Going large in private equity

Consider the following scenario: you are a professional investment manager operating in a small European country, ambitious and excited by international private equity. You're confident you have the experience to successfully invest in the asset class: over the course of your career, you have invested directly in domestic early stage and expansion capital situations; you have put money into Silicon Valley venture funds; at one stage, you managed an international equities programme too. So you've been around the block, and you think now would be a good time to launch your own private equity fund investment business, initially at the kind of scale that befits a start-up: being able to invest between €100m and €200m to start with will do nicely. The asset class has broadened and deepened considerably, but even though there are more institutions across Europe interested in allocating to private equity, there remains the question of where you will source such clients. How widely will you have to cast the net?

As a first step you take the idea to the largest pension fund manager in the country – and find yourself pushing an open door. The institution is enthusiastic, in all but one respect: they are not interested in committing hundreds of millions of Euros to a private equity strategy. They're talking billions. Big numbers? Maybe, but you know this is too attractive an opportunity to pass up. You map out a plan, agree a structure -and you're in business. And not just that: with this kind of money, you can skip the LP apprenticeship. As far as the market is concerned, you've become a player overnight.

Unlikely as it may seem, this is what happened soon after Jens Bisgaard-Frantzen, in December 2000, approached ATP, Denmark's largest pension scheme and the biggest institutional investor in the country, to talk about private equity investment.

His timing was good. ATP, which on behalf of 4.3m Danes (out of a total population of 5.4m, this is not far from including everyone) manages more than €36bn of capital, was keen to deploy its assets more aggressively. Up until the mid 1990s, the pension fund had been content to take a passive, low-risk approach to asset management, running a small domestic equities allocation alongside a large fixed income programme. Then, in 1998, a new CEO arrived, Lars Rohde, who a year later brought in a new chief financial officer, Bjarne Graven-Larsen. The two men shared a conviction that ATP's capital should, and indeed could, work harder.

Engaging with private equity
At the time, a change in Danish tax law meant that pension funds had been given a greater incentive to commit a significant portion of their assets to private equity investment. An asset liability study conducted by McKinsey recommended that ATP should in fact move some 10 per cent of its capital into private equity and another five per cent into real estate. 10 per cent, or more than €3.5bn, was a far cry from what the group had allocated to unquoted investment up to that point. So when Bisgaard-Frantzen came along to share his thoughts on the asset class, he could hardly have hoped for a more receptive audience.

We are not too big in the long-term, but I wouldn't want to be any bigger for the time being

Part of what must have persuaded Graven-Larsen, who led the talks for ATP, to team up with this obviously highly motivated private equity professional was Bisgaard-Frantzen's background. There was considerable appeal in working with someone who had spent the early 1990s investing in domestic early stage and expansion capital situations, first on behalf of a listed Danish investment manager, then as an executive at Dansk Erhvervsinvestering, a Copenhagen-based venture capital firm. In 1994, Bisgaard-Frantzen left Erhvervsinvestering to become CFO of an oil exploration company before accepting a mandate from Sampension, a pension fund, to run a then loss-making DKr1bn (€130m) portfolio of direct investments.

After two years of further losses, company closures and some “tough decisions to not send good money after bad”, Bisgaard-Frantzen and his colleagues managed to turn the portfolio around. The fund delivered a 30 per cent IRR in 1998, 30 per cent again in 1999, and close to 40 per cent in 2000, he reports. He also made new investments for Sampension, sat on boards of portfolio companies and expanded his knowledge of what he calls “the nuts and bolts of operational management”. Bisgaard-Frantzen also invested in a number of venture capital funds and took over responsibility for Sampension's international equity portfolio. By the time he decided to move on in 2000 – “I felt I had reached the limit of what I would be able to achieve at Sampension” – these investments had generated a 2.8x cash return for the pension.

I believe in investing in the best managers you can find, managers with fire in their bellies

While developing the idea of setting up his own private equity fund of funds, Bisgaard-Frantzen had been sounding out a number of institutions as well as a number of angel investors, about their backing such a scheme.

Several were interested. Then the conversation with ATP got underway. Graven-Larsen made clear early on that ATP wasn't going to share Bisgaard-Frantzen's investment expertise with anyone, inviting him instead to build up the pension's in-house private equity management capabilities. This meant he had to explain to his other potential backers there wasn't going to be a deal. But it also meant that the question of where his investment capital would come from would be answered for years to come.

