Pilot’s Log Q&A
Luke Johnson
Risk Capital Partners

Wikipedia cites him as a "projector", in line with the 17th century term for a man involved in many different businesses, and in this edition of Pilot´s Log serial entrepreneur and founder of Risk Capital Partners, Luke Johnson, projects just what shape he thinks the private equity industry will take over the next two years. Luke also shares a few hard truths on what makes a good VC and a bad VC; the set-backs of impatience and false assumptions; and the disservice of pigeonholing us all into a “career for life”.
Interview by Katherine Steiner-Dicks

In the current economic climate, how can visionary-entrepreneurs get debt lenders to ´join´ a business strategy that requires not only a significant change in management, but a growth strategy requiring substantial cash?

With great difficulty. The short answer is banks are building their capital ratios and shrinking their balance sheets. They are unenthusiastic about lending in general—they worry that it is good money after bad. A lot of businesses are over leveraged and adding more debt is just throwing petrol on to the fire. Banks place companies into three categories: sure fire growth companies, those existing problem customers and newcos that they are willing to lend to. There are alternative options for companies, albeit mainly debt to equity swaps and the opportunity to pay down interest payments.

While we do development capital deals, we try to use leverage when we can. But in general, we invest higher amounts of equity and do not get involved in high multiples of EBITDA and debt. In some cases we are seeing modest debt from vendors, which can help the balance sheet a bit and permit an agreeable price to be reached.

How far down the management chain do you personally go in a turnaround to get the best grasp of where a company needs to make change?

Deep, in a turn around. Sometimes you have to take out the top layer and go deeper to the operational staff. We often believe in promotion from within and are not against junior management taking on more responsibility. It´s often the case that they have been working hard, but are feeling a great deal of frustration and are demoralised. If a company has a rotten culture and has been led by bad people, the current management won´t be of the quality that you want. The best people have usually gone.

In a turn around there is a lot of change in staff and not just in the board room. Those who have the responsibility will be going through a painful process, especially when firing.

Do you have your own method of assessing a target business? If so, what´s the first step you usually take and does this differ from other private equity investors?

Not sure if I can claim my own method. But I will say that there are hundreds of tests you should adopt-- with as many criteria as you can think of. You need to get so many perspectives—human capital, finance, technology, history of the business, legal, property, insurance, competitor analysis...

Do as much homework yourself. Some private equity houses rely on outsourcing everything. We make sure to visit multiple company sites, talk to branch managers and trial the customer experience firsthand.

There´s also the topic of morale and the qualitative matters of just how much a brand is worth. Is the company better than its competitors? What is its USP and is it in an attractive market to be in?

We are always learning, too. You sometimes make false assumptions. I´m impatient and sometimes can fail to ask questions, especially if it is a new sector to me. That is why it is often valuable to get in an industry expert. They may say “don´t do the deal”. And you may therefore miss an opportunity which you knew intuitively was a good deal. You have to get a gut feeling and ask yourself, despite the analysis: do you really like it? No deal is a deal in isolation.

Do you prefer to back a management team that you like or do you look first for a certain business ´type´ and see the management as secondary as the team can always be changed?

No. Management is fundamental. You want to buy a company that you rate. In the end, every business is a people business. You want a management team that is hungry, hard working, honest and dynamic. Management are primary and just like everyone else you want brilliant people.

There are times though that you may have two to three managers you like and supplement the others. But you always have to have people you believe in who are incentivised for the long haul.

What shape do you think the private equity industry will take over the course of the next two years as a result of the overshadowing debt crunch?

It will shrink. Mega funds have suffered and are battling to justify their fee structures. The desperation for LPs to enter the asset class is no longer so much of an issue as anticipated returns have turned south. The risk is that LPs will now allocate less towards private equity. One thing LPs did not consider fully is the illiquidity that private equity can pose and the matter of over commitment.

What is coming to light are the conflicts. The top of the market has become too greedy. Can the mega funds raise more funds? Can they cut their fee rates? Will they have to resort to raising smaller funds? And why should the junior executives continue to not share in the rewards? Eventually the younger talent will leave because people do not go into private equity to earn a salary.

The industry has a big political challenge ahead. And can expect an assault from many sources ranging from the EU, the US Congress, and envious politicians. But it will become more apparent what shape the mega funds will take as more big name investee companies go bust. It just takes a couple bad deals, such as EMI, to taint the industry.

How do you and your team at Risk Capital Partners differentiate yourselves from other private equity houses?

Have people on your books to fix problems no matter the size of the fund. Also, an element of emotional engagement is worth a lot as well. For example, if a VC is cold hearted and never really gains ownership or pride in an investment, then they can´t distinguish themselves as a private equity house. There have been times when I have been in board meetings with certain other VCs and all they have wanted to talk about are bank covenants.

A VC should make an effort and be something more than just money. A VC can help a business boost their contacts. You are worth more to the management as an entrepreneur. The problem is, many VCs are seen by entrepreneurs as short-term—all hit and run. Management have to see you as more than that. We work alongside teams, because as entrepreneurs, we´ve been there.

There´s also the issue of outbidding. If you just outbid all the time then you will get stuffed. That kind of portfolio in this climate will look shocking.

When a deal gets to a really frustrating point (i.e., unexpected management or customer issues or even a whopping legal bill) what stops you from ever losing your cool or long-term perspective?

I do lose my cool. You try to restrain yourself. You have to work with people and can´t fall out with them. You just can´t divorce. But these moments pass quickly and private equity is a long-term game.

Have or would you turn away from a deal that on paper looks great, but just doesn´t inspire you enough to take it on for the long-term?

Yes. You have certain criteria. Sometimes you have to increase prices. But if it´s on a moral basis, for example, looking at an arms business, I just wouldn´t feel comfortable. Just as I wouldn´t feel comfortable investing in tobacco.

I try to do deals that are uplifting, rather than mercenary. This way the staff benefit and it´s a virtuous circle that can make the business grow since customers are also happy. But some moments are all grief. That can be the nature of business. Sometimes when you look at what I would call a grubby business-- for example a door stop lending business-- and while there may be rational arguments for this, you just turn away. You ask yourself: Am I going to enjoy going to board meetings? When I drive up to the business will I feel embarrassed? Do I want this investment in my obituary?

I worry that private equity has become all about IRRs. I try to dig deep in a business. I love finding a niche business and the privilege of gaining the knowledge of that business. I love all of that.

Your accomplishments and talents to date have never been pigeonholed into any one practice or sector. So, what can we expect from you next?

It´s a terrible indictment in this world to be over categorised. We live longer than we used to with many of us having to work in more careers. It should be applauded. I prefer to range across various fields. Work is important to me--enjoying unexpected things--which means I do not conform to other people´s prejudices. Don´t get me wrong, there is value in having a specialism. But more people are becoming freelancers to pursue different career avenues. The concept of a job for life is over, and there are no more final salary pension schemes.

Loyalty has waned from both employee and employer. People need to be enlightened about what they do. For example, I write about venture capital and being an entrepreneur, because I enjoy it, and I am more valued for it because I am in the trenches, rather than just an observer.
One thing I have done new in my life this year is to go running more regularly. Since January, I have run every morning without fail. It has improved my outlook on things. It clears my head. I feel healthier. And besides missing out on the morning chaos of my young family, I achieve something before breakfast.