Adventures in Private Equity

Private equity investment professionals take it as axiomatic that their funds outperform stock markets, because the companies they invest in are tightly run, working to an agreed growth plan, which culminates at a fairly well-defined point, when a fund will exit. Whether they have financed a management buyout (MBO) or the classic venture capital high-tech start-up, private equity teams tend to take an extremely close interest in the businesses they have backed.

'Public curiosity in these deals is high,' says Javier Echarri, secretary general of the European Private Equity and Venture Capital Association (EVCA), 'and private equity specialists have an enormous amount of information, far beyond what an investor would get from a stock exchange-traded company, but discretion is always expected, for obvious reasons.'

GROWTH-ORIENTED DEALS

EVCA figures for 2004 show that more than €35bn was invested by private equity into close on 10,500 European businesses, with UK-based investors responsible for almost 37% of the total pot. This figure is expected to top €50bn for 2005. Buyouts account for around 70 per cent by value, with most of the remainder being business start-ups.

No longer are most MBOs spin offs from larger companies, a manoeuvre which is currently out of favour. The majority are growth-oriented public-to-private deals.

The turnaround component of venture capital is currently not significant because relatively few companies are running into trouble. MBOs are meanwhile getting bigger - the average deal is now around €14m - which reflects in part the increasing appetite for private equity, and the eagerness for funds to reinvest cash released by a growing number of exits.

'There is now far more recognition of private equity as an asset class,' says Peter Linthwaite, chief executive of the British Venture Capital Association (BVCA), 'but there is still some way to go.' A problem he identifies is that smaller institutional investors allocating around 2% of their cash to private equity, have difficulty finding the right vehicle. 'One of our challenges is making sure there is the right private equity vehicle for those funds, as well.'

SECONDARY INVESTMENT

The continued rise of the secondary market in private equity is evidence both of its liquidity and the belief that a further period of closely supervised private management can grow a company a stage further, so releasing even more value for a second group of investors. The fact that there is now a ready availability of finance for what is effectively a second management buyout, adds a third exit to the existing floatation or trade sales routes of cashing out.

Furthermore, Echarri points out that with the growing burden of Sarbanes- Oxley-style regulation for listed companies, managers are examining whether their market cap is sufficient to justify the compliance cost. The second private equity fund, providing the exit for its predecessor, will probably have deeper pockets and perhaps a subtly different skill set to oversee further expansion.

Inherent in all public-to-private deals is the assumption that properly focused on finite targets and freed from the attentions of analysts and share price fluctuations, all or most of an existing management can grow the business more successfully, especially since they themselves hold an equity stake.

DRIVE FOR GROWTH

Luke Ahern, an equity analyst and director of broking at AIM specialist stockbrokers Corporate Synergy, is deeply impatient of the performance of public companies. 'Do you see managers remortgaging their houses to buy equity in their public company?' he asks. 'You do in the private market, in a venture capital-backed deal. Executives feel that if they are going to be a proper principal, as opposed to a paid manager, the best way to do it is in the private environment.'

It is Ahern's contention that all public companies, and not just venture capitalists in a hurry, should have altogether braver management and more supportive boards. 'There is a lot of private equity money which is thinking both short- and long-term,' he says. 'There are massive hedge funds, there are massive private equity funds, and these people have all sorts of timeframes and are looking at all sorts of businesses throughout the world. There is also quite a lot of competition for these deals, but it is always private equity teams who are scouring the public markets for value.'

PAN-EUROPEAN EXPERIENCE

According to Echarri, in France, Germany and particularly Italy, putting together deals is very much a case of networking. All leading private equity funds maintain local offices to keep in touch with marketing opportunities. Setting up a deal may be a case of being able to reach the right people. However, once a transaction is agreed, no mature European market is significantly different from another in terms of execution or effectiveness.

The position is less certain in Eastern Europe, where private equity has generally gone into a mix of high-tech start-ups and privatisation-related deals. Poland's strong stock market and economic performance have given private equity funds a good exit, unlike in Hungary, where the Budapest exchange is still developing capacity.

Yet as Echarri points out, there remain anomalies in these 'new' European markets, such as the prohibition of Polish pension funds from investing in anything other than publicly quoted companies. Locals ought to be in their domestic private equity markets for their knowledge and understanding, as well as for the essential credibility of the sector.

'When you look across Europe, there are a number of opportunities for spins-off,' says Linthwaite. 'In Germany, there are still quite significant bank holdings in relatively large conglomerates. The opportunities are similar in France. Both countries still need to go through the quite major changes that took place in the UK in the late 1980s. We have had a very robust 2005 in the UK and Europe, in all areas: investment activities, sale of investments and raising new funds. Talking to BVCA members shows that the deal flow in the pipeline remains good and there are attractive opportunities.'

SEVERAL REGULATORY APPROACHES

Echarri is also optimistic, but worries about new European regulation, particularly the effect of the MIFID on a private equity industry that has worked hard at self-regulation and raising its profile and credibility. 'Since we have had the Lamfalussy Process in place, Brussels has set the principles, which tend to be right, and then the various countries implement them' he says. 'Unfortunately, this is where you get the variability of different national interpretations, and this is where we have major problems.'

EMPLOYMENT BOOST

One boost to private equity's image came from a survey into the impact of its investments on employment. It was not unexpected that in the five years to 2004, venture capital start-ups in Europea had created 580,000 new jobs. What surprised even the EVCA, as Echarri admits, was that MBOs created a further 420,000 jobs, making a million in all.

'In a period when Europe as a whole has lost jobs, this is impressive,' comments Echarri. 'Though companies tend to do much better after the investment period, we did not expect the figures to be that high. MBO companies have to rationalise to the maximum. However, while bringing market rigour to a company is healthy for the company itself, no one enjoys having to make major changes and close down units and lay off workers. This survey shows, however, that the long-term effect of an MBO is more, not fewer jobs.'

ABOUT THE EVCA

The European Private Equity and Venture Capital Association (EVCA) was established in 1983 and is based in Brussels. EVCA represents the European private equity sector and promotes the asset class both within Europe and throughout the world, with over 900 members in europe.

ABOUT THE BVCA

The British Venture Capital Association (BVCA) has over 300 members. They have now invested in over 11,000 companies, which in turn employ nearly three million people, or about one-fifth of all private sector employees. The UK industry accounts for 52 per cent of the whole of the European private equity and venture capital market.