#20 Private equity demystified
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Demystifying private equity on Fund Shack, with Oxford Said’s John Gilligan and the ICAEW Corporate Finance Faculty’s David Petrie
Private Equity Demystified is on the reading list of business schools from Boston to Singapore. It is now in its fourth edition, and in this podcast we speak with John Gilligan of Oxford Said and Visiting Professor at Imperial, who co-authored each editions alongside the late Mike Wright. We are also joined by David Petrie, Head of the Corporate Finance Faculty at the ICAEW, which has been a strong supporter of the initiative and, without whom, ‘the report would never have seen the light of day.’
We discuss the need to demystify, the outperformance debate, the power of M&A done well, and the need to adapt to a very uncertain future.
David John, welcome to fund shack. I was wondering if we could begin by John giving us a little bit of an overview as to the provenance of private equity demystified, which is now in its fourth edition. And then we can get onto the process of demystification and talking about private equity in this brave new world that we’re in. So I believe that the first edition of private equity demystified in about 2008, which was at the very Dawn of a very different kind of crisis. John, take us through it.
The backgrounds of this with a conversation over lunch, all good things happen over lunch. I was having lunch with Chris ward, who was the chairman of the Institute’s corporate finance faculty, the ICAEW. And at the time there was an investigation going on at the treasury select committee into the private equity industry. I was on gardening leave between leaving Deloitte and joining BDO. So I was one of the few people who was actually watching this live on tele because I was at home. Everybody else was obviously at work. So I said to Chris, have you seen the treasury select committee investigation? Cause it’s a little bit odd because the questions are very simplistic and the answers, therefore don’t make the industry look very show the answer in the best light. Shouldn’t somebody maybe write a note to somebody to just suggest how it basically works in principles so they could move on to the more interesting substance.
And what Chris said to me was, well, you’re not doing anything. Why don’t you do it? So I then phoned Mike Wright and Mike was my PhD supervisor at the time and said to Mike, well, you’re the leading academic in this field? Could you summarize all the academic stuff? And I had a sort of hidden agenda. I thought I’d get a free literature review for my PhD, but Mike saw through that one. So what happened was we did this and before we knew it, we went back to the ICAEW with Chris and said, well, we seem to have sort of written a bit of a book cause it got longer. And it just coincided with the ICAEW started to think about thought leadership and these sorts of things and such said, well, why don’t we just do it as a thought, a thought leadership piece and then the great, good fortune of life. We published it with a lot of help from people. And I said, it won’t be a huge amount of help from people actually. And then Harvard business school put it on their reading list and you thought, Oh, that’s handy. So that’s, that’s the background to it. And then once we were off the global financial crisis came along. We need to rewrite because the world changed dramatically. And we rewrote about every couple of years David and we’ve done it. So
A very kind of organic needs led process. David, why did you think that it was a project that was worth really kind of getting behind and supporting
Well, as John said, it, it, it had a very definite need at the time and you know, the, the BVCA does, does excellent work in this area. And it’s not to say, that, you know, they, they don’t constantly advocate the sector, but we, we felt that there was a little bit of a gap perhaps in the perception of politicians and policy makers really. You know, there is, there is this idea that if a particular professional body or a trade association comes to politicians and says, you know, well, you should be doing this because it’s in the national interest, they tend to say, well, w well, in the words of Mandy rice Davis, you know what you would say that wouldn’t you there is always this, this difficulty that they would tend to see them coming and say, well, of course you’ll pay to represent the, you are as it used to say, the voice of private equity and venture capital whereas the Institute of chartered accountants does as part of its Royal charter include the provision to act not only in the interests of the profession, but also in the wider public interest.
And so the analysis that John and Mike did, has kept things up to date really with what’s been going on private equity industry. Certainly, certainly hasn’t stood still, but as John has also said, it has become a really very comprehensive text. And it’s useful for members of the corporate finance faculty and more broadly people hoping to enter the private equity sector as well as principals and investors in it. I think these days, because it is such a comprehensive piece of work you know, I think they probably started off attempting to write a relatively short book and found that actually what it is an extremely complicated and nuanced sector actually, and to understand it properly, it isn’t possible simply to set it out briefly though our levels of complexity that I think that even people working in the sector may not fully appreciate. And the fact that it is it’s sites over 200 academic references means that when we’re having discussions with policy makers in white hall and Westminster about the importance of private equity and its contribution to the economy and so on, you know, the evidence is irrefutable.
