Private Affairs
Linda Roberts
20-May-07
Private equity in the UK originated in the late 18th century, when entrepreneurs sought out wealthy individuals to provide financial backing for their businesses. 20th century pioneers of the private equity firm included Slater-Walker and Hanson Trust and by the early 1980s a private equity industry was establishing in the UK. A number of private equity firms were founded at this time following on from the success of private equity investments in the US.
History shows that private equity backed companies grow faster than other types of companies. This is made possible by the provision of a combination of capital and experienced personal input from private equity executives, which sets it apart from other forms of finance.
Private equity is now a recognised asset class and has significantly altered the business landscape over the last 25 years. One in three companies sold today is bought with private equity finance and one in five employees in the private sector is employed by a company owned by private equity investors. In the UK, there are over 170 active private equity firms, which employ around 5,000 people, of which some 3,000 professional executives are active investors. They collectively provide several billion pounds annually to unquoted companies, of which around 80% (1,300 businesses) are located in the UK.
The latest British Venture Capital Association (BVCA) report on The Economic Impact of Private Equity in the UK published in November 2006 states that 'private equity backed companies are a significant driver of the UK economy and its global competitiveness.'. They 'create jobs at a considerably faster rate than other private sector companies. Over the five years to 2005/6, the number of people employed worldwide by UK private equity-backed companies increased by an average of 9% p.a. This compares dramatically with FTSE 100 and FTSE Mid-250 companies, at 1% p.a. and 2% p.a. respectively. Furthermore, nearly three-quarters of companies said their growth was organic, rather than by acquisition, following private equity backing.'. Over the same period 'private equity-backed companies generated total sales of £424 billion, exports of £48 billion and contributed over £26 billion in taxes.'.
But what is private equity? The BVCA defines private equity as 'the equity financing of unquoted companies at many stages in the life of a company from start-up to expansion or even management buy-outs (MBOs) or buy-ins (MBIs) of established companies. 'Venture capital' is a subset of private equity, covering the seed to expansion stages of investment.' The media tends to use the term to refer mainly to leveraged buy-outs where a company is bought with borrowed money in the hope of improving profits and selling it on at a higher price.
There have been many high profile investments recorded in the media where private equity firms have invested in companies listed on public exchanges and taken them private: such acquisitions include the purchase of AA by Permira and the purchase of Debenhams by a consortium of private equity firms. This proved a very successful strategy in the above mentioned acquisitions and reaped hundreds of millions of pounds in rewards for the private equity investors involved. A boom in the private equity industry followed resulting in £118bn spent in private equity takeovers in 2006 in Europe alone. The UK private equity industry is now the largest and most dynamic in Europe accounting for just over half of the whole European market, and worldwide is second in size only to the United States.
The key feature of private equity is that the investment funds are not raised through the public markets. The main sources of private equity in the UK are angel investors that provide smaller amounts of finance at an early stage in a business and private equity firms who may invest at all stages in a business for example providing venture capital or capital for buy-outs. Corporate venturers also provide equity capital. Respondents to a BVCA survey indicated that in 38% of private equity investments investors provided funds for managers to buy out or buy into their company and in the remaining 62% of cases funds were provided at the start-up to expansion stages. The remainder of this article considers the role of private equity firms in equity finance.
A private equity firm traditionally seeks out investment opportunities where the business has proven potential for realistic growth in an expanding market, supported up by a viable business plan and an experienced effective management team. It provides long-term, committed financial backing to help unquoted companies grow and succeed. It invests in companies looking to start up, expand, make acquisitions, turnaround or restructure a company. It may also provide replacement capital to free up personal wealth without selling the business outright, or funding for a management buyout by the existing management team or a management buy-in by a management team from outside the business. A typical business opportunity for a private equity firm would be one where a company is aiming to grow rapidly to a considerable size and can offer the prospect of significant turnover growth within five years. Figures from the BVCA suggest that the majority of private equity backed companies are medium-sized and fast growing, with average sales revenue of just over £46 million and an average labour force of 600 staff in the UK.
Institutional investors and wealthy individuals invest in private equity funds, which are in turn used by private equity firms for investment in target companies. Some funds may specialise in particular industry sectors or in a particular type of private equity investment such as leveraged buyouts. Depending on the size of the equity stake in the company they hold, private equity funds can determine how companies are managed. Where a fund takes a controlling stake in a company, it may bring in a new management team tasked with making the company more valuable.
Private equity firms often work in conjunction with other providers of finance to fully fund an acquisition. In particular management buy outs or buy ins are often highly geared: managers may be required to invest only a relatively small initial amount, with the promise of a greater equity stake if the company is successful. Bank lending provides some of the funding and as it is repaid (from cashflow) the value of the shares rise. If the private equity funding also includes redeemable funding through loan notes or preference shares, then as these are repaid the private equity firm is able to provide more capital, while taking a smaller equity stake itself: the management team therefore receives an equity stake that is proportionately larger than their initial investment.
