Denise Kingsmill: Are private equity firms venturers or vultures?

PE firms aren't all grasping asset-strippers. They also bring logic and persistence to distressed firms.

by Denise Kingsmill
Last Updated: 31 Aug 2010

Private equity (PE) has had a bad rap of late. Could this have anything to do with its name? Private anything these days smacks of secrecy, exclusivity and unfair advantage - think private schools, private medicine, private jets. And equity seems to be the very opposite of the debt mountain associated in the public mind with a PE deal. A change of name could help, but what the industry needs is a greater commitment to transparency and openness.

Despite the silky skills of Simon Walker, CEO of the British Private Equity & Venture Capital Association, PE seems to be mired in controversy, and its 'strip-and-flip' reputation persists. The unravelling of many well-publicised boom-time deals, such as the buyout of estate agent Foxtons, fuels this idea.

A clearer understanding of just what PE is and how it works would be a good start in improving its reputation. As bankers have discovered to their cost, a big perception gap can arise between industry insiders convinced of their own worth and mere mortals, whose bonus-free existence leaves them lacking sympathy for those whose work is, in the words of FSA chair Adair Turner, 'socially useless'. If PE is not to be tarred with the same brush as banking, more needs to be done to convince the outside world of its benefits to economic growth through entrepreneurialism.

In essence, PE is a way to invest in firms that are not publicly traded. It can take a number of forms. Venture capital is sometimes known as vulture capital because of the ruthless price extracted from company founders, who can find their stake severely reduced in exchange for hard-to-come-by start-up capital (we've all seen the opportunist would-be investors in Dragons' Den). Then there's mezzanine financing and the leveraged buy-out (LBO). This last form of private equity flourished in the boom times of cheap and readily available debt.

An LBO involves a private equity firm buying a public company - usually in conjunction with its management - by paying off its shareholders and running it privately. To do this, it injects its own capital and borrows money against the prospective future earnings of the target company - ie, leveraging. This allows the PE firm to acquire much bigger companies than it could otherwise afford. It then sets about finding efficiencies and cost reductions outside the regulatory limelight in which plcs have to operate. Sometimes, conglomerates too complex or extensive to be manageable are broken up into smaller, more agile and profitable companies. At others, brutal cost-cutting follows an LBO, involving redundancies, factory closures and management shake-outs. It is this that has given PE a bad name in some quarters.

But the other side of the story is illustrated by companies such as The Works, Allied Carpet Retail, Davy Markham, Crown Paints, TMD Friction, Waterford Wedgwood and Denby Pottery, which have been rescued from near-certain collapse by PE firms willing and able to turn them round. Manufacturer Davy Markham, for example, was bought for cash by Endless Private Equity, which invested in fixing systems and incentivised management. Endless turned it around into profit with union support and reintroduced an abandoned apprenticeship scheme. Endless also turned around Crown Paints, which, rather than going into receivership with possible large-scale losses, is now profitable for the first time in a decade.

A significant number of PE-owned businesses show strong growth and profitability through the recession. Well-known companies such as Poundland, Alliance Boots and New Look have bucked the trend in their sectors and are well placed for further growth after the downturn. Lesser-known companies such as consumer rentals business Brighthouse and pet store Pets At Home, owned by smaller private equity firms, have posted similar results.

Usually, when a company is established as profitable, the PE firm will seek to exit either by selling it to a trade buyer or returning it to public shareholders through an initial public offering - a form of corporate recycling. If its operations have been improved while in private hands, this is good for the public market. But criticism arises if the company is loaded with debt when it returns to the market, especially where the debt has been used to finance 'special dividends' for the buyout firm.

Private equity should not be seen as a white knight for every failing business, but it can take on challenging situations that conventional investors might shy away from. It also has a business model that others could learn from. With executives' money tied up in the business and rewards paid out only when a company is successfully grown and sold, there are no rewards for failure and no bonuses contingent on short-term speculation.

PE will have to adapt to a world of scarcer and more expensive debt. It will have to improve companies through operational means rather than financial engineering. The industry probably faces more regulatory scrutiny, as this is the tone of the times. What is vital is that it should not get caught up in blanket regulation designed to protect against systemic financial risk - which PE does not pose. As with all regulation imposed ex post facto, there's a risk of throwing innocent babies out with dirty bathwater. The industry can best avoid this by putting its own house in order, throwing some light into dark corners and emphasising the social and economic utility of what it does over and above the shedloads of money it enables some to make.

Baroness Kingsmill CBE has been a non-executive director of various private and public boards. She is a non-executive director of British Airways and Korn/Ferry International.

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