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What is private equity?

Investors turning to private equity can be put off by the lack of basic information about the asset class. In this extract from his book European Private Equity, Garry Sharp gives a straightforward definition of private equity, with explanations of the different stages involved and the levels of return that investors can expect.

This is an edited extract from European Private Equity: a practical guide for vendors, managers and entrepreneurs, a Euromoney Books title.

European Private Equity
A practical guide for vendors, managers and entrepreneurs

Garry Sharp

What is private equity?
Simply:
The provision of equity capital to companies whose shares are not listed on a recognised stock exchange.

Although the definition is straightforward, a closer examination will reveal the flexibility - not to mention the potential for immense complexity - which lies behind such a superficially simple concept. It will also begin to explain why the private equity markets have seen enormous growth since the early 1980s and are now such a significant element of corporate finance activity across Europe.

The private aspect

The fact that transactions are private - negotiated directly between investor and company, with no external parties other than professional advisers - has a number
of implications:

• Investment terms can be structured and tailored to match the precise requirements of the company and the investor; this often leads to highly complex structures which could not be explained, much less sold, to public market investors.
  
  
• Investors can be - and usually are - represented on the boards of their investee companies and play an active part in strategic decision-making.
  
  
• Similarly, reporting requirements will be negotiated directly between company and investor; as the shares are not publicly traded there is no requirement to abide by a quoted market's reporting rules. 
  
  
• With no external, public shareholders' interests to safeguard, financial regulatory issues do not play a significant role in structuring transactions. Although private equity firms who manage external clients' funds are regulated, as are corporate finance and other professional advisers, regulatory scrutiny does not generally extend to the details of individual transactions
  
  
• Because their shares are not quoted, investors' liquidity - ie, the ability to sell them quickly and easily - ranges from severely limited to non-existent. Investors are generally locked in to their shares until the company is either floated on a public market or sold to a third party. It is this factor more than any other which drives the close relationship that usually exists between investor and investee company.

The equity aspect

The sharing of risk and reward inherent in this type of finance separates it from the major alternative source of private company finance, ie, debt. The differences in principle are:

• Investors will receive the bulk of their returns as a result of the performance of the investee company. There will be no fixed limit to the investors' return, while on the other hand, should the company fail, there is little chance of them recouping any of the investment. This, in theory at least, tends to align investors' interests with those of management shareholders as they share a common goal of maximising shareholder value. This is in marked contrast to debt providers, who with only a fixed interest return available will be anxious to minimise risk and will generally seek some form of physical security to protect their investment in the event of failure.
  
  
• Returns will usually be heavily dependent on capital gain arising from the sale of shares in the investee, rather than a pre-agreed schedule for repayment of principal and an income flow arising from the investee company's cash flow.

In practice, the situation is often not so clear-cut. Investors often do attempt to build structures that contain an element of protection in the event of underperformance, and to achieve preferential rights to a company's free cash flow during the life of the investment. Also, many of the different types of funding structure in common use can drive a wedge between management and investor, as diverging perceptions of the future and differing views on potential risk and reward lead to conflicts (examples follow in later chapters). Nevertheless, the essence of private equity investing can be summarised as:

• Accepting a level of risk which would not be viable for a debt provider; 
  
  
• Providing support and guidance to the management team where appropriate;
  
  
• Linking returns to the performance of the company, and particularly to capital gain on exit; and
  
  
• Earning a commensurate return for so doing.

The flexibility of private equity finance, coupled with the levels of return that have been achieved from investing in unquoted companies, are the key to understanding its growth.

The range of private equity

It is a repeatedly told story that the Body Shop, a highly successful niche retailer of cosmetic products, was financed as a start-up by a £10,000 investment from a neighbour of the management team, an investment which yielded a many thousandfold return. Although tiny, this initial funding, where the investor accepted a high risk of failure in backing an inexperienced team at the earliest stage of developing an untried concept, in exchange for a minority equity stake, was a classic example of private equity funding at its purest.

At the other extreme, the e2 billion acquisition, by the massive investment firms Cinven and Investcorp, of Hoechst's speciality chemicals division in 1999 was also a private equity investment.

