Fitness drive, learning from private equity firms

Lean, 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.”