Here’s my unedited notes from the Thomson Buyouts East Symposium. This is the LP panel.
David Toll: This morning I’m grateful to have investment officers from four different institutions.
James Clarke, Ewing Marion Kauffman Foundation
Andrea Kramer, Hamilton Lane Advisors
Christopher McDonough, City of Phila, Board of Pensions & Investments
Philip Shaw, Invesco Private Capital
First, I’ll ask the panelists to give more color and detail on their portfolio funds, what type of returns they expect from their funds. We’ll talk about what they want to invest in now, how their due diligence practices are evolving, and how they look at the up-tick in carried interest and management fees.
Clarke: We’re essentially at our allocation. In the five years since I joined the foundation, my charge has been to put the portfolio more equally weighted between venture and buyouts. When I came aboard, the portfolio was almost exclusively venture.
Kramer: We have $68B we’re managing. We’re both an advisor and an asset manager. About $9 billion of that is discretionary. We called the trend toward big buyouts several years ago. We’ll continue to focus on big buyouts, but that will decrease in the coming years. We’re less heavily weighted in the middle market, but that’s very saturated. We’ll probably grow a little on the VC side but the disparity between top tier and middle tier is significant.
McDonough: We’re 75% buyout and 25% venture. As a public investor, it’s hard to gain access to the top tier venture funds and if you’re not in the top tier, you’re not worth doing venture.
Clarke: There are certain venture relations we have I will defend like a mother to its cubs. Our preferred allocation is about $15 million per fund, but you get a top tier fund that will only take a $3 million, and you know it’s possible they could return 10-20 times that.
Shaw: Our global strategy is 65% buyouts, 35% venture. 70% of our commitments to buyout funds tend to be with funds that are $1 billion or less. We actually think there’s more opportunity over time in small to mid-sized funds. We believe that the larger your capital base, the harder it is to deploy it effectively.
Toll: That’s a quick overview. I heard one common theme, is that money is moving out of venture capital, or not finding a space there, and is going into the buyout market. What kinds of buyout funds are you looking to back, how much money will you back them with?
Clarke: 2007 will be a much calmer year. I don’t know that my blood pressure could take another year like 2006, and even if my blood pressure could, my wife couldn’t. We’re not going to continue to double down from where we are. We’ll continue to back our best managers on re-ups. We attempt to be very loyal to our GPs when they deserve that loyalty. Those will be characterized by lower to mid-market in the U.S. The definitions have changed. Arguably a middle market fund is a $1 billion. We may say that’s cute in the future. We’ll continue to focus on the funds that are $300 to $500 million. In Europe we have a strong focus on single country funds. I hope to collect less frequent flyer miles this year.
Andrea: Last year was extraordinary. We looked at 512 funds and the year before that 478. It’s been an unbelievable run. The first two months of this year we looked at 100 funds. We will continue to focus on big buyouts, however the number of those we’ll likely pare back. I can’t speak to specific allocations, because each account is a specialized account. On the small end we’ll be focusing on new relationships. If we add a relationship, it’ll be because we’re moving someone else out. Last year we committed about $7 billion, almost $8 billion. Maybe this year it will be lower, but it will be a significant amount.
Clarke: This year we’ll be $60-$70 million, excluding distressed. People and partnerships change over time.
Toll: I was going to ask what kind of return is the cutoff point.
Clarke: We all think we’re smart right now because we’ve watched our GPs put up good numbers. We fall into an easy trap of trying to drive a car by looking in the rearview mirror. I had an hour long discussion with a GP looking at new carpet and cabinet he was getting for his house, then in the last five minutes we talked about the fund and then he had to jump on a call. That was it for me. I could tell where his mind was.
McDonough: We can be pretty specific in what we invest in. We do prefer small and lower middle market firms. Turnaround funds we think are attractive. I expect we’ll find one we like this year. We also like funds that focus on more growthy strategies. We have a small portion of our European funds and we’re trying to do more with that. We prefer pan-european funds. We started with FoFs. We don’t have a lot of time to spend talking to different funds.
Shaw: In Buyouts we expect to put out $100million -$150 million. We want to capture every vintage year. It’s something that blends those two. Because we have been at this for so many years, it would be entirely possible to re-up and create a portfolio on that basis. But we really don’t want stagnation, we want new blood in the portfolio. We want spinouts, talented individuals starting their own funds. We look for some specialization, which would imply expertise in a geographic location or a specific industry. That’s been a very effective thing. We have an emerging fund, but it’s tilted toward venture in California.
