Private Equity: Industry Review - Ed Mathias, The Carlyle Group

I'm very pleased to be here I'm particularly this week because it's the first week I'm after about seven months I have two of my colleagues here both who are future MBAs Evan Morgan and Dan Bowles and I have a family member somewhere hidden in the audience so you can kind of try and figure that out good let me just I don't want to dwell in my career let me just make a couple comments because I come to private equity from a slightly different route after graduating from school where I have to say Tom Robertson was my marketing professor and advisor I joined T rowe Price when it had less than 50 employees in less than 500 million dollars today it has four hundred and fifty billion so tells you how the industry has grown and then we were very active in starting a firm called new enterprise associates which i think is the largest venture capital firm by far and in 1986 we started the Carlyle Group if we started it this seems ridiculous today with five million dollars and we the money was allocated two million for working capital and three million for investment and the idea was that the investors one of whom was the Mellon family whom I knew did not want to be diluted so the take they made the some of the money be allocated for deals so I come to this business with a both a public and a private market background now you should have three handouts one is a copy of the charts we're going to look at today secondly I hope you got a Carlisle annual report and thirdly each year for the last say 20 years I have done an investment report on the industry and I'd say a third of the people throw it away think it's ridiculous a third really like it and a third don't care but it's been a way for me to keep in touch with people and build relationships over time and one of the things I'm going to stress is the importance of that in our business let me turn now and speak a little bit about the Carlyle Group this is going to be kind of a Cook's Tour we're going to go through private equity very quickly and if any of you have questions or if you want me to dwell on something just raise your hand and hopefully I'll see it or Evan or Dan they'll each take half of the room and we'll do it the let's talk a little bit about Carlisle as I said we started in 1986 with five million dollars three of which we could invest and kind of live by our wits for a while today we have 86 billion dollars we have 667 funds we operate around the world our see we have 1,300 investors and we have almost a thousand employees about 400 of which are investment professionals and as you look at the industry you'll see that each of the major firms has a different strategy I'm not going to comment on the others if you want I could speak about it later but ours is people on the ground and diverse offices and our funds are semi-autonomous and so the Japanese fund or the middle-eastern fund or the European fund basically are people on the ground in their locations but to borrow a phrase from Woodward and Bernstein follow the money I don't know if any of you remember that from the Nixon days but so every investment decision comes through the central office I'm going to wrong right here and what we do I'm going to focus first because I think it's the most important on the investment committees but each fund has an investment committee with people in the Washington office senior investment professionals sit on it and it's more like a capital commitments committee of a brokerage firm and we don't exhaustively review the due diligence but we look at every deal to see if it makes sense and there has to be approval no matter what from the investment committee as we've grown you can see we've developed quite a bureaucracy that's my term and all these are areas that have a tremendous impact on the firm and one of the real problems today and I guess this has always been true as if you're a larger firm you have to fight the bureaucracy every day to keep the entrepreneurial spirit so I mean we have external affairs legal things that you probably don't think about the Foreign Corrupt Practices Act contracts etc it gets fairly complicated on the investment side we divide ourselves up not just geographically by by function we have a buyout group we have a growth or expansion capital we have leveraged finance we have real estate one thing that's missing here or two things are missing that a Blackstone would have are one the advisory business which we are not going to go in the other is the asset management business and that would be whether it be hedge funds public securities or whatever this is you may laugh at this but one of the important things in investment is to stand back and ask what's going on and there's some enduring truths and I'm not going to have to go through every one of these but I think as you look at careers and look at investments and look at companies that if you ask yourself some of these questions it might improve your decision-making and the reason I highlight these is some we have gone through a tremendous cycle in our business where money followed performance we think excess capital drove down returns size definitely has an impact notoriety regression to the mean is a very powerful force and when you look at some charts if the numbers look unsustainable they probably are and the people have said the most dangerous phrase in investing is it's different this time now I am going to tell you some reasons as we go down why it's different but I think these are things that are important to keep in mind and as you think about private equity or alternative assets they're part and parcel of the financial system they do not operate in a vacuum and what happens in the financial markets influences us we don't influence it to any great extent a couple things I want to highlight I'm not going to walk you through this whole chart but we know now there's enough data people talk about earning four and five and ten times their money we know now whether it be venture capital real estate private equity if you return to the investor two times they're invested capital you're a very successful fund certainly top quartile maybe top decile so that's where you want to get now these numbers as Evan has pointed out to me many times do not allow for the staging end of investments but if you take the money day one and you want to earn two times you can see what happens how it goes down with a holding period and in private equity there's another factor that you have to make up for is we have to pay back the fees and we have hurdle rates at 8% and the fees compound at 8% and when you take deal fees investment management fees etc you create yourself quite a hurdle if you don't start returning capital most of our clients look at the IRR today which is in my opinion a fallacious number but we're starting to see people think more about money in money out the way people have traditionally talked about real estate so this is something you should keep on your desk along with this now remember Warren Buffett's rule first rules don't lose money and second rule don't ignore the first rule if you have a wipeout in a private equity portfolio it is very difficult to make up then sure they claim it's not so difficult because you have some big hits and we'll talk about that in a minute but this is just arithmetic but it's very powerful you know private equity and venture capital have at times gotten tremendous publicity I just wanted to kind of put in perspective where they stand relative to the financial markets and this is just the US market not in the as you know the US stock market's probably about 40% of the total you know what the number to market if financial market stock market isn't kappa these days it's China but you can see major stock exchanges Evan these are the right numbers fifteen billion stock funds of mutual funds four point seven hedge funds somewhere around two trillion with leverage private equity we're not sure exactly number but something like this and then you get down to venture capital which is impetus mall so within the scope of the financial markets these are not huge assets and I thought just take a look at market caps of certain companies so you can see Exxon has a market cap that's bigger than the venture capital business Microsoft's cash is two times what venture capital raises a year and again we could play around with these numbers and talk about it but it's just for perspective so a Cisco is a much more active venture capital investor really than anyone else if you look at the money they have so let's talk a little bit about private equity now having that in perspective we went through what I would call the perfect storm that the numbers aren't firm but went from like 2002 to 2007 the returns look tremendous especially versus the stock market there were a tremendous amounts of cash paid back again primarily through recapitalizations and this was a tremendous opportunity because interest rates were coming down and banks were lending more so what you could do is