The Impact of Private Equity Investors on Their Portfolio Companies

The Impact of Private Equity Investors on their Portfolio Companies

Mike Wright Centre for Management Buyout Research Nottingham University Business School

www.cmbor.org Centre for Management Buy-out Research

 Identified emergence of UK buy-out and private equity market

early 1980s  Organised first European buy-out conference in 1981

 Centre for Management Buy-out Research (CMBOR)

 Established in 1986 at Nottingham University Business School

 To examine developments in UK & European buy-out markets in

comprehensive and independent manner  25 years of research into MBO/MBIs

 Established world leading database of buy-outs

 Currently >25,000 buy-outs in UK and Europe  Number of publications generated from database including:

 UK Quarterly Review and European MBO Review

 Academic Articles

200000 1600 180000 Private1400 Equity & Portfolio Companies160000 140000 1200 120000 1000 100000 800 80000 600 n 60000 illio m umber

N € 400 40000

200 20000 0 0 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Number Value (€m)

 From Folklore to Science

 Summarize main themes from over 100 studies covering

US and Europe (Gilligan and Wright, 2010)  Performance, growth and their drivers

 Role of Boards

 Employment and employee relations

 Asset sales, Longevity and distress

Source: CMBOR Do Buyouts Improve Firm Performance?

 Buy-outs improve profitability

 Operating profitability of PE backed buy-outs greater than

for comparable non-buyouts by 4.5% over first three buyout years

 Industry specialisation of private equity firm important  Similar evidence from France & NL  BUT Public to Privates [PTPs]

 Emerging US and UK evidence suggests accounting

returns on 1990s/2000s deals are not as great as for 1980s deals [Guo et al., 2009; Weir et al., 2008]

Source: CMBOR/Barclays Private Equity/Deloitte Do Buyouts Improve Firm Performance?

 Buy-outs improve productivity

 Total factor productivity (TFP) assessed 36,000 UK manufacturing establishments

 4,877 experienced MBO between 1994-8

 MBO establishments were approx. 2% less productive than comparable plants before transfer ownership

 After MBO substantial productivity increase  [see also Davis et al., 2009 for US]

Does PE Affect Growth & Investment?

 Refocusing & divestment greater than non-buyouts  Buy-outs improve entrepreneurial actions

 New product development

 Role of private equity firms  CAPEX & R&D mixed evidence  Divisional buyouts greater growth in sales, efficiency & profits (Meuleman et al., 2009)  PE backed buyouts increase patent cites (Lerner et al., 2008)

 Strategic control systems enable growth

What Drives Performance Changes?

 Management team shareholding has largest impact on equity returns

 After adjusting for management selecting an attractive deal

 Paying a lower price gives greater scope for greater equity for management  Gains in LBOs > Gains in Leveraged Recapitalizations What is the role of PE and the Board?

 Active PE firm monitoring important

 Industry specialism & experience of deals done

 Boards:

 in PE buyouts active, non-bureaucratic boards that help lead strategies to create value

 in listed corporations accompany management’s strategy and tend to focus on risk management What is the role of PE boards in distress deals?

 Listed corporation non-executive directors appear generally less involved than boards in PE-backed buyouts when restructuring becomes necessary  PE firm boards more rigorous and timely in distress  PE firms have an important role in restructuring distressed portfolio firms and their strategies even following debt/equity swaps  Listed corporations can face greater problems in injecting new cash as they need to issue a formal investment proposal  [Wilson, Wright, Cressy, 2010]

Does PE adversely affect employment & wages?

Years relative to year of deal Variables t + 1 t + 2 t + 3 t + 4 t + 5 MBO Employment -2.28% 2.96% 7.46% 21.43% 26.02% MBI Employment -10.22% -9.70% -11.10% -3.35% -5.02% Source: Wright et al. (2007)/CMBOR

 Employment  Now many studies – employment effect contingent  Davis et al. (2008) employment grows more slowly & declines more rapidly in PE until t+4; greenfield growth (US)

 Boucly et al. (2009) 3 years following LBO, targets grow faster than peers by 13% (France)

 (Amess & Wright, 2007, 2010; Amess, Girma & Wright, 2008) (UK)  Majority of deals increase employment after initial fall

 Employment growth in MBOs higher than non-LBOs but lower in MBIs

 Buyouts whether PE or not no different employment change compared to matched firms

 M&A has more negative effect than PE on employment

 Wage growth in MBOs & MBIs, lower than non-LBOs

What is Impact of PE Buyouts on Employee Relations?

