Why Private Equity works
There are a number of common sense reasons why private equity investments tend to deliver superior returns to those generated by quoted equities. I shall now itemise a number of the main factors, although they are not necessarily included in any order of significance. But the combination of these mostly qualitative advantages means private equity is likely to outperform publicly traded investments, which is anyway reflected in the statistics.
Firstly, capital structure:
Ours is an era of relatively low interest rates, so debt is nominally cheap, at least in terms of servicing costs. Typically buy-outs tend to have at least 60% gearing and sometimes two-thirds leverage. Corporate finance theory teaches that this amplifies gains to the equity holders. Quoted companies generally have much lower levels of borrowings, because institutional investors seem unhappy with high debt levels. The typical quoted company might appear to have a safer financial structure, but while default rates remain low, lower risk arrangements with lower debt to equity ratios will inevitably show lower returns.
In the last 9 months interest rates have started to rise, and so debt is not as cheap as it once was, and this will inevitably cut in to returns. However, on an historical basis debt is still pretty cheap and so financial leverage continues to pay. Moreover, there is an argument that such structures provide discipline to management: having to work within banking covenants acts as a fierce set of requirements – whereas companies with less pressure inevitable have more lax controls over such things as working capital.
Secondly, management incentives:
Managers in private equity backed firms usually have much greater direct participation in the equity of their firm than public company executives. Consequently they behave more like owners, and are less distracted by the perks of office that too often seduce PLC directors. I am constantly amazed at how much fuss PLC managers make of things like company cars, service contracts, expense accounts and the size of their office. Too often they obsess about titles and office politics. Sometimes it is amazing any work gets done in big corporates.
The Chief Executive of a FTSE100 company, who has spent most of his life in the corporate world – but got involved in an MBO some years ago – said to me at a dinner last week that participating in the buy out was the first time in his career he had really bothered to go around and turn off the lights before leaving the office. It changes the mind set. Buy out managers want to make capital gains – to them, salary, status and so forth are secondary. So the interests between managers and owners are more directly aligned in private equity. And the government’s inducement of 10% tax thanks to taper relief on capital gains has acted as an ever greater incentive to management to deliver.
Indeed I suspect a crisis of sorts is building among large public companies. They are finding it harder and harder to recruit and appoint the best talent to act as captains of industry. All the brains are going into private equity backed companies. The exodus of able managers from the public arena is turning into a torrent. Some still enjoy the boastful moment at the golf club when they can proudly state that they run a major public company. But most are sensible and see the upsides of private equity. The rewards are greater and the priorities much clearer. Moreover, public company directors are obliged to disclose details of their salaries, option packages and so forth to the world, and regularly get labelled fat cats by newspapers and union leaders. Unsurprisingly they dislike the barracking and door-stepping that goes with the territory.
Ultimately, chief executives and finance directors of PLCs are employees, agents, who these days have many issues to think about. They don’t just act on behalf of shareholders – they have to worry about ‘stakeholders’. This amorphous category includes employees, suppliers, customers and all the communities these people live in. If you stretch the definition a bit almost anyone can be a stakeholder of a major public company. Great for the stakeholder universe – not necessarily so good for the CEO, who must sometimes wonder what his priorities are.
Moreover boards of public companies now spend almost as much time on corporate governance as they do actually running the business. PLC boards themselves are chock full of the great and the good, such that some have almost become exercises in political correctness. Managing all these competing interests is a nightmare. Leaders of major public companies are becoming more like politicians than rugged entrepreneurs. And public companies are becoming social institutions, adrift from their original purpose as engines of profit for their owners. Meanwhile the media and the state bears down ever more on large, publicly traded corporates with ever more intrusion, more regulation – because they are soft targets. Yet still we hold these great expectations for growth and employment and dividends from these major concerns.
And for two months of the year, bosses of public companies must traipse around the offices of hundreds of money managers who own their shares, discussing the company’s results. These investing institutions generally know little about the companies they own; increasingly they are hedge funds who churn their portfolios like dervishes. Yet the CEO has to genuflect to all of them. The distraction is immense, but is all part of the tedious circus of managing a stock market company
A third reason why private equity works:
Involved owners. Executives at private equity houses who invest in private equity typically look after a just a handful of companies and frequently sit on the boards of the companies in which they invest. They get monthly management accounts and tend to have powerful subscription agreements, which give them considerable rights in the event of problems. Fund managers of quoted securities, on the other hand, often have portfolios of 100 or more holdings and see managers only occasionally. They tend to have fairly small percentage holdings, and so forcing through change is difficult. This concentration of ownership and effort is healthy.