refinance you get a higher debt ratio and lower interest rates and it was an enormous advantage and of course those days ended but a lot of the returns came from recapitalizations and then I think it was a in 2007 or 2008 90% of the high-yield market was recaps ah one thing that people haven't recognized as an appeal of private equity is for a financial institution you're getting non-recourse leverage if I went to the pen investment committee and said look we'd like to lever up we'd like to do an individual investment we want Craig karna goalie the CFO to take on five hundred million dollars in debt I mean he would shoot us but when you get it through a private equity fund it's an inherent way of building leverage into your portfolio and people realize that so as you had performance you started to see increased allocations we saw a lot of new investors a very traditional pattern private equity became the heroes of the era and we've had other heroes some of whom have crashed but you saw Steve Schwarzman David Rubenstein David Bonham and Henry Kravis on the front page of the papers they were in the front page of of Newsweek etc or Businessweek the industry started to institutionalize when we started we had primarily individual investors a few small institutions some fairly sophisticated people some more international than others but it started to spread to all institutions so what you saw for our industry is a tremendous growth in assets so like I said we started with three million dollar fund our second fund was a hundred million I think our third was 500 and our last fund was 15 billion so it was a quite a quite a change I just want to spend a minute on how investors thought about this and what brought us into it and a school like Penn are you all familiar with a spending rule how they think about how the endowment works is that something you've talked about or in essence a spending rule for pen pen believes that they can spend about four-and-a-half percent of the endowment that the capital market return will be about eight percent and that by reinvesting the money that you don't spend you keep up with inflation so you have a spending rule and then pension funds of course have an actuarial assumption the better that is the less money they have to put in so there's some interest in keeping that high so what you ended up with was a situation where rightfully or wrongly people were not that excited about stocks they weren't that excited about fixed income and so they moved very dramatically to alternatives and diversifying assets whether it be hedge funds private equity whatever and firms like CalPERS were writing 250 500 million-dollar checks to private equity firms it was really quite staggering I was a tier a price if we could pick up a two million dollar account we were really excited and it was quite a change and then people of course the whole strategies you have to keep up with inflation and people have varying views about that okay you know what happened to the stock market but again this affects our business quite dramatically because private equity while the market was languishing was showing very good returns this has not been updated and the numbers are very soft but basically what you have is that these kind of assets were providing a much higher return than the Nasdaq or the S&P 500 now these numbers are nowhere near what people talked about 30 35 % 40% I just want to make the point again you can look at this as your leisure financial crises are nothing new markets live and die with them this time was maybe a little more on risk but we've been through a lot of different ones over time and again each of these things we could spend a long time on okay what happened we went through a very difficult period people's performance expectations changed quite a bit their risk tolerances and preferences changed in good times people are looking at the upside and bad times are concerned about the downside and there were tremendous changes in how investors looked at this that private investments when you go into a Carlyle fund or KKR fund and effect you're locking your money up for 12 years if you're with t rowe Price with an institutional common stock fund you call that night the bank transfers it over and it's your money you liquidate it next day you do it Hong Kong whatever but you have your money right away and these the premium for locking money up for 12 years went up dramatically as a result of what people saw during this environment the availability of bank lending just stopped as you recall the banks were just frozen they had all these other problems so people in our business could not get credit it wasn't a question of price it was just availability everyone stopped fundraising hit a wall and we had dramatic you'll see some of the numbers but what happened here is as the private as the public market shrunk people's percentage in private equity and hedge funds etc which were relatively stable went up they called the denominator effect and it was just a number that came out this week Yale and I think this is the correct number has about a 14 billion dollar portfolio they have seven billion dollars of uncommitted call capital calls from private equity and other funds and this is a very it just changes people's attitude the way they invested so firms like ours who had very large pools of capital ended up not being able to invest which the clients then say well why are you sitting on our money why don't you return it you know the fees are being accrued compounding so you get yourself a real hurdle to get over but if you look at the buyout business which we'll see there was virtually no investment made over a period of 18 months and then finally the phenomena of the buyers and the sellers were so far ahead on prices I mean we were looking at current conditions having to put more equity in what the price should be the sellers were thinking about what the price might have been two years ago and so that Golf has closed a little and one sides going to have to capitulate I think it's going to be us but it hasn't happened yet okay so what happened in private equity there were fewer smaller investments fewer investments and smaller investments exit stopped virtually no distributions and historically limited partners have thought that they're never going to invest more than 75% of what they allocate because the you'll get money back to offset that that stopped fundraising fell precipitously are you familiar with how the banks flex they have certain latitude within the lending agreements they all went to the max or they withdrew I mean there was a phrase if you change your seat at the table it was a material adverse closet function and it stopped and people just withdrew from the market we were dealing with covenant light loans I mean there were nothing in the loans that could cause you problems and one of the reasons we haven't had bankruptcies is because the loans were so covenant light the firm's started thinking how could they invest their money they started looking at different deal parameters and we're going to dwell on that in a minute but historically firms like ours did plain-vanilla LBOs you borrowed money you bought a company you paid down the debt and you made a certain rate of return now you're starting to see minority investments you know pipes lots of different things cabal's of people together but the other thing is that there were widespread fears of what was going to happen I mean 12 months ago maybe 13 months ago we were at the nadir I mean people thought the banks were going under we were going to be out of business I don't know the endowments were done markets we I think the markets turning with March 12th of last year but it was a really rough period and so you had all these fears and this is just some of the great publicity that our industry has received at the time for a break this goes way back barbarians at the gate but this was an industry which was very quiet it wasn't very well known and I think be three or four things generated a lot of publicity one was the returns to was he had a number of the stars three some of the deals started to have a much more pervasive impact than was the case here too for when KKR and TPG bought Texas utilities they had a deal with a rate Commission they had to deal with consumers they had to deal with the lenders they had to deal with the environmentalists this was something when you're doing small deals you do not have to worry about those type of constituencies okay but let's ask what didn't happen there were there was a lot of talk that there was going to be widespread bankruptcies among the big deals that were done in 2007-2008 it didn't happen I'm not going to say it's not going to happen but you're starting to see these things get refinanced some of them are so covenant light the banks are going to in five or six years end up owning the companies but there hasn't been the collateral damage that people predicted you may have seen like Blackstone just refinanced Hilton and there's a mountain of debt out there but