01 August 2010
2010 Q2 Investor Letter
A colleague of mine used to respond to pretty much any question about the status of any subject by concluding that the answer was finely balanced with a potential to fall either way. As I look at the world today, I find myself having similar thoughts. Whether I consider the stability of global politics or the chances of economic growth in the West, I see fragile balances. The risk is that one of these areas might topple over, setting off a dangerous chain of events.
This backdrop, along with the overhang of equity to invest in the private equity industry, makes successful investing at this time very challenging. While it is still possible to make good private equity investments, potential risks are everywhere, and caution and care are vital. It is clear that engaging in fundamental operational change, a core competency at Terra Firma, is essential to building value in this environment. The last time the world experienced widespread economic concerns prior to mid-2007, private equity enjoyed easily accessible low risk/high return opportunities that generated extraordinary returns for the vintage 2002/3 period. I doubt, however, that this will be repeated in the current environment for the vintage years 2008/9.
Let me start with politics. One might argue that the world has always had political crises, will always have political crises, and that history shows that they only rarely develop into horrific events that drag in most of the world such as WWI or WWII. In the last 50 years, one can point to any number of events that might have led to wider conflict such as the Cuban missile crisis, the Vietnam War, the Suez crisis or numerous civil wars, disturbances or confrontations. However, the difference is that, until recently, there was a world political order that helped maintain balance in the world. Until the fall of the Berlin wall, there was the equilibrium of the cold war that created a bi-polar world led by the US and the USSR. Post the collapse of the Soviet Union, there was the uni-polar world led by the US. Now, the world is shifting, rapidly, from American hegemony to a multi-polar world without a truly dominant player or well-defined system of diffusing or containing conflict. The US’s domestic economic issues, combined with its overstretched military brought on by its operations in Iraq and Afghanistan, mean that its ability to diffuse crises and impose order is fading.
At the same time, China, India, Brazil and Iran are growing to be true regional powers. A multi-polar world is inherently less stable than a bi- or uni-polar world as there is not a well-defined political will or system to resolve issues. Unfortunately, one need only look at the United Nations to see this is the case. As I look around the world, I find an ever-expanding list of areas of concern. I will pick just three examples where I believe people are not fully aware of the wider risks that could develop if any one of these situations develops into a full flown crisis.
Top of the list would be North Korea, a failing state, which is far more dangerous than I think most people realise. Post the sinking of the South Korean naval ship, Cheonan, earlier this year, it has become clear that no-one, not the South Koreans, the Japanese, the Americans or even the Chinese is in a position to keep North Korea in check. While the chance of a full military conflict involving North Korea is still unlikely, I would say the odds are less than 1 in 10, not the 1 in 100 chance that many people seem to think. North Korea only has about 24 million people, but it borders South Korea with 50 million, and there are about 70 million people in China in the provinces on its northern border. Furthermore, at its closest point, Japan is only about 200 miles away with a population of over 125 million. Should the situation deteriorate, we could find a military conflict involving nearly 300 million people while, in contrast, if North Korea was to stabilise and recover it could provide a huge opportunity for South Korea.
Moving to the Americas, I would highlight Mexico’s drug war, where the Government has 45,000 troops engaged in fighting the cartels. This situation is steadily worsening. Since 2006, it is estimated that over 23,000 people have been killed. What began as a police operation has evolved into a war, which has huge political, social and economic ramifications. If the recent car bomb in July in the border town of Ciudad Juarez is the sign of things to come, then Mexico’s vital manufacturing base along the US border will suffer. Clearly, this area has already suffered from the economic difficulties in the US. Mexico could pose an extremely difficult challenge for the US if the drug war was to continue to escalate or spill over into the US along its nearly 2,000 mile long border with Mexico. Again, the converse is also true as a dynamic and economically growing peaceful Mexico could provide the US with great opportunity.
