Chairman's letters

01 May 2007

2007 Q1 Investor Letter

Dear Limited Partners,

Private equity is now firmly in the big leagues. In 2006 alone, it:

• made up 25% of the world’s M&A activity;

• was the sponsor to 50% of IPOs;

• issued 40% of all high yield debt;

• accounted for 50% of leveraged loans; and

• raised over $400 billion.

These figures demonstrate the critical role private equity now plays in today’s financial markets and shows the kind of firepower that is at its disposal. With the huge amount of capital raised in recent years, combined with highly favourable debt markets, private equity can approach pretty much any target it likes. Furthermore, with the power of equity bridges which are readily available, these numbers actually underestimate private equity’s true potential size.

So, private equity is now able to bid for the largest and best known companies in the world. Here in the UK, Sainsbury’s and Boots, two FTSE-100 groups with brands that are dear to consumers’ hearts have both been approached. While the Sainsbury bid has fallen away, Alliance Boots now looks certain to become the largest private equity deal in European history, if sadly not at the hands of Terra Firma, as I believe that it is 
a business with terrific potential for successful operational and strategic change for which we had developed a compelling business plan.

Acres of forestry must have been chopped down in order to print all that has been written about the Alliance Boots saga. The truth is that its eventual acquirer, KKR, is paying a fair price for the business, and will find substantial value in the company. As strong as our conviction is about the potential in the group, with KKR having acquired over 25% of the Alliance Boots’ shares and therefore being able to block the type of UK takeover offer that requires 75% shareholder approval, we felt it would have been imprudent to continue.

The fact that there is value in the largest companies is entirely logical, and should not be a surprise. Just because a business is big does not mean it is well-run. In fact, I have long believed that larger companies are often the worse run, and are therefore where private equity can make the largest contribution. The larger the business, the more complex the operations and the more likely that they will benefit from change but, and it is a crucial “but”, the more likely that ownership is spread amongst a multitude of shareholders with differing agendas, the more likely that the status quo will prevail. For the good of employees, customers, investors, and the market in general, private equity should be approaching, and buying, these types of businesses.

However, we should be under no illusion; when you go from doing small deals to doing deals that touch the entire public, you go from a one-way relationship, with you just owning the company, to a two-way relationship, with the company owning you as well. The private equity world is discovering this, and fast.

I think this is no bad thing. Private equity has much to be proud of with its strong record in creating jobs, restructuring companies and helping businesses to grow. However, we all need to do a much better job of actually illustrating the benefits of private equity to the wider world, and we all need to become more open. While this is starting to happen, it will not be an easy journey. A private equity firm can undertake challenging restructurings quickly, and, unlike a public company, it is easy for the media to pick on a new owner to blame for the pain a restructuring causes. We should not forget that an emotive argument about people losing their jobs is more appealing to newspapers than the more long-term rationale for a business restructuring or indeed that strong investment performance benefits the wider public through the performance of their pension funds. It is an argument in which, at last, the private equity universe is starting to become actively engaged, and it is important that it does so since the recent negative comments about the industry have occurred while the economy and private equity has been performing well – if we do not engage fully now, imagine what might happen when the tide turns and performance falls.

In fact, that is where my concern with private equity becoming so large really lies. It is not that it will anger the public by what it does to the large, well-known companies that it buys, but that it will disappoint the public through a lowering of the performance that it delivers to the insurance companies, pension funds and other institutions who invest in it on behalf of them. I worry that private equity will simply buy large companies in order to put money to work and will not engage in the new difficult strategies and corporate change programmes which deliver real value. At one extreme, private equity could become a leveraged play on the market cycle with returns becoming increasingly lower and more correlated to the public market. If this occurs, then who will need private equity? Similar returns could be delivered by a computer generated derivative, which would be vastly cheaper for investors.

Of course, investing is always affected by market cycles, and the larger private equity becomes, the more difficult it will be for it to remain an “alternative” asset class that is not highly market correlated. However, relative to the public markets, private equity has huge potential for further expansion because while private equity has grown, public markets have exploded. TXU, the largest deal on record, was only 0.39% of the S&P 500 when it was announced, and, to put that in perspective, RJR Nabisco was 1.26% of the S&P 500 when it occurred in 1989. In other words, there are still plenty of large deals out there for private equity to do.

The overall returns in private equity are hugely driven by the top quartile performers. If they do what the best practitioners have always done beyond financial engineering, namely add value by tackling companies that could do better, then despite all the money raised, I believe private equity will continue to outperform. Furthermore, I think it will be able to deal with the increased attention and focus from different groups in society that are part and parcel of being a significant section of the economy. However, if, the best and the biggest take the easy way out, and start to invest more and more money for the sake of it, their performance will become more and more cyclical, and they will cease to be “alternative” investors. In that case, we had all better watch out. Private equity players will then need to start to worry not about trade unions and politicians, but computer derivative programmes, which are not criticising them, but out-performing them.

Best wishes

Guy Hands – CEO, Terra Firma.

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