RSS feedsLean, mean and ready for action. Businesses that successfully complete a venture capital, or private equity, workout appear focused and efficient, with highly incentivised management teams ready to take on any and all challenges.
The Homebase experience demonstrates the impact private equity can have on a business. Sold off by J Sainsbury in a management buy-out in December 2000, the DIY chain spent just two years in Permira’s private equity hands before being sold in December 2002 to GUS for around £900m, generating a return of approximately six times the original equity investment. (see FD interview, page 22)
Chris Woodhouse and Rob Templeman, the FD and CEO during Homebase’s transformation, are now installed at Debenhams, which they took private with the backing of CVC, Texas Pacific and Merrill Lynch in 2003. “It was a highly leveraged transaction,” says Tony Stockil, CEO of Javelin Group, a retail consultancy, which has undertaken 20 retail due diligence engagements for private equity investors in as many months. “The initial focus of Rob and his colleagues was to de-risk the business as quickly as possible and pay down debt. So they looked at things like working capital, and how it could be better managed. For example, they reduced the size of the float, tightened up on receivables and lengthened the time for payables. Having a mass of debt just focuses the mind on cash in a way that publicly-owned retailers don’t have to be.”
The office products supplier office2office is now listed on the London Stock Exchange, but was previously backed by Electra and then Gresham. It’s finance director, Mark Cunningham, confirms there was always a strong cash focus in the business. “We have always had that emphasis on cashflow,” he says, “but part of that may have come from Electra. It had a strong focus on key drivers in terms of value growth and one of those was cash management.”
Stockil suggests that FDs of plcs could simulate the cash pressure felt by PE-backed companies. If they ‘pretended’ they were suddenly burdened with debt, they would be able to find cash and return it to investors. By tightening up on working capital and applying higher hurdle rates to projects, they would also increase long-term shareholder value.
Estimates of how much cash can be generated from a post buy-out business – without hurting it – is key to any pre-acquisition planning, and to the first 100 days of post-acquisition action. “But it’s important to say it’s not just about cash,” Stockil stresses. “If it were, retailers would just be asset-stripped and sold off for spare parts.
“Debenhams is a better business now than it was before acquisition, because it is now thinking about the value when it comes to sell the business again. No one will buy a business that has simply been stripped to the core. So after cash, there’s then a focus on laying strong foundations for growth and demonstrating growth potential.” This, Stockil explains, is why Debenhams is now developing its smaller format, Desire, appropriate for smaller shopping centres and focused on the core womenswear offering, including the ‘designers at’ proposition, which is unique to Debenhams.
No second chances
So could publicly-owned retailers, and other sector players, learn from this growth focus? Stockil believes so. Blue chips can be burdened with certain hobby horses, perhaps favourite projects of the CEO or chairman, that haven’t delivered yet, but are repeatedly given another chance. “Private equity has little tolerance for that,” Stockil says. “Anything that’s ‘wish list’ or a marginal opportunity gets cut – because cash is so tight. Cash is focused on what will make a short- to medium-term return. The certainty of a return has to be that much greater. Too often, publicly-owned retailers apply a relatively low hurdle rate to their more speculative investments.”
Luke Ahern, director of broking at AIM-specialist stockbrokers Corporate S ynergy, certainly believes there are lessons to be learned from the PE sector about generating shareholder value. “These FDs [in PE-backed businesses] are not emotionally attached to any aspect of the cost base,” he says. “Every asset and every line in the P&L is looked at to see how efficient it is. There is no mercy shown for underperforming assets.” PE-backed management teams may, for example, be less sentimental about where the head office is located. “Does it really have to be in such a fashionable part of town?” queries Ahern. “Remember how long Marks & Spencer clung to its luxurious Baker Street head office, long after it should have sold it and moved to somewhere more appropriate.”
Stockil highlights another PE-related procedure, which all FDs might want to consider. “One of the techniques applied by management going into a PE-backed business with a lot of debt,” he says, “is that they get all the senior management teams to come and present their plans to them – what they are focusing on, what investments they want to make. They make everybody justify every item in their budget. That’s something a lot of incumbent management teams don’t do.”
Similarly, established management teams in publicly-owned businesses may not always be as rigorous in their supplier agreements and selection. That said, it might be easier to renegotiate terms after a PE deal. “It gives you a good excuse,” Stockil confirms. “You are suddenly burdened with debt and can communicate to everyone that this is an emergency. You need to batten down the hatches and need suppliers to improve terms a little. Sometimes, the previous or incumbent management finds this hard to do because they have been dealing with those suppliers for years. You can get too cosy with suppliers and they become friends. That makes it harder to negotiate.”
