Not a day passes without news or concerns expressed about private equity taking on bigger businesses for acquisition.
The latest in Australia is an emblematic deal. It is the A$370 million bid by Archer Capital Pty Ltd to acquire Rebel Sport Ltd. It overcame a key hurdle yesterday when the bid was approved by a requisite majority of Rebel shareholders.
As the next step, Rebel Sport, a publicly listed company on Australia's ASX, will de-list from the Australian Stock Exchange if approved on 19 March by Justice Lindgrin of the Federal Court.
The challenge for the acquirer of the Rebel Sport business will then be to get more value from that Australian sporting equipment, apparel and footwear retailer than its shareholders and managers were achieving as a large public company.
This article briefly discusses some aspects of private equity and some issues at stake. In using the title of this article, and the photo of a Roman coin with images of Brutus and his dagger, our perspective is not that gloom is appropriate. Instead, caution is in order as regards trends in private equity. As illustrated by the above graphic reflecting the US position, while the rise and rise of private equity is evident it still represents in the US and Australia a tiny percentage of capital markets as a whole.
1. What is private equity?
Like the term "venture capital", the term "private equity" can mean different things in different eras and countries.
For the purposes of this article private equity is defined as:
a type of private investment (ie not traded in a stock exchange), typically seeking a majority stake or full ownership, and involving investors who are typically obliged to remain committed for the total lifetime of a fund or until investments have been divested;
looking for a deal exit, with options including an IPO, trade sale, sale in the secondary market (ie sale to other private equity firms) or sale to the management; and
a broad concept that ranges from provision of seed or venture capital through to development capital of various types and extending to buyouts.
As in the Rebel Sports bid, in Australia in recent years "private equity" has come to refer in particular to transactions involving public companies going private.
These public-to-private bids have included private equity acquisition of Just Jeans, Freedom Furniture and perhaps shortly Qantas Airways - for which a bid is on the table valued at A$11.1 billion by Airline Partners Australia (Macquarie Bank, Texas Pacific Group, Allco Finance Group, and Onex Corp).
2. What is the level of private equity activity in Australia?
There were 86 private equity deals in Australia in 2006 according to Thomson Financial Data. Thomson counted in its numbers all announced deals (including pending and successful deals) as of 31 December 2006. It's figures, including those in the next few paragraphs, were cited in the February 2007 issue of The AFR Magazine.
The 86 deals in 2006 was up from 75 in 2005 and 40 in 2004.
In terms of dollars, the value of pending and successful deals in 2006 was A$34 billion, up from about A$3 billion in 2005 and A$2 billion in 2004. Bloating the 2006 dollar value was the announced, but rejected, A$18 billion bid for Coles Myer by Kohlberg Kravis Roberts backed by Carlyle, Texas Pacific and CVC.
So in Australia, as in the US and the UK, the number of private equity deals announced have increased as has the average deal value.
3. Why is private equity popular?
It should be noted that private equity is basking in some reflected glory.
Equity markets have been on a roll with higher corporate earnings, lower interest rates (until recently) in historical terms, and the benefits of advances in technology and financial industry deregulation.
These trends in capital markets generally have helped in a growing class of global investors and cross-border capital flows, which include private equity.
One reason often stated for the popularity of private equity is that corporate regulation has become so excessive, oppressive or burdensome post Sarbanes-Oxley and CLERP amendments that one consequence is corporations and their investors and advisers have elected to bail out of public markets (ie stock exchanges) and go private.
That's one of the negative push reasons.
It's a "fashionable" view said the CEO of the Australian Stock Exchange last month, Robert Elstone. He summarised the ASX position saying "...it is too early in the evolution of private equity in Australia to form a view on the medium to longer-term impact on the Australian capital market from a public/private mix of ownership perspective." He also noted the ASX is a stakeholder in that evolution along with the Australian Securities and Investments Commission, Australian Prudential Regulatory Authority and the Reserve Bank of Australia.
There is also a positive pull reason favouring private equity.
The view here, as supported by a recent AVCAL report (Economic Impact of Private Equity and Venture Capital in Australia 2006), has been expressed that corporates backed by private equity create value by outperforming their competitors, their sector and the stock market generally. In other words the view is that it is not just asset price inflation or rising P/E ratios alone.
The stock market (at least in the US) is not giving the level of return that private equity funds seem to be getting. As regards the position in the United States, this was strongly put in an October 30, 2006 Gluttons at the Gate BusinessWeek cover story.
It seems credible that the hands-on style that distinguishes private equity from say traditional portfolio investors may help corporates be fast and nimble like the best-of-breed small and medium-sized enterprises (SMEs) while also providing attractive financial incentives to senior executives (who are often required, by private equiteers, to invest personally).
4. What are the available business exit options?
Common approaches for improving valuation or capitalising on a private equity investment include those below.
Leveraged buy-out - the PE fund uses debt to finance a major part of the buyout. When the value improves, the returns to the equity portion are magnified by the high debt component.
Improve profitability eg with more experienced management, networks, and technical knowledge.
Buy and sell at favourable prices - buy when market valuation multiples are low and sell when they improve.
