04 December 2012
2012 Q3 Investor Letter
As we approach the end of 2012, Europe is facing the same political and economic problems which have confronted it over the past few years, and it has still not come up with a solution. In this quarter, Europe may not be facing the real possibility of economic meltdown as it did earlier in the year, but neither is it showing any evidence of the sort of growth needed to pull the continent out of its economic malaise.
The latest round of monetary and fiscal actions across Europe is viewed by the markets as insufficient to solve Europe's fundamental problems. However, the markets also understand that, for the moment, the richer nations are committed to bailing out the poorer ones in order to stave off the collapse of the Eurozone dream. Investors continue to favour higher-rated government bonds such as US Treasuries, UK Gilts and German Bunds. Meanwhile, the amount of bank lending and equity investment in Europe is being squeezed and continues to decline. Recent downgrades to IMF growth forecasts provide further concern as to when Europe might recover. What is clear is that the continent has gone ex-growth and it is not clear whether the situation will take two, five or twenty years to reverse.
The lack of growth in the Eurozone and the growing political problems this is causing may force the ECB to inject more money into the system. However, bailouts only provide a short-term respite and do not tackle the fundamental and unsustainable structural problems of the poorer European countries. It has been clear to me for some time that a major political shift is required in Europe in order to achieve true collective European-wide decision making and responsibility.
Europe faces two major issues. At a national level, the transfer of wealth that the Euro provided hid the inefficiencies of many member countries while, at the European level, the huge expansion of lending to poorer European nations removed the discipline that was needed to force structural integration. In short, inefficient countries have been both subsidised by the wealthier Euro countries, and allowed to accumulate massive borrowings from them, whilst not being forced to undertake the structural reforms that would start to make them competitive.
In the UK, the problems are substantially different from those of Europe. While it might not be good for the UK's political position in Europe, and it is certainly not good for the integration of Europe, the UK is likely to become less connected to Europe. This is probably the only feasible economic solution as they become both politically and economically less in step with each other. As the UK population realises its economic predicament and how Europe is not helping to solve this, detachment from Europe will become inevitable. It is interesting that even the Labour party is now scoring points against the Conservatives by being anti-Europe, whereas traditionally the Conservatives were seen as the more sceptical party on Europe.
Across the Atlantic, President Obama was re-elected and it’s déjà vu with another fiscal standoff approaching. The Presidential election gave us a welcome respite from analysing the impact forced deleveraging could have on the global economy. However, this looks increasingly unlikely to be an issue as loose monetary policy looks likely to be the order of the day for some time. Romney’s candidacy meanwhile inevitably threw the spotlight on the private equity industry. Hundreds of millions of dollars were spent by his rivals on promoting a relentlessly negative image of the sector’s role in the economy. This must be used by private equity firms as a catalyst to be pro-active in using transparency to sell the positives of private equity in the way that Terra Firma has long advocated.
As the macro environment continues to be challenging and we find ourselves living in ‘Groundhog Day’, we sense the increasing frustration of private equity investors and ask: as a private equity investor in the current environment, is it better to be a buyer or a seller?
On the buy side, it is difficult to buy European assets at levels that allow attractive returns. Price expectations remain high and buyers are struggling with the availability of debt, which continues to be both expensive and scarce. Several European banks have sold portfolios of loans at a marked discount this year in an effort to meet stricter capital requirements and these banks, for the most part, are not making loans to private equity firms. However, even those banks willing to finance private equity deals are substantially limiting their own positions. The problem of obtaining debt finance from banks could become even greater given the approaching debt wall. The industry has so far managed to defer this issue through partial refinancing and amend-and-extend agreements, but this debt wall will need to be addressed.
I believe Terra Firma has done an excellent job at navigating the difficult debt situation. We have taken advantage of low rates in the US to refinance EverPower’s 150 MW wind farm in California. We have also put significant resources into ensuring real progress on the forthcoming refinancings of both Deutsche Annington and Tank & Rast in Germany.
We have also benefited from the economic turmoil as it facilitated both of Terra Firma’s new investments in 2012 - The Garden Centre Group and Four Seasons Health Care. They are similar to each other in that both transactions were subject to drawn-out processes and involved negotiating with banks whose ownership of the assets was a legacy of debt-for-equity swaps. They were also both ripe targets for the kind of business change that is at the heart of Terra Firma’s approach. In The Garden Centre Group, we have a business which is crying out for strategic and operational transformation. Four Seasons Health Care required an immediate transformation of its capital structure on acquisition, which Terra Firma was able to deliver.
In terms of further acquisition opportunities, the renewable energy sector is very attractive. Today, the industry offers investors more predictability and less risk than was the case three years ago. From our initial involvement nine years ago, Terra Firma has taken a different approach from most other investors in the renewable energy sector. We have developed and built stand-alone, self-sustaining companies that can manage large-scale portfolios of renewable energy infrastructure projects. This kind of transformational approach is Terra Firma’s proven sweet spot. We are the leading investor in the sector globally, having invested more than twice that of our closest competitors and built three best-in-class renewable energy generation businesses across a range of geographies and technologies in Infinis, RTR and EverPower. The industry at large now needs to mature from comprising assets managed as add-ons within traditional fossil-fuelled energy companies to being a significant and economically sustainable industry in its own right.
