Adam Gates interview with Odgers Berndtson's Head of Private Equity
As we enter 2018, the outlook in private equity is an interesting one. With valuations at an all-time record high, funds have some challenges to work through. We talk to Odgers Berndtson’s Head of Private Equity and Venture Capital, Simon Havers, about how he sees the year developing:
Simon, how are you seeing the market for private equity shaping up for 2018?
At the recent BVCA Summit, Harry Nicholson (EY Partner), whose view on the market I rate highly, espoused the theme for 2018 being “pay up for good assets with good growth potential and grow them faster than anyone else”. Yes valuations are high, but there are still deals to be done, and the key then becomes the speed of execution and what funds do post deal to grow the business. If you have a plan for how to double revenues of a business for example, you now need to make that happen in two to three years, as opposed to four or five years.
Is there a common theme as to how funds are going to do this?
Not really from what I can see; I think many funds are at sea on it. Some funds I speak to have a notion that harnessing technology is important, to not only reduce cost and increase efficiency, but also to drive revenues up; for example could there be a better use of mobile and social media in consumer facing industries and other relevant methods in B2B organisations. I think overall, funds are spending more time on growing businesses post deal through operational improvements, than they have been in previous years.
Is there a silver bullet as to how funds can determine whether a deal is a good deal or not? Do they know everything about a company before they complete?
I think this is tricky. To win a deal a firm needs to offer rapid movement from initial terms to completion and therefore they don’t always have the luxury of time for doing massive amounts of due diligence, commercial or otherwise. Similarly, if a fund puts in lots of effort in investigating a business before they make a bid, it can become expensive, as you will need to commit resource before you even know it’s you who is going to buy it, especially in a competitive market where there might be 10, 20 or even 100 other potential buyers. You could spend an awful lot of money investigating each one before deciding to bid, so funds tend not to, unless there is resource available to conduct a quick and cost effective study.
If you wound back 10 years then there was the concept that funds could get deals either by participating in auctions run by corporate finance firms or by doing your own desk research, discovering companies which may be open to a conversation, cosying up to them and getting the deal done. These two things have now merged into one because you’re unlikely to win an auction process unless you’ve previously built up substantial inside knowledge of the business by other means and at the same time the number of business owners willing to sell their business in a proprietary deal without hiring advisors to make the process competitive, has also greatly reduced. Buyers have understood you can’t be sure of getting the best price that way.
How reliant are funds on getting the management team right, and is this enough in a competitive market? Are you seeing more focus on post deal value creation?
The problem internal teams are always going to have, is having the right resource at the right time. Access to quality flexible resource is therefore increasingly attractive. Funds will generally have generic senior resource, for example an experienced war horse who has been a CEO themselves and who can chair things. A handful of funds might have someone on the operational improvement side, who for example, is an IT specialist and can review systems and technology. However as we know it very much depends on what type of IT specialist is needed given the topic is so broad. For example, there will be times when you will want to review a portfolio company’s CRM system but you’re unlikely to have a world class CRM expert on your bench, drawing a salary and waiting for the day when this is needed, as it’s too expensive and unnecessary. However, having access to these people on an ad hoc basis is interesting for funds.
There is also a lumpiness to deal doing. You don’t get a steady drip of one deal a month to look at; instead you might get seven in January and then none in February, so in essence funds will always want access to available resource, on demand and at short notice, which is where flexible resource networks of consultants like Odgers Connect are so valuable.
How are funds managing the impending interest rate rises and fiscal policy globally? Can the pure LBOs survive as rates start to rise, especially given high valuations?
Personally I’m not sure interest rate rises will have too much effect on fund strategy. When I started in PE in 1994, if you borrowed senior debt from a bank, then it came with a tight set of legal terms which gave the bank the right to step in and take control at the first sign of trouble, far in advance of anything going majorly wrong in the company. If you were not paying debt back to schedule, the bank would step in and could demand you spend a large sum on a Big 4 firm to come in and do a comprehensive review. A lender trying to lend on those terms today, in a world awash with capital, would be unlikely to find anyone wanting to borrow that money because the market has been forced to move to what is covenant-light or covenant-loose. This is where the banks have little power beyond the loan. Things have to get extreme before banks now get involved; so for existing deals, rising interest rates are unlikely to have too much of an impact. Of course for new deals being done, there is less room to manoeuvre when rates are increasing, and so then I go back to my point about speed of execution and the onus on doing more to grow the asset through operational improvements.
Simon you look after both PE and VC clients for Odgers, what are you seeing from the VC firms in terms of themes and areas of investment, especially given the capital raised by Silicon Valley venture capital funds?
I think it’s a bit mixed in VC. It’s an area that’s talked about a lot, especially given the tech boom, for example in the payments industry. Although venture returns have been good on average, overall returns are being pumped up by a few amazingly successful companies that have achieved unicorn status by having $100m put in for 10%, and/or exited as unicorns and delivered a cash return to the investors. There have been various analyses that show if you strip out the massive home runs, which tend to be handled by the elite funds, the returns from some others in the VC industry are not that great.
What’s the PE view on web 2.0 companies and technology disruption?
