Investing from first principles

It's not unusual for entrepreneurs who have had a taste of private equity to change sides and enter the industry themselves: deal participants are often more than ready to become dealmakers. What is less common though is for them to move across and to join the private equity buyside and become an LP. Phil Cooper, a trained journalist who went into advertising before dropping it all in the late 1970s and starting to build companies instead, has done exactly that though.

What is also rare is for someone with this kind of background to join Goldman Sachs, one of the leading, and also ostensibly traditional, investment banks on Wall Street, relatively late on in their careers and be given free reign to set up a new operation from scratch ? in private equity of all things. Cooper did this too, joining the bank in 1996 when he was in his mid-forties, to start building a private equity fund of funds investment business.

At the time Cooper had already set up his own private equity investment vehicle, but several people (including his wife) persuaded him that Goldman was worth joining. Today he still enjoys talking about the fact that as a professional he grew up outside the Goldman culture, and can't resist the occasional joke about the bank's seriousness and straight-faced style. Back in 1996, however, when after several rounds of conversations Goldman offered him the chance to effectively implement his original plan for a private equity asset management business but inside the bank, Cooper accepted. ?The reputation, the clients, the distribution network, the people and a 130 year long history of making proprietary investments ? all that was very attractive,? he says.

Cooper therefore came in and started to build a private equity fund of funds (FoF) business as part of Goldman Sachs Asset Management. In April 1997, the group closed its first FoF at over $900m, three and a half times its initial fundraising target, in part benefiting from the increasingly strong demand for private equity from high net worth investors. The bank was impressed. ?This could not have happened anywhere but Goldman Sachs,? says Cooper. ?They were 100 per cent supportive in these early days and let us get on with building the business.? For Cooper that meant a chance to put to the test some of the ideas about private equity investment he had developed ever since his first encounters with venture capitalists in the 1970s.

Early entrepreneurial days
At that time, there were little more than a dozen early stage investment firms operating in the US. Cooper, having rid himself of that unfulfilling advertising job, started talking to them about a business idea, which was based on a way of applying information software to financial analysis. ?At the time it was a stunning idea, combining financial analysis with colour-graphics. This was before spreadsheets, and there were no PCs or powerful microcomputer operating systems, so we had come up with our own.?

In 1980, when Cooper was 29, the business secured initial funding from an angel investor and expansion funding from three venture capitalists. The start up ? Computer Pictures – was a success, and Cooper sold after two and a half years.

Cooper then devoted himself to business studies at MIT, earning a Masters Degree at the Sloan School of Management, before returning to the fray and launching three more companies, each time with the help of venture capitalists. Two of them succeeded, the third failed, with Cooper at the helm as CEO, an experience that he says taught him ?80 per cent of what I know about running companies.?

It was around that time that Scott Sperling, then Head of Private Equity at Harvard University's endowment who went on to become a general partner of Thomas H. Lee Partners, took Cooper aside. Cooper was a good entrepreneur, said Sperling, but much better on the financial side. ?Scott was right,? says Cooper, ?I had in fact started to realise myself that I enjoyed the financial stuff better, but sometimes you need someone else to tell you these things.?

So Cooper set up a small investment partnership, backed by Harvard, and spent the next two years managing this money and advancing his knowledge of quantitative portfolio analysis. Next he joined Rogers Casey, a large investment consultant, to manage a separate account for a large US institution which, like many of its peers, had recently developed a sudden appetite for alternative investments and was prepared to commit between five and six per cent of its assets to private equity. ?This was a big statement, unheard of at the time,? Cooper recalls.

?What I was trying to figure out was, what is the most rational and rewarding way for a fiduciary investor to get the best private equity risk/return profile and to attain predictable portfolio behaviour? To come up with the answer I thought I had to apply both my own experience as an investor, study history, and marry both to modern portfolio theory.?

Bucket filling doesn't work
Discussing the investment philosophy that he began to develop from the 1980s onwards, it seems that a significant part of Cooper's interest in portfolio theory is in uncovering the traps to avoid when investing in alternative assets. On the whole, he isn't impressed with how other investors approach private equity: ?There is too little historical understanding of the investment process in the asset class, and not enough attention being paid to first principles.?

Cooper believes that too much attention is being given to ideas that derive from mainstream asset allocation theory, particularly the notion that an ?optimal? investment strategy can be constructed in the abstract by coming up with an ideal asset mix first and then implementing it by purchasing, index tracker-like, the required components as dictated by the blueprint. This, says Cooper, may work in public markets, but falls down when applied to non-tradable securities in the inefficient private markets. For in these markets, there is just not enough accurate, recent projectable data available to plug into the optimisation models that asset allocation relies upon. ?The time series you need to feed into an optimiser are typically not there in private equity. It does make you wonder where the volatilities and realised returns that people use in their spreadsheets and optimisers actually come from. Too many investors in private equity are caught up in sophistic analysis, trying to strike the optimal balance between sub-sectors, products or countries.?

