Chairman's letters

01 January 2009

Wilton Park Speech, 2009

Alternative investments have been around for a very long time, occupying the portfolios of high net worth individuals and endowments for several decades.  

As the bull market in stocks and bonds roared through the 1980s and 1990s, institutional investors focused on conventional investments.   

However, by the end of the 1990s real bond yields had fallen enormously and broad equity valuations had reached historic highs.  So institutional investors – pension plans, corporates and endowments – began to turn en masse to alternatives as a new source for investment returns.

A wide variety of hedge fund and private equity strategies had indeed been producing attractive returns with relatively low levels of risk for some time. Even better, the returns from alternatives appeared to be uncorrelated with stock and bond markets.  So the early adopters – institutions with the courage to act first – were rewarded.

These early institutional successes and investments became the marketing materials for a wide variety of alternative investment managers, and the raw data – high returns, low risk and low correlations – were fed into asset allocation models.  

These backward-looking quant models “loved” alternatives, luring institutional investors into these new asset classes - hedge funds, property funds, forestry, commodities, private equity, distressed debt, equity long-short and all manner of arbitrage and relative value trades.   

The commitments poured in from institutions world-wide, and alternative managers quickly developed products to accommodate the demand. 

We now know that this did not work out well when the 2007 credit crash came.  But does this mean that alternative investing does not work? No not at all - but it does mean that alternative investing needs to be just that – an alternative investment class to liquid classes such as cash, bonds and public equities.  However, alternatives should not become the norm or even a large proportion of a portfolio. 

Indeed as the allocations to alternatives shrink we, in private equity, are going to enter an era of very good returns over the next decade. The worldwide recession, global political realignment and Western banking crisis will create tremendous dislocations and there will be opportunities to acquire companies at outstanding valuations.  

Unfortunately the marketing materials and investment statistics of the last two years  are not going to provide much support for GPs.  Indeed recent private equity vintages are likely to show negative returns with high correlations to the public markets.   

So, many investors will be cutting commitments to private equity.  

Making commitments to private equity will take a high level of courage, but that is the environment that creates opportunities. 

So what went wrong?  Why have the alternative managers failed to deliver?  In short, because they were not actually ‘alternatives’ at all by the end of the bull market – they were simply perfectly normal investments but with greater leverage and less liquidity. 

Many investment strategies were, in reality, not adding very much value – but their investments were going up in mark-to-market value.  As leverage on leverage was easily available valuations went up but more than anything else the enormous flow of institutional capital looking for a home distorted the returns, risk and correlations of alternative strategies.   This huge flow of institutional capital into all sorts of strategies – large buyouts, emerging market equities, merger arbitrage – and all types of hedge funds dramatically changed and eventually eliminated the very opportunities that had attracted investors in the first place. 

At the same time many asset managers changed their business model from investing for their own and their clients’ accounts to maximise investment returns to focusing on gathering assets.  Management fees alone became immensely profitable, so profitable that Blackstone, Fortress and Och Ziff were able to take their businesses public and attract investors who were effectively investing in leveraged fees, earned on leveraged funds investing in leveraged companies.  

And when an investment manager no longer has his own capital at risk and is relying on long-term carried interest for his success, a fundamental misalignment between investment managers and their investors occurs.  Heads the manager wins, tails the investor loses.  

However, despite the current difficulties and recent history of alternatives, I strongly believe that alternatives merit investment, particularly in today’s environment.  Investors are going to have to be discriminating in selecting investment managers.  

In my view two areas require particular focus: first, alignment of interest; and second, the sources of return – how does the manager add value? 

As to the first factor, it is clear that alignment is not achieved merely by sharing in the profits.  All too often managers have received profits from their carry long before the success of the overall fund is assured.  At Terra Firma we believe in whole fund carry, so we are only paid when the profit of the fund is achieved. Additionally, Terra Firma and its employees have over €400 million invested in its funds, so we feel pain alongside our investors.  

By contrast, it is all too common for many managers to put less and less as a percentage of their own capital at risk as they raise subsequent funds.   I believe the exact opposite is required.  That there is no better alignment than having the manager remain a significant investor. 

Secondly, what are the sources of returns – and what expertise has the manager?  As my expertise is private equity, I will stick to discussing this area. 

Many private equity practitioners would have you believe that private equity returns come from some secret formula.  But as I have been arguing for years, in reality, there are three simple ways in which private equity makes its money:- debt and financial arbitrage; - multiple arbitrage; - bold operational and strategic change.

The first – debt and financial arbitrage – involves using money to make money. At its simplest, firms borrow at a rate cheaper than the yield on their assets, and earn the spread. 

In normal markets, this technique is a primary driver of returns.

However, opportunities to make money like this have currently disappeared because the debt markets for large buyouts are closed in Europe and the US. Banks have simply stopped lending in any real size, and what debt is available is extortionately expensive. 

The second – multiple arbitrage – is simply buying something at a lower valuation, and with the benefits of rising financial markets, selling it at a higher valuation later. 

Until 2007, this had been a reliable source of returns for nearly two decades. But it is difficult to see many opportunities for this today because there is no certainty when valuations will stabilise and even less as to when they will start to increase again. 

Importantly both these approaches are beta-driven, in that they are market dependent. They are therefore insufficient to drive value across the whole business cycle. To truly add value, the private equity industry must therefore focus its effort on the third - operational and strategic change - if they hope to deliver sustainable and consistent returns to their investors. 

When I made this argument three years ago – before the great asset price realignment – I was told to keep quiet, not to scare the horses, and to let the good times keep rolling.

The private equity industry, along with many others in financial services, has been able to make huge sums of money without actually adding a great deal of Alpha value through Beta.  Unfortunately, over the last three years, the markets have reversed this trend. 

I do not believe that the crisis in the credit markets is just a cyclical blip or the result of a sudden withdrawal of liquidity which will simply work its way through the system. 

Rather, it signifies a structural change taking place in the financial markets which will make life substantially harder for all for the foreseeable future.  The norm should be banking systems in balance, as the UK was in 1997, not a system like the UK in 2007 with the need for daily foreign borrowing of nearly US$1 trillion.

So while private equity firms will still have to possess skills for arranging financings and structuring deals, it is now obvious that these skills alone will be insufficient. Investors will, and should, therefore allocate only to those private equity firms with the right alignment of interest; those who are transparent and who have the skills and resources to build value in businesses over the long term.  

Frankly, this is what private equity is supposed to be about - delivering fundamental change and developing and improving the operations of a business over the long term while not having to worry about quarterly results and the daily stock market price. However, operational and strategic change of this type is not easy. It needs more resources and different resources from the financial engineering skills that dominate most private equity firms.  

In many instances, for example, it requires the personnel and the skills to replace most, if not all, of senior management in a target company, and this is something most private equity firms have shied away from doing in recent years. Yet this is where private equity adds most value and moves businesses and economies forward.

There will be opportunities out there in the next decade to buy companies in need of change as sellers’ expectations become more realistic and bargains begin to emerge.  This will enable those private equity firms who possess real operational and strategic abilities to outperform the general market and provide good long term returns to their investors. 

The private equity model that I have just described is interested in creating long-term value.  It seeks to build business models that will endure across turbulent economic cycles and deliver consistent returns.

Thank you.

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