Private Equity in the U.S.: Building a New Future

VOLUME 22 | NUMBER 4 | FALL 2010

APPLIED CORPORATE FINANCEJournal of

A M O R G A N S T A N L E Y P U B L I C A T I O N

In This Issue: Payout Policy and Communicating with Investors

Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance)

8 Keith Sherin, General Electric

The Value of Reputation in Corporate Finance and Investment Banking (and the Related Roles of Regulation and Market Efficiency)

18 Jonathan Macey, Yale Law School

Maintaining a Flexible Payout Policy in a Mature Industry: The Case of Crown Cork and Seal in the Connelly Era

30 James Ang, Florida State University, and

Tom Arnold, C. Mitchell Conover, and Carol Lancaster,

University of Richmond

Is Carl Icahn Good for (Long-Term) Shareholders? A Case Study in Shareholder Activism

45 Vinod Venkiteshwaran, Texas A&M University-Corpus Christi,

and Subramanian R. Iyer and Ramesh P. Rao,

Oklahoma State University

Drexel University Center for Corporate Governance Roundtable on Risk Management, Corporate Governance, and the Search for Long-Term Investors

58 Panelists: Scott Bauguess, U.S. Securities and Exchange

Commission; Jim Dunigan, PNC Asset Management Group;

Damien Park, Hedge Fund Solutions; Patrick McGurn,

Risk Metrics; Don Chew, Morgan Stanley. Moderated by

Ralph Walkling, Drexel University.

Blockholders Are More Common in the United States Than You Might Think 75 Clifford G. Holderness, Boston College

Private Equity in the U.K.: Building a New Future 86 Mike Wright, Center for Management Buy-out Research

and EMLyon, and Andrew Jackson and Steve Frobisher,

PAConsulting Group Limited and Center for Management

Buy-out Research

Should Asset Managers Hedge Their “Fees at Risk”? 96 Bernd Scherer, EDHEC Business School, London

Measuring Corporate Liquidity Risk 103 Håkan Jankensgård, Lund University

The Beta Dilemma in Emerging Markets 110 Luis E. Pereiro, Universidad Torcuato Di Tella

86 Journal of Applied Corporate Finance • Volume 22 Number 4 A Morgan Stanley Publication • Fall 2010

Private Equity in the U.K.: Building a New Future

1. Kaplan, S. 2009, “The Future of Private Equity. Journal of Applied Corporate Finance, 21(3): 8–20; Cumming, D., Siegel, D.S. and Wright, M. 2007. Private Equity, Leveraged Buy-outs and Governance. Journal of Corporate Finance, 13: 439–460.

2. Thompson, S., Wright, M. and Robbie, K. 1989. Management buyouts, debt and efficiency: some evidence from the U.K. Journal of Applied Corporate Finance, 2(1): 76–86.

3. Kaplan, S. N. and Stein, J. 1993. The evolution of buy-out pricing in the 1980s. Quarterly Journal of Economics, 108: 313–357.

4. Andrade, G. and Kaplan, S. 1998. How costly is financial (not economic) distress? Evidence from highly leveraged transactions that became distressed. Journal of Finance, 53: 1443–1493; Citron, D., Wright, M., Rippington, F. and Ball, R., 2003. Secured creditor recovery rates from management buyouts in distress. European Financial Man-agement, 9: 141–162.

5. Kaplan, S.N. and Schoar, A. 2005. Private equity returns: persistence and capital flows. Journal of Finance, 60: 1791–1823.

Buring the global recession that began in 2007, the sources of leveraged finance dried up, the volume of private equity deals plummeted to a 15-year low, and restructurings rose sharply. Such

dramatic changes marked the end of what finance scholars now refer to as the “second great wave” of the global private equity movement. Among its accomplishments, the most recent wave of PE deals saw record billions of capital infusions into PE firms by institutional investors, and record amounts of capital put to work in portfolio companies. Nevertheless, in many cases, the returns from such investments do not look promising. And facing a wall of refinancing requirements in the next few years, and constraints on leveraged finance, the future of the PE movement is far from clear.

In this article, we argue that, despite the recent downturn, private equity firms still have an important role to play in the global economy. At the same time, however, many PE firms may need to rethink their strategies. Practices that have worked in the past may not produce acceptable returns in the future. Although many firms still have large amounts of capital to invest, the financial environment has clearly changed, and financial lever-age will almost certainly be lower than in the past. At the same time, specialized operating expertise has become more critical to success than ever, and those private equity investors that have not acquired it are especially likely to find that past success in raising capital is no guarantee of future success.

This article offers a number of reminders about the key elements of the private equity model that have helped them to increase the efficiency and value of their portfo-lio companies—and in an increasing number of cases, to achieve significant growth in the process. Using the findings of academic research together with our interviews with PE practitioners in the U.K., we try to show what others can learn from the best and most experienced PE firms. Over the past two or three decades, such firms have developed the operat-ing talents and skills that have enabled them to transform many of their portfolio companies—talents and skills that

less experienced PE firms will need to acquire to avoid the ongoing “shake-out” stemming from the scarcity of financing and other adverse changes in the PE environment.

