In an exclusive Q&A with SuperReturn365, Neil Harper, Managing Director and Chief Investment Officer at Morgan Stanley Alternative Investment Partners, shares his views on the key evaluation factors and diligence required for fund selection in today's private equity market.
Research suggests that the persistence of returns in private equity in the last decade has gone down. Is this something you’re seeing?
I've seen that research which suggests that 10-15 years ago persistence in both buyouts and venture capital was reasonable, meaning past track record was something of an indicator of future performance. Analysis of more recent performance across funds, however, seems to show that persistence is less strong, particularly when it comes to buyouts.
That academic work is well founded and based on large sample sets, whereas we only invest in a smaller number of managers. I can only really give my opinion based on our experience, which has generally been that persistence within our manager group is reasonably strong. That said, you can't rely solely on past track records or use them as your primary criterion when deciding whether to back the next fund or not. Typically private equity firms will raise more money in their subsequent fund and they might be moving into slightly different segments, adjusting their geographic scope a little bit and so on. There are also environmental factors - the competitive set around them has changed for example. Simply applying past performance with so many variable factors across funds cannot be reliable.
The way I see it, even if return persistence is not that great, there are persistent capabilities over time that you can base your diligence on. The thought process - the secret sauce if you like - is figuring out how relevant those persistent capabilities are to a different market environment going forwards.
Is it becoming more difficult to evaluate funds then?
I think it is. The private equity industry has matured considerably over the last 20 years; one of the results of which is that there are many more managers targeting many more segments with much more intermediation and competition. In the current market we’re seeing pretty high prices, loose credit and all those other things that give way to a more difficult environment with a lot of dry powder and easy fundraising. 20 years ago we were in a golden age for buyouts, but things are much more competitive today and diligence and the granularity of any approach to assessing a manager on a blind pool basis has to be far greater.
It's more nuanced. You need to look at a lot of other factors beyond track record and capabilities as well as having a wider view on the market segment, capital supply/demand for that segment, competitive intensity, and so on. It's more multi-faceted now and it's more complex.
What factors are becoming more important when it comes to fund evaluation?
When looking at track record, it's not so much the return component that's important; it's how the return was generated. One of the things we spend a lot of time thinking about is the disaggregation of prior deal performance and trying to understand how that return was generated with a view to establishing how relevant those return drivers will be in a different environment going forwards.
It's very multifaceted; the disaggregated version of track record is important, but it's only one piece of the puzzle.
Fund size, cheque size, competitive intensity of the GP’s target market segment are all critically important. We try to take a forward-looking view of capital raised or that will be raised for the segment. Demand for capital from the segment - so the flow of opportunities and how much excess capital or capital deficit there is - is also important. Some of the macro and micro features are important. In emerging markets, macro characteristics can be very important while in developed markets we tend to be more focused on the micro drivers in the segment the manager is targeting.
There are also a whole host of softer issues around economic alignment: how well aligned are the most important members of the GP; how much evidence do you have of them committing meaningful proportions of their net worth to the fund you're backing; what's the balance in terms of the team compensation in the form of management fees versus upside from carry? Then there are other alignment issues such as how long the team has worked together, how are decisions made, how they evaluate each other and how they develop people within the team. What do their networks look like, how do they reference, how do they interact with management teams, what feedback do we get from management teams? It's very multifaceted; the disaggregated version of track record is important, but it's only one piece of the puzzle.
How challenging is it to get that granular level of detail?
It takes time, experience and the dedication of resource, but it can be done. Our programme involves primaries, secondaries and co-investments. Primary evaluation can take place over a longer timescale; we'll often evaluate teams for months - in some cases years - before we back them; it takes time. With secondaries and co-investments, they are driven by specific deal situations and specific assets so we need to come to a decision more rapidly.
One approach that gives us a lot of diligence comfort and evidence is working on asset based underwriting at the same time as we're working on fund underwriting. So in other words, working on co-investments and/or secondaries as we're doing diligence on a primary. Not only does it provide additional comfort by being able to diligence some assets and the investment thesis, but you also get a close-up view of how the GP works. It really helps with understanding their discipline of thinking, how the team works together, how they develop an investment thesis, the detail of their analytics, their modelling, how they think about management team relationships and the development of management packages.
In a world of heightened valuations and a more competitive private equity environment, it’s incredibly helpful to get this view during diligence and we’re increasingly doing packaged deals where we're doing diligence on the primary fund and on a co-investment at the same time. This has become an important part of the market in recent years and we've done a large number of them.
Under the spotlight: Neil Harper
Neil Harper is the Chief Investment Officer for Morgan Stanley AIP Private Markets, a ~$10bn global fund and co-investment business, and is based in the London office. He has 27 years of relevant industry experience and has worked and invested in Europe, North America, Asia, Latin America, and Africa. Prior to joining Morgan Stanley AIP, he was a Partner at McKinsey & Company based for periods of time in Europe, North America and Asia providing consulting services to clients on corporate and business unit strategy, performance improvement, mergers and acquisitions and corporate finance.