02 November 2011
2011 Q3 Investor Letter - TFDA
In 2007, the European markets, along with others around the world, were booming. There was a vast amount of equity and debt available. The banking sector was seen as very strong, and expectations of GDP growth were high. Four years on, the world has changed, and Europe in particular is a different place.
The challenges facing the Eurozone, and indeed the whole of Europe, are severe. I do not believe that we will see a return to growth and stability in Europe for at least the next 10 years, although there will be improvements on the edges. The ‘crisis’ will not be resolved in one sweeping gesture, and will instead be papered-over through a series of ‘political fudges’ with governments using a mixture of available tools rather than relying on a more aggressive single strategy that could more quickly achieve long-term stability.
The main tools available to European governments to achieve long-term stability in Europe are: (1) changing the membership of the Eurozone; (2) having the richer, more stable countries bail-out the poorer countries; (3) creating a European federal state; and (4) imposing austerity at the individual country level. Any one of these tools could solve the problem if implemented aggressively, but none is popular or simple. Instead, we will see a combination of a little of each of these. So we have: the possibility of one or more of the troubled countries being ejected from the Eurozone; there being some bail-out by the richer countries, but not a full bail-out; the introduction of a series of federalist-type programmes (such as standardised VAT, a banking transaction tax or some form of credit insurance tax), but not the creation of a federal state of Europe; and, there will be some fiscal responsibility and belt-tightening at the country level, but not sufficient to solve the problems that the current imbalances are causing. This ‘great European fudge’ in time will achieve short-term stability, but not longer-term growth. So rather than seeing a comprehensive ‘fix’, we will see slow movement with slow growth for the next five to ten years and a continuing difficult macro-economic environment during that time.
Within that macro-climate, we will also continue to have a very weak European banking system. For European banks to be able to start lending aggressively again they need to either shrink their balance sheets, raise capital or be nationalised. Most European banks have asset portfolios that are far too large for their balance sheets; however, assets cannot be dumped onto the market as the banks cannot sustain the discounts that would be required to dispose of their excess assets. We believed back in early spring this year that approximately €300 billion of capital was needed to recapitalise the European banks – we were laughed at then. Now it is accepted that the banks need somewhere between €275 billion and €350 billion to be able to start lending aggressively again. That level of capital is not going to be made available to them. We have already seen some governments move down the path of nationalisation – owning larger and larger percentages of weak European banks as and when required. But instituting a comprehensive nationalisation policy would be not only difficult, but highly unpopular.
Each of these actions, if implemented aggressively, could solve the problems facing the European banking system today. Yet, none will be implemented wholly or aggressively, rather, a combination of these approaches will help keep the banks solvent. Governments will nationalise the weakest banks, some banks will find some capital and, although we won’t see a fire sale of bank assets, we will see some assets entering the market. The banks will however remain very weak and unable to lend sufficient funds to support real European growth for some years to come.
What does this mean for Private Equity?
At our annual investor conference in July 2006, I referred to the five years from 2002 to 2006 as ‘the Woodstock years’ for Private Equity. Returns were extraordinary and capital flowed in greater and greater quantities into funds, and in increasing amounts back to investors. Private Equity was producing above-trend returns, but it was also slowly losing the demand and supply equation that had made those returns possible.
Since then, we have endured harsh economic conditions and weak capital markets. The opportunities for creative financing and reducing the cost of capital have all but gone. The period from 2008 to 2012 will be seen as ‘the wilderness years’ – five years in which the private equity model was severely challenged; five years which brought out the best in private equity, but which also exposed some of the industry’s worst characteristics.
Let’s start with the best:
Superior Model. There is plenty of evidence that the private equity model has been more effective at achieving fundamental strategic and operational change in businesses than other models of corporate ownership. While there are examples of publicly-listed companies that have reinvented themselves, and private equity-owned businesses that have achieved very little, Private Equity for the most part offers the best model for transforming companies.
