A wall of money

Richard Young analyses the private equity market in the UK and considers the impact and consequences

Private equity (PE) has been riding a wave of cash. Over the past 20 or so years, high returns for investors in PE funds have attracted a vast amount of money into the sector. The British Venture Capital Association (BVCA), which represents most UK PE firms, says its members invested £190m in the UK during 1984. By 2005, that had risen to £6.8bn – plus an additional £3.9bn outside the UK. ‘The industry is very buoyant, with the strong track record for exits [firms crystallising their profits] driving even more money into this asset class,’ says Paul Canning, director of mid-market specialist PE house Gresham.

So where is all this money coming from? Well, with stock markets delivering historically modest returns (and public companies now open to competition from fleet-footed, technology-enabled global rivals, making them much riskier than they were 20 years ago), property fully valued and interest rates low, the traditional homes for pension funds and savings are looking less attractive, just as PE has been hitting the headlines.

But the corollary of that is… where once PE firms could pick and choose their investments, now many of them have an acute need to invest the ‘wall of money’ that investors have thrown their way. They are desperate to buy up companies wherever they can find them. ‘The key challenge is finding real value-enhancing deals and businesses, with even more competition chasing few quality assets – there is some danger of overheating,’ says Canning.

Another PE manager told us that management buy-out (MBO) deals that might have taken a month or even longer to conclude a couple of years ago are now getting done in a week – that includes due diligence, financial structuring and negotiating with the management team over their equity slice. It is a sign of how desperate PE managers are getting to fund suitable vehicles.

‘It is a tough environment out there – and it’s got more competitive, with choosy VC [venture capitalist] houses fighting over quality businesses,’ says Jonny Allatt, investment manager at regional specialist NVM Private Equity. ‘That’s driven up the sort of EBITDA [earnings before interest, tax, depreciation and amortisation] multiples we’ve been seeing. So while a couple of years ago four to six times earnings was the norm, we’re probably looking at five to seven times being quite common now.’ Higher purchase prices mean PE backers can expect lower returns when they sell the business – and it means management will have to work harder to generate the cash that drives value in PE deals.

PE breaks down into three main areas. Venture capital – investment to build a start-up company into a viable business. MBOs – where the people who run a business buy it out of their corporate parent and become joint owners with their PE backers. And leveraged buy-outs (LBOs) – where large companies are bought (often off the stock exchange in deals called ‘public to private’ or P2P) by PE firms who pay for the deal by loading the business up with huge amounts of debt.

LBOs have a long history – one of the most dramatic and engaging business books ever written, Barbarians at the Gate, was the story of how PE firm Kohlberg Kravis Roberts (KKR) raised US$25bn to buy RJR Nabisco in 1988. Now KKR and other US players such as Blackstone, Carlyle, Texas Pacific and a whole swathe of PE divisions of the big banks are hugely active, and often work in teams to hunt down ‘assets’ they consider attractive. Recent deals include Burger King (bought for US$1.5bn from Diageo), VNU (taken private in an US$9.6bn deal last year) and Philips Semiconductor (US$10bn last August).

The LBO market is active in the UK, partly thanks to the need for the big US operators to seek out new targets, and partly thanks to a thriving domestic pride of PE firms such as Apax Partners (which bought Yell for US$3bn in 2001), CVC (the AA for US$1.5bn in 2004), Permira (which bought Birds Eye out of Unilever last year) and, of course, 3i (in the process of buying AWG for nearly US$10bn).

But although they argue that PE backing focuses the minds of management, forces efficiency and financial discipline and generates good returns for both investors and vendors alike, some of these big deals seem to be based in part on financial engineering.

The greatest controversies arise where PE backers load a business up with debt, take out hundreds of millions of dollars in fees and special dividends and then promptly float with a newly burdened balance sheet. It is this sort of deal that has an increasing number of observers questioning the appeal of PE. In a recent letter to the Financial Times, Fidelity International’s chief investment officer Michael Gordon wrote: ‘Institutions and their advisers are choosing to move into a form of investment that provides little real diversification from equities over time; comes with higher risks because of leverage; has far less transparency than a portfolio of listed stocks – and for which the institution has to pay premium fees.’

