Monday, 16 September 2002
AFR BOSS CLUB
Speaker:
Bill FerrisIt's tough out there in the public capital markets, but long-time venture capitalist Bill Ferris sees boom times for private equity.
Bill is the executive chairman of Castle Harlan Australian Mezzanine Partners and the author of
Nothing Ventured, Nothing Gained - a memoir of his involvement in venture capital over three decades. He predicted more successful management buy-outs and growth as "unloved assets" find their way back into the hands
of owner drivers.
Transcript
This is an edited transcript of the presentation by Mr Bill Ferris, the executive chairman of Castle Harlan Australian Mezzanine Partners to the AFR BOSS Club seminar in Sydney on September 16, 2002.
I got into the venture capital business back in the early 70s here and I was sort of swimming against the tide because banks and the community generally didn't really know what it was and you were sort of trying to explain it all. It was a decade or so swimming against the tide. And later on, in 1987, with my partner Joe Skrzynski, I formed Australian Mezzanine Investments and after we had a few tough years, we became profitable. Then rolling the clock forward to about two years ago, we sold a half interest in the business to a New York based private equity firm called Castle Harlan, hence this long name, with the acronym, which we lovingly hold on to as our brand now.
So in selling that half interest in the business, we were concerned with a few things. Did we have a franchise value after all these years and could we cash in on some of that while still staying in the business and building it. That turned out to be a tick. Secondly, and most importantly, we had recognised that to build the private equity business in Australia we needed to have access to due diligence internationally, we needed to be able to attract the best people and offer them exchange opportunities offshore for learning and for experience and fun and so on. And we either have to pony up and do that ourselves by expanding offshore, and open offices offshore and so on, or we could tie in with someone that was already doing that, who we liked and thought the same as we did.
And thirdly we wanted to crack the riddle that has bedevilled Australian private equity funds managers like us in recent decades - well ever since I've been involved with it anyway. Since 1970, the riddle of accessing international capital in any meaningful licks and we believed the tying up of the right New York based firm that had a great track record, we could probably crack that, and as I'll talk through briefly in CHAMP's structure, that did happen for us.
We were able to tap into the international pension fund market, which supplies 99% of the world's venture capital. Unwittingly this country has had a barrier, like a huge non-tariff barrier, preventing any of that capital ever coming to Australia. Hopefully Cabinet, within the next week or two, might actually deal with it as an issue.
Venture capital of course means so many things to different people, and already just meeting a few here tonight, some of you are really into early stage stuff and have clients, or are already running small businesses and so on. And then there is the expansion capital area which has been our core business in a way, providing expansion capital pre-IPO type money, pre-going public type money. My other business partner, (I think he is here tonight) Su-Ming Wong, runs CHAMP Ventures.
And then there's the buyout business and I see many of our friends from the lending institutions that are particularly interested in the buyout sector, which is a rapidly expanding part of the capital market.
So you know it's across the board. Woody Allen once said to his audience in New York - have you heard this story - I've finally worked out what venture capitalists do. They're this bunch of really bright young men and women on Wall Street and they get together and they invest other people's money patiently and aggressively over a long period of time .... until there's absolutely nothing left.
So it does mean lots of different things to different people obviously, but let me nonetheless press on and tell you at least about CHAMP in structure terms. We regard ourselves as a complete capital provider across the private equity markets in Australia. At the early stage end of that business, under the umbrella of CHAMP Ventures, we also have an innovation fund called AMWIN. We invest in, as the name would imply, early stage start ups, sometimes pre-revenue businesses, technology intensive companies, some in the life sciences, some internet intensive businesses and so on.
In the expansion stage business, we've managed three funds: AMIT, AMIT #2, AMIT #3 totalling $160 million odd in later stage provision of risk capital to existing private companies with business plans, with sales, and with dreams; and we're in the process of forming the CHAMP Ventures #5 fund, which we hope will top out at about $150 million. It's a really tough market out there raising funds right now, but we look like we'll be somewhere between $100m and $150m. And the MBO stage on the right hand side there, is a buyout fund dedicated to only doing and funding buyouts; in this CHAMP buyout fund, we raised together with Castle Harlan Inc $570 million.
