Chairman's letters

01 February 2007

2006 Q4 Investor Letter

Dear Limited Partner,

As a youngster, I was fascinated by those who excelled in their field and each Christmas received a Guinness Book of Records. However, it was never a wholly satisfying read. The records, facts and statistics were good for holiday trivia, but I never learnt the answers to the really interesting questions – what drove these people to achieve their record and how did they achieve it?

The big stories of 2006 in private equity have all involved records; fundraising, deal size, liquidity and record fees. Again, good for holiday trivia, but once more I have some anxiety as to the questions – why and how the market has grown so rapidly and can it continue?

At Terra Firma in 2006, the major focus was to capitalise on the performance of the portfolio businesses and use the strength of the markets to realise value. The sales of Sutton and East Surrey Water, East Surrey Pipelines/BGCL and the WRG landfill business, combined with the refinancing of Tank & Rast delivered €1,090m to our investors and returned 56% of the Fund. We have also retained the upside potential from earnings growth by holding rather than selling Infinis, Phoenix Natural Gas and Tank & Rast.

We have been considered in our approach to acquisitions; we continued to build out Odeon/UCI in Europe with the acquisition of cinemas in Spain, Portugal and Italy and we made one major acquisition, AWAS. This was a company with an untenable business model in a cyclical sector which had suffered badly since 9/11. Later you will read how well AWAS is performing as the market recovers and as new management implements a new operational model. We bought AWAS because the market was being overly conservative on aircraft leasing and we believed that this would change as the cyclical demand for aircraft outstrips supply. In most transactions this year, however, we have found that the market has been more bullish than us and we have seen even risky assets trade for record prices.

We appreciate enormously the great support shown by our limited partners. TFCP III is now approaching a final close which will provide Terra Firma with the necessary capital to acquire large, complex businesses in a period when the investment climate will be less benign and we are well aware that making high returns will be more difficult than in the last four years. We have also benefited from co-investment in AWAS and through co-investment commitments for our bids for Compass SSP and for Thames Water. Although we acquired neither, we will continue to arrange pre-bid syndicates with our LPs given the scale of many of our target companies.

Deutsche Annington is a typically large and growing business that we have built through ongoing acquisitions since 2000. This year, the sell down of 50% of TFCP I’s interest and the commitment of €1,050m of capital by our partners provided a partial exit for TFCP I, acquisition capital for the company and an opportunity for our investors to participate in Germany’s largest and strongest residential real estate business. It continues to perform well and we will offer a further opportunity to invest in early 2007.

Last week, I interviewed a candidate for an analyst role and as he had met the team, I sought his perspective on Terra Firma. He first complemented our track record, but then explained how it was our team that, for him, was different to others. “I could join a typical wood-panelled, West End-based Oxbridge and Ivy League private equity firm or I could join Terra Firma; and I have chosen Terra Firma, if you will have me”. This gave me cause to stop and think. To succeed we must be open to new ideas, encourage different views and be adaptable as financial markets and business sectors change. Diversity of background, culture, profession, nationality, training and opinion feeds the creativity we seek in order to create value. It may not get us in the Guinness Book of Records, but 18 nationalities and 27 languages certainly helps in an international business such as ours.

We have continued to grow the Terra Firma team organically and strengthen the portfolio company management. Frank Pray has joined as CEO of AWAS, having successfully grown CIT Aviation Finance. Lord Birt, formerly Director General of the BBC and strategy advisor to the Prime Minister has guided WRG through to exit as Chairman and is a member of Terra Incognita, our political and economic advisory body. Dr Phil Nolan, former CEO of Eircom, was appointed Chairman of Infinis, and, together with CEO Alan Lovell, is driving the growth of the company as the UK’s leading renewable energy business.

Within Terra Firma, we continue to add skills and experience selectively. We are in the process of growing the team to prepare for the prospects of a less benign and more demanding climate in the next 2 to 3 years. In our Quarterly Report, I have addressed the concerns that may change the investment climate and may even preserve 2006 as the year of records. I believe we are very well placed to flourish in a more demanding market and look forward to a successful 2007 and beyond.

Yours,

Guy Hands

CEO

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