Chairman's letters

29 February 2012

Guy Hands' speech at Super Return, Berlin - “Economic storm clouds and options in Europe: where can Private Equity find value?”

The father of innovation is necessity and out of the current economic crisis will by necessity come innovation. Be happy, GPs and LPs, for now is the time to focus on the opportunities to invest in Europe. I for one (possibly the only one), cannot think of a better place than Europe to be investing Private Equity money today.

However, European confidence in the sustainability of long term growth has been undermined, and within Europe we find searching questions being asked about the appropriateness of free market capitalism. Meanwhile, the West as a whole is trying to adjust to the effects of power and influence moving to the East and other emerging areas.

The situation in Europe today reminds me of how I felt as a teenager in 1970s pre-Thatcher Britain, living in a country with constant strikes, falling living standards and seemingly no way out of its debt crisis. The UK in the 1960s was suffering from the break-up of the British Empire and the costs of the Second World War. In an attempt to try and stimulate the economy and maintain its position in the world, Britain took on massive debts and by 1976 found itself in economic crisis and reliant on the IMF for a bail-out. Similarly to the UK in the 70s, what is clear is that for Europe things changed forever in 2008.

The result of that change is that many in Southern Europe will face years of austerity, just as the UK did in the mid-70s. Today the political courage to make the sort of fundamental economic adjustments needed in Italy, Greece, Spain and Portugal that Thatcher did in the UK in the early 80s does not exist, and hence austerity will be drawn out for many years rather than dealt with quickly through structural change.

I do not, however (with the wisdom of age), agree with the more pessimistic commentators who are proclaiming that Europe is finished. Though back in 1976, with the anger of youth as a 17 year old schoolboy I did feel that Britain was finished. Today’s real tragedy is that many of the young of Europe must feel as I did then. But while it is true for the people of Europe that the medium term outlook is by no means favourable, it is not hopeless and just as for the UK in the early 80s, if the political will to take the radical steps needed is there then the same positive economic result can follow.

What we are seeing today is a very painful economic correction where the fundamentals are being caught up with and countries are having to reduce their debt levels and populations are having to adjust their expectations of what their governments can provide to them, and where they fit  in the world and what the effects of living longer will be on their pensions. In the US this adjustment is needed largely as a result of the credit bubble that was created under political pressure from both parties to provide home ownership to all and the massive amount of sub-prime mortgages created. While in Europe the need for adjustment was created by a political dream which pretended that all Euro countries were equal. All of us in the West are now paying to correct these two political fallacies and it has been forgotten along the way that the causes were the direct result of well intentioned but misconceived political policies. This was no accident.

The world as a whole though will keep growing. Indeed the World Bank is forecasting global growth of 4.7pc. We are not seeing a failure of global capitalism. Indeed outside the West capitalism is alive, well and healthier than ever. But for the moment the focus is on Europe’s financial and political problems. This focus will stay on the European continent until there is clarity on how Europe’s problems will be solved.

But Europe will make it through, it is just a matter of time. Eventually sound political decisions will be made, people will become realistic, politicians will develop courage, and the right economic framework will be established. But Spain today is not Britain in 1982, it is more like Britain in 1976. So those of us in Private Equity should plan on at least 8 more years of high volatility and low growth in Europe.

Against this economic and political backdrop, I want to talk about what the lack of confidence to invest in Europe means for private equity. First we need to focus on the fact that we have another problem in Europe, and that is, unlike in the US, the banking system is very, very weak.  To achieve European growth will need increased lending and leverage, it will need an increase in the velocity of money, not a decrease. That is very much the opposite of what most Western European politicians are preaching.

Europe needs increased lending to the private sector, an increasing velocity of money, a lowering of taxes, and an increase in confidence. None of these are currently on the long term agenda for Europe. Instead, for European banks to start lending aggressively again, they are being obliged meet new capital rules. To meet them they will need to either shrink their balance sheets, raise more capital or be nationalised. Shrinking their balance sheets has proved difficult. Most European banks have loan portfolios that are far too large, but their loans are illiquid at the price levels they have them and consequently they can’t sell them. Consequently, most European banks simply cannot sell large quantities of loans because their balance sheets cannot afford the discounts demanded by potential buyers.

Raising capital cannot be done without destroying the value of the existing equity, and governments for all the talk of running banks better, do not want to have to take responsibility themselves – note RBS in the UK and the bonus debacle.

So, to keep the banking system in Europe solvent, a combination of approaches is going to be needed. First we need day to day liquidity and we are seeing this today with the action of the ECB. Additionally, some Governments will nationalise the weakest banks, but not enough of them, some banks will sell assets, but not enough, and some will raise new capital, but it will not be sufficient. What this means is that European banks will find short-term stability over the next few months – and this may be enough time for the market to recover around them and for some of them to gain long term stability. However, we won’t be seeing European banks back in full lending mode to the private sector for the next three to five years. The long term objective for Europe over the next five years is to avoid following the Japanese example, when public sector and government borrowing squeezes out the private sector.

