A large European universal bank was recently trying to lure a bright twenty-something MBA graduate from a US leveraged buy-out (LBO) firm to come to work in its London investment banking business. The target proposed an unusual bargain. He would come and work for the bank if it would compensate him for giving up his share in the capital gains he expected to make from the eventual sales of companies in his current employer’s private-equity portfolio. As a signing-on fee he demanded $25 million. Even at a bank used to offering two-year guaranteed earnings of $2 million or more to key employees, recruiters were stunned by the demand from someone with no more than five years’ work experience.
An investment banker at Goldman Sachs recently returned to his alma mater, Stanford University, to recruit. In years past, its best students would grab any chance to work for the world’s most prestigious investment bank, famous for enriching its partners. This year, the seven brightest students extended offers were a little cooler. Most were considering other options. Their choice would be either Goldman or a private-equity firm.
Private equity is hot, and the numbers being bandied about in that business on the sizes of buy-out funds, the returns to investors, and the personal wealth of the cleverest, or luckiest, individuals are jaw-dropping. Since the start of 1996, some $65 billion has been raised for private-equity investment in the US alone. Assuming the typical US LBO acquisition is capitalized with 25% equity, that translates into the financial capacity for deals worth $260 billion. At present acquisition rates, that means financial firepower to do more than five years’ transactions has already been assembled.
The reason that so much money is being dedicated to the sector is not hard to fathom: booming public stock markets have provided high exit multiples for private-equity buyers floating off acquisitions they made two or three years ago. That has enabled private-equity funds to outperform even booming markets by a healthy margin. The typical fund prospectus put out by the sponsors that have raised that $65 billion promises investors at least a 30% annual return. Institutions like pension funds are allocating higher proportions of their assets, assets that were already swelling in line with bullish stock markets, to this hot sector. For huge US pension funds, small LBO funds, to which they might allocate $10 million, are a waste of time. Some insist on a minimum contribution of $100 million but at the same time refuse to put up more than 10% of any one fund. Hence the proliferation of $1 billion or larger LBO funds in the US. There are between 75 and 100 of them.
The personal wealth of principal players in private equity can only be guessed at; the junior partner asking to be bought out for $25 million provides a hint of what’s on offer. The economics of private equity is changing as funds grow in size. Fund managers typically earn two sources of revenue: a management fee, usually 2% on funds committed by outside investors, and a carry a share in the profits on invested capital. In years past, private-equity funds spent their fees on overheads and hoped to profit from the carry. A pan-European private equity firm like BC Partners, with a £300 million ($490 million) fund, might spend most of its £6 million fee paying salaries, maintaining offices in London, Paris, Hamburg and Milan and conducting due diligence on prospective acquisitions (it can take a man-year to evaluate a single deal).
Recently funds have been getting much larger. In the US, KKR has one of the largest at $5 billion and can now buy large businesses by writing a single cheque, as it did in its recent purchase of the Act3 cinema chain for $650 million. It then moves quickly to put in debt, replacing much of its own equity within a few weeks. To be considered in the US premier league, an LBO fund would have to have $3 billion of equity capital. At that level even a knock-down 1.5% management fee would bring in $45 million.
Now for the first time, these kinds of large funds are springing up in the less mature European buy-out market, swollen by commitments from US investors. BC Partners closed an Ecu1 billion fund in October. Once that would have been huge: now it’s just par for the course. Doughty Hanson closed a $2.5 billion fund in September. Schroder Ventures converted a number of its country funds into a $1 billion European fund. UK investment bank Charterhouse runs a £800 million fund. CVC closed a $840 million fund last year. Today the management fees alone on the largest funds are enough to make the partners of small specialist fund managers wealthy before they do a single deal.
