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Private equity - a new hope: why venture capital has come of age

‘There has rarely been as good a time for private equity or venture capital transactions.' Robert Donaldson of Baker Tilly provides a brief outline of the current economic climate and explains why private equity is so attractive now.

The difference in the general health of the economy today compared with 2000 is enormous. The world stock markets' 11 September hangover appeared to be subsiding in 2002 just as the corporate governance scandals of Enron and WorldCom struck.

The thought that huge accounting discrepancies could be hidden for so long in two of the world's biggest companies sent shivers around the market. Investors caught a cold and the hibernating bear of the 1990s woke up, effectively pulling the plug on any IPO activity.

As always when the risks of the equity market are too high, investors take flight to quality - bonds. Unfortunately, a string of high profile, investment-grade defaults and corporate failures has meant that even these traditional safe havens are closed. The markets are on the floor and the only way up is to improve trading performance. At least consumers still have an insatiable appetite to borrow and spend, don't they?

The recent news that the US consumer has finally succumbed to the pressures of massive economic uncertainty, the Iraq war and corporate failures will send ripples of fear around the world. Demand is weakening. It has been a torrid 18 months and the prognosis for the next 18 is not good. Gordon Brown is revising his growth estimates. Even in a time of doom, gloom and uncertainty life must carry on for business owners. How do stock market jitters, weakening consumer confidence and the impact of war affect current and future strategic plans? Is it all a disaster or are there opportunities?

Business opportunities
With the IPO market dead owners who are looking to realise the investment of time and money in their businesses are looking for trade sales. In some industries this could mean buyers with seriously depressed share prices. This has several effects:

• Buyers that previously may have considered your company as a strategic fit or a platform to enter into a new market may now feel that they should be refocusing on internal issues, cutting costs, repairing balance sheets and so on.
  
• Acquisitions are risky and in a bear market risk is punished. Balfour Beatty's share price plunged 11 per cent as a result of announcing a new acquisition and it is likely that many large corporations will not be willing to run that gauntlet.
  
• The price earnings multiples of even the most attractive shares have been significantly reduced and it is unlikely that those companies with the appetite to buy are willing to pay a premium price.
  
• Potential buyers do not have readily available routes to cash, rights issues are at deep discounts and bond markets are dead, so even those that are willing may not be able to buy.

Conversely, depressed share prices and economic uncertainty could present a number of opportunities. Now is the time for large companies to retrench, cut costs and repair balance sheets. Directors are looking to appease shareholders by refocusing on core activities or sticking to what they know best. As a result there are now a number of companies sitting on divisions or subsidiaries that are not part of their future plans. This could be the time to start investigating aggressive expansion through acquisition or perhaps becoming your own boss through an MBO.

However, exits, acquisitions and development all require one thing: cash. Where is it going to come from at a time like this? Never fear, all is not lost; the almost forgotten, battered hero from dotcom start-up investments is ready to charge over the hills and save the day. There has rarely been as good a time for private equity or venture capital transactions.

Venture capitalists
While in some quarters it is popular to refer to venture capitalists as ‘vulture' capitalists (the terminology being a fair reflection of how tough they are in negotiations), it can blinker you to all the private equity community can offer. To understand this fully we need to think about exactly what venture capitalists are, what they are not and why they are such an attractive opportunity now.

• A private equity institution is an organisation set up to invest money, raised mainly from insurance companies and pension funds, in projects that it thinks will make a significant return in three to five years.
  
• Private equity investors are not in the business of running businesses. They invest in a management's vision and rely on it to deliver this business plan.
  
• Private equity is not simply money for MBOs and development capital. Private equity investors are flexible. They offer opportunities for cash-out deals (which can provide owners of family businesses a chance both to realise their success and pass on their business to future generations) and in some industries they have the appetite to buy the company outright.

Using private equity as an exit route from your business can protect you from some of the risks of selling to the trade. Obviously, such investors are not interested in exploiting your trade secrets but just as importantly they are not beholden to shareholders and should be able to make decisions quickly.

The above has always been true about private equity, so why is it so attractive now?

• In recent years more than £100bn has been raised by private equity institutions.
  
• In the last 12 months they have suffered from a dearth of good quality projects and have made few new investments.
  
• If new investment opportunities are reduced then so too are the chances for significant returns.
  
• Poor returns affect the institution's ability to raise further funds in the future.

In summary, the private equity community is desperate for good quality projects to invest in and because it is not beholden to shareholders or share prices it is largely unaffected by the depressed stock market. Private equity is certainly a route you should be considering, but do not be too hasty. Private equity investors are professional dealmakers and transactions with them, be they development capital, institutional buy-out, MBO or MBI need to be handled carefully. You must be well prepared and advised before you launch yourself into their arms.

Copyright © 2003 Business Money

Robert Donaldson is head of London lead advisory at Baker Tilly.

Baker Tilly is the UK's 7th largest firm of chartered accountants and business advisers. The firm provides its growing and established owner managed business clients with audit, personal and corporate taxation, consultancy, corporate finance, financial services and business recovery. For more information please visit www.bakertilly.co.uk 

Business Money is the monthly industry journal for UK business finance professionals. It monitors and reports on over three hundred different sources of business funding, their terms and preferences. For more information please visit www.business-money.com