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Institutional Investor Profile: Ralph Aerni, Head of Private Equity, SCM Strategic Capital Management AG

Ralph Aerni describes in detail what SCM's due diligence process entails, why his firm considers first-time funds and why he thinks it is important to actively involve clients in the process of making investment decisions.

SCM Strategic Capital Management AG was established in 1996 as one of the first European advisors/gatekeepers focused on institutional private equity and - since 2003 - on international real estate portfolios. Services include investment strategy, asset allocation, screening and due diligence of private equity and real estate funds as well as investment monitoring/controlling and reporting. The firm provides discretionary and non-discretionary advisory services to a number of large pension funds and insurance companies throughout Europe. Total assets advised/managed currently exceed $ 3 billion.

What type of investments do you look for?

In our capacity as non-discretionary advisor to large public state and corporate pension funds, our focus is driven by our clients' investment appetite. Our clients have given us global mandates, although it is fair to say that our clients' capital is to a large extend deployed in mature private equity markets, i.e. in the USA and in Europe. SCM advised its clients on some occasions to make commitments outside the USA and in Europe but only if the Manager has a proven, strong realized track record and SCM is comfortable with the legal environment.

Do you invest directly?

No. Co-investing not only requires a different skill set than fund investing but it also means that a fund investor builds additional exposure to certain companies, industries or geographies with the result that it increases risks very specifically with regard to individual portfolio companies. Co- / direct investments should only be considered if a private equity program reaches a size which allows to build a diversified portfolio of co-investments. The level of diversification by vintage, geography, industry and manager should not be less than in the case for fund investments which again illustrates the importance of reaching a critical mass. It is also important to make sure you have a pool of professionals with the skills to make direct / co-investments in portfolio companies.

What size of investments do you make?

SCM clients typically make commitments in the area of € 5 to € 25 million each, depending on a fund's risk profile.

How does your investment process work?

SCM has implemented a structured and ISO certified investment process that, on the one hand, reflects its clients' internal approval processes and, on the other hand, is a reflection of our own experience that due diligences shall address issues and topics properly and in a way that allows us to compare funds on exactly the same criteria. SCM's due diligence process has been designed in a manner that enables our firm to transfer due diligence findings in always the same format to its clients.

How many investments do you intend to make over the next year?

As in the past, SCM intends to make commitments to 8 - 12 different managers per annum on behalf of its clients.

What is your expected future allocation?

The annual commitment budget depends on existing and new SCM clients' future allocations for private equity. SCM's annual commitment budget for the year 2005 exceeds € 200 million. In this regard it is important to understand that SCM has always given advice to its clients to spread the total commitment budgets evenly over different vintages and stages. As in the past, SCM will not jump on any bandwagon, meaning that we will continue to build well diversified, conservative private equity portfolios.

How do you find out about good investments?

During the last two years SCM has substantially increased its research capabilities with the result that today, SCM's research publications are amongst the most quoted in the private equity press. SCM's controlling team monitors the performance data of about 400 partnerships (directly and indirectly held through fund-of-funds) and SCM's due diligence team reviews more than 250 fund offerings a year. This proprietary performance data allows SCM to track funds of a large sample of managers. The accumulation of proprietary data puts SCM in the favourable situation that gives our firm the ability to meet with top-tier managers in between fundraising cycles, and it furthermore allows us to analyze managers' exit capabilities and to track trends related to terms & conditions. These ongoing research projects result in numerous annual publications such as "Performance Review", "Exit Study", "Market Review" and "Terms & Conditions". Moreover, SCM allocates substantial research resources to cover topics that become important at one point in time, for example the buyout fundraising in Europe this year. SCM has carried out a detailed analysis of the European LBO market and the key findings of this study will obviously flow into SCM's investment activities. To keep a long story short, SCM has always supported its due diligence recommendations with key findings from its research activities and the firm does take every effort to strengthen this approach even more.

What is your appetite for first-time funds?

In general, SCM clients have a preference for managers who have an investment history, i.e. an attributable realized track record as a team. This does not exclude first-time funds that are managed by a group of professionals who have gone through a spin-out but it typically excludes first-time funds that are managed by a "motley crew".

How do you assess first-time funds?

Even if we deal with a first-time fund that meets the above mentioned criteria, the due diligence will not eliminate all uncertainties. The biggest hurdles one has to overcome are the track record analysis, the deal sourcing capabilities and the question of the stability of the management team. An investor will never get an answer to the question if and how other professionals from the old firm were involved in deals or how important the firm's brand was for the deal-sourcing. Another issue one needs to get comfortable with is the question of whether these professionals will have the same success in their new roles as entrepreneurs and whether they offer an environment that attracts the best professionals. However, the SCM due diligence process addresses all these issues in an appropriate manner, and we believe that we have all the instruments in place to enable us to assess a first-time fund properly.

