Optos, with Douglas Anderson and Anne Glover

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Anne Glover is CEO of Amadeus Capital Partners. This is the story of how she saw the potential in Douglas Anderson’s break through optical medical device concept to create a world leading business from scratch. Optos has since saved the sight of, perhaps, millions of people.

A lot is written about how venture capital works, but this very human story conveys so well the uncertainty and challenges, as well as the judgement and persistence that it takes, to build a truly valuable company from scratch.

Alistair Lester, CEO of Aon M&A on protecting and enhancing returns

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Alistair Lester, CEO of Aon M&A on protecting and enhancing returns
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Alistair Lester is CEO of Aon’s M&A and transactions services business in EMEA. This is not the conversation you think. Aon has spent recent years building out its capabilities across the risk spectrum.

Or watch the video version here.

 

Transcript

Ross Butler:

Alistair, you are the CEO of Aon’s M&A business in EMEA, but it’s not your first bout there. You started in the graduate scheme some 25 years ago, and in the mid 90s working for private equity clients. And I wanted to start by asking you to what extent has the insurance services industry over that quite long timeframe responded to the pace of change in the world and the risks that businesses and private equity firms face today?

Alistair Lester:

There’s been a huge amount of change of course, in the world. The insurance industry is not renowned for being particularly speedy in terms of pace of change, but actually there’s been a pretty significant amount of change within the insurance industry and particularly within the part of the insurance industry and the broader professional services aspects of our world that faces off to the M&A and private equity ecosystem. When I think back to being told that what we did for private equity firms was a niche part of our industry and a niche part of a firm that I previously worked for.

Alistair Lester:

I think we, as an industry, are really only just starting to embrace the scale of that relationship opportunity in the same way in the last three, four, five years, a couple of good examples of what’s really driven that Ross. If you go back two, three years, if I said to a PE firm, what do you think of Aon, Aon could do to help you? They might say, I know you, we talked to you on the limited partner side, you’ve got a big investment management arm of your business, and we talked to them about LP investments, or you are an LP in our fund or, or they might likely have said insurance due diligence. And they might’ve said something more recently, this warranty and indemnity insurance, or as we call it in the US, reps and warranties insurance product,  which has genuinely exploded in the last four to five years in utilization in PE.

Alistair Lester:

And yes,  we do all of those things, but what’s really exciting for us is our ability over the last few years as our industries evolve, and as Aon has evolved to bring multiple advisory capabilities, multiple advisory work streams to life on the one hand and multiple or an increased number of financially motivated insurance instruments to bear on the other hand and much more sophistication and science around how we really do develop, deliver value in the portfolio. So when you have that conversation now with clients who’ve been on that journey over the last three, four years, they would absolutely recognize our industry. And particularly our firm, I think, has been leading the charge in areas like cyber consulting, in intellectual property consulting and advisory and valuation, of course, in risk and assurance in the broad set of human capital from retirement benefits, but also talent reward and compensation aspects of deals.

Alistair Lester:

Then on the instrument side, looking at the adjacencies to warranty, and indemnity insurance like loan contingent risk insurance, be that tax insurance be that litigation insurance we’ve pioneered a product called judgment preservation insurance. We’ve pioneered the ability to wrap insurance around your intangible assets or intellectual property. You can potentially use those instruments as collateral, which enable you then to access different forms of financing. So really the big change has been this institutional-industrial realization there is an opportunity to marry up what has traditionally been seen as a relatively lazy, perhaps enormous pool of insurance capital with all the parts of the capital markets and bridge the two in a way that drives value into private equity deals, because as you and I both know, private equity are just so hungry for what they call new technology and new ideas, and that’s been a fantastic accelerator for what we do.

Ross Butler:

Why is AON providing the services that it is providing? What’s the journey from your insurance services capabilities to the services that you’ve currently  just outlined?

Alistair Lester:

The world lives in a world of risk, and Aon as a firm is all about risk. We are a risk business. Insurance is an instrument that can help clients manage their risk. But what we don’t do is just deliver insurance products. We also deliver a range of advisory capabilities that help clients understand, identify and mitigate risk insurance instruments are just one part of the mitigation aspects of how you deal with risk. Every deal that any client does, they price risk into their deal, and they deal with risk in a deal in different ways. Maybe they priced chips. Price chips are a result of people identifying risks they’re not comfortable with. Maybe they seek contractual recourse against the seller against the counterparty, and maybe that contractual recourse is somehow secured through escrows. Maybe, as a buyer, if I identify risk in a deal, I defer an element of the consideration to see if that risk crystallizes, and if it does, I’ve protected myself because I’m not having to pay my deferred element of the consideration. All of those things are well-established approaches to dealing with risk in a deal. Those risks need to be identified for people to be able to understand them and then come up with solutions for them. So, the exciting point is we think those three buckets of price-chipping contractual recourse, and deferred consideration, they’re all perfectly valid ways of dealing with it, but none of them are actually optimal ways of dealing with risk in a transaction. By contrast, optimal approaches can include solving them through more insight into those issues, so you get more comfort with them. We can provide that in a range of ways across people, risk and cyber risk and intellectual property risk, et cetera, et cetera. But secondly, by introducing an insurance instrument, which can take that risk away in a far more attractive way and deal with those potential risks in a far more attractive way, potentially than price chipping or deferring, or getting contractual recourse against the counterparty.

Ross Butler:

And all of this kind of moves you further towards, I suppose, insurance being a purely defensive product. You’ve got a clear line of sight to enhancing returns through all of this.

Alistair Lester:

You’ve teed it up beautifully. So, we talk about what we do is securing investments and enhancing returns. That is our little strapline. We think with our advisory capabilities, we can give you much more insight into what you’re getting into. We think with some of the core traditional insurance solutions that are out there, very plain vanilla, traditional insurance solutions, you can secure that investment. But actually going to your point on enhancing returns, we think that we are able to deliver these structured insurance instruments across a wide range of areas, including structured credit and tax and litigation, et cetera, whereby spending a pound, a dollar or a Euro on that instrument you are realizing or recognizing multiples of that either in the enterprise value or somewhere in the capital structure of the transaction.

Alistair Lester:

That is a very different way to think about insurance, where for most of us, including people who live and breathe it, you know, renewing our car insurance or home insurance, or even our business insurance every year, what you’re really looking for is a way of reducing the cost of insurance, because you see it as a sunk cost. You don’t see it as a return generating instrument, whereas with a lot of what we’re doing, it’s spend a dollar or Euro pound on that instrument, and you will see a multiple of that somewhere in your enterprise value or capital structure.

Ross Butler:

It seems to me that risks over the, say, that 25 year period, have gone from being relatively tangible, relatively geographically, constrained to being much more intangible, much more distributed across the world, less physical and therefore just much more complex. And I suppose, as a result of that, harder to quantify and I guess where there’s complexity there is opportunity, which is why it’s logical for insurance providers to have expanded in this way. Is that a reasonable reading?

Alistair Lester:

I think that’s, that’s a very astute reading Ross. I think this is why Aon has diversified its capability set, for exactly those reasons, And if you double-click on intellectual property, as an example, and intangible assets, as an example, you only have to look at the huge rotation of the S&P500 over the last 40 years, which has gone from being, completely dominated by hard assets, tangible asset values, and companies who operated in those areas to companies, which are absolutely intangible asset rich and intellectual property based. And as a result, by the way, the insurance industry, some argue, has struggled to stay relevant as it could have done growth of global insurance premiums has lagged global GDP growth for that reason, because the insurance products are not as relevant as they need to be to what’s going on in the world traditionally. So, Aon made a move into intellectual property – and this is what Aon has done brilliantly – we have purchased capability and talent in adjacent areas to us. So, we bought a business, which was one of the leading intellectual property consulting businesses. And then what we’ve done is we have worked with that business to deploy that capability into a private equity context. We’ve worked with that business to build insurance instruments that can deal with intangible risk and intangible assets in a way that wasn’t previously being addressed. And we’ve gone one step further by helping to use both of those things, the insights and the capability we have on the advisory side, the risk modeling, the quants capability we have on the valuation side to then build product, which is enabling and opening the door to IP, rich companies, to access financing, using insurance as a collateral around their intellectual property in a way that’s never been possible before.

Alistair Lester:

So that’s an absolutely spot on. What Aon has done over the last five to ten years is it’s added inorganically areas of talent and capability, whether it’s in cyber, whether it’s in intellectual property, the talent world, we’ve added businesses and people who have bought different skill sets to our firm. Many of whom have had zero exposure to the insurance industry before. But actually by bringing these people into our industry, they are giving us perspectives on different emerging risks, which we’re able to support clients from an advisory point of view with, but also match those risks into the huge pool of insurance capital and start to build some new and evolved and developing insurance solutions that, that provide answers.

Ross Butler:

Tell me a little bit more about the, the IP services, in the specific context of venture capital and private equity. What type of business is it most useful for?

Alistair Lester:

So we think that one of the things we’re most excited about is we’ve always had a relatively limited story for the VC end of the private equity and financial sponsor community that is truly value added. We have an ability to identify, map and value the unique intellectual property, particularly the patents, but not just the patents, it can be data. It can be trade secrets, et cetera of individual companies. By doing so, we place a value on that, on that intellectual property, through a proprietary valuation methodology. We have the former head of intellectual property at Phillips in the Netherlands, global head of IP at Phillips. We have the former general accountants of general counsel for patents from Microsoft, right. People who honestly, if you ask them, ‘Would you ever, five years ago, can you ever see yourself working at Aon?’ They would have said, ‘absolutely not. Why would I?’ So we have some unbelievably deep talent in the IP space. I think we have more of the top 300 recognized global IP strategists working for Aon than there are at any other company in the world. And no one would know that right.

Alistair Lester:

We then spent a long time persuading the insurance industry of the efficacy of that valuation methodology, and there are many other parts of the capital market’s ecosystem, which rely on the underlying security of insurance to enable financing. We look in the aircraft, leasing space, residual value insurance on aircraft hall is, is a critical requirement for aircraft leasing. You know, finance use of aircraft leasing require certainty over what the, the aircraft may be worth at the end of the 10 year lease. And the way they’ve got that in the past is through residual value insurance that provides the underlying security, really what we’re doing and intellectual property is a similar thesis. We are valuing the intellectual property for a proprietary methodology. We then were demonstrating the efficacy of that valuation to the insurance market who are then wrapping an insurance policy around that value, not at a hundred cents on the dollar at a discount to the value, maybe 50 cents on the dollar by wrapping insurance security around what were previously intangible assets.

Alistair Lester:

You are turning them into tangible collateral. And what can you do with tangible collateral is you could raise finance against it. So, now we think we’re inventing or pioneering at least a new potential way for firms who are in the maybe series B series C stage to raise working capital and runway capital. Because up until today, the primary way for those firms to raise money has been to raise equity founders that owners don’t like raising equity, it’s diluted, it’s expensive, it’s painful all of those things and actually being able to, or they go and raise venture debt. And venture debt performs an essential service, but also it’s not, it’s got a lot of complexity to it. We think we have an instrument now, which can enable you to access pretty straightforward, not cheap, but pretty straightforward debt secured against an insurance wrapper, which is wrapping your intangible assets. And we think by doing that, we are potentially reinventing how you finance early stage companies. The British Business Bank wrote a paper probably two years ago saying why can’t banks recognize intangible assets more as collateral for financing? We think we are leading the answer to that question, which is- what can you do if you do it in this particular way?

Ross Butler:

I assume that larger businesses with large IP people folio, they’ve got other financing options.

Alistair Lester:

A hundred percent. That’s a great question. But, and yet, we also have clients who are approaching us and asking whether we can collateralize their IP portfolio for the purposes of satisfying pension trustees. Right. For example. So, you know, we need to provide collateral to our pension trustees. Maybe this is a product that we could use to satisfy our pension trustees over pension liabilities and future pension contributions. We’ve got financial institutions who are approaching us and asking whether this is a product that they could use to satisfy some regulatory capital requirements, right. So, you know, is this a product that could satisfy the banking regulators to a certain level that intellectual previously unrecognized intellectual property that they held in their business is now something they can collateralize and use to enhance their financing of, of whatever obligations they have. So it isn’t just the venture answer, but we’re seeing particular appetite and interest in the venture backed community in the early stage businesses area at the moment.

Ross Butler:

That’s a great example of allowing people to focus on the upside and enhance their returns. I don’t want to spend the whole time talking about COVID, but obviously it’s completely changed the nature of, and scale of risk. That touches on so many parts of business, so I’m thinking particularly like cyber, for example. I was speaking to a CEO the other day, he’s based in London, 90% of his employees are in India. Geographically remote. Can’t get out to them very easily. All of these risks seem to be not really thought of, just a couple of years ago.

Alistair Lester:

We launched our cyber- M&A private equity focused business, getting on for two years ago now. We did it for a couple of reasons. Outside of private equity and M&A, Aon had made an inorganic acquisition in a company called Strauss Frieberg, which was one of the leading global cyber risk consultancies that grew up in the US and again, I I’d imagine if you spoke to many of the people inside the original business, they had not had anything to do with the cyber insurance worlds. They were deep cyber risk consulting people. Then we built a client facing delivery of some of the capabilities within that business, and we did that by, we actually bought across people from the big four who were providing private equity, cyber due diligence, which was just emerging two or three years ago. We bought some of those people across. And the exciting thing is, we were able to persuade them of a couple of things, which I think we’ve proven out, which is one. We have the in-house technical cyber capability that we just bought this business with deep technical cyber risk capability. But two, we also have in our industry, a huge amount of data insight from cyber insurance. So we know what is happening in the cyber risk world, because cyber insurers are paying claims for our clients. So we know what’s, what’s creating those claims and we know how much is being paid for those claims and how those claims are being managed and how the risk of being mitigated to avoid them happening.

Alistair Lester:

Again, you put together deep cyber technical expertise with quant data, true deep, rich data over what is actually going on in the cyber world, which is causing financial loss. And you’ve got a unique skillset. So, our cyber team, actually very specific to private equity, have built something called Portfolio Scanner, a piece of proprietary tech, which blends in automated threat analysis with a quant model. We’ve done this for a number of PE firms. You can run it at relatively low cost, to come and run a six month cyber review across your portfolio. You can run it in very quick time, automatically across your entire portfolio, and it gives you a traffic light outfits of which firms in your portfolio need a closer, deeper dive from a cyber risk point of view.

Alistair Lester:

It’s no guarantee that there’s no problems in the ones that are green or amber, but it will tell you from an outside-in point of view, an unobtrusive outside-in points of view, where we think based on outside threat and industry sector knowledge and claims statistics from cyber insurance, you should be going to look Mr. GP to double-check that firm is doing what it should be around cyber risk. We actually ran that for a GP last year. And one of the firms that came out on the red of the traffic lights, we literally just reported to the sponsor. And just 10 days later, as we were going through the action plan, they had a ransomware attack. And that led into a huge recovery exercise. Again, no guarantee that if we ran that exercise six months earlier, the ransomware attack wouldn’t have happened, but certainly there would have been more awareness within that firm of the risks and, and hopefully some, some mitigating actions would have been taken.

New Speaker:

What’s really powerful areas that is all consulting work, but we’re delivering technical and rich data insight in an, in an automated manner, in a highly efficient manner, real time. We are launching and delivering within three to four weeks, not let’s run a long cyber risk consulting project, which takes many months because by the time the speed of the world’s changing so much that, you know, six, nine months’ time, it’s a different threat. It’s a different group of people. It’s a different type of ransomware, whatever it is, you know, you need to be keeping on top of this on a regular basis.

Alistair Lester:

So a lot of our PE funds now are actually running Portfolio Scanner on a regular basis, but at six months or 12 monthly, and they run it, it’s just a, it’s a health check across their portfolio. And it just helps them stay in touch with, with exactly what’s going on. And, you know, we were quite excited. We ran it for Cinven, which reported that in their ESG report.