It is grounded in very solid research is, is not simply the view of a trade body. This is really solid stuff, but it also works very well for practitioners, for our, you know, younger chartered accountants who are wanting to make their fortune and private equity. This is a really good place to start in terms of how, what are the nuts and bolts of the business. So this is why business schools above it. And I’m sure John would be able to talk about this a lot more because it really genuinely is on the reading list of business schools from Harvard to Hong Kong. So it works at all sorts of different levels. It, but it busts myths on the sector and explains that it does add to economic value. And it also is candid about some of the criticisms leveled against it, but it also provides a very useful how to guide and that’s what we like. So you know, we, we are delighted to support it and to continue to do so, because it works for us at so many different levels.
I think that’s a really great summary. That is really the impression that I got reading it as well. David, just to look at the political side, I mean, it’s not an apolitical book, but it is incredibly balanced. And I think there’s a lot of academic work out there. Even that’s highly critical of private equity. And I think where, where things are known and the facts are put forward and when then where they’re not known, I actually think you’ve got a section John saying, you know, look, look at the evidence base. And often it’s not there for private equity.
Well, one of the things we set out to do was not to be an advocate for any particular point of view, but to allow people to get to the point where they can ask the question and decide for themselves. So the whole idea of gathering together, the evidence was we only use evidence that is rigorously academic. So we don’t, for example, use pretty much any evidence produced by people who have an ax to grind one way or the other. So we wouldn’t use evidence from a trade body without commenting on it. So it’s all of the, all of the reference cited a peer reviewed. So the first point is we’ve done the exercise to get the data in one place. If you look in the appendix in appendix six, I think it is, it’s all there. It’s summarized in one paragraph. So you’d have to read the paper either, but there are paper references there.
If you want to read the paper. So if you want to dive into there, you can go there if you want. And the idea is to say, well, this is what we know, but here’s, here’s what we don’t know. And here’s the stuff that, where people have strong opinions where their opinions are based upon evidence. That’s. I mean, the evidence has been growing, but evidence is incomplete because one of the problems, I mean, it says it on the 10th, private, you know, it, I don’t think private is private because deliberately secretive. I never, I’ve never believed that. I think the private equity didn’t really care about communicating outside of its closed circle for a long time, because they never really thought about it. When we started, we made the point that private just means not quoted. It doesn’t mean secrets. It’s become, there’s become a public interest in it because it’s not so big and that’s legitimate. But back in the day, people say it’s secretive. It wasn’t secretive. They just hadn’t really thought about communicating with the people who didn’t to that point, how an interest. So we have, we’ve been through this process of unpeeling, the onion, where data has become available. People would come or interested. And a lot of the early academic research turned out to be wrong because the data was wrong. So a lot of it’s been rewritten. Some of it good, some of it bad.
Yeah. I certainly didn’t get the feel that I’d be, I was being preached to, and to David’s point that it can appeal to many different constituencies. It really does feel like a manual. I feel like if you gave me a hundred million, I can at least go through the motions of managing a private equity fund. And every time I get stuck, I could just pick it up. Now there’s a, there’s a, there’s a lot of skill that goes into it, but you certainly kind of hit all the points in terms of, you know, from start to finish.
The thing that we learned as we were writing, it was we started by, we were the first people to sort of sit down and try and write something that wasn’t either aimed at the management of the company during the buy-out or the investor in a fund. But we’re trying to just say, look, here’s the big picture. And here’s how it works. So it was more curiosity than, than anything else. And what became clear as we did each edition was this is an industry that is very intricate. It’s not complicated, but it’s very, very intricate.
