Guy Hands urges smaller private equity managers to return to their entrepreneurial roots
Guy Hands was the star turn at the Guernsey Fund Forum in London on Thursday. Having lived on the island for seven years, the chairman and CIO of Terra Firma Capital Partners has already proved that Guernsey is not just a tax haven. In fact, Hands told his London audience that the island is not a tax haven at all: it levies an income tax at a rate of 26 per cent. He also pointed out that it has several Marks & Spencer stores and enough restaurants to dine at a different one every night of the year, so it is far from boring either.
More importantly, Hands advised private equity managers to return their entrepreneurial roots. His reasoning is that smaller managers in particular need to bypass rather than confront their larger competitors for capital and investment opportunities. In his view, the industry is now bifurcated between a handful of large public or semi-public firms such as Blackstone and Carlyle (which control 85 per cent of committed capital) and smaller firms (that control the remaining 15 per cent).
The smaller firms, says Hands, are struggling to exit existing investments, let alone raise new money. Illiquid investments, despite the growth of the secondary arm of the industry and the revival of the IPO market, are still proving hard to realise. Hands noted that the average life of a smaller fund had risen to 13 years, and was likely to grow longer still. It was in this context - namely, the question of what the 15 per cent can do now to remain relevant to the industry at all - that he gave his advice to return to the entrepreneurial roots of private equity, where fun as well as opportunity is probably more plentiful.
Hands sees no point in smaller firms attempting to compete with the top 40 private equity houses. He reckons the endowments and pension funds which fuel the industry value the institutional quality of the larger firms, because they want to be confident that managers can actually execute transactions, but that they are unhappy to be paying lavish management and performance fees for leveraged beta - which is what they are getting from the major firms. Some investments by the larger houses, said Hands, are thought to be returning as little as 50 basis points.
This is the opportunity for smaller managers: to generate alpha. It entails investors taking the risk of backing small teams - as Hands noted, if two members of a five person GP firm leave, that is 40 per cent of the key personnel lost - but he thinks they are prepared to do it provided the prospective returns are high. Hands says risk appetite is higher now among investors than it was 12 months ago. Investors he has spoken to are seeking double digit returns on infrastructural investment, which is more than twice the 5 per cent average infrastructure is returning at present. "If your choice is zero or 12 per cent but risky, investors are taking the 12 per cent," said Hands.
However, he also said that fee structures need to be attractive. An attractive fee structure is not synonymous with a low one, added Hands. He said investors need to be confident that the manager can cover the costs of running the firm, including retaining the right people. However, investors also want to be sure that GPs are working for the carry, and fee structures are expected to be designed to deliver exactly that. "Skin in the game" impresses LPs too, said Hands. A GP who contributes 5 per cent of a small fund impresses investors much more than a 1 per cent contribution from a GP at a large firm, even if the absolute amount is smaller.
Hands said one institutional investor had offered Terra Firma a 50 per cent carry with a hurdle of 20 per cent if the GPs were prepared to put up 30 per cent of the money. As he pointed out, giving away such a large proportion of the equity and equity return is not necessarily a stupid idea for an investor. What matters is that it can only be done by a small firm, and never by a large one. Small firms do not have to pay hundreds of salaries, so they can focus on creating wealth. This sharing of risk is what Hands meant when he advised the industry to return to its roots.
Hands did not duck the corollary of all this advice: the current generation of private equity managers cannot expect to be as rich as their predecessors, he said. Compensation levels in cash terms at smaller firms will need to go down, if they are to enable GPs to reinvest more in the business.
Hands says private equity firms need to become more like investment firms. "If you are not willing after 20 years to put money into a deal it is a `no, no,’" he said. Hands added that, in his experience, funds always do better when the GPs have "skin in the game." He added that "skin in the game" and high returns were perfectly correlated at Terra Firma, and that the top performing company in the Terra Firma portfolio paid the principals the least, but also afforded them the most "skin in the game."