Ross Butler:

That makes perfect sense to me, marrying the qualitative in the quantitative. I’ve long felt that you have the cyber professionals who are focused on best practice and process, but you’ve also got the kind of the unknown quantitative part, which is the elephant in the room. And you know, companies that pay ransoms, they don’t publicize it, of course. And one suspects that it is a much, much bigger problem than most people realize had they had to send a press release out and it was in the media. And so there’s something of a disconnect between the scale of the problem and what to do about it. And it sounds like you’re able to contextualize the problem and then find the solution, which feels to me like where I’d want to be.

Alistair Lester:

Yeah. Yeah. Look, I think just one thing I’d add is, is I’ve just talked about that in a portfolio context, which is critical. The other thing we’re learning is fascinating is our clients who go through that exercise, looking inside the portfolio, across the portfolio, they almost without fail, ensure they implement pre-investment cyber due diligence as a specific work stream going forward. A lot of firms haven’t been. Or they felt that their IT DD covers cyber. They’re close cousins, but they are distinctly different things. By the way, we’ve also got to make sure we’re okay as we’re going into new deals and this whole workstream of cyber due diligence, which we think where that evolving further into what we call digital and tech DD, where you’re looking at yes, the cyber risks.

We had a client say to us not long ago, every deal is now a tech deal, right. So let’s look at the tech in that business and understand how risk-exposed it is. We just brought a guy in from Turner & Townsend, a well-respected property consultants. Again, not an insurance guy, he’s a risk consulting person, but he’s able now to deliver his risk advice in a much more informed and contextual way because of the data and the insights we can provide from inside the industry. And that’s why we’re bridging the advisory and the risk transfer together.

Ross Butler:

So just so I’ve got the lexicon straight, you’ve got it, diligence, which is like you, your internal systems, and processes, and making sure that they’re efficient and functioning. You’ve got cyber, which is like security and stopping attacks. And you’ve got digital and tech, which is

Alistair Lester:

It’s performance risk. We ran a deal for a PE fund who was buying a, a reasonably well-known real estate platform. Right. And actually what we helped them understand was how many of the hits on the platform were from bots and how many were genuinely from independent consumers, right. And that goes to value. You want to pay for the consumer. So it starts to become not just a risk issue, but also evaluation issue, which is exciting.

Ross Butler:

What about people risk? Do you do anything in that domain? Obviously there’s a link with, with cyber and behavioral behaviors.

Alistair Lester:

We do it very broadly. And I think traditionally again, when people thought, well, what would Aon do in the human capital space to help us? It would be, well, we’ll do some actuarial work on the pension plan, or we’ll do some look at life and medical insurance and make sure that we’re meeting employee benefit risk. But again, Aon bought a business not long ago called QT, now rebranded Aon Assessment Solutions, they are a bunch of psychiatrists and psychologists. We had an infrastructure client who was funds, who was buying a, a bus business. I mean, lots of infrastructure funds by bus businesses. I think EQT had just bought a big one in the US.

New Speaker:

Interesting little story: we were arranging motor insurance for the bus company and they have to have it. And one of the things that drives motor insurance is, is driver’s safety. The price of motor insurance is driven by how safely, how well do you train your drivers. We brought in our Aon assessment colleagues to create a framework for the type of personality that they wanted to hire and to maintain as bus drivers and to put it very crudely, you are looking for people who are less aggressive on the accelerator, on the gas pedal. There are characteristics which are going to lend you to be more heavy or less heavy on the gas pedal. So that had two incredible benefits.

Alistair Lester:

One: By doing that, and by demonstrating to the insurance company that they were hiring that sort of person that puts the risk in a better light, it enables Aon to secure a better price for the core old-fashioned motor insurance for the buses. But here’s the other thing you could also demonstrate: how the fuel consumption of the fleet would reduce and the environmental positive environmental impacts. And of course, the economic positive impact in terms of reduced gas fields and fuel bills for the bus fleet. You’re going to value in way more ways than just one, which is we can help you reduce your insurance premium. We could also help you reduce your operating costs through reduction of fuel consumption, and we can demonstrate that you’re thinking about that through an ESG lens in a world where those things are increasingly important. It’s a really good example of how we’ve gone from being an insurance broker to adding these other elements to a value.

Ross Butler:

And that comes from presumably the psychological profiling of the people

Alistair Lester:

Right. So when you go and hire now bus company, you need to hire people with these characteristics, which we have defined for you, and it’s now built into your, your recruitment processes.

Ross Butler:

There’s a huge change that’s, that’s happening in terms of the work environment. Are you’re doing some thinking on this area.

Alistair Lester:

So again, we have an enormous human capital practice who stretch right across, you know, governance, board consulting, compensation, talent, et cetera. And, and we have, we’re one of the firms we sponsored in various countries, something called the Work Travel convene. So we brought together in Australia, in the US and the UK in different countries, large employers. And we’ve done that over the last 12 months. And this isn’t, you know, the private equity and M&A world, but this is more broadly as Aon. And what we tried to do in the private equity community is then bring the conclusions and the insights that, that are being created from those sort of exercises into P funds into their portfolio. But the work travel convene is really trying to look in that crystal ball about where this is going, what are the implications for the workforce?

Alistair Lester:

One of our big areas of course, is terms and conditions of employment and benefit packages, and how do you construct compensation packages to reflect different working environments and all of those sorts of things. So a huge amount of work in progress on that. And I think a lot of clients are increasingly looking for help in that area, because as you say, there’s so much uncertainty.

Ross Butler:

Yeah. I think also private equity firms are increasingly focusing on people and talent and talent retention is their core asset. And you’ve got private equity firms hiring HR, internal HR people to just think about that within the portfolio.

Alistair Lester:

Again, one thing that people won’t know probably is Aon has two businesses, one called Radford, and one called McLagan. They are two leading compensation consulting and compensation data businesses. In fact, McLagan is probably recognized in the general partner and the, in the PE community as being the leading private equity compensation consultant in the world. We know we build many of the, many of the maps, many of the GP carry plans, they come through McLagan insight, but again, Aon in the past culturally McLagan would have been run as a very independent business, delivering his value to its clients in a, in a slightly isolated way.

Alistair Lester:

The way that the firm has been reorganized in the last few years is, is around what we call Aon United which is really about bringing the whole of the firms and the clients, and the fact that we have people who are delivering compensation and talent advice to a large number of PE funds, you then think about how can you maximize compensation particularly through carry of your general partner practitioners through the ever-increasing adoption of innovative solutions and innovative financing structures, right? So those things are linked as well. We can help you maximize returns in your portfolio companies, which then drive your compensation structure that we’ve helped you put in place by the way, through these ideas over here. So, these things are not all individually separate from each other. They are all intertwined.

Ross Butler:

I’ve got a couple of other COVID things on my list. Supply chains, which I assume is bread and butter for insurance services, but global supply chains, given international relations and protectionism, is, it’s not in a good place.

Alistair Lester:

That’s a critical factor. One of the most important parts of the insurance world, which is probably overlooked is two areas, but one is business interruption insurance. That’s come under the real spotlight as a result of COVID. I mean, let’s be honest and, and not necessarily the most positive spotlights, and we’ll see how that all plays out, hopefully positively for policy holders who have valid claims. People in our industry have been talking about supply chain risk for a long time. I think what COVID has done is accelerate that and now there really are needs for firms to really, truly understand their supply chain, but not just because of the, the revenue and the, and the financial risks, but also increasingly through an ESG lens as well, you know, modern slavery background checking, all of these sorts of things are really important in the supply chain.

Ross Butler:

I’ve written a couple of things down from your preamble, but I can’t quite read my writing. Judgment preservation insurance. Is that right? Yeah.

Alistair Lester:

So that’s a, that’s a new area we’ve developed over the last year or so. So we’ve invested heavily in, in our litigation risk group. So there again, there is a theory, a thesis that we would like clients to see litigation as a potential asset, rather than just something they unfortunately have to go through. If you’re bringing a claim against somebody and you believe you’re going to win. And more than that, perhaps you’ve won at the first quarter or the second court. We developed a product which will enable you to ensure as much of that judgment as you can. And in the event that it progresses to the next layer and you lose, then the insurance, it provides you that, that capital. And here’s the thing that that’s really exciting. So we just closed the deal for a client who had won a significant judgment against the large US firm. And we were able to secure several hundred million dollars of insurance, which by the way, it was not the total amount of the judgment award. It was a substantial tranche of it, but by no means a majority, we were able to secure some, several hundred million dollars in judgment preservation insurance, which very simply said in the event that this is overturned, you are going to be indemnified by the insurance company, and that’s nice to have, right. But here’s the really positive and interesting thing: that firm was then able to use the judgment preservation insurance to access third party financing. So the insurance became collateral to access financing. Litigation funding has become a big thing, right? Litigation financing has been around a long time. It’s absolutely got a place. It provides a very essential service. But we are introducing new ideas, which potentially are alternatives to that, arguably again at a lower cost of capital. And that’s super exciting. We’ve hired people in our firm from litigation, funders and litigators who understand that world. And what we’re really doing is using their knowledge and insight with our capability of building insurance, structured insurance instruments and structured products to, to redefine how, how clients can, can see, find value in those sort of situations and see them as assets.

Ross Butler:

In a private equity context, every moment counts, it’s the distraction, I would imagine more than anything, you don’t want it as a standing board item, when you’re trying to grow a business fast.

Alistair Lester:

This is exactly right. And certainly when you come into exit, right, what you do not want is uncertainty over litigation and exit. So we do a significant amount of wrapping up litigation like we do within the tax world. What insurance is very good at Ross is, is rapping, is bridging low probability, but high financial risk situations into certainty, right? And of course that costs money, which is the premium. But that’s what insurance can be very good at. And if you can, you can do that increasingly with tax. Some brilliant advisors around the world will tell clients, this should be fine. What you get from the big four, what you get from the lawyers is we’ve done this before. This should be fine. What you don’t know is whether someone on the other side of the deal table to you has the same view.

Alistair Lester:

Maybe they are a large conservative, strategic, maybe it’s the first time they’ve done a deal in that jurisdiction, whatever their motivations are for feeding the risk, the perception of the risk is different to your perception of a risk. And those are the sorts of things that can derail deals, right? They can get, they can, they, you know, they, they become distractions from actually, this is fundamentally a good business. We want to buy here, but we’re getting distracted by negotiating and arguing over whether we think this one piece of litigation is more or less likely to happen or more or less likely to cost this amount of money, right, and insurance can deal with those situations by giving you a well, we can sell you, it will cost you this to take this issue away. Now, all of that cost makes sense in the context of the data.

Alistair Lester:

It doesn’t, but at least it gives you something, a point of certainty, which you can get a resolution on and that’s becoming much more understood and that’s relevant in tax too. And you can push further by the way, without getting too off piece into further adjacencies around structured credit. So the same broad thesis Ross applies in receivables financing. So one of the things COVID has done is really drive a real increase in the amount of receivables financing that go on in the market. What many don’t appreciate is if you can wrap insurance around those receivables in an appropriate manner, you can de-risk that portfolio receivables. If you’re de-risking that portfolio of receivables, you can arguably lengthen the tenor and reduce the coupon on the financing terms you’ve got. So it’s the same thesis. And just in a slightly different situation.

Ross Butler:

So do you have a classic CEO 3 or 5 year vision for Aon in M&A?

Alistair Lester:

I do. We’re living in the middle of the hottest market we’ve seen in, in a long time. We’ll see how long that lasts. But I think, I still think we’re scratching the surface in terms of the value we can bring to our clients. If I’m really harsh on ourselves, we still are delivering one or two of our core traditional value propositions into a deal. And actually if we just paused and, and delved a little deeper into the deal or had the right conversation in the right way at the right time, there are multiple live opportunities that we have allowed our clients to leave value on the table because we haven’t been either able to identify or able to articulate how we could find a way to help them to, to find that value and bring that value off the table. So that’s really the key thing. I think we’ve grown enormously in the last three to four years. There is still huge white space for us, we think because there’s just, we’re very fortunate. We’ve got an incredible breadth of services and we’re backed up by this incredible ability to bring capital, to bear in a way which hasn’t happened before. And honestly, we’re scratching the surface.

Ross Butler:

Alistair, thanks so much for your thoughts and for coming on to Fund Shack. 

 

Alistair Lester:

Listen, thank you so much for having us Ross. It’s been great.

 

Dan Aylott, Cambridge Associates

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Dan Aylott, Cambridge Associates
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Dan Aylott is Head of European Private Investments at Cambridge Associates.

This is a Fund Shack ‘private chat’ about the large opportunity set in the European private equity market, from buyouts through to venture capital, with a focus on growth strategies in all these markets.

Alternatively, you can listen to the filmed version here.

Transcript:

Ross Butler:

You’re listening to fund Shack. I’m Ross Butler. And today I’m speaking with Dan Aylott managing director and head of European private investments at Cambridge Associates, where he’s responsible for EMEA private equity and venture capital research. Dan works with clients to help them build, manage, and monitor their private market allocations. So he has fantastic insight into the industry and some unique perspectives on the market, which he was good enough to share with me. Enjoy!

Ross Butler:

Welcome to Fund Shack. You’ve been at Cambridge associates for a fair while now, but I believe you’ve just undertaken it a new role. Can you tell us a little bit about that?

Dan Aylott:

Yeah. Hi Ross. And I’m very happy to very actively speaking to you today. I’ve been at Cambridge just over nine years. I’ve been in the industry now for a whopping 20 years. I started with a private equity team in year 2000. I joined Cambridge nine years ago to work with clients on their private markets portfolios. So for the first sort of eight and a half years at Cambridge, that’s been my primary focus. And then last year, my role changed slightly. So I now I’m head of European private investments, which entails me having a mix of responsibilities.

Dan Aylott:

My primary responsibility going forward is to cover the European private equity and venture capital research function here, which means that, were tasked with finding best ideas and high conviction managers. But for our clients, I’ve brought some client relationships with me. I continue to work with some of our key clients at the firm. And yeah, excited by the change. Even when I was working predominantly with clients, I was often, doing manager due diligence and looking and scouring for ideas for, for those clients’ portfolios. So this is just a, really an extension to, to that role. But I’m excited. We’ve got a, a large opportunity set, I think, in, in European private equity and venture where we’re adding resources to the team so that we can we can cover all of those opportunities. And I’m very excited by what lies ahead.

Ross Butler:

What’s particularly exciting. You, what parts of the market do you really like the look over at the moment?

Dan Aylott:

I’m passionate about all parts of the market really, but I think for us at the moment, there’s a real desire and hunger to look for growth strategies, and that can be anything from very early stage venture through to growth, equity and buyouts that have a growth slant to them. We’ve long been talking about the benefits of growth and how growth is the predominant factor in achieving outsize returns in private markets portfolios. That’s where a lot of very interesting ideas are coming from right now. Certainly, in the venture space the ecosystem there has really been growing and expanding in Europe in particular, there’s always been a very sort of well-established U S venture market as everyone obviously knows.

Dan Aylott:

I think Europe has often been thought about as being in the shadows of the US and even potentially China and Asia to some extent, but I think recently we’ve seen some strong performance coming out of Europe and some the manager universe, if you like, sort of expanding in all directions with many interesting strategies for us to, to look at and to answer, consider for our clients.

Ross Butler:

Tell us a little bit about that if you would that. Can you quantify the, the growth of European venture in the last half a decade or so?

Dan Aylott:

In the last year alone, there was $20 billion raised by European VCs, but there was 40 billion invested in Europe. So that gives you a sense that the market is very attractive and is attracting investment from all over the world. In fact, and that’s really feeding into a very buoyant and a flourishing ecosystem. So it’s definitely an area of growth and, and definitely an area where we’re seeing lots of very interesting opportunities There’s always been well-established firms in, in the venture space in Europe for a long time. We’re seeing a lot of managers spinning out. Operators, people who’ve run or worked in senior positions in technology companies and have done very well made a lot of money, want to continue to invest in the space. Joining forces with investors to create new firms that I think are particularly interesting.

Ross Butler:

Then what underlies this growth? Was it just a question of time in the market, because for a long time, European venture capital it underperformed and it was, and it was subscale and perhaps to a degree, it is still subscale, but, but what underlies it’s, it’s, it’s recent growth?

