It's results day at 3i, Europe's largest listed private equity group.
Not too long ago, this would have been an unhappy experience for its senior team. In the early part of the decade, the company suffered big losses – £142 million in 2001, widening to almost £1 billion by 2002 – after a series of big bets on the technology sector exploded in the dotcom crash. 3i was forced to retrench as its share price plummeted, closing smaller offices and making nearly 200 redundancies. The group was in danger of becoming better known for its alumni and its long history than its deal-making.
Five years on, however, the atmosphere in 3i's gleaming new offices in London's Victoria is very different. The group's results for the financial year to the end of March have been even better than expected – a profit of more than £1 billion for the first time following £830 million of asset sales; net asset value up for the fourth consecutive year; an £800 million dividend to shareholders. In the lobby I pass Philip Yea, group chief executive since 2004 – not surprisingly, he looks rather pleased with life.
So what has changed? A look at the company's recent performance statements identifies the biggest financial contributor: the Buyouts team, led by managing partner Jonathan Russell, is now 3i's most successful and profitable division. Last year it had another bumper year, delivering a 54 percent return on equity and raising its biggest ever fund, the €5 billion EuroFund V – a remarkable change in fortunes for a team that had struggled to hit its fundraising target last time around.
Several factors have made 3i's turnaround possible. The steady recovery of the economy; buoyant credit markets; the explosion of private equity; the arrival of Yea – all have played their part. But the influence of the genial Russell – whose period at the helm has seen 3i Buyouts become one of Europe's leading mid-market investors – cannot be ignored.
3i has seen plenty of ups and downs in its time, of course. The group has been around since 1945, when it was created by the UK Government to invest risk capital in growing British businesses. It was celebrating its 50th birthday at a time when some of today's buyout giants were still in short trousers. In 1983, chief executive Jon Foulds re-branded the former Investors In Industry as 3i, beginning its transformation into a fullyfledged commercial enterprise.
Russell, who joined the firm a few years afterwards, in 1986, believes this was a formative moment for the group's fortunes. He had started his career as an optician, before opting for an MBA at London Business School. Not tempted by the prospect of a career in investment banking or consulting, he decided to follow his roots (both his father and grandfather were entrepreneurial types) and try his luck in private equity.
The company he joined was very different from its current incarnation: “It was a totally different beast. The business was doing lots of tiny deals in the UK, and was in the early stages of throwing off its institutional shackles.”
To be competitive we needed to match the market rate. So we introduced a carry structure, which did away with the leakage of people
3i went on to list on the London Stock Exchange in 1994, but by the time he took charge of the buyout division in 1999, Russell was convinced that bigger changes were needed to bring the group into the 21st century. “The industry was modernising, and the mentality had changed completely. Deals were now much more private equity-led, rather than managementled as they were before. We were trying to operate an old model in a new market.” Moreover, the buyout team was still very dependent on third party funds, and Russell knew that the track record of the current portfolio was not strong enough to raise more.
The following year, the division was overhauled. Russell felt the business needed to do fewer deals and penetrate new markets. “In 1999 we did 110 deals, of which 95 were in the UK; in 2002 we did 13, with just 4 in the UK,” he says. The old approach of each office doing separate deals was also out. “We turned it into a truly pan-European buyout business, rather than a number of offices running virtually autonomously.” These days a typical deal team might be drawn from Amsterdam, London and Aberdeen, as with the recent acquisition of Dockwise.
There were other organisational changes too. “We took out lots of structure and hierarchy, so there were just 15 senior partners running the business. We changed the way we assessed opportunities, bringing more rigour to the screening and due diligence process. And we introduced a more hands-on, developmental approach to portfolio management.” By 2001, the Buyouts division was operating as a separate business line, alongside Growth and Venture Capital.
But there was another significant problem for Russell. The business's compensation structure was designed for a public company, not a private equity firm – and it was becoming impossible for it to compete with its ambitious rivals. 3i was becoming a training ground for the rest of the industry (as evidenced by the huge proportion of private equity's leading lights who began their careers there). Today the group hates the association, but the fact remains that it was too easy for rivals to lure away top talent with big salary packages and carried interest.