And if you don’t understand the intricacies, you can’t draw the right conclusions. So the classic one is taxation of current interest. Taxation carried interests top of the agenda at the moment. Most people don’t understand a really important point about the taxation carried interest. The definition of carried interest in, the tax legislation is that amount of capital that is taxed as carry that amount of, of return. That’s taxed as capital in an LP agreement, carried interest is 20% of the return. They’re two different things because the return has interest fees and capital. So in the tax legislation, it’s defined as capital in the LP agreement. It’s 20% of all the profit. If you do the arithmetic and look at how much return comes from interest fees and capital, you’ll find it’s Ferris and fund to fund, obviously, but a lot of return comes from interest and fees.
That’s taxes, income. So a large proportion of carried interest is taxed as income already, but unless you know, that the definition and the tax legislation is different to the definition in the LP agreement, you’d never know that. And you have no idea how much time I spend talking to journalists explaining that the thing that’s certain in the tax legislation is different to the thing that’s written in the LP agreement. And it makes a difference what the tax rate is and has any journalists picked up on it and written it in front of genders. They’re interested in, and now we’ve, you know, there was an article in the Ft recently, and that point has now been been made, but it’s not try explaining that in a headline. And it’s not very exciting either, but it’s important.
Yeah, we certainly find it very useful when we’re talking to officials in the treasury and so on about fiscal policy and how that relates to government investment programs and the development of new funds and so on, which is what we’ve been quite busy attempting to assist within the faculty over the, certainly over the past nine to 12 months as the government has looked at other measures, which might increase the flow of funding into those bits of the, that are short of cash. And you know, there are all sorts of you know, in a crisis, all ideas are considered however, however, left field. And so sometimes it’s been quite helpful to us to be able to explain to people just how some of these things work, but in a context of an open meeting, you can’t necessarily do that. It’s actually quite handy to say, I’ll tell you what, I’ve got, something that I suggest you have a look at that just, you know, you can’t really say to people, you need to start with the basics, but if you are looking to do that, this is, this really is a very, very good place.
So I do use that to help people gather a sort of a background understanding of how some of these things really do work. And and, and it really is. It really is very effective from, from that perspective. And also, I think one of the other things that is particularly important about this latest edition is that John covers in some detail, not just some of the changes over the past two or three years in terms of the way that private equity funds have been well doing just that raising funds and structuring themselves and what this means for the broader economy in terms of systemic risk. So there are some important factors there that the government officials and the bank of England have been looking at, and we’ve had helped them use this addition to explain, but also more broader questions about, you know, how should public money be allocated to support businesses that might be struggling at the moment.
And again, that is touched on in the addendum to the text, which John wrote with Jim Strang after the original copy had gone to press. So there are a few, well, not a few, there were a lot of very important policy implications throughout the document, I think all throughout the publication, but we’ve certainly found it been very useful to support our work in determining policy, which then in turn leads to government intervention. So it’s it’s a useful underpin to actual fiscal policy when it’s working at its best. And I can say that there have been times when we have used it to to aid understanding and and it, and it’s proven very effective.
I thought that the book was worth getting just for the penname that you wrote John with with Jim Strang, which is just a couple of pages, but I thought it was really interesting looking at how things are, you know, cause everything’s changed now. Right. But my impression from those pages was actually that I’d be relatively sanguine from the perspective of a private equity fund investor, but that perhaps some other constituents might feel some heat.
Yeah. Jim Strang and I read that in April and it was the first thing that was first time we’ve ever tried to write anything with people when we couldn’t sit in a room together. So it was first time we did anything over zoom, which was the first word thing, but the private equity she’s been through a number of cycles. I mean, depending on how old you, I started in 1988, I lost track of how many crises I’ve done. This is obviously a longer and different one, but the industry has come through. Many of them and each time has gone in, there’s been this fear that the leveraging things will cause a problem. That’s essentially at the heart of what they, what the issue is. People concern that overleveraging things will amplify results that are bad and that will be bad. And we’ve argued for 13 years or whatever you were writing that because the funds haven’t been leveraged.