So if we put all that together and we do get in the CHAMP Ventures #5 fund, we'll have roughly some $900 million to $950 million of equity capital over this period. So we're a reasonably sized player in this Australian private capital market.
The common thing across all of that activity is that we're looking for growth. The early stage business would normally involve us in $1 million to $3 million type investments. The expansion capital is more in the $5 million to $15 million size, and in the MBO investment area our sweet spot is to complete transactions where our equity into the deal is an average of $50 million, and where we might go up to $100 million if it was the absolute right transaction.
So on and through all of that, we’re trying to fund growth, high growth. Growth on the top line, growth on the bottom line, and that's the common theme because, to state the obvious, if we can grow the companies, we do pretty well on the bottom line for our investors.
I hope the next table dispels Woody Allen's mythology. This chart tracks the returns at the fund level, so it's before our modest management fees. The right hand column here, IRR, is essentially the calculation that says your money back plus an annually compounding rate of return of X. So you can see, in the first fund, it was okay, it was not a tearaway, but it was something of a pioneering fund back then and we achieved reasonable outcomes. Since those days we've improved with the old learning curve helping us and a bit of luck, and so the investors have had over a long period of time now cash to cash outcomes that start to underline the fact that you really can make really good money out of this business. And by the way, compare it currently with public equities performances, and you should wonder why there isn't a lot more money going to the private equity business, particularly in this country.
That fourth line down - MBOs - is a summary of eight transactions we did in the expansion capital funds and we had one fizzer, but the rest of them produced an aggregate 82% IRR and the penny dropped for us that we ought to do more of these. That's why we went on and created a dedicated buyout fund. We haven't put its numbers up because it's only just started, its been going for two years and we've made three buyout deals in that fund, which I can talk about in Q&A if there's an interest, and I'll also talk about why I think MBOs are going to be the name of the game going forward.
I had the opportunity to take a few months off a couple of years ago and try my hand at writing this book "Nothing Ventured, Nothing Gained". I've always enjoyed writing and I thought this will be fun, and I had a few months holiday, just tooling around with my wife offshore. I would write in the mornings and then we'd get together and do something else in the afternoon. It was just great fun to be able to have that luxury, that indulgence, that challenge.
I was writing the book with enough distance or perspective so that what were once terrible wounds and sores became quite humorous to me, relatively speaking. I could stand back from some of it and I thought well what through all the good, the bad and the ugly are the lessons for me? Are there any? And I started working on this and these repeated events and experiences came up and formed themselves into lessons for me. I came up with about 20. I thought I'd share three of those tonight. You'd have to buy the book to get the other 17 and I do have, if anybody should be interested, forms for that.
Now the first one is, "Beware of solutions looking for problems. The marketplace is more important than the science." Okay, pretty obvious I suppose, but the earliest lesson that really jumps out, the earliest anecdote in a way that jumps out was the light bulb. You know, it took something close to 40 years before that concept of the filament and having a bulb that sold in the shop and made anybody a buck, was like 40 years for the Edison Corporation.
More recently in my lifetime, the laser beam cost me a poultice and many others in the venture capital business back in the 70s. I invested in a Queensland based company and it was the classic solution in search of a marketable problem. Years later of course, cutting and surgery and measurement and scanning and all those great applications that you just knew had to be there, did eventually come along and other people made money while some of us lost it all in that particular technology.
In the life of the Australian Mezzanine funds (and I wish I could blame Su-Ming but I can't because he didn't have much to do with this particular investment), there's a company called Rumentek. This was a company that came to us from the CSIRO, or rather a few entrepreneurs who'd commercialised, or were in the process of commercialising some spectacular technology out of the CSIRO. It was dealing with, as the name would imply, ruminant animals. The problems with ruminants like cattle, is that they have four stomachs, unlike us with one. Their advantage is they can eat anything without alka seltzer and so on and just eat what they like, but they're very inefficient converters. So if you feed them more than 5% or 6% of fat, lipids and protein, in the first stomach it's toxic, and so they barff it out the back end and you spend a lot of money feeding them and nothing converts and it takes a long time and so on.