There is perhaps no other type of financing structure that can accommodate such a range of transactions (one 130,000 times the size of the other) within the basic principles outlined above.

It helps when tackling such a vast range to break it down into categories, and the following types of investment definitions are generally accepted. Note, however, that the lines between these different categories are often not clear-cut and, based as they are on a range of subjective judgements, can be interpreted in varying ways by different investors. Each of these transaction types has its own separate set of issues, which will be reviewed in depth in later chapters.

Seed capital/seed corn
The provision of funding to develop a concept, or product idea, to the stage at which its practical and commercial viability can be assessed.

A well-known example of seed corn funding was the provision of US$100,000 to the developers of the Trivial Pursuit board game, enabling them to develop the concept to prototype and demonstration stage.

Start-up
This is self explanatory. The differentiator between a seed corn and a start-up stage company is that the latter is ready to begin trading. However, there is in practice a clear overlap between the two, as the open marketplace is the only true test of commercial viability; the start-up company may be ready to start selling, but its product or service offering will generally face significant refinements in practice.

Early stage
Any company that has commenced trading, but has not moved into profitability or proved its commercial viability, is referred to as an early stage investment.

The term ‘early stage' is also used generically to describe all investments in the above three categories.

Development (or expansion) capital
Equity funding provided to help an established, profitable company grow more rapidly than it would otherwise be capable of. Finance might be used for product development, geographical expansion, acquisition or investment in areas such as production facilities, research and development or marketing.

Again, the lines between categories can be blurred; for example, providing finance to take a profitable but stagnant business into a radically new area will raise similar questions to those applying to much younger companies.

Replacement capital
The provision of finance to buy out a minority shareholder; for example, a retiring member of the management team, or an external or corporate shareholder. Although these transactions can appear to be the most straightforward as there is no change in the management of the underlying business, the introduction of a new, institutional shareholder with its demands and disciplines can often raise major issues for companies that had previously been closely controlled (see the ‘Ownership and management' box comment).

Management buy-out (MBO)
The acquisition of a company (usually a subsidiary being disposed of by a larger group, but not uncommonly a family-owned company) by a combination of its incumbent management team and private equity investors.

Management buy-in (MBI)
Similar to an MBO, with the crucial difference that the management team will be new to the target company.

Buy-in/buy-out
Similar again, but with a management team combining elements of both old and new.

Institutional buy-out (IBO)
A development of the late 1990s, an IBO is the outright purchase of a company by a private equity investor (or syndicate of investors), with no, or very limited, equity participation by the management team. In these transactions the senior team will effectively be hired by the investor to run the business on its behalf, a situation which has parallels with quoted companies.

Related to the growth of IBOs has been the sale by auction. The vendor of a company for sale will seek to obtain the highest possible price for it by appointing a corporate finance adviser to secure competing bids from both private equity investors and potential trade acquirers. The adviser will compile an information memorandum about the target company, on the basis of which interested parties will be invited to make offers. Only those making the best offers will be invited to look more closely at the company. This process has dismayed many in the private equity industry, as it damages the link between investors and management which is at the heart of unquoted investing, and of course makes it more difficult to acquire companies cheaply (this topic is revisited in Chapter 2).

Secondary buy-out
The refinancing of a private equity-backed company by a new investor, which usually sees an exit for the original investor.

A good, recent example of a secondary buy-out is the Netherlands-based European fresh seafood supplier Heiploeg Shellfish. This was purchased from UK food group Hazelwood Foods in 1995, in a £59 million MBO backed by CVC, Gilde and ABN AMRO. In August 2000, UBS Capital funded a e260 million secondary buy-out, which saw exits for the previous investors while management rolled over their equity holdings.

Rescue/turnaround
A limited number of investors specialise in underperforming companies, often using a cash crisis, imminent receivership or recovery action by lenders to buy in cheaply, installing a new management team and providing sufficient funding to allow implementation of a recovery plan.

