There comes a time when every captive private equity unit has to decide whether it wants to unfurl itself from the embrace of its parent company and forge its own identity or stay at home and keep the family name.
“Spinning out” has provided the industry with a number of “hit the ground running” firms over the years – usually backed by a cornerstone investment from the parent company – including CVC Capital Partners from Citigroup, BC Partners from Baring and Permira from Schroder Ventures Europe, while Bridgepoint evolved from NatWest Equity Partners in 2000 and Montague Private Equity from HSBC Bank in 2003.
“What does a private equity group get out of the relationship with its parent?” asks Rod Richards, managing partner of London-based lower mid-market private equity firm
“If the parent is a big investor and is supportive in difficult times, helping with the deal flow, then they bring something to the party and that changes the dynamic,” he says. “If the answer is nothing, though; if they are just taking a share of the profits, then it is difficult to see why that would be valuable.”
Richards should know. A 21-year veteran of the business, he left McKinsey & Co in 1986 to join F&C Ventures, the private equity arm of Foreign & Colonial, which had been launched five years earlier. In 2001, Richards oversaw the spinout from Foreign & Colonial and the birth of Graphite Capital.
“There can be concerns for investors about conflict of interest when it comes to floating companies through a subsidiary of the owners,” says Richards, “but the bigger concern is if they aren’t a big investor in your funds, as it doesn’t make fundraising any easier. If you are part of a big group that doesn’t invest in your funds, it can be a difficult message to sell.”
Since the split, the firm hasn’t looked back and in May this year raised its seventh buyout fund with total commitments of £475m, as well as £80m in a co-investment fund to deploy alongside Graphite Capital Partners VII in the event of larger transactions.
“The co-investment fund highlights what we are trying to do,” says Richards. “We often see deals we are interested in which we might not have the funds to bid for, but we wanted to get some balance and not burn a hole in our pockets if the fund size got too big.”
The fund was also a considerable step up on its predecessor, which raised £375m in April 2003. Much of this can be attributed to Graphite’s track record of nearly 100 investments since 1991, of which two-thirds have been realised, generating an overall multiple of 3.5 times cost and an IRR of more than 40%.
Despite the larger fund size, Richards says it is important to stick with a tried-and-trusted strategy, saying: “Consistency is important. Investors know what they are going to get with us.
“The deals that we do have gotten bigger over time, as with everybody else, but we’re still looking at doing 15 to 20 deals in the fund, not just six big ones,” he says. “We have that flexibility to just do one deal per year, but we could do six or seven. We’ll certainly stick in the main to enterprise values of £20m to £200m.”
The biggest “threat” of high pricing precipitating the freeze in the credit markets, says Richards, is the prospect of the larger transaction-focused mid-market firms moving down on deals and competing with Graphite.
“If you don’t get as much debt, you won’t get as good a price going forward, but the flipside of that is that if the whole market experiences a credit crunch, then the market will adjust the pricing,” he says. “It’s not going to stop deals happening. That would only happen if we couldn’t be competitive against trade bidders or if prices fell so much that vendors didn’t want to sell.”
For Graphite Capital, the majority of those vendors have been founder-owners.
“One of our main skills is in dealing with founders,” says Richards. “They aren’t entirely financially driven, which means they tend to sell when it suits them rather than being influenced by a particular time in the cycle. They also have high levels of emotional attachment, which is important to deal with.”
For that reason, he adds, founders often leave some money and control in the business.
“The amount they leave in often gives a quite disproportionate percentage of equity due to the debt being used in a buyout,” says Richards. “You have to assume that that relationship is as important as the price. You have to gauge just how key the founder is to the business: if they drive everything, taking them out will be more downside than upside. In some cases, the opposite is true.”
Building management for the future is equally important in-house, he concludes, saying: “You have to have the maximum level of resources, so you need to have enough people in the team to deal with the peaks and troughs.”
Key to that, adds Richards, is injecting enough youth into the mix as the senior staff members take on a more parental role.
“You can end up with a team of people in their early 50s who don’t want to stay up all night on deals, so you have to keep bringing in young, ambitious talent if you want to survive,” he says.
With a new raft of hires on the cards following the recent fundraising, Graphite looks set to stand on its own for some time to come.