Chairman's letters

27 February 2013

Guy Hands speech at SuperReturn Berlin - "Ex-Growth Europe: How Will Private Equity Continue To Produce Good Returns?"

Five years ago at a similar conference, I suggested that the banking community wasn’t going to be providing substantial levels of credit to the European private equity community any time soon.

I was told by a number of GPs that my suggestion that liquidity was drying up was wrong. I was actually being too optimistic about the ability of the banks to lend. As a result of the credit crunch, European private equity and indeed the world’s international markets have been through, to say the least, difficult times over the last five years.

However a year ago at this very event, I suggested that, while the economic storm clouds over Europe were not going to dissipate soon, 2013 would be the first of many better years for private equity. Looking back on that speech, I focused on the fact that politicians’ inability to take clear economic decisions provided an opportunity for private equity to invest the necessary capital to help take us out of this period of austerity.

When I gave that speech, you may remember that Europe was in a period of acute economic and political crisis. The chances of the Eurozone remaining intact looked, at best, challenging.

A year on, thanks to the support, it has to be said, of the German government and of the German taxpayer, the crisis in Europe is not as acute. However, over the next few years, we will continue to see political volatility with no clear way forward for Europe.

This is a very different world to the pre-2007 world of consensus, market economy based politics. Investors meanwhile are adjusting to a new reality. They are recognising that, despite stagnant economic conditions, the best GPs are still driving real returns. They are becoming less distracted by the chaotic politics in countries across Europe.

In France we have seen the election of a socialist government on a radical left-wing platform, even if it now appears to be losing its revolutionary fervour. But the French political problems are currently no match for what is going on in Spain and Italy. These countries are suffering from politically self-inflicted wounds which make the emergence of a sustainable recovery in the eurozone seem even more distant.

In Spain, allegations of corruption against the governing party have ensnared the Prime Minister, and undermined the credibility of the government when they most need to inspire confidence in their stewardship of the economy.

In Italy, the latest elections have yielded no clear result. The prolonged uncertainty this will cause is likely to put a lot of pressure on markets, and may even force Italy into a bail-out.

Voters have sent a clear message that they are weary of the austerity measures of Monti and his technocrat government. But at the same time, they are fed up with the corruption of past regimes – hence over 25% of the vote going to a comedian and his party of inexperienced, anti-establishment figures. Given the size of the Italian economy relative to the eurozone, until a new government is established and a fiscal plan is agreed, this uncertainty will weigh on Europe.

Meanwhile, the UK is creating its own special problems by threatening to leave the European Union. The government is subjecting businesses to years of uncertainty, rather than working closer with Germany to pursue the British objective of free trade. Given the precarious state of the UK economy, especially in light of the recent downgrade from Moody’s, the last thing the UK needs is more uncertainty.

However, I think we in private equity are right to ignore short term political instability, and focus instead on the opportunities where we can create long-term value. Ours is, by definition, a long-term business. To give a timely example, while some have criticised Warren Buffett for the price he is paying for Heinz, I think they miss the fundamental point that he is investing for the long term and while he has been negative on private equity in the past we should welcome him in to the private equity club. He of all people recognises that private equity is not about short-term trading strategies, though you do of course have to get your entry price right.

Turning specifically to Europe, while there may not be the same level of opportunities as in the US where the debt markets have reopened fully, there are increasing opportunities for private equity. For example, in order to meet their capital requirements, banks are slowly shedding assets. Similarly, businesses which need to focus on their core activities are starting to divest non-core divisions.

At Terra Firma, we focus on three types of businesses: renewable energy infrastructure, operational real estate and transformational private equity. We like these areas because they fit our strategy, which is to focus on transactions which meet three characteristics: asset-backed, in essential industries and in need of transformational change.

In focusing on businesses with those three characteristics – asset-backed, in essential industries and in need of transformational change – we found ourselves over the last ten years drawn to the area of renewable energy infrastructure.

In the first place, assets are available to purchase from major utilities who are sticking to their traditional businesses. Second, the macro political environment is helpful thanks to Europe’s ambitious environmental targets. Third and most importantly, the fundamental economics of the sector are improving as the cost of energy generation relative to the competition provided by the dirty energy producers is falling fast.

Critics of renewable energy point to the government subsidies given to the sector as an unfair advantage. However, this argument ignores the fact that fossil fuel industries globally receive government subsidies many times greater than the renewable energy industry. Most accept that the infrastructure costs for nuclear energy make it fundamentally uneconomic without substantial subsidies. But it is less well known just how much coal, gas and oil also benefit from government support.

Taking another industry which fits the characteristics of our strategy, residential housing is an essential industry that will provide investment opportunities despite the economic cycle or broader macro-economic issues. For this reason, Terra Firma completed the largest European LBO since 2008 last year when we bought Annington Homes, which is the largest residential housing company in the UK. Similarly, our refinancing of Deutsche Annington, the largest private residential landlord in Germany, was successful in large part because the credit markets recognised that the demand for rented property will remain strong despite the ongoing European economic slowdown.

Many speakers have already suggested that focus and consistency of strategy are key to GPs creating value, and I agree. However, that consistency comes with the cost of some tough periods. For example, for Terra Firma and many other GPs, the valuations of our asset-backed businesses fell between 2007 and 2010 while the cost of borrowing went up. As valuations fell, we had to focus on increasing earnings in the midst of an economic storm. Deutsche Annington’s debt was eventually refinanced at a cost below 3% last year, after over two years of negotiations. Earnings between 2007 and 2012 had risen from 430 million euros to 515 million euros, which gave lenders confidence that even in an economically tough time, the company would continue to perform well.

In today’s world, you need focus, discipline and a never-give-up attitude. Outside the mega-funds, GPs need to specialise in a particular sector or geography or have a unique investment philosophy. They also need a simple proposition that they can clearly communicate to investors.

At Terra Firma we focus on creating value in the businesses we acquire through five levers:

1. Transforming strategy.

2. Strengthening and/or changing management.

3. Creating value though capex.

4. Building through mergers and acquisitions.

5. And lowering the cost of capital.

The larger GPs can have many different strategies and still provide beta through mega funds. However, outside that gilded cage, private equity GPs need to create value through a focused strategy and operational and strategic change. Such change does not necessarily mean cost-cutting, but more often than not, investing in growth to create successful businesses. 

Being a Brit speaking in Germany, I would hope that in the same way that I have recently lost my innate Euro-scepticism, German politicians may now lose their private equity scepticism. By creating value, private equity can play a critical role in regenerating the economies of Europe.

In Terra Firma, we have invested over 7 billion euros in capex in our businesses over the past several years, money that was largely raised outside of Europe and has created many jobs.

Focusing on transforming business is what differentiates private equity from other models of corporate ownership – and from other asset classes. Private equity is fundamentally about long-term transformational investment. We raise capital that is committed for ten years and we use it to improve businesses. 

In contrast, the demands of quarterly reporting mean that listed companies have struggled to maintain a long-term perspective. The private equity model aligns the interests of owners and management together.

Private equity speeds up decision-making and ensures that all are in the same boat and rowing in the same direction. I don’t want to suggest that the political risk in Europe can be ignored nor that private equity is the answer to all of Europe’s growth problems. However, experience shows that as long as you factor in the political risks, then the political storm clouds can be navigated and deals made to work.

In Europe, there will be a period of volatility, both politically and economically, over the next few years. Crises will continue to occur. But for private equity firms prepared to take the long view and invest in sectors where they can add value, I believe there are substantial opportunities to be had in Europe and that private equity can contribute to a European economic recovery.

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