2006 was one of the best years ever for private equity. There were more and bigger deals than ever before, and PE owned businesses turned in a better performance than their publicly-owned peers. The BVCA says PE owned firms grew exports by 6% and investment by 18%. The respective figures for the whole UK economy are 2% and 1%.
Growth brings rewards, and imposes responsibilities: in 2007 the industry is facing key challenges around transparency, regulation and governance. In the United States the SEC may move to regulate, while in the UK, the Financial Services Authority is consulting on issues which may result in new regulations.
Higher expectations of responsibility and growth are good reasons for the industry to carry on getting it right at every stage of the lifecycle: buying, owning and selling businesses in such a way that adds value for the shareholders, who are increasingly in the guise of pension funds or other collective investment vehicles, the public. And, as PE houses become more accountable to those stakeholders, it is very helpful where possible to demonstrate what they do to add value.
Recent Ernst & Young research shows that a focus on value well before purchase brings rewards: in some cases PE firms had been working for two years on their purchase targets, understanding the market, sector, industry, and the target itself. Early focus helps identify inherent value that can be delivered after acquisition. Understanding what is required of management, where possible, before the beginning of the formal sale process also pays off. With the bulk of transactions set to be competitive auctions in 2007, the lesson from our research is that on more than 70% of winning auction deals the PE house already had the target under consideration well in advance of receiving the Information Memorandum.
We expect secondary deals to continue their growth in 2007, and in those circumstances this preliminary groundwork will become even more important.
Secondaries are part of a long term trend; I do not support the view that you cut costs and make one-off improvements, leaving nothing for the next PE buyer to do. Where there is rapid change in a market, each set of changes creates new opportunities for repositioning and creating value, and that repositioning is often likely to be easier to do in private rather than public ownership.
Delivering the plan:
After taking control of the business, it is important to start delivering the business plan immediately. In most transactions there is a recognition that what you do in the first 100 days will probably drive your subsequent success. At this stage it is important to preserve value and manage the risk in the entity, and to do that you need to have basic controls and reporting systems in place. When you take a division out of a corporate structure, you may find a number of the processes and controls are left behind with the corporate host. If you are not careful you can lose – as well as gain – an awful lot of value in three months, so you want to make sure for example that you are managing working capital properly, your receivables, payables, and inventory. This can make the difference between your financing being tight and being comfortable. In the first 100 days the owners need a very clear vision of where they are taking the company: our research clearly showed that the most important factors behind exceptional returns are having a robust plan in place and driving it forward with the right management. The result: PE houses saw the value of their businesses increase by 26% per annum, while their publicly owned competitors averaged 12%.
In the first three months, you will also need to discover if the managers and staff are equipped for the speed and pace of the journey they are going to be asked to make. It may come as a shock, especially if they have not been through the experience of PE ownership before. When we asked our research participants what they would have done differently, almost one in every five said they would have changed top management sooner.
I recognise that there are some concerns about the availability of the management talent necessary to take on the challenge of working under PE ownership. Private Equity does have an advantage over many corporates: it can attract the best talent, and will continue to do so because it can offer the most competitive rewards. Public markets can be hamstrung by their anxiety about whether people are over-paid as soon as above-average rewards are put on the table. You need to be very clear about what is expected of people – and about what incentives are available to reward achievement. Private Equity can afford, within the context of the specific business, to buy the best management available. There is no excuse for you, as the asset custodian, not to get the very best. The PE house has the power to make the changes necessary and the tools to create the alternative leadership.
The last stage of ownership is selling well. Our research showed that an appropriate focus on the exit can make a significant difference to the value created: in the research sample 40% placed significant focus on the exit process, multi tracking the exit route, keeping potential buyers abreast of the value generated in the business, and generating competition in the market. Those who focused strongly on the exit achieved returns at least 7% above average. Those with a less aggressive approach to the exit saw returns 21% below the average. Certainly in Europe, where the majority of transactions are auctions, and increasingly so in North America, vendor due diligence brings great benefits, minimising the disruption of the business whilst ensuring the benefits of the auction process.
As we move forward into 2007 and beyond, the increasing size of the biggest transactions means we will see more ‘club’ deals, with two or more parties joining together to buy an asset, because of the size of the equity cheque that needs to be written.
Club deals present their own dynamics, which do require care and attention to detail. Club buyers need to be sure their responsibilities are clearly allocated, and that there is a robust process around how value will be delivered after the acquisition. They need to think about how they will manage if things do not turn out as well as expected. This is probably an area where we are going to see some issues in 2007 because it is unlikely that every consortium transaction is going to turn out to be exactly on plan. Equally, when club deals want to exit, everyone needs to be comfortable with the timing, the progress that has been made on delivering the plan, and the process for the sale.
More and bigger deals, whether they are from clubs, consortia, or individual houses, will inevitably attract more attention from regulators and the media. Today, where private equity employs nearly one in every five of the UK private sector working population, it should be no surprise that the FSA views this as a large and important piece of the economy and therefore feels duty bound to make sure nothing happens to cause a large and dramatic failure that might undermine confidence in the whole industry. The higher profile that Private Equity is developing as a result of its size and growth will inevitably attract more attention from the media. For them, any hint of secrecy produces a suspicion of conspiracies behind closed doors. I am a firm advocate of transparency. In principle there’s nothing anti-competitive about PE houses or a PE house and a corporate partnering to bid for a large asset, as long as there are safeguards around regulation, governance and transparency. PE returns can be generated by improving businesses in ways that the public markets do not seem to be able to do consistently. The businesses sold by PE houses often will have been strengthened by investment, management and subsequent growth after a process of rapid change. That creates winners, and the bulk of the capital gains from those winners is going back into the pockets of ordinary people. The Private Equity industry overall generates healthy change in the businesses it owns to the benefit of all stakeholders. Being more accountable for that success through transparency is likely to bring, on balance, more advantage than disadvantage.
By Simon Perry, Global Head of Private Equity, Ernst & Young