02 August 2011
2011 Q2 Investor Letter - TFCP II and III
As I have said over the last few years, high levels of volatility in financial markets are set to continue for the foreseeable future. The imbalances in the West will not be dealt with easily and will cause grave concern for the world’s economic system for some time to come. In the 1970s, when the West confronted similar problems, it grew its way out of them, largely through globalisation. This time any solution will involve the pain of reallocating the global economic cake. This will require substantial political will – something that the West has demonstrated recently it does not have.
In Europe, company and sovereign debt problems are typically being addressed by an ‘amend and pretend’ policy and there has been a failure to deal with the weaknesses in the banking system. As a consequence, there are few effective ways of dealing with the sovereign debt issues that are affecting Europe without jeopardising the overall banking system. My estimate, based on conversations with senior bankers in Europe, is that somewhere around €300 billion of fresh bank equity needs to be injected into the European banking system if European banks, including those based in the UK, are going to be strong enough to take the pain needed to clean up the European company and sovereign debt problems. Only then will they be in a position to start actively lending again to small- and medium-sized businesses, and it is only by promoting growth within those that general European economic growth will be rekindled.
European politicians are avoiding the question of how to recapitalise the European banks and are instead focused on the debate between those who want fiscal and political union and those who will not accept its consequences. Pro-union supporters are clear that, in the long term, the choice for the Eurozone is either to evolve into a federalist Europe or to face the political and economic consequences of the breakdown of the European Union. Opponents, meanwhile, want to leave Greece and other peripheral countries to the fate of the free market and have them leave the euro.
While it is difficult to predict the outcome of this debate, it is clear that the route of European political and fiscal union would take time and would continue to require substantial economic support from Germany. The alternative option, of Greece and other peripheral countries leaving the euro, would see the southern European Union countries becoming substantially poorer than they are today, but regaining the ability to determine their own futures.
Meanwhile in the US, the political impasse over raising the debt ceiling has demonstrated that while ‘extend and pretend’ is not sound fiscal policy, it is the only policy for which there is any political consensus amongst American politicians. With the US economy barely out of recession, if at all, it is clear that persistent high levels of borrowing by the US government, and the effects of pumping vast amounts of money into the US financial system, has been as unsuccessful in the US as it was in Japan. While the long-term economic problems the US faces are, on the face of it, far greater than those in Europe, the view has always been that the American people are united and have the political will to solve such problems in time. Unfortunately, recent events have put America’s political will in the spotlight and shown it to be lacking. It is little wonder that S&P downgraded the US credit rating and that central banks are increasingly nervous of holding the dollar. The West is likely, for the time being, to muddle through these crises.
In my opinion, the adjustments needed in the West will become increasingly painful, both economically and socially, the longer that the overspending in the US and the lack of banking capital in Europe are allowed to persist. At the same time, political instability in the rest of the world is going to increase and the West will be progressively less able to affect what happens. Involvement in political unrest occurring in non-Western countries through military action, like that taken in Libya, will become increasingly expensive; and citizens in the West will become less and less likely to support such actions.
Investors and the capital markets are also searching for stability. While credit conditions had eased considerably since the worst of the credit crisis, they are now tightening again, and we are still at risk of returning to conditions as bad or worse than those that existed in 2008/2009. It is little wonder in these circumstances that Western investors are searching for safety, be that through buying gold or keeping their money in cash. This, of course, further starves the Western economic system of the funds needed to grow and increases the likelihood of a meltdown. If history is any guide to the future, Western governments now have less than 18 months to restore confidence before the effects of a reduction in long-term investment push their economies into a depression.
The private equity market
As an investor in private equity, these conditions provide relative opportunity, but this is combined with more risk than we have seen for over 30 years. In a more volatile and uncertain world, private equity still has the ability to outperform the public markets. There may indeed be great investment opportunities for European GPs, subject to the availability of investment capital. Of course, investment capital seldom flows at a steady pace. Under euphoric conditions, the flood of money overwhelms reasonable investment opportunities. It is hard to think of an asset class or strategy that has not been pushed up to staggering valuation heights by a wave of cash seeking outsized returns in the past three decades. Conversely, in pessimistic times, available funds disappear and entire areas of the market are starved for capital and valuations fall to significant lows. No one can consistently predict the ebb and flow of capital and in private equity, the exercise is made even more difficult by the inherent illiquidity of the types of assets we purchase. It is the safe harbour of private ownership that enables us to build long-term value in companies, but it also deprives us of the ability to sell quickly if market conditions change. However, even those who can sell at short notice and who are paid to ‘market time’ – mutual fund and hedge fund managers – show little consistent ability to time markets.
It is more sensible to adopt a consistent long-term approach to investing, especially in private equity. Investors are better served by committing roughly equal amounts of capital in any given year to the asset class, rather than doubling investments during boom times and halving investment amounts during bad times. Clearly, the approach of ‘equal year investing’ requires a high degree of discipline as there is great temptation to increase allocations when investment returns increase.
