Guy Hands, head of UK-based buyout firm Terra Firma Capital Partners, has just published his latest quarterly letter. In it, he first reiterates a gloomy economic outlook that he first hinted at in the salad days of 2006. Then he goes on to suggest that private equity firms have three strategies available to them:
1. Don’t Invest
2. Switch Investment Strategy
3. Invest in Downturn-Resistant Businesses
One might argue that a number of private equity firms have already adopted the first option. In fact, I think I made that argument yesterday. The problem with it, Hands correctly points out, is that this option is antithetical to private equity. If you’re not going to invest, then hand back committed capital to limited partners. After all, it worked for some of the best – and some of the worst – VC firms back in 2002 and 2003. Hands does point out, however, that PE firms are particularly resistant to parting with their commitments – a sentiment I’ve heard ruefully repeated by limited partners. “VCs are an arrogant bunch, but they’re humble compared to buyout guys,” one explained.
I too am made uncomfortable by the idea of a “private equity” fund investing in “corporate opportunities” – because the return profile is different, and because it’s unclear if many of the actual investors have enough relevant experience. But, that said, most firms doing this are limited by LPAs from investing too much of their general funds into such deals. Moreover, the majority of these investments have been made out of the types of specially-raised vehicles Hands is talking about. In other words, I think firms taking this option have, at least partially, followed Hands’ advice.
The third and final option is the one that Hands says Terra Firma has adopted: Investing in industry sectors less likely to be affected by a downturn. This basically translates into asset-backed businesses in need of management, operational or strategic alterations.
Makes sense, but only so long as that’s what a firm has traditionally done. For example, imagine you are a tech-focused fund, which primarily invests in asset-light companies that are heavy on IP. If you switch focus, then aren’t you running into Hands’ objection to Option #2 (i.e., straying from the investment thesis presented to LPs during fundraising)? Moreover, there is a legitimate concern that certain firms are taking this option too much to heart – by refocusing on asset-heavy areas like infrastructure and real estate, which have lower return profiles than do traditional leveraged buyouts.
So let me suggest a fourth option, particularly for firms that don’t already focus on asset-heavy deals: Do Invest. The best PE returns are always found by investing in a down market, and CEOs/boards are nearing the acceptance phase of their valuation grief cycle. Firms don’t need to switch strategies in order to succeed, as it opens them up to the very contradictions Hands seems to fall into.
If this doesn’t work for you, then go back to the Don’t Invest option. Tell LPs that you’re shrinking the fund size. As the VC experience proved, it will garner admiration from your LPs, and reduce the risk that you’ll do something stupid. Be a trailblazer. But, as I said, it would be best to just return to work.