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When it comes to fledgling companies private equity has the edge on spotting a winner. Simon Keane reveals the secret success of buy-out backed floats

rivate equity-backed floats perform twice as good as ordinary IPOs, its official. There is a lot of hype about buy-out firms selling off plum assets and milking what remains for cash to breaking point, but now researchers at the Cass Business School have put these myths to bed once and for all.

While IPO activity may have temporarily ground to a halt – as almost all, bar resources companies, have been heavily de-rated – now may be an apt time for reflection. Cass looked at almost 2,000 floats over the past ten years and found that private equity-backed companies out-performed the FTSE All-Share in their first year by 20%, that compares very favourably to an 11% gain from the other floats.

Debenhams, now struggling with huge debts and stripped of its property estate, is often held up as a cautionary tale about private equity ownership and at today’s 65p, anyone who bought in at the offer price of 195p in May 2006, will rightly be feeling sore. But for every Debenhams there are enough success stories to cancel out the disappointment.

While Cass does not name the 144 private companies it studied a cursory glance down the FTSE 350 and you will soon be able to spot some of them. Just look at FTSE 100 motor insurance specialist Admiral, up 196% since its float in September 2004 or testing specialist Intertek, 145% the stronger since coming to market in May 2002, then there is Punch Taverns, which, despite the sharp correction in the past year, is still 128% stronger than when it joined the main market back in 2002.

You might say that the Cass report, commissioned as it was by the the British Private Equity and Venture Capital Association (BVCA), was only ever going to find in favour of the industry. But these findings are given credibility as they also flag poor performance from the venture capitalists, that sub-set of the private equity industry which focuses on smaller companies – floats from this segment underperformed the All-Share by 7.2% in year one.

Cass looked at 1,735 IPOs on the main market and Aim between January 1995 to December 2006 of which 144 came from private equity proper (the buy-out houses such as Blackstone, CVC, Texas Pacific Group et al) and 238 from the venture capital stable. In acknowledging the problems down at the the VC end (presumably many of the BVCA’s members will not have been too happy to see their dismal performance in black and white) Cass demonstrates an independence of thought.

Float your boat

So, with the numbers in support of private equity, what exactly is it that makes its floats so good? Let’s not kid ourselves this bunch isn’t big into capital expenditure and R&D – when you are dealing with the kind of debt levels involved in buy-outs investment invariably plays second fiddle as cash becomes king. So if it is not because these companies are well invested then what is it? The answer probably lies in the fact that the buy-out houses have a knack at identifying growth opportunities that the public market can’t see.

Fund managers have yearly performance targets to meet so horizons are understandably much shorter. If a company, which otherwise possesses strong long-term growth, is going through a rough patch they can’t hang around while earnings fall. Ask yourself, who would have been willing to back care home owner Southern Cross Healthcare had it not been for Blackstone Capital Partners? With Blackstone’s support Southern swept up care home businesses when the sector was suffering from over supply. With an ageing population the long-term dynamics of this industry are fantastic but it needed a backer about to hold through the tough times. Since its IPO is July 2006 Southern’s shares are up 79%.

Private equity is not only able to see growth that the public market can’t, it can also unlock growth by effecting change. Driven by a management with equity ownership it can achieve things that stock market investors can’t. When Intertek was part of Inchcape, at the time a sprawling conglomerate, the company’s value was never going to be realised. Once extracted from Inchcape in 1996 under the leadership of Richard Nelson (now deputy chairman but chief executive at the time) management has turned a £380 million company (that was the price paid to Inchcape) into a business with a market value today of £1.6 billion. Yes, clearly private equity took its pound of flesh, but stock market investors also enjoyed much of this unlocked growth.

Both Southern Cross and Intertek are spectacular growth stories and both demonstrate how the obsession about private equity under-investing to bleed companies for cash misses the point. In both cases, for private equity to be interested then first and foremost the growth potential had to be there, the operational efficiencies – cutting out unnecessary overheads, keeping a tight control on investment, improving working capital management – came afterwards to convert as much as possible of that earnings growth into cash.

A Swift one

Aston Swift is vice president at Intertek and has been at the company since 1996, which was the year its management bought the business out with the backing of Charterhouse Group. With responsibility for treasury it was Swift’s job to keep tabs on the cash flow statement and mediate with Intertek’s lenders who had put up the necessary £300 million of debt against the £80 million of equity necessary to purchase the company from Inchcape.

Swift recalls having about eight banking covenants to satisfy including one limiting the amount of capital expenditure to around £15 million a year (that compares with around £40 million to £45 million being spent at present). But tight cash flow management was only part of the equation as management, with Charterhouse’s help, set about closing underperforming units (those that were either producing slow growth or making a loss) and improving the earnings prospects of the remaining businesses.

‘The key thing for Charterhouse was to exit the company with good growth prospects,’ recalls Swift. ‘On the operational side they had to make sure that the right management was running the divisions. Getting the right people in place and making sure we were in the high-margin high-growth areas, those were the priorities.’ It is hard to imagine this sort entrepreneurial go-getting attitude at an industrial conglomerate.

