Close-Up Look at Private Equity as the Industry Grows and Adapts
As Chairman of Financial Sponsor Coverage, Scott Phillips has helped steer the Societe Generale Americas business supporting Private Equity for over two decades and has worked with PE firms across the globe. As the industry continues to evolve into something that looks and acts far different than it did at its beginning, we took the opportunity to ask Scott about his view of Private Equity, where it’s headed, what its challenges and opportunities are, and what matters to PE firms when hiring banks.
What strikes you as the biggest change the PE industry has undergone over your long career?
The Private Equity industry is constantly changing due to the need to drive returns for its investors. In the earliest stages of the industry, financial leverage was the main driver of returns. As competition for investments grew, valuations increased and financial leverage no longer was as important as other value drivers such as operational improvement or expansion through acquisitions or organic growth.
More recently, the biggest innovation has been the advent of credit businesses (investing in debt securities and loans) within PE firms, which has led the bigger firms to be reclassified as Alternative Asset Managers.
What have been the most significant regulatory changes for private equity since the financial crisis?
I would say that the largest changes in regulation since the Financial Crisis have been the enactment of the Volcker Rule and the establishment by the Federal Reserve Bank of leveraged lending guidelines for Fed regulated banks. The Volcker Rule, among other things, prohibits banks from owning or investing in hedge funds and PE funds. This caused banks such as Societe Generale to exit its business investing in PE funds, and caused several of our bigger clients to be spun out from the banks that owned them, thus changing the landscape of the PE industry. More recently, the Fed has established lending guidelines that cap overall leverage and deal structures, which has created limits on the amount and level of financing banks can use in a leveraged buyout.
Is it harder for PE funds to raise capital because of the increased capital requirements for banks?
Maybe not directly, as the ability of PE firms to raise funds is directly correlated to their returns. Obviously if banks are not able to offer as much leverage, that could affect returns the PE firms enjoy on their investments. However, as noted above, PE firms now generate a much smaller share of their returns from financial leverage. Their success or failure is much more tied to their ability to make operating improvements in the businesses they own or increase their growth rates through M&A.
As you’ve noted, the PE firms have expanded into lending in many cases. Are they now competitors as well as clients for banks?
It is true that some PE firms, such as Apollo, KKR, Blackstone, and Carlyle, have ventured into the direct lending business, which has disintermediated the banks. This is one of the unintended consequences of regulations on the banks. However, these large PE firms are only the most recent entrants into direct lending, as the direct lending industry has been growing rapidly for many years.
In turn, Societe Generale has developed products working closely with the credit arms of our large PE clients and providing them advice and financing.
How important are client relationships in winning PE business?
Client relationships are the most important aspect to winning PE business. However, given how competitive this client base is, banks need to deliver to be able to maintain the relationship. Having a client trust that a bank, as led by its relationship officer, can secure the promised financing and push a deal over the finish line by the expected deadline goes an incredibly long way and is arguably as or more important than offering the most competitive financing.
Before providing financing to a private equity fund, on what basis do you evaluate the fund? What metrics do you use to decide if a fund is worth the risk/return?
We have multiple ways of providing capital or ideas to PE firms. The primary avenues are to: 1) finance their acquisitions, which is always done on a non-recourse basis where the cash flows of the target are the source of repayment; or 2) to finance the PE firm or fund itself, and the lending criteria are ratings based.
In all cases, when deciding to provide financing, after the relationship banker provides the support for doing business with the PE firm, the bank will consider the credit strength of the target or counterparty. Depending on the type of deal and business line being utilized, the bank will evaluate different aspects of the fund or deal. This evaluation will always include detailed due diligence and a credit analysis that passes through all internal risk department and senior management approval processes.
You spent many years in London covering private equity firms. Is there a difference between PE in Europe and the US?
The PE landscape in Europe is very similar to that in the US, at least at the large cap end of the market. US PE firms moved over to Europe in the late 90s and early 2000s and captured massive market share from the indigenous European PE firms. Societe Generale set up Financial Sponsor Coverage in the UK in 2001 just as this was occurring, so many of our earliest relationships were established with American firms at the same time we were growing with the big European firms. This has allowed us in the last few years to move back across the ocean and establish a presence with the American firms on their home turf.
At the mid-cap and small cap end of the PE market, Europe is quite different, with strong local PE players in each major European country. This is particularly true in France, and Societe Generale has a very strong business through our mid cap investment banking group with these PE firms.
Finally, because this has become such an important topic across finance and to Societe Generale, to what extent do environmental factors come into play when Societe Generale evaluates whether to help finance a PE transaction?
Environmental factors are a critical part of any lending decision we make, but it is fair to say they are most acutely analyzed when we do a deal in the natural resources and infrastructure spaces. The good news is that our clients tend to have the same Environmental Social Governance (ESG) guidelines and principles as we do as a bank, so we do not face conflicts between what our clients want to do and what we as a bank are willing to do.