01 November 2007
2007 Q3 Investor Letter
As we are all well aware, the environment that private equity faces has changed dramatically in the last few months. Some weeks ago, I attended a conference for senior LPs and GPs and what I found amazing was how incredibly positive the GPs were on the prospects for private equity over the next few years. However, in my view, it is going to take some time for the debt markets to return to any kind of normality and for there to be the normal positive spread between risk-adjusted equity yields and debt. Hence, while I don’t want to be a doom-sayer, I felt I should share with you some of the issues facing the world markets that I shared with the conference attendees and which are keeping me up at night, in contrast to the sound sleep of my other GP colleagues.
First, there is the obvious one, the credit crunch. Many people seem to be viewing this as some kind of “blip” which will pass quickly. I simply do not believe this will be the case. My last July guestimate was that something like $3 trillion of liquidity would be taken out of the global financial system over the following 18 months as the banks face something like $300 billion of losses. Mark to market accounting will take its toll, many more people will get fired, and some, most likely in the US, will go to jail for “fiddling” the books. These losses may largely be in the sub-prime market in the US, but will extend over time to other areas such as LBOs and CLOs. Not only is much less debt going to be available, but the price of it will be much higher, and while the investment banks digest the loans that are already on their balance sheets, lending to large buyout investors will continue to be difficult for them.
Second, there is the very real question of how much this financial crisis will spill into the broader economies of the world and, in particular, to the US and UK. Dieter Helm discusses this in his subsequent article, but my view is that these economies have been driven by the consumer, who is now up against a brick wall, over-leveraged and with no room for manoeuvre. The ensuing reduction in consumer expenditure will mean recessions are inevitable, but will probably be delayed until after the US elections by the lowering of interest rates.
Third, there is the fact that the world political climate is increasingly unhelpful. Localisation, not globalisation, is becoming the driver as people worry about issues closer to home which will need funding. Business taxes are likely to go up to fund these problems and these taxes will not just be on GPs, but on LPs and portfolio companies themselves.
On the global front, the world is becoming increasingly unstable, with fundamentalism continuing to rise. The division between the “haves” and the “have nots” is becoming larger which is further fuelling political tensions. On top of all this, the world is still failing to reckon with global warming and the unpredictable effects and consequences that this will have on all areas of life.
With all of these concerns, one would expect the world stock markets to be down, and down heavily, but this simply has not been the case. With a movement away from alternatives, and with interest rates being relatively low, investors are unsure where to put their money. The listed equity markets have therefore been seen by many as a long-term safe harbour. Indeed, by mid-October, the listed equity markets had basically returned to their pre-credit crunch peaks.
From a private equity perspective, this means that sellers’ price expectations have remained high, as those areas of the world that are still awash with liquidity continue to make purchases. This might help protect exit valuations, but, with the availability of finance having decreased, doing large buyout deals in the first half of 2008 will be far more difficult than in the first half of 2007. This is already evidenced by the decline in the value of transactions that have been completed since June. Furthermore, on the exit front, those countries with liquidity, such as Russia, China and the Middle East, are all subject to the political uncertainty I mention above. I believe all of this will lead to either a sharply lower equity market within the next year or alternatively, and I think more likely, a stagnant equity market for some time with consumer brand-based businesses tending to underperform and asset-rich businesses overperforming the general market.
Now, I could be wrong, and, while I think all of the above concerns are very real, I don’t believe they will all occur – or certainly not at the same time with the same force. However, I am a believer that the things that are most dangerous are those risks that one is not thinking about. Or, as someone once put it, it’s not what you know that you don’t know that gets you into trouble, it’s what you don’t know you don’t know that does!
So, in such a challenging environment, what should an LP look for from private equity general partners? I think that there are basically four types of GP:
• Transformers – GPs who have been in the business for years and have the proven ability and size to adjust to different environments or find attractive new opportunities;
• Focusers – GPs who have stayed focused on one particular strategy, developing both expertise and a reputation in that area;
• Traditionalists – GPs who do not have the resources or the desire to adjust to new environments and who are not particularly focused; and
• Newbies – GPs who are new and have yet to be proven (typically founded during favourable markets).
In the pre-summer 2007 era, all of these groups should have made money as leverage was plentiful, there was a positive spread between debt and equity and prices continued to rise. However, in the new environment, the “Transformers” and “Focusers” are where, I believe, one wants to be. These are the groups that perform in difficult markets, although I do believe there is a danger that, once a group is of such a size as to be a “Transformer”, it can start to lose its alignment with its investors. Such groups can start to think more about fee income than capital gain and can also plan on going public – which has its own challenges.
