Bringing private equity to investors
With Russell Pillemer, CEO of Pengana Capital.
Matt Heine: Hi and welcome to this episode of Between Meetings. I'm your host Matt Heine. Today we're joined by another don of the industry who originally grew up in South Africa in Johannesburg and moved to Australia at the age of 20 to play soccer and to study. He went on to join Goldman Sachs as an investment banker and then spent time in New York. When he returned to Australia he set up Pengana Capital with his former colleague and our former Prime Minister Michael Turnbull, welcome to the show Russell Pillemer.
Russell Pillemer: Thanks Matt, nice to be here.
MH: Now, not everyone grew up in South Africa I'm a bit intrigued about what that was growing up as a boy in Johannesburg, what was happening in the country at the time?
RP: South Africa was a fantastic place to grow up, at least for a young, white person and I must say growing up there we weren't really that conscious about Apartheid and what that all meant, and it was only in my later years when I became a teenager et cetera did we really become conscious about that. And although it was fantastic as I said for a white South African kid, it was obviously a very harsh place in those days for non-whites.
My family decided to move out of South Africa when I was a teenager. My father hated the idea of Apartheid, it really sat very badly with him and felt that the family needed to move to a better environment. We moved here in 1986, and my father was a real visionary at the time. It wasn't a lot of South Africans who had moved to Australia, we were one of the earlier families who moved here before the mass migration I guess. So my dad was a real visionary, he unfortunately actually passed away last week.
MH: I'm sorry to hear that.
RP: No, thank you. It's great credit to him that my entire family and my father's family, my mother's family all live in Australia so I think at last count there's about 90 family members who live here.
MH: Oh, wow. And what was he doing in South Africa before he moved over?
RP: My father was a life insurance broker and a very successful one and what I actually never really appreciated is he moved here at the age of 48 without any networks, any contacts and had to start up all over again, quite a daunting task and really a great guy and a hard worker, and he actually gave me a love for the financial services industry and that's I guess how I initially got into the whole industry.
MH: So did he establish another life business in Australia?
RP: He sure did, he established a very successful life insurance brokerage called North City Financial Services, and that grew into quite a large business and he made a success second time around.
MH: That's amazing story, and did you go and help him out back in the early days, as a 20 year old in his business?
RP: I used to actually help him with his spreadsheets, my dad was very non technical, could never use Excel, and when I learnt how to use Excel it was actually in its infancy at that point in time. I did used to go into the office and help him out somewhat.
MH: And then what did you go on to study at university?
RP: I did accounting finance honours at New South Wales Uni, actually had originally enrolled into medical school. I started it at university in South Africa, but quickly figure out that that wasn't for me, and finance was really where I wanted to be.
MH: Your mother had wanted you to be a doctor or a lawyer?
RP: No doubt, no doubt. I think every Jewish mother wants their son to be a doctor, so I went into the finance industry. My family moved over to Australia when I was in my second year of university and I transitioned over from Wits University in South Africa to New South Wales Uni, which is a great place to study.
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MH: And how did you end up in investment banking?
RP: After I finished university I actually wanted to go into investment banking. My dad said, his advice at the time was very old school and he said I needed a real job rather than becoming an investment banker, and convinced me that I should go into accounting. I did my professional year, I worked at Ernst and Young which is fantastic, did that for about 18 months, as soon as I'd finished my professional year I started looking for a job in investment banking and I actually got hired by Credit Suisse First Boston who was a real powerhouse in the Australian investment banking in those days. Worked there for about a year and a half and then got offered a job to work at Goldman Sachs in Sydney with a view to sending me to New York and that was irresistible, so I took that up and that's how I went on the journey that I did.
MH: That was in the financial institutions group. So you're looking at mergers acquisitions of fund managers, insurers. What were some of the transactions you were doing with them?
RP: Yeah, in Australia I focused on financial services in general. The sorts of deals I was involved with was the demutualization of National Mutual, the acquisition ... these are all old, hopefully most of the listeners still remember this.