A Brief History of PETo understand where the private equity business in the U.K. is now headed, it’s helpful to retrace its path over the last three decades. During the first great wave of private equity transac-tions in the early to mid-1980s, the sector enjoyed remarkable financial successes that were driven by significant increases in portfolio company profitability and productivity (and, in some cases, employment)1 in both the U.S. and Europe.2 PE firms typically made major changes in both the capital struc-tures and managerial incentives of the companies they owned. These changes helped produce above-average returns for the limited partners of the PE firms, which in turn helped them attract and put to work even more investment capital.

By the end of the decade, however, the increase in lever-age, purchase prices, and default rates3 led to a sharp reversal of PE profitability, market conditions, and activity. But even though default rates rose, the financial expertise and owner-ship incentives of the PE firms enabled the companies to experience high recovery rates—or recoveries well above those experienced by financially distressed public companies.4 And this effectiveness in managing high leverage and preserving value in financially troubled companies has no doubt contrib-uted greatly to the ability of the best PE firms to outperform the market on a consistent basis.5

The “second wave” of private equity, which started in the U.S. in the mid 1990s, took hold in the U.K. in the late 1990s. And as shown in Figure 1, the total value of PE transactions in the U.K. reached a record high of £42.2 billion in 2007, thanks in part to favorable macroeconomic and stock market conditions. In the early 2000s, a plentiful supply of attractive companies in Europe, including corporate divisions, small listed entities, and even existing PE-backed buyouts, helped to fuel remarkable market growth. Particularly in Europe,

by Mike Wright, Center for Management Buy-out Research and EMLyon, and Andrew Jackson and Steve Frobisher, PAConsulting Group Limited and Center for Management Buy-out Research

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87Journal of Applied Corporate Finance • Volume 22 Number 4 A Morgan Stanley Publication • Fall 2010

family-controlled companies increasingly viewed PE-backed vehicles as an acceptable succession option. At the same time, sprawling corporations faced increased pressure from the demands of globalization to reconfigure themselves, provid-ing numerous opportunities for PE firms to acquire divisions, many of which were viewed as “non-strategic” and ripe for cost reduction (see Figure 2).

During this same period, the Public-to-Private (PTP) market evolved from providing opportunities mainly for smaller listed corporations disillusioned with the stock market to presenting larger companies with the prospect of achieving significant increases in efficiency and value through dramatic

changes in ownership and capital structure. As an example of the early, smaller PTPs, the U.K. homebuilder Wainhomes was taken private in 1999 in a PE-backed management buyout for £88 million, and then sold in 2001 for £132 million to the construction group Wilson Connolly. But in the next few years, the PTP market saw a growing series of investor buyouts (IBOs) of listed corporations (in which PE firms lead the deal and management gets small equity stakes or stock options). As one example of a highly successful IBO, in 2003 the retailer Debenhams was taken private in a £1.7 billion IBO led by Permira, the Blackstone Group, and Goldman Sachs, after which management set about improving margins and working

Figure 1 U.K. (PE Backed) Deals

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Table 1 Types of Senior Debt and Margins Above LIBOR (U.K.)

Type of Senior Debt 2004 2005 2006 2007

Tranche A 225 218 224 217

Tranche B 275 250 262 265

Tranche C 327 283 308 303

6. Citron, D., Robbie, K. and Wright, M. 1997. Loan covenants and relationship banking in MBOs. Accounting and Business Research, 27, 277–296.

capital, cutting costs in the supply chain, and controlling capital expenditures. Following a major releveraging in 2005 that enabled investors to cash out part of their capital gain, Debenhams went public again in 2006.

This period also saw significant growth in secondary buyouts—sales of portfolio companies from one PE firm to another. Although traditionally viewed as a last resort, attitudes changed as the pressures on maturing PE funds to make returns to their LPs led to an increased supply of targets for newly raised funds. In 2007 the number of secondary (or “tertiary”) PE-backed deals was eight times that of a decade earlier, with total transaction volume peaking at £11 billion, 20 times the 1997 level.

Institutional investors in the U.S. and U.K. were increas-ingly attracted to PE as an asset class. Institutional investors in the U.S. were also persuaded that there were potentially attractive returns from investing in funds targeting less devel-oped (and hence less competitive) PE markets offering greater opportunities for restructuring deals. As a result, the amount of capital raised by PE funds in the U.K. increased dramati-cally (as can be seen in Figure 3).

Throughout the 2000s the level of corporate-led M&A activity declined, as cheap capital and the increased leverage available to PE reduced the ability of corporate buyers to compete. The value of buyouts as a share of all U.K. M&A activity rose from 18% in 2000 to a record 63% in 2007. PE bidders, as a result of raising ever larger funds and easy access to debt, were able to go after increasingly large targets. The average size of U.K. “mega-deals” (those with a transaction value of at least £100 million) doubled from £300 million in 2004 to £600 million in 2007.

