01 December 2010
2010 Annual Review Letter
Welcome to the fourth Annual Review of Terra Firma in which we are pleased to present Terra Firma and our portfolio businesses.
Strategic change and operational improvement in our portfolio businesses are at the heart of what we do at Terra Firma. We strongly believe that, by focusing on these strengths, we will deliver the greatest value to all of our stakeholders as we build sustainable businesses. 2010 was a year of modest economic growth in the West and continued recovery in the financial markets. For Terra Firma, it was a year of significant achievements for our portfolio companies as we detail in this Annual Review.
Clearly, the big public issue for Terra Firma in 2010 was EMI and the associated litigation. Whilst EMI was operationally transformed by the Terra Firma team under our ownership (with a doubling of EMI’s earnings), the relationship between Terra Firma and Citigroup during our ownership of EMI was not a happy one. This culminated in our court case about material misrepresentations made by Citigroup with regard to the auction for EMI in 2007. It was a difficult (and highly unusual) decision to sue one’s bank, but the merits of the case and our strong belief that our first duty was to our investors caused us to proceed with the litigation.
The credit crunch created an untenable situation for deals done just prior to that time and hence the timing of our bid for EMI became a material factor in the success of the deal. That timing was determined by the apparent existence of a competitive auction – something that we believe Citigroup misled us about. Had we known there was no competitive auction we would not have bid and, had the bid deadline been pushed back, the imminent decline of markets for securitisations and leveraged loans would have become more apparent and the deal could never have been completed. Still, the outcome of the trial was not what we wanted or expected (and is currently being appealed). While EMI is now part of our history, we have learnt a lot from the experience, and included later in this Annual Review are some of the lessons learnt from what happened post the auction.
Turning back to our other portfolio companies, we worked hard on improving and growing our portfolio businesses throughout 2010, as well as sourcing and evaluating acquisition opportunities to complement and enhance them. Terra Firma continues to own businesses across a diverse number of sectors including: green energy; infrastructure; ‘affordable’ housing; agriculture; transportation leasing; and entertainment.
This year’s Annual Review documents a year of solid results and steady improvement across the portfolio. For example, in the entertainment sector, Odeon & UCI reported 14% EBITDA growth year-on-year as audiences embraced the year’s strong 3D film slate. Despite the difficult housing market in the UK, Annington achieved higher rental income in 2010, and is poised to do well in 2011 with the release of 175 new units by the Ministry of Defence in the first quarter. In Germany, Deutsche Annington generated over €500 million in EBITDA for the first time in its history. Meanwhile, AWAS, our aircraft leasing business, refinanced $530 million of its Jetstream/Jetbridge debt in June and negotiated a $600 million loan in the autumn. In renewable energy, Infinis demonstrated another strong performance as year-to-date EBITDA rose 52% to £75 million. In the US, EverPower continued to invest heavily in its wind farms, making excellent progress on its development pipeline. Phoenix Group exceeded its target for natural gas connections, despite challenging economic and weather conditions in Northern Ireland. Similarly, Tank and Rast overcame a soft consumer economy in Germany and severe weather to post an increase in year-on-year EBITDA. Finally, at CPC, our agricultural investment in Australia, we maintained a high level of investment in the business and made an acquisition to continue to build scale. All these successes are testimony to the dedication of the employees at our portfolio companies and the strength of the working relationship between Terra Firma and the management of our portfolio businesses.
2010 marked an important year for the private equity industry as a whole – and a year of consolidation at Terra Firma. The private equity industry entered the year still reeling from the bust that had followed the boom period of 2004 to 2007, but the private equity industry began to take measurable steps towards recovery. However, available capital for private equity worldwide (‘dry powder‘) remained at an all time high, while the supply of investment opportunities offering attractive returns lingered at low levels, and hence investing for target returns was tough. Consequently, Terra Firma used 2010 to ensure that our investment strategy was firmly focused on our core thesis of investing in operating assets. We continued to scour the market seeking those investment opportunities that complement Terra Firma’s existing portfolio and fit squarely within Terra Firma’s investment model. We made bolt-on acquisitions that will improve the ultimate value of our portfolio companies such as at Odeon & UCI, where we acquired three key Italian sites. We also found new opportunities such as Rete Rinnovabile (RTR), a leading Italian solar generation business that will further solidify our market- leading position in the green energy industry.
Our investment activity in 2010 and the successes of our portfolio businesses meant that we moved from a feeling of gloom, which the credit crisis had cast upon us all, to one of measured optimism. Whilst not everything went our way in 2010, the year presented us with a unique opportunity to both build and reflect.
Having taken the time to look back on our experiences since the formation of Terra Firma in 2002, we have learnt from the pitfalls caused by the frenetic market activity that led to the 2007 bust. It is clear that all private equity firms in the period running up to 2007 maximised leverage to the greatest possible extent. In a stable economic environment, this was an entirely appropriate strategy. However, in a volatile economic environment, private equity firms must moderate their appetite for leverage in order to ensure the sustainability of their portfolio businesses even if it means sacrificing some potential return. In this way, the businesses become less vulnerable to a boom and bust cycle (as such a cycle will certainly re-occur). We have carefully analysed both the private equity industry and, within that industry, the particular business of Terra Firma, as we would any company we were looking to buy in order to determine what we did right and what may need to be changed.
