Victims of their own success

Could stranded motorists waiting by their broken-down jalopies for the AA
patrol to arrive have opened up the first chink in the seemingly impregnable
armour of private equity?

In autumn 2006, Volkswagen announced it was cancelling its contract with the
AA, owned by private equity houses Permira and CVC, and was switching to the
RAC. The news came in the wake of research which showed that the AA had slipped
from first to third place in roadside response times.

Critics blamed the private equity owners for cutting 3,000 staff since they
acquired the company. The news raised the question of whether the private equity
approach – focused on making quick returns to investors through cost-cutting and
debt leverage – is always in the long-term interests of companies.

“If cost-cutting annoys employees and demotivates management, it may not be
as effective as a mid-term strategy,” says Leon Stephenson at law firm Reed
Smith.

“Whether a private equity portfolio company will be able to offer the same
level of service or the same quality product while operating on a lower cost
base is debatable,” adds Daniel Shear of the UK200 Group.

Image conscious
Then there’s the question of image. Somerfield quit the Ethical Trading
Initiative last year after being taken over by financier Robert Tchenquiz and
private equity firm Apax Partners. Criticis claimed that the supermarket chain
was more interested in profits than paying fair wages and prices to suppliers in
developing countries – a charge it hotly denied.

No one is decrying the success of the private equity phenomenon during the
past decade, least of all Peter Linthwaite, chief executive of the British
Venture Capital Association, who extolled its many wonders in the December issue
of Financial Director.

Provisional figures suggest that more than 1,000 private equity deals were
completed in Europe in 2006, with a total value of about £111bn. In the UK,
private equity-owned companies are said to employ 27% of the workforce.

Yet there are mounting concerns about the extent of debt that private equity
firms often load on to the companies they acquire. “Many private equity deals
are highly leveraged and, in some cases, the private equity investors declare
themselves a dividend shortly after completion, which reduces their cashflow
burden,” says Shear, partner at BKL Corporate Finance.

“The debt finance is funding a dividend and the portfolio company is saddled
with paying off the debt, including interest, long after the private equity
investors have made an exit from the company. I’ve had experience of private
equity using the dividend-stripping technique to get their money back. You can
understand what the FDs’ reaction is to that when suddenly they are taking on
more debt with more interest payments every three months,” says Stephenson.

Debt rating
Standard & Poor’s points out that private equity debt leverage can lead to a
downgrade in debt rating – and a consequent increase in the cost of debt for the
company concerned. The ratings agency argues that liquidity in the lending
market is driving leveraged levels and so increasing the chances borrowers may
breach their covenants.

Belinda Richards at Deloitte says that private equity’s rise has been so
dramatic it may have become the victim of its own success. “The competition for
deals is so intense that private equity can, at times, overpay. This raises the
question of what happens after the deal.”

Richards accepts that private equity probably has the edge over a corporate
buyer when it comes to making management and structural changes post-deal, but
investors will always have an eye on their exit. Trade buyers may not be so
radical, so quick to make their changes, but that’s because they’re not looking
to divest in anything from one-to-five years’ time.

Private equity investors pride themselves on their ability to create value in
a company. “The perception that private equity are simply asset strippers is
wide of the mark. What private equity investors apply to their portfolio
companies is industry expertise, clear focus, management incentives, equity
investment to develop the business, and support and nurturing that allows the
company to go into fast forward,” says Mark Barrow at Close Brothers.

Yet the reality is that the “fast forward” is usually heading for an early
exit and the private equity investors have no financial interest in how much
value will be created by the firm after they have left. The growth of the
secondary private equity market in the past few years suggests it’s becoming
more difficult to exit from investments.

“There’s a danger that private equity investment will increasingly become a
victim of its own success. If the portfolio company is unable to sustain growth,
and assuming multiples are unable to rise much further, then either the private
equity houses will make losses on some of their investments, or they’ll
increasingly have to cut costs in portfolio to facilitate an eventual exit,”
warns Shear.

Stranded motorists may not be private equity’s only victims.