01 December 2008
2008 Annual Review Letter
I am delighted to present the second Annual Review of Terra Firma and its portfolio businesses.
In the time since our last Annual Review, the financial world has changed beyond recognition. Governments now own, or effectively control, many of the biggest financial institutions on the planet. Some financial groups are breaking apart, others are merging, and a few have simply ceased to exist. The dramatic worldwide decline in stock market values has destroyed more than five years of growth in the value of listed investments. Nominal stock market valuations in the UK are effectively back to those last seen in 1997, while real share values have retreated to 1993 levels. Most Western countries are now in recession, and the key question is whether this will develop into a global depression.
Over the last four years, I have expressed great concern about the state of Western economies, how leveraged they were, and about our financial systems. However, I did not foresee either the speed with which recent events would unfold or how systemic and deep the collapse would be.
During the last 10 years, unfortunately, virtually all governments, banks, consumers, commentators, economists and investors in the West adopted the same thesis justifying a belief in perpetual economic growth. There was a widespread conviction that the economic cycle had been tamed and that diversification and syndication could somehow eliminate the risk of economic bust. Meanwhile, if the West did need money, the new emerging economies of Asia and the oil rich economies of the Middle East would provide a bottomless pit which would bail the West out.
Much has been, and undoubtedly will be, written about the driving forces behind the resulting extraordinary bubble, the subsequent implosion in the financial sector, and its effect on the real economy. One of the key questions is: what were the causes behind the unprecedented levels of leverage that were allowed to build up? For Western economies, the period from 2002 through to 2008 saw many developed nations abandon sustainable fiscal rectitude for uninhibited, short-term prosperity. In the UK, regulators and shareholders acquiesced while six major banks increased their aggregate reliance on wholesale, unsecured funding from £38bn in 2003 to £498bn in 2008 in order to finance increasingly speculative lending.
In retrospect, it is almost beyond belief that sophisticated, developed nations put themselves in a position where they were so dependent on foreign funding. The easing of monetary policy clearly played a major role in encouraging banks, individuals and companies to borrow as debt became cheaper than ever before. However there were, I believe, two equally important contributory factors: first, a lack of transparency; and second, inappropriate incentive schemes at many financial institutions. Leverage is particularly dangerous when it is masked in opaque structures, and many people simply did not know how dependent the Western banking systems had become upon short term foreign funding. This danger was further compounded as many key market players had powerful incentives to keep the illusion of perpetual motion going. Across the G-7, senior bank executives, economists, regulators and politicians not only loudly claimed credit for the “new economic paradigm” but also benefited substantially from it. In reality, the “Great Moderation” was merely a very large bubble waiting to burst.
Eighteen months ago, in order to be more like public companies, private equity in the United Kingdom was enjoined to become more open and to explain to stakeholders at large its activities and why it was beneficial to the overall economy. This initiative was entirely appropriate given that private equity firms purchase and control businesses that affect the lives of a wide range of stakeholders. Terra Firma and other private equity groups continue to work hard to improve on this front, and I hope you find this Annual Review informative. However, it is now clear that the same task should have been given to a much wider group of companies in the financial world - including those with public filing requirements. The truth is that banks and their activities, which most thought were of little interest to those outside the financial community, have been shown to be of critical importance to all.
At the very least, the board of directors and auditors of public companies should have ensured that appropriate disclosure was provided to stakeholders. The boards of private equity-owned businesses are typically made up of people who have relevant sector expertise and therefore understand the business they are overseeing. The same cannot be said of some public companies - particularly banks - where the members of the boards uniformly have impeccable reputations and world class connections, but often lack the expertise to oversee complex financial operations. Furthermore, going forward, we must surely increase the overall degree and clarity of information that public audited accounts provide.
I also believe we have to return to a banking system where there is a division between commercial lending banks, which take deposits and are effectively back-stopped by the Government, and investment banks, which take a variety of significant risks in pursuit of fees and quick gains. The Glass-Steagall Act was a sensible reaction to the 1930s depression, and it is a tragedy that the hubris of bankers, regulators and politicians resulted in its repeal. It needs to be reinstated globally as soon as possible, and backed by real regulatory teeth. Commercial banks must get back to what they are meant to do, while those investment banks who are entrepreneurial and inventive should continue to operate but without a taxpayer-backed safety-net. We cannot afford a financial system where heads the investment bankers win and tails everybody loses.
Turning to compensation, better, longer-term structures, such as those that are found in private equity, would also have helped to prevent recent events. The short-term bonus culture of most financial groups meant that many senior executives were incentivised to ignore or avoid longer-term risks, whilst enjoying extraordinary short-term gains. Simple share schemes are just as dangerous as yearly cash bonuses and have, perhaps, even greater dangers as they push management teams to grow their business, year on year, regardless of the risks. In this race for wealth, again, all too many parties became complicit. Over the past several decades, government budgets – and in the US, political campaigns – have been major beneficiaries of the short-term bonus culture. As income tax revenues soared, politicians were able to fund pet projects without concern for the longer-term fiscal consequences. Now rueing their unsustainable largesse, they have become finance’s harshest critics.
As I have argued publicly for several years, to be effective, incentive structures must be long term in nature, and by long term I mean at least 5-10 years. Moreover, I am a strong proponent of clear, simple, fully-understood tax and regulatory rules that encourage such forms of remuneration. In my opinion, there is no better way to nurture a good, sustainable entrepreneurial environment for business. Unfortunately, this is not what has been happening in certain Western countries, in particular the UK, where the ever increasing complexity and level of tax has resulted in non-economic actions and inefficiencies.
All of the employees of Terra Firma know that their rewards depend on the longer-term performance that our portfolio businesses deliver to our investors. The operational performance of our portfolio has been strong, but the investment climate has been harsh on the valuations of our businesses. As a result, Terra Firma will in March distribute back to investors the carried interest (payments for strong investment performance) that had previously been earned (accrued in escrow, but not paid) and which would have formed the bulk of the reward for Terra Firma’s senior team’s hard work since 2004. This is absolutely right; our investors have suffered and therefore our rewards should suffer at the same time. Such longer-term rewards throughout the entire financial system would have led to a very different world to the one we find ourselves in today.
In the current climate, private equity groups must focus more than ever on ensuring their businesses are operationally robust in order to generate returns for their investors. This emphasis on operations will mean that private equity will continue to help the economy and will be one of the forces that help us recover from the current troubles. At Terra Firma, we have always considered this one of our key strengths, and, as you review the performance of our portfolio companies, I hope you will agree that they have, to date, weathered the financial storm, and are being managed to deliver lasting value to our investors and our key stakeholders. We are exceedingly fortunate in having approximately 50% of Terra Firma III still to invest and investing over the next two years will, I believe, provide some quite incredible opportunities for success and enable Terra Firma III to return a substantial profit to our investors.
Finally, as someone who believes that there is virtually nothing new in human behaviour the following quote by Abraham Lincoln seems rather poignant.
“As an individual who undertakes to live by borrowing soon finds his original means devoured by interest, and, next, no one left to borrow from, so must it be with a government."
Guy Hands - CEO, Terra Firma