I have been asked this morning to speak on the theme of "the challenges facing the private equity industry". If some observers are to be believed, such an address would be a challenge in itself. Parts of the press and the occasional colourful figure within the industry itself would suggest that such a topic deserves the sort of argument that Emperor Hirohito made in August 1945 when broadcasting the fact of his country's surrender to the United States where he solemnly declared "The war has developed not necessarily to Japan's advantage". This is not, however, the case that I intend to offer to you today. There are immense challenges facing private equity at present - both internal and external - but, in truth, there are huge challenges facing everyone involved in British business at every dimension. Yet private equity has underlying assets, in more senses than one, which will enable it not merely to survive the present storm but to thrive in its aftermath. What we face today is the mother of all stress tests. Yet the evidence available so far is that we are more than capable of enduring these very harsh conditions.
Let me start with a little background. One of the interesting things about private equity and venture capital is that it is both a very old and a quite new sector. It is old in the sense that the principle of inventing new business ideas or intervening to rescue companies that are fundamentally sound but the subject of imperfect management have been with us for an eternity. I have no doubt that whoever invented the wheel did not immediately recognize its commercial potential. This remains the core of what private equity and venture capital exists to do. I have not spent my professional life engaging in magic financial tricks cast upon a balance sheet but instead in the at times deeply unfashionable slog of improving the machinery of the businesses which we have had the pleasure of encountering so that the end product is more attractive to customers and consumers and hence more successful as a result.
But for most of that same professional life private equity has not been an activity which claimed headlines in the financial pages of the newspapers. That outcome has only occurred in this decade with a small number of very large and strategically bold companies taking charge of household name companies (many of which to be brutally frank had not been well organized for some time) and subsequently becoming something close to household names themselves with the rest of the private equity industry finding itself forced into the limelight. "Private" no longer means "private" as it once did and private equity now finds itself playing a different, and less low-key, role in the economic landscape. This is the reality and the BVCA in particular has had to be rebooted and retooled to meet these conditions. This does not, nevertheless, alter the fundamentals. If asked to provide a three word explanation as to what private equity exists to do I would still reply "to improve companies". That is what we should be judged on, it is what I expect to be judged on, and it is what I am happy to be judged on, and that is why society should see us as, to use another simple three word phrase, "a good thing".
The core of the challenges which exist immediately can be divided into the internal and the external. The internal are market conditions. They involve persuading banks, who until their own earthquake occurred were partners with private equity in the quest to improve companies, that they should be ready to lend for new deals and be prepared to be patient and positive as private equity houses seek to manage portfolio companies through what has been the sharpest international economic decline since the 1930s and which is not over by any means. A further internal challenge involves convincing investors, limited partners, that private equity remains an incredibly sound place to put their money for long-term investment not just the comparatively short-term rewards of the recent past. These are robust challenges in themselves but the economic is matched by the political. Private equity has to prepare itself for a possible change of government in Britain probably next year, with the upheaval that such a transition always begins, and, somewhat more pressingly, the threat of truly crass regulation being imposed not at the behest of anyone in Westminster or Whitehall but by edict from Brussels.
In a sensible and sane world I would be discussing market conditions first and mentioning the political context as something close to an afterthought. Regrettably I cannot. Such is the character of the proposals which emerged at the Euro equivalent of warp speed, driven purely by partisan politics, and such is the pace at which events might develop in the next few months that I must start with the external not least because of the need to mobilise everyone in this audience to ensure that serious harm is avoided not only for the likes of companies such as my own but all of the hundreds of portfolio companies over which private equity has an influence and the entire British economy writ large.
We are not naïve about the question of regulation. We did not cause the current economic meltdown, in many senses we are the victims of it. It is obvious, though, that the atmosphere in continental Europe today is one of "there has been a crime, we must be seen making arrests, never mind the evidence". As an industry, private equity embraces the need for a robust system of disclosure and notably greater transparency and we also support a degree of standardization across Europe, not least because despite the logic of the internal market there is plenty of petty protectionism out there as far as private equity is concerned. The United Kingdom can rightly claim to be the market leader as far as reform is concerned, with the Walker innovations, overseen by a Guidelines Monitoring Group, in which members entirely independent of the industry by background constitute a majority, ensuring that large companies which employ substantial numbers of employees make available crucial information about their activities.
This has been completely ignored in Brussels. A Directive is on the table which is barely literate, plainly aimed at one industry, the hedge funds, but extended incoherently to include others such as ourselves but not additional private entities, and which its own authors do not seem that keen on defending. It is intrusive across many spheres - capital requirements, valuations and so forth - but surreal in its implications for portfolio companies which are owned by mid-market private equity participants. It means that the FSA here in London could find itself compelled to regulate the likes of Tyrell's Crisps, Telepizza or the West Cornwall Pasty Company as if these institutions were in the same league as the major banks or massive insurance companies. It is a recipe for red tape and will prove a dire burden.
Paradoxically, the stated purpose of this drive is to offset "systemic risks" to the financial system. There have been made explanations for the financial crisis offered but until now crisps, pizza and pasties have not been among them. The press releases which accompanied the Directive when it was released on April 29 casually conceded that private equity did not pose a systemic risk to the wider economic architecture but then proceeded to lay down legislative notions irrespectively. We have been accused by some of making too much noise about all this but I do not apologise for the level of volume. Almost 60% of private equity in Europe is based in this country. We would be far and away the biggest losers if the Directive were to stifle private equity creativity in the manner that I fear that it might. And yet if these new rules were imposed those who benefited from the decline of London, Manchester or Edinburgh would not be Paris, Frankfurt or Milan but Dubai, Zurich and New York. Europe would be less shooting itself in the foot than squarely in the temple. Our politicians need to wake up as to what is going on.