In recent years there have been many high profile cases where private equity firms have used a combination of their own private equity fund and debt to buy 'high-street name' companies which they feel are underperforming. The company is then resold at a profit within three to seven years. The well publicised high levels of debt used for such acquisitions has brought the industry some criticism and City experts including some of the banks that lend to the private equity firms have raised concerns about the levels of debt being taken on in light of rising interest rates.
One of the benefits of private equity funding over traditional bank loans is that the returns to the private equity firm are intrinsically linked to the business — growth and success. It faces the risk of failure just like any other shareholder. The more successful the company is, the better the returns all investors will receive. If the business is struggling, the private equity firm is financially incentivised to work hard to ensure that the company is turned around. If the business fails, private equity investors will rank after banks and other lenders and could lose their investment. Most of its reward is realised as a capital gain through an 'exit' which may include floating the company on a stock market, selling their shares back to the management or selling their shares to another investor for example another private equity firm or company. Initial public offerings (IPOs) are a successful exit route for companies that have thrived as a result of private equity backing. Research published by the BVCA and the London Stock Exchange (LSE) shows that from 1998-2004 around 50% of UK companies that floated on the LSE main market were private equity backed. In addition, the after-market performance of private equity-backed IPOs was significantly better than those that did not receive private equity funding. The Alternative Investment Market (AIM) is also proving an important potential exit route: of the private equity-backed companies firms responding to a BVCA survey 20% said they were anticipating obtaining a stock exchange quotation. Of these, 65% expected to seek quotation on AIM, 23% on the Official List of the LSE and 3% on NASDAQ.
Private equity firms portray themselves as empowering business leaders to run their companies in an effective and efficient manner. They provide both financial backing and practical guidance, work closely with the management team they support and provide strategy input and management changes as necessary. High levels of debt are required to fund the acquisitions and therefore by their nature private equity firms take a close interest in their investments. Released from appeasing a potentially short-term focussed shareholder base, companies are able to take strategic long term decisions.
The media often portrays private equity firms as buying companies at a cut down price, stripping the assets and reselling the companies making outrageous profits in the process. The speed with which Debenhams returned to the market — just over two years — and the 200% return on investment has done little to help this image. Criticism has also been laid by the unions: the GMB union publicly branded the private equity firm Permira 'buccaneering asset-strippers' after the AA dismissed over a quarter of its staff while under Permira's ownership. The reality is acquisitions are often funded with high levels of debt and the private company is shielded from the information requirements levied on public companies. In response to concerns over transparency the BVCA announced in March 2007 its intention to establish a review of transparency and disclosure in the private equity industry with a view to forming a voluntary code or set of guidelines on a 'comply or explain' basis.
If the aforementioned BVCA report is to be believed, most private equity backed companies regard the investment in their business as a positive step. In a contributing survey to the report 92% of responding companies said that without private equity the business would not have existed at all or would have developed less rapidly. Additionally around two-thirds of respondents identified strategic direction, financial advice and help with contacts as being key ways in which private equity houses had helped with the development of their businesses. 76% of respondents from companies where a private equity financed management buy-out had occurred thought that their MBO had had either a positive or a very positive impact in terms of more effective management and 66% thought that the MBO had given them more freedom to innovate. In addition to the provision of finance, 71% of MBOs considered that 'financial advice' was the most important contribution from their private equity investor.
So how can an angel investor invest in private equity deals? Generally to become an investor in a private equity fund as a member of a private equity firm you would need to be both very wealthy and be a Chief Executive or hold a position of similar standing that reflects your success and influence as a business leader. Typically such investors will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, the investor will only benefit from investments made by a firm where the investment is made from the specific fund that they have invested in. There are however some private equity firms that deal at the lower value end of the market. For example, Pi Capital aggregates private money from entrepreneurs, directors, full time private investors and others to invest in profitable UK companies requiring between £2 million and £5 million of equity. Investment criteria of private equity firms that are members of the BVCA are available on the BVCA website at:http://www.bvca.co.uk/searchdirectory/scripts/fullmembers.cgi.
If your wealth and business status does not yet fit the profile required for membership of a private equity firm then investment trusts or venture capital trusts (VCT) could be the investment route of choice. Some investment trusts, such as Graphite Enterprise IT invest in both private equity companies and funds. Others, such as Pantheon International Participations are similar to funds of funds in that they offer exposure to a variety of funds run by different private equity firms. Some venture capital trusts also invest in private equity and offer a tempting 30% income tax rebate on their initial investment to investors in new issues, provided they hold the VCT for five years, in addition to no tax on income and gains. However the gross assets rule restricts managers to investing only in companies with gross assets of no more than £7m prior to investing and £8m afterwards. The wealth manager of any of the major investment houses, for example Goldman Sachs or Barclays Wealth, will be able to offer advice. If you want to keep things simple, the easy route to reaping the benefits from private equity investments could be just purchasing shares in a public limited company that focuses on private equity investment, for example 3i PLC.
Whatever investment choices you make bear in mind that the success of your investment will have as much to do with the quality of the private equity firm or trust manager that you select as the suitability of the underlying investee companies.
Linda Roberts is a contributing writer to The Angel Investor and can be reached at linda.roberts@it-allies.co.uk
