Chairman's letters

31 December 2011

2011 Annual Review Letter

Welcome to our fifth Annual Review of Terra Firma and its portfolio businesses.

After an encouraging first half, 2011 turned out to be a tough year as further weaknesses in the European banking system were revealed, Europe struggled to find fiscal policy consensus and global recovery speeds became increasingly uneven.

Against this challenging backdrop, the performance of Terra Firma’s funds during 2011 was impressive.

This year’s Annual Review records a year in which we have added value to our existing portfolio businesses through strategic and operational improvements, invested in our existing businesses through add-on acquisitions, and acquired a new business in the portfolio. This last investment in 2011 was Rete Rinnovabile S.r.l. (RTR), today the leading solar photovoltaic power generation business in Italy.

During 2011, we spent nearly €1.9 billion on building and developing our businesses. This was funded by a combination of cash from within the businesses, funding at the portfolio business level, and in the case of Terra Firma Capital Partners III, new equity. This sum is a reflection of our deep commitment to continued investment in our businesses as well as the number of attractive opportunities for capital expenditure and add-on acquisitions we continue to see across the portfolio.

The steady improvement in the performance of our businesses – displayed in their combined EBITDA growth of 12% last year - reflects the quality of their management and our hands-on approach to guiding their teams. Our strategy has always been to work intensively with our portfolio companies to create value in five ways: changing strategy; strengthening management; improving assets through capital expenditure; building the business through bolt-on acquisitions; and, where possible, lowering the business’s cost of capital.

As I explain in my market outlook later in this letter, reducing the cost of capital has not been possible in Europe for the last few years. However, this constraint has not limited Terra Firma’s ability to create value. We have embraced and sharpened our focus on the areas of business transformation we can control – strategic change, building better management teams, making accretive investments and building scale.

Portfolio Business Performance

AWAS, our aircraft leasing business, met or exceeded all of its key financial targets, achieving an 11% increase in full year Operational Profit Before Tax. During 2011, substantial investment was made to diversify AWAS’s fleet and drive superior yields.

Phoenix Group, the pre-eminent natural gas business in Northern Ireland, delivered strong financial performance and connected over 9,700 new customers to its gas network in Northern Ireland, well ahead of plan. Odeon & UCI, the largest pan-European cinema operator, also continued its successful expansion programme, completing six acquisitions across Europe and the roll-out of its digital format in the UK during the year.

Tank & Rast, the German motorway service station operator, again posted a year-on-year increase in EBITDA despite the negative impact of high fuel prices on consumer spending in Germany. The business made encouraging progress with its two key initiatives, the roll-out of our high quality toilet system, Sanifair, and the tendering of fuel supply contracts for its service stations.

Our renewable energy investments also expanded significantly during the year. In the UK, Infinis, the UK's largest independent renewable energy generator, delivered strong profit growth well ahead of budget. It continued to diversify its portfolio, particularly in wind generation, by both acquiring and constructing wind assets. EverPower, our US wind development business, also made good progress by building out its development portfolio and starting commercial operations of its second wind farm, the 53 MW Howard project in New York State.

As mentioned earlier, we acquired RTR in Italy, our third renewable energy platform, in March of 2011. We have already substantially expanded the business with two subsequent acquisitions, more than doubling RTR’s generation capacity and firmly establishing the business as Italy's leading solar generator. Performance has exceeded our expectations and we are very pleased with its progress to date.

CPC, our agricultural investment in Australia, delivered EBITDA ahead of budget and acquired two further properties during the year.

Lastly, in housing, Annington Homes performed ahead of the prior year despite flat market conditions in the UK. At the same time, Deutsche Annington delivered a good operating performance, exceeding its EBITDA target and launching a strategic initiative to improve the cost and quality of its caretaker and maintenance services by bringing them in-house. This initiative is accretive and continues to improve the living standards of its tenants, a priority for the business.

While focusing on visible business transformation, we have continued to seek opportunities to lower our businesses’ cost of capital. In light of market constraints on leverage, our ability to attract new finance at attractive rates is a reflection of the high quality of our businesses.

Odeon & UCI’s operating company debt was refinanced at an attractive rate through a £475 million private placement, AWAS secured over $1 billion in new debt financing and successfully reduced the cost of its $530 million term loan by 250bps, and Deutsche Annington raised €50 million in commercial mortgage backed securities (CMBS) in what others might have characterised as a closed market. Deutsche Annington’s CMBS issuance is an important sign of confidence as we progress with negotiations to refinance the bulk of the business’s debt over the next year.

Market Outlook

Our expectation for several years has been that the Eurozone will see anaemic growth this decade. Austerity measures, increased movement towards fiscal and political union, and the support of the weaker states by the more fiscally sound ones will hopefully provide sufficient room for European politicians to muddle through the sovereign debt crisis, but little more.

