Private Equity Investing: A Conversation with Glenn Hutchins

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Glenn Hutchins is a co-founder of Silver Lake, a technology private equity firm. In addition to his work in the private sector, Hutchins has served as a special advisor to President Clinton on economic and healthcare policy and currently serves as a director of the Federal Reserve Bank of New York. He is a director of the Harvard Management Company, which is responsible for the Harvard University Endowment, a board member of the Economics Club of New York, and is vice chairman of The Brookings Institution, where he helped establish the Hutchins Center on Fiscal and Monetary Policy. He received his BA, MBA, and JD from Harvard University.

BM: What are your top priorities when you invest and how do you go about seeing value in companies?

GH: When you make an investment, you want to find the highest risk adjusted rate of return. The important question here is not “return” but “risk adjusted return” because risk and reward are intimately linked. If you imagine a risk return curve, with risk and return both increasing from lower left to upper right, I live in this world called alternatives, which is private equity, hedge funds, venture capital, etc., where we are supposed to take a high degree of risk and generate a high degree of return. And we’re trying to get as much of an increment of return for as little an increment of risk as possible in each investment.

The second point is that I work to build a portfolio. If you look, for instance, at a portfolio of fifteen transactions, I try to make a series of investments that have at least two kinds of characteristics: one, they are diversified with respect to the upside opportunities that they’re exposed to, and second, they are diversified with respect to the risks they present. If each individual investment has a good risk-reward ratio and each portfolio is constructed with a good mix of investments, you should end up with a superior rate of return over the entire portfolio.

Remember that you can only lose 1x your money but, if you are successful, you can make many multiples of your money. In a portfolio of fifteen transactions, if you have 2 or 3 that are unsuccessful, 2 or 3 that are very successful and then about 9-10 that are moderately successful, you can produce a very successful overall portfolio. So its individual, microeconomic investment analysis combined with portfolio construction.

BM: Where are the best opportunities for private equity investing likely to be in the next few years? 

GH: Fifteen years ago, I decided to put all my eggs in the technology basket because I thought it had the best risk-return characteristics. There are fundamental trends that suggest that technology will continue to grow much more rapidly than the rest of the economy, essentially taking market share from every other sector in the economy. That’s because of all the products and services your generation lives with as digital natives. Certainly the most powerful economic force in my lifetime (and I would argue that perhaps the most important economic force in the history of capitalism) has been something called ‘Moore’s Law’. There’s some debate about what exactly it is, but roughly it’s the doubling of the capacity of a semiconductor every 18 months. That means that every year and a half these technological devices are better, faster, and cheaper than before. If you are reasonably good investor, you can piggy-back on this juggernaut of a trend to outperform. To give you an example, the use of the ‘network’ (and all these devices connected to the network) is growing at a rate that approaches 100% per year. Others can make great investments in the energy economy and the consumer economy and the financial services economy; they can go to Brazil or China and be a very successful investors. But I don’t see a need for that because I am a very long way from running out of opportunities to invest in technology.BM: One of the biggest challenges for a lot of technology companies has been the question of monetization, and a lot of IT companies—even highly valued ones—have found it difficult to generate revenues. To what extent has the industry has been successful in establishing viable business models for its products?

GH: That’s a really good question. The first half of my answer resides in the way I think about investing. I’m not a venture capitalist. I make large-scale investments in mature technology companies. So you can make a judgment – which seems pretty straightforward – that smartphones are going to grow in number and capability, and will have a rapid replacement cycle. You don’t have to guess whether its going to be an Android phone, an iPhone or some other device that will win – because you can make very good investments in companies in the supply chain for those goods, whether its in the semiconductors or microprocessors or storage devices or other underlying technology. You can have very good business models independent of how much money the people who sell those devices make or what the monetization model is of the companies that run their services and content over those devices.

The second big point is that as an investor, one of my rules is to seek companies with positive cashflow which I define as EBITDA exceeding capital expenditures. In other words, I think businesses are in business to make money and generate return on capital. There are some very good investors who know how to invest in business that are losing money; I’m not as good at that. Furthermore, it’s very clear that if you get it right on the web, there are some enormous monetization opportunities. There are obviously very valuable, sustainable monetization and profit generation models among internet companies. Look at companies like Google or Facebook; once they turned the corner on profitability, they gushed profits.  The third point is that there is a natural monopoly effect in technology. Google dominates search; Facebook gets social; Amazon has retail; WhatsApp seized text messaging, etc. This tends to concentrate profitability in one or perhaps two companies in a sector and the companies that establish the prominent position can be highly profitable. There’s a big difference between the winner and all the others. The fourth point is that there’s a decision an emerging company has to make about whether to continue to invest to grow or whether to harvest profits. Do you keep investing ahead of your revenue and profitability in order to capture more of the market or do you turn off investing in order to generate cash flow? That’s a decision that young companies in their rapid growth phase have to grapple with.

BM: The big news in the markets these last couple months has been the dropping oil prices. How do you think they will affect the alternative energy sector and the economy more broadly?

GH: It seems clear that the drop in energy prices is a huge net positive to the economy, because it gives the equivalent of a bonus or a tax cut to consumers which is enormous, especially to people who are in the lower income strata where gasoline is a very high part of their annual budget and where wages have generally stagnated since the beginning of this recovery. It also has enormous social benefits, because it gives a boost to people whose incomes have flat-lined. So I think its both a social good as well as an economic positive. There are some economic negatives that are associated with slower paces of investment in both drilling and E&P (exploration & production) of energy. On the other hand, the lower prices stimulate the construction of energy intensive industries and industrial output in the United States. So it’s a mixed bag but on balance powerfully positive for consumers.  Clearly, when one invests in commodities, one has to live with volatility. That’s just a fact of life in that business.