Dan Aylott:

There’s a number of things that you might want to point to. When I started in the industry 20 years ago, roster the European venture landscape was really not on the map. I was joking with a colleague this morning about how, diligence used to be done. Data rooms came in the form of a, of, of envelopes packages in envelopes that were sent to you via the post. So that, that age has me somewhat, but the venture capital market obviously had been impacted by the.com crash. There were very few European venture firms last minute.com perhaps was, was the most famous impacted obviously when, when the crash happened. So really nowhere on the map where performance really wasn’t, wasn’t there either.

Dan Aylott:

And it takes a long time in venture for performance to come through. I think since the financial crisis, there’s several things that have happened. We’ve been in a very low-rate environment for a long time. So people have been seeking growth and seeking alpha from different areas of their portfolio. And I think that, venture and growth has been an area that has if that, that, that growth and that innovation that can’t be sort of captured anywhere else in, in portfolios. I also think it became a little bit uncalled to be a banker or or go into financial services after the last financial crisis. And there was an impetus perhaps, but for young people coming out of universities, strong tech universities to think about doing something different.

Dan Aylott:

So there’s a number of factors I think that has fed into it. And I think as, as we’ve seen performance improve in Europe and we have some statistics that show over recent horizons one year, three year, five year European venture growth has actually performed strongly versus the U S and Asia. And I think as that performance has started to come through its European venture has caught the attention if you like of investors. And from that, and the more capital that flows into the, into the industry, the more opportunities that it creates.

Ross Butler:

That’s all directionally very positive. But the venture managers that I speak still tend to complain about a relative lack of capital in Europe compared to their us counterparts. Would you, would you agree with that?

Dan Aylott:

I mean, I would. I don’t know how, what the best way of saying it… It is… Underserved relative to other markets. Something like10% of jobs in the US are currently within companies that are VC backed and the equivalent number in Europe is 1% that is still quite concentrated around markets like the UK and Europe. But what happens with LPs generally is that there’s a lag. So the PE investors see performance coming through and then think, well, okay, this looks interested. I’m now going to start committing capital to these types of strategies. And so that’s what I think we’re seeing here is that we were convinced Cambridge that European venture and growth is an interesting space for our clients to commit capital finding great ideas for them to do so. There’s some convincing to be done around European venture capital and growth for certain investors, because historically performance in Europe has been difficult.

Dan Aylott:

The exit environment has been a little more challenging, and that’s being addressed. I think in some ways, here in here in Europe, there are changes to the regulations around listings, for example, that might make it easier for technology companies to go public. But that’s just one example, but there are, there are changing in a positive direction in Europe. And so, I think it’s just a matter of time for people to continue for investors to continue to see that positive momentum coming through. And I think that the capital will continue to flow into it. Abut I think it’s today, or you’re right. I think there’s still, more to go for. I think the overhang of capital in Europe is much less than it is in Europe. sorry, then it is in the U S apologies. Yeah. so, there’s some interesting dynamics in, in Europe that were, that we’re keeping our eyes on.

Ross Butler:

I’ve heard one hypothesis, which is that in fact, if more capital accrues to European venture and growth capital, you might see returns increase relatively counter-intuitively because of that sub scale element to the industry. Is that something that you would agree with, or do you think that the more capital that flows in will, will eventually kind of push returns down?

Dan Aylott:

Yeah, it’s an interesting thought. I mean, the fundraising market at the moment is really, really frothy. And boy, there’s lots of capital being raised everywhere, not just in Europe. I think the general perception is that the more, that more capital that gets raised, the more likely it is that returns will tail off. So it depends, I think you still have to keep disciplined. I think the key is for the managers that raise the capital that are successful at raising the capital stick to their strategies and, and remain disciplined in, in the areas that they’re good at and the areas that they can, they can produce, the attractive returns for their clients. And I think if managers can do that then, then, then returns will still be maintained. I think, as I’ve said, I think the, the universe of opportunities continues to grow for some of the reasons we mentioned earlier, more entrepreneurs, more, data scientists coming out of, of universities, more, more M&A from corporates looking to improve and acquire additive technologies.

Dan Aylott:

So as the universe continues to expand, I think that there is enough opportunity for more, more firms, more managers, more funds to be raised, but there probably will come an inflection point, right. Where, where potentially there becomes too much money and the overhang becomes too great. The managers either become ill, disciplined, or valuations get so high that it can then impact returns. And that’s always the concern and something that we’re focused on a lot,

Ross Butler:

But we’re not, we’re not close to that point though. Would you say….

Dan Aylott:

I don’t think we are in Europe yet. No, absolutely. I think there’s probably quite a way to go. We still like to see our managers remain disciplined, as it relates to fund size and strategy. But there does seem to be, an increasing opportunity set. And back to that stat, I mentioned earlier about 20 billion raised by European VCs, 40 billion invested, that tells you that even managers outside of Europe are looking at Europe as a potentially fertile place to invest. And I think that will continue and we’re seeing more and more, for example, U S firms setting up offices in Europe that haven’t previously had boots on the ground here. And so I do think there’s a way to go on that.

Ross Butler:

So if I’m a European venture manager or growth manager, it’s a good time to hit the road and start fundraising, but I’ve got to be disciplined. I’ve got to stick to my knitting as they used to say to what degree do I have latitude with regards to kind of think about different fund structures or sub sectors. Do you think there’s, there’s investor appetite to see firms explore those kinds of innovations?

Dan Aylott:

Yes I think so Ross. We are seeing, in terms of funds raised, ‘opportunities’ funds or, or ‘overage’ funds so that they can continue to back the winners in their portfolio. And this has been a phenomenon that we’ve seen for a few years now and that can work really well. Managers want to continue to invest with their best companies and if they can select the winners in their portfolio, then the benefits to their investors are all great. And obviously, investors must be comfortable for the longer hold periods that that entails. But we’ve seen, we’ve seen a lot of that happening in terms of fundraising and that’s one way for managers to expand their offering if you, like.

Dan Aylott:

I think the other side is that increasingly we’ve been seeing specialization across the, across the market and this applies to the buyout space. It applies to growth, and also it applies to venture where we’re seeing managers really sort of focus on what they understand what they know best. And it might be areas of things like FinTech. It might be AI, it might be SAS or consumer. And, and we’re seeing an increasing level of specialization with, with some firms. This can, this can be interesting. It allows LPs and investors to really kind of construct their own portfolios in the way that they want to, if they have a, a belief, for example, that FinTech is where the greatest opportunities are going to be. They can add some FinTech opportunities, maybe some crypto, that’s another area where managers are really specializing. And so we’re seeing an increasing amount of that. Again, we still like to see managers remain disciplined, raise the right amount of capital to prosecute that strategy. And that’s always the key consideration for us, but we’re definitely seeing more of that in the venture space and frankly, elsewhere in private markets. There’ this theory that as, as a market evolves there becomes more specialization and more deeper domain expertise within the managers.

Ross Butler:

And is that a firm or fund or both phenomenon? So, I’m thinking if I’m a generalist venture capital manager, is it the right strategy to start raising very siloed funds,

Dan Aylott:

Different strategies, work for different managers, right? There are definitely, there are definitely examples where people have been successful at doing just that as you described. So, they raise different vehicles within, under the same firm umbrella and have dedicated teams prosecuting on those strategies. They raise a, a one fund, one pool of capital, and they have teams within their firm that specialize in certain areas, but ultimately investors get a diversified portfolio across those, across those themes. And then the other thing is the other way of doing it is to be a single strategy firm with a very clear specialization in what you’re doing, whether that’s crypto, whether it’s digital health or, whatever the sub strategy is. And so there’s different ways to play at Ross. And there will be different ways it will work for different firms. I don’t think there’s a one size fits all answer to that really.

Ross Butler:

Does Europe have any particular sub sector advantage advantages in either of those kind of very broad spaces? I mean, you mentioned a couple already FinTech and

Dan Aylott:

Yeah, it’s interesting. I, and I think these, these sub strategies are still emerging, really Ross. I think we’re watching closely areas like FinTech, and I think the fragmented European sort of financial services markets are helpful to that. And the, the different currencies in, in Europe can be helpful to spawn interesting opportunities across FinTech. So that’s one area. I think Europe is a leader in yeah, environment, environmental issues. And so climate tech could be an area that Europe excels at. And, and there are some, some managers that we’ve seen that are focused on, on those types of strategies, agritech, climate tech energy, that kind of thing. But yes, I think there are certain areas that that Europe has a unique kind of positioning for areas such as, SAS and enterprise of enterprise software, SAS digital health, I think are probably a little more global in their, in their sort of their reach if you like, or applicability. So I think we’re seeing as much innovation there in Europe as perhaps we have in the U S although probably, a few years behind in terms of the development of the market, as we’ve talked about already. So

Ross Butler:

In the UK versus the rest of Europe, because obviously the UK is still in Europe given the events of the last year, rather than put Brexit on the back burner. But, but how are things looking from a vendor perspective there,

Dan Aylott:

That’s a good question because Brexit, like you say, we’ve been talking about Brexit now for, for, for more than four years, right? It’s well, when you’re coming up for five years and I think when then the referendum result happened I talk about this as well in the context of bias, but I think just the uncertainty around Brexit was the key thing. Now that we have some certainty, I think people can adapt and they can, adjust their, their, their business models to deal with, the additional admin that’s related to Brexit. I think the key thing we were concerned about were, was talent and movement of talent. So I think we still got a way to go really Ross before we can answer that. And no one has a crystal ball. I, what I would say is that particularly in the venture space in Europe, there have been, hubs that have, have, have grown up in Europe, places like Berlin cities in central and Eastern Europe in the Nordics, there are the French ecosystem is flourishing for venture.

Dan Aylott:

And so I think, I think venture capital really i, a pan European phenomenon, although, as I mentioned, earlier in terms of venture backed employment predominantly, it still resides within the UK as a, as a percentage of the overall market. But I think perhaps what we’ll see is a more even distribution of that across Europe.

Ross Butler:

Can we talk a little bit about the exit market you’ve already touched on the fact that there’ve been some easing with regards to IPO restrictions, what’s your general view on gone on, on the exit world?

Dan Aylott:

I mean, I, I don’t know if the regular, I haven’t seen the regulations around listing. I think we’re still being debated, but I think it’s been recognized that in Europe there needs to be an easier path to listing companies, venture backed companies. And so that is, that is I think, still under review. I don’t, I haven’t seen the results of that of that review yet. But as I said earlier, I think large corporates have become more acquisitive. So there’s probably more opportunity for M and a, and there’s also the U S market. So European companies can still can still go to the U S for, for their access. I think it’s still something that’s improving. And for example, there’s been some very successful life sciences exits the, they don’t necessarily hit the Heights of some of the U S listings that we’ve seen, but that they are happening and, and producing some very attractive returns for investors. And I think that that will continue to be an improving picture as time goes on and will help again adding to the to the attractiveness of the European market.

Ross Butler:

I guess one of the things that the venture industry has struggled with is, is a lack of natural institutional investors that are venture capital minded. But I assume that that’s something also that will develop and, and grow over time as investors gain experience in the asset class.

Dan Aylott:

I think so Ross, yeah. And it comes down to risk really, and the perception of risk. Right. And we work with clients of all shapes and sizes, right? With all different types of programs. We’ve, we’ve Cambridge, Cambridge associates. We have been advocates for venture for many decades and our clients have done extremely well from their venture allocations. And so, I think, I think overall, we have an easier time of convincing clients of the benefit of venture, but look, it’s a, it’s a re it’s a riskier asset class when you look at the loss ratios, for example, in funds they’re still very high. So that doesn’t mean that, as I’ve said, performance has continued to improve in Europe and has been, for mthe right managers in the U S have been extremely strong.

Dan Aylott:

And the point there is that the winners, far outweigh the losses, right? You, you need to pick funds who can find those breakout deals that are going to produce the returns that investors are looking for. But I think there’s still this perception that venture overall is a riskier part of the market. And so, I do think that as a, as I mentioned earlier, as the returns continue to solidify and be strong more and more investors will take note more and more investors will take a closer look at venture and find us a place for it, an allocation for it in their portfolios. Particularly as the traditional. And, if you look back at the buyout opportunity in Europe, the early two thousands, there was a lot of low hanging fruit, white space returns were very strong. People could generate great returns. Second decade returns have moderated. It’s been harder to differentiate yourself. The market has become more efficient. And I think as those parts of LPs portfolios start to see that there’ll be looking for other ways to generate outsized returns

Ross Butler:

That you also cover private, private equity buy outs, but from a growth perspective. So what, what are you seeing there are there? I mean, it’s easy to call yourself a growth-oriented buyout specialists, but how do you determine that that’s actually the case?

Dan Aylott:

Growth is a strong determinant of returns. And so, when we’re looking at managers, we’re looking at, what type of businesses they’re buying what are the growth rates in those business in terms of, of revenue and, and how are they helping to maintain and even grow that revenue over there, over their whole periods? That’s not to say that we, we don’t look at any managers with a different strategy. But I think increasingly over time, we’ve seen that just, buying, buying companies, applying a bit of leverage, making a few operational changes to increase margins. Doesn’t really, doesn’t really cut it in terms of achieving the sorts of returns that investors would, should, should expect from this asset class. And you really need to have an element of growth. Now that growth can be, it can be a quiet, it can be organic, there’s different ways of, of looking for growth in buyouts. But that’s what we’re focused on. We’re always looking to see where that growth is coming from. And I think, as I said, it’s an important determinant of returns.

 

Ross Butler:

We’ve also seen buyout firms move into the venture space as well, which I suppose with some buyout firms has a cultural effect, because there was once a very clear division between the VC and buyouts for a long time, and perhaps that’s not so clear anymore.

 

Dan Aylott:

I’m not sure that’s true. There have been some examples of some buyout firms establishing venture teams. There are some buyout firms that feel that having a venture program or a small venture fund alongside their private equity business is additive because they get to get, they get to see innovation and it’s kind of earliest form and that can inform where they want to look in that buyout strategies. I don’t, I haven’t seen a lot of that actually, Ross there’s some definitely some examples. And I think you’re right. I think the, probably the issue is that it’s a very different skillset, a different mindset. You need dedicated resources for it clearly. And so it’s difficult, it’s difficult to integrate. And a private equity mindset is different from a venture mindset in many ways, private equity is all about preserving capital, not losing any capital.

I mean, venture in venture capital it’s, it’s, it’s almost expected that money will be lost. As I said earlier, loss ratios are still somewhere in the 30 to 40 range. I think it might even be higher. I don’t have the numbers in front of me, but it’s almost expected that a part of your portfolio will fail and, and as entrepreneurs that’s okay. You’ve got to focus on your winners in, in venture. So it’s a very different mindset, and I think it’s hard for a private equity firm to have that sort of similar approach. But no doubt, as you mentioned, there’s been a few firms that are doing it and some doing it successfully,

Ross Butler:

Going back to the sector idea, does that also apply in terms of specialization? Does that also apply to the buyout world in the same way?

Dan Aylott:

Yeah, definitely. And it’s probably a little more advanced, I would say, in, in, in buyouts potentially where we’ve Cambridge associates long been investing in managers that have sector specialisms. So again, predominantly, or I would say the US has been ahead of the head of Europe in that. So, in, in sectors like healthcare and sectors like technology, there’s actually a few opportunities in Europe for those types of, of investments, but we still believe that sector specialization and deep domain expertise, is a positive for, for investors. And we’ve, we’ve got the performance numbers to show that actually the, , if you’re a specialist, you, you outperform your generalist counterparts. And I think in areas, for example, like healthcare in, in Europe, where again a fairly underserved space for specialists, it’s an, it’s a sector that has long been invested in by generalist managers.

