Interesting that veterinary pharmaceuticals supplier Dechra Pharmaceuticals (DPH) should be a target for private equity buyers. Interesting, but perhaps also odd. After all, there is a case for saying Dechra’s business model is the antithesis of what private equity wants. So maybe the fact that the world’s third-biggest private equity fund is willing to stump up £4.6bn for Cheshire-based Dechra tells us as much about the industry’s shortcomings as it does about Dechra’s attractions.
Of course, the popular perception of private equity is that it has no shortcomings; at least, none in the commercial sense. The industry may be run by the archetypal barbarians at the gate, for whom the milk of human kindness only has relevance if it can be bottled and sold, but no one suggests these guys and gals are anything but razor sharp.
Chart 1 does not actually put a lie to that notion, but it does suggest private equity players are more Premier League average than Lionel Messi and Erling Haaland rolled into one. The chart takes the 10-year share price performance of three of private equity’s biggest players, let’s call them the ‘terrible triplets’, rolls them into one and compares the result with the S&P 500 index of leading US companies. The triplets are KKR (US:KKR), the original barbarians who besieged RJR Nabisco in the most famous leveraged buyout of them all, Blackstone (US:BX) and Carlyle (US:CG). Combined, these three run funds well clear of $2tn, or, to put that into a chilling context, approaching that of the aggregate market value of the UK’s FTSE 100 index.
The comparative performance shown in the chart confirms two reservations about private equity. First, as it gets bigger, its performance increasingly becomes average. That is the ineluctable consequence of size. In aggregate, private equity owns and runs companies whose value might be as big as Europe’s public equity markets put together, therefore it would be unrealistic to expect them to produce overall returns much different from the markets’ average.
Except that private equity’s biggest category, buyouts, runs on a different fuel from the type that powers most publicly listed companies – leverage. This high-octane stuff can deliver a bigger bang for its buck and did so during the past 15 years of low and falling interest rates. But it also comes with an inherent risk. Thus, as Chart 1 shows, the outperformance by the terrible triplets was at its most marked as interest rates dropped to their lowest while the world cowered in fear of Covid-19. Interest rates that barely registered on the gauge and a super-glut of savings then powered private equity’s best ever year for deal-making in 2021. The global aggregate value of buyouts topped $1tn spread across about 2,500 deals. Both of those figures were about twice their long-run average.
Leverage versus buyouts
The great advantage of leverage, especially when delivered via a company’s capital structure, is that it applies a fixed cost – or, more accurately, a sticky cost – to a firm’s capital. As profit exceeds that cost, most of the extra revenue flows through to the holders of the sliver of equity that owns the company; in private equity’s case, these are the limited partners, who put up most of the capital, and the general partners, who run the show.
However – and this is the second reservation – leverage comes with a brutal downside. When interest rates rise, the cost of capital rises, too. For companies with financing already in place this does not matter – or not for a while. Eventually, however, the effect of higher rates will be to siphon off profit. Meanwhile, for would-be deals yet to sort out financing, it matters immediately. More equity is needed in a company’s capital structure, which usually means lower returns. Alternatively, deals don’t get done, or – perhaps worst – get done on bad terms for private equity.
Certainly, this is the danger in an industry awash with capital to invest. ‘Dry powder’ is the trade name and, according to the 2023 Global Private Equity Report from management consultant Bain & Company, the industry ended 2022 with a record $3.7tn of the stuff. That is triple the amount of 10 years ago and almost 30 per cent is earmarked for buyout deals. Given that the effect of higher interest rates is a bit like a rising tide, ‘damp powder’ might now be a better expression for this arsenal, especially as Bain’s report adds, ominously, that “GPs [general partners] will be eager to put it to work as soon as possible”.
Fears such as these help explain the spectacular collapse in the average share price of the terrible triplets since autumn 2021 when it became clear persistent inflation would mean a return to interest rates measured in whole numbers rather than in fractions (Chart 1 again). Yet that share price collapse arguably reveals a broader truth about private equity – basically, it’s no longer that special. The days are long gone when private equity was just that – private; when its practitioners seemed to be the Knights Templars of capitalism, a semi-mystical order with privileged access to hidden truths, forbidden knowledge and powerful people.
