Capital attraction

Mark Dye is a freelance journalist based in London.

Several factors determine why a family business seeks to attract external capital, ranging from expansion to a change in generational ownership. Mark Dye spoke to John Mackie of Parallel to find out if obtaining private equity is the answer

Today the UK represents the second largest private equity industry in the world, second only to the US. Already the largest in Europe, last year the UK marketplace represented more than 50% of total European activity in private equity.

Indeed, businesses that have private equity backing now employ 2.7 million people in the UK, roughly 18% of the private sector workforce. Moreover, nearly £10 billion was invested in over 1500 companies in 2004, with London increasingly becoming the portal for Europe in the sense that most of the pan-European fund managers are based here.

At the heart of this  sits John Mackie, outgoing chief executive of the British Venture Capital Association (BVCA) and director with Parallel, a company specialising in providing private equity to the European marketplace.

Mackie, a former disc jockey and retail general manager turned chartered accountant, looks every inch like a man you can trust. His demeanour is laid back; his voice crisp and engaging, delivered with refreshing undertones of Teeside. Yet underneath, you sense a man very much at home in the City – traits honed during spells at 3i in Glasgow and Reading before eventually settling at Morgan Grenfell in London for eight years.

Following a spell of ill health which saw him take early retirement from his post at Morgan Grenfell, Mackie got used to the idea of family values in business when he took on a job as chief executive of the BVCA for three days a week in 2000.

With a staff of ten and revenues totalling just £2.5 million, the BVCA is a tight-knit affair which provides events, networking training and authoritative research for executives in member firms. In addition, the association delivers media and public policy work, which he says is incredibly important for ensuring there is an appropriate regulatory, legal and taxation framework in the UK to support the industry.

So if Mackie is used to the idea of family values, have family businesses warmed to the idea of private equity and is it right for those seeking to retain control? Well, there are several factors that may determine why a family business seeks to attract external capital, ranging from efforts to grow the business, a change in generational ownership or perhaps certain shareholders needing a cash injection for a variety of reasons.

According to Mackie, the whole issue of control is rather interesting. "Some people regard this as having 51% of the shares," he says. "Others think of it as having control of the constitution of the board while others regard it as not having to report to outsiders. If we think of this in the legal sense, 50.1% of the share capital of this business and therefore voting control, it really comes down to what the ambitions are for the business and how the family wishes to resolve that. I have seen instances where current shareholders end up with a 20-25% stake, but a business that is growing five times faster than it otherwise would have done. So, yes, they have a much smaller stake and they have given up control, but they now have a much faster growing business because of the external capital they have been able to attract."

The flip side of the coin is those negotiations where retaining control is more important than the rate of growth, a scenario which Mackie says can go either way. "Sometimes it's just a case of being able to match these and sometimes not. The one thing I would say in the context of control is that the way to address it is to at least start having discussions and explore what is possible with two or three private equity firms for the amount of capital you are trying to raise taking into account their desires and your desires."

At Parallel, Mackie helps investors wanting to get exposure to the private equity asset class. It is broadly accepted that private equity in the long-term will have superior returns, but as Mackie points out, there are pluses and minuses as to how you get there.

When thinking about a private equity portfolio, families also need to accept that the asset class is illiquid and that ventures require a long-term commitment unlike the quoted markets. Diversification is also key. Most experts would advise you, whatever amount of capital you are putting in, against committing to one fund. Diversification over time matters too.

"What you don't want to do, as we call it, is pick just one vintage year and imagine that 2006 is going to be a great one," adds Mackie. "None of us can predict the future. I think those are the sorts of features about private equity that people need to accept."

As a company, Parallel has what it believes is a unique network in Europe comprising six deal partners all of whom originate transactions for Parallel. Collectively, not only does this unique deal flow mechanism create predictable deal flow (something which is virtually unique in itself in the world of private equity), they also create for Parallel's investors a hugely diversified UK and European investment portfolio – with investment risk widely spread by sector and geography.

With portfolio diversification assured, Parallel tackles diversification over time by operating under an annual pool basis. Put simply, if you wanted to commit £30m, you could choose to slot it all into one year. However, what is much more likely is that you would invest £10m a year for three years, thus ensuring time diversification.

