SOME OF THE biggest names on the UK high street, such as PizzaExpress, Holmes Place, Selfridges and Allders, have succumbed to public-to-private (PTP) bids this year. In the first weeks of last month alone, Macdonalds Hotels in Scotland received a Bank of Scotland-backed management buyout offer and Iceland-based retail group Baugur snapped up London toy store Hamleys.
In continental Europe, Hg Capital has secured German car parts maker WET Automotive and Advent International is in the process of taking Romanian pharmaceuticals firm Terapia private in one of eastern Europe’s first PTP transactions. Paribas Affaires Industrielles is trying to secure French optician Grandvision and the high-profile bidding war for UK retail group Debenhams is still being waged.
The rash of high-profile PTP bids is in large part a result of the unprecedented liquidity of private-equity funds, which have a wall of cash they are under pressure to invest. European Venture Capital Association figures estimate that a total e45 billion was available for investment in European buyouts at the end of 2002.
And while private-equity houses have cash to spend, public companies are still comparatively affordable. In bull markets listed companies tend to be beyond the financial reach of private-equity houses, trading at a 25% to 30% premium to private companies. Today, even in rallying equity markets – by early September the FTSE100 was 30% up and the DJ Stoxx 600 index up 36% from March lows – share prices are still a long way below 1999 and 2000 peaks. Thus financial sponsors can afford to go shopping for listed companies.
Low borrowing costs are also a factor in the flurry of PTP bids, as is the fact that the loan market, which provides at least 70% of the debt involved in the average leveraged buyout, has overcome its aversion to the risk involved in PTP deals. Lenders suffered hefty losses from a few high-profile disasters in the late 1980s such as retail groups Magnet and Isosceles/Gateway (now Somerfield) and worry about the lower amount of pre-completion due diligence possible compared with a corporate disposal. However, banks are now proving more inclined to support these deals.
Crucially, the corporate M&A scene is still quiet. Usually, trade buyers can outbid financial sponsors in an auction, because of the synergies and cost savings they can derive from integrating acquisitions in their existing businesses. However, few corporates are looking to take on more debt to acquire earnings growth, leaving the way clear for private-equity houses.
Outside the private-equity investment community, however, antipathy to PTP deals is growing. This applies particularly to larger companies and to management buyouts, where the company executives stand to gain so much and clearly face conflicts of interest.
Several fund managers believe that today’s share prices do not reflect the true value of some companies – especially the larger retailers, which have strong cashflows and substantial property assets. These fund managers pose a pertinent question. If company executives believe they can grow profits for a private-equity house, could they not do the same for the current owners of the business – and without all the funding involved in a leveraged buyout?
“We feel that some public companies are definitely being sold too cheaply,” says Ruth Keattch, fund manager at Deutsche Asset Management. “Often, fund managers sell for the short-term profit, due to quarterly performance pressure. They should be looking at long-term value creation for their clients.”
The costs of going private Private-equity buyers reject the argument that they are getting companies on the cheap and that PTP deals are just about arbitraging stock market timing. They point to the substantial premium they have to pay to take a company private. In the case of PizzaExpress, for example, the shares hit a low of 247p before the bid speculation, but ultimately sponsors TDR and Capricorn Ventures paid 387p to take the company private in June. “Some mid-cap companies are severely undervalued by the stock market. But we usually have to pay a big premium to take a company private, so the shareholders should actually be getting a good deal,” says Will Schmidt, managing director at Advent International.
In addition, private-equity fund managers insist that if they do make a substantial profit from the companies they take private, it is because of the strategic changes that they make post-acquisition.
Examples back up both arguments. While most PTP deals done in the past few years remain in private-equity portfolios and have yet to be exited, cases abound of both public and conglomerate divested firms that have been strategically transformed after a buyout, such as DIY groups Focus Wickes and Homebase, betting shop chain William Hill, upholsterer Wardle Storeys and gaming company Gala.
