Something is bugging Guy Hands, but it is not what you might think. In fact, as we sit in his beautifully sunlit conference room above the Guernsey waterfront, his falling out with the U.S. bank Citigroup Inc. over his firm's £4.2 billion ($6.6 billion) acquisition of EMI Group Ltd. is one of two subjects he has declared off limits for our interview. The other is fundraising, although his firm, Terra Firma Capital Partners Ltd., is not yet formally in a fundraising period. No matter. Most of the information is already public, much of it in the private equity firm's own annual report. We don't need to talk about it here and now.
Instead, what is bothering Hands is the continued closure of the securitization market and its failure to come back in any meaningful way since credit markets crashed in 2007. That's really what he feels killed the EMI investment, and it's a subject he returns to several times in the course of the next 90 minutes.
Hands does not consider that EMI was an intrinsically bad investment. The plan from the beginning had been to transform the business, turn it round, increase its earnings over the life of the investment, possibly combine it with Warner Music Group and sell it on. By the time the bank took back the keys to the company early this year, Hands says Terra Firma had already doubled EMI's earnings.
"We were only three years into the transformation of the business, and we had another four years to go," he says. "And it's our belief we would have doubled the earnings again."
But without securitization, says the 52-year-old Hands, who enjoys a reputation as one of the pioneers of the technique in Europe, the investment was doomed. Hands held on to the company for too long, thinking the market for securitizations would come back, so that Terra Firma's bad patch just took longer to work through than it otherwise might have.
"The reality of our bad patch was that it wasn't bigger [than what other people went through at the time]; it was more concentrated, and we fought harder," says Hands. "If we'd thrown in the towel back in 2008, it wouldn't have been an issue at all for Terra Firma.
"The issue was that we didn't throw in the towel, and we decided we would try and get the company to be successful, whereas most people who did 2007 deals went back to their banks when the market changed in 2008 and said: 'Fine! Have the keys! And we'll get on with our lives.'?"
Hands won't name names, but he talks about a particularly large deal in which, he says, the private equity firm involved got away with it because the news was soon forgotten. By contrast, EMI stayed in the news precisely because Terra Firma did not give in but stuck it out in the belief the securitization markets would come back. That would have enabled the firm to pay off Citigroup, which had lent £2.6 billion for the acquisition, and allowed Hands to get on with the business of giving his investors "the chance of getting something."
It's an interesting idea. Maybe Hands is right that his trouble with EMI would have passed over as quickly as some of the other badly timed deals of the era, such as TPG Capital's investment at Washington Mutual Inc., or -- at the other end of the scale -- Apax Partners LLP's decision to give back to the banks the British arm of business-to-business publisher Incisive Media Investments Ltd. while retaining control of its separately funded U.S. unit American Lawyer Media. But EMI is not a bank or business-to-business publisher. It is one of the genuinely iconic names of 20th-century culture, with deep resonance to generations of music lovers. Nor did any individual at TPG or Apax have so much of his personal reputation riding on the success of the deal as Hands did with EMI.
With Citi's agreement in November to split the company and sell the recorded music business to Vivendi SA's Universal Music Group and the publishing arm to Sony Corp., we shall never really know how people would have reacted. It is hard to imagine that the public or the stars, who had loudly opposed the music company's sale to private equity in the first place, would have been so forgiving. "I hate Terra Firma" was the much-quoted outburst by sharp-tongued British singer-songwriter Lilly Allen and one of the milder things said about either the buyout firm or its chairman as they cleaned up EMI's balance sheet and stopped subsidizing the lifestyles of some company acts.
Does Hands now regret that he did not simply throw in the towel?
"I couldn't have looked in the mirror and done it," he says. "It might have been the best thing for Terra Firma, but it would have been the wrong thing for our investors. And, of course, if it had worked, and the markets had come back, and we'd been able to do the securitization, you'd all be saying: 'Great job!' "
Which brings us neatly back to the securitization of assets and cash flow at portfolio businesses to fund leverage. One of the first securitizations Hands says he worked on was for mobile home parks in the U.S. back in August 1990 when he was at Goldman, Sachs & Co. Those were the days when every site in a deal would be visited individually, physical due diligence conducted, the sustainability of cash flow streams assessed and a judgment taken on whether, say, mobile home dwellers were feckless drug addicts or reliable old people and Mexican immigrants. It was a far cry from the way securitizations were done by the time of the subprime crisis in 2007, which ultimately led to the collapse and closure of the markets.
"By 2007," laments Hands, "there was no visiting of sites. It was all done by ticker tape. The problem of doing it by computers was that they were vital to the volume of securitization being done, but they reduced the reliance on human beings doing underwriting. Clearly, having to visit every site was silly. I don't know whether [visiting] 10% is the right number. But I know zero is as silly as 100%."
Whatever the reason, securitization has not come back. And private equity firms are facing an era of lower returns, with higher equity tabs and less daring valuations. It does not matter if the firm relied more on financial engineering during the upturn or, like Terra Firma, stuck to its tradition of changing managements, business plans and corporate structures, setting aside about half of any investment for capital expenditure and follow-on deals. The nature of leveraged buyouts and private equity has profoundly changed -- and for years to come.