But we, as I said, we believe in that sector specialism, and that’s an additional domain expertise such that, managers that have that focus should have an advantage. And so we’re definitely watching that. There’s a, there’s a handful of managers where we’re interested in, in Europe for our clients and looking to invest the capital on their behalf in, in those strategies across the size range, by outsize ranges. Yeah, not so much, actually. So I would say that specialization tends to start in the smallest end of the market. And there’s a number of factors there. So probably related to spin out so often, we’ve seen sector teams or sector heads spin out of generalist firms to set up a dedicated sector fund. Those funds naturally being first-time funds being more focused and more specialized will be smaller.

Now over time, we fully expect some of those, those funds and those managers to grow and expand and, and become larger. But there are very few large specialists in the European market, unlike in the US where we’ve seen the emergence of some very large say technology players and increasingly healthcare specialists, certainly some consumer specialists in the U S that are now multi-billion dollar funds. I think we’ve got some way to go in Europe before we have that level of opportunities at the larger end, but we’re seeing several interesting things at the smaller end of the market where, arguably markets are more efficient. I think they’re more efficient, they’re more reasonably priced from a valuation perspective. And where investors and managers with real domain expertise have an advantage. So I think it’s interesting for the low middle market and the middle market at this point.

Ross Butler:

Dan it’s mid-April, and I understand this is your first day back in the office for the best, best part of a year. How’s it, how’s it going to affect ’em and how has it been affecting kind of day-to-day business where you are?

Dan Aylott:

It feels very strange to be back in the office today. It feels like my first day at work again, but having been on calls like this on zoom for the last year I think we’ve all got quite used to it. So it’s been very interesting to see how managers have dealt with, with this pandemic how they’ve dealt with deal origination sourcing of new transactions, which largely has been done virtually on calls like this and the fundraising process. So, I’ve been involved in a number of DDS over the last year where everything has been done virtually. I have personally find I’m looking forward to being able to get back to meeting managers in their offices. But actually I’m always amazed at how well this industry adapts and, and in particular for this crisis and the specifics around the pandemic, I think the industry has moved incredibly to adapt to this new environment.

It will be interesting to see how things unfold as easing unlocks. I think that the preference for meeting face to face and that sort of real interaction with, with, with managers will still prevail. And I think we’ll have definitely be meeting in person again, hopefully soon. I think the industry is probably more aware of the carbon footprint it has now in terms of travel. So I fully expect, and I know here at Cambridge Associates, we’re definitely thinking that through in terms of what makes, what makes sense and, and going forward in terms of our travel policy. But I think it will, I think it will have to come back in many ways. I had a manager asked me the other day, we’re planning our annual meeting in November.

Ross Butler:

What format would you prefer for AGMs etc? In-Person or virtual?

Dan Aylott:

Actually both. Please! I think investors will want the option. I think going forward they’ll will demand to have different ways of doing things. So it will be very interesting. I it’s been, it’s been really surprising to me how quickly the market rebounded from a fundraising perspective. So, Q1, and I think through the majority of Q2 last year, everyone was focused on their portfolios, trying to understand what COVID meant for their portfolio companies shoring up those portfolios. Making sure that, their companies can survive this period. And then I think beyond Q2 as, as it emerged that certain sectors strategies where we’re going to be fine and resilient through this, I think the fundraising market really came back and, technology, healthcare, all the things that we’ve talked about, very resilient through this.

And I think that will continue. I think that’s an acceleration in innovation if you like that, we’ll just, just continue. So it will be interesting. I think this is going to be a fascinating period for everyone in the industry to see how this unfolds. But I’m expecting to continue to do some of this, some of this sort of virtual meetings and discussions and conversations with managers, with colleagues but I’m also expecting to have some more interaction face-to-face as things ease and as, as, as prospects live writer globally,

Ross Butler:

I do hope so, Dan, and thanks so much for sparing your time and your insights.

Dan Aylott:

Pleasure. I really enjoyed it. Thanks Ross. Appreciate it.

 

Cyril Demaria on Asset allocation and private markets

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Fund Shack
Cyril Demaria on Asset allocation and private markets
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Cyril Demaria is a leading private equity thinker, fund investor, and affiliate professor at EDHEC. He is the author of numerous books on alternative investment, most recently co-authoring Asset Allocation and Private Markets (March 2021).

This is a Fund Shack ‘private chat’ about the difficulties of reconciling a liquid with an illiquid investment programme, and how institutional investors can begin to reconcile these two investments universes.

Check out his earlier conversation on ESG, here.

#24 Bob Long, Conversus, on making private equity accessible

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#24 Bob Long, Conversus, on making private equity accessible
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Subscribe on Apple Podcasts | Spotify 

You can watch the video version of this private chat with Bob Long (with speed controls here.)

 

[Transcript]

Today I’m speaking with Bob Long CEO of Conversus. Bob originally listed Conversus Capital in Europe in 2007, and it was the largest listed private equity vehicle of its day. He recently relaunched the Conversus brand within the private markets, giant StepStone, and together they’ve recently launched the new liquid evergreen private equity vehicle that appears to solve the discount problem that plagues listed private equity, and that’s a tough problem to solve. So here we go….

It’s some years since I first came across, Conversus. And since then it’s had something of a rebirth and you’ve launched a novel vehicle, which is opening up access to private equity for a large potential investor base. I was wondering if you could start by giving us the little potted history of the Conversus brand.

Bob Long:

Sure. Happy to do that and good to see you again. So Conversus as you may know, comes from the Latin for conversion, and we think of Conversus as converting the advantages in private markets historically enjoyed by institutions into opportunities for individual investors. And that was the theme of converses capital. The publicly traded trust that we launched in 2007 on the European stock exchange and what led you and I to get connected back in those days. So we ran that business for five years and we learned that that publicly listed investment trust. And I should say we weren’t actually a trust, but that’s, that’s the term used for those vehicles, the listed private equity vehicles, that structure really didn’t work very well. And there are great names and great firms who’ve run listed trusts on the London stock exchange for decades. Those trusts have generated net asset value wildly in excess of the footsie index over that period of time.

Bob Long:

But nonetheless, the stocks trade at a deep discount to net asset value. And so as, as one of my investors said versus capital, you come to work every day trying to generate growth net asset value. And we did frankly, a job we’re very proud of in that regard, but I eat stock price. And so the stock price of Conversus Capital did not keep up with the net asset value performance. So we did the right thing for investors and we sold the portfolio at a premium to the stock price and a result in a transaction that worked out very well for investors. Now, today, those other names that I mentioned again, great names run by great people. They continue to trade at a material discount in most cases to net asset value. And so we simply think Tim Smith, my partner in Conversus Capital, my partner in Conversus, StepStone, we simply think we have a better mouse trap in the form of a tender fund.

Bob Long:

So that’s sort of the deep background on how we got there. Maybe I’ll move from there into how we all came together as a team. So we sold Conversus capital Tim Smith and I did in 2012, and then I went to run a listed business development company in the United States. That’s the closest thing to a listed alternatives vehicle available in the us markets. I did that and Tim started a distribution business in the UK, and we learned various things along that way, but we’ve been dreaming this dream that there was a better way to provide for individual investors in smaller institutions access to top tier private markets. Fortunately, I reconnected with Tom cinema. Who’d been a colleague at bank of America, along with Tim for 15 years, Tom had left BoA to go run a business called CNL, which was one of the leaders and the retail alternative space in the United States and Tom and his number two Neil Menard head of distribution were in the process and had left CNL.

Bob Long:

And we’re also sort of dreaming the same dream we had. And Tom and I had old friends reconnected and the four of us banded together. I happen to own the Conversus brand. So we came together as converse us, and we knew we had expertise in structuring. We knew we understood what retail investors really needed and wanted. But we also knew that in this day and age, the investment management capabilities necessary to create a world class best in breed, truly institutional caliber investment team process sourcing execution well is a really high bar, a really high bar. I grew up in a small town and they have a saying, don’t bring a knife to a gunfight and for us to go and build our own investment team seemed like bringing a knife to a gunfight. So we came together under the Conversus brand and then went through a process of meeting and interviewing numerous firms who were prominent and successful in the private markets and had a goal of expanding their capabilities into retail, to offering individual investors in small institutions. And we were thrilled to a form of partnership with StepStone who is has been a great partner for us. And we are a wholly owned subsidiaries converse. This is simply a brand that is used to convey the institutional capabilities of StepStone to the retail audience. We stop there and see what questions that raises for you.

Ross Butler:

Well, that’s a great introduction. Thank you, Bob. I mean, the first question is StepStone, I understand is a very large asset manager, but actually I don’t think it’s that all that well known. So could you just give us a little bit of insight into, into them?

Bob Long:

I will. And I have to say Ross you’re in the majority. The StepStone is, is the largest asset manager. Well, not well-known even among financial services professionals. It’s just, it is what it is. And they recognize that, or the firm recently went public on the United States stock exchange. So it’s it’s, it’s changing, but StepStone is a fascinating firm. They were formed in 2007 by a group of people who believe that the fund to funds model was not the way forward. And I believe they were right about that. And they believed that more customized solutions built around a highly data driven investment process was the way forward. Now they started in 2007 and I’ve heard some of the stories tough time to start. Heck I, IPO to listed investment vehicle on the Amsterdam stock exchange in 2007. So I know what it’s like to start a business in 2007, but they started in 2007.

Bob Long:

They built a tremendous firm that today has $330 billion of assets. They are one of the five largest allocators of capital to the private markets globally. Our firm allocated $53 billion to the private markets last year. And so that, that breadth and scale has been extremely helpful to Conversus, but I’ll come back to that. So that StepStone bothered 50 people, 13 countries, 19 offices, primarily serving a hundred of the world’s largest and most sophisticated institutions, primarily doing that through bespoke separate account or fund of fund type structures where they meet the needs of those large institutions.

Ross Butler:

So an organization of that size can do whatever it wants. So what did Bob long and Conversus 2.0, bring to their party?

Bob Long:

Yeah, that’s a good question. And here’s the candid answer we met with a lot of people and had had frankly, a fair amount of interest in our team. Stepstone in some ways needed us less and wanted us more StepStone had been around the retail business. They had a few relationships they’d studied it carefully and they recognized unlike some other larger organizations that do a great job with w with liquid structuring, investing, distributing, liquid securities, mutual funds and whatnot. Stepstone understood that there were unique structuring and distribution capabilities necessary. They wanted a team focused on it. They knew enough to know that there’s frankly not been a lot of success in I won’t name names, but many very large liquid asset managers. That the names that you all know have dabbled in offering private markets or alternative assets to individual investors using the same sales teams in the same concepts, the same messages they use for mutual funds and liquid security stocks and bonds. And frankly, there aren’t many good examples of that working out. And there are numerous of examples of large well-known firms, great firms, not succeeding and steps on saw that and share the same perspective we have, which is you need a dedicated team. You need to sell this differently and you need to structure it in a way that’s genuinely investor centric for individuals. So that’s why we came together with them and they have been fantastic partners.

Ross Butler:

Yeah, the retail that the kind of the mass market has proven a really tough nut to crack for, for private markets. It’s a real shame in my view that they all the listed vehicles trade on a discount, but have you, do you think you have cracked it? And if you have cracked it, you know, what have you got? Tell us what you got.

Bob Long:

What we’re trying to do is in our first fund, Conversus, StepStone, private markets, which we call CPRIM. Our goal is to deliver the illiquidity premium and diversification benefits of private markets, private assets in a form with quarterly liquidity at a hundred percent of nav for 5% of the fund, not 5% of your investment, but 5% of the fund. So the idea is that most investors should be able to get liquid in their investment. Most quarters, not every quarter, if we have another March, 2020 you may not, we may not be able to honor all investor requests. And we’re very upfront about that in a given quarter, we may have to so-called gate in a given quarter, but most investors should be able to get their money out most of the time and experience private market asset returns. And so that’s frankly hard to do, because to do it, you have to minimize cash drag. You can’t just have a bunch of liquid securities or cash on the balance sheet. You have to be able to predict capital calls and distributions. If you’re gonna have a diversified portfolio that includes funds and is open architecture, and you have to be able to source off those investments.

Ross Butler:

So in normal times, investors can take out they can redeem their offering, but at any one time only 5% of the whole fund can be redeemed. Correct?

Bob Long:

Correct.

Ross Butler:

And so let’s take an extreme situation, say there’s another, credit crisis, but whatever reason everyone wants out, it’s going to take many quarters to start winding it down, and everyone will be locked in to some degree.

Bob Long:

This is an evergreen vehicle. So we take money in monthly and we offer the liquidity quarterly. So the idea is when you invest in CPRIM, your money’s actually invested. It’s not just committed the way it would be to a regular draw-down fund. So it’s similar to the listed investment trusts in that way. And there’s your money is invested. So getting to your liquidity question, it’s a very good question. Here’s why I think we think that’s extremely unlikely to happen. First of all, we will have thousands and thousands of individual investors globally. So the probability that all the investors want out at a given point in time seems to me are frankly, basically impossible. You’ll have investors who learned the lessons of the financial crisis and, and frankly, the lessons of 2020. And that if there is a market dislocation, when, when there’s a market dislocation, because they will happen again, yes, there will be investors who seek liquidity, but they’ll also be investors who think this is a great time to invest more capital. So, and you may have, we have a significant investment coming in from Latin America right now, for example 15, 20% of the capital over the last couple of months, but that will grow over time and we’ll have capital coming in from Europe. We have some coming in from Europe, we’ll have some information. You can imagine a regional crisis where those investors decided that they need their money out, but the probability global dislocations in all markets that calls all of our investors to want to liquidate at one time, it seems almost impossible to me that said the same phenomenon would occurred at the same pressures would occur if we had another global finance. And in that event, we certainly have the ability to redeem more than 5% in a given quarter.

Bob Long:

And if you look at the backgrounds and history of the four principles of Conversus and what we’ve done during times of stress and pressure with investment vehicles, I think we’ve shown a track record of being willing to do the right thing, including selling Conversus capital, which was a permanent capital vehicle, the largest in the world with $2 billion of assets generating quite a bit of revenue, frankly, but we sold the portfolio because that was the right thing for investors. So I don’t think that will happen here, but we do have the ability to sell assets if we need to. And importantly, we’re ultimately governed by an independent board. This vehicle is structured like that mutual it’s listed under the 40 act, which is sort of technical, but it’s, it’s, it’s governed like a mutual fund in the United States. We have a majority independent board proud to say that independent board has invested about a million and a half dollars of their own money in this fund. You don’t see that very often, that that is real, that’s a substantial commitment. So they are reputationally and financially and ethically bound to do and that could of course take all kinds of actions as as controlling the, as controlling the board to make sure we did the right thing in an circumstance. So we feel like we have the governance in place to protect investors in a deep downside case.

Ross Butler:

I can get access to private markets and I can get out on a quarterly basis in normal times asset value. And that’s the key difference, isn’t it, to the investment trust world

Bob Long:

I ran a publicly traded business development company in the US and I ran one of these listed investment trusts in Europe. So I’m think I, maybe the only person that’s ever been CEO of two of those things, plus the, a Tinder fund here in the U S which is the structure, what we call the list of trust in the public paid of business development companies in the U S you can sell those every day, but you may not like the price because they historically traded less than now with CPRIM. You cannot sell it every day. We require 90 days notice, and it’s quarterly, but you will like the price. It is a hybrid, and we are very proud to be very upfront about that. We are not alchemists, you know, we can’t instantly turn it liquid assets into liquidity, but we think we’ve got the right balance of monthly subscriptions, evergreen capital, quarterly liquidity with notice. It is interesting and useful to arrange the people in them. I’m happy to say that today we’ve gotten really strong market reception. People see that. I mean, people say investors and, and portfolio managers see, I have a place in my portfolio for private market returns, with a high likelihood of quarterly liquidity and a real strong likelihood that over a couple of quarters, I’ll be able to get my investment out there. There’s a place in my portfolio for private market returns without sort of liquidity profile. And that’s that’s what we’re offering.

Ross Butler:

So it sounds like the Holy grail of liquid access to private markets that are more or less invested in those underlying license most of the time. So let’s go back to where you were before I cut you off. How do you, how do you pull it off then?