The leap of faith - venture capital redefined

At the risk of simplification, it is possible to draw a crude distinction between the first three types of transaction - seed corn, start-up and early stage - and the rest. The difference is that investments in these younger companies require a significant leap of faith, and the willingness to accept a very high level of risk, on the part of the investor.

Typically, products or services, management and markets will be unproven to a significant degree. In contrast, when looking at the more established companies, investors are able, to some extent at least, to extrapolate from past performance, reviewing historic trading figures and management competence, and are investing in companies that have revenues, market presence and demonstrable value.

The term ‘venture capital' was originally applied to unquoted investing, as it emerged in the late 1970s and early 1980s. At that time the focus was on young, often technology-driven companies, with investors accepting high levels of risk and taking an active part in management of their investee companies. However, from the late 1980s an increasing focus on development finance and MBOs emerged (this is examined more closely in subsequent chapters), and it became clear that the industry was lessening its involvement with younger companies, so that the term venture capital was becoming misleading. Hence the adoption of private equity as an overall phrase encompassing the range of unquoted investment activity, with venture capital increasingly being applied only to start-up and early stage investments. This usage is also more in line with the US application of the phrase. However, the distinction between the terms has not taken root in Europe and for this reason, and for the sake of variety, for the most part the terms ‘private equity', ‘venture capital' and ‘unquoted investment' are taken to be synonymous.

The growth of private equity

Transactions on the scale of the Hoechst acquisition have only emerged in recent years as a result of the spectacular growth in the unquoted investment industry. Exhibits 1.1–1.6 demonstrate this growth.

The growth has two important drivers; one is the range of financing situations for which private equity is an appropriate solution, while the second is the level of return which unquoted investments have generated in recent years. This has attracted ever growing interest from investors, with greater fund commitments to the sector. Before looking at these returns, it is worth identifying some interesting trends hidden within the overall figures quoted above.

Types of investments
Management buy-outs/buy-ins accounted for 53 per cent of total investments by value in 1999, broadly the same as the previous year, as was the 29 per cent accounted for by expansion capital. If 5 per cent for replacement capital deals is added in it is clear that the overwhelming majority of funds go to established companies, which is what critics of the venture capital industry have been saying for the past 10 years. The 13 per cent invested in start-up and seed stage companies was, however, up a couple of points on 1998.
The good news for entrepreneurs in these statistics is the overall growth in absolute amounts, so that by keeping just ahead of this growth early stage businesses raised a total of €3.2 billion, nearly twice the 1998 level.

Numbers of investments
Average investment sizes are increasing. In 1997, 6,252 companies received private equity funding, implying a mean investment size of €1.5 million. With 7,628 companies financed in 1998, this increased to e1.9 million, and again in 1999 to €2.2 million with 11,253 companies receiving investment.

Country breakdown
Reflecting the more advanced state of the unquoted industry, the United Kingdom accounted for nearly half (46 per cent) of the total invested, followed by Germany at 13 per cent and France at 11 per cent. However, the trend is clear - the United Kingdom accounted for the majority of European investing before 1997 and its proportion can be expected to continue to fall as major European countries develop their unquoted activities.

Investment returns from private equity

The major sources of funding for private equity investing are the major institutional investors - pension funds, insurance companies and banks - who allocate a small, but growing, percentage of their funds under management to unquoted companies. As reviewed later in the ‘Industry structure' section, these funds are invested either directly by dedicated in-house teams or, more commonly, allocated to specialist, independent private equity management firms.

The major incentive for fund managers to invest in unquoted companies is the ability to earn above average rates of return. A spate of recent surveys - which were commissioned by various parts of the private equity industry in order to attract more investment - have demonstrated the rewards achievable from these investments.

The most recent of these available, the Bannock Consulting/Venture Economics/EVCA 200 Investments Benchmark Report published in July 2000, looks at 497 private equity funds, with E68 billion of funds under management. This shows the average annual return over the last five years as follows:

Venture funds                      24.1% per annum
Buy-out funds                      26.0%
Generalist funds                   20.7%

These levels are broadly equivalent to those earned from investing in European quoted markets across the same time period (the Morgan Stanley European Equity Index showed an annualised return of 24.7 per cent per annum, for example).

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