Taking Stock

Many private equity managers are currently taking comfort from the prophetical truisms circulating the market. The industry's counter-cyclical nature - largely forgotten during the boom years - is back in vogue, with all manner of historical performance figures being dredged out to highlight how investments made in a downturn provide the best returns.

One of the most common assertions is that the public markets currently offer a great buying opportunity, with depressed stock prices turning many listed assets into potential buyout bargains. Indeed, accountancy firm BDO Stoy Hayward recently held a conference in London suggesting that the current climate has created a 'window of opportunity' for public-to-private transactions.

Difficult deals
But before getting carried away with notions of how profitable 2009 de-listings will be, it is worth remembering that this is not the first time since the current crisis emerged that public market deal opportunities have been highlighted. In fact as long ago as Q3 2007, as stock markets across Europe dipped sharply in the wake of the implosion in the American housing market, people were discussing the potential for profitable buyouts of quoted businesses.

However this, along with the many times it has been said since, turned out to be a false dawn. Though there were a few buyouts sourced from the public markets in 2008, in most regions this merely represented stagnation of, or a decline from, the numbers seen in 2007. Ask most deal doers why this is and most would immediately point to the much maligned dearth of debt in the market, which has caused a slowdown in deal numbers generally.

But to simply blame a lack of leverage does not tell the full story. Rather, public market transactions are time consuming and costly affairs that do not offer nearly the same deliverability promise as standard buyouts. "A deal typically begins with 20-30% shareholder interest in a sale, following which there is a lot of costly negotiating and due diligence to go through. Even then, incumbent shareholders are often nervous about a sale as they feel they might lose out," explains BDO partner Peter Hemmington.

The issue that cost often does not stack up favourably against potential risk is compounded by the reduced size of the majority of public market businesses at the moment, which some counter-intuitively argue could negatively impact potential rewards. "People get carried away with the valuation drop but the reality is that a lot of the viable target businesses out there are now too small for most private equity houses. When you factor in the execution risks of take-privates the cost/benefit analysis often doesn't stack up," suggests Matthew Doughty, partner at law firm Addleshaw Goddard.

Indeed, with 71% of businesses on London's AIM having a market-cap currently of less than £20m (and 40% less than £5m), most investments would represent such a small proportion of any fund that even a home run would make only a moderate impact on overall returns. Richard Chapman of ECI Partners (which completed two de-listings in 2008) concurs, though he does also note that some smaller businesses are made more attractive by the existing debt on their balance sheet, which can be paid down and turned into additional profit down the line (and also potentially removes the need for acquisition leverage).

However, though there may be fewer investment options than is often made apparent, with more than 1,500 companies quoted on AIM alone there are plenty of targets out there that should pique the attention of investors. Moreover, Doughty notes that even assets which are smaller than the typical investment range of a fund could be good potential targets for buy-and-build platform investments. With many funds adapting to a new economic climate in which organic expansion is difficult by adopting acquisitive growth strategies, these businesses may therefore offer rich pickings to investors.

Evolution
And attempting to utilise the public markets to adapt to the current downturn in dealflow is likely not to be exclusively (or even primarily) the preserve of the small- and mid-market. With debt difficult to secure - and multiples far reduced even when deals can be leveraged - the large-cap business model is effectively dead in the water. This has been emphatically evidenced recently by the swathe of problems being reported in the large buyout space as results season reaches its climax.

The problem these firms face is two-fold: managing an incumbent portfolio comprising many over-priced, over-leveraged and underperforming assets; and trying to put capital to work in an area of the market where debt is critical to the functioning and success of the investment model.

According to Tim Stocks, head of European securities at law firm Taylor Wessing, public market deals - and specifically PIPE transactions - could provide a solution. "Analysts estimate that listed companies will seek to collectively raise up to €300bn in 2009, most likely through rights issues. Only about €100bn is thought to be available through traditional channels, so many may turn to cash-rich private equity firms for the remainder."

The problem with such deals is that they traditionally offer little scope for private equity firms to actively manage the business or gain any substantial equity holding, which obviously changes the returns profile of the investment. Stocks, though, suggests that these obstacles will not apply, as rights issues are currently being offered at an average 57% discount to market value (based on issues so far in 2009), which itself is well down on true asset value.

The combination of these factors, he argues, will allow investors to invest at a price that leaves significant room to generate attractive returns without the need for leverage. He further asserts that the low prices and liquidity issues will drive companies to compromise on terms, such as board seats and investment size. "If businesses need the capital then they have to accept the terms. Private equity backers may well therefore get seats on the board and could get as much as 50% of the company's share capital in any deal."

As for whether LPs will be comfortable with this strategy shift, Stocks is bullish: "It might mean having to go back to LPs and changing the mandate by offering investors either a reduced commitment to, or to opt out of, the fund. But big firms have to find a way to deploy capital and the lack of debt limits their investment options." Others, however, remain less sure, understandably highlighting that this is not so much a modification to the private equity model as a departure from it. "It's hard to see why LPs would pay a 2% management fee to do something they could go and do on their own anyway; that's not why they allocate to private equity," comments Hemington.

Moreover, it is not just about whether or not private equity funds and their LPs are comfortable with the notion of PIPEs; it is also about whether or not incumbent investors are comfortable with having private equity investors in their business. "Private equity money is expensive money so there has to be a reason why the company would want to take it - and the reason has be positive rather than simply because of a lack of other options," says Chapman. A window of opportunity?
Whether or not the current low public market valuations represent an attractive investment opportunity is something of a misnomer. Yes, the fact that businesses are trading at a perceived significant discount to their intrinsic worth does imply that money can be made from venturing into the space. But the simplicity of this argument avoids dealing with the problems of take-privates, which are extremely time consuming and involve substantial higher execution risks and cost.

Indeed, such is the complex nature of these transactions that some small- and mid-market investors simply do not consider them. "Unlike with other deals, the cash confirmation required under blue book means that investors have to commit to providing funding before they can get security against the asset. This is only really an issue if the deal goes through but it is very psychologically damaging for those unfamiliar with these deals," notes Hemington.

As for PIPE deals, once again the reasoning for why there may be a rise in such deals makes sense, but it remains doubtful that there will be the sort of strategy sea-change that will precipitate a major increase. "Private equity firms operating widely on the public market remains conceptually difficult; it takes a different skill set to be successful and the whole investment model changes," Doughty agrees.

Therefore it is unlikely that there will be a large-scale surge in either take-privates or PIPEs in the coming year. However, as Andrew Carpenter, partner at Addleshaw Goddard, explains, public market deals may well see significantly increased activity as part of a broader drive by private equity firms to adapt their investment strategy to the more difficult economic climate. "What will certainly happen in the coming months is more lateral thinking on the part of investors. Those that have the mandate will opportunistically target P2P, PIPE or distressed investments; others may seek stretch their mandates."

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