19 June 2008
Guy Hands' speech at the Terra Firma Investor Conference - June 2008, Abbey Road Studios (London)
Good afternoon, thank you for coming and welcome.
I would like to start by revisiting some of my comments from our conferences of recent years – the speech equivalent of marking-to-market. It is a dangerous thing to do as a lot of CEOs and politicians have recently found out.
In June two years ago, I said that 2006 would be the Woodstock year of private equity, “a cool year” and as good as it could get but I also said “there may be trouble ahead”.
I suggested over the course of the next twelve months more and more debt would be used with ever more complex structures and even more covenant-light terms.
I also thought the top of the market was coming and predicted that the expected Blackstone IPO would mark it. But I said I could not predict exactly when over the next couple of years the end of cheap leverage would come.
I said that as an industry and as an economy we were all flying far too close to the sun with too much hubris. I also looked at the levels of personal debt out there, and I said that at some point the consumer would balk.
So in 2006, I thought the next 12 months would be wonderful, and indeed they were, but that a credit crisis would come and, I predicted, probably sometime in 2008.
In June of 2007 I reinforced many of the same continuing trends such as ballooning debt levels. “We have seen the consumer getting yet-more leveraged by the day as banks rushed to lend to anything that moved, including 115% mortgages issued by lenders such as Northern Rock”.
And, I outlined some new trends, such as large amounts of equity coming from non-traditional purchasers from new areas of the world.
So, in June 2007, as in 2006, I predicted that credit markets would collapse, but I did not predict that they would collapse within a month of last year’s conference, neither that they would collapse on such a drastic scale, nor that it would cause such turmoil. I still felt we had six months at least.
In December 2006, I outlined three goals for Terra Firma to achieve in 2007:
First, to re-finance or sell all existing portfolio businesses. Fortunately we managed to get that done just in time with some transactions only closing last September
Second, to raise a new fund of at least €4 billion, which we completed in May of last year, raising €5.4 billion.
Third, to close a deal which fitted within our strategy and gave us the potential to make Terra Firma-type returns.
That deal turned out to be EMI, and just to show you this recap is not selective recall, here’s exactly what I said about EMI at last year’s conference:
“The deal offers a combination of downside protection from the steady earnings of its publishing business and a complementary opportunity to re-position its recorded music business thus making it a very attractive opportunity.”
I continued “And I do mean reposition the recorded business; it will be radical; very radical, and, we would not be doing this deal without the security and underpinning of publishing”
That statement is as true today as it was when I said it.
However, the accelerated timing of the expected credit collapse has clearly effected that deal in many ways beyond what I could have imagined, and I will talk about that later.
Since our last conference we have entered into a perfect storm: events that mean that we are living and working in a completely different environment than the one we were just a year ago.
We find ourselves in a period of turmoil, particularly in the financial markets. We see the world entirely differently: the US is no longer the superpower in many parts of the world.
While in the real economy we are seeing the start of the kind of bear market we have not seen for a long time with increased inflation and unemployment but decreasing real asset prices. Many of you will never have worked in a bear market like this, since we have just exited a 25 year period of protracted economic stability and growth that started back in late 1982. However, we are now facing tough times that will last for several years, possibly a decade or more.
At Terra Firma, even as the storm swirls about us, we are continuing to focus on building our firm, and being prepared to benefit from whatever the markets throw at us.
It would be easy in this environment to do as some have done and simply, go to ground, go to the beach, or change what one does.
But instead we have focussed even more intently on what we have always done and we have sought ways to do it better. As well, we have also become even more transparent, regardless of the resulting negative press as we believe this benefits all of our stakeholders.
Terra Firma, as an independent firm, is now six years old. We are now substantially larger than we were when we set out in 2002. We have now grown to become nearly 120 people, including 80 professionals. We have clearly come a long way in our own development – but we must, much like our portfolio companies, be open to continued change and improvement.
