Chairman's letters

01 February 2012

Guy Hands' speech at 18th VC & PE Conference, Harvard Business School - "My first forty years in Private Equity"

Good afternoon.

It is an honour to be invited to speak at Harvard Business School.  

The first time that I came to Boston was in 1980. I flew over on Laker Airways for £300 return on a family holiday together with my girlfriend. My parents had swapped their house in Sevenoaks, Kent, England for a house in Concord, Massachusetts, USA. They also swapped my father’s company provided Volvo estate car, my mother didn’t drive, for the homeowners 60s open top red sports car and his wife’s early 70s gas guzzler. Finally, we swapped oil fired central heating (it was a cold English summer) for electric air conditioning (it was a very hot New England summer).

I was at university at the time, Oxford, and my girlfriend was at university, Cambridge. 

Besides driving the open top sports car around New England and swimming in Waldon pond we also spent a substantial amount of time trying to sell English water colour paintings to the art galleries that existed along Newbury Street, Boston back in 1980.  

Unfortunately we did not have as much success in Newbury Street as my girlfriend and I were having selling paintings out of my art shop in Little Clarendon Street, Oxford. Or maybe it was fortunate as two years later, with my art business suffering from the austerity created by Thatcher in order to turn the UK economy around, I found myself in a position where being an art dealer was not going to keep the roof over my head, both figuratively and literally.  

The nearly 200 year old building I was leasing on a full repairing lease from University College, Oxford was starting to collapse and I found myself needing £40,000 to repair the roof in rather a hurry. 

The local bank manager decided I needed a proper job and hence on the basis that Goldman Sachs paid more than anyone else I joined Goldman Sachs as a bond trader.

I have always been obsessed with business and my earliest memories are of starting business ventures. These normally failed having taken up vast amounts of time and energy.  

While other children played with toy soldiers or learnt the piano I spoke to my great uncle about the stock market and traded cigarette cards, stamps and coins. 

As a severe dyslexic, my time at school from age five was horrible. I couldn’t tell right from left or back from forward so not only was my academic work atrocious but on the sports field I was a liability.  

Not surprisingly the other boys had little sympathy and, having had my teeth knocked out, the state primary school I was at decided I should leave. Hence I was sent to a residential school for children with severe learning difficulties when I was nine.

I was there for two and a half years, and while in some ways it was a very traditional English boarding school with corporal punishment, cold showers and steel sprung beds, they did find time to focus me on what I was best at – maths. So while my spelling made no progress while I was there and my reading barely improved they got my maths to shine.

At 12 I found myself sent back to a normal state school. 

However, by the end of the second year at high school I was second to last in a class of 32, and 98th in a year of 100. My English, French and Latin results were appalling. My class teacher’s reaction was that I was a hopeless case and should leave the school. 

My reaction was to go over his head and do a deal directly with the headmaster. Probably the most important deal of my life. I got the headmaster to agree that if I came higher than fifth out of 100 in my best subjects, I could drop languages and jump to the fourth year.  

I came fourth in the year, with the top marks in maths, physics and chemistry.

More importantly to me, however, my business ventures were beginning to bear fruit, in particular “Pobbles”.

“Pobbles” were small stones with stuck on plastic wobbly eyes and shells for feet. These I had my friends selling to their sisters and the local shops and while I never became rich through selling “Pobbles” it gave me enough money to buy a camera for my next business venture.  

As a photographer my technical skills were appalling, I had to re-shoot two white dogs three times as my use of lighting managed to produce pink and then grey fur in the first two shoots, before I finally got it right.  

However, I persevered and by 17 was doing weddings, school photographs and portraits and making what was a liveable wage while at high school as well as winning second prize in a national photojournalistic competition.  

I then diversified into the direct selling of art before, at Oxford University, I opened an art gallery – hence my trip down Newbury Street, Boston. 

While the net economic result of all this business activity per hour was probably less than I would have earned delivering newspapers it gave me two important things – firstly, a bottom-up understanding of what it is to run a small business and secondly, my wife, as the girlfriend tramping down Newbury Street with me became my wife in 1984.

Joining Goldman’s, after Oxford, in 1982 was a wonderful experience. The similarities between Europe today and the austerity measures that Greece, Portugal, Italy, Spain, Ireland and others face, and the austerity measures that the UK was going through are closer than people realise.

Likewise, the volatility in the markets. However, 1982 we now know was the start of 25 years of the most incredible bull market and I think unfortunately 2012 is not.

2012, for Greece, feels more like 1976 for the UK and if I am right there is at least seven more years of pain before most of Europe starts to see real growth.

At Goldman I initially traded European government, supra-national and bank debt before being put in charge of the Eurobond trading desk, just prior to Big Bang in 1986.

