Chairman's letters

01 August 2007

2007 Q2 Investor Letter

Dear Partners,

As Europe closes down for its annual summer holiday after what has been a very turbulent time in the market, it is appropriate to reflect on the four key objectives Terra Firma set itself for 2007, especially as this turbulence is likely to remain with us for some time. The objectives were as follows:

1. Complete the fund raising of TFCP III;

2. Make some key hires, especially on the operational side;

3. Take advantage of the strong conditions in financial markets to sell the remaining companies 
in TFCP I and to either sell or re-finance the existing portfolio of TFCP II; and

4. Start investing TFCP III, taking advantage of the debt markets to make sure deals were attractively financed.

It was clear last Christmas, as indeed it had been for some time, that the extraordinary availability of cheap and easy debt would not continue forever. At Terra Firma’s 2006 conference, I said I could not be sure when it would go, whether we had six months, twelve months or two years, but I was sure that it would not be longer than that. In reality, we ended up with thirteen months. However, as we expected the debt markets to dry up at some time, we wasted no time and we have already managed to achieve perhaps 85% of the objectives we set for the year. I want to use this letter to run through the 2007 goals, talk about the new environment and discuss what that means for us going forward.

Dealing with the first objective, as you know, we successfully closed TFCP III in May of this year at nearly €5.2 billion or €5.4 billion when you include the team’s contribution of €215 million. This was a huge success and has given us the firepower to tackle the largest deals, where competition is less ferocious and where there are some great opportunities for exceptional returns.

On the second goal, we have made a number of key hires in the last six months. We are now over 100 people strong, with more than 70 professionals. Three examples illustrate the calibre of our recent joiners at the Managing Director level. Chris Roling joined us as Managing Director Portfolio Businesses, working alongside Fraser Duncan, after many years at ICI, Pepsi Co and Kellogg’s. Ashley Unwin will be joining us later this summer as Managing Director for Talent, having previously been the Senior Partner of the People and Change Practice at Deloitte. Ashley will have a key role to play in recruiting new management as we re-organise and restructure portfolio companies. Lastly, I am delighted to announce that Peter Cornell, the former Global Managing Partner of the law firm Clifford Chance, will be joining us as Managing Director for Stakeholder Relationships, helping us as we deal increasingly with regulators and governments and also playing a role with our banks and investors.

We have achieved most of what we wanted on the third point as well. We sold the remainder of the portfolio of TFCP I, so that Annington Homes is now the only business that is managed solely for Nomura. The profitable sale of the remaining businesses has been good news both for Nomura and for Terra Firma, and it enables the group to focus fully on TFCP III, TFCP II and TFDA.

On TFCP II, the strong environment enabled us to refinance the Odeon and UCI cinema deal, returning 36% of the initial investment. We also refinanced and sold part of Tank & Rast so that this deal has already returned 5.2x cash invested and the fund still owns approximately 50% of the company. All of the portfolio companies of TFCP II are now securely financed as a result of these re-financings.

Thus we come to the last objective, the investing of TFCP III. Here we have already had two successes, but the change in the environment means that investing over the rest of the year is going to be much more challenging. The first deal in TFCP III has been completed with an investment into AWAS which financed the acquisition of Pegasus and thus created the third largest global aircraft leasing business. The re-financing of this business is also underway and, while it is taking longer and may include flex terms, it will get done on highly beneficial terms. The second deal will be EMI which fortunately also had its financing secured before the current liquidity crunch. We have a firm underwriting from Citigroup and are working in close partnership with them to get their underwriting syndicated down in whatever period of time makes most sense. Clearly in today’s circumstances, good partners like Citigroup are important. Just as the environment is going to sort out the strong private equity firms from the weak, it will bring a similar definition to the banking arena. However, the other deals that we have been working on for the last 6 to 12 months have all been affected one way or another by the current squeeze in the credit markets and are going to prove very challenging to get financed.