However, in other cases sponsors have made huge profits on exit that are merely attributable to the fact that they bought at the bottom of the cycle and sold out at the top. With buyouts such as insurer Willis Corroon, stockbroker Collins Stewart, directory provider Yell and chemicals company Vianova, which were all hugely profitable for the private-equity houses, it is harder to point to many post-buyout strategic changes or improvements.
For many, this year’s rash of PTP deals has exposed the inefficiencies of the equity markets, which have marked some stocks down too far. If conventional shareholders feel they are not getting a good deal, do they have anyone to blame but themselves? “Some public-to-private deals do look like good deals for the private-equity houses. But this is a free market, other private investors can enter the race and shareholders do not have to sell out if they don’t think they are getting a fair price,” says Peter Davies, chief executive of Rubicon, the owner of clothing brands Warehouse and Principles. Rubicon was bought out from retail group Arcadia when Philip Green took it private last year.
Why are company executives and public shareholders so willing to sell out to the private-equity predators?
For some company executives, the simple answer is greed. Usually, management is offered a stake, which can lead to huge payouts at exit time. In July, Yell’s chief executive, John Condron, made £5.5 million ($8.8 million) selling shares in the flotation that followed just two years after the company’s buyout. Similarly, senior Debenhams executives have been offered nearly 7% of the business if Permira is successful in its takeover.
Lured by riches, company executives often strong-arm boards to accept private-equity bids. Also, given the current tirades against fat-cat bonuses granted to listed-company bosses, private ownership offers CEOs the chance to shelter from such embarrassing public scrutiny.
| Tusa: managements need to be taught to treat shareholders as owners, informing them of offers and changes early on |
Tired of waiting There are other disincentives to public ownership. Many company managements and shareholders – especially in small-cap listed firms – are tired of continuing low valuations and the lack of analyst research and interest from the equity community. For some shareholders, accepting private-equity offers often seems the only alternative to holding out for a full price recovery that may or may not come about far in the future. The ratings trap, or lack of appetite for equity capital raisings by small-cap companies, is another factor in shareholders’ and executives’ willingness to sell, especially when a firm’s strong performance is not matched by a rising share price.
Such was the plight of IT firm Rolfe & Nolan. “Our small-cap IT business was highly undervalued and there were no benefits to remaining public,” says the company’s CEO, Bob Freeman. “We could not secure new investors or raise money on the capital markets and our current investors wanted to sell. So when Hg Capital approached us it was a no-brainer decision.” Hg took the company private this year in a £15 million deal.
Private-equity firms inject cash for development at a time when many companies are unable to raise finance in the public capital markets. They allow debt to be put on the capital structure, which can be used to rehabilitate the company. “Being private means that you can make decisions faster,” says Rubicon’s Davies. “You can employ strategies that, although they may be negative in the short term, are more beneficial for the company in the long term, without having the pressure of quarterly reports to the City.”
In the post-Enron era, public companies face far stricter financial reporting controls. For many UK CEOs, the 2003 Higgs Report, which was compiled for UK finance minister Gordon Brown to set out guidelines for corporate governance for UK companies, represents an increasingly onerous burden. After accounting scandals at Dutch retail group Ahold, similarly detailed annual reports and disclosure regulations are being introduced across Europe, often putting public companies at a substantial disadvantage to private competitors.
Despite this, a growing number of shareholders and fund managers are beginning to chafe against what they perceive to be low-ball private-equity bids – especially where they feel the business model could be developed just as well under public ownership.
In a landmark case, Deutsche Asset Management refused to sell its shares in UK health club group Fitness First to private-equity house Cinven in June. DeAM felt that Fitness First would deliver far greater value over time and that Cinven’s offer did not compensate for the loss of this future value. Although Fitness First had been rolled out too fast and had become over-extended, in DeAM’s view this did not imply that accepting the take-private offer made sense. “Fitness First could have remained public, slowed the roll-out pace and then, as it is highly cash generative, paid out substantial dividends to shareholders,” says DeAM’s Keattch. “The private-equity model is precisely the same – to slow down the roll-outs and run the business for cash.”