Big Bang of course changed the way that banking worked in the UK forever. From a cosy business that relied totally on trust, it became overnight a dog-eat-dog business which relied on the size of your balance sheet and your ability to get information about large capital flows in advance of other people.

Goldman was the place to be in London in the late 80s as we saw more capital flows than anyone else and took the largest positions. We thought we were masters of the universe. However, one thing we missed spotting was what was happening to Japan.

As the Japanese market hit nearly 40,000 in 1989, we were building up across Goldman’s trading desks a huge position in low quality credits, which we intended to sell into what seemed a bottomless pit of Japanese financial institutional demand. 

Unfortunately, we got it wrong.  The Japanese asset bubble burst and with it so did demand for lower grade credits. Meanwhile, we were long billions of low grade paper and assets with no natural buyers in sight.

Consequently, in 1990, I formed a group called ‘Global Asset Structuring’ at Goldman. It was our job to look at low grade credits and assets and determine if they were able to be securitised in a way that could provide liquidity at a lower cost and in greater size than the traditional markets. In Europe I became known as the father of securitisation.

This was a business that I loved.

Tramping around Scottsdale, Arizona, in a thick woollen suit in 100 degrees heat looking at adult mobile home parks might not be everyone’s idea of fun, but it got me back to what I enjoyed doing most – examining businesses in detail and determining how they could be made to work better.

While I was looking at businesses in the US, I was also looking at them closer to home in the UK. In 1994, I asked John Corzine, who was just about to be made CEO, if Goldman would back me to buy businesses that I felt were undervalued in the UK. He said no but the Japanese bank, Nomura, said yes. Consequently I joined Nomura in London in December 1994.

Arriving at Nomura I was given 16 people who had never done anything in private equity before.  

At my introductory meeting with the team on my first day I told them we would invest £1 billion of the bank’s capital over the next two years in asset-backed businesses such as pubs, trains and houses. 

On hearing this, my new colleagues promptly decided to go out for a very long liquid lunch from which they did not return that day. They had determined that clearly I was mad.

Right from the start our philosophy was that we would not invest in over-capitalised, fast growth sectors. 

We would look for undervalued businesses that others had overlooked where some entrepreneurial thinking could improve the business and create value. 

We enjoyed eight hugely successful years doing just that.

The business that we created, Nomura’s Principal Finance Group, became, in 1995, the first private equity group to invest in the UK pub sector. 

We bought messy portfolios of ‘tied’ pubs – or bars as they would be called here. Being ‘tied’ meant that they had to buy their beer from the brewer that they were tied to. They were performing badly, were riddled with management problems, and most people were scared away from investing in them because of threats of litigation. 

Many of the tenants were challenging the legality of the ‘tie’ agreements through the UK and European courts. 

We saw this as an opportunity as we were prepared to negotiate with the tenants to find a deal where both sides could win. We looked at each pub, asset by asset, doing an individual business plan for each pub from which we worked out how much each publican could afford in rent, we then offered the publican a free-of-tie deal on a new rent basis.  Most publicans accepted the offer and many of these newly freed businessmen went on to be highly successful.

The deal we did with the tenants, while not maximising the immediate cash flow we could receive, was a fair deal and we felt that with appropriate adjustments over time, to rents both upwards and downwards to reflect changing conditions, we could build a sustainable business for both sides.

I’ve never begrudged the fact that the people we sold the business to managed to make several times the money they invested in it after buying it from us by focusing on short term profits in order to maximise the company’s share price and the value of their stock options.However, what they left behind is a broken system and I would not have been happy to leave a business in that state.

My business philosophy, which goes back to having experienced as a 20 year old the pain of trying to get a small business to be sustainable over the long term, is that you should think not just about the short term and making quick profits but also whether you are you creating something that is sustainable and provides real value. 

Often this leads to very difficult choices, choices regarding how much people are paid, how much is taken out by shareholders, and how much you take out yourself.

You are never going to get these choices right but if I didn’t spend a lot of my time trying to get them right, and purely focused on how much I could make, then frankly I wouldn’t be able to look at myself in the mirror each morning.

Post our first pub deal we did a large number of deals including Angel Trains, a portfolio of old rolling stock which we bought from the UK Government. We put in a new management team, invested in refurbishing the trains, purchased new trains and focussed on what Angel Trains clients wanted.  

This investment ended up with an IRR in the mid-hundreds and was probably our most successful investment.  Angel Trains is now Europe’s leading train leasing company and some of the management we brought in are still there 15 years later. 

By 2002 we had invested nearly €10 billion. However, by then, Japan had been declining for 13 years and Nomura felt that it could no longer commit so much capital to European private equity. Consequently at the end of March 2002 the business spun-out of Nomura and Terra Firma was born as an independent private equity firm.

Our strategy would remain the same, however, we would now be an independent company. 

