What private equity wants

Almost, but not quite; and certainly not in the UK in Year One after the pandemic when private equity, which mostly values things in terms of US dollars, sees a sterling-denominated corporate landscape dotted with appetising bargains.

Thus – mostly American – private equity is sniffing around the UK as never before (see Table 1). Not surprising, perhaps, considering how cheap much of UK plc looks in comparison with listed US companies. For this, Brexit is still partly to be blamed for its hit on sterling. As shown in Chart 1, which effectively prices the FTSE 100 index in US dollars, the value of UK stocks has withered in relation to their US counterparts. True, the tech-rich nature of the S&P 500 index has been a big factor since Covid-19 struck. Even so, the rating of the average FTSE 100 stock stands at less than 13 times its forecast earnings compared with over 22 times for its S&P counterpart. Small wonder that private equity – loaded with capital on a scale never seen before (see Chart 2) – likes what it sees.

It caused concern this spring by stomping into the sensitive space of the UK’s defence industry; first at Senior (SNR), then at Meggitt (MGGT) and most recently at Ultra Electronics (ULE). But concern turned to consternation when it went after an English icon, the supermarkets operator, Wm Morrison (MRW), which is as Yorkshire as Freddie Trueman or Wensleydale cheese and not, according to this caricature, a company to be owned by something as grubby as private equity.

Morrison’s fate might even be determined by the time you read this. Yet in the heated debate about private equity, what tends to be missing is a basic understanding of what the industry is, what its objectives are and what methods it uses to identify potential investment opportunities. Sure, private investors will rarely, if ever, understand a company in the detail that a private-equity general partner does. That is simply a function of the work that has to be done if you are looking to buy 100 per cent of a company’s equity as opposed to a few thousand shares. Yet from the private investor’s perspective, that does not necessarily matter; know a little about how PE operates and it may be feasible to anticipate where it may turn to next.

Private equity in some form has existed about as long as capitalism. The wealthy individuals who gathered in the City of London’s coffee houses in the late 17th century and formed syndicates to back individual entrepreneurs were, in effect, private equity’s first ‘limited partners’. The funds they raised were then – as now – managed by ‘general partners’ who channelled capital to the entrepreneurs who developed both England’s burgeoning trade with the world beyond Europe and an insurance industry to underwrite some of the risks.

However, the first recognised private-equity vehicle, the American Research and Development Company, was founded in 1946 and sold 14 years later for a 3,600 per cent profit. By 1958, a change in the US tax code allowed the formation of business investment corporations, which would seed small businesses with capital provided by wealthy investors and offer management advice. In Europe, the first private equity fund was founded in Germany in 1960. This took the opportunity to offer capital to that country’s vast Mittelstand of small and medium-sized founder-owned companies.

For 30 years, private equity stayed a relatively obscure and misunderstood form of finance until the financial liberalisation of the 1980s initiated waves of high profile buyouts funded with lots of debt – hence the term, ‘leveraged’. Many misconceptions of how modern private-equity funds operate comes from this era, especially the distinction between private-equity funds and corporate raiders, which was well and truly blurred by the fight for RJR Nabisco, a foods to tobacco conglomerate, in 1988. This involved any firm that was anything on Wall Street and ended with Kohlberg Kravis Roberts & Co, the original barbarians at the gate and forerunner of today’s KKR & Co (US:KKR), winning as much through its aggression as the size of its $31bn bid, which, actually, wasn’t the highest among RJR’s suitors.

Corporate raiders, or asset strippers as they are pejoratively known, act to take over distressed companies at a price level below the intrinsic value of their assets – determined by traditional balance sheet analysis – and turn a profit by breaking up the company and selling those assets for more than the total buyout price.

Traditional private equity rarely operates like this. According to management consultant Bain & Company, in 2020 the average corporate buy-out has been held for 4.5 years before being ‘flipped’, though that figure was down from 5.9 years in 2014. However, the venture capital side of private equity (not the focus of this feature) generally keeps holdings for much longer.

From its earliest days, private equity has provided an element of business advice with the aim of improving the companies it controls. After all, how else can PE funds sell on their investments for profit?

Even private equity’s more entertaining failures – the disastrous acquisition of music group EMI by Guy Hands’ Terra Firma fund at the height of the credit boom in 2007, for instance – had the goal of improving the underlying business. Perhaps predictably, EMI’s roster of artistic talent proved resistant to the productivity improvements demanded by modern management theory, as well as the cancellation of EMI’s provision of “Fruit and Flowers” as part of everyday production expenses. Even taking those factors into consideration, the ultimate failure still rested on the fact that the £2.4bn price Terra Firma paid for EMI was just too high. In the resulting lawsuit between Hands and Citigroup, Hands claimed he lost £200m of his own money because of the deal.

Terra Firma might have forgotten some of the basic valuation rules in EMI’s case. PE funds still work to specific criteria when identifying takeover targets and it should surprise precisely no one that the criteria they use are similar to how private investors should assess a company.

●  First, though not necessarily in order of importance, are questions of the market position and competitive advantages of a target company. In other words, an interesting buy-out candidate needs a wide “moat”, which means it should be able to protect its market share. There is limited point in buying into a market where barriers to entry are so low that new competitors can easily enter.

●  A business should have a least three ways in which it can grow. These are likely to revolve around its ability to expand into new territory, to acquire more customers, or to develop a variety of products and services.

