Danske: We’ve seen up to 50% carried interest

As it continues to invest its sixth fund of funds, which closed on €700m this month, Danske Private Equity principal Jesper Knutssøn talks to PEI about the firm's plans and the “aggressive” fund terms it’s seeing in the market.

Earlier this month Danske Private Equity closed its sixth fund of funds on its €700 million hard-cap. With 40 percent of the fund already invested, the firm is finding no shortage of interesting investment opportunities. 

However, as Danske principal Jesper Knutssøn explains to Private Equity International, the firm is also seeing extremely aggressive fund terms and increasingly frustrating behaviour from GPs, who have the upper hand in today’s fundraising environment.

Q. How was the fundraising environment this time around?

A. It was one of the quickest fundraises we have ever done. We started in late 2014 and in April 2015 we had our first close on €603 million, so in less than 5 months we basically had the fund raised. By summer ’15 the fund was – in principle – closed for new investors, but there have been some regulatory challenges for some investors which have delayed the final close.

It’s been quite a positive market for us. People have acknowledged that we deliver a compelling product that they like, and therefore we’ve been able to attract interest, even though fund of funds managers tend to have a hard time raising capital.

We’ve been deploying the capital of Fund VI since April last year – now close to 40 percent of the fund – and we expect with the current deal flow that we will deploy the remainder of the capital over a shorter period of time than usual. Normally it’s a three-year process, but it seems as if we might already be done by mid-next year, so fundraising will start already next year, 2017, for our Fund VII.

Q. How has Danske’s investor base changed over the course of its funds?

A. Our first fund was funded purely by Danish LPs, mostly large pension funds and life insurance companies. Over the funds we have expanded the investor base to encompass European investors and for Fund VI our first North American investor. It’s been a high priority for us to broaden our investor base, making it not only Danish/Nordic but also rest of Europe and we have now started to slowly penetrate the North American market as well.

We don’t have a huge number of investors, and we like to keep them close to home by offering them a very deep service in terms of helping them with private equity issues of all kinds.

Q. The fund has a European module and a North American module – how does that work?

A. It’s actually the investors who decide where to put the money. An LP can have 100 percent of his/her capital in one module or they can split 50-50 or 30-70. It is entirely up to the investors. As it happens ever since Fund I, the final outcome has always been around 50-50.

You will have six to eight funds in each of the two modules, and the investors can choose that. So if you were to choose Danske Private Equity Partners VI Europe only, then you would have a portfolio of six to eight European funds. We think a selective and focused portfolio is the right way to invest in private equity.

Q. Danske has kept its fund size relatively consistent since inception, with its first fund, a 2000-vintage, closing on €550 million and each new fund no more than €50 million larger than its predecessor. Why is that?

Our strategy is very much focused around the lower end of the market. We don’t want to invest in too-large funds. Also we believe strongly in fund picking. Therefore, we have a specific approach of being fund pickers; we will have a selective portfolio of maximum 15 funds in Europe and North America combined. Making only 15 investments from a €700 million fund is around €45 million per ticket. We believe that this gives you an optimal diversification without becoming over-diversified.

We will take up to 50 percent of a fund. We like to go in heavily and be the most, or among the most important LPs in a GP set-up, thereby gaining influence, deep access in our DD, information sharing and so forth.

Q. What are you looking for in a fund?

A. We really want funds to have an operational angle and to take an operational role in their portfolio companies. The fund managers have to prove to us that they can bring value and that they activate themselves in a certain respect. They have to prove that they actually help their underlying companies in many ways, disregarding the effect of the different cycles. This is what we spend a large part of our due diligence verifying.

Q. How does Danske differentiate itself from its competitors?

A. I think one of the most important differentiation factors is this specific fund picking attitude in the lower end of the market. Each of our fund investments will have a significant influence on our overall performance. Most other competitors would have a broader portfolio of, say, 30 to 50 funds, and we believe this is too many. We believe that over-diversification will tend to give you average or median returns. We expect to make strong returns, and that our fund picking – not having more than 15 funds globally – will give us that result.

Q. How would you rate the quality of the managers in your segment of the market today?

A. We actually think there are a lot of good opportunities in the market just now. There’s a lot of interesting fundraisings. The problem is not so much the availability; it’s the very, very aggressive terms that some of these GPs put out to the market. We feel quite challenged by some of these setups – they could be even re-ups – that suddenly throw things at us which are not acceptable in terms of fees, carry and hurdles, and excessive fund size, and extra funds with no relevance to the main funds etc. Everything, basically.

Q. What are some of the more extreme terms you’ve seen?

A. I’ve seen up to 50 percent carried interest, and I’ve seen worse than that. Also I’ve seen hurdle rates being pushed down to 0. I’ve seen fund sizes trebling. There’s all kinds of horrendous examples of bad behaviour and lack of discipline. It is true that the GPs have the upper hand in the negotiations currently. It’s difficult to get access, difficult to get an allocation, and LPs have to live with that, or they have to decline. Which we do, actually, quite frequently.

It is extremely frustrating when funds exceed their hard-caps, because we’ve kept our size for 15 years. We do that because our strategy says we must do so. We could have raised more money if we wanted to, but it wouldn’t be in line with deploying the capital in the best way possible for us.

This is exactly the same thing that goes for the GPs we see in the market. When they triple their fund size, how can they claim that nothing changes and that they’re easily able to deploy the capital in the same way they used to? It simply doesn’t add up. So returns will probably come down due to this, and therefore sometimes it will be time to say ‘no’ and find a new GP to support.

Q. How about the terms on Danske’s funds?

A. Danske’s terms are quite cheap, I think most people would say. We have a very competitive management fee and a carried interest scheme with a high hurdle rate. Our fees have gone down every time we’ve raised a fund. It is correct at this level, and it fits the size of the organisation.