Being independent meant that we would have the freedom to create the business we wanted. Something that was really distinctive.  

Indeed over the next 10 years creating this distinctiveness is something that I, and my partners, have spent a lot of time focusing on.  

I often wondered why it was so difficult in the financial services markets to put in place good management structures, good controls and strong cultures. In Terra Firma I learnt to understand the problems involved. 

The biggest, of course, is that in private equity the transactions are defining in themselves as each one is very substantial. A typical business by contrast has thousands and thousands of little decisions that need making and as long as you get the majority right then that is all that can be expected. While in private equity one mistake can be fatal.

However, the great thing about the financial services business is that you can create a new product or do a new deal each day.

The tough thing as an owner/manager is finding a way to harness creativity and focus it on creating value for the long term not just the short term. Unfortunately most compensation structures focus on the short term not the long term. By contrast the traditional strength of private equity compensation structures has been the long term nature of carried interest.

In 2009, having got a good understanding of the issues involved in managing this creativity but feeling I needed help on the answers I promoted my General Counsel, Tim Pryce, to be CEO. Tim’s background was very different to mine, whereas I am an entrepreneur Tim is a lawyer; my background was Goldman, Tim’s was GE; Tim is practical, measured and execution focused; I am creative, expressive and strategically focused.

We split our responsibilities not along the conventional corporate lines as our Chairman and CEO titles would suggest but rather along the lines of our respective strengths. I focus on culture, deals and creativity. Tim focuses on people, organisation and delivery.

Working together will enable us to create the firm that I have always believed in but with controls and discipline that will enable it to function efficiently, effectively and with less volatility in its results.

One thing we both believe in passionately is the importance in an international firm of diversity.

We also like businesses with no internal boundaries, where each team member has the freedom to contribute to all aspects of the business.

So while Terra Firma is only 100 people, we have a real melting pot of different professional and cultural backgrounds and approaches all under one roof.

The team consists of 19 different nationalities, speak 26 languages fluently and has attended 56 different universities. We have a higher proportion of women than any other major European private equity firm. We also combine operational, financial, legal and tax experts in each deal team.

We have a graduate entry programme which is unique in Europe with all graduates being encouraged to challenge the accepted wisdom and bring their own personal perspective from day one to transactions and the business as a whole.

Since spinning out from Nomura in 2002 we have continued to buy businesses that needed to be transformed - motorway service stations in Germany; gas and water supply businesses in the UK; cattle farms in Australia, the largest cinema chain in Europe and we have become the largest private equity investor in green energy in Europe.

As with all private equity firms we suffered from the collapse of the credit markets in 2008. While most of our businesses survived the downturn and are continuing to do well, unfortunately we lost control of EMI, the company on which we did our most successful turnaround but also suffered our most major loss.

With EMI our business plan was right and we more than doubled earnings over three years. But the securitisation of the receivables we planned was never possible and the debt proved unrefinanceable, hence Citibank seized the company and sold it.

The last four years have been for private equity what I have described as the wilderness years. But to understand what happened in 2008 we need to look back at the period from 2002 to 2007.

During this period private equity boomed. It had a compound average growth rate year on year of 53% and by 2007 global private equity funds were able to raise $239 billion in just one year and with available debt that gave it over $700 billion of spending power for just that one year.

Deals were getting bigger and bigger. It was the era of the mega deal and the mega fund; what I described in summer 2006 as the “Woodstock years”.

It was clear in the summer of 2006 that the extraordinary availability of cheap and easy debt would not continue forever.

All the warning bells of an overheated debt market were ringing – covenant-light deals, 14x prospective EBITDA packages, “bought” deals, vendor due diligence being accepted by banks, existing management teams being listened to. All in all it seemed just too comfortable.

The market clearly was heading towards a peak and I said so at several industry conferences.

I was pulled aside at one of them by the head of a mega fund and told “Please be quiet Guy. Don’t scare the horses”.

However, I never thought that we would face a global banking crisis as severe as we did. My assumption was that this was just a typical bull market of the type I had seen several times since 1982 and we would simply suffer a normal correction.

However, from June 2007, things in the Western banking system began to go horribly wrong.

The problems in the US mortgage markets spilled into the credit markets globally and we faced a global credit crunch.

As the credit crunch hit, the leverage market for large buyouts became extremely challenging. Credit terms changed dramatically in the summer of 2007 - the price of debt; the amount available and the covenants.

Terra Firma had just committed to the acquisition of EMI. It was the last large deal in Europe. We were quickly caught-up in the market fallout from the collapse of the sub-prime mortgage market in the US. Mega deals became impossible in Europe as did the refinancing of them.

Of course it wasn’t just banks that would be affected; in time countries would be too.

The private equity industry in Europe has since had four years in the wilderness. Some people predicted that private equity in Europe was broken for ever and would not recover. But so far, many have been surprised by its resilience.

