Chairman's letters

23 September 2008

Speech at Super Return Asia, Hong Kong - “What were the mistakes made by US and European private equity and how might Asian private equity learn from them?”

Considering the vast wealth created by some General Partners, private equity hardly sounds like an industry which has made mistakes.  After all, this is an industry which in the last 15 years has gone from something few people had even heard of to one of the most powerful forces in the financial world.

In 1993 private equity raised only about $25 billion, whereas last year the sum was $628 billion.  And then there is the fee income all this generates even when it is not being put to work. It is estimated that General Partners will earn about $7 billion this year just from committed, but un-invested capital.

It is therefore perhaps odd to question any industry that has gone through such a period of stellar growth. However, I believe that the credit crunch will show up some fundamental fault lines in the current business model for private equity which do need addressing.  More importantly, all the focus in the press is on only one half of the private equity relationship.  We all know about the vast sums created by, and for, the General Partner, but we often forget the Limited Partners and where they fit in this relationship.  After all, it is their money and support that has created the private equity industry.

Perhaps to give some context as to how I view what has happened in the financial markets in recent years, I can start by looking back 25 years to when I started in the City of London at Goldman Sachs in July 1982.

My then boss, Eddy, gave me some advice which has guided me ever since. He said there were three golden rules to investing;

1. What goes up will come down and may never go up again.

2. You are only as good as your last trade.

3. The politicians will eventually mess it all up, cause it to end in disaster. Just give them time.

However, the next 25 years seemed to prove Eddy wrong and we all saw an almost straight line growth in the value of financial services companies and financial instruments.  Values kept going up and when they came down they did not stay down for long.

The next trade was almost always bigger and better than the last one; and finally the politicians seemed to have broken the economic cycle and all were preaching the same economic policies with a total conviction that they were right.

Unfortunately the liquidity crunch and equity crash of the last 12 months has shown that maybe Eddy was right and not those in power in Western economies.

I believe we are seeing the start of the kind of bear market not seen for a very long time - with:
¥ increased unemployment;
¥ decreasing real asset prices;
¥ increased government regulation;
¥ increased union and worker power;¥ increased nationalisations and re-nationalisations;
¥ increased nationalism; and, more than anything else,
¥ the return of the power of the state in Western economies.

Let me tell you another thing about Eddy which helps illustrate this: he lent me cash so I could buy my first flat.  It cost me £39,000 and the best mortgage I could get was on the basis of a maximum LTV of 70%. I therefore needed a deposit of £12,000 of which I had £3,000, so Eddy lent me the rest.

I tell the story to show four things: how little central London flats cost then (that same flat would have sold for £500,000 at the peak in June 2007); secondly, the fact that one needed to save some equity first before borrowing, thirdly how low gearing levels were and, finally, just how long we have been in a bull market for.

I should also add that Eddy, as a sensible banker, only lent against known collateral and he had a fairly good idea of my ability to meet the conditions of his loan!  Indeed I paid it back in full with my first bonus from Goldman Sachs.

Twenty five years on, the bull market saw mortgage Loan to value in the UK and US housing markets go from 70% to 110%.  In the capital markets the equity yield valuation peaked at 2.1% and is now 4.3% with some predicting it will reach 7%.  Private equity LBOs saw senior debt grow from an average 30% of enterprise value to up to 85% and now we are back to sub 50%.

Looking back again, this time to half way through the period – in December 1994, when I left Goldman Sachs - I set up the forerunner of Terra Firma, Nomura’s Principal Finance Group.

I arrived at Nomura in London and was given 16 people who had never done anything in private equity before.  They were earning an average total compensation package of under £40,000 a year.  Interestingly, one of the team last year, now at a public company, was paid £1.8 million cash excluding options and pension benefits.  How things have changed. At my introductory meeting with the team on my first day I told them we would invest £1 billion of the bank’s capital over the next two years in asset-backed businesses such as pubs, trains and houses.  On hearing this, my new colleagues promptly decided to go out for lunch at the nearest pub, as clearly I was mad!When they returned to work the next day after a very long and mainly liquid lunch (typical for the time), I thought I ought to give them three rules to guide our investing. These rules were all focused on distributable cash and they were:
¥ more is better than less
¥ sooner is better than later
¥ and certainty is better than uncertainty.

These very simple three rules were unfortunately increasingly broken by the UK and US private equity community in the years running up to the credit crunch.

Let me take each rule in turn and examine how these simple rules were not just forgotten but indeed turned on their heads:

One, more is better than less.
Well in the giddy days of the private equity bull market, bizarrely, the hot idea was to invest in companies with the highest rather than the lowest multiples of distributable cash as they were the companies displaying the strongest potential and where you could put the most equity to work and indeed often get the highest leverage.

Two, sooner is better than later.
Rather than investing in businesses where you would get your money back quickly, the hot sectors were those attracting long debt packages and return profiles where often no cash would ever be returned from distributable cash flows.  Investments were in areas like infrastructure or leased property where no one would actually know if you had been successful or not for many years until you finally refinanced or exited.

