The Private Angle

Mergers and acquisitions used to be the almost exclusive preserve of the corporate sector. But recent data from JP Morgan reveals that private equity buyers accounted for 10% of such deals in the US and 20% in Europe from Q1 2001 to Q2 2004. Increasingly, corporates, particularly publicly listed ones, face stiff competition from institutional buyers when bidding for businesses.

Mark Pacitti, private equity partner at Deloitte, scotches the old myth that trade buyers will pay more for a business than institutional buyers. “It is often the case that financial buyers will outbid them,” he says. “You may find when you get down to the last three bidders for a business that they are all financial buyers.”

With $150bn available for investment in private equity in the US and UK, according to JP Morgan, institutions certainly have the financial strength to compete against trade buyers. But some argue that that competition is unfair because corporates are fighting with one arm tied behind their backs.

“Private equity firms have been able to raise and then pay down low-cost debt during the recent low interest rate regime,” explains Ken Lever, FD of UK/US-listed engineering group Tomkins. “Their timescales have tended to be three-to-five years. They have been in a better position than many corporates that, because they are principally concerned with growing the value of their business, have to look at a much longer timescale, say, between seven and 10 years. At the same time, because of the scrutiny they are under, they are less able to leverage themselves as highly as a private equity firm,” he says.

Hence, as debt is cheaper than equity, institutional buyers have an advantage over corporates in that they can justify paying higher prices – and generate lower returns – and still make economic returns for their investors.

Lever adds, moreover, that if you gear up your capital too highly a significant risk premium attaches to your cost of equity as shareholders start to worry. Not so with private sector financial buyers.

The higher leveraged buyer can also offset the cost of interest against tax which, in effect, amounts to a subsidy from the taxman that the hamstrung listed corporate cannot enjoy to such a degree. Dividends, of course, are not tax deductible.

And private equity buyers (and their management teams) can gear up so that it takes just a small increase in the enterprise value to result in huge returns for the equity holders.

Or perhaps financial buyers simply overpay. “Sometimes we can’t understand the prices they’re prepared to pay,” says Lever. “We look at the strategic fit, the synergies available and the sort of multiples that financial buyers are bidding and it seems the price is much too high.”

Others will argue that the real issue is not whether the playing field is level but what is better for the business.

John Snook, senior partner at Close Brothers Private Equity, says that private equity buyers give greater motivation to management because of the greater financial gain they can make as part owners of the business.

“Private equity firms don’t go bust,” he adds. “A surprising number of acquired businesses are subsequently offered back to the vendor due to the pressures facing a trade purchaser – perhaps from overextending on the acquisition trail or from other businesses. This just doesn’t happen to private equity houses.”

In such a discussion there is a risk of a one-size-fits-all expectation, that either a trade buyer or private equity is always the right way to go. Pacitti suggests getting back to the fundamentals of the business. “Who are the shareholders?” he asks. “What are the business activities, strategies and objectives, and what is the ambition of the management team?”

Once you’ve assessed these factors then the path to follow might be clearer. A trade buyer might, for example, find synergies to exploit in the acquired business. Being able to harness the resources of a large group may spur a smaller business to heights it would have struggled much longer to scale. Equally, if the business for sale prides itself on its independence and team spirit, big corporate ways might not be the best way of driving it forward.

Pacitti explains that trade buyers tend to change strategy. “They may start unbundling their non-core activities and this may result in a previously acquired business being thrust back onto the market.”

It may be that focus on p/e ratio and capital structure is not the best way to look at a business. That is certainly the view of Debenhams FD Chris Woodhouse. The former FD of Homebase and deputy chairman of Halfords – both of which were supported by private equity – says the key to their success is in good management practices. “Managing a company well is not dictated by who the shareholders are.” At Homebase, for example, the management team grew the sales line by 18% in a year and a half. “The reason the Halfords float was so successful is because the sales line and medium-term growth prospects in the business were strong,” he says.

Not surprisingly, Woodhouse prefers doing his current job in a privately held business because it is easier to be outside the public gaze. He also believes the rewards available are greater. But public gaze and rewards aside, the idea that private equity providers are short-term supporters is no longer the case. This may have much to do with the difficulty of finding exits, either through public markets or via a flotation.

Michael Queen, FD at FTSE-100 company 3i, Europe’s largest venture capital business, is able to see the arguments from both sides. “When we invest in a business, we typically expect to hold the company for anything between three and eight years. We always assume we are going to sell that business to a sophisticated buyer, so we strengthen that company’s business model and market position because we want to make it attractive. We look at that business’s position in its market for a period of 10-to-15 years. And that is positively glacial by quoted company standards.”

Queen believes there has been a trend over the past 10 years of talented management moving to privately funded companies. “They prefer to be involved in driving the business model, not being involved in corporate governance,” he says (see article, page 24).

Finance directors share the view that businesses supported by private equity offer more attractions than public listed companies. With a moribund stock market, for the most part unwilling or unable to provide new equity to businesses, and private equity funds bulging at their seams, the future looks like one-way traffic. This poses some interesting questions about the role of stock markets in providing equity and where investors should go to get the best returns – but that’s another story.