01 June 2012
Speech to Limited Partner Group - June 2012
The situation in southern Europe today reminds me of how I felt as a teenager in 1970s pre-Thatcher Britain, living in a country with constant strikes, falling living standards and seemingly no way out of its debt crisis.
The UK in the 1960s was suffering from the break-up of the British Empire and the costs of the Second World War.
In an attempt to try and stimulate the economy and maintain its position in the world, Britain took on massive debts and by 1976 found itself in economic crisis and reliant on the IMF for a bail-out.
In the 70s, it was clear that the breakup of the British Empire had changed things for Britain forever. For Europe things changed forever in 2008 when the Western democratic belief in unlimited borrowing to cover unsustainable spending was exposed as a false hope.
The result is that many in Southern Europe will face years of austerity, just as many in the UK did from the mid-70s.
Today the political courage to make the sort of fundamental economic adjustments needed in Italy, Greece, Spain and Portugal that Thatcher made in the UK in the early 80s does not exist. Austerity measures will be drawn out for many years rather than dealt with quickly through the structural changes needed to achieve the provision of jobs for the young and fair sustainable pensions for the old.
Germany is the economic giant of Europe and the Germany of today has a passion for economic, political and social stability, hence Germany’s desire to stabilise the Eurozone.
The German political system believes that it is the duty of the German government to lead Europe through this crisis.
It considers that it has no choice but to enforce fiscal discipline on the weaker Eurozone countries in order to maintain the European political union.
Its policy's reflect what Germany underwent when West Germany merged with East Germany. That merger effectively meant that for ten years West Germans sacrificed increased living standards to improve the living standards of their fellow countrymen in the East.
German politicians see the present crisis as not only full of risks, but also ripe with opportunity. A large majority of German politicians are willing to spend money on supporting reform policies in Southern Europe, as long as these policies improve the prospect of enhanced stability inside the Eurozone for future decades and further integration.
This belief is universal among mainstream German politicians, even though the public do not support expenditure to support this grand plan.
However, support comes at a price and Germany is only willing to commit resources, with the receipts of promise from the recipients that reforms will be implemented.
Given the painful nature of these reforms, they will need time to gain political support and will only be implemented in phases.
This means that Germany is only willing to give money in phases. The money will be provided, but it comes with strings attached.
Germany’s power and resolve are strong, however it is becoming increasingly isolated due to its insistence on austerity while other countries increasingly demand more growth-oriented policies. In the last month it has become clear that Germany is being forced by events to reassess its stance.
Although Greece has become the current poster child for the Southern European countries, it is not alone, and instability in Greece could easily ripple through other weaker member states.
Spanish banks are in a mess as is the Spanish government and while the bank bail-out will help Spain, we are also seeing Spain and indeed Italy dangerously close to being unable to manage their debt unassisted.
Greece is only going to survive within the Eurozone if it can muster some form of support for the austerity measures already agreed with the IMF and the other Eurozone members.
However Greece leaving the Eurozone would not be a disaster.
What is more worrying are the ramifications of the rise of European political parties on the extreme left and right.
If this leads to a breakdown in Western Europe of the post-war political consensus that has supported a plural political system based on Western democratic values, then things will become very different indeed.
A break down, I believe is highly unlikely but the numbers of people voting for the extreme right and the extreme left is raising concerns about Europe’s future political direction.
This sort of political and social instability is what Germany has been so determined to prevent for the last 60 years.
Germany’s strength within the Eurozone and the depth of Germany’s commitment to see a successful outcome should give us some confidence that things will ultimately be resolved – but it is going to take at least 5-10 years to achieve this if it is possible at all.
The issue is largely political and social and not economic as Europe as a single economic unit would be extremely strong.
However for the European economy, without economic integration we can expect a very bumpy ride.
Against this economic and political backdrop, I want to talk about the prospects for private equity investment in Europe.
Europe needs increased lending to the private sector, an increased velocity of money, a lowering of taxes, and it’s confidence back again.
None of these are currently on the long term agenda. Instead, European banks are being obliged to meet new capital requirements under Basel III.
These rules will have the effect of further dampening any slight prospects of growth. To meet these new requirements, banks will need to shrink their balance sheets, raise more capital or be nationalised.
Shrinking their balance sheets has proved difficult. Most European banks have loan portfolios that are far too large, and their loans are illiquid at the price levels they have them marked at. Consequently they can’t sell them as their balance sheets cannot afford the discounts demanded by potential buyers.
Raising capital cannot be done without destroying the value of the existing equity, and governments, for all their talk of wanting to run banks better, do not want to have to take responsibility themselves.
So, to keep the banking system in Europe solvent, a combination of approaches is going to be needed.
In response to the acute needs, the ECB has provided liquidity in an attempt to reassure the markets.