Secondly, with low European growth rates, the public stock markets will prove an unexciting place to invest money.

These two key negatives: low levels of lending and a mediocre stock market, however, will not lead to bad results for European Private Equity on investments done post 2013. In spite of these two negatives, the Private Equity markets in Europe will have very interesting opportunities and provide very good returns over the next few years. The secret to Private Equity’s investment success in Europe post 2013 will be the changing balance in the demand and supply dynamics of private transactions in Europe and the opportunity for Private Equity to be used as Transformation Capital. Every asset manager likes to claim they have that bit of magic, every trader likes to think they can read the market, but the truth is that they are affected by supply and demand and the same is true of Private Equity.

While demand and supply dynamics were substantially in favour of the seller in 2006/2007, we have already begun to see this changing slowly over the last five years.  The dynamics will, by the end of 2013, be firmly in favour of the buyer and Europe will become an extremely attractive place to invest in private equity.

On the demand side, the availability of capital to invest in deals in Europe is reducing rapidly. A year ago there was an overhang globally of over €300bn. More than half of this will be gone by the middle of this year and by the end of 2013 the overhang will be largely gone. Funds will only be able to invest what they can then raise, rather than living off the overhang. And as one LP said to me yesterday, 85p.c. of his GPs are raising money over the next 18 months.

Meanwhile, in Europe, the amount that new funds raise for investment in private equity over the next few years will possibly be less than a third of what was raised annually at the peak.

Additionally, not only will the capital available for private equity deals in Europe be much lower, but each transaction will require a lot more equity. Leverage levels today will remain low hence the equity needed to complete a transaction will be about double the amount that was required in 2007. So we have a third as much equity and it goes half as far. And we should not forget that between 2012 and 2016 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 some deals done in 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.  This means yet lower demand.

On the supply side, opportunities will be emerging from banks, governments, private equity funds and strategics. All will be sellers of suitable companies for Private Equity to invest in and transform. I don’t believe the market will be flooded with opportunities as some have suggested, but supply will be much higher than in the recent past.

In particular, banks will not dump assets on the market all at once, rather they will be selective about what they sell and the price at which they sell it. They simply cannot sustain the required discounts from par that would be needed for mass disposals. Anyone in this room who has been in negotiations with a bank that is selling any of its assets at a loss will know that it is a much more difficult discussion than if they were selling at a profit. The banks in Europe simply aren’t getting the pressure they got in the US to clean up their balance sheets. Consequently, their strongest most marketable assets are likely to come onto the market first. This means that, over time, more assets will become available for investors looking for transformation opportunities. These bank assets will have had little to no capex investment made in them for some time. They will reach the market under managed, under invested in, with an outdated strategy and a disillusioned management team. They will indeed be perfect for Private Equity.

However, banks will not be alone in selling businesses. Governments and quasi government institutions will also be selling assets across Europe. The UK Government sold off many assets and businesses 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 (though many GPs will get extensions), many of which have become over time zombie companies.

This is exactly what the private equity market should be looking for - businesses that need transformation with new strategies, new management teams, and new investment. It is what the private equity model has proven it is good at. Finally, large companies will also be disposing of non-core assets, when they have the confidence to invest in new opportunities.

Consequently 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 focus in Private Equity must be on using the equity capital we have raised from around the world to transform, build and grow sustainable businesses in Europe of real value.  It is how we will make returns for the pensioners whose money we manage, and the best hope for the sustained recovery in Europe that the politicians say they want to see.

The years since the credit 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 from other models of corporate ownership – and from other asset classes. Private equity is fundamentally about long-term transformational investment.  We raise capital that is committed for ten years and we use it to improve businesses.  In contrast, in the public markets, the importance of quarterly reporting means that listed companies have for some time struggled to maintain a long-term perspective, we have that luxury.

The governments of Europe should realise that Private equity provides a long term source of capital.  We invest in capex and in acquisitions to grow businesses, we do not have to worry about paying current dividends and we create sustainable jobs.

We find and transform orphaned businesses. Businesses that, with investment and attention, will have an important role to play in Europe’s economic recovery. And we in Private Equity create more jobs per Euro than any other corporate model.

The private equity model is effective in achieving growth as it aligns the interests of owners and management together. Private Equity speeds up decision-making and ensures that we all are in the same boat and rowing in the same direction.  This alignment of interest combined with the long term reward mechanism of Private Equity through carry makes the industry effective at attracting entrepreneurial people – and deploying their skills. People who enjoy the challenge of transforming businesses and who are in this industry because they love transforming businesses, not just making money.

Their skills and determination, coupled with Private Equity’s ability to take a long-term view, will allow the Private Equity industry in Europe to transform businesses and deliver sustainable growth and good returns, and to drive growth in Europe. Hence be happy as Private Equity in Europe will enjoy a very successful period from 2013 to the end of the decade.

Thank you


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