Chairman's letters

18 March 2015

Guy Hands Speech at DVCA Copenhagen

Thank you for having me here to address you. Denmark is an important jurisdiction for private equity, both in terms of GPs and LPs. I am glad to see that the DVCA continues to flourish, with over 200 members.

I am going to talk today about why I think a part of the private equity community is going to start returning to its roots and becoming more genuinely “private”. Let me explain what I mean by that. The industry has had it very good for a long time. There is a lot of talk about how successful and resilient it is. Now, don’t get me wrong. The industry is right to be proud of many of its achievements. But perhaps we ought to be more critical. After all, we analyse other industries for a living and are critical of them.

If we were to do the same to our own, we might conclude that the customers, i.e. the investors, are moving away from the main product of the industry, which is traditional blind pool private equity fund. Our investors increasingly want something different. We have all seen how they are putting increasingly more money into separate accounts, co-investments, joint ventures, and directs. Yet still the whole industry is obsessed with fund raising as a measure of its performance. It is all about ‘how big is my fund’. Few talk about the returns our investors are receiving. So we need to start focusing on what investors really want.

When I speak to endowments, pension funds and sovereign wealth funds, they are largely after three things from GPs: they want alpha, they want good ideas, and they want alignment on investments. They want to know that GPs have the ability to execute, and that returns rather than the fees are what is personally driving them. They want alignment with decision makers, a strong commitment, and they want to know that those same decision-makers will lose if the investment doesn’t work out.

So I think for smaller GPs the industry will start to return to its roots of 30 to 40 years ago. When the industry began in the 1970s, it came out of club deals, which evolved into the first small private funds of the 1980s. Back then two things were very different from today: deals were backed by a smaller number of investors, and the GP was expected to have a level of skin in the game that by today’s standards would be considered enormous. You look at how much “skin in the game” GPs now have and it is usually as little as 1%. Putting up just 1% is not being aligned with your investors. Meanwhile, incentives, for many private equity executives, are out of line.

So what will the future look like for private equity?

I believe it will diverge along two paths. Brand name mega GPs are very good at what they do and have become institutionalised. They will remain attractive because those who invest in them know what they are getting. They will become increasingly transparent and public. They will continue to get larger and many will become generalist asset managers, while some will become old style investment banks. But they will not be able to create much alpha when they employ thousands of people and manage hundreds of billions of dollars. Their funds will continue to create beta, and they will attract investors looking for 1.5x returns.

The smaller firms, in contrast, will become more and more specialist, because they can do things the mega firms cannot. They will take advantage of being smaller, more nimble and more flexible. The smaller GPs will tend to focus on around twenty close LP relationships and will work with them on a much more private basis. These GPs will put more skin in the game in order to build the close relationships they need with their own small group of LPs. As an LP, this is a good thing. If I was investing in funds, I would put 50% into the largest 20 or so “me too” funds as they will give me beta and they are all pretty good. Then for alpha, I would focus on smaller firms. The right size of funds now for alpha is around 500m – 2bn euros, a little bit like goldilocks and the three bears: not too big, not too small.

Back in 2012, when we went out to raise just such a fund – our Special Opportunity Fund I – it was not the easiest process. However, it’s already achieved 2x in 3 years and we put 30% of the money in to it ourselves. Many investors balked when they heard about it because it wasn’t traditional – many people did not want to pay fees on what they saw as a direct, we ended up only finding eight investors who would pay carry and fees. It has been a very successful investment and our investors, including ourselves, are very pleased with it. The endowments, pension funds, and sovereign wealth funds who invested really like it.

I recently had a conversation with a sovereign wealth fund that invested who was asking for good ideas. They asked us if going forward we would be willing to put up a third of the equity on deals.   But in return, they offered us 50% carry above 20% returns. That’s a wonderful carry situation if you think you can return 28% plus. But on the other hand you have to put your money where your mouth is and be certain you can drive those results. If we find a deal that makes sense on those terms we’ll put up the money and be on a plane to see them.

I recently announced that we have a billion euros in equity available for new deals and funds. That’s because we are coming off the most successful period in our history in terms of money returned to our investors and profits made for them. We have returned more than six billion Euros to our investors over the last three years and produced cash profits for them in excess of four billion Euros.  And Terra Firma has been the biggest investor in its own funds so we have also done well from this.Our strategy for deploying this capital is to be entrepreneurial, opportunistic, strongly aligned with our investors’ interests, minimise fees, maximise carry, and to go for alpha.

We are not leaving fundraising behind – we will still raise traditional blind funds because it does make sense in certain circumstances. What we are creating is an architecture where we are flexible enough to act quickly when we know we have the right idea, be it a fund or a deal, and to use our own firepower to ensure the best transactions happen. Investors are not interested in the average of what we can do. They want alpha from us. They are aware of our track record – both the brilliant deals, and the occasional horrible one.

I carry the deals that have not worked out as scars on my back. I would rather that every deal I touched turned out like Angel Trains or more recently Deutsche Annington. But I am motivated and humbled by the memories of the unsuccessful deals – they are what keep me awake at night. In Europe, the crisis has left many underperforming businesses in its wake. Three to four years ago the equity in these businesses was worthless and it made no sense to sell them.

But with the continued economic recovery and increase in values, potential sellers are finally beginning to let go of assets that they have been holding on to for years thus creating significant opportunities. Going forward for the smaller firms, Private Equity will mean being more aligned with your investors, putting much more of your own skin in the game, giving them what they really want, minimising their fees, maximising their returns.

The way that private equity will go is “back to the future”.

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