Chairman's letters

13 November 2015

2015 Q3 Investor letter (Extracts)

In September, the Federal Reserve opted not to raise rates, while only months earlier the first hike in nearly ten years had been widely anticipated. As the autumn has progressed, the Fed’s decision has proved to be a wise one, as the global economic recovery appears ever more fragile and unpredictable.

I would like to focus on three key themes which are affecting the global economy and which have been with us for some time, but whose impact has become much clearer as 2015 has progressed.

The first of these is increasingly unstable global politics. The political upheaval in the Middle East and the Russian approach to Ukraine have come as a surprise to many. Meanwhile, the rapid rise of radical parties on both the left and the right in many Western nations has also surprised the political establishment.

The consequences are being felt right across Europe, from Greece to Spain to France, and most recently in Poland with the electoral victory of a right-wing, Eurosceptic party. A wave of nationalism is leading the European electorate to vote for populist, inwardly-focused parties. In turn, this is leading to a breakdown of the social democratic consensus which has underpinned the European project since its founding. Germany’s Chancellor Angela Merkel, Europe’s most powerful politician, has put her political capital to work defending the European project, but it is under threat nevertheless.

This is most evident in the UK, where Prime Minister David Cameron is attempting to renegotiate Britain’s membership of the European Union (‘EU’). Despite his efforts, it looks increasingly unlikely that he will be able to hold the Tory party together to support Britain’s continued place in the EU. The 2017 referendum on EU membership will be a far more closely fought battle than Cameron could ever have expected when he first announced it.

The EU has disappointed the political left because its coffers can no longer afford the expensive social programmes that countries have promised voters over the past few decades. Meanwhile, for the political right, the EU’s free movement of labour, through which hundreds of thousands of refugees are now travelling, is acting as a lightning rod for nationalism. Across the political spectrum, disillusionment with the European project is leading to the election of politicians who aim to dismantle it, and who intend to proceed in an independent and sometimes confrontational way. I believe strongly that a breakdown of European unity would lead to future conflict between European nations – something which the EU had aimed, through its existence, to confine to history.

The second key theme I see is increasing regulation of everything from business through to social relationships. Throughout the 1980s and 1990s, most industrialised countries were keen to deregulate in order to let the power of the market bring prosperity to their economies and give their citizens more freedom in an increasingly liberalised Western world. However, since the financial crisis in 2008 and the growth of global terrorism, the pendulum has swung in the other direction. I do not intend in this letter to discuss the change in many governments’ approach to people’s freedoms, but I do want to discuss their approach to business. The clearest example is in banking. Politicians, keen to avoid another crisis, are tying up financial institutions with reams of red tape. The Dodd-Frank Act in the US, for example, required financial regulators to create hundreds of new rules. Yet this complexity will do little to protect consumers or the economy; it has simply created a more complicated and fragile system, and is holding back economic growth at a time when the world sorely needs it.

This is particularly clear in Europe. While banks in the US were quick to cleanse their balance sheets of toxic assets, many European lenders still haven’t written down the non-performing assets they hold. This in turn constrains their ability to lend to newer, more productive businesses as their money is tied up in keeping ‘zombie’ companies alive, and has contributed to the stagnation Europe is experiencing. And as European regulators continue to tie the banks up with further rules and capital requirements, it is difficult to see what will break this cycle.

Meanwhile, the extraordinary revelation of Volkswagen’s systemic emissions testing fraud will surely lead to even more government oversight of industry. While Volkswagen’s actions were clearly reprehensible, governments around the globe are taking from it the lesson that private enterprise cannot be trusted to behave in a responsible manner, and must be restrained accordingly. Regulators in the West are going to be tougher, more punitive and far less trusting, not just of banks, but of all business activities. This will of course pose a challenge to any business trying to create value and jobs.