So the CSIRO scientists said well you know if we could mask, if we could fool those guys, if we could mask this stuff, get it through the first stomach to the fourth stomach, they would convert efficiently, it would cost less and by the way we can feed them a diet that will get rid of the bad fats in the meats and the milks.
Well we looked at this and we reckoned it was the best agri-business deal since the merino sheep, and it was of course. And the trials were successful, the lab tests were clearly successful, the early trials were okay, certainly convincing enough for us to start funding, and we began to give them $7 million in sort of milestone commercialising attempts. And what happened with this deal was, basically this slide will show you, that we put in $7 million and out of that came absolutely nothing as it happened; what happened here was again the classic solution in search of a problem.
Coles and Woolworths and the bigger retailers who needed those products said, look if you can do a couple of things, give us the product at no extra cost, we'll put it in, and if you can also advertise nationally and promote why our customers should come in and use this healthy, you beaut different product, you've got us. And here's this little Rumentek high-tech company struggling to pay the wages and unable to cope with either of those issues. There was no budget for anybody's promotion costs and you know you look back on it and say well isn't that pretty obvious, why the hell didn't you sort that out before you went into this business plan, but I just submit to you that sometimes the excitement of the solution can drive you and the excitement of the science (which by the way is unchallenged and does work) drives you.
And the post script here is that Land 'o' Lakes in America, the biggest butter producer in northern America, has now decided they needed a spreadable butter. If the animal produces no cholesterol fats in it, and you can use this technology to feed a diet, for example a canola based diet to the animal, in 30 days the entire fatty composition of the animal converts, changes with the result that it has no bad fats, only good fats, and it produces milk naturally with no cholesterol and bad fats. It is the cholesterol, the bad fats that makes butter go hard when you put it in the frig. The good fats just spread like margarine.
So they wanted a spreadable butter as a marketable product and they've now selected this technology, we hope, for their launch of the spreadable butter. We still own 25% of this company, it doesn't have any creditors, and if any of you do want to buy shares in this company, you never know, it might just come back. I don't know. It would be lovely if it did.
But that was a $7 million hit to our funders; a big hit and a tough lesson.
The next one: "Critical analysis of the venture's core proposition is what distinguishes a sensible risk investment from a punt."
I put that up because nowadays many people think venture capitalists get all these applications and just throw darts at the wall! The fact is we don't do that. We spend an awful lot of time with a lot of money and effort to really look at the core proposition of what comes into us. By "core proposition", I mean simply what is different about this business, what is defensible about it, and what may be even daring about this business plan and can the entrepreneur tell it to you in one page. What's different, what's defensible, what's daring.
To illustrate what I mean, I've chosen this company, Austal Ships which is, as the picture will show, a high speed ferry manufacturer; we invested in this company, in '95 I think, and they were building 40 metre passenger ferries, that's 100 metre vehicle ferry. They wanted to build bigger boats, they wanted to have bigger shipyards and they needed a lot of money, $15 million of equity to be able to make that transition. Their proposition was, the core proposition here was up to 200 kms in trip mileage, a high speed jet propelled planning boat like this was a lot cheaper than bridges or tunnels and was a lot cheaper than air lifts up and down by the time you got to the airport, took a 200 km trip, landed at the other side and so on. And you know that was the core proposition we backed.
They also build beautiful luxury mega-yachts for the filthy rich around the world. This is Greg Norman's new boat which launches next month. It's 260 feet, it's got a 43' sports fisherman that he puts across the stern. And so the company has, because of its outstanding management team, broadened the product range tremendously.