MH: Certainly my old man having sold his business to National Mutual, so that's a name that not many people still remember.
RP: Yeah and then the acquisition of The State Bank of New South Wales by Colonial before they were acquired by CBA and the sale of the BT Funds management business. So I worked on a whole-
MH: It really has gone a full circle since those days.
RP: Absolutely, when I went to New York, I did two stints in New York, but my second stint in New York in the late '90s until 2002, I focused strictly on funds management, so all my transactions I was engaged with was funds management M&A, and you can imagine Goldman Sachs in New York, that was a major business in and of itself and I got to see the working of the best of the funds management businesses in the marketplace, and it's from there that I actually developed the idea of starting the Pengana business.
MH: Over in New York what were the typical transactions revolving around fund managers building up to get big scale, was it demergers, what was happening in the industry there?
RP: Everybody was looking for scale and really what we focused on at Goldman was a sell side mandate. So in investment banking it's much better to be on the sell side than it is on the buy side because there's many buyers for every transaction so you might not be a winner, but if you're on the sell side you usually get a deal done. So Goldman focused on the sell side and what I particularly focused on was the small medium size fund mentioned businesses that we usually owned by one or two individuals who would put themselves up for the sale and were usually be acquired by some larger groups. And, it was really those types of businesses that were the best businesses in the marketplace. Unfortunately, many times these businesses go on to fail when they're actually acquired by a big institution who actually loses the cultural elements.
So I got to get a deep understanding about how to build a funds management business, what makes a funds management business tick and how do and how to manage a funds management business for the long term without negatively impacting the performance of the business, especially through the growth. And so one of the key factors that I noticed in funds management was that size was often the enemy of the fund manager. If you had too much money, then you just could not perform to the same level as you could when you had a moderate amount of money. And so that was one of the key aspects that I really learned now it seems a basic lesson and for those of us in the industry, we all know that.
MH: Well, not necessarily, cause you just said, that the transactions you were doing were actually getting scale, it was about building really big businesses really quickly, and yet the business you've set up is the complete opposite of that.
RP: Absolutely. So when I was doing those transactions, I was taking these small, mid size amazing businesses and I was selling them into these large conglomerates or a big institutions. It was post that a period of time that these tendencies were identified, but actually in the build up in the growth of those businesses, you could see exactly how they should be managed. As I said many times it [did 00:08:11] work out well, but occasionally it didn't work out nicely and you could take your lessons from where it worked out well to see how you can grow a business.
MH: So self-education with no risk?
RP: Yeah, absolutely.
MH: Now it would have been a big move for you moving from the security of a big investment bank, presumably an attractive salary, a regular income to set up your own business. What was it that ultimately made you decide to take a step out of the bank and do something yourself?
RP: Yeah, I think in hindsight I'd call it a stupidity and the reason why I say that jokingly, but I actually think if I actually look back at that point in time, I probably didn't understand the risks enough of starting my own business. And I think a lot of the success that we have has actually been based upon some luck of what's happened to me in the business. So it's turned out fantastically, but at the time I didn't quite realise how much it would depend upon that luck and I'll talk a little bit later about what some of those elements of luck were.
So the things which really inspired me to get out of my own, there were a couple of them. So personally I always loved the idea of building my own business and probably from my father, watching him build his own business I always had that desire to run my own business. I also had some good mentors in New York, people who had built their own businesses, some of the fund managers or who I became particularly close to I did the sell side deals for and I got some good inspiration from them as well. And then finally, I was working in New York but I wanted to come back to Australia. When my wife and I left for New York we had one kid by the time we came back, we had three with another one on the way.
MH: It would be hard to live in New York with one child, let alone four.
RP: Absolutely, and the whole family is in Australia we love Australia. I've always wanted my kids to grow up in Sydney and so we decided to move back here and the idea of moving from Wall Street to coming back and working in the small Goldman Sachs office in Australia just wasn't an attractive for me. So I thought I'll go out on my own and-
MH: So moved from a small Goldman Sachs office to an office with probably yourself and Malcolm.
