Terra Firma’s Guy Hands talks frankly about what he has learned from the £1.6bn loss of EMI and how he intends to get Fund III ‘back to flat’.
Guy Hands was not, as was reported in the press, “furious” when he found out EMI, the music group his firm Terra Firma had acquired in 2007, had been seized by its creditor Citigroup in February.
“That was just not true; I wasn’t furious at all,” Hands reflects from the other side of the vast boardroom table in Terra Firma’s Guernsey offices.
Behind him, through floor-to-ceiling windows, is a panoramic view of the peaceful shorefront town of St. Peter Port, the sea beyond and the other Channel Islands. “We agreed with Citi that a capital restructuring needed to take place.”
Neither was he – as other commentators had suggested – delighted to have EMI taken off his plate.
If it was neither anger nor relief that he felt, what was it? Hands glances to his right as he considers the question. “Sadness,” he says after a long pause. “I think most of all it was just sad.”
The sadness, he explains, was for two reasons. The first being that he had genuinely held out hope that Citi would come around to Terra Firma’s valuation of the business, which would have paved the way to a consensual restructuring of the music group’s debt load.
Terra Firma, the private equity firm founded by Hands in 2002, has over the last three years become inextricably linked to its doomed investment in EMI, the music publishing giant that Hands’ firm de-listed from the London Stock Exchange at the height of the credit boom in the summer of 2007.
Terra Firma paid £4 billion for it, which included a debt package underwritten by Citi. It was soon clear that the company was saddled with too much debt. After failed negotiations to restructure the loan, which due to currency fluctuations grew in size to around £3.4 billion, and a court case in which Terra Firma unsuccessfully tried to sue Citi for tricking it into doing the deal, Hands’ firm ultimately lost the company in February this year, along with £1.58 billion of Terra Firma funds.
The second reason for his sadness, Hands continues, is that he feels that under Citi’s ownership, EMI is likely to broken up, split into its two divisions: recorded music and music publishing. Terra Firma, says Hands, had supported the EMI management’s view that “maintaining a single entity made most sense”.
When pressed on why a break-up of EMI would be a cause for sadness, Hands launches into a detailed analysis of the fundamental shifts underway in the music industry, how music is sold to consumers and what the industry will look like in 2016. It seems clear from the discussion that the sadness felt at the loss of EMI is – in part – because here is a man who enjoyed the extreme challenge of trying to steer a vast historic business through the choppy waters of an industry undergoing dramatic structural change.
He speaks animatedly about the different skill sets and personalities that make a recorded music executive different to a music publishing executive (“they are both creative, but in different ways”). As an investor, Hands is renowned in part for his attention to detail and this comes across loud and clear as he dissects the state of the music industry today and where it is headed.
The challenge of steering the EMI investment to a successful conclusion was made impossible by the confluence of five separate factors, says Hands: a perfect storm. “Just about everything that could go wrong did,” he laments. First Citi was unable to syndicate the loan out to other investors. Terra Firma, meanwhile, was unable to syndicate out some of its equity. A planned securitisation of EMI’s assets did not go ahead. The debt had been hedged to protect against currency moves in such a way that it grew in size. Falling multiples meant EMI instantly dropped in value as a business. “If only three out of five had gone wrong, we would have been fine,” says Hands.
On the various issues connected with financial markets, Hands is adamant that after its bailout by the US government during the financial crisis, Citi would have been unable to help EMI, even if it had wanted to.
“Our naïve view when we went into this deal was that Citi was our partner,” he says. After the government bailout and departure of chief executive Chuck Prince and vice chairman Michael Klein “the people who took over the business wanted to shoot everything created by the former regime, which is not unusual in business. We were seen as the ultimate embarrassment in terms of what Citi had done. We had no friends left there and we became a lightning rod for the bank’s internal battles.”
In July 2007 Prince had famously remarked on the bank’s leveraged lending activity: “As long as the music is playing, you’ve got to get up and dance. We are still dancing.”
“I have no doubt in my mind that he was referring to EMI,” says Hands.
WHAT WENT RIGHT
The operational changes Terra Firma made to EMI were more effective than had even been hoped, explains Hands. After acquiring a business with earnings of £170 million (Terra Firma had based its bid on the “hopelessly optimistic” current year earnings of £320 million presented by the management, says Hands), Terra Firma’s turnaround of the business led to earnings of £334 million in 2010. “The financial effects of those changes were incredible,” he says with some pride. “Ironically, if we hadn’t made those changes, Citi would be getting nothing back on their loan.”
The notion that – financial market turmoil aside – the EMI investment was actually going very well adds a little credibility to the rumours that suggest Terra Firma might make another play for EMI. There is certainly a hint of unfinished business in the way Hands discusses the company.
The rumours, however, have only a slim grounding in reality, says Hands. He is careful not to rule it out altogether, but in his view the chance is “very, very small”. Considering a bid is a far cry from putting one in. “We have looked at [British football club] Manchester United three times, but we have never put a bid in or even approached its owners.”