Bob Long:

Yeah, this is this is something that I’ve been thinking about since 2006, when we were putting together converses capital. And it is difficult. It’s quite challenging. The reason we’re able to do it in Conversus StepStone is first and foremost, we designed an investment strategy. That’s not private equity only so included real estate infrastructure and private debt assets that naturally produce some liquidity, organically produce some liquid. Second. We focused primarily on secondaries and later stage secondaries. So assets that are expected and have generally do generate liquidity realizations, a relatively short period of time. And by that, I mean, sort of expected liquidity profile of a couple of years. Whereas, you know, the typical private investment fund is 15 years. And if you get an individual co-investment it’s five years, so structuring the portfolio right, having the right mix of assets is critical. Secondly, it’s about data.

Bob Long:

Stepstone is built as good a data system as is available in the world today. It’s called StepStone private intelligence, spy, cool name. It’s actually really cool to demo also. And I can give you stats tens of thousands of portfolio companies, thousands of meetings every year that are recorded with general partners, giving us an idea of when individual companies are going to be sold tens of thousands of phones tracks. So they built what we think of as the Bloomberg machine for the private markets. So they have extraordinary data that’s been collected. And then when you commit as much as anybody in the world to the private markets, these general partners have an incentive to share a lot of information with you and they are they’re also incented for you to buy their secondary assets. So the data that allows us to predict when assets, when a capital calls going to occur, when a liquidity event is going to occur is really, really important.

Bob Long:

We think StepStone has, has the best data.

Ross Butler:

So that’s your gun in the gunfight.

Bob Long:

That it is. And lastly, it’s the opportunity. It’s the, it’s the scale and breadth. So as we select individual assets and we have about 40, 40 transactions 40 funds, and co-invest in the fund today, as we select each individual asset, the portfolio manager needs to be able to choose among a variety of assets with different liquidity profiles. I think of it as a stew. And you know, when you add an onion, onions, never come in exactly the 1.2, five ounces that you were looking for, right. It’s always a little more low. Okay. So once you add something to the stew that has a certain liquidity profile, that changes what you need next. So you need a vast back to get it exactly right. You need a vast, vast array and StepStone invest in over 300 separate transactions in a year.

Bob Long:

We’re closing more than a deal every business day. So just think about that. So the variety of things that our portfolio managers have to choose from to create that just right liquidity profile, that limits cash drags, you can’t have a lot of unfunded allows you to hit your returns and also gives you visibility into liquidity for up to 5% of the fund on a quarterly basis. The ability to do that, to do that, they have to be have great insights into the cashflow dynamics of each asset plus the existing assets. So the one you’re about to choose, or that pool you’re choosing from the pool of assets you already have, and then a series of data models. Stepstone has made an extraordinary investment in data and analytics. Dr. Lisa Larson runs that team for us. We have 30 people in data science and engineering. So we’ve made an extraordinary commitment to that. Unlike some of our competitors, we’ve built proprietary tools. We built tools specifically for this that we built in house. And that allows us to predict capital calls and distributions. This is an open architecture. This is not a proprietary StepStone product. So this is private equity, private debt, real estate and infrastructure. It is across what we believe to be the best managers globally. We access that by making commitments to new funds, primaries find funds on the secondary market, and co-investing alongside leading general partners. Now in the near term, we can do all those things. So think about it as s a three by four matrix, each of the asset classes and all the ways that institutions access those asset classes.

Bob Long:

So we can do that now today to build out the right cashflow profile. We’ve been focused mostly on private equity and mostly on secondaries because secondaries and private equity are the deepest secondary market available. COVID gave us some specific opportunities. That was probably a one-time thing, but that was helpful. And so we started building up with private equity secondaries, but over time, we’ll diversify and eventually be about 60% private equity, another third real assets combination of real estate and infrastructure and a little bit of private debt. And we expect to have little to no cash to be able to run this portfolio with little to no cash drag in it and make it essentially self-funding over long term.

Ross Butler:

And over the longterm, depending on what the profile looks like, you can then invest in a bit more primary, private equity and less secondary as time goes on.

Bob Long:

So of course the advantage of secondaries is the cashflow profile, the disadvantage is you’ve got to take what’s on offer. If you have a high conviction in a given manager and believe they’re the best and their funds may not be for sale and certainly may not be for sale at a price that you like. So primaries are an important part of the strategy. You don’t see those kicking in a material way until year three or four.

Ross Butler:

How many underlying funds do you expect to have

Bob Long:

Well, today we have about 40, but we’re building up, we’ll be well, North of a hundred and maybe well, in excess of that, although we’ll be well, North of a hundred in the near term maybe said differently, your real investment or the most important metric is at the portfolio company level manager does matter, but we seek to have no individual portfolio company greater than 1% of the portfolio. So this will be very diversified. We believe retail investors in small institutions are not primarily looking for a swing for the fences. If that analogy translates, you know, the highest octane strategy we think we can give them the beta of top tier private markets now not the beta of the whole asset class, but the beta of the top half. We believe we can do that in a package with liquidity and reasonable fees, sort of like an ETF, if you’re familiar with that, that concept. So like an ETF for private markets, a core holding low fee simple, easy to use, very diversified, unlikely to produce the extraordinary and a 25% returns you may get. And I hope you do get in an individual private markets fund, but also with considerably less risk. So that’s what we’re trying to do. It’s not a swing for the Vincent strategy. It’s a core steady, get you the diversification benefits of private markets and get you the return premium. The illiquidity premium of private markets do that in a structure with bare fees and liquidity. We think the world needs that.

Ross Butler:

What do you mean by fair fees?

Bob Long:

We’re charging 140 basis points management fee at the CPRIM level and no carried interest. We chose to make this a simple flat management fee structure. So 140 basis points is what we’re charging. If we invest in a five one on the secondary market, they’re charging fees too. So there’s no way to get diversity without some layer of double fees that doesn’t exist because StepStone has the scale that it has. And has it gets the volume discounts that it does has the ability to select those underlying fund fees or acquired fund fees to use the technical term there about, we think there were about 90 basis points in the near term, going down to 60 basis points. So if you think about it this way

Bob Long:

You get the best of StepStone. The same thing, stepsone would get the largest institutions for 200 basis points. And we think we think that’s square. I frankly think that’s very fair. And I’m also proud to say that the 140 basis points that we charge at the CPRIM level is pretty similar. Not exactly, but it’s right on top of what steps would charge your university endowment. If they were asked to put together a portfolio of all these asset classes, you know, all the broad market asset classes that includes secondaries and co-invest, which frankly typically carry a higher fee than a simple fund to funds primary, primary commitment. Now, piece of this that I may have left out that might puzzle our listeners. How do you get there? How do you do that? What, well, the answer is StepStone is doing the co-investments, which it typically gets at no fee and no carry for the 140 basis points. There’s no separate. So we’re not investing in the StepStone co-invest fund, which exists, or the StepStone secondaries fund, which also exists. Those are small compared to their, their bespoke sec separate accounts, but they, they do that. They offer that for small institutions, we are getting the same deals, but you’re 140 basis points covers that. So StepStone has made a real commitment to, to this vehicle by by giving us a very fair fee fee deal on those secondaries in Coleman.

Ross Butler:

How large can this vehicle get before it’s structured? He doesn’t work or, or return start to be eroded

Bob Long:

Ross. I think it can be very, very large, certainly 10 billion or more. And here’s how I get there. First of all, scale, frankly helps us on the cashflow predictions, just simple law of large numbers, right? If you have more funds you will be wrong when you project an individual fund is going to liquidate an individual portfolio company next year, it’ll happen this year, or it’ll happen the year after that. It’s absolutely. But if you have more and more funds, you will you’ll benefit from that. Also, you know, there are fixed expenses, SCC expenses, and whatnot in a vehicle like this legal fees. So a larger fund does bring those down. So you get some economies of scale. So at the margin scale benefits us. But let me answer your harder question. Like when did, when do you have to go down the risk reward profile, but I think 10 billion at a minimum for the following reason, a portfolio like this, you’ll see the assets turnover every three to four years, we need to commit to new or close on new investments of about three to 4 billion per year. Well, StepStone committed $53 billion last year. So I think it’s, it’s a question we don’t begin asking until we’re certainly North of 5 billion cutting in half the, I just used and probably North of 10 billion. And then we’d have to ask ourselves and our independent board who would make this decision by the way. And that’s critical. It was StepStone, still able to do this, you know, should we continue raising capital? So I think we can be quite large. And frankly, if you look at our fee structure, we are the cheapest, we’re the low-cost provider in our market. We designed this because we believe at that fee level, because we believe this can be very, very, very large, many, many billions of dollars.

Ross Butler:

The potential investor base is high net worth individuals, correct?

Bob Long:

And smaller institutions, according to your research, they’d say hat, what’s the appetite among let’s start with high net worth or private markets.

Ross Butler:

How do you think about high net worth and how do you access them?

Bob Long:

We’re available to the so-called accredited investor in the U S which is our individuals with a million dollars of net worth the studies we’ve seen. And there are no great perfect studies, but the studies we’ve seen the most recent one I saw was done by Morgan Stanley. The average investor has 1% or less lavish high net worth investor as 1% or less. Meanwhile, your college endowments have 20, 30%. Your pension funds have a similar percentage in a world where it’s straight to zero. Most of the leading lights believe public equities from here which have had a great run are likely to generate four, five, 6% returns on a go-forward basis. I think, I think the appetite of pro of individual investors is substantial for private assets, the hold backs. And it’s been that way by the way, it’s gotten worse or the problem for financial advisors who typically the way we enter interject directly or interact directly with individual investors.

Bob Long:

It’s gotten worse. As interest rates have gone down as prospects for global growth have flattened or, or said differently as the stock. I’m not a public market stock pro prognosticator, but certainly hard to see how the current slope of a line remains the same. Let’s put it that way. So as public markets are certainly fully priced, I won’t say over price because I’m not an expert, but fully priced bonds are yielding zero, the traditional 60 40 portfolio for individuals just, just doesn’t work. And so that but that’s been the case for a while. So why have an individual deal? This was the case in 2007, we formed converses capital because we saw this huge opportunity, right? Well, Conversus capital was listed. It was only available to qualified purchasers. it traded at a discount despite good investment performance, great investment performance may be so immodest.

Bob Long:

The challenge is you’ve got to make easy. You know, we say we’re investor centric and everybody says they’re investor central, but let me, let me break that down. We, we, our taglines are convenient, easy to do business, simple documents, short, sweet, clear, efficient. That’s a nice word for cheap. You know, we’re the lowest fee provider in our market space, and we want to be that, and then transparent. And this retail alternatives world, there’s been a history of hidden fees or less full disclosure or miss complex structures. In fact, they’re structures that have come on the market in the U S from great firms recently that have very complex carry arrangements that only those of us that are recovered lawyers like myself, not only, but, but they’re very complex carry arrangement. So we we’ve tried to avoid all that. So you’ve got to make it easy for individuals.

Bob Long:

Why do individuals not want to commit to funds? Well, first of all, the minimums are high. If you go to a typical private bank, it’s $250,000 or more, if you commit to a fund to funds to get the diversity, while you have capital calls and distribution. So you don’t know when the money’s going to be called, you don’t know when it’s going to come back. There’s typically complex tax reporting for U S investors that comes through the form of the dreaded K one partnership, a tax filing where a 10 99 vehicles. So very simple tax reporting that comes in January of every year. So it’s really about making it easy for individuals to do what they want to do, which is to have the diversification and return premium benefits of probable.

Ross Butler:

And just remind me again, what your minimum is.

Bob Long:

Our minimum is $50,000 us. I think the demand is extraordinary and certainly the reception we’ve received for what we have to do is really stay focused on making it easy and frankly easier. We need to constantly be focused on making it even easier for people to do business with us and being incredibly transparent about what’s in our portfolio, how it’s performing, where are the risks are those the things we need to focus on? And I, and we are as a management team.

Ross Butler:

Yeah. Well, when I think of the size of the potential, cause this all sounds like it makes perfect sense, but when I think of the size of the opportunity, I just think, well, why hasn’t BlackRock just jumped in here and done this. And I suppose he binds to that to some degree, but it still seems surprising to me that there’s this big opportunity out there. And you’re kind of relatively small team jumping in with StepStone is managing to access that

Bob Long:

Well, I’m glad you BlackRock just made a filing for a fund that’s quite competitive with ours. I don’t know that they started raising capital. So that’s certainly the brand name in our space, but I’ll say this, whether it be BlackRock or any of the other names that people bring them on as the largest investment and asset managers in the world to create a fund that starts and stays on the upswing of the private equity J curve or the private markets J curve, which is what we’re seeking to do, right? You don’t have that dip in the beginning. People would, who would invest in that when people can come in later to do that those large firms have to be able to access secondaries and to be able to buy secondaries, you need the favor of the general partners and they are commercial.

Bob Long:

And they favor those who commit primary capital to them in 10 in billion dollar chunks. And so StepStone and being one of the few firms is committing tens of billions of dollars globally, to all types of private market funds. We feel like that’s our competitive advantage. We don’t have yet the brand advantage of the firm you mentioned, and there are other firms that I’m sure you and our listeners have in the back of their minds and the front of their minds. But what we do have is the size scale data to be able to execute on this investment strategy, which requires you to be able to do secondaries and no coat, no fee co-invest to keep your overall fee load down and match institutional pricing and be able to do it from a, the ability to picks some, so many different choices to assemble a portfolio that hits just that right balance of returns and liquidity and diversity. So that’s why StepStone is well presented, presented, and we look forward to competing with the others.

Ross Butler:

Well, it all makes perfect sense on paper, Bob, but the proof of the pudding is in the eating. I think you’ve been running for six months or so. How’s it going

Bob Long:

If only the next six months would be as good as the last six months Ross. We are up in our net asset value 31% over the first six months. So, and we’ve been positive every month. We report our net asset value every month. So we have that transparency. We’ve been up every month since inception. And we’re thrilled with that performance that performance will not continue and not do the scent in a six month period consistently. The fund was not designed to do that. It’s do diversify them. So I should, as you explain, how do we do that? Well, we call it some COVID tailwinds. We invested in funds in the fall of last year and some that were priced off of a March 31 net asset value. When you do a secondary you’re buying off the last quarter, the net asset value as reported by that general partner.

Bob Long:

And so we were able to buy some deals at very attractive prices, as limited partners in those funds needed liquidity or wanted to rebalance their portfolio. We committed to those in the middle of last year, the way secondaries work, they didn’t close. They tend to close on quarter end. So the way that works is the convention. A number of those closed as September 30 slash October one, a number of more closed at more a December 31. And you saw in January a big bump in our main asset value. So we’ve benefited from that. So we’ve benefited from discounts, but we also bought some assets that we feel really good about. We’ve already had a number of IPO’s in the portfolio, which generally come in a mark up to where the investments were held.

Bob Long:

We’ve had a number of liquidity events in the portfolio. So we’ve frankly COVID was a terrible time to raise money, but was a really good time to be investing. So we benefited from that and we’re really pleased to be at about a hundred million dollars of net asset value today after six months and have a 31% now to increase or return for our initial investors so far. So that feels good. We’re continuing to invest in secondaries as we’ve grown larger, we’re buying more co-investments you don’t want to be really concentrated. So on a a hundred million dollar portfolio, you know, you, you don’t want to take on a $10 million co-invest, but you can certainly take on three, $5 million co-invest. Cause we expect to be a billion dollars within the next couple of years. So co-invest are more available to us now from a portfolio construction perspective, and we’re doing more of those and those again, they generally come with no feet and no carry we’ll continue to do some primaries. We were mostly private equity in the beginning, cause that’s what we could buy. And the pricing was good. We’ve started to add some real assets and we’ll eventually add some private debt. Although while you know, our, our five-year expectation is we’ll be five to 10% private debt given where interest rates are today. We may not do private debt over the next year, or certainly not in a material component.

Ross Butler:

Great. Well, thank you for sharing the structure of it. I just find it fascinating and it is novel. I think. So it was worth going through in, in detail. But I mean, I think you might’ve coined the term democratizing private equity and something that’s that I’m particularly interested in because I think private equity should be democratized. And this seems like an important contribution to that.