Legendary profits
As to profits on actual transactions, some have become the stuff of legend. Venture-capital investors in European low-cost airline Ryanair made many times their money in under a year when it floated in Dublin. Funds managed by Doughty Hanson took out 15 times their initial equity investment in Swiss watchmaker Tag Heuer after 10 months when it floated last year. Investcorp made such huge gains on the sale of its shares in Gucci in 1995 having bought half the company in 1989 from feuding Gucci family members and a further 50% in 1993 when it was making large losses that the proceeds transformed Investcorp’s business. It used the huge liquidity it received to set up new hedge fund-like investment vehicles for its investing clients in the Gulf states.
In some cases, investors are making big returns without even fully realizing investments. Bankers Trust Capital Partners spent $80 million buying into Finnish fishing-gear maker Repola and recently took out a $210 million special dividend while still retaining a 26% stake. One investor thought about publishing a tombstone for a recent deal but decided not to. It’s a sure sign that something extraordinary is going on when bankers are embarrassed by the profits they’re making.
The obvious danger for the private-equity business is that it might become a victim of its own success. US institutions eager to continue making high private-equity returns now face the challenge of too much money chasing too few deals. A few fund managers will try to dampen outside investors’ expectations and accept lower returns for the level of risk they have been used to taking. US LBO firm TA Associates, for example, which concentrates on medium-sized deals, has had annual returns in the high teens and up to 20% every year since 1968, irrespective of economic cycles.
It’s an impressive record. But it’s no great marketing pitch to promise investors 20% returns when everyone else is promising 30%. More fund managers will take greater risks to maintain the recent high level of returns, either by overpaying, overleveraging, speeding the whole investment-to-exit process and doing less due diligence, or by going into earlier-stage investments or new and less familiar industry sectors and geographic regions.
Some US investors are becoming more active in Latin America: other fund managers and outside investors see a better opportunity in Europe, where such developments as the approach of Emu, deregulation, the dismantling of protectionism and the growing acceptance of shareholder value by managements, promise to generate the kinds of transactions on which private equity thrives.
The status of private-equity firms in Europe has risen markedly. Two or three years ago the M&A departments of the large investment and commercial banks would dismiss venture capitalists as small fry. The venture capitalists would plead to see the M&A departments’ lists of businesses for sale, without much success. “But, as an investment banker recently remarked to me, having $1 billion on your T-shirt changes all that,” says Peter Smitham, chairman of Schroder Ventures. “It means that whenever a European company has a large business for sale, they want to talk to you. Today, we see most of the major disposals.”
This year, CinVen, the old venture-capital arm of the UK coal board pension fund which itself went independent recently, set a record by paying £1.1 billion to acquire from Générale des Eaux its UK and French hospital groups, General Healthcare and Générale de Santé of France. Investcorp paid Granada £476 million for the Welcome Break motorway services division. BC Partners recently completed the ffr2.5 billion ($419 million) acquisition of franking-machine maker Neopost. Other independent private-equity fund managers and their in-house equivalents at commercial and investment banks now talk about making $1 billion acquisitions of their own. Nomura recently amazed competitors by presenting Brent Walker with a cheque for £700 million for the William Hill betting shops. Had Nomura not delivered this knock-out KKR-style bid, the company would probably have gone through a management buy-out to CVC, formerly Citicorp venture capital, another newly independent European private-equity firm.
Now the leading European M&A firms court the larger private-equity firms assiduously with dedicated relationship managers. And with good reason such funds can be a source of fee earnings in three ways, from providing acquisition finance, from leading IPOs of portfolio companies and from completing M&A assignments for companies seeking to sell businesses. All the private-equity firms want from investment banks in return is a flow of good ideas for acquisitions. And while the same M&A firms are busily advising Europe’s largest companies on how to dispose of non-core businesses and focus on core operations, plenty of opportunities will arise.
