Return to search

When is an exit not an exit?

When it’s a recapitalisation. These transactions have been on the rise over recent months as private equity firms have sought to take advantage of a hot debt market and return cash to limited partners. But how much longer can the good times last? Vicky Meek reports.

When Graphite Capital looked at its exit options earlier this year for Wagamama, the noodle bar chain that it invested in back in 1996, flotation seemed the most sensible and lucrative choice. “We wanted to realise our investment, but knew that the company still had a long growth story ahead,” says Andy Gray, partner at Graphite. The firm would have sold part of its majority shareholding, but retained a substantial portion of the business. But things didn’t turn out that way.

“We got two-thirds down that line and we also considered some very good offers from people looking to buy the business. But an alternative emerged,” says Gray. Hutton Collins approached Graphite, saying that it was interested in providing a payment in kind facility. Graphite also knew that banks were keener to lend than they had been in previous years. The stage was set for Graphite’s £63m recapitalisation of the business, £47m of which was debt provided by The Royal Bank of Scotland and £17m of which came from Hutton Collins. The deal gave Graphite a return of five times its investment, while allowing it to keep a majority stake.

“The recapitalisation was a good alternative to floating the business,” explains Gray. “Bank debt enabled us to take more money out of the business than a float would have done, helping us to boost returns. But it also allowed us to retain control of the company.” Since the refinancing, Wagamama has restructured the business, separating it into three geographic regions. As a result, Graphite’s exit may end up being completed in stages: the UK business is pretty mature and Gray suggests the firm may get out in two to four years; the other two are more early stage and so may require a longer holding period, but have potential for faster growth.

Unsurprisingly, Graphite is not the only firm to have spotted the attractions of recapitalising businesses in its portfolio. This year has seen a steady increase in the number of recaps. Figures from CMBOR for the first six months of 2004 (see graph) show that there were 84 recapitalisations in Europe, almost as many as the 87 recorded for the whole of 2003. There have been many more recaps announced since the end of June and so it looks as though this year could be a bumper one for this type of transaction. But why is this happening now?

It’s a difficult question to answer, partly because the reasons for recapitalising a business vary wildly. Graphite’s rationale with Wagamama, that it wanted to retain part of a growth story, is only part of the answer. Gray also says that floating the business would have been a difficult route to exit in current market conditions: “There was a time when public market investors’ appetite was easier to read and you could be pretty much assured that a company’s stock would rise on flotation. That doesn’t happen now. It’s difficult to get a business away to begin with and then, once it has gone public, the share price could well fall through no fault of the company management. The public markets are not attractive at the moment.”

And it’s not just public markets that are proving tricky. As James Stewart of ECI Partners points out: “Trade buyers have been scarce over the last couple of years.” With few acquirers on the horizon and mounting pressure from limited partners to return cash, some firms have found that recapitalisations are a good means of keeping their investors happy, while also de-risking their investments in portfolio companies. “There is definitely a trend towards longer holding periods,” says Peter Taylor, chief executive of Duke Street Capital. “There is a large overhang of unexited deals in private equity portfolios and firms are under pressure to return cash to LPs. Recaps are one way of doing this.”

But one of the key drivers at the moment is the availability of debt, without which the recaps couldn’t take place. The trend for aggressive debt offerings we have seen in the buyout market – witness the Saga deal in which banks were said to be offering debt finance at multiples of EBITDA as high as nine times – is also playing out in refinancings. “There is extraordinary liquidity in the debt markets at the moment,” says Daniel Morland, director in the debt advisory team at Close Brothers Corporate Finance. “That is partly because there has been a lack of jumbo deals over recent times – we haven’t seen many multi-billion deals being done in Europe. As a result, banks are underlent across their portfolios. But it’s also because there is a lot of institutional money in the market at the moment.”

Taylor agrees. “The debt markets have been warming up over the last year or so and more recently, they have been getting very hot,” he says. “There has always been a rule of thumb that you can’t take debt in a refinancing to higher multiples than those in the original deal, although we may see that rule disappear.” One of the reasons is confidence in the markets. “Credit quality has been very good over recent years,” adds Taylor. “It’s been a long while since we have seen a major disaster in which senior debt providers have lost their principal.”

This confidence has led banks to revise their views about certain markets too, allowing some firms to recapitalise businesses for which they found it hard to raise debt finance in the original deal. HgCapital’s refinancing of FTE Automotive is one example of this. When HgCapital originally acquired the manufacturer of hydraulic components for passenger car clutch and brake systems from its US parent in 2002, getting debt finance for the deal was an issue. “When we bought the company, banks were very nervous about Germany,” says Trevor Bayley of HgCapital in Frankfurt. “It didn’t help that we were in the process of changing management and needed to close the deal without a CEO and that none of the lenders had really heard of FTE.” The firm had to tap the London markets to raise the necessary senior debt because the deal was too large for the market in Frankfurt.