Russell gives chairman Baroness Hogg much of the credit for changing this. “To be competitive we needed to match the market rate. So we introduced a carry structure, which did away with the leakage of people.” The new structure has not been completely able to prevent the loss of high flyers – notably four of the division's top performers left to form Exponent Private Equity in 2004 – but it does seem to have stopped the rot. 3i now boasts retention rates of almost 90 percent.
Slowly but surely, the changes began to have an impact. “The effect was clear – in the 90s the IRRs were in single digits, but from 2002 onwards we were seeing IRRs of 50, 60 percent.” Unfortunately, the turnaround came too late for the 2003 vintage Eurofund IV, which struggled to meet its target and forced the business to take a bigger-than-intended contribution from its balance sheet. “It was still a bit too early to see the effects when we were raising Eurofund IV, which is why that process was tough.”
But Russell's team continued to land big wins – including the sale of directories business YBR and online payments company Travelex – and as a result, when Eurofund V hit the road last year, fundraising was a very different story. “For those people who stuck with us in Fund IV, or didn't invest but stayed close to us, they could definitely see the effect [of the changes] by the time we came to raise Eurofund V – which made that process very easy.” The firm beat its €3.5 billion target with ease, finishing on €5 billion.
In Russell's mind at least, there is no doubt that the right changes were made. “We're now so much more market-focused and value-focused. It's just a hundred times better as a business.”
So what was the key to this? Has the division turned itself around by becoming like every other buyout firm – by adopting a more aggressive, cut-throat culture?
Russell says the firm has “a very open, collegiate culture where everyone has a voice.” He talks about hiring “honest, straightforward people, with a bit of humility – which is relatively rare in private equity.” Personal integrity is also very important, he insists. As any recruiters will tell you, not many of these qualities tend to have a prominent place on the wish list of some of the bigger buyout firms.
Russell's line is even corroborated by former colleagues, who describe a non-hierarchical environment where even junior recruits are free to proffer their opinions. “In fact, we operate more like a partnership than most private firms,” Russell argues. “For example, everyone knows what kind of carry everyone else gets. How many other firms can say that?”
In fact, we operate more like a partnership than most private firms,” Russell argues. “For example, everyone knows what kind of carry everyone else gets. How many other firms can say that?
Russell himself is relaxed and charming company, even though it's results day. But then it's easy to be relaxed when you're making a 54 percent annual return. What about when the cycle turns, as it almost certainly will? Surely public ownership will become a lot more burdensome then? For this very reason, many big financial institutions have in the past spun off their buyout arms, in the belief that the cyclical nature of their results made them ill-equipped for the short term demands of the public market.
But Russell is unflustered. “I've seen what it's like during difficult times, and it wasn't very nice. But even as a private firm you're still talking to your stakeholders – we're doing it more publicly, but it's basically just more of the same.” And, he says, public shareholders tend to be unfairly maligned. “You're not talking to uninformed people. If you're doing sensible things, shareholders will recognise that.”
At a recent debate, 3i's chief executive Philip Yea discussed the convergence of private equity and public markets and suggested we would see more targeted pools of capital, like 3i's recently-listed infrastructure and quoted private equity funds. In that case, why invest in a diversified group like 3i, which covers a broad range of investments? “You invest in the group because of its accumulated knowledge; because of the breadth and strength of the network; because the different areas can leverage off each other.” But would the buyout division not do better on its own, without the need to carry the less well-performing venture division? He dismisses the idea. “We couldn't afford this kind of infrastructure as a pure buyout business.”
So what about the flipside – what benefits does public ownership give 3i? “Permanent capital is nice,” he smiles (the recent rush of private equity groups to list specific funds or portions of their management company suggests they agree). Others are of a more long term nature. “There's also a benefit to having a corporate structure, which protects the business from the whims of an individual or small group of individuals. That's good for the sustainability of your model.”
3i's identity as a public company seems to be fundamental to the way it operates. But could this be a weakness, as competition intensifies?
Some of 3i's rivals look at the firm and wonder where it will play in the coming years. With a €5 billion fund to put to work, 3i is now at the upper end of the mid-market, and is likely to face competition from some of the bigger funds coming down as they try to put their mega-funds to work. “I wonder how it will compete with the bigger players,” says a rival. “I'm not really sure what its competitive advantage is against these guys.”
