Chairman's letters

18 November 2015

Guy Hands Speech at SuperInvestor Amsterdam: Putting the ‘Partner’ back in ‘General Partner’

Good morning. At the end of last year, Terra Firma celebrated its 20th anniversary. Overthe past two decades, I’ve looked at and considered a vast number of different private equity business models: partnerships, public companies, family offices, sovereign wealth funds, bank-sponsored teams, co-operatives and even crowdfunded groups.

However, the one constant I’ve noticed is that the people I interview for jobs have, over the years, become less and less happy. Interviewing private equity people makes one feel like an agony aunt – no one seems satisfied and everyone seems envious and critical of everyone else.

It’s a little bit like the divorce rate in Beverly Hills, where, as people get more successful, the divorce rate goes up. As one private equity person put it to me, if I’m performing at a nine-and-a-half, why should I be surrounded by people who are only sixes? Meanwhile, he told me his wife was a five – surprise, surprise, they are now divorced, and his senior private equity people have quit.

20 years ago, the few of us who were in this industry ate in modestly priced restaurants and drank modestly priced wine, held our conferences in 3-star hotels. They lasted half a day, and we had a great time. Now, those of us still in the industry go out to ludicrously expensive restaurants and drink ludicrously expensive wine, and hold our conferences in 5-star hotels, and they last for days. However, this isn’t just a bunch of cranky old men and women – the youngsters I interview are just as dissatisfied as the older professionals.

I think this unhappiness exists because, 20 years ago, the relationship between GPs and LPs was a positive and close one. Most GPs knew their LPs well, and frequently saw them, and most firms were small, with very few even approaching 100 people. Today, it often seems like GPs and LPs are co-existing in a broken marriage for the sake of appearances. The majority of people work in firms where they tell me that they are not noticed, and have simply become a cog in a hugely successful money machine.

This needs to change.

It’s time for some therapy, and for people in the industry to make some radical decisions, unless they’re content to continue to get rich while feeling underappreciated and unfulfilled in their business relationships.

When you run into relationship issues, the first thing to focus on is communication. One needs to listen to the other person and understand where they are coming from.

When I talk to my investors – and I’ve met nearly every one of Terra Firma’s 190 LPs over the last year – I listen to really understand what they want from us. The same important points came up in nearly every meeting, a few of which I would like to share with you.

The first message I received was that LPs wanted alignment. They want GPs to have ‘skin in the game’. They want to look across the table and know that the GP is working for their LPs, and not just for themselves.

If an investment team has a substantial portion of their liquid net worth invested in a fund, you know that they are not motivated just by fees – their main objective will be to protect and grow their own capital alongside that of investors.

At Terra Firma, this means we are not going to sponsor any fund, or any deal, unless we can put at least 10% of our own money into it. We are not going to make our money on fees – we are going to make it through carry, and we are only going to get paid if our investors make money. The relationships within a GP are, not surprisingly, similar to the relationships between GPs and LPs. Only 15% of most people’s motivation is money. So what do people working at a GP want if it’s not money?

Not surprisingly, it’s the same thing that investors want – an alignment of interest. A feeling of working together. At Terra Firma, that means people want a stake in the firm, its future, and a feeling of belonging. So, for the first time in 20 years, I am going to share ownership in the firm with my senior team. They can have a greater participation in our successes, and they can also share in the challenges and difficulties that any business can face.

LPs also told me that they wanted fewer relationships, and they wanted closer relationships.

This makes perfect sense – LPs want to understand what their GPs are up to. But the reality is that it goes both ways. For GPs to deliver good outcomes for LPs, we also need to have fewer relationships. It just isn’t possible to have close relationships with hundreds of LPs.

Earlier this year, investors in the Terra Firma Capital Partners II Fund voted to approve a one-year extension for the Fund. We needed approval from investors representing 75% of interests, and we ended up with approval from 96%.