RP: Absolutely just the two of us to begin with, just the two of us. And I guess Malcolm was also a great person to go into business with because he was very well connected, he is well connected and just a great guy to start a business with, and he really backed me and my vision and together we set about building the business and it's been 16, 17 years since then. Malcolm was only in the business for a few years because you obviously went into politics and then, decided that it was better for him to sell out of his operating businesses. But certainly in those initial stages, he was fantastic to have him as a partner.
MH: And how did you go in those very early days where you were doing everything from probably making cups of coffee through to trying to win prospective clients, as well as going and finding a number of managers to actually go and sell to the clients.
RP: It was exciting, but at the same time a little bit frustrating. In investment banking, working on Wall Street everyday you're getting to the office there's another deal to do and every deal is bigger than the next, and then starting your own business you've got to deal with the mundane, the side of our business and it was frustrating but very exciting when you actually had the vision in your head about what you were trying to do. And it also, I think it's always takes much longer, more expensive to start businesses than you think. Everybody says this, but you always think you're going to be different, but that is the case.
MH: And are there any lessons that you can remember that you would or things that you would have done differently at the start?
RP: Oh, I think there was a lot of things I would have done differently at the start, but I think it's a journey and I think your journey gets you to ultimately the right place. So maybe if I would've done things differently, I might not have landed up in the right place at the same time. So if I had to go back and do it all again, I think I would've done the same thing. But, yeah, very different lives. What I think was absolutely critical was we had a business plan, the core of the business plan, and we've kept that core of that business plan the same right from the beginning, but we've adapted it around the edges, as we've learnt our lessons over time, but fundamentally what we were trying to do, we've kept that vision the same.
MH: You started talking about luck before you were saying you've got lucky a couple of times. As we know, people that work hard tend to get lucky, what were you referring to?
RP: So my luckiest occurrences were meeting some of the fund managers that I did and getting them to agree to come on board with Pengana. So our initial team, Steve Black and Ed Prendergast-
MH: We know them very well.
RP: Absolutely, who run the Goldman Sachs... who run the Pengana Emerging Companies Fund that was the luckiest break that I got. At the time Steve was running the Goldman Sachs JBwere Small Cap Fund, I think it was called the Emerging Companies Fund and I managed to persuade Steve to join us and build the business.
MH: Had you worked closely with him in his previous role?
RP: I had not. I'd only heard of him by reputation, and thought I'll give it a go and see if I can get him to join us. And as I say I think luck had a lot to do with it, but also we shared a common vision and what Steve's frustrations were the same types of issues that I've identified in terms of managing too much money in a small space. So Steve and Ed obviously manage a small cap fund. In small caps, you have to keep the size to a manageable level because otherwise if you have too much money every time you buy and sell stocks, you move prices et cetera.
Steve wanted to manage a smaller fund and we spoke about how we could do this and how it would still make economic sense to manage a smaller fund. And we were one of the very first, if not the first in the market place to put a market out performance fee on our fund. And so we got paid to the extent that we outperformed the market so we could afford to keep ourselves out our fund size small, but we vastly outperformed the market over many many years and made our money through performance and our clients are happy and we were happy. So it made a lot of sense, although at the time it was very novel and a lot of people said we would never raise money if we embarked in that structure.
MH: I have to say that used to be very unpopular and now it's almost people are happy to pay zero and pay a high performance fee.
RP: Absolutely. So that was my first stroke of luck meeting Steven and Ed and then a few years later, meeting Rick Kessler who runs our Australian, our Aussie Equity Fund. And then once again, we had a very common vision about what we're trying to do, [Red 00:15:10] agreed to come on board and we were able to over the many years grow a very large and fantastic fund.
MH: So at the time, this sort of the boutique distribution model I guess you could call it, it was quite novel. Was there anyone else doing it in the space at the time? Now there's obviously a number of different parties you got Fidante et cetera all have jumped into that space. Was it a new model that you came up with or have you done something different to what they're doing?