Now, there’s, there’s been changed in the fund structure, which means that’s creeping in. And we kind of said in 2007 that’ll happen. And it is a, but we don’t think at the moment is any evidence that that’s going to cause any kind of systemic risk. But the thing that is different is the structure of the banking market, which is radically different. And that’s, that’s the overflow from the last crisis. You know, the GFC changed the rules of banking to make the economics of leveraged finance different. There’s more catio on capital in banks now than they used to be against leveraged debt. And that allowed the debt funds to come into the market. So many of the debt funds in Europe essentially were the mezzanine funds. You started moving down the capital structure and then the us model came over here.
Those funds are leveraged and indeed some of those funds leverage each other and there’s as yet, that’s not yet been through the mill in Europe, it’s been through the men in the States. The concern is that some of the smaller funds, because these funds are actually relatively shorter, so privately funds 10 years. So if you’re going to have a crisis, every, every decade, you’ve got to probably hit war on average debt funds are shorter. So if you raised one in your first fund and you went into the crisis, you will have no ability to have no track record, to raise money for the next ones. So we have a, quite a fragile environment for some of the new entrance into that market over the last decade. And when we come out of that, of this crisis, which we will in the world will be better.
It will be, it’ll be interesting who survives and who doesn’t, if you pitched yourself as a retail uni charge provider or a travel sector specialist, you know, the world got bad and there’s nothing you could done about it. It’s just, it’s just a caustic event. Conversely, if you’re a turnaround investor, maybe the world got more interesting. But the one thing we do know from each crisis, this is always been a good time for the equity investor writing checks. When the world has been bad, has been a good strategy over the years for the, for the GP. Interestingly for the LP, the evidence is that you can’t pick the time to invest because you don’t make the investment decision that the GP does. So when you can make an LP decision today, or your GP might not invest the money into three years, so you won’t miss this, this with this window,
Which some could say is central to its inherent advantage because you can’t just flip flop and change your mind. You’re, you’re stuck in it through good and bad.
That’s the reason it doesn’t spread risk is because you, you, you made your bet and you bet on it. Now the secondary markets and the ability to do leverage positions, changes out of bet and it’s eating away at the edges of it. The analogy that runs through my head is a bit like you know, when people used to snip the edge of coins in the 17th century, there comes a point when you’ve debased the coin. We’re not there yet, but that’s, that’s, that’s a sort of a similar analogy. We’re just chipping away at the model a bit, bit by bit. And the original model of you. And I set up something for 10 years at the end of 10 years, if I’ve made some money, you pay me 20% of it. And if we haven’t, you don’t, that models are now evolving very rapidly.
Yeah. And, and so the jury is out on the performance of debt bonds, but do either of you have a gut feeling with regards to the impact of debt funds on mainstream private equity. If we were to hit a situation where there was a lot of workouts and insolvencies and so on,
I mean, that’s organizationally, that’s the interesting thing about the smaller funds is they don’t have the internal organization to do that because they weren’t jumping around long enough and working things out is, is a labor intensive exercise. So then one of my, one of my colleagues I’ve been on the investment committee, a big issue, investor impact investor. One of my colleagues is of work is a partner of a workout fund. And what they do is they buy other people’s problems and solve them so that, you know, there are routes to, to solve these problems. But the original investor went to the benefit of that when you invest in. So there is a question as to are there enough people to know how to do this and all the in the right place, because they’re originally in the banks, the banks had workout departments. Now, maybe those people are all the people that are sitting in the, the debt funds now, because many of them would have left. But, you know, that’s the question
I think the other couple of other interesting things to say about that question, Ross as well. I mean, the first thing is that we’ve not really seen the level of insolvencies that we were anticipating, or indeed that many of us anticipated at the beginning of this back in back this time, last year, really all last March when we went into the first lockdown you know, the statistics are very, very clear. You know, the number of insolvencies is Cigna is, is less in Q4 of of last year than it was in 2019. So that’s, that’s the, that’s the first situation. I think many of these businesses are not that many of the difficulties for debt funds haven’t yet hit. As John has mentioned, you know, those private equity houses that have found themselves with businesses where they’re working, capital’s got stretched to such a level that there that businesses is unsustainable.
