01 November 2009
2009 Q3 Investor Letter
Based on some of my letters and speeches predicting a smaller private equity industry, some people have concluded that I am negative on private equity. This is certainly not the case. The fact is that the industry needs to shrink because, on the whole, we raised too much capital too quickly. As General Partners, we must change and improve how we organise and apply ourselves to the investing of your capital, in order to generate more value for you, our investors. Indeed, the private equity industry is already adjusting constructively as it shrinks. Fundamentally, I believe that the private equity model of business ownership is superior to any of the alternatives, but that is not to say that it can expand without limit. My view on private equity is similar to that of Churchill’s on democracy as being “the worst form of government except all others that have been tried.”
The private equity industry will be significantly smaller in the medium term and this will be a good thing. Some observers believe that its shrinkage is an ominous sign of its decline as a form of ownership and force for change. Those who make this claim are missing the point; size is not a measurement of effectiveness. It is a bit like what President Sarkozy was arguing for when he wanted to add 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. The size of GDP, or its rate of growth, is clearly not necessarily a reflection of positive experiences or the satisfaction of the general population. 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 £58 per week per person. Which country’s population is better off?
A smaller private equity industry will improve the alignment of interest between GPs and LPs and will enable GPs to add more value to their portfolio companies. While the increase in size of the private equity industry over the last decade has undoubtedly been good for the economics of GPs, I am unconvinced that it has been good for LPs. As I have commented before, the truth is that private equity reached a size whereby it generated so much fee income for GPs that much of the long-term alignment of interest between GPs and LPs ceased to exist. What mattered most to GPs was investing quickly so they could raise bigger funds and generate more fees. Long-term investment performance and the income generated 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, private equity struggled to find a sufficient number of deals where it could truly create value, and returns became increasingly market dependent. As we all know, the costs involved in making, managing and exiting a private equity investment are significant. Private equity can only justify these costs by adding lasting strategic and operational value. However, adding such value is not just difficult to achieve, the opportunity to do so does not come along all the time. LPs, therefore, will be better off if private equity does fewer deals, leaves more businesses in the public domain and allows LPs to commit more capital to the public debt markets. This would provide businesses with the debt financing that banks are no longer able to deliver. In truth, during the bubble years, the ever-increasing amounts of cheaper leverage provided by banks disguised the fact that private equity was struggling to find opportunities that offered suitable returns and that returns, on a risk-adjusted basis, were becoming lower and lower.
The removal of gearing from the industry and the exposure of leverage’s central role in generating returns during the boom years is requiring private equity to add more value to its businesses. At Terra Firma, we have long believed that value is driven through having a large operational team dedicated to doing just that. Therefore, we continue to seek additional operational personnel at the highest levels, as we believe that operational capability is key to the value proposition of our business model and our ability to take on further investments and grow.
Returning to the outlook for the industry, I believe future funds will be half as big as they were during the bubble period and will take twice as long to invest. Correspondingly, GP income will fall very significantly. The simple maths would imply a 75% decline in GP overall fee income, and that is before any change in fee arrangements brought about by LP pressure. Such a fundamental shift downward in the income of GPs will have a significant impact on the motivation of many GPs 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. LPs 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. The lack of stability among certain groups is thus a major concern for many LPs. Some recent high profile examples illustrate how the process of downsizing in private equity is proving to be anything but smooth, and that will continue to be the case.
Currently, there remains a significant amount of capital in the private equity system that is generating fees and providing a cushion for private equity employees. However, the partners at GPs are realising that future capital raising, and therefore GP income, will be substantially lower than in the past. Moreover, most carry on current funds is under water and there are partners at GPs 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, LPs are quite rightly asserting that a deal is a deal and why should they change the carry hurdle? In fact, these issues arise not just at GPs but in portfolio companies where most long-term incentive plans (“LTIPS”) are also substantially under water. Handling such compensation matters is undoubtedly very difficult and needs to be done sensitively.
At Terra Firma, we have always sought to address this by not offering the highest levels of current compensation. Our model of having a large team, funded by a basic management fee and crediting to LPs all other fees that we earn, simply does not allow for it. There is no discussion about re-dividing surplus cash amongst employees because there is no surplus cash. The wealth creation of our employees is only driven by the capital they invest in our funds and the carry that they might earn if the funds are successful. Terra Firma, including the investment by its employees, is the largest LP in TFCP III, and this creates a very high degree of alignment with our investors. We take a similar approach to the compensation of key executives in our portfolio businesses who equally do not expect large salaries or big cash bonuses.
For some potential employees, both within Terra Firma and within our portfolio companies, this model has made us less attractive and they have chosen to work elsewhere. However, I am certain that our approach to remuneration has created a better and more stable organisation for those who work at Terra Firma and in our portfolio companies and provides a much closer alignment with the interests of our LPs.
In fact, I think the changes to private equity that I describe above 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 fixated on making as much money as quickly as possible. All of this will change the focus of private equity back to where it should be, on the business of making sound long-term, value-added investments as opposed to delivering clever financial engineering.
Given my roots as an entrepreneur, I could never be anything other than fundamentally pro private equity. So, while the next period will be a painful one for the industry to go through, I believe the changes underway will make for a smaller, better industry that truly delivers value for its investors.
With best wishes