Private equity: An uneasy bedfellow wakes up to a crisis

Like the tourists looking for fake watches in Hong Kong’s Temple Street market, the fast-growing number of private equity firms shopping in the luxury goods sector must be wary of buying something they regret once they return home.

Until recently, the closest most buy-out executives came to luxury goods was deciding whether to slip into Armani or Ermenegildo Zegna suits in the morning while choosing between Rolex and TAG Heuer watches for the evening.

But all that has changed in recent years as a number of well-known brands have fallen into the hands of private equity, including Jimmy Choo, shoemaker to the stars, Agent Provocateur, the lingerie brand, and Bavaria Yachtbau, the yacht maker.

The biggest deal so far was Permira’s €2.6bn ($4.1bn) acquisition last year of Valentino, the Italian maker of evening gowns for celebrities, which also controls the Hugo Boss, Marlboro Classics and M Missoni brands.

This frenzy of dealmaking made last year a record for luxury goods buy-outs, with nine private equity deals in the sector valued at $3.57bn, according to Dealogic.

Yet almost as soon as private equity started snapping up luxury assets, the credit crunch unfolded, putting a damper on bonuses in Wall Street and the City of London and generating concern about the strength of the global economy.

“The wealth-creation cycle is decelerating and the feel-good factor is evaporating,” says Antoine Colonna, luxury goods analyst at Merrill Lynch.

“The question is not whether a deceleration is ahead but whether it proves stronger than expectations.”

He adds that the luxury sector is in the fourth and least attractive phase of his so-called “luxury goods clock”, when growth weakens and valuation multiples contract, requiring investors to be extremely selective about where they put their money.

This could spell trouble for recent investments in the luxury sector, renowned for its strong cyclical nature. It may also make private equity executives think twice about new deals, especially as the credit crunch makes them harder to finance.

The credit turmoil already seems to have reduced private equity’s appetite for luxury deals, even if it has not disappeared completely. So far this year there have been five deals valued at only $115m, says Dealogic.

Last month Apax Partners pulled out of talks to buy a stake in Escada, the German fashion house, and recently ditched plans to float Tommy Hilfiger, the all-American fashion brand it acquired for $1.6bn in 2006.

Roberto Cavalli appointed Merrill Lynch last summer to examine a flotation or sale of a minority stake of the Italian fashion business, but since then it has struggled to flush out a bid, in spite of reported interest from Blackstone, Cinven, and Carlyle.

However, there are still some signs of optimism. One bright spot is Candover’s plan to float the Ferretti yacht-building business – whose brands include Pershing and Riva – on the Milan stock exchange with a valuation as high as €3bn (4.7bn).

Candover bought Ferretti for €1.7bn only in October 2006 and, having expanded production, is already looking to capitalise on booming sales of its made-to-measure pleasure craft, which can be more than 50m in length.

Demand for these “super-yachts”, which can fetch as much as €50m each, is particularly strong from fast-growing numbers of millionaires in Russia, the Middle East and Asia.

“We only sell 400 of these boats a year and we have a strong order book for the next three years,” says a person close to the Ferretti flotation plans. “Dubai is building a 40,000-berth marina, so Ferretti is an easy business to understand.”

But one private equity executive with experience of the super-yacht industry is more sceptical, saying: “Historically, these big yacht makers have been heavily cyclical, but usually with a late-stage cycle, so maybe they’ll get out of Ferretti just in time.”

David McCorquodale, UK head of consumer markets at KPMG corporate finance, says that while private equity will always find it hard to challenge the big luxury maisons of LVMH or Richemont, it can still play a niche role in the sector.

He says smaller local luxury brands can benefit from private equity’s ability to improve their governance and invest in expanding their product range, as shown by Jimmy Choo’s growth under a series of buy-out firms.

More mature brands, such as Valentino or Ducati, the Italian motorcycle maker floated by TPG in 1999, can also benefit, he says. “For older brands it is more about breathing fresh life into them and dealing with succession issues.”

He adds that rising luxury sales in emerging markets create another opportunity for private equity. “With Russia, China, India and the Middle East markets opening up there is a lot of new wealthy consumers to go for, so capital can be put to work.”

However, Mr Colonna at Merrill Lynch says private equity’s desire to sell a company after two or three years can make it an uneasy bedfellow for luxury brands.

“You can’t do anything in this sector in three years,” he says. “It takes a long time to build a luxury brand, but you can destroy it very quickly.”

As an example, he cites TPG Capital’s investment in Bally, the Swiss-based shoemaker, which ran into trouble soon after being completed in October 1999, requiring almost a decade of restructuring before being sold last month.

“Look at Bally. Do you really think TPG wanted to own that company for almost 10 years?” asks Mr Colonna. “No, they wanted to do it in two-to-three years. But once an egg is broken, it is very hard to unscramble the omelette.”

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