Chairman's letters

01 January 2009

Guy Hands' speech at SuperReturn 2009, Paris - “Is the private equity LBO model broken due to falling returns and lack of leverage?"

Good morning and thanks for joining me today.

Unquestionably the private equity industry faces numerous challenges in today’s markets.  Some pundits predict a new golden era, while others are writing our obituary.  The reality is that while some aspects of the industry are broken and need to be fixed much of the industry is good and here to stay. 

Private equity still has a vital role to play in the economy and client portfolios.  However, I would like to spend the next few minutes talking about what’s broken and how to fix it. 

There is a lot of talk at the moment about the failures of LBOs, and indeed about whether or not the private equity model is destined to fail. Some believe that tightness in the credit markets and the lack of leverage available will lead to the end for private equity. 

These observers point out that the industry is getting smaller and that this is an ominous sign of private equity’s decline as a form of ownership. 

In my opinion, those who make this claim are fundamentally missing the point. Size is not a measurement of effectiveness. A large private equity market ruled by a handful of mega-funds is not necessarily indicative of a healthy market, and a smaller one does not necessarily indicate that the model is broken. 

As we’re in Paris, I’ll use something President Sarkozy recently said to illustrate the point:  earlier this year he suggested adding a “happiness” index into how we judge the success of economies, as opposed to blindly accepting the conventional wisdom that bigger is always better and growth is always good. For instance, Japan’s GDP over the last decade has shrunk and prices have fallen, but people are finding goods are more affordable, healthcare continues to be available at a high standard and the population is largely debt-free. 

Contrast this to the UK where, in the run up to the crash, GDP grew substantially but for most young people houses remain unaffordable, healthcare and education standards are falling, they are scared of crime and the average consumer now has around £30,000 of debt while the Government borrows on average £58 per week per person. Which country’s population is better off?

I believe that the huge increase in size that our industry experienced in the run up to 2008 was the factor that has caused most of the negative issues we now face.

While this increase in size was undoubtedly a good thing for the short term economics of General Partners, it has not been good for Limited Partners, for investment returns or indeed long term for most General Partners. 

The expansion period changed the industry in two ways.  First it distorted the alignment of interest between General Partner and Limited Partner. Second, bigger funds combined with ever increasing supplies of leverage were supposed to find increased returns and new opportunities at an ever increasing rate.  In contrast to this expectation, size and leverage instead fundamentally destroyed private equity’s position as an alternative investment.  

As I have commented before, private equity reached a size in the bubble era where it generated so much fee income for General Partners that much of the long-term alignment of interest between General Partners and Limited Partners ceased to exist.  What mattered most to General Partners was investing quickly so they could raise bigger funds and generate more fees.  Long-term investment performance and alignment through carried interest became a secondary motivation. 

In fact, performance almost became a minor consideration, because, as a result of the huge amount of capital raised that needed to be invested, the private equity industry found itself struggling to find a sufficient number of deals where it could truly create value.  Thus returns became increasingly market dependent.  

In contrast to public equity the costs involved in funding, making, managing and exiting a private equity investment are significant. 

Consequently private equity can only justify these costs by adding lasting strategic and operational value to its portfolio companies and not being simply a leveraged proxy for the public markets.    

However, creating such value is very difficult to achieve and the opportunity to do so is not present at all times.  In truth, during the bubble years, the ever-increasing amounts of cheap leverage provided by banks disguised the fact that private equity was struggling to find opportunities that offered suitable returns for its ever growing pool of equity. 

General Partners were stretching to find attractive LBO opportunities and hence real returns, on a risk-adjusted basis, were becoming lower and lower, especially as entry prices were being driven up by the flood of leveraged capital.  

However, I am optimistic about the future because the LBO model is being forced back to its roots.

Going forward, General Partners will work on fewer deals and their focus will be on driving real operational and strategic value in businesses. This was the reason behind the adoption of private equity as an ‘alternative investment strategy’ by the endowments all those years ago.  In moving the LBO model in this direction, we will once again be an industry that delivers returns that are not highly correlated to the public equity market. 

Over recent years LBO investments ceased to be alternative due in large part to having too much, not too little leverage.  The lack of leverage that now exists has unearthed leverage’s central role in generating returns during the boom years. 

We need to remember the two big differences between private equity investing and long only investing in public stocks. One is illiquidity, and as we have seen in recent times, the more you need liquidity, the less that is available. And the second is that, in private equity you control the business; you own it and are accountable for its performance and you are responsible for what decisions it takes during the tough times.  

The fact is though that if you have a view on currency or a country etc, then private equity is not the way to play it.

So while the illiquidity of private equity has disadvantages for investors, the advantages of having control, for those with the guts to be bold, far outweigh the disadvantages so long as one is able to maintain optionality over the investment. 

