John K. Castle is the recipient of the 2015 Peter Hilton Founder’s Award
What are the pros and cons of having so much capital available chasing a relatively small population of deals?
Probably the prices being paid are somewhat higher, and ultimately the returns will be somewhat lower, but as I say “it is all relative.” If your bonds are getting two to three percent max, there is a fair chance that the money you can make in the public equity market is not that high. With all time high stock prices, and indexes/DOW/SP and so forth, the money in private equity is probably not going to have as high a return.
And it (private equity) has been so dependent, virtually all of the big money has come from defined benefit plans, and the biggest money these days comes from state funds, as you point out, the California’s, and the New York’s, and the Oregon’s/Michigan’s and so forth. Those are the guys that write checks for $1OO million, $200 million, or even $500 million on occasion. It is very likely that over the next 20 years the amounts of money that they are going to be able to write in checks is going to diminish because they’re substituting defined contribution for defined benefit plans. There have been some little ways that employees have been able to go into private equity through defined contribution plans, but it is not well established/well organized and you know, Australia, they marked the market (of defined contribution plans) I think monthly. As a result of them marking the market monthly, people can trade in and out; they can take effectively the equivalent of their 401k plan and put more or less in private equity. Private equity is a massive contributor to returns, I mean on several boards private equity has added 1,000 bases points of return above and beyond the average return in the portfolio. The portfolio has been up 10 percent in the last 10 years, private equity has been up 20 percent.
So you look across the landscape of private equity, you mentioned before how there is less and less defined benefit plans out there, especially when you see what a lot of defined benefits have been doing to localities and municipalities. They’ve kind of fallen out of favor in the corporate world, maybe 15-20 years ago, and now they’ve been challenged at even the local level, especially challenged to meet their payment obligations over the long term, NY State being one of them. As you look forward, there is that pool of capital that seems to be declining, and the industry has really faced a lot of challenges from a regulatory and legislative stand point as of late as well, it has not always been favorably looked upon in congress—that kind of culminated with the most recent election where Mitt Romney was brought under attack because he was a big-name capital guy. Do you see these challenges continuing for private equity and do you think it’s going to change the industry over the long term, or do you think the fact that we are really funding middle market businesses will eventually prevail and the right message will get out?
Well what happened to Mitt Romney, I don’t think is necessarily. I have every reason to think he is probably a pretty charitable guy, and if you’re a Mormon you are supposed to tithe and give your 10 percent, and I suspect Romney gives his 10 percent, there is no reason to think he doesn’t. I think what happens in the political sphere is heavily a function of what politicians try to get away with; they try to paint people as being ugly. I mean our good friends the Koch’s, David Koch gave $1.3 billion away in recent years, and the nurses at New York Presbyterian hospital are picketing around him and his most recent $100 million gift because they want to give the money back to him because it’s David Koch. David Koch is a very charitable man who has good intentions, and I don’t think he’s hurtful to anybody, he believes in markets and stuff like that but he is trying to contribute.
Right now the landscape is such that there are record levels of capital out there for investment.
The world is pretty competitive right now, and part of the reason that there are record levels of capital for investment is because you don’t have a fixed income—In Europe I guess you pay ¼ of a percent just to keep your money in the bank. And clearly if you’re trying to earn anything on a fixed income portfolio, you are talking about very slim pickings, and frankly in terms of real terms you’re getting almost no return at all. Even if you buy the ten year and get 2.5 percent, with inflation being almost 2 percent they are taxing you at 2.5 percent—you are losing money every day.
It is interesting that you mentioned pension funds as being a source of capital back then, you know it speaks to a model that private equities have had for quite some time, but really broadly speaking how has private equity changed over the past 30/40 years?
Well I will answer that and I know among other things that are on your mind: what are some of the big issues private equity will have to deal with in the future? And one of the biggest issues is the fact that pension funds, in terms of defined benefit plans, are in decline. And basically most companies are going to defined contribution programs and so forth. Historically, all of the money invested into private equity funds were heavily defined benefit plans. And as those decline, it isn’t at all absolutely clear whether or not defined contribution plans will fill up any gaps, so there may be significantly less money available for private equity activities in the future than there have been in the past.
Now, with respect to the issue: how has the business changed? It has become more specialized and a lot more sophisticated. If one goes back to the late 60s early 70s, these funds were generally called venture capital funds. That didn’t mean that they weren’t making leveraged private equity transactions, but that they might also be doing some early startup or startup types of transactions, and doing some growth investing. So, there was a whole broad spectrum of types of investments that were being done by funds similar to our DLJ Sprout fund and today each of those has become a subspecialty or even a full specialty in the industry; you know LBO’s are one thing, and venture capital/early startups are another thing, and growth capital is a third thing. Within the LBO area, you have mega deals, mid-market deals, small deals. So a wide range of size of transactions are taking place, and now funds have reached a point where they focus on specific industries—some people do retail, some people do manufacturing, some people do media and things of that nature. In 1969 you kind of did everything, so the industry has become considerably more sophisticated and considerably more specialized. You had a major change in terms of how people view themselves and in the way the business operates today as opposed to 50 years ago.
What about these pension funds that think they can do private equity, and they start making direct investments? That is something that started with the Canadian pension funds and Calpers.It seems that Calpers have hit a little bump in the road with their recent investiture, or planned investiture.
Well, if they’re going to do that they are going to have to build a very significant staff to do it. Historically, many of them have had compensation problems doing that, the state legislature says “Oh you can’t be paying any kind of money that kind of money, forget that, $90,000 is a lot.” There has been an aspect, because of the fact that you had big private equity funds, you could be paying people huge amounts of money but it wasn’t a part of the public record. You also get a lot more diversification by virtue of the fact that you are able to have a series of funds that do this for you, as opposed to having a team of 20 people you’re probably still going to be relatively limited to number of names you invest in and so forth.
Ontario teachers, the chairman for a long time was a man who had been the President of the Toronto Dominion Bank. He was one of the first investors to the Sprout Fund. I remember going to see him about the Envirotech investment, and the bank thought they could only do ¾ of a million, so they had a man down the street with a check for a quarter of a million, gave me the check, I put it in my wallet and brought it back to New York. The subsequent chairman was a woman who also made investments in Sprout Fund. So the people who have been behind the Ontario teachers program were in fact very interested in private equity.