Many private equity firms grew rapidly between 2002 and 2007, and Terra Firma was no exception. However, the private equity industry believed that its business model could defy the normal laws of rapid growth by capturing all the economic benefits of scale without suffering from the problems caused through strong growth. Terra Firma, in common with most of our competitors, expanded our business to take advantage of the market opportunity presented by the huge increase in the demand for private equity. We grew our fund size, our employee numbers and our geographical presence.
At Terra Firma, we saw the opportunity to apply our contrarian and interventionist investment approach on a much larger scale. We had invested successfully at Nomura from 1995 and formed a highly motivated team following our spin-out in 2002. We then had great success with TFCP II between 2003 and 2006 and were highly confident that we could manage a significantly larger fund, making much larger investments without compromising our investment success. From a core of about 60 employees, we began to hire in anticipation of having much more capital to invest. In a short period of time, we effectively doubled the size of our team and brought in new, high quality people on both the financial and operating sides of the organisation.
As we proceeded to raise TFCP III in the halcyon days of 2007, we recognised that we needed to do bigger deals. The €500 million to €1.5 billion deals that were the hallmark of TFCP II would not suffice in an investment environment built upon a €5 billion plus fund along with an enormous appetite among our investors for co-investment. In those days, Terra Firma was convinced that we could replicate our investment strategy on deals of €3 billion plus. Focusing on deals of this size meant that our universe of potential investments shrunk significantly, and a much larger proportion of our deals would now have to be sourced from public-to-private transactions. Our interest in 2007–2008 in Alliance Boots, Intercontinental Hotels and then EMI (to name but a few of the listed targets we looked at) was indicative of the size of companies that were required to make our fund size work. While these companies clearly met our investment objectives and disciplines, they required much larger teams than we had deployed historically, and much greater reliance on continued liquidity in the capital markets.
The investor demand for private equity was enormous in 2007, and we raised the soft cap on TFCP III from €3 billion to a hard cap of €5.4 billion: still not satisfying all investor interest. Indeed, we had over €3 billion of unsatisfied investor interest when we closed the fund in May 2007 after just over a year of fundraising. This investor demand was based on the performance of TFCP II, and the quantity of potential investment opportunities. This environment created a unique circumstance for us, one that was robustly debated both internally and externally: should we keep the fund open and raise several € billion more in investment capital or close it? Ironically, had we continued to market TFCP III and focused our investment activity on investing the over 30% of TFCP II that was still available, we would have avoided doing a huge deal near the top of the credit cycle. Indeed, if we had closed TFCP III sometime in late 2008, after fully investing TFCP II, then we would have had €7 – €10 billion of uninvested capital in the new fund at a more opportune point in the investment cycle. However, we chose to close TFCP III at €5.4 billion in May 2007, and focused on investing the new capital, whilst finding co-investment opportunities for our investors, and utilising the remainder of TFCP II’s capital in cross-funded deals with TFCP III.
As we all now know, it did not turn out as we expected it would. We made two acquisitions before the financial crisis hit, one was EMI and the other was Pegasus (an add-on to AWAS). In the case of AWAS and its combination with Pegasus, the business has gone on to be operationally very successful and continues to grow having had the full support of its banks. Unfortunately in the case of EMI, despite the incredible effort of the Terra Firma team and the employees and artists in EMI, the loss of the business to Citigroup was a very disappointing outcome. What makes long-term success in business is having the ability to learn from such events and ensuring that history doesn’t repeat itself.
In the process of analysing what happened with EMI, we also gained enormous insight into the steps needed to drive Terra Firma forward in today’s private equity market. Our immediate task is to continue to achieve strong returns for TFCP II and TFDA and to recover all of the capital for our investors in TFCP III. We are hopeful that our green energy investments and our aircraft business will collectively make substantially more profit than we lost on EMI. While this will be a great recovery, we accept that when we seek to raise another fund it will be significantly smaller than TFCP III, probably in the range of €2 – €3 billion compared with the €7 – €10 billion that we could have raised back in 2008. However, a €2 – €3 billion fund will allow us to return to the €250 – €500 million initial equity investment size that is our hallmark. In the meantime, we have been restoring Terra Firma to a size where we all share a common DNA. In other words, we are going back to where we were in 2006 with approximately 60 professionals. We also intend to change the Limited Partnership Agreement for our next fund to prohibit cross-fund investments and restrict the maximum amount we can invest in any one transaction to 15% of the fund with a view to selling down 5% to co-investors, thus leaving our fund investors with an exposure to any one deal of 10%. This will limit the co-investment underwriting pool to 5% rather than 20%.
We deeply appreciate the support of all our stakeholders across our portfolio businesses throughout the past year during what has been a challenging time. In 2011, all of us at Terra Firma are highly motivated to build and recover value for our investors, particularly those investors in TFCP III. Obviously, we have a large financial incentive, as we are among the largest investors in all our funds and the largest in TFCP III. However, our strongest motivation is to do the right thing for all our investors and stakeholders: that is our mission.