Any private equity firm that has been around for more than three decades must know a thing or two about business cycles. Therefore, such a firm might reasonably be expected to greet headlines about chaos in financial markets and economic decline with a degree of calm. In this respect, Adams Street Partners' chief executive Bon French and partner Hanneke Smits, who is also global head of the firm's partnership investments, do not disappoint. At the firm's rather grand London office in Grosvenor Place, which runs parallel to the gardens of Buckingham Palace, the two are asked to reflect on current market conditions for private equity funds.
Their responses by no means understate the difficulties that lie ahead. Smits offers the following: “I think for a while we thought we were facing a Wall Street issue in the US rather than a Main Street issue, but in buyout portfolios that are exposed to the consumer or construction industries, we're seeing a real decline in growth in the underlying businesses that we were not anticipating towards the end of last year.”
Nor is this the only concern expressed. Given the mountain of capital currently sitting idle in larger buyout funds' coffers as a consequence of the ongoing debt crisis, French acknowledges investors' concerns “that people may go off-strategy by re-visiting PIPEs [private investments in public equity], going global or dabbling in new sectors”.
However, he thinks it likely that many funds will respond to the difficulties in a very pragmatic way by simply extending their commitment periods. He refers to previous occasions, such as the boom/bust of the late 1980s and early 1990s, when GPs have waited patiently for conditions to improve before investing most of a fund's total capital in the last one or two years of a designated five- or six-year investment period. Hence: “If you raised a fund in 2007, you might not be back in the market again until 2013.”
Speaking of the apparently bleak prospects for businesses that private equity firms acquired at high debt multiples in 2006 and 2007, French says: “You're seeing a decline in values with the move to mark-to-market. Values dropped in the December to March period and I expect they will continue to do so for a while yet. In the venture capital market, it took three years to get to the stock market peak of 2000 and then it wasn't until the second quarter of 2003 that you saw the low point in valuations.”
But while he sees some similarities between the experiences of the larger buyout market today and the venture market of the early 2000s, he also sees disparities that provide room for optimism: “There were a lot of write-offs then. The buyout market today is different because the bubble was in credit not in equity. GPs have been paying too much, but the companies they have bought are very often highly profitable and successful. Returns will be reduced, but I wouldn't expect wholesale bankruptcies and write-offs.”
French and Smits speak from a deep well of experience. French joined Adams Street Partners' predecessor, First Chicago Investment Advisors, back in 1980. The firm became Brinson Partners in 1989 before adopting its current name following a spinout on 1st January 2001. At press time, Adams Street was preparing to buy the 24.9 percent stake that UBS Brinson had retained following the spinout – thus granting the firm full independence.
It was in 1979, a year before French joined, that First Chicago, which had been making direct venture investments since its foundation in 1972, was able to boast the first-ever private equity fund of funds. The firm had raised a direct fund in 1976 and, three years later, got permission from clients to invest in partnerships from it, making it a formal, commingled vehicle.
French says: “[The firm] identified the top 15 cities for venture investment in the US and by 1983 we'd made 22 limited partnership investments in those cities – places like Atlanta, Dallas, Denver and Minnesota in addition to Silicon Valley and Route 128 in Boston. It worked quite well – 1983 turned out to be a bubble year that delivered a 100 percent rate of return. The fund was wound up in 1996 and made a 20 percent rate of return overall.”
Although the firm will still make direct investments on an opportunistic basis – its website says it will make around eight to 12 of these per year – its core business is now closed-end funds of funds. French says that around 90 percent of Adams Street's capital is today invested in primary and secondary partnerships and approximately ten percent in direct investments.
Given the firm's long history, it's not surprising that many significant landmarks have been passed along the way – some of which are noted on a historical timeline on its website. In 1985, for example, the firm worked with Venture Economics to produce the first performance benchmarks for private equity and, as a consequence, establish it as an asset class in its own right. As well as contributing all its own partnership performance data to the project, French says Adams Street encouraged rival firms including HarbourVest Partners to follow suit.
Two years later, in 1987, Bart Holaday, former head of the private equity group at Brinson Partners and a current board member of Adams Street Partners, launched a five-person ad hoc committee to write the industry's first set of valuation guidelines. The committee ruminated long and hard, French recalls: “It took two years to say how you should mark up, mark down and discount for restricted stock etc.” The hard work of the committee bore fruit as, according to French, it was used as the basis for the current BVCA, EVCA and PEIGG guidelines.
French picked up the baton from former boss Holaday in making a meaningful contribution to the industry's credibility. In 1992, as a member of the Association for Investment Management and Research (now known as the CFA Institute), French served on a committee that set out standards for reporting performance. Smits, meanwhile, is currently chair of the EVCA's investor relations committee.