At the same time Terra Firma must stick to its core investment principles. This becomes even more important in a tough market: a good market is forgiving of investors who lack discipline. In such a market, it is easy to make money. Not so in a difficult market.
The principles we need to stick to are these:
1) Alignment of interest with our investors. Alignment of interest must be a two way street – all too often the private equity General Partner wins in rising markets, but is insulated from losses in falling markets.
Now more than ever, it is essential we share the risk of this challenging environment with our investors and stay totally focused on what we invest in and what we do. True alignment of this type is what really differentiates a pure private equity firm from the managers of public companies, consultants and asset allocators.
2) We need to re-emphasize our fiduciary duty to our clients. This applies to the people who interact directly with our Limited Partners, as well as those who operate in the background and our portfolio companies. You expect a consistent strategy; you expect us to be able to execute it; and you expect us to have the resources to do it. You also expect us to be transparent about how things are going and what we are doing even if at times we do not agree with everyone. You our investors come with different objectives and from different geographies. Consistency of strategy, industry knowledge, openness and appropriate resources are all key to communicating with you.
We will not travel with the herd. Terra Firma is a contrarian organisation: looking for different, difficult, messy investments that need strategic and operational change. We challenge the status quo and find ways to do things better.
This is our philosophy – it is what we do – and we need to stick to it all the more in a difficult market. We must have the courage of our convictions and the courage to stick to our strategy.
We believe that by sticking to our principles, we will prosper and come out of the other side of this downturn stronger and better able to capitalise on the opportunities that will occur in the future.
The market is not there yet; we are in a period of ‘dead cat bounce’, even if for some the market still feels dead.
But there is still one hell of a credit hangover to come. However, after the hangover there will be tremendous deals to be done. In the meantime, we must avoid temptation – temptation to do deals that might well look attractive, but do not fit our strategy or key skills.
Right now there are real and immediate impediments to completing deals of the size and type we do. Even with prices down 20%, there is no available leverage, and interest costs are up, so expected returns down. Leverage at best is now 50% to 60%, it was 80%. Debt is priced at 550 over LIBOR when once it was 200 over.
But over the next few years, contrarian thinking and operational intervention and strategic redirection will be particularly valuable skills in acquiring businesses.
You have always expected us to make changes in our portfolio businesses in order that we build long term value and respond to market conditions. In an environment where financial engineering and leverage have limited utility, these operational and strategic capacities become critical. I don’t see leverage coming back for a very long time in Europe. Banks are shoring up their balance sheets, but they are not going back to leveraged lending.
Making change in our portfolio businesses is not a one-time event – we do not just make initial modifications to the business and then do nothing more or sell them on. We focus continuously on ongoing assessment and continued improvement to our portfolio businesses, including raising equity capital, when it is accretive.
Let me conclude by talking about our priorities for the next 12 months. We have four major priorities for Terra Firma in the next year. We need to:
- De-risk the EMI transaction by focussing on the strong cash flow businesses of music publishing and catalogue whilst not allowing them to cross-subsidise new release. However, at the same time we must be bold with new release and ensure that it becomes an entrepreneurial business that focuses on profits and not market share and glamour
- At AWAS, we need to take advantage of the current weakness in the aircraft market to expand the highly successful and unique platform we have built by purchasing more assets at cheap prices as we always planned to do. We now have that opportunity, let’s ensure we exploit it.
- We all need to work hard to ensure the current portfolio maintains its value in these challenging times and moves forward. We must acknowledge that exits will be difficult over the next four years and we might need to raise additional equity in order to be able to continue to build some of our portfolio businesses and take full advantage of the platforms we have created.
- We should acquire a new portfolio company for TFCP III. It won’t be easy, and we will have to piece the deal together bit by bit, but as I said these difficult times will produce opportunities. We therefore will work hard to bring at least one deal over the finish line though at the same time we will remain price disciplined.
Our execution of these priorities will form the basis for judging us at next year’s conference and next years mark to market.
For now however, let’s turn back to this year and examine what is happening in the current portfolio of TFCPII and TFCP III deals.