I suppose there’s no other sources of capital. Then they’ve, they’ve taken some fairly urgent action or some too desperate action in some cases. So there have been some high profile, private equity backed failures in the sort of within the sort of six months kind of horizon of the crisis biting. But they could, well, if some of those could well have been businesses that were already struggling for a variety of different reasons, I think what is also interesting is what you’ve seen or what we’ve seen more broadly with the actions that private equity took you know, over the past nine to 12 months. So the first thing that they did was look very carefully at their existing portfolio. Some businesses were doing well and others were clearly under a great deal of strain. So the things that private equities consistently argued that it does well is bring professional management into businesses.
So in, you know, ask providing an external perspective and looking at ways in which the business could be adjusted, working capital management could be improved yet further diff unfortunately difficult decisions could be taken in terms of reducing operating capacity and sadly reducing head counts. And so on the private equity funds took those. They, they move very quickly with their existing portfolio businesses, but then they also found that they had a lot of investee companies that were pretty much business as usual and alongside that they also changed their investment philosophy and private equity for, for many years is recognize that it can change the significantly changed the value of investee companies by building together similar companies as so-called buy and build approach. They recognized that this was a very, this was a, this was still a way you could do deals during lockdown. So John said they could, you know, you can, de-risk an investment because chances are what you already know the sector by definition with buy and bill, because you’ve got an investee company in it they’re already, so you’ve done your due diligence on the market and the dynamics of that, your content about that.
And there’s a very good chance that the management team probably also know personally, you know, the other people within the target company, they met, they certainly know the customer base, the dynamics of it and so on. So that the private equity houses are able to use their existing resources, existing management teams, and so on to help them do due diligence, due diligence, investment targets. So we saw that developing as a way for getting transactions done.
The great truth of private equity is cost of capital drives a lot of things. If that’s cheap, then, then transaction sizes rise and the are recalled giving a lecture 18 months or so ago with a colleague from Goldman Sachs he said, look, it’s a bit like being in, in the final of the French open, which still has you still have to win by two clear games in the French open, so you can keep playing till the end. So it could be 17 all, you know, the ends on the way, but you have no idea whether it’s going to be 1917 or 39 37, but it felt like that before we came into the crisis, because we were at the top of the market. And so when we submitted the book to the publishers, we actually said, again, we submit this nine we’re at the top of the market.
We had no idea virus was going to be the thing that disrupted it. I was completely surprised it was all obviously, but it’s still the case that we have this strange atmosphere across the capital markets where the cost of capital is distorted by quantitative easing and low interest rates means that the asset value inflates and when that’s unwound, the asset values will fall. We just don’t know if that’s going to unwind quickly or slowly or how that’s going to happen because nobody’s ever done it before. And the change of government in the state Springs to Janet Yellen back to the table. And she was in the process of slowly unwinding that towards the end of the Obama era has moved. Music has changed because the world’s changed. But that’s the kind of the, the big unspoken elephant in the room is what happens if interest rates rise significantly, because that goes back to the evidence-based, doesn’t it? Because the majority of the growth in this industry, I mean, it was a cottage industry before quantitative easing almost, and now it’s huge for many years.
So yeah, nobody knows. And I guess the, the other thing going back to David’s point is, yeah, there have been some sectors that have done phenomenally well, you know, software being the quintessential beneficiary of lockdowns. And then there are the sectors that I think David was alluding to where they’ve they’ve had problems, but those that are backed by investors with deep pockets, see it as a time to go hunting. And they may well emerge even stronger because they will dominate their sector, I guess, having rolled it all up. I mean, there, there is that. I mean, there’s the buy and bill thing is an interesting change. One of the questions that perplexed me since I started doing this all those years ago is all the academic evidence. We have suggests the M&A generally destroys value and all the academic stuff we’ve got about private equities, generally private equity at a gross level, outperforms markets, private is an M&A driven business.
That’s what we did. So how come the business that is focused on M&A and pretty much something else is outperforming the market when all M&A token taken around generally suggests that it’s quite distorted. And this is the kind of question that we wrestled with for years and years and years. It’s what we call the paradox of private equity is people do M&A and they make larger gains that larger returns than if they didn’t.
