“The private equity industry is in the midst of a far-reaching structural change that is leading to a bifurcation of the industry,” says Guy Hands, chairman and chief investment officer of Terra Firma. With a track record in the industry that spans well over 20 years his views should not be ignored. He has seen some of the most innovative transactions of their time, including the securitisation of rental income as a key financing tool. He also played a role in one of the most controversial deals, with Terra Firma’s takeover and subsequent loss of EMI, the troubled British music group.
Private equity has moved from being an exotic asset class for the thought leaders of the investment world to the mainstream. It has found favour with institutional investors such as pension funds and sovereign wealth funds. But the transformation has led to a radical change in what the asset class itself represents and the returns investors can achieve.
Hands’ view is that the enormous growth and institutionalisation of the PE industry has led to the vast majority of PE investments becoming beta plays and not true alpha generators. For investors, it means today that returns of 9% after fees would be welcomed. Two decades ago, in contrast, returns of 20% or more would have been common.
The key problem, Hands believes, is that most funds still operate on the same leveraged buyout (LBO) model that has existed for 30 or more years. That is despite the enormous growth of the industry. General partners (GPs) in PE firms make assumptions on how to improve companies that are in line with both the management and other investors. That is hardly surprising, since everyone is basing their assessments on the same management presentations.
The variation between GPs on their assumptions about the cost of finance and exit multiples is therefore small. To compound this effect, the people involved in the business tend to have similar backgrounds. Were it not for competitive pressure everyone would come out with almost identical prices.
The successful funds are generally based on one or two individuals and two or three successful deals. Conversely, the worse-than-average funds are generally based on two or three bad deals.
The basic recipe seen in the marketplace is something that can be concocted by any intelligent investment banker without a great deal of value added, although there are exceptions. The deals that stand out are those based on a radical strategic plan for the business. Otherwise they will not make a difference.
Such deals are worth paying a lot for. Hands argues that those are the deals that gave birth to the PE industry itself. The thought leaders of the investment world, such as the US endowments, invested money with individuals who had also raised significant capital of their own from family and friends. Such individuals received a large share of the successful returns.
The fact that most PE investment has become a play on market risk does not make PE a bad investment for institutional investors. But for CEOs of pension funds, paying fees on committed capital to PE firms that invest only 10% each year is difficult to justify.
The question then becomes: will institutions continue to pay what they were used to paying, or will they find a way around it? Big institutions are finding lots of different ways around it. One is just mimicking the leverage of PE investments in the listed markets. Twenty years ago, the PE market would have beaten the returns on such a strategy; 10 years ago, they would have equalled it, but from about five years ago, PE would have done worse, says Hands.
Another route for pension funds involves forming internal teams to manage PE investments. For example, the Canada Pension Plan Investment Board has over 1,100 staff and one of the largest PE portfolios in the world.
The third way is to negotiate on fees. This option is becoming increasing popular among the world’s largest PE investors. CalPERS, for example, decided to focus on just 30 PE firms, giving them much larger mandates, but requiring more competitive fee structures. For the PE firms, Hands says such arrangements are difficult to refuse as they guarantee survival for the foreseeable future. But the downside, he argues, is that they can lead to PE firms becoming more like the old financial institutions that the founders of PE originally left.
The PE industry is becoming bifurcated as a result of these trends. A relatively small number of large firms are, in reality, semi-public listed companies or want to be public. They represent about 85% of the money that is raised. The remainder represent the vast majority of firms which now face a challenging existence. They have to be in perpetual fundraising mode, with senior partners constantly on the road rather than making deals.
Not surprisingly perhaps, Hands does not see Terra Firma as one of the struggling small firms perpetually fundraising. But neither is it one of the large semi-public entities whose future is assured.
Instead, Hands argues that he is going back to the roots of the PE industry, when GPs were heavily invested alongside limited partners (LPs) and thus had considerable “skin in the game”. Key to this is that Terra Firma already has €1bn of capital to deploy, generated from a series of successful exits in recent years.
As a major investor in its own future transactions, Terra Firma has an incentive to generate alpha and to search for the best deals. These will often be the kind of complex, difficult ones that it can handle because of its operational, financial, regulatory and legal expertise. Hands, with plenty of uninvested capital of his own, can call on a group of co-investors for any large deals, but says he also will continue to raise funds.
Having a fund gives the advantage of certainty of capital and therefore speed in deal negotiations, but it also leads to constraints in what he can do. One important challenge for the industry, Hands says, is over the quality and availability of deals. He says the current low-interest-rate environment has resulted in high market valuations, and he has not been willing to invest at over-inflated prices. He notes that exits are at a record high but new deals are at historical lows.
It is clear that Hands is focused on making innovative investments. He pledges that in future Terra Firma will not charge any fees on un-invested capital. His vision is of an entrepreneurial, creative firm that is closely aligned with its investors. It generates alpha and that, in turn, maximises carry and minimises fees. The question is whether in the current environment he can find the kind of alpha-generating deals that investors will want to back.