High value for the UK

Criticism from some politicians and trade unions about the role of private equity in the UK has gained prominence in recent months, partly thanks to buyout houses’ ability to target ever-larger companies.

Controversy has focused on buyout house activity at household name companies. This has included the restructuring at car breakdown service the AA and the possible buyouts of supermarket chain J Sainsbury and pharmacy chain Boots.

However, it is important to recognise that it is only the very large UK and international buyout houses that are active in the more controversial deals, according to Steve Tudge, a director at mid-market house ECI.

“The criticism of private equity probably relates more to the mega-deals than the mid-market, as we’re less involved in the kind of negative restructuring some of the larger houses are accused of,” Tudge says.

He points out that 2006 was similar to the year before in terms of the number of deals, although the average size of deals was up and continues to rise. “Deal sizes are growing and that’s true even if you strip out the mega deals, which can distort the overall figures,” he says.

Andrew Hartley, joint managing director of August Equity, notes that last year the UK had 123 deals in the £10m–£50m range, 31 in the £50m–£100m range and about 25 above that.

“It shows that in the UK the vast majority of deals are sub-£100m and that’s why we’re in that market, as there are a lot of opportunities,” he says.

But Hartley acknowledges that although many firms have raised larger funds to address bigger deals, the market remains competitive, with new entrants and new funds.

“A lot of people are under pressure to deploy capital, but the more mature players are prepared to hold back and only choose the right deals,” Hartley says. “We don’t want to get sucked into unsustainable price wars.”

Ian Armitage, chief executive of HgCapital, says that the number of houses active in the mid-market has probably doubled in the last five years.

“As a result, houses will be seeking to differentiate themselves and I think we’ll see more specialisation,” he says. “The picture will be a lot different in a few years’ time, with very few generalist houses remaining.”

HgCapital focuses on five sectors covering 70% of the market, but in future a growing number of houses are likely to specialise in perhaps a single sector or market, such as turnaround transactions, says Armitage.

This increased competition for assets, combined with other factors such as the continued availability of cheap debt, means that valuations have remained strong. Some in the market believe valuations are probably at or near their peak.

Armitage says he believes valuations have probably topped and that recently there has been some evidence of prices falling a little.

“There is currently no difference in pricing paid for an A-list or a B-list asset, whereas you would normally expect a higher-quality asset to fetch more money,” he says. “The current situation is down to the huge amount of debt that is available and the fact people are still feeling very confident about prospects.”

Another factor driving valuations is trade buyer activity. Baird Capital Partners Europe operates in the £30m–£300m market and specialises in industrial and business services companies. David Silver, a managing director, says that the activity of trade buyers is partly fuelling the current market. He has observed strong interest for UK assets by US buyers, European and even some Asian companies.

This is a double-edge sword for buyout houses, as it means that they can sell portfolio companies for higher sums but that they may have to pay more themselves if they are in competition with trade buyers. In many cases, says Silver, trade buyers are simply willing to pay more than private equity houses.

“Strategic buyers can generate synergies but also they often have in their sights one or two companies they really want and they know that if a buyout house acquires those companies they won’t be back on the market for several years,” he says.

Silver adds: “Four to five years ago an industrial business may have sold for 6–7x Ebitda. Today, that figure could be 8–9 times. That’s a reflection of the strength of the market, and particularly the debt market, which is underpinning valuations.”

Other houses selling companies are also benefiting from the return of trade buyers. ECI’s Tudge says that the house’s last four exits have gone to trade buyers. The other factor fuelling exits is the strength of the secondary market.

“The secondary market has given us a base level of activity that we can rely on, so even if there is reduced activity by entrepreneurs or large corporates, there will always be portfolio churn,” says Tudge.

Linked to the growth of the secondary market is the changing relationship in the UK between the public and private equity markets. Legal and General Ventures’ chief executive Adrian Johnson believes this is one of the most interesting developments in the UK market.

“The fact that private equity funds can consider bidding for major quoted companies like Sainsbury and Boots, within a few weeks of each other, is a major change to the landscape and the interaction between the stock market and private equity,” Johnson says. Not long ago, he adds, the idea that private equity could acquire such companies would have seemed fanciful.

But today, the firepower of the private equity houses is such that the UK public market is finding it hard to compete, says Johnson. He points to LGV’s sale last December of Tragus, which owns restaurant chains such as Café Rouge and Bella Italia.

LGV had assumed the exit would be through an IPO and was preparing for that. Flotation was seen as the obvious exit, given that Tragus was benefiting from high levels of organic growth and was a UK-oriented business in a sector that had undergone some re-rating.

“But, while we were thinking of flotation we began to receive offers for the company from other sources, at prices higher than we could have got from an IPO,” says Johnson. LGV sold Tragus to Blackstone for £267m.

Johnson, like others in the mid-market, believes the negative publicity attached to some of the high-profile take-privates takes attention away from the positive role of the rest of the market.

“The current political debate is fuelled by the activities of a small number of very big funds looking to buy high-profile companies,” he says. “Inevitably, when you buy a company like the AA or Sainsbury you’ll attract public attention but the downside is that people don’t see what the rest of us are doing in taking a growing company and helping it grow even more, become more successful and valuable.”

Paul Marson Smith, chief executive of lower mid-market house Gresham, agrees, saying: “It is the mega-funds that are being criticised but the bulk of the market is in growth-oriented funds like us.”

He adds that three-quarters of Gresham’s investment gains come from profit improvement at portfolio companies. “It’s not from financial engineering or a funds under management exercise, but growth-oriented profit improvement,” he says.

Despite the bullish market for exits, acquiring good assets has become even more difficult, says Marson Smith.

“It’s got tougher, with new entrants and competition, but that is inevitable at the peak of a market and all we can do is stick to the fundamentals of sales, profits, and cashflow,” he says, adding: “We stick to what we do best and avoid drifting or becoming complacent.”

Gresham’s strategy has been to identify undervalued assets, transform them and sell them at a good return. But because today is a sellers’ market it has got harder to find good buying opportunities, says Marson Smith.

“There is a lot of MOT failures out there polished up by investment banks but we’re not interested in them,” he says.

His approach, Marson Smith says, is all about origination, which leverages on the house’s knowledge of sectors and its relationships with management teams.

“We want to be able to offer our investors good performance through the cycles, not just in the good times,” he says and returns continue to be strong.

“In the last three years we’ve realised 30 investments at an average of 3x money, with sectors like support services providing returns of 4x money,” Marson Smith says.

Whether such returns will be maintained is another question, as there are many in the market who expect the increased competition and uncertain economic factors to affect performance.

The current market bullishness is going to end at some stage, believes Baird’s David Silver, although he acknowledges that there have been warnings about downturns in the past that have not materialised.

“At the beginning of 2006 we thought there would be a weakening in the second half of the year or the last quarter, but it didn’t happen,” Silver says. “The public markets wobbled in the first quarter of this year but have largely recovered.”

He believes that there will be an end to the current cycle and that valuations will be affected, but that M&A activity be sustained because there is so much private equity money available.

LGV’s Adrian Johnson also believes there will be some correction in the market in the short term but nothing that will dramatically alter the trend that has seen private equity occupy such an important part of the economy. He is concerned, however, about prices being paid for some assets.

“Everything you look at these days seems to be expensive on a historical basis and profit multiples have soared,” he says. “People buying some of these companies are doing so on the assumption that things will still be rosy in three to five years’ time, and that may not be the case.”