PRINT THIS PAGE The changing face of private equity07/12/2005. Source: PKF. John Gilligan
In this article John Gilligan, corporate finance partner at PKF, takes a look at how the private equity industry in Britain has evolved. In the early days of private equity in Britain, he says, there were only a few equity providers, with relatively little money to invest. Many larger transactions were too big for any one investor, so consequently many were syndicated. The industry became geared towards relatively young, bright, personable individuals. Indeed, many private equity businesses explicitly differentiated themselves by recruiting the most charismatic characters - if not always the brightest. Since you needed to bag a share of the cosy market where deal-flow could come from syndication, it helped if your people were "nice".
The popularity of the management buy-out exploded in the mid to late 1980s. A heady cocktail of financial engineering, inflation to help "pay down" debt and management teams buying from the inside of the business, gave those who worked in the industry the Midas touch. The model worked, and attracted increasing volumes of money. The industry would regularly trumpet its successes as investors while vendors looked on from the sidelines.
However, after boasting of these impressive gains, it was naïve to imagine that vendors would simply suffer in silence. Vendors' reaction, when it came, was to seize control of the process of sale to try to stop managers from "stealing" businesses from under their noses. This evolved into the current situation where most (if not all) sales to management go through some form of auction process, often involving only private equity firms.
The reaction of the private equity industry has been to change its means of differentiation: size and sector have emerged as the major strategies. Those who have broken free from the pack to become the industry giants pursue bigger and bigger deals, deploying large amounts of capital. They are well on the road to becoming multinational conglomerates competing in an international deal market. The people in these firms no longer have the same requirements that they had in the past, even if many at the top are the very same people. Their deal-flow comes largely courtesy of investment bankers. They do not need to get along with the incumbent management - they won't necessarily even meet them before exclusivity has been awarded, and may well rely on an investing Chairman to provide the real sector support.
These days, private equity firms need to get to see every deal possible, and to buy as cheaply as they can negotiate in a competitive auction. The skills of financial engineering are almost wholly commoditised. The so-called "stapled offer", whereby an investment bank sends the debt package to the purchaser with the information on the business, is the clearest evidence of this. The vendor is saying, "I don't care about your financial engineering, it's so simple, and I've done it for you." The interpersonal skills that built enduring relationships of trust between market participants no longer count for much. Everybody is in the private equity market today, and on a deal you rarely see the same face twice.
Apart from good judgement, the next best skill to have today is negotiation. Since the only objective in round one of a multi-round auction is to have the option to bid again, credibly, in round two, it makes sense for each participant to bid as much as is plausible in round one. The only risk in overbidding is the damage to credibility if the second round bid is lower. Round two may be the time to start spending money on advisers and due diligence - putting the bidder at financial risk. In the past it was possible to offset this risk by getting advisers to work contingent on success, but this is increasingly banned (in the case of lawyers and accountants) or at least fought against. Bizarrely, in a world with only four big accountancy firms, at the top of the market it has started to become a point of differentiation if you actually have an accounting adviser.
In this form of the process, the bidders' objectives are to maximise the probability of being given exclusivity, subject to the constraint of abort cost budgets. Thus the skills required are very different. Who cares if you are a "good bloke", or have tremendous financial skills? It would be far more valuable to have the best negotiators on your bid than to have the best financial engineers. It's not helpful if your team leader doesn't understand the basic financial structure, but this understanding is not necessary to success. In the future, we might expect to see a private equity industry with fewer personable professionals and more professional poker players.
It is perhaps ironic, then, that the industry has little understanding of game theory. I know of no course that teaches corporate financiers or private equity investors the theory that underpins multi-part auctions. The private equity industry places more emphasis on teaching regulation and compliance in its training programmes than it does on teaching people to be good at getting what they want. Many firms still talk about being a "team player" as a necessary characteristic of their recruits. But what is the advantage of being a team player in a poker game? True, empathising with your opponent might show you the best way to beat them; on the other hand, it may erode your will to win at all costs.
John Gilligan is a corporate finance partner at PKF accountants and business advisers and a Special Lecturer at The University of Nottingham Business School. He began his career at 3i in 1988 and spent ten years with Deloitte, latterly as a corporate finance partner. He has also been a non-exec on the board of a number of private companies and was a member of the ICAEW Corporate Finance Training Faculty. For further information on PKF visit http://www.pkf.co.uk
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