Helping to fuel this increase in purchase prices, the amount of debt available for larger deals rose dramatically, thanks in large part to the growth of collateralized debt obliga-tions (CDOs) and collateralized loan obligations (CLOs), as well as second lien debt, as alternatives to traditional mezza-nine financing. The amount of senior debt available was increased by adding to traditional “A” layers a “B” or even “C” tranche in which capital repayment began either after the “A” tranche was paid off or as a bullet repayment at the end of the loan period. Lenders competed to offer more debt by reducing the price and maximizing the amount available. As shown in Table 1, the average charge over LIBOR for A, B and C tranches of senior debt in U.K. deals fell in 2005 and by 2007 were still well below 2004 levels (Table 1).

In addition to carrying lower interest charges, buyout lending agreements, which traditionally contained both more and a greater variety of covenants than general bank lending agreements,6 also became less restrictive as banks were persuaded to reduce the number of covenants, and to

Figure 3 U.K. (PE Backed) Buy Outs and Funds Raised

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7. TSC 2007. Private Equity Vol. 1. London: HMSO 8. Young, R. 2010. Do the numbers add up? Real Deals, March 25, 2010, pp. 12–13.

loosen those that remained.7 As in the U.S., these trends resulted in a sharp rise in the overall volume of debt invested in private equity buyouts in Europe (see Figure 4). And the average proportion of debt in the financial structures of U.K. private equity backed buyouts rose significantly (Figure 5). The change was most visible in larger deals, with the debt/EBIT multiples in U.K. buyouts of £100 million or more rising from 8 times in 1997 to a peak of 12 times in 2007.

One predictable result of this abundance of capital and credit, along with the pressure on PE firms to put their capital to work, was a growth in the willingness of such firms to pay higher prices for increasingly risky companies. Little consider-

ation was given to the possibility of a downturn (much less the financial crisis, recession, and credit crunch that eventually materialized). And using a practice that sounds like a contra-diction of the private equity model, some PE firms actually outsourced their due diligence to third parties.8 If one agrees with Michael Jensen’s much-cited statement that the best PE firms know more about the businesses they buy than “has ever been known before,” then the outsourcing of due diligence does not fit the model; indeed, it suggests a renunciation of one of a PE firm’s main sources of competitive advantage—some might even call it an abdication of responsibility.

Nevertheless, in an increasingly common practice known

Figure 4 Trends in Debt Raised for Private Equity Deals in Europe

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9. See Audra Boone and Harold Mulherin, “Is There One Best Way to Sell a Company? Auctions vs. Negotiated Sales,” Journal of Applied Corporate Finance, Vol. 21 No. 3 (Summer 2009).

10. Meerkott, H. and Liechtenstein, H., 2008. Get ready for the private equity shake-out. Boston Consulting Group/IESE.

11. For example, Terra Firma announced it had cut the equity value of EMI by a half (Financial Times, 13.7.09), while Apax Partners announced it had written the equity value of EMAP to zero.

12. CMBOR. 2010. U.K. Management Buyouts. CMBOR, Autumn.13. Andrade, G. and Kaplan, S. 1998. How costly is financial (not economic) dis-

tress? Evidence from highly leveraged transactions that became distressed. Journal of Finance, 53: 1443–1493.

14. Whether or not leverage is controlled for. Wilson, N., Wright, M. and Altanlar, A. 2009. Private equity, buyouts, leverage and failure. CMBOR Working Paper.

as “vendor due diligence,” due diligence was outsourced to third parties and combined with a prearranged debt package to create a streamlined auction process. But there is another fundamental problem inherent in this process: As recent research on auctions in IPOs and M&A suggests, the auction process, precisely by attracting inexperienced investors, often has the effect of reducing valuations by discouraging partici-pation by the most sophisticated and best-positioned potential buyers.9 To the extent this is so, reliance on third-party due diligence is likely to be symptomatic of a process dominated by less experienced PE firms without the internal operating skills (or access to them through partnerships) to produce acceptable returns on investment for their limited partners. And as recent research has clearly demonstrated, it is only the best (the top quarter or third of ) PE firms that have outperformed the market—and in fact outperformed with remarkable consistency.

But, of course, none of this was likely to deter newcom-ers to the PE industry, for whom the attractions were—and continue to be—substantial. The possibility of participating in carried interest opened up attractive options for individuals with extensive deal experience in corporate finance houses and investment banks. It was carried interest that enabled GPs to create significant returns for their firms and, with the help of favorable tax treatment in the U.K. and elsewhere, their individual partners. These arrangements could generate levels of wealth creation unlikely to be seen in other corporate or banking industries. And given the small amounts of equity the PE firms were putting into their own deals, once a firm succeeded in raising capital from its LPs, the price of entry into the industry was low. Viewed in this light, the flood of inexpe-rienced firms into the industry—and the wave of overpriced, overleveraged deals—seems entirely predictable.

The Financial Crisis and an Increasingly Hostile Environment for PEDuring much of its existence, private equity in the U.K. has had a low public profile, with deals dominated by middle-market buyouts that were not household names. Generally buoyant economic conditions through the middle of 2007 meant that few deals up to this point were in need of restruc-turings involving significant job losses. And private equity deals in the U.K. contributed to the growth of an entrepre-neurial culture. While public corporations in the U.K. were subjected to increased governance regulation starting with

the Cadbury Code (in 1992), PE activity was largely sheltered from the scrutiny of the wider investment community.

