Institutional Investor Profile: Mark Calnan CFA, Investment Consultant - Manager Research, Watson Wyatt Worldwide

Watson Wyatt Worldwide is a New York Stock Exchange-listed company, which advises on over $2tn of client assets globally and employs 7,000 associates in 32 countries. In the UK, Watson Wyatt advises over 50 of the FTSE 100 corporate pension schemes, providing human capital, financial management and investment consulting services. Watson Wyatt has a large and growing private equity advisory business within which it researches both direct funds and funds of funds on behalf of its clients, typically blue-chip corporate pension schemes. The private equity team is part of a broader manager research group which researches managers across all asset classes on behalf of Watson Wyatt's clients.

The private equity team is global, with members of the team located in London, New York, Stamford, Hong Kong, Sydney and Toronto. There are 15 investment professionals on the team, seven of whom are based in Europe, four in North America and four in Asia. The private equity group offers solutions individually tailored to a client's size, specific circumstances and governance structure. Watson Wyatt does not manage funds.

What does your hybrid model comprise?

'Historically, given the size of our clients' private equity allocations (typically about five per cent for those clients that invest in the asset class), they invested in the asset class through funds of funds for ease of governance. Approximately four years ago we started talking to some of our larger clients, ie those clients with the governance ability and appetite, about investing directly in funds in some areas of the market.

We started doing that at the larger end of the buy-out market and special situations (specifically distressed investing). Over time, our strategy has evolved somewhat and we will now consider all direct funds in excess of $1bn. This is by no means a strict 'screen'; rather it ensures that we focus our resources and do not try to be all things to all people. In addition to our direct fund research, we have been researching funds of funds for in excess of 15 years. Researching both implementation approaches, ie direct funds and funds of funds, allows our larger clients to pursue a hybrid model. This is where our clients use direct funds in certain areas of the market and funds of funds for those segments of the market where we believe that a fund of funds can justify the extra layer of fees. Typically, this results in 50 to 60 per cent of client capital directed towards direct fund investments and the remainder in funds of funds and secondary funds.

Areas in which we prefer to use funds of funds are venture capital, due to the challenge of new investors accessing the premier managers, and areas such as small-cap buy-outs and emerging markets, where the broad and geographically diverse manager universes and, in the case of emerging markets, the need for a variety of language skills, suggest that funds of funds can add some value from a selection perspective. We think that the hybrid model combines the best of funds of funds and direct managers.

Whilst we have seen a very healthy interest in our hybrid model, we will always have clients that do not want to pursue the direct fund investment route due to their size or governance constraints. Conversely, we have a small number of clients who invest only in direct funds as they are not willing to pay the double layer of fees associated with a fund of funds. In aggregate, this provides a good balance between direct and fund of funds investments.'

What about your portfolio construction?

'Our view is that in private equity you need broad diversification by geography, stage, vintage year, industry and transaction size. As such, clients' portfolios will be built with this diversification in mind, although we will avoid certain areas of the market and overweight others on a tactical basis.'

Do you do any direct private equity investments at all?

'Our business is focused on finding direct managers and fund of funds managers. We do not participate in direct deals and co-investments.'

What size of investments do you make?

'To direct managers, the range for the aggregate commitments from our underlying client base has been $20-300m in the past, with an average somewhere between $40m and $50m. We have recently selectively added one or two clients that we work with on private equity so we expect that average to increase to $100-150m over the next year or so.

On the fund of funds side, the range is even broader. Our smaller clients typically write $10-20m cheques and the larger clients may write cheques in excess of $100m to globally diversified funds of funds. Aggregate commitment sizes to specialist funds of funds are typically smaller, given the more focused nature of these products.'

How many manager relationships do you currently have?

'Overall, our underlying client base has about 40 to 50 manager relationships between them (including both direct funds and funds of funds). We expect the number of direct fund relationships to increase over the next year or two as we take on additional clients for whom we will be building their programmes. That said, we are very focused on capacity issues so we monitor the number of active manager relationships our clients have carefully and regularly. This ensures our clients are only committing to what we consider "best-in-class" managers.'

How much capital do you intend to commit over the next 12 months?

'We expect our clients to commit somewhere between $1bn and $1.5bn to direct managers and, broadly consistent with the aforementioned 60/40 ratio, between $750m and $1bn to funds of funds.'

How do you find the right managers for your clients' portfolios?

'The private equity world is a hugely competitive space with a host of managers raising large pools of capital over the past few years. A large proportion of these will generate disappointing returns. The aim of our due diligence is to find out how a specific manager stands out in this hugely competitive market, in terms of deal sourcing, decision-making and how they add value to a business post-acquisition.

