The rules for creating a successful business haven’t changed since the crash of 2008, it’s just become a lot harder to get away with running a company badly. Criticaleye’s inaugural Private Equity Retreat brought together dealmakers from around the world to find out just how companies are being built in the right way to achieve lucrative exits.
A key theme to emerge was that many players within the private equity industry need to rethink their approach to value creation. At present, a large number of firms are stuck in limbo – they can’t sell their portfolio companies, or at least not for the price they need to create a return, and they’re unable to raise new funds.
Rather than question the validity of funding structures and the limited partnership model, it was felt that the issue was more to do with how certain PE firms worked with management teams. Wol Kolade, Managing Partner at ISIS Equity Partners, comments: “It’s not that something has gone wrong with the model – it’s the pace at which firms need to adapt. It is not just about the returns either, but how you made them and what the economic weather was like when you did it.
“If it was all concentrated between 2003 and 2007, then there will be an awful lot of questions asked, as a lot of people found it easy to make money around that time. But if you start being able to sell businesses in 2011, for example, and made good returns, that starts to differentiate you a bit.”
As banks revise their approach to providing credit, so partners across the asset classes, be that venture capital, PE or even the big buy-out houses, need to really understand what makes a successful business tick.
Mike Ellwood, MD of Corporate Banking at Santander, says: “The days of generating value through financial engineering have probably gone. If you want to create real value, it is now more about reshaping the model of the business.
“I have seen some of the mid-market firms begin to look at smaller businesses, with a view to growing them. It is harder work but there is more upside, rather than buying things which are ready-cut and need some form of financial remodelling.”
In many instances, debt will be needed but it was argued that a structural change, driven partly by political pressures and new capital requirements post-Basel III, is underway in the UK market where debt funding complements bank funding. “It is pretty tough for any of us [banks] in the mid-market to have an appetite much above a £25 million hold level,” continues Mike. “Finding enough providers to do deals when you want, say, £125 million or so of debt isn’t easy, so I think the emergence of funds to accommodate that market is something we need to watch over the next couple of years.”
It’s not a new proposition by any means (3i used to have a debt fund), but this, combined with the increased proportions of equity in most deals, does mean that a number of PE firms are re-evaluating exit strategies and their tactics for driving returns.
Scaling-up
The importance of UK businesses expanding overseas has been stressed repeatedly since the credit crunch hit these shores. The fact is that now, in most cases, it will be even harder to sell a business unless you have demonstrated a scalable, international model for driving growth.
Steve Parkin, CEO of Mayborn Group, a 3i-backed company which makes products for babies and toddlers, comments that six years ago 60 per cent of the company’s revenue came from the UK whereas 40 per cent was international. “By the end of this year, we will have reversed that completely,” he says.
By driving innovation, new product development and focusing on what he wanted from partners, initially in the US and then elsewhere, he has built a scalable business. “We negotiated in a way that most US businesses don’t do with their retailers. It was relatively anal in terms of details, but then we worked in partnership together to go and deliver the goals we set,” he says.
In the space of two years, the US now accounts for 20 per cent of revenue and by the end of 2015 Steve expects this to rise to 30 per cent. Having proven the model in a notoriously tough market, he is now looking to Asia and parts of Europe too.
For Andy Dunkley, CEO of Lee Cooper Brands, the mission of the Sun Capital Partners-backed jeans giant was very much of the turnaround variety. Since taking the hotseat in 2009, he’s completely reinvented the business model, driving an innovative international strategy which has seen the headcount cut from 2,500 to 12 key staff.
“There was a very clear message from all of the stakeholders within the business: this far and no further. Firstly, the board had to stop thinking that somebody else could solve their problems, which is a big issue for a lot of businesses that are in financial difficulty,” he says.
Drawing on his international experience, Andy has devised a licensing model that has seen him negotiate deals in countries as far flung as Romania, Taiwan, Turkey, China, and Russia. This year, Lee Cooper’s retail sales were £251 million and the company has seen overall profits for the past two years grow more than 20 per cent.
“There’s a great temptation to just survive when you’re in a turnaround position but that’s not enough,” he says. “What’s driven me on, and we’re yet to achieve it, is that I think we’ve now got a business that is marketable and we’ll get an exit for investors.”
Make the grade
In terms of viable exit routes, trade was seen by Criticaleye Members at the Retreat as the most desirable because of the higher strategic premiums paid, while PE firms continued to hunt for good secondary and tertiary transactions.
“The great thing about private equity is they are set up to do deals,” says Sangeeta Desai, ex-Chief Operating Officer at HIT Entertainment, which was courted by PE and trade buyers before being acquired last year by games company Mattel. “That’s their business and so they are very quick. They know how to conduct due diligence and they know what they’re looking for, which is very efficient and helpful to the process. It keeps the momentum going.”
It is, however, a nervy, tense climate for M&A where vendor expectations are disproportionately high. Corporates may be sitting on plenty of cash but they remain risk averse and, when opportunities do arise, the due diligence will be protracted and clinical. As for the secondary and tertiary market, there are plenty of PE firms with cash to spend, but they are selecting only the very best assets and therefore there is a competitive premium for those businesses too.
Quick wins will be hard to come by, bringing us back to the question of how to build long-term value. Kitty Hall, Founder and a Non-executive Director of geophysical contractor ARKeX, comments: “The best VCs provide wide-ranging support to their portfolio companies and, when it is a specialist sector fund, they can draw on a network of useful contacts within the industry. Sector specialists often have high-level relationships with customers, fellow technology companies and, importantly for the exit, the key corporate finance houses.”
Too often there has been a disconnect between management teams and investors. “One point of caution is where the individual venture capitalist does not personally have direct experience of running a business and the day-to-day operational issues the entrepreneur faces,” adds Kitty. “Potentially, they can focus too much on corporate matters… at the expense of the key elements of business building.”
For all this, there are firms that get it right and understand what the value proposition needs to be and, although the search for growth may be incredibly tough, it is important to remember that there are amazing entrepreneurs finding ways to thrive in this new reality.
“With all the doom and gloom, people are still growing companies by a compound annual growth rate of 50 per cent to 60 per cent,” says Wol.
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