Diligent Danes

With ongoing economic uncertainty fuelling continued market pessimism, and rumours aplenty of a domino effect of LPs defaulting as capital calls come in later in the year, announcing a new fund is currently unlikely to be met with enthusiasm. But investors still have capital to deploy, albeit a smaller pool. Consequently, there is widespread belief that LPs are only looking to back existing fund managers, and even then, only at lower levels than previously.

Conversely, Kjerulf suggests that even existing relationships provide no guarantee of commitment, asserting that "automatic re-ups are a thing of the past". Certainly, an increasing number of LPs have expressed that they will conduct due diligence as if it was a first commitment, and due diligence has also increased in terms of the level of scrutiny being applied, "It is indeed a very thorough examination." He stresses that Danske does not have a set formula for commitments, with all prospects considered on a case-by-case basis, regardless of whether or not Danske has subscribed to the fund before.

Damage control

The first concern relates to the adaptability of the fund. If the offered product is not a new fund, but an annex fund to one or more previous funds, the main issue is how much of the capital will be allocated to new investments and how much will be used for "repair capital", as Kjerulf phrases it. In the current climate this is a particularly relevant issue, as companies need additional capital to survive the downturn and tackle already instigated expansion plans or decreases in demand, especially with exit plans effectively on hold.

Investment strategies are not the only aspect under scrutiny: the fund management team is equally important. "We speak to both current team members and employees that have left the firm," Kjerulf reveals. Danske's investment team also speaks to managers of current and previous portfolio companies, looking for both success stories and investments that didn't go according to plan and examining how these were dealt with.

Ghosts of the past

The same thorough analysis applies to existing portfolio funds, with strict requirements for quarterly reporting. In what Kjerulf labels their "reporting regime", the team examines all investments in the portfolios of the funds they back, examining risk, covenants, how long the GP can fund each company, budgets for each investment case, developments in turnover, and profit and loss.

Danske is in a fortunate position: the tax system in Denmark requires strict reporting, making the job of obtaining the necessary information much easier. Kjerulf observes, however, that they are no longer the only fund investor asking questions - it seems most LPs have increased their information requirements following the credit crunch.

While on the subject of legacy portfolio, the most prominent issue continues to be the levels of debt in existing portfolio companies. These problems, however, have had a lesser effect in the more conservative Nordic region and Kjerulf, who previously worked in acquisition finance, asserts that the same is true of Danske's portfolio. "We have preferred, and still prefer, GPs with prudent financing strategies," he says. "One of the criteria for our fund investments is the leverage levels GPs apply in their deals; overall our fund managers have a high share of equity in their deals. Because of this, we were to a certain extent well prepared to meet the crisis."

Although financial theory would dictate that lower debt levels translate into lower risk and returns adjust accordingly, Kjerulf disagrees. Despite accepting longer holding periods, as there is no such thing as a quick flip courtesy of financial engineering, Danske does not settle for lower returns. "The most important factor is what they can do operationally, that is our mantra and that is what will separate the wheat from the chaff going forward."

Second chances

With incumbent funds often proving a challenge and new fund launches proving elusive, there is the much-asked question of secondary market opportunities. Stakes are trading at discounted prices, mostly due to the slashing of net asset values when the year-end financial reports came in. However, there is still a great of deal of uncertainty as to where valuations will end. According to Kjerulf, Danske has seen a drastic increase in deal flow from the secondaries market, but there seems to be much talk, and less action. "Many sellers are putting their fund stakes up for sale, only to pull out of the deal when they receive the price indications - in most cases considerably lower than initially expected," he says.

He does concede, though, that there are cases where vendors are forced to sell. Indeed, market rumour suggests that high-net-worth individuals in continental Europe will be the first to default. As these investors are important backers of many growth capital and venture funds, these segments are likely to be worst hit, and Kjerulf does not rule out that we might see such defaults in the Nordic region as well.

However, he conversely argues that Nordic pension funds and insurance companies, although their private equity portfolios have been built over a very short period of time, are seasoned investors with good traditions for risk management. Despite imbalances in their portfolios, appetite for the asset class remains present. "Nordic GPs will still have the backing of regional institutional investors," Kjerulf concludes.

Significantly, Danske and its Nordic counterparts still have the means to invest, unlike many US LPs, which are not committing new capital and in many cases ask their fund managers not to make capital calls. Particularly for the Nordic region, the presence of many government-backed fund investors with mandates and resources to invest through every cycle allow their fund managers to benefit from favourable opportunities in the current market. A fund-of-funds, Danske still encourages their fund managers to invest: "We want our GPs to benefit from current low valuations in the market, by way of add-on acquisitions for example," Kjerulf says - adding that Danske will ask for specific examples of potential targets and action plans to execute these deals, again reiterating the close attention Danske pays to its portfolio.

In fact, one adviser described these Nordic fund investors as a "disciplining factor" in the market with their extensive due diligence and wide-ranging reporting requirements. As Kjerulf says: "We are a demanding LP, we want to know how hands-on the GPs are and how they do things. Capability to execute plans and sense of urgency is crucial." Nordic GPs should start preparing their books.

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• Topics
• LPs
• Nordics