They've got small ferries, big ferries, they've got military applications now, having sold one of these to the US Marines in Okinawa. They've got a converted version of that vessel which is a troop movement vessel, and it turns out that they can move a battalion of men on this single craft with all their equipment, Jeeps, guns, etc. The alternative is like 60 Skyhawks, fly them in, other aircraft fly in the Jeeps and the weaponry, they try and marry the men back together again with all their stuff and off they go. Well this vessel is so much more efficient and very exciting for the company.
Our investment, from our #2 fund (oh it was '94, I'm sorry) we put in $7.5 million and we pulled out a total of $27 million which was roughly four times our money in that period. The company went on to become a public company, as it is today, and is in fact the world leader, not number two or number three, but the world leader in high speed ferry production and sales world-wide, which is a great story for what expansion capital can do.
So having boasted that good analysis is important in what we do, the third lesson I have to own up to is that "Timing is more important than analysis." It's not a lesson that some of my partners agree with I should add, but it's something that I believe is the case.
The best illustration of this one is the LookSmart company. Some of you will recall this company, and perhaps this story, but LookSmart was and is the search engine business. The fellow who championed it was an ex-McKinsey guy, Evan Thornley, a very able man. He came to see us in '97, really at the start, if you think back it's not that far, but you know it was pretty early on in this whole hype, this whole excitement about the internet and what it could do. Evan sat in our office and said, I remember him saying he had a burn rate of $500,000 a month, and I asked him how much cash he had and he said oh we're fine, we've got $400,000.
So we knew we had a few weeks only to do a deal, and we did do I think a sensible analysis of what was needed. His proposition, his core proposition was we're going to be a category driven engine, not a word driven one. Remember at the time most of the emphasis from Yahoo and Lycos and others is that you'd key in a word and you'd get a mountain of stuff that you didn't really want to get. Evan was leading this category driven search process and he would develop intellectual property on the way through by customising the databases. He would hire hundreds, literally hundreds, which he did, students in Melbourne and San Francisco to edit other people's websites, to edit databases in museums and other such receptacles around the world, and build this proprietary database which he would over time licence to Microsoft and others, which he did.
So we thought well okay, if this works, we get everything right and the wind is behind us, we could make ten times our money in this venture. And so we initially put up $2.2 million to get the business plan to a second level, and what happened was the $2.2 million turned into $245 million cash, which was 111 times the original investment in less than 2 years. On the way there and pre-IPO, we did a second round and we put up another $3.2 million from our second fund, which also did well, turning in $29 million.
But timing dwarfed analysis. What happened here was a ramp up of excitement about the internet; analysis just went nowhere and people were hopping into this stream of belief about backing these things. We took it to the IPO market in America on NASDAQ and it listed at $2.5 billion Australian capitalisation. It was the highest technology float then and since, or ever in the history of Australia I think, and we exited the day after escrow expired and I think it was 21 days after that when the market collapsed. You remember the tech market collapse happened, and therein lies the story about timing dwarfing analysis.
So turning from those few lessons, and perhaps talking to another thing that was referred to in the opening remarks about outlook and some predictions or thoughts about what's coming in the private equity markets, I think in the immediate future, by which I mean this next year or so, the outlook is just terrific. If you're a private equity manager, funds manager, and you've got cash, the public equities market aren't going anywhere other than sideways and perhaps further south. I don't want that to happen by the way, but that's my belief. I think the markets, not so much here but elsewhere, are still overpriced, but certainly the public markets are not providing solutions for private equity and private risk requirements, and in those times private equity players come into their own because we can offer solutions and we can get set at prices that are sensible and not you know, not through the roof.
If I think back - and I've seen this several times since 1970 when I started in this business - the brokers, God bless them, there's always this phase where people were being floated and promised whatever they wanted by brokers through mainly the retail markets, and pricing went through the window, out the window, and we've seen that previously in the late 90s and now you won't see it for quite a time to come, and the private equity markets benefit when things come back to that sort of sanity.
So in the short term, and from our own anecdotal experience, we are seeing both in the early stage, expansion capital and buyout phases of our business, more activity at better prices. So I believe that it's a fantastic time for private equity in this country.
