More Hands

Go pay a visit to Terra Firma's brand new offices at 2 More London Riverside. If you do, forget the suave settings of Mayfair, home to most other self-respecting private equity firms in London. This is quite different. Walk in the large open-plan office and there is glass everywhere. The Terra Firma headquarters has the look and feel of a small but busy trading floor (except it isn't very noisy); to the left and right are the offices of the group's managing directors. And at the far end of the room, facing north across the water and behind even more glass is Guy Hands' own space: mission control.

Such is the layout of the floor that you are left in no doubt as to who runs this operation. Hands' office dominates. At first you think he doesn't have a door to close behind him. From his desk, he can see all and hear much of what goes on at any time, and his people can see and hear him. Until, that is, he wants some privacy: at the push of a button, a massive glass door rolls across the floor and shuts quietly. The total visibility remains unchanged, but the sound is now locked in. Behind Hands' desk, several of London's most famous landmarks compete for the visitor's attention.

Hands is clearly excited by the new space (he also likes the rent he says), and you can see why. Although one shouldn't vest too much significance in the you-are-where-you-live principle, this office says something about its tenants.

Hands points out that the finishing still leaves some things to be desired. And getting the lighting right took time as well. People tend to work better in sunlight, he explains, but at first too much of it was flooding in, “people had to wear sunglasses”. He goes on to talk about brightness and avoiding SAD (Seasonal Affective Disorder), and I am reminded that this is a man renowned, among other things, for an awesome ability to focus on details.

EARLY DAYS
2 More London is an appropriate home for a private equity firm that isn't like most other private equity firms. When Terra Firma arrived on the scene in 2002, its founder was already one of the most famous people in the City. Today, by his own admission, the brand “Guy Hands” is still more powerful than “Terra Firma”.

Whilst those at other buyout groups grew over time, the team that Hands led out of Nomura in 2002 was big from the start – big in terms of headcount, bigger still in terms of ambition, and with a huge appetite for capital.

€3 billion was the number on the cover of its debut PPM that year, much more than any private equity start-up in Europe had ever attempted to raise. The target proved elusive but as Guy Hands won't be slow to remind you, the fund tops the table of largest first-time private equity funds ever raised in Europe, with over €2 billion in third party commitments.

Still, the failure to secure that extra billion meant that Terra Firma hasn't been able to move as fast as Hands had hoped. According to its creator, the Terra Firma business model stipulates that roughly €1.5 billion of equity is invested every year. Since closing the fund in February 2004, about €1.25 billion has been deployed, with about €250 million returned to investor so far.

With over 50 percent of the fund invested already, the firm will have to launch the next fund sooner than originally planned. At that point, the priority will be to get a bit closer to the €4.5 billion that Terra Firma really wants to raise per fund so that Hands can take his foot off the brake. This isn't going to happen over night though: “We'd hope to raise a bit more next time, but it's unlikely we'll make a big leap,” he says cautiously.

CONCENTRATION
What Hands didn't do after the first fund had closed was to order his troops to invest it in smaller deals. Terra Firma deliberately does fewer deals than its competitors and puts a proportionally larger amount piece of the fund on the table with each one, preferably via a buy-and-build strategy and over a longer holding period. “It takes us closer to having all our eggs in the same basket, but we're watching that basket very closely”, says Hands. “It's why we have 90 people.” Five investments are already in the current fund. Another two to three deals will complete the portfolio.

Picking fewer, bigger deals isn't in line with the emphasis placed on risk reduction through diversification that most other private equity strategists live by. It is in fact the opposite, but Hands is never without conviction. “Personally, I think doing a diversified portfolio with fewer people to support it is more risky than doing a concentrated portfolio but having enough people to look after every individual deal.” Up to 16 professionals can be assigned to a Terra Firma investment – from the initial due diligence right through to the early stages of executing the business plan that is written into the acquisition model.

To minimise the risk of any of these hand-selected investments breaking, they need to be chosen carefully. But some will fracture regardless. So won't a failed investment be more damaging the less diversified the fund in question? What happens if there is another Meridien for example?

In July 2001, Nomura PFG led the consortium that acquired Meridien, the hotel group, in a £2.3 billion transaction. After the terrorist attacks of September 11, the business nosedived and collapsed under the weight of its debt soon after. None of the equity was recovered, and Normura was forced to write off its entire £213 million investment.

