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Private equity versus debt

Marc Smith is deputy editor of Families in Business.

In the search for long-term growth, companies today have to consider more than debt financing. With private equity experiencing unprecedented growth, you may require a partner with strategic expertise to help you expand. Marc Smith weighs up the options

The announcement that United Biscuits (UB) is to sell up to a consortium of private equity groups is just one of the latest movements in a trend that is giving CEOs around the world some serious food for thought.
The buyout of the leading European snack manufacturer by Blackstone and PAI Partners, for an undiclosed fee, is believed to be made up of both equity and debt. The UK-based firm, which was born out of the merger of family businesses McVitie & Price and MacFarlane Lang in 1948, is the owner of well-known brands such as Hula Hoops, KP nuts and Jacob's crackers. It is the number-one player in the UK biscuit market, joint number one in the Netherlands and number two in France and Belgium – so why did it feel the need to sell up lock, stock and barrel?
Outgoing CEO Malcolm Ritchie said Blackstone were chosen thanks to their successful track record of owning and developing companies such as UB. "I believe the company will benefit from their involvement. We delivered a strong half-year result and we continue to see opportunities to further develop our key brands in all sectors," he said.

Value added
So is PE now the only route for growing businesses to finance their expansion, and have the rules of the game changed?
PE is officially booming. Research body Private Equity Intelligence forecasts that fundraising will hit a record $400 billion when all the sums are done for 2006. This represents a 6% increase on 2005, when $283 billion was raised – itself a record. Historically low interest rates and falling company valuations allied with continuing mistrust of public corporate management – think Enron and WorldCom – are persuading investors to abandon the traditional stocks route and invest money in PE.
Traditionally, companies seeking PE were early-stage businesses with few real assets. More mature companies with steady growth were more likely to choose debt financing. Today this is no longer the case, with even well-established firms looking to finance growth through PE or, more commonly, through a mixture of the two.

Searching for PE may be a complex and time-consuming process, but no collateral is required, the business will be cash-rich as long as profits are secured, and there is short- to mid-term security. "PE is an appropriate and value-adding model for businesses," believes Mark O'Hare, managing director of Private Equity Intelligence. "Like a certain brand of beer, it reaches the parts that others can't reach!"

However, it can be as much a question of politics as of economics. The biggest problem that family businesses often have with PE is relinquishing ownership. But because equity providers are willing to accept potential downside risks – something banks won't do – they naturally expect to share in the upside (ie, the profits) as well.
Nevertheless, for families wishing to maintain majority ownership, there is no reason why PE should not be seriously considered. The fast-growing UK restaurant chain Giraffe provides an example. PE group 3i, which has a portfolio of food outlets, has invested £10 million for a minority stake in the business, founded by husband and wife team Russel and Juliette Joffe. CEO Russel commented: "We have chosen to partner with 3i due to its strong sector credentials and its extensive experience in supporting fast-growing companies."

Up-to-date knowledge of specific sectors is just one way that PE can provide family businesses with an extra helping hand. "You may have a great product, but simply going to a bank and getting some cash is only half the story," says Anthony Cockett, director of Citigroup Private Bank. "If your requirement is for financial or strategic expertise and you want to grow your business across geographies or product lines then PE executives can move into a business and help it grow."
Lessening your liability
The debt financing sector is also looking healthy. The US congressional budget office's latest Budget and Economic Outlook reports that the real cost of corporate borrowing is expected to remain near its current level, which is close to the average for the post-war period. Throughout the world's financial districts, meanwhile, fierce competition within the banking sector means those seeking capital are able to shop around for deals – it is a buyer's market.

In contrast to PE, debt financing can be arranged comparatively quickly and easily. Providing you have sufficient collateral to offset the loan, you can borrow without relinquishing any ownership or profits. This said, heavily leveraged firms can suffer from a heavy cash drain as a result of repayments and suboptimal growth. However, "If a bank is willing to lend you the money, then that's probably route one," believes Cockett.
Johan H. Andresen Jr, owner and CEO of Norwegian family group Ferd, agrees. "Family businesses who wish to compete on a global scale should first finance debt – both to finance growth and in order to get a competitive return on equity – before seeking PE," he argues. PE is often "part of a strategic move that includes more than simply the injection of fresh capital."

So, what are the prospects for 2007? Conditions for debt financing look stable, with interest rates expected to remain historically low. Competition within the banking sector is set to continue, which means businesses will still have a range of offers to choose from. "There is a lot of debt available for the right company," says Cockett. "Family businesses should now be able to raise debt more easily than previously, although I know they don't always feel that way."

The PE market, however, looks more unpredictable. First, given the amount of money that is pouring into the sector, are we looking at a bubble that will burst in the coming 12 months? Not according to O'Hare, who believes the record growth experienced in 2006 is "a peak within a rising trend". Second, there is the US Department of Justice's inquiry into anti-competitive behaviour – the so-called "club deals" – between some PE firms. Again O'Hare is optimistic, despite the launch of a federal lawsuit in the US by individual shareholders. "It is not a real concern, although [the industry] is taking it seriously," he says. Finally, there is the perceived gluttony of PE groups. Business Week has reported how some firms are extracting huge dividends within weeks of buying companies and financing them by saddling the companies with huge debts. While this doesn't necessarily reflect on those PE firms who simply invest in – as opposed to buy out – other companies, there is undoubtedly a trust issue. However, O'Hare believes that, "Making a quick buck is not their raison d'être, although, naturally, they won't resist short-term profit if they feel it benefits all parties. The majority of PE firms are patient and in it for the long-term."

The golden rule seems to be to look realistically at what you are hoping to achieve in terms of growth, and find a partner – whether it be a bank who will provide debt or a PE group – whose goals align with those of your business. "If you are just looking for capital then look at the debt route," advises Cockett, "but if the issues you are dealing with are getting too big for the family to handle then you need to look at bringing in a PE partner." In other words, don't bite off more than you can chew.

3i, Alternatives, debt, ferd, Investment
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