Buyout houses and the lure of minority investing

"There is a real hunger from entrepreneurs for something different to traditional buyouts; something that does not involve a straight sale and debt, but a partner that can bring expertise and benefits," says Simon Turner, managing partner and co-founder of Inflexion Private Equity (pictured, left), which recently closed its debut Partnership Capital fund dedicated solely to taking minority positions.

While buyout players taking minority positions is nothing new, Inflexion's £400m minority-focused fund has brought about a level of definition to these sorts of deals. "Partnership Capital represents a natural evolution; it is a more sophisticated product. It allows for the nuances of entrepreneurs and their varied motivations," explains Turner.

Evolution not revolution
It is important to note the increase in minority deals is by no means a revolution of private equity; rather, an evolution. And this idea is neatly reflected in what these deals are attempting to achieve: "In each opportunity there is a shareholder group that wants to evolve over time. They do not want to jump from A to D, they want to do B and C as well," says Turner.

Minority investing first came to the fore in the 1990s when 3i notably focused on the strategy. However, the industry's initial foray into minority investing highlighted the difficulties of these transactions. Having invested in family-owned companies, which typically do not seek a realisation event, 3i was often caught for long periods by these deals. However, the listed firm boasts some success in the area, with its minority investment in Cannon Avent, purchased in 1995 and sold in 2005 generating 15.1x, and Pets at Home, acquired in 1996, generating 3.6x when exited in 2004.

What is different this time round is a clear awareness these deals provide a means for transition – the normal rules of buyouts cannot be applied here.
Thanks to this better understanding of minority investments, those who have been quietly doing them over the past decade are beginning to see more interest from their buyout peers. "People are increasingly recognising the merits of minority deals," says Luke Jones, partner at MML Capital, a firm that has long positioned itself as a minority investor.

Not for sale
The lines between minority investing and growth capital or venture can seem somewhat blurred. The main differentiator for minority investments is the "money out" aspect; that these deals provide a resolution to a company's existing shareholder base.

Says David Whileman, partner at Inflexion and head of the Partnership fund (pictured, right): "These are typically businesses that are not for sale – they do not want a revolution, they want an evolution. Minority investments allow companies to retain their culture, to keep people and access all the benefits of private equity. And for LPs, these deals enable them to access businesses that are not for sale but have very exciting high-growth prospects."

Jones echoes this idea: "If you are speaking to owners who will retain a majority stake, approaching the deal with an ownership or control mentality is unlikely to work. The entrepreneur is effectively inviting you into their business, and so the deal has to be designed accordingly."

If these businesses are not for sale, then how can GPs effectively originate these transactions? According to Mark Nicolson, partner at SL Capital, the nature of these deals lends itself to more opportunities: "By going in as a minority investor it widens the opportunity set. From speaking to managers, having the flexibility to offer a minority investment has meant they have won deals over competitors seeking a majority. It is inherently risky but it can be more attractive to some vendors, as it can unlock deals."

Outside of Inflexion's, MML's and ECI's aforementioned efforts in the space, other firms that have been quietly transacting on these terms include General Atlantic, which has indeed unlocked deals that seemed completely off the table for private equity, such as Markit, Axel Springer and Santander Asset Management.

Subtle stake
Although minority deals arguably bring about more opportunities, because the emphasis is on partnership, and because buyout houses are no longer in the driving seat, it would be foolish to think this strategy is open to all.

"This model is hard to replicate, there is a lot of subtlety," says Whileman. "You need strong references, a track record  and you need to offer more than just private equity. These companies want real value add. Demonstrating we have invested in our business to deliver the overseas network of offices solely for their benefit is just one differentiating factor."

The most crucial part of these transactions to get right is the relationship with management. "You need to establish a candid dynamic with the entrepreneur - that is what is really at the core of this," says Turner.

The importance of that relationship means these deals will undoubtedly take longer to reach completion. "On the Partnership side, management teams are assiduous in finding out about Inflexion, they want to know how you react and work. Often with entrepreneurs, their business is part of them so it is very important for them to know how we can work together. Over the years there have been great businesses that we have had to walk away from because the chemistry was not there," says Turner.

Jones believes this management-friendly approach is key to accessing minority deals: "We have developed relationships with advisers who recognise our track record in doing minority deals in the lower mid-market. We have set ourselves up accordingly to be management-friendly, easy to deal with, take a partnership approach and show flexibility around how we structure deals and the associated legal framework."

Fair treatment
However, even the strongest of relationships can crack under pressure, meaning some level of legal protection is obligatory. Says Whileman: "We do not write our terms down from a controlling mindset. Neither are we a risk-averse debt provider with restrictive covenants. We are a genuine minority so have the appropriate agreements ensuring fair treatment as an equity partner."