But the situation has changed dramatically over the last couple of years. FTE is now much better known in the banking community and it has grown organically and through acquisitions. It has also increased profitability from €33m in 2002 to a forecast €58m for this financial year. As a result, completing a €225m refinancing of the business in September was a much easier task. “There were 17 banks in the syndicate this time around,” says Bayley. The deal has produced a return of €91m to HgCapital and allowed it to take a larger stake in the business.

Industri Kapital’s recent €350m refinancing of garden tools manufacturer Gardena tells a similar story. “When we originally invested two and a half years ago, banks were quite nervous,” says Industri Kapital director Detlef Dienstel. “It was post 9/11 and the uncertainty that followed meant that debt was not easy to raise. But Gardena’s performance has been good and banks are more confident now. It wasn’t so hard this time around.”

The increase in recaps also highlights a shift in mentality among banks. Not so long ago banks were not keen to refinance businesses. “It’s the sign of a maturing market,” explains Bayley. “Banks used to be reluctant to allow private equity houses to reduce their exposure to a business because they took comfort in the investors retaining their high stake. That’s now less of a concern. Many now realise that just because a firm has taken money out of a company, it doesn’t mean they are less hungry. In fact, you could argue that they are more so because they know it’s a good company and will work harder to get the best returns.”

This shift in attitudes has been helped along by the current high levels of liquidity in the market. “Banks were always cautious of recaps,” says Morland. “Previously, they would only have allowed a private equity house to cash in their original investment; now, they are allowing them to take out profit, too. That simply wouldn’t have happened three years ago and demonstrates how hot the market has got.”

With so much debt available, there seems little doubt that some firms are looking at recaps in advance of their fund raising efforts. With so many funds slated to come to market over the coming 18 months, coupled with a tight exit market, it is inevitable that some will be tempted to refinance businesses in an attempt to boost cash-on-cash returns and therefore make themselves more attractive to potential investors. It’s a point picked up by Bailey. “Limited partners like to have cash returned to them,” he says. “But there is a nervousness about the trend for increased recaps. If firms are thinking of them as a substitute for exit in advance of fund raising, they may find it backfires. In our experience, we’ve found that LPs are concerned about the legacy portfolio a firm has to manage.”

Rhonda Ryan at Insight Investment is one LP who has noticed an increase in recaps in her portfolio. She has also noticed that groups in fund raising mode point to the cash returned to LPs from recaps they have completed from their previous funds. She looks at each case on its own merit. “If a recap is being done to improve returns and give cash back to LPs, that’s great,” she says. “But a recap is not a substitute for an exit. If a firm is recapping simply for their fund raising, then we’ll know because we’ll question the partners.”

Most firms stress the point that a recap isn’t an exit, anyway. “Exits are the ultimate litmus test for any private equity fund,” says ECI’s Stewart. “A refinancing should not be used as an alternative.” His firm recently refinanced three businesses: Sedgemoor, Gregory Pennington and Tragus and the reason was different in each case. For Tragus, the rationale was to help fund expansion, with Gregory Pennington it was to take advantage of the fact that the business had repaid its original debt ahead of schedule and therefore to repay preference shares and loan stock, and with Sedgemoor, the refinancing allowed the business to change banks to one that was more aligned with the business’ interests, according to Stewart.

Some even point to the fact that they don’t always take much cash out of the deal. Duke Street Capital’s recent refinancing of three portfolio companies, Paragon Healthcare, Galaxie Hotels and Esporta, is one example of this. “The rationale for recapping these businesses was similar,” says Taylor. “They are all capital intensive businesses and needed finance to expand. It made sense to use the debt markets for that finance, rather than put in more equity. We didn’t do these deals to get cash back. Our feeling is that we will do that later on through further releveraging and ultimately through the sale of the businesses.”

Sovereign Capital’s Peter Brooks, meanwhile, says that refinancing is part of the firm’s investment strategy. The firm recently recapped two businesses: Choice, a residential care home business, and Senad, which operates residential schools. In the process, Sovereign returned 40% of the amount invested from its first fund. “We raised our fund on the basis that our holding periods would be five years or more,” he explains. “Our buy-and-build strategy dictates this. So refinancings are a way for us to return cash to LPs earlier.” But there is another reason. “We have drawn down our capital more quickly than anticipated. For our larger LPs, that isn’t an issue because they have the cash available. But for the sake of our smaller LPs, we have a commitment to return cash as soon as possible.”

The reasons for recapping, therefore, are almost as numerous as the number of recaps completed. And many believe that, with a trend towards longer holding periods and an increasing willingness among banks to provide debt in this type of transaction, recaps are here to stay. They may well be. But it may not be so easy to raise debt finance in the future. The recent increases in recaps are likely to be a case of firms making hay while the sun is shining. Everyone knows that debt markets are cyclical. While the economy remains benign, high levels of gearing are not too much of an issue. If we see a downturn, that gearing could become a problem in companies unable to service their debts. The debt structures that are being put in place today could be the defaults of tomorrow. And, as Bayley points out: “It only takes a few bad deals for the debt market to close up completely.”