Advantage private equity
29 July 2016
Serial entrepreneur Luke Johnson, best known for his involvement with Pizza Express and Channel 4, told the Guernsey Funds Forum why he believes that private equity is not only a route for business success, it is also very exciting. This is an edited version of his speech, which was published in the July edition of Business Brief.
I have been an entrepreneur and investor since 1980. When I was aged 18 at university, I started a student nightclub and I have continued, approximately, in that vein ever since. For the last few decades I have specialised in businesses in Britain. Mainly small and medium enterprises, private companies, which I hope to help transform through my involvement and that of my investing partners. I focus largely on consumer brands, especially in the hospitality, leisure and entertainment sectors.
Broadly speaking, I and my colleagues look for companies which we can double in size during our ownerships. Part of the reason I tend to focus at the end of the market I do is because that is so much harder if you are buying very large businesses. I think the transformation of a small medium business into a bigger one is what is really exciting. And when we double the size of a business, thanks to leverage, we would hope to treble our money, in terms of our capital gain.
Private equity makes money essentially in three ways in its investments. They grow the profits, and that should always be the first, and is certainly the route to most of my most profitable businesses. They also, if they can, expand the exit multiple over the entry multiple. So a higher multiple when they sell than when they buy, and they also generate net cash during their ownership. Either they take that off the balance sheet when they sell it, or they reduce debt that they used to buy the business in the first place. If you get those three right, that is what I call the triple tri – the tri-factor.
My experience in investing generally started in the early 1980s, when I was an analyst at a stockbroker in Kleinwort Benson, and I looked at quoted investing. But I have found over the last couple of decades that private equity and private investing, investing in private businesses, has several vital attractions and advantages over the quoted arena. And that is why, for example, Guernsey is benefiting so much from the growth in investment overall, into private equity and the growth of major institutional private equity funds.
So private equity money is patient capital. I think private equity limited partners judge the general partners over a five to 10-year view, unlike the stock market, which are often judged, literally, on the daily fluctuations of share prices or possibly six months reporting, if the company itself is quoted. Whereas in private equity the limited partners commit for up to 10 years, and they cannot take their money back.
This patient capital allows for sensible investment horizons. It is what I would call the extreme opposite of hedge funds. They are the other end of the scale.
Another advantage private equity has over quoted investors is that private equity are active investors. They sit on boards. We receive monthly management numbers, annual budgets. We get involved in things like senior appointments and capital expenditure programmes.
Private equity does not, I believe, passively observe. What we try to do is add value, in practical ways, be it financing, personnel, marketing, property, IT and so forth. In this area it helps to have what I call domain knowledge. We are what I consider to be fairly specialist, industrially, as a private equity investor, and I think that, for many, is the way ahead. Really understand your stuff. I think that gives you more credibility, with management and vendors and limited partners, in terms of adding value, rather than financial engineering, which I do not think is the future for private equity.
Private equity digs deeper. Its due diligence before buying should be really rigorous and thorough. Financial, legal, industrial, commercial, markets, customers and so on. Private equity has really got to understand in a company before buying it, because we cannot just change our mind and sell the shares. We are stuck in it, so we had better get it right.
I am always astonished, when doing a roadshow, taking a company public, how fund managers make a decision in 35 minutes. Wow. I mean, they are very clever, I would not deny that and a lot of them make great returns. But I think running a portfolio of 100 companies, making a decision in half an hour, is a very different game to what we do, which is a handful of companies, hugely concentrated investments, and holding them for five or even 10 years.
Private equity must possess this focus. As I say, typical quoted fund managers will hold dozens of stocks if not more. At Risk Capital, our boutique fund which I founded 16 years ago, we have fewer than 10 principal holdings, so we really concentrate on them. We have big, highly liquid stakes in all of them. Each of them are really meaningful to us. And I would say, in our case, we invariably have a decent chunk of our wealth in them, and in a number of the cases, all the money is ours. It really hurts when it is your money, and I think that matters too.
Another advantage is that we are always ready as an asset class, as managers, or we should be, to buy and to sell. I think it is all very ironic in a way that public companies are sadly very much subject to the whims and fashions of markets and cycles for the media and so forth.
I have had the experience quite often of big plcs, under pressure, being forced to sell at the bottom because the investment community decides they need to focus, or they need to raise cash for whatever reason, and private equity is there waiting to buy. And then, quite often, when things are riding incredibly high and multiples are full and everyone is full of enthusiasm and excitement, they are badgered to buy. And private equity is there, very happy to sell to them, right at the top of the market. It is very ironic to me that industrial buyers, who should really know their stuff, often get the cycles wrong because their hands are forced.
Another advantage I think private equity has, many argue it is the single biggest trick in the book, is that private equity has aligned interests. I work with partners in the private equity-backed businesses that we co-own. They are owners with us. They are entrepreneurs, very often, in our case, founders, and we are both jointly shareholders in the same enterprise, and we win or lose together. They have huge incentives to do well and make considerable capital gains.
Unfortunately, in major public companies, too often, as we all know, it is ultimately about status and power, hierarchy, office politics, bureaucracy, and disproportionate salaries. I think one of the most damaging things for capitalism on the whole, in a philosophical sense, is the business of employee managers, being paid two or even 200 or more times what the people at the bottom are paid. No company I am involved with does the chief executive earn more than 20 times what the least highly paid person in that business, because they are not really working for the salary. That is the secondary issue. The principal issue is they are owner-entrepreneurs, running their own business, looking to make a capital gain. This is at the heart of why small new businesses can defeat giant corporations.