RP: It was an absolutely new model and to large extent, it still is quite a distinct model. So we've very different to a group like Fidante or Pinnacle, et Cetera. So what Pengana is and I think this is, I've mentioned before that we stuck to our model and this is the model that I'm talking about. When we started the business, we were unusual in that we started with a clean sheet of paper. We didn't start with the funds managing team, we started with an idea and a structure and then which I believe from everything I'd seen in the US market was the ideal way to build a funds management business and then we hired our teams onto the platform.
Because of that, I think we had a substantial advantage in the marketplace and so while we different to the other structures out in the marketplace, Pengana is not a collection of distinct businesses. So if you look at something like Pinnacle or Fidante, they separate businesses and the house has a stake in each of them. Pengana is not that at all, Pengana is one business, we're one brand, we're one back office, we're one sales team, et cetera. What we are is a series of partnerships with the funds management teams who manage our individual strategies and we share the economics with them like true partners, but these are not distinct businesses. That is much stronger proposition for a number of reasons, both to investors and to the fund managers than a minority or majority stakes in distinct businesses. And so we very different to the other businesses and market place.
MH: And certainly speaking to Steven and Ed they love the fact that they can just turn up to work in the morning and just managed money and don't have to worry about anything else.
RP: Absolutely. Steven and Ed are typical of that type of fund manager who could go out on their own and could build their own business, they've certainly got their own individual brands, so they don't need Pengana, but they recognise the value that Pengana brings to them in that partnership and that's exactly the type of fund managers that we are looking to partner with. Not The people who need to have their own names on the door, but the people who want to be part of something bigger and better and they also recognise that it's better for investors, that they're part of Pengana because they don't have to worry about running a distinct business. They leave everything up to Pengana and they can strictly focus on managing the portfolios.
MH: So that must've actually been very challenging in the early guys where you were just starting a business, not only did you have to find fund managers that were good at their job, had great processes and good track record, but they had to buy into your business model as well.
RP: Absolutely. That's probably the most challenging thing but getting back to luck, we were lucky enough that Steve and Ed did agree to join and we got instant credibility from them joining because they're such legends in the marketplace.
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MH: And you're now starting to diversify into some other areas. I think you've got one listed investment trust and I believe you have taken another one out to the market. Should we just talk for what you're doing in that space and what's next?
RP: So a couple of years ago we decided that international equities really are our major growth focus, we put together a fantastic team to manage international equities portfolio managed by Jordan Cvetanovski and Steven Glass who are two fantastic fund managers, and we'd been building up that strategy. We acquired the Hunter Hall business through a reverse takeover a couple of years ago and all the money that was managed by the Hunter Hall business is now managed by a Jordan, Steve and their team, and so that's the third leg of our business at the moment. Track record is fantastic there, and in particular how their team performs in a down market. And if you look at the last quarter of last year, the out performance was very valuable to investors in that strategy. So that's the third leg of our business and then the fourth leg of our business is what we're doing at the moment and that is putting together a strategy, for our investors to gain access to private equity.
Private equity is a fantastic asset class. If you look into the marketplace at the sophisticated end of the market, all the big institutions, sovereign wealth funds, pension funds globally et cetera, have a lot of allocation to private equity. Even in Australia, look at the future fund I think it's got 15 or 16% of their portfolio in private equity. It's generally viewed as a superior asset class, the returns are really high and actually the risks are quite low if you do it in the right format. Unfortunately, for individual investors in Australia they have not had this opportunity to invest in private equity in a way that's very easily usable in their portfolios. The key reason for this is private equity is inherently illiquid, and if you go into an individual property equity fund, you might be stuck in the 10 or 15 years.
