01 November 2010
2010 Q3 Investor Letter
My recent letters have set out my concerns about the global economy, and suggested that all investors, particularly illiquid investors, should proceed with great caution. I am afraid that the last three months have done little to change that view. Most countries in the Western world are displaying, at best, anaemic economic growth with little hope of change in the near future. Furthermore, the frustration of such tough economic conditions is becoming more apparent among electorates. The latest US mid-term elections and the disenchantment the electorate displayed in returning the country to divided government is an obvious example. The recent strikes and blockades of fuel refineries in France is another. Disquiet such as this will make the necessary reforms in the West all the more difficult to accomplish. Nonetheless, most stock markets have been moving steadily higher. This is not illogical as many major companies no longer reflect the strength of their local economy, but instead their ability to source production cheaply, be it in the form of labour or materials. Consequently, Western multinational companies and banks could perform strongly even while Western economies stagnate, living standards drop and unemployment remains high.
Similarly, those in the private equity industry who have the skills and resources to change the operations and strategy of businesses and who have the mettle to be contrarian will be able to generate attractive returns – even if their local economy is stagnating. Undoubtedly these types of returns will take longer to deliver as compared to those that come from rising market multiples or through debt and equity recapitalisations. However, it is precisely this type of value creation that investors should be seeking when they invest in alternative assets.
As you know, an operational approach has always been at the centre of Terra Firma’s investment strategy. I trust therefore, as you read this quarterly report, that you will be heartened by the results achieved by our portfolio companies. The simple fact is that nearly all our investments are delivering strong results, despite the uncertain environment.
All but one of our 10 portfolio companies are operating in line with, or above, their demanding 2010 budgets. To highlight just a few examples, the EBITDA for Odeon & UCI is 13% ahead of its target and over 30% ahead of the prior year as of the end of September. These results are due to improving retail and ticket price performance, and strong management of costs. Furthermore, the company is leading the way in Europe in rolling out digital and 3D technology to its cinemas. AWAS, our aircraft leasing business, has Operating Profit Before Tax (OPBT) that is 38% above its year-to-date budget. The company’s strong position in Asia and Latin America is a key driver both for the current and future performance. In residential housing, our German residential housing company, DAIG, is nearly 5% ahead of its year-to-date budget for its key operating metric, Funds From Operations (FFO). As a result of the total restructuring of the group over the last two years, DAIG is the clear front-runner in the residential property industry in Germany.
These strong operational results have also been accompanied by an improvement in the capital structure of a number of our businesses. AWAS, for example, recently refinanced its original acquisition facility, several years ahead of schedule, with a $600 million bond offering at 7%, which was better than our expectations. Since the quarter end, EverPower has also reached an advanced stage of negotiations to refinance its debt on more favourable terms. In fact, no company in the portfolio has a major financing requirement for close to three years.
This performance is the direct result of strong teamwork between Terra Firma and the management of our portfolio businesses. We build, maintain and work with the strongest possible management teams and I am pleased that we have recruited some excellent talent in recent months. For instance, Ray Sisson has become CEO of AWAS, bringing extensive aviation experience, most recently from GE Commercial Aviation. At Infinis, Eric Machiels, formerly a Terra Firma Business Director, has now become permanent CEO having been acting CEO since August of last year. We have also been able to make strong hires at the CFO level. At DAIG, Stefan Kirsten, who was previously CFO at Metro AG and ThyssenKrupp AG will join the business at the start of 2011, and earlier in the year Jens Kimming became CFO of Tank & Rast from the international plastics group, Plastal.
Excellent financial performance and sound balance sheets are the prerequisites for building value for our investors as we operate through these challenging times. However, this environment also has significant implications for new deals. As I mentioned in my last letter, the huge capital overhang that exists in private equity is leading to an extraordinary number of secondary transactions and high multiples for such deals. Unfortunately, the third quarter offered no relief on this front, with 50% of all European deals for the year being secondary transactions and prices remaining at more than 17x earnings before interest and tax, according to the Centre for Management Buyout Research at Nottingham University.
