Chairman's letters

20 November 2008

Speech to Super Investor, Paris - “The Future of Private Equity, how low can returns go?”

I suppose I deserve this topic as I’ve been saying for the last 15 months that things are going to get really, really bad!

However, I am a contrarian - so, I suppose I should now be positive; and indeed I am going to start by trying to be positive and looking for the silver lining that comes out of this financial storm.

My time in private equity has not always been easy when it comes to my relationship with my fellow General Partners.

I’ve been to General Partner gatherings, and various events, and though no one has actually thrown things at me, there has been a sense of uneasiness as I’ve walked into the room. I have been compared by some to the ghost of Banquo.

I’ve been taken aside by some General Partners and told “Please be quiet Guy.  Don’t scare the horses.”

However, in the last few months in the financial world there has been a change in attitude.  General Partners are becoming kinder, softer people and more accepting of differing views. Macho men are now in touch with their metro sexual side. They are displaying humility, empathy, tenderness – in fact, some are discovering that they are really quite nice people underneath all the bravado and they are willing to talk to me.

A year ago I said, to all who would listen, that the credit crunch was far more serious than people realised and that bankers in Europe were back in their baskets and would not be coming out for some time.

I said that the debt markets were closed and would stay closed for the foreseeable future with banks having stopped lending in any real size to anyone.

I also said that $3.5 trillion would be needed immediately from governments in order to keep the levels of liquidity at a level which would allow our financial systems to continue to operate.
I also said that the crisis would clearly spill into the broader economies of the world and that recessions were inevitable in the US, UK and Europe, and that the equity markets would plunge.

And what did many people say at the time?  They said I was at worst, barking mad and at best just plain wrong.  More importantly, they didn’t want to listen or consider the possibility that I could be right and what it would mean.

I told our investors there was a 40% chance of a depression as bad as the 1930s and I sent out the JK Galbraith book “The great crash” for Christmas.  Followed at our investor conference last June by the book “The Panic of 1907: Lessons Learned from the Market’s Perfect Storm”. 

Additionally, I told my team that the average General Partner would experience a decline in annual General Partner income of at least 75% and that fund raising would fall to below half of the annual levels of 2006 and 2007 with investment periods doubling in duration.

I suggested that bankers were hurting a great deal, and would not be lending into private equity mega deals for the foreseeable future.

The point being that when banks suffer, we all suffer, and that General Partners would have to face a world with less capital for private equity, lower fees and dwindling earnings.

And I said that “we were all in this together and that we would all suffer together” and I meant we would all suffer – for the excesses of the recent good times in the Western economies have not just been enjoyed by those in the banking world, in financial services, in accountancy or in  the legal  profession.

Many others on main street have also lived it up, and not just the senior executives and CEOs of public companies who have been rewarded with enormous pay increases over the last ten years.  But also many individuals like the gentleman in England who borrowed from Northern Rock and used the proceeds to invest in an Icelandic bank thus making a positive spread which he used to finance luxury holidays.  Or the young couples who used 110% mortgages to finance their honeymoons and new cars.  We had never had it so good and in the West, it was all driven by cheap debt and cheap foreign goods.

Indeed, in the US, in the first quarter of 2006, home equity extraction accounted for nearly 10% of all personal expenditure - effectively 20% of after tax spending.

So, many people have benefited from the credit boom of the last five years. Unfortunately almost all of us in the West, and particularly our children, will suffer from the coming down turn, the reduction in credit and the debt burden we are carrying.

The 2006 and 2007 era was one of such unfettered euphoria that our children and grandchildren will probably never ever see the like again.  We’d had it just too good, as I said at our conference in June 2006, “those were the days my friends, we thought they’d never end”.

But I want to be positive, and indeed, I stand before you today trying hard to be an optimist looking forward to a tough future but with realistic expectations.

Yes, I believe at least 50% of Hedge Funds will go out of business.

Yes, I believe average returns for the 2006/2007 private equity vintages in Europe will be negative.

Yes, I believe that the number of people employed in private equity will fall and those that remain will be paid substantially less.

But I still, on balance, do not believe we need to go into a 1930s style depression which took over 25 years and a world war to recover from and prevented the US stock market from fully recovering in real terms for a whole generation.

