Q&A - Lynsey Register, Investment Manager, Hermes Private Equity

Given the downturn in the markets, would you, as an LP, do anything differently now? What advice would you give to a first-time investor?

Private equity is a long-term asset class and, as such, it is difficult to change course once a route has been plotted. At Hermes Private Equity, we have a long-term, rolling three to five-year strategy plan which we review annually to identify interesting shorter term tactical investment opportunities. Whilst the current downturn has not lead us to substantially change our core focus it has given rise to some interesting near-term opportunities. Starting a couple of years ago, we tilted the portfolio more towards the Asia markets and with the downturn, we looked to secondaries and distressed turnaround players where we saw shorter term opportunities. Also, with the sale of our direct investment business, we have been able to broaden our remit and look again at the UK lower-mid-market sector.

For a first-time investor, caution is paramount. Private equity is an illiquid asset class with an inherent risk because of its long-term time frame. As an LP, you need to be aware of your risk appetite and ensure that your portfolio is diversified by vintages, geography and sectors. You have to maintain a healthy level of scepticism as GPs have well developed sophisticated marketing machines. Resourcing is very important, as a lot of time for us is spent on the ground sourcing, doing due diligence and maintaining our portfolio and relationships. The workload increases exponentially from the outset until the portfolio starts to mature. In addition to an experienced investment team, it is equally important to have a strong back office function given the increasing importance of reporting and transparency. Often too little credit is given to these teams.

What would you say is the biggest change in terms of how a GP treats its LPs now?

There has been a notable divide within our portfolio between those managers that are proactive and have been building up their investor relations teams, and those that have been more passive. On the whole, the larger buyout houses are those that have been more proactive, possibly as a reaction to their poor image to date or because of the scale and resources they have at their fingertips. Many investors are looking to narrow their portfolio of funds and GPs that are slower to react, and have not taken steps to address those issues, will likely find their next fundraising more difficult as LPs will start to vote with their feet.

There have been some well documented instances in the press where LPs have flexed their muscles in terms of fund size, stricter governance and better terms. As LPs gain a coordinated voice, through associations such as the PEIA and ILPA, I think we will see more of this going forward and GPs will eventually concede more changes in terms of fees and fund size reductions.

What is more relevant when assessing the merit of a GP, their track record or the current underlying portfolio?

It is impossible not to consider both of these aspects. We like to invest in managers whose track record has seen them invest through all market cycles - they've seen it all before which should, in theory, mean that they are more prepared. Those that took advantage of the boom period in terms of exits now have a fantastic track record and a smaller legacy portfolio, which puts them in a better position to invest now. However, an aspect in the prior track record we carefully consider is how those returns were achieved, for example, through leverage, operational improvement or profit growth, as undeniably the latter is more sustainable.

We don't want to see our buyout GPs falling in love with their investments and holding onto them for extended periods. Especially for those early realisations in a fund, we would rather see an exit at a reasonable multiple to get capital back to investors than hold out for eight-plus years in the hope of the big win, as you never know what is around the corner. One other aspect of the recession is a leveling of the playing field in terms of current underlying portfolios. In some cases, the downturn has masked companies that were struggling prior to the crisis. Now that the economy is picking up, we have to look to see if there were fundamental underlying problems within a portfolio or whether these investments were just more cyclical than originally thought.

What is the best indication of the true skill of a GP - cash in versus out in the last five years, or current performance (realised and unrealised)?

Again, both are critical. Cash-in versus -out is very important as private equity is a three part process that involves buying well, managing well and selling well. GPs spend a lot of time talking about proprietary deal flow and their operational capabilities, but few speak about their exit process. The best managers, and those that stick out in my mind, are those that have a clear idea of exit routes when they acquire a company and can show real exit experience. While realisations demonstrate the team's ability to exit, in terms of the unrealised portfolio we track not only the valuations, but also the underlying financial performance of portfolio companies. This includes EBITDA, covenants, headroom and performance against the manager's original plan. Although in this market GPs are often far behind their original plan - the question is how far, and will companies survive and will an equity cure be needed? This is an area where transparency and communication is critical for LPs.

Do you see the typical 10+2 year fund structure changing at all in the future?

No, I don't believe this will change in the near future because we haven't yet seen a reasonable alternative. We have seen the odd fund come to market with a shorter or longer term, like an 8+2 or a 15+2 vehicle. If a three to five-year holding period is required, a 10-year term is still tenable, as we don't want to see funds rushing to deploy capital too fast in a shorter investment period or being forced to exit too early. There is definitely some discontent from LPs about the current fund structure, but so far the alternatives, including listed vehicles, have proven to be even more unattractive.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• GPs
• UK / Ireland