But by the second half of 2007, as the private equity market matured, competition among funds had helped push up entry purchase multiples on £100 million plus on U.K. transactions to 18 times EBITDA, up from 12 a decade earlier. As corporate restructuring programs passed their peak, fewer divisional targets were available)—and with funds having trawled over listed corporations, there were fewer obvious attractive targets for PTP deals. Significant numbers of portfolio companies saw their debt trading at distress levels,10 and several U.K.-based PE firms announced significant write-downs.11 The number of PE-backed buyouts in the U.K. that entered receivership rose from 42 in 2006 to 50 in 2007. However, the anticipated sharp increase failed to materialize as macroeconomic conditions began to deterio-rate. In 2008, 53 PE-backed deals went into receivership, with a further 56 in 2009.12

But PE firms engaged in proactive and effective restruc-turing. Despite widespread predictions of the end of private equity, only 10 out of the 74 U.K. buyouts (with an initial transaction value of at least £10 million) that went into receiv-erships during the first half of 2009 involved PE-backed deals. Consistent with the findings of studies13 after the first wave of PE deals, this constitutes suggestive evidence that PE firms have been far more effective than both large corporates and other private owners in preserving value in financially troubled companies.

What’s more, despite repeated warnings of financial doom in the popular business press, PE-backed deals completed in the U.K. after 2003 were not significantly more likely to fail than other comparable private firms.14 Formal insolvency was avoided in a number of high-profile distressed PE portfolio companies through the use of debt-for-equity swaps with banks, secondary buyouts, and trade sales.

For example, by March 2008 the £144 million buyout of Travelsphere Holdings that closed in 2006 was struggling to service its debt and in danger of breaching its covenants—and in January 2009, it was sold to the banks in a debt-equity swap. In another case, the £222 million Apax-led Incisive Media deal, which was also completed in 2006, breached covenants at the end of 2008. Following an extensive period of attempts at restructuring, a debt-equity swap was completed in early September that reduced Apax’s stake to a nominal level. And in a third example, Faith Shoes, a £64 million shoe


15. Guo, S., Hotchkiss, E. and Song, W. 2007. Do buyouts (Still) create value? SSRN Working Paper; Weir, C. Jones, P. and Wright, M. 2008. Public to private transactions, private equity and performance in the U.K.: an empirical analysis of the impact of going private. Available at SSRN: http://ssrn.com/abstract=1138616.

16. Nikoskelainen, E. and Wright, M., 2007. The impact of corporate governance mechanisms on value increase in leveraged buyouts. Journal of Corporate Finance, 13(4), 511–537.

17. Thomas, M. 2009. The Zombie Economy: Leadership in Times of Uncertainty. London: PAConsulting Group.

18. ICAEW/Ipos-Mori. 2009. SMEs access to finance: research report. London.ICAEW.

19. Havers, S. (Chair of BVCA). 2009. The Challenges Facing the Industry, presenta-tion at INSEAD.

20. ICAEW/Ipos-Mori. 2009. SMEs access to finance: research report. London.ICAEW.

21. Simon Havers, op.cit.22. Citron, D., Robbie, K. and Wright, M. 1997. Loan covenants and relationship

banking in MBOs. Accounting and Business Research, 27, 277–296.23. PSE Group in European Parliament (2007) Hedge Funds and Private Equity—A

Critical Analysis. Report of the PSE-Group in European Parliament; TUC (2007) Private Equity—a TUC Perspective. Trades Union Congress Evidence to the Treasury Committee Inquiry, May.

24. TSC 2007.

company buyout led by Bridgepoint, later experienced trading difficulties that required an additional £15 million equity injection from the PE backer. After the company’s bankers declined a debt-for-equity swap, the company was acquired by the retail group Kinnaird along with the distress fund Agilo, which enabled the shoe and clothing retail activities of these parties to be combined.

What do we know about the profitability of the second wave of PE deals? Earlier studies have shown that PTPs completed in the first wave of the 1980s generated signifi-cant increases in profitability. But in the case of more recent PTPs in the U.K. (and this is true of the U.S. as well), studies show increases in value, but no improvements in operating profitability.15 And for those companies that have chosen to exit through secondary buyouts, generating value has proved even more difficult. Recent studies have reported that the index-adjusted median equity IRR to the sellers in secondary buyouts (21%) was only about half that obtained in trade sales (43%), and a fifth of that in IPO exits (99%).16

But this outcome is by no means unexpected. IPOs are clearly the most successful transactions in the sense that such firms have enough growth opportunities as well as inherent profitability to attract public investors. But, as Steve Kaplan showed in “The Staying Power of LBOs,” the buyouts that return to public ownership are the exception rather than the rule. The vast majority remain private companies, with some finding corporate buyers but most staying in the hands of PE firms or other private owners. And along with the reduced risk of mature buyouts, the expected returns are understand-ably lower.