BM: In 2014, the US economy did surprisingly well. Will 2015 be as a good, and what needs to be done to improve matters?

GH: The recovery that started in late 2009 has been the slowest recovery in modern American history. When compared to all the recoveries since World War Two as well as to the rebounds which followed the two worst economic declines in our recent history – the Great Depression and the recession of the 80’s – this was the slowest economic recovery in recent memory. That is almost certainly because we experienced what’s called a ‘balance sheet recession’, meaning that debt had built up—primarily at households but also all over the economy. And it’s taken five years both to get those debt levels down and to get the asset values, primarily in houses but also in equities (because Americans’ wealth is in households and equities), to the point where people felt their balance sheets were right side up again after they had been upside down for five years. It was a tough grind that muted consumption and caused the economic growth to be  closer to 2% than 3%. But now seems to be behind us. Job creation in the fourth quarter of 2015 was the best since before the financial crisis. The big issue for growth in the coming year is what happens to wages and incomes, because our GDP is still roughly 70% in consumption and consumption is driven by wages and incomes. Almost all the consumption gains in this recovery have come from people in the upper levels of income whose wealth is more closely tied to market than to wages. If your assets are in markets and your wealth is determined by the level of stock values, you’ve done well in this recovery. If your income is in wages and your wealth is determined by the value of your house, you’ve done poorly. And so in 2015, to drive economic growth closer to 3% than to 2%, we need to see an increase in wage incomes and those gains will need to be spent. These are two very different things that together could enable consumption gains to look more like 4 or 5%  which would, in turn, drive overall economic growth to the 3% range.

There are two important caveats: First, the big question is whether our employment markets have improved to the point where people who work can demand higher wages. Or is there still a huge amount of downward pressure on wages that comes from labor markets around the world, the introduction of technology and downward pressure on inflation expectations? In this second case, you end up with flat wages which means you’re not going to get the bump to GDP growth that you would otherwise get. Secondly, if people do enjoy increases in household incomes, will it be spent? Their new mentality might resemble that of people who came out of the depression in the 30’s determined to save and pay down debt rather than to spend. Savings and debt reductions are very good individually and are highly beneficial in the long run but, collectively and in the short run, lead to lower consumption, less aggregate demand and slower growth. The credit card companies have reported that, so far, about two-thirds to three-quarters of the bonus that has come to consumers from declining energy prices has been saved or used to reduce debt and only 25-30% is being spent. But that’s only a very early indicator. So, first you need wage growth and then people have to be willing to spend it. There’s also a third question – which is a separate but interesting – which is “what will they buy?” People are spending a lot more on electronic goods and buckets of data to use their devices than what they used to and are spending less on household furnishings, clothing, and entertainment (like eating out at restaurants and going to theaters). So there’s also a shift in where the spending is going in today’s economy which means that, if consumers do start to spend more, there will be meaningful winners and losers.

BM: Do you think the United States will continue to hold a competitive edge in entrepreneurship and technology?

GH: Absolutely. There’s no place in the world quite like the United States and Silicon Valley for basic research, the technology that turns that research into products, the innovation and organizational capacity that turns those products into companies, and then the capital markets that fund those companies from their infancy with venture capital all the way through to the public markets. There’s no other combination like that in the world and we are the envy of the world as a result. Now there are some countries which are investing very aggressively in parts of all this and will do better in the future than they are doing today. China and India are the two most notable ones. So will they catch up? Sure. Will we fall behind? I seriously doubt it.

BM: You’ve mentioned your belief in the importance of developing practical skills for the workforce. Do you think it’s a good thing that so many ivy-leaguers want to go into financial services, and what advice do you have for those who do want to?

GH: As I said earlier, our financial markets are the envy of the world. We have very smart people working at the center of those financial markets, collecting savings from around the world and figuring out the best places for them to be allocated to generate good returns for a host of important constituencies such as pension funds and endowments (paying for scholarships, research budgets, retirements and so on). And let’s not forget that the efficient allocation of capital to highest return opportunities is an extraordinarily important contributor to overall economic growth. So, I think that having the most talented people allocating capital in the world’s biggest capital market is hugely beneficial for our country. And I think it would be a big mistake to somehow send a message that its a less worthy or a less respectable profession. The other place where I see a substantial flow of young people is to startups. A lot of kids are migrating out to Silicon Valley or are coming to New York – what they call ‘Silicon Alley’ – and are getting involved in inventing technologies, starting companies and hiring lots of people. I think that is great too. Also, its not like all young people are going into business. A large number of the students I talk to want to be teachers or do public service and that’s very good too. We all understand why it’s good to have really smart students who are ambitious, idealistic and capable become teachers and public servants. So while there’s a big flow to Wall Street, there’s also a big flow to Main Street. And I think both those are both good and neither one is better than the other in some way.   The young people I talk to are interested in finance, they are interested in teaching, they are interested in technology, and they are interested in public service. Meeting these young people gives me a huge amount of confidence about the future because all these really smart, hardworking, idealistic and ambitious young people are certainly going create something fabulous.

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Benjamin Marrow

Benjamin Marrow is a senior editor of Yale Economic Review. Contact him at benjamin.marrow@yale.edu.

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