so far it hasn't happened secondly people said that the general partners were going to default on their loans on their investments and I'd have you talked at all about the own risk terms if you default okay but basically when you make a commitment to a private equity deal heretofore the terms have been extraordinarily favorable to the GP so once you invest a certain amount of money if you don't continue investing that the losses to your own risk you basically they recapture I won't go through all the details but you recapture a portion of the money there was a lot of talk and money raised for secondary sales you may have read Stanford wanted to sell a billion dollars other firms it just didn't happen and I one of the reasons it didn't happen is that there could be no agreement on price the buyers thought that they would that sellers were in such distress that they made demands that were just unreasonable and these are reasonably complicated deals because if you want to buy a piece of Carlyle v let's say I'm a seller you're a buyer you're not only buying the asset but you are buying the obligation to continue the stream you have to finance the rest of it also that the GPS have put a very interesting clause in there that we have to approve any transfer so if KKR were to have a secondary fund we wouldn't be real anxious to sell them a piece of our fund so for a lot of reasons this didn't happen there is still a massive amount of money out there geared for secondary secondary purchases and maybe if the prices go up the market will do it you may have seen China just committed a billion five to this area okay there was no implosion of private equity firms there was a lot of talk of that there was a lot of talk of group of government action regulations again there was a lot of talk one of the problems now with taxing carried interest is there's no carried interest there's not going to be for a while but there was talk of that there was talk of making registration with the SEC etc it just so far it hasn't happened there are some things on the horizon you've probably read about the Volcker rule these things are very complex I mean how can you tell when Goldman Sachs is operating as a principal or as an agent and when they lend to a company if they're invested in it I mean it would be a real problem disaggregating that that would be good for us if they could do it there was a thought that the banks would just be stuck with these leveraged loan portfolios forever it didn't happen I don't know if you've watched what's happened in the credit markets but the credit markets are up a staggering rate in the last 12 months probably the average credit is up 60 70 % and it's been indiscriminate it's not just the higher quality it's everything there's been no sense that private equity contributes to systemic risk I mean we are not Citigroup or JP Morgan or someone if it's it would contribute to that there were some fears of that and then thirdly I don't think there lastly I don't think there's been an abandoned in a private equity you may have seen for whatever reason Yale just announced they're increasing their thing we still see lots of interest the form of the interest is changing but there's still much much interest this is just the deals I'm not going to go through these but these are the deals most of the big deals in history aside from RJR we're done in the last couple years these are very large this is of course Texas utilities which all of these have issues but it Hilton but it looks like they're going to work out not to be provide returns the private equity the investors but not to go bankrupt let's look at fundraising this goes way back you can see on a quarterly basis you can see by the year and it probably correlates with performance and distribution now we're down to you know a relatively small number compared to what we knew in these periods and there's a lot these numbers are indicative they're kind of soft because they capture a lot of different kind of funds but you can see the trends are pretty clear the availability of leverage you can see the heyday coming down and these are factors that really influence our returns again going way back you weren't putting you weren't putting much equity in these deals at all today you're up there somewhere near fifty percent and that gives the lenders a lot more support but it also has to drive down the rates of return and how many people here think the stock market will compound at 10 percent over the next five years how many less okay so if you think the stock markets pick seven if you think the stock market is going to compound at seven historically what people would say is I want 500 basis points above that for LBOs or venture give or take you know you're talking 12% return expectation for the investor not 35 or 40 but the issue then becomes once we get down into that type of rate of return we don't earn much money the carry only becomes worthwhile if you have a high high earnings rate this is true for hedge funds whatever one of the things that we're seeing is that the investors are very interested in making sure that we're not earning money from income I mean the history at y'all you're all familiar with how the economics of funds I mean basically we charge two-and-twenty historically that came about through venture capital when very small firms needed the 2% people never envisioned you would be layering funds so when you have kleiner perkins 12 or Carlyle 7 you're collecting fees on five six seven funds which means fear probably you can earn a fair amount of operating income clients perceive that is not in their best interest and so there's going to be pressure in that regard so for us the real thing is use the expenses to use the income to cover your expenses but the carry provides the incentive and if the carry is not high enough if the returns aren't high enough the carry won't justify sort of it make your economics work that's a chi Hopis that's kind of got lost in my own thought process there okay you can see the average LBO perch's it it's down a couple turns it's still relative prices are still relatively high if you talk to most LBO players today they'll say the prices are very high and partially that's institutionalization there's a lot of competition you know there's a thousand firms with uh I think over a billion dollars today the but what this really says if you pay this kind of price you have and the kind of leverage that you can put on it you have to create value or grow the company financial engineering itself it's not going to provide the return you need now if you looked at this chart as an academic you say something's going on well as I said the loan market just sort of went away and it's coming back primarily because of the yield curve and the banks are working through their problems but that's a major major change these are public to private transactions you can see again very very heavy these are the the big deals the Texas utilities the Hilton's etcetera were done but again these have gone away and what we see now is a lot more strategic buyers in the marketplace so we're competing with strategics in addition to competing among ourselves equity distributions of capital are really important to the investor it changes the IRR it enables them to continue investing and so on and you can see you know we're doing great in these periods and now it's come down it's very very very small you'll probably see this start to pick up there's no question that you cannot raise a successor fund if you haven't distributed capital and probably it's going to be on the order of at least 75% return of capital before you can raise another fund and if you want your existing investors I mean that is essential I talked a little bit before about how horizons expanded this is cash flows or equity flows into the emerging markets you can see while the trends are very positive the numbers are still relatively small and of course the most interest is in Asia and we still see that we see Asia is important both in terms of market opportunity and in terms of the interest on the part of investors but still it's a relatively small number now we're active in these markets one thing that we're seeing in Asia is local competition is really picking up I mean our problem is not with the black stones and the kk r's of the world we're competing with the local investors many of whom have Wharton MBAs they have either direct or tacit state support and they operate in the local currency and you may have seen almost all the major firms are forming RMB funds so that you can transact with less restrictions not totally and wait for instance we have two large funds are focused on Asia one is a buyout fund and the other is a growth fund the buyout fund is subject to much more scrutiny than the Growth Fund but when you see these numbers say our Growth Fund they remind you of what they used to call and venture capital hockey stick now like the downside is thirty five percent a year you know the upside is sixty percent and interestingly they're making it so