Steering clear of private equity's bottom quartile funds

Kelvin Liu of Invesco's fund of private equity fund unit gives a few tips on how to find a good manager.
Asian investors sometimes get into private equity thinking that they are likely to hit the jackpot. Often they end up disappointed after the markets crest, and they find their funds are among the outliers and underperformers. ThatÆs often enough to put off their investment committees from future private equity investment.

We spoke to Kelvin Liu, principal at Invesco Private Capital, who handles their private equity fund of funds focusing on asset allocation. The firm currently manages $4 billion within a series of global funds of funds. He is based in San Francisco and is visiting Hong Kong this week.

Where are your funds exposed?

Liu: It is a global fund, so, itÆs US and Europe principally. Asia has become more sophisticated and investable. We have just a little into Africa and the Eastern Bloc. About 30% of our total exposure is outside of the US.

In Asia, a lot of people invested here in the 1980s and early-1990s. IÆm generalising just a little, but many of them didnÆt make much money back then. The laws and regulations governing private equity were not as strong, nor was corporate governance. Since 2001 that has changed. For example China and Indian deals have made very attractive returns since then and investorÆs money has returned.

What are you looking for in an Asian manager?

To be profitable, that they have a good track record and make money and understand the local environment. We want them to adhere to high ethical standards. On top of what we look for in the US, we look for them to be foreign-educated outside of Asia as by proxy that that exposes them to corporate governance issues.

The experience from brand name funds has been gravitating towards Asia, and given the credit crunch in America that trend might increase. Buy-outs have been affected in this market by virtue of the leverage required. Venture capital is remaining resilient due to the lower leverage and the continuing demand for new technology.

In Asia, weÆre seeing the big banks becoming very cautious about syndications but for a lot of the Chinese and Japanese deals, they donÆt syndicate internationally but among local banks, so they have been less affected.

What advice do you give to investors who may have had bad experiences in private equity?

Choosing managers is harder than just going and meeting them. Now, I might sound a bit self-serving here, but engaging a manager who knows how to choose a private equity fund properly is important.

Because it is a complicated job, thatÆs why funds of funds exist. The histories are short, private equity managers seldom have been out there more than ten years, so they may have done just a handful of funds, and that means only a couple of reference points.

Private equity funds can also get access to funds with capacity issues. Individual funds and partners often respect an experienced investor and accept their money because they know that they wonÆt panic when the market corrects by 30%. Sometimes individual investors do. Also all the relationships are already in place between the manager and the fund of funds.

What is the range of private equity investors out there?

Institutional investors might range from say $1 billion up to the big players like Calpers or Government of Singapore. If youÆre small it doesnÆt make sense to build your own allocation team because your private equity allocation is usually small, say 10-15%. You canÆt diversify with $100 million, Yale ranks as one of the most aggressive with 25% going to private equity.

Now Calpers might have $25 billion to spend on private equity. To fill that they might have to write out cheques for $500 million. There arenÆt many managers who can swallow that either. Yet investors donÆt want to write $50 million cheques and have hundreds of investments. That makes them almost into a benchmark fund, simply buying across the board, exposing them to the entire asset class, rather than being able to be selective.

Are there hot sectors that private equity managers should be setting up funds in to get interest from investors like yourselves?

Warren Buffett says that you canÆt invest just looking at the macro situation and betting everything on one sector. We want to match the skill sets. If you find an investment banker who has never looked at tech, but he sees tech is hot, he decides to start a fund and writes his business plan on the back of a napkin, then I have to ask him what makes him the great guru.

This does happen. ThereÆs plenty of that going on in hot areas. LetÆs say for example in green tech. The new funds sell the sizzle. Often I think that I know more about green tech than they do. I wouldnÆt put a dollar with them.

By the same token, if you have fantastic skill sets in, for example, science, maybe say in nanotechnology, I would still advise caution about the place you are setting up your fund. For example, if you wanted to go to China; because there may not be the cutting edge technology deals in that environment to be able to mature your business.
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