Q&A with Pantheon's Helen Steers

Alice Murray: What were the key events or developments for the private equity industry in 2013?

Helen Steers: The major development was the return of confidence in the market, which translated into lots of exits. It was a banner year for us for distributions. Increased distributions have many benefits: for investors it is incredibly important to see liquidity coming back after so many years where there wasn't that much activity on the exit side, nor on the new deal side. Seeing cash being returned renews people's confidence in the market. On a practical level, an increase in distributions means there is additional money that needs to be reinvested.

With public markets having had such a strong year, the denominator effect actually had a positive impact on demand for private equity. Before, we had the reverse impact, where public markets had crashed and private equity had remained relatively steady so investors were over-allocated. Now, with the public markets all increasing in value (Nasdaq up by 35% last year), people have more confidence in committing to private equity.

Partner Helen Steers on the latest trends and her expectations for the coming months

Plus, sentiment towards Europe improved in the second half of the year. All of a sudden, from people not wanting to consider Europe at all, now they really do want to talk about Europe. In the US, not only is there renewed interest in Europe, there almost seems to be enthusiasm for Europe.

AM: Fundraising for European GPs picked up in the second half of last year, with firms including Graphite, August and Vitruvian reaching impressive closes. Will this fundraising success continue into 2014?

HS: Yes, fundraising success will continue but it will be a bifurcated market. You'll see some managers racing to their first close, but the market is unforgiving and if there are teams that have had wobbles in the portfolio, or if they've got looming succession issues that haven't been addressed, they will struggle. Timing is also important; sometimes we see managers going out too early instead of waiting until they've secured exits to show investors. They go out with lots of promises but the market isn't accepting promises. If you look at the successful fundraises, it's because those GPs have delivered on investors' expectations.

And, LPs are still reducing the number of relationships in their portfolios, making it a tough environment. The best funds build momentum very quickly and some of their peers may not be as lucky if they come up against some of the must-have brands.

It will certainly be easier than it was in 2012, which was a very difficult year. Last year was better if you hit the market with the right product. In 2014 it will be easier partly because managers have had another year to add value to companies, gain traction and deliver exits, which LPs really value.

Cash distributions from 2013 will also be a major boost because it is the proof of the pudding. You can only go so far on potential exits; at some point you need to see cold hard cash.

AM: What are the key themes you will be looking for with funds out on the road this year?

HS: Environmental, social and corporate governance (ESG) is a theme that has become a lot more mainstream. Managers must have their socially responsible investment policy, procedures and reporting in place before they launch their funds. LPs are not as forgiving as they used to be.

ESG has become a source of value creation, whereas before it was often done fairly half-heartedly, just to tick a box. Now, there is a genuine recognition that this is a way to add value. The managers that are switched onto ESG will have case studies to demonstrate how it works and concrete benefits that have accrued to their portfolio companies.

LP reporting is also a focus. If managers don't report properly, in a timely and transparent manner, they will be punished by the market. When we contact a GP and want to know detailed portfolio information we expect an immediate response. We believe managers should have the right systems in place so that they can push a button and get that specific number.

Terms and succession planning have also become a lot more transparent. We've always asked these questions and we used to get a little bit of push-back. Now the good GPs have concrete plans - they know how their organisation is likely to evolve over the next five years and they're prepared for the question.

Regarding strategy, it has become fashionable to insist on operational improvements - every GP now says they add value operationally. The difference now is that LPs are asking for evidence. GPs have to be able to demonstrate it. When we analyse cash flows, we can see if the bulk of returns are being made through leverage or multiple arbitrage, rather than through earnings growth. The spotlight has become even more strongly focused on operational improvements because exits have been delayed. When evaluating unrealised track records in recent years, we have had to delve deeper into portfolio companies and assess how profits were growing and how companies were evolving - this has become a whole new set of analyses that GPs have got used to providing.

Co-investment has become much more important and it is becoming quite common in the mid-market. It has been very well received by our clients as it meets their changing needs. And, aside from the obvious economic and commercial benefits, co-investment also offers a less tangible advantage, which is getting to know the GP better. When doing fund due diligence on a GP we often only get exposure to certain elements of the team. With co-investments, we meet a much wider range of investment professionals, at all levels. The advantage for the GP is they develop a much closer relationship with the LP and they don't have to syndicate with another buyout firm and therefore don't have to share part of their track record with a competitor.