‘The wilderness years’ have forced our industry to focus on what we do best – the creation of value, and therefore alpha, for our investors by transforming businesses.
Part of what gives Private Equity an edge is that we can manage our portfolio companies to long-term business objectives, rather than focusing on quarterly earnings objectives. Private equity-owned companies are liberated right from the closing of the purchase by having a longer investment horizon, thus having the opportunity to be creative and innovative in creating sustainable and successful businesses.
Rather than starting with what a business is today, or worse, what it needs to look like by the end of a quarter, we can determine what that business can look like in the future – maybe five to seven years ahead. We can then devise a plan to realise that possibility. As part of Terra Firma’s due diligence, we go through a process of planning the strategic and operational changes that we will make to create alpha. We focus specifically on five business drivers that, in our experience, are critical to adding value:
The first is to change a business’s strategy. Terra Firma brings to companies strategic insights that will transform the business. It might be the introduction of a new business model or perhaps the repositioning of a business within its market. For example, when we acquired WRG, we identified the potential of its fledgling waste-to-energy operations. We de-merged these waste-to-energy operations from WRG, appointed a new management team and have turned the operations into Infinis, the UK’s leading purely renewable energy generator.
Our second driver is to strengthen management. Once we have control of a business, our first move is typically to make several new appointments and ensure that strong incentives are in place to drive change. Our aim is to build top quartile management teams. We have even had to build entire management teams from scratch; RTR, our latest acquisition, was simply a collection of assets when we acquired it with no management at all.
Our third driver is to lower the business’s cost of capital. We typically achieve this by diversifying and stabilising cash flows to reduce business risk and by entering into a range of financial transactions such as securitisations or refinancings. In several cases, such as Odeon & UCI and WRG, we have bought businesses partly because we were confident that we could resolve legal and regulatory uncertainties that were inflating their financing costs.
Our fourth driver is to deploy capex. In the last year, capital expenditure across our portfolio was over €1 billion. Whether remodeling sites at Tank & Rast, maintaining and modernising Deutsche Annington’s housing stock, buying new aircraft for AWAS or building generating capacity in our renewable energy businesses, we invest consistently in our businesses in order to establish them as best-in-class. All capexis subject to strict return criteria and is controlled centrally by Terra Firma.
Our fifth and last driver is executing M&A. The strategic plans we develop for our portfolio businesses usually require significant M&A activity after the initial investment. For example, four of our current businesses, AWAS, Odeon & UCI, Infinis and Deutsche Annington, have been transformed by very large acquisitions that have redefined their scale and capabilities. In total, we have made over 30 major bolt-on acquisitions for the 30 portfolio businesses we have owned over the last 17 years.
What else has the Private Equity industry proved successful at in recent years?
Attracting the right talent. The Private Equity industry attracts entrepreneurs, financiers and operating professionals who want the challenge of transforming businesses, with the possibility of generating superior returns. That spirit, coupled with a long-term approach, makes private equity better at spotting opportunities to develop highly attractive businesses from a wide variety of situations. At Terra Firma, we have acquired orphaned assets, both from government privatisations and from the spin-offs from large corporates. Transforming businesses like these requires a tough entrepreneurial mind-set in order to see through the pain of completing a corporate transformation.
Speed and management focus. We can move faster than any other business model. Our willingness to challenge and, if necessary, change management is a particularly powerful driver of value creation. In Private Equity, the board is built by, and for, the investors. In addition, CEOs are hired to execute business plans, rather than first undertaking time-consuming strategic reviews to justify their appointments to shareholders. Moreover, we do not normally have to make these changes under the glare of the media spotlight. If the CEO makes decisions that create value, he is well rewarded and gets to keep his job. If, on the other hand, he does not then he will be quickly shown the door.
Proper alignment. We are also very effective at putting incentives in place that really do align the interests of management with the interests of the business’s owners.
