01 February 2009
2008 Q4 Investor Letter
We all know that 2008 was probably the most challenging investment year of our professional lives. The dramatic global decline in stock market values has destroyed more than five years of growth in the value of listed investments. Indeed, UK valuations are effectively back to 1997 levels without allowing for inflation. After adjusting for inflation, values have basically retreated to 1993 levels. Valuations of private equity portfolio companies, given the high levels of leverage utilised by the industry in recent years, should logically fall even further. While I would like to believe that value added by private equity firms is the reason why such mark downs are not occurring, I am afraid the realist in me ascribes it more to a great reluctance by many private equity participants to be realistic and open about their portfolio companies.
At Terra Firma, our portfolio businesses have continued to perform well from an operational point of view, with nearly all having achieved higher year-on-year EBITDA results. In fact, a number of them have met the very tough budgets we set for 2008. EMI, for example, reported an increase in group EBITDA of 202% for the first six months of its fiscal year. I would like to thank the management teams of all our portfolio businesses and the operational teams at Terra Firma for the outstanding job they did in 2008. Furthermore, the Terra Firma businesses are well-financed and do not face any large re-financings in the near term. However, currency translation and continued contraction in market valuation multiples mean that the mark-to-market valuations of nearly all businesses in Terra Firma’s portfolio have declined since September, and some have declined significantly.
As I said last quarter, while fair market accounting in this environment is very painful, it is the best estimate we have. The valuations this quarter are an honest reflection of where things stood at the end of 2008. Only mark-to-market values allow an investor to compare an investment to the alternative of holding cash. We continue to believe that the ultimate performance of the portfolio businesses will be much stronger than where we stand today. However, if one needs to raise cash now, as unfortunately some private equity investors do, those future valuations are not relevant.
These markets also have a direct effect on the earnings within Terra Firma. Terra Firma has always sought to be as fully aligned with our LPs as possible. Having carry payments made to the Terra Firma team only at the back-end of a fund is an important part of this alignment. A demonstration of this alignment is the fact that escrowed carry payments on TFCP II will be distributed back to LPs in March. As you know, Terra Firma and the team have over €400 million committed to the various Terra Firma funds – the commitment to TFCP III having been increased by over €100 million shortly before closing in order to maintain Terra Firma’s position as a major investor as the fund size increased. Thus, all in Terra Firma have a strong incentive to drive the investment performance of all our funds to achieve their ultimate success.
The future is something everyone, particularly those in the investment arena, is worrying about a great deal these days, and with good reason. Western economies are already in recession and face a real risk that these recessions turn into depressions. Meanwhile, the global banking industry is still in a critical condition, despite a series of government bailouts, guarantees, capital injections and outright takeovers. There are serious questions about investing in any asset class at this point in time. Nevertheless, investing continues albeit at a substantially reduced pace.
Unfortunately, the asset allocation models that enslave much of the investment industry are essentially backward looking. Given the current economic data and the recent performance of the capital markets, they suggest that now is the time to move to safety and to invest in government bonds. Indeed, many of the larger US funds appear to be doing exactly that – reducing allocations to equities – especially private equity, in favour of fixed income investments. These are the same models that guided these funds into mortgage-backed securities, high yield bonds, commodities and emerging market equities when the risks in those securities were at record levels.
Now, I am not suggesting that we have reached the bottom of the market, but it does seem bizarre to me to avoid entire asset classes, such as equity, simply because the class has fallen in value. This is especially true of private equity where it takes time to invest the capital. If you look at the history of investing, you will find that in very difficult periods, the most money is typically made by those who are contrarian and buck the trend.
So being a contrarian myself, I would argue that there will be no better time to put money in private equity than once the current overhang in the market has been invested. At that point, we will have entered into an environment which will offer values that have not been seen for years. The fact that there will probably be less money going into private equity is exactly the reason why one would want to invest in it! Investors will, however, have to exercise great courage as they will have to make commitments to private equity before there is incontrovertible evidence that the crisis has passed.
Here at Terra Firma, I would describe us as cautiously optimistic about the prospects for investing in the upcoming period. As you know, we ceased new investments from mid-2007 as we started to see the problems unfold and as our expectations of the future were far gloomier than those of our peers. We took a very conservative position and, as a result, we have significant capital in both TFCP III and TFDA to invest.
The deals that we are currently seeing are classic Terra Firma opportunities. They are backed by assets, cater to basic needs and require the kind of operational expertise that is a core strength of Terra Firma. Almost no business is recession proof, but we believe that businesses which display these characteristics are at the lower end of the risk spectrum. Asset backing is particularly important as we believe that, despite the economic downturn, the significant increase in global money supply will ultimately produce global inflation. Asset-backed deals should perform well in such an environment.
These opportunities also have another common theme; a distressed seller and prices that reflect the immediate liquidity needs of either the vendor or the business itself. Yet there is nothing fundamentally wrong with the company or its assets. Some of these hard assets could trade at as low as 50 per cent of recent valuations and a substantial discount to replacement cost. As a result, we are looking at investments that require a large amount of equity relative to debt, companies that need to restructure their balance sheets and smaller companies that can be used as platforms to acquire similar assets from other sellers facing difficulty. If this sounds like hard work, it is because it is hard work. It represents a fundamental return to traditional private equity principles. These transactions will not be easy to negotiate or to close. In addition, they will require significant resources and expertise in completing the due diligence, the re-structuring of the balance sheet and in making the operational improvement. However, Terra Firma has the professionals and the experience to deliver on such opportunities. While the current environment means that we must persevere to maintain and recover value in the existing portfolio, I am optimistic that it also means the transactions that Terra Firma undertakes in 2009 and 2010 will be capable of delivering a risk-adjusted return the likes of which we have not seen in a very long time.
We believe that this will mean that both TFCP II and TFCP III will end up having highly positive outcomes relative to other investment alternatives.
With best wishes
Guy Hands – CEO, Terra Firma