Bob Long:

I believe so, Ross, you know, we I may not have coined the term, but in Oh six and Oh eight, I was one of the more prominent people using it. I’ll, I’ll say that the we think individual investors over value liquidity in their PR and their portfolios. So we haven’t even talked about the 401k or defined retirement market here. Maybe that’s a separate conversation, but individual investors and C prime is designed to eventually be available. We want it to be available into 401k plans. It is available for the individual retirement accounts today, but individual investors tend to hold too much liquidity and not get paid for illiquidity family offices, institutions, pension funds long ago realized they needed to capitalize on the ability on it, the illiquidity premium. And I think we are seeing a secular trend of individual investors realizing that they don’t need to be able to sell everything they have today.

Bob Long:

They’re just not a reasonable set of facts where they need a hundred percent of their money today and they need to put some, it would benefit from putting some. And so this democratizing, it’s just, it’s just an expression of that. Individuals get more sophisticated information about investing about risk and returns is so much more available today, even than it was 15 years ago. When I started down this path, individuals are recognizing as our smaller institutions that they should and can afford to have some money in less liquid we’re, quarterly liquidity. But there are of course, other and I, they should have certain individuals should have some money in the longer lockup structures to the 10 and 15 year lockup structure, but individuals should have the benefit of that and get paid for it. So to the extent we have a retirement crisis, or to the extent we have an equity in we certainly have a problem with inequity and wealth creation. This is a tool, you know, the private markets are a tool and an option that shouldn’t and are available to a broader range of investors than they have been historically. And I believe that that serves both a financial goal, but also a a broader set of civic and civic goals for the certainly the developed economies.

Ross Butler:

I personally, I don’t think the word commitment is used enough. People talk a lot about liquidity or illiquidity and illiquidity somehow seems like a bad thing and you therefore need to be compensated with higher returns and you therefore need to take on more risk. And I’m not sure that that narrative is correct. I think you you are being rewarded because you are committing your capital, therefore giving the people who manage it more flexibility to make more money. I mean, it’s as simple as that. And so I think if the public narrative could change a little bit towards, this is just about commitment that could help them,

Bob Long:

You know the private equity industry in particular has not done a good job of managing PR and maybe we should have called ourselves the patient capital industry, but in, in life we often get paid for our patients and investors should get paid should get paid for their patients and typically do in the private markets.

Ross Butler:

Well, that seems like a good place to, to end Bob, thanks so much for, but it’s a pleasure.

Bob Long:

Good to see you. And thank you for the time. And thanks for those who are listening.

Ross Butler:

You’ve been listening to the fund shack podcast, make sure you subscribe and visit our website@fund-shack.com for many more video interviews. It’s the private capital channel for alternative investment professionals. Thanks for listening.

 

#23 Simon Witney on sustainability rules and corporate governance

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#23 Simon Witney on sustainability rules and corporate governance
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Simon Witney on sustainability and corporate governance.

In this episode, I’m speaking with Simon Witney, who’s probably the best known private equity lawyer in Europe. He’s currently a senior consultant at Travis Smith where he spends much of his time advising clients on sustainability. He’s been chairman of the BVCA’s Legal and accounting committee and Invest Europe’s Tax legal and regulatory committee. He is a visiting professor in practice in the law department of the London School of Economics, where he teaches.

And he has a new book out published by Cambridge university, press called Corporate Governance and Responsible Investment in Private Equity. Our conversation is in two parts. Firstly, we look at the new sustainability regulations and what they mean for companies and investors. And then we go on to look at corporate governance itself.

You can watch the video version (with speed controls and bookmarks here.)

Enjoy!

 

#22 Carl Bradshaw, Goodwin

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#22 Carl Bradshaw, Goodwin
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Carl Bradshaw is a partner in the law firm Goodwin’s private equity group. He has advised European, American and Asian private equity sponsors on cross border LBOs, public to privates, co-investments and special situations.

We talked in late March 2021 about deal appetite going into the second quarter of 2021 new deal-making processes and the rise of the special purpose acquisition company. You can watch the video version (with speed controls and bookmarks here).

Ross Butler:

You’re listening to Fund Shack. I’m talking with Carl Bradshaw, a partner in the law firm. Goodwin’s private equity group. Carl is based in London and has advised European American and Asian private equity sponsors on a wide range of transactions, including cross border elbows, public to privates co-investments and special situations.

Carl, welcome to fund Shack it’s mid-March and restrictions are slowly thawing away in Europe, fairly slowly in the UK though. How are you seeing the private equity market from a transaction perspective? And how would you characterize sentiment at the moment?

Carl Bradshaw:

Yeah, so Ross we’ve been sort of in this state however you wish to describe that for nearly a year now, the conclusion that we can say is that the industry is certainly resilient is certainly adaptable. Absolutely. There was a rush this time, last year for people to focus on keeping people safe and you know, wrapping up their portfolio companies, frankly, to all the things that were going on, making sure they had enough liquidity to survive initial shutdowns and lockdowns but very quickly people that to operate in this environment, whether that was, you know, using technology to get deals done, to meet people, to talk and look and evaluate or, or just in terms of actually finding opportunities. And you know, within months we were back into transactional activity certainly in, in, in the middle market where you had, but it’s a combination of processes that had been put on hold that were sort of pushed through and we’re ready to come to market either just to close off remaining elements or, you know, from start, start to finish, we saw that.

Carl Bradshaw:

And then you had a sort of new wave of, of deal activity where it was either very technology focused or very healthcare focused. And that has really sustained itself through to, through to now. I think obviously in, in some sectors, there’s, there’s been a pause and people are waiting to see what the vaccine does, what the government support measures do and when, and how they get withdrawn in order to assess sort of investment appetite. And obviously we need to see how consumers react, to those measures as well. But certainly in certain sectors, the market’s heating up and we’ll say pretty buoyant buyout activity, whether that’s funded through equity checks from the sponsor directly, or backed up with debt either coming in from, from still, still the bank, but increasingly so from the credit funds yeah, it’s, it, it sent me that to be seen. And in some cases we’re seeing some really competitive situations, but for the assets in the sectors, I mentioned that, you know, people want to, to deploy capital into

Ross Butler:

Those sectors, presumably being tech, healthcare.

Carl Bradshaw:

I think those are it certainly as you get into the middle market and, and above at the lower end, you’re seeing some life science you know, as a variation on that, on the healthcare theme. And even, even within technology, I think it’s, it’s not everything not everyone’s sort of pouring money into driverless cars. I think there’s been some quite a lot of thinking has been done on what segments are going to be most robust and have proven themselves most robust three, three dash periods, enterprise software, data analytics, and things of that nature are certainly still, it’s still very popular with, with PE sponsors.

Ross Butler:

It’s increasingly difficult to think of tech really as a sector in sofar as pretty much every business has. It is having to deal with some kind of tech enabled conundrum right now.

Carl Bradshaw:

Yeah, I think, I think that’s right. I mean, there’s, there’s often been a hesitancy for private equity to to market themselves as being into the tech sector. Right. And I think people, investors into be fathers might be a little bit scared off by some of the very high valuations that you see in the tech sector. And whether that growth the businesses like you, you have the opportunity to invest into is going to be sustainable. You know, other there’s other features of the tech sector, whether it’s the dynamics with founders and entrepreneurs or you know, the, the, the lack of the excellence of process that P has really become accustomed to that has stared at people traditionally away from deploying lots of private equity capital into that sector. But you’re right. I think it would be inaccurate to just group group all of the different segments in, in the same bucket.

Carl Bradshaw:

I think private equity has come around to the idea that yes, technology is in all parts of our life and tech enabled businesses means need to sort of find capital in order to grow in order to survive in, you know, the, the most dynamic areas of the economy today. So yes, there’s more and, and also, I guess there’s been some good good examples of success in that area, whether it’s fish there or Thoma Bravo or Hg, people have gone there, have taken the plunge in and done very well after that. So, certainly there’s no there’s not the same hesitancy as there may have been 10 years ago to, to invest in that area.

Ross Butler:

It’s strange given that their venture capital cousins live and breathe technology, I think Goodwin’s sometimes operates at the intersection of venture capital and private equity from what I’ve read.

Carl Bradshaw:

Yeah, very much so. I mean, we, we see that as our sort of strategic priority is to be as close to those two worlds as possible because we’re only seeing convergence and not divergence. And I think the, the peas are moving down into that space. One to just get smarter on technology and the pace at which it is you know, transform, transforming business. And they, they want to get an early early look to, I think the P exits or venture capital backed businesses exiting to pay. It’s just becoming more and more common. And I think even, even you know, in 2020, we sort of doubled on the amount of PE exits that were there the year before. So it is an area that people see that the opportunity, and I think getting, getting smarter is, is definitely something that is high on the agenda for our clients fit for Goodwin. We just say as part of the lifecycle model that we’ve tried to build around companies from a very early stage three, all the way to where they’re going through a strategic process, be that M and a selling out to P or, or going through it to the problem,

Ross Butler:

Going back to lock downs. Has anything changed in terms of the process of doing deals in the last year that you think possibly might end year in the, in the longer run? Yeah,

Carl Bradshaw:

I think, I mean, the obvious answer to that is travel. I think people will get on fewer planes and meet in person on a, on a less frequent basis. I don’t think it will go all together. There’s definitely a lot to be said for I guess both the, both the engagement that needs to be had between a management team and its potential new sponsor to, to get those people together is going to continue to be important. And I think, you know, people, people that are, that I talked to on the investor side are just, you know, itching at the opportunity to get in a room and have those conversations with the management teams or prospective management teams, I think on the advisory side whilst we’ve been efficiently through, you know, remotely and three screens definitely when it comes to getting things done, we would say some, some speed gains and just general sort of ability to get things over the line by being in the same, in the same room with each other.

Carl Bradshaw:

So I do see that coming back, but certainly the use of technology based on the outside intelligence begins early and has been happening from people’s bedrooms or studies, you know, for the last year that’s, that’s definitely a game to enjoy. And, and Adam was already the case, to be honest, there was a lot of technology starting to get deployed in whether that’s through data rooms, whether that’s through you know, the legal technology we use to sort of save street contracts and spit out findings. I think that that has accelerated over this process. And so we’ll certainly see, see that remain whether the remote what I’ve heard of virtual drones being used to do physical inspections, and obviously that, that saves some costs. And if you’re not fully committed on doing the deal, you might, you might think about that. But I think getting people together and on, on the ground is probably gonna come back as, as soon as it can.

Ross Butler:

It’s funny. Cause most people took a technology in terms of efficiency gains, but I guess was something like, you know, the, the classic late night deal negotiation high, it’s a highly collaborative exercise I assume. And just being with people is probably preferable, maybe even less tiring, even if it is late at night.

Carl Bradshaw:

Yeah. I see you had this, let’s not forget the psychological aspects of doing a very demanding job on it, on a deal. Yes, absolutely doing it physically in person with others helps. But yes, just, just getting through that process. I think what we’ve seen is whilst as, as well thought through, in as structured as they possibly can be in this very uncertain environment, there they are generally taking longer just to, to execute and getting, you know, getting the answer from someone who’s not knowing the room, we’ll just take extra time. And then in putting that to a conversation that moved on three or four paces can be difficult. So yes, I think that there’s merit to getting people together, certainly from, from our perspective as a, you know, we’re very much in a Prince trip culture as having people around from the outset of their careers that they can learn and see how these things are happening, I think is, is an important aspect as well.

Ross Butler:

Has anything changed in terms of contracting given the advent of lockdowns, I’m thinking, you know, provisions to give buyer’s assurance is that of thing.

Carl Bradshaw:

Yeah. So there’s a few sort of pieces of that, I guess. Initially there was great concern about, well, you know, the certainty of a deal actually happening. So if you had the leverage on the, on the buy side you would want, you know, potential out to the deal, if the lockdown or some sort of pandemic related aspect made for a materially different investment proposition and the one you thought you were signing up to three months earlier. And so certainly those conversations have been had, I would say by and large because the market is still very much, you know, lots of capital to deploy low interest rate environment. Sellers are invariably resisting those sort of deal uncertainties that you know, but that gives the buyer the right to walk away or renegotiate the deal. So that, that’s definitely one aspect that there’s been more conversations around and it very, very much turns on the sort of dynamic of a buyer and seller in any given situation.

Carl Bradshaw:

I think Ben, in terms of due diligence, your you’re seeing more scrutiny placed, not just on the underlying sort of the business and how compliant it’s been during this period, whether that’s the health and safety aspect of how it’s looked after its people or whether it’s made use of government support measures, you know, furlough schemes, deferral of taxes government loans, in some instances, you know, there’s, there’s definitely a lot of sensitivity to make sure businesses got that right, or where they haven’t, where when you remedy can be can be pursued. And then as I saw, aside from that, I think investors are looking through these businesses and out to their end customers, right? So instead of just supply to supply chain continuity, which has always been important, but come under the spotlight in the last 12 months, people are saying, well, you know, is that supplier or is that customer, what, what’s their solvency situation?

Carl Bradshaw:

Are they going to be able to continue? Can we get access to that information and diligence and evaluate it as part of this in entire cycle? So yes, there’s been a number of changes, but at the same time, it’s very sector specific. I think in the, where there’s competition for assets, we’re seeing very similar treatment given to businesses. You know, we will look at the financials, we’ll take the ties on the accounts. We will take a a large amount of comfort from re-investment on the part of the management team into the new deal. We will rely on insurance as far as possible, and we will present in a competitive auction, a very contract, but you know, the salaries are not going to have to do much thinking about as to whether it’s within, within the level of comfort or not. So yes, in some circumstances the pandemic has changed terms, but in, in other ways now, you know, we’re, we’re very much in similar territory of, of getting deals done on, on a seller favorable basis.

Ross Butler:

In addition to traditional private equity deals, you’ve got fair bit of experience in the distressed market, corporate distress fields. Are you, are you seeing, or do you anticipate an uptick or an increase in that kind of transaction?

Carl Bradshaw:

Yeah, so for me, those types of deals, whether that’s, you know, out and out distress or a special opportunities, special situation for private capital to be deployed into is different. Another type of private equity deal. It may find its way into a different area of the capital structure, but very much were using similar sort of private equity mindset and deal technology to, to get the deal done. I think the, the latest on the market is that actually there’s not a ton of activity right now. So in 2020 we probably saw cases that had been in a bad state of affairs, you know, financially distressed or underperforming for some period of time prior to the pandemic. And the pandemic was the final straw. Certainly, you know, retail, casual dining has had a very tough time in the last 12 months.

Carl Bradshaw:

And we’ve seen some of that. So we reacted on the restaurant and loan to own restructuring where the lenders to control. And recently we just closed the Clark’s choose transaction where Asian, Asian, private equity invested into, you know, an iconic British brand. So we’ve seen some of it, but I think that all came out of a relatively small window last year. Those sort of existing cases that needed support, I think by and large a lot of businesses have got by to this point through the government support measures, whether that’s, you know, loans or, or just the fact that business rates haven’t been there or at the same levels as, as they were previously. So I think we’re waiting to see, I think the expectation is absolutely there will be a further wave of distressed businesses, whether they make it through this difficult period or not remains to be seen.

Carl Bradshaw:

I think there’s the, there’s a race now between getting the vaccine out, getting consumer confidence to the level, it needs to be, to restore those businesses to somewhere near where they were previously, are people going to all of a sudden June go out and buy things, go out and eat in, in the places where, where they used to and offset against well, w where is the cash coming from to sort of reboot the working capital of these businesses? Right? So they have used the treasure chest to, to get through this period in order to go forward and compete. They’re gonna need likely injections of capital. Now, in some cases that may come from existing shareholders who have deep pockets. In other cases, they may tend to the public markets where currently there is good appetite to put money to work. But in, in many cases, I think they will turn to, you know, private credit, private equity, alternative investing and certainly that’s something where we’re building up for and hoped to, you know, in the, in the nicest possible way be well-prepared to fight, find capsule solutions for these businesses to take them forward.

