Co-piloted investments prepared for take off

Deploying ever-growing arsenals of capital is high on the list of priorities for private equity firms at the moment. As dry powder reaches record highs across the continent, the majority of discussions about fundraising are likely to include the words "specialisation", "differentiation" or "flexibility". Most people agree that minority buyouts are one way that private equity firms can meet these criteria, but the extent to which it needs to be emphasised is a point of contention.

Inflexion raised £400m for its first minority investment fund, Inflexion Partnership Capital Fund I, in 2014 and quickly burned through it, reaching 77% deployment by March 2018, by which time its successor had raised £1bn to pursue the same strategy. "The difference between Partnership Capital deals and deals from the mainstream buyout funds is that the businesses it invests in are not for sale," says David Whileman of Inflexion Private Equity.

The reason that it helps so much with deployment is simple, according to Houlihan Lokey's Johnny Colville: "The ability to do minority investments gives GPs access to a wider universe of opportunities. You have a lot of funds chasing the same assets, which means prices are being bid up to all-time highs. There are fewer investors with a minority strategy and therefore competition for assets is less crowded. The direct corollary of that is the ability to acquire businesses at better value – lower multiples."

Inflexion decided to separate the strategies of minority and majority investing into two vehicles to achieve two things: it allows LPs to choose whether they want to back just one or both, and it also reassures the management of target companies that the deal is really a partnership and not simply an indirect way of acquiring a majority stake.

The ability to do minority investments gives GPs access to a wider universe of opportunities. You have a lot of funds chasing the same assets, which means prices are being bid up to all-time highs" - Johnny Colville, Houlihan Lokey

Minority deals have been used in this way by private equity in the past, which has contributed to some slightly distrustful attitudes towards the industry from outsiders, especially older family-owned businesses. Bregal Milestone, indirectly backed by family money itself, was set up as a purely non-control investment firm in 2018. Founding partner Jan Bruennler explains the rationale: "A separate vehicle is not enough. In order to both earn the trust of entrepreneurs and take full advantage of minority opportunities for investors, minority investing needs to be in the DNA of a team or GP. It is a different approach to investing when you start from a position of true, mutually beneficial partnership between investor and entrepreneur, rather than seeing minorities as a plan B or a roundabout path to control."

Inflexion's Whileman has a different take on this. When asked whether it would have been better to have set up outside of Inflexion to provide a clearer distinction to entrepreneurs, he says: "If you raise specifically for minority investing, it helps to have a strong track record or an established brand."

Houlihan's Colville has a more nuanced take on the importance of having degrees of separation and any potential edge it might confer in an auction process. "If you have a dedicated minority fund, then you are able to offer alternatives to an owner," he says. "I would not say it is necessarily an advantage, but it does give you flexibility."

Striking a deal
Having the ability to structure a deal as a minority from the offset certainly has its benefits. Whileman explains how the GP identified the gap in the market for primary buyouts that were just not getting done. "The main reason that GPs, and Inflexion in particular, are doing minorities is because there is a big market there and we can use our experience and resources to really add value to those minority investments we make," he says. "In 2013, there were 67 mid-market private equity transactions in the UK and only 13 of them were companies where that was the first ever private equity deal."

Unquote Data shows that primary buyouts (from family and private vendors) constituted a historically low portion of deals in the UK mid-market (transactions with enterprise value of £50-500m) in 2013 at just 19%. This increased to 36% in 2013, before dropping down the next year and then rising to an all-time record of 45% in 2017. It is difficult to know how many of these deals were minority acquisitions, because of the private nature of the transactions in question. Nevertheless, looking at the GPs involved, there is the possibility that many of them were, and that more minority investment funds contributed, in part, to the increase in primary dealflow.

Bregal's Bruennler says this is the profile of many of the businesses he targets: "We focus on partnering with businesses led by strong owner-managers – founders or families – who want to retain control over their businesses, but bring a strong partner on board. Most of these business owners would not contemplate selling their businesses. They want to stay on board to benefit from further growth."

Looking across Europe, Colville observes strong regional variation. "There is a regional overlay to this as well," he says. "You see more of these types of deals in Germany, where there is a cultural reticence towards private equity, than you do in the UK or the Nordic region, where private equity is both more established and accepted."

This phenomenon is well documented in the private equity press and is still referred to regularly in panel discussions at industry conferences, even though the infamous "locusts" article in Der Spiegel was published more than a decade ago. This is a testament both to the resonance it had with the wider population and the seriousness with which the private equity community took the allegation. In any case, it is certainly true that primary deals have made up a larger portion of overall dealflow in Germany than in the UK, up to a record 55% in 2018, according to Unquote Data, so there is some evidence that attitudes are slowly changing.

Bruennler, on the other hand, puts less emphasis on the regional variation. "We do see different attitudes or emphasis on issues such as governance, financial leverage and investment horizon, but this is typically driven more by the lifecycle of a company than geography," he says. "A young growth company will have different priorities from a third-generation family business. But the principle of gaining a strong partner without losing control tends to appeal across the board."

