One of the best ways to get inside the head of British private equity boss Guy Hands is to study what gift he gives for Christmas. For years, Hands has sent friends and business associates a book he has recently read along with a letter discussing the work. The gift is designed to be both thoughtful and thought provoking.

Last Christmas, Hands chose The Trouble with Markets, a work by London economist Roger Bootle. I was particularly struck by his view that financial markets are distributive by nature and provide little benefit to society, rewarding those involved in markets out of proportion to the value of their work to society, wrote Hands of the book, which is subtitled Saving Capitalism From Itself.

That analysis seems particularly apt in view of the quick and remarkable return of the bonus culture to the banking world. Furthermore, in my view, such high pay levels attract many of the most talented individuals in society thus removing them from more entrepreneurial, creative or leadership roles in the 'real' economy.

Cynics might laugh at the idea of Hands as a defender of the real economy. In his heyday, the outspoken financier was known as the king of British private equity. More than anyone, Hands brought to Europe the idea of using cheap debt to pump apparently miraculous returns from dowdy businesses.

Three years ago, at the height of the bubble, Hands and his group Terra Firma bought British music company EMI -- home to artists from the Beatles to Kylie -- for 4 billion pounds, loading up on debt to finance the deal. As the financial crisis tightened, the deal began to unravel. Crippled by debt and spiraling interest payments and hit by a stronger U.S. dollar (in which some of the debt is priced), Terra Firma has struggled to keep control of its prize.

The EMI deal has become a symbol for the worst excesses of the boom era private equity world. Hands himself stands as an example of what has always been wrong with private equity, says a former colleague at Nomura, who asked not to be identified so he could speak frankly. They rode the wave of a bull market in debt but were not humble enough to know that was what they were doing.

ALL THAT GLITTERS

Famously tough and a fiery-tempered negotiator, Hands, 50, seems determined to hold onto his music firm. Despite debts of 3.3 billion pounds, Terra Firma has been unwilling to give its bankers Citigroup an inch in restructuring talks.

On June 14, Terra Firma is due to stump up the 105 million pounds needed to push EMI back within the terms of its loan. Failure would put the music company in the control of Citigroup, which advised Hands on EMI and put up 2.6 billion pounds for the purchase. The relationship between Hands and his creditors has so soured over the past couple of years that Terra Firma is suing Citigroup, accusing the bank and its principal dealmaker David Wormsley of fraud. Citigroup is contesting the suit.

But if the cash injection happens -- Terra Firma seems confident it has convinced enough of its current investors to open their wallets again -- Hands will have another year to nurture his real economy company back to success. Terra Firma is putting it all into EMI. If it blows up, they are finished. It's that binary, said an investor who sold his investment in Terra Firma in April because he didn't want the fund sinking more money into the music company. It's a high concentration, high risk strategy.

REVOLUTION

People who know Hands say he has always been an outsider. Singled out as a misfit at school, he was diagnosed with both dyslexia and dyspraxia, a motor learning difficulty that can affect co-ordination.

Numbers presented no such challenge. Hands could find things in a company's balance sheet that not even the company had noticed. He graduated from Oxford with a third class degree in politics and economics -- he dropped philosophy after a disagreement with a professor as to whether quantity or quality of pleasure was more important; Hands went for quantity -- and joined Goldman Sachs as a bond trader. The year was 1982 and London's markets would soon boom thanks to the 'big bang' of deregulation. By 1992, Hands was heading a new Goldman unit called Global Asset Structuring.

Securitization was still relatively unknown in Europe -- but Hands aimed to change that.

His plan was to work out ways to securitize assets in unfashionable industries such as real estate. His chance came when he joined Japanese bank Nomura, which promised him use of its large balance sheet at a low cost and with free rein to do deals. Hands dived straight in, financing everything from UK Ministry of Defense houses to train engines and carriages to high street gambling chain William Hill.

His financial wizardry was the envy of colleagues and rivals alike. Early successes were based on his ability to identify a target company's stable cash flows and then, once he had bought the firm, refinance the purchase by using securitization based on those cashflows. This was years before securitization became tainted because of its association with sub-prime lending and the credit crunch.

