04 February 2013
2012 Q4 Investor letter (Extracts)
As we enter 2013, the biggest global trend I see this year is that of markets taking a backseat to politics. From 1982 to 2007, we largely had markets in the driver’s seat, with financial institutions being given ever increasing freedom and support. However, since the 2008 credit crunch, the politicians have taken over. This makes it much harder to know where to invest.
This doesn’t mean there aren’t opportunities. Indeed, in the last months of 2012, Terra Firma closed several successful transactions which demonstrate that, with enough hard work, insight and determination, you can find opportunity even in these challenging markets.
In December, Terra Firma purchased Annington Homes from Nomura in the largest European LBO since 2008. The enterprise value was £3.2 billion, comprising of £450 million of new equity raised for the TFSOFI fund, £550 million of new debt in the form of a PIK issue and assumed existing debt of £2.2 billion. The PIK Notes were the second largest ever sterling high yield issue and the largest ever high yield issue by a debut issuer.
Also in December, we announced the successful completion of the refinancing of Deutsche Annington, Europe’s largest real estate refinancing of 2012. Deutsche Annington, which Terra Firma bought in 2001, lets and manages more than 210,000 apartments, making it the largest privately-owned residential landlord in Germany. As part of the refinancing, the outstanding GRAND debt was reduced from €4.3 billion to €3.8 billion.
Looking at the turmoil in Europe, 2013 will likely bring more of the same. The Eurozone countries will continue to muddle through, with their now-familiar cycle of reaching points of fear and panic, followed by relief at the latest rescue package or political pact.
For years now, people have been calling the situation in Europe a ‘crisis’. But at what point does an ongoing crisis become the new baseline? For a long time it has been my view that no collective decision regarding substantial fiscal integration of Europe will be reached in the foreseeable future, and hence this period of so-called crisis will continue for many years. The world is getting used to Europe living in a state of constant uncertainty and that is becoming the new reality. This makes the ‘crisis’ less of a concern and, maybe, not even a crisis at all. Perception, as always, is all important to markets.
We recently witnessed a couple of aspects of this new normalcy, starting with an agreement to cut the long-term EU budget for the first time ever. While this may not be large enough to influence Eurozone sceptics, it certainly shows that the UK working with Germany can act as an effective negotiator within the EU, and can wield power and influence within it.
We also saw Ireland taking steps to reschedule its crippling debt load, something the ECB has resisted for a long time. While it is a positive step that the powers within Europe are finally coming to grips with what needs to be done to resolve the crisis, in the grand scheme of things it is only a small step. Europe still has a long way to go before it arrives at a large-scale solution to its ongoing troubles.
When we look at the UK, the question is whether the coalition government has inflicted too much austerity or not enough. Some would argue that the government’s ambitious austerity programme has suffocated any possible recovery. Yet others look at the budget deficit, which is refusing to shrink, and say that the government isn’t going far enough. Either way, the country appears to be on the verge of a triple-dip recession. This situation calls for strong united leadership; however, the coalition sadly looks less capable than ever of co-operating on meaningful reforms.
Meanwhile, the Prime Minister, David Cameron, has called for a referendum on membership of the EU in 2017. While he stresses the importance of remaining in Europe, he has now unleashed several years of uncertainty onto the British people, British businesses and those who would seek to invest in Britain. Given the precarious state of the UK economy, the last thing the UK needs is more uncertainty.
The UK has ultimately been a huge beneficiary from being part of the EU. Many industries rely on access to the single market, and companies choose to locate their headquarters in London because of this access. Furthermore, British firms have benefitted from the free flow of labour and have been able to attract top talent from across the continent. This relationship between Continental Europe and the UK has been good for business.
Some suggest the UK leaves the EU, but remains in the European Economic Area, like Norway. But under this scenario, the UK would remain bound by almost all EU regulations, yet would no longer have a seat at the table where these regulations are decided.
By the same token, Europe is better off with the UK sticking around. The UK has consistently been one of the biggest supporters of liberal economic policies within the EU. Without the UK, Germany would have no-one else of sufficient size on its side against the protectionism of France. Understandably, the German Chancellor, Angela Merkel, is therefore keen to see the UK stay put. But here, again, we will have politics coming before economics. The political anger towards the UK in Europe is huge and Merkel might well decide that fighting for the UK to stay in Europe is just not worth it and it is better to let it leave.
It is interesting to compare the difficulties in Europe, with its inefficiency and high taxes, with the US, which is also having difficulty reducing its budget deficit but by contrast has lower taxes. There is plenty of scope to raise taxes in the US, so its fiscal problems can be solved, but at the moment there seems to be no political will to do so, in the same way that Europe lacks the political will to become more efficient. The US could be right back up there as the strongest economic powerhouse in the world again if it could get its political system to work effectively and Europe could have growth again if it had the political will to become competitive.
So until the US solves its fiscal problems and Europe solves its lack of competitiveness, people are going to be looking to Asia, in particular China, for global growth. China has recently undergone a major leadership change, and we are starting to see a change in its growth strategy. It is clear it is starting to turn slightly away from a focus on cultivating global trading relationships towards a more domestically-focused strategy.
Looking at Japan, I think we are also seeing a turning point. Twenty-three years on from the start of the crisis, we are starting to see some real change. Shinzo Abe, as Prime Minister, clearly wants to weaken the yen and reinflate the economy. However, I’m not sure we will see Japanese citizens change their habits of the last 20-plus years and suddenly start spending.
So where is world growth going to come from? Some would say that we have to look at emerging markets, but this is no longer a sure thing. Growth rates have been slowing in emerging markets like Brazil and India, and with the social risks that slower growth entails, politics is increasingly encroaching on those markets. We’ve seen an increase in volatility in emerging markets, and I think this will continue.
Thinking about where to invest, we continue to think that Europe makes sense. There are underlying macroeconomic issues, but there are also opportunities. Banks are shedding investments, and utilities are shedding non-core divisions, which provide ample opportunities on the buy-side.
We have proven that we have the expertise to make deals work in Europe – last year, Terra Firma was number one for LBO investments by value in Europe, the Middle East and Africa, with a 10% market share, and was in the top 10 globally. Of course there are politics to contend with in Europe as there are anywhere else, but we can work to understand the political risks and make the deals work.
There are many unknowns involved in investing and it is impossible to predict which of these unknowns are going to happen. In private equity, you have to evaluate your investment strategy, understand the variables and think through how you can make a difference. At Terra Firma we go further and ask: how can we transform a business?
We continue to see a lot of opportunity to use private equity’s key strengths to create long-term value. At Terra Firma, we excel at taking businesses that have been under invested, or badly managed, and working out how to improve them. It isn’t easy but time and again, over 18 years, we have proven that new strategies work. It is a great strength of the private equity industry model that we have been able to deliver bespoke solutions to major business issues without, for the most part, the distraction of the public markets or the press.
I would like to take this opportunity, on behalf of all of us at Terra Firma, to thank you for your support during 2012. I would also like to thank the directors and employees at our portfolio companies for the progress they have delivered this year, working closely with the Terra Firma team.
We have a lot to look forward to in 2013. We continue to review options which will help us return capital to investors. While the macroeconomic outlook remains uncertain, we will stay focused on our goals of transforming businesses and delivering value.
With best wishes,