Chairman's letters

09 March 2016

Guy Hands speech at SuperReturn Berlin: Private equity investment in an uncertain world

Last month, I spoke to an audience of several hundred students from around the world about how to forge their own paths in a time that feels increasingly more uncertain and scary. They felt that today is unusual in that they face more difficulties than previous generations have faced and they might be worse off than their parents.

I told them that they were wrong, the world in fact is normally a dangerous and unpredictable place, and in the past there has not been a guarantee that one will do better than one’s parents. Indeed, the approximately 50 years between the 1950s and the global financial crisis were a unique time of predictability and consistent development, and that period has now ended. 

The period started post the Second World War with the end of British and French imperialism, and the humiliation of these two countries during the Suez crisis – a humiliation which the right wing of the UK political class has never been able to quite get over. This is key to understanding why the UK is now considering leaving the EU, as some in Britain try to pull up the drawbridge to Europe and hope that by doing so that the problems of living in a global world will go away and that Britain can go back to a golden age.

Most people forget that in 1956, the US chose to support Arab independence rather than British and French imperialism. In doing, the US became one of the major players in the Middle East, along with the Soviet Union. The period of US dominance in the Middle East ended after the invasion of Afghanistan and the second Iraq war. Almost immediately thereafter, the American economy was badly damaged by the subprime mortgage crisis and the credit implosion of 2007. US global domination ended both politically and financially.

The West’s 50-year period of peace had begun and ended with American idealism. For 50 years, people around the world believed in the American dream of freedom, democracy and ever-increasing prosperity. America’s military and economic domination provided the world with stability, and gave rise to the biggest 50-year increase in living standards, population growth, life expectancy and productivity the world has ever seen. 

This was an unusual period, and those of my generation in the West were lucky to experience it. We are now returning to a world where uncertainty is normal, be it the rise of extremist politicians in the West, wars and failed states in the Middle East, heightened Russian militarism, the potential exit of Britain from the EU, and the possible breakdown of nation-states across Europe – be it Scotland leaving the UK, Catalonia leaving Spain or Flanders leaving Belgium, let alone what will happen to Ukraine and the other states that border Russia. In many ways, we are seeing the unwinding of the unfinished business of the Second World War, and the result of the humiliation of Russia following the Soviet break-up.  The conflicts and divisions of previous centuries are rising to the surface as we see America and the European Union weaken. And as division increases amongst allies, our enemies look on and plan how they can take advantage of the chaos.

Here in the West, we like to think that our people are better educated and more moderate than those elsewhere, and that the breakdowns that have occurred in Syria, Libya or Iraq couldn’t occur in Europe. We forget what happened when Yugoslavia broke apart, how friends turned on friends and the deaths which resulted. We’ve managed to largely forget the horrors that have occurred in Europe even within the short lifetimes of the students whom I was addressing, and we try to block from our minds the rise of extremism and increasing xenophobic violence across Europe. In short, we take peace for granted and forget how difficult it was to obtain, and how easily it can be lost.

I could talk for hours about the risks to European peace that are being encouraged by the success of extremist parties across Europe, about how the only certain winners from Britain leaving the EU will be Russia. Or how international institutions such as the EU and the UN have made the world a better place in spite of their obvious failings and need for reform. Or why, for the future of those students I met, and for other young people, I believe Britain staying in the EU is the right thing for Britain and for Europe. 

However, I recognise that this is a private equity conference, not a political conference. I will therefore move on, having I hope set the stage for you to consider the context that our industry in Europe will be operating in going forward. The world we will be operating in is not one for spreadsheets and computer geeks, but one for careful business judgment and people with experience.

In November, when I spoke at the SuperInvestor conference in Amsterdam, I pointed out that the private equity industry was changing and that many people in it were unhappy. At the time, many people questioned this view, asking why successful private equity people would want to call it quits on a business that paid them so well. However, since then, the press has been full of people retiring from private equity or leaving the industry in order to pursue other ambitions.

As I told that roomful of students in January: you have to figure out what you love and what you’re good at, and then go for it. Now most of you in this room are older than those students, which means you have less time to pursue your passion if you have not yet done so.

More people in our industry are saying to themselves, I’m 50, I can’t guarantee I’ll be healthy in 20 years, or even alive for that matter, so I may as well focus on doing what really makes me happy – whether that’s running a small farm, building and skippering a boat, becoming a philanthropist or even going into politics. You’re all lucky – you have the opportunity to make a choice.

Hopefully, some of you are still saying to yourselves each morning that you are passionate about private equity. That’s a good thing as investors in particular want to know that their GPs are committed, and that they love what they do. They know that you’ll find it a lot easier to commit if you are positive about what you are doing.

For those of you who follow football, it’s like being Leicester City. Last summer, no one would have expected them to be leading the Premier League – in fact, most people thought their manager would be fired after the first few games of the season. But Leicester City is an organisation which has found a strong belief in itself, and whose players are extremely committed – and today, they are top of the league.