Nomura's principal finance group, led by Hands, also invented the concept that a bank could compete with private equity by using its own capital to buy assets.

Not all of the deals worked. Nomura's purchase of leading UK consumer goods rental firm Thorn turned bad because Hands failed to see that the rise of cheap electronic goods would kill the television and video rental business. (Luckily, Hands found another buyer -- WestLB's principal finance unit -- for Thorn before things got really bad).

There were also grumbles from his colleagues. He never shared the juice with his team, said a former rival banker. He tried to make every important decision. When we did business with him, I'm not sure there was any robust internal debate.

EMI

Hands had flirted with the punk scene at university. Even today, with all his wealth and establishment credentials, there's a sense that he likes nothing better than raising two fingers to convention. A streak of that punk attitude was evident in the EMI deal.

Weeks after buying the music company in May, 2007 a smug-looking Hands stood in a Cambridge University hall before a room full of equally self-satisfied media executives. Describing his plans for his new purchase, Hands said that Terra Firma, the private equity group he had set up after leaving Nomura, looked for the worst business we can find in the most challenged sector.

He and his colleagues got really happy if it's really, really bad, he explained. EMI, our most recent investment, is a classic example. We're just hoping EMI is as bad as we think it is.

It was worse. Like all music companies, EMI had been hit by Internet piracy and the shift from selling physical albums in record stores to selling single tracks digitally. But EMI had other challenges as well. It was the third largest of the four music majors and had an especially weak presence in the U.S., the largest and most important market.

EMI is, in fact, two businesses. The most reliable part of the company, and most attractive to any private equity group, is music publishing. Every time a song EMI owns is played on the radio, on television or in an advert, it earns the company money. With a back catalog boasting the Beatles, Queen and Pink Floyd, EMI's publishing wing generates a stable flow of income. It's a very, very good publishing business, said one private equity music industry expert, who previously eyed a takeover. You would actively look to buy it.

EMI's problem was its other business: recorded music, which apart from a few high-profile acts like Robbie Williams and Radio Head was struggling badly. A generation of music lovers had become used to swapping songs for free. Sinking millions into new bands offered no guarantee of success and was increasingly risky.

EMI's financial health worsened, and in late 2006, after another in the seemingly perpetual rounds of merger talks with Warner Music collapsed, Chairman Eric Nicoli decided the company needed to find a buyer.

A consortium made up of private equity firms Apax Partners and KKR along with Credit Suisse First Boston discussed a possible buy out with EMI's board, Reuters has learned. A source familiar with the negotiations said that though the consortium liked EMI's publishing business they walked away because of the troubled recorded music division.

Permira, another private equity firm, also took a look at the business, and even tabled an indicative bid of 3.20 pounds a share. But EMI's board decided to play hard to get and knocked back the offer.

In November, 2006, according to Terra Firma's court submission in the Citigroup case, Citi's David Wormsley wrote to Hands to see if he might be interested in EMI. Hands asked to see the firm's books. But perhaps stung by Permira's cancellation of a new offer of 3.25 pounds a share, EMI refused to provide Terra Firma with the same level of due diligence and the deal died a few days before Christmas.

A MOMENTARY LAPSE OF REASON

As 2007 began, the pace of private equity deals grew ever more frenzied. In April, Terra Firma lost a battle with rival private equity firm KKR for British pharmaceutical retailer and wholesaler Alliance Boots. At 11.1 billion pounds, the sale was Europe's largest ever private equity deal. Was the king of securitization losing his touch?

Hands rejoined the race for EMI. Cerberus, Fortress, and JP Morgan's private equity arm One Equity were all interested, while Warner Music had offered 2.60 pounds a share. Arriving to the sale late, Hands placed his trust in friend Wormsley and Citigroup, which had advised him on close to 20 acquisitions, refinance deals or securitizations totaling some $57 billion. On May 18, a Friday, EMI asked would-be bidders to put in binding offers by the following Monday morning.