Instead of caving in to management pressure and selling, DeAM increased its stake to over the 10% mandatory squeeze-out level and Cinven was forced to take the company private with DeAM still holding a stake. “This was about the protection of long-term value and about ensuring that it accrues to the current shareholders,” says Keattch.
In an equally groundbreaking case the same month, Fidelity and M&G Investment Management refused to sell their shares in PizzaExpress when TDR Capital and Capricorn Ventures took the company private. Ultimately, the financial sponsors had to accept getting just 90% of the shares. “We did not believe the private-equity valuation reflected the long-term prospects of the business,” says Trelawny Williams, director of corporate finance at Fidelity.
The fact that shareholder revolts over Fitness First and PizzaExpress followed in such quick succession has raised questions about a new trend in public shareholder behaviour, with mainstream fund managers looking to spice up their performance with a private-equity component. Despite the loss in liquidity, which some funds couldn’t accept, more fund managers could start to devote part of their portfolios to these companies. “If the minority shareholders realize a significant profit when sponsors exit, this might encourage other fund managers to follow suit,” says Willie Orr, head of loans distribution at Bank of Scotland, which arranged the debt financings supporting the Fitness First and PizzaExpress buyouts.
This would be anathema to private-equity houses, which would have to relinquish a share of their gains. It would be even more worrying if the shareholders then started to disagree with the sponsors’ business model or eventual exit strategy. “If some shareholders refuse to sell, it is not ideal for private-equity houses, but there would only be a real problem if the shareholders prevent them from executing their plans,” says Manjit Dale, co-founder of TDR Capital.
| Melvin:”shareholders are getting far more involved in matters beyond basic financial results” |
Stealing private equity’s clothes For the more actively engaged fund managers, there are alternatives to accepting low-ball take-private offers. They can, for example, adopt a private-equity type of strategy, gearing up through share buybacks or borrowing and running a company for cash rather than topline growth. “Why don’t companies stay in the public arena, raise some debt, buy back the shares of those shareholders that want to sell and then run the business for cash?” suggests DeAm’s Keattch. “This way, you can return higher dividends to reward the remaining shareholders.”
The argument is particularly applicable to larger companies. While for small companies worth £50 million to £100 million the disadvantages of staying public can outweigh the advantages, even some major private-equity houses agree that the argument for going private is less convincing for companies with market caps of from £500 million to £1 billion plus. “In many cases, private-equity houses retain the same management and merely sell some property assets and gear up the company – and this costs £100 million in banking fees,” says Jon Moulton of Alchemy Partners. “The company could have adopted the same plan in the public markets.”
The view is remarkably objective – Alchemy has completed 21 PTP deals – more than any other private-equity house in Europe.
Some public companies are starting to do precisely that – selling assets and rewarding shareholders. UK utility Anglian Water recently rejected WestLB’s take-private offer. Instead, it used cash from non-core asset disposals to return dividends to shareholders.
If share buybacks are undertaken, the upside for long-term equity holders is preserved, while leaving an opportunity for shareholders who want to sell out to make an exit. UK business services group Rentokil Initial is an example of a company that has modified its model to take account of longer-term investors’ requirements, taking the emphasis off the pure growth for which it had become famous. Rentokil regenerated its previous business plan for 20% annual growth, opting for a slower growth rate and using excess cash to buy back shares. The stock market has responded positively to the strategy. “Opting for an ex-growth strategy does not have to mean you must go ex-stock market,” says one fund manager.
Somerfield has been cited as another good custodian of shareholder interests. The firm received a private-equity approach earlier this year, which it rejected. Instead, it is devising a broad array of alternative solutions, which include the possible realization of some property assets.
The key question is whether valuations will improve if companies take the emphasis off growth, as the equity markets tend to undervalue cash stories and overvalue sales-growth stories. “The stock market is a demanding master – it wants growth,” says TDR’s Dale.
