As a field geologist for one of the world’s largest mining companies, Claire Kendrick once wandered the Western Australian Outback looking for lead and zinc. She spent her days sifting through countless samples of raw materials to identify a few worthwhile minerals.
The skills she learned in the field serve her well today as Principal and Director of Private Equity Investment for Hirtle, Callaghan & Co. (HCC), a fund of funds in Philadelphia. Managing a diverse pool of funds requires the ability and patience to analyze large amounts of data to produce a successful result. It also requires a certain amount of toughness, of which she has plenty to spare.
Day to day, Kendrick and her team of four are responsible for managing $450 million of the HCC’s nearly $8 billion of assets, which she invests in venture capital, buyouts, real estate and distressed debt partnerships.
As gifted as she is at sorting through minerals and data, Kendrick is the farthest thing from a number cruncher who is most comfortable working alone. The 43-year-old has an easy melodic laugh and radiates an air of warmth and intelligence. She is one of those rare individuals who are just as skilled (and happy) playing sports as she is doing the research for a doctoral thesis. She played squash and lacrosse through her college years at Wellesley in Massachusetts, where she earned an AB in economics and geology. After a stint working as a field geologist for mining company BHP Billiton, she went back to school and earned her doctorate at Penn State, where she focused on the business side of mining.
She took all of that insight to Donaldson, Lufkin and Jenrette (now part of Credit Suisse First Boston) in 1992. As a bond analyst in the transportation field, she was responsible for credit analysis of airlines, ocean shipping, railroads, trucking companies and cruise lines. She remained at DLJ until 1996, earning the first of a long string of top analyst rankings from Institutional Investor, the bible of the investment banking industry.
In 1996 Kendrick went to Lehman Brothers to do much the same. A year later it was off to Prudential Securities, where she headed up the firms research in addition to remaining a top-ranked analyst for the transportation sector. After a four-year recruitment effort, HCC finally lured Kendrick away from Prudential in 2000 (before Prudential closed its institutional capital markets business). Upon joining HCC, she managed the firm’s research effort while simultaneously building the private equity platform from the ground up. After a few years, she shed the research responsibilities to focus solely on the private equity program, which she has expanded to include Europe and, very selectively, other parts of the globe.
Who Is HCC?
One tends to think of funds-of-funds as slightly more analytic, measured and thoughtful than the average VC firm. Hirtle Callaghan & Co. fits that profile. It was founded in 1988 by two Goldman Sachs asset managers with decades of experience working with high net worth individuals and families. Jon Hirtle and Don Callaghan approached their managers at Goldman one day with an innovative idea that would require the parent to give them the freedom and autonomy to select managers, services and assets outside of the confines of the Goldman family.
The two had the chutzpah to suggest to senior management that they could serve their clients better with that approach, buying the best services at the best price. When they were turned down cold, they knew they had a good idea, so they promptly left to launch their own firm. They started with one high net worth family LP in Pittsburg, a town known for both smart and wealthy families whose fortunes were earned in the last great technology revolution at the turn of the 20th century.
HCC’s concept is simple: to provide the outsourced services of a chief investment officer for small educational endowments and high net worth families. Essentially, HCC is buying and selling the best possible wealth creation and wealth preservation services for its group of 250 clients today and managing some $8 billion in assets. Its compensation model is similarly simple: It is paid a fractional percentage annually of the amount of a client’s funds that it has under management. “In that way there is no incentive to undersell or oversell a particular asset class to our clients,” Kendrick explains. Instead, HCC is motivated to increase its clients’ assets through proper diversification and thereby earn more from the assets it manages.
Kendrick says that HCC provides the full scope of investment vehicles for its clients, of which private equity is just part of the picture. The private equity group manages $450 million placed with 65 fund managers in buyouts, venture capital, real estate and distressed debt opportunities. The private equity target ranges are 20% to 30% for venture capital, 30% to 40 % for buyouts, and 30% to 40% for combined distressed debt/real estate. The allocation is designed specifically to perform well across the entire economic cycle. Among the buyout funds HCC participates in are Trivest, a Miami-based small to mid-market buyout fund, and Industri Kapital, a Sweden-based buyout fund. Its venture holdings include Globespan (formerly Jafco) and Denver-based Resource Capital, which does feasibility studies and mine development globally. For real estate, the company reaches out to managers in Europe, such as NIAM of Scandinavia, and Blackacre, a U.S. distressed real estate investor. For distressed debt, it has invested with Oaktree, the largest manager of distressed debts in the United States.
