A crowd gathers

In the competitive mid-market, private equity houses want to stand out from the crowd. But can being unique really make a difference in winning deals?

As the European private equity market matures, competition increases and sourcing deals becomes more difficult, mid-market houses are under pressure to differentiate themselves from the rest of the pack. With the stellar returns from buyouts in recent years, continued liquidity in the debt markets and a benign macro-economic climate, more and more firms have entered the private equity space making it difficult to secure exclusive deals and investors. To make themselves more attractive, some private equity houses have set up as sector specialists, while others focus on generating deal flow or use anti-competitive tactics during and before sale processes.

Andrew Hartley, managing director at £240m private equity house, August Equity, says: “In the US there has been increasing specialisation, with firms focusing on turnaround or specific sectors. Specialisation can also apply to the kind of approach taken by a firm, such as buy-and-build. We’re now seeing that same trend towards differentiation in Europe.”

David Silver, a managing director at Baird’s European investment banking team, notes that these days if a £70m business comes up for sale there may be 10 to 20 houses interested in acquiring it, including perhaps some larger buyout houses who see the potential in growing it through bolt-on acquisitions and smaller houses keen to look at bigger deals.

Because of this fierce competition many mid-market firms try to give themselves an advantage by getting talking to the management team early on. “A lot of people are trying to find ways to get to the management teams before the process starts,” says Silver: “Before the business formally comes up for sale PE houses are thinking about the non-executive chairman and talking to advisers about due diligence or to investment banks about valuation. We receive multiple calls when an information memorandum goes out.”

So, being quick off the mark and looking for an early angle on a potential acquisition can be important as sellers become more sophisticated. These days, it is increasingly rare for a company to change hands privately but savvy PE buyers still try to avoid auctions. Iain Kennedy, a partner at Duke Street Capital, a £2bn UK and France-based private equity house, points out that auctions increase the risk attached to deals because the buyout house has less time to consider the company, less access to information about the business and more competition. In the last two years, he says, Duke Street has generally succeeded in acquiring assets outside auctions.

“The trouble with auctions is that the asset goes to the firm that’s willing to pay the most, which is why we focus on businesses and sectors that are more complex and harder to sell,” says Kennedy: “These are sectors and businesses that do not necessarily lend themselves to auction.” In July 2005, Duke Street and Englefield Capital took Equity Insurance Group private. Duke Street’s interest in the company had been flagged up in the press six months earlier but no other competitors emerged because the business was regarded as too complex because there were doubts about Equity’s exposure to events such as 9/11 and hurricane Katrina. “It took time for us to make changes and ring fence the company’s exposure, but less than 18 months later we sold it at 2.5x money and a stellar IRR,” says Kennedy.

Much of the reason for the success of this deal was Duke Street’s willingness to take time doing the due diligence over a complicated transaction. Similarly many other firms would not have had the patience Duke Street showed in slowly transforming chilled food company Adelie into a £150m company. “We made six acquisitions to grow Adelie into a sizeable company and that took time and effort,” he says.

By taking this approach the firm has more time to get to know the company and its management. Kennedy says: “We can sit round the table with management, without intermediaries, and can see the business as it is, not how it appears when it has been plumped up for sale.”

Like Kennedy, co-founder of €1.1bn Palamon Capital Partners Michael Hoffman is also keen to stick out from the mid-market crowd. A former Warburg Pincus man, Hoffman helped set up Palamon in 1999 and from the outset he realised that the firm would need to be different if it was to compete successfully against the longer-established names.

“We didn’t want to be just another mid-market buyout player,” says Hoffman. He adds: “Differentiation is important because investors see all these firms and it can be hard to really tell them apart and know who to place your bets on.” Hoffman argues that in Europe there is an over-simplification in describing firms’ strategy as either buyout or venture capital. Palamon, he says, focuses on growth capital, rather than investing in the more mature companies that many other mid-market houses go for.

Palamon Capital avoids plain vanilla deals and backs companies with high topline growth of 15% to 40%. Hoffman says: “Our key approach is that we focus on growth, either development capital or buyouts in a growth model. That means moderate leverage and that we don’t need to compete in auctions.”

He adds that Palamon’s competitive edge is in building smaller companies into mature businesses: “It’s a very interesting area to be in because of the vast number of small and mid-sized family companies in Europe that can benefit from outside investors willing to work with them.”