Over the weekend, according to court documents, Wormsley continued to advise Hands to make a bid of 2.65 pounds a share despite knowing that Cerberus, the other main bidder, had pulled out of the race. Citigroup rejects this claim.

On Monday morning, EMI's board gave its blessing to the deal and Hands finally had his failing music company.

POPSCENE

For Christmas 2007, Hands sent his business associates copies of JK Galbraith's The Great Crash, 1929. Speculation, wrote Galbraith in his account, comes down to the belief that it is possible to become rich without real work. While it lasted, there was never a more agreeable way of making money, the economist noted, after describing how the wonders of leverage struck Wall Street with a force comparable to the invention of the wheel.

Galbraith may have been writing 50 years earlier, but he gives us a pretty good description of the crazed LBO industry during the run up to 2007. The book and letter that year provided poignant epitaphs to an era of cheap debt that the Briton himself had helped conjure.

Hands had bought EMI believing that he could securitize its publishing assets, raise 1.5 billion pounds -- around 8 or 9 times earnings -- and combine the recorded music business with that from Warner Music. Citigroup was confident Terra Firma would be able to buy both music companies, a person familiar with the negotiations told Reuters.

But securitizing the catalog -- David Bowie had done something similar in the late 1990s when he issued bonds against future revenue -- would require more creativity and perseverance than it had just a few years earlier. By summer 2007 that trick was gone, said one former Citigroup banker. Hands pressed on because he wanted to hang out with Mick Jagger.

As well, the recorded music division was in worse shape than Hands had anticipated. First year profits were a meager 60 million pounds, just over a third the 170 million pounds Terra Firma had projected.

The company Hands had bought was stale. I dreaded going to see them, Paul McCartney told The Times newspaper in 2007 after finally leaving his label of four decades. Everybody at EMI had become a part of the furniture.

Hands brought in the former BBC director-general John Birt to lead a strategic review. Birt, known for his cost cutting and unintelligible business-speak, uncovered a long list of excesses and shoddy business practices: expensive flowers, candles, and luxury apartments. Hands told staff they should stop attending parties and work harder. Artists, he said, needed to behave better. There is no reason why we should not be more selective in whom we choose to work with, he wrote in an internal memo. There has been a lot of talk about what labels offer to artists and to the consumer. However, there is not much talk about how artists should work with their label.

Long-standing practices such as paying a band or artist an advance were dismissed as 'fun economics' that had to end. Hands was right: the music industry is full of quirky customs and excess. But in pushing for changes, he alienated the people at the heart of the business. He woefully misjudged what sort of business it was, a rival music publisher recently told Reuters. He completely failed to understand the very mercurial nature of the most important people, which is the artists. And they're not employees who jump to their new bosses tune.

As successive Terra Firma executives quit or got it in the neck, as one deal adviser puts it, global recorded music revenues continued to plummet. By early 2008, aides acting as security guards escorted Hands into a central London building so he could tell EMI staff that he was making a third of them redundant. For a man who came from nowhere to buy a company like EMI, and then to say all that he did, he did immense damage, Brian Southall, a former EMI staffer who wrote a book about the firm recalls. Who was he trying to impress? Was it a big balls thing? I'm better and bigger than all of you?

TROUBLE

One of the problems was Hands's business style, which tended to keep colleagues in the dark about anything they weren't directly working on. Friend and fellow private equity boss Jon Moulton describes Hands as very much the leader, who runs his firm divided down into need to know activity.

Radiohead quit the label, accusing management of acting like a confused bull in a china shop. Robbie Williams, one of EMI's biggest artists, pondered leaving and Williams' co-manager Tim Clark said that Hands was acting like a plantation owner with a vanity purchase.

You have to understand how to manage your talent and they're not like selling a tin of baked beans, the senior executive at the rival label told Reuters.

The former banking rival blames hubris. He got away from trying to be a finance guy to being an operations guy, the banker said. Buying and then financing is very different from buying and trying to manage.

