SWC Talks to Guy Hands

February 25, 2015 by Loch Adamson

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Guy Hands, Chairman and CIO of London-based private equity firm Terra Firma Capital Partners, has developed a new funding model for his firm. Rather than getting out on the road looking to raise a new commingled fund, Hands has decided to commit €1 billion of the firm’s own money to deploy into new deals alongside co-investors.


Last week Hands talked with Sovereign Wealth Center's Victoria Barbary about his new model and the future of the private equity industry. The transcript is edited for grammar, space, and context.

SWC: What prompted you to move toward your new funding model?

Three things moved us toward this.

Number one is the conversations we’ve had with our investors. I would say there’ve been about a dozen investors — mainly sovereign wealth funds, but some endowments, some high-net-worth individuals and some pension [funds] — that have indicated that they need to put a very large amount of money into private equity, because they have large and growing assets under management and the returns available are substantially better than a lot of other forms of investment. This has forced them to do ever-bigger investments with fewer and fewer private equity funds, but those private equity funds are more and more what they describe as "me too" funds that will give them beta. They’re very institutionalized funds, and these investors feel that while they’re very high-quality, they’re not particularly exciting.

These investors also feel that they have the ability to take a pocket of money and invest it in more entrepreneurial fund managers and more entrepreneurial deals. What shocked me when I started to discuss this [funding model] with people was that they almost universally made it clear that they’re not looking at this as a way of saving fees. They were looking at it as a way of gaining alpha, and they were quite happy to pay carry. I’d always assumed that they’d want to get it for nothing, which sort of put me off. But one sovereign wealth fund said: "Look, to be quite frank Guy, we’re never going to lose a deal because of our willingness to give carry, but we don’t particularly like paying fees. What we want is skin in the game from the entrepreneur or the firm."

Number two is that we had one idea that should really have worked but didn’t. We came up with a really good investment concept back in 2011, 2012: to find large, renewable energy infrastructure projects, which were then very cheap, with the intention that we would buy a number of them and exit when the market tightened. We hired a team of people to do it, but when we went out and tried to fundraise we found that the people who would have had us as partners weren’t interested in putting money into a fund structure with lots of other people. They wanted to have a much more exclusive relationship.

We missed that trend. By the time we got traction for the fund, returns had gone from 15 percent to 10 percent, and by the time we were ready to invest they were sub-ten. We were being asked to put €150 million into the fund ourselves — and frankly we didn’t want to do it and they didn’t want to invest unless we did that — but I didn’t want to invest at sub-ten percent and we had missed the opportunity to make 15 percent-plus. We had the expertise, we committed the money and yet we never benefitted from it. That was very disappointing. We came to the conclusion that there are times when the traditional fund model isn’t the right structure for some of the more successful ideas and deals out there.

The third motivation was that we’d always put very large amounts of our own money into deals. In 2011 things looked pretty bad, but we continued to work hard on all the transactions we had and reversed the situation. We returned €6.5 billion to our investors and ourselves and made €4 billion in profits; we ended up with a very large pool of money from that. So we went out and talked to other people and asked how we should use this pool. They said: "Why don’t we get together and use it to get some things going."

SWC: So does this structure makes it quicker to get into deals?

It’s really all about having close relationships with people. But if you build up those relationships then you can get into deals more quickly.

In the same way as the investor community has said that they want to have half as many relationships, on the investment side, we’ve said it’s better for us as a GP [general partner] to have maybe 20 really close relationships rather than over 200 relationships which are just not close enough.

In that situation, I have the disadvantage in that I’ve got just too many mistresses and it’s impossible to service any of them to a level where I really feel that I have a deep enough relationship.

SWC: What do you think are the biggest challenges of implementing this model?

The biggest challenge is that you do have to pay people: the organisation itself costs money. So in an ideal world you wouldn’t charge any fees and you’d get paid totally on carry. However, in reality there is a need for some fees.

Private equity compensation levels have increased enormously over the last 14 or 15 years; they’re probably up three-fold. And the reason they’re up is the size of the funds; as the funds went up, compensation levels went up. So the model that I’m suggesting really does need to bring those compensation levels down, because otherwise you end up with a fee-structured business, rather than a carry-structured business. So it’s a little bit of a jolt to get people to accept that.

I’ve been interviewing people over the last six months and they’re really interested in this model. They think it’s so much better than working in a large institution because they don’t like being part of a thousand people. And then the rubber hits the road and we say that we won’t be paying you seven figures, and they say, "I’m not sure I want to do take less money." So you just end up going round in circles.

I think its going to take some unusual individuals and a different generation. But persuading people to give up these incredibly high salaries and bonuses they’ve ended up earning is going to be our main challenge.

Part of the problem is that the investment community has pushed for stability in private equity firms and the way you achieve stability is to give people a big paycheck to tie them in. But that doesn’t improve performance and it doesn’t improve alignment of interest. Trying to get the balance right between not paying people too much, so they’re still motivated and incentivized, and not paying them too little, so you can’t hold onto them, is incredibly difficult.

SWC: Do SWFs have the ability to help with investment management?

It varies institution to institution. There’s huge variation. In one deal we’re doing, the sovereign wealth fund we’re working with can help us because they have relationships which will be very important in terms of the distribution of the product. So sometimes you can identify up-front exactly what it is that they can bring to the table. Other times, it’s more passive. And other times it just pops up. It does vary hugely.

SWC: Is the closed-end fund structure going to wane?

The closed-end fund structure has hit its natural limit. It’s still the biggest thing out there, it will continue to be very large. It’s still going to be seen by most people as the way they can get exposure to private equity. But it’s not going to be 90 percent of the market, it’s not even going to be 60 percent of the market. It’s going to be more like 50 percent of the market. Once sovereign wealth funds send out the message that they use closed-end funds with big institutional firms for beta and everything else they do is for alpha, I think that’s probably where people will go.

Some sovereign wealth funds will probably say we’ll put 10 percent into more unusual structures and direct investments and seeding funds, and others will say we want to be 70:30 the other way. At the moment the majority of what most people have is in funds, but a lot of them are saying they want to go more like 50:50.

SWC: Will you be able to do a wider range of deals with this model?

Definitely. It’s very clear — and a lot of us missed it — that for a fund, a private equity firm might be very prescriptive about the type of opportunities it can go after. But if you’re going for either what they term as opportunistic funds, or for individual deals, sovereign wealth funds are far more willing to look at deals on a case by case basis, which is both easier and more difficult. It’s a lot more difficult in some ways because it’s hard to work out what they’re looking for; you can’t just tick boxes.

Once you start moving into this side of things you’ve got to have something really exciting and then they’ll give you the time. If it isn’t, no matter how good it is, it’s just going to get buried because it’s just too "me too." I’ve been surprised by some of the things that some of the sovereign wealth funds have done because they’ve said they don’t want to do this, they don’t want to do that, and yet they’ve gone and done it. But they say the structure was different, the alignment of interests was there and we really think these guys are going to make a go of it.

What they’re really saying — as one of them said to me — is: "We want the best of Guy, not the average guy." Bring us your best ideas, don’t just bring your average ideas, and that’s logical.


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