Chairman's letters

01 July 2009

Speech to Investor Dinner - July 2009, Beijing

Good evening, and thank you for being here with us.

I’ve been visiting Beijing regularly for three years now, and every time I visit, I feel more positive about the long-term opportunities that China offers.

But you don’t need me to tell you that, economically, the West is going through a very difficult time, and that in the short-term, life is going to remain challenging.

Unquestionably the last 18 months have been dreadful in the West, both from an economic and an investment perspective. China’s ability to ride through the storm is very impressive.  However, the West remains economically unstable, and despite the rally earlier this year in our public equities and credit markets, we are still nearer the market’s bottom than what was the market top.

Such circumstances offer exciting opportunities for those firms which understand the history and dynamics of economic downturns. But understanding and knowledge alone will not be enough to make profits.

The truth is that in this difficult period, my industry - private equity - can thrive only if it returns to its roots, realigns itself with its investors, and focuses on how to improve the strategic and operational performance of businesses.

But it will be a slow and difficult journey for the firms that attempt it, and it will not be helped by the difficult market conditions that I believe will persist for many years yet.

There has been much talk recently in the West of ‘green shoots’, and anyone who knows me will not be surprised to hear that I’m not sure how real those shoots are. 

I do not believe that we are at the end of this recession, or at the start of a bull market. 

The green-shoots that are visible in the West are the result of unprecedented stimulus spending across the globe. This has in turn been financed by the most extraordinary amount of public debt.   

Such policies, while undoubtedly necessary in the short-term, will inevitably have consequences, and will create other long-term problems.  

But this will create opportunities for the private equity firms who know how to take advantage of such circumstances, and indeed we’re beginning to see attractive valuations in certain sectors. 

Of course, the collapse in equity valuations has meant that, for private equity firms who mark their holdings to market, this has been a brutal year. 

Any long-only equity investor over the last five years is going to have considerable problems in their portfolio because inevitably, investments were made at the top of the market. 

But looking ahead for private equity, there are going to be some extraordinary opportunities out there in Western economies.

Deals will be smaller, requiring less initial equity with investments that we can then seek to build on by investing further capital and look to benefit from synergies by purchasing competitors.  

We will, of course, have to do all of this with very limited debt. 

And to instigate fundamental operational change in businesses, private equity firms will need hands-on resources, not just consultants and executives on-loan.

These are not management skills or disciplines that are acquired or learnt overnight.  Indeed, doing this often requires the private equity firm to replace most, if not all, of senior management in the target company, something few private equity firms have done successfully in recent years

And I am sure there will be sellers of Western businesses at compelling values over the next few years.

The fact is that there are businesses out there which are over-leveraged and which will need to sell non-core assets and there are situations where the entire business is over-burdened with debt. 

In addition, there will be fewer buyers of companies going forward.  

The private equity industry as a whole will clearly shrink.  

Thus, when deals occur, those who are bold and have capital will face less competition, and there will be compelling opportunities to profit.  

A huge example of over leveraged owners who will be forced to sell businesses, whether they like it or not, are the governments of the West. 

We will therefore see a return to government-led sales, the last spate of which we saw in mid-late 1990s.

Historically, Terra Firma has done extremely well in taking over former state-owned businesses. These can be challenging investments – they typically lack both a sensible corporate structure and a private sector ethos. 

In managing them, one has to be aware of a broad range of stakeholder concerns, and in certain cases, operate within the constraints of binding social protection agreements. 

But if one can navigate these waters successfully – and Terra Firma has shown it has the skills and judgments to do so – there are considerable rewards.  

Our willingness to tackle such challenges, and work with government, has allowed us to acquire the likes of Tank & Rast, Annington, and Deutsche Annington, and fundamentally change them to deliver great results.  

Creative, complex deals such as these are the hallmark of Terra Firma’s past, and I believe they’ll continue to feature prominently in our future. 

But the real key to our long-term success, during both the boom and bust periods, is our alignment of interest with our investors.

As we all know, one of the major causes of the economic downturn was that, for too long, many senior executives in banks and other financial institutions were incentivised to ignore longer-term risks, whilst enjoying extraordinary short-term gains.  

As I have argued publicly for several years now, to be effective, incentive structures must be long term in nature, and by long term I mean at least 5-10 years. This is one characteristic of private equity.

But moreover, investors should also look at which private equity firms have more of their own money invested in their funds as a percentage of their personal net worth.

In good times and even more importantly in tough times, the importance of alignment of interest cannot be overstated: it is at the core of Terra Firma’s model.

If you are an investor and your private equity firm loses some of your money, you want them to suffer with you and learn by their mistakes.

In March this year we returned approximately $100 million of escrowed carry to our investors.

This cash, which had accrued because of our investment out-performance since 2004 through to 2007, would have formed a very nice reward for the hard work of Terra Firma’s senior team.  However, we invested in EMI and so we returned the capital to our investors and it was undoubtedly the right thing to do. 

This is true partnership – suffering together when times are tough, and celebrating together when our investments are successful.

That is my vision for private equity – it is a long-term partnership built on patience, trust and shared rewards.

Thank you for listening.

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