A gourmet guide to private equity

In this shadowy corner of the corporate world, rich pickings are to be made by grabbing neglected morsels and spicing them up for a quick sale.

by Andrew Wileman

In the UK, three million people work for firms that have been invested in by private equity (PE). That's 20% of the private-sector workforce. Over the past five years, PE has accounted for 25% of all M&A value in the UK and 15% to 20% in Europe. Total European deal value grew from under $10 billion in 1995 to more than $150 billion last year.

In 2005, the PE guys did their first $10 billion deal in Europe, taking out Danish telco TDC. Texas Pacific Group (TPG) has just closed the biggest new fund to date, at $14 billion. In Europe, up to $200 billion of private equity may soon be looking for a home; add two to three times that in debt capacity and you have a $700 billion war chest, which could buy 25% of the whole FTSE-100 index.

Rumours were flying in March about a $35 billion bid for BT. A German politician called PE practitioners 'locusts', munching the assets of European business - while Frankfurt was happily hosting the annual SuperReturn industry conference, a discreet gathering of serious money.

Some of the UK's top private-equity deals of the past five years include Moto service stations, Coral bookmaker's, Travelex, Somerfield, AA, Saga, lots of pubs, Gala bingo, NCP, Travelodge motels, Brake Brothers catering, Yell, Le Meridien. So if you're in your fifties and taking a drive up the M1 and you eat in a motorway service station, stay at a roadside motel, sink a pint in a Unique Pub, break down and get rescued by the AA, then look for a new car in the Yellow Pages, you're in PE land.

In the 1980s with KKR and RJR-Nabisco, the barbarians were at the gate.

Now they're in the Capitol, at the banqueting table, bumping into Caesar's statues and raiding his wine cellar. How does this shadowy industry acually work? Here's the MT lowdown ...

For a start, there are a lot of these guys. A great analysis by Bain, the strategy consultancy, which has a large PE practice, gives me the facts on all PE deals in western Europe valued at more than $75 million over the past 10 years. There are just over 1,400 deals, total value $600 billion. They involved more than 250 PE players. The top 20 account for about half of the money. The top two, CVC & Cinven, account for 4% to 5% each.

The leading European PE houses are listed in the table on page 35. Most business people would know only a few names. These businesses don't go looking for publicity.

What are some of their key characteristics? Almost all are independent specialist firms. They're not part of top-drawer investment banks like Morgan Stanley, or of monster financial institutions like Citigroup.

Many started out that way, but were spun out of their banking parents.

The only mainstream investment bank in the top 20 is Goldman Sachs. The US-based firms (KKR, Blackstone and TPG, all in the global top 10) are specialist start-ups.

These highly influential firms employ very few people. In Europe, the average team of investment professionals might be 40 or 50 people, including 10 to 20 partners. But it's often much less - the top US players have only five to 10 partners and 15 to 20 staff. Most of the leading businesses in Europe are still European or Euro-centred, although the three US players are among the largest operators here.

The personalities of those who run them are low-key - a big contrast with entrepreneur dealmakers like Philip Green or Robert Tchenguiz (see MT Interview). Who on the list is known outside a tight circle of financiers?

Perhaps Guy Hands. Apart from occasional forays to Davos and Frankfurt, the PE world is discreet - with good reason, given the private net worth that is being created for each partner.

How does it all work? What do these firms actually do? And what is the basis of private equity growth and investment returns? Most PE buyouts are corporate divestments: big public corporations selling off an unloved or non-core business. A Cinven analysis of 300 or so large European deals from 1996 to 2003 broke them down in percent-of-deal values as: 54% corporate divestitures; 19% secondary buyouts (one PE firm selling on to another); 13% public-to-private (buyouts of whole public companies); 7% family; and 6% other.

A steady supply of assets comes on to the market. Public corporations put assets on the block for several reasons, including diversification strategies that have failed and now need to be unravelled; a negative view on business prospects; or limits on the amount of debt they can take on to boost equity returns.

But big corporations don't usually give away assets at a massive discount.

PE buyers have to have ways to extract extra value, since they are looking to achieve two to three times their equity stake over a three to five-year period. They might list their methods as...

Leverage (gearing). PE deals ratchet up the ratio of debt to equity.

