Numerous family-owned company founders in Europe are now approaching retirement age and having to confront succession and change of ownership issues. All too often, however, founders are failing to find suitable or willing family members to take over the company reins. Joanna Hickey reports.
To resolve their succession dilemmas, increasingly owners have been turning increasingly to private equity firms in the past two years and the number of leveraged buyouts of family-owned companies in Europe has grown significantly as a result. In a March 2005 European Venture Capital & Private Equity Association (EVCA)/Centre for Management Buy-Out Research (CMBOR) survey of European family-owned company buyouts, 31% of the companies questioned said succession would not have taken place without private equity involvement.
According to the survey, in 2003 some 60% of the total private equity investments in Europe were invested to re-energise and revitalise existing, often family-owned, companies and according to CMBOR, up to one quarter of all European buyouts come from family/private sources.
Firms may be too small to go public, or be unable or unwilling to endure the demands of the IPO process and the rigours of public company life, while trade buyers may not be in evidence. Even if other exit options are on offer for firms with generational issues, an LBO is often the more attractive route. This is because a buyout allows the owner to retain a minority stake or achieve a gradual exit; something that is far harder if the company is sold to a trade buyer.
The post-acquisition, synergy-driven factory closures and redundancies often involved in corporate acquisitions can be of great concern to the founder. “Many private owners are hesitant to sell to a key competitor they have been fighting with for the last four decades. Plus, there is the social aspect, owners do not want to be responsible for selling to a corporate that then closes down manufacturing units and makes redundancies,” says Karsten Hartmann, director at HgCapital.
The LBO route is also attractive as many companies go on to perform better after a leveraged buyout, leaving a successful legacy for the vendor. According to the EVCA/CMBOR survey, from a starting point of a 13.3% growth rate in the year before the buyout, turnover in the family buyouts surveyed increased yearly and the compound annual growth rate was 15.4% for the three years post- buyout. The average number of employees grew by 67.3%, from 263 before the buyout to 440 after the buyout. The greatest growth was observed in companies with 50 or fewer employees (388%). Meanwhile, exports grew from 23.9% before to 28.4% after the buyout.
This improved post-buyout performance is partly attributed to the significant financial incentives on offer to the new management, which usually has a stake in the company. Also, in addition to injecting the finance necessary for growth, the LBO process can revitalise and rehabilitate companies. Private equity firms can play a crucial role in the development of management and business strategy, while the company can profit from the sponsor’s network of contacts.
The case of Eco Group, an Italy-based producer of coils and coolers for the air treatment industry, illustrates the extent to which companies’ performance can improve with private equity involvement. After failing to find a suitable successor, in 1999 the founding family decided to sell out through a management buy-in backed by the Italian private equity team that set up PM & Partners. During the investment period, between 1999 and 2004, turnover increased from €95m to €200m, the company’s European market share reached 17% compared to 13% in 2001 and the employee base rose to 1,593 from 926 before the buy-in.
Challenges for sponsors
For private equity firms looking to buy family-owned companies, there are a number of challenges and issues to address. Firstly, industry experts say sensitivity and diplomacy are crucial, as these deals involve an emotional aspect foreign to other types of buyout. To secure its target, the private equity house has to tread more carefully when approaching the vendor and also must often make more compromises than usual.
“Not all private equity firms can do family buyouts. These deals are very different from corporate divestments and require a very different skill-set. It is a more intimate transaction as the owners have often invested most of their career and indeed their life in the company. You need to be far more sensitive and recognise that the vendors are not purely motivated by price,” says Jonathan Russell, head of European buyouts at 3i.
The fact that these deals are not purely price motivated is very attractive to private equity firms, which are highly motivated by price. This factor can work to the private equity firm’s advantage when, for example, the seller wants assurances that the employees remaining with the business post-sale do not get made redundant. If these are jobs the private equity firm envisaged keeping anyway, they can agree to this as a specific clause in the sale and purchase agreement and win a price chip for doing so.
Private equity firms also need to accept the fact that, unlike in most corporate divestments and secondary buyouts, some family owners want to retain a stake in the company after the buyout. Likewise, the private equity firm may not be interested in buying the business unless the owner stays involved, which is most likely to occur in instances where a lot of the firm’s knowledge and supplier relationships is are invested in one individual. This frequently occurs where two or more families own a company and only one family wants to sell out.
In other cases, even if the sponsor has a controlling stake, it still has to tolerate a more diluted equity stake than normal, which can impact its own returns. Although debt to equity structures are usually the same as in other buyouts, the composition of the equity can therefore be quite different and the sponsor often has to work in more of a partnership with the vendor after the buyout.
Such was the case with UK printing business Williams Lea, in which 3i invested in 2004. Rather than taking a majority stake, 3i acquired a substantial minority stake alongside family members and invested funds for growth. Steven Nicholls, director at 3i, says: “In businesses facing generational change, you have to be prepared to invest on their terms sometimes. That’s fine with us.”