Differentiation can mean different things, depending on who the audience is. According to Andrew Hartley of August Equity, two main considerations for mid-market firms are how they are regarded by management teams and by the intermediary community. To be well regarded by management teams a house needs to be seen as having credibility and relevant experience.

For August, having that credibility is, in large part, about its sector expertise, says Hartley: “If you’re meeting a management team you don’t want to give the impression you’ve read the business plan half an hour before the meeting. You want to show that you understand the sector and that you’ve sat on the boards of similar companies and added value.”

While the management teams will often be reached through face-to-face contact, the intermediary community will be reached by marketing and communications, says Hartley. These include PR, advertising and the firm’s website. “It’s a fragmented market so you need to hit different parts of it as often as possible,” he says: “It’s about hard work, as there are no short-cuts.”

This kind of branding is important in showing the market what the house’s strengths are and what it is not focusing on. Duke Street’s Iain Kennedy says: “We’re known to intermediaries as a buy-and-build house, so they won’t call us about auctions, which is fine by us. We’re known as a house willing to take on the more complex assets.”

Some houses market themselves on the basis that they can provide a single package of finance for deals, known as single source or integrated finance. Lower mid-market house Close Brothers Growth Capital is one of these firms and managing director Bill Crossan says the model is particularly attractive to management teams. “We can be flexible about debt,” he says. “A lot of people are providing debt but they’re often looking for their money back in a short time, just as the business is getting on its feet.”

The single source approach means that the firm can spread the pricing across all of the money to blend the return. This can enable management to take a majority stake. Crossan says: “One of the main advantages of single source finance is that it removes the tension that exists between debt and equity financing and means that the management team is dealing with one financing party, who is more attuned to the needs of the business. On a practical level it means that there is only one set of lawyers, one set of documents and one person from the financing side to deal with.”

European Capital also offers a one-stop shop for finance and managing director Simon Henderson points out that a further differentiator is that the house holds on to the mezzanine. “We sell down the senior debt a few weeks after the transaction but keep the mezzanine, which means that we are a lower-risk proposition for a management team,” he says, noting that this approach removes the potential for conflict that can arise when a third party is holding the mezzanine.

For non-single source private equity houses, having good systems in place to deal with the banking arrangements can bring an advantage. Travers Smith partner Phil Sanderson says “Currently it’s a sellers’ market and a market that favours management teams, but one area where buyout houses can have power is in the banking arrangements. We often now see people from the private equity house, together with the lawyers and maybe a debt advisory person, drafting term sheets and then getting the banks to bid for the business. Some houses have agreements with particular banks on set documents, which are negotiated in more detail after the deal is closed.”

As well as the financial structuring, a very important differentiator is the way that a private equity house originates deals. In order to source its own deals and, as far as possible, avoid auction processes, Duke Street is willing to spend a lot of time and effort in getting to know management teams and entrepreneurs in particular sectors. Iain Kennedy says: “We believe in going deep down into sectors and really understanding them and patiently getting to know key people.”

For example, he says, the firm had first wanted to back food industry entrepreneur Bill Hazeldean in 1998 but the partnership only materialised in early 2006 when he was brought in to help with the development of Adelie Food Holdings. Deal origination is crucial to the firm’s success, says Kennedy. “We have two partners whose main job is to focus on deal origination and all our partners are expected to contribute to deal flow and they know that this role will influence their promotion prospects and bonus.”

Having a reputation of being a good partner for management teams is one useful differentiator. “Certain houses have a reputation of being more partnering to management and that can be a significant advantage,” says Phil Sanderson, adding that relationships with management teams are important, particularly in the secondary and tertiary markets. “If a private equity house does not think that the management team will stick up its hand for that house it generally won’t bother going on with the process,” he says.

Sanderson adds that a reputation can be positive or negative. It can be positive if, for example, it swings the opinions of management teams to go with a particular firm. But a reputation can be damaging if it is one that suggests a particular house can be a bit slippery to negotiate with. “Various houses in recent years have had a reputation for being a price chipper, or for dragging the sale process out, but in today’s market you can’t behave like that and win many deals,” he says.

Some private equity directors believe that the benefits of differentiation in helping firms acquire assets are limited, unless that differentiation helps those firms justify paying a good price for the asset. Paul Goodson, a partner at Barclays Private Equity, says that because of the dominance of auction processes a firm must position itself as the highest bidder but have the confidence that it can make money at that price.

