Chairman's letters

07 April 2017

2016 Q4 Investor Letter (Extracts)

I recently spoke at Bloomberg’s Private Equity Forum to reflect on the surprise events of 2016 and to discuss our industry’s outlook for 2017. Most of us agreed that, with the UK’s Brexit vote and Donald Trump’s election as President in the US, the investment landscape is barely recognisable compared with a year ago. However, what I found most interesting was that there is a lack of cohesion in our industry as to how we should react to these events going forwards.

At Terra Firma, we have made significant changes to adapt to the new challenges we face, most visibly through the forming of our new leadership team of Justin King, Andrew Géczy and I. The investment environment is changing rapidly, and I believe that building an open and transparent culture through the right leadership is crucial to deal with the uncertain business and political environment in which we now find ourselves. Indeed, it is an environment which is likely to continue for the foreseeable future as uncertainty becomes the new norm.

A willingness to change one’s business, whether in terms of people, culture or processes, is not something that comes naturally to successful organisations. However, given the events of 2016, it is more important now than ever to adapt and build for the future. As the past 12 months have shown, you can never predict what will happen, and you can never predict what the reaction will be.

In the immediate aftermath of the UK’s Brexit vote on 23 June of last year, it looked as though the markets were following the predictions of most experts and analysts in our industry. Sterling plunged to a 30-year low, the FTSE 100 Index fell by 6 per cent, and the FTSE 250 Index plummeted by 14 per cent. Meanwhile, the Bank of England slashed its UK growth forecast from 2.3 per cent to 0.8 per cent for 2017, meaning that the UK’s growth would become the second-lowest of the G7 economies, as opposed to second-highest if it had elected to stay in the EU. And leaders from the manufacturing and finance sectors threatened to take large parts of their businesses out of the UK.

However, while these predictions may eventually turn out to be true, the immediate reaction has been reversed. While the FTSE 100’s recovery was initially explained away by the fall in value of the pound sterling, it went on to record 14 consecutive sessions of gains, and the FTSE 250 rose above pre-referendum levels. The Bank of England’s growth forecast has also been revised upwards to 2 per cent – not as high as prior to the referendum, but far more optimistic than many imagined. 

The markets’ reactions to events in the US were even more surprising. The very idea of Donald Trump becoming US President caused fear throughout most of 2016. However, once the result was confirmed, Trump’s rhetoric of protectionism was quickly reinterpreted by the markets as a strong commitment to domestic investment. Despite further potential political disruption, the US is now regarded as the safest bet by many for the coming year.

I suppose that, in hindsight, this unpredictability should not have surprised me. After all, I was a trader for 12 years of my life. When I was at Goldman Sachs, I quickly learned that, even when you might be proven right in the long-term, the short-term can be very different. Focusing on long-term objectives as a trader will almost inevitably lead to financial failure in the short term, and the under-performance of macro-strategy hedge funds demonstrates this.

In 2007, if Hank Paulson, the then US Secretary of the Treasury, had taken his bets months earlier than he did, he could have lost all of his money. Things were just as bad – the markets just didn’t recognise it. Others saw this as well, but Paulson bet his reputation and career on the collapse of the mortgage market and his timing was perfect. As so often with investing, timing can be everything.

Before 2007, the environment was very different. The finance industry was controlled by individual heavyweights who had built second-tier banks into institutions with global power. They made enormous amounts of money for their banks, their investors and themselves. But it all went wrong from mid-2007. Today they get the blame for what happened, but their leadership style was encouraged by the regulators, investors, politicians and culture of the time. 

Today the world is very different and far more difficult to predict. Interest rates will not continue to fall for the next 25 years; the world is not becoming more pro-business or more pro-globalisation, nor more peaceful. However, regardless of what they say, many companies and leaders continue to behave in the same way as pre-2007. They hire the same types of people, reward them in the same way and expect them to achieve the same types of success that were possible in the pre-2007 environment. But it won’t work. In the post-2007 world, we need to take different approaches. In 2007, people could behave pretty much as they pleased so long as they performed – performance was the only thing that mattered. 

I have changed my thoughts radically over the past 10 years about what it means to build a first-class organisation in a world where no-one can predict what will happen, and no-one is an expert. I have drawn inspiration from Jack Welch, the former Chairman and CEO of General Electric, who identified the people within his organisation according to four types of employees. He defined his employees as ‘keepers’, ‘team players’, ‘no-hopers’ and those who were a ‘tough call’ – in other words, they performed highly but did not align with the firm’s culture and values.

In most businesses, particularly financial organisations, not only were these ‘tough calls’ kept, they were rewarded with even more money to motivate them. This approach certainly created more wealthy individuals, but not necessarily more wealthy firms.

At Terra Firma, we have evolved Jack Welch’s approach to assess performance, behaviour and culture for everyone at the firm and our portfolio businesses going forwards. In a world which is so uncertain, we will focus solely on people who promote teamwork and knowledge-sharing.

People who are only interested in creating wealth for themselves, who do not align with our firm and our investors will not be ‘tough calls’ – they will have no place at Terra Firma. Our aim is for everyone to both perform at the top level and promote the right behaviours. People who do both of these things naturally are rare, but we will seek to attract people with the right foundations of talent and behaviours to train, coach, mentor, develop and motivate them within our own organisation.

Justin and Andrew have built a new leadership team with me based on partnership, transparency and alignment. They both clearly fit the profile of being high-performers and exemplary leaders. What makes them stand out to me is that they are committed to building a firm with the right culture, which can continually adapt and succeed in a world where unpredictability is the new norm. Over the next few months I hope you will have the chance to meet Justin and Andrew and to get to know them.

2017 will be another uncertain year for the private equity industry, but I believe there will be opportunities to invest. The biggest challenge will be finding good deals and having the right resources to manage them. But we can create some certainty by focusing on what we can control, rather than what we can’t.

If we continue to build quality businesses, work together to achieve this and retain an ability to adapt, we can overcome short-term volatility and continue to align with our investors’ interests in the long term.

Parts of this text were originally used in a speech at Bloomberg’s Private Equity Forum 2017 on 19 January.

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