Can a collegiate, humble firm really compete against the fiercest deal-makers in the industry? The sceptics point to 3i's recent failure to seal a £1 billion deal for UK-listed estate agency Countrywide – which later fell to US firm Apollo Management's higher bid. While other observers argue this was just a case of good financial discipline. Who is right? “We are disciplined,” agrees Russell. “At the same time you've got to have some balls – you can't opt out every time you think it's a full price or you'll never buy anything. But if you are going to step out of your box on price, you need to be pretty sure that you can do something special with the business.”
Does it still rankle to have lost out for Countrywide? “You can't get upset about someone paying more than you, or you'll be slitting your wrists on a weekly basis. I'm very philosophical about it. People value things differently, so if someone wants to pay more, fantastic. It's too rich for my blood, but good for them.”
Pricing is likely to remain an issue. Russell says opportunities to beat the market with proprietary deals are “getting rarer every year,” and at the moment, “the risk is that you're buying at the top of the valuation cycle”.
We'll stay in the mid-market. All our relationships are there, and we can make good money there
But in general terms, Russell has no ambitions to be competing with the mega-funds. “We'll stay in the mid-market. All our relationships are there, and we can make good money there.” And in his eyes, this is a broad church. “I take a pragmatic view. We go where we can find value in a business. If one of my team brings me a €100m deal they're really taken with, and we think we can make money from it, we'll do it.”
He believes the engine room of the business's growth is likely to be outside the UK, the market where it has been so well-known for so long. “Two-thirds of our buyout business has been outside the UK for three years, and if anything we see that increasing.” This may mean Central and Eastern Europe – the firm has hired ex-Advent deal-maker Zoltan Toth as it looks to build a region-specific team, and earmarked 10 percent of Eurofund V for deals there – or it could mean Asia, where 3i has had a presence for many years and hopes to invest another 10 percent of the fund.
I ask him what his ambitions are for the business. “We want to increase our sector specialisms; to continue building our turnaround team; and to continue our geographical expansion.” He still believes that the 3i network can give the business an advantage here. “Very few people are as penetrated as we are. We've been in some of these places for a very long time.”
It is clear that Russell has played a key role in turning an under-performing business line into an influential mid-market operator. The challenge now is to continue the division's rapid development as competition intensifies, but one thing is for sure: this former optician is not looking at the future through rose-tinted glasses.
“TRANSPARENCY DOESN'T HAVE TO BE A PROBLEM”
One area where 3i is sure to have an influential voice is in the ongoing debate about greater transparency.
As a listed company for more than ten years it knows all about disclosure, which is why its chairwoman Baroness Hogg has been invited to join Sir David Walker's BVCA-sponsored working party on improving transparency in private equity. In the company's most recent results statement, the Baroness drew attention to her company's “pioneering approach to governance and corporate responsibility issues in the industry.”
Jonathan Russell, head of 3i's buyout group, accepts that some of the industry's problems are self-inflicted. “This is an industry that has scaled significantly in size in a very short period of time, and it perhaps hasn't done the hard work needed to protect itself. That creates an opportunity for critics to weigh in.”
However, he thinks the debate is also a natural consequence of private equity's increasing significance. “What we're seeing is the growing pains of the industry. If you're going to buy internationally important assets that are in the public eye, there's going to be a different level of scrutiny and you need to be answerable. But if you accept that, it doesn't have to be a problem.”
Russell believes firms are justified in resisting calls to publicise more information about the performance of portfolio companies, in the interests of protecting competitive advantage – “I think that argument is a sound one”, he says.
Yet 3i portfolio company HSS has provided an interesting template. The tool hire business, which 3i bought in 2003, recently held an open press conference at which it published an annual report and talked through its financial and operating performance – something that as a private company, it was under no obligation to do. In this particular case, the company was keen to publicise details of its turnaround under private ownership. But this kind of transparency could soften the industry's public image.
Russell also believes the industry could go much further in disclosing more information about fund performance – information firms already produce for their limited partners. It is important, he says, to engender confidence that investors are making an informed choice. “And this will only happen if there is confidence that LPs are getting a consistent level of open, audited data, using comparators that are standard across the industry.”