According to Mackie, coverage of the five leading economies, accounts for around 80% of total European GDP in the original 15 EU countries. That's not to dismiss those not within that group, he says, but nonetheless, getting into those five leading economies means you can cover most of Europe. "So we are providing European diversification, and that leads to looking at where the future opportunities lie with private equity. Right now, the UK is the largest and most developed by a long way."

This 'remarkably clever' business model is one of the very reasons Mackie joined the company. He says investors get a competitive fee structure, a portfolio spread and, rather unusually, when Parallel attracts new investors, it can put the money to work immediately with no time lags.

Knowing most of the people there already made it an easy decision. "People are everything in this industry, so if you get the people right you usually succeed," he says. Its track record was an additional factor.

"If you look at our industry, the people who are able to attract institutional investment for the long term and create a sustainable business are those that have a track record of successful investing and Parallel has that and has that in spades," he remarks. To date the company has invested almost £1bn in almost 260 companies. Mackie adds: "We have realised £936m from half of that and now have a residual portfolio valued in excess of £500m. So our realised profit is around £500m since we were established in 1997 and our total realised internal rate of return [IRR] is 34% a year – another reason why Parallel became the obvious place to spend more executive time."

As investing in private equity becomes more fashionable, there are a raft of new investors. Right now, says Mackie, these comprise family offices, high net worth individuals, very significant amounts of money from pension funds, significant amounts from insurance companies, from banks, from foundations in the US and indeed from fund of funds – who themselves typically are collectively a force of smaller pension funds, smaller insurance companies and so on.

Despite this, the vast majority of private equity money around the globe comes from institutional sources. But going back to the opportunity in Europe, Mackie firmly believes that pan European diversification holds the key here in terms of growth opportunities.

"There is no doubt in my mind that in the economies we've talked about – France, Germany, Italy and Spain – there is still a whole swathe of industrial restructuring to come. These really are just at the start of privatising state-owned assets," he says. "And finally in those jurisdictions, particularly France and Germany, if you look at the return on value of non-banking assets that are owned by the banks, they'd have to be sold into the marketplace over the next three to seven years because of Basle II and pressures on capital adequacy. There is very significant M&A [merger and acquisition] activity to come in those jurisdictions over the next three to seven years."

He adds that as an industry, even though Parallel might not be principal buyers in those very large M&A transactions, they will inevitably have a spill-over effect into subsidiaries that have been sold off, that is business that spins out of those very large transactions. That, typically, is where the company will have a role to play.

Speculating at gains over the next nought to ten years in private equity, experts believe that the UK market will remain active, posting modest year-on-year growth. Mackie sees significant opportunities in France and Germany, with Spain and Italy vying for third and fourth place in terms of absolute volumes. These will catch the eye as they may present much higher growth markets, but it's important to remember that they're starting from a very low base.

Looking at some of the countries that joined the EU a couple of years back, says Mackie, in percentage terms their rate of growth in private equity will be very high indeed. "But of course they are starting from almost a zero base, so in terms of being able to deploy significant amounts of capital, I think it's the UK and the other big four European economies where the significant amount of capital will be put to work."

Of course, people divide the market in various ways, but putting it simplistically it can be separated into three parts. There is the early stage start-up technology type of investing, venture capital, then private equity which, according to Mackie, divides into mid-market buyout type transactions and very large leverage transactions. "I think that most people would accept that a transaction below £500m is probably in the mid-market; a transaction that is above £500m being seen as a large transaction."

Mackie says that historically it is the long-term rates of return from mid-market transactions and the very large buyouts that are the best on average. In the most recent BVCA survey, ten-year returns across the asset class as a whole were running at 14.9% per year.

Certainly the best returns are being made in the mid-market and from large buyouts. This is because the venture end, which is proving much more difficult right across Europe, is not attracting as much large capital while the mid market and large buyouts continue to attract ever-increasing amounts of investment.

But, says Mackie, it isn't that people are suddenly buying into it, it's been a more general growth over the last six to seven years of people committing more capital to the asset class. This is since it has become better known, been more generally accepted for its long-term performance compared to other asset classes, and because there is a longer trail of data that supports the numbers we are talking about.

"We had performance data ten years ago, but it was over a shorter timeframe and over a much smaller base of private equity practitioners, so people quite rightly questioned whether that was sustainable," laments Mackie. "What we're seeing now is a 20-year trail of data and a much larger number of private equity managers and people accepting that the returns are there."