AM: Last year saw several successful PE-backed IPOs. Will public listings return as a viable exit route for private equity?

HS: The increased number of IPOs has been a really positive development for the market because they are very visible, so a wider audience can review these private equity-backed companies, which list successfully and then trade well. It is good for private equity as an asset class to demonstrate how well these companies have succeeded.

Also, the process of preparing for an IPO attracts extra attention, putting more focus on the company, which can then spur interest from trade buyers or secondary buyout players. It won't become a major exit route in Europe, but it's important from an emblematic point of view and for building confidence.

AM: European private equity appears to be more accepting of alternative lenders for financing deals. Will this increased liquidity in the debt market help to boost dealflow?

HS: At the top of the market the high-yield bond market has been very active. Further down the market there has been a boom in non-bank lending, which seems set to continue; everyday there seems to be another debt fund closed in Europe. It's a sign of how markets work - there was a vacuum created by the banks pulling back and so people have created interesting products that meet investors' demand for yield.

AM: Are there any particular geographies, regions or sectors that you are particularly interested in this year?

HS: We've been a very long-term overweight investor in northern Europe, long before it became fashionable. Northern Europe appears to have been "discovered" by investors in recent years, but we've always been overweight in the Nordic area in particular. We also invest heavily in Germany, Benelux and the UK.

There are very good fundamentals in these regions. The infrastructure is great in terms of regulatory, tax and legal frameworks. They are outward-looking economies too; the Nordic markets are very export-orientated, partly because they have to look beyond their small local markets. One thing that is often forgotten is that there are some large corporates in these countries, which set the pace for the rest of the economy. Also, there are a lot of management teams that have worked for these big conglomerates and have gained great international exposure - that's a huge advantage.

We'd like to invest more in Germany but dealflow has been slower than we would have liked recently. And we've been a longstanding investor in CEE and Russia.

In terms of sectors, we're interested in GPs that deal with the key challenges that Europe faces; managers that target certain demographic groups, as well as those that provide solutions to problem areas for governments, such as outsourcing services that can't be provided by the state anymore. Another area of interest is some of the healthcare segments that are being deregulated, where we have seen examples of this already, particularly in diagnostics and pharmacies.

AM: European venture seemed to gain positive momentum in 2013, will this be the year that it returns in a serious way?

HS: Europe has had a hard time producing really big venture exits, but recently we've had Criteo and SuperCell, and then there's King.com in the pipeline.

The big problem with venture in Europe is, unlike buyouts where you can invest in a good top-quartile fund and outperform public markets by 600-700 basis points, in venture you absolutely have to invest in the top 5-10% of funds. I think most of the recent successes have been concentrated in the best-known funds.

It's a segment where success really does breed success: you get some fantastic companies being built by outstanding people, exits being achieved and that, in turn, attracts the best entrepreneurs to the most successful VCs - so it becomes increasingly rarefied. I would love to see venture becoming more successful in general, but even in the US it's the same thing, where only the top-performing funds receive overwhelming investor interest and produce these exceptional returns.

Also, the top European venture funds can now compete with their US counterparts. You see the big US venture guys coming over to Berlin and London to bid for the best businesses. We've seen some top US names coming into B and C rounds where the seed or A round investors are European.

AM: What are the main challenges for private equity in 2014 and what are your hopes for the coming year?

HS: We were disappointed with deal volume in 2013; we expected it to pick up given all the positive momentum in the market and the fact that debt markets have come back. There have been lots of distributions, which has brought back confidence and growth is returning, albeit unevenly, yet we didn't see the uptick in new deals that we wanted to see, which was frustrating. And that's not because there isn't any dry powder. There is still a bit of a mismatch between seller price expectations and what buyers are willing to spend. Looking at median entry prices in our European portfolio, it suggests that pricing is still fairly subdued in the mid-market. So, my wish for 2014 is more deals.

My other wish for this year is that people remember 2006-07. Markets have very short memories and we're seeing some worrying debt packages on offer now at the top end of the market, which are cov-lite and carrying huge multiples. People need to remember the lessons learned in 2006-07 because so much value was destroyed in that period and it would be a disaster for the industry if we haven't learnt our lessons.

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