01 May 2009
2009 Q1 Investor Letter
While the debate continues as to the state of the general economic environment around the world and as to what and who caused the market turmoil, I believe it is imperative that the private equity industry returns to focussing on our businesses of investing and managing capital. We need to move on from talking about how difficult everything has become and whether it was ‘aggressive bankers’, ‘complacent politicians’ or ‘negligent regulators’ who are responsible for the current situation.
Here at Terra Firma, as I said in my last letter, there is a lot to do. This environment will produce many new interesting opportunities and the existing portfolio businesses require substantial focus to ensure their operational performance remains strong. I believe it is inevitable that the Dollar, Euro and Sterling economies will retract, relative to the rest of the world, and that these economies will also suffer from the inevitable inflationary impact of printing money. The West has no natural right to be the economic powerhouse of the world, and, consequently, the West needs to be realistic about the competition it faces from the rest of the world if it is to retain capital and expertise. However, I also think that, around the world, private equity will be well positioned to operate in this environment if it focuses on its core skills and concentrates on where it can add the most value.
If private equity is to justify its existence as an asset class in the future, private equity will need to find investments and build platforms which benefit from the structural problems facing the Western economies and capitalise on the growth in the East. For example, a successful private equity group should be able to acquire businesses that will benefit from higher rates of inflation. Moreover, in such an environment entry valuations should be attractive and each acquisition should be able to provide strong cash on cash returns. However, funds will be required to add operational and strategic value as there will be fewer opportunities to ‘flip’ deals or manufacture IRRs. While none of this will be easy, if private equity successfully builds value in its portfolios, then the investments made over the next two years may be the best for a generation and will create long term sustainable value for all stakeholders.
Earlier this month, I spoke at the US SuperReturn Conference where I was asked how private equity should respond to the current environment. I suggested that LPs should look at three criteria to ensure that the GPs in which they invest will add value and make investments along the lines that I have just described:
Alignment of interest – In good times and even more importantly in tough times, the importance of alignment of interest cannot be overstated. It is at the core of the private equity model. GPs should lose money every time they lose money for their LPs. If GPs suffer with their LPs they will learn from their mistakes. As unpleasant as it is, the current difficulties and the pain people are feeling is a valuable learning experience.
Long term investment horizon – Financial engineering and market timing (essentially selling into a hot market) are not sustainable long term strategies for making money in the capital markets. This is true whether you invest in stocks, bonds or in private equity. None of us can predict the economic cycle or the hot markets several years out. If we could, there would be much easier ways to make money than private equity! We at Terra Firma believe that investments should be held for as long as returns are above the implied long term cost of capital. We have never pinned our hopes on market appreciation, excess leverage or spotting the latest bubble. If that is all private equity were about then it would be little better than speculating on leveraged stocks and one’s future wealth would be entirely dependent on luck in the capital markets.
Operational and strategic capability – This is the reason why Terra Firma has a large operational team, even though we only seek to close two deals a year at most. We do not buy companies and just hope that existing management and consultants can sort them out. We must be in control and drive the plan. This sort of investing requires us to have our own operational resources so as to narrow the level of uncertainty in a deal as much as possible. Successful private equity investing requires both having a strong plan and having the people to execute that plan.
At Terra Firma, we know we are going to have to work even harder to deliver value to our investors in these markets. Deals will have to be pieced together slowly, using significantly less leverage than in the past. These acquisitions will require more fundamental operational and strategic change. We have the resources to do this, but such resources will only be effective if they are focused.
Therefore, as you know, I recently decided that Terra Firma had grown to such a size that I could no longer oversee its day to day management as well as concentrate on both our current and our potential investments. We have grown to a business with a portfolio that operates in over 60 countries; has approximately 200 investors; and €11bn under management. I know that I will add the most value if I am focused on finding and executing deals rather than administrating. For this reason, I have become Chairman and Chief Investment Officer, with Tim Pryce becoming Chief Executive Officer. Tim has been our General Counsel since the start of Terra Firma and a close colleague of mine for nine years. I am now full time in the trenches focussing on investments, and I am very excited about it!
Many of you already know Tim, and he is obviously keen to meet all of our partners. As CEO, he will be responsible for regulatory oversight, an area that has grown significantly in recent years, financial management, people management and the general infrastructure of the business. These areas are of vital importance for any business, and they need the full time attention of a CEO. I have no doubt that Tim will excel in his new role.
Terra Firma’s investment decisions will continue to be made by the GP in Guernsey where I will be permanently based. My being based there, along with the other members of the GP, will allow us to focus exclusively on where Terra Firma invests its LPs‘ capital and on maximising the value from the portfolio with less distractions.
In sum, I continue to believe that the West faces a bleak economic outlook in the medium term. Nevertheless, I remain convinced that there are great opportunities for Terra Firma and that the next few years could be one of the best times to commit capital to private equity. We at Terra Firma are used to getting our hands dirty and this is what is going to be needed more than ever. We are focussing intensively on our current businesses, which as you can see from this report are still performing well operationally, and we will continue to seek out those opportunities where our engaged, interventionist approach will genuinely bring about improvements in the businesses we buy.
Thank you for your continued support, and I look forward to seeing many of you at one of our forthcoming investor conferences around the world.
With best wishes