Recovering investors

Among the many things that Switzerland is well known for, its financial services sector, thanks to a long tradition of providing high quality – and famously discrete – asset management and private banking services to investors, is one of the most significant. A less wellknown phenomenon is that Switzerland in recent years has become an increasingly important market place for private equity investment management and product innovation. A quick skim of the country's map and you can circle a number of private equity centres.

The most obvious is of course Zurich, the country's German-speaking capital, but in its vicinity are other less familiar places playing home to organisations that now rank among Europe's most visible facilitators of institutional and private investment into international private equity. Zurich-based institutions such as Swiss Re, Swiss Life and Bank Julius Bör, the private bank, operate fund of funds businesses from the city. Dedicated fund of funds manager Adveq Management is also based in Zurich, as are asset management giants UBS (serving pension funds through its Global Asset Management business) and Credit Suisse who are offering fund investment products to institutional clients. This is despite the fact that the banking parents of both houses are currently engaged in selling off private equity assets from their balance sheets.

Short train journeys from Zurich Hauptbahnhof will take you to the nearby satellite towns along the shores of picturesque Lake Zurich, where some of the country's leading alternative asset management specialists reside. These are less familiar places with people doing less familiar things with the asset class. Taking advantage of better cantonal tax treatments – and cheaper office space away from the city – in towns such as Zug, Pföffikon and Zollikon are Partners Group, LGT Capital, Capital Dynamics and SCM Strategic Capital Management amongst others.

Another important location for private equity in Switzerland is Geneva. Alternative asset managers including Unigestion and a team within Lombard Odier Darier Hentsch & Cie, the private bank, are also headquartered in the city, as are several managers of direct investment funds.

These houses have grown into often sizeable private equity fiduciaries, benefiting from the fact that Swiss investors started to move into the asset class before many of their counterparts in continental Europe. Virtually all of Switzerland's large insurers, unlike their German peers for example, began making meaningful commitments to the asset class from 1996 onwards and accelerated their activities thereafter. Several Swiss pension funds followed a similar strategy.

product innovation. Castle Private Equity, launched in 1997 as a joint venture of LGT and Partners Group, was the first closed-end private equity fund to list on the SWX Swiss Exchange. Similar structures emerged soon thereafter. Partners Group, which today manages approximately $4.6bn across several private equity and hedge fund programmes, subsequently pioneered the world's first convertible bond structures used to provide investors with access to diversified fund portfolios. Two such structures, listed as Princess Private Equity Holding and Pearl Holding on the Swiss Stock Exchange, raised a combined total of $1.3bn in 1999 and 2001 respectively. Both vehicles were issued with a capital-protecting insurance wrap underwritten by Swiss Re and rated triple-A by ratings agency Standard & Poor's. Partners Group, together with Capital Dynamics, has also been active in developing securitisation techniques to collateralise private equity cash flows.

Why not buy shares?'
It is ironic that Switzerland's early large-scale foray into the asset class combined with the country's knack for developing structured investment instruments were among the key factors that ultimately led to Swiss investors being harder hit by the market crash in 2001 than investors elsewhere. When stock markets went into free fall, Swiss investors were caught overexposed to both public and private equity. The repercussions of this are still being felt today.

“It's still a difficult market,” says André Jaeggi, a managing director at Adveq Management, which manages approximately €1bn of investment in US and European venture capital and buyout funds. “Institutions with established private equity programmes are carrying on, but those that started in 1997 to aggressively scale up their public equity allocations and then moved into private equity have been unbelievably hard hit. They still haven't recovered and have no capacity for new risk.”

Benedickt Brenninkmeijer, CEO of listed fund of funds Shape Capital, a Bank Julius Bör affiliate which in 2001 raised SFr137m through an Initial Public Offering, makes a similar point: “Those investors who have seen their public equity positions collapse and who went into the wrong private equity vehicles are still in the middle of a process of changing their advisors, their investment processes and sometimes their own decision-makers. New allocations are not at the front of their minds.”

In the public markets, investors' misery was epitomised by the downfall of star fund manager Martin Ebner, thought of by many as Switzerland's answer to Warren Buffet until his equity portfolio was discovered to be nowhere near diversified enough to cope with the downturn. In private equity, it was publicly quoted investment trust Private Equity Holding (PEH) that came to symbolise the problems that continue to preoccupy Swiss private equity investors to this day.

Private Equity Holding
PEH, initially managed by Bank Vontobel before being taken over by Swiss Life Private Equity Partners when alarm bells started to ring in 2001, raised over SFr1.3bn to build a fund of funds portfolio heavily skewed towards venture capital. At its peak, its market capitalisation was over SFr1.6bn. Its subsequent demise is a long – and widely publicised – tale that many Swiss market practitioners are tired of hearing about, although it very much remains a topic of conversation in local private equity circles as well as abroad.