 Occupational pension schemes: increase but shift to defined contribution schemes based on investment performance and contributions open to new members  Increase in regular team briefings; Internal promotion as norm; work organised around team working for the majority of the staff; Formal grievance procedure; incentive pay schemes; non- managerial training  Little change in union representation; 2/3 unions in favor neutral towards buyout

 More consultative committees, more influential; increased focus on employment issues and especially on discussing company’s future  Evidence of direct meetings between PE firms and employee representatives

 [Bacon et al., 2008a, b]

What is Impact of PE Buyouts in Different Social Contexts on Employee Relations?

 Differences in Portfolio company context

 All contexts show increase in new high performance work practices (HPWPs) after buyout; significant differences between contexts disappear after buyout  Differences in PE firm origin

 Buy-outs backed by Anglo-American firms are as likely to introduce HPWPs (except for more financial incentives) as those backed by non-Anglo-American PE firms, suggesting some adaptation to local institutional contexts.  Time-scale

 PE investment results in greater increases in HPWPs longer the anticipated time to exit.

 The impact of PE on HPWPs is affected more by length of the investment relationship (heterogeneity of PE firm effect) than the countries where PE is going to or is coming from  [Bacon et al., 2010a, b]

What is the Extent of Asset Sales? Substantial sell-offs mainly in few large & PTP deals

Partial Sale Year CE UK No. Val. (€m) No. Val. (£m) 2000 36 420 78 4352 2001 30 51 94 8905 2002 32 2644 69 4837 2003 35 922 76 2974 2004 49 2938 73 8619 2005 54 2236 99 9145 2006 44 3786 72 6688 2007 49 6472 60 5379 2008 30 5654 44 495

 Number & value of partial sales small share of deal volume and

value Do PE Deals Involve Short Term Flipping of Assets?

80 70 70 60 60

50 50

40 40 £50‐500m 30 30 Over £500m

20 20 avge months to exit to avge months 10 10

0 0

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: CMBOR

 Overall increasing time to exit but heterogeneous longevity  (see also Stromberg, 2008)

 Secondary buy-outs take longer to exit

 PE-backed MBOs IPO sooner; those backed by active PE exit sooner & perform better

Can PE provide a role in distressed firms? Receiverships Increasing Source of Buy-outs

120 1200

100 1000

80 800

60 600 million

Number £ 40 400

20 200

0 0 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Total Number Total Value (£m) What is happening to Leverage & Pricing in PE Buyouts? 60

50  Dramatic fall in senior 40 debt in financing structures in 2008 30 20

over above £10m 10

deals 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

 Substantial increase Equity Mezzanine Debt Loan Note Other Finance in senior debt pricing Type of Senior Debt 04 05 06 07 08 above LIBOR, especially for less Tranche A 225 218 224 217 285 traditional layers Tranche B 275 250 262 265 338

Tranche C 327 283 308 303 396

Note: Data shows basis points above LIBOR Does Higher Leverage Increase Likelihood of Failure?  Failed vs non-failed buyouts  Failure rate affected by leverage, timing of deal & by default probability on buyout (Wright et al., 1996)

 PE buyout failure vs non-buyout failure (Wilson, Wright & Altanlar, 2010)  7million firm years 1995-2009 including all UK companies  PE-backed buyouts have a significantly better coverage ratio (the ability to pay interest on debt from profit and cash-flow) than non-private equity backed businesses.  Leveraged firms [of any kind] more likely to fail  After taking into account leverage and other factors:

 Private Equity backed buyouts post 2003 not significantly different in failure likelihood than non-buyouts

 Buyouts and buyins without private equity more likely to fail

What is the recovery rate in failed PE deals? ?

 Secured creditors recover 62% average on bankruptcy; 30% sold as going concerns (Citron, Wright, 2008)

 Recovery rates from failed PE buyouts (63%) more than twice those in failed listed corporations (26-30%) [Wilson,Wright & Cressy, 2010)

 Dependent on proactive working between PE firms and banks

 Banks may soon seek to recover value through equity sales, which may increase receiverships or sales to distress funds. Deal Types and Involvement of PE Firms

PE Model/ Managerial Managers’ Expertise LeveragePortfolio Mgt& ConflictedInnovative Buy-Skills Financial Constrained outs [weakBuy-outs complements] [strong negative LowerMonitoring Leverage Radicalsubstitutes] Buy-outs Operational [strong positive & Close Value [weak substitutes] complements]

