The list of political and economic uncertainties currently jangling investors’ nerves is long. Not least among them are an upcoming referendum on the UK’s membership of the European Union, a US presidential election, fears around Chinese economic growth and persistent speculation about the onset of another global financial crisis.
“I’ve been doing this for 35 years as a mainstream large pension fund investor, then a specialist private equity investor, and I’ve never known so much genuine uncertainty,” says Peter Gale, Hermes GPE’s head of private equity and chief investment officer, sitting in a quiet meeting room in the investor and advisor’s offices a stone’s throw from the Tower of London.
The debate in the UK over whether to stay in the European Union or leave is indicative of a yearning for answers, Gale suggests. “People are picking this up – the fragility of the UK economy – and they are wanting to pin it on something. ‘Oh, it’s Europe and we’ll be better off if we’re not in Europe.’ And the alternative is true: ‘Yes, the way to protect ourselves from this uncertainty is to delve further into Europe.’ But there is no answer, the only answer is for everyone to absolutely be on their toes.”
Hermes GPE is a division of Hermes Investment Management, which was established in 1983 as the in-house investment manager for its shareholder, the BT Pension Scheme. BTPS is the UK’s largest pension fund with £43 billion ($62.3 billion; €55.6 billion) of assets as of June 2015.
In the face of all this macroeconomic uncertainty, Hermes GPE has not slowed its investment pace. Its second co-investment vehicle, PEC II, closed in 2014 on $480 million and is now fully deployed across around 40 deals.
Hermes GPE has been advising and investing across the private equity asset class for the past 25 years, with offices today in London, New York and Singapore. “We don’t mind how we do it, whether it’s through funds, co-investment or secondaries. The name of the game is to try to create effective pots of private equity [capital] – irrespective of the implementation mechanism – that will deliver the investment result that the ultimate clients, basically the big pension funds, need,” Gale says.
However, the firm’s focus – like that of many limited partners today – is shifting further towards co-investment. A third of its assets under management are allocated to co-investments and this is expected to grow, not least because of a £1 billion mandate from BTPS awarded last August to invest 50-50 in both funds and co-investments.
The relationship between Hermes GPE and BTPS is “very, very close”, Gale notes. He is speaking about the two institutions’ longstanding interaction, but it also applies geographically. BTPS and Hermes GPE occupy offices a few floors apart at 1 Portsoken Street.
Of Hermes GPE’s $6.5 billion of assets under management, BTPS accounts for about two-thirds, although that is expected to shrink as the firm attracts more large institutional clients to its investment programmes, which include co-investment funds and segregated accounts. PEC II was the firm’s first co-investment fund with capital committed from third-party investors in addition to BTPS. The firm is now fundraising for a third co-investment vehicle, which, like its predecessor, is hoping to attract a small “club” of major funds with well-established private equity programmes that are compatible with that of BTPS.
PEC III has held a first close on around $150 million toward a $300 million target with a hard-cap of $400 million. As reported earlier by PEI, it is understood to have two investors, BTPS and another longstanding client, already on board. As it seeks five or six partners, the firm is leveraging its existing relationships.
The fund is understood to be looking for investors who share the same investment philosophy and take a long-term view of co-investment.
Key to that philosophy is retaining an element of control over assets, something that investing in a blind pool cannot offer. Investors its earlier fund included the State Teachers Retirement System of Ohio and the London Pensions Fund Authority, which is understood to be likely to roll over into the new vehicle. A spokesman for the LPFA said the fund had a “good relationship” with Hermes GPE but declined to comment on future fund commitments.
In line with a UK government mandate to reduce the number of local government pension schemes from 89 to six groups, the LPFA has combined assets with the Lancashire County Pension Fund to create a £10 billion pool. Others are doing the same. Through existing relationships, Hermes GPE is understood to be working with some of them. “The current movement [to pool assets] will create more similar-sized blocks of money which we […] would love to work with [across products]. So we look at London as very much a forerunner,” Gale says.
HOW IT WORKS
Like its predecessor, Hermes GPE PEC III will source its dealflow through the general partner relationships of its small cadre of LPs, or “club investors”. Opportunities are then assessed, selected and executed by Hermes GPE on behalf of the club.
“What the club members are not necessarily doing is harvesting the potential dealflow as efficiently as they might,” Gale says. “The club works through everyone contributing. We’re the agent, the conduit, and then we make it work. But we need the building block of the right partners.
“The advantage to the club members is they don’t have to take on the risk of getting it right or wrong and they don’t have to cope with the management time.”
There is also cost, a major incentive for LPs everywhere to allocate capital to co-investment. “The fee leakage from our style of investing is a lot lower than just relying on blind pot investing,” Gale says.
Across the firm’s products, it follows the industry model of management fee, carried interest and hurdle, but at a lower level than the typical 2 percent fee, 20 percent carry. The majority of Hermes GPE’s co-investments are understood to be sourced on a fee-free and carry-free basis and fees are charged on money invested, not on commitments.