Let me give you an example of how dramatically credit terms have changed this summer. Six weeks ago, we were looking at one deal where the blended cost of the debt package was 300 bp over EURIBOR; today it’s 600 bp over. At a 4:1 leverage ratio, this extra cost of debt means the price of acquiring the company would need to go down by around 30% in order to achieve the same return on equity. In another deal, the price of the most junior tranche of debt, the sub mezzanine, has gone from being 450 bp over to 1,500 bp over EURIBOR! Of course, it is not just the price of debt that has changed; it is the quantum and the covenants as well. Until recently, you could find debt packages for deals in certain sectors at up to 14x EBITDA, but in those same sectors today, you would be lucky to find 10x. Covenants for the first six months of the year were all but non existent, but that is changing fast as we return to a more normal world where banks price both risk and their ability to control a company if things go wrong.

As I have stated for the last eighteen months, there was no doubt that the financing environment of recent times had to change. My belief had always been that the cheap credit market would end not because of a credit event in the LBO market, but because the banks would wake up one day with too much LBO paper and nowhere to go with it. This, I felt, would not lead to a meltdown, but to a substantial slowing in buyout activity. The question going forward is am I right and the consequences will simply be a slow down, or could it be better and simply be a blip, or could it be worse and result in a meltdown?

I do not believe that this is a blip. A number of the best known banks have significant, unsyndicated loans on their books which have been made to buyout groups on terms that are far out of the market. I have seen estimates that such loans could total $250 billion, and if they are marked to market, the banks would probably be sitting on a $30 billion loss. While this is significant it is a manageable exposure and, if the banks do not panic and try and force the loans to market, the overhang should work itself out over the next few quarters without any meltdown. The economies of the world are generally healthy and listed market valuations do not look too stretched, except on certain stocks where there is either a buyout premium or where the companies themselves are directly affected by the financial markets. These stocks will inevitably decline 15-30% from their peaks of earlier this year.

However, while I do not believe there will be a meltdown, one scenario in which it could occur is if the banks do decide to push these loans onto the market. The debt markets will then undoubtedly decline further and this could well affect the broader market. It is clear that most of the debt that has been arranged recently has been syndicated out to hedge funds, which have borrowed from the same banks in order to be able to buy the paper. Panic in the hedge fund market would lead to significant redemptions which would in turn lead to more selling and more decline. We have already seen a bit of this phenomena, but so far it has been fairly well contained. However, if the banks force the issue more, hedge funds will start to go under and the banks will get their loans back from the hedge funds, which will put more of the very same paper on their books. A desperate circle would ensue.

My belief is that the banks will not panic and we will therefore just have a major slow down, although we have seen a few brief signs of panic in the past few weeks. In the end, people will keep their heads, and although there will be no major financial crisis, there will also not be much going on in the LBO market in the next 12 to 24 months compared to the last 12 months. Banks have become much more reluctant lenders, and it will take time for vendors to reduce their price expectations.

So what does such an environment mean for the buyout groups? Well, it means the days of simply buying a good company, financing it well and enjoying a great return are over. The debt simply will not be there in the right quantum or terms. Returns are going to come from fundamentally improving the performance of companies, and that is exactly what Terra Firma seeks to do.

Terra Firma is therefore going to be following two approaches in these more difficult times. The first is what I call the “puzzle strategy”. No longer will we put deals together in a few weeks; they will take months and possibly years. We will have to work even harder than before to put each piece of the puzzle in place. No more calling all the banks into a room and telling them that they have 10 days to come up with a package. Those days are long gone.

The second is the “equity strategy”. We are going to focus on deals that require large amounts of equity as a percentage of the capital structure and focus on delivering value from operational and strategic change. Fortunately, the size and scale of our team will allow us not only to deliver the operational improvement needed for the second strategy, but also to secure what financing is available in order to be able to execute on the first.

To sum up, Terra Firma had a great first six months and we have managed to achieve approximately 85% of our objectives. However the final 15% (successfully investing a sizeable proportion of TFCPIII) is going to take a lot of effort and we might well not be able to make much further progress in the next six months. We will, however, continue to focus on those deals that are already in our pipeline. Our experience has always been that deals that take many years to come to fruition, such as Tank & Rast (which we looked at for five years before acquiring it), are often the best. We might get lucky in the next few months and put a capital structure together which meets vendors’ expectations, but it is not going to be easy and we are 
not relying on luck.

As usual, I would greatly appreciate your opinions and any feedback you have on this letter and in particular on our tactics for the investment environment going forward.

Best wishes

Guy Hands – CEO, Terra Firma

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