Chairman's letters

10 July 2015

Guy Hands Speech at Terra Firma Hong Kong Investment Summit

Good afternoon and thank you all for being here today. It is very good to be in Hong Kong again and to see so many of our investors and friends here. I always look forward to my visits to Hong Kong, which I think is one of the most dynamic and creative places in the world.

I’m here today to talk about the future. The future of private equity, and the future of Terra Firma. If I look at the future, I think there are two things for me to focus on. One is the PE industry as a whole, and the other is, obviously, Terra Firma, and how does it fit into that? How do we take the last 13 years of partnership relationships – over 190 worldwide – and how do we bring that to another level and develop it in the future?

Over the last last 3-4 months I’ve raised some ideas and had an interchange of thoughts, processes, fears, dreams, ambitions, with about 50 investors in Europe, North America, the Middle East and Asia.

And I think today is a good opportunity to talk about what I heard, and what I learnt, and to share with you.

There were some very consistent points, very important points, that came up in most of those fifty meetings.

Number one:  investors want alpha from their private equity investments.

And that might sound like a statement of the obvious, but the reality is, over the last few years, the alpha delivered by private equity has reduced, and investors have seen that. PE has done very well because since 2009, the markets have done very well. But the actual alpha provided by PE has reduced substantially.

As a number of sophisticated investors said to me, the PE industry is really providing us with leveraged beta. And expensive leveraged beta at that.

And some, a handful, went further and said, ‘we can create, effectively, something that tracks what private equity does, but at a vastly lower cost for a handful of basis points.’

And some went even further, and said, if the private equity industry doesn’t change, they’re going to get “dis-intermediated”, the same way as a lot of other asset managers have, in a lot of other businesses.

Secondly, and I suppose not surprisingly, following on from this, pretty well all the investors I saw, said they wanted lower fees. They believe that fees were too high, particularly in two areas: un-invested capital, where they pointed out that the current amount of money available will last about 10 years, so on average they will be paying 7.5% per annum on invested capital. Additionally they saw fees as far too high on large funds, where they feel the amount earned is so enormous now, that in reality the carry has become pretty irrelevant and the larger GP’s are just managing for fees.

Now, when we formed Terra Firma back in 2002, we looked at the relationship between LPs and GPs, how GPs got paid and how LPs paid GPs, and we became one of the first PE firms to agree not to charge any monitoring, any board or any transaction fees, and further, to refund (and this is back in 2002) to refund 100% of these fees that we earned.

And that was pretty unusual at the time. Today, it’s not quite universal out there, but it’s almost universal.

Well I am going to announce another first. Going forward, and I hope this becomes the norm in the industry, going forward we will not charge any fees on uninvested capital. We will only charge fees on invested capital.

The next thing that investors said to me was that they wanted fewer relationships, but they wanted closer relationships.

Now to be blunt and honest, this is a two-way thing. I can well understand LPs not wanting to have so many relationships, so that they can get a better understanding of what the GP is doing. But the reality is that for GPs to give a proper service to LPs, GPs as well need to have fewer relationships. You can’t actually have a really close relationship with 190 LPs.

So, I am sure this is a strange thing for a GP to say, but we actually want to have less relationships, but we want to have much deeper relationships. We want to have relationships where we can co-invest together, where we can discuss what is going on in the market. I am not saying that we will go back quite to the relationship, we had when Nomura was our sole backer, where we could literally walk upstairs and shoot the breeze, discuss a deal, but I want to go back to the sort of relationship where you can get on the phone and you can go round the majority of your investors in around two and a half hours and say “what do you think about this?”

The final point was that, and I think in some ways, the most important point, and I say that because of what we’ve seen in all of our businesses over the last 20 years, LPs wanted GPs to have “skin in the game”. They wanted a real, economic alignment of interest. Because, as some of them said, they saw this as the biggest indicator of future performance. The reality from all the surveys out there that they’ve done is that the past is no indication of the future performance of a PE fund – there is absolutely no correlation at all. But whether people have skin in the game or not is a very big indicator.

So, in the same way as we will not charge fees on any uncommitted capital, going forward, we are similarly not going to sponsor any deal, unless we can put at least 10% of our own money into it. Because we think that’s important to you our investors and to our own alignment of interest.  

