By ANDREW ROSS SORKIN, New York Times
“We all had too much money. It was just too easy.”
That’s the unvarnished appraisal of the private equity business by Guy Hands, perhaps best known for his unfortunate $4.73 billion purchase of the record company EMI in March 2007, the peak of the buyout boom — a bet that will almost certainly lose his investors and his firm, Terra Firma, a fortune.
That ill-timed acquisition aside, Mr. Hands’s surprisingly candid assessment of the private equity industry is worth sharing. He was in the midst of the industry’s growth to dizzying heights during the debt-fueled boom, and he is now having to deal with the aftermath of its shopping spree. Like others, he is desperately trying to keep businesses afloat and pay off the equivalent of huge monthly mortgage payments to the banks that financed them.
Mr. Hands, a large man with unruly hair who is a name-brand financier in his hometown, London, was in New York last week to meet with investors and speak at a conference. A longtime investor who started his career at Goldman Sachs, he made his reputation investing for Nomura. His net worth is estimated at more than $400 million.
Over afternoon tea at the Jumeirah Essex House hotel by Central Park, Mr. Hands, who now lives on the island of Guernsey to escape British taxes, offered the most frank assessment of the private equity world — including his mistakes — I had ever heard from anyone still gainfully employed in the business.
He had prepared remarks for a conference that morning, but didn’t get to air many of them. Some of his most provocative thoughts were in his notes, which he shared with me. Most strikingly, he grabbed the third rail of the private equity world: the fee structure that gave the firms 2 percent of assets under management, plus 20 percent of profits.
The problem, he said, was that the funds had grown so big that the 2 percent became just as important as the 20 percent.
“Clearly a large number of P.E. firms were totally overpaid at the peak of the market,” he said. “The fees were an entirely unwarranted windfall, as the managers did not use the excess fees to invest in resources to grow the skill base of their funds.”
He estimated that the private equity firms’ “net earnings will decline a minimum of 80 percent from the peak in 2007.”
Success had less to do with performance or risk management, he said, and more to do with bulking up. “It is time for investors to see through the elaborate marketing machines created by the industry,” he said.
Between sips of his mint tea, he said that during the boom, investors had thrown so much money at so many private equity firms — some of which formed consortiums to buy businesses from one another — that they were “really investing in the same thing so their capital was competing against itself, driving up prices.”
He also argued that private equity firms formed consortiums not to spread risk, but because, ultimately, it was easier than going “through the pain of gaining internal consensus to do something contrarian.” The big firms would counter that consortiums allowed them to buy bigger companies and to spread the risk.
With banks still holding back on loans, some on Wall Street have suggested that the private equity industry is dead. Others argue that the biggest firms — the Blackstone Group, Fortress Investments, Kohlberg Kravis Roberts & Company, which is planning to go public — will survive, albeit in a different form. Last year, Stephen A. Schwarzman, the co-founder of Blackstone, said, “The people rooting for the collapse of private equity are going to be disappointed.”
Mr. Hands is not rooting for the industry’s demise, but he is predicting it will wither. The firms still have funds big enough to last them at least a decade, as they provide steady fees. “Right now, the big firms have a tower of fees,” he said. “But the tower starts to collapse over time.”
As the funds dry up, Mr. Hands expects the firms will struggle to raise enough new money to support the hundreds of employees they now employ. His prediction has a precedent — that’s what happened to venture capital after the late 1990s. The industry shrank sharply after it became clear that too much money was chasing too few deals.
But the pattern may play out in slower motion for private equity. “Neither the banks nor P.E. want to come clean about mistakes,” he wrote in his notes. “Hence companies will live as zombies unable to grow their businesses or make long-term commitments. Meanwhile banks will try to suck out as much money as they can in fees and postpone recognizing the full extent of the losses of their underwriting decisions.”
In the end, he said, “Many P.E. firms are hoping that daylight doesn’t shine on the corpses of their companies, so they are reluctant to restructure too quickly.”
Of course, it’s possible that some firms will make terrific bets now, in the depressed economy, and will come out even stronger when things improve.
Mr. Hands is quite open that he made an awful mistake with EMI, which desperately needs to be restructured or sold (most likely to Warner Music, eventually).
His timing was off, he says, but not by much. If, by chance, he had waited several weeks, the deal probably wouldn’t have happened. The securitization market was about to seize up, which would have pushed him into a higher interest rate, making it impossible to sell some of the business to co-investors.
“If the EMI auction started two weeks later, it wouldn’t have occurred,” he said. “We wouldn’t have bought it. We’d have 90 percent of our funds still to invest and we’d look like geniuses.”
The good news for Mr. Hands is that most analysts, and even his own investors, give him high marks for operating the business very well, squeezing out every last efficiency.
The bad news is that he has been unable to invest in the company’s future and any additional cash goes only to one place: Citigroup, which provided the financing for the deal.
The bank has become Mr. Hands’s de facto boss now that there is more debt on the books than equity. “Negotiations with one’s bankers, when the debt is so large in relation to the earnings, are always difficult,” he said.