the Econo the boom there it's like the California Gold Rush but the competition is increasing as I said dramatically Africa looks like one of them in next frontier markets I think this is a misnomer I think these are emerged to markets and the emerging markets are northern Africa South southeastern Asia etc and what you're seeing in terms of the buyout funds is you're have the very large funds the KKR is the Carlisle's the black stones who are going to be global and then you're gonna have the middle market or the national L funds who are going to be operating mainly in the US this just gives you a sense in a more systemic way of some of the issues we've touched on but yet we've gone through as you would in any industry stages and I'm going to touch on some of these things we've alluded to some of them but you can kind of see that and you have all the charts this is one of my favorite charts I may need Evan to help explain this to me as we go through it but what we tried to do was to show what it takes to build a successful fund and I'm going to spend a minute or two on this because I think it's really important to your thought process we know that netting two times the fund is very very attractive the investor if you can do this in any asset class over a five year period you will have certainly a top quartile and probably a top decile fund so what we did to show you the dynamics here in Evan if there's a problem here to bail me out this is the fun-sized you have to get this amount to get to get here this is these are the fees these are the pref this is the equity you have in addition to these returning so you get if going to take 80% of this and they're going to take 20 these are the numbers and then what we tried to do these are the assumptions five-year horizons a 2% management fee the compounds you need an 8% preferred return which compounds and then the 20% carry and what we did we just made some wild assumptions about what you had to achieve in terms of the portfolio to get there and what this says this is a plug number you have to have well let me put it this way you have to limit the number of wipeouts and you have to have a few investments return 5 to 7 times your money I mean these are probably things you know we try to do it in sort of a more systemic way and venture capital the numbers would be these two would be very different because you have more wipeouts you need more big hits so one of the questions is given today's prices leverage etc can we get this number of companies in that will return five plus times and it becomes a much more difficult problem as the funds get larger so our 15 billion dollar fund one percent one hundred and fifty million dollars so if we're going to make thirty investments you can see each one has to be relatively large euros Warren Buffett has pointed out that universe gets relatively low so this is a way I mean this is kind of a chart we're thinking about in the business this is really I call it the billion dollar challenge we have to multiply this by 15 for our big fund okay one of the big hurdles facing us is we have a mountain of debt that has to be refinanced in this period that's a real challenge and every buyout fund is focused on this you may have seen men shinned before Blackstone just redid Hilton this is really important and there's a fear because of what's going on with the government that rates may be much higher two or three years from now than they are today and you could really hit a wall so there's a trump Mendes amount of activity to try to get this taken care of sooner rather than later and that means attention to the current portfolio versus New Deal's okay let's kind of I'm going to walk through now some of the current issues and challenges facing our business and if I get too depressed they turn this over to Dan or Evan to chat about it but like any business you know our we're in somewhat of a cycle and right now we're in a situation as are all forms of asset management where you're undergoing tremendous structural change this is true of the Wall Street firms this is true of traditional money managers this is true of private equity I mean this is a I don't want to say once-in-a-lifetime but certainly once in a generation change and that we have to deal with a lot of issues that are going to end some of which are going to take a long time to resolve okay I'm going to go down these investment performance this is our lifeblood if we can perform at a very high level we will not be held captive to some of these other trends I mean the people that can really perform are not going to have as much feed pressure they're not going to have as much trouble raising money and particularly in venture capital but also in private equity the difference between the top tier and the top quartile and the third quartile is dramatic if you look at fixed income managers there's probably a 20 basis point difference between first quartile and third quartile it could be a thousand basis points in venture capital or private equity so there's going to be a migration of money to the best performing firms and we can later discussing on what might constitute or how you might be a best performer but this is really going to be important and it looked like the classroom consensus was that returns in the public market might be something like 7% now it's just illogical that private equity could achieve 35% when it's a semi institution analyzed very competitive higher equity positions higher cost debt that we can earn those kind of returns so the question is how much do people expect and how much can we earn I think most institutions are thinking of this two ways the major investors one is 500 basis points over the market when they pencil in a return they think 16 to 18 percent if you could return 16 percent net to your investors you'd be in pretty good shape now people dream 35 40 but 15 16 would be very good I think okay the major investors in the country have come together as a group and issued a set of principles as to what they should do now there is some belief which I don't adhere to that this is a violation of antitrust I'm not sure the Justice Department is going to protect private equity but they're talking about fees and terms things like fee on invested capital versus committed huge number and again if you play around with these numbers you'll find out that the carry does not influence their return as much as the fees now can you imagine paying a 25 or 30 percent fee on private equity that's that's the way it works I mean let's say we have a billion dollar fund two and a half percent fee so the fee is Evan twenty five million dollars okay so if we invest a hundred million the first year we're paying 25 million over a hundred fee you have to think about that but it's a pretty staggering number if you change that the dynamic changes dramatically and invested big investors figure that out we've historically collected deal fees so when you do a deal you collect a fee you're really just borrowing from the fund because you have to pay it back but you're you have the use of the money same with monitoring fees the pressure on that is very very strong is to either return them to the limited's or not to have them and there are a lot of other soldered nuances but the pressure on fees in terms is going to be there in all likelihood funds will be smaller as I said our fund was 15 billion Blackstone's last fund was 17 they've been in the market for about two years and I believe they've raised nine or so uh-huh so there's a feeling that smaller funds are better and that mega funds are at least today in somewhat little repute and we're going to have to hold our deals probably longer partially because of the markets but partially because it takes longer to create the value when your financial engineering if the market goes your way you can do it right away if we have to create value and build these companies it's going to take longer the same with debt availability terms costs all of which are going to extract a price we talked about this shift the value creation versus financial engineering this is very important our industry has become extraordinarily visible there's a huge push for transparency I mean we're much less susceptible that than the hedge funds because we really don't care about trading positions or current information but we have to be much more careful about disclosure and regulation across the board I mean we operate in different states our companies all have problems their foreign rules etc and then there's something here that is a very very important factor for our industry are you all familiar with FASB 157 yes it's basically yeah guest a market right that's the energy and everything in the cost what that takes is tremendous and it's had a huge impact on our portfolio one of the things that investors really liked about private equity was that they didn't mark-to-market it showed even if it wasn't real it showed a real sense of stability so you were marking really at cost for a long time so you didn't get the volatility now and