Limited Partners Feature

Introduction Lawrence Schloss Andrew Kwee and Tycho Sneyers Marco Masotti Stephen Vogt Marc Sacks

The advantages of diversification, as Marc Sacks, a senior managing director at Chicago financial services firm Mesirow Financial Holdings Inc., eagerly recounts, are manifold. Though it did have some exposure to funds managed by the industry's big guns, such as Apax Partners LLP, Bain Capital LLC and TPG Capital, the firm managed to skirt some of the problems plaguing much larger institutions whose portfolios are more heavily exposed to high-priced megabuyouts. That's just one of them, says Sacks, who oversees Mesirow's private equity portfolio of about $3.5 billion, with a team of 20 professionals.

Mesirow's fund-of-funds investments cover the gamut from buyouts to distressed, mezzanine, secondaries and non-U.S. assets. It also makes direct investments alongside general partners, Sacks says, "to maximize performance." In a recent interview with The Deal magazine, he elaborated on the virtues of having diversified assets.

The Deal magazine: How does this cycle compare with prior cycles?

Marc Sacks: This time, in the last six to 12 months, we're seeing more recovery in value than in the post-telecom bubble era. The 2006 and '07 PE vintages won't be great, but they'll clearly be a heck of a lot better than '99 and 2000. Even large LBOs completed in '06 and '07 at very high prices were done with pretty forgiving capital structures, with PIK debt and covenant-lite loans, and very friendly high-yield and leveraged-loan markets that allowed PE-backed companies to refinance deals and amend-and-extend maturities. That really gave them a lot of burning room to build cash flow into the huge amounts of debt taken on. As a result, the bankruptcies that have taken place from deals done at peak multiples of peak cash flows have been very, very low. That's a good thing.

I'd be much more concerned about limited partners that had exposure mostly to these large-cap U.S. and European funds, where much of the capital overhang resides. That's also, by the way, where most of the damage or at least the relatively poor returns will come from in the next five years. The strategy that's worked for us for 20 years continues to work: Invest in a diversified portfolio of top-tier private equity and venture capital over three- to four-year commitment cycles, allocating capital over multiple vintage years and multiple strategies. That way you smooth out the impact of a frothy, overheated market in '06, and you'll have relatively little exposure to bubbles.

How have your fund portfolios performed in the past year?

Most private equity portfolios industrywide have done very well. In the last two quarters of 2010, many LPs' portfolios were up in the order of 25% or more, just because of the value recoveries, versus the first two quarters. In Q4 alone, some LPs saw their portfolios written up 20% to 25%.

Some LPs that had dry powder also managed to buy secondaries from LPs at very deep discounts in '09 and '10. Those have generally all been written back to cost, and performance has been spectacular on these deals. Even among '06 and '07 funds, there were crappy funds and funds that have done relatively well. Look, we continue to winnow out the future top-quartile performers by looking for managers that showed price discipline and had a more tempered investment pace during those peak years. If you put all your money out during the boom and blew all your capital out in those two peak years, even if you're not underwater now, you won't perform. Those that spread it out a bit and invested in '09 and '10 at far, far lower valuations would have some very successful funds.

Are all your underlying funds performing well?

We have a couple of underperforming funds, like everyone. The other thing we did in 2010 is, we made fewer investments. We weren't happy with the quality of some of the managers that came back, so instead of our normal 14 to 15 funds a year, we did about 10. For our asset classes, venture capital and growth equity is about 25%. Buyouts -- mostly middle market, with some large -- is 35% to 40%. Special situation, including mezzanine, strategy-focused and distressed, is 15% to 20%; non-U.S. is 20% to 25%. In 2010, we committed probably about $275 million to 10 funds. In 2009 we only did eight funds, representing about $150 million for the same reason: the lack of quality funds. We just dialed it back.

In 2011 it's early days, but we expect that with some very good funds returning, with liquidity and valuations up, and returns really surging, we will probably be back to more normal levels, and put out probably $400 million of capital.

How do you determine future top-quartile performers?

For us it's all about loss rates. More than performance, there's quantity and quality of returns. We look for managers who showed pricing discipline and tempered pace of investing in '06, those who've generated relatively high return of capital and have relatively few wipeouts. Even when they've not realized assets, we dig deep into the portfolio and look for progress in terms of cash flow and revenues. When firms come back and ask us for new capital, we do a very conservative and tough mark-to-market of unrealized deals. That often gets us to where we just walk away because the portfolio may be a lot less than what the GP is carrying it at.

You do discounted cash flow?

We generally weight very heavily on actual cash flow. We're mostly focused on a conservative multiple of trailing or reasonable this-year cash flow to come up with a mark-to-market. In most cases it's below what the GPs carry it; in some cases it's above. In a sense, we're asking ourselves the question: If we have to liquidate this asset today, what would be a bulletproof exit value?

The other way to differentiate the great funds: We pick funds that got out. In VC, there's a very small group that's actually gone to cash in the last two years. They took cash off the table and distributed gains in the last six to 12 months. There's a big, big bright line between the managers who weren't smart enough to do that and those who weren't capable or were too greedy, and were sitting with these portfolios year after year, and those who went to cash.

The weaker GPs are probably not going to survive. We don't know how many of these GPs won't be able to raise capital [and] survive this cycle. Maybe 20%? 25%? Maybe more? There's definitely a flight to capital, and there should be.

To what extent have you been agreeing to re-up?

The general view is that we are going to be very critical and very tough on every single re-up. We'll back managers who have performed, distributed cash, shown discipline. There's one more piece: We'll back those who do not have troublesome succession issues going on inside the firm. At the end of the day, there's a smaller, ever-shrinking number of managers who are producing most of the value. You need to know who they are, stay with them or drop them if they move out of their sweet spot.

How have your own funds grown?

Discipline starts at home. If I were an LP with some fund-of-funds raising too much damn money, I'd be very worried about that. I think the opportunity set is static or shrinking. If you're raising twice as much money as you raised the last time, I can do the math on this. I know what the management fee stream looks like.

The way to destroy performance is to invest in too many funds. In a normal fund-of-funds portfolio, we should have somewhere between 30 to 35 managers over a three- to four-year cycle. Some competitors do 30 to 35 managers a year, doing 150 in a fund-of-funds. I can tell you there are not 150 triple-A managers in the world. There's maybe a dozen guys a year who are excellent, not 40. The only reason they're committing to 40 is that they must put the money to work. And they will.