DON'T GIVE UP

Despite all the problems, some analysts and industry executives believe EMI may finally be coming good. Concentrating on its core, big-selling artists such as Robbie Williams and Coldplay has paid off, while re-releases from the Beatles' back catalog have kept the registers ringing. New acts such as Tinie Tempah and Roll Deep have recently broken through; Lady Antebellum have stormed the charts in the U.S. That's lifted operating profits more than 60 percent between 2008 and 2009 to some 190 million pounds.

Hands has brought in executives from outside the industry. New chairman Charles Allen, who was known for keeping a tight lid on costs during his time at British broadcaster ITV, has looked to boost digital offerings and develop new sales methods. Even Williams's co-manager Clark has come around. As they've become more involved they've changed some of their thinking, Clark told Reuters. They've retained some of their better ideas and dumped some of the ones that clearly weren't ever going to work.

Ted Cohen, a Senior Vice President of EMI's digital unit until mid-2006 and now a consultant, also believes the firm is better run. Six months ago I would not have been so bullish, he said. But it feels better. Previously it had gone from being one of the most nimble companies to being dogged down by process. Now, going into the office it feels vibrant again.

EMI would like to bring in more young people, women and ethnic minorities. Some 20 percent of staff -- about 400 people -- earn more than 100,000 pounds a year. A figure of 10 percent would be more in keeping with the industry, though EMI would need to find around 30 million pounds to fund redundancy payouts.

GET OUT OF MY HOUSE

Hands's gift at the end of 2008 was a financial history of the world by British historian Niall Ferguson. It is wrong to think (as Shakespeare's Antonio did) of all lenders of money as mere leeches, sucking the life's blood out of unfortunate debtors, Ferguson wrote. Loan sharks may behave that way, but banks have evolved.

The frustration Hands now has toward his bankers is undisguised -- and the feeling is mutual. Citi clearly wants control of EMI so it can claw back some of its money, a London-based investment banker said. Talks broke down last autumn when Citigroup rejected a plan to cut debt by 1 billion pounds in return for a 1 billion pound equity injection from Canada Pension Plan Investment Board and other investors, one source familiar with the scheme said.

A separate source familiar with negotiations said Terra Firma had rejected another proposal to swap debt in exchange for Citigroup taking a majority equity stake in EMI, though the first source denies that Citigroup ever made a properly drawn up proposal. Whatever the case, they all could have gotten out of there, said a private equity lawyer who has dealt with litigation between buyout firms and banks and is familiar with the talks. It's personal now and I don't think it's going away.

Then there's the suit against Citigroup. This whole thing is a nuisance and the refuge of scoundrels. You don't sue your banker, one senior private equity figure told Reuters. Some in the industry speculate that it's a high-risk attempt by Hands to get Citigroup back to the negotiating table.

THE LONG AND WINDING ROAD

For a former punk, Hands has done well. He owns a home in Kent that used to belong to Sir Winston Churchill and produces wine and olive oil on a 1,700-acre estate in Tuscany. But when he's not traveling, he spends his time in self-imposed financial exile in a five-bedroom house on Guernsey, a 25-square mile island in the English Channel.

Guy's real permanent home is at 35,000 feet in a plane, said a friend and colleague from the Nomura days.

In a court submission in the Citigroup case earlier this year, Hands said he had moved away from his wife Julia and their four children, two of whom are still at school in Kent, to shelter his income from the British taxman. He has not visited his elderly parents in England, he said, and would not do so except in case of emergency. His family makes the 35 minute plane trip to Guernsey to see him on weekends. My residence in Guernsey is real, not a sham or a mere moniker for an otherwise unvisited location, he told the court.

Sources familiar with the talks say the company has received recent approaches for EMI's publishing business, including one from private equity firm KKR and music company BMG. Discussions on price value the business at 8 to 10 times earnings, which Hands believes is too low. And perhaps he'd prefer to hang on to his real world company -- and continue to rail at the markets and the finance men that he once embraced.

(Additional reporting by Alex Chambers, Georgina Prodhan and Quentin Webb in London and Yinka Adegoke in New York; Editing by Simon Robinson and Sara Ledwith)

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