We believe people drive returns in fund management. As such, we focus our time meeting key decision makers at an organisation at an early stage. Meeting with people across the seniority range within an organisation, both formally and informally, to understand what makes them tick, is a vital part of our process. It is important to us that we have team members of varying levels of seniority in the same room to get a better feel for team dynamics. We dig deep to find out about the quality and integrity of people. Our relationships across the industry help us immensely with our reference calls.

An equally important part of our due diligence is our track record analysis. Prior to July of last year, the recent past had been a phenomenal period for the asset class. The key question is to work out how sustainable this record is. This has to be a judgement call but track record attribution can provide some valuable information. Specifically, we look for managers who have generated a significant proportion of past returns through earnings growth - this is a much more repeatable return driver than simple financial engineering. All managers like to talk about their capability in this regard, but these claims are not always supported by the data. We also do lots of public market comparisons and need to have evidence that our clients are not paying private equity fees simply for leveraged beta. We are a broad-based research platform and therefore we get a healthy level of internal debate on this kind of issue from our colleagues in other research teams, particularly public equity and hedge funds.'

Do you invest in distressed debt funds?

'We conducted some preliminary market research late in 2005 because we thought that, given the market conditions, distressed was something that our clients should be actively considering. Subsequently, we undertook a project to identify who we considered to be the most attractive players in the market. Our clients then made significant commitments to a number of specialist distressed managers in late 2006 and 2007. There is a lot of un-invested capital in these funds and we feel pretty good about these commitments given current turmoil in the markets.'

Would you look at secondaries?

'Similar to co-investments, direct secondaries participation is not something we consider on behalf of our clients. However, our clients do commit to secondary managers. It is a helpful way to mitigate the J-Curve effect. At the moment it looks as if it is a good time to have some un-called commitments with high quality secondaries managers as pricing seems to be coming down. Given the current market conditions, some LPs who began investing in 2006/7 will be questioning whether private equity is providing the realisations that they hoped it would. Others, such as banks, will be forced sellers to provide much needed liquidity for their damaged balance sheets. We note, however, that secondaries managers are collectively raising a huge pool of capital to invest in these opportunities and therefore investors in secondaries funds must be discriminating in the selection of their managers.'

What advice would you give to an investor new to the asset class?

'We promote prudence given the current market conditions. We believe that now is a very interesting time to begin building a private equity programme as there will undoubtedly be some great opportunities over the next few years. However, clients must be thoughtful and considered in their approach and select managers who will avoid catching the proverbial falling knife.

We are convinced that over the long term, the best private equity managers do generate a premium over the quoted markets that justifies the extra governance effort and the extra fees. In the current environment, we specifically warn clients about potential strategy drift. Having raised huge pools of capital, we see some managers doing things, such as PIPEs and investing in new geographies, that they have not done in the past. Their track records might be fantastic, but if they are doing inconsistent deals going forward, this is a big "red flag" for us.'

What do you think are the biggest challenges facing the industry?

'In the short term, the challenge is to work the current capital overhang through the system in a disciplined and measured fashion, without taking unrewarded risks with LPs' capital. Managers have to be innovative as this is what investors pay high prices for, but there is a fine line between innovation and desperation.

Over the long term, I think the industry has to improve its alignment with its investors. Fees across the industry, bearing in mind that an average manager will often not outperform public markets on a net basis, are in general too high. As such, only a relatively small proportion of the manager universe will justify its fees over the long term. With returns likely to shift downwards going forward, we expect headline fees to come down over time as LPs differentiate between the top performers and median performers. We believe other terms, such as managers calculating carried interest over a preferred return rather than a hurdle rate, ie a manager takes 20 per cent of all returns once the preferred return is reached rather than the difference between returns and the hurdle rate, are too positively skewed in favour of managers and should be subject to reconsideration in the future.

Historically, private equity managers have lived by the motto - "I get rich if you do". Now, with huge fund size increases over recent years and listed management companies, etc, private equity managers are in danger of promoting the mentality of "I get rich regardless". This is a dangerous reputation for the industry to inadvertently promote. One way of addressing this is for those managers who are unable to find opportunities to deploy their capital without demonstrating strategy drift, to hand capital back to investors. This will provide evidence of some empathy and humility on the part of the GP and prove that the manager is sharing an LP's pain. Those managers who are willing to question conventional wisdom and build a reputation of being LP-friendly in these challenging times might be the managers that are most competitively positioned during the next downturn.'

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