It is that optionality that allows you to steer a business through difficulties and changing markets. If you can do this, you will be well positioned to grow the business when we come out the other side of this economic storm and deliver value to your Limited Partners.  

I therefore believe that the LBO private equity model can be fixed but it is going to be painful as the industry gets back to the reason behind its formation.

General Partners who make this adjustment will provide good returns for their Limited Partners. Furthermore, those returns will be more consistent than those of recent years. 

Turning to the macro economy, I think that unfortunately we are more likely in the eye of the storm rather than through the storm. There is $7 trillion of financing up for refinancing in the next few years. Banks have not really dealt with the issue, especially those now under effective state ownership in Europe, and any real growth in the West will be difficult until this occurs.  

Nonetheless, even the most difficult economic environments yield opportunities for those who are bold enough.

The fact is though, as we have seen from the remarkably low level of new deal activity this year, few people are bold enough to act or transact yet.  

In my opinion, the good opportunities that private equity should pursue going forward will all have similar characteristics.

First, they will come from forced sellers who face some type of financing challenge, either with a particular business or elsewhere in their portfolio. 

Second, they will require the purchaser to take a contrarian view, to believe that a business is not only cheap in relation to recent historic levels but it is also cheap intrinsically. In today’s market, investors have to take the most uncomfortable of views – the contrarian view – in order to find value.  This is a stance that few are currently willing to take.  

Third, as discussed earlier, these deals will be made with a very significant equity component, with little leverage.  

Fourth, while many of these deals may start small, part of the investment thesis will be to invest further capital to generate additional value.  This may be through capital expenditure on building or improving the assets, or through using these businesses as platforms to make further acquisitions in the same sector.   

Fifth, these will be deals which need significant operational and strategic improvement and real business expertise, not financial engineering. 

However, the part of the private equity model that is in most trouble is the business model that many General Partners have been using to attract people into private equity which assumed massive continual growth of the private equity industry.

I saw an IPO prospectus for a General Partner a couple of years ago which had the General Partner growing to have assets under management of $200 billion. 

It is clear however that going forward it is going to be much more difficult to raise private equity capital. In fact, future funds will likely be half as big as they were during the bubble period and will take twice as long to invest. Correspondingly, General Partner income will fall very significantly.  The simple maths would imply a 75% decline in General Partner overall per annum fee income, and that is before any change in fee arrangements brought about by Limited Partner pressure.

Such a fundamental shift downward in the income of General Partners will have a significant impact on the motivation of many General Partners and will result in a sizable number of people exiting the industry.

While this contraction will be good for the long-term health of the industry, the process of change will be painful. Limited Partners have a substantial interest in understanding who will leave the business, how they will leave and when they will leave, as they have a great deal of capital invested in portfolio companies that still require management and oversight, not to mention undrawn capital commitments.   

Some recent high profile examples illustrate how the process of downsizing in private equity is proving to be anything but smooth. 

I am not suggesting there will be a wholesale meltdown of General Partners. There remains a significant amount of capital in the private equity system that is generating fees and providing a cushion for private equity employees, so the exodus is likely to be measured. 

However, the partners at General Partners are realising that future capital raising, and therefore General Partner income, will be substantially lower than in the past. Moreover, most carry on current funds is under water and there are partners at General Partners who are asking, or considering asking, for the hurdles to be reset on the capital already under management. 

In other cases, younger partners are asking for increased cash compensation that can only be funded out of older partners’ pockets.  The response of many older partners, when asked such a question, is unsurprisingly “no”.    

Meanwhile Limited Partners are quite rightly asserting that a deal is a deal and why should they change the carry hurdle? In fact, these compensation issues are arising not just at General Partners but also in private equity portfolio companies where most long-term incentive plans are substantially under water. Terra Firma has spent a large amount of time dealing with this issue sensitively.  

These are substantial problems that our industry face today both in the management of private equity firms and in the management of our LBO investments, and they must be dealt with sensitively as they will dictate our environment and our success going forward. 

So, the days of making a quick buck in private equity are over and while some General Partners might still be able to get very rich, it is going to take a lot longer and be far more difficult.  

I think the changes to private equity that I have discussed will result in a different type of person joining our industry in the future.  The new entrants will come with less financial experience and have more operational expertise.  They will be genuinely interested in business as opposed to being focused on making as much money as quickly as possible.  

All of these factors will change the LBO model back to what it should be.  

We face challenges at numerous levels but despite this I still believe the private equity strategy at its roots has much to offer as an alternative asset class in this new environment.  

If private equity can add operational value to businesses, move businesses forward and help them deal with our radically changing world, then we will generate attractive returns for our limited partners and add value for all stakeholders.  

In the future, the private equity industry will be smaller, but it will be considerably better at delivering long-term value which is exactly what the LBO model should be about. 

Thank you.

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