Hands’ parallel with Man United is an interesting one. If he thought tussling with the stakeholders of a record label – highly paid musicians among them – was a tricky business, he would want to steer well clear of football fans, whose vitriol against financial investors is legendary.
DON’T DOUBLE DOWN
It’s hard to see how a very public £1.6 billion loss could not shake an investor’s confidence, even one with a track record like Hands has at Terra Firma. His investors, says Hands, have told him to try to not let the experience knock him.
“Around Christmas time through to the New Year [some weeks after the trial had concluded], I had a lot of calls from investors telling me to just stay calm and don’t let it affect my confidence,” he recalls. “They said ‘Guy, if you go back to just hitting singles, we will back you next time. If you try to hit the ball out of the park again…even if you do hit the ball out of the park…we are going to be nervous’.”
What LPs wanted him to avoid, he elaborates, is the feeling that he has something to prove. Hands harks back to his experiences as a young man on a trading desk in the 1980s. “The natural thing [after a big bet that goes wrong] is to want to prove yourself. It’s tough to come back in just small stages, but it’s good advice and we are trying to keep to it.”
As a young teenager, Hands used to play poker – and win – against the hardened middle-aged workers of a cold storage company in a local pub called the Bullfinch in Sevenoaks, the Kent town in which he grew up. Decades later he is recalibrating his appetite for risk.
The sporting reference to “hitting singes” rather than trying to smash the ball out of the park refers to making smaller investments: buy-and-builds that can be drip fed equity over time rather than taking one large injection up front.
As an example of the deal model he knows he has to follow, Hands points to Infinis, a renewable energy business that started life as a corporate carve-out with £10 million in earnings in 2003 and now has earnings of more than £100 million. “We have just steadily added on to the business with a mixture of organic growth and acquisitions over five years and we will probably make 3x or 4x on it … maybe a bit more.”
But, he continues, “it’s not a very noisy business; it’s not very dramatic. There are no dramatic key decisions to be made, but lots of small ones. It’s just trying to get the operations better, trying to get the conversion up if you are a wind farm. Trying to get the gas collection – in terms of energy waste – higher and downage lower.”
It is clear that there is only so much excitement that a business like Infinis can rouse, especially after the roller-coaster ride of EMI. The same could be said of Terra Firma’s investments in Australian cattle ranches. “First you work out a plan for increasing the carrying capacity of a farm, then you start to put in the infrastructure to achieve it. Then you start to breed the cows out so you can fill that capacity. Four years later you start to sell the cows and you get the economics,” he continues. “It doesn’t attract much attention. When you say you have increased the carrying capacity from 40,000 head of cattle to 48,000 head of cattle, no one gets that excited.”
LESS EXCITEMENT, MORE PROFIT
Hands happily discusses the finer points of renewable energy and Australian agriculture, but he is significantly less animated than when talking about EMI. Are these investments boring by comparison? “They’re less exciting businesses, but they are very profitable. Your effect on them is more gradual, it’s a lot of smaller steps and there is less volatility.”
As a professional investor, Hands has felt the pain of the boom-bust cycle as intensely as anyone. But importantly – and unlike some of his peers – he is still in business. As we have said in these pages before, the €2 billion in dry powder remaining in Fund III could be Terra Firma’s saviour. Hands knows how his investors want him to put it to work – slowly and steadily – but does he feel the investment environment today, with price multiples as high as ever and debt availability coming back fast, is conducive to such prudent investment? Are we not approaching the headiness we saw in 2007?
“It’s funny,” he says. “It feels very, very different, but the numbers would indicate it’s quite similar. There was a confidence in 2007 which doesn’t exist today. Although the numbers might give you similar indications, peoples’ approach is much more sensible than it was in 2007.”
Throughout the meeting Hands gives much thought to the questions posed and takes time to consider his responses.
He takes a long pause and looks away to consider the intricacies of today’s deal-doing environment. “The reality is,” he picks up the thread, “that most of the people who didn’t invest at the time were just lucky. The pressure one felt at the time to invest and to use money raised was extraordinary. No one foresaw the interconnections in the markets and the crash that would result from the subprime collapse.”
LPs, he continues, were clamouring for co-investment opportunities. “This is why Terra Firma did 30 percent in EMI; the idea was to sell it down to our co-investors. We never aimed for the fund to be 30 percent EMI, and we were doing exactly what we said we would do in providing lots of co-investment opportunity. It’s just that, given what happened in the market immediately after we did the deal, virtually no-one wanted it.”
Hands switches his focus back to the original question of how the investment environment today differs from 2007. “The difference today is the mentality. We have all been hit pretty hard. Memories are normally short for these sorts of things, but no one who has been through the last few years will forget it quickly.”
Even the expensive looking deals done today could turn out reasonably well, generating “solid mid-teen returns, rather than 20 percent-plus”, he says.
While Hands fully recognises the fact that industry-wide returns will come down, where does he see his third fund, which raised €5.4 billion in 2007, finishing up? It is battling, after all, against an immediate 30 percent handicap following the loss of EMI.
“Our aim is to get back to flat and make a small margin. When you wipe out 30 percent of your fund, getting back to flat is not easy.” A quick mental calculation concludes that – gross of fees – Fund III is going to have to make 2x on the rest of its equity.
