01 February 2010
2009 Q4 Investor Letter
As we move in to a new decade, many people have been saying good riddance to 2009 and the past decade. Well, 2009 was certainly not great, but it definitely turned out to be a lot better than most people feared and, for the West, the decade ended as a decade lost rather than being a disaster. The year-end headlines in private equity for 2009 were pretty grim reading with leverage levels, fund raising and deal volumes all hitting lows not seen for many years. However, economies started to stabilise and portfolio businesses generally performed better than feared. Indeed towards the latter part of the year, as capital markets recovered, re-capitalisations and even a few exits started to take place. Overall, it looked like it was going to be much worse in early 2009 when economic Armageddon was being widely predicted.
But, while 2009 outperformed expectations, I feel 2010 is likely to disappoint, because expectations are now too high. In the first few weeks of this year, this optimism has already been tested as numerous IPOs have been pulled for private equity sponsored portfolio companies. To the extent exits are taking place, they appear to be of the “pass the parcel” variety as one private equity fund sells a company to another private equity fund. Without any appreciable exits through IPOs or trade buyers, 2010 may fail to live up to investor expectations.
General Partners have entered 2010 with the hope that the fund raising environment will improve. Again, I fear this year will prove disappointing for private equity firms seeking to raise new funds. I expect investors will dig deeper into track records, and find it difficult to come away with clear conclusions. As a result, investors will have to rely more heavily on gaining meaningful insights into what added value the firm provides and will ask to spend even more time with the investment and operational professionals at all levels. This means that the fund raising process will be even longer than many are already expecting. However, at Terra Firma, we will remain focused, as I discuss in this letter, on continuing to build value in all our portfolio businesses and seeking new investment opportunities for TFCP III, and not on fundraising.
The broader markets in 2010 will also face the problem of unrealistic expectations. Markets are supposed to anticipate economic results, but I do not think this is currently the case. I believe the gains in the equity market of last year will most likely prove unsustainable. Economic growth remains fragile at best, despite the exceptionally loose monetary policy in nearly the entire Western world, and governments providing almost unheard of levels of fiscal stimulus. We all know that the level of government sector indebtedness is not maintainable in the long term and that means that this fiscal stimulus will have to be withdrawn at some point. Furthermore, the level of indebtedness of the private consumer in the West means that consumers are unlikely to be willing or able to fill the gap that will be created.
To use a medical analogy, the Western economy is on a life support machine and it has stabilised, but what we do not know is what will happen when the machine is turned off. I am afraid that there is more likely to be a “W” shaped recovery than a “V” shaped one. Moreover, there is the possibility of a “fish hook” recovery where the economy only partly recovers and does not quite return to the level where it started. I think that the equity markets have raced ahead as investors have desperately sought returns in this low interest rate environment. Consequently, I believe that markets will, at best, be volatile in the upcoming period, and could fall back significantly as sufficient economic growth and profits fail to materialise to the extent necessary to keep people’s expectations fulfilled.
I say “I think” and “I believe” because the one thing I do know is that making confident predictions in the current environment is more difficult than at any time over the last 30 years. We are witnessing the most extraordinary shift in economic power from the West to the East in a remarkably short time frame. The world is in a period of political, social and economic transition, and it is always challenging to predict the performance of anything: companies; industries; government policy; or countries that are going through transition.
As you know, Terra Firma has specialised in investing in industries and companies that are undergoing change or transition. Indeed, actually bringing such change to companies is fundamental to our investment thesis and is what we do. We know that transition periods are not easy. They are volatile times and it is difficult to execute transactions. However, investments made at such times can be extremely profitable. As a result, I am excited by the opportunities I see for Terra Firma and private equity in general, despite my expectation of a gloomy outlook for the West over the next few years.
In my opinion, it is not the job of GPs in private equity to attempt to market time. Frankly, if an investor believes they know which way markets are heading, there are far better, far cheaper and far more liquid ways of playing such beliefs than by investing in private equity. Of course, rising markets are very beneficial to private equity returns, as the industry’s performance between 2003 and 2007 demonstrates, but private equity should be an alternative investment that strives to be less, not more correlated with market performance. My view is that a private equity GP’s job is to buy businesses and then make them deliver more cash, more often and with more certainty. This is not easy, but if a GP successfully executes this strategy, and is willing, and able, to hold businesses through the ups and downs of the cycle, then it will make money for its LPs.
When leverage was widely available, it appeared relatively easy to deliver more cash, more frequently. Ever increasing levels of debt combined with declining interest rates enabled enhanced cash flows to be passed on to the equity holders through releveraging. Of course, this has had repercussions from a risk perspective, which I will return to later. But even leaving risk to one side, given the current availability of leverage, such a strategy for improving returns is simply not possible at the moment. In today’s world, increasing cash flows to equity will only come from improvement in the operations or corporate strategy of a business.
