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Private Equity

Terra Firma realigns focus, approach

One private equity manager has gone back to the future in its approach to managing client money, as investors are finding deal sourcing difficult in the current markets.

A tricky period for making private equity deals last year led to Terra Firma Capital Partners Ltd. taking a good look in the mirror the middle of last year, and significantly changing the way it deals with client money, sources deals and reaps its own rewards.

“There were enormous amounts of money sitting in private equity firms — there is over $1 trillion uninvested right now — and at the same time we saw (sovereign wealth funds) and pension funds willing to invest directly themselves,” rather than through a private equity firm, said Guy Hands, chairman and chief investment officer at the London-based firm, in an exclusive interview.

Executives at the firm — which returned more than €6 billion ($6.6 billion) to investors and made more than €4 billion of profits for those clients, in the three years through 2014, in what Mr. Hands said was a “spectacular time” — realized that they needed to balance two things. Those were the firm's and clients' desire for alpha, and the fact that finding that alpha was more difficult “since the correlation between private equity and the other markets has become closer over the last 20 years.”

The result was a realization that executives needed to be more selective and entrepreneurial, and to take more time investing money. Mr. Hands said Terra Firma executives also were keen to better align its interests with those of its clients. A major change was to decide not to charge fees on uninvested capital. “The last thing (investors) want is a (general partner) who wants to invest money quickly just to earn fees,” he said. Another was to “look to invest at least 10% in any investment or strategy, to make it clear that we are investing for alpha rather than for fees,” he said.

Mr. Hands believes that is where Terra Firma has gone “back to the future. That is quite a big departure from the traditional institutional private equity blind pool fund. It is much closer to what existed back in the (19)70s.”

High prices

Terra Firma has always invested in what Mr. Hands labeled “transformational deals.” The firm takes companies within a sector where they are trading as a fourth-quartile firm, and works to bring them up to trade as a first-quartile firm. While that takes time, people-power and is particularly analytical, Mr. Hands said 28 out of 33 deals that the firm has made (since it was founded 20 years ago) have been transformational. “Virtually all have done well operationally and strategically — although some less well financially.” He did not elaborate further.

But those deals are not easy to find. Pricing to date, he said, is higher than what Terra Firma has been willing to shell out. “We are still working to find deals at a price we want to pay. The issue is that you have to buy (these transformational targets) at the right price and at the right time as well as doing a good job strategically and operationally.”

One of the problems is the current low-interest-rate environment. If they remain low and liquidity in the private equity markets remains high for the next 10 years, “then the deals aren't expensive at all. The problem is if it doesn't, then deals are tremendously expensive,” said Mr. Hands.

Of the current market, Mr. Hands said Terra Firma executives are “pretty nervous,” and are betting the current environment turns within the next decade. There's a lot riding on the wrong call, he said. “We are seeing deals where we would like to put on just 50% debt. While others are looking to put on 65% senior (debt) and 15% (junior debt) — that gives 80% leverage. They may gain higher returns, but if the markets go wrong then the deal will blow up.”

Mr. Hands' view that the market is currently overvalued means Terra Firma is holding lower levels of debt right now, to compensate for that nervousness.

Investors, however, are less sure of their positions. “(They) are all over the place out there — some are more positive than us, some more negative,” said Mr. Hands. “But we are finding that overall investors want to get their money invested.”

They are generally willing to accept lower returns than is usual from private equity allocations. With investors usually looking to private equity strategies to add returns in the double digits, “an 8% return frankly gives them far more than elsewhere.”

Plenty of good, large private equity firms, he said, are “willing to provide beta and low returns in order to earn high fees.” However, that 8% doesn't give Terra Firma any carry, and Mr. Hands said the firm will not be giving up on its style just to earn a quick fee. “In contrast, we are intent on providing an alpha model, which will take longer to invest and involve more heavy lifting,” he said.