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Trends in Private Equity Michael Joseph Lloyds TSB Development Capital New sources of money Over the past decade there has been increasing acceptance of privateequity as an asset class f

Private Equity

Trends in Private Equity

Michael Joseph

Lloyds TSB Development Capital

New sources of money

Over the past decade there has been increasing acceptance of privateequity as an asset class for fund managers Although UK fund man-agers have yet to commit as much as US fund managers to privateequity (private equity is 0.5 per cent of asset allocation in the UKversus 2 per cent in the US), this recognition has created enormousgrowth in the sector It has been driven primarily by the very strongreturns made by private equity investors, particularly as a result ofseeing private equity funds buying cheap as the economy came out ofthe last recession, then make fabulous returns on flotation or trade sale

at the top of the market There is now £41billion worth of investmentunder management in the private equity sector (according to theBritish Venture Capital Association)

This growth has a number of implications:

1 There has been a tremendous swing towards managing money forother people, as opposed to own-balance sheet finance The differ-ence between own-balance sheet funds and managed funds is thatmanaged funds have to be returned to their owners at some stage

If a portfolio has to be liquidated according to a fixed timetable, thenthose managing the investment will naturally want to pursueopportunities which offer short-term gains rather than long-termgains, and gains which can be easily realised

2 Funds are getting bigger The natural response to this is to look forbigger opportunities The result has been that competition for thelargest buy-outs is very tight

3 Funds are looking to Europe for opportunities As the UK privateequity market has become more competitive, the European markethas begun to look very attractive

The result of these three trends is that the sources of capital available

to you if you are running a small to medium-sized enterprise (ie up to

£30m value) have probably declined

Furthermore, within the SME sector the trend has been towardsmanagement buy-outs and buy-ins, because there is a perception thatthe returns are great and the risks are small It is also easier to engineer

an exit from a buy-out within a short timescale The result is that most

of the venture capital funds available have been going towardsrestructuring ownership rather than enabling entrepreneurs to growtheir businesses

Less money is invested in development or expansion in the UKthan in the US This has meant that the willingness of quality man-agement to go into start-ups and developing the potential of SMEs

is very much less than it is on the other side of the Atlantic TheBritish venture capitalist is not a venture capitalist in the true sense

of the word

While the big funds in the UK market have been concentrating onbig deals and looking to Europe, this has not necessarily been a totalsuccess for all concerned

The unanswered question about the current European ment is whether the deals that have been done will generate liquiditywithin the time frame of the funds It is still doubtful whether fundsdevoted to France and Germany are making an adequate return oncapital now, ten years or more after the market was first opened up Ifthere are any winners they will be in the big ticket deals

environ-The downturn in 2001 will have a knock-on effect on the privateequity sector In times of financial turmoil, people launching newfunds will find it harder to make their targets It should be remem-bered that historically a downturn has been a very good time to invest

in private equity The three to five year time horizon means that one isbuying at the bottom of the cycle and selling at the top

The tax environment is now very much more favourable to venture capital investment, both at the institutional level and

the individual level, than it was ten years ago This alone may beenough to ensure that private equity prospers in difficult times.

It is unlikely that fund managers will reduce the assets allocated toprivate equity because of short-term conditions in the public markets.There is now an awareness of entrepreneurialism Most people nowwant to work for themselves There is no longer any security in a bigcompany There is a wide appreciation of the benefits of equity own-ership It has been a quiet entrepreneurial revolution It is not going toturn back

Trends in Private Equity 85

Case study

Lloyds TSB Development Capital (LDC) and SMEs

Lloyds Development Capital’s view of the market is differentfrom many of its competitors It has concentrated on the UK and

on the SME market within the UK It has no intention of raisingoutside funds, so it can take a slightly longer-term view of itsinvestments than it would have to if it were operating a closedend fund

