November 4, 2016
Interviewed by: Privcap
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Bain’s Pagliuca: Prepare for Falling Multiples

Bain Capital’s Steve Pagliuca shares his analysis on the macroeconomy, technology disruptions, social displacement, and how these forces affect the ability of GPs to delivery returns to their investors. Also  his proposed cure for the US national debt.

Bain Capital’s Steve Pagliuca shares his analysis on the macroeconomy, technology disruptions, social displacement, and how these forces affect the ability of GPs to delivery returns to their investors. Also  his proposed cure for the US national debt.

Macro Outlook: Prepare for Falling Multiples
With Steve Pagliuca of Bain Capital

Michael Ricciardi, Mercury Capital Advisors: I had the good fortune of knowing Steve back in business school, ’80 to ’82. We’re here today to chat with Steve about all the successes that Bain has had, and where he sees Bain going, and where he sees the economy going in general. So, Steve, welcome.

Steve Pagliuca, Bain Capital: It’s great to be here.

Ricciardi: When we got out of school in ’82. We had the good fortune of being right at the inception of a massive bull market, and so now the 10-Year trade is somewhere between, let’s call it, one and three eighths and one and five eighths, somewhere in there. And so, how do you guys still manage to ferret out value, given all these changes that have taken place in the market?

Pagliuca: It is certainly a different environment than it was when we got out of school. Never seen interest rates this low for this long, and that has made asset prices very expensive. So I would argue that the industry in general, including Bain Capital, we’ve benefited by our operating expertise and the ability drive growth and earnings in companies with the management teams. But then we’ve benefited by large multiple expansion that went on as those interest rates kept coming down, and the [great ?] economy until 2008.

Because of the quantitative easing and because of the search for yield, asset prices have gone very high. So the business is very tough. Many deals we look at, they’re not going to generate the returns at the prices you have to pay. So we’ve now built specialized expertise and done many, many deals in each of those areas, and that’s paid off in terms of our understanding of the industry, what are good companies, what companies need to be improved, and then specifically going in and looking for transformational situations.

And multiples are at the high end of the range; I don’t see them going much higher. So you’ve got to plan for reduced multiples, or the same multiples, so you’ve got to grow the companies and grow the earnings, so you can make a good return for investors.

Ricciardi: So my recollection is when you were coming out of Duke you contemplated being an economist. And so, were you Janet Yellen right now, what might you be contemplating doing with the fed and open market operations?

Pagliuca: Well, I did contemplate being an economist, and I couldn’t afford to get the PhD, so that’s why I got the summer job for Bain. And I like Bain so much, they just asked me to get the MBA and not the PhD. I would call myself a practicing economist in terms of buying companies and working all over the world. But I think the issue we do have, stepping back, from a business standpoint, is we have to get back to some kind of normalized interest rate environment. We’re certainly not that right now with the rates being so, so low, capital being cheap, inflating asset prices, and also really tough on pensioners and people that need fixed incomes.

So the real tightrope that the fed has to walk, is how fast and how high do you bring interest rates back to a normalized level? You haven’t seen this monetary expansion ever. Milton Friedman might be turning over in his grave…

Ricciardi: Completely new paradigm.

Pagliuca: ….in the history of time. New paradigm. But that’s what they have to do. They have to find a way to walk that up to normalized levels without killing the economy, without hurting trade, and all the rest of the things that go along with that.

Ricciardi: Without any focus on either of the candidates, do you have a sense as to the implications of that election and how it might impact not just the economy of the US but the global economy?

Pagliuca: We’ve built up the GDP of the entire world; the standard of living in India and China and emerging markets has gone up dramatically in our 30 years of being in business.

That’s good for the world. What’s bad is that’s caused a lot of volatility as jobs go from the advanced economies to the emerging economies, and the emerging economies become more competitive. You find an awful lot of dislocation, and dislocation that used to take years takes months now with technology, and communications and the portability of business throughout the world. So we haven’t done a very good job of absorbing the shocks from those dislocations, and you’re seeing the political fallout of that right now, because people all over the world are saying, you know, my life is more volatile, we don’t have enough jobs, we don’t have enough good jobs.