So buying a business valued at $1 billion that under its previous owners had little debt might be financed by $250 million of equity and $750 million of debt. If overall business value can be increased by 25% to $1.25 billion, equity investors make a 100% return on their money: $500 million back on $250 million invested. PE deals can do this because the PE investors have made a better assessment of the real cashflow risks (or not) of the business and invest only in quite safe, bond-like low-growth businesses.

Business focus and timeframe. PE owners are focused on that simple math of 2-3x equity in 3-5 years. The need to meet much higher interest payments forces a focus on urgent cash generation and urgent debt pay-down. So non-core assets are sold, cash costs and capital expenditure ruthlessly pruned and investment focused on the core (products, customers, channels) with a short payback horizon.

Management motivation and effectiveness. As part of the re-financing deal, the top management team can buy in to a large equity upside, along with the PE owner, so they are better motivated. And they become aligned with shareholder objectives around cash generation and a three to five-year exit - in contrast to the more complex long-term career motivations of managers in large public corporations. Moreover, managers in public companies are now under intense regulatory scrutiny as well as relentless pressure to demonstrate quarterly earnings performance. This is both distracting and disabling; in contrast, working for a PE owner can be refreshing and empowering.

PE owner activism and close control. PE owners maintain a tight grip on their investments and sit on the board, often intervening aggressively to drive strategy, performance and management changes - in contrast with the distant, diffuse and passive relationship between institutional shareholders and public companies.

The above is the PE industry's official line, anyway. Here's the cynic's view, Mr Startlingly Frank PE Partner speaking ...

Big corporations often do stupid diversifications that take a decade to unwind; when they decide to put things right they want to do it yesterday, so they flog stuff off at fire-sale prices.

All I do is borrow a shed-load of money and whack up the gearing, hack out all discretionary costs (particularly waste-of-space head office staff), flog off as many assets (business lines, properties, brands, anything else) as I can a.s.a.p., and stop paying my suppliers for six months - then flip the business quick before anything turns nasty. And I get my debt funding from those perennial suckers the big banks, which are quite happy taking on huge extra risk for an extra 100 basis points, since today's lending manager will be long gone with his bonus when the debt recoveries team is called in.

I can do all this with near-zero fixed cost in my PE business and no personal investment, and take 20% of all deal profits, plus an annual fee of 2% of asset value to keep my tailor happy.

While I'm stuck with owning the business, I dangle some serious dosh in front of the CEO and his sidekicks to wake them up. This is, after all, the same mediocre management team that has been running the business for the past 10 years. Then I bang the table and shout at them when they miss this month's Ebitda budget (I call this my Proprietary Value-Added, a.k.a. my 100-Day Plan).

But I'd have to admit that if you adjust for different levels of gearing, long-run returns from private equity are no better than investing in the general stock market - I've been riding a rising tide for the past decade of ever-lower interest rates and increasing asset values ...

Where does the truth lie, between the industry's view and the cynic's view? Take the question of relative returns to investors. The PE industry talks about expectations of a 20%- 25% after-tax return on a fund, maybe now being cut back to 15%-20% as deals get more expensive. This is a stellar number if achievable, truly the holy grail for any large pension fund looking at 4% pre-tax returns on 10-year gilts. No wonder institutional investors are throwing a wall of money at private equity.

But it is actually difficult, if not impossible, to get any good objective long-run data on this issue. Most of the huge investment growth of the past 10 years is still tied up in ongoing funds. PE firms themselves provide almost no insight into long-run investment performance. The past decade has been a consistently benign environment for highly leveraged deals, with low and declining interest rates, the longest run of strong GDP growth in history and low default rates on junk debt.

The best attempt at scientific evaluation has been made by David Swensen, chief investment officer since 1985 for the Yale University endowment fund, in his book Pioneering Portfolio Management (2000). Looking at more than 500 PE deals between 1987 and 1998 (a great period for equity returns), he compared their returns with the one you'd have made on the S&P-500 if the same levels of leverage (debt to equity) had been applied - which they weren't. He found that average PE returns were much lower than the Standard & Poor's. PE's excess returns came from taking on excess risk and they didn't get enough reward for that risk.

