Chairman's letters

09 April 2013

Guy Hands speech at SuperReturn China - "Private Equity Investing: What Lessons Can The Private Equity Community In China Learn From The Mistakes Others Have Made Elsewhere"

As the private equity market in China continues to develop and mature, I think it would be useful to look at the global private equity industry’s recent past to see what lessons can be learnt. Private equity has made a number of mistakes, and by identifying and understanding them, Chinese private equity may be able to avoid a repeat of these errors.

In the period that led up to 2007 western politicians and central bank governors claimed to have found a new economic paradigm. A paradigm in which there would be continuous real growth around the world. It is now clear that things were never as good as claimed by the politicians, nor as bad as feared by the market pessimists in 2009.

The traditional investment banking view of private equity is that it is based on the three pillars of leverage, arbitrage and packaging.

You start by buying something based on leverage, buying something with a certain yield, which with leverage creates a much more attractive running yield.

Then there’s arbitrage: by selling a company through an IPO, you can take something worth 8 times earnings, for example, and sell it into the public markets at 12 times.

Finally, there’s packaging: you focus on making the company look good for a period by cutting costs, and hope that people won’t spot any underlying problems before you can sell it on.

This is what some people still think private equity is all about, and to be fair, this strategy more or less worked between 2002 and 2006, when credit was flowing easily and the capital markets were very active. During this time this three-pillar strategy provided an easy route to profits. The market expanded greatly and everyone did very well.

However, this merry-go-round finished in the West in 2007. The tide went out, and many firms were left holding overleveraged companies whose fancy packaging wore off, and where arbitrage opportunities no longer existed. Businesses that had been financed using the cheap, available liquidity found themselves highly leveraged and could not be refinanced as planned. These businesses also found that they could not be sold on, as the IPO markets had seized up.  While the IPO markets have more recently opened up again in places like New York and Hong Kong, in the UK and Europe, private equity firms are still finding it extremely difficult to get an IPO done. Only 25 companies floated in the UK and Europe in 2012, raising just $11 billion. This compares to 136 companies which IPO’d back in 2000, raising $69.7 billion. 

Everyone had trusted their spreadsheet models which told them they would make a profit, but the numbers didn’t add up any more. People thought that the three pillars would make them money, but they became just sideshows to what should be the main focus of private equity, transforming businesses to create long term value. While leverage, arbitrage and packaging are certainly useful tools, they do not, in themselves, create value. You cannot rely on them alone.

At Terra Firma, we don’t focus on the window dressing. We put our attention on where we can really add value, which is by transforming the underlying businesses.  We do this by focusing on five key drivers to create value:

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.

Of course we use leverage, but the key is to be thoughtful and careful about how and when you use it. Just because a bank is offering to lend you money, does not necessarily mean you should take it. Meanwhile, an IPO is a very sensible exit option for many companies, but you cannot rely upon IPOs to realise value. Packaging is about selling – it is very important to present your business well, but underneath it are the day-to-day workings of the company. If they are not working well, then the packaging is ultimately worthless.

The real value comes from transforming businesses. 

This is much harder work, and it is certainly not a get-rich-quick scheme. It takes a lot of time and energy to devise the right strategy for a business and then implement it, but that is ultimately where private equity generates value.

At Terra Firma, we focus on three types of businesses: renewable energy infrastructure, operational real estate and transformational private equity.

We focus on these areas because they fit our strategy, which is to do transactions which meet three characteristics: asset-backed, in essential industries and in need of transformational change.

By sticking resolutely to our strategy, Terra Firma has more than doubled the value of its 2007 private equity fund over the last three years, and significantly increased the value of the equity invested in our four current funds.

At Terra Firma, we focus on applying our five drivers to each of our businesses in order to identify the best way of transforming them into something better.  And the best proof of this strategy is the number of successful deals we had in the last year, even as the market environment proved challenging.

At the end of last year, Terra Firma achieved Europe’s largest real estate refinancing of 2012. This was the refinancing of Deutsche Annington, our German residential real estate company, for €4.3 billion. We also completed the largest European LBO since 2008 with the purchase of Annington Homes from Nomura for £3.2 billion.

The deal to buy Annington, which owns the UK Ministry of Defence’s married quarters estate, was the seventh largest LBO globally since 2008 and, to do it, we raised a £450 million fund.

