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A blurring of the lines between public and private capital

The past six months have seen an unprecedented blurring of the lines between public and private capital in the UK. There are those that believe this trend will turn out to be little more than a flash in the pan, a transitional effect as normal business returns to the public markets. But an increasing number of industry players are accepting that the boundaries have been irrevocably altered and that we are experiencing a seismic shift in the equity capital markets from which there is no turning back.

As is always the case when the market senses pricing anomalies, it begins to adapt. At the core of the drive towards these new, hybrid structures are vocal public market institutional investors such as Anthony Bolton of Fidelity, as well as Andy Brough of Schroders, Gervaise Williams of M&G and Ruth Keattch of Deutsche, who have all decided that they are being ripped off by private equity firms stealing value from the market.

‘Some of them certainly seem to take the view that private equity firms are siphoning value from the public markets, notwithstanding the fact that most public to privates leave shareholders with a substantial premium to the pre-speculation price of their shares,’ said Martin Clarke, a partner at Permira who recently completed the take-private of New Look. ‘If the market saw more value than we were offering surely it would simply reject it.’

Either way, these colossi of the public markets, men and women who have the power to influence the appointment of senior executives to ITV, shame management into binning plans for huge pay hikes and force others to spend time involuntarily in their gardens, remain convinced that the market has seen the departure of too many public companies at knock down prices.

Consider, they say, Holmes Place, which was bought out by Permira at what might be seen as a distressed price. Or Esporta, which was taken private through a hostile bid by Duke Street Capital and Cannons, bought out by Royal Bank Development Capital. And that’s just in the health & fitness sector.

But the market has felt their collective pain and has come up with a solution to deliver value back to the public market institutions. Corporate broking houses such as Collins Stewart have led the charge on the accelerated IPO front, while corporate law firm Travers Smith Braithwaite, has come up with a structure to allow investing institutions to retain their stakes when a company is taken private.

‘With Public to privates we have seen institutions refusing to accept the offer on the table, in some cases buying in the market to take them over the ten per cent that precludes a squeeze out of the rump equity,’ said Spencer Summerfield of Travers Smith Braithwaite. ‘They are managing to persuade their trustees that holding this illiquid stock once it has been de-listed does not break minimum funding requirement rules. Fitness First with Deutsche Asset Management and Pizza Express with Fidelity and M&G are good examples. Our model essentially formalizes the desire of the institutions to keep a carried interest in the business through an AiM listed structure.’

On the other side of the fence, institutions are gathering together to compete with private equity firms, buying assets directly from vendors. Perversely in some cases the vendor itself is a private equity house. Recent examples include Centreparcs, which was owned by MidOcean Capital and Centaur, which was a Veronis Suhler Stevenson portfolio company. More recently still there has been talk of Premier Lodge owners Texas Pacific following the same route.

‘In all these cases the broker puts together a group of willing institutions to buy the business, which then vests into an AiM vehicle,’ said Summerfield. ‘Technically, for the short period of time that it takes before the shares in the acquiring company are trading on the market, these public market institutions own a private business. But once the trustees were given comfort that this is simply an expedient method to capture value through listing a company that they wouldn’t otherwise get access to, they were happy. And this structure provides a sorely needed pipeline of new quotes in which public market institutions can invest.’

In some cases, the muddle of broking houses acting effectively as the acquirer of these businesses on behalf of an investor group has pitted broker against client in bidding for the same asset, as was the case with Numis and its Accelerated IPO of Centaur. Tricky stuff indeed.

So, does all this provide a real threat to private equity? After all, the private equity sales pitch claims that through a combination of clever buying, then applying collective ingenuity and management experience to transform a business over time out of the short-termist scrutiny of the public markets, and finally exiting well through an increasingly bewildering variety of options, absolute returns in the region of twenty to forty per cent can be generated.

Pretty punchy stuff in a low inflation, low GDP environment, where increasing intermediation has made the old model of buying cheap and flogging expensive unavailable. And bear in mind that the relative return folks investing in the public markets are only expected by trustees to make between eight and 12 per cent returns at best. That means they can afford to pay more for assets in the first place. How on earth can private equity compete with that?

Peter Taylor, CEO of Duke Street Capital welcomes the competition. ‘For a start, we are unlikely to want to buy the sorts of businesses that the generally more risk adverse public market investors would be prepared to back. At Duke Street we like businesses that we can transform, using financial firepower and best-in-class management, to become the number one or two in their sector. It’s all about adding significant value to businesses rather than buying mature businesses and running them for cash.’

