Chairman's letters

01 December 2009

2009 Annual Review Letter

Dear All

I am delighted to present the third Annual Review of Terra Firma and its portfolio businesses.

Those who have read our previous annual reviews will know that Terra Firma has always believed that private equity adds value for all its stakeholders through the fundamental improvement of the operations of its investments. In the current environment this is truer than ever, and I therefore wanted to start my letter by providing you with some headlines on what we have achieved in our portfolio. We currently operate businesses in six industries: energy; motorway service stations; housing; agriculture; transportation leasing and entertainment. We have achieved significant milestones in each of our portfolio businesses:

Energy: We are one of the largest independent investors in green energy in the world. In 2009, we were ranked third worldwide in M&A transactions in the sector, only behind state-owned entities from China and Norway. Through EverPower and Infinis, we now produce almost 500 megawatts of green energy per annum which provides enough electricity to power 550,000 households. In development, we have projects that will produce a total of two gigawatts of green energy, enough electricity to run nearly one million additional households. In addition, the natural gas supplied by PNG in Northern Ireland produces 25% less carbon dioxide than oil does and virtually no sulphur dioxide.

Motorway service stations: Tank & Rast provides restaurant and toilet facilities to 500 million customers a year in Germany and is the fourth biggest caterer in the country behind McDonald’s, Burger King and Lufthansa. We have increased the EBITDA over the last five years from approximately €125 million to €180 million and customer satisfaction has risen from 70% to 98%.

Housing: We are the largest private landlord in Germany, through Deutsche Annington, and one of the largest in the UK, through Annington. In Germany, where we have responsibility for the maintenance of the properties, we have spent over €700 million in the last five years. In 2009, we opened a new customer service centre which has improved, on average, our availability to tenants by over 50%. Furthermore, we now provide a 24/7 hotline for urgent repairs which is an industry first.

Agriculture: This year we purchased Consolidated Pastoral Company (‘CPC’), the second largest beef producer in Australia with a collection of farms that covers an area of 14 million acres. Our 346,000 cattle are grass fed, providing protein for the Far East through more environmentally sustainable methods of farming than corn fed beef. Whilst it is early days, we are already focusing on how to invest additional capital to make more efficient use of our precious water resources thereby increasing the productivity of the land.

Transportation leasing: We have transformed AWAS from a marginal player in the global aircraft leasing sector into one of the largest independent aircraft leasing businesses in the world, with a current fleet of over 200 aircraft and an order book of an additional 124 planes. With a highly diversified customer base of around 100 airlines in about 45 countries, AWAS’ performance has been resilient in the face of a severe cyclical downturn in the aviation sector. More specifically, by December 2009, AWAS was achieving fleet utilisation of over 98%, and through the 2009 financial year AWAS’ underlying earnings were maintained at 2008 levels. Both of these results are outstanding in the context of one of the most difficult years ever experienced by the aviation sector.

Entertainment: Odeon is one of the largest cinema chains in the world and the largest in Europe. Since we acquired the company, EBITDA has increased by 25% and by the end of the first quarter of 2010 we will have converted over 350 screens to 3D. We believe that cinemas remain extremely good value in the entertainment sector and therefore continue to invest in expanding the chain where appropriate. In our other entertainment business, EMI, earnings increased from approximately £165 million to nearly £300 million over the first full fiscal year of Terra Firma’s ownership. On the creative side, in the last 18 months, EMI has signed new agreements with over 200 artists and has continued to win numerous artistic accolades including 24 awards at the 2010 Grammys. While we are proud of our operational accomplishments at EMI, its capital structure has proven challenging. Unfortunately, despite great effort, Terra Firma did not reach agreement with Citibank on a restructuring of EMI’s debt during 2009. Nonetheless, EMI continues to be focused on driving further operational improvement in the business.

In short, Terra Firma is busy creating value in essential businesses throughout the world in an extremely difficult environment.

Since the middle of 2007, we have found ourselves in a new financial period, facing substantial uncertainty. Many of the familiar relationships of the past thirty years have been wiped clean by the financial collapse that occurred in 2008. From 1980 onwards, we became accustomed to Western economies and societies being buoyed by strong financial markets, declining interest rates, low inflation, liberalised international trade and steady economic growth. While we suffered periodic recessions and even sharp market declines, these periods were relatively short-lived. An entire generation of business executives and investors built their careers and drew their experience from this three-decade period.