so you had a very low correlation with the markets now you have to mark to the market and most use a period of triangulation to do it I mean you look at transactions you look at free cash flow you just whatever you surround the problem and you come up with a value interestingly the limited partners have an obligation to authenticate those values it's just causing a lot of issues so we spend a huge amount of time on this now we have to the accountants make sure that you have some volatility introduced in the portfolio so it's it's having to pronounce the fact interestingly these funds the valuations did not go down anywhere near as much as the market for a variety of reasons a lot of which they were based on cash flow analysis okay I talked before about the fact that a lot of our traditional investors are tapped out the CalPERS allow the endowments are not going to be the source of capital they've been so but there are new sources of capital developing the sovereign wealth funds a lot of foreign banks whatever but it interestingly a lot of them have very differing styles they're very interested in Co investment they sometimes don't like funds sometimes they want side accounts sometimes they feel that you know they should get certain fee breaks etc etc this is a very controversial subject I mean my own feeling is that all the major firms will Republic and we've seen Blackstone as public KKR s public Apollo is coming off the Goldman exchange trees on the Goldman exchange but I think there are a lot of reasons for that one is a monetization of the partners in this firm these firms well I think they have no intention of leaving now certainly feel that they have created brand they've created value and there should be some way to get liquid a permanent capital could be very very valuable if the tax law has changed to where we're getting paying ordinary income on partner karat unlimited partner carry but can invest our own money at capital gains rates the spread would be quite dramatic and having access to that I think is important one other thing I should say is the industries consolidate having a currency to make acquisitions could be very valuable because most acquisitions in this business people want a portion tax-free and a portion in cash so if you have a public currency that nobody has to argue over the value makes a big difference now are there conflicts of this is this good for the LPS I mean we could talk about that for a long time I think the perception on the part of LPS is bad for them because there's going to be more another constituency that they have to compete with that you have to show steady earnings to be a public company etc this is occurring the repositioning we thought of ourselves as an LBO firm than a private equity firm and now we're kind of thinking of ourselves as alternative asset management and this is a natural migration probably the best example is Blackstone which has real estate they have private equity they have advisory they have credit they have hedge fund funds etc and this is a challenge which will impact some of you it's typically the people who ran these firms were investors but investors never want to turn the reins over to non investors and you know it's the eternal conflict so you have a whole series of issues regarding to how organizations are managed and most of the major firms the founders are still there and when the founders are there basically they do whatever they want I mean you can have committees whatever but the founders have a disproportionate influence but we're starting to think about some of the issues about Career Development I mean historically when you came into a Carlyle I mean you were just you know out for a pass you know you worked on this you worked on that today these firms are becoming much more institutionalized so you might be hired for the automotive group you might be hired for the healthcare group but you don't have sort of the range that you might have had so how do we move people around how do we develop them and it's a very interesting thing to think about is the entry-level qualifications are much different than the Senior Partner qualifications I mean most of our senior partners I'm absolutely convinced could not Twitter they don't know Facebook they couldn't do spreadsheets backwards but they know relationships they know deals they know what the critical elements how do we take advantage of how do we develop people to have those skills down the road when we're compartmentalizing them initially I mean we don't want base of our people out looking for deals this event and in succession I think it's something of a Trojan horse because most of the senior people love what they do and I don't think they have a good to have a good situation I don't think they're going anywhere but that's something if you're public company you have to address are you interested all in venture capital we could spend a couple minutes on that that's a venture in my opinion building companies is eternal I mean creation of wealth it's truly an American phenomena has not succeeded in our form anyplace else probably the closest is in China where there are a lot of entrepreneurial companies but they tend not to have capital come in the question today is has to do with the traditional model is the traditional model broken or has it changed is this secular or cyclical and I always this is one of my favorite quotes from Bill Parcells you are what your record is aside from Google and a couple other issues the record of venture capital over a long period of time has been abysmal I mean it's been abysmal in terms of distributions it's been abysmal in terms of IRR whatever and we're now down as you can see from the numbers I'll show you in a minute the tourists have left we're now down to the people who really believed in the religion and it's a relatively small group and it's made small by there are not a lot of non-believers and a lot of major institutions have just figured out it can't impact them you know if Penn has a seven or eight billion dollar portfolio 1% 80 million what do we get from putting 5 million dollars with Sequoia a lot of bookkeeping you know they're going to invest a million dollars a year for us so a lot of the big institutions have opted out a lot of other people don't like the results so you have a dwindling pool which I'll talk to in a minute has changed the whole dynamic aventure this is the way venture kind of works and this is like an accordion it compresses and expands at times you get all these people are very interested in startups whatever at other times they wouldn't touch them so now the only people providing seed capital are the angel investors and so what I call serial entrepreneurs you have a few traditional venture capital firms you know the Kleiner's the Sequoias benchmarks who basically see the best deals you maybe they have a network they see things they really have a long time doing this but even then their record with few exceptions has not been great and then you have the people who like to get on the train before it gets there and these are various people who will put money in later stage what they call expansion or growth financing I guess you can guess what year this was happens to be ten years ago but that was the dot-com bubble everybody loved it last year there was fifteen billion dollars raised and again I said that's one-third the cash that Microsoft has so this has become a relatively small industry though you'll see in a minute there are a lot of reasons why venture capital and entrepreneurship is important to the country we talked about distributions this seated the pot and 50 cent but look at this now last year was two billion dollars this is a real problem and you're probably aware there's been structural changes on Wall Street that preclude a lot of small companies from going public we could go into some of the details of that but believe me the goldman sachs of the world are not going to do a 50 million dollar deal so you're really restricted either selling to a strategic or holding the company until you can build it to a critical size now facebook wants a go public or twitter i mean there are the exceptions to the rule but in general it's a very tough area though this is not to say that there are not a lot of exciting things taking place and I mean this is just a quick list but there are lots of pockets of opportunity but they're being addressed in different ways and venture capital is very important to the country I don't think there's a diminution of interest in starting companies we see it every day they're just being funded in a non-traditional way but these are companies all came out of venture capital and the Venture Capital Association would make the point that they are creating jobs and they've done more than the S&P 500 fortune 500 whatever but there's no question that the entrepreneurial spirit and we see I'd say I don't say every day but certainly three or four times a week we see people come to us with a big idea and they're funding them in very unusual ways but