Chairman's letters

01 November 2011

Guy Hands' speech at SuperInvestor, Paris - "The best and worst of Private Equity; lessons from the wilderness years"

These are ‘the wilderness years’ for the Private Equity industry in Europe. And we look set to continue to endure, harsh economic conditions and volatile and illiquid capital markets.

The opportunities for creative financing and reducing the cost of capital have gone for the foreseeable future. Meanwhile private equity pundits have been confused by what they have seen, leaping from proclaiming the death of Private Equity to marvelling at its “bounce-back-ability”.

How very different from the ‘the Woodstock years’, that period from 2002 to 2006 when credit was booming. Great quantities of capital flowed into funds and back to investors, creating extraordinary returns - sometimes without the need to create sustainable value in the process. When credit dried up and “the wilderness years” began, some GPs had slipped into bad habits.

This morning, I would like to explain the essential characteristics of resilient private equity investment as I see them and to examine the best and the worst in the industry. There are lessons for us all here which will be valuable to remember as we approach a market that I believe will become considerably more attractive for European private equity from 2013 onwards.

Let’s start with what private equity does best.

First Private Equity industry attracts entrepreneurs, financiers and operating professionals who want the challenge of transforming businesses – with the possibility of generating superior returns. That spirit, coupled with a long-term approach, makes us better at spotting opportunities to develop highly attractive businesses from a wide variety of situations.

At Terra Firma we have acquired and transformed orphaned assets, both through government privatisations and through buying divisions from large corporates. Transforming businesses like these requires a tough entrepreneurial mind-set in order to see through the pain of completing a corporate transformation.

Second, longer-term objectives: part of what gives private equity an edge is that we do not have to manage our portfolio companies to the drum-beat of quarterly earnings and can manage for the long term. Publicly listed companies are constrained by the short-term. Their ability to achieve strategic change is often sacrificed in their quest to appease investors. In contrast we have the time to be more creative and ambitious in our plans.

Rather than starting with what a business is today, or worse, what it needs to look like by the end of a quarter, we can look ahead five to seven years - and imagine what a business could become.

Third, speed and management focus: we can move faster than any other business model. Our willingness to challenge, and if necessary, change management is a particularly powerful driver of value creation. In the private equity model, the board is built by, and for, the investors.

In addition, CEOs are hired to execute business plans, rather than undertaking time-consuming strategic reviews to justify their appointment. If the CEO makes decisions that create value, he is well rewarded. If on the other hand he does not then he will be shown the door.

Fourth, proper alignment: We are also very effective at putting incentives in place that really do align the interests of management with the interests of the business’s owners.

The “wilderness years” have also focused Limited Partners on achieving better alignment of interest between themselves and the General Partners. With the recent round of fundraisings, there has been a renewed focus on this and at long-last we are seeing the end of transaction, monitoring and directors’ fees.

In summary, I think that there is plenty of evidence that the private equity model has been more effective at achieving transformational change in businesses than other models of corporate ownership.

The “wilderness years” have forced our industry to focus on what we do best - creating value by transforming businesses.

But what have we learned about the less attractive characteristics of the industry?

There is no shortage of criticism from the media. However, these criticisms are simply not representative of the industry; they are largely polemic, and help to raise passions and sell newspapers.

I am referring to some of the bad habits that the industry developed during ‘the Woodstock era’ – habits that it has not yet kicked.

In contrast to the stereotype view the press portrays, here is my list of Private Equity’s worst faults:

Asset gathering. Many in private equity became fixated on raising bigger funds and developing different products across the spectrum of alternative investments. Clearly, the asset-gathering model can be incredibly rewarding for GPs. However, by becoming asset gatherers, I believe that we risk losing the entrepreneurial spirit that delivers value for our LPs.

Private equity must have “skin in the game,” if its asset base is so heavy that the General Partner can get very rich on fees alone, then the General Partner starts to lose its focus on driving returns and earning carry. Asset gathering threatens to put private equity into the mainstream of the fund management industry, that so many of us originally set out to challenge.

Putting deal quantity ahead of quality. Too often, success in private equity has been measured by the quantity of deals sourced and closed and the fees earned. Instead it should be measured by looking at the quality of the work we do in transforming businesses. In the boom years, we thought that we could both maximize fees and deal flow and keep quality high. However, in pursuing volume, private equity has diluted its ability to create alpha.

The conveyor-belt mentality encouraged GPs to do deals outside of their areas of core competence. This inevitably diluted their proposition and I believe that it slowly undermined the performance of our industry.

Perverse marketing incentives. As an industry, we spend a disproportionate amount of time fundraising. Instead, the talents of entrepreneurial people should be put to productive use in buying and transforming companies, not spent on continuous fundraising.

The fund model also creates pressure to deploy capital rapidly once raised and to harvest investments quickly. While this may help to market future funds, it does not maximise value.

Club deals: These dilute accountability and control.

In an era where businesses really need clarity of decision-making, club deals can only be justified if the Private Equity firms involved have near identical outlooks – something which is highly unlikely.

Lastly, pass the parcel deals. In aggregate, they impose large and hidden transaction fees and risks on investors.

You may not agree with me about all the vices on this list. However, as an industry we must focus on raising our game.

Right from the start it is vital that we know where value can be created in our businesses.

Five business drivers are, in our experience, critical to adding value to businesses:

The first is to change a business’s strategy. When looking at a potential investment, I don’t put too much faith in what the incumbent management team says is possible. I am far more interested in what my team thinks.