David, that a controversial statement, I guess, from your perspective as a chief executive, the corporate finance faculty.
We tend to take a slightly different view in a rather more optimistic view to the value added by M&A than than, than perhaps Johnson indicated in the academic evidence. We always used to be entertained by a report that used to be published by one of the major accounting firms suggesting that M&A destroyed value. And we thought, why the hell are these guys publishing this? But of course, what they were publishing this fall was because they, the, they are, their argument ran of course, well, smart M and a with good due diligence and so on and all of these things. But of course, nobody goes into a transaction expecting it’s a fail. You know, so what, what has happened that has may have resulted in reduction in value, and the answer is things haven’t worked out the way you thought they would.
Yeah. So why is that? And these, these can be systemic issues. They can be political, you know, it’s all the usual, the usual analysis that John and his colleagues teach their students in business school. One of the areas in their pastoral analysis has changed beyond their imagination, original imagination. If there’s something fundamentally wrong with the target, then even some of the largest examples illustrate that it is possible typically to take legal action against the the sellers. Americans are making a very unfair to Americans by the way, for any Americans watching, but in the unit in the U S I should say, I should preface my remarks by saying that the use of warranty and indemnity insurance is become much more widespread than it ever was 10 or 15 years ago. And also the propensity to claim against those policies, which is where my well, I’ve dragged my Americans into it.
You know, the, there is evidence that suggests that American acquirers are more inclined to claim against WNI policies than perhaps it’s typically the case in Europe. And that, again, I think is a function of the way that those transactions are done again on the basis of completion accounts rather than the lock box mechanism, which is you know custom and practice in the UK, but it’s not to say that these things, you know, won’t won’t change. And but I think, I think there are lots of probably lots of factors actually, which might contribute to things, not working in quite the way that people expect, but it’s not something that we tend to like to talk about. And a few years ago Vince cable had had a good look at this and commissioned a piece of piece of research.
Looking at the value that M&A did actually add to the markets and that particular research illustrated that the impact was, was relatively neutral. But in the corporate finance faculty, we give an award every year to the public company that has added most to shareholder value through the use of M&A activity. And this year we did an analysis to look at past winners of these awards, because of course, as many people know, a lot of companies fear the curse of the award. As soon as you get given an award values collapsed, and something goes horribly wrong. This is not the case, actually, in, in eight out of 10 of the businesses that we gave an award to. And given that they were all public companies, if you’d invested in the stock of each of those businesses, you’d have, you’d have generated a return. That was significantly ahead of any average industry and most tracker funds, because these businesses were making very judicious use of M&A and very effective use of M&A to add to shareholder value.
Yeah. what, what, what may am I kind of pick to weigh out over the decade was trying to answer this question, how come this thing is happening? And we think on the conclusion of the book in a sentence is we think it’s about process. We think it’s the fact that private equity firms are good at doing this stuff because they do it in a fixed process. So there are other, like, there’s this idea that great deals get done over a napkin, sitting in a bar over a bottle of wine between two entrepreneurs. Those are the ones that probably go wrong, because if you do a process and you have a process that you do every time, what you do is you select out the failures quite, quite efficiently. You know, there, there are waves that can swamp you like this tsunami of, of, of the virus.
But if you select it are all the things that you could have selected out reasonably, then you avoid the losses when you avoid the losses, that makes a big difference to where you’re going. And we think, but we haven’t yet been able to demonstrate, cause we haven’t figured out. We never quite figured out how to do it. In fact, I’m doing some work at the moment that I called Tim Galpin, Oxford on this is what is defining the success of private equity is two things. One is the, on the way in, there’s a process that not only buys as well, but implements the purchase process. Post-Completion well, so the a hundred day plan thing. So due diligence turns into action. And secondly, the focus on exit makes people do it quickly, because if there’s one thing to say, I’m going to change the strategy of this business over the next decade.