The third theme I see impacting the global investment environment is the long-term effects of the injection of enormous amounts of liquidity into the global economy. Since 2008, central banks have created trillions of dollars of liquidity. While this has had a strong positive effect on asset values, it is important to remember that this money was created instantly, and it can disappear just as quickly – with a corresponding impact on asset values. It is also much easier to pump in liquidity than it is to achieve actual economic growth, as countries around the world have discovered. Most central banks are therefore reluctant to start draining liquidity from the system – the Fed being the most notable example.

Since 2009, a lot of this money has flowed into alternative asset classes such as private equity; at the end of 2014, private equity firms were sitting on $1.2 billion of dry powder, according to a report from Bain & Co, which is leading to ever-higher multiples being paid for acquisitions.

The effect of all this cheap excess liquidity has been to enrich borrowers at the expense of savers. Organisations that can borrow cheaply, such as hedge funds and large corporates, have taken advantage of historically low rates to borrow and re-invest at a higher rate, earning the difference and driving returns on equity. Meanwhile, savers, in particular pensioners, are suffering. The return on their savings has shrunk to practically zero, and at the same time they are living longer than ever and therefore need their savings to last longer.

Given all of this uncertainty, it is very difficult to say which geographies and sectors will outperform in the coming years. However, I know that there will be good opportunities, and I am confident that Terra Firma can take advantage of them because our investment strategy is not based on picking sectors or countries, nor is it based on timing the markets. For the past 20 years, we have undertaken business transformation with great success.

We find businesses that we know we can improve through the application of our five key value drivers: transforming strategy, strengthening management, developing through capital expenditure, building through mergers and acquisitions and lowering the cost of capital.

There are always going to be factors outside our control which can impact an investment. While we remain aware of these, we choose to focus on all the elements of a business which we can control and improve, and that is how we have successfully delivered value across our portfolio over the past two decades.

With the global economic outlook so uncertain, it is more important than ever that private equity focuses on generating alpha for investors. At Terra Firma, we focus on transforming the businesses we buy into best-in-class operators.

We have built a team with tremendous expertise in operational transformation, and I am very pleased that in September we strengthened that team further with the appointment of Justin King as Vice Chairman and Head of Portfolio Businesses.

Justin was CEO of Sainsbury’s from 2004 until 2014. He brings to Terra Firma over 30 years’ experience of turning around and growing consumer goods and retail businesses, as well as the experience of leading a FTSE 100 business through a successful turnaround.

Justin has taken over responsibility for the management of our portfolio businesses. Terra Firma is a great fit for Justin because we have a portfolio of businesses in various stages of development where he can add significant value. We have been transforming businesses for over 20 years and have built up tremendous operational expertise internally. Justin is the right person to harness that expertise and drive our change agenda within the existing portfolio.

We were also pleased to welcome Peter Miholich in September as a Managing Director. Peter was most recently a Managing Director at Nomura in London, where he was responsible for the principal credit business in EMEA. Before Nomura, Peter ran his own company which specialised in sourcing, structuring and executing transactions for two leading global hedge funds. Until 2012, Peter was the Global Head of Strategic Equity and Head of Structuring at RBS, where he oversaw a structured lending portfolio of $5 billion.

Peter brings a wealth of credit structuring experience to Terra Firma, which will allow us to explore additional ways of delivering value in the credit space.

We have also strengthened the management of the firm, which will enable us to tackle future opportunities more quickly and effectively. Head of Tax, Dominic Spiri, was promoted to Chief Financial Officer, and General Counsel, Trudy Cooke, was promoted to Chief Operating Officer.

Justin, Dominic and Trudy will be joining Terra Firma’s senior management team alongside me and CEO Tim Pryce. This five-person management team incorporates substantial internal knowledge and experience, while also bringing on board significant talent and a fresh perspective from Justin.

Having marked Terra Firma’s 20-year anniversary last December, we are now focused on equipping the firm for future years of success. This enhanced management team and structure will allow us to maximise the value within our existing portfolio, as well as seize future opportunities to transform businesses and generate returns for our investors.

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