The other obvious reason is that we've got frankly a management capability in this country, and ideas generating capability that is proving itself, sometimes in spite of the odds, and of course we live off that, and we back that. So again I'm very optimistic. I'm not optimistic I might say about the institutions seeing it that way. We and the other private equity managers need the institutions to buy into that and it's very tough I guess for them when their public equities portfolios have gone negative, to convince their own investment committees and trustees that they should get up and put more bets into the private equity market. That is what they should do, logically. It will be tough for them to cross that bridge I think.
But having a crack perhaps a little further than the immediate year, let me just put up a few predictions as they relate to my sector. I think the Australian Venture Capital Association boasts 140 paid up fund managers. There will be fewer of them and they will be larger. We have lots of very small managers that won't make it. The successful venture capitalists now will increasingly have to really add value to their investee clients with recruitment, business development efforts and advice, introductions, networking, all that sort of stuff, and indeed with arranging re-finances and exits, IPOs and whatever it takes; and to do that you need people, you need high quality due diligence, you probably need it globally, just like in everybody else's business, and so as night follows day there will be consolidation in our sector in the next number of years, and I suspect fewer but larger and better VCs by 2010.
I think another one is that the next LookSmart will be a life sciences deal, personal prediction. I believe that because we have this rich legacy of medical research, this prowess around the country in terms of the universities and research institutes' achievements, and in spite of a lack of scale compared with our American and European counterparts, mark my word that the next 100 to 1 deal you see will come out of the life sciences area.
In our own funds, we've invested in some really exciting life sciences deals, one dealing with carbohydrates. It turns out that Australia is in the top two or three world-wide in terms of excellence in carbohydrates research. We're in an arthritis company, a company dealing with what they call the C5A receptor, which if they crack it and get a monoclonal antibody that can block the stuff that gets in there in the first place that makes you get rheumatoid arthritis. The odds of getting there aren't high, but if you get there, they're huge hits.
We've got another company which is a classic. It's got the silver bullet if it works. In the lab it kills off every cancerous cell that's been presented to it so far without affecting the host cells, you know the classic holy grail. Will it get there, will it get through trials, will it do it? Who knows. If it did, it would knock LookSmart into a cocked hat of course. So you know someone will get there. We mightn't but somebody will.
And of course a lot of the cynics about life sciences in Australia are accurately pointing out that, boy, you need scale here. You know to get through phase one toxicity trials, to get to meaningful numbers of phase two human trials, and then to get FDA approval and how long, and how much money, it's big. But if you think back to the great mining boom here in the sixties (and it was a fabulous minerals exploration phase here in this country), lots of mineral explorers did pretty well farming in and farming out. They didn't try and do it all themselves, they proved up enough, got to the right partner, kept a royalty. You know there's ways of making money here, ways of developing IP here that doesn't mean you have to own the whole thing all the way through and be the distributor. So I'm more optimistic than some, although it will take a lot of sleepless nights for people I think.
And returning to an earlier theme about buyouts, I think buyouts, management buyouts will dominate the private equity markets over the next decade in this country. I already reckon that 75% of the dollars invested by all of us in the venture capital business will be in this area, and some years it will be almost all the money invested. And as soon as 2005, probably a billion dollars a year of equity will go into that part of the business. Now a billion dollars will be cranked up by the specialist buyout lending banks at sort of three to one, and so one billion equals four billion dollars of transactions, and I think that's quite modest. I think we'll see a lot more than that.
Why? Well we're continuing to see that, as public equity markets and the performance of public companies looks a bit ordinary, the push to get back to the knitting to get rid of non-core assets, will accelerate. We've seen that already with the likes of Pacific Dunlop, BHP and CSR and so on, and there are more and more managers out there saying good professional management and proprietorship are not mutually exclusive. I too can make a bundle out of doing a good job here as a proprietor, I want to be in this business, the current owners don't regard this as exciting or core. I can't get money for capex, I know if I could where I could spend it wisely, let me have a go at this.
I mentioned the banks. We do now have a banking community that is interested in funding buyouts, and that wasn't always the case. It's really picked up in the last three years.