Throughout 2009, many investors tried to read the signs of economic stabilisation as the first indications of a sustained recovery. Understandably, they were drawing on experiences that had held true in the past. However, the imbalances we have created in the West through deficit spending and borrowing by governments and consumers have produced a period where the way forward looks unfamiliar. This uncertainty is compounded by increasing economic and political power in the East. In the government sector alone, total debt for many Western countries is approaching 100% of GDP or more, a level normally reached only at a time of major war. Before this crisis, the US was already running up debt to finance two wars and its health and retirement benefit programmes. Then the US was forced to finance the bank bailouts and stimulus plans, piling more debt on top of an existing debt mountain. The US deficit for 2010 is now estimated by the Obama Administration to be $1.55 trillion with annual deficits not declining below $700 billion for the foreseeable future.

As difficult as the situation is for the US, total public and private debt in the UK grew at a staggering 157% of GDP from 2000 to 2008 (over twice the US growth rate) according to a study released by McKinsey at the start of 2010. This puts the UK in a class with Spain, whose total debt grew at 150% of GDP. The UK will clearly suffer a long and painful period as it unwinds this level of leverage over the next decade. If it fails to clean up its balance sheet the UK could find itself cast into a category with the weakest states in Europe.

This situation is creating an increasingly fractious political and social environment in the West. The policy solutions for addressing the high levels of debt and the basic imbalances in the UK economy call for political courage. Unfortunately, the political horizon only runs to the next election and not to the five to ten years that will be needed to address the UK’s problems. Social strains are opening up throughout the West. Income inequality, which grew steadily in the past 30 years, did not lead to social unrest because the rising economy masked its impact. However, in an era of persistently high unemployment, particularly among the young, these tensions are surfacing in the form of extreme anti-immigration movements and in the rise of fringe parties throughout the Western world.

Looking ahead, some believe the Western ship is headed towards Japanese-style deflation, while others, and I include myself in this camp, think we will in time encounter a serious bout of inflation. Is there a path between these two outcomes? Perhaps. In his excellent book, ‘Money for Nothing’, the economist Roger Bootle suggests that there is a chance that we can navigate a middle course and return to prosperity if we can avoid the protectionist trade policy that is currently gaining currency in both the US and the European Union. Protectionism does huge harm to consumers, taxpayers and to the economies of the world. In times of economic crisis the standard political reaction, however, is to become more protectionist. This would be a terrible mistake. The West needs to be receptive to China and the rest of the developing world and they, in turn, need to be open to the West and accept changes in currency rates. The world needs to encourage openness, flexibility and entrepreneurship.

So what does today’s continuing uncertain climate mean for private equity firms? I see both challenge and opportunity. The challenge is that, until the last few years, returns could be enhanced by continually increasing leverage. However, given the current lack of credit, in order to generate returns private equity firms will need to deliver real value and improve cash flows to equity by making improvements in the operations or corporate strategies of their portfolio businesses. For those firms that can do this, there will be real opportunity.

Given my views on the economy and the capital markets, I believe that private equity firms should now be looking to reduce the level of leverage in their existing portfolio companies and be extremely careful about what leverage they use in new deals. This is why Terra Firma will be bringing down the level of leverage in our portfolio companies over the next few years. If the economy is stable and markets continue to go up, this approach will deliver good returns, but will not maximise them. However, it will reduce the risks to the portfolio if, as I expect, the Western economy fails to return to sustained economic growth for the next few years. In short, it will improve the risk-adjusted returns of our portfolio, and I firmly believe this is the right strategy in the current environment.

This is an environment that also creates great prospects to invest in specific companies and situations, where one can drive operational change and manage risk. As I said, in this regard Terra Firma is well positioned. We have long believed that delivering such operational improvement is absolutely key to the private equity value proposition. A strong operational team has always been central to our business and we continue to seek to expand our operational resources. Our operating team is vital not only to delivering strategic change, but also to pushing our companies hard. The difference between achieving poor or good performance is attention to detail and the pursuit of every opportunity to add value, be it expanding the Sanifair rest room concept to other businesses beyond the motorway service stations at Tank & Rast or sourcing low-cost turbines for EverPower. This attention to detail means that overall, and despite the economic environment, the total EBITDA of the Terra Firma portfolio grew by approximately 2% in 2009. To put this in perspective, while it is still too early to have year-end data for public companies, the reported EBITDA for the FTSE 250 companies for the 12 months to Q309 actually declined by more than 10% and by almost 25% for the Dow Jones 600 (Europe) companies. As you review the performance of our portfolio businesses, I hope you will agree that operational focus and control has made a huge difference to our portfolio’s performance in these challenging times.