Most of our investors were happy with our exit strategies for the remaining businesses, and they voted in favour of the extension. Yet I probably spend more time and energy on the remaining 4% who are unhappy than the 96% who are happy.

So, much like LPs, we want to have fewer relationships, but we want those relationships to be much deeper. We want to have relationships where we can co-invest together, where we can discuss what is going on in the market, and where we can quickly coordinate to seize investment opportunities as they arise.

The mirror image of this exists within GPs. When I interview people, many say they want to come into work each day feeling that they are part of a dynamic team where they know everyone and everyone is working together with the same agenda.

As private equity firms have grown, that has become more difficult to achieve. In Terra Firma, we are addressing that by giving people the opportunity to run their own strategies and build businesses.

On the one hand, this is clearly very exciting. On the other hand, it does require people with different personalities and capabilities from those typically found in our industry. While we are willing to support people with both capital and resources, they can’t be people who are happy being cogs in the machine. They have to be willing to take risks, invest in the future, train and manage people, build a business, and convince me and my LPs that we should invest with them – in short, they need to be similar to the founders of the private equity industry.

One of the challenges, of course, is that in the short term, they will earn less. However, long term, if they are successful, they could be both fulfilled and wealthy.

In founding Terra Firma, I turned down multi-million pound packages in the investment banking industry for 85,000 pounds a year, but an opportunity to pursue my vision. Today, at Terra Firma, we are lucky enough to have a billion euros of capital, and we are looking for people with vision and who are willing to take personal risk to pursue their dreams.

In 2002, we believed we were the first major private equity firm to agree not to charge any monitoring, board, financing or M&A fees, along with the refund of 100% of any transaction fees that we earned.

Today, this is pretty much standard.

LPs have been telling me recently that they do not like paying fees on committed but uninvested capital. Firms are sitting on $1.3 trillion of dry powder, earning GPs $20 billion in fees on money that isn’t being put to work.

Earlier this year, I announced another first for our industry. Terra Firma will no longer charge any fees on uninvested capital. We will only charge fees on invested capital.

Likewise, for those joining Terra Firma to run their own business and strategy, their success will be directly aligned with Terra Firma’s and our investors’. They will be paid largely on the success of their strategy and their ability to build a business. Changing the relationship between LP and GP, and the relationships within a GP, and changing the business model in this way, is not just going to be more fulfilling. Justin, myself and the senior team at Terra Firma believe that it also will provide what private equity investors are searching for: alpha.

The industry has done very well since 2009 because the markets have done very well, but the actual alpha provided by private equity has fallen substantially. A number of sophisticated investors told me that private equity is really providing them with leveraged beta – and expensive leveraged beta at that. As Joseph Cotterill reported this week in the FT, an academic study recently found that if you put together a portfolio of small-cap, undervalued listed companies with what they called “buyout-friendly characteristics,” that portfolio would have returned 23 per cent a year from 1965 to 2013.

Meanwhile, the Cambridge Associates US Private Equity index has returned 13.5 per cent a year over the past 25 years, and the S&P 500 has returned less than 10 per cent in that time. However, as you would expect from a good journalist, Joseph points out some of the flaws in this calculation, though that won’t stop private equity’s detractors from using the statistics.

Whichever way you look at it, alpha is not easy to achieve.

However, to achieve alpha, I believe we need to change. As with all businesses, there are only three things you can change. What you do, who does it, and how you organise yourself.

I still believe what the private equity industry does is worthwhile and adds real value. However, in a world of bigger firms, how we are organised does need to change. We need to give people a feeling of ownership and independence, but with the discipline that an organisation can bring.

We also need to change who does it. We need fewer highly paid, box-ticking number-crunchers, and more entrepreneurial, insightful businesspeople. That is why, in Terra Firma, we are delighted that Justin King has joined us. We look forward to putting together a family of equally visionary business people who can successfully invest ours and our investors’ money, while at the same time, having a lot of fun. In every good marriage, you need to be able to laugh. As every singles advert says, “Wanted: GSOH.”

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