AltAssets
December 2, 2003
Gerken on the sophomoric attitude
of some private equity fund managers, on why
the industry missed an opportunity in the
disclosure debate, on why he's positive about
private equity and on the difficulty of judgment
calls.
Based in California and set up in 1989,
Gerken Capital Associates describes itself
as an alternative equity merchant banking
boutique. A fund of funds, it takes equity
positions in the general partnership of a
variety of equity funds, including some private
equity houses. It invests in funds based in
the US, Europe, Asia and Latin America and
acts as a ‘non-managing general partner'
and also as a limited partner. Its investors
are internationally based institutions. Gerken
was previously a Managing Director and Group
Head of Prudential Securities Technology Investment
Banking Division and GP to the Prudential
Securities Venture Capital Funds.
How would you describe the position
of a ‘non-managing general partner'?
‘It's slightly different from being a
straight limited partner. We take a stake
in the management companies of private equity
firms - and that can be anything from a three
to 50 per cent stake. So we take on the liability
that a general partner would take on, but
we are not involved in the day-to-day decisions
about which investments are made. We are very
involved in helping managers build their funds
and helping them formulate and align their
strategy. Every one of the funds that we get
involved with is in a different state of development.
So, for example, the earlier the stage of
development, the more hands-on we are in getting
the firm established. If the firm is more
developed, we tend to help them with a particular
initiative.
‘Having said all that, we are also limited
partners in several of the funds in which
we have invested. The funds in our portfolio
range from funds of funds, to primary funds
and secondaries funds. We think of it as a
diverse family of funds in the alternative
equity universe, which by way of our very
active involvement in those funds, we have
a very broad base of intelligence globally.
That helps us formulate some interesting,
out of the box-type assessments in tricky
periods such as the one we're going through
now. There are a lot of funds out there that
were set up in around 1995 by some very bright
people. The problem is that they are not seasoned
private equity investors. And to be able to
tap into the expertise of individuals that
have been in the business for five cycles
and have the corresponding Rolodex and who
are still active is invaluable to them.'
How do limited partners view your
involvement with the funds?
‘Firms want to have the best “directors”
on the board of the fund - as should limited
partners. On the one hand, you want to make
sure that these people are independent and
that there are no conflicts of interest. However,
if you have someone who is active in the industry,
they will be involved with other funds and
some people may see this as a conflict of
interest. My view is that we have to be 100
per cent transparent in everything that we
do. If a conflict of interest arises, we can
always abstain on a particular issue. That
situation hasn't yet arisen because we have
been very open about what we do.
‘We do get asked about our involvement
when investors are looking at one of our funds,
but we think that we add a positive slant.
We take the view that we help funds avoid
the traps and pitfalls that can present themselves.
This is not an experiment, after all, you
are dealing with other people's money. You
are paid to get it right, not to make mistakes.
You need to surround yourself with people
who can help you avoid those mistakes. If
you are new to the fund management game, then
you need to get people on board who are motivated
and incentivised economically to pay attention.
If you haven't experienced this type of economic
dip, it's hard to work out what the next move
should be. Should you sit on your investments?
Should you, on a risk-adjusted basis, align
your portfolio accordingly? The more experienced
people that you have around you to help you
formulate an opinion, the better the eventual
decision will be.'
How does your investment process work?
‘The process is fairly similar to one
that a limited partner would use when assessing
investment prospects. But it does differ in
that we are looking for a specific type of
fund. We look for situations in which our
experience and network can have a material
impact on the success of a given fund. We
are not interested in being passive investors
that just sit on the board - we need to feel
that we can make a real difference to the
business tomorrow. Clearly, we are looking
for good managers, but we are also looking
for funds that are facing an interesting inflexion
point. Look at Latin America and PIPE financings,
for example. We're always trying to assess
the right asset class given the prevailing
investment climate with the view of being
forward-thinking. We don't just look at what
has happened over the last few years, but
try to work out what are going to be the more
interesting opportunities going forward while
keeping both feet on the ground when we think
about it.'
How do you find out about investment
opportunities?
‘The most important source for us is
our network. Having been involved in the business
for many years, it means that there is a ready
pipeline. I know most of these funds. I have
visited them. The trick for me is to keep
in touch with the successor management teams.
Many of the managers I originally knew were
around in the late 1970s or early 1980s and
many of them have now moved on. We are on
the lists of all the placement agents and
so we often get to hear about opportunities
that way. I also hear about funds through
the meetings that I attend on a regular basis.
