01 May 2008
2008 Q1 Investor Letter
Most of you know that I have been gloomy about the economic environment for some time. At Terra Firma’s annual conference in 2006, I gave a speech with the main theme “There may be trouble ahead,” in which I pointed out that most in private equity were ignoring the signs of an economic downturn and that we were living in the “Woodstock summer” for private equity. Last summer, as that downturn started to bite, I said that there was a 40 per cent chance that capital market conditions would become as bad as they were in 1989 and that the banks would take losses of at least $500 billion. I also said that there was a 10 per cent chance that the situation would become as grave as the UK banking crisis of 1973. Many commentators took me to task for my pessimistic views, but, as it turns out, I was being optimistic.
So, what do investors do if they believe the global economy will deteriorate in the short term? I spent the formative years of my career as a trader at Goldman Sachs, and, back then, the answer was simple: you went short. If you are a hedge fund, the answer is still simple: you go short. However, this relatively straightforward option is not available to a private equity general partner, who must always be long. So what does a long-term private equity investor do in a worsening economic environment? There are three main options, and only one makes sense to me.
The first option is simply not to invest. As my wife frequently points out to me, some of my best decisions have been to do nothing at all. The carried-interest structure of private equity, and, in Terra Firma’s case the €200 million plus that the team has committed to TFCP III, mean that both limited and general partners’ interests are fully aligned in seeking to make only investments that will perform over the long term. However, not investing for a sustained period of time is not really an option because limited partners have made an asset allocation decision to invest in private equity. So, while limited partners expect general partners to use caution when investing, they also expect them, and indeed are paying them, to invest during the fund’s investment period. This is, after all, why they committed to the fund in the first place. Consequently if a private equity firm really believes that there are unlikely to be good opportunities in the investment period, it should simply hand back the capital to its LPs. However, few, if any, private equity firms (other than some VC firms after the dot-com bubble) have ever done such a thing.
The second option is to switch investment strategy. With the change in return expectations in Europe and the US for large deals, some private equity groups that previously focused on large buyouts have suddenly become distressed debt investors, while other firms with little or no experience beyond their local markets are “looking to Asia,” where the economic climate seems rosier. Successful private equity investing attracts people who are creative and innovative, and investment strategies do, of course, have to evolve. However, some of the recent "evolutions" look like knee-jerk reactions to the market rather than well-thought out strategic moves and what is more, this approach means using the capital entrusted to one strategy, to pursue another. If a firm wants to undertake new investment strategies, it should hand back the committed, but undrawn, capital to LPs, and ask for their re-commitment. The firm one chooses to back to do mega-deals may well not be the firm one chooses to back in, for example, the mid-market. The LPs should have the opportunity to decide.
There is a third option, and this is the one that is central to our philosophy at Terra Firma: to invest in areas which are less likely to be affected by a downturn. We have always believed that by focusing on asset-backed businesses which need operational, strategic and management change, we can capture significant upside, while partially protecting ourselves against any downside from a worsening economic climate. Whilst following this strategy early in a bear market may still lead to investors suffering mark to market losses in the short term, most private equity investors are more concerned about creating value over the whole economic cycle, than they are with achieving performance in any particular part of that cycle. To further long-term value creation, private equity compensation structures generally encourage the pursuit of longer-term rather than short-term returns.
However, as I wrote in the last Quarterly Report, I do have major concerns over what happens to investment strategy when general partners’ and investors’ compensation become less aligned. The long-term alignment of interest between investor and employee is of the utmost importance not only for private equity, but also for the banking industry and the stability of world financial markets - and is a subject in its own right which I can only touch on here. I think, however, that it is worth noting here that we see alignment with our limited partners as just as vital as our overall investment philosophy of sticking to our knitting.
I would now like to update you on the Terra Firma portfolio and how it is performing against the backdrop of a more testing market environment.