The Present: Challenging Economic ConditionsThe challenge of finding a profitable exit strategy has, of course, been complicated by adverse economic conditions. Following the onset in 2008 of the deepest global recession since the 1930s, a policy of “quantitative easing” was initi-ated in the U.K. to maintain some stability and so prevent a freefall. And even at the time of this writing (October 2010), the economic outlook remains uncertain, with bank lending and consumer spending at very low levels.17 Securitization markets remain closed, which along with other bank lend-ing restrictions, means a shortage of debt for both existing portfolio companies and new larger deals.18 And industry practitioners in the U.K. note that credit committees continue

to be overly cautious in making decisions to lend to oppor-tunities proposed even by PE firms with records of previous success.19

Contributing to such concerns, there has been a growing number of covenant breaches. In addition to those companies that have completed debt-for-equity swaps, notable examples of breached covenants among larger U.K. deals include EMI, Mayfair Gaming, Firth Rixson, Caradon Plumbing, and Foxtons. In a handful of cases, U.K. lenders responded to covenant breaches by PE portfolio firms by forcing them into bankruptcy.20, 21 But as time passed and the crisis deepened, the lenders increasingly began to work constructively with PE firms and buyout clients to address the causes of covenant breaches in ways that preserved value.22 Lenders became more responsive to proactive approaches from PE firms with potential solutions to distress problems. Experienced lenders began to recognize the importance of continuing to involve PE firms so that the portfolio firm could recover value, as lenders realized that they did not have the expertise to take the business forward. Coordination of the resolution of problems in distressed deals with many different debt providers who had different objectives was addressed through the establish-ment of “thought-leader” groups involving representatives of the more experienced debt providers.

On top of these market difficulties, PE is also facing external challenges as well. In continental Europe, critics have long regarded private equity as a direct threat to the European social model, claiming that its performance improvements have come at the expense of workers.23 More recently, the potentially negative effects of highly leveraged deals have come under scrutiny by the U.K. Financial Services Author-ity (FSA). And in the U.K. as well as Europe, debate ranged from public hearings to proposed legislative reform.24 In the U.K. the Walker Report proposed that PE firms investing in large deals be required to report annually on their investment approach and their portfolio companies. These proposals were largely in line with requirements for listed corporations.

In November 2010, the European Parliament voted a Directive on Alternative Investment Fund Managers, which introduces new regulations for PE and hedge funds that include requirements for the disclosure of remuneration for funds’ executives, disclosure of information on portfolio companies and the prevention of so-called ‘asset-stripping,’ disclosure of PE firms’ plans for the business and for employ-


25. For details see http://ec.europa.eu/internal_market/investment/alternative_invest-ments_en.htm.

26. BVCA. 2009. Private Equity and Venture Capital Performance Measurement Survey 2008, London: BVCA.

27. Diller, C. and Kaserer, C. 2008. What drives private equity returns? Funds inflow, skilled GPs and/or risk? European Financial Management.

28. Cressy, R., Malipiero, A. and Munari, F. (2007), “Playing to their strengths? Evidence that specialization in the Private Equity industry confers competitive advan-

tage,” Journal of Corporate Finance, 13: 647–669; Meuleman, M., Amess, K., Wright, M., and Scholes, L. 2009. “Agency, Strategic Entrepreneurship and the Per-formance of Private Equity Backed Buyouts,” Entrepreneurship Theory and Practice, 33, 213–240.

29. For further insights see: http://www.distressed-debt-investing.com/2010/09/exclusive-interview-jon-moulton.html.

ment.25 Though the Directive did not introduce limits on the amount of leverage in portfolio companies, it insisted that leverage in each alternative investment fund be kept at “manageable” levels.

The Future of Private Equity in the U.K.Having reviewed the past performance and present condi-tions in the U.K. and global private equity markets, we now draw on recent studies of the U.K. market and our interviews with U.K. executives to identify building blocks for the future success of PE. The recent dramatic changes in the economic environment mean that many PE funds will have to develop new business models to raise themselves to best practice levels. For many, if not most PE firms, raising funds will be a major challenge. The most important determinant of a fund’s ability to attract new capital is historical performance, and with the current market offering LPs a large menu of PE fund invest-ment opportunities, the smart money is likely to gravitate to funds run by firms with a demonstrated ability to maintain operating returns in their portfolio companies in bad times as well as good.

As noted earlier, while PE buyout funds have outperformed other forms of private equity/venture capital investment and alternative investment classes, the above average returns have been earned mainly by the upper quartile of U.K. funds, which have shown a remarkable degree of persistence from one year to the next.26 Research has also shown that the returns of European GPs vary predictably with their industry and sector skills and years of experience.27 And this naturally causes the available funds to flow to a select number of PE funds. Those PE firms that have been more proactive and successful in restructuring portfolio companies are able to send positive signals to LPs that at least some value has been preserved in distressed deals.

As just one example, Investcorp sold its 1997 £473 million buyout of the motorway services group Welcome Break (which had been experiencing trading difficulties) to Appia Invest-ments for a reported £500 million in 2008.