And even though the returns are great, a lot of people don't have the stomach for such a long term investment. We looked at this problem and said how can we create a solution that's usable for investors? We actually, when we created the solution, we thought we were particularly smart that we had come up with a solution only afterwards we did we realise that the wheel was invented a long long time ago and it was by the property trust industry. So property trust industry realised that they've got a very illiquid underlying asset class. And how did they get it to investors in a usable format? They unitized it and listed it and so they didn't have to worry about holding lots of cash in the property in a portfolio to fund redemptions, investors who want to get at can just get out on market. And so we've done the exact same thing but with private equity, so-
MH: Different to an LSA though, whereby NTA can be over or under depending on the supply and demand? Is it why it's trading [crosstalk 00:21:28]
RP: Well it can be, it's an LIT so listed investment trust so no different to a listed property trust or listed infrastructure trust but the underlying asset is private equity rather than property or infrastructure and investors can get in and out at whatever price. Now we would hope because of the quality of the offering and what we can generate for investors both in terms of returns as well as, volatility and lack of correlation with listed equities. They will trade very strongly and we would obviously hope that it trades at a premium to its NTA but that's essentially the proposition. What we did is we did a joint venture with a group called Grosvenor Capital who are global leader in private equity investing.
What particularly attracted us, you need somebody who really understands the space and in particular you need somebody who has got connections with the best private equity firms. The key in private equity investing is to be able to invest with these top tier managers who don't need your money, so you can't access them as an individual investor You probably need to write a 10 or $20 million check-
MH: It's a fund to fund structure fund?
RP: It's a fund to fund structure and Grosvenor has access to these top ranked funds. And so we've done a JV with Grosvenor, Grosvenor will be selecting and investing in the funds as well as the fund to fund structure as well as co-invest and will be listed. This will be the first time that Australian individual investors and superannuation funds will have an opportunity to buy into private equity offering, a global private equity offering that is listed on the ASX.
MH: That's exciting and that that private equity space is fascinating, but to your point before, having capital locked up for five or seven years really doesn't suit a lot of investors, particularly where it's through superannuation.
RP: Yeah, absolutely. So it's quite interesting that a lot of investors will after the fact, be willing to hold onto their investments for 10 or 15 years as they should be because if you hold them for the long term, you probably get the most out of your investments. However, going into it they don't want to feel they tied up for that period of time, so we've given them that option.
MH: Yeah, I looked at one recently, which was 10 years and it actually makes sense because if you look at any successful business typically takes between 10 and 20 years for it to really get to maturity and be worth something but it's a long time for anyone to [convince 00:23:47].
RP: The other problem you've got with private equities, it's usually done on a draw down basis. So what happens is that you make your investment, but it's called, your capital is called over three or four or five years. It's then invested solidly for five years and then it's given back to you over the following five years. So whilst your internal rate of return or IRR might be really high on the investment, all the money's not invested for a long period of time. So you can see those high rates of return, but you're actually not seeing an impact in your portfolio because you're only partially invested through the period. With us you put it into private equity, it stays there as the private equity rolls off so it's reinvested in more private equity. So it's a perpetual vehicle and you should constantly be able to get that private equity return. And if you want to put in your portfolio at a five or six or 7% allocation, it can stay in your portfolio, you don't have to worry about the capital being returned to you.
MH: And given your investment banking background is probably inevitable that you're going to launch a product this. We might change direction just quickly if that's all right. Historically you were the chairman of Centric Wealth, so you've obviously had some good insights into what makes a successful high net worth practise and firm, what's your take on the Royal Commission and what the industry's going to look in the next couple of years or even five years?
RP: Yes. I think that's really... Vertical integration is a thing of the past, and I think it should be a thing of the past. I think the separation of advice from funds management is really an essential component of the industry going forward. Now interestingly enough, vertical integration was for some reason not targeted in the commission, but I think that even though the recommendations didn't come out and stop and put an end to vertical integration, I think the industry has become aware of it enough and it's had enough talk of it that it will actually be self governing and it will become a thing of the past. I think that's the biggest issue in the industry. The cleanup of the industry is inevitable and all the disclosures that came out in the marketplace were fantastic and I'd say a wake up call to the industry. But, if you look at the financial advisors in the market, 99.99% of financial advisors that I've come across are fantastic.