The refrain that Hands returns to again is that he cannot again “roll the dice” on a big bet like EMI. If he is going to double the remaining capital in Fund III, he is going to have to do it by hitting singles.
OUT OF THE LIMELIGHT
In previous conversations with LPs in Terra Firma funds, one topic raised was the very public nature of the entire EMI investment from start to finish. It is one thing to suffer a meaty investment loss; investors can forgive this. It is another thing, however, for LPs to see the drama played out on a near daily basis in the mainstream press. This was something they were not used to and something they do not welcome.
But in his long career, Hands has never been one to shy away from engaging with the press or standing on a conference podium and delivering forthright opinions to his peers. Indeed, he was addressing conference delegates in Paris just a couple of weeks after the conclusion of the trial against Citi in New York.
One might think that the very public drama of the EMI investment would make him reconsider his position as one of the industry’s most open figureheads. Not so, he says. “From February 2008 up until when Citi took over EMI I was not speaking to the press at all. Publicity during that time was greater than it has ever been before and most of it was negative. I don’t think the lesson is that one wants to be more private and hide from the press.”
Instead Hands is resolved to steer clear of deals as high-profile as EMI. “The good news,” he quips, “is that is there isn’t another deal out there that would attract as much attention… except perhaps Man United football club.”
Hands shifts from a moment of jocularity to serious contemplation. After a long pause, he says: “I am trying very hard to not take the negative and often completely wrong press coverage during the period as meaning I should be negative towards the press.”
Three years of increasingly intense media coverage has taken its toll on Hands from a personal perspective. “I’d be lying if I said it wasn’t incredibly upsetting. It’s a tough thing to go through and it’s tough for the family too.” Hands has a wife and four children.
The press coverage intensified during the very public law suit that Terra Firma brought against Citi, accusing the bank of misleading it during the auction process for EMI, accelerating the bidding process and tricking Terra Firma into overpaying for the business. The trial kicked off in late October 2010 and lasted just under three weeks. The jury ultimately ruled against Terra Firma.
Going back over the court case, Hands reinforces the point that the whole process of bringing the law suit was not a matter of pride on his part, or a personal vendetta against Citi banker David Wormsley, but a matter of Terra Firma’s obligations to its investors. “The people it was most for were were those investors who would never invest with us again. The only thing we could give back to them was pursuing what we saw as a legitimate claim.”
As far as Hands is concerned, it’s “difficult to see what sum of money we could ever have won which would have justified it from a personal point of view.”
IN FIVE YEARS’ TIME
Looking down the track, Hands believes that in five years’ time he will be doing the same thing he is today. “I think the next few years are about forming, not about storming,” he says.
In order to do this, he will need his team around him. After some high profile departures from Terra Firma, the question is how to motivate and retain a team when they are working on a fund that is underwater and clearly not going to pay carry. “We are focusing our attention on a smaller group of people,” says Hands, explaining that the firm’s infrastructure had been built up to accommodate a €10 billion follow-on fund. “We knew we would lose – and indeed needed to lose – some of the senior people.”
Perhaps more importantly, Hands will have to either convince his current investors to back him once more, or find a new set of LPs (or most likely do a little of both). It’s obviously impossible to say without knowing the ultimate fund performance numbers whether the LPs will be there for him for the next fund, but Hands seems to take some heart from the 85 percent vote he received to inject more money into EMI last August. “We know they were willing to put more money into EMI last August. We don’t however yet know if they will be willing to put more money into Terra Firma,” he states plainly. “The track record over the last 15 years, even with EMI, is very good, and we have learnt from EMI.”
Therein lies a deal-breaker in many LPs’ eyes. What exactly has Guy Hands learned from the EMI investment?
Aside from the continuing theme of getting back to “hitting singles”, Hands is adamant about a couple of very specific investment lessons. The first relates to underwriting equity for co-investments. Five years ago, Terra Firma would underwrite a deal with 30 percent of the fund’s equity and look to sell down 20 percent to co-investors, leaving a 10 percent fund exposure. From now on it will probably only underwrite 15 percent and look to sell down just 5 percent. “That cuts our risk by 75 percent in terms of overexposure,” he notes.
The second lesson relates to participating in take-private auction processes. “I’m not sure I’d want to do another competitive auction on a public-to-private,” he says.
Private equity has two great advantages, explains Hands. One is the deep due diligence it can do on its target away from the glare of public markets. The other is the deep operational control it can subsequently exercise on the asset it has acquired. A competitive public auction gives away one of those advantages. “And that is an advantage that I think is worth an awful lot of money,” he asserts.
In 2007, Hands notoriously described bankers as being like whimpering dogs, who had been hit hard and were “not going to come out of their baskets”. As we sit in the Guernsey boardroom he harks back to the comment. “We have been hit pretty hard, and even the most resilient person is unlikely to want to put themselves in the same position again. It’s going to take an awful lot for someone to persuade me to do another competitive public-to-private high profile deal.”
After a moment he adds,“I think one EMI in one’s life is enough.” That should be music to his LPs’ ears.