As part of its strategy of supporting SMEs, it has been ing its activity outside London It now has offices in Nottingham,Reading, Leeds and Birmingham, as well as the capital

diversify-Over the last few years, LDC has become one of the largest andmost active venture capitalists in the UK (it is the leading investor

in the mid-market sector) It has invested in over 350 businesses

in its 20-year history, recently investing £105 million in 25 deals in

2000 and £115million in 27 transactions in 2001

Typical of the type of deal it gets involved in is Encon

The Encon story

In 1987, LDC led an equity syndicate of five members whichinvested £2 million of risk capital in the Encon Group Encon, aprivate company, was then a distributor of insulation materialswith a small number of depots in the UK and a contracting/instal-lation subsidiary

Encon’s trading track record, pre the equity investment, was asfollows:

over-(i) re-start of the plants, including additional engineering capitalexpenditure;

(ii) working capital to cover the planned growth of stock anddebtors for the expansion in group trading activities

The equity investors obtained an equity stake of 22.5% in theEncon Group

The next three years (1988–90) were years of real achievement.The manufacturing businesses produced quality products andwon market share in a tough sector The Group also made anumber of acquisitions with the assistance of additional bankfunding The largest of these helped to double the size of its dis-tribution business to 20 depots Encon’s first overseas depot wasalso opened in France

The business then grew rapidly:

Trends in Private Equity 87

aspirations of Encon’s senior management and the investinginstitutions

By 31 August 1990, Bank of Scotland had increased its support

to £12 million (split equally between overdraft and term loan)secured primarily by good book debts of £17 million

To strengthen the balance sheet, the equity investors ‘followed’their initial stake with a second stage capital injection of £3 mil-lion in December 1990, which was used to reduce some of thebank debt The investors increased their equity stake to 32.5% inthe process

The trading year 1990–91 proved to be the most difficult one inthe Group’s relatively short history The UK economy weakened,moving from ‘slowdown’ status to an ever deepening and seem-ingly endless recession The building construction sector sufferedenormously Housing starts fell rapidly, new commercial buildshalted and, not surprisingly, the price of building materials fell Encon fought hard to maintain its market share, but withprices falling and bad debts increasing it soon became impossible

to make sufficient earnings to cover fixed overheads A gramme of rationalisation was begun during the trading year, butthis involved closure costs of circa £1 million In the year end

pro-31 August 1991 the following trading result ensued:

Sales £71.0million

Loss (£3.1million)

The compounding effect of very high interest rates on a highlygeared business dependent on the construction sector during aneconomic recession was graphically illustrated in that result

LDC, as lead investor, maintained its belief that Encon, by now

a sizeable player in its market, still had considerable unrealisedpotential With hindsight, Encon’s management had made somestrategic errors during the previous growth phase But the teamwere intelligent, receptive, hardworking and motivated torestore company performance – though it was recognised thatany turnaround would take two to three years

A series of meetings took place between management/investors/Bank of Scotland and it became clear that Enconrequired a further capital injection to see it through the recession

The Bank of Scotland exposure had, by now, increased to £13 lion (split equally between overdraft and term loan) but Encon’sdebtor book had fallen to £16 million, and the Bank’s cover wasreducing

LDC succeeded in arranging third-round funding of £3.5 lion from the syndicate (although at this stage one investordropped out) The total equity from the investors increased to

mil-£8.5 million, and their equity stake rose to 85% It was alsoacknowledged that Encon was unlikely to be in a position to payany dividends for at least another two years

Bank of Scotland agreed to suspend its scheduled loan capitalrepayments and also agreed to reduce its interest rate to a fixedcharge of 5% for one year to assist cash flow

As a condition of the new equity funding, the investorsappointed a new non-executive Chairman with turnaroundexperience to assist the management team

The trading year 1991–92 was another year of mixed fortunes.The programme of rationalisation continued and exceptionalcosts that year from redundancies and closures totalled £1.8 mil-lion Bad debt write-offs rose to £1 million as numerous customers

Bank Interest (£1.9million)

Trading Loss for Year (£4.8million)

The reliance on Bank funding had increased to circa £15 million(£8 million on overdraft, £7 million on term loan) This wassecured by debtors £12 million, stock £4 million, freehold £1 mil-lion, plant and machinery £6 million On a forced sale basis, it wasunlikely that Bank of Scotland would have fully recovered theirlending and any shareholder value had gone completely