The other problem with taking a conventional asset allocation approach to private equity is that the general partnerships that are capable of producing sufficiently strong returns and are therefore worth backing are thin on the ground. Asset allocation models, in Cooper's opinion, leave investors with several unequally sized, empty buckets that require filling, regardless of whether there are funds of the right quality that can bring about the projected outcome. As a result, such strategies he feels are bound to disappoint.

Compounding this ideological problem are other operational ones, says Cooper. Few limited partners have got the time, the resources or the expertise to select managers properly. ?Fund selection is often done badly. Many investors are sold to rather than buying.?

The ship owner's dilemma
Goldman's own approach to portfolio construction is based on ideas that Cooper says have been in use for thousands of years. One guiding principle for risk takers is that they can be certain that they will run into bad luck sooner or later, but can have little or no idea where exactly disaster will strike. ?It's the ship owner's dilemma: how can he protect a vessel from sinking following an accident at sea?? Given you can't predict where the ship might be holed, a sensibly built ship's hull is divided into several equal volume compartments, so that if any one of them fills with water, the ship still won't sink because others remain dry. Imagine, on the other hand, the risks that would face a ship with compartments of varying sizes. This equal volume compartment approach can apply to an investment portfolio too.

It's the principle underlying a Goldman Sachs private equity fund of funds portfolio: it's designed to withstand as much adverse market pressure and individual manager problems as possible. ?A fund has a life of ten years or more, and you have no idea how the cycle is going to develop over this period. But you have to think about your potential downside. We believe you should have 20 or 25 equally weighted partnership investments in your fund and make sure that no two of them pursue the same investment strategy. If one of them implodes, the others should continue to perform.? This is why each of the firm's six FoFs raised so far are invested globally, and why there are roughly equal portions of venture capital, distressed and other sub-segments of private equity in all of them.

Another idea is to raise a new fund regularly so as to be able to systematically diversify over time. Unlike other investors, the group has no rules limiting how dominant an investor it should be in any given partnership. ?The idea that a limited partner should contribute no more than x per cent of a manager's capital is ludicrous. If you have found a fund that you want to invest in, surely you're going to want to put as much capital in as is best for your portfolio, regardless of whether you end up putting in 5 or 25 per cent of the fund's assets,? declares Cooper.

Common sense? Perhaps, but Cooper insists that execution is difficult. Much depends on getting manager selection right ? which is therefore taken extremely seriously. Goldman's due diligence is exhaustive and costly (the 70-strong group runs its own quantitative analysis team to assist in the process). The process also requires considerable travel and in-depth analysis of prospective general partner groups right down to portfolio company level. Over the past five years, the group has run its ruler over some 2,500 private equity funds worldwide. Only around 130 (a little over five per cent) have received money. The group recently opened a London office, headed by John Shearburn, to expand its coverage of the growing European private equity market. More than 80 European partnerships have been analysed by the new office, but only one commitment to a new manager has been made, along with follow-on investments in some managers that Goldman had invested in previously.

Despite its relative youth, the group has made a significant impression on the market. In just over six years, it has gathered some $11bn in assets, managed across the six primary funds of funds, a dedicated venture fund, a distressed debt and equity fund and two secondary funds. Of this amount, the bank and its employees, underlining Goldman's own commitment to the project, have invested $700m.

Understanding the market
Cooper believes that another feature of a successful private equity franchise is to work with clients that understand the business. ?It's crucial for us to have the right clients. We like to get past the obvious questions and create a level playing field in terms of market knowledge.?

Rivals say they're impressed with what Goldman has built so far, even if a long term performance track record has yet to be established. To make sure investors are kept up to speed with valuation issues and return projections, they receive annual reports that contain the manager's own thoughts and interpretations as to how the portfolio is developing.

Delivering the returns that will demonstrate the superiority of the adopted investment approach is nevertheless the key challenge for Cooper and his colleagues. There is also the task of growing the business over the coming years. The aim is less to scale the core FoF operation by adding to its capital under management as to expand into other specialist areas of private equity investment. Cooper is still engrossed thinking about the future of the asset class and wants to make sure the group can be in a position to help develop new products and participate in changing the structure of the market.

One area he has been keen on from the start is secondaries. Cooper believes that this market will be dominated in future by integrated operators that are active in primary investments as well, because they should have better valuation skills and superior access to general partners than dedicated secondary buyers. Alongside investing in conventional secondary deals, Goldman is also a keen promoter of synthetic secondary deals, i.e. transactions where acquired private equity assets are rolled into newly established partnerships. These are expected to play a significant role in future private equity market consolidations, both among direct investors and funds of funds.

On a yet more fundamental level, Cooper also predicts that private equity and real estate investment will move closer to each other, and that the boundaries between private equity managers and hedge funds will become increasingly blurred as well.

Cooper is clear that he wants Goldman Sachs Asset Management to be as close to these trends as possible. To merely be running a well-established operation without permanently testing the limits of its capabilities would not, in his estimation, be stimulating enough. The bank, for its part, recognises the strategic value of this business. Given that it is already the world's third largest discretionary manager of private equity fund of funds capital, it's a business worth watching.