One imagines that roles such as these come quite naturally to French and Smits. In conversation, both come across as thoughtful, measured and analytical. It's no surprise to hear French describe Adams Street's approach to investing as “disciplined and cautious”. This, perhaps, is also illustrated by the firm's patient approach to expanding its operations overseas. It wasn't until 1997 that Smits was recruited to grow the firm's global operations from London – adding a third office to existing bases in Chicago and Menlo Park. A further nine years passed before the next new location was added to the network. Piau-Voon Wang, who joined the London office in 1999, is now at the helm of the Singapore operation, which was launched in 2006.
On the theme of Asia, Smits stresses that Adams Street is disinclined to act in haste. “In any new market, you shouldn't rush in,” she says. “There will be great and not so great practitioners and you have to make sure you do your homework. There has been a helpful tailwind in India and China but many managers there have very short track records. You shouldn't worry about holding back and missing a good fund or two.” This should not be seen as scepticism about emerging markets' prospects. Smits adds that she would expect India, China and Russia to account for at least 10 percent of Adams Street's total portfolio within the next three years – compared with 2 to 3 percent at present.
With the global network in place, the emphasis remains on retaining the discipline and caution referred to by French. He says that the firm never intended all the authority for making fund commitments to remain in Chicago. Nor, however, did it want people “going off and doing their own thing”. Consequently: “There is a lot of cross-fertilisation of staff between offices”. There is also a weekly investment meeting by videoconference across the four offices each Monday, which Smits chairs. Coordinating this across the various time zones is no straightforward matter, she says. Nonetheless, as its four-hour length would indicate, it is viewed as a priority. Given that, according to French, Adams Street sees around 1,000 investment propositions per year, nor is this entirely surprising.
For a firm that appears steadfastly methodical in its approach, it is interesting to discover that this absolutely does not exclude offering support to first-time funds. The UK's Vitruvian Partners and Matrix Partners' China fund are cited as recent examples of debut offerings that Adams Street has chosen to invest in, but its overall history of backing start-ups is impressive: since inception, says French, the firm has backed 33 first-time venture capital funds – 30 in North America and three outside – and 25 first-time buyout or growth capital funds.
Furthermore, Adams Street does not necessarily reject debut fund propositions of a less than orthodox nature. For example, London-based buyout house Terra Firma Capital Partners is, regardless of its merits, something of an anomaly by mainstream private equity standards. The mercurial and imposing personality of founder Guy Hands and the firm's apparent willingness to take bold bets and build highly concentrated portfolios are characteristics that arguably don't sit all that comfortably with conventional limited partner due diligence. And yet Adams Street invested in the first Terra Firma fund, the €2 billion Terra Firma Capital Partners II, which closed in February 2004.
Smits says certain aspects of Terra Firma's proposition provided comfort. For one thing, Hands and the other founders of the business had already been investing together for eight years in the Principal Finance team at Nomura. For another, Adams Street identified certain similarities between the strategic approaches of Terra Firma and Fortress Investment Group, a New York-based asset management firm that Adams Street had been supporting since 1995. Nonetheless, she also points out that part of the decision-making process is about “gut feel”. Ultimately this is needed to avoid missing out on those funds that, in Smits' words, are “outside the box”.
UNDERWEIGHT IN BUYOUTS
Backing an unusual fund is, in fact, far from the only bold decision Adams Street has taken over the years. French points to the firm's determination to avoid jumping on the buyout bandwagon at a time when it would have been easier to do so. “We've been underweight in buyouts over the last three or four years,” he says. “It wasn't easy but we've been through cycles before and, when funds are coming back for money more quickly, you want to avoid getting pulled in at the top.” He adds, with what seems like relish: “That's where the math comes in.”
Currently, French and co are applying “the math” to secondary opportunities, in which the firm invested around $350 million last year. Says French: “More secondary buyout transactions have been predicted and we are seeing that. Some LPs want to reduce their allocations significantly, and quite a lot of secondaries are emerging in relation to 2005-2007 vintage deals. But the values have not really come down yet and we are waiting for that to work through the system. We think there will be good opportunities in six to 12 months' time.”
Smits feels this is a fascinating time in the private equity industry, not least because LBO funds need to answer some big questions. Should they lengthen their investment periods? Or even consider more radical courses of action such as tinkering with fee structures or handing capital back to investors? Smits' view is that putting pressure on GPs at this point in the cycle will produce the wrong results. “If investments are not made for a period of time, we won't be complaining. You don't want bad investments to be made just because people are worried about justifying fees.”
It's a testing time for LPs as well – and those that have been through a few cycles before are surely best placed to avoid losing their heads.