“One way is to be a sector specialist, so that you have more knowledge of the kind of opportunities that can help justify a higher price than others are willing to pay,” he says. Another tactic is being close to management before the sale process begins, so that insights into the future potential of the business can be gained.

Finally, given that private equity investment, particularly in the mid-market, is very much about relationships and individual skills, do ‘star partners’ help firms differentiate themselves? Duke Street Capital’s Iain Kennedy is sceptical: “Apart from one or two individuals, such as Jon Moulton or Ronald Cohen, how many private equity figures can most people in the financial world name? It’s true that there are individuals in the industry who are known for their expertise in a particular sector, such as healthcare or financial services, but I don’t believe there are many so-called star partners.”

Andrew Hartley of August Equity is also sceptical. “People skills are very important in this business but I don’t feel particularly comfortable with the idea of star partners because private equity is very much a team business. Yes, there are some outstanding individuals but if a firm started talking about its star partners I’d say it was in danger of believing its own hype.”

Closing the deal quickly

One of the most important differentiators for mid-market firms is how quickly they can close a deal, as vendors are more likely to want to do business with people able to move fast.

Speed of execution has become increasingly important in today’s auction-driven market. Phil Sanderson, a partner at law firm Travers Smith, remembers being impressed by the speed at which Lion Capital were willing to work in acquiring shoe brand Jimmy Choo in December 2004.

Sanderson says: “We were working on the deal for the vendors, Phoenix, and I remember a meeting with the Lion Capital guys on the Sunday at which they promised they’d be able to sign a contract by close of play on Wednesday.”

He adds: “Of course, the price needs to be right but that kind of deliverability is very attractive to vendors and can avoid the asset going to auction, as it did in the Jimmy Choo case. Since that time a lot more firms have realised the benefits of being able to move quickly.”

David Silver, a managing director at Baird’s European investment banking team, says: “A number of firms differentiate themselves by their ability to close deals quickly and much of that boils down to being well prepared before the information memorandum comes out.”

He cites firms such as Darwin Private Equity, a new firm set up by former directors at Permira and CVC and focusing on the lower mid-market: “They’re aiming to bring large LBO experience to the mid-market, including speed and certainty in closing deals,” says Silver.

He argues that to achieve rapid decision-making it is important the houses are willing to invest in due diligence long before the second round bid. “In the past it could take six to eight weeks to close, while today it can be done in a matter of days”, says Silver, adding: “That’s why it can be important for a firm to commit to an asset and do what it takes to be able to close quickly.”

Of course, there needs to be agreement on price but speed and certainty, in relation to the completion, are also critical considerations: “The last thing the vendor wants is to agree a price and go into exclusive talks with someone, only to find that it is taking ages to close the deal.”

Phil Sanderson of Travers Smith says that the firm spends a lot of time with private equity clients discussing ways in which they can streamline their processes so as to be able to move more rapidly.

He points to the example of Bridgepoint in its acquisition of clothing retailer Fat Face from Advent International in March 2007. Bridgepoint beat off at least three other private equity rivals to acquire the company. By closing the deal within 48 hours Bridgepoint effectively pre-empted the auction before it could get going, says Sanderson.

But how is it possible to move so quickly and still carry out due diligence? Sanderson points out that Bridgepoint’s bid did not come from a standing start, as they’d already done a lot of preparation, such as commercial due diligence. “If you have the CDD and the vendor’s financial due diligence you’re a long way there, and the legal due diligence can be done quite quickly in many cases.”

One way of being able to move quickly is having all the finance in place at the outset. Simon Henderson, a managing director at European Capital, says the house offers a one-stop shop for buyouts that gives it a significant competitive advantage. “It means we do buyouts where we provide all of the funds and, as far as I know, we’re the only firm that does that across Europe,” he says.

Other institutions that could do this, but choose not to, are the large banks that have both private equity and leveraged debt arms. “But the heads of the leveraged finance divisions don’t like the idea of not being able to lend to other firms,” says Henderson.

It is mainly in the mid-market that this kind of one-stop shop approach makes sense, he says, because for very large transactions a one-stop shop model could mean taking on excessively large exposure.

“We did three buyouts last year and two of them – Farrow & Ball and Whitworths – we won because we could move fastest,” says Henderson, adding that the firm had done the due diligence and could save time by not needing to negotiate a credit agreement or covenants with the banks.

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