However, this will undoubtedly be the worst recession since the 1930s and it will be much more painful, and last longer than people think.  All of us have friends who have now lost their jobs, or are living in fear of losing them and we all have friends with no hope of receiving a pension that will be able to sustain their living standards into their old age. We all know young people who have studied hard and obtained qualifications only to have no prospects of work.  All of us have portfolio companies under pressure that will not be able to continue to employ the same number of people going forward or carry out their capex plans.

And no one should underestimate the personal effects of this human tragedy and just how difficult it will be for people to readjust their lives to the new reality.

But what can we in private equity do? 

At present, I meet three types of private equity General Partner:

One, those in denial: some of whom are trying to go forward using the same business model as in the past, continuing to bet on red;

Two, those caught in the headlights: who are scared stiff and not sure they really want to be in this business anymore; and 

Three, those who are working on developing new business models which allow them to go forward in this difficult economic environment and add real value.

As this recession deepens, the world will be looking for scapegoats and we are most definitely easy targets.  Therefore the urgent question for private equity, is how do we take what was good about our business and make sure it is not thrown out with the bath water?  For private equity has a vital role to play in rebuilding growth in our economies.

We need to build a long term private equity business which does provide something different from the public markets.  It cannot just be a play on leverage or the purchasing of distressed assets at cheap prices.  We need to truly enhance returns not just increase earnings and volatility through leverage.

And so, I come back to what I always say about private equity.  It should be about doing deals which deliver fundamental change and develop and improve the operations of our businesses. 

Private equity should be about supporting growth and focusing on the core strengths in our companies. This is the way for private equity to generate true alpha as opposed to simply owning an investment with a high beta due to high leverage.

Implementing operational and strategic change of this type is not easy; it requires more people and different skills.  It requires specialist operational personnel who can supplement many of the senior management skills in a target company.

This is the positive story of private equity; this is the part of private equity that adds value and moves businesses forward.

The huge global stock market correction is now generating substantial investment opportunities for private equity.  Indeed at Terra Firma, in the last few weeks our deal pipeline has got busier as we finally see sellers’ expectations become more realistic about price, their companies and their business plans. So there are grounds for optimism.

However, there is a major issue going forward.  An excess of debt may well have caused the current problems, but a complete dearth of debt may now hit our returns no matter how good we are at bringing on operational and strategic change.

So the question for returns is - how much debt will come back for private equity and on what kind of terms?

In looking at this we need to be realistic, governments are still bailing out the banks, and my $3.5 trillion number will prove too low.  With governments as shareholders they will be unlikely to encourage their banks to lend to private equity firms, and will most certainly insist on tougher terms.  Governments’ clear priority will be to have the banks make loans to individuals for housing and for family businesses and not make loans to what they see as faceless and secretive private equity firms.

Certain leaders in the private equity industry may have thought that transparency was something to wink at, something that the world would move on from and forget, or as one CEO of a GP put it to me:

“Guy, all this noise about transparency is only from the little people”.

I disagree.  Terra Firma supported the Walker report and indeed produced an annual report that went beyond it.  For without the support of the politicians and the public, our businesses can not succeed or even exist in Europe.  

Banks have come to be seen as much needed utilities.  Their existence, like electricity or water, is essential to our way of life, and as recent events have shown, the public expect governments to ensure the banks are there and able to do their job providing liquidity and extending credit.  

So, far from removing the urgency for private equity to work better with the wider community, the credit crunch has increased the need for us to work with the world at large and provide value to all stakeholders.

So I said I want to be optimistic, and relatively speaking I am.

I keep seeing papers entitled things like “Armageddon” and “the new dark ages”. If one believed that then one should cash-up and run.  However I don’t believe that we are all doomed and the world is coming to an economic end. Private equity will continue, although it will be smaller and less well paid.

There will be a significant number of good opportunities for us to add value.  Those General Partners who focus on generating alpha and have real operational and strategic abilities will clearly outperform the rest and will be able to provide good returns.

But I am afraid that returns in private equity for the majority of firms are coming down not only for the deals already done at high prices in 2006 and 2007 but also for future deals which will also generate lower returns.  

How far returns fall is not just dependent on the deals we do, but also on how we as an industry handle ourselves.  If we want to succeed we are going to have to be responsible global citizens, to be transparent, to engage with all stakeholders.  Doing this will give the newly nationalized banks and sovereign funds a reason to support us.  And we will perform considerably better than if we withdraw and hide from the debate.

Right now, as Simply Red sang “Money’s too tight to mention” and for the good of our future returns, we must react and change how we do business.

Thank you.

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