They do a great job for their clients, they are very highly valued by their clients and hopefully the impact of the Royal Commission does not negatively impact those good independent financial advisors who do such a great job for their clients. It would be a real pity if advice became more scarce in this marketplace. I think more investors need advice rather than less and so regulations should not impede that. I think that is a danger that that does happen.
MH: And there's certainly a view that it's going to become increasingly expensive to deliver advice and it's actually middle Australia that's not gonna be able to afford it. Whereas those at the higher end, high net worths will clearly be able to afford it and we might see the emergence of some [mobile 00:26:54] operators versus smaller balances. Have you put much thought into where you think that the businesses really should be focusing in the next couple of years?
RP: Yeah, I think there's a real risk here that advice becomes too expensive and just becomes unavailable, but also that advice becomes dumbed down because that's an easier way to deliver it. A great example of this would be, the focus becomes on... The focus is on costs and we find there's a bit of this tendency going on in the marketplace that if it's low cost, it must be good, or it must be acceptable for lower end clients. It is not the case and investors at all different wealth levels should be able to afford advice. Certainly if you look at the funds management models, investors get charged a fee based upon the size of the assets they invest.
So it doesn't matter whether you're rich or your poor, you should be able to get that funds management service at the same price. So there's no reason why an investor with lower balances should not be able to access high quality, or be at higher costs type investments. What I say to investors that are worried about costs, when you fly on an airline, do you fly on the cheapest airline or do you fly on an airline that's going to give you peace of mind because if the skies become cloudy and there's a storm do you want, is your safety paramount to you? And they should think about their investments in exactly the same way. You want to be with the fund manager who is going to be able to manage your investments through different environments, and not go for the cheap option which is going to inevitably be an inferior option.
MH: That's a great analogy. And do you think, the reason that Centric was very successful was that ability to really clearly explaining the value proposition to their investors?
RP: Yes. Centric had a very clear value proposition for investors and Centric focused on a specific segment of the market, which was a higher net worth top investor and they could afford to take the time to tailor their investments for their client base. And they were also an independent, I think they weren't allowed to use the word Independence because there's some illegal-
MH: Not aligned.
RP: Not aligned, but they genuinely were not aligned and had none of those conflicts that some of the other business models out there had and so they were particularly successful and they also had a fantastic set of advisors. And at the end of the day, the people who run financial services businesses and are dealing with clouds are so important. You need to have high quality individuals and the accounts will follow the individual advisors.
MH: Do you see the direct market in Australia growing in the next couple of years as a result of the cost increase, but also have more products your own being available broadly on the ASX.
RP: Yes, we do see that growing and we actually over the past few years we've seen a massive growth in that market. I think it's driven by several factors, one of them which I find quite intriguing is that there's a lot of investors out there who might be nearing retirement age or in retirement age, who actually want to manage their own portfolios and actually they built up some wealth and they've taken active interest and rather than just handing it over to financial advisors actually want to make decisions themselves. So we've seen that market working really nicely and it's also become easier to make direct investments. So whether you're going through unit trusts or going through platforms or going straight to the listed markets we've seen this explosion in products on the ASX and that's really just ease of use. Click a button and you've acquired your stock or sold your stock rather than having to fill out paperwork. And this all makes sense and I think that will just continue to grow and grow.
MH: And certainly the experience in the UK, post RDR is almost half of markets directing half to an advisor, with crossover at different times in their life, but hasn't quite worked out like that yet in Australia.
RP: Yeah. Because look, I think a financial advisors still provide a fantastic service and unless you are an investor who really understands how to put a good diversified portfolio together, you much better off going through a financial advisor.
MH: Excellent. Russell, I need to get to my next meeting, but it's been great chatting to you. Thank you so much for your time, you've had been very generous with your backstory as well, and, all the best with the capital rates.
RP: Thanks Matt. It's great to chat to you.