Ross Butler:

Well, that’s a perfect segue because I did want to ask you about specs, which is obviously all the rage, but really only in the U S to a great degree. But last year was huge and this year is even bigger. Pro-rata do you have any views on the prospects for special acquisition vehicles

Carl Bradshaw:

And get really closely? I mean all the teams in the U S are absolutely inundated with spot instructions on inquiries. And just to, to kind of break that down a little bit, these are essentially the code in the U S these blank check companies. So they’re put together by a management team or a sponsor effectively as a shell company that is then put to the public market investors, pull money into these vehicles, and then the vehicle goes out and finds it at target a cloud product company that then takes to the public market. So it’s almost like a reverse IPO for those private companies. And it’s attractive to investors because they almost get a sort of single purpose, private equity vehicle, right. It’s something they can back if they know the sponsor, they know the management team they can put money towards it.

Carl Bradshaw:

And then, you know, they, they back these management teams and sponsors to go out and find it a great private company. And, and it’s also attractive sometimes. So they’ve project companies looking to raise finance, you know, to fund it it’s next stage of growth because it takes what is otherwise seen as an arduous listing IPO process out of the equation. And they only have to do one negotiation with the spec management team or that all the sponsors. So it does bring that execution advantage, I think for, for public strategy. We haven’t seen all that much of them in the UK. They have existed. I mean, there’s businesses like the engineering giant Melrose, that was a spec from 2003. So they, they are around, but, you know, on a comparable basis. So in the U S there’s something like 223 spots listed this year already.

Carl Bradshaw:

And in the UK, there were for all of last year and, you know, a grand total of 300 million was, was raised through that process it in the UK. So there’s a huge disparity. And I think there is definitely an effort on the part of London stock exchange and other sort of market majors to look at that and assess, you know, are, are we missing out on this opportunity? And I think that they’re coming under pressure because you’ll see homegrown talent that would otherwise, you know, potentially IDEO in the UK or other European markets either look instead of the us and, and potentially even B B not the victim, but the target of these U S rates backs, right? So it’s, it’s a great investment opportunity going into the North American capital markets instead of staying, staying in Europe. And I think there’s two, two particular pressure points that is and, and it all comes down to the nuances between the, the UK capital markets regime and which is similar in some respects and elsewhere in Europe and what they currently have in the U S so one of these is the redemption feature.

Carl Bradshaw:

So in, in the us, you, you, as an investor, put your money into this spot, the spot goes out and finds a target, and then comes back to the shareholders and says, do you want to, do you want to have to make this acquisition or not? So it’s put to a vote at that at that time, you can either vote no vote. Yes. but you can also you know, redeem your investment. So if you lose the value, you’re still not locked in and you can get your money out. And someone else who likes that, that investment can come in in your place. So there’s that advantage that kind of transparency over the, the acquisition and the liquidity that, that you get through that. And then the other the other feature of the UK regime is that because it’s considered as a reverse listing effectively at the time, the SPAC makes the acquisition or announces the acquisition the shares in that spot or suspended for traded and they’re suspended until a perspective on the deal is, is published and there’s no deadlines.

Carl Bradshaw:

So we still have 2017 rates back. That perspective didn’t have it hasn’t been done in that deadlines not being, or that deliverable hasn’t been met. So it, it does create that uncertainty for investors, which I think, you know, looking at it objectively means, you know, w if you had the choice, would you prefer the us model or the current UK model? I think, you know, people are voting with their feet and, and investing into, into the U S backs. I mean, that, that particular feature is there for investor protection. I think when the announcements made that can be a lot of volatility in share price. And so having that, the suspension for a short period of time may make some sense, but it’s certainly something that, that people are looking into is, is a reform needed. There was a review conducted recently by Lord Hill and delivered to the government and at the start of the month, that really looked into all of those things as a, as a sort of holistic EK listing review. And certainly those two features were, were underlined as well as the things that were probably most, most in need of some sort of reform in order to increase spank activity in, in the UK. And the threat is not just coming from the U S but I think now you’ll start to see European markets moving pretty quickly in it. I would say at the current rate, you know, by the end of this year, we could see much more activity in the European markets on that front,

Ross Butler:

Any, any ones in particular.

Carl Bradshaw:

So Amsterdam, I think, has made noises in the last few weeks where they are readying themselves to, to, you know, make, make a viable and attractive destination for the specs, the visual specs to be raised.

Ross Butler:

So if I understand you correctly, it sounds like the, the, the Americans would, their redemption system is created kind of a, a market based optionality for investors. Whereas in the UK, you have more of a regulatory based freeze on everything. And is that a reasonable interpretation? Yeah,

Carl Bradshaw:

But that’s exactly right. I think it’s the, the, just new liquidity, but also the, the, the involvement in that acquisition decision, almost that you get in the U S that you’re not saying encouraged me here in the UK you know, this bank has the options of the acquisition to a vote, but it’s not a regulatory requirement in the same way as it is in the us. Yeah. That is a key distinction.

Ross Butler:

Yeah. It’s, I find it fascinating because, I mean, obviously the number of public companies has been falling for a very long time. And presumably this is going to put that into, into reverse. And it must say something about, I mean, you said at the start where you implied at the start, I think it’s, to some degree, an arbitrage against the cumbersome nature of IPO processes, would you say yes.

Carl Bradshaw:

Yeah. I think there’s definitely a benefit to the, to the company, not having to go through that IPA, do the road shows with multiple investors, you know, in that sort of preparatory stage and just goes straight from a to B you know, suddenly be a public company, having negotiated a deal in a set of terms with you know, with a sponsor. I think that’s, that’s very attractive for companies.

Ross Butler:

Tell us a little bit about Goodwins and your personal aspirations for activity in, in private equity, in a kind of near or medium term, what would you like to see happen and what do you want to get involved in?

Carl Bradshaw:

So Goodwin’s been around in Europe for just under 10 years, but we’re originally a us headquartered firm. We’ve grown internationally into Europe and across into Asia about 1300 lawyers in total, and really we have a very focused strategy. So we’re trying to play in the most dynamic areas of the economy. Private equity is absolutely core to that strategy alongside technology, life science, real estate and financial institutions. And you know, we’ve, we’ve scaled out incredibly quickly in the last year within private equity in London in particular. So we’ve now got upon a bench of about 10 partners, associates another, another 20. And we’re trying to be deep, not just in that transactional capability, but across all areas that touch the private equity ecosystem. So we’ve got one of the largest fund formation things in the market. We’re building out in tact, we’re building out in debt we’re building out in restructuring. So we can really be that go-to sort of destination firm for complex premium private equity work.

Ross Butler:

Carl, it’s been a pleasure talking with you. Thanks very much for your insights this morning.

Ross Butler:

You’ve been listening to the fund shack podcast, make sure you subscribe and visit our website@fun-shack.com for many more video interviews. It’s the private capital channel for alternative investment professionals.

#21 Patrick Sheehan on sustainable prosperity and venture capital

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#21 Patrick Sheehan on sustainable prosperity and venture capital
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Patrick Sheehan of ETF Partners talks to Fund Shack’s Ross Butler about creating sustainable prosperity with venture capital. You can watch the video version here

Patrick Sheehan is a founding partner of ETF Partners, a leading European growth capital firm investing in innovative companies that have the potential to create a more sustainable future.

ROSS BUTLER

Patrick, welcome to fund shack. You set up ETF partners way back in 2006, then called the Environmental Technologies Fund. It must be strange that everyone’s caught up with you.

PATRICK SHEEHAN

It’s wonderful that people are much more conscious about sustainability and that’s great actually. You know, I’d like to think that haven’t quite caught up to be honest about it, but I’m being picky. No, we, that I I’ve been in venture capital over 20 years in Europe, in Silicon Valley back again and, and wanted to do my own thing. And so, so actually I and my colleagues sat down and thought what what’s worthwhile, right? What gives us a sense of being useful? And, and the idea that we could show that venture capital had a role to play in solving really big problems was it was just very attractive back then. And you know, I think the only thing we got wrong was we were a decade too early, but I think that’s by starting early and suffering the pains that any entrepreneur does actually of battling along for a decade has been good for us. And, and I think that’s probably why now we, we really feel we have a, an authentic leadership position.

ROSS BUTLER

Yeah. You were in Silicon Valley and had a successful venture capital career out there before you did any of this stuff.

PATRICK SHEEHAN

I’m really of confess to everyone listening, I started in venture capital in 1985, but back then it was a very different world that was in the UK sort of pre venture capital, if you will. And then Silicon Valley, my time, that was the.com era. So, so I’ve lived in a few different eras and, and the world keeps surprising us, right. We’re in a new one now.

ROSS BUTLER

Your thesis, while it was called the moments technologies fund, your investment thesis, must’ve evolved fairly significantly in the last 16, 14 years. 15. Yeah.

PATRICK SHEEHAN

I’d love to say yes, but not really. I think it was, I mean, in essence, it’s unchanged in, in the actually, you know, I’m an optimist and optimists are the people who can make change happen. I tend to think. So. I think it’s important to be optimistic. And I, I really feel that technology can supply a lot of the answers to achieving sustainable prosperity and venture capital can be really in a range of those technologies. And so that belief is unchanged. That’s, that’s what we do. And we’re never going to change what that is. We’re still investing across Europe, but change is not subtle under the hood. Actually, I’m happy to go into it, but it’s around learning where we can apply venture capital and where we actually it’s a bit harder because I think if we go back 15 years, we, we, we, we saw the needs. And so we wanted to apply venture capital, but it’s, you know, you can’t use a scalpel on every operation, right?

ROSS BUTLER

Well, this is exactly what I wanted to talk to you about actually, because we’ve got this global problem and it’s going to take a lot of solving, where does venture capital fit in?

PATRICK SHEEHAN

So I think it’s really important, but it brings, it has constraints as well as benefits, right? So venture capital allows people to take bigger risks and bigger opportunity, but, but actually we all typically all invest from 10 year fixed life funds. We need results in that timeframe where we have a potentially large, but still strange capital. So it works on, on some sets of problems, whether it can be quite quickly, very rapid growth. It works less well on a range of others, which are also important for the writer. So you know, I don’t think it works for nuclear fusion particularly well, there, there are some venture backed startups in that area. That’s I think massively important technology for 20 or 30 years time perhaps. Right. So, so we deal in the big term, which I think is, you know, results in, in a few years to 10 years, but not more. And, and we have to find companies that can grow pretty rapidly with relatively constrained capital, even in this venture capital environment. And so that’s a subset which has focused us more and more on digital technologies. And by the way, we can invest outside that area. But the sweet spot for us becomes digital technologies that deliver sustainable benefits. And it’s still pretty broad, but, but it’s not everything right

ROSS BUTLER

Out with the solar panel Passover or raised out with the wind farms. And then with smart digital technologies that help help us be more efficient.

PATRICK SHEEHAN

From our narrow perspective. Yes. But when we started out 15 years ago, there was a boom in solar, by the way, just to give you an illustration. And I remember when we talked to our investors at the time saying to them that there were then in 2006, seven over 50 thin film photovoltaics, it’s not just all federal tax, but just this one time. And, and there’s really the market for one or two, right. And revenue growth rates of those companies was probably 70% per annum, but there was very little margin in it. So we said, well, we’re probably never going to do those. Right. And that’s, that’s a low margin. It’s, it’s like the computer memory business used to be right. It’s all going to go to China. And, and sadly it has. So we have to be very careful of the sectors we play in, right. But there’s, there’s enough real innovation and added value to sustain and create durable businesses. So that really hasn’t changed going back to what hasn’t, hasn’t changed actually, Europe when we started was a great place to be. And it’s just got better. Europe’s really coming of agents. So we, we, our focus is Europe and we find some really really fabulous companies. Now,

ROSS BUTLER

In what sense is it, has it got better repeats entrepreneurs and technology is being spun out, that kind of thing.

PATRICK SHEEHAN

Yeah. Well then venture capital’s matured over the past 15 years, it’s become much more global industry. And, and so people know the roadmap now in a way that they didn’t before and, and people are much more focused on high growth companies and how to create them and know what the game plan is. And so it’s not just, there are more repeat entrepreneurs. There are people who have worked for successful entrepreneurs and there’s a much bigger ecosystem. So overall we just see better quality opportunities because there are people who are much more, you know, a greater number of people who are highly engaged and, and well, it’s really honestly refreshing if I think back over, there’s been a rapid change in the past 18 months around sustainability. Right. but, but it’s, it’s refreshing now that entrepreneurs have been selecting us in some of the recent investments we’ve made because of our brand values and our real values. And they quizzed us not on the usual venture capital, blah, blah, blah, but on the, you know, are you sincere? Cause we want, we want to deliver a positive impact and we want to make sure that you’re right behind us. And and we are, and so they’ve selected us and that’s, that’s, that’s, that’s so refreshing. Right? So having backing people where there’s aligned values makes life so much more simple.

ROSS BUTLER

That’s interesting because given that you aren’t doing like large renewable projects, but you are investing in more digital companies. To some degree, I look at your portfolio and I think, well, that, that could make sense regardless of the climate change pressure. And so you could get an entrepreneur that has set up a business that you find attractive for, for a set of reasons. And instead of for another set of reasons, but increasingly it sounds like they are

PATRICK SHEEHAN

That’s, that’s exactly right. So we’re, we’re not backing uncommercial companies. And what I like to say is the need is the opportunity actually. And so there is great need, right? And that’s why major industries are transforming that speed. And that’s why there’s opportunity for us, right? Our investors want to make as much money as possible to be clear right now, no one cuts us any breaks this. We say to them, we want to, to do well and to do good. It’s not all so on the entrepreneurs, we back could be backed by anybody, but, but they do tend to like the fact that we have a common agenda, the common mission. And I think that creates a better level of trust. Really. So our competition is, is quite diverse and it is some environmental funds. It is some mainstream funds.

ROSS BUTLER

I find your, your ETF’s flavor of environmentalism, very easy to swallow because it’s, you, you caught it optimistic and it is. But it’s also, I find very different to the kind of very pessimistic and is Knight anti humanistic anti-human view of environmental in the environment. And you’re, you’re effectively saying we, we, we have an efficiency problem. We just need to do more with what we’ve got or more with less. And, you know, that’s human progress in a nutshell, really.

PATRICK SHEEHAN

I mean, it’s the story of civilization really. And you know, I think the challenge of climate change is critical. The challenge of well, broadly of sustainable prosperity is critical, but, but good luck trying to convince someone, we need a more sustainable planet. Therefore everyone should be poorer. I mean, I would argue that that’s just not practical, right? We’ll spend so much time arguing about it. It’ll never happen. And so the, the, the way to make progress fastest is to use the system. We have capitalism, right? There’s many faults with it, but it’s there. Let’s not spend a decade changing it. Let’s just use it and get on with it. And, and to aim for delivering prosperity because there’s durable demand for it. And it isn’t incompatible by and large w we’re living more sustainably and a progress creates efficiency. And so I’m sure there are flaws with this argument at the nausea and by the way, and you know, it’s not innovation delivers unexpected things, so we’re not always right. But, but as a general theme, I think it’s profoundly important to think that way. And an innovation is absolutely the key.

ROSS BUTLER

You don’t say sustainable growth, you’re saying sustainable prosperity, which is a slightly different thing.

PATRICK SHEEHAN

Yes. Cause prosperity, I think is a better word. When people think of growth, they think of increasing consumption. I think actually, you know, you can have prosperity with decreasing consumption. You know, there’s only so much time you’re only going to eat in a meal, but we probably enjoy eating nicer meals. Right. So it’s, it’s moving towards a better quality world rather than a higher volume world, if you will.

ROSS BUTLER

So I’ve said that I liked your view of environmentalism, but I guess the flip side to that is to what extent does that view and how venture capital solves climate change really affects the big, the big problem? What, what’s the scale of the solution that venture capital brings? Is that a tiny piece or is it an important piece?

