Chairman's letters

01 November 2008

2008 Q3 Investor Letter

Dear Partners,

Eighteen months ago, private equity was very much in the news. The focus and the attention that private equity was receiving were relentless. The heads of some of the largest funds appeared in front of Parliamentary committees in the UK and Senate committees in the US. Newspapers described how these secretive organisations were lining their pockets at the expense of the rest of society. In the UK, Sir David Walker was charged with reviewing the disclosure levels of private equity and encouraging greater transparency. A debate raged about how these barbarians could be, if not kept from the gate, then at least brought under control.

Inevitably, the markets turned out to be far more effective at controlling the ambitions of some private equity firms than any governmental or regulatory committee could be. So, as the world struggles through the most challenging economic crisis in over 70 years, private equity has moved out of the glare of the spotlight and been replaced by stories of bank failures, government bailouts and system-wide collapse. This state of affairs seems to have encouraged some in private equity to try and act as if the events of 18 months ago can now be ignored, adopting an attitude of ‘out of mind, out of sight’.

This is short-sighted. If we want to build a sustainable private equity industry that delivers value for our limited partners, then it is more important than ever to be open and transparent. In this oncoming recession, when the world will be looking for scapegoats, private equity needs to illustrate to society at large that it has a role to play in rekindling growth and optimism in our economies. If private equity does what I have always believed it is supposed to do, and focuses on deals where it can deliver fundamental change to businesses and improve their operations, then it will be easy to demonstrate the value it can add. If not, people will continue to think that we are merely a shadowy leveraged play on the public markets, and we will offer little of real value to our investors.

Such openness is also vital to private equity’s future success for another reason: debt. An excess of debt may well have caused the current problems, but a complete dearth of debt will hit our returns no matter how operational and strategic our deals are. As an industry, we need to be realistic. Governments are bailing out the banks and my earlier estimates of this costing $3.5 trillion – dismissed at the time as being absurdly pessimistic – will now prove too low. But as shareholders, governments are unlikely to compel the banks to prioritise lending to private equity groups. Governments will want scarce capital to be used by banks to make loans to home owners, small businesses and major public corporations, not faceless, secretive private equity firms.

Without the support of all of our stakeholders, our business cannot succeed. It is for these reasons that Terra Firma has been a firm supporter of the Walker Guidelines and why our Annual Review went beyond the required levels of disclosure. Indeed, we prepared full annual reviews for all of our portfolio businesses, whether or not they were required by the Walker Guidelines. Such interaction and communication is vital even if, at times, the messages are less than palatable. The most recent review we published was for Maltby Capital, the vehicle which holds Terra Firma’s investment in EMI. Explaining in frank, open terms, the difficulties, failings and challenges of EMI to the public at large was neither easy nor pleasurable, but it was necessary. The subsequent comments that we have received from LPs, the press and other parts of the community have proven that this is so, and have served to re-enforce to us that our transparent approach is the right one.

In preparing this quarter’s Investor Report, we made another decision with regards to being open and upfront. Given the huge volatility and mark downs that have been prevalent in the listed markets, we decided to treat 30 September as if it were a year end, and engaged in a full bottom-up review of the valuations of Terra Firma’s portfolios and have had those processes audited by KPMG. Some may say that this was unnecessary, that the only important valuation of a portfolio company in private equity is the one attained when it is ultimately sold. However, we do not believe this is the view of our LPs. Once again, you will see that this step has not been an easy one.

As you all know, private equity valuations have two major components, the operating performance of the portfolio company itself (somewhat within a GP’s control) and the application of some multiple or discount rate from listed comparable companies or recent transactions (completely outside a GP’s control) to value that operating performance. On the first, I am pleased that the performance of Terra Firma’s portfolio companies has continued to be strong with most hitting budget and showing substantial year-on-year improvement. However, on the second, obviously the valuations of assets and businesses across all sectors have plummeted and, for private equity, this decline is magnified by the higher levels of leverage. As a result, some of Terra Firma’s portfolio companies, such as EMI, have been marked down significantly. While we are all working hard to ensure that the final performances of these investments are positive ones, we must be open and realistic about where things stand today and the fact that we cannot predict where valuations will be in the future.

An inaccurate, non-transparent and over-optimistic approach to valuations was one of the primary causes of the current economic chaos. It made the huge growth in CDOs, CLOs and other such alphabet derivatives possible. Investors’ blind reliance on complex financial models, agency ratings which contained, but did not allow for, systemic risk, plus optimistic assumptions about returns, future risks and a continuing positive economic cycle created the justification for ever higher multiples and even greater leverage ratios. Models are great tools, but a craftsman cannot rely merely on his tools, he must use skill and take responsibility for his work. When it comes to valuations, this necessitates an honest appraisal of the new reality.

Private equity, if it is to prosper going forward, must seek to appeal to all stakeholders and offer economic advantages over the public ownership model. I believe private equity will change and it will prosper. In fact, compared to some, I am a relative optimist. Yes, I believe private equity fundraising will decline by 50% compared to recent years. Yes, I believe that average returns for 2006/2007 will be negative, and yes, I believe the number of people employed in private equity will fall, with those remaining earning substantially less than they have over the last few years. However, while I believe we are going into a period of painful readjustment, I do not believe that we are going into a 1930s’ style depression from which it will take 25 years to recover.

Of course, this period will not be easy either for GPs or LPs. As far as GPs are concerned, those private equity firms that stay in denial, remain closed and simply follow the same old private equity model will most likely not survive. However, those firms which are open and transparent, which adapt their approach to the new and challenging world that we face will not only survive the current period, but will help build a sustainable private equity industry for the future which will deliver great benefits not just to its investors, but to the community at large.

With best wishes

Guy Hands – CEO, Terra Firma

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