For starters, today there are just too many private equity firms, to the extent that ‘semi-public’ might be a better descriptor of the industry than ‘private’. It’s not just that the world’s biggest private equity firms all have stock market listings, including Dechra’s suitor, the private equity arm of EQT (SE:EQT), whose shares are listed on Stockholm’s exchange. Even big private equity firms that remain privately owned are obliged to report much as if they were listed. As a result, familiarity has rubbed away the mystique and has bred indifference.
Simultaneously, it has become clear that the people running private equity are much the same as the folk running most businesses in the developed world. More or less, they have the same background, the same business degrees from the same business schools; they know the same things, say the same things, use the same spreadsheets and the same jargon; even have the same orthodontically-perfected smiles. They are interchangeable.
A proof of sorts is that it was no surprise to see that one possible link between EQT and Dechra is Kate Swann, the former boss of fast-foods supplier SSP (SSPG) and WH Smith (SMWH). She has been an EQT ‘adviser’ since 2020 and is a director of online pet supplies retailer Zooplus, which EQT was keen to buy in 2021. Thus there may be logic in EQT wanting to buy Dechra, especially as it also controls IVC Evidensia, a veterinary chain where Swann is a director and whose chief executive, Simon Smith, followed Swann from SSP and WH Smith. Similarly, EQT also has a stake in pet insurer Bought by Many, acquired via a fundraising in 2021.
Bootstrapping: growing by acquisition
On the other hand, as noted earlier, Dechra’s business model has been pretty well the diametric opposite of what a private equity owner would want. It is the ultimate ‘bootstrapping’ operation, where a company grows its earnings per share primarily via acquisitions. There is nothing especially clever about this. If, say, Company A issues new shares to buy the equity in Company B and if A’s shares sell for a higher rating than B’s then, as a result of acquiring B’s profit, Company A will add to its earnings. Simple as that.
So bootstrapping achieves what all company bosses and shareholders want – to grow their company’s earnings. The downside is that the process can foster an illusion. The growth in earnings may be real enough, but growth in value does not necessarily follow. When Company A, whose shares are rated at 20 times earnings, uses its paper to buy Company B’s for 10 times earnings, it may be buying an inferior business, whose rating is lower for a reason. As a result, A’s own rating may be dragged down. If, say, it drops to 15 times, it won’t matter that its earnings grow by 20 per cent because of consolidating B. The value of its shares will still fall and shareholders will be worse off.
This is not to say the strategy is necessarily bad. Growth by acquisition can work. In Dechra’s case, the process of buying veterinary products, often unwanted by conventional pharmaceuticals companies, seems to have worked spectacularly well, as Chart 2 indicates. Taking April 2004 as an arbitrary starting point, even after the 30 per cent fall seen since December 2021, Dechra’s share price has risen 30 times in that 19-year period while the FTSE All-Share index has not even risen two times. Further proof that investors love Dechra’s strategy is its share rating. Even now, it is about 30 times forecast earnings for the current year and peaked at about 45 times.
Yet ultimately bootstrapping brings its own demise. With growth, each succeeding deal must be bigger than the previous one to make an impression. That also means the cost of failure rises. And it is not as though Dechra’s acquisition habit looks sated. Even in the past 12 months it has done its two biggest deals to date, spending almost £400mn.
Flush with cash though it is, private equity does not want the acquisition addiction of its investments. Throwing off cash rather than sucking it in is much preferred. This may be why stock market investors seem sceptical that the Dechra deal will actually get done. Sure, by the time you read this, the situation may be very different. But at its current £37.66, Dechra’s share price is a good 7 per cent below EQT’s provisional offer. That gap may tempt in some punters, although I’m not sure I’d be one. A fair chance of a 7 per cent profit doesn’t obviously compensate for the slightly smaller chance of, say, a 30 per cent loss.
bearbull@ft.com
