Finding the Upside in PE

Driving growth requires management teams to combine ruthless focus with an agile response to both challenges and opportunities. Ernst & Young’s private equity specialist, Harry Nicholson, explains why CEOs of PE-backed businesses should be doing more to create fresh exit options

The total number of exits of private equity-owned businesses across Europe rose to 83 in 2011, according to Ernst & Young’s research of European businesses worth more than €150 million at the time of PE investment. This was the highest recorded number of exits since the peak years of 2006/7.

Harry Nicholson, Partner at E&Y, who has been advising on PE deals for more than two decades, provides a snapshot of European deal activity in the mid and large buyout sectors of the market.

What drives a successful sale in the current market?

Quite simply, it has to be a very good business. Remember, the majority of buyers of PE-backed businesses at present are other PE firms. While there are plenty of PE buyers around with cash to spend, they are selecting only the very best assets. To continue to generate attractive returns, PE firms must seek out the investments with the most potential, then work actively with those companies to achieve that potential.

However, secondaries are not going to clear the overhang of unrealised PE investments, so the piece that needs more thinking about is the hook for trade buyers. Therefore, as the interested seller, what more can you do to really think about who might be interested and why?

In practice, what can vendors do to attract trade buyers?

It’s harder to sell a business today unless you have demonstrated a scalable, often international model for driving growth. Trade buyers from the US and Asia-Pacific are clearly showing more interest in the mid to large end of the market in Europe. So as a potential seller, you’ve got to broaden your horizons and think creatively about who might be interested, particularly on the international stage, and why they might be interested in your business. Sometimes the trade buyers, and their investment rationale, may be obvious. But there are evidently benefits to be gained from management teams challenging their own thinking. It is something that, to date, too few private equity owned businesses have undertaken.

It’s then a case of helping to make it happen. Wear out some shoe leather and get out there and spread the word. Remember, there’s a huge backlog in the market, all hoping that it happens to them too. There are simply too many sellers and not enough buyers. With buyers more circumspect and with the focus, as ever, on business fundamentals, achieving any exit in today’s context means more effort is required all round.

Does the PE model need to change in order to create new opportunities for an exit?

It’s about rekindling the intensity of the original investment case, looking for new drivers of value that others haven’t seen, the pooling of great minds, intelligence and expertise. It’s about returning to the mentality of ‘this is what we’re going for and why’.

It’s always a big challenge. I’ve seen examples of where a business will almost hit the wall but manage to limp along. There’s a great temptation to just survive when you’re in such a position and the macro market looks unkind for years ahead, but that’s not enough.

This is a challenge of leadership. Can CEOs find the inspiration and decisiveness needed for change, which will increase cash flows and create fresh exit options? Waiting for the tide to rise just doesn’t feel like the right thing to do. Business leaders should be asking, ‘How do I make something happen to create value?’

What’s the mood among PE firms?

For the PE guys, they’re thinking: ‘I really want to crystallise my best deals, which will help me raise funds, but for the rest of my portfolio, as long as they don’t mess up, we’ll wait and see…’ That’s why it’s beholden on management in some of these companies to rattle the cage and create the urgency, because there won’t be that intensity coming down from the GPs [general partners] to force that in many cases.

Is the financing landscape for deals improving?

Deals are getting done and leverage hasn’t gone away. There’s still finance for a performing business that’s shown some ability to absorb external shocks and has some resilience to its earnings and cash flow. Sure, the leverage ratios are off their peaks, but it’s not a reformatting of the financing model and there’s still a significant leverage arbitrage built into the PE model. For the right deals, the money’s still there.

What about refinancing the existing portfolio?

That’s the bigger question because there is a raft of businesses struggling under the capital structures that were taken on in 2005 to 2007. The data we’ve looked at shows that in the biggest buy-outs, close to one-in-five may still be facing financial distress. Few are acting recklessly. So, as a PE firm faced with a business that is still making some money but which can’t refinance then, actually, you don’t want to sell it in today’s market because you won’t get top dollar. If it’s still meeting its interest repayments, you’ll keep it running. The LPs [limited partners] could kick up a fuss and get a consortium together to try and put a bit of pressure on the GP, but if they ask them to act fast and crystallise those investments to release cash, are they going to get the right value for those assets selling in today’s tough market?

Has the dynamic between management and sponsor changed?

In the largest deals, the boom years of the early noughties where PE backing was a one-way street to riches are over. For great management, they’re now asking: ‘Is PE the path to fame and fortune or not?’ Therefore, the opportunities have become more of a hard sell for PE to get management engaged and interested.

For incumbent management teams, incentive structures that looked good in 2006/7 don’t look very exciting in 2013. The model for me has always been a combination of carrot and stick: the stick being the financial leverage and the discipline that brings, with the carrot being the alignment of objectives, so if you can make it work we’re all going to do very well.

But the crash meant it ended up being just a stick for management teams. As a result, some management teams have been changed, while others have reacted to the challenge and opportunity of the ‘new normal’. Often, this has been followed by a rebasing of management incentives to re-create equity upside (for management, the prize of creating the new plan). It’s been a major trend in the last few years and it is still working its way through the PE environment.

Incentive structures that looked good in 2006/7 don’t look very exciting in 2013


Harry-Nicholson-webHarry Nicholson, Partner, Ernst & Young

Harry Nicholson is a Partner at Ernst & Young, the global professional services firm. He heads the Commercial Advisory practice which provides market, customer, industry and business advice to clients engaged in transactions and strategy development. Harry advised on his first PE deal in 1992, and has been actively engaged in the industry since then on new investments, realisations, re-financings and restructurings. He leads Ernst & Young’s annual global research programme, ‘How do private equity investors create value?’, and is a member of the British Venture Capital Association’s Research Advisory Board.

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