Turning to the sell side, it is proving difficult to sell European assets at the prices that GPs and their investors expect and hence to return capital to LPs. Traditional exit routes have almost disappeared due to an unreceptive climate for IPOs and the stretched balance sheets of many strategic players. In time, we should start to see strategic buyers returning to the market, but whether this will create sufficient competition amongst buyers to drive prices high enough to generate good returns for private equity sellers of legacy businesses remains to be seen.
The flow of private equity investment into Europe has suffered – this quarter deal volumes have continued to fall - and the European market has become dominated by secondary deals. Pass-the-parcel transactions between private equity firms account for almost half of all buyouts this year, a figure that has now become the norm since it jumped from 26% in 2007. This is not necessarily a bad thing. Private equity firms can add value to a business at many stages in the life cycle of a company’s growth and development. It does, however, highlight the lack of diversity in exit options for private equity firms requiring divestment of their portfolio companies. Consequently, the time horizons of private equity funds are getting longer as extensions are requested and granted, and investment holding periods are growing from the traditional three to five or possibly seven years. This is a trend that will continue.
Valuations are yet to move back to their 2007 highs due to a lack of confidence in the sustainability of earnings and the lack of growth in the economy. The volatility of multiples is not something we can control and therefore Terra Firma continues to focus on building growth in its own portfolio businesses. For the most part we have been successful at this, despite the economic backdrop over the last few years. AWAS, for example, has increased OPBT by $203 million since its acquisition in 2006 and Infinis has increased its operating capacity by more than ten-fold since inception.
Notwithstanding the challenging environment, there are three businesses in TFCP II that we believe have reached a good point in their growth trajectories and which we are preparing for sale over the course of the next 12 to 18 months.
Odeon & UCI is a classic Terra Firma investment. Under our ownership, the business has not only been transformed into the leading pan-European cinema operator, but it continues to grow. It has been a tough year for the cinema industry, with the weather, film slate and Olympics all contributing to reduced customer volumes. However, we are confident that the attractive fundamentals of the Odeon platform and its pre-eminent market presence will enable us to secure a successful exit for the business. Subject to market conditions, we envisage a sale within the next 18 months of either the whole business or the independent sale of the OpCo and PropCo depending on which option will maximise value.
Following the successful sale of its gas supply business to Airtricity (a subsidiary of SSE) earlier this year, Phoenix Group, the owner and operator of the largest gas network in Northern Ireland, is now able to focus solely on its distribution business. While we are still working towards a conclusion of the Competition Commission process, we are confident of securing a stable regulatory environment and a platform for growing its Regulated Asset Value as we target a 2013 exit for the business.
Lastly, our renewable energy team is focused on achieving a successful sale of Infinis, now the UK’s leading independent renewable energy company. The transformation of this business is typical of Terra Firma’s brand of value creation. While Infinis would be a prime IPO candidate, challenging capital markets mean that we are assessing all alternative options to make sure we obtain the most lucrative exit for the business.
So while it is a tough environment for exiting businesses, we do not believe it is an impossible one. We feel there is a market for world class businesses in sectors that have steady cash flows and that it is possible to attract widespread demand from different regions of the globe – particularly those that are experiencing growth and looking to develop local expertise through international acquisitions.
With a broad mandate, private equity has the advantage of being able to take advantage of opportunities as they arise – be it on the buy side or the sell side. Many large private equity firms manage several live funds of different vintages at different stages of the investment cycle and therefore, irrespective of market conditions, may be both buyers and sellers – depending on where they see the best opportunities for their investors.
Fundamentally, private equity makes money through change. Critics of the industry often speculate as to what makes private equity produce such good returns. Do private equity firms have access to better information or insight, or are they able to predict which way the public markets will go? While we would all like to believe we can do the latter, the major reason that the industry has enjoyed alpha returns over the years is because private equity firms are not afraid to adapt and change. Further, whether it be through the implementation of strategic or financial change, operational improvement, capital expenditure or M&A activity, private equity-owned businesses are not afraid to think ‘outside the box’ and weather the growing pains that public companies cannot afford.
Claims that private equity is simply about buying cheap, sacking staff, exporting jobs and loading businesses up with debt before breaking them up for sale for short-term profit are a gross misrepresentation. In fact, it is publicly-listed companies that, because of quarterly reporting and shareholder pressure, are forced to think all too short-term. In contrast, private equity, by raising capital which it can deploy over a ten-year period, has the freedom to look far beyond the next quarter. Private equity has the opportunity to work out where a business should be in five or seven years and devise and deliver the strategic and operational changes to achieve that goal. It is no quick fix. At Terra Firma, our average involvement with the businesses we buy is now over five years, a focus on the long-term which is by no means exceptional in our industry today.
With best wishes,