(upbeat music) - Welcome back to the L.E.K. Financial Services Insights Interviews series, Richard, thank you again for your time.
- Thank you.
- On this occasion, we're talking about the business of private equity investing, and you yourself are a partner of Cabot Square Capital. I wonder whether you might give us a background to yourself, Cabot Square and how you got into private equity in the first place.
- So I started my career actually in consulting, much like your good self Pete, and I didn't realise at the time that I joined the consulting firm that I did, that about 80% of their work was actually advising private equity firms. So this was back in the early 2000s around the .com time. Having done that for five years, I decided that rather than advising private equity firms and helping them due diligence the businesses that they were acquiring and then stepping away and not seeing whether they actually turned out how we thought they would, I thought it would be much more interesting to jump onto the principal side and do it myself.
So in 2006, so getting on for 18 years ago, I joined Cabot Square, and as you rightly say, I'm one of six partners at the firm, and I actually cover pretty much all aspects of what it is to be a private equity firm in that I'm involved in fundraising, I'm involved in underwriting transactions, doing transactions, managing businesses and ultimately exiting them. So hopefully good chat about what it is like to be in private equity today.
- Indeed, and that really comes to the first set of topics is around the private equity investing environment. So I think with thinking first about the GP side, so actually the business of doing the investing, there's been a huge amount of debate in public and private around private equity market conditions over the last couple of years. So macroeconomic challenges are obvious. The interest rates have gone up considerably.
So what are the challenges that those have presented to you as a private equity investor, I suppose recognising all of the functions that you've mentioned, from fundraising through to deployment, through to realising value at the end.
- So I would say that, I mean, to put a bit of context around the, the whole thing the last number of decades has seen an enormous development in effectively bull run for private equity in terms of the amount of capital that has been allocated to private equity as a strategy over that time. And an absolute proliferation of different strategies, different platforms, different approaches to private equity. So running up to 18 months ago, an increasing sophistication and an increasing competition within the private equity market, interest rates rising has all sorts of different impacts on that whole piece.
So starting at the sort of LP end, so the investors in private equity funds, a rising interest rate environment means that they have different considerations for how they're allocating capital to different strategies. And I know that we will come on to come onto talking about the LP side shortly, but certainly on that front, even prior to the interest rates going up, there was a widening mismatch between the amount of capital that was being allocated to private equity and the amount that was actually being distributed back to the investors. So people will talk about it being a very difficult fundraising environment in the last 12, 18 months.
And it certainly has been and a number of LPs have pulled back on providing additional capital into the space. But some of that was almost preloaded into there because there was an expectation of return of capital from these businesses. And actually the impact therefore of the higher interest rates has been a dulling down of the M&A market and an extension even further of some of those returns. So that's one impact.
I would say the second impact within existing portfolios. And I would say I'm making some of these comments from an industry wide perspective, because we as a firm actually use debt slightly differently than typical private equity firms. But a typical leverage buyout type strategy has just seen the cost of capital sitting within a business go up dramatically overnight and also put in place refinancing considerations to replace that debt at some later point. And corporate finance 101 tells you that if your cost of capital goes up, probably your value's gone down to compensate for that.
So that's been an impact. And then another impact has been that has created a wider bid off spread between the buyer and the seller. And it's harder to bridge that bid off spread by using leverage to bridge that. Now I'll just very quickly say what the impact is on us, which is we don't typically use acquisition type finance because we're a specialist investor in specialty lending and other asset origination platforms in different sectors.
Most of the debt that we raise is actually matched to the asset balances and moves up and down depending on whether we're generating yielding assets that it cannot offset it. So we've had a very different experience to what generic private equity will have had.
- Yeah, and I think on that valuation front, it's quite interesting to see how different fronts have responded to that, right. And acting as both buyers and sellers where of course there's naturally been reluctance to sell, not not at a loss exactly, but at a lower valuation than you perhaps might have been expected, but equally, sometimes same people same week on the buy side saying, well, of course we'll pay less for this element that's coming through. And I think for a while there was a degree of denial around those valuations having come down and some of that from people perhaps who've been in the industry less than the two decades than you have and have gone through the whole of their career to now, up to fairly senior levels in fact.