Toll: have your expectations changed?
Shaw: We’re always trying to look at the top quartile. I think it’s harder today than it has been to get a strong multiple return on an asset basis. It still has become more competitive and more efficient.
Toll: What keeps you awake at night about the buyout market?
Clarke: I’m turning into a very nervous person as we go later into the cycle. I don’t know how much longer this party is going to last. It can’t go on forever. At some point it stops and it’s a question of how badly we get banged up when the car comes to a stop.
Toll: It seems like the party has been going on for the last 25 years. Does the music ever really stop?
Clarke: I’ve just hired an intern to help me through this. I’m reading dusty magazines about the 1980s buyout boom. The party doesn’t completely stop, it’ll find its way into other venues. It was only two years after the KKR deal we saw defaults hitting 30percent. We have attempted to invest more evenly across the cycle.
Toll: Andrea, what’s keeping you up at night?
Andrea: The visibility of PE. It’s been around for a long time, it’s like Forbes returning to the Gordon gecko cover. It could be in the form of legislation and additional regulation. I think that is really the thing we’re focusing on. This model is scalable and sustainable, it’s really those political issues that keep us up.
Toll: You’re alluding to the proposal to tax carry. How would that affect the market?
Andrea: The immediate reaction is “that really sucks,” that’s the initial reaction. It may take some players out of the market, which isn’t necessarily a bad thing.
Chris: The most concerning thing for us is the money flowing into all sectors. I think GPs will continue to find new and exciting ways to invest. But deals that shouldn’t get done will get done and people will pay more to get deals done, which will cut returns.
Toll: We saw earlier, that It’s really the health of the debt market that’s sustaining these markets.
Chris: What happens if that debt market becomes less healthy?
Shaw: Fundraising is just staggering. What worries me most is funds that on the basis on good numbers and strong aggregate demand can double or triple the size of their funds. The quality portfolios they developed with limited resources changes. They will have to either have more deals or larger deals or both and have to go away from a very successful formula and will face different issues. There’s always the psychology that if there’s strong demand now, let’s make the best of it right now and raise as much as we can, full steam ahead! The cyclality of the business. I’ll point to VC. Buyouts are a different animal, but it also moves in cycles. In the late nineties buyout guys thought they had lost the game and were investing in VC funds. If I had a dollar right now, I’d personally look for venture.
Toll: What if a firm comes to you and says we won’t double the size of the fund, but we need to raise the carried interest to 25% or 30 percent?
Shaw: It’s a wonderful profession that provides great financial and personal returns. It’s also good for the economy. In general, people should be paid well for what they do. We’d face the reality and if we liked the fund we’d be willing to pay for performance. But we’d like to see some hurdle rate, like if they do a 2x return they’d get a higher carry. I’d want some sort of platform return before I pay that, but we don’t always get that.
Andrea: We’ve done premium carries and we’ll probably continue doing that. For us the focus is about net returns. Providence was one of ours. The cash on cash returns is essential. We’re trying to at least hit a hurdle of 25% IRR net.
Toll: I’d like to hear about the latest due diligence questions you have. We’re going to have Kevin give us an elevator pitch and he’ll take a couple of questions.
Kevin: I have no doubt that what I’m about to describe doesn’t fit your idea of what a fund should be. But anybody’s who’s got the vision to see what we’re doing is going to make a lot of money. Seeking to raise a $150 million intellectual property investment fund. We’ve done $100=M in IP monetization strategies. We identify IP value at Fortune 500 companies that isn’t making money for them and take it out. This is a way to invest directly in the technology. The returns are silly, with 40% to 50% returns. There’s one fund doing this already called Intellectual Ventures in California. We’re looking for someone who believes in what we’re doing.
James: The Kauffman foundation has been doing some work in this area with a program called iBridge to get technology over the tech transfer speed bump.
Andrea: what does the management team look like that’s taking the asset. Where are you finding those management teams?
Kevin: Our goal is to take the management team out of the equation. We invest directly in the technology. We have IP experts in every category. I started out looking into universities and found them lacking. We go to corporations instead. We look for areas where there are active licensing markets. There’s also an opportunity to sell patents. If you find good opportunities you can dress them up and flip them.