Day in the Life
Kendrick’s typical day starts around 9 a.m. An hour reading trade press is followed by the day’s main event, a meeting of the private equity team. First, client and in-house requests are tackled. Second, reports from existing managers are reviewed. Next, a small but important part of each meeting is the review of new private placement memorandums and pitches for funding. Kendrick says that her group receives five PPMs per week, or around 250 PPMs each year. One member of the team prepares a written one page summary of each PPM, from which discussion of a potential investment can begin. Kendrick says that detailed analysis is not only important with regard to separating the wheat from the chaff, but because it reveals trends about the current flow of money, such as the recent popularity in homeland security and energy.
On average, Kendrick’s group meets with 1.5 new fund managers per week or about 75 per year. On the day we spoke, Kendrick was attending one such in-house pitch, by a new U.S. power fund, while her team was out attending a biotech meeting in New York. Even where investment is unlikely for HCC, Kendrick notes that she and her team garner valuable information from every meeting on sector dynamics, changing legislation, research and development cycles.
After a lengthy selection process, HCC’s typical first meeting with a prospective fund manager is about two hours long. As a fund moves through due diligence, other meetings will take place and several conference calls will occur. The entire team participates in these, and after each encounter a vote is taken. Each of the team is responsible for defending his or her vote about whether or not HCC should invest. Kendrick makes the point that this is a process she uses to groom her successors at the firm, to ensure that the next person in line for her job has already faced the daunting decisions that she currently makes.
Asked about the worst pitch she’s ever experienced, Kendrick describes a presentation by the managers of a real estate fund that came to the meeting with large blank sheets of paper that they taped to the walls of the room and then proceeded to draw on over the course of the pitch. They had no slides, no charts, no helpful statistics. “At one point Jon [Hirtle] walks into the meeting, and just turns and walks back out,” Kendrick says. “We didn’t invest.”
Kendrick can come up with a short list of common problems with VC pitches in a heartbeat. The first warning sign is when fee structures are out of whack. The GP may be asking for far too much or it may not have thought through structure thoroughly. Is the clawback pre-tax or post tax? Who is paying the placement fees? How are broken deal costs handled? Another warning sign is when a VC speaks ill of management teams at portfolio companies, “original owners” (of properties being sold, for example) or co-investment partners.
“When I hear a VC badmouthing an existing owner, my sense is that in general the GP has a hostile and self-congratulatory attitude,” she says. “Unfortunately that attitude will color all of the interactions or transactions of that GP, thereby affecting M&A possibilities, lender relationships, co-investment partners’ willingness to add more capital, and ultimately the success of the investment. A hostile attitude tends to trump all of the positives that a fund manager may bring to the table-even experience and past successes.”
The other big thing that the HCC team keenly seeks with potential GPs is an understanding of the level of discipline that a manager brings to its work. Does the manager log in all of its business plans? Is there a process in place to handle all aspects of due diligence? Is there orderly decision-making and follow-through? Does the GP know when to cut funding to losers? Can the GP walk you through the actual due diligence conducted on any of its holdings? “It is discipline that separates good GPs from great GPs over the long haul,” Kendrick notes.
Most of Kendrick’s days revolve around the monitoring of existing managers and the selection of new managers. It’s where the HCC team focuses its extensive due diligence, because, Kendrick and her team pick “around 10” new managers each year out of the 250 or more pitches it receives. That’s a pretty tough acceptance level.
LP Report Card
Each year VCJ speaks to LPs to produce a “report card” about the performance of venture capital general partners. We asked Kendrick to go through the eight areas of the report card to get her insights.
Write Downs: Kendrick says that concerns about writing down vintage 1999-2001 funds are “over,” and that people tend to forget that the venture industry historically has always written off investments. Depending upon the stage of investing, VCs have a default rate for portfolio companies of 40% to 60%, with only a handful of real successes. While some LPs are still saying that there is an ongoing problem with write downs, Kendrick says that if you go back to 1993, 1995, or 1997 vintages you’ll see that today we’re at about the historic average level for write-offs.
Succession Issues: Kendrick says it is a big shortcoming at lots of firms. “We had a fund just yesterday where the number two person left because the number one person at the firm wasn’t sharing enough of the carry interested. It’s common. We see this all the time. It’s part of the entrepreneurial nature of VC firms. It takes a person with great confidence to start a new firm, someone who as no fear. The founder will set the tone for a firm, establish the culture, and determine whether or not it’s going to be successful. But that same confidence can easily work as a detriment to a fund over time, because new innovations are squashed, the business model does not evolve as it should, and the other innovators at the firm are not paid enough. It’s a double-edged sword. On the other hand, that is how you get new firms and new funds.”