Despite this, compared with the well-worn legal paths of a typical buyout deal, minority investments can face a wide spectrum of outcomes, meaning the legal framework needs to incorporate the myriad of possibilities. "A key skillset when transacting minority deals is to design a legal framework that works for both the institution and the owner/manager," says Jones. "To do this you really need to understand management's ultimate intentions and where their sensitivities lie. Sometimes you may be dealing with a family-owned company that never intends to sell and, therefore, you design your exit mechanisms around that."

Jones Day partner Mike Weir says a broader range of veto rights is needed for these deals, "not only to protect abuse of minority positions, but also rights over operational matters, over debt, changes in direction of the company, deviation from the budget and business plan."

As these deals are slightly less hands-on compared with buyouts, the investment is typically centred around annual plans, with the investor signing off on the initial plan and then each year subsequently.

One eye on the exit
But the key legal concern is exiting the investment. "That is the main area of tension on these deals. That is where they really differ from control investing," says Weir. "Typically, there is a time frame, a proscribed period to reach exit and when that deadline hits, the rights kick in. Or there are financial targets, with the investor having the ability to force an exit if those targets are not met."

Weir has noted a shift in the legal focus of minority deals more recently. Traditionally, these deals used put options, but this strategy is not always viable as the company needs to be in a position to buy out the investor if enforced. "The market is now moving towards minority investors being able to drag majority shareholders to a realisation event at those times, so the investor is still able to control the exit."

Outside of being in a position to force an exit, there are further protections private equity houses build into these deals, such as an ability to appoint new directors if the business is underperforming. Or, alternative mechanisms whereby under the terms of the investment (as preferred ordinary shares) the return is more expensive after a certain time; essentially the interest rate of the investment is pushed up over time.

While it may seem as though these deals are much more demanding from a legal perspective, they can also bring benefits. "Minority deals may allow for avoiding change of control, which, depending on the circumstances, can be quite important. It may, for example, allow the parties to avoid certain regulatory issues or termination triggers under existing contracts," says Weir.

Tick tock
Whichever way these deals are cut, and however much the focus needs to be on partnership, there is no escaping the time pressures of a limited partnership agreement. ECI managing partner David Ewing, is clear on the ultimate goal of these investments: "We are seeking to help grow and realise medium-term shareholder value and we only want to partner with entrepreneurs that are aligned with that. If a business is underperforming or the management team is not willing or able to exit, we need to be able to effect change and our style is to be upfront about that. In our experience, entrepreneurs and managers who are continuing shareholders understand that. All shareholders want the best possible people to work in these companies and, as such, if a continuing founder is not delivering in their position as a manager they need to think about stepping back."

Minority deals are typically all-equity, at the entry stage at least, thereby removing a key mechanism for generating returns – financial leverage. According to Turner, Inflexion's minority deals have performed well: "Looking at our partnership deals over the past 15 years, the returns have been the same as buyouts. They come in a different form, though, as typically these deals do not have debt, but they have the same growth elements."

Ewing agrees: "We have been doing minority deals for many decades and we have not been able to discern a pattern between returns. Holiday Autos was fantastic first time around as a minority deal and again when we sold it via CarTrawler as a more typical buyout."

For SL Capital's Nicolson, the ability to generate buyout-sized returns comes down to the GP: "It depends on the manager. We are invested with a manager where the track record is just as successful on majorities as well as minorities because of its ability to select the right deals and partnerships."

PR panacea
Given these deals have the potential to generate alpha akin to buyouts, unlock previously restricted deals and position private equity as a partner, is it possible that minority investing could improve the industry's image? "The corporate finance community thrives on innovation. This is a compelling and unique product, meeting an increasing realisation that private equity does not have to be just about control," says Whileman.

"Undoubtedly it is the case that private equity does have a whiff of sulphur about it and the industry could sometimes help itself more by engaging and being a responsible owner. In our own small way, the Partnership fund has to operate differently. It has to be very collaborative with the business community, we have to be flexible, focus on the partnership approach, which is founded in trust," says Turner.

And it is that refreshed conversation with management and the business community that could make all the difference. "These management teams are taking a proactive, positive decision to bring in private equity to help grow their businesses," says Jones. "They are recognising the expertise and benefits of private equity, not ending up with an owner who has just paid the highest price."

If the mindset of business owners and entrepreneurs can be adjusted away from seeing private equity as a controller, but rather as a partner with expertise and deep resources to drive growth, solve complex shareholder bases, and transition the company to the next phase, there is hope that the asset class could reap more than healthy rewards.

 

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• Topics
• Buyouts
• Minority investing
• Inflexion Private Equity