Along with the ability to operate with high leverage and general expertise in financial management, LPs also want to see clear evidence of operating expertise and continuity in PE firms and their portfolio companies. For example, our interviews with PE firms in the U.K. suggest that they need to give careful attention to recruiting and developing the next generation of executives.

As in the U.S., studies of PE investments in the U.K show

that significant monitoring of and involvement in portfo-lio companies contribute significantly to the above-average profitability and growth of the best (and also generally the most experienced and industry-specialized) PE firms.28 Using evidence from a representative sample of 238 buyouts completed during 1993-2003, we found this effect to be strongest for buyouts of divisions and where the PE firms had a more intense involvement with their portfolio companies. By contrast, many other PE funds, especially new entrants, have taken a light touch not only in managing their portfolio businesses, but in defining their own strategy and focus. Though such PE firms often claim to have a particular focus on a selected industry (or industries), such claims often prove questionable when looked into. Strategic insight, along with active board development and monitoring of portfolio companies, are bound to be important differentiators of successful PE funds in the future.

Skill Changes RequiredThe investment teams in many PE firms will need to develop new strengths or partnerships to manage their way through the current recession-like conditions. In the past two waves of private equity, many less experienced PE firms in the U.K. relied heavily on outside expertise. In some cases, this meant giving excessive leeway, if not free reign, to the incumbent manage-ments of their portfolio companies. In other cases, it involved bringing in new, highly experienced managers to create value from delivering an agreed-upon business plan or business trans-formation. As already noted, the relative importance in the PE sector of delivering operating value has greatly increased, partic-ularly the ability to preserve the value of distressed businesses, whether those already within the firm’s portfolios, or those targeted as new acquisitions. In fact, the conventional wisdom among the PE executives we interviewed was that most PE firms are likely to find that the best approach involves combining external specialists or developing their own in-house capabili-ties in distressed debt with expertise in turning around company performance. As one example, Better Capital, led by highly experienced private equity player Jon Moulton, was recently established with this aim.29

Although the best PE firms in the U.K. have had such expertise for some time, this represents a significant departure for many other firms, which historically have focused on deal management, financial structuring, and developing an exit strategy to ensure transactions make it across the finish line. To acquire the operating expertise required to develop an industry focus and capability, many U.K. firms will find it


30. BVCA. 2009. Distressed debt. London: BVCA.31. http://www.endlessllp.com/.32. http://www.independent.co.uk/news/business/news/private-equity-firms-help-

to-bail-out-countrywide-1624896.html.33. Nikoskelainen, E. and Wright, M., 2007. The impact of corporate governance

mechanisms on value increase in leveraged buyouts. Journal of Corporate Finance, 13(4), 511–537.

34. Stromberg, P. 2008. “The new demography of private equity,” in Lerner, J. and Gurung, A. (eds.), ‘The Global Impact of Private Equity Report 2008’, Globalization of Alternative Investments, Working Papers Volume 1, World Economic Forum.

35. CMBOR, 2010. Management Buyouts in the U.K. Management Buyouts, Spring.

necessary to devote more attention to recruiting a network of seasoned corporate managers, some of whom will have exited from earlier investments and are still looking for opportuni-ties to create significant value.

Finally, such operating skills will also continue to prove valuable for U.K. distressed debt and turnaround funds.30 For example, in 2008 turnaround specialist Endless acquired The Works, a leading discount book retailer comprising a chain of 260 stores that was bought out in 2005, but had been in the bankruptcy process for over three months when acquired by Endless.31 A new management team with previous experience in this market was introduced and the business reestablished as the leading U.K. discount book retailer by returning to the core principles of securing the best products at the best prices through the quality and flexibility of its supply chain and a lean operating base. After recording losses, the Works delivered an EBITDA of about £3 million in its first year of trading post-bankruptcy.

In another example involving distress and turnaround funds, in early 2009 the Apollo Management-led 2007 buyout of the U.K.’s largest real estate agency group Countrywide encountered problems in servicing its debt.32 In May, a deal was proposed by distress fund Oaktree Capital along with Alchemy Special Opportunities Fund that involved an injection of £75 million of equity that would enable significant reduction in debt. In the following year, the company increased market share and in early 2010 concluded a 25-year exclusive license to the Sotheby’s International Realty® brand across the U.K.

But this leads to one last point about debt and financial leverage. Although debt financing for buyouts has recovered from the depths of the crisis, the levels seen in 2006 and 2007 are unlikely to be repeated in the foreseeable future. And this has a number of implications for future deals. First of all, to achieve target returns, a greater proportion will have to be derived from value created through improvements in internal governance and business performance.33 At the same time, deal entry prices will need to be kept at lower levels to generate those returns.

Another consequence of such financing constraints is an increase in the expected holding period for PE investments. Despite charges of “quick flipping” directed at PE firms, several studies of U.S. firms have shown that the average time to exit from PE investments is now about five years, and that the same is true of U.K. firms as well (see Figure 6). Although a small percentage of PE portfolio companies exit within two or three years,34 in an environment where more value is expected to be created through improvements in

business performance, investment holding periods are likely to become even longer. And while this may reduce expected IRRs, it may well focus management efforts more towards sustained value-enhancement strategies.

