Private Equity in Europe

According to UK-based Private Equity Intelligence, private equity funds raised a record $406bn in 2006. The private equity boom is projected to continue in coming years as high-wealth investors, pension funds, university endowments and other institutional investors pour capital into high-yielding PE funds. Against an average annual return of 8.7% on Standard & Poor's listed companies, leading PE firms are generating returns of 30%-40%.

The growth of private investment funds in recent years has boosted both the number and size of PE transactions. General partner firms that manage private equity funds typically borrow upwards of $3 for every $1 of invested cash, empowering fund managers to tap low-cost credit to finance leveraged buyouts.

The formation of multi-fund consortia (club deals) further enlarges that capacity of PE firms to undertake LBOs. In November 2006, an investor group comprising Kohlberg Kravis Roberts, Bain Capital and Merrill Lynch Private Equity completed a leveraged buyout of Hospital Corporation of America worth $33bn, eclipsing the record set in 1988 with KKR's acquisition of RJR Nabisco.

The HCA deal was soon surpassed by Blackstone Group's $38.9bn LBO of Equity Office Properties Trust. KKR set the mark even higher in February 2007, joining Goldman Sachs and Texas Pacific Group to acquire the Dallas-based utility company TXU in a deal valued at $45bn.

PRIVATE EQUITY-DRIVEN BUYOUTS

Analysts now place the outer boundary of PE-driven leveraged buyouts at roughly $80bn, a threshold that has prompted murmurs of impending acquisitions of large-cap public companies such as Dow Chemical, Home Depot, Sprint, Time Warner and Viacom. On May 14, DaimlerChrysler announced the sale of an 80% share of its struggling Chrysler unit to Cerberus Capital Management. The $7.4bn transaction marks the first reprivatisation of an American 'big three' auto manufacturer.

Beyond its impact on specific acquisition targets, the explosion of private equity is generating significant spill-over to the international investor community. The growth in PE transactions is accelerating the current surge in mergers and acquisition. Global M&As reached $3.8tn in 2006, surpassing the 2000 record of $3.1tn, of which upwards, of 25% was initiated by private equity firms.

The capacity of the large PE firms to amass gigantic amounts of capital is also boosting international asset valuations, heightening competitive pressure on multinational corporations pursuing strategic investments.

EUROPEAN PRIVATE EQUITY

Like venture capital, hedge funds, mezzanine capital and other asset classes, the private equity sphere is dominated by the US. 62% of new PE funds raised in 2006 came from the US against 26% from Europe.

31 of the world's 50 largest private equity funds (measured in terms of capital raised between 2002 and 2006) are based in the US, with the well-known American 'megafunds' (Carlyle Group, Kohlberg Kravis Roberts, Goldman Sachs, Blackstone Group and Texas Pacific Group) occupying the top five positions.

The largest European PE firms, London-based Permira and Apax Partners, rank sixth and seventh respectively. Of the 16 European private equity firms on the top 50 list, 11 are based in London. Continental-headquartered PE firms on the list are limited to two Amsterdam-based companies (AlpInvest and ABN Amro Capital), two Stockholm companies (EQT and Nordic Capital) and one Paris-based firm (PAI Partners).

But while American companies are spearheading the global expansion of private equity, the PE market in Europe is exhibiting rapid growth. European-based funds raised some $90bn in 2006, a 25% increase over the level of 2005. Of that, 66% came from European pension funds and 'funds of funds', signalling the growing contribution of private equity to the European Union's campaign to accelerate capital market deepening.

Moreover, these numbers do not capture US-generated private equity funds reaching Europe. In April 2006, Kohlberg Kravis Roberts purchased a 4.5% equity stake in Germany's Deutsche Telekom, a transatlantic manifestation of the PIPE (private investment in public equity) approach favoured by American PEs as entrees to public corporations.

The following month KKR joined Blackstone and Boston-based Thomas H Lee Partners to undertake a $9.7bn acquisition of Holland's VNU, the parent of the media information company Nielsen. In October 2006, KKR bought a 50% stake in the French floor products manufacturer Tarkett.

NEW POSSIBILITIES IN PRIVATE EQUITY

Following their American counterparts, European private equity firms are leveraging their growing funds to pursue large transactions that would have been out of reach just a few years ago.

For example, in May 2006 Dutch-based Sebastian Holdings announced a $50bn bid for Vivendi, the French media giant whose international holdings include Universal Music. While the Vivendi board rejected the offer, Sebastian Holding's bid signalled an expansion of the average transaction size of European PE deals as regional funds and LBO financing options expand.

Equally significant, American and European-based private equity firms are forming partnerships to fund large transatlantic deals. In August 2006, a consortium led by KKR and AlpInvestors purchased an 80% stake in the semiconductor division of Philips Electronics, which the new majority owners have since rebranded as NXP Semiconductors. In September of that year, Permira joined Blackstone, Carlyle, and Texas Pacific Group to purchase Freescale Semiconductor, the chip manufacturer long associated with Motorola.

In addition to illustrating the quickening of transatlantic PE flows, the NXP and Freescale deals signal the private equity markets' renewed interest in information technology five years after bursting of the IT bubble. American-European PE consortia are also moving aggressively into the broadcasting arena, demonstrated by the December 2006 acquisition of Germany's ProSiebenSat.1 Media AG by KKR and Pelmira.