The years since the crash have forced the private equity industry in Europe to get back-to-basics, to concentrate on what private equity is good at: creating value by transforming businesses. It is what differentiates us most from other models of corporate ownership – and other asset classes.

Private equity is fundamentally about long-term investment. We raise capital that is committed for ten years.  In contrast, quarterly reporting means that public companies struggle to take a long-term perspective.

Private equity provides a long term source of capital.  We are prepared to make investments in capex and further acquisitions to grow businesses and we do not have to worry about paying current dividends. We are good at finding and transforming orphaned assets. Businesses that, with investment, will have an important role to play in the economy.

The private equity model is extremely effective at aligning the interests of owners and of management – and it speeds up decision-making. It is also very effective at attracting entrepreneurial people – and deploying their skills effectively.

In the future, whether in the West or in China, the industry needs a mix of entrepreneurs, financiers and operating professionals. These are people who will rise to the challenge of transforming businesses. This entrepreneurial spirit, along with combining a diversity of skills and taking a long-term approach, will allow you to spot opportunities to develop highly attractive sustainable businesses across a wide variety of situations. But you do need some clear rules to exploit those opportunities. 

They are focused on looking at distributable cash and they are:

• more is better than less

• sooner is better than later

• and certainty is better than uncertainty.

These three very simple rules were unfortunately increasingly broken by the UK and US private equity community in the years running up to the credit crunch. Let me take each in turn and examine how they were not just forgotten but indeed turned on their heads.

First: more is better than less.

In the giddy days of the private equity bull market, the hot idea was to invest in companies with the highest multiples of distributable cash.  These companies were paying the lowest dividends, and theoretically their leverage meant that you could get the biggest bang for your buck. Thus people believed that in an up market, this would give them greater profits.

Effectively, people were paying a premium for receiving less. Unfortunately, the markets didn’t continue to go up at the expected rate, and many of these businesses lost substantial value.

Second: sooner is better than later.

Rather than investing in businesses where you would get your money back quickly, the hot sectors were those that attracted very long term debt packages that sucked out all the cash flow, and hence where the return profiles meant that no cash would ever be returned from distributable cash flows. Consequently, you were simply hoping that somebody else would buy the asset from you on the basis that it had increased in value, even though it still could pay no dividends.

Third: certainty is better than uncertainty.

Rather than investing in certainty, US and UK private equity focused on companies which needed the existing management to make changes to their business model, even though these management teams had not done it for the previous shareholders.  Many of these private equity houses did not have the resources to do it themselves if the existing management proved unwilling or incapable of change, which many management teams did.  In these circumstances, they had bought a business based on one business plan, but which was continuing to operate on a very different one.

Let me address how each of these rules should be applied.

The first rule:  “More is better than less.”

Private equity firms should look at what multiple they are buying the businesses at. While buying a business on a high multiple can work in a boom time, the economic environment is cyclical. In a downturn, distributable cash is key.

The second rule: “Sooner is better than later.”

While it’s fine to invest all distributable cash in a business, or even use it to simply pay down debt, you do have to take into account your exit horizon.  When you exit, buyers, in normal markets, will be looking for cash to be generated by the business, and will want dividends. In normal markets, not many investors are willing to wait a long time before they receive a return, however strong the markets are.

Which leads me to the third rule: “Certainty is better than uncertainty.”

At Terra Firma, we thrive on tackling things that need to change.  Changing businesses like this delivers outsized returns over the long term, whatever the market. We are set up to do this.  It is why we have a large operationally focused staff, even though we only average two to three deals a year. It is why we do not buy companies and then hope that existing management and consultants can sort them out or that the markets will save them or that they will become hot.  We must be in control, we must drive our plans for the companies we buy. The operational and strategic change we focus on requires us to have our own resources in the companies we buy to ensure there is as little uncertainty as possible.

Successful private equity investing requires certainty as to what your goal is, and then having a plan and the people to drive the company to that goal. 

While private equity in China faces its own unique set of challenges, not least the difficult IPO exit market, the principles of creating value remain the same.  During the boom years, firms forgot this, and were seduced by the appearance of easy profits.

We’ve seen the consequences of this in European private equity.

For private equity to flourish long-term in China, firms should focus on the hard work of transforming businesses and adding value. It is not easy, but it is the only sure way of finding success.

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