Gale, however, stresses that co-investment is a “genuine investment activity” and not just a way for LPs to achieve a fee reduction. Hermes GPE, he reiterates over the course of our conversation, is investment-led.
Since PEC II began investing, the firm has undertaken a “radical shift” in strategy, moving out of the large buyout space in the US and Europe and moving “right down from the several billion of enterprise value in the mid-part of the 2000s to the several hundred million of enterprise value over the last three four years”, and into new geographies.
The rationale is simple. “For the last two or three years, it’s been our view that potentially these [large buyouts] are fully valued or over-valued in certain circumstances. The risk-reward for large buyouts in mature markets has moved against them. Private equity can only work off the market circumstance that it finds itself in,” Gale cautions, noting there is no “mystical skill that can create value out of nothing. If the market circumstances are bad, the returns will be bad.”
Hermes GPE has adapted its approach and also changed its investment criteria, still conducting buyouts but swerving the use of gearing and targeting business with low leverage and strong potential for organic growth. This has required an extension of its geographical reach.
“Growth is a very precious commodity, one has to look very carefully to find it. It has involved spreading our tentacles more widely geographically and that’s meant us moving into Eastern Europe, Africa and South-East Asia in particular,” Gale says. The firm does not exclude India, China or South America but, says Gale, it has not found “much genuine growth at a sensible valuation” in China and in India: “We haven’t found the right growth culture.”
Like other investors, Hermes GPE is trying to tap into the emergence of an affluent middle class in many of the world’s growth economies. Investments within this theme include a retail store operator in Indonesia; an e-commerce business described as the ‘Amazon’ of Turkey; a food distributor and an ice cream business in Africa; and a digital media business in China.
It has invested in a data analytics business, a wireless payment processing business and a leather recycler as examples of its “disruptive innovation” strategy; and targeting new infrastructure, it has invested in a telecommunications infrastructure provider in Africa.
“The style of businesses tends to differ depending on which region we’re looking at, but the investment characteristics are the same: lower debt, high organic growth,” Gale says.
Of its successful investments, Gale points to a seminal co-investment it did alongside 3i Group in 2001 in UK low-cost airline Go Fly. Go was founded in 1998 by British Airways, purchased in a management buyout led by 3i in 2001 and bought by easyJet in 2002.
“We’re in and out. It’s still the most successful investment in terms of IRR we’ve had and that’s a classic example of what can be done,” says Gale. The opportunities to invest in similarly disruptive businesses 15 years later are “infinitely greater”. “Then it was the odd exception. It has now become mainstream.”
Gale’s 18-strong investment team, which may add an additional two heads this year, rejects 90 percent of the opportunities it sees. PEC III has yet to strike its first deal following the first close but has a “very full pipeline”, Gale says. When asked if three offices are enough to support a global co-investment strategy, Gale responds: “How many offices do you need? How long is a piece of string? We think there is a danger in having too many, so the key is to have sufficient to keep the unity of the investment culture. So we have decided three, reflecting those geographies and those time zones, is sufficient for us. The evidence to date, given the quality of our dealflow, is that that is working very well.”
Over the firm’s 15-year track record of co-investment, it has generated an internal rate of return of 26 percent and a multiple of 1.8x on realised investments. Based on a December valuation, PEC II is generating an IRR in the “high 30s” in dollar terms, Gale says. “We are very pleased with our change in strategy from large buyouts to growth. We think we we’re ahead of the game. The results are far stronger and far more immediate than we were anticipating by quite a factor.”
'CO-INVESTMENT IS A RARE SKILL'
Co-investment is a skilled investment activity, not a route to lower fees, warns Gale.
Although large LPs have sophisticated in-house investment teams “the bit that is rare in the marketplace is the ability to select co-investments, which is a very dangerous exercise because it can work rather well, or very badly. The range of outcome on a co-investment portfolio is enormous.
“Most LPs through their co-investment activity are seeking a fee reduction; by itself, we believe that’s a mistake. Individually these co-investments are very risky assets. That fact you’re getting in, in inverted commas, ‘for free’, is irrelevant in relation to the potential loss or gain.
“I think GPs are using it very much as a marketing tool and it’s not that. That’s dangerous. If you do it properly, it’s a legitimate way of creating alpha.”
Gale takes the long-term view on co-investment, emphasising the benefits of investment control, the quality of the asset, timing, the right economic circumstances and building a diversified portfolio “because no one can actually foresee the future with absolute certainty”.
He takes issue with what he describes as the short-term interest in co-investment driven by hot private equity markets. “When the tide goes out, because it will, a lot of these [investments] will go broke. Typically it’s the highly-geared, larger buyouts that will go broke and a lot of people will get a very sore head.”