PATRICK SHEEHAN

It’s a really good question. It doesn’t solve everything to be clear. So how it fits in as an important piece of the puzzle though, I think so venture capital is not going to help with the rollout of solar. It’s not gonna help with, with delivering renewables at mass scale. That’s, that’s, you know, maybe a big infrastructure funds will do that. There’s different types of money, but it’s still an, a lot of money, but where venture capital plays a role as improving the efficiency of all that. So this is not solving the problem in the next year or two at all, right, when next year or two is urgent, we need more renewables, I think, but it is solving the problem of the next decade or two of making sure that we’re as efficient and effective as possible over that timeframe. And you know, you look at the cost curves of things like solar and wind.

Solar has probably fallen 90% in cost in the past 10 years, when more than 50% of costs in the past 10 years, that’s innovation and that’s and, and I think you can safely extrapolate that cost curve for another decade based on innovation. So it’s really critical. The impact of that is not quite so linear either because once these, these technologies become cost competitive or even cheaper, then they change other industries, right? And as you roll them out, the rate limiting step not becomes not the cost of their deployment is the intelligence with which you can use them. So other technologies are required. And then I think in that, in that, in that wave of know how to, to make efficient use of these new renewables of the electric car industry and the consequential problems, you know, et cetera. Now, I think venture capital has an enormous role to play and a lot of prior experience to draw on.

ROSS BUTLER

Yeah, it’s a classic venture capital conundrum though. The world is being disrupted by a mega-trend, what are the, all the unexpected con unintended consequences around that, that we can, we can explore it when people talk about this dramatic decline in the cost of solar and the learning curve and so on. It sounds amazing. Is it as amazing as it sounds though, because I mean, there are obviously the intermittency issues and so on. I kind of, whenever I hear it, I think, wow, the world is about to change dramatically and the energy companies are stuffed, but it doesn’t seem to be the case.

PATRICK SHEEHAN

Well I think we live in a world that’s quite hard to forecast. I think you can forecast cost reduction curves, by the way. I think you, it’s hard to forecast the consequences of the very easily. But, but if I go back in time 10 years ago, if I tried to talk to the CEO of an energy company, I couldn’t, and then I, then I might more recently you’ve talked to the marketing department who were claiming to do things on behalf of the energy company. And, and there was that, that sort of denial and obstructive constructive confusion. But in the past year or two, I can talk to the CEOs of energy companies. And by the way, I can say to them, you’re a bit stuffed, aren’t you? And they probably say yes. And so what’s important is these are bright and smart people. They live on the same planet as us. I’m not getting it. Then they are really engaged on how to solve the problem. And so they are beginning to innovate and do things. And so I, you know, I’m not one of these people who thinks big, big companies are the problem and evil. I think actually they are now beginning to change rapidly and will really be part of parts of the revolution. And so I think we need to support them rather than just attack them.

ROSS BUTLER

We live in a world where everyone wants to quantify everything, but it’s very difficult to be able to quantify potential impact. And, and so, so what I wanted to ask you was what are the most promising areas where the kind of incremental change, the incremental improvement could make a difference. But it’s going to be a very subjective answer, I guess you’re going to have to give.

PATRICK SHEEHAN

Yeah. And the best things tend to surprise us. Of course. So happy to answer that question, but there’s an implied agreement in what you said that, you know, that, that actually the most impactful things are often the hardest to quantify, right? Because you can quantify the predictable and the predictable is often less impactful. Holy See, now how it’s impactful. One of the problems of funding innovation suddenly the government and policy level is it’s really hard to quantify the benefits of the unknowns from innovation, right? And so that tends to be a stumbling block. So we are very focused on delivering innovation and impact, and we try to quantify it by the way for each of our companies, but we don’t get too hung up about it. Right. Otherwise you fall into let’s do that because it’s measurable as opposed to let’s do that because we think it’s impactful, right.

Even before the pandemic, we had started to look very hard at the logistics sector because it’s, it’s being quite, it had to been quite resistant to technology and actually quite a, quite a polluting industry. It depends on how you measure it. And so we we’d started to make one or two investments there. We made one before the pandemic certainly struggling. We made one after that, they’ve actually unsurprisingly and I’ll be doing very well. And so, so, you know, logistics and efficient distribution I think is, is a very important area for us. Mobility, I guess obviously remains profoundly important because the whole car industry is changing rapidly. And that, that has consequential impacts outside of its own industry into many things, not most obviously energy, but many other sectors as well. We we’ve looked and keep looking very hard at the what’s called the energy transition.

And again, this is a vast industry already changing rapidly, and we’re looking very carefully at very smart data companies. I’m hesitant here because I don’t really want to say AI because it’s such a buzz word, but I’ll say it anyway because that, but using intelligence to, to make smarter, better informed decisions. And in this past year, we, we, we invested, I’ll give you an example in a company called deep sea that uses genuine artificial intelligence to, to improve the efficiency of the shipping industry. And that’s a big polluter and, and enabling ships to operate as a measurably improved performance is, is very impactful. Now it doesn’t solve the problem that the shipping industry is polluting, but it it’s actually an incredibly efficient and quick way to, to improve the situation.

ROSS BUTLER

Oh, that makes total sense because obviously heavy transportation is one of the hardest things to, to, to get off of oil, to replace or oil. And so any improvement there,

PATRICK SHEEHAN

And, and particularly for us, we’re looking at where can we use technology to, to create improvement. And we’re, we’re looking increasingly at sustainable foods these days and at the, the impact of the rise of the green consumer, you know, we’re seeing very interesting companies popping up now. Not, not so long ago, we invested in another gentleman neobank had a digital bank, like, you know, there’s Monzo or Revolut, many others out there, and they’ve become very big, very quickly. And we found these guys in Germany who really able and nice people, who’ve created a green equivalent of one of those. So tomorrow is, is the green revenue, the green Monzo. And you know, I’m very happy with it. And it’s, it’s, it appeals very strongly to in, you know, engaged people, people who are engaged in sustainability want personally to do something with their money that that’s helpful for for climate changes, as opposed to potentially harmful. And so, and so if we’re finding different themes not all of them obvious where we think there’s big impact happening or about to happen. Let me try a

ROSS BUTLER

You did a deal called the modern milkmen. One component to all of this is, is behavioral obviously. And some of that behavior just harks back to the past. So I did a little bit of work with P and G who were introducing reusable, adamantium shampoo bottles. And that’d be rolled out across Europe this year. And, and you know, you might say great innovation, or you might say, well, that’s kind of 1950s

PATRICK SHEEHAN

Sort of back to the future sort of thing. But, but now the modern Melbourne is, is, is a really interesting company, actually, because if you’re English, you mean when you think of an old fashioned milk van and whistling and walking around in the morning and that all died. And they died in the name of efficiency and supermarkets delivering milk in much cheaper plastic containers. But the founder of Bob Milton, who Simon is a very able entrepreneur, very thoughtful guy. He told me he was inspired by, by David Attenborough’s blue planet actually decided that he really ought to do something now in his third startup, that to get rid of waste. And eventually he focused on essential grocery deliveries as an area where it would be relatively easy to get rid of waste. So it is a little bit of a back to the future thing and that the milk comes in glass bottles. There’s no plastic, you know, there’s no, there’s no waste wrapping. And, but there, the front-end may look delightfully traditional. The backend is, is you know, there’s a lot of digital science, a lot of know-how, there’s a lot of efficiency through micro distribution centers. And some of the jargon flips at the back end from old fashioned to very, very modern. And that company is doing extraordinarily well, actually.

ROSS BUTLER

I wasn’t being cynical by bringing it up at all. It’s like, no one wants to throw stuff away. And, and, and most people will even be put out a little bit, I would say in order to just feel like they’re not being unduly waste where you don’t have to be a greening to.

PATRICK SHEEHAN

And honestly, when I tell people about it, they nearly all say, great. Is does that deliver in my area? Right? Yeah. That’s a fairly easy check. And then I think one of the things we are seeing is this is sort of an efficient localism, if you will. And it’s, it’s far more green to avoid transporting stuff around the planet. And, and frankly, there’s probably better quality produce if it’s more local and more fresh. Yeah.

ROSS BUTLER

  1. So you are hesitant, you were hesitant to mention it, but it is very, very hot to, to what degree can it kind of create efficiencies that’s decreased simply put carbon emissions, would you, it,

PATRICK SHEEHAN

Well, I’m hesitant, hesitant to mention it because it’s overused as many buzzwords get, and it’s sort of from, from a, some cynical perspective, it’s just a good way to bump up valuation, to start waving your hands and start talking about AI. My second reason for cynicism is that the, the underlying science has not evolved very fast, right? Well, it has evolved is the speed with which computers can crunch numbers. And so using established, and if not old algorithms plus computing power, now you can deliver more. And so I think you know, I’d like to see more real innovation in the algorithms actually, but, but nonetheless computing power has evolved in such a way that there’s a far more applicability of these sledgehammers. And they’re very effective on certain classes of problems, right? So shipping is actually a really good class a problem.

And that, it, it it’s a bounded problem, as they say, it’s not, it’s not an open-ended question. You know, if you, if you wanted to use AI to find out about America, you know, forget it, it’s too vague question. But if you want to use AI to optimize a set of parameters that you know about, and, you know, you can’t have ridiculous parameters because it’s self-evident, then, then you’ve got a problem you can solve. So there, I think it’s really good for certain categories of optimization problem or certain categories of drug selection problem, but it, it’s not good for everything yet. And, and it will take a real intellectual revolution as well as a computing revolution. I think before we get to the science fiction end of the spectrum, it’s great for some things, but, but and we’re really keen that she’s to see more AI real-world applications that can drive efficiency. So we’re definitely on the lookout for those. And, and I think we will see more by the way, because of course, compute power continues to increase the storage costs continue to go down. And so, so applicability will rise for sure, but I think it’s, it’s, it’s nibbling at the real world rather than taking it over. Yeah.

ROSS BUTLER

I’m glad I asked that that’s fascinating and a slightly more prosaically you invest across Europe, even though you’re based in London. What’s it, you know, Europe has a pretty good reputation as as being environmentally aware and has been for some time, but what’s it like for entrepreneurial businesses doing business in Europe, perhaps in terms of government incentives, doing business with government, doing business with cities you know from a, from a, let’s say from a green perspective, and then just from a business perspective.

PATRICK SHEEHAN

So Europe is, is, there’s not one country, right? It’s complex and diverse and culturally different, you know, A-list but, but doing business with, with a sustainability agenda, I think is, is just a commercial advantage because there is more support, there is more Goodwill. And you specifically asked about governments and cities. Well, one of the outcomes of the pandemic is that European governments are gearing up to deploy a lot of in effect reconstruction money into the economy with a view as to the type of economy they want, and they want a green economy in Europe. And so, so actually we are expecting a lot of investment in and around the green economy and the acceleration of, of sustainability and that that’s, I think, going to be clearer and clearer as we go through this year. And you know, the UK is hosting cop 26 in November, I think, and there will be announcements in the UK, but actually the EU is putting money forward.

Denmark is putting money into its economy on, along this agenda, et cetera. So I think governments will be a source of capital of potentially large scale of capital, but it will move slowly and probably with a certain momentum rather than you know, what’s the phrase these days, this is not a speed boat. Cities you think should be faster, but, but actually when we have companies that they invest in smart or selling to cities, looking to become smart and intelligent, and it’s not an easy market because procurement cycles are still long, right? They’re still somewhat political, et cetera. So there’s great opportunity, but, but it’s not easy. But that said, if you’re an entrepreneur thinking about, or actually on sustainability, these are not the only benefits it’s, it’s frankly, much easier to recruit people. So we find our companies can by being genuinely focused on sustainability recruit better people more easily and how great to staff loyalty and greater satisfaction, you know, and that then extends beyond staff into their ecosystem generally. So, so I think actually in essence being green is increasingly just good business.

ROSS BUTLER

Hmm. Well, that’s such an important point because I mean, PE people in the businesses that you back is the most important thing. So if you were getting better talent for less money, or just better talent per se, it’s not the less money, sorry,

PATRICK SHEEHAN

But because you have to, you know, the deal is you have to give people the best opportunity. You have to give them as learning opportunity, but, but, but newer generations are find this much more appealing. And so it is easier to get better talent.

ROSS BUTLER

Good to go back to, you mentioned cop 22. And one of the criticisms of, of the the state led targets, I guess, is that that they can be seen as bad value for money. If you’re going to spend so much money on something that you pretty much know is going to be pretty inefficient, surely you should channel a bit more into an area that’s very, very kind of laser targeted on also making a return. Yeah,

PATRICK SHEEHAN

Innovation delivers a huge bang for the buck. And, and governments could sensibly deploy more capital there. But but, but typically infrastructure projects get more capital because they’re easier to quantify. So let’s, let’s make it pertinent to the UK. You know, only one of our geographies, but, but we’re spending 50 or 70 billion. I forget how much on a new train line from London to, to Birmingham Manchester. And, you know, maybe that’s a good thing, but it’s a hell of a lot of money. And a small fraction of that would have a profound impact on not just addressing climate change, but on the economic competitiveness of the entire country. So, so, but how would you rationalize that quantify? Well, that’s a bit harder, right? So, so the, the uncertainty and the femoral nature of innovation means it’s relatively underfunded. I think

ROSS BUTLER

Patrick, I wonder if you could leave me feeling really optimistic about the world, because, you know, w we’re all inundated with climate change doom and gloom, you have an optimistic outlook, you know, when you’re when you’re not in work mode and, and not in necessarily ETF mode, but just Patrick sheer mode, how do you generally feel about about progress on this score and, and where we’re headed?

PATRICK SHEEHAN

I am somewhat schizophrenia. I overall I’m optimistic because I think, well, there’s always a crisis, right? If you go through history I used to argue with my fellow students when I was a student about, about the upcoming nuclear apocalypse, right? And, and at least half of them thought there would be one before we got to the age we are now. And I was always on the, on the optimistic end of the spectrum saying the trend of civilization is, is positive. And that there are bumps in the road. If we apply ourselves, then we can do magical things. And you see that repeated through history. It does, I think bad news sells better, right? And it, and it is easier to stoke fear than to stoke hope. But, but, but actually there’s been an astonishing progress in the quality of living around the world, in our lifetime, right there, the, the there’s a billion, fewer Chinese people in poverty life expectancy’s gone up, Health’s gone up.

Education is going up. The internet has profoundly changed the way which we can collaborate. And by the way, you see the power of collaboration and the speed we can now deliver vaccines. People said it was impossible to deliver a vaccine in 18 or less has been less. And so actually, I, I think w w there’s a lot to go out. And if we, if we worry too much, you know, we’d like to fall off the tightrope, but there is no choice. Now, if we want to sustain a good standard of living for the, what is it, seven or 8 billion people on the planet we have to go forward and we have to be creative. And we, we have to be optimistic within that. I think we have to plan rationally, right? And on the concerns long-term planning long-term funding of innovation and technology being one sub sub set of that I think is really important. And there’s probably not enough of that. And so, so I’m a little bit schizophrenia, but not the optimistic.

ROSS BUTLER

I asked you to leave me optimistic and you’ve done exactly that. I’m really glad I asked the question, Patrick, thanks so much for sharing your thoughts and sparing your time.

#20 Private equity demystified

Fund Shack
Fund Shack
#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.

Ross Butler

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.

John Gilligan

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

Ross

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

David Petrie

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.

Ross

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.

John Gilligan

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.

Ross Butler

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.

John Gilligan

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.

David Petrie

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.

Ross Butler

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.

John Gilligan

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.

John Gilligan

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,

Ross Butler

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.

John Gilligan

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

David Petrie

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.

John Gilligan

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.

Ross Butler

David, that a controversial statement, I guess, from your perspective as a chief executive, the corporate finance faculty.

David Petrie

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.

John Gilligan

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.

David Petrie

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.

John Gilligan

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

Ross Butler

And he’s coming on again soon to talk about his new book on, on governance, which, sorry,

John Gilligan

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.

Ross Butler

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.

John Gilligan.

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.

Ross Butler

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

John Gilligan

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.

Ross Butler

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.

John Gilligan

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.