The biggest impediment to European growth still remains the weak state of the banking sector. Europe’s financial system needs increased lending to the private sector, an increased velocity of money in circulation, and a willingness to shake off past troubles and move forward with vigour. Instead, European banks are being obliged to meet new capital rules which require them to shrink their balance sheets, raise more capital or face nationalisation. Most have loan portfolios that are far too large and illiquid, and therefore shrinking their balance sheets has proved difficult. Raising capital is equally difficult for banks as it cannot be done today without destroying the value of the existing equity.

In response, some European governments will have to nationalise the weakest banks, some banks will sell assets, and some banks will raise new capital. I doubt that the scale of nationalisation, of asset sales, or of capital raises will be sufficient to provide a solid foundation for renewed lending. The actions of the ECB have so far provided day-to-day liquidity, but little more, and I do not expect to see European banks back in full lending mode for at least the next three years.

Meanwhile, the strong consensus amongst European leaders for continued austerity is starting to crack. We are going to see increasing political tension between the German leadership, which continues to push for austerity combined with cost-saving and structural reforms, and countries that want to move forward with more growth-oriented policies without even making the structural reforms that are necessary to increase Europe's competitiveness. This conflict will manifest itself not just in the corridors of power but also on the streets and in the ballot box. Greece is clearly an economy that should never have been part of the Eurozone and the task for European politicians will be to find a compromise that allows Greece to leave the euro without economic contagion affecting other European nations.

What Europe needs today is structural reform, cost cutting, a tax regime that incentivises productive investment and an employment regime that incentivises job creation. However, I do not see a change in these areas from the negative attitudes to business and wealth creation that most European politicians espouse. While many talk growth, they lack the understanding that growth comes not from an attitude of clinging to the past and penalising success and forward thinking, but from a confidence that productivity and investment will be rewarded. 

Amongst this doom and gloom, we see opportunity. The market in Europe will, as the decade rolls on, offer very interesting investment options as the balance of supply and demand for the kind of assets that Terra Firma invests in changes.

There are several factors that are likely to depress demand for the assets that Terra Firma wants to buy. First, there is less capital overhanging the market. A little over a year ago there was an overhang of over €300 billion in the private equity market. Although some funds may get extensions, by the end of 2013 this money will largely be gone, removed from the private equity capital pool as the 2006 and 2007 vintage fund commitment periods expire. Funds will then only be able to rely on what they can now raise as new capital.

Second, demand will be depressed by anaemic fundraising for European funds over the next few years, with perhaps as little as €50 billion raised per year. That is less than a third of what was raised at the peak of private equity fundraising five years ago. Low growth coupled with anxieties about a possible Eurozone break-up in the longer term is deterring many investors from committing to Europe.

Third, there is far less debt available for asset purchases. Leverage ratios are currently at 40 to 60% loan-to-value, compared with up to 85% in 2007. After 2012, therefore, not only will there be less private equity capital available to complete transactions, but each transaction will also require considerably more capital than it would have four to five years ago. In addition, the €3 trillion of leveraged deals done in the boom years will come up for refinancing between 2012 and 2016. These refinancings will, for the most part, only be achieved if investors are willing to pump more equity into the businesses in question. That is equity that will not be available for new deals.

Putting these factors together, it is clear that demand for private equity deals will not be high in Europe for a number of years. This is in sharp contrast to 2007, when huge demand, supported by cheap debt, inflated prices.

On the supply side, opportunities are beginning to emerge from banks, governments, private equity funds and strategic investors selling non-core assets.

Banks are selling off assets in an attempt to shrink their balance sheets, but they are still being selective about what assets they sell and when. Banks have to take losses on many of their disposals and they cannot afford to take too many losses at one time. In the meantime, those companies controlled by banks are starved of investment and suffer from demotivated management teams.

This is an ideal situation for private equity to add value. Those private equity firms who are equipped with the expertise to add strategic and operational insights can transform and revitalise these 'zombie businesses'. Our two latest investments, The Garden Centre Group and Four Seasons Health Care, are both good examples. These are the sorts of businesses that private equity should target as they exhibit a pressing need for transformation through increased levels of investment and refocused, committed management.

Facing these supply and demand dynamics, the European market will enter into a new phase. In this phase, private equity can contribute to a European recovery through the hard work and intellect of its professionals working in concert with management teams, replacing bank credit committees with a focused long-term equity owner. The focus must be on using capital raised from around the world to transform, build and grow sustainable businesses of real value in Europe.


In 2012, we celebrate Terra Firma’s tenth anniversary as an independent firm. During that time, our investment philosophy has remained consistent and relevant, and to carry it out we have built a team of people who share a passion for transforming businesses.

The European environment will play to Terra Firma's strengths. Our ability to take a long-term view, our experience of working constructively with governments, our track record of investing in complex situations and understanding regulated industries, and our aptitude for transforming businesses leave us well placed to ensure our investors benefit from the opportunities ahead.

On behalf of all of us at Terra Firma, I would like to take this opportunity to thank all our stakeholders for their support during 2011. I would also like to thank the directors and employees of our portfolio companies for the performance that they, working alongside the Terra Firma team, have delivered.

With best wishes,

Guy Hands

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