And I think the manifestation of these, all these elections, are kind of extreme positions saying we’re not happy with the progress of government, and my life is not getting better, and we want you to do something, and people tend to go to extremes.

Ricciardi: Technological obsolescence has been around, for all intents and purposes, forever; every time there’s a new invention, a new creation, people will be disenfranchised in a particular industry. Bearing that in mind, there’s a particular –

Pagliuca: But it’s moving faster now.

Ricciardi: Are there any industries that you guys focus on in particular that you think are right for disruption, that would be something that you guys would contemplate looking at?

Pagliuca: Technology is changing everything, from retail, to medical, all the groups, including financial services. So we often look for companies that maybe they’re public and they’re undergoing some transformation, it’s better to take them private, because the public markets punish companies that miss earnings. And so we’re allowed to go in and invest, look at new products, try to make that digital transformation, or from selling software as a product to software as a service. Private equity is doing that in a big way, and technology’s become a huge investment area, and everything that technology affects.

Ricciardi: Amongst the Millennials there’s been a trend toward investing through robo-advisors? Do you have any sense as to how that could play out in the intermediate to longer term?

Pagliuca: I think that’s disruption in the financial services area. I was fortunate to be an investor in [Datech ?] a long time ago, which was a state-of-the-art electronic trading platform, which also owned the island which was an electronic stock exchange. And you’ve seen those platforms really lower the cost of trading from what it used to be at an average broker of $60 down to 9.99. You’re seeing the same thing happen today, and financial services, I think, the internet has change everything in financial services, and made loans more available, credit more available, and it’s a great area to invest and transform, but it’s definitely going to put pressure on pricing.

Ricciardi: Steve, markets that you would not participate in, what are you shying away from, and what are you gravitating toward these days?

Pagliuca: The great thinking about private equity is we have a long term time rise, and we’re able to be in investments 10, 12, 14 years with extensions on funds.

Many of our investors invested with us in Europe, and we had a great fund there, because we’ve taken advantage of these dislocations, and been able to build great companies. For example, Worldpay, which is now a public company, was the second largest, probably equal to the largest processor of credit cards in the UK. It was a forced divestiture from the Royal Bank of Scotland.

Now, stepping back, you’re going to say, well, is that a good time to invest in the UK with slow growth and all sorts of issues? Well, we invested because we saw credit penetrating the economy even more in the UK instead of the cash, and we saw a company that could be expanded dramatically with new products and new services. So that’s why I say, any investment you do has to really look at the microeconomics first, and then you put a macro overlay to say, what about currency, what about the government situation, what about that area of the economy?

Ricciardi: Steve, the national debt continues to climb with reckless abandon; it’s approaching $20 trillion. You’ve been a proponent of various measures to how one might contemplate reducing that debt in some reasonable time period. Could you please address that?

Pagliuca: Absolutely. The national debt has grown from a trillion dollars, which was a huge issue – Everett Dirksen, I think back in the early eighties, had that clock, and everybody was focused on Armageddon when it became a trillion dollars. It’s now close to 20 trillion. And so, in our business, in my business career it’s grown from one trillion to 20 trillion. The interesting thing is the interest rates have come down so much that the government is actually paying less in debt service than it was when we had much smaller numbers of deficits five years ago. But I think that’s misleading, because at some point interest rates will go up, those costs will go up, and that’ll really impact the ability of the government to do services and fund the operation.

So I’ve been a proponent of taking a long term view of this and saying we’ve got to find a way to slowly raise tax rates, and flatten expenditures, so not dramatically, but just do it a little bit per year for ten years, and when those lines cross, we’ll get a balanced budget again. We got to make those lines cross. I don’t think they’ve crossed since Bill Clinton was president, and we just have to do that because it’ll start to eat up too much of our budget.

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