Did he ever wonder whether what ATP wanted him to take on could simply be too much money? “You have to wonder whether your basket might be too big for the market. But my first reaction was ‘this is great. We can have a two per cent share of the global private equity fund market and be influential without being dominant.’”

Bisgaard-Frantzen agreed with ATP that a portion of its alternative investment scheme should be outsourced. As a result, while he and his team at ATP Private Equity Partners (ATP PEP) look after the bulk of the group's unquoted investments, two external managers, Goldman Sachs Private Equity Group and Danske Private

Equity, have also been mandated. It's a healthy arrangement, he says, allowing ATP PEP to benchmark itself against their performance and process.

Size can be an issue
Today, two and a half years after ATP PEP was set up, Bisgaard-Frantzen's enthusiasm for the task at hand remains undiminished, even though ATP's appetite for private equity investment opportunities has proven somewhat excessive for the market in its current condition. According to the original blueprint, ATP PEP was to have put out €3.5bn by 2005, a target that has since been modified, with 2007 now being the less aggressive new deadline for that total being committed. “We've been finding it difficult to deploy capital as planned. We have found fewer managers we wanted to back, and we've been emphasising commitments to the mid-market, where is it harder to invest large amounts of money. We are not too big in the long-term, but I wouldn't want to be any bigger for the time being,” declares Bisgaard-Frantzen.

ATP PEP's first vehicle is a €1.275bn fund. It is currently 30 per cent invested, and is intended to be fully deployed by year end 2004. The objective is to make investments of between €10m to €75m in US and European partnerships, and the fund can co-invest up to €25m of equity capital in individual transactions.

Would you ever invest in a toll bridge?

So far the fund has made two commitments to large European buyout funds, Nordic Capital IV and Cinven III, with which it has also co-invested in the 2003 acquisition of Gala, the UK bingo club operator. In the mid-market, it has invested in UK-based Graphite Capital VI and Waterland Private Equity Fund II in the Netherlands, while also backing US groups Lindsay Goldberg & Bessemer, Lake Capital Partners and Pfingsten Partners, an Illinois-based firm. On the venture side, ATP PEP I is an investor in Abingworth Bioventures IV, the heavily oversubscribed biotech fund that closed in July this year at $350m.

It is also noteworthy which funds ATP PEP have elected not to invest in: market sources say that the group have passed on Permira's latest offering and have also said ‘no thanks’ to Altor Equity Partners's inaugural fund.

The fact that Bisgaard-Frantzen and his team -five investment professionals and another four support and monitoring staff at present – have decided to build up their portfolio at a slower pace than initially envisaged suggests the task of investing such a sizeable amount of capital is being approached with rigor, thoughtfulness – and confidence. Money has not been splashed around. Other limited partners who have been active in the asset class for longer than ATP PEP give credit to the thoroughness the group has demonstrated in manager selection so far, citing as evidence that they have passed on some of the best-selling offerings this year that other LPs have piled into (Permira and Altor being cases in point). It is tempting to imagine how many LPs -and GPs – speculated that this relative newcomer to private equity fund selection, and keen to put a large amount of cash to work quickly, would simply have hoovered up all those funds. Particularly as many of these peers clearly deemed them good enough, and especially at a time when credible firms looking for funding are relatively scarce.

On being selective
Instead ATP PEP has been picky, and by all accounts true to an investment philosophy that has its roots in many of Bisgaard-Frantzen's fundamental ideas and beliefs about the private equity business. It's hard to imagine the soft-spoken Dane ever tiring of discussing this philosophy, which he clearly is keen to further hone and develop as the group's exposure to the asset class increases.

One key principle that has guided the pension fund's foray into unquoted investment from the beginning is that private equity investors should not asset allocate. Channeling fixed amounts of capital into specific sub-segments of private equity from the top down doesn't work, says Bisgaard-Frantzen. To him, success in private equity is a function of being able to consistently pick top-performing general partners: “I believe in investing in the best managers you can find out there, managers with fire in their bellies. Most of the value we can add is in manager selection, which is why we have concentrated on manager sourcing and due diligence.”