However it is increasingly likely that political leaders will directly have to step in to stabilise banks in the short term.
Over the medium term, we will see more Governments nationalising the weakest banks and more banks selling assets and raising new capital where they can.
However, these steps are not likely to be sufficient to solve the deep-rooted problems effecting the European banking system.
So we won’t be seeing European banks back in full lending mode to the private sector for at least the next five years.
The long term objective for Europe has to be to avoid following the Japanese example, when public sector and government borrowing squeezed out the private sector.
With low European growth rates, the public stock markets will prove an unexciting place to invest money.
I believe that European equity markets will end this decade no higher than where they started it.
The impact on Private Equity
These two key negatives - low levels of lending and poorly performing markets - however, will not lead to bad results for European Private Equity on investments made post 2012.
Despite the negatives, the Private Equity markets in Europe will have very interesting opportunities and provide very good returns over the next few years.
The secret to Private Equity’s investment success in Europe over the next few years will be the changing balance in the demand and supply dynamics of private transactions in Europe and the opportunity for Private Equity to be used as transformational capital.
Every asset manager likes to claim they have that bit of magic, every trader likes to think they can read the market, but the truth is that they cannot and that they are affected by supply and demand and the same is true of Private Equity.
While demand and supply dynamics were substantially in favour of the seller in 2006/2007, we have begun to see this changing slowly over the last five years.
The dynamics will, by the end of 2013, be firmly in favour of the buyer and Europe will become an extremely attractive place to invest in private equity.
Let’s look at demand first:
On the demand side, the availability of capital to invest in deals in Europe is reducing rapidly.
The money that private equity funds have available to invest in the market has reduced each year since 2008.
A year ago there was an overhang globally of over €300bn. By the end of 2013 that overhang will largely be gone as the investment periods expire on firms’ 2007 and 2008 vintage funds.
Funds will then only be able to invest what they can then raise, rather than living off the overhang.
The PE fund raising market has been very tight over the last three years and there are no signs that this will change any time soon.
This is particularly so in Europe, where competition is high and firms are having to spend more and more time on the road to achieve success.
The amount that new funds raise for investment in European private equity over the next few years will possibly be around a third of what was raised annually at the peak.
There is also a change in the mix of investors; being driven by regulation.
I have already mentioned the effect of Basel III on the banks, and in Europe, Solvency II, comes into place on 1 January 2014.
The US is also adopting much of Basel III. In addition, the Volker Rule has specifically placed limits on the amount of capital that banks can invest in private equity.
Together, these regulations are reducing the ability of many long-standing investors to re invest in Private equity.
The second reason that demand for new deals will be reduced is the lack of leverage available.
Not only will the equity available for private equity deals in Europe be much lower, but each transaction will require a lot more equity.
If leverage levels remain low the equity needed to complete a transaction will be about double the amount required in 2007. So firms have a third as much equity and it will go half as far.
And we should not forget that between 2012 and 2016 there will be €3 trillion of leveraged deals done in the boom years that will come up for refinancing.
With current leverage ratios where they are – at a maximum of 60-70% LTV versus the 85% LTVs of some deals done in 2007 – these refinancings will only be achieved if more equity is pumped into them. This is equity that will not be available for new deals. This means yet lower demand.
It is a sharp contrast to 2007, when huge demand, fed by cheap debt, was inflating prices. Investment in quasi infrastructure deals was particularly hot. Terra Firma saw people with little experience of European transformation willing to take on big transformational investments that needed substantial operational change. Terra Firma was priced out of market sectors we knew well.
Today, we have the reverse; infrastructure funds are now looking for security from 30-year contracts. They are happy to get 10% returns. They do not want the risk of getting involved with complicated business transformations.
Let’s now turn to what is happening on the supply side.
In Europe, opportunities will emerge from banks, governments, private equity funds and strategics. All will be sellers of suitable companies for Private Equity to invest in and transform.
Banks will not dump assets on the market but will be selective about what they sell and the price at which they sell at. They simply cannot sustain the required discounts from par that would be needed for mass disposals.
The banks in Europe simply aren’t getting the same pressure as the banks in the US got to clean up their balance sheets. Nor has there been the same support for the banks that the US authorities provided that enabled the cleaning up of bank balance sheets.
The strongest most marketable European bank assets are likely to come onto the market.
Overtime these bank assets will have had little to no capex investment invested in them for many years.
They will reach the market under managed, under invested in, with an outdated strategy and a disillusioned management team.
Banks will not be alone in selling businesses. Governments and quasi government institutions will also be selling assets across Europe.
The UK Government sold off many assets and businesses a long time ago. We will see more of this from other European Governments as they try to use a combination of structural reforms and the sale of assets to reduce their deficits and draw in investment.
