The changing face of fund manager selection

The factors that determine outperformance in private equity have changed, away from financial engineering in favour of EBITDA growth in underlying companies. This has affected the relative strengths of different private equity business models. While no model is superior, it is important for investors to understand how the different models create value, and which markets and sectors are best suited to the different approaches. There are three different models, in Akina's view:

Financial investors. These are typically generalists with diversified portfolios who refrain from being intimately involved with the operations of their portfolio companies but instead rely on finding undervalued companies or use financial support to aid company growth.

Industrial investors. Typically specialists that often focus on a particular sector. This sort of investor gravitates towards manufacturing or technology-related fields where specialist expertise is necessary. With fewer investments typically than financial investors, they also have more time to work closely with their companies.

Mixed investors. These combine both financial and industrial strategies. Mixed investors tend to prefer a small set of particular sectors but also have greater diversification in their portfolio. Despite focusing on certain sectors, this group often brings in external help for sector expertise, typically in the form of an industrial advisory board.

After classifying the funds, managers are then evaluated along a set of specific criteria reflecting the overall private equity lifecycle (moving from entry to exit).

Value investing is perhaps the most vital performance outcome. Value investing is not simply buying on the cheap. Rather, it is the skill of recognising good value for money. This is a subtle but important difference. Being a successful private equity value investor requires a profound understanding of the performance drivers of the underlying companies, and the ability to correctly assess and play the cycle. Experience has shown that there are relatively few who can consistently pull this off.

Value investing is particularly important for financial investors, where price and timing are the main contributors to performance. We find that successful financial investors are in almost all cases good value investors, often using their financial and analytical skills to find opportunities in complex situations from which others might shy away.

Industrial investors have more leeway. While they too will look to avoid overpaying at entry, because they are more hands-on they can afford to pay more for an acquisition if the business case supports it. Here, the relevant skills are those needed to successfully implement a transformation strategy.

To determine who has a knack for value investing we compare entry prices with historical sector multiples or prevailing market prices in the sector. Another valuable approach is to compare the fund's entries with its exits, especially on those deals where the entry price seemed high. Managers typically justify such purchases by pointing to the potential in the company. If, despite the entry price, this potential is consistently realised at exit, then the manager clearly has a talent for spotting value. This bodes well for overall performance.

It is also important to understand the dynamics that determine the consistent implementation and institutionalisation of a given business model. Here the human factor is at play, which explains why GP succession is such an important topic being (more) often a threat for a sustainable development. This also explains why past track records become less important in times where the performance persistence thesis does frequently not hold anymore. The outperformers of the past won't automatically be the outperformers of tomorrow in the current volatile environment.

Ralf Gleisberg is principal of Zurich-based fund-of-funds Akina Partners.

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• Topics
• Fund-of-funds
• Akina
• Switzerland