Privately Speaking: Neuberger's fertile ground

Neuberger Berman has been a serious player in asset management for decades but its move toward becoming one in private equity has been a more recent phenomenon.

The New York-headquartered firm was founded in 1939 and has global assets under management of $237 billion, of which some $35 billion is in private equity.

The company was one of the biggest movers in Private Equity International’s PEI 300 last year, rising from 63rd in 2014 to 23rd, and it has committed around $2 billion to private equity in each of the last three years.

A tripling of private equity assets over the past eight years bears testament to this rapid expansion, with the vast majority through organic growth. Like many of its peers, a key driver has been a sharp increase in separate customised accounts, or what it terms private investment portfolios, but growth has also come from a number of more specialised strategies, such as healthcare royalties, co-investment, secondaries and consumer brands.

Head of global alternatives, Anthony Tutrone has witnessed all of these developments, having joined the firm in that position in 2002 and spent his entire 30-year career in private equity.

Head of European private equity, Joana Rocha Scaff joined in 2005 after working as an investment banker in Latin America, US and Europe, focusing on telecoms and media. She moved to the UK four years ago to run its European private equity operations.

Tutrone emphasises that the successful development of the private equity offering has been dependent on listening closely to what products its clients wanted and being proactive in creating them.

“Some of our competitors were unwilling to really accept what is being demanded by clients. Our view as investors is [that we need] to analyse what was happening in the market and act on it,” he says.

Of the firm’s private investment portfolios, which Tutrone insists are not simply fund of fund accounts, $17.8 billion is in fund investing programmes, while $10 billion is in customised accounts, with the latter growing quickest.

When he took over the business, 100 percent was in commingled fund of funds accounts, and while Tutrone is keen to emphasise that the traditional fund business remains important for smaller clients, there is little doubt that growing the customised mandates is a particular focus for his team.

“The bulk of the $10 billion is from highly sophisticated clients who just may not have the team or resources to manage their private equity portfolio, or some segments within it,” he says.

The firm is able to leverage its broader expertise across its global asset classes. Within its private equity team, there are around 100 dedicated investment professionals. Despite the recent rise to prominence of a handful of sovereign wealth funds and so-called “super-LPs”, the majority of limited partners simply don’t have the scale to match its investment processes, he says.

“For clients to replicate that, it would take a massive investment. So when a client comes to us with a specific need, we can fill the gap, and because of our scale and scope, we can also do it pretty inexpensively.”

Another issue for many LPs, is the relatively high barriers to entry, Rocha Scaff says. “[Private equity] remains a relatively difficult asset class to access. You may have the capital to invest and the budget to hire a team but building the investment relationships to get your allocation right can be a challenge,” she says.

Tutrone was on the buyout side before joining Neuberger Berman, and he has seen the industry evolve to a scenario where absolute returns have declined.

“I was part of a team that raised a billion dollars in 1988,” he recalls. “It was predominantly a US industry and very inefficient at the time. It was hard not to make money.

“I was putting together the financial deal based on 35-45 percent IRRs. You could buy something from a corporate and generate magnificent returns for investors. You don’t run models like that anymore.

“When I started you were either a buyout or a venture person. Today the industry has been cut in a thousand different ways.”

Neuberger had a brief dalliance as a public company between 1999 and 2003 before Lehman bought the business. Five years on from the global financial crisis that Lehman’s collapse helped to trigger, Tutrone and his fellow partners bought themselves out of the wreckage.

Having been at the centre of the meltdown, the experience produced a tight bond between the partners, which is also apparent at their parent company. No senior private equity partner has been lost to a competitor in a decade and Tutrone puts this down to being a private company owned by its employees, and the sense of alignment that comes with it.

The firm is unencumbered by public company reporting, Tutrone says. There have been no spin-outs, just 'spin-ins'.

Recent examples have included the 2015 acquisition of Merrill Lynch’s $1 billion fund of funds business and the structured transaction that lifted the direct private equity team out of Italian bank Intesa Sanpaolo.

The latter team, now known as NB Renaissance Partners, came with its current investments of around €300 million, but Neuberger also provided it with a further €300 million to invest in private equity.

“The bank wanted to do it as a partnership because it had a great relationship with Italian entrepreneurs and family-owned businesses which from time to time need equity capital,” says Tutrone.

Rocha Scaff is keen to emphasise that organic growth – rather than acquisition – remains the biggest single driver of the increase in private equity assets at the firm, and it has been a beneficiary of the increased desire for private equity from US pension plans in particular.

Between 2006 and 2013, Rocha Scaff says, US pension plans increased their allocation to alternatives from 10 percent to 25 percent.

“With relatively lower returns coming from fixed income and other mainstream asset classes, investors have shifted their portfolio allocations towards alternatives. Within alternatives, the bulk of the capital has been allocated to private equity and real estate,” she says.

