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Institutional investor profile: Michael Granoff, President and CEO, Pomona Capital

Granoff on survival of the fittest in a Darwinian private equity industry, on the question of access and the challenges it presents investors, on what the future holds for the secondaries market and on paying the right price for quality assets.

How would you describe your investment philosophy and how has it impacted on the way your business has developed?

'Our philosophy has always been to make the capital follow the deals and not the other way round. What this means is that our business has grown significantly over the last couple of years as opportunities have grown. We now manage a little over $2.4bn, fairly evenly divided between primary and secondary strategies. We are currently drawing towards the end of fundraising for our fourth fund of funds, which is targeting $250m, and we will begin raising our next secondaries fund in the third quarter.

'The new secondaries fund will be targeting $600m, making it approximately the same size as its predecessor. We have invested the last fund relatively quickly and the early results are quite promising, but we don’t necessarily think there is a tidal wave of deal flow on the horizon. And so in contrast to some others in our business, we are keeping the fund size fairly modest.'

Have there been any other significant strategic developments for Pomona in recent months?

'Probably the most significant strategic change that we have carried out took place at the end of last year. We took over the management of ING’s US insurance company’s private equity operations. The move increased our assets under management by around $1.1bn, split between a legacy portfolio valued at in the region of $600m and a $500m customised fund of funds programme which we have built on ING’s behalf.'

What type of investments are you currently looking for?

'We don’t have any strong bias other than quality. Obviously, in an ideal world, our portfolios would be broadly diversified across industry, stage, geography, and vintage. But given the very wide dispersion of returns between funds, the strategy that we have found to work the best is to buy interests in the highest quality funds at the best possible price.

'You have to remember that on the secondaries side in particular, we can only buy from what we see. It may seem like a good idea to increase our exposure to a certain region or sector, but there is no guarantee that a seller for such a fund will be available or that any funds that are available in this area will be of a sufficient quality.

'But looking back at our most recent secondaries portfolio, approximately 25 per cent of funds are European-based and the remaining 75 per cent are US funds. The majority of our European interests are what I would call UK-centric buy-out funds, such as Candover, BC Partners and Charterhouse, while in the US we invest in both buy-outs and venture.'

What are your views on the venture market?

'The digestive process in private equity takes a long time. The buy-out market has obviously rebounded; but I would say that the current situation for the venture market is that it has just simply stopped falling. This means that there are likely to be some interesting opportunities emerging on the venture side, and we have been increasingly focussing on venture product as a result.'

Would you consider investing outside of Europe and the US?

'We do have a very limited exposure to the rest of the world, as part of wider portfolios. But it is not something that we are really looking to do.'

What are you views on the secondaries market and how it has developed?

'In some ways it hasn’t changed all that much. When we launched Pomona ten years ago we placed a lot of emphasis on positioning our business in the least efficient part of the market. This meant proactively sourcing less competitive transactions and staying clear of major auctions. We were very disciplined about the price we were willing to pay and we were very focussed on quality, which meant restricting fund size.

'If you fast-forward ten years, contrary to popular belief, the supply and demand picture is actually very similar. We still have the same concerns regarding competition and, in fact, we still find ourselves bidding against the same people that we faced when we first started out.'

How would you describe deal flow in the secondaries market?

'Deal flow has been quite strong. The market is really just a function of two variables, how much money goes into private equity and how much of that turns over. Accumulatively, a great deal of capital has been invested in the asset class over recent years. We have seen more limited partners investing more capital in more funds. So the market has gained a real breadth as well as depth. The turnover rate of this capital is a function of the internal affairs of limited partners and also of what is going on in the world in general.

'In terms of secondaries deal flow today, this has lead us to a healthy situation, but not a tidal wave. There are firms that have raised enormous amounts of money in secondaries funds, betting on a surging market. While I think that deal flow is going to continue to be pretty strong going forward, I don’t think any dramatic growth is around the corner.'

What size of investments do you typically make?

'Our secondaries transactions tend to be valued at around $50m, while our primary fund investments fall in the region of $10m to $20m.'

What do you look for in a private equity manager?

'It really isn’t all that complicated. What we look for in a general partner team is what those general partners look for in portfolio companies and their management. We want people to run their business like a business. We want people who have a sustainable competitive advantage. We want teams that are seeing the best deals first and that have a methology for how they approach those opportunities. We want to see groups that have a system for managing risk and that have transparent compensation schemes. I don’t think any of these things are unique to private equity, it is simply a case of good business sense.'

How do you conduct your due diligence?

'We do have a lot of sources of information and a lot of relationships that really help us, but in the end I think it comes down to a combination of research, reputation and a lot of sweat.

'You also have to remember that we own interests in about 190 different funds, so it is not often that we find ourselves looking at a firm that we don’t already know. Most of the funds that we invest in on both a secondary and a primary basis are funds that we already own an interest in, or at least firms that we have looked at carefully in the past.'

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

'The advice that I would give to a new investor in private equity is to keep a foot in both the primary and secondary sides of the business and to divide your commitments between the two. The secondaries dimension gives you a whole host of advantages, not least the rare gift of hindsight, while the primary business allows you to look ahead.

'I would also advise new investors to be very conscious of the disparities between the best funds and the also-rans. Allocating to the asset class is unlikely to be a very rewarding experience unless you can guarantee access to the very best. Private equity is very different to other types of investing in that median returns really aren’t all that good.'

How much of a problem is the question of access for investors in private equity funds?

'Access is a huge problem. If you can consistently gain access to the best performing funds, your private equity investments will outperform almost every other asset class. But if you can’t, you are better off getting out of the game. So, the trick is to devise an investment strategy that allows you access to the better funds in a diversified way over time. Secondaries investments and fund of funds are both possible routes in to the top quartile. But even then it is becoming a harder and harder proposition, no matter how much money you have.

'On the venture capital side, the pools of capital being raised are dramatically smaller than they once were, while demand has remained fairly constant. Investors are therefore being squeezed out. But on the buy-out side, the top firms are raising massive multi billion dollar funds and access is still a major issue.

'We have just committed to two funds, Hellman & Friedman and Bain Capital, both of which were largely closed to new investors, and in the case of Hellman, we know that several existing investors, including fund of funds, were also denied access. This is certainly a market that is becoming tougher to penetrate over time. Much of this is a reaction to the bubble bursting which has led to a flight to quality.'

Are there any other overriding issues in the market?

'I don’t think that there are any overriding issues besides performance. The challenge is, as it always was, to identify good opportunities at a reasonable price. There are also generational issues. The industry is reaching a stage of maturity where we are starting to see a great deal of turnover among general partners. Founders, whose names are integrally associated with the branding of many firms, are beginning to retire or are no longer working full time.

'This issue of succession is particularly pertinent to private equity because it is such a long-term commitment. Investors like to be sure, when they commit to a fund, that they are committing to the same individuals who will be responsible for their capital ten years down the line. If this is not the case then they want to see a comprehensive succession plan in place. I don’t think this is a major issue but I do think that it is an issue.'

What do you think the future holds for the private equity industry?

'We live in a Darwinian world and the private equity industry is no exception. Only the fittest will survive. On the primary side, the key for investors is to identify which funds will be the best performing over the next ten years. That is a tough one to call and once you have made your decision, it is hard to change your mind.

'I don’t see huge changes on the secondaries side. I think it will continue to be a good place to operate if you do it right. But if you make mistakes, I think the punishment will be pretty severe.'

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