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Newsroom & speeches
14 October 2009
Too often, we hear criticisms of private equity as an asset stripping, job cutting, quick flipping industry. This is not a view to which I subscribe.
We hear less frequently about the valuable part private equity can and does play in the UK economy – as a provider of capital to ambitious firms; as an active owner, driving to deliver long-term value; and in turning around firms that are not achieving their potential, by giving them new direction and leadership.
Whatever the form of ownership a company has, the real issues, both for the government and the investors whose money is at stake, is for the health of the company concerned; for the workers whose jobs depend on the company’s success; for the ability of that firm to grow and innovate; and for the impact on the economy as a whole.
To achieve these, firms need investment and effective owners.
Let us be under no illusions that private equity is perfect.
In particular, the dealings of private equity firms can be opaque, though I appreciate the work that you as an industry and the BVCA have done to address this.
Private equity as a provider of capital
Private equity and venture capital may still only play a relatively small role in our economy, but it is significant and growing.
I recognise that the recent challenging economic conditions have put many private equity firms and funds under pressure.
Some of you have had to respond to falling investor confidence and tightening access to finance; finance which has been re-priced to reflect changed perceptions of risk.
The outlook for realisations has become more challenging. Your clients are beginning to question asset allocations (in the light of correlation experience), fund structures and fee models.
Given these circumstances, I can appreciate that private equity firms must give priority to protecting their existing funds and portfolio investments, some of which were made at values which, with hindsight, were too high or with capital structures and debt levels which appear unsuited to today’s climate.
However the private equity industry has funds to invest – reportedly over US $1 trillion worldwide in uninvested capital – and there are many companies out there that are fundamentally strong, but have taken a battering, which are solid businesses with excellent potential under the right ownership and which will benefit from an injection of new capital, term debt, management guidance and ideas.
Peter Mandelson spoke to you 7 months ago and laid down a challenge – to you and to Government – to back innovation, whether through developing entrepreneurial start-ups or growing medium-sized firms into world beaters.
As a government we are doing our bit.
We’ve launched the Capital for Enterprise Fund, the UK Innovation Investment Fund, and the Growth Capital Review – to which the government will respond in the Pre-Budget Report.
We have taken on board the policy suggestions in the BVCA and NESTA joint report, From Funding Gaps to Thin Markets: UK Government Support for Early Stage Venture Capital.
I endorse Peter Mandelson’s challenge.
According to BVCA figures, the UK is host to the better part of 60% of Europe’s Private Equity and Venture Capital industry.
We need you to invest sensibly, to help ambitious firms grow and develop, to put money behind innovation and to help finance the recovery.
The BVCA’s tagline is “the voice of long-term investment”.
You may have read my article in Monday’s Financial Times, where I called for a new age of enlightened institutional investor owners who drive for long-term value. I am championing the cause of good governance. Private equity can be a positive force here.
For many listed firms, the chains that link the owners of capital, through savings products or pensions, to institutional investors, to fund managers, and finally to the boards of companies and the executives who exercise control over those firms, are long and complex.
Private equity shortens this chain, giving the owners of capital timely and necessary information and enabling them to provide much clearer direction to the businesses they are financing.
The shorter chain, the clearer direction and accountability, have the potential to create companies that deliver higher long-term value.
This to me is the fundamental source of advantage enjoyed by private equity – not privacy for privacy’s sake, or use of elaborate financial engineering.
There is a significant body of research that illustrates the capacity for private equity to add value.
Acharya, Hahn and Kehoe (2009) conducted an in-depth study analysing the composition of the IRRs generated by 12 relatively large UK deals undertaken by a selection of mature private equity houses between 1996 and 2004.
Their results showed that roughly 20-30% came from pure alpha or outperformance, whilst a further 25-35% came from the amplification of this alpha through leverage.
The remainder was due to exposure to the quoted sector, that is, beta, and the gearing amplification of this effect.
In simple terms, what this illustrates is that roughly one third of the returns generated by large PE deals can be attributed to pure value creation.
These results are striking.
However, if you look at the facts on the specific differences between the public and private equity models it is perhaps less surprising that the private equity arena drives superior returns.
The Spencer Stuart 2005 board index for the top 150 UK firms showed that in roughly 90% of private equity owned firms there was contact between the GP and CEO at least once a week.
In addition, management incentivisation in the private equity arena appears to achieve stronger alignment with the interests of investors and investee companies than is sometimes the case with public equity.
The Spencer Stuart report suggests that the effectiveness of governance seems to make an important contribution towards producing superior returns.
However, there can be disadvantages to the private equity model, not least the reliance in some cases on too much debt, and/or the wrong type of debt.