Let me restate our position briefly and with vigour. There can be no justification for requiring public disclosure for private equity firms and the companies that they own while leaving other privately-owned competitors (which may be run by oligarchs, continental banks, family offices and conglomerates) free to operate within the confines of relative commercial confidentiality. Regulating companies purely because they are owned by private equity shows a shocking lack of intellectual rigour. Uniformly applied one-size-fits-all standards are the worst possible basis for effective regulation. The Commission has chosen to ignore in-depth analysis carried out by distinguished experts into the causes of the financial crisis in this country, Europe itself and the United States by the Obama Administration. It has ignored the European central Bank which has estimated that the aggregate amount of all the money lent to private equity backed companies in 2007 - the very peak of the boom - constituted starkly less than 1% of European banks assets. This Directive would be bad for investors, bad for private equity and bad for ordinary citizens. It would be a barrier to economic recovery at precisely the wrong moment. I urge all of you to support the BVCA in its efforts to take on this proposal in the months which lie ahead of us.
Turning now to what should have been the essence of my remarks today, the minor matter of market conditions. Business and the banks should consider each other as partners and in many respects we do. If banks are unwilling to co-finance new deals then, in many cases, those transactions will not take place and the chance for private equity to intervene to save ailing and failing companies will be lost. There is, I have to report, evidence emerging to the BVCA that attractive opportunities are being lost through overly cautious credit committee decisions or non-decisions such as the delay in these bodies reaching a conclusion. Where there are solid opportunities to invest, credit committees should avoid being dogmatically conservative and have the resolve to back private equity clients who can invariably demonstrate an outstanding record of success. The recession will be shorter and far less painful if lending resumes at normal and healthy levels rather than the bankers together retreating to the caves.
I can understand the rationale for taking a cautious approach when banks are under huge pressure to shore up balances and bolster capital ratios. This strategy will not, I have to point out, get us back on to a path of recovery and renewal. It will end up prolonging the recession, slowing the pace of growth and stoking the unemployment figures. The long-term implications of this attitude for the bank far outweigh any short-term benefits they might obtain. Dealing with the excessive weight of any individual via suggesting a rigorous diet and more exercise is one thing. Imposing a hunger strike is quite another.
In case this seems self-serving let me cite a couple of relevant statistics to you. Figures from Nottingham University reveal that in the downturns during the 1980-1997 period private equity firms were one of the primary providers of financing for companies struggling to access capital. Furthermore, in the 2001-2002 slowdown, buy-out activity accounted for almost 40% of the total UK market for general M&A activity by value - an increase from just 18% in 2000. Private equity is, in other words, an extremely welcome counter-cyclical operator if it is allowed to fulfill that function. It is therefore imperative that the banks should be eagerly supporting requests from private equity clients to fund new deals in order to spur economic recovery and to haul the country out of recession.
Much the same applies to existing deals and discussions between banks, private equity and portfolio companies. Some banks and bankers have been excellent friends in need but others have assumed the posture of total strangers. BVCA members have informed us of continuing examples of persistently obstructive and unhelpful behavior from certain institutions. It is in the interests of the banks to work constructively with private equity to resolve situations with a view to the long-term, rather than take a destructive short-term perspective, looking for a quick out which would harm the underlying company, its employees and its often very satisfied customers, as well as the relationship with the private equity house. There should be no excuse for taking a falsely macho stand on covenant breaches, forcing basically decent businesses to the wall. Attempting to slash leveraged loan exposure overnight and with scant regard for the health of the core business itself will lead to value destruction. We would like to see a new protocol, perhaps based on the old "London rules" for companies in need of some restructuring.
I turn, finally, to the people who in many ways matter the most to us - our investors. Institutional investors are the life blood of the private equity and venture capital sectors. Our industry has consistently achieved returns for these investors, such as pension funds, over a number of years very significantly in excess of the public markets and other asset classes. With many pension funds facing crippling deficits, long-term sources of profits, such as private equity, will be crucial to their health and to the retirement incomes of many millions of people.
The numbers reinforce my assertion. The BVCA's latest performance measurement survey indicates that private equity and venture capital funds continue to outperform other asset categories over the long-term, with a combined ten-year internal rate of return of 15.4% against 3.7% for total UK pension fund assets and 1.2% for the FTSE all-share index over the same ten year period. The same data also highlights that funds invested during previous economic downturns have produced splendid returns for investors, with funds raised in 1994, for example, showing a superb aggregate 10-year IRR touching 40%.
Our past success must never induce within us a complacency which leads us to assume that investors will unthinkingly continue to investor their money in private equity funds. We must continue to prove our worth, create tangible value and generate robust returns if we are to count on investor support in the future. We currently have an astonishing opportunity to do precisely that and show the enormous advantages that private equity can demonstrate as backers of companies in this difficult recession. If circumstances are obliging the whole of the private equity market to return to its roots, focusing on strategic and operational improvements about all else and with a lesser emphasis on debt than might have been the case a couple of years ago then that, in my view, is no bad thing. If there is a lazy impression out there that private equity only makes money in the good times and is best avoided in the bad times then now is the moment to slay that myth.
I appreciate that I have set out a lot of challenges at quite an early hour in the morning. I have risked breaking one of Albert Einstein's golden rules namely "no mind can function until at least one hour after consuming breakfast". I have staked out this territory out of confidence and not in trepidation. These are testing times for private equity but we are at our best when tested. If politicians have the sense to leave us be, bankers have the intelligence to act in partnership with us and investors can be convinced of what I believe to be an impressive argument, supported by the facts than private equity will emerge from the recession stronger for the experience. If it does, then not only business but society will be enriched by the endeavour. We are here for the long-term. We will be here in the long-term. Thank You.