Three, certainty is better than uncertainty. 
In the final stages, rather than investing in certainty, US and UK private equity focused on companies which needed the existing management to change and improve the business model, even though they had not done it for the previous shareholders.  Many of these private equity houses did not have the resources to do it themselves if management proved unwilling or incapable of change.

However, there is of course an area where General Partners clearly did not forget the importance of cash – that is in their own level of remuneration either through their management fees or indeed through the flotation of their management companies. In this area, sooner rather than later has definitely recently been the mantra as partnerships looked to sell out.

With ever shorter, rather than longer, equity lock-ups for the founders the selling of as much of the company as possible (or borrowing against it) became the chief objective. Rather that than the long wait for future fees and the uncertainty of the value of future carry. Private equity General Partners clearly could see the opportunity to earn vast amounts by going public.

I was advised for instance by several bankers that the public markets would put a valuation of 30% of assets under management on any General Partner which showed it could raise at least €5 billion and could produce a growth plan.  This 30% was on money raised, not even invested and for Terra Firma it produced a valuation of €2.5bn.

And indeed if you look at General Partner IPOs, and some of the private sales which have taken place, some General Partners have managed to get as much as 40% on every dollar raised, based on expectations of future fundraising, future investing and future performance.

The trouble is that an environment had been created in which private equity was incentivised to earn as quickly as possible as much as it could.  To do this General Partners needed to raise and invest as quickly as they could.  So with a 25-year bull market in the background, private equity forgot about the need for alignment between Limited Partners and General Partners; and General Partners could earn up to 20 years of fees up-front by selling out. It meant that, in traditional terms, the market was valuing a General Partner at 20 times annual revenue not even 20 times net earnings.

So, what might we learn from the bubble that we have just seen so decisively burst? Well I think my three principles still apply, and I, as one of the largest investors in Terra Firma’s funds will push hard to make sure they are adhered to by all in Terra Firma.

The first rule:  “More is better than less”
Limited Partners should look to invest in General Partners which have more money invested in their funds as a percentage of their personal net worth.  In good times, and even more importantly in tough times, the importance of alignment of interest cannot be overstated: it is key.

If you are a Limited Partner and your General Partner loses some of your money, you want him to feel pain as much as possible so he learns by his mistakes and suffers with you.  For instance, at Terra Firma, we have about $600 million invested in our funds - virtually 100% of our net worth - and other than the management fee, we take no other fees.  Carry and our investment in our funds are what determines our earnings, and if our Limited Partners suffer, we will suffer too.

The second rule: “Sooner is better than later”
Investing for the long term makes sense, but only if you are in control of your own destiny.

Looking to the capital markets, either debt or equity (where you are not in control), to generate your investment return through financial engineering and by selling into the latest hot market is simply not sustainable or sensible in the long term. None of us can predict the economic cycle or the hot markets several years out. If we could there would be much easier ways to make money than private equity.

Remember what Eddy said about ‘what goes up, comes down’?  At Terra Firma, we believe that investments should be held for as long as returns are above the implied long term cost of capital. Therefore, we are always looking to improve the operating performance of our businesses.  To drive our returns we should not be pinning our hopes on long term market rises, excess leverage or spotting the latest bubble.

Which leads me to…

The third rule “certainty is better than uncertainty”
At Terra Firma, we thrive on tackling things that need to change, we look for the big, the bad and the ugly. Changing businesses like this delivers outsized returns over the long term whatever the market.

We are set up to do this.  It is why we have over 120 people including a large operationally focused staff, even though we only average two deals a year.

It is why we do not buy companies and hope that existing management and consultants can sort them out or that the markets will save them or that they will become hot.  We must be in control, we must drive the plan.

This operational and strategic change requires us to have our own resources to ensure there is as little uncertainty as possible.

Successful private equity investing requires certainty as to what your goal is and then having a plan and the people to drive the company to that goal.  Without people and a plan to improve a company, private equity is little better than gambling on leveraged stocks.

So I believe that for private equity my three rules are as appropriate today, in 2008, as they were in 1994.

But to conclude, there is one of Eddy’s rules that I have not commented on, and that is the idea that governments will always mess things up.  Back in 1999, the outlook in the West could not have been rosier.

The US and European economies were about to enter a decade in the strongest position, relative to the rest of the world, we had seen in modern times and with no short-term prospect of economic or military competition from anyone.

After the dot com bubble however, Western governments provided an environment which was awash with liquidity, and where the money men and the ‘suits’ became rock stars and celebrities.  A short-term reward culture permeated the financial services of the West.  It encouraged a society that allowed traditional compensation plans for commercial bankers, based on seniority, to be replaced by huge annual bonuses rather than long term compensation.  This contributed to creating an over-leveraged asset bubble the likes of which we had never seen and probably will never see again.

Only nine years later, the West now faces a decline in real living standards of at least 10% and a decline in real asset values of 30% before our economies can once again be in balance with what spending can be afforded either personally, corporately or by governments.  I don’t think I need say anymore about Eddy’s last rule.
So the lessons to be learnt?  Well basically, Eddy was right:
keep a focus on alignment of interest - don’t let hubris get the better of you – you are only as good as your last trade
the politicians will mess it up eventually just give them the time
and thirdly, and maybe most importantly, what goes up must come down and it might not go back up again for a very long time.

Thank you.

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