The trust used an aggressive overcommitment strategy which, once the bubble had burst, left it exposed to capital calls from fund managers who for the most part were nowhere near making distributions. Moreover, PEH hadn't hedged its position, so when the market turned and liquidity disappeared, public and private market volatility worked against it – to the horror especially of those investors who had bought shares in PEH at a premium to its Net Asset Value at the time of the trust's last rights issue in 2000. These investors were now looking at a substantial discount premium.

Market participants say it is no accident that listed private equity vehicles proved so popular in Switzerland when private equity was in demand at the height of the market. (It's notable that nowhere else in Europe did these vehicles take off). “There is an asset management mentality here. People like their derivatives,” quips one. Another says that ‘why not buy shares?’ was a rhetorical question that seemed to make sense to many investors at the time. Many Swiss investors liked the idea of gaining exposure to private equity through securities that looked familiar, and which would allow them to circumvent any regulatory problems that investing in alternative assets through limited partnerships might have triggered. The problem was that these products were being sold to investors who often didn't know very much about private equity, and during a once-in-a-lifetime technology boom.

In early 2003, when PEH breached terms of a bridge loan that Swiss Life had put into place to help cover its unfounded commitments, the investment company teetered on the brink of insolvency. Swiss Life, which by then had parted company with the entire executive team of the trust's manager, Swiss Life Private Equity Partners, managed to avert the crisis. The insurer first extended the loan facility to PEH and then, in the autumn, sold the bulk of the vehicle's fund investments and outstanding commitments to DLJ Strategic Partners, a secondary fund affiliated with Credit Suisse Private Equity. Swiss Life in turn agreed to extend financing for the transaction.

The rescue mission by Swiss Life was led by Peter Derendinger, a former Credit Suisse private banking executive and turnaround specialist who had been parachuted in to take control of Swiss Life's private equity business and return PEH to profitability. The trust is now debt-free and cash flow positive and in August of this year posted its first quarterly profit in two years. Derendinger says NAV is now stable, although not yet rising. He also reports investors in the scaled-back vehicle are satisfied with what has been achieved this year. The group continues to negotiate reductions of outstanding capital commitments, and although no new investment is planned, Swiss Life says it is committed to PEH's future, as well as to that of 5E Holding, a SFr130m fund of funds vehicle it manages which is invested in Central and Eastern Europe.

Not bad, but not good either
Swiss private equity practitioners interviewed for this article acknowledge that Swiss Life has succeeded in avoiding a situation that could potentially have turned out far worse. The fact that PEH was pulled back from the brink is roundly applauded, but there also remains a groundswell of anger and near unanimous agreement that the episode has significantly damaged public perception of the asset class in the country and beyond. Unsurprisingly, financial journalists far and wide spent a great deal of time writing about the subject, and something as seemingly trivial as the trust's name, ‘Private Equity Holding’, meant private equity as a whole didn't make it out of negative headlines in the press for months. As one fund investor in Zurich says: “This should never have happened. The people who started PEH had no experience in private equity investment, they went in too aggressively, and they mismanaged the portfolio thereafter.” Another says PEH was a case of ‘product before strategy’ – a view shared by many.

Although Swiss Life is not alone today in wanting to look forward rather than backward, the episode is worth relating because it stands out as an extreme in a market where private equity generally has had a testing time over the past two years. Many first time investors learned the hard way that they had invested at the wrong time, or had used the wrong instruments.

“A number of institutions, notably pension funds, even tried their hands at investing directly in companies. Most of them realised soon that that didn't work”, recalls Ulrich Niederer, head of alterative advisory services at UBS Global Asset Management, which manages over SFr1bn in private equity commitments on behalf of a number of Swiss pension schemes, including the bank's own.

Needless to say that as a result of the crisis, new investment activity has been distinctly subdued. Stefan Hepp, a partner and co-founder of Zurich-based gatekeeper SCM, which on a non-discretionary basis advises mainly Swiss pension plans on approximately $1.8bn of capital allocated to private equity, says that in 2001 and 2002, not a single pension fund that hadn't already invested in the asset class launched a new programme.

Light at the end of the tunnel
Today, listed private equity vehicles other than PEH continue to trade at discounts to NAV, although they never plunged as deeply. More importantly though, there are now signs that a recovery is getting underway. For a start, as Brenninkmeijer at Shape Capital observes, local press coverage of private equity has become more positive in recent months.

Now the asset class is getting back on people's agenda. As Hepp at SCM observes: “In the summer, pension fund trustees started to think about private equity again, often pulling investment plans out of their drawers that had been left there ever since the market went into free fall,” he says.

SCM recently completed a survey of 195 predominantly large pension funds in Switzerland with combined assets of SFr203bn, accounting for 40 per cent of Swiss pension capital. On average, those among the schemes that were already active in the asset class (60 pensions said they were not) had around three per cent committed to private equity, of which two per cent had been drawn.

The data also shows that while contributions from Swiss insurers to the asset class dropped from 60 per cent in 2000 to 25 per cent in 2002, pensions increased their share from 20 per cent to 42 per cent during this period. And new pension money is looking for access. Hepp says SCM, which recently won a mandate from the Canton of Zurich, one of the largest public sector pensions in the country, already has an additional $150m in client moneys to allocate for next year.