Others admit to leaving a majority equity stake in the hands of owners, who wouldn’t be able to psychologically to complete the deal otherwise. Instead the private equity firm relies on an ownership structure whereby control to all intents and purposes transfers across to them through mechanisms such as preference shares, voting rights, tag along and drag along, for example.
Another challenge facing private equity firms doing family-owned business buyouts is, in some countries, the cultural perception of private equity. There are still some enduring negative views of the private equity industry as mere asset-strippers or short-term investors that will go on to sell out to a trade buyer after five years, with the possible redundancies and closures this can entail. Others feel that resorting to private equity has some connotations with distressed financial situations and, also, in some European countries, a lack of awareness of the private equity industry and what it can offer is another obstacle.
Such views have deterred some family business owners from choosing the LBO route in the past. Cultural issues have in particular been apparent in Germany, Italy and Spain and are one of the reasons why there are far fewer buyouts in these countries than in France or the UK. Given the vast size of the Mittelstand, Germany in particular has disappointed industry players.
However, private equity professionals say these cultural obstacles are gradually receding with every successful buyout that is completed. “The penetration of private equity into Southern Europe is improving and previous, more negative cultural and social perceptions of private equity are fading,” says 3i’s Russell.
Another major issue for private equity houses looking to buy out family-owned firms is the purchase price negotiation. Agreeing a price can be far more arduous than in other types of buyout, as emotions, rather than EBITDA and cash flow facts and figures, often hold sway. Also, the owner’s view of its company valuation can be some way above that of the marketplace. These difficulties have prompted a number of US and UK private equity firms to shy away from family buyouts.
It is important for sponsors to gauge the vendor’s price expectations early on, to prevent spending lots of time on a deal that will only founder in the end. “Family buyouts regularly fall through because of failure to agree a price. Founders can have an unrealistic view of what their company is worth and be unmoved by comparative company valuations or financial calculations. In corporate divestments, the vendor and sponsor are working off a far more similar platform,” says Christian Krause, investment manager at German private equity firm BayBG.
Gaining access to information and the company’s accounts can also be very difficult, as the vendors can be reluctant to disclose confidential information to external parties. Meeting all of the company managers and conducting extensive due diligence can be difficult alsotoo, which can mean the sponsor has a less complete picture of the target than in other types of buyout.
“We are normally only able to talk with a very restricted number of people, usually the founder, CFO and CEO. This makes it far harder to get a picture of the quality of the management than in a corporate divestment and means you have to take greater risk on board,” says Francesco Panfilo, founding partner of Italian private equity firm PM & Partners.
After the buyout has taken place, the private equity firm often has to introduce many more operational changes than it would in a corporate divestment, public-to-private or secondary buyout. “In owner-managed companies, if the company has been very tightly controlled by the founder, after he disappears the wheels can sometimes fall off. Post-buyout management is easier if the company has been run by the owner’s management team,” says Philipp Schwalber, associate director at HgCapital in Germany.
In cases where even the most senior employees are unused to shouldering responsibility, the private equity firm needs to bring in far more people than usual. “In a family company, the owner often rules the company like a little kingdom. As new owners, we have to establish an entirely new management culture. We need to hire far more people than in other buyouts, especially financial directors and sales and marketing staff,” says Christian Krause at BayBG.
In addition, sponsors say that often, in the years leading up to the buyout, the company may have lost its way slightly, as the owner ages and becomes less engaged. Often investment in vital things such as technology and equipment has been lacking, or the company has been slow to respond to strategic trends.
There is often therefore more strategic work and business development involved in these types of deals. However, sponsors argue this is actually positive in the long run. The fact that any improvements the private equity firm makes are applied to a relatively low starting point is another reason why family deals can have such a good record of post-buyout performance. “Often, family firms perform so much better after the buyout as so little has been done to improve the business in the preceding few years. Sometimes relatively simple changes and investment can make a huge difference,” says Krause.
Despite the various issues and potential obstacles to address, family-owned firms are therefore becoming an increasingly fertile and profitable hunting ground for private equity firms. Going forward, t The volume and number of deals are expected to keep rising., This which is just as well, given the sharply growing need to resolve succession issues among Europe’s vast network of family-owned companies. According to a 2003 European Commission report on the Transfer of Businesses, 1.5 million European enterprises could close in the next 10 years because of a lack of an obvious successor, with a loss of six million jobs.
Indeed, faced with the potential collapse of so many companies, experts say buyouts of family-owned businesses need to rise far more quickly than they have to date, in order to safeguard Europe’s economy. To this end, the EVCA has been lobbying the EU to review legislation in order to favour buyouts of family-owned businesses. “EU legislation that improves tax incentives for small and medium- sized company sellers, such as the UK’s taper relief, plus legislation that improves the tax deductibility and treatment of LBO debt for these sorts of deals would help promote more family buyouts,” says Graeme Ward, partner at Ashurst.