There are currently 441 partnerships in ATP PEP's database, groups that the team has had contact with since July 2001. Half of them have come to Copenhagen, others have been approached during what Bisgaard-Frantzen calls “survey” and “due diligence trips” to the main private equity locations in Europe and North America. Only a fraction of these groups have made ATP PEP's list of most wanted fund managers: “So far we've identified some 70 GPs worldwide that we want to have a close relationship with, who we want to meet up with on a regular basis. Ideally, we would have an investing relationship with most of them.”

We're occasionally criticising general partners for not sticking to their strategies, so we are certainly not going to drift ourselves

The reason why Bisgaard-Frantzen wants to have a regular exchange with GPs, even when they are not fundraising, is that he thinks it is critical to understand what he calls their “investment DNA”: How are GPs approaching a deal? Why are they making the investments they are making? This is the qualitative part of ATP PEP's due diligence process, which general partners need to pass with flying colours if they are to stand a chance of receiving a commitment. Bisgaard-Frantzen says he is fond of asking GPs hypothetical questions like, ‘would you ever invest in a toll bridge?’, and then analysing whatever answer is given for clues about their mindsets as investors.

Accepting that there is a considerable amount of art in the science of choosing the funds that are worth backing, does he as an investor engaging in the all-important selection process consider himself a risk-taker? “Yes. As an investor in private equity, you have to be. Compared to equity or fixed interest investors, I'm certainly not risk-averse at all.” But neither does he think of himself as a maverick: investment decisions are taken partly with a view to limiting risk to an extent that is consistent with his own, personal preferences. “If I were to compose a portfolio purely for myself, it would probably look more or less the same – a certain amount of venture and a good chunk of mid- and large-cap buyout funds.”

In the case of ATP PEP's debut portfolio, the amount of venture is in fact likely to be smaller than the 20 to 30 per cent originally envisaged. Bisgaard-Frantzen says, like several other significant investors currently assessing the venture space, the fund's exposure to venture is going to be more like 10 per cent. “We haven't seen enough quality venture funds in the market yet, but I must emphasise that this is not a negative statement about venture funds. We've been very cautious. This is our first fund of funds, and we're building it quite conservatively, because we have some aspirations. We are not experimenting at all. I've experimented in the past, and I think it's necessary to do that again, but not with the current fund.”

Alignment of interest
But regardless of how much risk ATP PEP, or indeed any investor, is willing to take on at any point in the investment cycle, he or she certainly ought to have enough ‘skin in the game’ to ensure interests are aligned. When negotiating with ATP how the private equity business was going to be structured, Bisgaard-Frantzen insisted that he and his colleagues be given the opportunity to participate in the investments they would be making on behalf of Danish pensioners. “I wanted a structure where I could co-invest, not because I'm a wealthy man, but because I think it's important to put your money where your mouth is, to show that you believe in the project and to install an incentive scheme.” Every member of the ATP PEP team is entitled to receiving carried interest, an arrangement that focuses minds and which is likely to bring a degree of internal stability to this young but growing team that other limited partner organisations are often lacking.

Managing money for other people is the ultimate market test

Alignment of interest obviously also extends to investors' relationships with general partners, and it doesn't surprise that this is another subject that Bisgaard-Frantzen is thinking carefully about. He doesn't want to be seen as “activist”, aggressively pushing for better terms when negotiating with GPs or taking radical positions on any other parts of the GP/LP relationship. But he is nevertheless adamant that certain terms and conditions governing limited partnership agreements are in need of revision to accommodate the changing fundamentals and lower return expectations of the business. What's needed, he says, is more constructive discussions between LPs and GPs: “I believe in educated dialogue. We should be able to share our calculations and discuss them with the GPs to give them our view and to establish a common ground.”

At a GP gathering held in September in the south of France, Bisgaard-Frantzen did just that. He argued that in today's market environment where private equity was likely to generate lower absolute returns than in the past, lower management fees would actually benefit both LPs and GPs. To make his point, he asked the audience to consider the fictitious case of two €500m partnerships, one organised in 1997, the other formed in 2003. He assumed that both funds charged a management fee of 2 per cent, and that the 1997 fund would return a gross multiple of 3x cash and 44 per cent IRR, whereas the 2003 fund would come in at 2x cash and 26 per cent IRR.

Bisgaard-Frantzen then proceeded to show that at a 2 per cent management fee, all other things being equal, investors in the lower-performing 2003 fund would absorb a greater share of the loss than the GP relative to the 1997 fund. Moreover, the management fee would make up a larger proportion of the GP's total income in 2003 than it did in 1997. And, because higher fees mean less capital available for investment, had the 2003 charged a reduced management fee of just 1 per cent, it would have generated an additional €60m in investment gain to be distributed between both parties.