THE DECLINE OF CLUB DEALS

As well as being head of Europe, Rocha Scaff is a partner in the co-investing team, which was set up as a dedicated function by Tutrone a decade ago. It had grown to $4.8 billion by 1 January 2016. With other roles including being a member of the firm's Latin American Private Equity and Private Investment Portfolio investment committees, as well as being on the LP committee at the BVCA, Rocha Scaff is well placed to analyse co-investment trends. She believes to do it well requires a markedly different skillset to primary investing.

“How to execute co-investments in a professional and responsive manner is the hard part for many LPs because this is not like fund investing, where you can take your time.

“Co-investment is an opportunistic transaction; the manager needs capital and you may only have a few weeks to make a decision. If something goes wrong you don’t have a manager to hide behind – it’s your fault because you are selecting the transaction in which you participate.

“You have to understand tangible things; valuation, capital structure, business model, industry and competitive dynamics, growth strategy, and whether the exit path is realistic.”

The co-investment team considers around 180 co-investment opportunities a year which provides Rocha Scaff with a strong gauge of investor appetite for them. She estimates that around half of the GPs she speaks to say their investor base is keen to undertake co-investments, but when a real opportunity comes around, that numbers drop dramatically.

“For those that even get round to signing the non-disclosure agreement, many others fail to make an investment strictly due to lack of process or resources.

“There is a meaningful distinction between wanting to do co-invest and really doing it,” she says, although for some it may simply be that the proposed deal is ultimately unattractive.

Rocha Scaff believes the co-investment model is developing along two distinct routes; syndicated co-investments, and one where the GP prefers a single, often large, LP partner to invest with.

The syndicated approach involves GPs striking a deal and taking the equity risk through their fund before distributing segments of the deal to various LPs, normally meaning relatively smaller stakes for the latter.

But the single partner route, is gaining greater traction, she believes, pointing to a general decline in the number of club deals.

“The scenario where three or four GPs partner together to do a deal is not a situation you see that often anymore, so GPs are now partnering with large LPs to do a deal.

“This is often more attractive for the GP, as in our experience they tend to keep control of the deal, while having a sophisticated partner underwriting the deal alongside them.”

A relative dearth of club deals in the latest cycle is down to three factors, she believes.

First, after the huge popularity of club deals in 2005-07, the aftermath from the global financial crisis left many club investments underwater and GPs at odds in terms of how to solve the issues (or “multiple chefs in the kitchen”, as Rocha Scaff puts it).

Second, she says, a number of LPs were annoyed to find themselves investing with GP A and GP B assuming diversification, only to find the GPs had clustered their exposure, often leaving those GPs heavily exposed to the same underlying companies.

The third has been the impact of the regulator, with the US Securities and Exchange Commission (SEC) alleging collusion between GPs in a number of club deals, leading to a string of significant fines, she adds.

“That’s why the largest LPs – with the resources and the capital base – have emerged as a much more viable path for co-investments in the latest cycle.”

Tutrone believes that most limited partners now understand that co-investment is also highly capital efficient.

“The beauty of co-invest is that there is typically no unfunded portion, so it’s an extremely effective tool in the portfolio and LPs have figured that out.”

In terms of the current focus from both regulators and investors on transparency and fees, Tutrone believes that his firm has been at the forefront of the move to drive fees down across its various private equity strategies.

And just as limited partner appetite for co-investment has increased, so has a demand for greater transparency on fees and fund terms.

Tutrone thinks that the SEC has broadly done a good job so far in pushing for better disclosure.

“The regulator doesn’t always get everything right, but it has got this right in terms of getting more transparency and disclosure [on fees]. They have been effective in forcing GPs to move in that direction.”

However, while he thinks the combination of regulatory pressure and more effective LP bargaining power has served investors well, ever greater demand for the asset class has meant the power has slipped inexorably back toward the best performing GPs. “The truth is there is a lot of money coming into the industry and it’s focused on the better GPs. For those that have had low turnover or not changed strategy and produced strong performance, fundraising has got easier.”

Very often, LPs have bent to GP fees and conditions, he says, because they want to gain access to the best performing funds as competition heats up.

“There is a secular trend for investors to break into private equity for the first time. While the US market is quite mature, private equity is still at a nascent stage in many other markets.”

But he believes most of the good GPs are smart enough to realise that the rosy current fundraising environment “may not last forever” so are not pushing investors too hard; LPs will remember if they have been stepped on in previous fundraising rounds.

At the same time, the firm has also been active in rationalising its relationships, just as some LPs have reduced their GP relationships.

“Almost every investor we talk to has this on their mind, because private equity is extraordinarily labour intensive. Investors want strong, close partnerships, which is harder to do with 100 global clients than with 35,” Tutrone says.

“You can negotiate more favourable terms if you concentrate your bets. You can have a lot more leverage because you can negotiate terms, meaning your expenses are lower.”