Chairman's letters

01 February 2008

2007 Q4 Investor Letter

Dear Partners,

There seems to be a daily sea of articles and analysis about the causes of the current “credit crunch”. Of course, at this stage, this “credit crunch” is really only the drying up of liquidity for certain types of deal. In my view, the banks are only dealing with a fraction of their true potential credit losses. The full scale of the problem will only become visible over the next 2-4 years, and, I believe, will be 4-5 times the size of the losses that the banks have taken to date. Sub-prime mortgages, complex structured products, all with an ever increasing number of acronyms (CDOs, SIVs, CLOs etc.), and overly aggressive buyout lending are all sharing the blame in different proportions. Over the next few years, these capital market products will be vilified and responsibility for the economic ills that are undoubtedly going to beset Western economies will be laid at their door. However, in my view, it is the incentive structures, both in the political and banking arenas, that are the major causes of today’s problems, and indeed it is here that one should look in order to prevent similar problems occurring again. I may well come back to how today’s media world leads politicians to try and pursue policies that provide immediate, rather than long-term, gratification another time, but in this letter, I want to focus on the incentives in the banking world.

Incentives clearly are important and, in any profession, people should only be paid exceptionally for delivering truly outstanding performance. In the financial world, this means providing a return on capital which is better than that of the market, but without a commensurate increase in risk. As you know, “alpha” is the term for this out-performance and “beta” refers to the return provided by the market.

In the few years up to the summer of 2007, investment banks and the financial “experts” employed by them, seemed to deliver alpha and the employees were paid handsomely for it. As the complex techniques which had delivered this supposed alpha became more and more common in the market, these techniques became less effective in delivering supposed out-performance. Thus ever more aggressive strategies were introduced with ever more complex innovations, all in the ongoing quest to find more “supposed” alpha.

Of course, we now understand the truth behind the returns of these years. They were not alpha at all because, while the returns were high, so was the risk. It just did not manifest itself over that time period. All the recent talk about exceptional occurrences and once in a lifetime circumstances are irrelevant. That is what risk looks like; if it were completely commonplace and happened all the time, it would not be risk!

The incentive structures in the banking sector did not just fail to take this creation of fake alpha into account, they positively encouraged such behaviour. The payout of annual bonuses to those that had apparently generated alpha meant that only the events which had occurred in that year were considered in determining those bonuses. The fact is that risk does not work in annual cycles. Employees were, and indeed still are, incentivised to push the envelope, be paid out and let somebody else worry about the consequences. The fact that the same incentivisation system also applies to those who are in senior management and should be overseeing and managing their employees to prevent this happening simply exacerbates the problem. The recent trauma in the financial markets cost some high profile people their jobs, but not before they had been paid handsomely, on an annual basis, for overseeing the operations during the years that created those problems. Amazingly, they were then paid even more handsomely and publicly to leave. Ideally, those earlier bonuses should either have been clawed back when losses materialised or not paid on an annual basis in the first place.

Under the current structure, when things go wrong, it is not those who have been paid well who are penalised, but the shareholders of the financial institutions and the public at large. In fact, given that governments are ultimately lenders of last resort, it is nearly always the tax-payer that picks up the tab. I am afraid that it will stay that way and the world will remain vulnerable to crashes of this recent nature until shareholders demand that compensation starts to be truly long-term.

Such a long-term compensation structure is not a theoretical idea that belongs in text books; the traditional private equity model of performance-related compensation addresses many of these points. A carry structure which only pays out after the GP has delivered a return superior to that of the market (the traditional hurdle rate), and delivered that return on the whole fund over a 10 year period, goes a long way to addressing many of the issues discussed above. In such a structure, short-term, illusionary alpha is not valuable to employees and so there is no incentive to create it.

The last private equity boom, during the period up to 2000, provides a good illustration of how this carry structure works. Funds formed at the end of this period often had one or two home run investments early in the fund lifecycle where the companies, if they so much as mentioned the internet, had gone public. Fund investors appeared to be sitting on large gains, albeit only paper ones. If the annual compensation model had been in place at those funds, huge payouts would have occurred on the basis of these paper profits. However, as it turned out, the crash (risk) took place, illusionary alpha was shown for what it was, and many of those early gains evaporated and so did potential early carry payments. Funds returned to their more traditional investment strategies, instead of trying to re-label old businesses with “.com” and ride the market.

I am not saying that the carry system is perfect, but it is better than many others. A structure that aligns interests to help create value in businesses over the long-term has got to be a good thing; although by changing tax rules so that long-term capital gains are taxed more like annual income, governments around the world are actually encouraging businesses to be less long-term in their approach. It is also regrettable that over recent years some private equity practitioners seem to have been working to lessen the importance of carry in the compensation structure and replace it with more fee-type revenue. They are keen to do this because fees are more reliable than carry and, through the public markets and other means, it is now possible to monetise tomorrow’s fees today. However, this reduces the alignment of interest between the GP and the LP which, in my view, has been so vital to private equity’s success. I have commented before that I believe removing this alignment of interest will only worsen private equity’s performance, and I still passionately believe that to be the case. One of the justifications for the move towards fee-based income has been to help attract or retain talent who would otherwise go to investment banks or hedge funds for the annual bonus compensation. Given recent events, and the level of job security at those institutions, I would hope that pressure is now somewhat abating.

At Terra Firma, I have always strived to ensure that my team realises that managing money is a huge responsibility and that our investment performance directly impacts people’s day to day lives through their retirement plans or insurance policies. We should only be paid for producing true alpha for those people, and full fund, back-ended carry, plus the personal investment of team members, is the best way to ensure that people are incentivised to do that. Our employees will suffer first hand should the investments that Terra Firma makes not deliver true alpha. TFCP II, which was launched over five years ago, has not yet paid out any carry and it will not, until the likes of EMI and its other investments have been nurtured to higher levels of performance and then exited. This will likely be several years down the line. Whilst not perfect, private equity compensation structures that are calculated over a long-term period are far superior to the annual bonus culture. The future stability of the financial markets would be enhanced if other parts of the financial community followed suit.

Best wishes

Guy Hands – CEO, Terra Firma

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