From an investor’s point of view, private equity funds need to be right-sized; both for the resources of the GP and for the investment opportunities available. We have arrived at the €3 billion target for our next Terra Firma fund by carefully structuring our economics – determining the structure and size of the team and the ideal size for our portfolio investments, including the use of follow-on capital. Our goal is to have the necessary capital available to be able to build a well-structured portfolio of companies that fits squarely into our sweet spot.
Raising the right-sized fund would appear the obvious and rational thing to do. However, this argument does not drive the current size of most funds as, unfortunately, the private equity fund-raising process disproportionately ties up the resources of each private equity team for a considerable time. Indeed, each firm sends a significant portion of its investment talent on the road every two to four years for 12 to 24 months in order to raise fresh capital. That talent spends about one-third of its time marketing, rather than doing deals or focusing on the portfolio companies. This is not a problem Terra Firma can address on its own: the length of the investment cycle and fund-raising period are driven by the industry as a whole. We will continue to devote appropriate resources to this endeavour in order to compete for funds; however, it would dramatically improve the prospects for returns and drive down the costs for GPs and LPs alike if we could, as an industry, agree a more streamlined process for marketing funds.
Worse still, the length and arduousness of the fund-raising process creates a huge temptation to take on as much capital as it is possible to raise, which only serves to hurt potential returns. If one has to be on the road for a year or more, most firms will rationally accept as much capital as investors are willing to commit to in order to justify the costs and efforts of the marketing process. Often that additional capital either gets invested too hastily within the first couple of years or is only drawn down over an extended period of time, creating a major drag on returns.
As Terra Firma moves into its own fund-raising process, these issues are clearly very much on our mind. However, in one way we are extremely fortunate. Our strategy of focusing on asset-rich businesses, changing their strategies to maximise economic value and improving their operational performance has been consistent over the last 17 years. This approach is more appropriate for today’s markets than at any other time I have seen. Indeed, in a world where people are increasingly concerned about paper assets, be they euro, sterling or dollar, and where gold is reaching all-time highs, investing in assets and then managing them to maximise their value is, we believe, an excellent strategy for private equity.
Turning to the developments in TFCP II and TFCP III, I am pleased to report that we have had another good quarter. Our portfolio companies were either on, or ahead of, budgeted EBITDA for the year-to-date, with Tank & Rast being the only exception as its business continues to suffer from the effect of high fuel prices in Germany. However, in Tank & Rast, we are beginning to see the benefit from a recently implemented fuel supply project. It is ahead of plan and we hope to catch up some, or all, of the difference in budgeted EBITDA by the end of the year.
CPC, our Australian beef producer, also encountered a challenge when, on the 7th June, the Australian government temporarily suspended the export of live cattle to Indonesia following evidence of inhumane slaughtering practices in a few Indonesian abattoirs. The suspension has since been lifted. Whilst CPC’s practices are best-in-class, the company’s results could still be impacted later in the year as a result of interrupted shipments and the cost of increased compliance with the emerging legislation.
During the quarter, we took a number of actions to build our businesses. Highlights included Odeon & UCI completing a £475 million private placement to refinance its debt in order to fund the expansion of the business’s footprint across Europe. The company made four acquisitions in the period, adding significantly to its operations in Ireland, Italy and Spain. There was some speculation about a possible sale of Odeon & UCI and indeed, several parties have expressed interest. However, the prices offered did not recognise the growth in the business.
We also re-priced AWAS’s $530 million term loan facility, improving the margin by 250 bps and giving the business increased flexibility to support its ambitious growth plans.
During the quarter, Infinis doubled its wind energy capacity by acquiring three operational wind farms from Scottish and Southern Energy plc with 97 MW in aggregate. This acquisition further consolidated Infinis’s position as one of the leading onshore wind energy developers and generators in the UK.
Our newest business, RTR, also completed its first acquisition, acquiring a further 19 MW of photovoltaic capacity. It has recently made a second purchase of an additional 78 MW of capacity, bringing its total to 241 MW. RTR is now comfortably the leading solar energy generator in Italy.
At the end of the second quarter, TFCP II’s cash-on-cash multiple was 1.75x and our aim remains to increase it to at least 2.3x by the time the Fund is wound up. Our objective for TFCP III is to make at least a 1x net return for our investors and, as I mentioned in my Q1 letter, we are clear about the need to balance creativity with prudence as we recover value for the Fund after the losses of EMI.
Finally, we continue to strengthen the Terra Firma team and, amongst several appointments, I was particularly pleased to welcome Kamal Tabet as Terra Firma’s new Head of Investor Relations and a Managing Director. Kamal previously had global responsibility for Financial Sponsors at Citigroup.
I look forward to seeing many of you at our annual conference in Rome in October or at one of the regional conferences that follow.
With best wishes,