Right now we are building the Terra Firma team for the future, and we are looking for people who will be committed for the next ten to twenty years, people who passionately enjoy private equity and who want to be in it because there is nothing else they would rather be doing. 

The team that Justin and I are looking for will all have to have the following three characteristics:- First, they have to be able to generate alpha. Every morning they need to be able to look themselves in the mirror and answer the question, how can I add value for our investors today?- Second, they have to want to be aligned with our investors, and to succeed or fail alongside them, getting paid based on performance, not just for working hard.- And third, they have to enjoy the business they are in and respect the people they work with.

These three factors are vital to building a successful, cohesive and committed team.

Private equity is entering a period where the winners won’t be the savviest financial engineers or the best fundraisers. Success will come to organisations where people have shared values, and where they are focused on the long term. These organisations will include people who will go the extra mile and roll up their sleeves to work on their portfolio businesses and analyse deals – because that is where alpha is generated.

Private equity firms make money by taking a close look at the businesses they buy, and then figuring out what they can change to make the business better and more profitable. Yet all too often, we do not apply this same scrutiny to our own private equity organisations. We rest on our laurels and assume that what worked in the past will work in the future. If our industry wants to be as successful over the next 20 years as it has been over the last 20, this has to change, for if as an industry we do not change, then there is a real risk that we will be disintermediated away.

At Terra Firma, we did for ourselves what we have been doing with our portfolio businesses for 20 years. We asked our customers: what changes do we need to make to ensure the long-term success of our firm? 

They told us that they wanted closer, better alignment, because if a GP has strong commitment and shared interest with its investors, then they could trust the GP to take the right risks and seize the right opportunities which would lead to alpha.

Last year at this same event, I announced Terra Firma’s shift towards closer partnership with LPs, with a focus on fewer, deeper relationships, no fees on uninvested capital and a 10% GP stake in every investment we made in order to ensure alignment of interest. While it made headlines at the time for being radical and different, in the year since I’ve seen others within our industry start to reassess their position on this front. 

By agreeing not to charge fees on uninvested capital, we had to make changes within our own organisation. Since we will only make money based on the long-term success of our investments, it made sense to structure people’s pay accordingly. We have therefore abolished short-term bonuses for our investment team and are instead giving them long-term incentives with aligned interests in Terra Firma funds and investments. 

As an industry, we need to shift to a longer term pay structure – investors are fed up with paying fees, and they want to see better alignment, which means GPs getting paid when LPs get returns, not GPs charging management fees on uninvested capital which they then use to pay themselves cash bonuses.

At Terra Firma, we have cancelled cash bonuses for professionals and reduced salaries. Instead we are compensating our employees with long-term incentives on the businesses and assets we own, as well as through allocating equity in the firm itself to the most senior members of Terra Firma. 

In addition to being committed and aligned to their investors, many GPs going forward will need to have a substantially differentiated offering to succeed in this changing private equity landscape. You can’t just rely on financial engineering anymore. 

While the megafunds are essentially delivering leveraged beta, many private equity investors still want alpha. Alpha is difficult and time-consuming to achieve, but smaller GPs can operate more nimbly and they have the flexibility to seize opportunities for creating alpha.

Alpha can come from a number of sources. 

It can come through deep, granular analysis of a business which guides your hands-on operational transformation. We have done this with our investment in garden centres in the UK – by understanding each and every garden centre, and the community in which they are situated, we have been able to customise each store’s offering and thus drive much higher revenue and earnings.

Alpha can also come through identifying long-term trends and fundamentally repositioning a business in response. Terra Firma did this with its pub investments. While many investors at the time saw pubs as an industry in terminal decline, we saw that while the old concept of a pub was no longer relevant, there was still a role for pubs in British life – they just looked a bit different. An old boozer could find new life as a gastropub, or a family-friendly pub, or even as a shop or restaurant. This insight helped us generate outstanding returns on our pub investments.

These are just a couple of examples of how a firm can generate alpha, if it has the flexibility to do so. An essential part of the flexibility needed to create alpha is having the ability to work closely with investors who can understand your approach, and who will support you when you take risks that have the potential to be hugely successful.

There are still plenty of investors who want to invest with the mega-funds and achieve safe beta.  But for LPs looking for alpha, the future is a closer partnership with fewer GPs.

Today there is more demand for private equity investment than ever before, but we must not take our investors for granted. If they are unhappy with our industry, they will find alternatives. Not all of them will necessarily go down the Canadian route of investing directly, but I wouldn’t be surprised if many more do. However, if we GPs partner closely with our investors, together we can seize the opportunities that changing markets throw up to create significant value.

The way to navigate this uncertain world is to work as GPs together with our investors, and to ensure that we are all aligned and pulling in the same direction.

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