Chairman's letters

21 May 2013

2013 Q1 Investor Letter (Extracts)

As economic and political difficulties continue to rumble on in Europe, we find investors growing tolerant of what has become background noise. Most are returning to normal levels of investment activity, as evidenced by the rallying of global stock markets in the past 12 months. Investors are searching for returns in an environment where growth is increasingly elusive – not just in Europe but throughout the world – rather than focusing purely on capital preservation. The European crisis has, for the moment, been relegated to a sideshow – albeit one with many surprises, as we have continued to see in the first few months of this year. 

In March, the crisis centred on Cyprus, an economy representing just 0.1% of Europe’s GDP. The initial proposed solution to address the insolvency of the island’s banks and contribute to an international bailout was for all bank depositors to suffer losses. Although this plan was eventually revised so only the larger depositors will suffer, it has raised questions about just how much central support the European banks and their depositors can rely on. In many ways, what has occurred in Cyprus will, in the long term, prove to have been a positive turning point, though it is distressing to witness the suffering of ordinary Cypriots as their economy melts down. What this episode has brought to the fore is the absurd concept that all banks within the EU are identical and that depositors do not need to consider credit risk. It has come as a shock to many that depositors need to think carefully about where they put their money.

Had this risk been clearly understood by depositors from the first day of the euro, we could have avoided many of the problems faced by Europe today as we would not have seen the inflow of such large amounts of money to the periphery countries. This would have kept living standards down relative to the core European countries, but it would have substantially reduced the risk of a European crisis and these periphery countries would have remained far more competitive. Instead, they experienced asset and wage inflation and a corresponding decline in competitiveness.

Since it joined the euro, Greece has seen average earnings increase by around 31%, while in Germany wages rose by only about 6% over the same period. German competitiveness in relation to Greece increased substantially over the period as productivity levels in each country rose by roughly the same amount. However, during this period, the cost of Greek government debt converged with that of Germany, with the spread narrowing to as little as 3.2% in 2005.

It is now clear that the different countries within Europe should have their credit priced at substantially different levels, and that putting a euro into one bank is not necessarily the same – or as safe – as putting a euro into another bank. The sooner that credit throughout Europe is priced at correct levels and countries benefit or suffer from making the correct or incorrect economic decisions, the sooner we have a chance of seeing the European periphery economies move forward. Additionally, and importantly, voters need to take responsibility for the choices they make in selecting governments rather than blaming the outcomes on others. To date, the financial support for economic mistakes made by governments in the periphery has come largely from Germany at the cost of domestic German living standards, and the electorate there is understandably fed up with providing money for seemingly endless bail-outs. The periphery will not be able to count on this support for much longer.

In the UK, the recent passing of former Prime Minister Margaret Thatcher has reopened the debate on her legacy. Many people do not remember what Britain was like in the 1970s, and how desperate its economic situation was. The ‘three-day week’ caused sporadic electricity supply, hence schools and factories were closed and homework was done by candlelight. Inflation was soaring (peaking at 25% in

1975) and the country was suffering an enormous brain drain. Britain was most definitely not a country of choice for professionals or the global elite like it is today. Thatcher had the confidence and vision not only to stop the decline, but to reverse it. Her policies were not all perfect, and certainly some of her actions caused substantial collateral damage. Most notably, her total belief in the market and contempt for state planning meant that even in areas where central planning is essential, such as energy policy and infrastructure, she killed off the desire for government to plan appropriately for a whole generation.

While Thatcher believed in the free market, she also believed in total budgetary discipline, something which was forgotten by the Labour Party leading up to 2007. In the 1970s William Hague, the current

UK Foreign Minister, famously extolled the need to “roll back the frontiers of the state”. And this was the core theme of Thatcherism.

In looking at the question of the role of the state, I believe in a mixed economy – one that needs government planning in certain areas, with other areas best left to the market. The UK had far too much state control in the 1970s; however, by 2007 it had gone to the other extreme and needed to impose state control on certain areas. The major problem today is that, since 2007, politicians have mistaken the lack of central planning and appropriate government control for a failure of the markets, and they are now seeking to remedy their mistakes by trying to control everything. They have focused the blame on bankers, rather than analysing the political, governmental and regulatory failures which contributed to the crisis.

As in the 1970s, politics are once again dominating the world’s economic decisions. Thatcher, during her time, tried to make politicians politically agnostic with regard to economic policy, but today many politicians are using economic policy to further their own political agendas with no concern as to the long-term economic effects of their policies.