‘The wilderness years’ have also supplied the opportunity for Limited Partners to achieve better alignment of interest between themselves and the General Partners. With the recent round of fundraisings, there has been a renewed focus on this and at long last, we are seeing the end of transaction, monitoring and directors’ fees. This is something Terra Firma took a firm stance on back in 2002 when it decided to rebate 100% of all fees earned.
Before we get too complacent, what have we learned about the less attractive characteristics of the Private Equity industry?
There is no shortage of criticism from the media. However, I am not thinking of the media’s stereotypical view of the Private Equity industry – the asset strippers who deploy excessive leverage and have scant regard for employees’ jobs and welfare (although there are undoubtedly examples that fit this media stereotype of Private Equity – just as there are terrible anecdotes about public companies). These stereotypes are simply not representative of the industry; they are largely polemic, and help to raise passions and sell newspapers. Here, in contrast to the stereotype view the press portrays, is my list of Private Equity’s worst faults:
Club deals. These types of deals dilute accountability and control. In an era where businesses really need clarity of decision-making, club deals can only be justified if the private equity firms involved have near identical outlooks – something which is highly unlikely. Terra Firma does not participate in club deals because we could not push through the measures we need to achieve true business transformation within the constraints of such arrangements.
Pass the parcel deals. In aggregate, they impose large and hidden transaction fees and risks on investors. Terra Firma has only done four secondary buyouts in 17 years out of 30 deals.
Putting deal quantity ahead of quality. In a previous letter, I described the conveyor belt mentality that permeated ‘the Woodstock years’. Too often, success in private equity has been measured by the quantity of deals sourced and closed and the fees earned. Instead, it should be measured by looking at the quality of work we do in transforming businesses. In the boom years, we thought that we could both maximise fees and deal flow and keep quality high. However, in pursuing volume, private equity diluted its ability to create alpha.
Asset gathering. Many in private equity became fixated on raising bigger funds and developing products across the spectrum of alternative investments. Clearly, the asset-gathering model can be incredibly rewarding for General Partners. However, by becoming asset gatherers, I believe that we risk losing the entrepreneurial spirit that delivers value for our Limited Partners. Private equity must have some ‘skin in the game’ – if its asset base is so heavy that the General Partner can get very rich on fees alone, then the General Partner starts to lose its focus on driving returns and earning carry. Asset gathering threatens to put private equity into the mainstream of the fund management industry that so many of us originally set out to challenge.
Perverse marketing incentives. In my second quarter letter this year, I raised concerns about how the fund model creates an undue emphasis on marketing. As an industry, we spend a disproportionate amount of time fundraising. Instead, the talents of entrepreneurial people should be put to productive use in buying and transforming companies, not spent on continuous fundraising. The fund model also creates pressure to deploy capital rapidly once raised and to harvest investments quickly. While this may help to market future funds, it does not maximise value.
Private Equity has much to be proud of and much to offer investors. We need to be unashamed in beating the drum for our industry. To do this with credibility, we must focus on what we do best: building businesses and creating real value for our investors.
Turning to Deutsche Annington’s performance for the quarter; its Sales business was above budget for the third successive quarter, driven by high volumes and sales being achieved above where the properties were last valued. This performance was partially offset by the Rental business which was slightly short of budget due to a reduction in rental income because of increased sales and vacancy rates remaining above expectations.
Through Project Clear Water, the business is on track to realise significant savings in internal costs over the full year. Following this success, new initiatives aim to improve property, facility and infrastructure management by internalising these critical functions over the next two years. Some 80 suppliers will be consolidated into one joint venture to provide basic repair and maintenance, and one external supplier to provide outside property care. Over the next two years, these process improvements, efficiency gains and the resulting VAT savings are expect to contribute to an improvement in Deutsche Annington’s EBITDA run-rate of some €20–25 million.
In regard to the group’s debt restructuring, our project team is focused on achieving a consensual and orderly refinancing of GRAND well ahead of its maturity date in July 2013. The team is making good progress and is in negotiation with the group of note holders that has been formed.
We very much appreciate your ongoing support.
With best wishes,