In recent months, Sainsbury's, Whitbread and Boots have all been targets of bids from private equity groups. Much of the attendant publicity has been negative. PE has become the business that everyone loves to hate. Job losses of more than 3,000 at the AA, taken over by PE groups CVC and Permira in 2004, have led to claims of uncaring capitalism; stories of £25m—plus returns for PE professionals after five years have brought back memories of Gordon Gekko-style greed. When Sainsbury's saw off a hostile
bid from CVC last April, the Transport and General Workers Union, which represents 25,000 of the supermarket's workers, said it was "excellent news for Sainsbury employees, customers and the public interest".
"Private equity," T&G spokesman Brian Revell declared, "is a dangerous form of ownership based on debt and extraction of wealth at the expense of good management, jobs and the welfare of employees."
Government ministers are equally suspicious. Private equity adopts an aggressive approach to tax-pushing concessionary schemes, such as taper relief, to the limit; a Treasury review of private equity's tax breaks is currently under way.
Meanwhile, consumer groups and high-profile commentators such as Will Hutton, chief executive of the Work Foundation, point to the lack of accountability and transparency that are characteristic of private equity-owned companies. (The supermarket chain Somerfield pulled out of the Ethical Trading Initiative after financier Robert Tchenguiz and private equity house Apax Partners took it over.)
Private equity's toughest critics, however, come from inside the investment industry. Michael Gordon, chief investment officer at Fidelity International, admits that buy-out firms may "unlock value in a sleepy business" but says it can be at the expense of longer-term stakeholders such as employees, customers and suppliers, who have to work with a business loaded with debt long after the private equity investors head for the door.
And last November, the widely respected banking and financial services conglomerate Citigroup published research claiming that private equity's enhanced returns over publicly-quoted companies are the result of loading its businesses with higher-risk debt rather than underlying better performance.
But none of these critics looks like stopping the growth of private equity in the near future. The industry now employs more than two and a half million people in the UK. And, in the first months of 2006, it raised £11.2bn in capital on the London Stock Exchange, according to the Guardian newspaper.
Behind its growth lies, in part, lucrative (but less publicised) deals with owner-managers and small to medium-sized enterprises (SMEs). What does it have to teach them about enterprise; what contribution does it make? Here, leading members of the industry offer a 10-point defence of their role.
1 Strategic edge
Peter Linthwaite, chief executive of the British Venture Capital Association, says: "I think the benefit that private equity brings to the owner-managed SME is a greater breadth of strategic thinking. PE professionals have seen it all before because they've done similar deals."
Private equity strengthens an SME's strategy, says Alex Brebbia, a director of Barclays Ventures, encouraging other investors to "follow the money". He cites the case of Medical Diagnostic and Imaging (MDI), which runs patient-scanning clinics.
"When investors support the roll-out of a concept or a strategy, it gives the business an edge over others. MDI had only one clinic when we invested. Now it has three and it should have six in 12 months' time. It was able to do this because the funders were able and willing to continue to invest further funds behind a strong team executing a well thought out plan."
2 Long-term value creation
Too many companies get distracted by diversions, says Wol Kolade, managing partner at Isis Equity Partners. Private equity means clearer direction. "What we try to do is to chart a course that seems to make sense over the medium term as opposed to one that's subject to the latest fashion."
Brebbia says that private equity helps a business to think of longer-term value rather than short-term profit. PE professionals would, for example, discourage reliance on one big client—however lucrative the deal may seem.
Charles Sherwood, a partner at international firm Permira, sums up the key value creation contribution of private equity like this: "There's a very close relationship between shareholder and manager, between officer and owner. This closeness is both financial, with incentives clearly aligned, and also physical—we are around the boardroom table together. As a result, trust is high and communication channels short. This makes for rapid decision-making."
3 Culture of enterprise
When private equity invests in a company, it focuses the management on the future and helps realise plans that previous owners might have stifled.
"Private equity is less likely to contribute blinding insight than to create an environment in which the insights of others, often long held, can be put to work quickly and effectively," says Sherwood. "In this sense, it is less a process of creation, more one of liberation."
When Isis backed Tricom, a £70m-turnover distributor of plumbing and heating equipment, it was attracted by the research-based approach that had led its excellent management team to focus on a counter-intuitive strategy of targeting smaller builders' merchants. In four years, turnover rose to £120m and net operating margins from two to 3.5 per cent.
4 Bold decision-making
Private equity professionals insist the press is wrong to portray them as ruthless axemen, sacking staff from the companies they take over. But Linthwaite admits that when private equity moves into a company for the first time, "it will look at the strengths of the business, but also at how the weaknesses can be addressed".
