Chairman's letters

07 December 2016

2016 Q3 Investor Letter (Extracts)

I would like to start by thanking those of you who joined us at our Annual Conference in London in September, and for the feedback you have shared since. I believe it was our most successful conference of recent years, and it allowed me the opportunity to thank you for the commitment you have shown us over the past several years.

In my address, I spoke about Terra Firma’s past and future. We are now entering a new chapter in our history, and with important changes underway at the firm, I want to reflect on three things with you: what went wrong for Terra Firma between 2007 and 2014; what I have learnt from the experience; and what Terra Firma will do differently going forwards.

First, let me explain what I got wrong. For the 25 years leading up to 2007, the world moved in a clear direction, and Terra Firma’s investment approach was based on three trends which underpinned it.When I joined the finance industry with Goldman Sachs in 1982, US long-term bonds were trading at over 14 per cent, and UK income tax had just come down from 83 per cent to 60 per cent. At this time,banks and businesses were not highly regarded by the public or by the establishment. However, from 1982 things changed, and the world evolved.

The first trend in the years that followed was that governments became increasingly pro-business. Deregulation was initiated with Reaganomics and Thatcherism, and UK corporation tax fell from 52 per cent in 1982 to 30 per cent by 2007.

The second trend was that banks became bigger after being privatised in Europe, and then were increasingly supported by governments worldwide. For a country to have the biggest banks was seen as a huge positive; if bankers were not quite controlling the world, they certainly had a seat at the table of influence. ‘Fred the Shred’ was knighted in 2004 for his services to banking for turning RBS into the world’s largest company by assets. And in the late 1990s Bob Rubin, an ex-head of Goldman Sachs, persuaded Bill Clinton to repeal the Glass-Steagall Act, removing a major constraint to commercial banks in taking risks and growing their balance sheets.

During these 25 years of unprecedented growth, a third trend occurred: the banking industry became increasingly reliant on off-balance sheet asset-backed financing. When I started non-homogenous asset-backed securitisation at Goldman Sachs in 1989, we underwrote on an asset-by-asset basis. Outside of the mortgage, car lending and credit card markets, there were very few people involved in securitisation worldwide. But changes in banking laws and regulations meant that securitisation moved from being a niche practice to a mainstream component of the finance industry.

Everything went well during these 25 years: governments became pro-business, banks became bigger and asset-backed securitisation underpinned the financial industry. However, in 2007 the financial crisis happened and the world in which banks operated completely changed. People lost confidence in these three areas and since then, the world has been antibusiness, anti-banking and anti-securitisation.

Every business we owned in 2007 relied on these three areas doing well, but each did badly. We were resilient. We did everything we could to improve our businesses operationally and recover the moneywe had invested on our investors’ behalf. Eventually, in 2013, the reduction in interest rates and the liquidity provided by governmentsin Europe gave us an opportunity to start the process of exiting our businesses profitably.

We began with the refinancing of Deutsche Annington and Tank & Rast, both of which had faced enormous challenges at the end of 2010. We subsequently turned these into two of our most successful investments. But we still faced strong headwinds: retrospective regulation changes affected RTR in Italy and Infinis in the UK. And social care spending cuts of 8 per cent in real terms over the past four years have severely affected Four Seasons Health Care Group.

I had always known that Terra Firma could not control what happened in the macro environment. However, my mistake was not adapting to new circumstances quickly enough. I did not change our investment approach after the credit crunch set in from 2008 onwards, and relied instead on my previous experiences. With hindsight, I have learnt some important lessons.

First and foremost, I learnt that you can run a business incredibly well strategically and operationally, but still lose money if your capital structure is wrong for the market at the time. For over 20 yearsTerra Firma has developed the right strategies and executed remarkable transformations, and we have also refinanced well, with the one exception until now being EMI. 

However, I did not see the macro-environmental changes coming, and I did not adapt quickly enough. In fairness, others did not see these changes coming either, but this failure to adapt made me realise that I needed new senior leaders to help to lead Terra Firma alongside me. These people should not just support me in carrying out a strategy; as one investor told me, Terra Firma needed more leaders like me. They should challenge Terra Firma’s strategy, complement my own skills and be partners in driving Terra Firma forwards.

Today at Terra Firma, I have those two partners with me: Andrew Géczy, our new CEO, and Justin King, who joined as Vice Chairman and Head of Portfolio Businesses one year ago. Terra Firma is no longer run by one person; it is run by three. Each of us is alike in terms of having strong, passionate views and personalities. But each of us has had different life experiences, and our views are not always the same. These diverse perspectives will be key to shaping our future approach to investment decisions and operating our businesses.

In Justin, we have a world-class operator with 30 years’ experience working in the world’s leading consumer-facing businesses. He excels in motivating people to deliver against a plan, and he is a skilled communicator. Andrew, meanwhile, is a highly experienced financier who has managed and built teams comprising people of diverse backgrounds. He has been at the top table of some of the world’s leading banks for over 25 years. Together, with my own experience as an investor and an entrepreneur, this senior leadership team has almost 100 years of experience at the very top of the business and finance worlds.

With the three of us working in partnership, Terra Firma’s ability to recognise and adapt to macroeconomic changes like those which occurred in 2007 and 2008 is fundamentally enhanced. For example, our experience of working in world-class organisations will be vital to interpreting the investment landscape around Brexit. Our approach to investing and decision-making with this new leadership team in place will ensure that Terra Firma adapts to the environment faster and more successfully than its competitors.

I have never doubted that Terra Firma can extract optimal value from any micro situation. We have a 22-year track record of achieving significant operational transformations. Going forwards, we will collectively and constantly assess our macro environment as well, taking decisions that fit with our contemporary view of the world. This will apply equally to our existing portfolio businesses and potential new deals. 

Justin, Andrew and I are absolutely committed to delivering maximum value for our investors, and we look forward to working with you as partners to achieve this.

Thank you for your continuing support of Terra Firma.

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