Chairman's letters

20 November 2013

Guy Hands Speech at SuperInvestor Paris – "Unlocking Value in a New Era of Private Equity"

There is a perception in the media, among politicians and the wider public that private equity is an easy way to make money. It’s claimed that private equity houses buy companies on the cheap, put on excessive leverage, package them up… and sell them at a profit.

Now, buying cheap, leverage and presenting well are certainly useful, and they are quite rightly used in our industry. However, they are only a small part of what private equity does, and we all need to work together to do a better job of promoting the positive things private equity does.

Where is the private equity industry heading? Clearly 2008 through 2012 was tough for private equity, but the industry has recovered from the great credit crisis and today is doing as well as ever. During the period of recovery, private equity firms diverged between the large players, who are often public or aiming to go public, and specialist GPs. 

The larger firms are increasingly adopting an asset management model. This allows them to be more price competitive due to their size and their diversification of products, but because of their size and range of different products they will find it difficult to beat the investment beta the industry produces.

This is not, however, necessarily a bad thing, as beta returns in Private Equity are very attractive, and many LPs will choose to invest in private equity just aiming to achieve beta and hence will feel safer investing in the big brand names at lower cost and with less volatility. A recent study conducted by Stephen Kaplan at the University of Chicago found that the average buyout fund performance has exceeded that of public markets for most vintages over a long period of time. The average outperformance of a private equity fund versus the S&P 500 was found to be 3% per annum, which equates to between 20% and 27% over the life of a typical buyout fund. However, for some LPs alpha returns will remain highly desirable and well worth searching for in spite of the higher costs and greater volatility involved in achieving them. In today’s market, specialist GPs are best positioned to create alpha. 

Creating alpha requires clear skills, and being able to demonstrate that those skills exist is what will attract LPs to invest in the specialist GPs. McKinsey’s recent white paper called “Getting to the heart of PE returns” points out that LPs are now seeking fewer but deeper relationships with the stronger performing funds, and are scrutinising fees more closely. Consequently, GPs will need to be able to demonstrate to LPs that they understand the key drivers of their own performance and are charging appropriate fees. 

McKinsey highlight three areas which one should focus on in order to understand how a GP has driven returns in the businesses that make up their track record:

One, strategy – How has the business been repositioned, and what impact has this had on investment performance? What has been the contribution of mergers and acquisitions and large scale investment on the business?

Two, management performance – How much has management been able to grow the business organically? How well have margins been managed and what improvements have been made in capital efficiency?

Three, changes to ‘cost of capital’ – What performance has been generated through a re-pricing of the sector? How has leverage contributed to overall performance?

Terra Firma agrees with this analysis and has, over the last nearly 20 years, focussed our creation of alpha on the use of five key value drivers.

  • One, identifying a transformational strategy for the business.
  • Two, strengthening the management team.
  • Three, investing in capital expenditure to enable organic growth.
  • Four, building through mergers and acquisitions
  • Five, lowering the cost of capital

I’d like to share with you a few examples of how we have implemented these drivers across our portfolio. 

First, changing strategy. Let’s take Infinis, which we floated last week. It was spun out of WRG, a waste recycling business which viewed landfill gas as a waste product. To them landfill gas was a dangerous nuisance, and they paid people to get rid of it. Even when they did convert this gas into energy, rather than flaring it, they did it through outsourcing the management of the sites.  

By contrast, we established Infinis to focus on this business and to treat landfill gas not as a waste product, but as a source of energy. We hired over 400 people, invested in infrastructure and technology, and created Europe’s largest pure green energy company. Terra Firma took the business from a waste-to-energy 60% conversion rate to one in the upper 90s today. We have multiplied the earnings tenfold, and based on the flotation valuation of last week, this transaction will achieve a multiple of over 13 times.

Our second driver is strengthening management. As an example I will use Annington Homes, the largest private owner of residential property in England and Wales. When we brought Annington in 1996, we wanted a management team that would focus on delivering our strategy of selling second-hand houses at affordable prices to key workers. It didn’t mean putting in lots of fancy bathrooms and designer kitchens, which is what the first CEOs wanted to do, and we went through four management teams in under two years. 

Our fourth CEO, James Hopkins, understood our strategy and how to execute it. He focused on who the customer was, and organised the business to make the houses safe, attractive and affordable. James intended to stay at Annington for 5 years, but that has now turned to 15, and he is locked in through his LTIP for at least another 10.  A GP has to have the confidence to hire and fire management teams quickly if they are right or wrong for the business. After 3 firings, we fixed on James and together with Terra Firma, James and his team have had great success in managing this business. Over the years prior to Nomura selling it in 2012, Annington delivered nearly £1.5bn in value on an initial investment of about £200m

Terra Firma’s third value driver is capex. Contrary to those who think private equity strips assets from businesses, Terra Firma invests heavily in the businesses we buy. Across our buyout funds TFCP II and TFCP III, if we exclude EMI we have invested approximately €5bn of equity into private equity deals; however we have invested nearly €8bn in capex. To take one example, in Tank & Rast, which operates 90% of the motorway concessions on the German autobahn, we have invested over €500 million. The previous owners of Tank & Rast invested roughly the same amount of capex over about the same time period. 