Which private-equity firms are best positioned to take advantage of these opportunities? From Finland to Spain, Europe is dotted with small, nationally focused venture-capital groups. Some, like CinVen, are large but biased mainly towards the UK, the largest European market for buy-outs. But only a handful of firms most obviously Doughty Hanson, BC Partners, CVC and Schroder Ventures combine large funds under management, an appetite for larger transactions and European networks of offices and partners in several countries. To these key accounts may eventually be added some US buy-out firms. KKR, AEA and Texas Pacific have all done the odd large European deal. None, yet, has large European networks.
The present leaders among the European private equity buyers have big ambitions. Simon Palley, partner at BC Partners, explains his group’s preference for larger deals: “Large transactions offer more stability as they tend to have better management and systems. It’s easier to attract good management to them. Improving operating performance can be achieved by pushing the right buttons at the top of the company. And large businesses are more liquid as exits through IPOs and trade sales are possible.” In Europe, the old UK venturecapitalists, such as Candover, NatWest Equity Partners and 3i, which all used to show each other their deals and syndicate the equity between them, are falling behind. The bigger, independent, pan-European groups want to do large deals on their own.
On Monday, October 13, five multi-billion dollar cross-border M&A deals were unveiled, demonstrating the growing pace of corporate restructuring. Today those kinds of deals will provide spin-off transactions, such as disposals of unwanted divisions, for private-equity buyers. What’s more: “In another two years financial buyers, as well as strategic buyers, will be doing those kinds of headline deals,” says Charles Bott, executive director at Goldman Sachs who covers private-equity firms.
These would be gutsy bids for a financial buyer to make. It would take supreme confidence to outbid an industrial which might be able to factor into its own bid price the future savings it could make from merging the target company with its own operations. But financial buyers have advantages of their own. A corporate buyer can either pay cash for a company, which means gearing up its own balance sheet, or use its equity. Financial buyers can be much more flexible in how they structure deals. And there is a lot of money suddenly available to them, not just equity capital but new forms of debt finance as well. “This is a big industry now,” says Bott. And in future, financial buyers might begin to resemble strategic industry buyers more closely.
This has been the experience of private-equity investing in the US. There, corporate buyers have benefited from booming markets lifting the value of their acquisition currency, their own equity. To compete, US LBO firms came up with the strategy of leveraged build-ups. They would acquire a company in a certain sector as a platform for future acquisitions, add to it with other deals and consolidate and rationalize just like a corporate buyer.
After a while, the distinction between corporate buyer and strategic industrial buyer blurred. KKR developed an expertise in publishing and its vehicle company K3 is regularly invited to review publishing-business M&A deals. Donaldson Lufkin & Jenrette’s (DLJ’s) merchant banking fund developed a speciality in pharmaceuticals.
There are signs of this beginning to happen in Europe. For example, Advent is very active in the chemicals sector. Meanwhile Schroder Ventures has, over seven years, built up an Italian-based logistics and warehousing business, Tecnologistica, through 27 acquisitions, mainly from Olivetti and Pirelli.
CVC bought Entrelec, a French maker of electrical connectors in 1994. Its then owners, private-equity group LBO France, had been working on a possible Entrelec flotation. But its senior management, led by chief executive Pierre Bauer, was more interested in growing through acquisition and wanted to buy a company called Schiele. CVC first bought out Entrelec and then supported its acquisition of Schiele. CVC later floated the combined group.
According to CVC chairman Michael Smith, this typifies the group’s approach. “Increasingly we’ve been thinking beyond the first deal and looking to add further transactions in sectors that are consolidating.” Injecting more equity and debt into a portfolio of companies is not the normal approach of buy-out firms, which are usually keener to pay off debt and make a quick exit. The build-up approach requires rigorous due diligence on the initial deal. “Because we were buying from another buy-out group, we agonized over whether we were doing the right thing with Entrelec,” says Smith. “If LBO France wanted out, why should CVC go in?”