He says: “Pension funds have replaced the insurance companies, which in the early days were much bigger hitters, as the most important source of capital for private equity in Switzerland. We think this will be a medium-term phenomenon, because insurers need to rebuild their reserves first to be able to increase their equity allocations again. Faced with shrinking surpluses, insurers became net sellers of equity in 2001 and 2002. As a result, equity allocations fell by more than half during the downturn.”

LPs put a lot of emphasis on checks and balances now, and they will notice very quickly if a manager's processes are not up to scratch

Hepp is not alone in asserting that despite continuing difficulties, the market is getting back on its feet. Hanspeter Bader, executive director private equity at Unigestion, says ‘investor feedback’ has been improving in the past six months. Ivan Vercoutère, head of private equity at FoF heavyweight LGT, agrees: “We still need more capital market stability and an improvement of private equity returns, but the appetite for the asset class is coming back,” he says.

Fund managers are looking to make the most of this gradual change of sentiment. Several fundraising efforts are underway at present. Unigestion is currently in the market looking to raise between €150m and €200m from European institutions to add to its €700m of private equity capital already invested. Swiss Re is raising a €400m vehicle, looking to add third party capital to a sizeable cornerstone investment from its balance sheet. Partners Group, which to date has already invested some €800m in secondaries, is raising its first dedicated secondaries fund, also with a €400m target.

A new approach in a new climate
It is a sign of the times that structured products are not on the menu at this point. The consensus seems to be at present that their cost-effectiveness remains unproven. Instead, managers are deploying plain vanilla limited partnership structures to market new products. According to Peter Derendinger at Swiss Life PEP, this is evidence that simplicity is considered a virtue at the moment. “It's obvious that many investors didn't understand what they were buying at the time, and some don't even understand their own books today. One lesson from recent history is that clients need simple products,” he says.

But, like many of his peers, Derendinger also believes that private equity is likely to soon stage a comeback in Switzerland. First, however, investors need to do more “homework” as he puts it, and sort through problems in their portfolios. Derendinger sees a business opportunity here: he says he and his team of 17 (down from 25 before Derendinger arrived), having been ‘hardened’ by Swiss Life's own restructuring experience, are interested in working with other limited partners on an advisory basis to help them manage their exposure to the asset class. Secondaries-related advisory work is also an area that Zug-based investment advisors Capital Dynamics are now highlighting as a core interest as well.

Fund managers also continue to devote a great deal of energy to internal projects, building out their due diligence, monitoring and reporting capabilities. Partners Group and LGT for example are heavily investing in their IT infrastructure supporting their primary and secondaries investment activities in both private equity and hedge funds. Robust source data and systems are considered essential.

Efforts such as these stem in part from a recognition that in an increasingly competitive market, and at a time when many investors are still taking a dim view of private equity as an asset class after recent disappointments, funds of funds and investment advisors need to demonstrate an ability to add value, both for existing and potentially new clients. Developing and maintaining client relationships based on trust is equally important. And as Adveq's Jaeggi points out, professionalism is essential too: “Funds of funds must think of themselves as pure service providers to the LP. And they have to live best practice: LPs put a lot of emphasis on checks and balances now, and they will notice very quickly if a manager's processes are not up to scratch – which is a good thing.”

Now and then
A recovery among domestic investors is likely to give a boost to private equity fund managers across the country, even though none of the leading participants are active in their home market only. They have become increasingly international asset management operations. Partners Group has built up a particularly significant franchise in Germany for example; Unigestion has clients in Switzerland, Germany, France, Austria and the Nordic region; and LGT recently flagged its appetite for doing business in the UK when it secured a mandate from the London Pension Fund Authority. “We all happen to be based here, but we're talking about almost ‘virtually Swiss’ businesses really,” says a Zurich-based manager. “The last time I bumped into a Swiss competitor was in Stockholm.”

Still, Switzerland is certainly not a bad place to be. Local investors' pockets are still deeper than many, despite the recent problems, and when these investors fully (re)discover the asset class, the local houses should be well positioned to sign up new clients.

Some practitioners argue that, albeit for understandable reasons, the recovery is not happening quickly enough. They are concerned that local investors' current restraint, be it deliberate or by necessity, means they are going to miss out on some of the best investment opportunities that have been available in years.

Others have the related worry that once the buy side move fully back into capital deployment mode, the market might get swamped with more capital than it will be able to absorb. Practitioners in and around Zurich are speculating for instance whether the asset management operations of UBS and Credit Suisse might be ramping up their private equity allocations to a more meaningful percentage of total assets under management any time soon. If they did, the sheer volume of capital these firms have under management would mean that even a small percentage point increase would create a wall of money.

Even if this doesn't happen, many are certain that in the medium term, private equity will be back in vogue with Swiss investors. And, as Urs Wietlisbach, co-founder and co-chairman of Partners Group, puts it: “Once that happens, there will be a lot happening in Switzerland. You can see it coming.” Managers will be making make sure their houses are in order in readiness.