This was true of the PE industry as a whole. The top-tier firms consistently outperformed the average, so the top players may have a real edge in dealmaking and execution. But you can't just bet on the PE model on average to get superior returns.

Who is at the top of the food chain? Who gets the red meat and who are the dung beetles? There are two big red-meat winners: top management at the companies invested in and the PE partners themselves.

The UK Centre for Management Buyout Research recently produced the first extensive study of who makes what out of management buyouts. They looked at more than 300 PE-backed British deals over 10 years from 1994 to 2004.

Here are the average numbers.

The average deal value was £330 million, of which a third was equity.

Average equity profit on exit was £290 million (a high multiple of equity investment in this favourable period). Top management received about £50 million of that, PE firms got £60 million, and PE investors got the balance, £180 million.

Top management typically means a CEO plus a core team of between five and 20. The CEO might get up to 30% of the £50 million (£15 million).

The next top 10 managers might share £30 million to £40 million.

So these 300 deals created 300 CEOs with a net worth of at least £15 million each - if they did only one deal. For serial PE-backed entrepreneurs like Rob Templeman and John Lovering, the duo until recently resident at Debenhams, net worths could be £100 million-plus. But such cases are rare. The basic CEO expectation on a good-sized deal would be £10 million to £20 million-plus over five years.

This is a lot bigger share of the pie than management would see in most large public companies in the UK, even with an expanded business and even given the upward momentum in top management pay packages. Take Stuart Rose at M&S. If he doubles M&S's profit over five years, he is reported to be on an incentive package of about £10 million (plus base salary, pension etc). But if M&S were a private-equity deal, with a normal stock allocation to the CEO, Rose would be looking at an upside in the £40 million to £50 million-plus bracket - taxed as a capital gain in Luxembourg rather than as income in the UK.

So private equity is often viewed as the investment model that is shifting the balance of power and return away from capital - now over-available and cheap - towards the scarce resource of good management talent. The star PE manager can extract a star package, like Beckham and Rooney. But what about those senior long-serving partners at the top PE firms? They've gone very quiet. They like to promote the idea that PE super-returns accrue mainly to management talent.

Let's look at their numbers. Ignore the annual 2% management fees and other services fee income (at least $1 million a year per investment professional) and assume that just pays the rent. Focus on the juicy fillet, the 'carry', the 20% share in eventual equity profits.

Say a Top 10 European fund has a cumulative deal value, over multiple funds, of about $20 billion (see table above). Given a 2:1 ratio of debt to equity, that's probably $7 billion of equity. Let's say that the average eventual equity value or payout (over the last 10 good years) is 2.5x; that's a $10 billion profit, on which the fund's carry, at 20%, is $2 billion. If that $2 billion is shared out mainly among, say, 10 senior long-serving partners who've been with the firm for 10 years, that's $200 million each.

Even making a conservative reduction to that calculation, we can assume that out of the top 20 European PE firms there are at least 100 senior partners in the £100 million-plus net worth bracket and several heavy-hitters well into the £200 million zone. At least half of those hundred-millioners are London-based - the annual City Rich List seriously underestimates the number of PE names.

To give another context: these are players who felt they had to take their business out of the top investment banks, because these institutions wanted, reasonably enough, to split the deal profits in return for their brand, network and capital. The PE partners didn't need to split anything - they could raise the cash on their own and make more money outside Morgan Stanley or Goldman Sachs. (Cash is not the only consideration: there are often problems with client conflict inside an investment bank.) Management might now get to eat steak, but the financial intermediaries and packagers still get the prime cuts.

If PE partners are the top predators, who are the herbivores, the dozy sheep? In poker speak, who's the fish? (If you look around the table and you don't know, you're it).

No prizes. It's the debt providers, the banks and other lending institutions.

They take on 80% of the risk and get 20% of the reward. They've had a long lucky streak with low default rates, but at some point the chickens will come a-flapping.

As they did in the late '80s on high-leverage deals like Isosceles (then Gateway, now Somerfield, a great repeat deal-churner) and Magnet. Or more recently in the bitter-sweet tale of BoxClever: Guy Hands at Nomura doing a great deal on Robin Saunders at WestLB, leaving WestLB with a $600 million write-off. The RJR-Nabisco deal never made money for its lenders and investors, only for KKR. (But gearing ratios of 10:1 were common then, making bankers look as prudent as Gordon Brown now.)