Terra Firma has long believed that delivering such operational improvement is absolutely key to the private equity value proposition. We have always had a strong operational team, and we continue to seek to expand our operational resources through additional senior hires. Our operating team is vital not only to delivering big picture strategic change, but also for pushing our companies hard. At the moment, the difference between achieving poor or good performance is attention to detail and the pursuit of every opportunity to add value, be it installing coffee shops in the foyers of Odeon cinemas or seeking new alternative land uses at Consolidated Pastoral Company. This attention to detail means that overall, despite the environment, the total EBITDA of the Terra Firma portfolio grew by approximately 2% in 2009. To put this in perspective, while it is still too early to have year end data for public companies, the EBITDA for the FTSE 250 companies for twelve months to Q3 actually declined by more than 10% and by almost 25% for the Dow Jones 600 (Europe) companies. Operational focus and control has made a huge difference to our portfolio’s performance in these challenging times.
There is no denying that an appropriate amount of leverage is useful in amplifying the increased cashflow that comes from operational change. Lending should increase in 2010, but I do not believe we will come any where close to the levels achieved during the boom. Banks, under the watchful eye of regulators, will rebuild their liquidity and look for a return on their cash, but will remain cautious. However, as I said above, to be successful in the long term, a private equity investor needs not only to deliver more cash, more often, but also with more certainty. The last two years have painfully shown us the dramatic effect that too much leverage can have on the certainty of cash flows in bumpy times. Given my views on the economy, and the capital markets, I think GPs should at this time be looking to reduce the level of leverage in their existing portfolio companies and be extremely careful about what leverage they use in new deals.
This is why, at Terra Firma, we will be bringing down the level of leverage in our portfolio companies over the next few years. If the economy is stable and markets continue to go up, then this approach to leverage combined with operational and strategic change will deliver good returns, but will not maximise them. However, it will reduce the risks to the portfolio if, as I fully expect, the Western world finds itself limping along for the next few years. In short, it will improve the risk-adjusted returns of our portfolio, and I firmly believe it is the right strategy in the current environment.
Terra Firma is well positioned, given our approach and resources, to capitalise on the current investment climate. Nonetheless, the key ingredient to all of this is that one must first find businesses in which one can improve operations or change strategy. There is an English saying which reportedly comes from a famous 18th century recipe for jugged hare, where the opening instruction is, not surprisingly and quite simply, “First, catch your hare”. The same sentiment applies to private equity. The sourcing of transactions in the current climate is as important as ever, but undoubtedly far more difficult.
For much of 2009, there was a general belief that private equity would benefit from the market dislocation by being able to pick up good companies at cheap prices. Indeed, this was one of the key attractions of CPC and EverPower, the two deals we completed last year. However, few transactions actually occurred at such low prices, and the increase in equity markets since last year means that sellers are unwilling to sell now at bargain basement prices.
While sourcing will be tough there will undoubtedly be interesting areas for private equity players who are willing to roll up their sleeves and become operationally involved. There are sectors that are fragmented and amenable to bolt-on acquisitions. There are businesses that require sizable capex or development capital and there are whole industries, which have companies that need good, old fashioned operational improvement. To find the types of opportunity that I am talking about, the ones that can really deliver value, GPs will have to identify trends and sectors that are attractive and not wait for their advisors to do so. They will need to understand the factors driving an industry and how these macro themes affect the underlying players in that industry. If GPs are not able to identify opportunities for value that others cannot see, then nearly all opportunities in the new environment will seem expensive.
This approach of identifying macro themes first and specific opportunities second has always been Terra Firma’s approach. This method is illustrated by our two most recent deals. We thoroughly explored the key drivers in meat production and wind power for a considerable period of time, turning down numerous potential opportunities before completing the CPC and EverPower deals.
In order to maximise our deal flow, Terra Firma has recently re-organised our investment teams into a larger number of smaller, more specialised teams in order to be best positioned to source and create interesting investment opportunities. Each smaller team has both geographic and sector specialisations which reflect the investment experience and language skills of its members. I should stress that we will still remain opportunistic about the areas that are of interest to Terra Firma and that this move is not designed to limit which sectors we pursue. However, this re-organisation will ensure that we have better and deeper coverage of the geographies or sectors we find interesting at any particular time. In addition, it is very empowering for the Financial Managing Directors and their teams to have direct accountability for sectors and geographies, and marks a further step in Terra Firma’s growth and development.
In conclusion, 2010 will not be an easy year for anyone in private equity, and I think it will definitely be tougher than most people expect. However, I am convinced that for those private equity firms which are appropriately structured and have individuals who add real value to their businesses and are ready to work hard, it will offer opportunities. Terra Firma is such a firm, and, as a firm, we look forward to working for you, repaying your trust in us and to what we will accomplish in the upcoming period.
With best wishes