BACKLASH AGAINST PRIVATE EQUITY

Similar to the US, Europe is experiencing growing public rancour over the economic, political, and social repercussions of the private equity phenomenon.

In February 2007, European labour unions staged demonstrations at a Frankfurt private equity conference, brandishing placards claiming the event was a 'conference of locusts' and asserting that 'private equity equals asset stripping'.

The key development precipitating this outburst was the announcement of a bid to purchase the venerable British supermarket chain J Sainsbury by a PE consortium of London-based CVC Capital Partners and the American megafunds Blackstone, Kohlberg Kravis Roberts and Texas Pacific Group.

In late April, the ubiquitous KKR closed a $14bn acquisition of the British pharmaceutical distributor Alliance Boots, the third largest pharmacy chain in Europe and the first FTSE 100 firm to be purchased by a private equity firm. The London-based beverage / confectionary firm Cadbury Schweppes was also rumoured to be a potential private equity target.

PROS AND CONS OF PRIVATE EQUITY

To date, most private equity transactions in Europe have occurred in industries outside the public's radar screen. But the increased visibility of American and European PE firms in the media, retail and branded consumer sectors is bound to intensify debates over the virtues and demerits of private equity.

Counterclaims by professional groups (notably the European Private Equity and Venture Capital Association) citing the contributions of PE acquisitions to enterprise revenue growth, profitability and job creation are unlikely to quell these controversies.

Meanwhile, the European private equity industry is receiving increasing scrutiny by EU regulations. This development mirrors trends in the United States, where the Justice Department has signalled growing concern over the anti-trust implications of megafund PE transactions and the Financial Accounting Standards Board has issued a new accounting rule (SFAS 157) governing private equity firms' reporting of the 'fair values' of their portfolio companies.

Heightened regulation raises serious issues for both American private equity funds (whose rapid growth reflects the investor community's desire for alternatives to public companies in the Sarbanes Oxley era) and European PE firms (whose expansion is an important component of the EU's capital market development campaign launched in 2000 by the Lamfulussy 'Committee of Wise Men').

PRIVATE EQUITY AND THE EUROPEAN SME SECTOR

The foregoing discussion has focused on large companies that form the centrepiece of the investment strategies of American and European megafunds. But European small and medium enterprises (SMEs) are also of growing interest to the PE community.

In spring 2007, Business Week released its latest 'Europe's 500' report listing top-performing companies (measured in terms of employment growth and revenue growth) in the EU member countries and three non-member states (Iceland, Norway and Switzerland). 12.4% of the winning companies are small firms (fewer than 100 employees), while 66% are mid-sized (101-1000 employees). Furthermore, 73.4% of the winners are privately owned firms rather than publicly traded companies.

The dominance of privately owned small and medium enterprises on the Europe 500 list illustrates both the vital role of European SME sector in job creation, and the potential for expansion of European PE transactions in the small and medium-enterprise sphere.

Most of these companies are too small to be interesting to large European PE firms like Permira, Apax, CVC, Cinven and 3i Group or their American counterparts like Carlyle, KKR, Blackstone, Texas Pacific Group and Bain Capital. But they offer considerable appeal to the hundreds of smaller PE firms that have sprouted on both sides of the Atlantic and that are parsing the global SME arena for suitable acquisition targets.

Equally illuminating is the geographic distribution of the Europe 500 companies. Unsurprisingly, Germany, the UK and France account for the lion's share of leading performers. But companies headquartered in Central and Eastern Europe also figure prominently in the Business Week study.

Hungary and Slovenia lead the CEE list with 11 and 10 firms respectively, followed by Czech Republic and Poland. A smattering of companies located in Estonia, Latvia, and Lithuania also appear on the list, demonstrating the upward migration of the tiny Baltic economies in the European value chain. Collectively, the Central and East European firms on the list well outperform West European companies in both employment and revenue growth.

The sector allocation of top performing companies in the CEE countries is also noteworthy, indicating the emergence of clusters of excellence in key industries of growing interest to private equity funds; automotive (Czech Republic), chemicals (Slovenia), food and beverages (Poland), information technology (Hungary), retail (Latvia), steel (Lithuania), and transportation and logistics (Estonia).

A NEW FRONTIER FOR PRIVATE EQUITY

These findings echo the growing consensus of private equity professionals that Central and Eastern Europe represents the new frontier of European private equity. PE firms pursuing SME acquisitions in Western Europe and the US often encounter family ownership and succession issues that frustrate deal closures.

By contrast, the SME sectors of Central and Eastern Europe consist primarily of entrepreneurial firms created in the early post-communist years that have now reached a level of maturation that renders them attractive acquisition targets. Also the regional subsidiaries of Western multinationals that were created in the 1990s and that have reaped the benefits of transfers of capital, technology, and operational best practices from their parent companies.

Furthermore, in contrast to SMEs based in the BRIC countries and other emerging markets, CEE-based small and medium enterprises operate in legal / regulatory conditions aligned with EU norms.

Accordingly, Central and Eastern Europe constitutes a rich target area for private equity firms seeking emerging market-valuations in a business-friendly environment.