Looking forward to the contraction

HarbourVest Partners, the Boston-based mainstay of private equity, has witnessed some major ups and downs in almost three decades of involvement in the asset class. Brooks Zug (above), Martha Vorlicek (right) and John Toomey (above right) met with Christopher Witkowsky to explain the firm's philosophy, its views on terms and conditions, and its belief that a scaled-down industry means scaled-up returns

From its perch near the top of One Financial Center in the heart of downtown Boston, HarbourVest Partners has a clear view of the city's traffic flow – jets taking off from Logan airport, distant ships sailing in Boston harbour and clattering trains meandering through the city.

The lofty vantage point afforded by its Boston headquarters seems entirely appropriate for this 27-year-old firm. After all, its position as one of the world's largest funds of funds and secondaries players affords it a clear view of the industry in which it plies its trade – private equity.

And the firm has seen a lot. Since its founding in 1982, HarbourVest has lived through several recessions and bubbles, and, from the long experience it has gained along the way, has formed a strong philosophy that it believes will ensure consistency and success through the best and worst of times.

One of its major beliefs is to align its interests with those of its investors in such a way that they do not have to come back to the firm in down times and ask for concessions. And it puts its money where its mouth is. The firm has long given investors in most of its funds a graduated management fee structure, under which the fee scales up over the early years of the fund, rather than having 100 percent of the fee charged on day one. Furthermore, its latest secondaries fund, Dover Street VII, ties a portion of the management fee to drawn capital rather than committed capital.

“Because of the larger fund size, we didn't want any perceived pressure to put capital to work,” says Martha Vorlicek, HarbourVest's chief financial officer and chief operator. “A portion of the fee was carved out and is based on drawn capital as opposed to committed capital, which was essentially a more favourable fee structure for the LPs.”

The firm strives to achieve this type of equitable relationship as a general partner, but as a major LP in private equity funds, HarbourVest also is in the forefront of a movement by limited partners around the world pushing for better terms and conditions from their GPs, including lower fees and better governance of funds.

HarbourVest has clear views as both an investor and a GP of the tectonic shifts in the private equity industry, changes that in some cases will permanently alter the landscape and force GPs and LPs to navigate some possible cracks in the once-solid foundations of the industry.

“We've continued to learn the lessons of the past all over again,” says Brooks Zug, senior managing director and a founder of HarbourVest, during a recent interview, talking about the market downturn and the effects it has had on private equity. “This business is cyclical like every other investment business.

“We're all reminded that we should consistently invest in the asset class and not try to outguess the market, particularly when it could be at or near its peak. Unfortunately, the vast amounts of money go into the market at the peak, while the least amounts always go in at the trough.”

HarbourVest, as one of the world's largest funds of funds managers, is an investor in many private equity funds. It has seen good times and rough times and tries to keep a consistent approach to investing, not getting too caught up in the hot trends of the day.

We've continued to learn the lessons of the past all over again. This business is cyclical like every other investment business

Brooks Zug

“One thing we've observed over time is that there are periods when certain parts of the industry appear to be in great favour. It was venture capital in 1999, buyouts in 2005 and 2006, Asia in the last several years and maybe today it's secondaries. We've always taken the view and advised our investors not to load up on one segment of the market or one geography at a time when it's hot because that's almost always the worst time to invest,” Zug says.

The firm could be said to take a contrarian view, often under-weighting hot areas, such as large buyout funds in 2005 and 2006.

“ Same thing with venture; no one has seen meaningful returns in venture capital portfolios for 10 years except for deals that were done back in 1997 and 1998. Google, for example, is one of the biggest winners we've had in our portfolio,” he says. “But that was an investment made by two general partners in our portfolio back in 1998. For funds formed in the last 10 years, we haven't seen meaningful performance in the venture space. That could mean it's going to come soon, but a lot of people are shying away from that market because it's been so long since we've seen performance.”

As an LP, HarbourVest has long tried to negotiate with general partners on certain terms and conditions, especially the transaction fee. But in some cases, when the firm invests with GPs which have long track records of success, the fee structure doesn't matter as much.

“We've always chosen quality of manager over specific terms. On the other hand, there are some specific terms in the industry that have always been issues, that we've tried to improve upon,” Zug says. “But when you come right down to it, you still want to invest in the best people and sometimes that means you may have to accept terms that you don't like.”

HarbourVest has pushed for GPs to offset more of the management fee with transaction fees. “We for one have always been pushing to get at least 80 percent of transaction fees credited to the LPs … but even more preferable would be 100 percent to the LPs,” Zug says.

We've had a steady stream of our investors coming through our shop over the last eight to 12 months, focusing on operational due diligence

Martha Vorlicek

HarbourVest also has pushed for a “scale up” system, in which management fees would gradually increase over time as the LP's commitments are drawn down and as the fund is invested, rather than having 100 percent of the management fee charged from the beginning of the fund.

“In the past decade or two we haven't had as much success,” Zug says on the subject of trying to convince GPs to adopt a gradually increasing management fee. “Way back in the 80s we did have management fees gradually increase in the first few years, to some degree coinciding with the actual investment of the dollars. If it was based on committed capital, the management fee would scale up: in the first year it would be at 25 percent, in the second year 50 percent and maybe it took three or four years to get to a full fee based on committed capital. That way, the fee somewhat coincided with the draw down and investment of capital.