Going for co-control
When it comes to post-deal value creation from a minority position, private equity firms are still actively involved, but it is fair to say that a slightly different approach is required. "We do not have a different box of tricks for minority investing and we add value in much the same way as with majority deals," says Inflexion's Whileman. "The difference is that when I engage with investee companies that we have in the Partnership Capital Fund, it is more like a menu basis. It is their choice what they take on board. They are in control. We offer our network and resources and the company can pick and choose what to engage with."

Bruennler agrees with this and says that, in terms of effort and impact, Bregal can be very hands-on and operational when required, or focus more on strategic and financial issues, such as M&A, in other situations. "But what is different is that, unlike in a buyout, the framework for all these initiatives is a strategy agreed with the entrepreneur and majority owner, which is implemented by playing to the strengths of each partner."

An example of this was the fund's investment in Irish IT company Arkphire last year. "Both our investment and operating teams worked closely with the founders to build a 180-day plan. It has only been three months, but Arkphire has already closed its first acquisition, strengthened governance and reporting, and is on track to deliver 30% growth. This strategic support was no less important in our discussions with the entrepreneurs leading up to the transaction than the financial terms."

Inflexion's Whileman makes the point that in some cases the de-risking aspect of selling a minority stake allows management teams to be a bit more ambitious. Inflexion recently supported its Partnership Capital portfolio company Huws Gray with the sizeable bolt-on acquisition of Ridgeons. "The original transaction was very much about helping them to de-risk themselves," says Whileman. "But they came in the next day and said: 'We have a successful formula. Let's try to really scale it.' With all their eggs in one basket, I do not think it could have been as bold as that."

In the case of Huws Gray, Inflexion used its capital markets experience to support the business in raising the appropriate acquisition debt. However, in general, these transactions have lower leverage levels than majority deals, says Houlihan's Colville: "Leverage in minority deals is typically less, partly because the entry multiple tends to be lower. But also, the majority owners are less well versed in the capital markets than professional investors and tend to view debt more negatively."

Essentially, the lower leverage is another function of the shared control. "Quite often you will see a founder or owner who is unwilling to give up control: they want control of their destiny, they want control of their budget and they want to choose the moment of exit," says Colville. "If they are strong believers in future growth, it means they are both a buyer and a seller."

Room for manoeuvre
The type of deal is not always set in stone from the start, says Colville: "Typically, at the start of a process you have a view whether there will be a majority deal on the table or a minority deal or capital raise. But this can change during the course of a transaction."

This is the type of situation where the extra options of separate vehicles can be particularly useful, says Inflexion's Whileman. "At the outset, when we meet companies we meet them as Inflexion, so we do not pre-judge what the opportunity is. If it is clear early on that shareholders are looking to sell and extract from the business, then the buyout fund is more appropriate. But where they do not want to sell or they could do something else with an investor on board, it is more likely to be a Partnership Capital deal."

While Inflexion does not aim to move companies between funds or increase its stake to a majority, Whileman says: "There are certain situations where things change, and the shareholder structure needs to change and we can help with that." He gives the example of IT consultancy K2. "The founder needed to re-look at his own portfolio and we bought his shares from him. This was great for the company because it was able to not miss a beat and did not have to worry about going through a whole process again."

The biggest challenge is getting across to entrepreneurs that there is a different type of private equity that doesn't involve losing control of the business" - David Whileman, Inflexion Private Equity

The situation with K2 was an example of what Whileman sees as the biggest problem with entrepreneurship in the UK: "The biggest challenge is getting across to entrepreneurs that there is a different type of private equity that does not involve losing control of the business." Bregal's Bruennler says: "The challenge is identifying and nurturing relationships with top entrepreneurs – a minority partnership requires mutual trust and respect and a shared vision for a business, which is established over a longer time."

In any case, it appears likely that more minority funds will be raised in 2019 because, as Bruennler puts it: "For investors, a differentiated minority strategy gives an opportunity to generate differentiated returns by investing off-market in growing companies alongside strong entrepreneurs, often with considerably less downside risk than in a conventional buyout strategy."

This is a contentious subject and one industry source speaking to Unquote on the condition of anonymity, said: "LPs are happy with minority funds as long as the flagship keeps performing, but they are aware that growth-focused vehicles are more vulnerable to a downturn."

Whileman, on the other hand, has a different view about how minority investing is correlated to economic cycles. "I have been doing minority investing for 20 years and it goes through cycles," he says. "At present, it is generating more private equity interest, as many are looking for other ways of deploying capital. But you need to be in it for the long term as, in terms of economic cycles, the peak for minority investing is still to come. It is usually when there is a bit of a downturn and when you start to come out of it you get maximum interest in minority deals. At that point, entrepreneurs are not looking to sell, but they do see opportunities to accelerate growth with additional resources."

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