Thus even after gearing up and running a business for cash, the share price will not necessarily rise. Also, many public companies cannot raise the debt required to buy back shares. “It would be difficult to replicate a private-equity structure in the public arena,” says Charlie Geffen, head of private equity at Ashurst Morris Crisp. “The stock markets would not accept such a high level of gearing. The return on private equity is higher because it is riskier and companies borrow more – it is a different asset class to public equity.”
Until the equity markets start to value cashflow as well as growth, or allow for more creative financial structures, companies will continue to be taken private.
As well as making history in the leveraged buyout market, Fitness First and PizzaExpress are also deemed to be landmark cases in the move from traditional value-based investing towards shareholder activism.
To date, shareholder engagement in Europe has largely been confined to remuneration issues. Fat-cat rows – where shareholders revolt against rewards-for-failure pay deals granted to senior executives – abound, with notorious spats in the UK involving GlaxoSmithKline, WPP, Burberry, Christian Salvesen and HSBC this year.
Some in the market reckon this is the limit to possible engagement for shareholders. “Portfolio fund managers or public shareholders cannot possibly get engaged – they have too many assets in their portfolio,” says Edmund Truell, CEO of Duke Street Capital. Alchemy’s Moulton concurs. “If you own just 6% to 8% of a company, there is little you can do to influence strategy,” he says.
If a private-equity fund bids for a company, public shareholders that become engaged in fighting the bid off to the point of seeking access to price-sensitive information face constraints on liquidity – something that is of paramount importance to most shareholders. “It would be more constructive if in cases where a few fund managers have blocked management recommended take-privates the shareholders had got engaged earlier on in the process. But usually shareholders do not want to have inside information in an M&A situation, as it restricts their ability to buy and sell their shares,” says Julian Treger, joint managing director at fund manager Active Value.
It is not a shareholder’s job to run a company and because of their investment philosophy many shareholders do not even want to get engaged. For example, most tracker funds just want liquidity and are not interested in active engagement.
Small-cap apathy At the small-cap end of the scale, there is often extreme shareholder apathy. “Shareholders could have more influence if they united, but they only ever get involved in extreme cases and usually only voice their disapproval by marking down prices,” says one fund manager.
Nevertheless, a growing number of shareholders are proving that greater engagement is possible. DeAM, Fidelity, Morley, Baillie Gifford, Active Value and Hermes in the UK; ABP and PGGM in the Netherlands; and AP3 in Sweden are just a few of the growing number of active fund managers now influencing far more than just fat-cat remuneration.
“Shareholders are getting far more involved now in matters beyond basic financial results,” says Colin Melvin, head of corporate governance at Hermes. “They are looking at capital structure, board composition and M&A situations and are talking more frequently with management about governance and strategy.”
In March, shareholders got closely involved with the strategic decisions regarding the future of Six Continents, rejecting Hugh Osmond’s takeover bid and instead backing management’s plan to demerge the hotels from the pubs business. Meanwhile, after some Debenhams shareholders complained that Permira’s £1.54 billion bid was too low, management decided to pay rival bidders CVC and Texas Pacific £1 million a week towards due diligence costs, to try to extract a better price for the company.
Engagement can also keep good companies clean and prevent them from destroying their value potential through making acquisitions. In August, DeAM was involved in discussions that led medical devices company Smith & Nephew to walk away from the bidding war for Swiss orthopaedics company Centerpulse, believing it would compromise its reputation and value by overpaying. S&N had offered £1.5 billion for Centerpulse, but refused to raise its offer after rival bidder Zimmer of the US tabled a £1.85 billion offer.