Despite the trading results, the fundamental operations of thebusiness were sound and improving all the time Working capitalwas under firm control, stocks had been reduced, credit control

Trends in Private Equity 89

tightened and the product sales mix improved The simple thingswere all being done well and it was possible to envisage a picturewhere rising sales and improved margins – as the UK moved out

of recession – would restore profit to the bottom line

LDC and two of the remaining four co-investors agreed upon acapital restructuring, and the management and Bank of Scotlandwere involved at every stage in the negotiations The bank debtreduced by £5 million, and the balance sheet picture improved.The investors injected a further £2.5 million of equity andretained a 60% equity stake Bank of Scotland agreed to convert

£2.5 million of debt to preference share capital, and also obtained

to focus more on future strategies rather than on fire fighting,which had been a feature for so long in the past

Towards the end of 1996, the shareholders discussed the bility of seeking an exit, probably by way of a trade sale At thisstage the company’s auditors, KPMG, were also brought into playthrough their corporate finance specialists and they indicatedthat Encon might be valued somewhere between £30 million to

possi-£40 million A discreet selling process was then begun

In November 1997, the shareholders sold out their stakes toanother institutional investor Encon was valued at £35 million –not a bad result compared to the situation in 1992! The result was

a good one for all classes of shareholder:

• The management team made a substantial capital gain

• Those investing institutions which kept faith with the Grouprecovered all the cost of their investment plus a substantialcapital gain

• Bank of Scotland recovered all their debt, preference shares,and made a substantial capital gain

At one stage, it had looked as if everyone might be a loser Byworking together and understanding each other’s needs, thepain was shared by all the interested parties during Encon’s mostdifficult trading period Ultimately, all the shareholders enjoyedthe satisfaction and reward of a successful turnaround which haddepended upon all round co-operation

of continuing to happen It is a fact of life that private companies areovercome by events (generally filed under death, divorce or debt – theinfamous ‘3Ds’ beloved of estate agents) and have to be sold comewhat may

Businesses need to get into shape regardless of whether the market

is up or down and there are a number of considerations to think about

if you have the luxury of planning your sale

Focus on strengths

In the capital markets it is easier to value a company that can bepigeonholed – and in the capital markets no one wants difficulty.Even relatively small companies often find that they have developed

a number of differing strands to the business, which makes it difficult

to categorise them

Many public companies are currently selling off non-core parts oftheir businesses at a loss These ‘less sexy’ elements have had theeffect of analysts down-rating the business as a whole and signifi-cantly reducing value For example, Tomkins plc recently sold Smith &

Wesson Corp at a loss of over £100 million and increased its overallvalue.

Put yourself in the position of a prospective purchaser and thinkwhat would catch their eye about this business Is it the breadth ofyour customer base? Perhaps your expertise in a certain area? If youare in a service industry, is it your people?

Make sure that everyone knows what the company does Make surethat it is good at that one thing and take care not to get distracted bydabbling in areas of peripheral interest

Gain critical mass

There is no doubt that scale is king Without the right critical mass youwill not attract the attention of buyers who themselves have access tofunds to pay for your business Your size could hinder your organicgrowth if customers regard you as too small to handle their contracts.You are unlikely to retain good staff if you are unable to offer the samecareer opportunities as larger competitors

While you need to be achieving organic growth, an acquisition oralliance is more likely to make the difference that you require in profitmultiples The reduction in overheads and other savings that you canshake out of the balance sheet, plus the increased volume of sales, willhelp to progress your profits up the scale from £100,000 to your first

£1 million and onwards to £10 million Each step up the scale will add

to the multiples used to value the business

Thus, you must start thinking about possible acquisitions, or, natively, build up alliances with companies that you might subse-quently acquire Look at gaining greater geographic reach by aligningyourself with a similar business in a different location Another option

alter-is to hook up with a company offering something slightly different butdrawing on the same customer base Avoid at all costs an alliance with

a business that has a very different offering to your own or with panies either up- or downstream from you in the process, for theserarely work

com-Geographic or sector coverage

This ties in very closely with focus – you need to know what sectoryou are in and achieve good coverage Concentrate on building sector

coverage – companies that have made it to number one or two in theirchosen market are far more attractive than those that are numberthree or less