Ken Landsberg, Managing Director of ECI Partners sees an advantage in the new paradigm. ‘When we exited Hoseasons, having transformed it over a four year period, we did so through a secondary disposal to Hg. Had an Accelerated IPO then been an option we might well have looked at it. There is clearly an advantage in securing rapid and complete exits for portfolio companies. As owners they would normally be locked in for a portion of their equity while an Accelerated IPO allows for a whole, guaranteed exit.”

Toby Boyle who heads up Henderson Private Capital’s European private equity business maintains that there will always be a role for private equity, not least because managers are increasingly attracted to it. ‘Private equity adds value to companies in a way that is not available to publicly quoted companies because of issues such as short term disclosure, lack of capital availability, the experience of private equity people including operating partners, using businesses as a platform for consolidation, and so on. Private equity actively stimulates rapid change, while change in quoted companies is usually at the margin. The management teams of target companies increasingly prefer the private equity route.’

Which is an interesting point in itself. Capital availability and competition influence the outcome of a transaction, but so does the ‘people factor’. The highest rank of managerial talent increasingly seems to prefer to take the private capital route, out of the glare of public scrutiny and the constraints imposed by public market corporate governance requirements. Sir John Banham, Chairman of ECI and himself a serial and successful manager of businesses such as Tarmac, Whitbread and Kingfisher is now happy to be in private equity. ‘The best managers are heading away from the public markets where there is a chance to make a meaningful impact on a business and to generate impressive absolute returns for their backers and some real wealth for themselves.’

Recent high profile examples might be Jon Lovering, now at Debenhams, Keith Hamill and Simon Burke currently attempting to take WH Smith private, Tom Singh at New Look and, if his offer is accepted, Lord Kirkham at DFS. Who can blame institutions for following the talent as it heads off the public markets?

In the two key examples to date of a partial private, Fitness First and Pizza Express, institutions responded to the offer made by the private equity fund by buying in the market to ensure that they were able to maintain their investment position. Permission to hold rump equity in a private company, however, in the same way as with an Accelerated IPO, needs to be sought from trustees in each case. However, once that battle has been fought and won, there is little to stop institutions responding in the same way to the next offer from a private equity fund. But this does not necessarily bother the private equity investors.

‘We are more than happy to have quoted company investors as our partners,’ said Taylor. ‘We bought into Marie-Brizzard, a leading drinks business in France, and ended up keeping the stock exchange quote. That can give you flexibility to raise further capital for the business by issuing new shares or to make acquisitions using paper. In the case of taking a business private, institutions who don’t want to sell effectively reduce the funding requirement for our bid in the first instance. At exit, rump investors can form the nucleus of a book-building exercise as part of the placing of our shares back into the market.

In any event, new structures are increasingly being created to get around any problems in persuading trustees to let institutions stay in for the ride. Travers Smith Braithwaite’s solution satisfies the liquidity requirements of the institutional investors using the AiM quoted vehicle while private equity backers are content so long as they retain the principal control of the business. Boyle explains, ‘while the private equity company always has some investor reporting requirements, investors in private equity companies know they are in for the long term and that they need to get comfortable with that. To date, no one has used the AiM structure but it has been mooted for both Canary Wharf and more recently WH Smith.’

For the first time institutional investors can directly maintain a carry while accessing the potential returns offered by leveraged buy-outs. And there are even tax advantages through access to the taper relief offered by the AiM vehicle.

Furthermore, the structure allows private equity funds to pay less on the way, thereby using less of their equity for the same enterprise value of the business. In effect, this gives their equity much higher leverage than would be normal and therefore the firepower to buy larger businesses than their equity cap would normally allow.

On the way out the AiM vehicle can also act as a ready made Accelerated IPO vehicle. ‘If you’ve already got the AiM vehicle there, it provides a quick route to take advantage of a window in the market when investors are ready to see an IPO positively,’ said Landsberg. ‘Traditional book building can take too long if the market is less than robust.’

‘Private Equity firms are interested in Accelerated IPOs for several reasons,’ added Summerfield. ‘It provides another alternative at exit, it provides a guaranteed exit without having to be locked into a normal float and it can be used as a useful bargaining tool during trade auctions.’

‘When all is said and done it ends up being the same institutions investing in these situations, whether through partial privates or Accelerated IPOs, as would invest in private equity funds,’ said Taylor. ‘This way they are just doing it more directly. And now they appear to be getting comfortable with it all we are bound to see more examples.’

So is this all a flash in the pan or an irreversible trend destined to reshape listed and unlisted markets alike? Only time will give us a real answer, but it certainly looks like the line between private and public capital is indeed becoming less distinct.

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