Tough negotiations with suppliers can generate bad press, but Jon Mortimore, CFO of Travelodge, backed by Permira, believes 4 suppliers can benefit in the medium- to long-term. “In the short-term, suppliers suffer because of the price pressure,” he admits. “But because the medium- to long-term view is about growing value, in the medium-term suppliers do better because they have more volume going through. We are building hotels. We have been driving suppliers hard, but because of that we can afford to open more hotels and they can build more rooms for us. So, because [supplier] cost savings are reinvested in the business to reduce room prices, that stimulates more customer demand. If suppliers are willing to journey with you, they can benefit in the long term. But it may take time to get there.”
Empowering management
One reason that PE-backed companies may be so successful is because management in former subsidiaries are suddenly empowered to put plans into action. “In a buyout, management is freed up to focus wholly on their own business and what is right for it, rather than looking at other people’s agenda,” says Paul Thomas, chief operating officer of private equity firm Gresham. Management’s identification with the plan also makes a big difference, says Thomas.
“The fact that management has come up with ideas and has the freedom to deliver them means it is much more wedded to the strategy and the delivery of it. Buyouts empower people.” This suggests large corporate groups could investigate how to empower their own subsidiary management teams, to stimulate more dynamic performance.
Travelodge CFO Mortimore, who has previously worked for blue chip companies including WH Smith, appreciates the empowering nature of the PE-backed environment. “You end up with like-minded people put in charge and there is very much one agenda,” he says. “In my experience there are hardly any political rows, or rows about your direction. You can have massive rows about timing, or how you will get there, but those arguments are held in a much more positive light. Everything is more focused and life is much more simple.”
If PE life can be simpler, it can also be tougher. Fitness for the job is perhaps even more crucial in the private equity world. “Everyone focuses on the quality of management, but private equity will make changes more rapidly if management isn’t delivering,” says Simon Perry, a senior transactions advisory services partner at Ernst & Young. Jon Moulton, managing partner of Alchemy Partners, agrees. “FDs are the most frequent casualty of the buy-out or buy-in,” he says. Those who don’t make the grade will be quickly replaced.
“It is also important that management is appropriately incentivised,” says Perry. In a traditional blue chip company, a standard corporate incentivisation model may not be appropriate for all parts of the business. Similarly, salaried personnel may be less inclined to go the extra mile to achieve outstanding results. On the other hand, in PE-backed businesses, the incentivisation is very clear. Management teams are typically investors. “They are gearing themselves up to have higher debt and interest levels,” says Ahern. “These FDs have probably taken out extra mortgages and they are gearing themselves up to make more money and to do it quickly. They are in a hurry. These are not lifestyle people.”
Patrick Dunne, a director at 3i, also notes that the PE industry has extremely clear objectives. “They are probably more obvious and more clearly stated in a PE situation than in a corporate,” he says, “where the internal politics might be different and you are competing with other subsidiaries and finance isn’t as high up the agenda. In a PE deal there is a value creation plan from the outset. There is a clear number of steps and the FD will be responsible for a number of those. It’s a very energising process.”
Stimulating focus
Sometimes, the threat of a PE-backed bid can stimulate greater focus in a listed company. Ahern refers to Philip Green’s bid for Marks & Spencer. “That brought out a VC-type mentality in the boardroom to sort out issues,” Ahern says. “Stuart Rose came on board. They sold the financial services arm. They were suddenly in a hurry, but it was only when they had been bid for that they took action. It’s funny how people come up with ideas for increasing shareholder value when they are under the cosh.”
Alchemy’s Moulton sums up the focus that PE backers bring to a business. “The key thing they will do is focus on the medium-term cash and the fact that the company is on a three to five-year path,” he says. There will be a defensive focus, in terms of trying to repay debt, as well as a focus on value growth. “That’s about buying the right company, integrating the right companies, running the right IT system and getting management the right information,” Moulton says. “There shouldn’t be any difference between these things in a PE-backed company and in other companies.”
The fact that PE houses find investment opportunities suggests differences can and do exist, with some corporates not as fit for business as they might be. Moulton tells it straight: “We like buying companies with a bad structure, very poor reporting and no tax planning, because these are opportunities we can then exploit.”