We need to bring strategic insights that will transform businesses. It might be the introduction of a new business model, or perhaps the repositioning of a business within its market. The insights may be driven by our macro view of where an industry is going or they may be based on a micro view of the individual business.

The second driver is to strengthen the management team. Once we have control of a business we typically make several new appointments and ensure that strong incentives for management are in place to drive change.

Our aim is to build top quartile management teams. We have even had to build entire management teams from scratch as with RTR, our latest acquisition, which was simply a collection of assets when we acquired it with no management at all.

Next we aim to lower the business’s cost of capital. Yes, financial transactions like securitizations or refinancings were so much easier in the Woodstock years, but there are still opportunities today.

We have to look for ways to reduce business risk by diversifying and stabilising cash flows. In several cases, such as Inntrepreneur and WRG, we have bought businesses partly because we were confident that we could resolve legal and regulatory uncertainties that were inflating their financing costs. Our last two drivers are all about investment.

Deploying capex is key. In the last year, capital expenditure across our portfolio was over €1billion. Whether remodelling sites at Tank & Rast, maintaining and modernising Deutsche Annington’s housing stock, buying new aircraft for AWAS or building generating capacity in our renewable energy businesses, we invest consistently in our businesses in order to establish them as best-in-class.

However all capex is subject to strict return criteria and is controlled centrally by Terra Firma.

Finally, our plans usually require some significant M&A activity after the initial deal.

For example, three of our current businesses, AWAS, Odeon/UCI and Infinis, have been transformed by very large acquisitions that have redefined their scale and capabilities. In total we have made over 30 major bolt-on acquisitions for the 30 portfolio businesses we have owned over the last 17 years.

While the M&A market has been quiet recently, I think that there will be plenty of opportunity in 18-24 months time, for reasons that I will come to in a moment.

For Terra Firma, the last few years have reinforced the logic of our approach. We must not be distracted from our approach, but must continue to do what we are best at – investing in asset-backed businesses in essential industries, then transforming them by applying new strategies, intensive management and sustained investment. It has worked for many years, and I believe will be particularly appropriate in the coming years.

So what do I think is around the corner?

Right now I have two predictions.

First, until a convincing solution to the Euro is hammered out amongst politicians, we are in for a long period of volatility.

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

By contrast, a Private Equity industry rediscovering the importance of generating alpha offers an attractive investment proposition. Private equity will not provide a “safe harbour”, but it can provide a reasonable environment in which to build businesses.

Most fund managers don’t like to admit that Demand/Supply dynamics affect returns. Rather they would like the world to believe that achieving excellent returns from investment opportunities is about having a “magic touch.” However, Demand/Supply dynamics affects private equity returns as much as for any other market.

So let’s take the demand side first. Funds available to invest in Europe will be very low as the availability of equity starts to drops off in 2013. A year ago I said there was too much equity. Nothing was being sold and there was an overhang of over €300bn. More than half of this overhang is still not invested and funds will get extensions, but by the end of 2013 the money will largely be gone. Funds will only be able to rely on what they can then raise, rather than relying on the overhang.

What will be raised for Europe over the next few years will be low – possibly €50bn a year. The amount of capital raised will be less than 1/3 of what was raised annually at the peak.

Post-2012 not only will the capital available for private equity deals be much lower, each transaction will require 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 once required.

Additionally between 2013 – 2015 there will be €3 trillion of leveraged deals 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 require the investment of substantially more equity. Funds will seek more equity from their investors in order to support their portfolios, and this equity will not be put into new deals.

Rather we will see more cross-fund investment in order to stabilise earlier funds. On this €3 trillion of leveraged deals, if 15% more equity is required, then €450bn of new equity will be needed.

Without the availability of substantial further equity to invest in new deals, the demand for new deals will be very low.

Consequently, on a positive note, there will be less competition for deals, in contrast to the Woodstock years, when bankers were only too willing to lend and investors to invest.

The result of all this cheap lending and increased investment was that prices were inflated and opportunities disappeared. Investment in quasi infrastructure deals at the time was particularly hot. Many of us were getting squeezed out of the market sectors we knew well.

Today, we have the reverse. Infrastructure funds are now looking for security from 30 year contracts. They do not want the risk of uncertain change programmes.

They are happy to get 8% returns. Many investors are also gone and the market for transformative deals has been left to those that specialise in them. The same pattern has been repeated across other sectors.

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 others have suggested, but supply will be much higher than in the recent past.

We already see 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 likely to come onto the market first. What this means is that there will be, over time, more assets available for an investor looking for transformation opportunities – as these bank assets will have had little to no capex investment and will reach the market under managed and unloved.

Governments and quasi government institutions will also be selling assets. The UK Government sold off 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. Why? Because, while many have plenty of cash, their banks want to reduce their balance sheets. Banks will therefore put increasing pressure on companies to sell assets to reduce their debts.

I therefore think that the European private equity market will enter into a new market phase soon. When we look back we will realise that the ‘wilderness years’ were a defining moment for our industry. They forced us to get back-to-basics – to find the faith again:

• To put investors’ interests first – by continuing to refresh our terms to ensure we are aligned with our investors.

• To ensure that we never forget to put quality ahead of quantity when it comes to making deals.

• But perhaps most of all, to remember that what we are best at is creating value by transforming businesses. It is what differentiates us most from other models of corporate ownership – and other asset classes.

Those who are able to transform and grow companies successfully will succeed so long as they remember the lessons of the Woodstock years.

Armed with these lessons and the market prospects ahead, I believe that, as an industry, we can offer an attractive environment in which to build businesses in the years ahead.

Thank you.

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