Buy-outs Adding

 Need strategies to grow portfolio firms organically or build-up

 Need to acquire expertise to add value & be sector focused

 Select portfolio management with business skills who can

identify and deliver on innovative development strategies  Need to be involved in portfolio firms beyond initial ‘100 days’

Conclusions

 Widespread evidence of positive impact of PE  Need for recalibration of traditional PE model rather than fixing a broken one  Elements of best practice detectable worldwide but believe have identified general challenges for a significant swathe of less experienced PE firms  Potential danger with pressure upon PE funds to invest

 Deals completed at entry prices posing major challenges to the generation of target returns

 Questioning of whether the lessons from the ending of the golden age have indeed been learnt Private Equity – a catalysts for change?

EC Restructuring Forum, Brussels, July 2010

Anne Holm Rannaleet

Section 1 Brief introduction to IK

Section 2 How can PE drive industrial change?

Section 3 Corporate Governance in a Private Equity setting

Section 4 Discussion

Section 1

Brief introduction to IK

• Founded in 1989

• €5.7 billion raised in six funds

Finland Norway Sweden • 69 investments Stockholm

• 51 exits1) Denmark London Hamburg Benelux Jersey Luxem- Germany, • Aggregated sales of portfolio Paris bourg Austria, Switzerland and companies approximately €8 billion Central France Eastern Europe • 30+ investment professionals of 9 nationalities

IK’s mission is to deliver above average returns to its investors by creating long-term Investment teams Investment advisory offices value in acquired businesses Fund administration office

1) Including partial exits © IK Investment Partners Investment strategy and process Confidential 5 Introduction to IK Investment Partners Creating regional and pan-European market leaders

Further international expansion

Develop on European scale - Buy and build strategy Acquire national Internationalise standards champion Broaden management team

Section 2

How can PE drive industrial change?

The IK way

Corporate Governance

Industry Strategic focus restructuring

Capital

Expansion Operational excellence

Strong Corporate Governance constitutes one of the cornerstones of IK’s approach to value creation

Themes Measures Examples

Refocus Business line restructuring

Benchmarking Operational excellence Transfer of best practices

Industrial restructuring Consolidation through mergers/acquisitions

Maintenance Dedication to service aspects After-sales

Market growth Expansion Product expansion

Actions

Operational Board of Directors – Appropriate board composition – Frequent board meetings – Strategic issues always board decisions

Continuous evaluation of management capabilities and requirements

Close partnership between IK and portfolio company management – Frequent informal contacts – Entrepreneurial management culture – Incentive schemes to align interests

Stimulate fast and professional decision making process

Actions

Identify core business(es) immediately

Find homes for non-core assets and focus on building the core business

Identify key strategic directions – Clear goals – Set deadlines

Tailor the organisation to fit strategy

Building a leading kitchen company through industry consolidation

Set strategic road-map for value creation

Actions

Initiate transfer of best practices through benchmarking

Set measurable performance targets

Increase organisation’s focus on capital efficiency

Implement systems for continuous performance improvement

Create best-in-class company

Actions

Enhance R&D and marketing efforts to: – Target new customer segments/ applications – Develop new products

Invest in production capacity

Expand after-sales and service

Pursue geographical expansion – Organic growth – Acquisitions

Invest in growth

Equity MEUR 100%

9 000 +107% -19% 8 000 13% -1% 7,575

7 000

6 000

5 000

4 000 2,769 3 000

2 000

1 000 Equity Earnings Multiple Debt Reduction Other Exit Investment0 Growth Arbitrage Valuation

Note: Based on weighted numbers as of 30 September 2009

Different industries…..

Different geographies……

Different situations…..

Different cycles…..

Is there a common denominator?

Section 3

Corporate Governance in a Private Equity setting

Sense of Urgency

Strong and Alignement of active owners interest

Does the ownership structure affect success? Momentum

Starka och Intresse- Aktiva ägare gemenskap Private Equity Public companies

Owner Owners (IK Fund)

Board Board

Management Management

Which are the differences?