Away from Europe, rising nationalism in Asia has led to increased tensions between China and Japan, while the highly polarised political debate in the US largely ignores the greater question of the country’s unsustainable long-term finances and how healthcare for the elderly is going to be funded.

This focus on politics in the economic decisions made by governments is not just an issue for the West, but increasingly one in emerging markets. Such decisions are gaining more attention as these countries become more crucial to the world economy, and hence investors need to be more focused on emerging market political risks. Political and economic volatility is higher in many of the world’s emerging economies than in developed markets and, as these countries come to represent an ever larger share of global GDP, investors must be prepared for the increased volatility in growth and returns that this will bring.

In Europe, the high cost of capital over the last few years – while aiming long term to provide some stability and keep asset prices under control – has had substantial negative effects. The growth that

Europe desperately needs is difficult to achieve when capital is so expensive. Governments, however, are limited in their options to change this situation. They could reduce what banks are allowed to earn or force banks to lend to riskier borrowers at an uneconomic cost, though both are unlikely to be implemented. Alternatively, they could put in place some form of guarantee to cover bank lending to businesses and consumers; however, in the UK the government has been severely criticised recently for offering government guarantees on home mortgages. This criticism seems appropriate as you only need to look across the Atlantic to see how much it ended up costing the US government to backstop similar promises there. Another alternative is infrastructure spending, which many governments discuss increasing, but it is not obvious how they would be able to fund it. As credit ratings for many countries are being cut, it could become very expensive. And quantitative easing, even when conducted on as grand a scale as the Federal Reserve has done, does not get an economy back to health – it just keeps it on life support.

The reality is that western countries need to get back to long-term economic equilibrium, but this won’t be possible as long as governments and consumers are spending too much relative to what they earn.

My estimate is that it will take as long as 10 to 20 years for Europe to return to a normal level of growth.

There are things that can be done to accelerate this process but they are related to structural issues, such as resolving labour market rigidity and over-regulation, which entrenched interests do not wish to see change. Yet if governments in Europe want to see a return to growth, they need to look at the costs of the excessive regulation of banks, labour markets and industries. When I speak to small business owners and entrepreneurs in Europe, what discourages them most from growing their businesses is not the cost of finance or capital, the uncertain economy or a lack of customers, but regulation. It’s a situation where a dose of Thatcherism in Europe might make all the difference.

For private equity, it is important to remember, however, that returns do not necessarily follow growth.

While a positive economic backdrop is certainly useful, it is not a prerequisite. In some rapidly growing economies, a lack of stability or the unpredictability of government action present a real risk to investments and entry costs can be very high. In contrast, in a lower growth region such as Europe, there are still many good opportunities to be had with less political risk and at lower prices.

At Terra Firma, there are five main things we do to transform our businesses: we transform the strategy, strengthen management, develop the business through capital expenditure, build through mergers and acquisitions and lower the cost of capital. In the period between 2007 and 2009, this fifth element ran into difficulty due to an unforeseen increase in the cost of capital. However, the cost of capital in Europe has now fallen to levels closer to historical, long-term averages. The cost of capital in Europe, while not as cheap as it was in 2007, is certainly cheaper than in 2010. However, it will not fall to a level as low as in the US, as European banks have significantly less equity capital than their US peers. Consequently, there is still a long way to go before European banks are strong enough to significantly increase lending to businesses and we see the markets as strong as they are in the US.

At Terra Firma, we continue to believe in the ability of private equity as an industry to build and grow successful businesses. While there may not be the same level of opportunities in Europe as in the US where the debt markets have reopened fully, there are increasing opportunities appearing in Europe for private equity. Banks are slowly shedding assets in order to meet their capital requirements. Similarly, businesses which need to focus on their core activities are starting to divest non-core divisions.

By creating value, private equity can play a critical role in regenerating the economies of Europe.

Focusing on transforming businesses is what differentiates private equity from other models of corporate ownership – and from other asset classes. Private equity is fundamentally about long-term transformational investment. In contrast, the demands of quarterly reporting mean that listed companies struggle to maintain a long-term perspective. The private equity model aligns the interests of owners and management for the long term.

The period of global economic uncertainty will continue and, particularly in Europe, crises are likely to continue to occur. But for private equity firms prepared to take the long view and invest in sectors where they can add value, there are great opportunities to be had and private equity can contribute to European economic recovery.

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