Investor Profile: Christophe Nicolas, Executive Director, Morgan Stanley Alternative Investment Partners

Established in 2000, Morgan Stanley Alternative Investment Partners is the fund of funds division of investment banking house Morgan Stanley. Operating in the lower end of the market, the firm has around $6bn under management allocated to private equity.

Christophe Nicolas has been an executive director at the firm since January 2009. Prior to this, he was a director with UK secondaries specialist Greenpark Capital for four years. Before this role, he was at European buy-out firm Permira for more than three years, where he specialised in transaction origination and execution in the media, leisure and business services sectors.

Morgan Stanley Private Markets Fund IV was closed on just over a billion dollars earlier this year.  How was the fundraising process for this vehicle?

“It was clearly different from last time.  Most investors who traditionally invest in private equity are either overinvested or are short of liquidity somewhere else outside of their private equity portfolio – and, therefore, they’ve got no money to invest.  We were fortunate as we tend to give visibility to our investors about our fundraising, so they knew it was coming.  We were also able to secure investment from new players in the private equity space who, believe it or not, had not really invested in the asset class so far.  They have probably avoided the bubble and the bad vintages, and I think they understand that right now is a good time to invest. We were able to get some of these investors.”

You are also raising a secondary fund. When do you see the secondary market reaching its anticipated uptick?

“The secondary market tells two stories, and there is only one story grabbing the headlines; that story is that the bid-ask spread has caused a dearth of deal flow and nothing is happening. This is very true for large secondary transactions, they’re just not transacting. The reason they are not happening is because prices have been depressed, so anybody who doesn’t have to exit will wait until pricing improves.  The pricing of secondaries today versus two years ago is astounding: you’ve gone from a premium of 30 per cent to a discount of 50 per cent for the same fund.  For the range that Morgan Stanley Alternative Investment Management does, the deals have been pretty steady and healthy.  We buy smaller portfolios of directs and smaller portfolios of fund interests.  By smaller I mean anywhere between $5m and $50m. On this scale the market is very much alive because there is no doubt that a lot of people need liquidity.  So, when we do a deal with a party, we are not asking them to exit private equity, we are not asking them to sell us a big portion of their portfolio; we essentially cherry pick three or four fund positions.  Also, we see a lot of distressed sellers. Many of them are institutions or funding officials that are significant investors in private equity who had a lot of money at work between 2004 and 2008.  It’s amazing how these high quality names make contact and want to sell within a matter of three or four weeks.  These are the kind of people we buy from.  We actually see very good deals flowing into our space.

Another issue is that a lot of secondary players have invested tons of money in secondaries and raised money quickly between 2005 and 2008.  But those portfolios are facing serious challenges.  Some of the secondary players are now at the point where they need to raise another fund, but they may only have about 20 or 30 per cent of their existing fund left, and that fund is hurting.  So they are looking to do exceptionally good transactions for the rest of the fund and then be able to return to their investors and say, ‘We made some mistakes but overall it’s going to be okay.  Give us some more money.’  So, people have been extremely conservative, sometimes for good reasons, but sometimes driven by the performance of their existing portfolio.

Morgan Stanley Alternative Investment Partners has always done secondaries, but it was an allocation of ten to 15 per cent from our main, flagship funds.  We did some secondaries in 2007 and 2008 but not much, as we just thought pricing was overheated.  It’s only this year that we’ve started with a dedicated fund and we’ve had some very interesting deals.”

Are the LP stakes you’re picking up in funds that you already wanted to be in, or are you evaluating new funds that you were not invested in previously?

“It’s a mixture. We may or may not already be investing with them, but we know the GP or LPs in those funds.  We have a wish list, like many other players, and go around the market looking for sellers in the funds on that list.  The other side of the deal flow is sellers coming to us and saying, ‘I know you are in this fund, I need a cheque ASAP. Can you give me an offer please?’

We have done a lot of deals with hedge funds. Hedge funds are distressed and we’ve completed a few direct secondaries deals with hedge funds that need to sell their private equity side pocket.

The rest of the deal flow comes from networking and talking to the right sellers. There is a huge amount of potential out there, but the problem is what do you focus on?  Hopefully you focus on the deal that will close.”

Going back to the fund of funds, are you looking at different types of funds to invest in since the downturn took effect?

“Our investments have remained pretty much consistent, with managers that we would have invested in anyway, in bad weather or good weather. That said, from time to time we have a market-driven and opportunistic approach within our generally structured  portfolio architecture..  For example, we have invested in a smaller fund that targets distressed US financial institutions, something we would not have done three years ago.  The growth capital and private equity yielding strategies are now of interest.

We have been following distressed special situations opportunities over the years.  The firm backed number of distressed managers that were less known back in 2004, 2005 and 2006.  We are still backing some of them, but many are now raising tons of money very quickly. That part of the market is witnessing a bubble or clearly decreasing returns. We intend to leave the bubble and focus on a particular strategy in distressed where there are niche opportunities.