Problems can arise because of the cost of credit, commitment to tight and inflexible repayment agreements or restrictive covenants, and in the inability to devote capital to potential opportunities, like expansions or new value creating combinations.
When the economic outlook is stable and confident, the implied risks of leverage are manageable.
But, when the outlook is negative, the restrictions on a business’s ability to react can prove fatal.
There are too many cases of operationally healthy businesses that have not, or will not survive the recession intact because of unsustainable capital structures.
The problem would not have arisen if borrowing levels had been kept lower, but private equity was not alone in being enveloped by exuberance when credit from banks appeared to be available in abundance and on good terms.
As the statistics already mentioned suggest, superior returns attributed to private equity in recent years can roughly be attributed 50/50 to added value through ownership and the positive effects of debt gearing.
That component added by gearing may be easier to book in the good times, but investment can be put at significant risk by debt when things go bad.
If a private equity firm is truly committed to the long view it will focus on delivering return through value creation – better ownership and direction.
It will use debt with caution, preferring to exploit the advantages of management, governance and ownership.
This element of return is clearly of much greater value to end investors, pension funds and others, who, all things being equal, should be much more willing to reward general partners for superior management and ownership, rather than simply applying debt leverage which produces outcomes not dissimilar to leveraging a public equity portfolio, which the end investor can do without the intervention of expensive general partners.
A greater focus on detailed attribution analysis of fund returns will facilitate identification of delivered alpha – which deserves to be well rewarded – as opposed to use of debt which should be largely eliminated as a source of significant additional return on a risk-adjusted attribution.
It surprises me that many investors in private equity funds, pension funds, endowment and insurers have not in the past pressed for greater insights into delivered risk adjusted returns.
I imagine that the experience of the last couple of years will encourage them to be far more enquiring.
This might also lead to the re-balancing of skills in some private equity management firms – increasing investment in operational management capability; corporate transformation competences; confidence in re-structuring and integrative transactions at the expense of subordinating financial engineering.
A recognition by investors in private equity funds that they have in the past over paid their managers for the simple task of gearing investment (and failed to appreciate the risks inherent in some gearing) is likely to lead them to revisit standard fee structures.
My sense is that management fees are likely to come down, but the best managers will have the opportunity to offset the adverse impact this will have on their revenues through the rewards they will earn by application of genuine ownership skills.
One issue I know causes concern to Private Equity, for both limited and unlimited partners, is the upcoming Alternative Investment Fund Managers Directive.
I have already given a number of speeches on this, so I will not spend too long on it today.
We have been quietly, actively and assiduously working on this for over six months – we are not Johnnie-come-latelies.
Progress is being made in negotiations, including in the priority issues identified by the BVCA.
There is, of course, a long way to go in these negotiations, particularly as the European Parliament has only recently begun its consideration of the text, but I believe we can be confident of an outcome significantly better than the Commission’s original proposal.
There is still work that the private equity industry can do to make its lobbying more effective.
Given that this was the first EU legislative initiative with such a focus on private equity, your industry had relatively little experience of engaging in the EU process.
Speaking frankly, I have to say that on occasions this lack of experience has been evident.
The UK private equity industry must not appear to be portrayed as an opponent of regulation, as a defender of special interests or as a non-constructive interlocutor in public debates.
I know, because I have worked for a long time in and with your industry, that this is not the case, but you can and need to do more to convince the rest of the world.
I urge you to ensure that you are speaking to the right people - to the MEPs who play such a central role in EU legislation, to the national governments whose economies can benefit from private equity investment, and to the Commission.
Representations must come from general partners, limited partners (the primary suppliers of equity capital to funds) and, most importantly, investee companies, many of whom have powerful stories to tell about the beneficial impact of private equity investment in supporting and growing business and employment.
Private equity must acknowledge that the financial sector is going to be subject to more intensive regulation and that Europe will play a more visible role in supervision. Jingoistic euro-scepticism is not the right language to employ.
You need to evidence and understand the motivations and the priorities of those you engage with; to discuss and not to lecture. To understand the deeply-held concerns that some have about private equity.
I believe the BVCA can draw useful lessons from the effective work of other European private equity trade bodies, particularly the BVK in Germany.
They have a targeted, in-depth strategy for engaging constructively with politicians and the media, detailing who they need to influence and how they intend to do it.
Private Equity is an area where the UK has a huge store of comparative and competitive advantage, and we have to make sure that this is properly represented in the public debate.
We have to do this from the perspective of the UK within Europe – it will be to the advantage of Europe as a whole if private equity is able to play its part in economic recovery.
