01 February 2011
2010 Q4 Investor Letter - TFCP II and III
The global economic environment was relatively benign in 2010 after several years of upheaval. The economies in which Terra Firma largely invests continued a slow process of recovery, experiencing modest growth in most sectors. At the same time, financial markets globally continued to recover from their lows of March 2009 and provided greater liquidity across almost every asset class. Similarly our funds, TFCP II and TFCP III, rebounded from their lows as valuations improved and our underlying portfolio businesses produced strong operating performances.
Turning first to investment performance, I am pleased to report that all our funds experienced solid recoveries from their position at the end of 2009. TFCP II currently has achieved a cash-on-cash multiple of 1.75x, a 9% improvement on the end of 2009. While still negative, TFCP III’s cash-on-cash multiple rose to 0.41x, an increase of 32%. I would expect TFCP III to continue to see its multiple increase as the fund begins to benefit from the positive performance of our more recent acquisitions. Terra Firma remains hopeful of returning all of the capital invested in TFCP III to our investors. Given the substantial investment by TFCP III in EMI this will not be easy, but we are encouraged by the prospects of our other investments in the fund and the potential acquisitions that our team are evaluating.
Making positive strategic changes and substantial operational improvements in the companies we buy is at the very heart of Terra Firma’s investment philosophy. Our operational focus is designed to drive long-term performance in conjunction with the strategic changes we are looking to achieve in our portfolio businesses. Strong operational oversight is also essential in delivering improving results year-on-year. As you will read in this report, our companies delivered solid results and strengthened their businesses across a wide range of industries during 2010. For example, Odeon & UCI reported 14% EBITDA growth year-on-year as audiences embraced the year’s strong 3D film slate. Meanwhile, AWAS refinanced $530 million of Jetstream/Jetbridge debt in June and negotiated a $600 million loan in the autumn. EverPower continued to invest heavily in its wind farms, making excellent progress on its development pipeline. EverPower’s prospects also improved due to the team's ability to negotiate better turbine pricing for its new projects. These successes are testimony to the strength of the working relationship between Terra Firma and the management of our portfolio businesses. Nowhere is this cooperation more evident than in the flow of people between Terra Firma and our businesses. During 2010, two people moved from Terra Firma into two of our portfolio businesses on a permanent basis: Eric Machiels joined Infinis as CEO and Ruth Prior joined EMI as CFO.
As you will be aware, on 1st February 2011, Citigroup assumed ownership of EMI having completed a debt for equity swap. We are disappointed that we could not reach an agreement with Citigroup (despite great efforts from our side) that would have involved us putting in more equity simultaneously with Citigroup writing down their debt. However, as we could not reach agreement with Citigroup on the valuation of EMI, they felt that it was in their interests to take over the business in order that it could be sold as and when they feel appropriate. Our direct involvement in EMI is therefore over. We continue to be indirectly involved through the appeal of the legal rulings made by the Court in relation to the litigation against Citigroup. Our lawyers will continue to progress this and we do not expect any rulings in this matter until sometime next year. Terra Firma, however, is moving forward and focusing on investing the remainder of TFCP III and the management of our existing portfolio.
From an economic and financial perspective, the year just concluded was better than many expected, with the financial markets continuing to recover, and the emerging economies driving global growth. By contrast, 2011, which most investors expect to be equally benign, will probably disappoint. Inflation and political unrest loom as growing concerns for international investors. Many will try to draw from the lessons of the OPEC-induced oil shock of the 1970s and from the response of the central bankers and governments in the West in the early 1980s. However, this time – as inflation accelerates – I am concerned that we will find that many Western governments and central banks are not in a position to break the inflationary cycle. The major source of this cycle is coming from the demand generated by the emerging world, notably China and India. This demand for raw materials, food and goods combined with powerful demographic forces, is producing pressures that the West simply cannot control. I do not believe that countries like China and India will be willing to rein in their pace of economic growth for the benefit of the West.
Going forward, most Western workers will see their standard of living continue to decline as their wages remain stagnant and the cost of consumer goods rises. Germany, over the last ten years, has seen living standards decline by approximately 4% and, for the average American, the decline has been almost 10%. I am afraid these trends will continue unless the West thoroughly restructures the way in which it operates. However, restructuring is not currently on the political agenda in any major Western economy. This decline in living standards coupled with high unemployment is likely to result in political discontent in many Western countries. In the long run, I expect the standard of living for Western workers to be brought into closer alignment with those in the emerging markets. This seismic change in the way the world’s wealth and earnings are divided will make investing substantially more difficult than it was from 1980 to 2007.
At Terra Firma, our investment strategy to deal with this environment will be to seek to acquire businesses that benefit from inflation, as well as those that can derive a substantial part of their revenues and profits from serving the emerging markets. Asset-rich businesses are a fertile hunting ground for these opportunities, although some of the traditional havens, such as commercial real estate, are not yet at attractive valuations.
Looking back on 2010, all of us at Terra Firma would like to acknowledge the employees at our portfolio companies. We are also deeply appreciative of the support shown to Terra Firma by our investors. In the autumn, just ahead of the trial, we asked you to approve a potential investment of another €622 million in EMI by TFCP II and TFCP III as part of our effort to reach agreement with Citigroup, and you supported us with a vote of over 80% of the partnerships. Your support for us during this difficult period, our focus on maximising the value of your investment and not utilising your money unless appropriate, combined with our own substantial investment in TFCP II and TFCP III has created a true partnership. Clearly the last few years have been difficult, but we feel we are well positioned today to invest in the unpredictable markets that lie ahead. We look forward to continuing to work with you and to managing the existing portfolio businesses whilst finding new opportunities to build value in 2011 and beyond.
With best wishes,