Overall, based on the overall feedback there, from you, our partners, I strongly believe that there is a need to recreate alignment between GPs and LPs in order to be in a position to recreate alpha together. In short the industry needs to go “back to the future”.

Now, going back to the future also chimes very well with some of the “mega trends” that are under way in the industry at the moment. And let me highlight a few of them, and you’ll probably understand why the fund of fund firm didn’t want me to continue to come to their conferences.

First, GPs out there are sitting on a record pile of “dry powder”, while new deals are at a 13 year low. There is more than $1 trillion of un-invested dry powder out there. And that is excluding roughly the same amount that’s been set aside by sovereign wealth funds etc. to invest directly or through co-investment vehicles.

LPs are not excited about paying $15bn a year in fees, with a less than 1 in 10 chance that the money gets invested each year.

Not surprisingly, on the face of that, the larger LPs are increasingly putting more money into specialist separate accounts, secondaries, co-investments, joint ventures, and directs.

As I said, by some estimates, only half the money now going into private equity investments, is going in from funds; the rest is going in directly.

Now a reason, of course, that the ‘dry powder’ out there is so high, is because valuations are also so high, and there is a severe shortage of deals on the table. The other side of that coin is that the market for exits is very good, and exits are at a record high.

Meanwhile, because investors tend to look at the past even though they should not, and because investors are getting huge amounts of capital back and investors are using that to reinvest in PE the big firms are getting bigger and bigger.

The big global private equity firms have become brand name asset managers. They’ve become household names.

But the amount of skin applied directly to funds is falling, a fair number of funds now put in less than 1% and that less than 1% is really not connected with the employees who are managing the money.

Sometimes you’ve got hundreds of employees and sometimes you’ve got literally thousands.

And those employees, and I interview a lot of them, have little or no real connection to their investments, to the firm, or to their investors. They have effectively become very like where they came from – investment bankers, or consultants.

Meanwhile, the smaller firms, the ones that are still entrepreneurial, the ones that still do have a big connection, are finding it difficult to survive.  Many of them, 140 in Europe alone, have not raised new funds since the credit crisis.

Now, in talking to investors out there, I came up with a message for Terra Firma, for ourselves, for myself, but also for those firms. And that is if you are going to survive in this new private equity world, you’re going to have to do something different from the big guys. The investors I met had absolutely no interest in smaller firms just doing the same thing. They wanted them to do something different.

But they also said that a lot of the smaller firms they see, are really just smaller ‘me too’ versions of the big firms.

Now away from that, investors continue to express confidence in the industry, but if you look at overall returns since the crisis, (and since the crisis should have been a very, very good time for Private Equity, particularly in the States, where the bail out of the banks really did help, and get transferred across to refinancings and revaluations) but if you
look at the returns in PE, most funds have not outperformed the public markets, even with the additional leverage they have.

And the US endowments, the original sponsors of the Private Equity industry, nearly forty years ago – the Harvards, the Princetons, the organisations which really do know this industry, they have recently started to cut back. Their estimate is they are going to cut back their allocation to Private Equity by 20% over the next year.

So, unless and until the Private Equity industry can start to add alpha again, there’s going to be a question mark hanging over the whole industry in terms of ‘are LPs really getting value for money at these fee levels?’

So what do these trends, these mega trends mean for a firm like Terra Firma? And here, what I did was I combined the trends out there, which are mega, with what I was told by the investors I saw. The number one thing that came across, is that in Private Equity, and in Terra Firma, we need to be much more creative, we need to be much more bold, we need to be much more entrepreneurial. We need to come up with new ideas, not copy old ideas. New ideas for our deals, new ideas for our funds, and new ideas for our businesses.

The old days of pouring over lists compiled by investments banks of deals that were going to come up for sale, choosing one of them, or five or six of them, and hoping there wasn’t too much competition so you could buy  reasonably cheap, and then sell on to someone else, those days have gone. As a Private Equity practitioner today, if you are going to create alpha, you need to be imaginative. You need to be able to think out of the box. You need to do something different.

But you also need to be quick. Too often, in the past, we have seen great opportunities out there, and then we’ve lost them, because it took too long to raise the money for the transaction, it was not part of our core strategy or it wasn’t suitable as an investment in a blind pool fund.

So we need to be much more flexible in how we raise money, much more flexible in how we get rewarded, and much more flexible in how we ensure that we know what investors want to do.