Portfolio Valuation: This issue is overblown, Kendrick says. She doesn’t expect that three different managers are going to put the same valuation on the same portfolio company. “They invest at different stages of a company’s life in different rounds. Each manager has specific expertise, and each will have a different, yet legitimate, view of what a company is worth or what it may become. We are paying management fees and carried interest for the GPs’ expertise (operational, managerial, financial), and second-guessing them is not wise. What is wise is to keep track of the write-ups, write-downs, and the write-offs and note whether these activities are reflective of the return ultimately generated by a fund.”
Management Fees: This is a hot button with Kendrick. “I am shocked by the number of firms who want 2.5% to 3% management fees instead of the industry standard of 2%, especially given the obvious truth that the 30% to 40% IRRs of the late 1990s are not guaranteed. It’s pure arrogance. At 3% we won’t invest. At 2.5%, it depends upon the waterfall of the carried interest. We will consider 2.5% if we’re not paying the GP’s taxes, if all of the third-party fees (like director fees) are returned to the partnership, and management fees and placement fees are recovered by LPs before the GPs take their slice. One of the dirty little secrets of the venture business is that even if a fund reports a net IRR of 17% to its LPs, the actual dollar return may be by 2 to 4 percentage points smaller because of the bleed off’ of hidden fees to the GP. We refer to the more egregious funds as bleeders’ and it makes us furious.”
Carry Structure: “Most VC firms are at 20% these days, but just as with management fees, the question is how do you measure the 20% and what does 20% actually mean? Is the carried interest paid out on a deal-by-deal basis? Is it pre- or post-tax? What is the structure of the clawback?”
Deployment of Funds: This isn’t a big issue. “We don’t have a lot of deployment problems with our fund managers because of our investment process. We have no preference for very large funds. Instead, most of our funds are smaller and can draw from a huge universe of opportunities. It is at the larger end of the deal spectrum where there are fewer deals and the competition is fierce with bidding and auctions. At the smaller end of the deal spectrum-for instance in the buyout universe-our funds see plenty of deals from families exiting their businesses and parent firms selling non-core assets. Repositioning these smaller assets can more easily yield a stellar return. In addition to average deal size, ease of deployment is also a reflection of overall fund size, and we are very specific about what we think is an appropriate size for any given investment strategy. Deployment is not generally a concern if funds are appropriately sized.”
Investment Drift: It’s not good, but it’s pretty common. “In the wild, bubble years, funds drifted away from their expertise, chasing returns in B-to-B, to B-to-C and telecom. Then, in the downturn, firms rushed headlong into distressed’ opportunities and biotech, without the skills to manage this type of portfolio. Now, we see hot spots in homeland security and energy, where many of the firms have no experience in these areas. LPs have to be sensitive to drift by the GPs. For example, one-quarter of our fund managers have added biotech investments over the last four years. And these are managers who weren’t involved in [life sciences] at all in the past. We are not thrilled, but we have said that’s fine’ if they keep it under 10% of the fund. This is why monitoring is so critical. With proper monitoring, we know our exposure to each industry, geography, interest rates sensitivity, currency movement and legislative event. We can use this knowledge and our future commitments to maintain proper diversification and manage risk.”
Communications: Improving, but could be better. “Three quarters of our managers have gotten better and one quarter have regressed and are telling us things like, We’re no longer releasing information like that.’ Those that have regressed have essentially gutted their quarterly reports of anything meaningful. Moreover, even their annual reports are sparse when it comes to revealing style and strategy. What is the logic in that? I call them Sequoia wannabes.’ [It’s as if they’re saying:] We’re so smart, gifted, and special that we can kick LPs out of our funds and laugh.’ I think of it as a kind of false modesty. It’s as though these managers are trying to somehow increase the value of their brand by being so persnickety, but I just think of it as being rude, arrogant and egotistical. And none of these three traits are indicative of a successful business model over the long run. We have no reason to invest in fund managers that are not open in their communications.”
One of the biggest problems that Kendrick faces is in mandatory communications from her managers, especially the late filing of K-1 reports (the annual reports of private equity firms), which GPs are required to provide to all LPs each year. Kendrick says that if she is she is lucky some will come in during July, but many come in as late as October, which means that LPs, including HCC, have to file two separate extensions with the IRS while it is waiting on these documents. “And some are even later, which means that we have to go ahead and file after a second extension and then amend, and re-file our tax reports the next year. It’s not a good use of anyone’s time.”