In the current environment, moreover, continuing to own portfolio companies and develop those with growth potential has some attractions. Our insights from the U.K. market lead us to envision, for example, a resurgence of “build-up” or “roll-up” strategies that begin with the purchase of a buyout platform company that provides the basis for a further series of consolidating acquisitions, generally in a fragmented industry sectors. Although such an approach takes longer to develop and exit from, the larger size of the company that results should open up greater exit opportunities at the end of the process. For PE firms, such a strategy puts a premium on the ability to identify and integrate target acquisitions.

Longer times to exit may also put pressure on traditional PE limited life fund structures. Either fund lives may need to become longer than the traditional seven to ten years, or we may expect to see further growth in listed PE firms. Such developments could have implications for traditional carried interest remuneration.

Increased Focus on Exit StrategiesRecent years have seen a significant increase in the number of PE investments being sold to other PE funds, and such second-ary buyout exits have been an especially important aspect of the U.K. market. Exit opportunities narrowed in 2008 and 2009. In the first half of 2009, exits in the U.K. amounted to a total of £960 million, as compared to a peak exit value of £26.9 billion in 2006. IPOs of PE-backed deals disappeared and exits through trade sales fell by almost 50%.

Given the significant change in market sentiment, the development and management of new exit strategies are now a critical focus for both existing portfolio investments and any future investments. While much hope was placed in IPOs as an exit option at the start of 2010, this failed to materialize, with only two buyouts coming to market in the first three quarters of the year.

Secondary buyouts have also been badly hit during the recent recession. But because PE firms now need to show LPs that they are both realizing gains and making new invest-ments, we can expect to see a recovery in this exit route. Indeed, evidence from the first three quarters of 2010 shows that secondary buyouts in the U.K. are on the rise, with 30 completed deals as compared to only 14 in the whole of 2009.35


36. http://realdeals.eu.com/mid_market/candover_supports_hilding_anders_re-structuring.

37. http://www.telegraph.co.uk/finance/newsbysector/retailandconsum-er/4742458/Bridgepoint-to-inject-fresh-cash-into-Fat-Face.html.

38. Without such mechanisms, the bankruptcy rate of PE-backed firms is not significantly different from that of non-PE backed firms.Gilligan, J. and Wright, M. 2010. Private Equity Demystified, 2nd edition, London: ICAEW.

39. Wilson, Wright and Altanlar, op.cit.

The Value of Proactive RestructuringDebt-equity restructurings often leave PE firms with a “signa-ture stake,” but little if any continuing involvement in the business. While a debt-equity swap helps avoid the formal bankruptcy process, it can have a devastating effect on growth strategy and future development. Banks are typically ill-equipped to provide added value in this respect even when finance becomes available again

The best PE firms in the U.K., most of which have extensive dealings with banks, have track records of working aggressively, but constructively with banks to preserve the value of financially troubled deals. Even after experiencing dilution of their equity, experienced lenders are recognizing the importance of PE firms retaining a board seat and continu-ing to function as the first point of contact with management. In cases where the banks’ exposure is not significantly larger than the remaining market value of the business, PE firms often inject further cash to maintain their position.

U.K.-based private equity firm Candover acquired Swedish-based bedmaker Hilding Anders in a €1 billion tertiary buyout in 2006, after which growth was fuelled by a number of acquisitions.36 The onset of recession led to realization of the need to reduce the debt burden and, in October 2009, Candover invested €38 million more to help the company avoid default. Candover also agreed to a deal with the company’s mezzanine lenders to swap approximately €100 million in loans for a 33% equity stake. The mezzanine lenders also provided a €48 million payment-in-kind loan and

Mezzvest agreed to invest €9.7 million. Following the invest-ment, Candover retained a 50.1% stake, while the company’s management received 17% as part of an incentive package.

In a second example, Fat Face, a retailer of life-style oriented outdoor clothing and accessories, was acquired in a secondary buyout by Bridgepoint in 2007 for £360 million.37 It was intended to expand the business by opening up to 15 new stores per year in the U.K. and developing interests in the Middle East, Hong Kong, and Singapore. In the year after, buyout sales increased 16% to £126.4 million and EBITDA rose 2.1% cent to £26.6 million. But as the recession devel-oped, there were concerns about the company’s ability to service its debt. At the end of May 2008, the company faced a banking covenant test of 7.5 times net debt to EBITDA, and in the third quarter Bridgepoint and management bought back a nominal £21.8 million of mostly second lien debt at 56p to the £1, reducing total debt to £168.2 million. Under this revised capital structure, debt represented six times EBITDA, reportedly high compared to the general retail sector but with some headroom in terms of banking covenants.

Furthermore, so-called equity cure provisions allow PE firms preemptively to inject further cash to address covenant breaches.38 Such measures, which amount to a kind of “pre-agreed” distress resolution mechanism designed to keep PE companies and their investors out of bankruptcy, go a long way toward explaining why the bankruptcy rates of financially distressed PE-backed firms are significantly lower than that of their non-PE counterparts.39 Contradicting the popular predic-

Figure 6 Holding Periods for Different Private Equity Deal Sizes

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

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50

40

30

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40. Wilson, N., Wright, M. and Cressy, R. 2010. Private Equity and Insolvency. London: BVCA.