To Bisgaard-Frantzen, these are compelling arguments in favour of a new approach to manager compensation. “Management fees should come down. We are paying a fee to enable the GP to run the operation, but their profit should be in the carry.” And it is not just the management fee that needs rebalancing: there is also the often sensitive issue of transaction fee distribution to consider. “We think transaction fees should be 100 per cent offset,” declares Bisgaard-Frantzen. “There might be some compromise, such as the GP taking abort costs for instance, but we don't think that transaction fees belong solely to the GP when they are not taking on any additional responsibility.”

ATP PEP is certainly not the only buyside representative to take a reformist stance on the issue of realigning interests between LPs and GPs. How much change their arguments can affect is difficult to predict though. In a business where the most highly regarded managers can still more or less dictate terms and conditions when fundraising and still sign up widespread institutional support from those investors without much resistance, there may never be much movement on fees. The fact that relatively few investors are willing to take the conversation, ATP-style, to general partners, let alone take the kind of activist stance that ATP itself wants to avoid, doesn't bode well for a change of practices any time soon either.

That said, if Bisgaard-Frantzen's prediction that private equity is evolving into a lower yielding asset class turns out to be right, fund economics on current terms may simply become unsustainable. The question is, just by how much will private equity's return generating potential decrease? Bisgaard-

Frantzen himself allows for moments of optimism here. “My expectation is that our first fund will generate between 12 and 15 per cent, although when the sun is shining and I am having a good day, I think we can return more. There are similar economic patterns today compared to what happened in the early 1990s, which produced some of the best vintages ever seen. We should make sure we get as much out of the current situation as possible.” In order to do this, once ATP PEP I is fully invested by the end of next year, the group is planning to deploy a further €570m, €615m and €660m in 2005, 2006 and 2007, respectively. There is also an additional €105m earmarked for co-investment. This will deliver a total equivalent to 10 per cent of ATP's total asset base. These are still large amounts to put out, and the group reserves the right to downwardly revise these figures depending on whether there be sufficient appropriate product available to deploy these amounts.

Market factors matter
Certainly, Bisgaard-Frantzen is confident the project is going in the right direction, partly because he believes competition among LPs for access to the best funds will not exceed a certain level.

Bisgaard-Frantzen thinks other institutions in Europe are unlikely to up their initial allocations to the asset class, thus keeping total capital supply to the market to a reasonable limit. With regard to the big US public sector institutions who have shown increasing interest in buying European buyout product, he believes those organisations that are not subject to FOIA-related pressures to disclose portfolio data actually enjoy a meaningful competitive advantage when it comes to maintaining relationships with the best-performing general partners.

Does he think what ATP PEP is doing is contrarian in some way? “A little bit, yes. But the most important thing for us is to come up with a strategy based on educated views and then to stick to that strategy. We're occasionally criticising general partners for not sticking to their strategies, so we are certainly not going to drift ourselves.”

That means ATP PEP won't move into secondaries or distressed investing -at least not for the time being. Bisgaard-Frantzen, while clearly attracted to the idea of adding more strategies to the ATP PEP proposition, is adamant that the move into these sub-segments needs to be well timed, and that it would also require a larger team with additional skills. The same goes for the prospect of ATP PEP ever taking on third party capital: “I wouldn't rule it out. Managing money for other people is the ultimate market test.”

It's a test Bisgaard-Frantzen clearly wants to sit, but not any time soon. The short-term ambitions remains to build up the asset base and, importantly, build a reputation among managers for being the type of investor that they want to have in their funds. That is why, while trying to keep a low profile in Denmark, Bisgaard-Frantzen is very keen to increase ATP PEP's visibility on the international scene. “The most important public relations issue we have is to increase our profile in the international GP community. We want to build our brand, based on rigorous manager selection and long-term relations, so that we get to a position where we become a preferred partner for the managers we want to invest with.”

As Bisgaard-Frantzen would be first to admit, it is early days. But general partners who haven't met him and his colleagues yet could do worse than book a trip to Copenhagen or at least make sure they play host during one of the team's survey trips. It could prove the beginning of a long and fruitful relationship.