Alternatively, you can achieve good geographic coverage with adegree of monopoly wherever you are Because the world is gettingsmaller, geographic growth flows more easily and quickly than inthe past Few companies achieve world coverage, but concentrating

on a single geographic market can have dire consequences as panies with exclusively US markets have recently discovered to theircost

com-Intellectual property and barriers to entry

How do you protect and distinguish what you have got? Barriers toentry take all forms and you have to be clear what they are There areplenty of obvious physical barriers in terms of the location you aredelivering products from, but there are many others in terms of com-fort levels Quite often, services or products are prescribed by profes-sionals outside or beyond the buyer, and that becomes a barrier.Approved supplier lists where purchases are only made from partiesknown to a group is another The slow decision-making and tender-ing processes of certain parts of the public sector create a barrier totrade How do you protect your intellectual property – is this anotherbarrier? Have you got anything special to offer?

People and incentives

Your employees will always have a view of where they stand incomparison to their contemporaries in the market Managing theirexpectations can be hard work as life becomes more sophisticated.Delivering tangible benefits generally has a much better long-termeffect than pure monetary rewards As a rule of thumb, it is not usu-ally the salary that keeps people in their jobs but seemingly nigglingthings that drive them into the arms of competitors Is their workingenvironment comfortable? How family-friendly is your company?Attracting and retaining good people is a vital ingredient in the process of shaping up for the market, whether in attaining mass or having the appropriate skills base to boost your marketposition

Shaping Up for the Market 93

Sale planning

The external perceptions of the company need to be looked at Youneed to have something to say to the outside world that differentiatesyou – and this can be done by employing a good public relationsadviser to make sure that you are on the map Nowadays, the vastmajority of businesses seeking to go to market have reasonable web-sites, but it is surprising how few have made a name for themselvesthrough press coverage of their activities The smaller the community

in which you operate, the more important this becomes It is too easy

to assume knowledge out in the wider world when none actuallyexists You should be constantly on the lookout for opportunities toraise the profile of your company

As part of your strategic considerations, you might want to considerwhether flotation is a serious option There are times when having alisting can make a difference; the market or the sector might expect it

of you or you might need to offer marketable securities to attract othercompanies or joint venture partners Today, however, with almost lim-itless private equity funding readily available, investment require-ments can usually be fulfilled without the need to float

Often, there is a need to think about a change of leadership or agement The person who has the wherewithal to get the business upand running may not be the best qualified to manage the growthphase taking the company to the next stage in its development Thereshould be a structured evolution within the management team toallow the business to expand and grow – and personal developmentand training are crucial for this Clearly, the owner wishing to sell upand retire must first become superfluous to the company

man-Flexible focus

The world is changing so rapidly that you must continually reviewwhat you are doing and how you are doing it – and thus change tomeet market demands This is not at complete odds with making surethat you stay focused on your business You need to be flexible enough

to review what is happening around you and keep your options open

to opportunities as they arise If you look around at companies thathave achieved their goals, this is perhaps the crux to their success

3.3

Raising Venture Capital –

A Working Guide for

Entrepreneurs

Nick Jones

Tenon Corporate Transactions

Many ambitious entrepreneurs seek venture capital to fuel the rapiddevelopment of their businesses The good news is that the amount offunds raised for venture capital investment is growing at a rapid rate

In 2000, external institutions and private individuals committed

£8,995 million to UK managed private equity funds for future ment This constituted an increase of 55 per cent on the 1999 figure of

invest-£5,813 million This substantial increase was principally due toincreased commitments from overseas insurance companies

In 2000, £1,885 million was invested in 341 companies The tion of this investment is shown in Table 3.3.1

distribu-This guide focuses on advice to entrepreneurs seeking funding forearly-stage or expansion projects, which received 75 per cent of thefunds invested in 2000 The comments do not apply to start-up ven-tures, which are generally difficult to fund

With the end of the Internet investment bubble in the first quarter

of 2001 and the continuing volatility in the TMT (technology, mediaand telecommunications) sector, the investment criteria of venturecapital companies has changed substantially They are now focused