03 March 2014
Guy Hands Speech at SuperReturn Berlin: "Private Equity: The Forces Impacting Returns"
Last year at this event I said that there were increasing opportunities in private equity in Europe, though not to the same level as in the US where the debt markets had reopened fully.
A year later, the balance has shifted. In the US, rising prices mean there is a lack of good buying opportunities. By contrast, assets in Europe are under-priced, while the European economy is poised for a recovery following years of crisis and uncertainty. Opportunities now exist in the recovering European market. Banks will increasingly dispose of the bad loans to zombie companies that they have been holding on their balance sheets, while corporates are focusing on their core businesses, which will also lead to disposals. And governments are selling assets to reduce debt levels.
Consequently, there is a compelling opportunity to invest in Europe, with the possibility of attractive returns for GPs with the right strategies. That is to focus on cash-starved companies, that have been neglected during years of recession and tight credit, which are now in need of new strategies and direction.
This is attractive but what will returns look like going forward? In answering this question we need to decide what we are seeking to achieve: alpha or beta. Private equity as an asset class will, over the long term, deliver substantial beta returns. The statistics on this are compelling. A study conducted by Stephen Kaplan at the University of Chicago found that buyout fund performance has exceeded that of public markets for most vintages over a long period of time, showing average outperformance of a private equity fund versus the S&P 500 to be 3% per annum.
This occurs because private equity has certain advantages when it comes to returns.
First, we in private equity can take a more long-term view. We raise capital that is committed for a decade and we use it to improve businesses. By contrast, listed companies have struggled to maintain a long-term perspective, largely due to the demands of quarterly reporting.
Operating outside the public markets also gives us the control and flexibility to make decisions about strategy and management swiftly and decisively. As an industry, we are good at effecting change.
Taken together these advantages create a positive beta effect for private equity compared with the public markets. However, what we are seeing when we look at these returns is the effect of a mixture of different alphas that produce the overall blended substantial beta of the private equity industry. And the drivers of alpha are different between private equity firms.
So what drives alpha? McKinsey recently did a white paper called “Getting to the heart of PE returns” that sets out a number of factors, such as management’s ability to grow a business organically, to improve capital efficiency, and to generate performance through re-pricing the offer. There are many others that are also valid. However, as the market has become more competitive over the past 20 years, using past performance to indicate future performance has become less and less reliable. What seems to matter most in selecting for alpha is not which particular levers a GP has used to drive returns in the past, but how well they understand and deploy these drivers.
If fund managers lack this fundamental understanding then investing with them is going to be a random walk. If they do have a good understanding then the question is whether they can consistently stay ahead of the competition and create alpha. An LP seeking alpha should look for a GP who can demonstrate that they both understand the key drivers of their own performance and are able to consistently apply them across their portfolio.
The GP should be able to articulate their drivers of value and be able to explain how they have generated significant value across deals. In today’s market it is often specialist GPs that are best positioned to create alpha for the reason that they are more focused.
Terra Firma today is the culmination of 20 years of investment experience, and we consistently implement five key value drivers across our portfolio businesses:
- Transforming strategy;
- Strengthening the management team;
- Investing in capital expenditure;
- Building through mergers and acquisitions; and
- Lowering the cost of capital.
Equally importantly, we invest only in asset-backed businesses that are in essential industries and require fundamental change.
I’d like to share with you the example of one of our newest acquisitions, The Garden Centre Group, to demonstrate how private equity can drive superior returns in a business.
In 2012 we acquired The Garden Centre Group from Lloyds, who had seized it from its previous owners after they defaulted on their debt. We paid £276 million for the business in comparison to the £450 million that was paid for it in 2006.
The Garden Centre Group fits all three of our investment criteria. First, it is asset-backed: at the time of acquisition, the business had 129 garden centres with 7.6 million square feet of retail space.
Second, it is in an essential industry: gardening is a fundamental part of British culture. 8 out of 10 British households have a garden, and the older demographic, one which is growing rapidly in the UK, is far more likely to engage in gardening.
And finally, it was a business in need of fundamental change. Under its previous owner as well as during its ownership by Lloyds, The Garden Centre Group had been severely capital constrained. It owns 139 garden centres in a very fragmented market, and we knew we could invest in growing the business both through capex and through consolidation.