It’s about understanding, as a PE firm, which investors can move quickly enough, which investors you can get close enough to, which investors, if you see something, can do it quickly.

It’s quite difficult for a Private Equity firm to accept that actually your LPs might have better information and better knowledge than you have. But going forward, I believe that creating alpha is about creating a partnership with some of your LPs, so that you can be quick, so that you won’t lose these opportunities, and so that you can bounce ideas off them and ask them,  ‘you’ve invested in 3,000 companies, have you ever seen this? Is there anything you remember about it?’

Now, that doesn’t mean the world is going to say goodbye to traditional blind pool funds – they’ll continue, but for major LP’s they will become less important.

Terra Firma today has a billion euros to spend because, we’ve been the biggest investor in our funds and 4 out of the 5 funds we have done have done very well. We like to be the biggest investor in our funds. We want to have more skin in the game than anyone else. And today having our own committed capital means that we can now concentrate on being more flexible, being more creative. We can use the capital to make investments off our balance sheet which could then be syndicated or sold down later, we can make investments in conjunction with our LPs, either as a co-investment
structure, a direct structure, or we could even set up a public company if we wanted to. We can look at how we can use that money, and be as creative and flexible as we need to.

Something that also came out of the conversations I had with people, was ‘what have you learnt over the last 20 years?’ We’ve learnt a lot. The scars will be there for the rest of my life, but we have learnt a lot.

But there are three lessons which I think are the most important:

Number one is to limit deal concentration in blind pool funds.

Number two, do not do cross fund deals.

And number three, nobody ever does a deal thinking it’s a bad deal. So try and equal invest. Something that Harvard look at when they look at investing in a Private Equity fund – you’ll find the statistics are really interesting when you start looking at different Private Equity firms on an equal investment basis. It tells you a lot about their ability to create value on individual deals.

So, we are going to be investing 10% at least in every deal we come up with, every strategy, every idea. We are not going to be charging anything on uncommitted capital, and we are going to be trying to have very deep, close relationships with our investors.

Our strategy going forward is going to be to be entrepreneurial, opportunistic, aligned to our investors, to minimise fees, but maximise carry, and above all, to generate alpha.

So, the big question, of course, is what are we going to actually invest this money in? Where do we see the big opportunities out there?

Let me answer that question, first by coming back to what you, our investors, think we’re good at:

Number one, you think we are very good at deal execution, business optimisation and credit analysis.

You think we’re good at this because we’re very thorough and you like the large pool of analysts we have, and the fact that we have people who have enormous long term experience working in the same way, and creating the same, strong, Terra Firma culture.

Your view is that our strengths are in transformational Private Equity, in Real Estate, in infrastructure and in complex transactions that require high levels of credit, legal, financial, regulatory, operational and technical expertise.

You don’t think we’re particularly good at commodities.  That’s probably true. I’m not sure anyone is particularly good at commodities.  Actually, it’s an interesting question whether anyone can predict where commodity prices are going to go over any length of time. And Private Equity isn’t the best place to do it.

Finally, you know that we have particular experience in Europe, most of our deals have been European. And you agree with us that Europe, going forward, is going to be a good hunting ground for the sort of deals we do best.

You have a situation where the banks are recovering – quantitative easing in Europe is going to allow a lot of these banks to sell their bad deals, deals which have been sitting around for years, without capital, without focus, with a disinterested management team. And these are the sort of deals you think we’re good at.

You like our 20 year track record, our ability to think out of the box. You like our ability to transform under-resourced or poorly-managed companies.

You like the way we use our five drivers – the ability to transform strategy, strengthen management, develop through capex, build through M&A and reduce the cost of capital.

On Real Estate, you think what’s been done on residential has been very good. You look at the success of Annington and the success of Deutsche Annington. You want us to focus on that. And when I look at the money we’ve got on our balance sheet, I think that’s an area where we should focus as well.

I want to be going for deals in Private Equity which produce 20% plus returns – I want to go for deals like the garden centre – deals which are unique. Deals on which we can bring our skills to bear. Deals which will create alpha for us and our LP’s.

I want to thank you all for  joining us today. The last twenty years have been an extraordinary experience and I can promise you the next twenty years will be just as interesting, they’ll be exciting, and they’ll be rewarding. Thank you. 

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