Deal decline

As a result, shareholder reticence has dented the flow to big deals over the past year. ‘The decline [in the overall MBO market in 2006] can be attributed to two main factors – there has been a significant decline in both public-to-privates and healthcare buyouts,’ says Tom Lamb, co-head of Barclays Private Equity, which sponsors Nottingham University’s Centre for Management Buy-out Research. ‘The P2P market has collapsed from £7bn for the whole of 2005 to only £2bn for the first three quarters of 2006. PE bids are either being rejected out of hand or being trumped or even pre-empted by aggressive trade buyers.’

Sainsbury shareholders, for example, who have been dogged by rumours of a mammoth take-private bid at the start of 2007, might take a leaf out of the books of HMV and ITV, both of which rebuffed PE overtures during 2006. A bid will doubtless be encouraged by the supermarket giant’s huge property portfolio. An acquirer could sell its properties, take a huge chunk of cash out of the business, then lease the property back. That is one hell of a pay-day for the backers – but one that, if they desired, the shareholders could do just as easily.

In fact this reticence to sell up on the part of Plc shareholders and boards, and the dearth of solid mid-market leveraged opportunities, has seen the emergence of the second big trend that will continue to dominate PE in the next few years as it has over the past couple: the secondary buy-out (SBO).

An SBO happens when one PE firm sells a company to another one. It makes a lot of sense: with a dearth of suitable companies available for purchase, a PE investment manager can pick up a business that is already used to the rigours of PE ownership, which has an appropriate financial structure (lots of debt) and whose management is well motivated by its equity stake. Best of all, it churns the cash in the funds. Investors want to see their money invested; they want the fund to cash out after a reasonable period; and investment managers need to deploy their funds to generate management fees – or they risk losing credibility as well as bonuses. So when the market for P2P deals is quiet and competition for good mid-market MBOs is intense, the SBO is a godsend.

The third trend we can expect to see continue is integrated finance. Many PE houses are little more than boutique operations of a handful of expert managers. They raise funds for their equity investments, then turn to debt providers for the leverage in deals. But when the big finance houses spotted the PE market, it didn’t take long for them to work out that providing the debt as well as the equity was a good business – whatever the exit multiple on the equity, they would be getting a constant flow of profits from the debt.

Debt is brilliant for the PE investor. Not only does it lower their equity exposure, but because in most jurisdictions interest payments are tax-deductable, it actually means they keep more of the cash that the business is generating. Writing in the Observer recently, GMB senior organiser Paul Maloney called this ‘an abuse of company law’ and demanded an end to the tax relief. With Labour MPs such as John Cruddas and Alan Johnson openly questioning the effect of big buy-outs, tighter PE regulation cannot be ruled out.

Of course, all the competition between PE firms for assets is good news for management teams looking to do an MBO. It means they are more likely to attract funding, get a deal away quickly, find a price that is attractive to shareholders or their parent company – and get a larger slice of equity for themselves. ‘In the larger MBOs, it’s all about financial engineering and making the numbers work for the strategy at the head office,’ says Allatt. ‘But at the smaller end, it’s much more about the people you’re backing. Being able to distinguish between the people and the business is important.’

However, last year’s changes to the tax rules governing Venture Capital Trusts will have an effect on new money coming into the system for these smaller deals. Essentially, the Chancellor has removed some of the tax advantages to investing in these vehicles.

Fundamentals

So the mid-market seems to be where the action is. ‘It’s very strong – the mid-market has seen more money allocated towards deals,’ says Canning. ‘It’s perceived as offering better value-enhancing opportunities as it’s a slightly less competitive process. But it comes back to fundamentals: the key is quality management, a business model with a USP [unique selling point] and a strong growth story.’ In other words, can the business generate cash to pay down debt, and growth to increase enterprise value?

All that adds up to a ‘good news, bad news’ situation for ambitious management teams and their finance functions. The good news? If you have a growing, cash-generative business, you won’t have to look too hard to find a few PE firms willing to back you with a few bricks from the ‘wall of money’ out there. The bad? They are going to work you – and hard – to ensure you deliver the numbers they need to make the deal work. Good luck.

Richard Young is a freelance writer and editor. He is consulting editor of Real FD magazine.