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Recent high profile appointments by venture capital firms of executives from listed groups have convinced some that publicly-owned companies are losing the battle to retain key talent. The lack of public scrutiny and the large potential rewards on offer in private equity are cited as the main draws for City chiefs. But is the sector as rewarding as it seems?
Below, the FT’s Peter Smith, and Roger Holmes and Stephan Lobmeyr from Change Capital Partners answer readers’ questions.
You can also read background articles on this issue by the FT’s Carlos Grande:
Public-to-private deals are a familiar part of the landscape in Britain. Can we expect more activity in continental Europe?
Roger Holmes and Stephan Lobmeyr: The first wave of public-to-private (P2P) deals came to the UK between 1985 and 1989 and picked up again in 1997. Since then the UK has had between 30-50 P2P per year. In Europe there was a similar development with a first wave between 1986-1991 and a pick-up in 1999. Since then Europe has had between 15 and 30 P2P per year.
— There are different drivers for these trends: The UK has traditionally had a much larger public and LBO market than continental Europe and takeover rules have been clarified earlier than in Europe. However, France, Germany, Italy and Holland have made important changes to the legal framework between 2002 and 2004 (mainly on the ability to debt finance targets and on squeeze-out rules) which should help their development of P2Ps. Lack of institutional liquidity for small public companies in Europe should be an additional driver for P2Ps, however cultural issues are also sometimes mentioned as less favourable in Europe.
— All these factors should lead to an increase of P2P activity in Europe over the coming years.
Peter Smith: There will definitely be more public to private deal activity in Europe in the coming years. Private equity has become more accepted in many European countries, allowing buy-out groups from the US and UK in particular to establish themselves in new markets, and build relationships with executives, investment banks, and debt providers.
And we have already had some breakthrough public to private deals in Germany and France, notably Blackstone’s purchase of Celanese, the German-listed chemicals business.
Germany is a hot deal market for the large buy-out groups, including Permira, Kohlberg Kravis Roberts, Apax, Texas Pacific, and Providence Equity. Some of these large buy-out groups are very keen to buy some of Germany’s largest listed business, and many more in the DAX 30 are in their sights.
The buy-out groups are very keen to put their capital to work. They have raised huge amounts of capital that must be deployed and there is increasing competition from within private equity. That means new markets and new sources of deal flow must be found. Public to privates, which it should also be remembered are often tough and complex transactions (and many end in failure), are therefore likely to be a feature.
Aside from remuneration and equity-ownership, is there anything else in the way that private equity runs businesses that make it a more attractive employer?
RH & SL: Yes, Private Equity offers management the prospect of significantly higher financial rewards through having a real equity stake in the business. But for the management teams we work with Private Equity is attractive just as much because of the work environment it offers. This is one of clear communication with a single knowledgeable investor, aligned around a common and worthwhile timescale (3-5 years), fast decision making and the ability for management to devote their time to doing what they enjoy - running and developing their business.
PS/FT: Private equity groups for years had a bad name as asset strippers and vultures, that did little more than slash costs, sack people and make huge profits for themselves in the process. While it is still true they make huge profits, private equity’s reputation has improved.
Private equity is now about a lot more than clever financial engineering, though a big part of the profits that private equity groups are able to generate results because of their use of leverage.
Typically a private equity executive will sit on the board of the portfolio company it owns. As a result, he or she will be intimately associated with the company’s progress, whether it’s delivering to budget, and whether management are able to deliver. In private equity-backed businesses, decision making can be incredibly fast, and this creates tremendous advantages no matter whether the company is doing well or badly. Doing well, the private equity group might release capital to make a flurry of bolt-on acquisitions, doing badly, and they can sack top management.
Aside from leverage effects, what does private equity do to add value to LBO targets? What stops existing management teams implementing similar restructuring? Also, acquisition multiples on LBO’s are rising, and returns are inevitably coming down. Has the current wave of activity reached a peak?
RH & SL: ‘Financial engineering’ can create value but it is increasingly important to also identify operational improvements if the value of the investment is to be maximised and good returns achieved in an increasingly competitive LBO market. Existing management teams may be able to leverage their balance sheets but it is crucial at the same time to create the environment that allows management teams to be successful in Private Equity, i.e. significant personal investment by management in acquiring an equity stake which aligns them with the investor, a common timescale of 3-5 years, an ability to take decisions rapidly and to devote all their time to running and developing the business. It may simply not be possible for an existing management team to create this environment, in which case they will not be able to match the impact of Private Equity and leverage in particular could be dangerous.
Considering the small number of private equity owned companies in Europe or even in the UK compared to the US and the opportunity which exists to improve the structure and efficiency of companies, especially in Continental Europe, we believe that there is still significant room for activity within this industry.
It’s obvious the private equity boom has been fuelled by very cheap money/borrowing rates and high liquidity, but what is the sensitivity of that growth to rising rates - for example, if cost of debt went up one per cent how would that affect returns?
