After two years of capital stockpiling, private equity firms are cashed up and looking to talk turkey. In this post-recession economy, however, has the market re-bounded so strongly that it has created a sellers’ market? Tim Brown talks to the private equity houses about their investments and whether or not UK manufacturers are on the shopping list.
The image of private equity (PE) has not always been a good one. The Michael Douglas portrayal of corporate raider Gordon Gekko typified the perception of PE in its 1980s reckless heyday of hostile takeovers, asset stripping and major layoffs.
As time has passed, old wounds have healed and despite the bump in the road that was the global financial crisis, the private equity landscape is now considerably different. “Twenty years ago,” says Mark Porter, a partner with Bain & Company, “it was all about financial engineering and gearing up the balance sheet and using the operating cash flow to pay down debt and sell the business as soon as possible. These days, that doesn’t work. These days, private equity firms have to find some way to add value to the businesses that they acquire…and get involved in the business.”
Simon Keeling, joint chairman of corporate finance advisory firm Corbett Keeling says that if you believe in the virtues of capitalism then you will likely agree with the Porter philosophy that building the value of a company is “an inherent part of business life”. “But,” says Keeling, “business is not just about building value. If you are one of the owners of a company, you also want to be able to turn that value into cash.”
So of course some elements of the PE process still remain – the need to cut costs and the need to sell…eventually. “Private equity owners are very good at rolling up their sleeves and getting their hands on the operations of the business and figuring out how to run it better,” says Porter. “Typically they will get involved in all aspects of the company including the commercial management (customers, pricing, identifying opportunities) or the more traditional areas of costs and capital.”
The private equity landscape According to the Centre for Private Equity Research (CMBOR) at Nottingham University, the UK PE 2010 market value recovered to £19.1 billion from the 2009 figure of just over £6bn. The beginning of 2011 has also showed promise with £3.5bn in investments recorded in the first quarter. In 2009, the 257 exits completed represented the lowest total since 1995. The 2009 total also included 166 creditor exits which was the highest number ever recorded by CMBOR. In 2010 the exit market improved with total exit volume rising to 275 while creditor exits fell to 115.
In the first quarter of this year 74 exits have completed but, according to Grant Thornton UK LLP’s latest Private Equity Barometer, UK private equity firms are planning to exit a dramatically higher proportion of their portfolio investments this year than previously. Manufacturing stands to be involved in its fair share of this market movement.
In terms of sector preference, more than a third (36%) of UK Private Equity firms see manufacturing as a key investment focus over the coming twelve months. The reason for this is largely due to a collection of macro-economic forces. “The general view is that there is more interest in UK manufacturing than there has been for some time,” says Neil MacDougall, managing partner with Silverfleet Capital. “I can’t help but feel that it has a lot to do with the exchange rate. I think the devaluation of the Pound against the Euro has made the UK, from a cost perspective, a lot more competitive than it has been for a decade if not longer.”
Mitch Titley, partner with Gresham Private Equity, says that even though Gresham has had a long standing interest in the manufacturing sector, the impact of the recession has meant that the sector has become more attractive. “There has been a huge political interest in manufacturing and there will be for the next few years as politicians have finally realised that the UK can’t be solely reliant on its service industries and that manufacturing is important for our growth,” says Titley.
According to Porter, the financial crisis has also presented new opportunities to the PE market with distressed corporate companies consolidating business interests. But there has been a polarisation in the corporate environment. Richard Skinner, a director at PriceWaterhouseCoopers (PwC), says that cash rich corporate companies have been able to pick up weaker competitors meaning they need to divest certain parts of their business which are not core to their strategy or because of competition concerns.
Porter says that corporate businesses that have accumulated have to do something with that money. “They either have to give it back to their shareholders, do some acquisition, or they make themselves a very attractive takeover target,” he says. “I do see some increased level of interest in these public to private acquisitions where private equity owners are looking to takeover a publicly listed company because they are sitting on a balance sheet that isn’t being properly used.”
Not only is there fierce interest but, compared to 2007, there are considerably fewer deals available. “Our biggest issue is that we have to compete more this year than for the past three,” says Silverfleet’s MacDougall. “This is particularly with corporate buyers as an alternative buyer. Corporate balance sheets are pretty strong and US corporations in particular have had access in particular to a hot high yield market to refinance some of their liabilities. Quite a few corporate balance sheets have quite significant amounts of cash which they would prefer to deploy back into their companies rather than doing special dividends.”
PE firms collectively hold approximately one trillion dollars in capital for investment. “For every company that comes up to be bought,” says Porter, “there are often five or more private equity firms competing for it. In order to be successful in acquiring the business, the private equity firm has to find some way to add value that the other firms do not have.”
Jonathan Sherry, head of M&A and private equity at Zurich says that the unused capital is known in the industry as ‘dry powder’. According to him, “the industry is not remunerated for unutilised investments and hates to give money back so there is a pressure to ‘use it or lose it’.”
Private equity in practice
So what it is that PE firms are looking for? Primarily PE houses look at businesses on an individual basis but there are sectors of specific interest including: renewables; security (home land security or cyber security); oil and gas; mining; food and beverage; agriculture production; and products related to an aging population. All these popular sectors have been driven by high prices and a view that the long term demand is strong.
According to Skinner of PwC, the characteristics PE firms look for include:
● A good aftermarket presence
● Niche technologies that can be defended (not just through patents)
● Supplies to a variety of end use sectors
● Solid emerging market presence
● Interesting part of the supply chain, with the ability to pass on raw material prices
● Strong management team
For a business looking to sell or for investment capital, private equity may indeed be the solution. The simplest route into the private equity market is for either the shareholders or management to approach a private equity investor directly, and they will then usually get a first meeting. The second route is through an introduction via an agent, who is often an investment bank.
If private equity is the desired direction, it is important to realise that there are several different ways of skinning the PE cat. According to Keeling, between debt and equity, “there is a whole spectrum of hybrid funding products such as junior debt, mezzanine and preference shares”. Consulting with a corporate finance advisor can make the decision easier.
Despite the variety of options, a majority of private equity firms will want to take equity in a business. Mitch Titley of Gresham says his company will always take equity but it is not always a majority stake. One of the Gresham’s current investments, Worcestershire-based PET plastic bottle manufacturer Esterform, is an example of this.
According to Zurich’s Sherry: “The general model for PE investment in the larger buy-out arena is to utilise both equity and debt which may not fit with ownermanagers’ appetites or the current financial position of the company.”
Aside from cost cutting, the exit is most likely to cause concern for management but, according to Porter, it is usually management that instigate the sale. In a private equity backed deal, the PE owners very often set aside a portion of the equity to the management team. This means that if the exit is successful then they are rewarded for that. “What we’ve always found is that the shareholders sitting alongside us are the management team. If the investment is going very well then the management’s shares have gone up in value significantly in that period of time. After five years, most management teams may decide it is time to bank and they want to take some money off the table: that is usually what triggers an exit.”
With fewer prospects in the market, and with PE firms hungry for equity, now may be the time to seize opportunities with new investors or owners. However, even though there is interest, businesses must still meet a high standard in order to be attractive to investors. The choice to enter into private equity is a big decision and one that requires research and, in the end, the choice needs to come down to who can develop the best relationship and add the greatest value to the business.