Meridien is the only deal that Hands has lost to date. It came at a time when fundraising for Terra Firma Capital Partners II (the slightly confusing name of its first fund, TFCP I is the moniker for the Nomura legacy portfolio) was in full swing, but Hands says contrary to the reaction the group had expected, investors took a “gratifyingly sophisticated” view on what had happened: many had had exposure to the hospitality sector before and accepted that a highly geared asset like Meridien couldn't have coped with a catastrophe of September 11 dimensions.

In any event, Hands is adamant that a more concentrated portfolio such as Terra Firma's can cope with a Meridien-style disaster just as well as a more diversified asset pool. “The reality is that private equity firms on average write off between 10 and 20 percent of their investments. So if we lose an investment out of the seven or eight in the fund, it will not hit us any harder.” Supporting this claim is the fact that the £213 million of equity sunk into Meridien accounted for just over five percent of the £3.8 billion that PFG invested for Nomura between 1994 and 2002.

What's more, downside protection is only part of what the firm's due diligence aims to achieve. Hands says he cares more about the question of whether the risk and reward inherent in a given investment proposition makes it one that Terra Firma should devote itself to – or whether there is in fact a better deal out there.

I look forward to getting the consolidation process done. At that point, we'll be storming

The stakes are high. A Terra Firma platform investment, prior to any acquisitions, needs to deliver a return of about 20 percent to be deemed a success. Add-ons should then take the IRR into the thirties.

This is despite the longer than average holding periods that a Terra Firma buy-and build is likely to undergo. One thing Hands clearly does not want to do is sell a winner prematurely. At Nomura, PFG built a portfolio of 8,000 UK pubs in what became one of its most profitable investments. “But if we'd kept going and got to 16,000, we would have made even greater returns. We knew there was more upside, but we didn't quite understand just how much, and the portfolio had got about big enough for Nomura anyway. But others like Texas Pacific had the guts to take pubs to a level beyond where we had gone, and they made enormous amounts of additional money.”

CREATIVE TENSION
Terra Firma uses a blend of operational and financial skills in pursuit of its investment objectives, and therefore employs both types of professional. The financial specialists will originate transactions and, instead of handing over to the operators post-completion, work closely alongside them in order to track the financial effects on the business of implementing the strategy.

Hands is emphatic that this approach is both the most effective as well as the most difficult emotionally. “You're taking two groups with completely different personalities and try and get them to work together. Both sides believe they're right, passionately. Some of our operators have been around for 30 years, and here they are, having to deal with 27-year olds who are telling them what the strategy should be. The young guys have all the imagination, all the drive and all the energy, but they have absolutely no idea what it means to operate a business.”

One thing we learned is that replacing managers isn't necessarily about whether they are good or bad. The question is, are they right for the task in hand?

When the two sides clash in strategy meetings, Hands says his is the role of a referee. “I sit there and I listen to the conversation and I see the frustrations on both sides' faces, and I have to try and put the two together.” But, he adds, the friction between operators and financiers is built into the firm deliberately: “It's crucial to get the best result.”

Consensus building wasn't part of Hands' agenda when he started his career as a bond trader at Goldman Sachs aged 22. It has been a long journey: “As a trader, I had no interest in fair play. What I was thinking about then was, how much money could I make, and how few prisoners would I have to take. Today I have a different perspective on how to do things.”

To those who find it surprising that a former trader should put so much emphasis on the operational improvement of investee companies, Hands will reply that he did in fact begin to develop his approach back on the trading floor at Goldmans. He became interested early on in understanding how the operational mistakes that companies were making affected their performance. At the time, he was mainly trading credit spreads of financial institutions. If he could work out why, out of two banks with the same credit ratings, one's spread would widen and the other's would tighten, he would make money. If one was making fewer errors than the other, Hands would know how to play his cards.

Later, while investing in principal deals at Nomura, Hands and his colleagues hit upon another critical factor of what is now the Terra Firma formula – the need to have the right management in place. The proactive management of management is another Terra Firma trademark.

For instance: Annington Homes, the housing business acquired by Hands in 1996 and which so far has produced a 6x money multiple and a near 100 percent compound IRR on an unrealised basis, spat out three CEOs before installing the one who Hands argues transformed the business. As for the rest of the Nomura portfolio, 90 percent of the companies' original chief executives didn't last the course.