In Europe, I think the economic pressures will bring fresh political challenges to the EU and the countries aspiring to join it. The former countries of Yugoslavia are prime examples of this tension. All of these countries, except for Slovenia, which is already a member, aspire to join the EU. The potential for these countries to enter the EU has brought them a measure of stability and improved living standards over the past decade, and allowed us to forget too easily that this region was wracked with civil war in the 1990s. However, peace and stability in the region remain fragile as demonstrated by rising tensions surrounding Kosovo’s declaration of independence. If Serbia, Bosnia-Herzegovina and Montenegro find their path to EU membership blocked and their banking sectors in trouble, it could well increase the demands in the area on the European peacekeeping mission and the need for additional economic support from the EU. Germany and France are already debating the costs of subsidising the likes of Greece, Spain and Portugal. While the wealthier countries in the EU have not yet moved away from such support, domestic challenges might force their governments to do so. If this pressure caused the wealthier EU countries to shut off the possibility of their poorer neighbours joining their club, it could have real implications for peace in the Balkan region. Alternatively, a Europe that continues to expand peacefully, and has Turkey as a member, could be the most powerful economic group in the world.
These are just three examples where I think people are underestimating the volatility of possible results and paying too little attention because they are preoccupied with more visible issues in places like Iran, Pakistan and Afghanistan. Unfortunately, there seem to be many more reasons to be concerned about global stability than to be relaxed. Even in countries which should have bright futures over the next 10 years, such as Canada, China, India, Singapore, Australia, Brazil and the Gulf States, it is easy to see global political concerns impacting them. One used to be able to look at a country and feel that it should be successful for at least one and possibly two generations, but in today’s world that simply is not the case. In the multi-polar world, there is no well understood mechanism for controlling and dealing with problems, which means that even countries that have great economic advantages cannot be certain that they will not be dragged into the unintended consequences of some regional conflict that could become global. While these are not comforting or happy thoughts, I believe investors ignore such political risk at their peril.
I am afraid that I also see the Western economic world in a pretty precarious balance. It is true that double-dip recessions are reassuringly rare (in the US for instance only two have occurred in the last hundred years; the first in 1937 and the other in 1981). However, when I look at the current state of the major Western economies, this historical fact provides me with little comfort. The truth is that, given the size of the current downturn, we are in economically unchartered waters. In the US for instance, there has been, from the economic peak to trough, a 6% loss of jobs; a 20% greater fall than in any recession since WWII. The usual prescriptions for fiscal and monetary policy that were developed since the Great Depression are being severely tested. While we have seen a significant amount of stimuli, we have only experienced a tepid amount of economic growth in the West. We have also unleashed a heated debate about whether we are on the verge of a period of increasing inflation or deflation.
Another great debate that is going on is whether or not the US, European and UK stock markets are overvalued. Much of the discussion about the prospects for these markets centres on the forecast for economic growth in the West. However, over the last 30 years, the world has steadily become more global and large multinationals that dominate stock market indices have become far less dependent on their domestic economies. Most multinationals have made a concerted effort to increase their independence as much as possible from their domestic economies and governments. Their strategy of building value for their shareholders often involves moving business activities from one continent to another as economic, regulatory, tax and employment circumstances dictate. Thus, a German automobile company can have incredible success outsourcing employment from Germany to China. The company does well and its stock market price improves, but the German economy loses jobs. Similarly, a US international banking conglomerate can achieve the same success by moving US white collar jobs to India. Thus, the future prospects for the majority of leading multinationals will come from their ability to move their cost base from the West to the East. Hence, their very success could be one of the major causes of the decline of Western economies. In other words, rising Western stock markets are no longer an indication of the strength of Western economies, but simply reflect the strength of the leading companies listed on their exchanges.
Given these unprecedented circumstances, it is not surprising that so much is being written at the moment about the trade-off between austerity and stimulus. The Keynesians warn that tightening fiscal policy at this point in time will topple the Western economies back into recession. The anti-Keynesians warn that debt levels are at dangerous levels relative to GDP, especially in a time of peace, and that fiscal policy must be tightened. The Economist estimates that US government net debt will be two thirds of its 2010 GDP, and with an estimated 2010 budget deficit of nearly 9% of GDP, the situation will become worse. Britain is in a similar position with an estimated 54% 2010 sovereign debt to GDP ratio, but a 2010 predicted budget deficit of over 10%. The anti-Keynesians argue that unless debt levels are reduced soon, Western countries will find themselves in a debt trap where confidence in their ability to repay their debt will erode, debt costs will soar and a Greek-style downward spiral will ensue. This debate is being waged at all levels; be it between world leaders such as President Obama (Keynesian) and Chancellor Merkel (anti-Keynesian) or the well publicised economic exchange between economist Paul Krugman (Keynesian) and financial historian Niall Ferguson (anti-Keynesian).