UK investment fund Active Value hit the headlines in June when it increased its stake in advertising agency Cordiant to block rival WPP’s offer. The fund is now engaging with Primedia over the South African media and entertainment firm’s voting pool and governance issues, with other shareholders. “We believe that if you own something, your responsibility is to get involved in how it is run,” says Active Value’s Treger. “Managements try to prevent shareholder engagement, as it fetters them. At present, engagement is still mostly focused on remuneration, not strategy. But Rome wasn’t built in a day and Six Continents and Debenhams show the situation is improving.”
| Public to Privates as a % of European LBOS |
| Source: Standard and Poor’s |
Corporate finance innovations Larger fund managers are finding a way around the insider information issue, which can be a major obstacle to true shareholder engagement. Several institutional investors are setting up corporate finance divisions, which are separated by Chinese walls from their fund management departments. Fidelity’s Williams says: “We set up our corporate finance department 18 months ago to be able to engage with company managements on strategic issues without damaging our firm’s ability to trade. This is a relatively new trend that several other fund managers are now employing.”
The more active fund managers are now setting out to educate company managements. “We are on a mission to get management to treat us as owners and inform us of offers or strategic changes early on, not at the last minute. That way we can influence the outcome, rather than merely having to choose whether to sell or not,” says Andrew Tusa, head of corporate governance at DeAM.
The easiest way to become engaged is to have larger stakes in fewer companies – again, rather like a private-equity fund. “If you run a concentrated portfolio, it is natural to have higher levels of engagement with managements,” says DeAM’s Tusa. However, the size of the stake is not as important as the shareholder’s ranking. “The size of your stake may be only 3% to 4%, but if you are the largest shareholder, or one of the top three, you have a lot of influence,” says Fidelity’s Williams.
The notion that short-term investors can never be as engaged as long-term fund managers is often flawed. “Some long-term funds, like tracking funds, do not have engagement as part of their philosophy, while short-term arbitrageurs like hedge funds can get very involved,” says Active Value’s Treger.
The UK is the most advanced country in Europe in terms of shareholder engagement. However, as Europe’s corporate landscape evolves and tax changes facilitate stock sales, the situation is improving. “Shares in many European countries were very closely held before and family foundation structures have held back UK-style shareholder activism,” says Hermes’ Melvin. “But the trend in Europe is towards more equity and more widely held equity.”
Pressure on European institutional investors to take their responsibilities seriously is increasing, from their own beneficiaries, governments and the press. “We are campaigning for greater rights and instances of engagement are growing. We got actively involved in Telecom Italia’s decision to merge with Olivetti this year and firms like Vendex have seen their shareholders push for a restructuring,” says Geert Raaijmakers, senior legal counsel at Dutch pension fund manager ABP.
Greater communication within the investment industry is deemed vital for effective engagement. It does not come naturally. “This is not a cosy fireside industry, it is extremely competitive and we are not used to talking collaboratively with other fund managers. However, to engage effectively, rather than just speaking to each other through intermediaries, we need to make more use of existing forums,” says DeAM’s Tusa.
The UK has several relevant forums, such as the Association of British Insurers (ABI), the Investment Management Association and the National Association of Pension Funds. Other European countries are establishing their own forums, such as SCGOP in the Netherlands, and there are pan-European groupings such as the European Asset Management Association and global advisory bodies such as the International Corporate Governance Network (ICGN).
These organizations provide the means for the investor community to come together under a collective banner. Following its July congress in Amsterdam, the ICGN is publishing best-practice guidelines to investors globally. “In the Netherlands, SCGOP is lobbying the ministry of finance for greater flexibility in the rules concerning insider trading. Those rules are very strict at the moment and they hinder, for example, close liaison between Dutch pension funds and company managements,” says ABP’s Raaijmakers.
The ABI has represented investors to the Financial Services Authority, giving a common voice to public shareholders, which helps them carry more weight. “The underlying issue is the rights of minority shareholders not to be steamrollered into accepting a public to private offer by one or two large shareholders. We have put this to the FSA for consideration in its pending Listing Rules Revision,” says Peter Montagnon at the ABI.
Striking the right balance is crucial, however. Too much engagement could send company managements running for cover to the private arena – the very thing many fund managers want to avoid.