Shortly after Staffline Recruitment completed an Isis-backed "Bimbo"—a combination of a management buy-in and management buy-out—the company hit hard times. Its traditional recruitment market turned down shortly after it had invested for expansion.
The company took tough and creative decisions. It strengthened the management team and developed an innovative way of delivering its services direct to customers, bypassing a conventional branch network.
5 New professional standards
Alex Brebbia argues that private equity can help SMEs improve the professionalism of their businesses. "It's common to find in SMEs that processes aren't documented and that a lot of important decisions are made by one person, rather than the top management team," he says.
When private equity backed a £15m management buy-out of Uninterruptible Power Supplies two years ago, it introduced an experienced chairman, John Pettifor. Says Brebbia: "He's been excellent at sharing his business experience with the management team, giving them a useful framework and toolkit for use in their strategic planning, budgeting, evaluation and incentivisation exercises. These disciplines not only help to ensure the business performs well, they will also make it more attractive to potential purchasers when the time comes to sell."
6 Cost management
PE professionals admit that they keep costs tight, but say they're not afraid to invest when there's a good prospect of handsome pay-backs. They see managing cashflow as crucial. "It's important to understand the value of cash versus profits," says Brebbia. "I'm talking about the timing and quantum of cash."
If a company is given the chance to bid for a profitable contract where cashflows come late it may, says Brebbia, need to turn it down: funding gaps aren't good for a business. Brebbia cites the example of Integral UK, a £125m-turnover facilities management provider. By focusing on cash—for example, by reducing debtor days—the company "materially improved" its cost of capital.
7 New money
Private equity has come in for criticism for wrapping up deals in complex financial structures "leveraged" with lots of debt. However, the most complex financing comes in the mega-billion deals, not where private equity moves in on an SME.
But debt is an important part of the philosophy of private equity deals, explains Sherwood. "The debt does not itself create value, but it does magnify the value created by other means. It also encourages a disciplined culture in which resources—in particular cash—are used thoughtfully."
"We are much more comfortable at understanding debt and how it works," says Kolade, adding that if private equity invests in a company it commits to it—and is prepared to fund it from deep pockets.
8 New blood
Private equity firms offer a different approach to recruitment. Most SMEs look at the wrong things, argues Simon Havers, managing director of Baird Capital Partners Europe (BCPE). He says: "I would characterise typical SME recruitment outside private equity as being part looking at how big the jobs were that somebody previously held, part sitting in a room and looking them in the eye to decide whether they are a good chap, and part taking up their references to see whether they've been stealing or not.
"We're less interested in the previous jobs people have held, much more in the measurable achievements they've made in those roles. When it comes to references, we're much more interested in referees that we identify ourselves."
Isis's Kolade agrees. After his private equity firm invested in fashion chain Fat Face, Isis helped the company recruit an experienced chairman and a team of second-tier managers to power growth.
9 Management motivation
Kolade tells the story of a friend who works for a successful private company. He'd built a profitable division of the company from scratch. Then he asked the owners if he could have a share of the business because he wanted to dedicate his working life to making it even more successful. Recalls Kolade: "They told him, 'There are owners and there are workers. You are a worker.'"
That approach is anathema to private equity. The companies private equity backs are successful because the senior managers who help to create the value often get to keep part of it. The original owners may get a smaller slice of the pie—but it's a much bigger pie.
When it comes to incentives, size matters, says Havers. "In an SME, a chief executive might get a five-figure sum as an annual bonus," he says. "In a private equity-backed company, he might get 10 per cent of the equity. If he increases the value of the company by £20m during his watch, he keeps £2m."
It's an approach that worked brilliantly at ArmorGroup, a BCPE-backed company that provides protective security services in hazardous environments. Twenty-five key managers shared 30 per cent of the equity. In three years, they increased turnover from £59m to £144m.
10 Rapid progress
When private equity invests in a company, it's not for life. Usually, the investors are looking for a hefty return on their investment in three to five years—when they "exit", by selling the company to other investors or floating it on a stock exchange. The medium-term horizon provides a focus for everything the company does.
"A private equity investor sees his investment as a project," says Havers. "He knows why he wants to buy the business—and that informs the roadmap of what needs to be achieved before it's sold. For example, you might buy a UK business and believe that you can turn it into a European one that some other investor will want to buy within a defined time period."
Having clearly defined medium-term goals can help a business progress more quickly. "It's that project mentality," Havers adds.
Last year, BCPE invested in Paddock Holdings, which makes multipoint locks. Havers says: "We wanted to achieve three things before we exit—increase sales substantially, modernise the UK manufacturing to make it world class and develop relationships with low-cost component suppliers in the Far East." After one year, sales are up 12 per cent and productivity has improved.
