Richard Willsher is a freelance journalist specialising in finance
Despite the size and power of some of the larger funds, private equity providers come in all shapes and sizes and may have a variety of investment appetites. But what are the pros and cons of this route for families? Richard Willsher takes a look at the evidence
Do private equity investors find family businesses attractive and what are they really looking for?
Private equity is a huge and rapidly expanding source of capital. Latest available figures from PriceWaterhouseCoopers Global Private Equity Report 2004 show that in 2003 $115 billion in private equity and venture capital was invested worldwide. This was an increase of 33% on the figure invested in 2002 and the final tally for 2004 is likely to demonstrate a similar rate of growth.
That private equity is a big business is amply demonstrated by research firm Private Equity Intelligence. It reports that it has identified 10 large funds, each with $4 billion or more to invest. The largest buy-out funds such as those assembled by Blackstone, Goldman Sachs, CVC European and Carlyle Partners are double this size. These funds are likely to invest money brought to them by large pension funds, insurance companies and such institutions. They are likely to run an investment book containing a large number of investee businesses. Some of these may be large family-owned enterprises, but their investment imperative will focus on achieving high returns regardless of the nature of the ownership of the business.
Vince O'Brien, chairman of the British Venture Capital Association (BVCA) and a director of London-based Montagu Private Equity, notes that investing institutions accept that when they invest in a private equity fund it is reasonably long term, "patient money", which they will be unlikely to get back for at least five years. It is therefore relatively high risk and they expect a commensurate return. Moreover, adds O'Brien: "The typical allocation that such an investor will make to private equity and which falls under "alternative assets" is likely to be no more than 3% to 5% of total assets in the UK, and in the USA something between 3 and 10%. These funds tend not to focus on any particular kind of company – family owned or otherwise – because they are in it to make a commercial return. They are less concerned with the ownership of the business than with the quality of the management and the quality of the business proposition."
But despite the size and power of the larger funds, private equity providers come in all shapes and sizes and may have a variety of investment appetites. For example, where the investors are wealthy family foundations, businesses or family offices they are likely to be interested in investing in entrepreneurial businesses whose culture they understand and empathise with. Michael Zacharia, an investment executive at Sand Aire Private Equity, a firm that specialises in investing in privately owned companies, says: "I think they want to share in other people's successes and feel a part of the building of a business." Like institutional investors they too will have decided on the scale of the allocation of their resources they want to make available and they will also have decided on the nature of their risk profile. "Our clients will give us guidelines based on risk but they may also be based on other issues. They may be looking for a fund that has no investment in anything related to say, tobacco or alcohol and we will search out offerings which meet their requirements."
Zacharia also notes that private equity investors may also prefer this approach over investing in the public markets. They are more comfortable with a private equity approach than with an institutional one, which is geared to quoted share price levels and positions that they can liquidate at a moment's notice.
This raises one key issue that is likely to preoccupy private equity investors; liquidity. Cashing in a private equity investment is not an easy thing to do because there is no open market for the shares. Investors are compelled to be in it for the long haul. They are therefore focused on the quality of the businesses they invest in and may rely on the private equity fund manager to look after their interests at the investee business.
This brings us to the thorny issue of control. Many family businesses are said to fear loss of control if they invite in a private equity investor. Others, however, may be endeavouring to relinquish control by either bringing in outside professional management or indeed to sell the business lock, stock and barrel, in which case loss of control is by no means an issue. Viewed from an investor's perspective a family business may bring with it risks having to do with discord among family members or owners of the business, which inhibit communication and professional management. Therefore, they want to overcome these obstacles to long-term growth and to achieve a good return on their investment.
"If you are a venture capital fund, for example," says Vince O'Brien, "and you want to make a good return, putting a minority piece of equity into a family company is not a good guarantee of a return on your invested funds. For example, in a large leveraged buy-out, you take control of a company. In a smaller transaction, investing in a minority is likely to be less attractive, unless it can get either a preferred rate of return or a significant say in the running of the business. They are looking to take significant equity stakes. You need to be a powerful investor."
However, once the private equity fund is involved in the business it will bring with it its expertise and experience of investee businesses. In addition it will be focused on growth and on achieving the goals that its fund providers expect.
It is also worth bearing in mind, in the context of the recent discussions on whether or not there is a developing convergence between private equity and hedge funds, that they do share key features. Firstly both are free of regulation and investors have chosen this form of "alternative" investment, away from the public markets. Secondly, accepting the risks involved in doing so, they look to achieve exceptional returns, well above those available in the public markets. Thirdly, those directors of hedge funds and private equity funds may invest their own money alongside those of their investors and are therefore highly motivated to achieve results. It is worth mentioning however, that where the two diverge is in the length of their investment view. Private equity timeframes typically contrast with the quick buck, which, by comparison, hedge funds appear to target.
So what sort of levels of return are private equity firms looking to achieve? This varies from market to market and sector to sector but, according to the European Venture Capital Association (EVCA) "since inception to end 2004, European private equity has generated a 9.1% cumulative net return a year on a preliminary basis". The BVCA says that in the UK, net returns that private equity firms have made over 10 years have been 14.8% a year, outperforming the FTSE 100 and FTSE 250 indices. However, this gives no more than a rough indication of yield because of the huge differences that are possible between highly successful and unsuccessful investments.
Some investors may prefer to invest directly in businesses rather than through a fund. They may seek a more hands-on role. In this case, accessing potential investments can be facilitated through business angel networks. We are, however, dealing with a radically different scale of investment. David Rose, of business angel investment exchange DCX, says that investments typically fall somewhere between £10,000 and £5 million because above this level it starts to become economic for a private equity to carry out the required due diligence. One of the appealing aspects of business angel investment could be the potential high levels of return. The EVCA calls for caution though: "While it is sometimes the ultimate objective of investors to be able to make direct investments into companies, compared with investing through funds, it requires more capital, a different skill set, more resources and different evaluation techniques. While this can be mitigated by co-investing with a fund and the rewards can be high, there is higher risk and the potential for complete loss of invested capital. This is recommended only to experienced private equity investors. For most investors, the use of private equity funds would be preferred, selected in-house or through outsourced selection." Business angel-type investments are usually into family or owner-managed businesses.
While one size and style of investment does not fit all, investors or all investee companies in the private equity market there are basic requirements for a potential investor to find a proposition attractive. Keith Arundale, European venture capital sector leader at PWC, says: "The issues are: is growth high enough? Is succession planning in place? Has it got a solid business plan and a well-rounded management? Is it revenue generating? Has it sourced its seed capital to get going, and is the business willing let go of a substantial portion of its equity?" If these questions are satisfactorily answered then private equity could be a source of funding that will enable the business, such as a family-owned and controlled one, to move on the next stage in its evolution.