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

As everybody else, SCM seeks to get access only to top-tier managers and the easiest way to make this assessment is to analyze the realized track record. However, in a due diligence SCM always digs into the mud and hopes to find elements which help us decide whether a new fund is likely to be a good fund or not. As it says in every PPM, the historical returns achieved by any prior funds are not a prediction of future performance or a guarantee of future results and therefore, it is most critical to carry out a due diligence in the same deepness as always. For example succession issues (changes in the management team and the ownership structure of the management company, reallocation of carried interest, etc.) or changes in the investment strategy or fundamental changes in the environment, to name but a few, could be factors that potentially affect the future returns even of firms that used to generate top quartile results.

How do you put together a new portfolio?

The investment goals and preferences of each client are obviously different and the existing portfolio of new clients must be taken into account when making such allocation recommendations. Therefore, there is no simple answer to this question. Our clients in many cases relied on our advice when the discussion about the asset allocation started. One of SCM's principles has been our conservative approach in building private equity portfolios and the fact that even in hypes one keeps the asset allocation, the annual commitment budgets and the diversification aspect in mind.

What are the most interesting countries / sectors going forward?

As mentioned above, SCM has no desire to gamble with its clients' money. Therefore, we will deploy a large portion of our clients' capital with the most successful small, mid-sized and large buyout firms in mature markets. As in the past, we will spread our clients' commitments evenly over several vintages and widely across all industries. However, SCM from time to time comes up with a recommendation to back experienced managers in emerging markets, for example a buyout fund in Russia. SCM has reviewed dozens of funds in Central & Eastern Europe and Russia in the recent years but none of the Managers convinced us until we met with the team of Baring Vostok. This is the first and only investment our clients have made in this region and to our best knowledge, we do not think that we will find a second opportunity like this in the foreseeable future.

How do you conduct your due diligence?

SCM has designed a due diligence template that addresses about 150 different topics and themes. Every fund, regardless of an existing relationship, has to go through and stand the same due diligence process. SCM's due diligence first starts with a business due diligence, and only after an initial investment decision has been made, we move into phase two and start the legal review that is done by SCM and a law firm in parallel. The latter particularly addresses legal points (e.g. limited liability), while SCM reviews the commercial terms, for example the waterfall or the economic terms in the event of a removal for cause or a no-fault removal. SCM keeps its clients actively involved in the decision-making process as it increases the client's awareness of private equity in general, which is a benefit to all parties. A positive side effect that has arisen from this two-phase due diligence process is the fact that third party legal costs can be kept at an affordable level.

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

Investing in private equity means that an investor has to deal with an inefficient, intransparent market. If this asset class is nonetheless of interest to an investor, SCM would give advice either to build the expertise internally or to get third party advice. It is critical to understand that the expertise shall cover all aspects related to fund investing as well as to investment controlling and monitoring. Additionally, one should be aware that deal-sourcing and fund-screening is by far not less important than the other aspects but it absorbs an incredible amount of time. One should also understand that if you sit in the middle of nowhere, you might get to see only those managers who were not able to raise their funds easily. Pension fund managers often do not have the resources to manage the complexity of a private equity program on their own. However, we have observed that some pension fund managers prefer to start investing the allocation on their own but over time, when the controlling aspects become much more relevant and the Finance Director starts to ask difficult questions, then they look around for support.

What irritates you about private equity?

I would not call it irritating but what sets me thinking are situations during due diligences or even during the fund's cycle where a GP tries to hold back information from LPs or where the information is only given in small portions and over time. We, of course, understand that the higher returns in private equity are partly a result of the lack of transparency in the market but, for example, this is no excuse not to communicate organization-related changes properly and promptly.

What's the biggest issue in the private equity industry?

After the downturn in the market and the lack of realisations, investors obviously want to see evidence that they make more money from their private equity investments than from traditional asset classes.

How do you think the market will change in the future?

Having built strong relationships with top tier managers is key in our business and will become even more important not only in venture capital but also in the buyout segment in the future. We have seen a tremendously increasing interest in European buyout funds from US institutions in the last two years, which raises the question whether the market - and not the buyout funds - can absorb this money without affecting the returns. Therefore, it is critical that the managers with whom our clients have a relationship maintain a price discipline and are willing to accept a hard cap on their new funds which reflects the investment sizes of their predecessor funds.

How would you describe the market environment in which you are operating (e.g. is the legal environment favourable / not favourable)?

In every business one has to deal with challenges and changes in the environment. As our business becomes increasingly international we were faced with client issues relating to their different legal, fiscal and tax environments. But overall, those issues do not really prevent such institutions from participating in the asset class. In our home market, Switzerland, pension funds' interest in the asset class is increasing and there is nothing to complain about as long as the legal environment allows your clients to invest in private equity partnerships in a tax efficient manner.

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