In my experience too many quoted fund managers are happy to enjoy a well paid, 9 to 5 existence and take long holidays. Private equity executives, on the other hand, work extremely long hours and are among the very brightest people working in the financial sector. They are driven and ambitious, and are willing to be tough when necessary. If a business severely underperforms they get appropriately rewarded. Traditional asset managers in organisations like insurance companies who are looking after pension money frequently sell their position rather than remove bad management. They are afraid of revealing that they made a bad bet on a company that’s gone wrong. Only a handful will ever undertake a proxy battle to sack incompetents. And if they do remove bosses – what then? They do not have the time, information, training or infrastructure to institute change and sort out a mess. And doing anything in a PLC requires circulars to shareholders, huge fees and dealing with burdensome regulation. Fixing private companies with problems is much swifter and less costly.
Hedge fund owners are little better. I interviewed various hedge fund managers recently in my role as Chairman of the trustees of a £150 million pension fund. They talked about a typical holding period for a particular share in months, not years. How can you make a serious investment on the basis of an 8 or 12 week punt? This is sheer speculation, not a serious undertaking. It destabilises companies and means shadowy, very short-term owners appear on share registers with dangerous agendas. Tiny activists holders can attempt to force a strategy upon a company without the requisite expert knowledge.
The fourth reason private equity works:
Time horizons. Private equity is relatively patient capital and concentrates on making returns over 5 to 7 years. Quoted companies must report to the stock market at least every six months and sometimes quarterly. I have even met Chief Executives of major public companies who have a screen with their company’s share price displayed in their office all the time. As if the minute-by-minute price fluctuations should matter!
This pressure for the shares to go up can be immense. Analysts and the media are forever clamouring for good news – and action like takeovers. This can tempt managers to over promise, with the inevitable consequences. It can also tempt executives to do deals for the sake of it, and overpay or buy the wrong company. The stock market is a volatile place, and often under rewards and over punishes companies when things go right or wrong. This schizophrenia encourages irrational behaviour by boards. I am constantly astonished how major industrial undertakings end up buying at the top and selling at the bottom. I will give you a couple of examples.
In the early 1990s a couple of clever entrepreneurs called Roger Myers and Karren Jones built up a restaurant chain called Café Rouge. It was a pioneering French brasserie formula, and Whitbread bought the business for a very high multiple, valuing it at perhaps £100 million. Now Whitbread are a huge company and have been in the food and drink business not just for decades but centuries, so really should know what they are doing. They have experienced hospitality managers, property, systems and so forth.
Unfortunately, as soon as it was sold to Whitbread, Café Rouge started to go wrong. Whitbread added some Italian restaurants to the business, but the results deteriorated further. After about seven years, Whitbread threw in the towel, and sold the lot for perhaps £20 million, taking a massive write-off of perhaps £100 million, or over 80% of their entire investment.
The business was sold to some clever entrepreneurs with backing from ECI who rapidly introduced better controls and marketing and improved essentials like customer service. They invested in the business and started opening a few new branches, with surprising success. Within two years they sold the company on for £80 million. It now forms the core of the substantial business Tragus, backed by Blackstone – the Café Rouge and Bella Italia businesses probably now make as much profit as the entire consideration Whitbread received as few years ago.
Another example of giant PLC incompetence is Aviva. They offered for sale in early 2004 their surveying and estate agency businesses, e.surv and Your Move. Despite having spent in total hundreds of millions assembling these assets, and them having a turnover of £135 million and underlying historic profits of at least £13 million, the senior management of Aviva decided to sell the businesses for just £42 million to the management. I offered almost 50% more than that, but the deal with management went ahead anyhow.
Lo and behold just over two years later the management and their backers Barclays Private Equity announced that they were looking at floating the business for £220 million – a 500% improvement on the price Aviva got (Aviva who had owned the assets for many years).