Private equity will also seek to realize assets from existing portfolios, many of which have, over time become ‘zombie’ companies. As many PE funds will never produce a € of carry and no one is focusing on these companies.
Finally, large companies will also be disposing of non-core assets, when they have the confidence to invest in new opportunities.
This year Terra Firma has made two significant acquisitions in the UK, Four Seasons Health Care and The Garden Centre Group. Both of these arose because of financing difficulties that the businesses were suffering in the aftermath of the credit crunch.
They are exactly the sort of opportunities that I believe are going to become increasingly common in Europe in the coming years.
This is what the private equity market should be looking for - businesses that need transformation with new strategies, new management teams, and new investment.
We are therefore seeing the market in Europe entering into a new phase. It will be a phase in which private equity can really contribute to a European recovery.
Recent performance of the industry
So what confidence does the Private Equity Industry’s performance in recent years give us that it can play a valuable role?
Despite widespread predictions of the death of the industry after the credit crunch, investors continue to see private equity as a key part of their portfolios.
Over the last ten years, buyout funds have increased in value by 2.5 times, a period in which the FTSEurofirst 300 Index fell approximately 10%.
The years since the credit crunch have forced the private equity industry in Europe to get back-to-basics. To concentrate on what private equity is good at: creating value by transforming businesses and this is good for investors.
Focusing on transforming business 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. We raise capital that is committed for ten years and we use it to improve businesses. In contrast, the dominance of quarterly reporting means that listed companies have struggled to maintain a long-term perspective.
The private equity model aligns the interests of owners and management together. Private Equity speeds up decision-making and ensures that all are in the same boat and rowing in the same direction..
How Terra Firma positions itself in the market
Having spoken about the broader environment and its impacts on the Private Equity industry, it is a natural progression for me to say a little about Terra Firma and how we position ourselves in the market.
There are three factors that distinguish us:
- Our people; and
- Our performance
At the core, it is Terra Firma’s investment philosophy that makes us unique. It has been consistent since the business was first established over 18 years ago.
All our investment ideas originate from our view of what is happening at the macro and global level. We look for trends that might create long-term opportunities. We then look for specific businesses that we believe are well positioned to benefit from those long term trends.
Growing demand for protein in Asia was a trend that led us to buy CPC, Australia’s second largest beef producer;
- Steady growth in air travel driven by the developing economies was a trend which led us to buy AWAS, now one of the world’s largest aircraft leasing businesses; and
- The long-term need for renewable energy in Europe is a trend which led us to build RTR, now Italy’s largest generator of electricity from solar power.
We are not afraid to look for deals that have been overlooked by others, perhaps because they are in complex or regulated sectors.
No matter where the ideas come from, every investment we look at must have three common characteristics:
First, it must be in an ‘essential industry’. An industry in which there is fundamental demand. Like energy, utilities, infrastructure, agriculture, leisure, affordable housing or asset leasing.
Second, the investment must be asset-backed. This helps to protect its value and to reduce its cost of capital. All our businesses are rich in assets, for example:
Phoenix, our gas distribution business in Northern Ireland, has a distribution network that supplies 230,000 properties; and
- Tank & Rast holds concessions for 90% of the service stations on the German Autobahn network.
Third, the business must require fundamental change. This gives us the opportunity to create value by transforming its strategy, repositioning it in a market and transforming its operational performance.
- We have turned a small division of a UK waste management company into the UK’s leading independent renewable generation business, Infinis.
- We also merged two cinema groups, Odeon & UCI, to create a European cinema platform which we have grown, through acquisition, into what is now Europe’s leading cinema group. It has a new business model and its scale has transformed its efficiency.
So the philosophy is simple – asset backed businesses in essential industries that require fundamental change. The first two underpin the value of our initial investment and the ‘change’ is where the potential to create value lies.
Our most recent acquisition, Four Seasons Health Care is a perfect fit with these criteria:
An aging population in the UK is driving increasing demand for elderly care, which is undoubtedly an essential industry.
Four Seasons has a property portfolio recently valued at over £900 million so is heavily asset backed.
Finally, it is in a sector that is in crisis and it has enormous opportunity to benefit by undergoing fundamental change as the sector is forced to adapt to changes in funding and the regulatory environment.
Having said that our philosophy is simple, how Terra Firma goes about transforming a business is not.
Terra Firma is a very active investor. In order to transform businesses we put them through a very intense period of highly interventionist supervision.
We always acquire control positions as it enables us to implement changes more rapidly. We do not do ‘club deals’.
Having identified a possible deal, we make sure that we have a very clear idea of how we are going to add value.
Through the due diligence process, we plan the strategic and operational changes that we will make. Our ideas are often likely to be very different from those of the incumbent management team.
Again, we have a clear ‘Terra Firma approach’ that we use to plan business transformations.
