07 June 2013
Guy Hands speech at SuperReturn US - "Why One Should Invest in Europe"
I am here today to talk about why one should invest in Europe.
Clearly it doesn’t seem the most natural of conclusions, given the Anglo/American press headlines. Many in the US and the UK believed that the euro was teetering on the brink of collapse throughout much of last year and that many European nations would need to be bailed out. And there’s no denying that the situation in Europe today is politically and financially difficult.
The economic crisis may have passed its most acute phase, and while last year’s crisis was never as bad as the press reported, there will be more crises to follow. Indeed it is difficult to see anything but political and economic volatility over the next few years with no clear way forward being agreed for the European Union.
However, it is important not to underestimate the political will of many countries and senior politicians in Europe to keep Europe together and to keep driving the European project forward.
From across the Atlantic, it may seem that the European Union is slowly being allowed to disintegrate by politicians whose immediate goal is to please their own national constituencies and stay in power. But the commitment to the project from most European politicians is real, and they are willing to do as much as is needed to keep the European united vision moving forward.
Meanwhile, economic growth in Europe has been lacklustre for some time, and this is unlikely to change soon without a fundamental restructuring of European labour and business practices.
However, at Terra Firma, we see a number of opportunities coming out of this environment.
Banks are continuing to deleverage and they are shedding some assets under pressure from regulators to shore up their capital ratios. Meanwhile, with the debt markets reopening, assets can be acquired with a reasonable cost of capital.
While in Europe, the cost of capital has not recovered to the extent it has in the US and this provides some protection on the downside when investing in Europe and opportunity on the upside in comparison with the US, where the cost of capital has hit historical lows and prices have moved up in tandem.
One of the biggest lessons we need to learn is that when things were going well, people made the mistake of assuming that things will continue to go well forever, and they made decisions based on the assumption of continuing good markets.
The fact is that markets over time tend to return to their long-term trend: they may go up, but they will correct – and they will tend to over-correct, which is when losses are made, before markets ultimately return to normal.
Markets fell in 2008 and fell further at the beginning of 2009, as the market corrected and then over-corrected. There had been a long period of rising asset prices, but, over a couple of years, the gains of many years were wiped out.
In the US, that loss has now been recovered. The adjustment was painful, but a decisive and quick recapitalisation of the banks allowed them to start lending again and for businesses to be restructured. This was highly profitable for US private equity and produced some great results.
However, in Europe the banking sector has not yet been recapitalised, and so there the cost of capital continues to be high and it has been far harder to make money with few businesses being restructured. There are exceptions, of course.
I’m very proud that last December Terra Firma completed the refinancing of Deutsche Annington, the largest real estate refinancing in Europe in 2012. It was not easy to get this deal done, and many people said it was impossible – but with a lot of hard work and determination, it got done.
Growth in Europe is sluggish, and is likely to remain slow for the foreseeable future.
Unless Europe is willing to undergo a total restructuring of its labour markets and business practices similar to what Germany did under Chancellor Schroeder in the period from 1998-2005, moving Germany from a sick man of Europe to an economic powerhouse.
However, it is important to understand what we mean when we talk about European ‘growth,’ and to put it into a context that is appropriate to PE investing. In particular when looking in the context of the PE industry in Europe, one firstly needs to remember that Europe is not ‘all the same’ – there are pockets of opportunity in all geographies in Europe, and each geography within Europe has to be looked at individually.
Secondly, historically there has been low correlation between European macro trends and PE returns in Europe.
Thirdly, PE is a long term business and one cannot ‘time’ markets – especially since the market view changes every 6 months or so.
Fourthly and more importantly in 5 to 10 years time at the point of exit the market will be most certainly different.
Finally, multiples are more conservative in Europe than in the US as there is less leverage, and hence when one invests in Europe they have more protection on the downside and more opportunity on the upside.
As a private equity firm operating in this environment, it is critical to seek out individual deals where one can add value at a micro level. While the macro environment is not good, the micro environment can be good. PE is a micro play not a macro play.
People often overestimate the macroeconomic effects on PE deals, both positive and negative, and overpay for growth in good times and underpay in bad times.
Therefore moving away from macroeconomic issues, I’d like to mention five micro factors which make Europe a good destination for private equity investment.
They are all consequences of the challenging economic environment in Europe, and they enable committed private equity firms with local knowledge to transform their underlying businesses and add value.
First, it is possible to make investments at good prices in Europe.
In 2007, there were a lot of private equity deals being done, and everyone was in the market to buy, which pushed up the price of assets. Today there is far less demand, and we are starting to see investment opportunities thanks to banks looking to shed distressed assets.
Terra Firma bought two very good companies from banks in 2012.
We purchased the Garden Centre Group from Lloyds for £276 million, just under the value of its debt. This compares to the £450 million that was paid for it in 2006.
Terra Firma also bought care home company Four Seasons from its banks for just over £800 million, after it had been bought for £1.4 billion again in 2006.
For both businesses, their earnings hardly changed between 2006 and 2012 – but the cost of debt for businesses in their sectors increased substantially, and hence their valuation multiples came down, allowing us to acquire them at very reasonable prices with very little leverage. In both cases with less than 50% of the debt they had in 2006.
These transactions were not easy to execute, and involved negotiating with banks that were under substantial stress and hence were not acting totally economically rationally.
The second positive factor in Europe is the opportunity to make strategic improvements. Many companies have not had a new or revised their strategy in the last few years as their management teams have had to focus on surviving through a very difficult economic situation. As a result, there are a lot of businesses in Europe struggling with unsuccessful or outdated strategies.
This provides a perfect opportunity for private equity firms with a hands-on approach to strategy and operations to improve business performance.
The third factor is capital expenditure.
The businesses which are struggling in Europe have not had spare cash for capex, and this leads to a lot of underinvested businesses being available in the market. Again, this is a good opportunity for a private equity firm to acquire sound but underperforming businesses, inject money into them to be spent on capex and transform them into more valuable, better performing companies.
The fourth factor is management.
Executives at many companies have spent the past few years having to keep a very watchful eye on costs and margins, and getting by without spare cash to invest in their business. Many of these managers are not short of ideas, but they are lacking resources and support. With private equity backing, these managers can be re-energised, and the companies they currently run can move forwards.
The fifth and final factor is M&A.
Despite recent improvements, the merger market in Europe has been slow due to the low prices that people have been willing to pay. That may remain the case for some time with major deals – although Annington Homes which we purchased last year was the largest European LBO since 2008. But I do believe there will be increasing examples of portfolio businesses in Europe carrying out merger strategies in order to grow and drive value creation.
If you focus on these five factors, many businesses in Europe are available to buy that provide positive investment opportunities through optimising one or more of these factors.
In conclusion, the macro situation in Europe is not good; however, PE is a micro business and it is clear why many businesses in Europe are struggling, and how private equity involvement can help them succeed.
In the US, money has flooded back into the private equity market, driving up prices and reducing opportunities. It will be a while yet until this occurs in Europe, but in the meantime there is less risk on the downside, and there are many opportunities to generate value on the upside.
I believe that there is great opportunity in Europe for the focused investor.