With the current fund, management turnover won't be quite as high, says Hands, but he agrees that a willingness to change management is still a key differentiator for the firm. “One thing we learned is that replacing managers isn't necessarily about whether they are good or bad. The question is, are they right for the task in hand?”

To illustrate the point, Hands cites Terra Firma's 2004 investments in European cinema groups UCI and Odeon, deals that closed on the same day. For the next 18 months, the focus here will be on integrating the two assets and on making suitable add-on acquisitions. Thereafter the firm is expecting to concentrate on introducing digital technology as cinemas the world over go digital. “The type of CEO to run the integration is different from someone who understands how to introduce a new technology with all its spin-offs.”

Hands says few CEOs are capable of adjusting to the changing needs of their business as it develops. If they can't, they need to go, for otherwise the business can't move forward fast enough. Says Hands: “After three to four years, either the CEO is still doing the same thing or he changes, but if he doesn't, you need a different person.” It's as simple as that.

Everyone has to perform at an absolute top level the whole time. We're just as harsh internally as we are with our CEOs

JAM TOMORROW
Whilst the investment team scrutinises prospective investments and monitors those already in the portfolio, there is the small matter of making sure that Terra Firma is itself progressing smoothly and smartly. Part of what Hands the owner-manager is having to keep an eye on is the cost of running the business. He says the firm's labour-intensive approach to private equity investing is unlikely to become the industry standard. “The reality is, this model is ludicrously expensive. If we didn't have the support of Bank of Scotland [both house bank and LP in the fund], we couldn't operate this way.”

This is despite the fact that Terra Firma salaries are below the industry average. Investment professionals are paid an average of £100,000. Hands himself is paid £250,000, and no one receives bonuses.

The team's entire upside is in the carry, with everyone including the secretarial staff being entitled to a piece of the fund's profits. Hands himself will take a 50 percent share, by far the largest portion going to any member of the team, which some of the investors needed to get comfortable with prior to going into the fund.

This is the compensation structure that Terra Firma uses to compete for talent in a market that Hands says is increasingly dominated by a small group of firms managing ever larger amounts of capital that thanks to their size can afford to pay big. “Some firms can even afford to compete with the hedge funds: hire a 27-year old and pay them £500,000. We'd rather have the right amount of people to do the deals, which limits what we can pay them.”

Can Terra Firma defend itself against the big spenders? Hands insists it can, in part because there is an “excitement” about the business, and in part because the younger people are given the opportunity to be promoted quickly.

Since the firm started, a number of senior and junior people have left. Investors in the fund attribute some of the departures to the fact that those leaving didn't like their compensation. But Hands says he has never been worried about people leaving. “Some LPs have criticised our turnover, but it allows the younger people to move up. We're not a university, we don't have the traditional private equity tenure. But it does mean that everyone has to perform at an absolute top level the whole time. We're just as harsh internally as we are with our CEOs.”

What about the CEO Guy Hands? Does the Terra Firma axiom of change or departure for top management beg the question of his own future at the helm of Terra Firma?

KEEPING SCORE
But of course Hands isn't about to discuss plans for his early retirement. Neither, he says, does the idea of taking his Blackberry onto a boat to go back to trading appeal at this point.

Hands says he intends to be working for another 25 to 30 years, and to use this time to build the Terra Firma brand. He says good progress has been made in this regard already. “Two years ago, it was all me and very little Terra Firma. And I think that made sense: at the beginning when you're driving the business, it's much easier to associate it with an individual. The skill is to slowly transform it over time into a brand and to realise that's where you're going. I know where I am aiming to be in 20 years. And I believe I'll get there. Then I will be able to ride into the sunset and leave someone younger and more aggressive to run the firm.”

The next two years are set aside for “forming” the business and taking it beyond the next fundraising. Then there will be four or five years of “norming” it – of creating a corporate culture where no one on the team has any doubt as to what the Terra Firma way of doing business looks or feels like. That's when he predicts the firm will be making great strides. “I look forward to getting the consolidation process done. At that point, we'll be storming.”

It'll also mean Hands can once again spend more of his time working on deals. He says he hates losing deals to others, but if someone else's bid is higher, that'll be that. “I'm competitive, but the most important thing for me is to make money – for me, for the group, for our investors. That's how I keep score.”