Suspenseful music

Terra Firma’s huge investment in music publishing company EMI is in distress. Market sources say it is currently valued at 10 pence on the pound and with Terra Firma at loggerheads with EMI’s lender, Citi, the future of the investment is at stake. And the future of EMI will significantly impact the future of Terra Firma, given its huge weight in two Terra Firma funds.

The most lucrative aspect of EMI is its huge catalogue of music dating back decades and including some of the biggest names in the business, like hip hop artist Snoop Dogg and rock bands Radiohead and Coldplay. The company, even before its sale to Terra Firma, was crafting a way to securitise the copyrights to its back catalogue of music.

Other aspects of the business, however, have proved challenging. The proliferation of music piracy on the internet cut into EMI’s revenues and the development of new acts into money makers requires significant investment.

“I don’t think it’s any secret the whole of the recorded music industry is in a state of flux, and it doesn’t really know which direction it’s going,” says one LP in Terra Firma’s funds. “So I think doing a deal in a business where it’s not clear what the business model will be isn’t a great move.”

Fighting back

Terra Firma has already moved aggressively to right the ailing investment, or at least find a way to ease the pain investors would experience in a total EMI blow-up. The firm says it has turned EMI around since buying it in 2007. It has cut costs and jobs, and has invested £250 million (€283 million; $408 million) to restructure the business into three distinct business units: new music, catalogue and music services. A new executive team has been recruited and the company has identified £200 million in cost savings expected to be achieved by March.

EMI: key deal for Terra Firma's success

Between 2008 and 2009, EMI’s recorded music division more than tripled its earnings before interest, taxes, depreciations and amortisations from £51 million to £163 million, says Terra Firma.

The EMI story took a shocking twist in December, when Terra Firma filed a lawsuit in which it claimed Citi tricked it into bidding for the music group. The bank, alleged Terra Firma, claimed that Cerberus Capital Management was still bidding for the company, when in fact it had dropped out of the auction process. Cerberus has declined comment on the matter.

The firm also claimed it was given only 11 days to complete due diligence on the deal after Citi informed it that EMI had accelerated the bid deadline. Terra Firma submitted a bid of £2.65 per share.

“If Terra Firma had known the true facts it would not have submitted any offer for EMI on Monday, 21 May 2007, but rather would have insisted on full additional due diligence and performed its own independent and detailed analysis of the company – the kind of analysis that would normally follow a busted auction,” the firm said.

The firm is seeking an unspecified amount in damages and reimbursement of all money received by Citi in connection with the investment.

One market observer with knowledge of Terra Firma says that the firm’s founder and chairman Guy Hands would become a “superstar” if the lawsuit were to succeed. But a limited partner with Terra Firma describes filing the lawsuit as a strange move.

“Saying your bank advisors didn’t tell you someone had dropped out, or that they dropped out at a lower price than you were looking at paying, seems a strange line to take. You would expect them to make their own line up about the right price to pay,” the LP says. “It raises questions about discipline.”  The same LP concedes that the lawsuit may just be a clever negotiating tactic. “I hope it is,” he says.

High stakes

Normally, the dissolution of one deal would not be a life-and-death matter for a private equity firm. In this case, however, the €2.2 billion of equity invested in EMI represents an unusually large concentration of capital for Terra Firma’s two most recent funds. It accounts for 30 percent of the firm’s €2.2 billion second fund and 30 percent of its €5.4 billion third fund.

If the EMI investment were to be lost entirely, sources tell PEI, Terra Firma’s second fund would still make money for its limited partners. The problem would be with the firm’s third fund, which would be severely hurt by an EMI loss.

Hands: facing the music

Terra Firma’s mission would be to salvage Fund III by generating outsized returns with the remaining capital. In this regard, the firm has a certain degree of flexibility: around 55 percent of the third fund has been invested, leaving a reasonable amount of capital left to draw down.

“They’ll have to strive with the other deals to make [Fund III] a performer, otherwise it’s going to be hard to compensate for this capital evaporation,” a source with knowledge of the EMI deal says. 

Some LPs were surprised that one deal would account for so much of the funds’ equity. “This is a big investment as a share of the fund,” says one LP. “What we didn’t expect is to see is such a big exposure to one deal.”

The ultimate outcome of Fund III is very likely to affect the way LPs see Terra Firma and Hands, and so reputational risk is involved.

A source close to the firm says Terra Firma’s track record is good enough to withstand a disappointing outcome for its third fund.

“TFCP III is not looking good in absolute terms, but in relative terms it will look better than some, because it decided to sit on cash,” the source says. “The overall track record of Terra Firma will still be top quartile.”

Skin in the game

Terra Firma’s limited partners can also take solace in the fact that Guy Hands has a good portion of his own wealth invested in the firm’s funds, one LP says: “He’s very motivated to get a positive outcome.”

The real consequences of the EMI situation will become clear when the time comes for Terra Firma to raise a fourth fund. “Unless they really prove they can turn around Fund III, they may not be able to raise Fund IV,” says one market source.

“I’d be surprised if we’d seen the last of Guy, although I’d be surprised if he were able to raise another Terra Firma fund in a hurry,” says the managing partner of a UK buyout firm. “But he does have some really good supporters.”

The future of Terra Firma will depend on the way it invests the rest of its capital in its most recent fund, and how well it can turn around Fund III in the face of one massively struggling investment. While the mainstream media will hungrily follow the twists and turns of the EMI saga, LPs will most likely be keeping a close eye on the rest of the portfolio.