I sense many of the clients I speak with largely ignore them; firms who are explicitly growth capital providers will be interested to put money into tech firms where they have proven unit economics, for most others there is a technology risk concern, unless they have a specific focus on the technology sector.
What are you seeing from your own PE clients regarding sector interest?
I think they’re all so desperate to get deals done that they’re looking everywhere their investment mandate allows them to, and for most funds that will be broad brush anywhere. You’ll have some funds that will go out on their fund raising and say they are only going to do healthcare or business services for example, and they will be constrained. The days where there was money to be made by spotting a niche sector that no one else has woken up to have gone; there are now 420 PE and VC firms operating in London, so 20 other firms will likely have spotted the same opportunity.
Therefore going back to funds needing a differentiator to get a deal over the line?
Yes I would agree; smart investors and investment committees have years of experience when it comes to deals and there’s a lot of intuitive decision making. However being cleverer than everyone else is a tough competitive advantage to pursue.
Another theme we may start to see is a shift to firms doing deals on a deal-by-deal basis rather than a whole fund basis. This is largely due to Limited Partners (LPs) wanting more influence on each deal i.e. raising money for individual deals which tends to have more transparency, so going back to the 80’s style of investing. Firms working deal-by-deal need to have smaller overheads so are attracted to the flexible cost of independent consultants such as those from Odgers Connect. I am seeing three trends driving this:
- Disappointing returns from some PE firms compared to public markets, which means while some funds have done well, and can raise plenty of capital, others who haven’t done as well may struggle to raise any on a fund basis. We may well see the headline fund raising number rise again: Apollo raised a $25bn fund recently, so the fact that someone else can’t raise $200m gets lost in the noise.
- Unhappiness with carried interest pay outs – it’s generally easier to earn carried interest if you are operating deal by deal rather than a whole fund basis. Typically investors have a choice to either work for an investment bank /corporate finance firm or a private equity fund. Whilst base salaries might be similar, working for a bank or corporate finance firm will generally pay out larger annual bonuses based on performance. Whereas in PE, with the promise of carried interest, the earning period is much longer and if tied to a whole fund then can be opaque, and in fact in some instances will never actually be paid out. (Simon is the co-author of the PEI 2017 Book – The Definitive Guide to Carried Interest).
- LP investors wanting a more active hand in where their money goes and increasingly building up their own co-investment teams, such as the Canadian pension funds; these are well equipped teams to look at individual deals and decide whether they want in or not. LPs have become more hands on and less trusting of the traditional fund model.
Are you seeing the impending Brexit change geographical investment strategies?
It’s not something I hear talked about. That may be because PE people tend to be rational and make decisions with their heads versus their hearts. We don’t know what is going to happen with Brexit so they feel a lack of information on which to have a rational discussion. I have met PE providers that fall into two camps: one says our job is we’ve raised a fund to invest and we will invest in the best opportunities for that year – we have been paid by investors to deploy capital into the market and we will do the best job we can. We can’t go back in three years and say we’ve not invested because valuations are too overpriced as this will seem weak to our investors. The other camp says that’s nonsense and that the essence of great PE is they know when to sell before a peak and they’re happy to sit on their hands and wait for a turn and then spend the whole fund when valuations are low. The first camp feel it’s arrogant to say you can predict a turn in the market.
And do you feel there is a turn coming?
It’s hard to see what would trigger it. Valuations are definitely high by historic measures. However this could unwind by profits rising over the next few years and catching up with valuations. There are record levels of capital to spend as well as high valuations. There’s also nothing to think that the US monetary authorities will suddenly throttle the money supply; with Trump in the White House, there is more likely a pro-business, pro-growth sentiment.
Finally, what type of work are you doing for your clients at the moment?
I’ve been very busy building internal management teams for VC firms. For one client we are working on their third senior appointment, for another client we’re onto our fourth. This is symptomatic of market demand, the market driving the growth and the evolution of VC firms which have more money to manage and historically limited internal capacity. In addition, the last 18 years of my career as an investor has been in hiring CEOs and management teams for portfolio companies and this is another area we are busy in. We work across all sectors because with over 1,000 people in our firm we have specialists in just about everything - but my early career as a software engineer gives me a bit of a bias towards the technology sector personally.
About Simon Havers
Simon is responsible for the private equity and venture capital practice at Odgers Berndtson. He combines his understanding of the PE and VC worlds with the considerable scale and resources of Odgers Berndtson, working with specialist colleagues to secure the best talent for PE and VC firms and their portfolio companies across all sectors. Simon's early career ranged from AI and encryption software through strategy consulting to the planning and rollout of the BBC World television channel. In 1994 he went into private equity, eventually leading Baird Capital for seven years and becoming Chairman of the British Private Equity and Venture Capital Association (BVCA). He has been a non-executive director of companies in the manufacturing, business services, healthcare, technology and media sectors including Cerillion and ArmorGroup International plc, which he IPO’d on the London main market. Simon holds an MBA, is a Chartered Management Accountant, and has a first class honours degree in engineering and management from Cambridge University. He lives in Bishops Stortford with his wife and their three children.