Chairman's letters

24 February 2006

Guy Hands' speech at the Deutsche Bank Conference - 2006

Good Morning. 

Before I address two critical themes that I see affecting private equity, I should let you know a little about Terra Firma. 

We were established in 2002 as an independent private equity firm and as the successor to Nomura’s Principal Finance Group (PFG) which I set up in 1994, having left Goldman Sachs, after nearly 13 years, to form a European private equity fund at Nomura. 

Over the last 11 years we have invested €8.1 billion of equity in 23 companies and produced an IRR of 49%.  

We have over 60 financial and operating professionals located in London and Frankfurt with wide-ranging expertise, including operational, financial and managerial experience.  This large and deep team enables Terra Firma to execute large control buyouts of asset-backed businesses most other private equity firms tend to avoid: 

  • The Big – we have done 15 LBOs of over €1billion each;
  • The Bad – we look for businesses in need of operational, managerial and strategic change;
  • The Ugly – we like businesses with regulatory issues in unfashionable sectors;
  • The Complex – we also like businesses with structural issues; 

Our most recent deals have included the acquisition of Waste Recycling Group, making us the biggest waste operator in the UK; the acquisition of Odeon and UCI, making us the biggest cinema operator in Europe; and the acquisition of Tank & Rast making us the biggest motorway service station operator in Germany. 

So we are a unique organisation, tailored to deliver superior returns to our investors from Terra Firma’s differentiated investment strategy.  

So, that’s Terra Firma and I’m glad we’re different as I believe there are two key issues facing large private equity groups today which will mean that differentiation and added value are key to success: 

  • Firstly, the growth of the “me-too” Mega funds
  • Secondly, the increasing involvement of politics in the alternative investment businesses 

1. The growth of the “me-too” Mega fund

In 2005, global private equity fund-raising reached new highs of over $264 billion; it has grown at a compound rate of 18.5% over the last five years and shows no signs of abating.  Last year’s fundraising alone gives the industry $1 trillion spending power. 

It is not impossible that the Private Equity industry could do a deal size of, or bigger than, RJR Nabisco in the next 12 months. 

Private equity already represents 30% of the number of UK M&A deals and represents 50% by value; in 2005, private equity was responsible for $255 billion of takeover activity worldwide. 

Something our hosts will appreciate is that, in the UK alone, private equity generates over £1 billion a year in fees for financial advisors. 

With fund sizes now topping $15 billion and add-on public vehicles of up to $5 billion with a leverage capability of four-to-one, and the endorsement of club deals as a winning concept, this can only accelerate the significance of private equity.  Indeed, no company, and I mean NO company, is totally safe from a public to private takeover. 

But the changes go further as over the last five years big global players have taken in most of the money.  Over $1 billion funds represent more than 80% of the capital raised for private equity in 2004/5.  In fact in 2005 the largest twelve private equity funds accounted for 50% of all the buy out capital raised. 

One has to ask if it is healthy for 50% of global private equity money to be in the hands of so few players? And if it is not, then it is surely even more potentially harmful when this group spends much of their time doing club deals with each other  - effectively offering Limited Partners no choice of investment strategy and taking out 25% of the equity value in fees every time a company is flipped between private equity funds. 

Furthermore, public equity is becoming steadily less important relative to private equity and, for investors there is progressively less choice of equity vehicles as equity is controlled by fewer and fewer firms. 

However, to be fair, to-date the larger and bigger global club deals have been very successful for both Limited Partners and General Partners.  The returns of mega funds and private equity over the last five years have been good although it is increasingly becoming more correlated with public equity. 

I worry that those returns that have been made on the back of a pretty simple formula – buy the business, back the management, leverage it up, sell it on and make money.  It is a nice formula, in fact, it is a great formula and there is no doubt it has made a lot of money.  The problem is that the world where such a simple formula works is coming to an end as we inevitably approach the end of this global bull market for credit and people will then not just be able to flip deals to the slow moving deer – they are actually going to need to add value. Because the market bubble is faltering and spreads will go up; so the ability to make money simply by sitting there while the world provides more credit is ending. 

Importantly the market is becoming increasingly attuned to the fact that private equity-backed IPOs tend to underperform the market.  For those private equity groups seeking exits via IPOs, that is a real problem  

And as the hubris grows in the private equity management teams around the World, society is increasingly focusing on the investment industry generally.   

You only have to look at the press to realise that Alternative Investing and Tax Strategies have moved from the business pages of the quality press to the front pages of the tabloids. 

And with the tabloids comes political focus; and hence my second major issue that is affecting private equity ie. the increasing influence of politics on our business. 

Let me give you key points to illustrate the impact on the general Alternative Investment landscape. 

Regulation is on the increase in the EU and worldwide; taxation of private equity is on the increase in EU and also worldwide.  This increase in regulation will affect all types of alternative investment. 

The increase in tax will indeed affect all alternative investments.  Economic stability is now the key focus of all central banks.  Therefore, it doesn’t help that alternative investment groups, especially hedge funds, are perceived to be the generators of instability. 

Investment returns are increasingly coming under the spotlight just as governments realise that pension deficits could be reduced through high investment returns.  Governments are therefore questioning whether good returns for alternative investment are sustainable in the long run or, whether they are just a short term phenomena.  This has not been helped by the recent poor performance of hedge funds and of listed private equity vehicles. 

This is all against a background of globally increasing interest spreads.  Its is no coincidence that Warren Buffet attacks the transaction costs of the investment community and then announces that he is giving all his money away.  Warren Buffet, more than anyone else alive today, knows where the long-term trends are going and they are not in favour of the “me-too” generalist Mega fund or the giant general hedge fund. 

To borrow a Darwinism, it won’t be the biggest and fittest who survive and prosper but those who are most adaptable. 

To beat market returns you will need a differentiated strategy – a strategy that adds, and is seen to add, value. 

Understanding where the politicians are coming from and avoiding their wrath will be key to not only a quiet life but to an economically healthy one too.  Our economic success is an easy target for politicians to attack to hide their political failures. 

And will Terra Firma adapt and provide above market returns in this environment? 

Well I think so, for three reasons: 

Firstly, we have recognised these issues and the threats and opportunities they provide and we will not chase size for the sake of it; 

Secondly, we have deliberately staffed up with the experience and expertise to deal with tighter political and regulatory focus; and 

Thirdly, we will continue to focus where others dare not tread.  The big, the bad and the ugly. 

Thank you.

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