Intermediaries, the accounting and legal firms, and others have special dedicated teams to pursuing buyouts and improving buyout services, and of course financial sponsors like ourselves have emerged and so there is money available now, and to some extent you've got to be able to move the market by letting boards of companies know that we provide an alternative to a trade sale. This is an alternative to trying to float a division off prematurely. This is an alternative to a de-merger that's badly planned.
So I think we'll see, for all those reasons, heaps more buyouts. So I guess to hit a pause button, the question of "why private equity works", I haven't really answered, but in the Q&A I can suggest two or three reasons that really jump out to answer that question if it's of interest. But I think I'll just wrap up for the moment and say that I do see great times ahead for private equity. It is clearly the most exciting and stimulating part of the capital markets in this country, or in any country. It is the essence of capitalism. It is where you get, you know, 25% compound growth, not compound growth rates, not 2%, 3%, 4% or 5%.
The public equities markets can only do so much and we're not going to have bad public equities markets in the next few years crowding out private equity, which is why I think we've got pretty good circumstances right now.
Q&A
Question:
It's said that we're a very innovative nation and yet it's also often said that there's a reluctance to support that innovation in Australia. I wonder how you feel about that? Is there something about our psyche that has our being innovative - but failing to support it?
Answer:
Big question. I think, historically, in a small market economy, rational behaviour, tends to be risk averse. You know you've got a small market, you've grown up with a protected economy, you look to Canberra for handouts, you deal with the local market and you know it sort of breeds this, and you hang on to being a monarchy, you don't take the risk of being a republic, you think of those things, this recipe for being risk averse we've built up.
But I'm not sure I'll be able to prove this. I certainly wouldn't be able to tonight, but my own sense is that the last few years have been really interesting. That there is a step change. People have got fed up a bit with all of that and there is sort of new stuff in the air about giving it a go. I mean whether it's a Cochlear - - - - ≠ I mean Michael Hirshorn is here tonight and may wish to comment. Cochlear is just a world class piece of innovation that has succeeded and still Australian owned IP. ResMed, the sleep disorder company: these are examples often run out. Other companies like LookSmart, smaller companies in our own portfolio, companies like Austal Ships, which is a very innovative company still based in Perth and doing it well. And in the life sciences, I think lots of young scientists go offshore - and they should go - - - - the trick is to get them back.
And then you get into this huge question about tax structures, options structures and scale, if it's in the life sciences. It's just really tough, but I'm much more optimistic than I was even three, four years ago, because I think younger people and Australia generally is more confident. It's certainly more confident than 20 years ago, for the right reasons, about its technology and about its ability to offer solutions and stand up for them anywhere in the world.
And you know if you say to the suppliers of venture capital around the world, don't come here because we're going to tax you as if you're corporations, whereas everywhere else in the world they are exempt for tax, both in America and elsewhere. Then you get a no brainer outcome, they don't come. And we've had that always. I bet the government will change that. I hope this month. There are things happening and I'd be interested around the room whether people have the same feeling as I do about that or whether they're less optimistic. I'm optimistic about it.
Question:
I come from a kind of a public policy perspective and I was interested that you divided your business into the early stage, the expansion stage and the MBO stage of your businesses and in public policy we always think of basically what we want to do in the public interest and what the outcome will be. So from a public policy perspective, you kind of group things together in terms of the public aim and the outcome, and it seemed to me that you were approaching things from a very different way, and I was just interested to know whether you thought it was possible to marry that public aim and outcome perspective with the way you were talking. It seems to me that a good reason to do that is the public interest isn't particularly interested in high risk and high return. A lot of public policy development is about comparatively low risk and low return but more definite outcome and it seems to me that a whole lot of health, education, disability and environment protection kind of public interest is interested in that kind of way of rolling things, so that you're looking at project outcome and low risk capital to support project outcome, which is about Australia expanding into the South-East Asia region in health and environment protection development.