it's getting done but it's just not the traditional venture capital fund I want to talk a little bit about putting our industry in context this is like a movie we've seen banks brokers asset managers hedge funds private equity it's really institutionalization monetization as you grow and it's a very similar pattern that happens and maybe you want to try and identify the next one coming but basically performance leads to growth of assets you start product line extension you get a brand the industry consolidates you go global this is a very controversial as you grow are you an asset manager or you an investor you know trading off that and then finally you go public or you sell the company and that's we're seeing that every day it's a little harder in private equity if you're a middle market firm who's going to buy you who's going to consolidate I mean clearly the big hedge funds and the big buyout funds could do strategic relationships or sales quite easily let's talk briefly about just finalized finish up with a career in private equity and some of these I've alluded to I mean first is we see tremendous interest I mean still we are getting inundated with resumes not just from MBA students but from all over the place and we have and I think other firms have this too we have a real dilemma now because the industry is in all likelihood going to be smaller in the private equity area if our next fund is five billion versus fifteen billion we're probably over staffed today so what do we do I mean what we have to do we have two great firms grow their own talent I mean there's no way that we're going to capture a cup top guy from KKR they're just not going to let them go and we wouldn't have to so we have to grow our own talent so that means that we have to have a more vigorous upper out policy and continue bringing people in and that is not easy I mean it's a mindset people in this business do not like personnel conflicts I mean our chief investment officer if I called him with a personnel like I'm out of town let me know when it's over I mean it's just not something that people like to deal but these are real live problems that we're gonna have to think of so the appeal and the interest in private equity and our type of investment is very real we also have to think how can we move younger people around to broaden their exposure I mean can we take a person from our buyout fund and put them in credit I mean the Goldman Sachs's of the world do that all the time say we don't have much opportunity in private equity you have a chance to make partner in commodities people run for the door that doesn't happen here so that's going to be a challenge I alluded to this before but it's very important the entry skills tend to be pretty hard people are looking for you know quantitative industry experience can they do this and that some of those skills do not naturally equate with being a senior partner and developing business dealing with banking relationships dealing with high-level professionals etc and in most of the firms I think the senior management has abrogated the responsibility of hiring so if you're going to if our automotive group is hiring somebody they have their own criteria I might have very different criteria you know again something we have to think about the funds you have large you have middle market small all of which have different characteristics the the career path seems to be that if I talk to people today coming into the business I mean typically you know they have an MBA they probably have some Wall Street experience they would like to come to a Carlisle or KKR but they're really basically back in the mind they're keeping their options open that they're looking maybe there's that will work out but if it doesn't you know maybe I go with a smaller firm maybe we start our own firm which is harder today etc but I think there's a lot more flexibility thought than coming I'm going to spend my life here I mean clearly this is a very interesting business a very challenging peer group you meet a lot of interesting people even if you're in a narrow discipline we've talked about you know career development of the path the one question I always think about is if you are joining Carlisle or KKR or Blackstone today how would you really distinguish yourself is it going to be by doing a big deal is it going to be by going into a new area is it going to be your boss becomes head of the firm but I think this is something people don't think about one thing I can tell you is people are not going to be indemnified for having this 2006 and 2007 you're going to have to make your own way and I think it's a real challenge thinking about that and that would be true at the major Wall Street firms too I mean Goldman has what 35,000 employees so historically if you think how have people truly gotten ahead I mean there are a lot of people say well they're smarter they work harder etc I mean typically those are attributes that most people have I mean what is it you join a firm early you get into a growth area early you get lucky on a big deal or whatever but there's some dislocation that happens that gets you moving and I think that's something everybody has to think about I put economics last not because it is last but because that's not the primary factor I mean I think in most careers if you do well the economics will follow I think the economics and this business are going to deflate a little bit they'll still be very good but it's not the driving force I just listed tooth I'm going to give you two pack these are two very well-known people that have listed their rules of investment I'm not going to go through them bill Conway who's our chief investment officer who gets very little he doesn't like publicity only focuses on investments he listed his own thoughts of what you can ponder these at your leisure and then there was a very well-known fellow of Wall Street Bob barrel who had ten rules that he thought about he was for 25 or 30 years the RO he was selected as the best technical analyst on Wall Street etc so I think with that will I'll finish up on the formula and if the things you'd like to discuss or issues you'd like to raise I'd be glad to entertain them that's a long time to talk so any questions problems yes yeah I really have to disaggregate that question because we do have an infrastructure fund and a lot of other firms do too that's a relatively new area that is the way in which private equity is migrating is different from what we did in the past to some extent if you take financial services historically we always had assets under what we did financial services doesn't you know called the Financial Group infrastructure is so intertwined with government agencies and how you get the fees and what type of returns and leverage I don't think we have enough experience yet to know in the infrastructure area what it does look like is the deals are priced not to provide a great return and what we're starting to see is a lot of interest in the emerging markets in international infrastructure which offers maybe higher returns with probably more risk power is very different we have an Energy Group Riverstone which has just been spectacular their funds have returned three or four times the capital and that area it's a huge area it's very relationship oriented tremendous amounts of activity and that has done very well alternative energy which everybody likes has not done as well and I think that's what you may have been alluding to that these are very tough would you are taking making wood pellets or ethanol or whatever these are very very tough businesses and there's a lot of interest in green and environmental but they so far haven't been there I don't know if that answers your crack it yes if you look at the kind of area of the private equity timeline you referred to as the Golden Age panel whose was back today when did you first realize that that was kind of coming to an end and what was your reaction of what you and Carlyle broadly speaking well our chief investment officer bill Conway wrote a sort of prescient analysis sort of as that was coming to an end so I'd say did we recognize that there were problems etc yes did we do enough action to take advantage of it no you never do I mean there's no way if you're managing a big pool of money you can go to an extreme position I'd say we did better than most but even having recognizing the underlying problems slowing down our activity it you could have done a lot more I mean every everybody kind of saw the excesses but it was like a narcotic yes if you join one of these firms today how do you ensure you have do you have any thoughts as to you're one of us yeah I actually do I'd say first the first job is you may have to disguise some of your personality to get the job that I think you have to kind of things come up all the time and I think you have to be prepared to take some chances you know let's say like I'll tell you a couple suggestions that I've made the Carlisle to various people I mean we're fairly active in telecommunications defense