Does the ownership structure affect success ? (cont.) Momentum

Starka och Intresse- aktiva ägare gemenskapp Private Equity Public companies

Board is the owner’s prolonged arm Often need to compromise different owners’ strategic agendas Smaller boards Can be more challenging and time Informal communication and decision consuming to find mutual consent making facilitated Quarterly earnings focus Value creation strategies are more easily agreed and pursued Largely institutional ownership

CEO rarely Chairman Risk of longer term lethargy

PE firms can exercise a stronger and more active influence on the board and management than in public companies

Sense of Urgency

Strong and Alignement Well-defined time horizon: exit is anticipated within 3-7 years active owners of interest

Detailed value creation plan prepared and agreed at the outset; needs to be executed and future growth platform put in place to ensure successful exit

The IRR-measure, which itself is return and time driven, makes timing of a successful exit paramount. Purchaser needs visibility on future value potential

Acquisition financing comes with a detailed amortisation plan which needs to be adhered to in order to avoid default on financial covenants

Strong and clear Sense of Urgency throughout system

Alignment of Interest in Private Equity

Momentum

Starka och Intresse- aktiva ägare gemenskap

The IK fund is the majority owner, but management and external board members co- invest in equity

- Investing on same commercial terms as IK - Option like programme to boost upside

PE firms share risks with their investors and are rewarded by the IRR delivered to the fund. Incentive programmes for management are predominantely also based on the IRR at exit

Common goal is clear to everyone from the start and also measurable (IRR)

High degree of common goal and alignment of interest

Corporate governance An active and competent board is a prerequisite for a successful investment

Industry Strategic focus restructuring ”The Investment case” presented to new board members is a platform for value creation and thereby

for the board work Expansion Operational excellence – Strategic agenda – Operational improvements – Financial goals

Detailed and effective framework for improved board work (”Board Guidelines”)

Division of responsibilities – owners vs. operators

To ensure a quick, structured and flexible decision making process

The company management team is responsible for day-to- day operations

IK is involved in strategic decisions at board level

Frequent informal contacts between IK and management

IK expects management to invest in the Portfolio Company

Portfolio company CEO member of the board of directors where legally possible

The purchase or sale of any real estate, business, shares or other securities

Changes of business focus and significant organizational changes

Major investments or divestments

Employment or discharge of top management

Important EHS matters

Significant law suits

Changes in credit arrangements

Publication of important information

Board of Director’s fees and auditor’s fees

Proposals on election of external advisors

Active ownership with clear agenda and alignment of interests

Control of investments & divestment process

Clear division of responsibilities

Leverage the know-how acquired and networks

PE model provides good setting for driving industrial change

Sigurt Vitols Wissenschaftszentrum Berlin für Sozialforschung

Presentation for the Restructuring Forum: The Impact of Financial Investors on Enterprises, Brussels 5/6 July 2010 Overview of Presentation

• „Angels vs. Demons“ debate too simplistic • Impact of PE on companies varies greatly: -- across company types -- across PE firms • Looming refinancing crisis? • Redirection of research and policy agenda necessary? Research: Leading or Lagging Public Debate? • „Angels or Demons?“ (Lutz/Achleitner 2009) • „Are PE Investors Good or Evil?“ (DIW 2009) • Most econometric studies of PE impact: -- measure „average“ effect of PE -- assume all PE firms the same PE Model • Different strategies: Growth vs. Operational Efficiencies vs. Turnaround • Potential changes: management, HRM, acquisitions, investment, R&D policy • Source of profits: increase in company value, tax benefits, market timing • Financing: different mixes of debt + equity • Debt: discipline device or danger to firm? Different PE Styles/Experience?

Source: Moody‘s „$640 billion and 640 days later“ PE Transaction/Equity Value by Deal Size, 2007-2009

5.7 6

4 3.1 2.6 3 2.1

0 Small Mid-market Large Mega

Source: Own calculations from EVCA Buyouts Report 2009 Were Mega-Deals a Market Failure?

Source: Moody‘s „$640 billion and 640 days later“ Different trade unionist experiences with PE

Source: Unionen „Owned by Private Equity“, 2008 survey of Swedish TU reps A Looming Refinancing Crisis?

Source: Moody‘s „$640 billion and 640 days later“ Distressed Exchange vs. Bankruptcy

Source: Moody‘s Private Equity 2009 A Research and Policy Agenda • Lack of transparency: a problem for research • Drivers of different PE strategies/impacts? • Best framework for encouraging „good“ and discouraging „bad“ PE outcomes? – Leverage cap in context of market failure – Employee information/consultation rights • Impact of distressed exchange vs. bankruptcy? • Policy measures for the looming refinancing crisis? THANK YOU FOR YOUR

ATTENTION!!!!!!!!!!!!!!!!!!!!