They tend to be a good source of industry
information. It's a collection of sources,
but we formulate it into our own proprietary
pipeline that we keep and monitor constantly.'
How does your due diligence process work?
We go through all the usual, regimented steps
that you might expect, but what we really
try and focus on is whether the GP group has
what it takes to go the distance. The hardest
thing for us or for anyone is that it is a
new relationship. You can do all the investigation,
the reference checks and the analysis of portfolio
companies, etc. But at the end of the day,
it is the GP and our firm. If we haven't worked
together before then you never know how it
will pan out until you roll up your sleeves.
Only then do you find out whether the chemistry
is right and whether everything that we had
identified that we wanted to happen will actually
happen. That's more of a subjective assessment.
So we try to spend a lot of time with the
general partners - this is more important
for us than for straight limited partners
because we are far more than passive investors.'
What puts you off a fund?
‘We're trying to zero in on groups with
experience that is directly related to the
investment strategy that they have outlined.
We want to see a 1.0 correlation there. We
want to see that they have the experience
and the deals behind them to make it work.
We're not interested in groups that are attempting
to trade off other people's achievements.
We want to make sure that we are getting the
information from stand-up people and that
they are totally transparent with us. We don't
want to see any misrepresentations - that
is our hot point. All we have and all they
have is a reputation. If you compromise that
through wrong decisions, then you're in trouble.'
What irritates you about private equity?
‘The one thing that stands out with the
advent of a lot of new funds is that there
seemed to be a notion that the allocation
process was a very simple exercise. There
are many funds who felt that there was nothing
to it. They thought that you just went out
and found the best funds - that was all there
was to it. This I believe is a sophomoric
attitude about how little intelligence it
takes. There is obviously a lot more to it
than that. I roll my eyes when I see a fund
of funds that comes into my office asking
if I want to come onto their board, saying
that I shouldn't worry about this or that
point. I think this is less of an issue in
the US than in Europe, where there is still
a lot of money flowing into the business.
But I can be sure that there will be a lot
fewer of these players out there in the future.
There will be a tremendous amount of consolidation
in this area. But this is what happens when
there is a lot of money to be made in an area.
It attracts a lot of people - not always seasoned,
professional people.
‘There is a lot more to investing than
picking, in anybody's league table, the top
quartile performers over the last five or
ten years. Getting the asset class right,
given the prevailing investment climate, getting
the right managers who will be successful
going forward, understanding the dynamics
within those partnerships and then being able
to ensure that changes get implemented - these
are all tough calls. I'm not sure that all
managers appreciate this.'
What is the biggest mistake that you
have ever made?
‘I think that it comes back to spending
time with the general partners and making
sure that they have the right ingredients
for success in the future. We haven't always
got that right. It's not that those that haven't
done well for us haven't been bright people.
Our business model is predicated on helping
funds, to be active and to assist them on
specific initiatives and sometimes it just
happens that we are not the best fit. When
that is the case, we constructively cut the
cord and allocate our resources elsewhere.
That's why it is so important to pick the
right managers in the first place.'
What is the biggest issue in private
equity at the moment?
‘I think that the biggest issue is consolidation.
We have about 2,000 funds in operation globally
right now. A large proportion of those players
will fall by the wayside because they just
won't be able to raise a successor fund.
‘The other issue is what appears to be
an excessive amount of capital overhang that
needs to be deployed. That will eventually
be worked off by way of funds handing money
back to limited partners, which is already
happening.
‘And another is that private equity leadership
should take a more active role in the debate
about transparency. Many of the public pension
funds are now being forced to deal with this
right now, but managers had the opportunity
to do something about this a few years ago.
They missed an opportunity there. They should
be more proactive and get involved in setting
guidelines. That way they will be able to
keep the legislators out.
‘Finally, the whole area of securitisation
of private equity portfolios, insured principal
guarantees and the cross-over with the hedge
fund industry present some very interesting
opportunities and challenged for the industry.'
How do you think that that the market will
change in the future?
‘We are going back to basics, with what
will be a stronger industry populated by more
experienced players. This is a process that
any industry goes through when it reaches
excess. You always see a shut-down and then
by some kind of correction, you tend to come
out with a stronger industry. Private equity
is going through a self-corrective process.
I am very positive about the industry and
believe that it has excellent prospects for
those that understand it. I'm hoping that
we'll start seeing a pick-up in M&A and
IPO activity by the second half of this year.
I'm more positive about the industry than
most people. The macro-fundamentals for the
economy and industry at large are better positioned
for growth now than when compared to 1995,
the inception point for the bull market run
and internet craze.'
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