My view is that the anti-Keynesians are right in the long term. However, I am afraid that tightening fiscal policy in the West may well upset the delicate balance that exists today and tip countries back into recession, but long term, there is no choice. It is simply impossible for economies to continue to amass debt at the current levels without facing dire consequences in the medium and long term and this has to be tackled sooner rather than later.
Ireland illustrates how painful such cuts can be. In the fourth quarter of 2008, Ireland knew that it needed to take action given its high level of indebtedness and government expenditure. Despite fiscal tightening of about 5% of GDP in 2009, it still ran a budget deficit of 14.3% of GDP. More public sector cuts in 2010 should reduce government spending by another 2.5% of GDP this year. As a result, the country is on track to have a budget shortfall of 11.5% of GDP this year and is making progress. However, the price of this austerity has been brutal with Ireland’s nominal GDP falling by over 16%.
Ireland is an extreme example. However, with confidence falling in the US and the UK, and a population that is highly indebted at a personal level, the consumer is unlikely to fill the space that will be created by the necessary tightening of government expenditure. The populations of many Western countries are therefore going to have to tighten their belts, and accept a lower standard of living if their economies are going to be put on a more sustainable, balanced long-term footing. This is not going to be easy, and I have to admit, I have been pleasantly surprised by how the UK Government is at least starting to grasp the nettle and getting potential support for its tough stance. It is not often I find myself quoting a Luxembourg prime minister, but Jean-Claude Juncker was quite right when he said of politicians 'We all know what to do, but we don’t know how to get re-elected once we have done it.'
Given all of the threats that I have outlined and the uncertainty in the world, one would expect that it should be a great time for private equity to buy businesses on the cheap. Indeed, back in 2009 much of the talk was whether investing in the next 24 months would be similar to the period in the 2002/3 vintages when companies could be acquired at attractive prices. The simple truth is that prices have recovered sharply from the 2009 lows and businesses are not cheap. According to the Centre for Management Buy-Out and Private Equity Research at Nottingham University, the average price paid for a European buyout, with an enterprise value of €500 million or above, in the first half of 2010 was more than 17.9x EBITDA – above the 2007 market peak – and these deals were done with debt levels of approximately one third to two thirds equity. Some argue that this is because earnings are depressed. However, as I have said many times, I think the chance of a 'V'-shaped economic recovery and a big upturn in corporate profits is highly unlikely. Thus, the multiples being paid are, indeed, high.
Competition for deals is intense and is fuelled by huge levels of uninvested capital which, in June, Preqin calculated stood at over $1 trillion with about $400 billion needing to be invested by the end of 2013. While some credit has returned to the markets, financial engineering cannot turn an expensive deal into a cheap one. These two factors – stock piles of dry powder and limited leverage – are not only driving prices, but are leading to the most extraordinary number of secondary deals. It is far easier for a GP to buy a deal from another GP than it is to execute a public to private transaction or negotiate with an industrial seller. In fact, on this score, the buyout world is beating the record it set in 2007. According to Dealogic, 47% of the value of all buyouts executed in Europe so far this year have been 'pass the parcel' deals, topping 2007’s figure of 39%.
Reducing the capital overhang is by no means easy. It is true that fund raising has slowed dramatically since its peak in 2007, but so too has the pace of investment. According to Preqin, buyout funds only raised $32 billion globally in the first two quarters of this year. However, Preqin’s figures also show that buyout deal volume over the same period was about $70 billion including both debt and equity. If one assumes a 33:66 debt to equity ratio, that means that only about $47 billion of the trillion dollars in dry powder was committed to deals. At this level of deal volume, in combination with investment period extensions, we can expect the private equity market to remain intensely competitive.
So where does that leave GPs right now if they want to invest successfully? Well, it means more than ever that they are going to have to be creative, and decidedly contrarian. Unless they want to pay through the nose, they are going to have to find opportunities by looking at businesses and assets differently from the crowd. They are going to have to figure out how to work closely with their portfolio businesses to grow them through operational and strategic change and not on the back of a rising financial tide. And they are going to have to be cautious and patient. There are no prizes at the moment for doing deals quickly as the market is simply not cheap.
Investing along these lines will deliver good returns, and just as importantly, uncorrelated results. I am sorry if this letter seems gloomy, but in investing, it is vital to be realistic. I believe the next few years are going to be tough for all asset classes. However, private equity investing based on improving businesses through strategic and operational change will offer the best safe harbour for investment. With patience, discipline and hard work a careful private equity investor can still produce excellent returns.