Against this background, as you would expect, we have continued to be conservative and cautious. Our objective is to remain true to ’Terra Firma’ style deals, in which we purchase companies in basic industries, with strong assets, and where we have the opportunity to effect meaningful operational improvement. I am therefore delighted that our patience has paid off and we have recently announced the purchase of Rete Rinnovabile S.r.l. (‘RTR’), the leading producer of solar electricity in Italy and the second largest buyout transaction in Italy so far this year. Through our portfolio companies, Infinis in the UK and EverPower in the US, we have deep experience in the renewable energy sector and it is this expertise that led to the early identification and execution of the RTR opportunity. The company is a spin out from Terna, Italy’s high and very high voltage grid operator. This type of purchase has all of the characteristics of a ‘Terra Firma’ deal, and I am sure RTR will be an exceptional platform for future acquisitions and growth in the sector.
Finally, I would be remiss if I did not cover EMI.
Firstly, thank you for your support over the last few years with regard to EMI. As you are aware we were not successful in the litigation in New York earlier this month. While we have moved past the trial, I do want to provide you with some context.
Jury trials are difficult to predict but certain factors weigh heavily on the outcome. One example is the set of instructions given to the jury by the judge, which are debated and determined during the course of the trial, and which frame how to consider the evidence and on what grounds. In our particular case, the judge asked the jury to find proof on four separate elements to establish the question of fraud. The judge’s instructions, which of course guided the jury’s deliberations, set a high bar for Terra Firma’s claim. In addition, the closing arguments from the leading lawyers on both sides were long, detailed, emotive and, under the court’s rules, left us as the plaintiff with no right of reply.
Having now lost, it would be easy for me and Terra Firma to say that the litigation is something we wish we had not undertaken. However, I, my other board members plus the senior team at Terra Firma are not of that view. We felt that it was our responsibility on behalf of our investors to bring this litigation once we became aware of the facts behind the auction and had advice from our advisors as to the strength of our case. Clearly, we anticipated that, if we lost, Terra Firma and I would be the subject of some difficult press commentary, and we are aware that such coverage is also difficult for you. However, we feel that, despite this, we were right not to have been deterred from following what we still feel was the right course of action.
What is now clear is that Citi had views on EMI back in 2007 when they made the loan to us and advised us, which were very different from what we and the other bidders understood. We did not form a full understanding of the situation with EMI until after the KPMG audit results in late 2008 when the full extent of channel stuffing etc, became clear. However, despite the starting position with the EMI investment we have managed to almost double its earnings to a solid £300 million per annum since we took over. Furthermore, the business is continuing to perform well this year even with its competitors performing very poorly as the physical music market continues to contract. This is something that everyone in the Terra Firma team should be proud of and, ironically, something that has substantially reduced any losses that Citi might make on their loans.
In the press recently there has been much misinformed commentary stating that Terra Firma could have done a deal with another private equity firm, a trade buyer or Citi to avoid the case. The reality is if there had ever been a deal that would have resulted in economic benefit to you, our investors, we would have taken the offer.
However, as we made clear to Citi in August, we continue to believe that EMI is not worth much more than 5x EBITDA. Consequently, while we have approval from 85% of our investors to put more money into EMI in order to achieve a full restructuring, we would not do this unless it was done at an appropriate valuation. We are not willing to put money into EMI unless we believe it will achieve a positive result for our investors.
There have been numerous other misquotes – for example around the reasons for our original EMI bid and our reliance on the fact we were a participant in an auction, however, I do not feel it worth correcting each and every one of these. If you would like further details on what happened at the trial or have questions relating to the resulting press coverage both Peter Cornell and Denelle Dixon-Thayer are more than happy to speak to you individually. Just let Peter Cornell know and he will happily arrange.
Going forward, we will continue to do our best for EMI and all of its stakeholders.
With regard to Terra Firma’s businesses generally and our new deal activity, I hope to be able to talk to all of you personally over the next few weeks and will have my assistants set up calls. In the meantime, I would like to close by thanking you again for your continued support which has been invaluable and for which all of us in Terra Firma are eternally grateful.
With best wishes,