And there’s another saying, I’m going to have to do it in the next three years, three to five years, and you can just work quicker. And we think those two things are at the heart of, or probably our conjecture is that those are at the heart of why this works. That sounds plausible to me, but could you not kind of zoom out a little bit further and say, well, the processes, the function of the structure of the LP structure, it’s not just the LP strip to think about the different surfaces. Imagine I sort of business GE some years ago, and they’re really good acquirers. They have an internal process, but it’s all internal. So it’s an internal process. And their level of knowledge in that process is limited by the number of transactions they do, which is a lot or used to be a lot when they were very inquisitive.
Now imagine that your, I don’t know, pick a fund, doesn’t matter. Most of those funds externalize the process. Private equity is a big user of the services provided by people like Amelia and other people know we did a lot more transactions than anybody else did. So we learned more. So the, you know, the big four accounting firms and GT and BDO below them do more transactions per year than any private equity fund in the world by orders of magnitude. So funnily enough, the people who have come across the problems tend to be in those footsteps. Some of them ended up moving into private equity. So one of the conjectures is that by externalizing a large proportion of that process to people that you work with consistently, you’ll get the benefits of their learnings. And therefore you avoid mistakes. You would have made had you not used external advisors, corporates use of external advice less, and therefore they’re more likely to fall for their own beliefs as it were. They don’t have an external check mechanism in the same way. So when we were conjecturing that, you know, you hear a lot about passion and vision, all these sorts of things in business schools, and my colleagues do all this, but maybe here competence is what we’re talking about. You know, being very competent, a process might make a hell of a big difference.
Yeah, yeah. I was just going to say that that certainly the view expressed of course by very many of the members of the corporate finance faculty who are themselves advisors and they do, as John says, they do, they do see the same things day in, day out. And you know, again even some of the larger or mid market houses, I guess in the UK might do 10, 15, 20 deals a year, but they’re certainly not seeing exactly the same thing in quite the same way. And the increasing specialism within the advisory firms as well, again, increases that level of expertise and that ability to be able to say you know, this, what this, this could be, this could prove to be one of those unforeseen difficulties that I was talking about a little time ago. They’re not really unforeseen they’re they’re things they’re factors in investment risk that people just might look at differently and be proud.
And to actually take a, perhaps an artificially optimistic view about at the time, because it happens to fit with company strategy. And I think that to, to sit alongside John’s analysis or perhaps to, to, to add to it or to add facto, no doubt they’re considering is that I think in private equity, they’re set up to monitor changes and KPIs within a business extremely closely and where things are going wrong. They will tend to know potentially anyway, not this is generalizing, but perhaps quicker than they might within a private company or public company, perhaps they will know sooner that something’s going wrong. And, and also perhaps they will be more inclined to take action sooner. You know, one of the facts and perhaps John I I’m worried that I don’t now have academic evidence to support this, but there is a lot of anecdotal evidence amongst the advisory community to suggest that private equity managers change management teams
There’s, there’s evidence of that. There’s, there is evidence that private actually changes management board, anybody else? Absolutely here.
Yeah. And they’re doing that in order to, they are proactive managers, they will step in and intervene. And there’s not necessarily perhaps the giving an investment, the benefit of the doubt, if we could call it that, that you might get in you know, a, a public company transaction where it might be, well, we don’t quite know why this isn’t working, how much of what we’ve bought is, is now integrated within the much larger organization. And therefore it’s less easy to assess exactly how much value that it’s actually added to the, to the, to the whole. Whereas if you’ve got the thing running discreetly, it’s much easier to to assess its performance. So there’s a whole series of different factors that are at work here and academic support and analysis of these things does allow for directors to challenge some of these, these concepts, these ideas that, you know, we know that we need to be careful with M and a, because, you know, we’re concerned it doesn’t necessarily add value. And how can we change our processes, try and minimize risk, taking it back to private equity demystified. That’s where, you know, some of the principles in private equity may not think about some of this stuff quite that way all the time, but having, going back to the text and say, yeah, actually that’s an interesting trend. We need to have a bit of a think about that. It’s really great
And he’s coming on again soon to talk about his new book on, on governance, which, sorry,
I was reading Simon Witney’s new book on Governance last night, a friend, and there’s a point that he makes in that book, which is far more scholarly than I am, and often a lot, lot smarter than I am. But the point he makes is, is that if you stand back from this and look at the simple decisions you make as a shareholder shareholders in public companies have the option to sell. So the private equity shareholder has to have the option to fire because they don’t have the option to sell. And so the reason you change the management is because you don’t have the option to bail out. And that’s, that’s the sort of the contract you enter into. You have this simple idea of if I don’t like you I’ll sell and that we know that will be affected, the market will make the price of the asset fall because of that, you can’t do that in the private equity world, or couldn’t historically get this bit of secondary trading. You can do it on now. So you have to have the option to fire because what else can you do now? There isn’t a third option. And that’s, that’s again, one of these things that David was saying, I mean, it changes the game. If you can’t sell, you got to do something else.
