10 MASTERING FINANCIAL MANAGEMENT / PRIVATE EQUITY PRIVATE EQUITY / MASTERING FINANCIAL MANAGEMENT 11 Private equity funds look for strength in numbers In recent years, surplus cash and increased liquidity have made it increasingly difficult for private equity funds to find good deals. The solution may include consortium investments and specialised portfolios

hirty years ago, the private the ∑12bn leveraged buy-out of Wind, the Ital- With state-owned assets of approximately ■ Substantial capital flows to private equity equity industry was not really ian telecommunications company; the $11.4bn ∑700bn privatised in Europe over the last 30 can be self-defeating in the sense that too an industry at all – the practice buy-out of SunGard, the US financial services years, the key question is: how much is left? much money is chasing too few deals. This of buying shares in private com- and data recovery company; the $6.6bn acqui- According to the website Privatization problem was identified by Professors Paul A panies for investment purposes sition of Toys R Us, the USretailer; and theBarometer EU governments still hold direct Gompers and Josh Lerner of Harvard Busi- was confined mainly to wealthy ∑4.3bn buy-out of Amadeus, the Spanish and indirect stakes worth almost ∑300bn, ness School, who found that the greater the Tfamilies, and they generally wanted to invest provider of IT solutions to the travel industry. mostly in France, Germany and Italy. How- supply of private equity capital to a fund, the in small, fast-growing companies at an early Venture capital also had a strong year, with ever, the actual privatisation potential is higher the prices paid for the acquired com- stage of development. Today, private equity the recovery of capital flows into European substantially larger if one takes into account panies. Subsequent research has confirmed is mainstream, sophisticated and US early-stage funds wholly-owned state enterprises as well as that this effect does indeed lower the returns and huge. It accounted for gathering momentum. public infrastructure. to private equity investment, with asymmet- about $500bn worth of deals in By The knock-on effects in ric information between buyers and sellers 2005, and the vast majority of PETER CORNELIUS, other industries were pro- and herd behaviour amplifying fundraising that sum was spent on buy- OLIVER GOTTSCHALG found. For example, private and investment cycles. In other words, the outs of established companies. equity deals generated sub- With more and more amount of attractive investment opportuni- However, the miracle could and MAURIZIO ZOLLO stantial demand for services ties is finite and, at some point, capital will be about to lose its shine. So such as advice on mergers flow into less attractive investments. many investors have piled and acquisitions, initial pub- capital to manage, the The recent surge in entry prices has been into private equity in recent years that it has lic offerings and loans. Investment banks interpreted by some market participants as a become increasingly difficult for private benefited to the tune of about $10bn, or talents and resources of sign of this “money-chasing-deal” phenome- equity fund managers, also known as “gen- nearly 20 per cent of their total revenues. non. According to the LCD Loan Review, eral partners”, to outperform the public mar- In the medium to long term, the outlook general partners have been published by US rating agency Standard & kets. As more and more capital has flowed for private equity looks equally rosy thanks Poors, European buy-outs have become par- into private equity products, so the talents to various macroeconomic factors. For exam- ticularly expensive, with average multiples and resources of the general partners have ple, in Europe, where the entire investment stretched to breaking point reaching 8.3 times earnings before interest, been stretched to breaking point. Many funds portfolio “at cost”, a measure of capital tax, depreciation and amortisation in 2005, up have grown excessively from one generation invested in portfolio companies, was still As far as the buy-out market is concerned, from a multiple of 6.8 in 2003. However, profit

to the next and, as the industry has become below ∑200bn at the end of last year, or less about 6,300 European and US companies growth and cash flows of underlying portfo- Nick Lowndes awash with liquidity, so it has become easier than 2 per cent of GDP. Even in the UK, have a value of more than $500m. Of these, lio companies have remained strong. And, for less able fund managers to survive. Con- Europe’s most attractive economy for pri- 3,600 are based in the US and 2,700 in Europe. encouragingly, average debt-to-equity ratios This effect may be compounded if less skilled But recent research by Prof Gottschalg returns through cost and revenue synergies sequently, the average returns on the asset vate equity, capital under management More than half appear to be unsuited to pri- have increased relatively moderately, despite fund managers help inflate acquisition mul- shows that managerial motivation can be has allowed them to outbid private equity class as a whole are under threat. stands at only about 3.5 per cent of GDP. To vate equity because their performance or highly liquid debt markets and historically tiples. As the variance of returns across indi- In the more mature private enhanced through non-financial mechanisms competitors in a number of recent deals. With too much money chasing too few reach the same degree of private equity activ- public ownership structure makes them dif- low interest rates. vidual investments and fund managers could after a buy-out and that this type of motiva- Some private equity investors have begun deals, the industry is putting itself through a ity