24 February 2005
Guy Hands' speech at Super Return 24 February 2005, Frankfurt
It is very easy at conferences to sound like an expert without ever being accountable - so I dug out what I said at this conference two years ago to see if, with the passage of time, it still made any sense and to ‘mark myself to market’.
I suggested then that there were three major drivers affecting private equity in Europe
- The increasing supply of capital available for private equity would lead to increased competition for deals, an acceptance of lower return expectations and acceptance of greater risk;
- Facing that increased competition, the old model of stripping out costs, polishing a company up and looking for a quick IPO would no longer be sufficient to produce top-quartile performance;
- The private equity market would split between the mega-funds and the boutique funds – the $20 billion gorilla private equity asset allocator fund would become the reality within five years for most of the money that was invested in private equity, while the boutiques would become specialists with higher returns and higher volatility
So where are we? What has happened since?
Let’s look at the impact of increased competition first:
What I Saw
The market has divided: some firms accepting lower rates of return, others looking for new ways to increase returns. This is reflected in a wide divergence of bid prices in auctions.
Whilst some 2002 deals have produced hugely impressive returns, we are now seeing acceptance of targeted gross returns in the16-18% range. It is very similar to what has been seen in the last 20 years bond market: yields have gone down and spreads have contracted.
This is reasonable in a market where the overall returns have declined and leverage has remained constant, but people are taking greater risk to achieve that return.
Some funds in the past have experienced three or more bad deals out of ten, accounting for over 30% of the fund. If this happens on expected returns of 16-18%, the impact of bad deals will be devastating on a fund.
In addition, leverage increases the likelihood of bad events being disastrous to investments. An over-stretched balance sheet cannot survive shocks.
When looking at investment in private equity, I suspect that smart investors will begin to focus, like they do in the hedge fund market, on the leverage used to achieve the total returns given.
A firm getting 20% on 60% debt, is both safer and better than one achieving 20% on 80% debt. Investors will increasingly focus on risk adjusted returns.
What I Did Not See
Competition in our market is not just amongst private equity firms. It is also coming from hedge funds, lenders wanting equity kickers and investment banks re-entering the principal finance arena.
And that competition from hedge funds and investment banks is not just for investments either. It is also for people: short term bonus-led remuneration is attractive to people and the lower-return environment has made carry much less attractive.
In response to more competition and lower fees, the amount of assets under management and net fees earned per partner has become the ‘name of the game’ for the majority of mega private equity firms.
I predict that most large fund managers in three years time will have increased their number of business lines. However, those that continue to focus on one thing will achieve greater returns, although their earnings from fees could well be sufficiently below their competitors.
Let’s turn to new ways to increase returns
What I Saw
Operational management teams within businesses are not good at investment or exits. Equally, investment professionals in private equity firms are not good at operational management. This contrast leads to the interesting dilemma of how to manage the control of private equity investments as both skill-sets are now required.
This is because achieving strategic change has to be fundamental, not incremental, if it is to add real value to investments. If acquisitions are managed the same way post-acquisition as they were before, then no value increase will occur - unless of course the market moves up or the cost of capital declines.
Therefore, you need to change the strategy and to manage both the initial and incremental investment in the business to add value – this means being very hands-on.
This need for increased operational and strategic change in the companies has led to our hands-on approach being seen as the model - which may or may not be right!
A greater focus on operations does not mean just having a lot of operational partners, it also means a larger team.
It is also about a state of mind, and having detailed processes to affect all areas of a business. It means going deep into business and kicking the tyres and getting one’s hands dirty. In short, I believe operational and strategic change does not come from the board planning and devising change but from working together with management on the implementation. It means being there with them every day.
What advantages does private equity have over other models of ownership?
Private equity’s advantage over hedge funds, public companies and indeed bank capital, has become its ability to look at long-term investments. This will lengthen the exit horizon, but lowest risk and the highest returns come from investing in a successful business you know well - so picking the right business and sectors and continuing to invest in them is critical.
As is having the guts to build a business over the long-term and holding on to it in order to benefit from internal compound rates of return. The reality is that every time a business is sold and bought, value gets left on the table.
For transformational performance, General Partners need to run winners and cut losers. Bizarrely in private equity, the tendency is often the reverse as General Partners want to show profits and hide losses in order to raise bigger and bigger funds.
I predict that some of the best performing funds will have long hold periods and will hence suffer least from competition from hedge funds. However, they will not have a track record that is easy to understand.
So has the market split between mega fund management companies and boutiques?
What I Saw
When I suggested that the $20 billion gorilla managers would appear in five years time, I was two years too late! They are here already.
This creates new issues for private equity. Most megas have become gorillas by increasing the number of distinct funds by geography, by sector, by business line and by sector of the capital structure.
Some fund managers are now running funds specialising in everything from energy markets to German residential housing, to Asian mezzanine finance, to secondaries.
Other mega funds have raised more than originally expected and have had to go from targeting mid-cap companies to targeting large companies with different risk profiles. They now also have different employee requirements to those that they expected.
Infrastructure funds, real estate funds, asset based funds and hedge funds have all appeared and are attempting to do private equity deals with lower returns but for the same fees, or indeed higher fees.
What I Did Not See
We have decided to stay where we are, one fund at a time with one return criteria: focussing on 20% plus returns – with a focus on higher returns (and hence carry). To do this we will accept the negative of lower fees per employee.
The question for Limited Partners today is whether to favour a general fund management firm or a specialised investment firm.
Some mega firms will focus on one line of specialised business. These specialised funds are less corporate, more opportunistic and more entrepreneurial - but as a group, they will have more volatility.
The fund managers are more corporate and institutionalised, more risk averse, but will put more money to work with less volatility - but lower returns.
I predict that for larger private equity asset management companies, fees will become increasingly important relative to carry. Hence, investors are going to want to understand more how the fees paid are being used and how they can use fees and carry in the bigger funds to continue to achieve alignment of interest.
And so to my conclusions
The market for investing has become more competitive, tougher and more crowded.
Most large private equity firms have reacted by diversifying their business lines in order to reduce their own risks. This provides a greater fee base for them and less dependence on performance.
We have decided to go the other way, not only with regard to the fund (just one and single focused), but also with regard to staffing levels (increased substantially) and to investing all of our own wealth in our next fund (aiming at 5% of fund size) – it will be interesting in two years to look back and see whether this decision is right.