Back to the underlying
But Smith now uses the deal as a concrete example to distinguish CVC’s approach as being about more than simply making a leveraged bet on the difference between private-market and public-stock-market multiples. “If you’re going to arbitrage markets like that,” says Smith, “you may as well be a bond salesman. We’re trying to go back to what venture capitalists did in the past, which is to emphasize understanding and management of the underlying businesses, rather than being obsessed with financial engineering.” Another example is Euramax, a maker of painted sheet and coil for use in construction and transport. In September 1996, CVC acquired Euramax, which has US and European operations, in a £170 million buy-out from its parent, Alumax. Its plan is to grow turnover from £322 million at the time of the buy-out to £500 million through acquisitions and then to seek an IPO. This year Euramax acquired Ohio-based Fabral and Indiana-based JTJ Laminating.
CVC is not the only European private-equity firm to talk this line. In fact, most do so. Few, it seems, wish to be regarded as financial engineers, nor, even worse, as merely lucky punters. But a cynic might suspect many are exactly that. In the 1990s conditions in Europe have been enormously favourable for private-equity firms, with the spread of corporate restructuring, booming public stock markets and low, stable interest rates. Not surprisingly, most firms have managed to produce strong performances. But many privately worry that such a happy combination of market conditions cannot last, and that Europe may be facing its own equivalent of US LBO firms’ problem: too much money, too few deals.
In the past two to three years, independent firms in Europe have raised around $12 billion for investing in LBO equity. At a conservative gearing ratio of two times debt to equity that allows for $36 billion of acquisitions. That’s before including the fire-power of the principal investing arms of the banks and securities firms themselves. It’s an open question whether all can be profitably invested or whether firms will only compete harder for the same deals. If they overpay, they could be hit if interest rates rise or Europe slumps.
But there are strong reasons for optimism. Comparison of ratios between private-equity funds and national GDP figures for European countries suggests there is huge potential for growth there. For 1996, the value of UK buy-outs represented 1.1% of GDP, more even than the US figure. But for many large European economies it’s tiny. France, Germany and Italy were all around 0.15%, while the largest ratios for continental countries were for Finland, Sweden and Switzerland at nearer 0.4%.
Johannes Huth, member of the management committee of Investcorp responsible for corporate investment in Europe and previously an M&A banker at Salomon Brothers, has worked in the German market for 15 years and charts the changing attitude of large European businesses to selling off parts of their operations: “A company like Siemens rarely sold businesses and almost never to financial buyers,” he says. “Following internal strategic reviews, the rise of awareness of shareholder value and advice from US investment banks, the conglomerates decided to concentrate their capital in fewer core businesses. So now they will sell businesses to release capital from non-core assets to areas where it will generate better returns. They have found that while in a sale there may be three or four interested strategic buyers, there are even more financial buyers. In the last 18 months it has become increasingly acceptable for the likes of Daimler-Benz, Pechiney, Siemens and Générale des Eaux to sell to financial buyers.”
For the managers of those non-core divisions, used to being fed just enough capital to survive but rarely given enough to grow, financial buyers can be a godsend. Often they will help these managers realize long-cherished plans for their divisions and at the same time incentivize them with equity. In an ideal transaction, the financial buyer will be a good guide to these managers, without ever running the company itself. BC Partners’ Palley cites Dutch-headquartered animal-feed group Nutreco, which BC Partners acquired along with other venture-capital investors and management in September 1994 for $550 million from British Petroleum.
Shaking up the structure
The first thing Nutreco’s new owners did was to install state-of-the-art cash management. Previously the company’s management had been unable to report even month-end cash balances. Now able to deliver such reports daily, they reduced expensive working capital. Meanwhile the new owners nudged management into hard decisions. Its nine business groups were reduced to two main divisions, and loss-making non-core businesses were sold. “The company had a small but mature compound-feed business in Chile,” recalls Palley, who had a seat on the company’s board. “We advised them to reduce investment there and put it into the aquaculture business which was running short of capacity.”
Palley adds: “We offered a useful external perspective. Management knew that the compound-feed business in Holland was maturing and we advised them to get ahead of that trend and reduce costs there.” Nutreco was publicly floated this June in an IPO led by Goldman Sachs and Rabobank. Its stock now trades on strong likely growth in the feed business for fish farming.