as the UK, continental Europe would ficult to acquire. However, research by McK- increase further, the successful selection of tion is a particularly important determinant to recognise the potential opportunities radical restructure in the search for higher require net investment flows to increase by insey, the management consultancy, ■ Excessive growth in fund size from one the funds that perform in the highest quar- equity markets, funds are of buy-out success. One key driver of such a shift from a stand-alone approach towards returns. For example, private equity funds 10 per cent annually over the next ten years suggests that the remainder is still big fund generation to the next can have a sig- tile becomes even more vital. motivation stems from the fact that man- a more portfolio-oriented one may bring are beginning to club together in order to – not an unrealistic scenario given the poten- enough to provide the private equity industry nificant detrimental effect on subsequent The private equity community has begun pooling their resources to agers of acquired companies may not only about. A number of them have become construct huge deals, reach out globally and tial demand for private equity financing. with plenty of growth. performance. As investors have grown to to recognise these challenges. For example, take financial but also emotional ownership increasingly industry-focused, and there are penetrate new markets. They are beginning An important source of demand will be On the supply side, recent survey evi- appreciate how important it is for their gen- investors are increasingly searching world- make mega-investments of the companies they manage, which pushes several examples where companies bought to manage their investments more actively – family-controlled companies, which typically dence, such as the Alternative Investing Sur- eral partner’s performance to be in the “top wide for opportunities, as evidenced by the them to do everything they can to make by private equity houses have made subse- with new governance and incentive struc- account for two-thirds of all enterprises in vey published by Russell Research, indicates quartile” of the market, more and more sharp rise in cross-border investment flows. “their” buy-out a success. quent acquisitions. tures, and the direct involvement of general industrialised countries and about half of that European and especially Japanese pen- money has flowed to general partners with a Several US private equity houses have opened ous owners for less than they were worth, or The second mechanism comes from the Nevertheless, for the industry as a whole, partners in the operational and strategic deci- economic output. In Europe, more than 2,250 sion funds and insurance companies actu- superior track record. This has raised the offices in Europe and some of them have the tax shielding effect of the large amount of more direct involvement of the acquiring adopting a new model where value is created sions of portfolio companies. And they are companies of this type have been involved in ally plan to continue to play catch-up and question of whether a private equity group been involved in top European buy-outs, such debt that was used in the transaction. buy-out group in the transaction. A recent through portfolio synergies will require a beginning to specialise in particular indus- European private equity transactions since increase their exposure towards US levels able to invest a $250m fund successfully over as TDC and Legrand in the UK, and Eircom However, the increasingly competitive Insead study shows that an active involve- fundamental change in mindset. This is part tries or sectors, on the basis that they can the early 1990s. On average, they accounted over the coming years. US institutional the past few years will be able to invest a Fixed Line in Ireland. ` market for corporate control and changes in ment of buy-out fund managers in financial, of private equity’s biggest challenge: find- enhance returns through synergy and col- for one in every five deals and, in some years, investors currently allocate around 7.5 per $1.5bn fund with equal success, using essen- While the penetration of the US market by the institutional environment have lowered strategic and operational decisions of the ing new ways to enhance the fundamental lective experience. for as many as one-third of European buy-out cent of their assets under management to tially the same team. European players has yet to reach the same the ability of buy-out investors to benefit acquired business is an important determi- performance of its portfolio companies in a Overall, the industry is shifting its focus transactions. private equity, but in Europe and Japan that While a general partner’s reputation and momentum, general partners on both sides of from these effects. Instead, increasing empha- nant of buy-out value creation, especially if way that makes it possible to profitably back to the performance of underlying invest- A key driver of this trend is the challenge share (including committed capital) is only 4 track record is a key determinant of his abil- the Atlantic have begun to look to Asia. sis lies on improvements in the fundamental the acquired unit was underperforming prior invest increasing amounts of capital. ments, and the “added value” that general of succession, according to the International and 2.5 per cent respectively. ity to raise subsequent – and larger – funds, Meanwhile, in the more mature markets, performance of the underlying business, and to the buy-out and buy-out fund managers partners can offer. Will this be enough to Business Owners Survey, published by Considerably more supply of capital is research by Professors Gottschalg and Zollo which are becoming increasingly competi- the ability of