But with the interest rates being, being so low, just as a base assumption, and so think, well hang on my, my equity yesterday was worth 1.5X, now it's worth 1X. It can't be true, and of course it's simple matter of arithmetic and it is, and it is taken a while for that to come through to the extent that people are starting to trade on that. So I guess my perspective was the bid offer spread that you're talking there has been narrowing over recent months and I think although it's still there and conditions are no doubt stickier than they were, certainly over the previous couple of very rapid years.
It feels to me personally, like more of the market is viable now and there's been enough talk in public from reputable investors around, we do need to recognise this has happened and this is in some sense a new normal and get back to it. So I suppose my expectation is that deal volumes this year will be better than last year, but perhaps not back towards normal levels, whatever it is that that means. But I'd certainly be interested in your perspective on those things.
- So punchline, definitely expect deal volumes to be better this year than last year. The whole piece around valuation is an absolutely enormous topic. And actually every single private equity firm in the market is running slightly different motivations around why they're doing what they're doing. So in a number of cases, it could be that LPs are putting pressure on them to return capital, and therefore, yes, they'd love to hold it for a bit longer, but actually, they need to sell now.
In fact, even if there is an acceptance of low valuation, and I would say, that's very sector specific. So it's not a given that the whole of private equity has seen low valuations, but to the extent that there is an acceptance that valuations have come down, one response is just a hold for longer. And this is the other thing that has exacerbated that mismatch between the return of capital and the amount of dry powder that's sitting on the sidelines, I would say that I would say another reason that the bid are spread is probably reducing is the pressure that a number of funds are now under to actually deploy.
And so whereas they might have been sitting there thinking, oh, well there's some bargains to be had because we're waiting for either some distress to come through or some sellers who are prepared to accept a lower price. I can completely imagine that actually there'll be some quite significant competition for good assets, which will drive the values back up again. So it's a very, very complicated picture. I would say one area that is pretty definitive is in the VC space where you've seen some very significant paper markups within both LP holdings and also within the VC funds themselves and there's some very painful moves to come with raising new capital from here on out.
And you've definitely started to see quite a lot of that over the last 18 months.
- Yeah, so we're agreed the conditions are in some sense difficult, but I wonder whether you feel it's more difficult or less difficult for different types of investors. So for example, whether it's by size of fund or by generalist versus specialist or things like that. And what's your view on that?
- So there, there's been a number of long term trends within the industry sort of before we talk about again, the last 18 months or so where we've been in a higher interest rate environment. One trend has been that large institutional LP investors have been reducing the number of GP relationships that they will hold at any given time. The natural outcome of that is more and more capital is being deployed up into the large multi managers who are managing multi strategies. And to some extent, the logic of that is quite simple.
It's, if I've got a billion pounds to allocate to private equity, why don't I allocate that billion pounds to someone who can put it across all four strategies that I'm trying to access, rather than holding multiple different, smaller relationships with smaller counterparties. And I think to some extent what that has then started to provide is almost a private diversification but almost index option for some of the larger LPs. But the other thing that's happened is there's been a very, very significant increase in the connectivity, different types of investor and the private equity community and the proliferation of different strategies.
And so you're seeing other types of investor coming in and using private equity to fulfil whatever particular objective that they're trying to deliver. And I think on that front, I think really that's about how you generating differentiated returns and you generally generate differentiated returns through specialist approach to what you're doing. So I think it has been for a long time and made even harder by the current environment to just be a generic generalist buyout fund. In fact, I'm not sure there are that many of those, or not many people would describe themselves as that anymore.
So I think that's very difficult, but I think in the mid-market space, you really have to be either a specialist team within a multi-strategy business or else you're going to find it very difficult to raise money but also make returns.
- Yeah, and obviously LPs, they have multiple options of where they would deploy capital. So sometimes I find that the press on this matter almost talks as if there's an amount of capital out there and it's either going to say yes or no, of course it can invest in all sorts of things. Do you think that more traditional LPs, and I suppose by that, I don't mean necessarily a traditional business model, but ones that have consistently invested in private equity over a number of years and perhaps decades, do you think there is a risk that they may allocate less to PE over the coming cycle or how would they go about that decision as to PE as an asset class in the first place?