As more sizeable divisions, like Nutreco, pass from the ownership of large public corporations to new financial buyers, the managers of giant European companies are taking a closer interest in the methods of private-equity owners. Some buyers, like CVC and Schroder Ventures, assemble strong advisory boards for their portfolio companies, often inviting senior executives of large public companies. This may provide a useful network and source of advice if a portfolio company later wants to add on an acquisition. In turn, it also offers some insights to the advisory board members. “They are often particularly interested in how we motivate managers of our portfolio companies,” says CVC’s Smith, “it’s something they want to do for their own bigger groups.”
It seems likely European private-equity markets will grow, but how far and how fast? Not everyone in the business is gung-ho, at least in public. Christophe Neizert, general manager of Advent says: “The Anglo-Saxon world is overestimating amounts that can be invested in Europe and markets are overheating.” Advent is one of the few private-equity firms to have profited from eastern German restructuring. But Neizert remains “very careful at the moment. German business is now doing a good job of restructuring and squeezing costs and that makes spin-off opportunities. But Germany has been terrible at creating new jobs; it’s not moving as fast as some Anglo-Saxon investors believe it could or should”.
Max Römer, founding partner of Frankfurt-based buy-out group Quadriga Capital, is concerned by the trend for rising prices in larger German buy-outs. “People are talking about 10 or 11 times ebit [earnings before interest and tax]. We would never do that. It may work out if interest rates stay low, but it will be a major risk if rates rise.” Quadriga prefers to concentrate on smaller deals, combing through the 2.6 million registered small and medium companies in Germany.
For those buyers that concentrate on larger deals, the danger is that these often turn into auctions and the winning bidder almost always pays a full price. Some conservative analysts who looked at William Hill point out that a reasonable multiple of six times its 1997 ebitda (earnings before interest, tax, depreciation and amortization) of £70 million would imply a bid price of £420 million. Nomura paid £700 million. To look anything like a good buy, Hill will have to grow operating earnings to £90 million in 1998 or 1999.
Investors in Europe were saying two and three years ago that buy-out funds were too large and that acquisition prices were too high, when firms were buying at around five times ebit. But investors that carried on buying have since exited with spectacular profits. The good times may roll a while longer.
Even if there’s a downturn, private-equity firms will almost certainly continue to buy. Their limited partners, the outside investors in their funds, have not given them money to keep in cash. The pressure to invest is a weakness of many participants, says Richard Bowley, managing director of Parthenon, an intermediary group that monitors some 350 private-equity funds and invests in some on behalf of institutional clients. “Even though fund managers face pressure from outside investors,” he says, “we would much rather they sat on their hands than overpaid. But that’s difficult, especially when cash is coming back at such a pace from earlier realized investments.” He adds: “Most buy-out groups recognize that the recent good years are unlikely to be repeated.”
The growth of leverage
That’s worrying in view of another closely connected trend in European buy-outs: growing use of leverage. This year, for the first time, unrated below investment-grade European companies have been able to sell bonds domestically. Banks, particularly US firms, are making a big push in their acquisition finance departments to win over private-equity buyers as clients. Morgan Stanley put together in one package a ffr2 billion five-tranche loan and a high-yield ffr500 million, 10-year floating-rate bond to finance the Neopost acquisition.
“Neopost transformed the leveraged finance market in Europe,” says Alan Jones, managing director and head of European leveraged finance at Morgan Stanley. “It will be used as the classic template for financing these deals.” It was indeed innovative. The loan portion, entirely underwritten by Morgan Stanley, included an unusually long-dated junior eight-year tranche paying 200 basis points over Pibor. Even more useful for BC Partners was the bond deal. This pays 237.5bp over Pibor, 5.88% at current low French interest rates.