the investing buy-out company have the necessary experience to effectively sustain its dizzying growth? accountants Grant Thornton, and encom- also expected from high net worth individu- suggests that investors should assess care- tive, private equity houses are pooling their to contribute to such improvements. advise the portfolio company management. PETER CORNELIUS is visiting professor passing 6,300 medium-sized family businesses als and through publicly-listed vehicles. The fully whether a private equity house trying funds to make “club deal” mega-investments. In doing so, buy-out groups rely on two Other research confirms that buy-outs lead at the Vlerick Leuven Gent Management Private equity: an industry snapshot worldwide. In Germany and the UK, for recent, heavily oversubscribed, flotation of to increase the size of its fund has the skills principal mechanisms. The first is aimed at to substantial improvements in the operating School and is an economist with AlpInvest example, more than one-third of company an investment vehicle on the Euronext and resources needed to successfully invest Performance drivers and incentives increasing the motivation of the employees performance of the acquired entity, which Partners. Last year was a busy one for anyone involved owners say they will consider stepping down exchange by Kohlberg Kravis Roberts, has the larger amount of money. and managers of the acquired business to manifests itself, among other things, in bet- [email protected] with private equity, and especially for the within the next 10 years, but only about one- attracted a particularly high level of market While globalised investment strategies might realise the full performance potential of their ter working capital management and better managers of buy-out funds. They raised an quarter say they intend to pass the business attention. ■ Increased capital inflows to private equity help sustain returns amid progressively operations. To this end, buy-out groups put utilisation of resources. Importantly, some of OLIVER GOTTSCHALG is assistant unprecedented amount of capital – about on to their children. reduce the ability of the industry to shed larger allocations to private equity, they are in place a number of processes that reduce these improvements persist even after the professor at HEC and co-ordinator of the ∑46bn in Europe and about $80bn in the US – Another important source of demand for Obstacles to high performance underperforming fund managers. If institu- unlikely to be sufficient in and of themselves. the agency conflict between equity investors buy-out group re-sells the business. Buyout Research Program at Insead. and established the five largest buy-out funds private equity will be the privatisation of tional investors find it difficult to meet their More fundamental changes in the mecha- and managers of the acquired companies. While both mechanisms for value creation [email protected] of all time. Meanwhile, the conditions for state-owned assets. In 2005, European pri- Some studies suggest that private equity out- target allocation to private equity with high- nisms through which private equity gener- These include the reduction of available free have now taken centre stage in the manage- MAURIZIO ZOLLO is associate professor at deploying that capital were good, as both vatisation receipts totalled almost ∑67bn. performs comparable public market invest- quality fund managers, some of them may be ates value are required and have already cash flow due to increased debt service ment philosophy of private equity invest- Insead, and the Shell Fellow of Business and sides of the Atlantic saw continued economic Notwithstanding buoyant stock markets, the ments, others find that historically the broad tempted to commit to fund managers with a begun, especially in the buy-out segment. requirements after a leveraged buy-out, as ment, they rely on the potential for the growth and corporate restructuring. majority of divestitures have been based on private equity market has actually under- less convincing track record. To the extent Historically, a large part of overall buy-out well as employee bonus plans or top man- stand-alone optimisation of the acquired the Environment. The total number of deals worldwide rose asset sales, which accounted for 56 per cent performed, with only the top general part- that this effect keeps less capable fund man- value creation has been coming from factors agement equity shares that align the incen- business. However, such an approach [email protected] significantly, with buy-outs in particular of the total value. An important example is ners consistently exceeding public market agers in business and that these continue to that had little to do with the actual perfor- tives of managers and owners. neglects potential synergistic benefits among The working papers of the studies growing in size and frequency. About 100 the French government’s decision to auction returns. As more money flows into private make poorly performing deals, it further mance of the underlying business. Examples As majority shareholders, buy-out fund portfolio companies. This results in a com- mentioned in this article are available were completed, averaging $350m in size. They off the three main operators of the highway equity, the challenge is increasing, owing to decreases the average returns to the asset include financial arbitrage, as investors were investment managers can always intervene petitive disadvantage with industrial buy- at www.buyoutresearch.org included a number of mega-deals, such as: system for ∑15bn. the following three mechanisms. class and could cause reputational damage. able to acquire businesses from their previ- or even replace underperforming managers. ers whose strategic focus on enhancing