Yeah. There’s an interesting interplay between the advantages of the governance model and the advantages of the process that you outlined as well. And obviously they’re interlinked, but they are separate as well. Yeah.
Yeah. I mean the governance thing sort of comes from the process. And so there’s a process on the way in which is a bit I know. Well, cause you know, I was an M and a person and then there’s a process once you’re in, which is, which is kind of embedded in the, in the governance piece. And the thing that strikes you when you deal with a private equity fund year on year on year, is how consistent that process is a cost of pay.
I’d really like to try and bring you two together on the point because I think it can be done listening to you both. And so let me try you on something, which is that the academics may have discovered that MNA may on average destroy value, but the average does not necessarily dictate the overall benefits of an activity. And David’s prize is highlighting people that have hits upon a successful formula and are accruing knowledge along the way. And your description of private equity does the same thing. And so while the average may destroy value the activity as a whole may be a creative
That’s absolutely. Right. Right. So the, the whole, one of the biggest problems that the conversation about private equity has generally is the average is a coastal over the place. So the average return on compared to the average return on a market, is that a meaningful thing? And the answer is, well, not really, it’s not meaningful for a number of reasons. One, nobody buys the average. When you put leverage into things, you make the dispersion of the distribution bigger because you amplify everything. So th th this constant question of does private equity outperform the market. I sort of got to the point where I don’t think the question makes any sense anymore because there’s now leveraging funds. So I, as an investor in the fund, first of all, investors don’t get the same deal. If I put a hundred million pounds to a fund, I get a different deal.
And if I put 1 million pounds at the same site, secondly, there’s leveraging funds that comes in and out. So depending upon when I’m in that fund, if I’m trading in the secondary market, my returns would be different to yours if you stayed in across the whole piece. So even within one fund, the LPs are getting different returns. So what does the average mean? No idea. And then there’s this, this, this whole question of what does it, what’s the average of what if you’re doing turnaround investments in France and I’m doing buy and builds in Spain? Are we doing anything similar? I don’t know my organization, it looked very similar when we draw an organization chart. I mean, might all be in my book and, you know, we might put them down as a private equity fund, but is it really sensible to compare us?
Because the strategy is really the question. The real question is an investor is what do you say you’re going to do? Did you do it and give him the risks I took? Did I get a return for it? And comparing, I know every always picks on KKR. So I was picking know some large buyout fund CBC, God fed. Doesn’t worry about it too. LDC or inflection, or I don’t know somebody else, is that a sensible thing to do know? It’s a bit like comparing the performance of somebody in Chelsea football club to somebody in Harlequins rugby club. They’re both playing a sport with a ball on a field, but they’re not trying to do the same thing.
Have you come across the American intelligence definition, the difference between a puzzle and a mystery, which helped probably mangle, but puzzles. Basically they have an answer, at least in theory, they can be sold computationally and mysteries don’t have a single answer. And even when you have all knowledge, it’s still unclear what it is. And so it strikes me that private equity demystified as a title is peculiarly appropriate. And obviously it’s very much needed as well. So it’s been a great pleasure speaking with you both. And I really commend the book. It’s it, it’s actually a good read as well. Thank you.
And also, so that everybody buys it, I don’t make any money out of it. We give all the money to the big issue where I’m a trustee of the charity. So if people want to give money to charity and also learn about, about private equity, as I said in the post on LinkedIn, it’s not bandaid, but it does a bit.