But there is still no shortage of worries out there in the global economy and we have not returned to economic equilibrium yet.

For us the main worry is the fragility of the Eurozone and the European banking system.

Europe is Terra Firma’s main focus and I have two predictions.

First, until a convincing and sustainable, political and economic solution to the Euro is hammered out amongst politicians and then accepted by the people of Europe, we are in for a long period of volatility.

Second, I do not believe that the European stock markets at the beginning of 2020 will be any higher than they were at the end of 2010. It will mean a second lost decade in the public markets.

However, while the public stock markets will prove an unexciting place to invest money in Europe over the next few years, by contrast the private markets will provide some very interesting opportunities.

The secret to these investment opportunities will be the changing balance in the demand and supply dynamics affecting private transactions in Europe.

While demand and supply dynamics were substantially in favour of the seller in 2006/2007, going forward we will start to see a change and within a few years the dynamics will be firmly in favour of the buyer and Europe will be an extremely attractive place to invest in private equity.

Let’s take the demand side first. Funds available to invest in Europe are reducing rapidly as the availability of equity drops.

A year ago there was an overhang of over €300bn of uninvested private equity capital.

More than half of this overhang will be gone by the middle of this year and by the end of 2013 the overhang will be virtually gone. Funds will only be able to invest what they can then raise, rather than relying on the overhang.

What will be raised for investment in European private equity over the next few years will be very little – possibly less than a third of what was raised annually at the peak.

After 2012 not only will the capital available for private equity deals be much lower, but each transaction will require a lot more equity. Leverage levels are low today and will remain low hence the equity needed to complete a transaction will be about double the amount that was required in 2007.

Additionally between 2013 and 2015 there will be €3 trillion of leveraged deals that were done in the boom years that will come up for refinancings.

With leverage ratios where they are – at a maximum of 60-70% LTV versus the 85% LTVs of 2007 – these refinancings will only be achieved if more equity is pumped into them. This is equity that will not be available for new deals. It means less demand for new deals.

While on the supply side, opportunities will emerge from banks, governments, private equity funds and strategics selling non-core assets. The market won’t be flooded with opportunities as some have suggested, but supply will be much higher than in the recent past.

We are already seeing banks selling off assets in an attempt to shrink their balance sheets. This will continue.

Banks will not dump the assets on the market all at once, rather they will be selective about what they sell as they cannot sustain the required discounts from par that would be needed for mass sales.

Their strongest most marketable assets are therefore likely to come onto the market first.

This means that there will be, over time, more assets available for investors looking for transformation opportunities – as these bank assets will have had little to no capex investment made for some time and will reach the market under managed and unloved.

This is exactly what the private equity market should be looking for - businesses that need new strategies, new management teams, and new investment. It is what the private equity model has proven it is good at.

The focus must be on investing to create, build and grow sustainable businesses of real value rather than speculating for quick returns. It is our best hope for the sustained recovery in Europe we need to see.

Banks will not be alone in selling businesses that need fixing.

Governments and quasi government institutions will also be selling assets across Europe.

The UK Government sold off many assets a long time ago. We will see much more of this from other European Governments. Private equity will also seek to realize assets from existing portfolios.

Meanwhile divisions of large companies will also be disposing of non-core assets.

In Europe the market will enter into a new phase. It will be a phase in which private equity can really contribute to a European recovery.

The years since the crash have forced the private equity industry in Europe to get back-to-basics.

To concentrate on what private equity is good at:

Creating value by transforming businesses. It is what differentiates us most from other models of corporate ownership – and other asset classes.

Private equity is fundamentally about long-term investment. We raise capital that is committed for ten years. In contrast quarterly reporting means that the public equity markets are struggling to have a long-term perspective.Private equity provides a long term source of capital. We are prepared to make investments in capex and further acquisitions to grow businesses and we do not have to worry about paying current dividends.

We are good at finding and transforming orphaned assets. Businesses that, with investment, could have an important role to play in an economic recovery.

The private equity model is extremely effective at aligning the interests of owners and of management – and it speeds up decision-making.

Lastly, this industry is very effective at attracting entrepreneurial people – and deploying their skills effectively. In the future it needs a mix of entrepreneurs, financiers and operating professionals who want the challenge of transforming businesses.

That entrepreneurial spirit, coupled with a diversity of skills and a long-term approach, allows us to spot opportunities to develop highly attractive sustainable businesses from a wide variety of situations.

So I believe that there is enormous opportunity for private equity to contribute in the difficult years ahead.

But if you are looking for a career just focusing on making money please don’t come in to the private equity industry. If just making money is what motivates you then focus instead on the banking industry or the hedge fund industry and leave private equity and the creation of long term value to those of us who love making businesses better.

Thank you.

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