41. Weir et al., Guo et al., Meuleman et al. Op. Cit.42. Wright, M., Hoskisson, R., Busenitz, L. and Dial. J. 2000. Entrepreneurial

growth through privatization: the upside of management buyouts. Academy of Man-agement Review, 25: 591–601.

43. Acharya, V., Kehoe, C. and Reyner 2009. Private Equity vs PLC Boards: A Comparison of Practices and Effectiveness. Journal of Applied Corporate Finance, 21(1), 45–56.

tions of massive defaults and losses on PE loans just three years ago, recent studies have shown that the more proactive approach of PE firms (both in the U.K. and U.S.) has resulted in shorter restructurings and significantly higher recovery rates (over 60% vs. 30%) for secured creditors of troubled PE portfolio compa-nies than for distressed listed corporations.40 For example, the failed private equity deals British Federal and Fairmile Fencing saw 100% of secured debt recovered in 2005. In contrast, the failed listed corporations DC Cook and MacKie International did not recover anything for secured creditors.

In addition to keeping their portfolio companies out of costly bankruptcy proceedings, those PE firms that are proac-tive in planning for and addressing financial trouble are likely to reap longer-term benefits from being in a more favored position when the banks begin to lend again.

The Importance of Building Operating Expertise Studies of both U.S. and U.K. buyouts during the second private equity wave suggest that performance improve-ments in both PTPs and secondary buyouts were especially challenging, given limited scope for cost-cutting strategies. Improvements in corporate governance and the emphasis on shareholder value in recent years have pushed general listed corporations to become more efficient, although there are undoubtedly laggards.41 While buyouts of divisions may offer the greatest growth opportunities, realizing the value of such investments is also more likely to require significant operating expertise.42 For this reason, PE executives with management expertise in these markets could play an important role in helping to create value in portfolio.

Following buyouts, PE firms in recent years have typically engaged in intensive 100-day appraisals that aim to confirm (or, if necessary, redirect) and begin to implement a portfolio company’s strategy to create value. The growing importance of strategies that include the development of new products, technologies, and markets suggests that, in the future, more PE firms will need to emulate the best practices of the estab-lished firms by becoming more closely involved in their portfolio companies after the initial 100-day period.

To the extent that they continue to maintain and develop their operating competence along with their expertise with finance and capital markets, the best PE firms in the U.K. (and elsewhere) are likely to continue to outperform listed corporations in businesses that don’t require large amounts of outside capital to grow. PE buyouts will likely continue to benefit from small, energetic, and intensely (thanks to their equity stakes) interested boards intent on developing and executing strategies that create value.43

Despite continuing attempts at increased regulation of PE in the U.K. and Europe, PE firms will likely continue to face fewer obstacles to value-increasing restructuring than listed corporations. The shelter afforded by a private equity buyout will likely continue to enable managers to effect restructuring and growth strategies that would be difficult as a listed corpo-ration concerned about initial adverse impacts of restructuring on their share price. But as the market continues to recover, and political pressure for noneconomic goals begins to resur-face, the entire industry will benefit from those PE firms that are able to demonstrate their commitment to balancing cost-cutting with more growth-oriented value adding strategies.

ConclusionsBased on our analysis of developments in the U.K., we have identified a number of key building blocks for creating a promising future for private equity that will involve some adjustments of the traditional model. The best PE firms have already developed the financial expertise required to manage high leverage (and the accompanying possibility of financial trouble) while preserving access to capital markets. At the same time, many of the best firms have developed impressive operat-ing capabilities—capabilities that will become more valuable as the role of leverage declines and the ability to realize growth opportunities becomes a large part of the PE strategy.

mike wright is Professor of Financial Studies at Nottingham Univer-

sity Business School and Director of the Center for Management Buyout

Research (CMBOR), which he founded in 1986, and a visiting profes-

sor at EMLyon, France. He has published extensively on private equity,

entrepreneurship and corporate governance. His most recent book is

Private Equity Demystified (with John Gilligan, 2nd edition, 2010). He

was recently ranked #1 worldwide for publications in entrepreneurship.

He is a member of the British Venture Capital and Private Equity Asso-

ciation Research Advisory Board.

Andrew JAckson is a Managing Consultant in PA Consulting Group’s

London office, as well as an affiliate of CMBOR. He has in-depth experi-

ence of working with executive teams and advising on corporate strategy,

business growth initiatives, and performance improvement. He has expe-

rience from advising on over 50 deals in the last 10 years across a wide

range of sectors and international exposure. Andrew is a qualified accoun-

tant, with experience working for PwC and Anderson Consulting.

steve Frobisher is a member of PA’s Management Group, and an affil-

iate of CMBOR. His focus is on strategic change management consulting,

including Managing for Shareholder Value (MSV), strategy development

and implementation, and post merger integration management. Steve is

a member of the Board of PA Strategy Partners Ltd.

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Private Equity in the U.S.: Building a New Future