Re-structure - sell under-performing or risky assets or business units which may affect market perceptions of the most valuable part of a business.
Make acquisitions to gain economies of scale, new products or markets.
5. What exposure is there from private equity debt levels?
Private equity ventures assist companies to secure capital for expansion and consolidation and that's a good thing. But when the debt levels in the capital injected grow to levels that may not be sustainable over the longer term, it is time for a cautionary note.
Unlike equity (which is risk capital) debt comes with the obligation to service it by regularly paying the interest on it. Compared to listed companies (see accompanying graphic), private equity funds have had a greater appetite for debt.
To service debt raised for acquisitions private equity funds in Australia have shown, as in the Rebel Sports case, a preference for brands which are also cash flow rich. Hence, many recent private equity bids in Australia have been for retailers and media enterprises.
In maturing private equity and M&A markets it has got tougher in Australia as in the United States and the United Kingdom. Targets are requiring bidders to pay more and with this the level of leverage may be increasing.
6. What other legal and financial concerns are there?
There is growing concern among regulators, governments and tax authorities about the impact of private equity activity on investors, debt levels, the tax revenue base, standards for performance reporting, and the overall financial system.
Governments are keen to ensure that private equity arrangements can withstand macroeconomic shocks. In Australia the Council of Financial Regulators is currently preparing a report on private equity.
Governments are also keen to ensure against erosion of their tax revenue base. The high interest cost of private equity debt (which is generally tax deductible) reduces the taxable income of businesses. This triggered the announcement this week of a Treasury Select Committee enquiry in England.
In the UK, the Financial Services Authority (FSA), the equivalent of the Australian Securities and Investments Commission, has been consistently stirring the pot of caution. In a November 2006 Discussion Paper it reiterates the risk of excessive leverage as a major concern regarding private equity. In a table row titled "Excessive leverage" it states that in its survey of private equity deals in the UK "Equity represented just 21% of the capital structures of the five largest transactions to which each surveyed bank had committed capital in the 12 months to June 2006." It is a very balanced paper, exceeding 94 pages in length. The FSA intends to issue a Feedback Statement in the northern hemisphere summer of 2007.
7. Valuations, due diligence, compliance and risk minimisation
Two proactive steps for risk reduction for participants involve taking care of accounting ratios and commissioning work to minimise risks. These are overviewed briefly.
7.1 Bid prices, valuation, rates of return and accounting ratios
Various accounting ratios are used by investors and fund managers when making decisions about investing in businesses. Use of some ratios on their own - including EBIT, EBITA and P/E ratios - does not present the full picture of the financial circumstances of an enterprise. Use of these ratios on their own can be misleading. Following is a fuller explaination of that point:
Significantly, EBIT (earnings before interest and tax) and EDITDA (earnings before interest, tax, depreciation and amortisation) enjoy a pivotal position in such ratios, except perhaps, the debt/equity ratio which gives a measure of a company's financial leverage or gearing.
EBIT and EBITDA are based on the productivity of a business and do not reflect how much a business is leveraged. Interest on the debts of a business is not deducted before arriving at EBIT or EBITDA.
A price to earnings ratio (PE ratio) or a purchase price multiple is also calculated using EBITDA. Although the ratio is a good comparison of a share transaction price against comparable transactions in the market, it too does not take into account the interest expense of a business, because EBIT is before interest. For this one needs to look at the whole of the financial statements, the balance sheet, profit and loss account and cash flow of a business.
With high levels of private equity debt, businesses taken over by private equity groups are prone to interest and currency hedging to levels that may, in some unfortunate instances, become an unsustainable drain on the resources of those businesses.
There is no doubt that private equity can serve a useful purpose by providing essential capital for businesses to grow and expand. But the lesson for all parties is to watch the debt levels and any turn in the interest rate cycle.
7.2 Risk management
Among the many other proactive steps which can be taken to cushion against downturns and regulatory concerns are:
improved legal risk management both before and after deals are done;
re-evaluation of assets, including intellectual property assets; and
in private equity club deals (ie financing consortia) ensuring compliance with the Trade Practices Act 1974 (Cth), including its prohibition of price fixing (covered by section 45A of the Act) and exclusionary provisions (sections 4D and 45).
The bottom line is that if the burden of debt or other concerns becomes unbearable they may become a dagger in the back of participants in private equity.
Financial Services Authority, Private equity: a discussion of risk and regulatory engagement, (November, 2006).
Geoffrey Colvin and Ram Charan, Private equity, private lives (Fortune, 27 November 2006).
Robert Gottliebsen, "Death of the public company looms" (The Weekend Australian, 3-4 February 2007, p. 41).
PriceWaterhouseCoopers and AVCAL Economic Impact of Private Equity and Venture Capital in Australia 2006.
Joachin Heel and Conor Kehoe, Why some private equity firms do better than others (The McKinsey Quarterly, 2005 Number 1).
Diana Farrell, Susan M. Lund, and Alexander N. Maasry, Mapping the global capital markets, January 2007: Europe rising (The McKinsey Quarterly, January 2007).