Risk & Economy » Regulation » Private equity will help fund recovery

As the economy slowly returns to health, UK businesses of all sizes are once again beginning to focus their attention on growth. But with banks still cagey about lending to anyone but the most creditworthy companies, and public markets remaining too expensive to access for smaller businesses, there is a scarcity of traditional capital available to give flight to any growth ambitions – so much so that Mervyn King, governor of the Bank of England, recently described the situation as “heartbreaking” in an address to Parliament.

Lending to UK business fell by almost £30bn over the past 12 months, according to UBS, while Bank of England figures show that loans to business dropped by £2.3bn in May, the third straight month in which lending fell.

The public markets have provided scant relief, as there were virtually no companies coming to market in the UK over the past 18 months, except for large and heavily-geared companies undertaking rights issues. And even those struggled to get off the ground. Ocado, the grocery delivery business which is part of Waitrose, pressed ahead with its planned flotation in late July, despite concerns of getting the IPO away in choppy financial markets. But even that traded at a heavy discount as the rights issue showed Ocado’s market value to be around £853m, compared with its own estimate of £1.2bn.

Others have also struggled. Merlin Entertainments, which runs Madame Tussaud’s and Legoland, pulled its planned £2bn flotation, while airline ticketing outfit Travelport abandoned its planned listing in February.

The situation has been even more difficult for SMEs. “To all intents and purposes the public market has been closed to small businesses. The public market is bearish rather than bullish. A lot of smaller public companies can’t raise money to grow their business,” says Ross Marshal, chief executive of Dunedin, a private equity outfit specialising in UK mid-market buyouts of between £10m and £75m.

No one expects that situation to improve any time soon. Nigel Reynolds, partner at PricewaterhouseCoopers, does not expect the market to open very much before next year and, without funding, SMEs cannot afford the cost of listing when there is scant promise of any return from the markets.

Even though private equity houses have had their own horror story of late, this has created an opportunity for some of them to fill the funding gap where creditworthy SMEs with a strong proposition are concerned.

“If we were to go to the Alternative Investment Market, the price of the transaction and governance costs is very high. It is only worthwhile if you are looking at a significant capital injection,” says Richard Lee, CEO of Creativity Software, a global supplier of location-based services to mobile network operators. The company received funding in April this year from MMC Ventures, a venture capital outfit that invests growth capital in UK companies.

Other SMEs also view private equity as the preferred funding alternative. “We are a £15.7m turnover business and public market funding is not really on our radar,” says Paul Keen, finance director of etc.venues, a provider of city centre training and conferences that was bought out by its management in a £21m deal in 2006.

But there are pitfalls to private equity growth capital. Most funding comes with strings attached. Investors typically look for a return of around 30 percent every year until exit – but there are more benefits for SMEs than just the cash injection. Most private equity investors are keenly involved in delivering a businesses’ growth in a short space of time and can table considerable experience in doing so.

That can be as powerful as it can be a burden. “You do hear horror stories of companies struggling with private equity and venture capital investors,” says Creativity Software’s Lee. “It is expensive money, but we got a fair deal with MMC.”

For SMEs, etc.venues’ FD Paul Keen believes that the downside tends to be worse for large companies. “A lot of that tends to happen in mega deals. Generally they are supporters of business,” he tells Financial Director. “Where the model works well is the triangle it creates between private equity, the business and banks: both parties have got the same interest in growing the business and banks like the fact there is oversight – that is not just the management. The money comes with huge benefits.”

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FD Report: SME funding

By Financial Director