● Stable and reliable cash flows are vital if debt – and the consequent leverage of equity returns – provides a substantial part of the consideration, as it will do in every conventional leveraged buy-out deal.

●  Requirements for additional capital should be low. In other words, candidate companies should be capable of generating significant amounts of cash profit from their operations; cash that will both finance future capital spending and go to the private-equity partnership that owns the company.

●  Favourable industry trends often help, as does a candidate company’s position within the industry.

●  Last, but not least, there is the question of a target’s existing management. This applies to any investment scenario, but it is frustratingly difficult to assess a management team’s capabilities partly because their performance is likely to be influenced by their incentives. Interestingly, whether by accident or design, private-equity funds often back founder-owned businesses.

Research this year by academics Nicholas Wilson, Shima Amini and Mike Wright in the British Journal of Management found particular patterns of acquisitions by private equity funds in the UK between 1995 and 2013. Their findings point to interesting – though conventional – conclusions, particularly that managing balance-sheet risk pushes PE funds to target certain types of companies. They are attracted to established companies that have a high proportion of tangible assets on the balance sheet, preferably offering good collateral, have a lower-than-average failure rate in their operations and an undiversified product range. In other words, those that tend to be cash machines. The academics also found that when private equity moved towards riskier investments they preferred high technology manufacturing industries, or service-sector companies.

In short, Messrs Wilson, Amini and Wright sum up that private-equity investors “continue to invest in companies outside the knowledge-intensive sector and choose targets that are more established, cash-generative and profitable, but can benefit from restructuring and further capital investment”.

The chief consistency seems to be that PE funds target companies that, although stable and cash generative, are underperforming their peer group for basic operational reasons. Granted, this time it might be different. The amount of capital – ‘dry powder’ – with which private equity is currently loaded sees to that. The best guess is that private equity’s fire power runs to almost $3 trillion. To put that into context, the market capitalisation of all 100 companies whose shares comprise the FTSE 100 index is $2.6 trillion. Granted, that $3 trillion covers all types of private equity, including venture capital, real estate and infrastructure funds, and not just the classic buy-out funds on which we are focused. Even so, as Chart 2 shows, buy-out funds command approaching $1 trillion. With resources on that scale even the most disciplined manager’s head might be turned.

Yet, doubtless, among the many private-equity deals that will be settled on UK soil this year there will be a range of the good, the bad and the ugly. Time will tell which fall into which category, but hindsight provides examples of the best and the worst, as the following two examples illustrate.

The Good: Pearson’s loss is BC Partners’ gain

Pearson (PSON), former owner of the Financial Times and Investors’ Chronicle, has had a rollercoaster ride since the retirement of Marjorie Scardino as chief executive in 2013 and the accession of John Fallon as her successor. A tenure marked by six profit warnings in seven years came to an end in 2020 with Fallon’s retirement. Notably, Pearson’s shares have risen by 55 per cent since he left.

The overall sense that Pearson seemed to be going nowhere under the previous regime and had little idea how to get there, was reinforced by the private equity deal it did to offload Mergermarket in 2013 to PE outfit BC Partners for £382m. Mergermarket is a business M&A information service that charges subscriptions for content that investment funds, banks and private equity funds use in their deal-making.

Unlike commoditised general news, you cannot find this sort of stuff with a Google search and finance firms have the money to pay big corporate subscriptions for the information advantage it offers. Bearing this in mind, Pearson’s decision to sell it cheaply seems even less logical. BC promptly packaged up Mergermarket with several other specialist information services, created a parent company called Acuris and sold a majority stake to Ireland-based PE fund ION Investments for £1bn in 2019, or a near 300 per cent profit on its investment.

The Bad: 3i stumbles from one bubble to the next

Technically, 3i (III) is an investment trust, but it acts much as a private equity house, providing capital to unlisted start-ups and to leverage buyouts. It relies on good portfolio management to keep debt manageable, the investments flowing and the risks acceptable. Unfortunately, that process came unstuck in the first decade of the new millennium.

The need to maintain a tempo of investments lay behind a dash into technology companies at the height of the dot-com boom in 1999. 3i was not the only fund guilty of this, but it ended up holding too many investments across too many areas, with an excess exposure to unproven technology businesses. The resulting bust sent 3i’s share price down 70 per cent, contributed to a negative total return of 24 per cent and left 70 per cent of its investments stuck in early-stage tech assets.

In an attempt to avoid such mistakes, Philip Yea became chief executive in 2004 to follow a strategy of fewer but bigger deals, while increasing 3i’s balance-sheet leverage by returning £500m in cash to shareholders. Yea, experienced as both a private-equity executive and corporate finance chief, aimed, in effect, to make 3i a bank, using return on assets, rather than net asset value, as a key measure of performance. Miserably, the impact of 2008’s ‘sub-prime’ credit crunch on 3i’s assets was disastrous and generated a negative return of 53 per cent by the end of 2009, while balance-sheet gearing soared to over 103 per cent as underlying investment values tanked. Yea left 3i that year.

So history tells us that private equity’s present blitz on the UK will produce its own horror stories. That’s made all the more likely because, according to the private-equity team at management consultant Bain & Co, currently, deals are only getting done at record multiples of profits. That presents an especial problem since PE has traditionally generated its returns via two routes – boosting the revenue of their companies and selling them at a higher multiple of profits than they bought at. If the second major source of returns is pretty well cut off then it may take all of private equity’s claimed ability to find alternative sources of profit. Either that, or it will end in tears.