retail etc I personally believe that agribusiness is going to be a very big area so for a young person to say go to the head of the LBO fund say look I'd like to learn something about agribusiness if you're right all of a sudden you become a team leader you jump over a lot of people don't know anything about agribusiness that that type of mindset I'll give you another example we're thinking of doing some more things in Asset Management that's a fledgling division for us maybe leave the buyout group and say I'd like to help build this division there won't be a lot of volunteers to do that I mean most people feel that everything's going to work out great you know I'm a member of the automotive team and if I stay here I'll be running the firm and get all this it's not going to happen so I think what you have to do is at some point you have to take some type of risk to differentiate yourself you know whether it be go with a small firm whether it be to kind of try and develop a new area whatever and we don't see much of that maybe I don't know heaven tell us what I cut I mean most people say well you know I'm working on a fifteen billion dollar fund I don't want to go to something that there's nothing to going on yes yeah buying 10 that's the consortium of investors that is trying to change the industry I don't think it will happen the extreme but I think I mean you could say they're jumping to the front of a parade and depending their leap pretending they're leading it some of the issues that they're talking about makes sense the buyers clearly have more power today and I think people where it's sensible will accede to some of their issues I mean they have certain issues that we would be crazy to give like can the limited partners put you out of business I mean that's sort of non-negotiable they know that should you change the fee structure some of the terms that'll get negotiated out so I think this is these are trends that are inexorable they're going to happen not to the extreme though yes how does the so you mentioned how the industry is to institution institution I'm not able to see the word it has gone to different stages and you mentioned a point about how there might be consolidation happening in the private equity industry yeah could you talk a little bit more about that because it has been such a cottage industry and different people think most of most often they want to break away and form smaller companies that isn't consolidated well you know it's not either/or I mean they're always going to be people that are entrepreneurial will go off and do their own thing today it's much harder to raise the money so not that it won't happen I think when in terms of consolidation there are firms that will want to be part of a bigger organization to have access to capital have access to marketing I think there are a lot of firms that will not get funded again a lot of people were at the periphery you know the CalPERS I think has something like 275 private equity firms there's just no chance that they're going to fund every one of them so the consolidation is going to take place in that way but I think it's inevitable I mean and it's really unwinding what happened in the glory days and someone once equated these funds the nuclear waste they have a half-life you know every year they go on forever but they're different kind of sweeping them up Limited's are going to say I don't want to keep paying the fees they'll get a vote they'll stop it so it's going to be sort of a war of attrition I think this the bigger firms are not they'll be consolidating not consolidated yes 39 okay now I'm really getting comfortable this yes well of course this gets back to the question be who hey they're always going to be opportunities you know whether it be currencies ETF funds whatever I think what I was really talking here is the major firms in the industry it's a pretty typical pattern I mean they create tremendous brand wealth and let's take for example KKR if you think KKR was worth 10 billion dollars and Henry Kravis and George Roberts let's pick a number own 50% then somebody has to pay them out five I mean these numbers sound ridiculous but somebody has to pay them out five billion dollars it's not going to be the junior people in the firm now they may say you know this is great why don't I just give it to all the junior people and we've had a great career and go on I mean I would take the other side of that bet but so I think monetization in some way to get the value of what you've created and to build a more enduring organization it's just inevitable I mean a lot of the small firms are not going to have any options really oh absolutely yeah the question was can you I mean we're seeing the sovereign wealth funds basically have tremendous capability to invest and you know if one of these funds invests with you they send some people over to learn the business they like co-investment they'll put a certain amount in but they want to be guaranteed co-investment yes I think there's no question about that they're very sophisticated investors in becoming more sell yes I want to come back to my colleagues question but being specific if you working a fund that just hasn't won by out what focus and there is no room to go in a high-growth area what are the things you need to focus on in order to progress and what are the partners go in terms of personal characteristics that make an associate or AVP kind of someone who is looked upon as a potential successor or kind of someone who is leading the firm and being groomed well you know in the situation you described is a very tough situation because if there's no growth you basically freeze in place and the senior partner has two questions get rid of the guy in the middle who's costing them more and promote you or just sit with the status quo that's why firms when they reach a certain size tend to diversify and do different things but a stagnant situation is not good for Career Development I mean there's just no question I mean there's no way to get around that so I guess the answer will be start thinking and looking yes and that's just a natural evolution so it's time to get larger Roger fish I think more and more we're seeing the need to be specialists even for small funds they tend to be medical or bio or industrial I mean did these are complex deals and interestingly some of the smaller deals are harder than the bigger deals because they don't have the infrastructure and they don't have the accounting systems and they don't have the information but there's no question there's a tremendous focus on specific industry knowledge you know I have a hard time thinking of anybody that's just out for a pass you know just we'll do anything now having said that our fund in Asia is industry agnostic we have a very successful Carlisle Asia Growth Fund they will do anything any type of format any type of industry and there their thought is we're betting on entrepreneurs we're betting on growth the industry knowledge is secondary so I think it's a little less important in the emerging markets but clearly having the industry expertise as a plus the question is as a young person if you develop industry expertise how do you either get out of that or take maximum advantage of it to some extent huge industry expertise is more valuable to an investment banker than it is to a private equity investor you have a lot more options to make money is that the LP community also looking for that well the flow of money is clearly too broad-based funds who have an industry focus within I mean industry specific funds typically are not that big so you know Providence has a media bias I mean we were looked at as a defense fund but you know KKR has certain but typically if you go out and say I want to raise a fund to do media deals it's much harder it means just not a lot of interest in that yes industry expertise English investors who just say will be agribusiness as one ah well you know the industry I'm really I think is hugely interested energy I mean their biases against people doing energy I mean if you say to somebody you know Wall Street you were going to go to banking or do you want to go into entertainment the great you want to go into energy know so I think energy is a huge area this huge number of transactions I think more and more private equity firms will go in that area so that's one I think agribusiness I don't know if I have any other sterling inside yes how do you see that in you know I think the traditional LBO market model does not work in the emerging markets did make a long story short me typically in India or China we're doing growth financings and once and while you can get some debt but it's not big I mean it's it's a different mindset a different way of doing deals and the lack of debt is offset by the high growth rates I mean it's but you do not get the kind of leverage and like in our China growth fund we do know leverage zero but I'd say what do you say Evan the average growth rates 50% 55% of years I mean you look at this if this were in the US you'd