Answer:
It should be very easy for me to answer that, it's a thesis isn't it? First of all, unashamedly what I'm talking about is how in a sense we make money for our investors and we do that across a spectrum of private equity for reasons of allocation and hedging and so on. But I think consistent with the public good or public policy outcomes, if you think historically, I believe there has been an imperfection in our capital marketplaces, borne out of whether it's cultural or whatever it is, or unwitting tax barriers and so on; success in generating good returns from risk investment will turn out to be consistent with policy outcomes. I'm absolutely convinced of that.
With regard to buyouts, which in a sense is the lowest risk part of what we do, what's turning out to be interesting is getting assets, unloved assets, back into the hands of proprietor/managers, owner/drivers if you will, is producing bottom line, is producing efficiencies just by returning a sense pf proprietorship to the assets, and there is a public policy outcome there.
I mean there's lots of stuff about new infrastructure requirements, but if we as a country worked our existing asset base just a little bit better, it's a fantastic return on assets. The incremental return is far better than new infrastructure, and you get very little discussion in public policy about that. And buyouts to some extent play to that policy platform because there's just a whole lot of assets out there run by public companies that don't know what the unloved division really is capable of, and that's why buyouts are going to work.
So it's a bit of a long winded answer to tie back to your point.
Question:
You touched on share options a little earlier, I thought I'd just throw a question in about that. A lot of public sentiment out there and in Canberra seems to be dead against the idea of share options. I know the venture capital community would like to see some reforms of share option rules. What's your position on that?
Answer:
Well I think the current discussion is absolutely overboard. Probably like many in the room, I find offensive some of the performance under-delivery, for an over-delivery of options and equity schemes that we've seen in some of the public companies here and offshore. But to brand options as some sort of ugly greedy non-purposeful thing is a damn shame I think and that's what I'm sort of sensing. Public companies around the country are scared to issue any options at all.
You know one of the reasons why private equity works is that we can keep governance in perspective. I just think this whole pendulum of governance has gone on a swing out of control and in the private equity companies we invest in, we don't allow process and bureaucracy to have supremacy and to get in the way of good business risk taking and good business building that goes with that. And you know, in a sense, private equity is becoming the last bulwark against over-regulation which could hijack the essence of good capitalism, and I think good capitalism and good option schemes go together and they need to have sensible caps and share of capitalisation and you know, I don't need to develop that, others can do that better than me here.
But that is one of the big differences I think between why private companies, private equity backed businesses, are going to do better in this next decade than public companies.
A related second reason for why private equity works, is that our capital is attached, it is not detached. It is not detached from responsibility and ownership. Public equity investors don't know anything about the company really. I mean they depend on their analysts and so on but they don't really know a lot about the engine rooms by comparison. I'm making my point a little controversial to get it across, but you know the private equity investor by comparison is in the engine room, is part of the business, knows the management, knows the product, has to add value if he's going to make a buck.
The public investor rings up his broker and buys or sells, and it's very different and I think the problem, the challenge to capitalism, is for owners to stay attached not detached, and I see a whole lot of stuff going out there in the capital markets now that works against that, and why I think private equity will work relative to public equity.
The other reason, and I'll stop lecturing about this, but I think the other big difference between private equity and public equity is that we focus on the strategic time line, not the quarterly earnings time line, and with it the analysts' reports quarterly. You build great businesses like Austal Ships strategic move by strategic move, not quarter by quarter. There's a big difference. And you go into the deal with that in mind and you back people who've got that in mind. It's a big difference and public companies can't afford to. Huge difference.
Question:
Do you think that a secondary private equity investment market could develop in Australia as it has in the USA?
Answer:
Well the barrier is the lack of depth in the portfolios existing in the private funds, but it could. Most of the big secondary market players, by the way, are people like Lexington Securities in America and Coller Capital in the UK. What they do is they buy up portfolios at a discount usually from funds managers like us. So we've got a fund and we've got say 15 companies in there and we've run out of time to sew them up or things have gone bad or whatever, but the secondary players will come in and just buy the whole thing and get on with it.