RH & SL: One should distinguish between existing and new deals:
A) On existing leveraged deals an increase in interest rates would lower returns. With a modest increase the company would create less cash and should be less valuable at exit.
It is important to note however, that weighted average cost of capital would still be less than in less leveraged companies, hence the leverage will continue to create value for the shareholders.
If the increase was massive, some highly leveraged companies could get into covenant or cash problems and require a restructuring of the balance sheet. This scenario might have an impact on the bank’s willingness to give new loans and hence might reduce activity.
B) New deals will possibly be less leveraged than with lower interest rates. This should lead to lower enterprise values, but would not necessarily impact activity levels.
Much has been written about the greater rewards public company executives can earn when running a private equity-backed company, as well as the operating latitude and reporting / regulatory freedoms that life away from the public market can allow. Much less has been said about the stress on such executives of working with focused, activist and demanding owners with aggressive time scales and high return thresholds. As context, I quote from a reference I took on a senior figure in the European private equity world, a partner at a major firm (I’ll call him Mr X), from a corporate finance advisor (I’ll call him Mr Y) who knew him well: We then returned to Mr X as a professional and a character. Mr Y observed that ‘Mr X is more of a non-executive who is not afraid to use his force...he is very focused on what he wants to accomplish and is less interested in having an atmosphere where everyone is happy...he wants to get to his goals.’ Mr Y went on to say that Mr X ‘is not a warm personality, not at all...he won’t make a lot of friends in companies, he is a tough Board man,’ but that there ‘are two sides to what management experiences in how he acts; on the one hand, he is not always happy, he is a tough negotiator.’ On the other hand, as shareholders themselves, management can be gratified through their own gains that ‘the company has achieved much more under Mr X’s plans’ than other, less ambitious ones.Do you have any views on whether senior management, once exposed to demands of the private equity world, might wish to return to the public arena, its more diffused shareholder bases and its less aspirational agendas? Shouldn’t the perhaps less tangible ‘downsides’ to management feature in the debate as well?
John Barber, Managing Director, Helix Associates London
RH & SL: Yes. It is a demanding environment that the more ambitious entrepreneurial manager will relish. But you can be human as well as tough and the best managers will combine both. Nevertheless it is not for everyone. There are those who are more risk averse and do not want the pressure or equally highly able managers who value their role as custodians of major public companies.
If you have skills in one area of finance/investment are they easily translated to the private equity field, i.e. a deal is a deal is a deal, hence the movement from hedge funds to private equity?
RH & SL: To be successful Private Equity requires a wide spectrum of financial and operational skills. Somebody who has a highly specialized financial skill such as a hedge fund manager could easily add value in a private equity team. However, for a hedge fund itself to be successful in Private Equity would require either special situations (such as distressed debt) or for the fund to invest in acquiring the different skills necessary to develop the business over a longer timescale.
Do you think that private equity serves a useful economic function? Bevis Comer
RH & SL: Yes. Private Equity has proved itself as a positive agent for change in the US, UK and increasingly in continental Europe. It has prompted industry restructuring when this is often necessary and it has a good record of creating jobs by investing in growth opportunities.
Private Equity has a meaningful timescale of c 3-5 years for its investments and maximizing the value of the business is most likely to be achieved with a growing company, with happy customers, motivated employees etc. In other words, maximizing the value of the business as a single imperative will benefit all shareholders of the business and hence have a “useful economic function”.
PS/FT: Private equity does make a meaningful contribution to the broader economy.
For starters, a lot of the capital that private equity invests originates from pensions schemes. So if the particular private equity funds are doing well, so too will the investment performance of the pension funds. Indeed, the hunt for higher returns means that many institutional investors are increasing their allocation to private equity.
Armed with greater amounts of capital, private equity groups are investing in all sectors and all geographies. These groups particularly like to exploit inefficient markets and are also prepared to take on industries and sectors that need restructuring or consolidating. Often these sectors can be viewed as unfashionable by other types of investors, so private equity capital here can be vital. Examples include the UK pubs sector and the global satellite industry.
Although private equity is a form of “risk capital”, and some of the businesses it backs will fail, it is also true that UK companies that are backed by private equity groups stand up favourably against their quoted competitors.
According to the British Venture Capital Association, the industry’s trade body, private-equity owned business in UK outperform their publicly-listed counterparts when it comes to job creation, sales growth and export growth.
The BVCA estimates that companies backed by the industry generate annual sales of £187bn, and employ 2.7m people, or 18 per cent of the private sector workforce.
However, the negatives might include the large, some might say excessive, profits that are generated by a small number of individuals within some of the buy-out groups. Also, private equity’s trick is to load its companies up with debt, the costs of which will typically wipe out much of the taxable profits that these businesses might otherwise pay.