We need to speak less about the threat to London of the draft AIMD and more about the lost opportunity to the economies of Europe if we unreasonably frustrate the availability of private equity capital and investment.
I do not pretend these issues are not to some extent a burden. However, the private equity industry has grown to a size which brings with it responsibilities to engage constructively in public policy debate.
You have already done this in the UK, for example through the Walker guidelines, and now you must do it in the EU.
Your excellent European umbrella organisations will play a vital role in this.
I am pleased to see that the industry has adopted the Walker Code with a positive spirit. As Brendan Barber acknowledged this morning, this is a significant step forward. And the Walker proposals are, in the main, similar to the proposed AIFM obligations.
However, a key difference is that the Walker guidelines limit the disclosure requirement to larger portfolio companies, on the basis that they are likely to be competing with larger public companies with similar reporting obligations.
Sir Mike Rake, who you heard from this morning has previously said "I believe that the industry in the United Kingdom recognises the benefits of transparency and the need to engage with interested parties and shareholders."
I agree with the sentiment Mike expresses. Private equity should have nothing to fear from transparency. But you still give an impression to some that you have things you would rather hide.
In April of this year, the Guidelines Monitoring Group said that they were considering whether the threshold of £500m used in the current definition of a ‘portfolio company’ should be lowered.
They stated that any action would depend on the outcome of the EU process.
But I see no reason why the industry should not set an example, take a lead, and convey a strong message of support for transparency, by bringing the threshold down to, say, £250m by 2010.
The whole Walker Guidelines process has served the industry and society well and is an example of how an industry can itself take effective action to address public concerns.
You should build on this momentum.
I am not saying that we should penalise private equity ownership by placing upon it burdens that do not apply to, for instance, family controlled businesses or subsidiaries of large multi-national corporations. However, I do believe that enlightened self-interest should be sufficient motivation for private equity to go beyond the Walker guidelines.
I have listened to concerns about the treatment of funds domiciled or managed outside the EU, and of the use by EU managers of non-EU administrators, custodians and other service providers.
The UK’s open approach to trade in financial services has enabled the City of London to develop as a global centre, and we are not about to change that.
We have successfully allowed non-EU funds to be marketed here for a number of years without the need for stringent equivalence tests.
To deny our institutional investors a global choice of fund manager would come at a direct cost to pension savers and others who rely on the returns from institutional investment funds.
It would lead to the EU industry becoming less efficient, by removing the discipline of global competition.
Allowing the use of custodians, valuers, administrators and delegated portfolio managers from outside the EU is also key to ensuring that the EU remains a viable centre for globally integrated fund management businesses.
Again there is no need for centralised equivalence tests, as the MiFID and UCITS directives already enable us to control delegation.
As long as managers maintain direct responsibility for all of their regulatory obligations, and supervisors maintain a right of veto over delegation arrangements, experience shows that relatively unrestricted delegation can be allowed, without compromising investor protection.
As well as being a source of good governance, private equity can be a source of real hope. The industry should be applauded for its work in furthering charitable and socially responsible projects, particularly the Private Equity Foundation, which seeks to deploy the 'private equity toolkit' of active engagement and long-term value creation within the traditional philanthropy sector.
Through its leadership, expertise and donations, the industry has supported a range of charitable causes, playing a valuable role in addressing some of the country’s most pressing issues.
Two years ago the Private Equity Foundation was set up to work in some of our poorest communities.
I am advised that the knowledge and results-focused management skills that are inherent in the private equity industry have been employed to help raise £16 million for youth charities, touching the lives of near to 20,000 children.
Two hundred private equity professionals, top lawyers, accountants and management consultants have given over 9,500 hours of their time for free to serve in fourteen charities.
I believe that, as an industry, you should be justly proud of the achievements of the Foundation in its first two years, and I would encourage you to continue to support those less fortunate with your time and expertise, and to make sure that your good work here is well understood.
Others sectors of the financial services industry would do well to seek to emulate the example set here by private equity, particularly at a time when there is a broad sense in society that banks and others have and continue to enjoy substantial support at some cost to the taxpayer, economy and public policy priorities.
To conclude, I’d like to stress the positive role that private equity can play in Britain’s economic recovery.
You can provide the capital British firms need to grow and develop, you can turn around failing firms, and you can provide the quality of active governance that many firms need.
The Walker review provided a clear way forward and I thoroughly support this. You can and now should do more.
We’re working with you on AIFMD, to ensure it is a practical, workable and positive set of reforms.
However, you can and must do more, individually and through your trade associations, to engage effectively with policy makers, so that the industry has the best possible representation and can continue to exercise its strengths to the benefit of the UK and EU economy.
Thank you.