However, despite operating through a much more challenging environment which included the economic downturn in 2008 and 2009, we saw a much better return from our investment than they did. EBITDA increased €91m since 2004, versus € 18m in the 7 years prior to our investment for an almost identical amount of capex. We achieved this, similarly to Annington, by focusing on what the customer wanted, rather than what the managers of the sites wanted. What the customer wanted were clean toilets. Previously the state of the toilets had been a reason to avoid Tank & Rast sites, but we invested in developing the Sanifair ultra clean toilet concept. This has proved extremely popular with customers, and the Sanifair concept has been so successful that it is now being rolled out in third party sites, such as train stations and shopping centres across continental Europe. This sort of improvement to the customer experience has helped drive up customer visits and profitability, and thanks to the investment in capex in Tank & Rast, Terra Firma has already realised a cash-on-cash multiple of over 5 times on the business.

We achieved this, similarly to Annington, by focusing on what the customer wanted, rather than what the managers of the sites wanted. What the customer wanted were clean toilets. Previously the state of the toilets had been a reason to avoid Tank & Rast sites, but we invested in developing the Sanifair ultra clean toilet concept. This has proved extremely popular with customers, and the Sanifair concept has been so successful that it is now being rolled out in third party sites, such as train stations and shopping centres across continental Europe. This sort of improvement to the customer experience has helped drive up customer visits and profitability, and thanks to the investment in capex in Tank & Rast, Terra Firma has already realised a cash-on-cash multiple of over 5 times on the business.

Our fourth key value driver is growing through mergers and acquisitions. When we acquired the aircraft lessor AWAS in 2006 it had been an under-invested, non-core asset, owned and managed by Morgan Stanley. We saw an opportunity to strengthen the portfolio through M&A activity and in 2007 we acquired Pegasus Aircraft Leasing. 

Today, AWAS is a completely different business from what it was in 2006. We have grown it from a book value of $2.3bn to $9.1bn, and reduced the average age of its fleet from 12.1 years to 5.5 years. AWAS is now one of the world’s leading aircraft companies, and it has won multiple industry awards, including two this year from Airfinance Journal.

Finally, our fifth key value driver is lowering the cost of capital. A great example of this is Deutsche Annington, our German residential property business. In 2006, Deutsche Annington successfully completed GRAND, a €5.8bn refinancing involving the securitisation of nearly 200,000 residential housing units. At the time, we looked like geniuses. It was the largest European securitisation of residential real estate ever, and we were able to borrow at an average cost of 3.3%, substantially bringing down our cost of capital. Back then the Holy Grail was to have over 80% leverage, and we were at 84%. However, in 2010 following the credit crunch the financing did not look so good. The market did not believe that we were going to be able to refinance this amount of debt.

Terra Firma worked with Deutsche Annington’s management team for the next two years, finally refinancing GRAND at the end of 2012. The company’s debt structure now includes unsecured investment grade bonds, traditional secured bonds and alternative secured financings and is one of the most flexible and cost effective in the European real estate sector, with an average debt cost of 2.3%. Deutsche Annington also possesses an investment grade rating from Standard & Poor’s, the only European residential housing company for which this is true. We were very pleased when earlier this year, the Banker magazine recognised this Terra Firma-led transformation of the capital structure with its European Real Estate Finance Deal of the Year award.

Yes, it took skill and knowledge to complete that restructuring, but more than anything it took attitude. There were many times during that transaction when something threatened to blow us off course, and most people working on a deal this difficult would have said forget it, there is no amount of money that is worth going through the hell of getting this deal done for.But the team kept going. They kept focusing on our objective and how they were going to get there and no one was going to stop them achieving it.

So searching for alpha is important: whether you identify it through using our five drivers or through McKinsey’s performance levers, but you also need to look for the right attitude.  In private equity things go right and things go wrong. When things are going right it’s easy. But it’s how you handle the things that go wrong that matters. 

Attitude gave us the confidence to turn a neglected, non-core business that dealt with poisonous gas into the UK’s leading independent renewable energy generator through the creation of Infinis. Attitude was what James had and why we settled on him as CEO number 4 of Annington, and why we haven’t let him go for 15 years. It’s not easy to find someone with the right attitude, but once you find them you should do everything you can to keep them around. Attitude allowed us to shift the focus at Tank & Rast from tenants to customers, and therefore unlock significantly more EBITDA growth than the previous owners. And attitude is what pushed us to transform AWAS from a small aircraft leasing company into one of the industry’s leading players.

If you have the right people, with the right attitude, focusing on how to produce alpha, then they are going to make the best of any situation.

Thank you.

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