throw it at you'd say it's never going to happen but so I think the model is different in the emerging countries and it's a it's much more equity based in high-growth and as you know in India it's much the real issue is governance between families because most of the companies are doing the deal or family deals at one expansion capital yessum have bigger fines and how do you see this as a per year for a car I approve today you have I was 90 billion dollars and find in 27 office what is see this optimal size for your group what you almost have to look at it by sector I mean if in the credit area we could grow exponentially the markets are just huge in in the u.s. buyout area I said I think you know the funds are going to be smaller ah and we see tremendous growth potential in some of the developing or merged or whatever you call them Brazil India China those funds will I think be bigger so if you have to look at it sort of individual I think the biggest factors a lot of funds will shrink dramatically or won't get funded I think there are other people who will try to affiliate with someone who can help them I mean Evercore which is a public investment bank in the last two weeks bought a placement agent bought a fund of funds and they bought a I mean they bought a traditional money manager and they bought a private equity firm and they're betting that they have the synergies or something so I think you're going to see attrition you're going to see some affiliations you can see some purchases this isn't going to happen in one day it's just a rose of pattern yes specialize and what do you think of I guess in that sense because here um you can wait out there a lot I should ask the professor leave there been a lot of studies made of what people really feel they got from their MBA and one is the credential the other is the relationships they made and the others the thought process I personally I am a big believer in that I it doesn't mean it wouldn't suit me to be pigeonholed you know in a very narrow job and so the question did you all have your own proclivities but the question is how do you get out of that I mean step one is how do you get into a Carlisle kk or however you want to get into goldman then the next question is once you're in there how do you distinguish yourself and kind of develop your own career but for some reason outstanding people stick out I mean I could tell in our company three or four people who are very young that if that have come to the attention of top management and eventually something will happen now we could get through why is that etc but it happens and you get on a fast track very quickly some it depends who you work for I mean in my opinion we interview a lot of people I'd say most of the people I don't if you want me to get into it I'll give you an opinion most of the people who we interview in my opinion have their priorities wrong because they want very specific what would I be doing isn't that and the real key questions are one who am i working for is this a person that's going to develop me or hold me back is this person has influence in the firm and then secondly the Moores in my opinion this is my own personality the more specific the job the worse would you say Evan that's yeah now Evan works for is with us he'd deal with every one of our senior partners that's his job that's a good job yeah why should he go to business canal but it's because of what the job it's flexible when he came he had no idea what he would be doing and we hire other people you're gonna be in the automotive GRU you remain in health group and a lot depends is the area hot like health care anybody that looked at our business today would say you should put more resources in health care okay we have a small health care group people should be jumping to get into that now your boss tries to stop you et cetera but that's the kind of thought process I think you have to have that's it I don't know if that answers your questions kind of a yes what are the problems private equity is a young professional it's a relatively use the skill outside in the real world view proxy but yes you don't know how to do anything you don't do sales you don't you can just be a Photoshop you can be CEO yeah III don't see that problem what I would I think the you've got the you've identified a problem but you have the wrong analysis the real problem I would see is that there's a gap in terms of what compensation is in private equity but but you might get in a comparable position I mean do our people have the skill sets and whatever to operate Procter & Gamble Corp movement absolutely but for whatever you know there's always saying in the Navy the pilots get paid faster not more to some extent that's true in private equity so our person five years out of school might be way way ahead of a person at Procter & Gamble or IBM and in their own mind to make that transition would be very hard they're gonna have to learn to live with it some of them but I think that's more an issue than the skillset and because I mean I can look at our hiring process we basically hire really top quality motivated people who will be successful at our firm or some place so I don't agree with your conclusion I agree with it's a problem but I think it's almost all economic orient or not wanting to move geographically would you recommend that of your own professional texture then working somebody portfolio without that's I was going to bring that up I mean one of the things if we go more into growth investing if you see a situation where you could go into the company and be a senior person and be a player right away that would be a very interesting option we had an interesting thing come up with one of the firm's I'm involved with where a young person is an expert on storage a now and he's a junior person that company doesn't have much influence what he thought was that the biggest idea he's seen offered him a position to be CEO or CEO that's what it looks to me like he should take he's got the expertise he's going to break out of the pack if it works and he's got storage knowledge you get another job but people don't from whatever reason they see that's pretty risky yes I didn't mean to get into career development I don't know this is a chatter you're right but it's a real it's a key issue for us you no longer viewed as a deal person I think that's a probably the reason holding back people from you know deal well that gets back to my point about risk you know if you really think about it it's illogical that a person could be good at finding deals structuring deals managing the fund managing the deal and exiting the deal I mean there are four disparate skills now people think they're Renaissance people that can do it all but it's not and so I think your point is more and more we're hiring operational people like Carlyle was extremely well known because we have a lot of these political people today when we add senior people there really have to run companies we have Lou Gerstner with us we have John Brown from BP we have Charles Rosati who ran the IRS so the emphasis and importance of operational skills is there it may may not be as glamorous but I mean this you have to make your own decisions in doing that I mean most people would agree with you know say I'm a deal person you know I can't confide but the real need in the firm may be elsewhere and it may be you'd have to go with a company yes so you mentioned about how there's so much negative press on private equity something like absent flows we don't get as much as gold I was skew you as white as an industry we have not taken a more proactive stance stance on a pushing positive PR in the industry maybe we should rather than you've seen our our industry would take umbrage of that that in fact would say we have we formed a private equity Council the companies have come together in an attempt to do some of this but you know sometimes you just can't change the news I mean some of the things that people have written about and talked about and the unions are after it means it's just the fact you have to deal with it and I think we've been fairly proactive I mean I don't know if you've seen but Carlisle and KKR have come out with green policies you know we're doing charitable things trying to help people get in scholarships but you know we're really an impetus --ml industry you know when they're talking about Citicorp or Citigroup going under and you know whether we're doing something it's and I think it's not you know these stories run their course I think private equity is coming out of the news and maybe we'll come back someday but it's just not as not as much going on we don't have as many problems well I appreciate it very much good luck to you all you

Channel: Wharton School

Views: 122,007

Rating: 4.8884892 out of 5

Keywords: private, equity, class, finance, lecture, private equity, carlyle, carlyle group, Kewsong Lee, Penn, Upenn, University of Pennsylvania, Ed Mathias, industry, course

Id: Pn4O4scLEuc

Length: 85min 16sec (5116 seconds)

Published: Sat Feb 19 2011