01 February 2011
2010 Q4 Investor Letter - TFDA
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. Germany in the past year indeed did better than most other Western economies due to the strong performance of its export-based businesses. However the German consumer did not fully benefit from the strength of the German economy and hence consumer demand in Germany remains muted. 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. However, the German banking sector continues to raise concerns due to its exposure to Eastern European countries, some of the peripheral European economies and suspicions as to whether loans have been correctly marked to market. TFDA continued to recover from its low valuation as the underlying portfolio continued to perform well and the credit markets freed up thereby increasing valuations for companies with leverage. I am pleased therefore to report that TFDA experienced a modest increase in its cash-on-cash multiple to 1.30x and TFDA’s per annum return is now a positive 6.1%. This performance for a real estate fund set up in 2006 is very good. However, it is still substantially below our objective. Terra Firma expects to see continued improvement in the performance of this fund as we move into 2011 and beyond.
Making positive strategic changes and achieving substantial operational improvements in the companies we buy is at the very heart of Terra Firma’s investment philosophy. We continue to drive long-term performance at Deutsche Annington (DAIG) in conjunction with the strategic changes we have implemented over the last few years. As you will read in this report, DAIG delivered solid results and strengthened both its Rental and Sales businesses during 2010 with EBITDA from continued operations exceeding €500 million for the first time in the history of the company.
As 2010 came to a close, the hiring of Stefan Kirsten as CFO completed the management team that we intend will drive the business through its next phase. Stefan has extensive experience in real estate and was the CFO for a DAX-listed company. Successfully using the liquid German Pfandbrief markets, DAIG also completed the refinancing of the Hallam portfolio, which was the first securitisation ever done in residential real estate in Germany. The Hallam portfolio went through a very strict independent valuation process, which confirmed the accuracy of DAIG’s property valuations. The company is also continuing to reap significant operating and service benefits from its Clear Water initiative which the new management team will continue to leverage. Terra Firma is focused on working with DAIG to use the remaining capital in TFDA to increase the returns on the TFDA fund.
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. The German economy expanded by 3.5% in 2010, after contracting 4.7% the prior year – the biggest decline since World War II. Nonetheless, household consumption only grew by 0.5% as it was the corporate and government sectors that led the advance. During the past year, the export sector increased by 14.2%, while imports grew by 13%. Although the German consumer has remained cautious, and retail sales fell in the last quarter of 2010, German unemployment fell to 7.4% in January, the lowest level since 1992. The behaviour of the German consumer will be critical as government stimulus wanes, and many of Germany’s trade partners experience sluggish activity.
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. However, Germany is far better positioned than most Western countries to cope and adapt to what the next few years could bring.
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 how the economy functions 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. Asset-rich businesses such as DAIG should perform relatively well in this environment and generate attractive returns for our investors.
The outlook for the German consumer and the residential rental market is significantly more positive in the next few years. f&b GmbH estimates that, although not uniform across the country, residential rents grew in all regions of Germany in 2010; ranging from 1.8% in the south of Germany (Bavaria and Baden Wuerttemberg) to 0.2–0.4% in North Rhine Westphalia. Looking ahead, Barclays Capital in a recent report estimated that residential rents for existing properties in Germany should increase by 1.0–1.5% per annum over the next three to five years, with higher growth rates in affluent metropolitan areas.
Meanwhile, the supply of housing is expected to remain in reasonable balance. While building permits are rising in response to improving conditions and low interest rates, the increase in supply should be absorbed both by demand, particularly in stronger markets, and the continued removal of housing stock in Eastern Germany. Although the German population, along with much of Europe, is aging, household formation continues to grow as people form smaller household units. As a result, we believe that the TFDA portfolio is well positioned.
Looking back on 2010, all of us at Terra Firma would like to acknowledge the employees at all of our portfolio companies, including DAIG. We are also deeply appreciative of the support shown to Terra Firma by our investors. We believe your support, our focus on maximising the value of your investment and our own investment in TFDA have created a true partnership. 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 as we manage TFDA in 2011 and beyond.
With best wishes,