“That's something I'd like to see the industry get back to, it's something we had in the 80s, and we got away from it when it became more of a sellers' market in the 90s, but it's something that ought to be high on our list today,” Zug says.

HarbourVest uses this structure in many of its own funds. “We think our investors shouldn't have to pay a full fee from day one just because they've committed all the capital, so our fees scale up gradually,” he says.

HarbourVest has been able to negotiate terms with some GPs successfully, but – showing a willingness to stand its ground – has declined to participate with other GPs who refused to budge on their terms and conditions.

“For those that have raised money in the last nine months, some have made concessions early in the process, reducing carried interest, for example,” Zug says. “That has helped them to reach their targets. Others have been stubborn and have turned away some investors early on who might have invested. If a GP changes his mind later and is more willing to accept different terms, by then the investor may have moved on.

“It's certainly something we are always looking at and in today's market environment, we have more flexibility and more negotiating leverage,” Zug says.

As the industry declines in terms of total capital, most managers will see a decline in their fund size

Brooks Zug

Perhaps because of its LP-friendly terms and conditions, HarbourVest has seen its own LPs raise objections. But, as a GP, the firm has noted investors growing more proactive in trying to monitor funds and making sure their capital is being protected.

In the new world of LP power, investors are taking matters into their own hands and performing on-site inspections.

“We've had a steady stream of our investors coming through our shop over the last eight to 12 months, focusing on operational due diligence,” says Vorlicek. “In the most extreme cases, they actually wanted to take a walk through the accounting department and count heads.

“LPs have asked for copies of policies and have asked to meet people in charge of various departments. They understandably want to reassure themselves that we are safeguarding their assets,” Vorlicek says. “There has been an increased focus on our internal operations from what we've seen previously.”

HarbourVest has also engaged in a complex and long-term internal control audit, known as an SAS 70 review, that very few independent firms undertake. In response to a number of its LPs asking for the SAS 70 review, HarbourVest began the process several years ago, Vorlicek says.

“We did not decide to undertake the review in response to the crisis. We recognised that it would be an advantage to our LPs to have an SAS 70 report on HarbourVest's internal controls with respect to their own audits,” Vorlicek says. “When our LPs are undergoing their own audit, it eases their burden if the managers with whom they've placed capital can produce one of these reports.”

The firm is not ignoring opportunities in the secondaries market, including stakes in large buyout funds from the heady days of 2005 to 2007. HarbourVest's philosophy is to not reject any opportunity outright until it is thoroughly studied and understood.

When looking at funds, HarbourVest seeks to understand how the underlying companies in the portfolios are performing, what the capital structures looks like and when the bulk of the debt becomes due, according to John Toomey, a managing director who works in the firm's secondaries business.

“Increasingly, it's also an evaluation of the manager and trying to assess whether that manager will raise a future fund. We want to be cautious and try to determine if there will be experienced individuals who will actually be managing those assets through to maturity and successful realisation,” Toomey says.

Historically, the best-performing private equity funds are those from recessionary periods, or just after a recession lifts, Zug says.

With a significant amount of dry powder, Harbourvest is poised for investments in secondaries and fund of funds opportunities. The firm closed its $2.9 billion Dover Street VII secondaries fund in April, and has invested about 19 percent of the capital so far.

It has already completed one major secondaries transaction this year, helping Lehman Brothers' venture capital arm spin out into an independent firm known as Tenaya Capital. As part of the deal, HarbourVest bought out a portion of Lehman's limited partner interests in Lehman Brothers Venture Partners III, IV and V in a synthetic secondary transaction.

The idea that some managers might slowly disappear from the industry is one that HarbourVest fully expects to become reality over time. The industry will contract, with smaller funds, less players and fewer suppliers of capital, as some new members of the LP community decide they have had enough.

“We're going to see less money raised. We're already starting to see that. Probably this year, next year and the year after, the industry will raise less than half of the capital – maybe even less than a third of the capital – it raised in 2005, 2006 and 2007,” Zug says. “So we're going to see a downsizing of the industry and that's going to come in the form of less capital raised and therefore less capital invested in the next few years.”

Long-term investors in private equity will be seeking out the likely survivors, encouraged by the prospect that funds put to work over the next few years may prove to be great performers.

“The very focused, financially driven and long-term LPs like HarbourVest are going to seek out the best surviving GPs, and hopefully most of those will come from our existing GP base,” says Philip Bilden, a managing director with the firm who established HarbourVest's Asia subsidiary in the 1990s.

Times of contraction in the industry have generally worked out well for those investors and managers that have stayed the course and continued to invest, Zug says.

“Some managers will be able to raise the size of funds they want. Some won't be able to raise any money. But most will probably raise less capital. As the industry declines in terms of total capital, most managers will see a decline in their fund size,” Zug says.

“Historically, that usually is the time when performance improves, because there's less capital, less competition and less pressure on pricing. Those that have capital will certainly be doing deals at much better pricing than we've seen for a few years, which, in the end, will be good for the industry.” The view from Harbourvest HQ, it seems, is clear and far-sighted.

HarbourVest Partners at a glance:
Founded: 1982

Total employees: 232

Offices: Boston, London, Hong Kong

US funds of funds: HarbourVest I to VIII

Non-US funds of funds: HarbourVest

International Private Equity Partners I to V

Secondaries funds: Dover Street I to VII

Direct/Co-Invest Programmes: 2004 Direct,

2007 Direct