Chairman's letters

14 August 2013

2013 Q2 Investor Letter (Extracts)

Nearly five years after the failure of Lehman Brothers tipped the western world into financial crisis and recession, there are growing signs that a recovery is under way. This has led to western markets performing strongly in 2013 with the MCSI World Index returning 7.1% in the first half of this year. Emerging markets, on the other hand, have suffered from unrest and uncertainty, with the MSCI Emerging Markets Index losing 10.9% over the same period.

Politics have become an increasingly important factor in markets. This is clear in emerging nations where political crises such as those in Egypt or Turkey have had a dramatic impact on their stock markets. But it is also the case in developed markets, where the internet age has eroded the power of major political parties, and increased the ability of ordinary citizens to comment on and influence major events.

On the one hand, the new technologies of smartphones and social networking represent a threat to peace and prosperity: witness the speed with which some groups in emerging nations have used them to organise large anti-government protests. However, they also represent a great opportunity. They have allowed a more direct dialogue between governments and the governed, with the recent protests in Brazil, for example, prompting action from the government that addresses its citizens’ concerns.

In China, the growing use of social media has forced the government to address a major complaint of Chinese citizens: environmental damage caused by rapid economic growth. China now generates far more pollution than the US, which is not surprising given that it has more than four times as many people. Yet while the US is successfully reducing CO2 emissions – which fell by 12% between 2007 and 2012 – China’s are increasing rapidly, growing nearly 10% in 2011 alone.

A major contributor to the reduction in US emissions has been an increased use of natural gas for electricity. In the past few years, advances in ‘fracking’ technology have helped the US unlock enormous reserves of natural gas which had previously been trapped in shale formations in the earth. This sent the price of natural gas plummeting in the US, aiding a nascent recovery as energy costs fell.

A significant driver of the divergence in emissions between the US and China has been through the US exporting its emissions: as its use of natural gas has increased so have its exports of coal, with China being the number one destination for this dirty fuel source. Pollution in China is having a significant impact on individuals’ quality of life. A recent study from Harvard University concluded that air pollution causes people in northern China to live an average of 5.5 years less than their southern counterparts. Another study has found that air pollution was responsible for 1.2m premature deaths in China in 2010. Rising greenhouse gas emissions will see these numbers continue to worsen.

The world has sufficient shale gas reserves to significantly reduce the use of coal and other dirty fuels, with China estimated to have the world’s largest shale gas reserves. China could substantially reduce its expected increase in emissions if it could tap into these.

However, fracking is a difficult process, further complicated by the fact that the geology of shale reserves varies widely from region to region; currently only the US has substantial experience in fracking. This creates an opportunity for the US to help the Chinese undertake an energy revolution. This would not only improve the quality of life for many Chinese, but would also be a boon for global emission reduction efforts.

International politics is the primary obstacle standing in the way of US-China co-operation on energy, and it will take a radical change on both sides for them to work together. China looks at the world from a long-term, strategic perspective. The US, by contrast, focuses on the present and on short-term consequences.

What the US needs now is a leadership which can have an open discussion with China about how both countries can help each other achieve their respective strategic objectives over the next 50 years – and co-operation on shale could be the centrepiece of such a discussion.

I believe China would be willing to engage in such a dialogue; over the years it has proved willing to co-operate with other powers on long-term initiatives. Many in the UK expected it to immediately take over Hong Kong when the British left in 1997, but instead China stuck to its agreement to allow Hong Kong a large degree of autonomy. The main question is not whether China would hold up its end of any bargain, but whether the US political system can be made to focus on 50-year objectives. Indeed, today it is difficult to get US politicians to focus on objectives that span the next five years.

Co-operation on global shale gas production could also help reduce international conflict over energy resources. American intervention in the Middle East over the last half century has largely been a consequence of its own energy needs, but it has driven global politics. The US can either use its shale expertise to turn inward and guard it as a competitive advantage or it can seize this opportunity to shape a new world order for the next 50 years, one where the US can continue to set the political agenda but in conjunction with China.

There is little doubt that the US-China relationship will dictate the course of international politics for decades to come. If the world’s two largest economies can agree on a mutually beneficial long-term energy policy, it is much more likely we will see peace and prosperity, and the world can start to make a significant impact on global greenhouse gas emissions. However, while shale provides the most direct solution in the short term, it is ultimately a limited resource; over the longer term, renewable energy sources such as solar and wind must be expanded in order to free countries from a reliance on fossil fuels.

Turning to the private equity industry generally, it is encouraging to see that 2013 is on track to be a big year for exits, with LPs enjoying large distributions. However, the picture isn’t the same everywhere, and we are seeing a divergence between exit markets in the US versus the rest of the world.

In the US, exits have been supported by strong equity markets – earlier this year the S&P 500 surpassed its pre-crisis high, signalling investor belief in a sustainable US recovery. We expect the US market for exits will stay strong this year since this market strength, combined with low interest rates, debt availability and significant amounts of cash sitting on corporate balance sheets, should ensure adequate demand for assets. By contrast, despite some recent positive signs, the economic outlook in Europe is still uncertain.

However, the positive performance of the US IPO market compared with that in Europe is down to more than just relative economic strength; the structure of the US market is far more advantageous for IPO exits than in Europe. The US equity markets offer a broader investor base than smaller European markets, with deeper liquidity. Markets in the US have also generally welcomed private equity-backed businesses, while Europe has been much more wary.

Nevertheless, in Europe we have started to see an IPO turnaround; European exit-led IPOs in the first half of 2013 reached €8 billion, exceeding the value of all European IPO exits in 2011 and 2012 combined. However, secondary buyouts are still the predominant method of exit by value for private equity in Europe, and we expect to see a further increase in sponsor-to-sponsor transactions since there is still a significant amount of dry powder waiting to be put to work.

When Terra Firma acquires a business, we set out our plan for transforming and exiting it. While we aim to complete this process within a set timeframe, the timing is not always perfect – markets can change, demand for certain assets can ebb and flow and new opportunities to transform the business can present themselves. We see through the full implementation of our vision for each business to ensure we can generate significant value for our investors.

At Terra Firma, we continue to focus on maximising the value of our current portfolios. Though we are witnessing an uneven economic recovery around the world, we are confident that our strategy of investing in and transforming asset-backed businesses in essential industries will continue to generate value. By taking the long view, private equity can look past political uncertainty and the volatile business cycle and focus on building strong, successful businesses.


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