Through the application of Terra Firma’s five key value drivers, less than two years into our ownership of the business, we have increased like-for-like EBITDA by more than 50% and acquired a further 10 garden centres.
First, we transformed the strategy. We conducted a site-by-site analysis of the estate and found that while the business served the gardening consumer well, it didn’t have a very attractive offering to the leisure customer, such as the family who enjoys a day out at a garden centre to look at the plants and have lunch. Consequently, we are reorienting the estate to ensure that we have a good offering for all garden centre customers and not just the plant specialists.
Second, we strengthened the management. We brought in a new CEO and a new Chairman, and we put in a former Terra Firma director as the new CFO.
Third, we are developing the estate through capital expenditure.
Fourth, we are growing the business through M&A. Since the acquisition we have grown the business through the purchase of 10 additional garden centres, and we have plans for further acquisitions.
And finally, we will look to lower the cost of capital. The freehold properties within the portfolio offer the potential to refinance at attractive rates once operational changes begin to produce results.
Together, these changes have already had a significant impact on the bottom line. Terra Firma has been able to make such an impact so quickly precisely because of the advantages of private equity: we were able to quickly take control, decide on a strategy and act upon it. We have a large team of in-house operational professionals who are overseeing the transformation to ensure its success, and we seconded Terra Firma staff to work directly in the business.
I would caution though that while we are consistent in our method, it cannot become formulaic and always needs to be able to adapt to differing circumstances. Additionally, at Terra Firma we are constantly seeking a better way of doing things, rather than simply continuing to do things the same way. A continual willingness to question and refine our strategy and its implementation in each business we own helps us do things better, and is driven by our philosophy.
The great advantage that private equity has is that the shareholder controls the business directly. However, this leads to private equity’s greatest challenge, which is knowing where to intervene and where not to.
Terra Firma has been regarded as one of Europe’s most interventionist private equity firms, but over the last 20 years we have learned that it’s not just about being interventionist, it’s about knowing where to be interventionist.
Many people say surely it’s also about knowing when to intervene, but my experience over the last 20 years has taught me that this is normally not the case. “When” is normally just an excuse for not taking the hard decision.
For example: Terra Firma has great financing skills, and it was totally appropriate that when it came to the Tank & Rast refinancing last year, a full team from Terra Firma worked hand-in-glove with management to get the deal done. This is a deal which has transformed the prospects for the company.
However, it is not our job to focus on other aspects of the business, such as how capex programs are implemented.
In some of our businesses in the past, we have not had confidence in the management team’s ability to implement the agreed strategy, and we have supported them with individuals working directly in the business, often as many as a dozen of them – the argument being that this was when it was right to intervene. However, experience has taught me that this is not when it is right to intervene. Instead, this is when it is right to change the management team, even if it means you’re making your third change in two years.
Terra Firma’s most successful deal ever involved changing the management team after the first board meeting. Our second most successful deal ever saw us change the management team four times in the first two years before we got the right team.
When operating a control model, as Terra Firma does, it is about knowing where to intervene in the business, and when to change management.
Private equity has the benefit of direct ownership, and the ultimate advantage of having the right, and indeed the obligation, to change management teams when necessary.
I recently interviewed an individual for a CEO role. Having inherited a senior team of 15 people five years earlier, he told me that he had only made one change on this team in five years as CEO. I did not hire him.
As LPs, you should not invest in GPs who claim to be interventionist but have not taken the tough decision to change management.
Right now in Europe we see a lot of businesses similar to The Garden Centre Group coming onto the market, and a lot of opportunities to drive value with our transformational and interventionist approach. As Europe emerges from the crisis, many businesses will have been starved of investment as they were seeking to conserve cash. Management teams in these businesses will have been downgraded, exhausted or poorly incentivised – a change of ownership can bring in stronger management or provide better motivation for the existing team.
Private equity’s biggest opportunity to create alpha is through deep operational transformation. This approach is not easy; indeed, it requires a large amount of time, people and investment capital. However, in an era of increasing uncertainty and volatility, it is the main way for private equity to deliver alpha.