We focus on five drivers to create value from the moment we start working on a deal, through to the day we exit.
I will use AWAS, the aircraft leasing business that we acquired in 2006, as an example:
Our first driver is strategy. We saw the potential to grow AWAS and to reduce the risks of operating in a notoriously cyclical industry by improving the mix of its fleet and reducing its dependence on a few key customers.
Next comes management. Typically we make several new appointments to ensure that we have the right team in place to execute the strategy.
However, in the case of AWAS, we ended up replacing almost the entire senior management team as it was so scattered around the globe that it hampered effective decision-making.
We have since worked very closely with the new team, challenging them with ambitious targets and providing them with strong incentives to deliver.
Third, we actively look for ways to deploy capital.
Many businesses we acquire have been capital constrained and we deploy capital to transform and grow them but only when strict capital criteria are met.
Since acquiring AWAS, we have invested almost € 2.8 billion, largely on new Boeing and Airbus aircraft to update its fleet.
Next, we look for acquisitions to drive synergies and growth.
For AWAS we acquired Pegasus, a rival leasing company, in 2007.
It had a younger fleet and by combining the two companies we created one of the world’s leading aircraft lessors – and realised more than $15m of annual synergies in the process.
Unlike many private equity firms, we tend to invest substantial further capital in our businesses post-acquisition, in order to grow them.
Lastly, we look for ways to reduce the cost of capital in order to create extra upside. With AWAS we put in place a more rigorous framework for managing credit and concentration risks.
From these drivers, you will sense how just how interventionist our approach is.
We don’t just buy businesses, we transform them. Our aim is always to build businesses to be “best-in-class”.
Next, our people
Our intensive, hands-on approach means that we are structured rather differently to other firms.
We have a very broad range of skill sets in-house focusing on the template for drawing value that we apply to all companies we buy.
From the very early days of Terra Firma we decided that we needed operational expertise - in business consulting, executive management and operational finance - in order to enable us to be able to transform businesses and create real value.
Therefore we have a large pool of operational expertise available.
Our culture is also distinctive. We are not only professionally diverse, but culturally diverse too. We have a team of around 80 people and it is drawn from 23 different countries.
That cultural diversity helps give us a global perspective on opportunities.
We have also a very open culture that has no internal boundaries. Teams are flat and flexible because that way everyone’s contribution can be heard – and we expect everyone to be entrepreneurial.
We are also committed to a similar level of transparency externally - in the level of disclosure that we provide to investors and to other stakeholders. A quick glance at our website will confirm this.
It is fair to say that Terra Firma’s operating model is expensive to run, but it means we can do more with our businesses and their operational results reflect this.
Back in April 2007, we had the best track record of any major Private Equity Firm worldwide, and it allowed us to raise the largest 2nd time fund ever raised. However, at the end of May, we did EMI which wiped out approximately 50% of the profits of our previous 10 years.
While operationally EMI was a great success with revenues staying flat during our ownership, in spite of a market that declined 17%, and EBITDA increasing over fourfold. With cashflow moving from a negative £250m to a positive £250m, we could not refinance the loan that Citigroup provided, and in February 2011, they seized the company.
At our nadir, TFCP II and TFCP III, which both had over 30% of EMI in them, were respectively marked at 1.5x and 0.3x in March 2009, but since then we have got back to doing what we do best; improving business and as of May this year, the funds are marked respectively at 1.8x and 0.6x.
So that whilst EMI was clearly a disaster for Terra Firma, one needs to remember that, since inception, Terra Firma has invested in 31 businesses and has completed transactions with an aggregate value of €44 billion. Indeed, away from EMI, our returns on Terra Firma II will be in excess of 30%, with an over 2.5x cash multiple.
Meanwhile, the last two years have seen both of our European buyout funds Terra Firma II & III, significantly outperform European stock markets, with both funds delivering over 20% like for like gains in 2010, against European stock market gains of 11%.
While, in 2011 when stock markets went down 7%, Fund II and Fund III went up 6% and 18% respectively on a like for like basis.
In summary, I have a fairly bleak view of the outlook for Europe, and have had since September 2007.
Nevertheless, I believe that the European private equity investment model is sound, as the industry has kicked its dependence on cheap finance, and has got back to what it is good at – business improvement.
This, combined with changing balance of supply and demand for investments, gives the industry attractive prospects, and an important role to play in Europe’s recovery.
Specifically, in our case Terra Firma’s approach is distinctive and focuses on not just improving, but also transforming businesses.
Our philosophy is simple, it is not dependent on leverage. Instead we focus on investing in ‘essential’ asset-based industries that need change.
We believe that this approach is very appropriate for today’s markets, as we begin to see a lot of under-invested, under-managed businesses coming to the market in Europe.