Morgan Stanley Alternative Investment Partners does not raise large funds. If you look at the amount of money we have in private equity, it is around $6.5bn. That’s what we’ve raised to date.  So, we are clearly a dwarf versus a hundred-plus billion dollars managed by players like Harbourvest or  Goldman.  The focus is very much on smaller managers with a build-for-purpose team and a specific niche of opportunity in private equity, because there is a chance for higher returns.  You do not necessarily see us in most branded funds.”

China is piquing a lot of interest at the moment. Is that a country in which you invest and do you think the fund management landscape has developed enough in China?

“Morgan Stanley Alternative Investment Partners has invested with less than a handful of managers in China.  We prefer the buy-out space there to anything else.  There is a higher turnover of GP teams in China than in other geographies and a distinct lack of track records. You’re trying to map that against what is on paper a great opportunity. We have been highly selective and targeted specific managers that have a technical right to succeed.  

Our specific areas would be former state-owned enterprises that are now in the hands of private equity and turning themselves into proper commercial operations.  That has been a very successful strategy. You look at those companies when they are bought and they pretty much generate zero profit.  After two or three years of applying good management practices, you arrive to margins which are similar or sometimes higher than what you find in the Western world, and with very attractive growth, which you don’t typically see today in the Western market.  

The exit market is currently a bit of a minefield.  The stock market in China, as is usual, is up and down.  There’s a whole host of people trying to exit portfolios in China, whether they are politically backed or not.  There’s a long line of people ready to go as and when they are authorised by the government and as and when the market conditions are there.  It is not for the faint-hearted.”

Are there any other geographies that you have your eye on?

“I don’t think any geography has become more attractive, necessarily.  I think Australia and Latin America have weathered the storm better than the rest of the world.  We are very cautious, and have always been very cautious, with the Middle East. The reason is that a lot of managers pop up each year.  They all raise money, but there are very few deals. We find it a tough proposition.”

What do you think are some of the biggest issues LPs are facing today and going forward?

“For a lot of them it’s a lack of liquidity. The second issue is unstable GP teams - funds where carried interest will never be paid, where the senior people are at fund generation four to ten; the owners have made a lot of money and are still hesitating on passing their batons to the next generation.  So, there will be a challenge for the next fundraising for LPs to decide which teams are actually now doing the deals, how the investment decisions are being made and how different the decisions are from before.  Although the fund has the same brand, is it really the same team?  This affects all segments of private equity.”

You believe there’s a generation shift occurring in the industry?

“The problem has clearly started.  There are already three or four funds situated in Europe that are half dead, and you should expect more to come.  There will be a challenge for LPs to avoid those unstable GP situations, and then find those new teams that are today where those guys going after the market were back in 2002 and 2003.  There will be a lot of work for investors in making sure that they are working with the right teams. As we assess new teams, more than ever, we need to find the right and complex balance in the longevity of a team’s track record and its stability and incentivisation going forward.”

Does Morgan Stanley Alternative Investment Partners work with placement agents?  If so, what value do you think they can add?

“We do and we usually find them very helpful; they are helpful in adding value by filtering. They help GP teams articulate their story and prepare all the documents to make sure we are ready to make a decision. All the obvious questions are answered. We’ve found that the decision making process is much smoother and much faster.  

There are some extreme decisions being made in the US against placement agents.  I am personally concerned that this might be a little bit like the Sarbanes-Oxley Act, which in 2002 essentially killed the Nasdaq. It was clearly a good idea to regulate modern markets, to raise the bar, raise the hurdle and thus know what kind of companies can access the Nasdaq.  But they went at it with a huge stick and caused a lot of harm.  It is true that some people have clearly abused the system and done unethical things, and they should be taken out of the market.  Saying to state pension plans, ‘I will not speak to any fund represented by a placement agent,’ seems to be going too far.  I hope we’re going to find a more balanced approach, though I am not too optimistic.”

What lasting effects do you think the downturn will have on the private equity industry?

“The first and foremost consequence is that the private equity industry in our view is going to shrink in dollar terms back to the 2002/2003 level. . There will be fewer managers around in the next three to four years.  Also, because of the tough fundraising climate, it is a good time to invest but nobody has the money to do so.  The next three or four vintages should be exceptionally good, but you need the money to invest.  New firms will probably be created; they will be spinoffs of existing teams deciding to go for it on their own.  You will see a new generation of very successful firms.  

This is not a static industry and that’s what I find exciting.  There are entrances and there are people who exit the stage.  The downturn will help produce new teams, new strategies and very new uses of private equity beyond just growth capital and buy-outs.  I see attractive funds in the energy sector, and in other  strategies that make non-conventional uses of private equity capital beyond buy-out or venture.  Those strategies, because they are in niche markets that are often less or not correlated to interest rates or stock market performance, continue to generate attractive  returns when traditional private equity strategies suffer from the weak financing  and exit markets in general.  We are also bullish on those strategies because they offer cash yielding securities to investors who have rightfully upped the bar on illiquid investments. In conclusion, we expect the next three to five years to offer outstanding investment opportunities in the private equity world for investors who will accept to be slightly contrarian and focused on specific opportunities created by the current market environment.”

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