If you look at the spread of industries, you would think that with all their cash, and their market share, and their vast brainpower and resources, large companies would invariably see off all the new innovators and upstarts, and yet, it does not happen like that. And whole industries – I look at, for example, the media entertainment industry that I have had lots of experience in, and you see the way that has been completely upended by a lot of nascent tech companies over the last 15 years or so, eating the lunch of the media giants. Why is that possible? It is not because the people running stuff from Silicon Valley are necessarily cleverer, but I think it is as much as anything because they have that vested interest in these new nascent businesses, where they are owner- entrepreneurs, and unfortunately, an awful lot of the people at the top of big public companies are there because they have been good at things like office politics and investor relations, and not actually good at innovation. Another huge advantage that I think private equity has, and this is obviously one that has to be treated with care, is they can employ leverage more happily than the public markets are generally willing to stomach. I very rarely borrow more than twice Ebitda in a deal I do. But some will go as far as five times, or even seven times. That is ballsy and if they call it right, they make a hell of a lot of money. But the stock market is very cautious about these things, and investors are very afraid of debt in quoted companies.
I think it is part of the pack and you should use it adroitly. Also investors and their consultants go bonkers about salaries and rewards for chief executives and others at public companies, which is fine, but I think when it comes to equity- linked incentives, they need to be a bit more broadminded in some cases, because if they want to see the flow of businesses go to the quoted markets, and not stay in private equity hands, then they need to realise that for many managers, it is a more enriching life in various ways, staying in private equity, than it is boasting at the golf club about how you run a plc. Obviously, private equity is private, and that has its advantages. Not just that you do not get the BBC knocking on your door talking about your salary, but because you can do things like turnarounds and restructurings more easily away from the media spotlight. I think medium- term that can often achieve better returns for shareholders and a lot of media organisations do not have the resources they used to to do the investigations. It is extraordinary to me how private equity situations can have their ups and downs and it is barely covered, and as a consequence, they can make very difficult decisions in private equity businesses and fi x them up a lot more easily than in the quoted market. And those are the reasons why private equity works. In the current climate, unlike quite a few asset classes, which I think are struggling, it is still probably more of a seller’s than a buyer’s market, for the right type of asset that would appeal to private equity buyers.
There is a huge weight of money to be invested. It is extraordinary that the fundraising climate seems as good as it has ever been. There has obviously been a big comeback of banks and bonds and so forth willing to lend to private equity deals which is good for the industry, as long as people do not get overexcited.
And there is this growing appetite among many different institutional investor types to become limited partners and invest in this asset class, from more and more pension funds to sovereign wealth funds. I think that the expansion of the alternative asset class is great news. For the advantages I outlined earlier, I think it is good news for industry, good news for Britain, because we are a world player, and obviously good news for Guernsey.
I do think, however, the industry must be careful. We have to focus on adding value, making a difference, and not quick flips, and not exclusively financial engineering. Because I think that game is actually over, and I think that leads to trouble politically and otherwise, and private equity leaves itself open to criticism if that is really how they make their money.
If you look at the returns and compare against other asset classes, I would argue that the outperformance derives from added value, not from leverage. It is important that private equity, managers and firms see that.
I think it is important that private equity avoids incendiary sectors, political and otherwise. Care homes being one, for example. I think they make themselves open to criticism if they invest in sensitive areas, and then treat it as a purely commercial transaction, without regard to the stakeholders as a whole. And sometimes, because private equity is private, they are not necessarily good at dealing with highly regulated industries and those that have a big public aspect to them in one form or another.
Private equity, to a degree, considering how much money it manages and the amount of industry and jobs that are connected with private equity-owned businesses, has been relatively fortunate to date that it has not suffered even a tiny fraction of the sort of criticism that, frankly, the banks have laboured under for the last eight years or so.
I would like to think that is because we are investing, we are helping to create jobs, we are innovating. But the industry should be under no illusion, things can turn and with some of the aspects I outlined earlier, it needs to be thoughtful.
I also think it is very interesting that the industry’s trade body is called the British Venture Capital Association. Actually, it should be called the British Private Equity Association With A Little Bit of Venture Capital.
I think there should be more of that early stage, higher risk, higher reward investing, because that is where the truly cutting edge innovation happens and where tomorrow’s FTSE players are going to emerge from.
One way or another, be it the industry, be it limited partners, institutions, government, society as a whole, we need to find more ways to find more capital to go into that sub-segment of the asset class, because I think it is the one that, longer-term, generates the most wealth, and that is really important.
Cakes and pastries – a case study
Luke Johnson and his two partners took control of Patisserie Valerie 11 years ago. It had six sites and was a £5m. a year revenue business. ‘Break even at best,’ said Mr Johnson. ‘In fact, the accounts were so rudimentary we couldn’t even decide if it was making a profi t a not. My two partners said we shouldn’t do it. And I said fascinating, we’re going ahead. I felt intuitively there was a great business bursting to get out.’ The business had been running since 1926 and though it was famous in Soho, it was ‘massively underexploited’. Now this year it is on course for £100m. revenue and more than 180 branches.
‘We’ve made I reckon about a 25- fold return, and we now dominate the classic cake and patisserie market in the UK. We did more or less everything known to man to transform that business, save preserve what I felt was the core integrity of the brand.
‘At the heart of that deal was exploiting the experience I and my partners had had, opening I reckon between us over 500 food and drink outlets over the last 25 years. Obviously they don’t all go as well as that. But it is an incredibly exciting thing to be involved in a journey like that, and that’s why I love what I do, and why I think private equity is a great business.’
Mr Johnson said that he intended that Patisserie Valerie would be coming to Guernsey soon.
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