"The 'L' has come out of 'LBO,' " says Hands. "The 'T' for 'Transformation' has got much bigger."
Even as he ponders the
structural changes in the sector, Hands is watching warily what happens to the euro, the U.S. economy and the macroeconomic situation. He's neither betting on early recovery nor predicting total doom.
"You are never as big as the world within which you operate," he says. "What happened in 2007 and what is continuing to happen today is far bigger than any individual private equity firm or any individual private equity investor. And if the euro were to disappear tomorrow, certain businesses would be wiped out, however good they look today, and certain businesses will have windfall profits. ... My strong view is that you deal with dramatic events by being transparent with your investors and fighting as hard as you can for them. And sometimes you'll get it right, and sometimes you'll get it wrong."
So as well as eventually raising a much more conservatively structured new fund (the one Hands will not discuss now, but said in his 2011 annual report would be about half the size of the £5.4 billion Fund III, with much reduced opportunity for co-investment by its limited partners, and banned from cross-investing with other Terra Firma funds or investing more than 10% of the total in one portfolio company), Terra Firma has been seeking other ways to make money for its investors.
The buyout shop has, for instance, recently opened an office in Beijing. But, says Hands, the object is not to seek investments in China, as so many private equity firms have been doing.
"We've opened an office in China, with the intention of trading," he says. "We're almost like 18th-century merchant traders. We're doing business there, looking at buying turbines, solar panels, advising on waste energy. We're selling beef into China and creating trading relationships for our portfolio companies.
"That might, long term, lead us to doing some investments, but they will be investments where we developed relationships and partnerships over a number of years. It will be more because the partners we are doing business with come to us and say: 'This is an opportunity. Is it something you'd like to look at?'
"We're not coming to China, saying: 'We've got lots of money' because they've got lots of money. We're coming to China saying: 'Where can we add value?' And if that leads to investment, fine. If not, we'll make money trading solar panels."
And what of coming home to Britain, where he grew up, where his four children grew up and went to school? What of the family home in Sevenoaks, outside London, where his wife still lives with their youngest daughter? In the spring of 2009 Hands moved away from mainland Britain to the offshore tax haven Guernsey in the Channel Islands, in protest at hefty taxes imposed on high earners after the banking crisis. He hasn't set foot in Britain since, although in the past most expatriates have relied on the assumption that being in the country for less than 90 days a year is acceptable.
So how does it feel to be a tax exile?
"Am I tax exile?" he asks, as if the thought hasn't previously occurred to him. "I don't look at it that way. The business I run is based in Guernsey. The Inland Revenue insists that businesses that are run offshore have their place of operations offshore. All I've done differently from most private equity people is I've moved to run it offshore, whereas most people fly to Guernsey, have their board meeting, get back in the plane and fly back to the U.K.
"I've made a decision that until the U.K. has a statutory definition of what being resident in the U.K. is or is not [for tax purposes], I will take a very conservative view. My conservative view is that if I don't go back, I cannot possibly be resident."
Sitting in his office in the tiny capital St. Peter Port, at the heart of the small financial district, Hands says he does not miss the bright lights of London. His wife visits him in Guernsey most weekends, and his youngest daughter comes out as well when she's not too busy with weekend sports. As a country boy at heart who grew up in an even smaller village in Somerset in the West of England, he's happy enough in this sleepy seaside town, with its feel of a mid-20th-century holiday resort. He doesn't sail because the rocky coast and the Channel's 40-foot tides mean you have to know what you are doing. But he uses the time saved on his morning commute to do "Pilates, yoga and exercise" -- and instead of the afternoon commute permits himself the luxury of working even longer hours.
This is not a man with something dark and painful gnawing at his innards. Securitization may be on his mind, but it clearly doesn't affect his appetite for life -- or food. Hands bubbles with enthusiasm as he leads the way onto the terrace for a quick guided tour of the horizon -- with the French coast in the distance and the Channel Islands of Sark, Herm and Alderney nearby -- and a brief introduction to the history of Guernsey. The island still swears fealty to the queen of England, in her historic, if historically slightly doubtful, role as duke of Normandy. (Bad King John, who spent his time battling Robin Hood, according to legend and Walt Disney, actually lost the title and the duchy's mainland territories to the king of France in 1204.)
Hands tells excitedly how the island spoke a local dialect of Norman French until the 1960s, but has clung to English rule since the Crusades, despite French invasions and attacks. It received a royal charter from Elizabeth I in the 16th century, granting it the right to free trade with Britain and to launch pirate attacks on Spanish shipping. Of course, no modern private equity manager considers himself a pirate, but Guernsey also held English lords' feudal wealth in trust from medieval times, and its historic role as an offshore financial center makes it a home away from home for the likes of Hands today.
Besides, says the sometime King of Securitization, as he has his assistant print out a list of the places he recommends, the islands have some very good restaurants.