So far in Australia there hasn't been the depth of the portfolios to warrant any serious players doing so; if the IPO market stays stagnant and people can't exit their investments as a result, it increases the odds of something like that developing. I'd like to see it develop because it will be another indication of the sophistication of the private equities market as it does get depth and grows. It will happen and will happen within 2010.
Question:
You mentioned that you think there's going to be consolidation in the VC sector and I assume by your own alignment that you think global firms are going to succeed. What do you think are the requirements for niche Australian firms to succeed in the private equity market?
Niche venture capital managers?
Yes, niche venture capital managers.
Answer:
Offshore we've seen specialist VC niche development pretty successfully in America and Europe. Here in the smaller market economy, it's much harder for a niche player, you know somebody who says I'm only going to invest in IT, I'm only going to invest in life sciences, or I'm only going to do buyouts. There is some of that and it will survive, but not on the scale that we're seeing offshore.
I think that our own model, which is across the suite of private equity and provides for the opportunities for networking and synergies and collegiate sort of interplay within our own private equity team of professionals and has worked in a small market economy like Australia and I think that model is a good model. I think the institutional investors here will drive for bigger, better funded, better resourced VC firms. They'll demand it and they'll drive that, a lot of that consolidation in fact.
Question:
You mentioned your funds are laid out in the early part of the portfolio, with the expansionary phase and the MBOs. Three distinct businesses I guess. What are the characteristics of the businesses that come under each of those? You know what turns you on to a business and what turns you off?
Answer:
Well there are some differences. The common thing is growth and believing that you've got --- you know when I was writing the book, I tried to put some structure into what it is that we do. I mentioned the core proposition. We try to really zero in and say: well what really is different about this business from other people in the same sector? The second thing was what about the people. Are there two, three, four, five key people here that have got money out, have real reasons for making this a success; what's their track record, but you know the people, it's pretty much everything.
And then the third thing is, well, if you've got an attractive core proposition, you've got a team of people that know what they're doing and are there for the right reasons and aren't going to rip you off, what do the numbers look like - what does their base plan tell you. I mean are you going to do this and beaver away at it for five or ten years and make 5% or you know what's the game plan, and that's when you start to get some variation across the stages of what we do.
In the very early stage of life sciences stuff, you know you've got to see that you've got a crack at, you know for the tearaway it's 100 to 1. Not that exactly but you know what I mean. It's a lot higher return than perhaps we'd demand of a buyout. For example, our recent buyout of Bradken Resources which we bought from Smorgon Steel, it was very established mature business, $300 million in sales, good market shares in all it does. $35 million cash flow and a steady 10% to 15% growth, and we don't demand 40% rates of return. You know it's a more modest outcome we need from that sort of company because the risk is lower. So the earlier we go, the higher the risk return we need. We would normally say that we're likely to be involved for four to seven years in our portfolio companies, pretty much across the board.
Question:
I guess there are four things that spring to my mind that make a good venture capitalist a private equity player, and one is you buy right and the other is you sell right, and the other is you just pick a good company that's sort of the right place at the right time, or you pick the right management team. In the venture capitalists that you admire that you'd model yourself after, what are they good at and what have you gotten better at over the last 30 odd years.
Answer:
Well you know in the real hype up in the internet phase, particularly in America, the leading venture capitalists there started saying that they no longer were that fascinated by backing the right people. They said give us the right core proposition, give us the right breakthrough and we'll find the people and some of them have been successful that way. But I think if you probably look at it nowadays, maybe it's a different outcome. Because our own experience has been you can get into a really tough deal and yet good people hang in there and get you an outcome.
And so what do we do differently? We've also had our share of heartaches, that's for sure, and we've also had a lot of deals that did go backwards but we scrambled and really, really worked hard at it in a hands on way to turn around and make profits. I think we've learned that really understanding the business, really understanding the business is absolutely critical. What else? I mean there are the occasions we've made investments and we didn't really have to get involved and everything went well. That is pretty rare. Usually something goes wrong along the way and you have to get in and help.
Venue
John Fairfax Publications, 201 Sussex Street, Sydney
