IN THE UK, where the hostility of fund managers to public-to-private (PTP) deals led by private-equity houses is most pronounced, several banks are working on structures to enable fund managers to participate profitably in such deals. One such structure, using convertible unsecured loan stock (Culs) listed on London junior equity market AIM, is arousing particular excitement.
The Culs structure was developed by Kinmont, a corporate finance advisory boutique, with Travers Smith Braithwaite, a 200-year-old City of London law firm. Kinmont was set up in March 2003 by four former senior UBS executives with expertise in corporate finance, property fund management, equity sales, and European banks.
According to Kinmont, between 30 and 40 buy-outs are now considering using the structure, with at least one deal dubbed "partial private" expected to be executed within the next few months. Another two or three might take place later in the year.
Data from Dealogic show that in 2003 almost half as much equity as the $48.4 billion raised in initial public offerings was taken off stock markets globally through PTP deals. In the UK, the $7.2 billion of equity sunk in PTP deals was greater than the $4.7 billion that was raised in IPOs.
The high volume of PTPs relative to IPOs can be explained by low equity valuations and low interest rates. If debt is cheap and the ability to raise equity constrained, then the case for being a publicly traded company is less compelling for many firms than at the height of a bull market.
Despite the buoyancy of the PTP market, though, the majority of proposed deals are smothered at birth. In the UK, leading law firms in the field estimate that up to 80% of PTP deals fails. This suggests the volume of deals could be many times greater were hurdles in their path to be removed.
A growing obstacle to PTP deals is fund managers' activism springing from their hostility towards private-equity houses that buy stakes in companies from them at low valuations only to sell shares back to them later at a substantial premium.
At least one prominent fund management firm has privately said that it would boycott any private equity-sponsored IPO unless the vendor could prove that it had made substantial changes that added value to the company.
Fund managers are suspicious of any purchase price offered by a private-equity team, even if it looks relatively attractive. They often believe that the private-equity house backing a deal must have an inside track on the target company through the management buy-out team and that it would not be involved in the transaction unless it thought it could triple its money within five years.
If a management team has a fantastic new strategy to improve a listed company's performance, shareholders can fairly ask why it could not be executed under their public ownership.
Such views are increasingly being acted on. In June last year, for example, Deutsche Asset Management, a big player in the UK small-cap and mid-cap market, resisted management pressure to sell a stake in Fitness First to private-equity house Cinven, which planned to take the health club group private. Instead Deutsche raised its stake in the company from 7.2% to 10.2%, just above the mandatory squeeze-out level, forcing Cinven to accept it as a shareholder in the delisted company.
Similarly, in the same month, first Fidelity and then M&G Investment Management refused to sell their shares in restaurant chain PizzaExpress to private-equity houses TDR Capital and Capricorn Ventures, again forcing the bidders to accept just 90% of the equity.
Not such a good deal
Suspicions and mistrust aside, fund managers are increasingly reluctant to allow PTP deals to continue without a challenge today because the equity market is just emerging from a long bear phase.
A bid with a high-sounding premium of, say, 50% might be ostensibly reasonable, but if that is based on a current share price of just $2 compared with, say, the $5 that a fund paid for the shares in the first place, it might not feel like a good deal.
For the first time in a while, institutions believe that the market might continue heading upwards, so an offer of hard cash from a private-equity group might not be as attractive as holding shares that are likely to increase in value and yield dividends.
Given the scale of the PTP trend, which is also being driven by the strong growth of private-equity funds, fund managers also have another concern. The private-equity community naturally tends to work its way through sectors, taking out a number of companies in succession, because the factors that make one company in a sector ripe for plucking are often to be found in others. In the past 12 to 18 months in the UK, for example, PTP activity driven by private-equity houses has been concentrated in the retail, property, and health and fitness sectors.
By acceding to a number of PTP deals concentrated in a particular sector, fund managers are limiting the number of companies and quality management teams that they themselves can access, affecting the potential performance of their own portfolios. Private-equity funds will tend to focus on the best management teams (themselves attracted by the prospects of self-enrichment), and the best growth and recovery stories.
Fundamentally it is not in the interests of fund managers to allow private-equity funds to profit at their expense. They do, after all, compete for asset allocations and in that competition alternative asset classes such as private equity and hedge funds are gaining ground.
If more PTP deals are to succeed, their financial sponsors might find it necessary to offer something more enticing than cash alone. Effectively, this means allowing participation in the deals themselves. B
Private-equity houses do not like to share profit and normally only do so among themselves when as individual houses they have insufficient money to finance an acquisition. Helping fund managers boost their performance with private-equity exposure is not exactly appetizing.