So, how does Terra Firma fit into these GP categories? The origins of Terra Firma go back to 1990 when I established the Global Asset Structuring Group (“GAS”) at Goldman Sachs in response to the 1989–1994 market correction. In 1994, I moved to Nomura and established the Principal Finance Group to focus on the same types of businesses as GAS, but as a principal investor. In 2002, we spun out to form Terra Firma. We have been centred on the same type of business for 17 years and are definitely a “focuser” and a “focuser” that was born out of recession when “necessity became the mother of invention”.
As you know, Terra Firma invests in large buyouts of businesses that most other private equity firms tend to avoid: companies in unfashionable sectors that are supported by assets; complex businesses with structural and regulatory issues; and businesses that are in need of change – operational, strategic and managerial.
In fact, we are not actually in the business of management buy-outs, but of Terra Firma buy-ins – using the approximately 100 people we have with financial, operational and strategic experience to effect change. Basically, Terra Firma invests in high added-value transactions focusing on assets, and it is a strategy that has done well and will continue to do well in the new environment. It will not be without its challenges as finding debt financing for deals will not be easy over the next year at least. However, by staying very close to our relationship banks and being realistic with regard to terms, timing and quantity, Terra Firma should be able to continue to obtain financing for the deals we want to do.
Our latest acquisition, that of EMI, is a great example of a quintessentially Terra Firma deal. EMI draws on Terra Firma’s full experience in strategically transforming businesses, repositioning assets, driving operational change, and growing and stabilising cash flows in an industry that is out of favour. It has all the attributes of a Terra Firma transaction:
• Asset-rich business – Publishing and Recorded Music catalogues;
• Industry in transformation – Impact of market change on consumer and artist behavior;
• Potential for consolidation – Acquisition of assets from other market participants;
• Potential for greater efficiency – Ability to use technology to reduce the cost base; and
• Opportunity for strong financing – An attractive initial financing package that took advantage of the pricing and terms that were available at the time and which provides the flexibility needed for Terra Firma’s planned changes.
Terra Firma plans to add value in many ways, including:
• Bringing focus – Making the people in the business understand what it is they are supposed to be doing, that is, that they are there to serve the customer and the artist and not to try and be or act like artists themselves;
• Driving operational change – Forcing the business to simplify its operations, reduce costs and start making decisions based on sound financial judgements; • Repositioning Recorded Music – Helping Recorded Music tackle the B2B and consumer digital opportunity/challenge;
• Exploiting assets – Moving the prioritisation of the exploitation of the catalogue from the bottom of the pile to the top; and
• Intervening – Changing the culture and displaying leadership where previously there was little and, what little there was, was confused.
These changes will not be easy and will require both extensive effort and resources. We are driving these value-added changes by putting approximately 45 people, both from Terra Firma and outside our firm, into the business. This total includes three seconded MDs, and I have taken on the role of non-executive Chairman. There is no doubt that EMI is a tremendous challenge, but it is also a huge opportunity and our success or failure will not be correlated to the markets, but to our ability to effect change, quickly and decisively. It is this type of deal that Terra Firma focuses on and from which it makes money.
But, EMI is a done deal, so going forward, what type of deal should Terra Firma do? You won’t be surprised to hear me say, more of the same. Our contrarian interventionist strategy focuses on assets that need transformation in how they are managed and is well suited to making money in more challenging environments such as that which we now face. As I mentioned in my last letter, we intend to focus on puzzle deals, where bringing all the pieces together takes time, and on deals which need significant amounts of equity. There is also a third strategy and those are “fallen-over” deals or deals that were over-leveraged in the recent heady environment and are in need of capital restructuring as well as strategic change which I believe will come into their own in about 18 months.
In sum, the private equity market has entered a new and far more challenging phase after the recent era of excessive leverage, but there are still money-making opportunities available; it is just that they will be more difficult to find and finance. GPs who have the experience to either adapt – the “Transformers” – or who have a disciplined strategy that works in such an era – the “Focusers” – will deliver the best returns.
Terra Firma intends to focus on the same type of deals that we have always done. Having been formed in recession, we are not frightened or dismayed about the times ahead and feel that we are well-positioned to take advantage of the opportunities that will be presented in this changed environment. It will not be easy, but I believe it will be profitable for all of us.
Guy Hands – CEO, Terra Firma