The investments that are solely in TFCP II are quite mature and have already delivered more than 100 per cent of the fund’s commitments back to LPs. Deals such as WRG, East Surrey Holdings and Tank & Rast have returned substantial value and most of the remaining underlying businesses have a reasonably low level of correlation to the economy. In fact, performance at the cinema business, Odeon/UCI, may improve in a downturn, as our analysis leads us to believe that more people go to the cinema in a recession because it is a relatively inexpensive form of entertainment. Protecting the value which has already been created is the primary concern for Terra Firma on these investments. So, in times like these, we firstly work hard to ensure that our investments are not pushed backwards and secondly look for longer-term opportunities to create value. Dealing with operational challenges, such as the effect of higher oil prices on reducing customer volumes at Tank & Rast, is crucial, but I am happy to report that this business is still outperforming expectations. However, in today’s financial markets, achieving operational performance is not enough; one must be constantly on top of the financing needs of the businesses as well. So, Terra Firma is scrutinising such requirements closely, and I am pleased to report that none of these businesses has a short-term financing requirement.
The investments which are in both TFCP II and TFCP III, namely AWAS and EMI, were made at a different point in the cycle to those just in TFCP II. We are still in the process of building value in these businesses and are having to work doubly hard to achieve this at what is the most sensitive point of the “J curve”. AWAS is clearly correlated to the world economy, however, its strategy is designed to enable it to succeed in an economic downturn. As the third-largest plane leasing business in the world, AWAS will find that weaker economies mean a softer leasing market. But a weaker dollar and softer asset prices will help it execute its longer-term strategic plan to purchase more assets. From a debt perspective, aircraft is one of the few areas where substantial debt financing is still available and the company has limited re-financing requirements in the next 12 months.
EMI is certainly not highly correlated to the economy. The issues and challenges facing the recorded new music side of the company are not due to the economic cycle, but to more fundamental shifts in consumer behaviour that are affecting the whole music industry. We are addressing these challenges, and working to develop a robust business model for the future. Meanwhile, and importantly, our investment has strong downside protection in the publishing and catalogue assets of the business, where revenues are on an upward trend.
Of course, the current banking environment is far from ideal for doing a major turnaround, but I am pleased to say that despite the challenges, substantial progress is being made in new music. As you will probably have seen in the press, we have made key hires, such as Douglas Merrill from Google, as head of Digital and Nick Gatfield from Universal as head of A&R, and the restructuring is well under way with a reduction in annual run-rate costs of £100 million set to be achieved by June. From a financing perspective, unfortunately, the crisis has been so deep that the debt package has had to remain on the balance sheet of the bank which provided it. Clearly, this is a time when all banks are under tremendous pressure, but this is not ideal for EMI. In all leveraged buyouts, your bank is your partner, and we have worked hard, and continue to work hard, to see if there are ways to help Citigroup syndicate or sell down this loan.
Overall, therefore, it is good to see how uncorrelated the Terra Firma investments are to the economic cycle. However, this downturn in the economic cycle will have some effect on performance. TFCP II is fully invested and has the benefit of having done its early deals at a more favourable time in the cycle, but its later deals will simply need more “heavy lifting” to deliver value. TFCP III will be the reverse: its early deals have been done in more testing times, but, with approximately 50 per cent of the fund yet to be invested, its later deals should be completed at a more favourable time in the cycle and at more advantageous prices. TFDA seems to be enjoying the best of both worlds: the initial investment into DAIG was made at an attractive valuation and, having slowed down acquisitions over the last two years, TFDA still has capital to make acquisitions at more attractive levels.
These times are not going to be easy for any private equity practitioner. But while the Terra Firma portfolio may be purely long, I believe it will weather the current conditions to deliver long-term value. However, we will have to work harder than ever and focus even more on our strategy and our businesses to create and maintain that value. Such value creation - rather than looking for new ways to earn fees – will be the focus of Terra Firma. Finally, today’s bear market will produce tomorrow’s opportunities and I believe that when they come, they will be some of the best for a long time and that Terra Firma will be well positioned to seize them.
Guy Hands – CEO, Terra Firma