01 August 2009
2009 Q2 Investor Letter
We are now in the longest and deepest recession of the post war era. It is, therefore, entirely understandable that investors are continually on the lookout for any sign of recovery, the so-called ‘green shoots’. People have pointed to a number of events such as the recent rise in stock prices, the narrowing of credit spreads and the re-opening of the US high yield market as indications that the recovery is underway.
Unfortunately, I am not so optimistic. The vast proportion of the increase in economic activity is the result of unprecedented government stimuli across the globe financed by an extraordinary issuance of public debt. Most of the structural underpinnings of the recession – the impaired balance sheets of financial institutions, Western consumers and governments – have yet to be adequately addressed, and thus I fear that weak economic conditions will persist. Indeed, when the Western economies finally do recover some time in the next decade, we are likely to experience a period of persistent inflation as a by-product of the stimuli.
For private equity firms, the current environment has necessitated significant markdowns of most portfolio companies. Despite the recent rally, the public equity markets are still well below their peaks, and the contraction in investment multiples means that mark-to-market accounting delivers low valuations. Nonetheless, as we shared at our recent Investor Conferences, the fundamental performance of our portfolio companies is holding up admirably, and this bodes well for the ultimate valuations when we eventually sell these companies.
Of course, the positive corollary of lower valuations is that it makes new investments more attractive, and we are seeing this across a wide range of sectors. The weakness in the economy is revealing distressed sellers, and many over-leveraged businesses are excellent targets for restructuring. Nonetheless, financing is limited and transactions will progress slowly. As a result, we are likely to do deals that start off smaller than those that we have done in recent years. However, our intention is that these platform deals will increase in size over time as we make additional investments. Terra Firma has a strong history of following this approach in recent deals with the likes of WRG, Odeon, AWAS and Deutsche Annington.
More generally though, attractive valuations and patience will not be sufficient to drive successful private equity investments in the current economic setting. To succeed, private equity is going to have to discard the ‘conveyor belt’ mentality that characterised the industry in the 2004–2007 era. Driven by plentiful credit and the unquenchable urge to get as big as possible, private equity became formulaic: acquire a company through a tightly controlled auction run by bankers; immediately restructure the balance sheet through a debt package offered by those same bankers; then engage the same bankers to run yet another auction process to sell the company (often to another private equity firm) and then yet again hire the same bankers to help raise a larger fund.
If everything was done according to the operating manual, the bankers were paid their fees, private equity generated big IRRs for their investors, and everyone was happy. Critical thought was not required; in fact, it was a hindrance because it raised uncomfortable questions that might upset the ‘process’ and slow down the conveyor belt. Private equity’s assembly line began to deliver something that was becoming little more than a leveraged version of public equities.
We have all learned the hard way that private equity is a much more sophisticated product and requires a far more creative and sensitive process to be successful. The boom era made private equity investing seem like an undergraduate degree course with a structured syllabus, set reading list and well-defined terms or semesters. In truth, as the emerging environment will show, successful investing is more like a doctorate. You need to come up with your own thesis. You need creative and innovative thinking, and there is no pre-determined start or finish to when you should invest or when you should exit.
Unsurprisingly, given the over-confidence the industry demonstrated both internally and externally between 2004 and 2007 in its rush for growth, the European Union and the US Government are both looking at the role of private equity in Western economies. However, regulation is not the answer. Only private equity can move itself away from the formulaic approach back to a more creative, value-added style of investing. Nonetheless, we need as an industry to pay very careful attention to governments as they may well impose restrictions that hamper our ability to deliver value. For example, the Alternative Investment Fund Managers’ Directive that is being debated in the EU includes, along with other initiatives, attempts to restrict the marketing in Europe of non-EU managed funds which would have serious consequences for international private equity. Furthermore, attempts to regulate leverage levels of portfolio businesses are also being considered. There is no evidence that private equity investments pose any systemic risk to our financial system, so there is no discernible reason to impose limits on gearing by private equity any more than for any other type of business enterprise. In fact, the mere discussion in Brussels of this type of restriction is creating enough uncertainty to hamper private equity’s ability to restructure the balance sheets of portfolio companies and ensure that capital is used efficiently to drive the performance and growth of our businesses.
In the next few years, Western governments will need a vibrant and thoughtful private equity industry more than ever before and not just to help stimulate the broader economy. As an overly-leveraged owner of many businesses and financial institutions, in the near future, governments will become active sellers of companies, as they were in the mid-late 1990s. This will play to a big strength at Terra Firma. We have done extremely well in taking over former state-owned firms. These businesses can be particularly challenging since they usually lack both a sensible corporate structure and a private sector ethos. In managing them, one has to accommodate a broad range of stakeholder concerns, and in certain cases, operate within the constraints of binding social protection agreements. However, private managers who can navigate these waters and work with all stakeholders can generate considerable long-term returns for investors. Annington, Tank and Rast and Deutsche Annington all show that Terra Firma has the skills and judgment to be able to invest successfully in this area.Whether we acquire businesses from government or distressed sellers, the key step is then to create value post-acquisition. Operational change means we will have to break a few eggs and upset the status quo. Terra Firma has long prided itself on its operational approach, and it certainly has a lot of people who excel at scrambling eggs and taking the heat of upsetting the status quo. There is no better example of this than EMI where we have achieved a remarkable turnaround in Recorded Music as a result of huge effort by Terra Firma’s professionals.
Operational advances in a portfolio company must, however, be supported by an appropriate capital structure, particularly in these difficult times. What was the right capital structure in 2007 is most definitely not the right capital structure in 2009. Terra Firma has deep and dedicated financial teams that have spent long hours strengthening the balance sheets of our portfolio companies. Obviously, EMI has been our largest challenge on this front, and we continue to work hard on a potential financial restructuring of the business. Despite all that has been achieved at EMI, the operational turnaround will only be meaningful if the capital structure of the business can be re-worked and de-leveraged. We are therefore most grateful that our Limited Partners have given us the necessary support to enable us to pursue such a potential restructuring. We are, of course, doing everything we can to deliver a positive result for all, but there can be no guarantee that we will be successful as the EMI deal was done at the very peak of the 2007 credit bubble.
In sum, while we face further economic challenges, I believe private equity has much to offer as an alternative asset class in this new environment. If private equity can add operational value to businesses and buttress those businesses with sound balance sheets, we will generate attractive returns for our Limited Partners. My belief is that in the future, the private equity industry will be smaller, but considerably better at delivering long-term value. The private equity players who survive the current difficulties will offer a truer form of alternative investing than the ‘conveyor belt’ that existed in the boom years, and we will all be better for it.
With best wishes