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Private equity: Private equity can help balance the books and promote growth

Private equity money has always rung alarm bells for family businesses – no one wants to relinquish power to outsiders. But outside input can have myriad benefits, including scope for expansion and independent pension arrangements, writes Bob Reynolds

Five years ago, the typical family business private equity deal was £10 million for 30% of the enterprise. Now, it is more usual to see venture capitalists paying £100 million for 100% of the business.
 
In the UK, an average of 600 deals, which include private equity involvement are concluded each year. As a rough rule of thumb, the high value transactions are venture capital (VC) only (£100 million and above) whereas the banks tend to partner with the private equity houses in lower price deals. These funding arrangements will involve classic bank products such as debt.

Private equity firms have always been interested in the family business sector but VCs have scaled upward in their expectations. And their motivation has changed. Now, most VCs want to buy family businesses outright, restructure them and dispose of them. The financial press is full of leading private equity houses buying underperforming family businesses and turning them around and stripping out the assets. This does not mean to say that there are no private equity houses left that are interested in the smallest family concerns, but that there are fewer of them.
 
A consolidation wave recently rippled through the SME sector and sparked interest by VCs in a range of family enterprises. Firms held, traditionally, in family hands in disaggregated ­markets such as tour operators and funeral directors suddenly started combining. Prices became high and the returns for the funding houses positive.

Those individuals who wish to carry on running their companies may well retain their traditional caution when it comes to outside involvement. Some owners and managers of family companies fight shy of outsiders pouring over the books and telling them how to run their businesses. But others are more transparent and for them private equity money can be a welcome development to promote expansion.

There are two principal reasons for seeking private equity funding as opposed to, for example, borrowing money from the bank. One is the stability that equity funding gives to the balance sheet. The other is the capacity of a venture capital arrangement to develop the business beyond financial structuring and to give it a more professional style of operation.

Business owners can tap into a diverse range of skills and systems open to a venture capital house. These can be applied across disciplines to streamline aspects of the business. Tony Bogod, family business partner at BDO Stoy Hayward, says: "Although the objectives of entrepreneurs and VCs may be different, they are both committed to the growth and well-being of the business. They will both be much closer to the venture and its targets than the bank or many other types of investor."
 
Private equity money has arole to play in succession planning, not least for the tax advantages. Two scenarios are most prevalent. In the first, the owner wants to pass on the company to the next generation but neither sons nor daughters want to be active players in taking the company forward. VCs may then take total control of the business leaving the retiring director a smooth exit. In the second case, private equity provides stability to make a change to a new generation while ensuring that the older generation secures retirement income.

Alex White, a private equity partner at BDO, says: "VCs can be useful in providing stability during succession. In many cases, the owner of the business will not have given much thought to retirement income. So when private equity comes in, the VCs can buy some of the owner's shares, allowing them to have capital to fund a pension. It can be harmful if the retiring director has to depend on the children to produce dividends. It can also be intimidating for the children."

White says that private equity does not work well in a family business when there are many shareholders. "They play no part in the running of the company and, although they remain emotionally attached, they are shareholders for the annual dividends only. If a venture capitalist buys in, the directors will concentrate on payments to the investor and so there are rarely any dividends for the length of the private equity investment. This can cause problems with the small shareholders."

Raising small sums of money in investment capital for smaller businesses has always been more difficult than securing larger amounts for bigger enterprises. The proportionate risk is, more often, lesser with enterprises with some career history behind them. They may have borrowed and met repayment schedules. More importantly, they will have grown and demonstrated a capacity for winning greater shares of markets.

The potential for greater returns is self evident. Investors want to minimise risk. Ambitious companies with profitable track records are always a safer bet. Also volumes around the world for the larger deals are starting to grow again as greater confidence seeps into the market. In March the world's largest ever private equity deal was announced when Carlyle Group raised $10 billion to spend on undervalued companies in Europe and the US. Daniel D'Aniello, a founding partner of Carlyle, said that private equity is enjoying a renaissance. Smaller family businesses, in contrast, are less attractive. They may be limited by their own imaginations and therefore can be less enticing.