Now defenders of Aviva’s management might argue that in the context of an enormous public company like Aviva, the priority was to exit a non-core business and focus on the main activity of insurance. The forgone profits were almost irrelevant when compared to the billions in annual profits recorded by Aviva. But to me that is the point: enormous legacy PLCs like Aviva are successful almost despite themselves.
They have just too many activities and too little control. They have such huge accumulations of market share that they struggle to do really badly – but even manage that sometimes. Meanwhile they tend to destroy value and jobs on an epic scale. All serious research shows that large undertakings do not create employment – jobs are created by newer, more dynamic firms, typically the sort of enterprises backed by private equity. Smaller firms just try harder.
A fifth reason why private equity outperforms:
Change. Often organisations simply need a shake up to do better. Someone needs to question and try things differently. New appointments need to made from outsiders with external experience. Buyouts can achieve this transformation. They can act as a catalyst to experiment and revolutionise the previous practices, which have perhaps grown stale and inefficient. Business is about constant evolution and companies can stagnate if owners become complacent and bored. New ownership with private equity can lead to more streamlined and challenging stewardship – with consequent benefit for the prosperity of the firm.
A sixth reason:
Privacy. It can be very difficult to do some things in the quoted arena. Turnarounds are a classic example. The stock market is intolerant of things going wrong and wants problems solved quickly – often unrealistically so. Too often this means PLCs are selling just at the lowest point in the cycle, while well funded private equity buyers are essentially always buyers if the price is right. Thus many of the best private equity deals are underperforming, unloved assets being disposed of by large quoted companies or foreign groups looking to shed non-core activities which are doing badly. Such fixer-uppers take time and can have false starts.
I was involved in a retail rescue in recent times. Initially we failed to change rapidly enough. Big mistake. Within six months all the new cash we had injected had evaporated, and the business was sliding towards crisis. So we changed the management and put some more money in and since then the business has hardly looked back. Recently we were often three times our original investment after less than two years. Carrying out such an operation under the glare of the public markets would have been almost impossible. But in private situations you can take rapid action to correct mistakes, even if there is short term pain, or an admission of error.
A seventh reason:
A sense of urgency. Although private equity is patient capital, all managers are aware of IRRs and the time cost of money. They know that if a difficult decision has to be made, then there is no time like the present. They hire individuals who can be decisive. There is little of the sense of delay and obfuscation too often apparent on the boards of many PLCs. Because the owners do not sit on the board, the agency problem arises and this disconnect can lead to drift and miscommunication. In private equity, everyone gets monthly management accounts and knows where they stand. Interests are aligned and a business plan and budget is jointly agreed between owners and managers.
An eighth reason:
Buying and selling is what private equity does best. In truth many private equity houses are more excited by the initial investments and the exits than anything else. They handle the other aspects of the job too – fund raising, monitoring, hiring managers and so forth. But what they truly know how to do is find deals, negotiate, move swiftly and with confidence, raise debt, deal with due diligence and all the other tasks of actually closing a transaction. This takes skill and experience and generally private equity types are better at it than public company types – because they do it all the time.
There are of course some advantages of being a public company. The profile can occasionally help a business – staff might believe in the options rather more, and it can be a cheap source of capital. I begin to struggle beyond this. I have served on the boards of various PLCs since 1989 and have been investing in private businesses for even longer, and the latter set-up is a better place in general. Just lately private equity has come under some fire from the media and certain factions such as the union movement. It is essential the industry addresses concerns about such issues as transparency, otherwise there is a risk this campaign becomes a bandwagon and onerous new regulations are forced upon the private equity world. All those who have benefited from the growth of private equity – lawyers, accountants, investment bankers, managers, pension funds, staff in buy outs and so forth – need to speak up and explain why it works and that the system is good for the British economy. The industry bodies need to talk about examples and give facts to rebut the ill-informed allegations. They need to understand that the mass media deals in sound bites, controversy and simple concepts, and play to audience.
Most of the criticism is based on ignorance and the politics of envy. It is an effort by certain left wing politicians and activists to find a new cause. The private equity industry need to improve their lobbying and PR skills and agree a convincing set of arguments and put their case across pro-actively. This must be carried out across the industry, not just by a few beleaguered spokespeople, in a comprehensive and sustained way. And this fight back should start right now. Otherwise the success of the industry might just be threatened. And that would be a great shame, not just for private equity houses, but the City of London and the prosperity of Britain as a whole. Thank you for listening.