Over the past few weeks we have seen Coles’ potential disposal to private equity players in Australia, TXU sold in the largest private equity deal in the United States, private equity circling J Sainsbury in England and Telecom selling Yellow Pages to private equity in New Zealand.
Increased pension savings has provided significant funds looking for reasonable return. This, in turn, has provided the private equity players with the liquidity to chase assets at the top end of town. No organisation can consider itself immune from attack on the grounds of its size. Through the use of arbitrage, financial engineering and active management, private equity investors aim to increase returns from their investments and eventually liquidate positions at healthy profits.
Directors of companies have duty to maximise value for their shareholders. Private equity presents number of challenges:
•While in the short term prices offered for business may well be in excess of current market value and represent gains to shareholders, it does beg the question how another owner can see more value in the business. preferred target is one that could be described as “fat and happy”. The balance sheet may have been allowed to become flabby and under geared and costs may be excessive. Private equity firms are well known for using financial leverage but also have been focusing on active ownership techniques to create value through cost reductions leaving no lazy manager or asset safe. With fewer compliance costs around public reporting, private equity also has structural advantage over traditional industry players.
•The presence of private equity investors means the ability to grow the business through acquisition is diminished. Often they work different type of model to the one applied by trade buyers with lower hurdle rates and considerable weighting given to exit values. Private equity often wins in the competition, which is surprising as they frequently have less to gain from synergy or market gains.
•Increasingly, private equity is seen as the employer of choice with financial rewards for hard work in an exciting environment with less compliance. Key management are often incentivised through shareholdings and options which can provide healthy profits when the exit strategy is executed.
So how should directors respond to this change in the environment bearing in mind their responsibility to their shareholders/investors to maximise value?
•First, there is need for increased vigilance that the company is performing to its potential. It needs to be lean and effective. Costs should be kept constantly under review and the balance sheet gearing at level which applies some tension to the business – if necessary through returning cash to shareholders if there is no need for it in the company and there are no reasonable prospects for investing further.
•Trade buyers need also to understand how private equity values business if they are to be able to compete in acquisitions. This involves the gearing, rates of return and terminal value considerations as well as cost down. Trade buyers should be able to identify more synergy benefits and so should be able to succeed in this area where they need to.
•Finally, to be successful in the longer term, companies and their directors will need to continually focus on individuals otherwise the flow of corporate talent from public companies into private equity will increase. The company with the most entrepreneurial and talented individuals will have the greatest chance of long-term success.
Some people have raised concerns that the current private equity boom is continuation and acceleration of the hollowing out of the New Zealand economy. While in the short term private equity has the potential to reduce the number of companies listed on the exchange, this could eventually reverse as private equity firms exit their positions through Initial Public Offerings. This will enhance the depth of exchange of traded equities and will also benefit the market to greater extent than direct foreign investment, where we have seen number of New Zealand companies become small subsidiaries of international groups with key operational decisions based offshore.
But perhaps the service that private equity will be seen to perform is to revitalise tired assets, manage intergenerational transfers of business and create wealth while at the same time contributing to healthy and invigorating market for business performance.
Jamie Schmidt is lead partner risk and assurance at Deloitte.
