I moderated at a private equity
conference in London last week on the subject of what private equity
firms are doing with respect to exiting in the current business
environment. Even if you are not from the private equity industry, I
believe the subject is still of general interest, as it provides
trends on what sophisticated market participants are doing in an
often difficult market.
The following chart gives an overview
of exits for the European private equity industry:
Private Equity Exits in Europe, 2007 to 2011 Q3
Source, European Venture Capital Association, Index Q1 2007 = 100
The main points made
at the conference about private equity exits were as follows:
Not all sectors and countries are experiencing downturns. Poland has
been the most robust market, thanks to its strong macroeconomic
performance vis-à-vis other countries. There have also been certain
sectors, such as IT and technology, that have performed quite well.
So there were still 160 private equity exits Europe-wide (*) in Q3
2011, the most recent statistics available – just to strategic
2. The number of firms written off by private
equity investors is also surprisingly common – also 160 firms in Q3
2011, Europe wide, in Q3 2011(*).
3. Most private equity
owners have postponed exits on a number of their investments. So for
example, whereas in the first half of the previous decade, the
average hold was only about 4 years (*), that number has no crept up
to 7-8 years for many PE firms.
4. As it his harder to grow
top-line revenues in many sectors of the economy, private equity
firms may hope that multiples improve over time; but hope, in itself,
is not a strategy. Many private equity firms are putting much more
emphasis on operational improvements to build value.
5. One of
the reasons for which it is so hard to exit in the current market is
the difficulty of giving performance forecasts. In many sectors, it
is very difficult to predict what will happen even in a
three-to-six-month horizon – the time it takes to move from a
Letter of Intent (LOI) to closing. In this type of environment, a
seller can either give a conservative forecast (which will greatly
diminish valuation), or provide a more optimistic forecast. If this
more optimistic forecast is missed, it will devastate the value of
the firm even more than under the former scenario, because it
destroys the credibility of management in forecasting performance,
even over the short-term.
One strategy for avoiding the risk
of missing budgets is to diminish, as much as possible, the period
between LOI and closing. For mid-sized companies, this might be
accomplished in 10-12 weeks, provided that there is an extremely
thorough advance preparation, which would include having everything
ready that an investor would want to have at their fingertips,
including a completed data room, perhaps even with a completed vendor
due diligence. Some competition in the process, to keep bidders
moving according to a preset time line, can also help prevent the
process from lagging.
In a nutshell, while the environment is
not easy for most private equity firms, there are some excellent
strategies to deal with the current situation. For those private
equity firms with capital available, it is generally a buyers’
market, and the diminished credit available from banks in most
countries means that companies generally seek more equity.
there is something of a shakeout happening in the Central European
private equity industry, this is not happening as quickly as some
pundits were forecasting in the months immediately after the Lehman
crisis. It is primarily those private equity firms that show a good
track record, even during the tough times, that will be more
successful at raising funds. There is something of a flight to
quality among those institutions and individuals who invest in
private equity funds. It will be even more difficult for new entrants
to compete against 10-15 years of positive track record.
prediction, therefore, is that over the coming five years, there will
be fewer but larger private equity firms active in Central Europe.
(*) Statistics provided courtesy of the
European Private Equity Association.
My last article discussed how strategic investors typically choose acquisition targets; this article does the same for private equity investors.
Private equity investors typically have a charter which sets out well-defined parameters for investments to be made by the fund, including:
- Nature of investments. Some funds like high-growth companies, others prefer investments with stable cash flow or dividends. Still others prefer turn-around situations.
- Geographic scope. Many Central European funds restrict themselves to EU member states, the bolder ones will venture in to former Yugoslavia or Turkey;
- Preferred sectors. Some funds are generalist funds that will look at just about any sector, others focus on one particular sector, such as transportation, infrastructure, telecommunications, etc.
- Investment size. Most funds will specify a minimum or maximum investment size (e.g. €5-25 million).
- Ownership interest. Some funds insist on control, others will take minority interests.
- Fresh equity. Many financial investors are not willing to buy out shareholders, they only want to inject fresh equity into a company (e.g. to fund growth). Others will consider a combination of fresh equity and buying out existing shareholders. Buyout funds will want to buy 100% of a company.
It is therefore important to find a good match between a private equity fund and a company. It is likely a waste of time to enter into discussions with a fund if the applicant company does not fit the fund’s criteria; investing in such a company would put fund management into breach vis-a-vis its own investors. Business owners should therefore do a little homework before approaching funds – the investment criteria are usually on the fund’s website.
The average private equity fund in Central Europe will typically screen a few hundred investment cases every year. Not more than a few will actually become the object of an investment. The vast majority of private equity funds typically have an investment committee that makes all the investment decisions, and a local person (who may or may not be a member of the investment committee), who basically becomes the protagonist of the investment to be made in a particular company, at the level of the committee. Hence the owner of a business must first convince the protagonist of his investment case. The owner of a business seldom, if ever, communicates directly with other members of the investment committee. Hence the written information prepared by the company, most notably the Information Memorandum prepared by the company, particularly its Executive Summary, may become an important indirect communication tool with the investment committee.
A financial investor will usually subject a company to an initial due diligence, using its own internal staff, before obtaining a green light from the investment committee to proceed with a full due diligence of the firm, using external advisors (at a minimum lawyers, possibly financial advisors, auditors, tax advisors, technical experts, etc.)
So what does a private equity firm look for in its investment choices:
- A solid business opportunity that reflects its acquisition criteria (e.g. growth, size, geographic parameters, etc.);
- Exit strategy – who are the likely buyers for the company? What are the chances for a successful exit?
- A strong management team, who is prepared to stay until the exit of the fund. (An owner-manager who is cashing out is often too high a risk for the private equity investor – please see my earlier article on the “One Man Show,” available here and here.
- Strong corporate governance – good decision structures, reporting systems, and strong documentation. Private equity investors seek management teams that are highly motivated, are prepared to agree to ambitious goals, and are prepared to work extraordinarily hard to achieve significant financial gains. Conversely, if results are not forthcoming, managers that own shares may find their ownership diluted.
- Manageable risks. No actual, pending or potential litigation, or the potential for surprises on the downside;
After the due diligence, the investment committee (or at least certain members) will usually review the due diligence report of lawyers and other advisors, and the proposed Sale and Purchase agreement.
Sometimes private equity firms will purchase what they call “bolt on” investments. Bolt on investments are do not typically need to satisfy all of the investment criteria (e.g. they may be smaller than usual, or management of a bolt-on investment may choose to exit), as the acquired bolt-on company would be purchased to create synergies with one of their existing portfolio companies.
Private equity firms have taken an ever-larger share of the M&A market in Central Europe. They are an important potential source of financing for mid-sized firms that must not be neglected.