27 February 2012
2011 Q4 Investor Letter (Extracts)
After an encouraging first half, 2011 turned out to be a tough year as concerns about the faltering global economic recovery generally, and the troubles in the Eurozone specifically, became more pronounced.
In the last month we have seen an up-tick in the markets, buoyed by a little New Year optimism. While I hope that 2012 proves to be a better year, I am not banking on long-term support from the markets.
The markets consider that prospects for the Eurozone are improving and that a Greek default is almost fully discounted. Our expectation is that this year the Eurozone will see only anaemic growth. Austerity measures, increased movement towards fiscal and political union, and support of the weaker states by the more fiscally sound will provide sufficient room for the European politicians to muddle through the sovereign debt crisis, but little more.
The biggest impediment to European growth remains the weak state of the banking sector. Europe’s banks need somewhere between €275 billion and €350 billion just to recapitalise themselves to a reasonable level. However, to be able to start lending aggressively, they probably need at least twice that, and that level of capital will not be found in today’s market unless it is provided by governments.
Assuming the Eurozone does not lurch towards break up, European banks will find some short-term stability over the coming months – and there may indeed be enough time for the market to recover around them and for them not to need further government bailouts. However, we will not see European banks back in full lending mode for the next five to ten years unless they are substantially recapitalised.
Low growth coupled with anxieties about a possible Eurozone break-up in the longer term will undoubtedly put some investors off committing to Europe. This, combined with the impact of a debt shortage, will lower demand for deals. On the supply side, opportunities will emerge from banks, governments, private equity funds, and strategic investors selling non-core assets. We are already seeing banks selling off assets in an attempt to shrink their balance sheets. As these assets come onto the market, many will have been starved of the investment and management needed to help them thrive. This is exactly what we are looking for – businesses that need new strategies, new management teams, investment and transformation. The result is that I am confident that there will be good opportunities going forward within Europe, with less money chasing them.
While the challenges in Europe are currently still the primary focus of global concern, unfortunately there are plenty of other political uncertainties facing the world economy. For this reason I expect markets to remain volatile for the foreseeable future although we may take some short-term comfort from two areas: China is showing signs of navigating towards a soft landing; and the US economy appears to be beginning to recover. The mood in the US was always likely to be a little more positive in an election year, particularly as increased productivity is beginning to reverse the tide of low-wage manufacturing jobs that were leaving its shores.
However, a lack of policy decisions until early 2013 will not help long-term growth and stability.
I am a passionate believer that the private equity industry contributes significantly to economic health and regeneration. In the last three years it has rediscovered its appetite for transforming businesses and there is plenty of evidence that the private equity ownership model is the most effective at achieving an alignment of interest between capital and management.
There is no doubt, however, that greater transparency could lead to a better understanding of the role that the private equity industry plays in society. Terra Firma aims to provide the highest levels of disclosure and transparency to its stakeholders, though sometimes this has been to our detriment. However, it is worth the effort to be transparent as it will serve us all well in the long-term. As heated debates on the future of capitalism rage, it is important that the private equity industry engages with its stakeholders in an open way.
Alignment of interest is one area where the industry has really made progress in recent years. I have largely been at odds with other private equity firms in calling for greater alignment between GPs and LPs.
With the tough and crowded fundraising market of the last year, more GPs are now adopting proposals which bring about a greater alignment of GPs and LPs. A number have also come up with more imaginative ideas to improve alignment. Blackstone and The State of New Jersey deserve recognition for their innovative strategic relationship, as do Kohlberg Kravis Roberts, Apollo Management and The Teacher Retirement System of Texas for their own strategic partnerships. We can expect to see a substantial growth in such partnerships over the next few years.
Across the industry, we are also seeing a reduction in fees which will benefit smaller investors who are too small to enter into strategic partnerships or negotiate fee discounts. With these changes, I think that private equity can claim to be providing a model for the rest of the financial services industry.
In 2012, we celebrate Terra Firma’s tenth anniversary as an independent group. The difficult environment now prevailing in Europe plays to our strengths. I am confident that 2012 holds much promise, both for our existing businesses and for new investment opportunities.
With best wishes,