Venture capitalists are seeking larger deals to exploit economies of scale – the average venture capitalist investment round was nearly $8 million last year, according to PwC – while individual angel investors are involved in rounds of less than $1 million. This leaves few sources of capital for entrepreneurs who need $2-$5 million to start their companies, says the Kaufmann Foundation, which fosters education and entrepreneurship.

In contrast, angels provided $22 billion in venture funding in 2004, topping $20.4 billion from venture capitalists. Their sophistication can be an annoyance to venture capitalists who intend to provide substantial financing in later rounds.

Marianne Hudson, executive director of ACA, a US business angels organisation, says: "There has been a fourfold growth in the past five years across the US. People saw a few groups operating, like Lore, Band of Angels and the Washington Dinner Club, and thought that this was maybe a good way to diversify risk and get a better financial return, as well as the social fun of it."

A raft of UK surveys designed to promote private equity alternatives to smaller businesses show that awareness of the benefits of venture capital involvement is strong. Between 35% and 50% of respondents believe that there are advantages in taking this route. Yet – at its most optimistic - only 5% said they would take a venture capital route.

One area where markets could open up is in the professional practice sector. The latest Smith & Williamson Professional Practices Survey of more than 100 managing and finance partners shows a majority of firms believe merger activity will continue apace and give rise to the need for external capital. Further, the survey found many firms would prefer some form of private equity or venture capital over a public offering on London's Alternative Investment Market, or the main market, or structured finance from a bank. Some law firms do still believe there is a value to goodwill and that retiring partners should be rewarded for building the practice to where it is today. Those practices could face significant exit costs, which may be difficult to meet when remaining partners want to draw high earnings or are looking to offload their problems with some form of merger. In such circumstances, external capital may be the answer. However, an outsider may be reluctant to fund the cost of paying out retiring partners unless this provides a longer-term benefit.

The next big growth area is family businesses in mainland Europe. Since 2000, private equity groups have financed more than 40,000 companies, employed more than 6.5 million people and floated 415 companies on stock markets, according to the European Private Equity and Venture Capital Association (EVCA).

A growing number of private equity groups operating in Europe have benefited from a single currency, a pan European debt market to finance deals, and the need by large European corporates to slim down and sell off non-core assets.

But in Europe, there are big variations. The UK is the biggest and most developed market, while France, Germany and Italy have occupied second place by virtue of one or two chunky deals in any one year.

Spain is set for a bumper 2005, with one deal alone – the leveraged buy-out of Amadeus, the Madrid-based travel IT company, in a deal worth $6.3 billion. Portugal, however, is a more difficult market. A number of large US and European private equity groups were disappointed with the privatisation of Portucel, Portugal's leading pulp and paper producer, and last year's auction of a large stake in Galp Energia, its largest oil company.

The US private equity group Carlyle went so far as to ask the government to suspend the sale to rival local bidder Petrocer after it failed to buy a large stake in Galp Energia. "The Portuguese often opt for a local solution," says a private equity executive from another firm with knowledge of Portugal.

"It is a relatively small economy so there are not a whole lot of industrial assets. Bringing in international capital would give Portugal an opportunity to build industrial champions."
 
However, Javier Echarri, EVCA secretary-general, says Portugal is not dissimilar to Germany with its strong local culture, and established links between family-owned companies and banks. "Portugal is in the opening-up phase. I am positive about the market although it maybe lagging behind some others," he says.

Although European private equity growth has been concentrated in buy-outs of big companies, the venture capital segment of the market, which focuses on developing infant business – usually in technology – has suffered.

Recent figures found that European venture capital investments rose from €8.4 billion to €9 billion last year, behind the US where $21 billion (€16.2 billion) was invested. A critical factor is the lack of an exit route for VC investors. Those European businesses that do manage to find the backing they need will sometimes turn to the US to help fund the next stage of their development. 

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