01 July 2008
2008 Q2 Investor Letter
The evidence continues to mount that the liquidity crunch that began last year will not be resolved anytime soon. There has been nothing but bad news in the financial markets so far this year. So, while the central banks and the capital markets have found solutions for immediate crises, such as Northern Rock and Bear Stearns, plus provided additional capital to a handful of major financial institutions, comprehensive solutions are not at hand. The global economy is starting to feel the strains of a world starved of liquidity and the start of a downturn in consumer and business demand.
For private equity, this environment poses a particular challenge as the current model for large, institutional private equity has not been tested by an extended period of adversity. Private equity has grown enormously since the time when, and this was only a few years ago, it acquired and managed small deals over five to seven year holding periods and thus was not very dependent on global liquidity conditions for its well-being. The unprecedented liquidity that has existed over the past seven years has fuelled ever larger funds and bigger transactions. During this time, global syndication and club deals lubricated private equity and the banking sector with ample fees and produced a seemingly virtuous cycle. Additionally, holding periods shortened and leverage levels grew, thus driving the kind of IRRs necessary to draw ever larger amounts of capital from LPs, which led to even bigger deals that were quickly recapitalised or sold to other private equity sponsors, thereby allowing GPs to raise even larger funds. Last year, at the peak, virtually no company in the FTSE 100 or S&P 500 was considered entirely immune from being taken private. While the typical private equity fund has a legal limitation of ten years with several possible extensions, many GPs and LPs had developed expectations that they would have their capital invested and returned within two to three years and see the fund in final liquidation within five to seven years.
Although we know that large-scale institutional private equity has worked well under conditions of ample liquidity and velocity, where GPs have traded with each other, we will now find out over the next few years how well it works when liquidity runs dry and holding periods lengthen. My belief is that private equity still will work, but will need to adapt to a more operational and strategic value creating model and rely less on financial engineering and trading skills.
In previous letters, I have focused on the role the credit crisis will play over the next two to three years in acquiring new portfolio companies (making it more difficult) and exiting existing companies (making it near impossible). In this letter, I want to focus on the question of how to provide capital to fund the expansion of portfolio companies. This is a critical subject for us, since our portfolio businesses are intending to execute business plans that are designed to deliver significant value to our investors over the long term, but need further capital to do so.
In 2007, Terra Firma took advantage of the ample liquidity and the financial engineering that was available to refinance virtually every one of our portfolio businesses and sell most of our legacy holdings. However, with capital market fundamentals deteriorating, we also put renewed emphasis on deals where changing the operational and strategic models of the businesses provides significant upside potential. While that model can reduce correlation to the credit cycle, the operations and capital expenditure plans of these businesses are still affected by reductions in liquidity. For instance, until the liquidity crunch, it was possible to use additional cheap subordinated or high-yield finance to fund capital expenditure or acquisition plans without the need for a full refinancing of the whole business. This type of financing has completely dried up.
The other alternative to arranging additional finance to expand a good private equity portfolio business is to sell it to another private equity firm. However, turnover within private equity (selling one private equity portfolio company to another private equity fund) is extremely costly even in healthy markets. The transaction costs, fees and employment bonuses generated by the sale of portfolio companies siphon off many basis points of return from long-term private equity investors’ returns (I estimate on average a reduction in IRRs of 6 per cent per annum). However, as long as the virtual circle persisted, investors were willing to participate even if they were not maximising their returns. Returns were good enough and the fees were hidden well enough for investors to continue fuelling private equity’s new institutional model.
Terra Firma believes though that the goal of private equity firms should be to hold and invest in their companies for as long as they can earn a return above their implied cost of capital. Long-term wealth is created through compounding returns inside our private equity businesses, not by trading assets amongst private equity fund managers.
There are compelling opportunities in our businesses to build wind farms, convert cinemas to digital or 3D, acquire aircraft and buy song publishing catalogues. However, as mentioned, bank financing has dried up or become prohibitively expensive and we do not believe that exiting our businesses and selling them to other private equity firms is in the interests of our investors. Furthermore, where bank financing is still available, we are being careful in calling on it. This is because we believe that conditions could deteriorate further and there is substantial risk that companies will be unable to rollover or refinance their debt facilities in the next few years if they push their borrowing levels to the limit.
The alternative is to consider putting additional equity into our businesses. Clearly, this is not an easy or automatic decision. We have had to re-examine the business plans for each of our portfolio companies to see if investments at the margin are still justified, given the higher cost of new equity compared with high yield debt. If a company’s investment plans do not add value for our investors, it is pointless to provide further equity. In most instances, however, whilst the capital markets have changed dramatically, the business case has remained the same or indeed improved.
Therefore, in looking to build our portfolio companies over the next few years, the appropriate course is often going to be to seek co-investment. Our LPs, of course, have come to expect us to present them with co-investment opportunities, but this time the co-investment will be slightly different.
Traditional co-investment has either allowed us to reduce the size of our position in a portfolio business in a fund at the time of purchase (our objective is a 10–15 per cent long-term holding) or helped to finance a major acquisition. The dramatic change in the capital markets and the outlook for the credit markets necessitates a different approach to co-investment. Rather than seeking to draw down all or substantially all of the co-investment capital at once, as with an acquisition, we expect that many of our opportunities will necessitate drawing down equity over time, more like a bank capex line. Thus, we will seek to raise a certain quantum of committed co-investment equity with the expectation that it will be drawn down over time to execute against the business plan of a portfolio company.
While the prospects for the capital markets and the economy are uncertain, we think there are still at least two certainties. First, we think there are ample opportunities to build our portfolio businesses and thereby add value for our investors even in a shaky economic environment. Second, we can expect to retain our businesses for a considerable period, with no exits expected until 2012. These certainties mean that we will be able to offer attractive co-investment opportunities which we will of course, share first with our existing investors.
As careful students of the capital markets, we continually evaluate our cost of capital and if we find that less expensive capital becomes available, we will seek it. However, we think that is most unlikely for some time. Thus, the sensible course at this point is to seek co-investment equity which will not only add value for existing investors, but will also provide attractive returns for co-investors. Please contact me if providing this type of co-investment equity interests you.
On a totally different subject, I am pleased that so many of you were able to attend our annual conference in London or join us during our recent roadshow. As I have said before, in today’s environment one of the most important things Terra Firma can do is be open and honest with our investors and I hope you found the conferences were just that – open and honest. Going forward, I hope you will take advantage of our quarterly conference calls which will start in September and will allow us to communicate yet more closely with you on a timely basis and ensure that we keep you fully apprised of developments at Terra Firma and our portfolio companies.
With best wishes
Guy Hands - CEO, Terra Firma