Forgive us our sins

The so-called “sin” industries of alcohol, gambling and pornography are rarely attractive for private equity. From a PR point of view they can be tricky to explain, government regulation can limit the scope of profitability and there are often restrictions in the fund documentation which prohibits firms from making deals in these areas.

Lion Capital, which recently acquired the largest vodka produce in Russia, clearly has no such restrictions. The company, which also produces read-to-drink alcoholic beverages and cost the private equity firm around $600m, controls approximately 5 percent of the market for vodka production in Russia. If the ethics of investing in a Russian alcohol producer when over 40,000 Russians die as a result of alcohol-related ill-health is questionable, the financial reasons are obvious. It is estimated that around 70% of all alcohol consumed in Russia is vodka, and with the Russian Alcohol portfolio also including premium brands, the company is well-placed to capture the growing middle-class earners migrating to more expensive products.

Sin industry investments are rare, although the gambling sector has attracted significant private equity appetite in recent years, especially in the UK where deregulation has seen profits rise rapidly. Candover and Cinven acquired Gala, the UK-based bingo and casino group, for £1.24bn, in January 2003, an investment motivated in large part by the-then imminent deregulation being discussed in parliament. As Marek Gumienny of Candover said to unquote” at the time: ‘Gaming de-regulation will radically change the business environment, removing the 24-hour rule, as well as allowing advertising and removing such restrictions as the location of gambling sites.’

The amended Gambling Act which finally came into force in 2005 made sweeping changes to the existing laws. Bookmakers were permitted to stay open in the evenings all year round and keep fruit machines that can pay out a maximum of £500 instead of the previous £35. In addition, the act removed the demand test for new casinos and betting shops and proposed the creation of scores of new casinos including Las-Vegas style “super-casinos.” The super-casinos plan has since been scrapped by Gordon Brown in the face of huge opposition, but the amended act has paved the way for a significant expansion of gambling facilities in the UK.

The governments of Continental Europe have been far less willing to embrace the spirit of competition in the gambling industry, in the face of EU pressure to dismantle the state-controlled monopolies which still operate in many European countries. The European Commission has issued warnings to a number of member states which have been steadfast in their refusal to encourage competition from foreign operators, in accordance with EU rules on the free movement of services. Denmark, Austria, Hungary and Portugal operate gambling monopolies but have reluctantly accepted external competition, while France and Greece were recently threatened with lawsuits should they bar foreign competitors entering the domestic markets. Italy was forced to accept competition in the gambling industry by the EU in 2007.

In Sweden, a test-case is developing which could have far-reaching implications for gambling regulation across Europe. In May this year gambling company Betsson opened a betting shop in Stockholm, deliberately breaching laws which state all bookmakers must be run by Svenska Spel, the state monopoly. Should the Swedish state back-down, and it is under pressure from the European Commission to do so, it could set a precedent for other firms considering a similar move and may spell the end of monopolies across Europe, opening up markets to domestic providers.

The example of Gala in the UK has shown the allure that gambling and betting operators hold for private equity investors. Candover and Cinven acquired the firm in 2003 from its previous private equity backer, Credit Suisse First Boston and PPM Ventures (now Silverfleet Capital). PPM originally acquired the firm in 1997 and Credit Suisse invested in 2000. In October 2005 Permira invested £200m to take a stake equal to Candover and Cinven’s in the company. In 2005 it was reported that Gala had increased EBITDA from £36m in 1997 to £145.8m. These sorts of figures show why Gala has been coveted by private equity and why deregulation across Europe would be warmly welcomed by the industry.

Private equity investments in pornography companies are rarer still, with one of the only and certainly the most recent investment being that made by French venture capital firm 123Venture, which earlier this year invested €1m in a €1.5m seed round of funding for YESforLOV, a company which produces sex toys and other products intended for “sensual well-being.” 123Venture told unquote” that the business was expected to benefit from ‘a relaxation of the taboos surrounding sex toys.’

All sin industries require a relaxation of taboos and a relatively liberal attitude to cultural mores. The tide of negative criticism directed at private equity in the UK last year and current discussions within the European Parliament concerning regulation of the industry should give private equity houses pause for thought when it comes to investing in these industries.

The private equity model, with an emphasis on intensive profit creation unrivalled among other forms of company ownership may not be the best model for these companies as it can open up private equity to different levels of criticism. Cutting alcohol prices, launching new alco-pops, encouraging gambling with creative advertising campaigns and pursuing expansion programs may be the best method for growing the top-line but they will often not find favour with governments or broad swaths of the public.

The inherent conflict between the means to generate revenue in these businesses and the desire to undertake ethical and socially responsible investing is something a private equity firm considering an investment in this area should examine carefully.

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