Is PE growth accelerating or peaking and actually about to decline?

Most PE professionals I spoke to think the answer is somewhere in the middle. The growth of PE is a long-term secular trend, because of all the factors described above. But we could be at the peak of this cycle (graph 1, p34). In fact, PE's share of total M&A deal value in the UK has already come down significantly from its peak in 2003, at 33% down to about 20% (graph 2). The growth cycle may have longer to run in Europe.

If PE is peaking, it's because the extra value it can add to an asset has been reduced. On one end of the equation, the sellers of those assets - mainly the big public corporations - are capturing more of the value.

Stock market multiples have recovered from their 2002 lows. Corporations are doing to themselves more of what a PE firm would do to them: gearing up, getting rid of non-core assets, cutting costs, giving cash back to shareholders.

Trade sales and mergers have made a strong comeback, with better valuations and the extra synergies that a PE deal cannot match. For example, Aviva's $30 billion bid for Prudential was partly based on annual operating synergies of $500 million, which (capitalised) would account for 25% of the bid price.

On the other end of the equation, PE buyers are having to pay higher prices. All significant deals now go to auction. Price/Ebitda multiples have gone up from about 6x in 2002 to 8-10x. Debt-to-equity ratios are up from 2:1 to 3:1 or 4:1. New animals are snuffling round the trough and driving up prices - like hedge funds, or banks dealing direct with management, trying to get a bigger piece of the pie.

There are other indicators of peakiness.

Secondary buyouts (one PE firm selling on to another) are increasing - churn by any other name. Inexperienced second-tier and third-tier banks and institutional investors are piling in. Old PE hands are tut-tutting about clumsy hedge funds. (Even U2's Bono is in, with a $1 billion media fund, Elevation Partners). Some lenders have stopped bothering with tight covenants, a cornerstone of the PE rationale. And some smart money is looking forward five years to see vulture funds scavenging around the carcasses of bank lenders' PE portfolios.

As PE gets more competitive, its market leaders know they have to evolve.

They have to find ways to add more value to the deals they do and to their own business model.

Most PE firms already claim they add lots of value. Every website blurb gives you a flavour and every fund-raising memorandum has the same list.

Geoff Cullinan, a senior adviser at Bain & Co's PE practice, summarises the following as the great lies of private equity: 'We are top quartile' (69% of funds in a recent survey said they were); 'We only do proprietary deals - with an inside track/unbeatable angle'; 'We have deep sector experience in our areas of speciality'; 'We back management'; 'We do really good 100-day plans'; 'We add value to our investments'.

According to Cullinan: 'Everyone talks about this, but very few deliver it. Only a handful of funds will consider radical restructuring, and no-one does turnarounds.'

Also, PE firms may look as though they have a lot of deal and business experience, but individual partner experience can be narrow. The four leaders are doing four to six deals a year (value over $75 million), across 10-20 partners. Any single partner could be managing only a handful of big deals and businesses over a five-year fund life. A partner interviewed for this article remembers one of his peers being shell-shocked recently by having to do his first-ever CEO firing, after 15 years in the business.

My own consulting experience bears out that view. I'm working with two businesses owned by PE firms in the European Top 10. In one case, the partners are happy to learn about the business and support a successful management team (this team is also happy: board meetings have become crisp and intelligent). In another case, the PE firm did close to nothing for several years on a misjudged and badly performing investment and is only now being proactive in a tough cost-cutting exercise.

But the top firms are getting serious. Clayton Dubilier & Rice (CDR) has Jack Welch evaluating and overseeing investments. Lou Gerstner, ex-IBM, is chairman of Carlyle. KKR has brought in several former operating managers as partners - a third of their 27 senior executives are now ex-operators, up from none 10 years ago. TPG is a similar story.

PE firms have always been active users of consultancies such as Bain, OC&C and McKinsey. Some are bringing those skills in-house, either by hiring ex-consultants or setting up internal consulting units (eg, Capstone inside KKR). Like consulting firms, they are trying to develop in-depth sector specialisations, such as media or retailing. And they are trying to move the agenda on from the old formula of gear-up/cost-cut/asset-flog/cash-squeeze. Most now talk about growth strategies and accelerated investment.