- So I think that allocations to private capital in general are absolutely here to stay as a core components of the allocation of most large LPs. It's quite interesting that when we talk about a difficult fundraising environment into private equity funds themselves, it's been a record fundraising environment in the secondaries markets where LPs are buying chunks of existing private equity fund structures. So I think the question is actually not so much, is less going to be applied to private equity or is there going to be a change in the allocation to that? It's more, what are the prevailing trends that each individual private equity firm has to respond to?
And ones that are clear are, there is a continued downward pressure on fees. How do you respond to that? There is also the move from defined benefit pension schemes to defined contribution pension schemes, and they will typically be looking for shorter term returns of capital and more discretion on how that is deployed. In fact, there was an article in the FT the other day that was saying the number of deal by deal or the amount of money being applied to deal by deal private equity has gone up fivefold, which again, is partly a function of all of that, what LPs don't want is they don't want a bunch of money sitting not doing anything, being charged fee on it and not being deployed.
So I think to prevent private equity seeing a reduced allocation, they need to be, and they are evolving and finding ways to deal with those types of situations.
- Yeah, I mean, I think the fundamental demand for private capital type situations I agree, it has to remain very, very substantial. I think what has happened though, as you say, it's rather raise the bar that LPs expect the GPs to clear, in terms of, well, fee justifying fees would be one thing, but also what are they truly, truly good at? Where are they expert and why are they differentiated from each other and things like that. So I suppose I expect the winning funds to be more winning and for it to be more difficult to be undifferentiated and perhaps play on simple things like financial engineering alone with multiple arbitrage expected at exit kind of almost by right.
- I think private equity funds in general have talked for years about operational improvements about deriving returns, not just from financial leverage. And now more than any time you need to actually prove that that is what you're doing. If you're an LP and you can generate a risk free return by sticking a load of money into a 5% yielding guild, suddenly your teens highly risky leveraged equity investment doesn't look quite as attractive as it did when, when interest rates were were zero. So by definition, there has to be a higher hurdle and a greater conviction in the fact that that is genuinely going to both differentiate your return profile and your risk profile, but outcompete some alternatives that are more liquid and and so on and could be alternatives for that allocation.
- Do you think there's any expectation whatsoever in the industry that conditions will return anytime soon to the 15 years that followed the GFC, and I mean, are there still people in denial about the various points you, that you and I were just making around demands on PE funds and what they're for?
- I mean, I can't imagine how anybody can think that we're, I mean, certainly the market consensus that we're not going back to zero interest rates anytime soon. I mean, presumably, and not least until we have another crisis of some form. But, so I don't think anybody assumes that we'll go back to there, but as I say, even without thinking about the interest rate environment, we're in a totally different competitive environment from a capital allocation perspective. And so I think the next 10 years are about how does the industry evolve and what do market operators within that look like in order to provide the type of return and the type of product that the investors actually are seeking from them.
- Yeah, I mean I think it's a tougher, more competitive, more specialised environment, one in which great returns is still available to the skilled.
- It's now a mature asset class, 25 years ago, it wasn't a mature asset class. And so that's both a positive in that it will always now figure in the allocations of larger LPs. But it does mean that like any industry, if there's a lot of competition, you need to work much harder to deliver what you say you're going to deliver.
- Yeah. Well, Richard, thank you very much indeed for your time and insights. I wonder whether it was a last cheeky question I might ask. If you were able to advise the Richard McDougall of 20 years ago prior to entering in private equity investment, what would you advise that person or indeed someone entering the PE industry now, I suppose based on what we've just said might be two very different pieces of advice?
(person laughing) - Yeah, probably the advice to somebody now is relatively straightforward, which is this is, this is a long term game and you are going to spend multiple years of your life in one, a fairly tight team in your private equity firm, but also the portfolio companies that you're working with. So really prioritise the people and think about who you are going to be spending your waking hours with. I think the advice or the notification I would make to myself is it is a long term game. I've been in this business for 18 years and it takes a long time to build businesses and develop them and gone are the days, if they ever really should have been there in the first place where it was buy a business, stuff a load of debt in, flip it after 18 months and everybody's a hero.
A, it shouldn't have been like that, but it is certainly not like that now. And if you're truly building, which you should be, you're truly building very high quality, growing, employing businesses that are growing the UK economy, you've got to be in it for the long run.
- Thank you very much, indeed. (upbeat music)