European high-yield bonds are developing in ways that suit private-equity buyers. Many dislike going to the US high-yield bond market because of the currency risk of borrowing in dollars and because of the standard five-year call protection. Bonds have to be serviced for at least five years before they can be repurchased. European firms, which have got used to early flotations on many investments, want to be able to pay off expensive high-yield debt earlier than that. Neopost is a strong candidate to float publicly within one year. Its high-yield bond deal allows for this. The borrower can retire debt on a sliding scale of repayment premiums from 108% after the first year. If the Neopost bonds are called after year one, investors will receive a total return of around 14%, at a time when Pibor is around 3.5%.
It’s a clever deal all round, but it leaves Neopost with a capital structure 82.5% debt and just 17.5% shareholders’ equity. However, simple measures such as debt-to-equity ratios are not always the best guide to how risky a deal is. A buy-out may have a conservative capital structure say 40% equity, 60% debt but if the buyer has paid a high 10 times ebitda as its acquisition price, such a deal may be even more risky than one with an 80% debt, 20% equity capital structure and an acquisition price only five times ebitda. The key ratios to watch are total debt to ebitda and ebitda to total interest expense.
BC Partners originally bought 16% of Neopost in 1992 when it was subject to a leveraged buy-out from Alcatel. Earlier this year, the other equity investor wished to sell but BC Partners saw strong potential. “It’s a very attractive stable business. Mail volumes continue to grow and there’s an opportunity here to switch from digital technology to new electronic and PC-based systems and capture new markets like the home office,” says BC’s Palley.
Burdened by new debt, Neopost’s ratio of ebitda to total interest payments has fallen from seven times to a still acceptable four, following the buy-out. Much of that debt is floating-rate and servicing costs could increase sharply if interest rates in France rose. Hedging would add 150bp to the present 6.1% weighted cost of debt service, but the borrower is unlikely to have hedged anywhere near all its floating-rate debt. Morgan Stanley’s own analysts calculate that the unrated company would probably rank as a strong single B or a weak double B credit, primarily because of the high degree of leverage.
US banks are strongly attracted by European prospects. But they are constrained by how much equity they can invest in large industrial companies (escaping these constraints was one incentive for the management of CVC to buy themselves out of Citicorp in 1993). The private-equity arms of leading US investment banks also face conflicts of interests. Goldman Sachs Capital Partners discovered this when it bought into German floor-covering maker Tarkett International in 1994. That was a profitable investment for Goldman, but one that later brought it into conflict with a long-standing US corporate client, Armstrong.
It’s a different kind of potential conflict that probably checks US investment banks’ ambitions to do merchant banking in Europe. They don’t want to risk conflict with the new breed of financial buyers by competing with them for good investments. These clients offer revenue not just from fees on acquisition finance but from later IPOs.
One of the biggest US names in merchant banking is DLJ. “Over the last 10-15 years no asset class has performed better than LBOs,” says its head of merchant banking, Lawrence Schloss. DLJ is being cautious in Europe, holding out its merchant banking and other related funds as a corporate finance resource for other deal leaders. Says Schloss: “This firm has principal investing in its blood; $800 million of our $3 billion fund belongs to DLJ and its employees. I am quite happy to invest in other people’s deals. If that helped a local buyer, great. He consequently will become an investment banking client.”
If the investment banks tread warily in Europe, that leaves just the independent US firms as potential competitors to the new pan-European giants. The biggest, KKR, has already experimented with relatively small deals such as the purchase and recent flotation of UK local newspaper group Newsquest. But the independent US boutiques haven’t flooded in. Perhaps that’s because many of their partners are rich already and aren’t attracted to different cultures, languages and legal, tax, and accounting systems. One banker says: “What the Americans all think when they look at a European private company is: ‘I know there’s more than one set of books. I just don’t know if there’s three or four.'” He doesn’t expect US LBO shops to dominate Europe any time soon. “There’s only one thing those guys hate more than losing money looking stupid.”