The sourcing of transactions in the current climate will be far more difficult for private equity than it has been over the last ten or so years due to the economic uncertainty we face. However, there will undoubtedly be interesting areas for private equity players who are prepared to analyse in depth industry trends and business dynamics and to engage in the operational details. There are economic sectors that are completely fragmented, lack market leadership and are amenable to bolt-on acquisitions. There are businesses that require sizeable capital expenditure or development capital and there are whole industries that have excellent prospects because they face growing markets despite the troubles in the West.

These types of opportunities are not readily apparent especially in the current economic environment. Favourable sector trends are often obscured or overlooked by the macroeconomic trends. Assets within an industry may look unattractive because they are improperly deployed. Analysing these themes over extended periods and then identifying specific investment opportunities has always been Terra Firma’s approach. This is illustrated by our two most recent investments in agriculture and green energy, both of which are exciting areas that can benefit significantly from operational input. We thoroughly explored the key drivers in meat production and wind power for a considerable period of time, turning down numerous potential opportunities, before acquiring CPC and EverPower.

Bringing a unique view to sectors and initiating change in companies is fundamental to what we do at Terra Firma. We know that transition periods are volatile and uncertain and make it difficult to execute transactions and manage businesses. However, investments made and businesses managed during such uncertain times can be highly successful. As you read this report, I think you will find ample evidence that our approach is sound, and that our managers have the ability to build value in our portfolio businesses despite the highly challenging and unsure road ahead. I am immensely proud of their efforts.

Successfully acquiring, managing and selling portfolio companies is just part of the responsibility of a private equity firm to its investors. The alignment of interest between the private equity firm and its investors is an equally critical component of our business, especially in this challenging environment. In this regard, the Institutional Limited Partners Association (’ILPA’) has issued Private Equity Principles addressing alignment, governance and transparency. I think these are, for the most part, a major step forward. For those readers interested, more detail can be found at Many of these principles have been part of Terra Firma’s modus operandi from the very beginning and it is for this reason that Terra Firma has decided to formally endorse them.

For example, the principles call for tighter distribution provisions for carried interest. Terra Firma’s funds are structured on a ’fund as a whole’ basis with cash hold-back arrangements. This ensures that our investors receive back all their contributed cash and an agreed return before Terra Firma is able to participate in the profits generated by its funds.

The principles also seek to refocus private equity firms on earning the majority of their compensation from the profits generated by the funds they manage rather than from earning excessive fee income. The principles therefore propose that private equity firms should not be paid ancillary fees such as ’monitoring’ or ’transaction’ fees. Terra Firma has always been of this view and so has never charged such fees. These principles also cover a number of governance issues including investment strategy consistency, the rights of investors, the operation of the fund Advisory Board and the independence of the fund auditor. Terra Firma has operated within many of these parameters since its inception.

The principles really reach the heart of the matter when they insist that the private equity firm should have substantial investments in the funds that it manages. This is unquestionably the best way to achieve alignment, and Terra Firma and its employees are among the largest investors in our funds.

One of the most important general principles set out by the ILPA is the importance of transparency. Terra Firma shares this belief as evidenced by this Annual Review and our quarterly reports to our investors. We believe all stakeholders in our businesses should understand the strategies and financial results of our portfolio companies, and that our investors should be able to fully comprehend the sources of our returns and valuations. However, while transparency is a laudable goal, it has to have sensible limits if private equity firms are to successfully manage their portfolio businesses. When transparency is taken to an extreme, it creates enormous damage as competitors and bankers are able to take advantage of portfolio businesses by simply reading the newspapers. The principles rightly reiterate that all proprietary information should be protected from public disclosure and Terra Firma fully supports this.

While many investors are taking a reasoned approach to private equity’s current difficulties, I am afraid that government attitudes to private equity are threatening to become destructive and punitive, especially on the regulatory front. While I wholeheartedly endorse government efforts to try to limit systemic risk in the financial system, I am alarmed when regulatory change becomes retaliatory. The private equity industry did indeed make its share of mistakes during the boom years. However, I think it is fair to say that our errors never threatened the financial system and that we have borne our losses without any bailouts from Western governments. Even so, politicians on both sides of the Atlantic facing angry voters have decided that private equity is an inviting target.

2010 will not be an easy year for anyone in private equity and I think it will definitely be tougher than most people expect. I would therefore like to thank all of our investors for their continued support in these tough times. I am convinced that for those private equity firms such as Terra Firma which focus on building value in their portfolio businesses through strategic and operational change, 2010 will offer opportunities both to invest and to grow our portfolio companies.

Best wishes

Guy Hands - Chairman, Terra Firma

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