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Smaller private equity firms can deliver Alpha, says Guy Hands

Private equity firms should go back to the future to deliver on investor demands for Alpha returns, according to Guy Hands.

Hands, Chairman and Chief Investment Officer of Terra Firma Capital Partners Limited, gave the keynote speech to a 500-strong audience at the Guernsey Funds Forum 2015 in London last week.

He said that the private equity industry is now split into two segments: the semi-public, listed companies such as Blackstone, Carlisle, CVC and Apax who represent about 85% of the money raised; and the remainder, which raises about 15% of the money but actually comprises the vast number of firms.

The latter have struggled to raise money since 2008 but he believes that, in fact, investors are demanding Alpha and these firms are better positioned because, “when you get to a certain size, you create Beta; it becomes impossible to create Alpha.” He added that his philosophy to achieve this is “to go back to the future, my belief is very much to go back to what we used to do.”

Hands said that the larger firms had got themselves a position which is not challengeable by smaller private equity firms and therefore these smaller firms would have to take a slightly different approach. They would have to accept that they aren’t going to be as rich as the last generation but they could still create a very successful firm and develop a very successful private equity industry.

Hands explained that he had been speaking with some of the world’s leading private equity investor groups. He said that they initially asked him for greater institutionalisation but he told them that this was the preserve of the larger organisations and instead he asked them to focus on their key demands of a medium sized private equity firm, such as Terra Firma.

The first was Alpha. They told him: “We want Alpha, what we’re getting from the industry today is Beta.” He told them: “Well that’s pretty obvious isn’t it, when you look at the charts now for the last few years? Private equity is just Beta, it’s just basically investing in a stock market and putting a little bit more leverage on.”

The second was execution. The investors told Hands that: “The problem is, the big firms we know can execute, they’ve got lots of people. But the smaller firms, if you’ve got say five principles in the firm and two of them leave, you’ve lost 40 per cent of your intellectual power…We want to know that you can execute, and we want therefore…to know that you’ve got the money to support your business.”

The third was low fees. However, he said he pressed very hard on this point and one account said: “We don’t want you to charge very low fees, because if the fees are too low, then you can’t pay your people. On the other hand, we don’t want you to charge high fees, because then all your people are doing is working for the fees; there’s a happy medium there.”

Hands followed up by asking whether a firm having “skin in the game” was important and the response was: “Yes, that matters a lot…Actually that’s probably the most important thing…In fact, the more the GPs [General Partner] willing to put in, the more we see it as a partnership, the more we see it as what actually private equity used to be like, and the more we feel it’s worth paying the fees, and worth paying the carry.”

Hands agreed: “There’s an extraordinary correlation that in every one of our businesses it’s absolutely, totally, and completely linear. The more skin in the game, the better the deal’s done, the less skin in the game, the worse the deal’s done, the more we’ve paid people and they’ve relied on getting paid, the worse the deal’s done.”

Hands said he has concluded that investors want four key things: low fees but not too low; people with the ability to execute but not so many that you start to dilute intellectual thinking; alignment of interest and, “above all, giving investors something they can’t get from the big firms, which is largely the ability to produce Alpha.”

He concluded: “I think for the smaller firms, for the firms who haven’t raised money since 2008, and there’s a lot out there in Europe, I think there’s a great opportunity out there but it’s not banging your head against that wall, it’s going around that wall. It’s not expecting to earn huge amounts of salaries, it’s about creating wealth, it’s about doing what private equity was originally formed to do when the industry started in the ‘70s, it really is just about going back to the future.”

Hands, a Guernsey resident, began proceedings by highlighting the Island’s close proximity and good transport links to the UK, its eating establishments, quality of schooling and community spirit.

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