ten-strong Paragon Advisors professional team, is in Certified Public Accountancy.

How does your private equity investment process actually work?

‘In the first instance, we work in conjunction with each client to design an asset allocation model that mirrors the family’s goals and objectives. This gives us an idea of our overall capacity for private equity investment at any given time. With that figure in mind, we then go out into the market place and identify three or four funds that look interesting to us and that we think will be good investments for our clients.

‘Having selected these funds, the next step for us is to go to our families and raise a pool of capital which will typically be somewhere in the range of $12m to $20m. We are essentially raising a series of fund of funds from which we make discretionary investments. However, we are quite unusual in that we know which funds we will be investing with before we go out fundraising. This means we are able to be very upfront with our clients with regards to where their money will be going.’

What type of investments do you look for?

‘Although we keep a very open mind when it comes to looking at funds, we tend to gravitate towards the middle-market. We do also have exposure to the larger end of the deal spectrum, but we usually access these funds via secondaries vehicles such as Lexington Capital.

‘My bias towards the middle market stems from a belief that these are the only groups that are still executing what I would call traditional private equity. The larger groups have outgrown the asset class, as it was originally conceived, and have had to alter the framework in which they operate as a result.

‘We also do very little pure early-stage investing, partly due to an isolated case of burnt fingers from a 2000 venture fund investment, but more because of the risk/return mandate that we receive from our clients. Our families tend to be principally concerned with conserving their capital. They have already made their money and are not really looking to make more home runs. They do have an allocation to higher risk asset classes such as the private equity buy-out market, but nothing so risky as venture.’

What are your preferences in terms of geography and sector?

‘We mainly invest in US based funds, although we have gained some exposure to Europe through secondaries funds such as Lexington. We also tend to invest in generalist firms rather than sector specialists as we focus more on the management team and their track record, than any particular market preference.’

What are your views on the secondaries industry?

'I am not sure that the secondaries business is going to be as lucrative as it has been for much longer because the market has been swamped by new entrants, which is damaging for returns. But when we first started investing with Lexington in the mid 1990s, I viewed it as a way to gain access to the large private equity funds while reducing the risk of that exposure. A secondaries fund allows you access to the primary fund three or four years into its life cycle. This means that not only can you take a good long look at the portfolio as it stands, but you also often end up buying those interests at a pretty good discount off the reported value. Secondaries funds are also very interesting from a cash flow perspective, because you are receiving distributions from the outset, which is clearly very different to the traditional buy-out scenario.’

What size of investments do you typically make?

‘We generally raise one pool of private equity capital per year, which will be somewhere between $12 and $20 million, and that typically finds $4 to $6 million invested with any one manager’

How do you go about putting a portfolio together?

‘We are very opportunistic. It somewhat depends on who is in the market at any particular time.’

How do you find out about good investment opportunities?

‘We have built up a fairly comprehensive knowledge and understanding of what is out there over the years. It has been an incremental process based on experience and word of mouth. One of our most valuable sources of information has always been our existing general partners. We ask them where they would put their money if they didn’t have their own fund. This tends to be the best gage of the quality of a management team because it is seen through the eyes of the competition. We also occasionally receive information from placement agents that looks interesting, so the initial introduction can come from a number of different sources.’

What do you look for in a good private equity manager?

‘Obviously a strong investment track record is very important. I also tend to place a lot of emphasis on the teams’ professional histories. We like to see strong operating backgrounds as opposed to pure financial engineering skill sets. If a portfolio company runs into difficulty, it is reassuring to think that its private equity owners have some relevant experience in running a company themselves. There are some solid groups that do not have that depth of operating experience and that are quite simply just talented investors. But I prefer to know for sure that these companies are in safe and experienced hands.’

What would put you off investing in a fund?

‘Really it is just a chemistry thing. I tend to shy away from a general partner if I feel that the ego has taken over. These are people I am going to spend a great deal of time with and that I am trusting with a great deal of money. Egocentric people can be very successful but they are not people I would wish to do business with. If the chemistry is not right in any type of relationship it simply isn’t worth getting involved.’

How would you describe your appetite for first time funds?

‘We have invested in first time funds in the past. We are invested in one fund based in Dallas, which was started up by two or three young guys who had left Hicks Muse. We were introduced to them via a recommendation from a hedge fund manager with whom we invest. We met with them and ended up committing to their debut fund and we will be committing to their next fund too. We have invested in other first time funds as well, but always where the partners had very impressive private equity pedigrees. If the team has a strong history in the industry it can certainly be worth taking a shot.’

How do you conduct your diligence?

‘We take the time to meet with the general partners and to really get to know them. In the end it goes back to this question of chemistry. We ask ourselves if these are people with whom we want to do business. We want to be sure that the communication will be good and the relationship will be solid. Looking at the numbers is important, but in the end, as I always say, it is the whites of their eyes that really tell the story. And ultimately, that is where the final decision is made.’

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

‘If you are going to invest in private equity then I think it is important that you establish an ongoing allocation to the asset class in your portfolio. In order to achieve the best results it is essential to invest your allocated capital gradually over a period of time with the objective of rolling that capital as deals are harvested. It is also very important to be well diversified.’

What do you think is the biggest issue in the private equity industry at the moment?

‘I don’t really see any dangerously dark clouds on the horizon for private equity at this point. I do think that there is a fair amount of money out there looking for deals at the moment, so competition is relatively high. But the economy is definitely picking up, which obviously helps, and I think private equity will continue to perform decently as an asset class, if not exceptionally, over the next five to ten years.’

What do you think the future holds for private equity?

‘I think that the private equity industry may well follow the path set by the hedge funds business. A lot of the big name firms that had not previously dabbled with hedge funds, moved into the asset class when traditional equities began producing dismal returns at the end of 1999 and going into 2000. The result of this increasingly crowded market was that the product was pushed further and further down towards retail customers. I think this may well happen in the private equity arena too. We are already seeing signs of this with the rise of BDCs, but I think there is more to come.’

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