So really adding value, not just talking about it, is on the PE agenda.

But they need to add value without becoming the very beast that PE emerged to exploit: the over-staffed, interfering conglomerate, second-guessing and under-mining line management and introducing value-destroying staff processes. When visions for growth start getting discussed, it all starts to sound very like the old conglomerate head office. It's a tricky line to walk.

PE will pursue two other routes to maintaining super returns: bigger deals and global reach. Bigger and more complex deals can reduce the level of price competition and limit the field to only the biggest PE firms.

To do these deals, top players are banding together more frequently - 'clubbing'. At $15 billion enterprise value, TDC had five PE firms involved (Apax, Blackstone, KKR, Permira and Providence); and Amadeus at $6 billion had BC in with Cinven. But there are risks here too; they could undermine another old PE raison d'etre: a single close owner with a simple strategy.

Extending global reach can bring new opportunities to PEs. The leading US players have already fanned out into the UK, continental Europe and Japan. Now they're looking further afield. KKR has just done the biggest PE deal to date in India, buying out Flextronics' Indian software unit for $1 billion. Blackstone's fourth office, after New York, London and Hamburg, is in Mumbai.

Will the European PE market continue to be dominated by European firms?

This is hard to call. Several partners now express doubts. The US players have stronger global reach and increasing global ambitions, are buying increasingly global businesses and raising funds from investors with global horizons. They also give a lot of fee income to the big investment banks that control the sell side and this buys a lot of reciprocal back-scratching.

It smells a bit like UK merchant banks in the 1980s: they couldn't see why their market logically had to end up dominated by US investment banks, but that's what happened.

The next big deal? ... 'Holy shit,' says Ross Johnson in the Prologue to Burrough's and Helyar's Barbarians at the Gate (1990). 'Now we've got to find seventeen billion dollars.' Global M&A volumes are now back over $3 trillion, up from a low of $1.3 trillion in 2002. It's feeding time again. Private equity is already a high-profile player in this latest M&A frenzy. And it has bigger fish to fry.

In 1986, RJR Nabisco was the biggest PE deal ever. It still is: $30 billion in 1986 money equals more than $60 billion today. That would put it up there with the biggest non-PE M&A deals of the past two years - trade deals like P&G/Gillette and AT&T/BellSouth, both worth about $60 billion.

Last year's $15 billion TDC deal was a nice hors d'oeuvre, Europe's biggest PE deal yet. At the banqueting table, the barbarians are eyeing up the main courses, the $30 billioners and $60 billioners, sharpening their knives ...


One of the UK's most successful managers in private equity, John Lovering has been a chairman-investor in nine deals over the past decade, including Odeon, Homebase, Fitness First, Debenhams and Somerfield. His three secrets of PE are: 'Buy well, sell well and don't mess it up too much in the middle'.

If there's no difference between good management in private and public companies, how can PE do it better? 'Get rid of initiative overload,' he urges. 'Public companies are run by clever people issuing new ideas every Monday.' So banish those nice-to-have initiatives. 'Weaken the staff departments - make heroes out of the line. If your job is called integrative strategic advisory consultative person, you are out of a job. Raise the bar.

'PE change can be very Maoist. It's a one-off opportunity to set higher expectations.' But, admits Lovering, it's very difficult to stay radical for long. 'So we don't allow ourselves to get bored; we make it explicit with our goals and our three to five-year time-frames.'

In a PE regime, executives and shareholders have the same goals. 'The IT head is no longer interested in doing the best SAP implementation ever so he can put it on his CV, unless it really generates cash.' None of this is unique to PE, though. You could achieve it in a public company environment. 'But that doesn't seem to happen so often, or so well.'

The burden of proof is on public companies, which need to simulate what PE does. 'Joint stock companies were invented in the 1800s. They were great when you needed to build railways with great slabs of money. But now they must stay relevant to investors and management,' Lovering argues.


Value (dollars bn)

AA 3.2
SAGA 2.4

S&N PUBS 4.2

NCP 1.2

YELL 3.0

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