Management unlocked the growth potential by moving into new businesses (laboratory testing) and through expanding its Asian presence into China, which was only a small part of the business when it was part of Inchcape. In the last full financial year under private ownership (2001) the top line grew 13% (from £399.1 million to £451.4 million), a growth rate that has since continued – sales grew 17% in 2007 (£664.5 million to £775.4 million) with an underlying rate of 13% stripping out acquisitions.

Halfords is another example of private equity spotting a growth story. Since the company was extracted from Boots, management has consistently delivered strong top-line growth through a strategy of making better use of store space (new mezzanine floors) and more effective marketing. When the company became public it wasn’t as if the attitudes instilled in the private days were abandoned. Far from it, at the time of float management had identified potential to expand retail space a further 20% through the introduction of more mezzanine floors or extension of existing mezzanines into supermezzanines.

Retail derivatives broker IG Group is perhaps one of the clearest examples of private equity spotting growth potential. When founder Stuart Wheeler wanted to sell his 25% holding in 2003 (to raise funds to renovate the family home Chilham Castle, Kent) the end result was a management buy-out. At the time shares in the company, which was listed on the main market, had taken a hammering following the delayed launch of a new internet platform and disillusioned shareholders holding another 25% also wanted out alongside Wheeler. Management leapt in with a buy-out backed by CVC Capital Partners.

It is probably fair to say that investors who sold out of IG back in 2003, disappointed with the short-term price performance, missed a trick. CVC just sat back and took its piece of the pie (chief executive Tim Howkins says he and the other executives were left to ‘run the company as we saw fit’) before re-floating the business in May 2005 at 120p. Since then revenues have risen by 145% (from £49.8 million in 2004 to £123 million in 2007) as IG has successfully capitalised on the growing appetite among wealthy UK private investors to spread bet and expanded its contracts for difference offering overseas. Reflecting this growth shares have risen by 220% to today'’s 384p.

And it is not just the case that private equity can unlock a growth opportunity, it can also create the opportunities as clearly seen with the example of Punch Taverns. With the backing of Texas Pacific Group, Punch pulled off what would have been impossible for a comparably sized public company by acquiring Allied Domecq’s estate of 1,802 pubs. That £2.75 billion acquisition was a huge purchase given the deal was probably about ten times the size of Punch Taverns at the time (think Evolution taking over FTSE 100 Schroders).

While new floats may be going through a bit of dry patch, invariably they will pick up again and when they do it is worth paying special attention to those from the buy-out stable. The stock market performance of venture capital-backed companies may not be much to shout about but the former buy-outs tend to be in a league of their own.

One of the limitations of the stock market is its inability to properly price a company’s long-term growth prospects. This is no slur on the fund managers as they have their yearly performance targets to meet, but it does give private equity the ability to add genuine value, value that stock market investors can also tap into.

Unlocking the full float potential

If you are a fund manager you will have access to the offer price on which Cass’s main findings are based. But if you are a private investor chances are you will have to buy in the market on the day of admission in which case returns are significantly diminished.

Cass has re-crunched its numbers to see what the returns would have looked like had you invested at the closing price on the day of admission. On this basis the 20% year-one FTSE All-Share outperformance of buy-out floats is reduced to 8.3%. For non private equity floats the 11% outperformance becomes a 7.2% under performance so you would have been better buying a tracker fund than bothered with new floats. The argument for a tracker is even stronger when you look at the performance of venture capital-backed floats which trailed the All-Share by 19.8% in the first year.

Outlook for IPOs

With ratings on most sectors, bar the resources companies now sharply down since last summer, it is unsurprising that overall there has been a dramatic reduction in the volume of floats this year.

So far in 2008 to the end of April there have been 41 IPOs on Aim versus 76 in the same period last year. But interestingly the number of floats on the main market have remained relatively stable with 15 this year to the end of April compared to 19 last year.

Floats from the big buy-out houses tend to go on to the main market while the smaller companies out the venture capital stable gravitate to Aim. It seems that the main market activity is holding up as investors are more willing to back big companies.

During the last bear market in 2002 we saw four major floats from the big buy-out houses namely Intertek, William Hill, HMV and Punch Taverns. Jonathan Hinton, partner at Ernst & Young says we ‘may get one or two large IPOs’ from the buy-out houses, although he’s not expecting a broad-based recovery in activity until next year.

FIVE STAR FLOATS

Raymarine

Shares up 40% since float

A failed bid and a slowdown in the US economy have taken some of the shine off the Raymarine story, but investors are still in the black even after recent share price falls. Raymarine was purchased by Hg Capital in 2001 and floated at 152p in December 2004. Between those dates, Raymarine invested heavily in new products, a revamped sales force, new IT systems and management, recruiting Malcolm Miller from Pace as chief executive.

A decision to outsource manufacturing from its own site in Portsmouth to a sub-contractor in Hungary came in summer 2005, after the flotation, although investment in new products has remained a strategic focus. Since the 2004 sales have risen by 40% and gross margin and adjusted operating profit have roughly doubled, with acquisitions only contributing a small percentage of the growth. Hg Capital retained a 26.9% stake upon flotation, selling 12% at 218p in March 2005 and completing its exit in 2006, well before Raymarine’s shares peaked at 490p in spring 2007. (RM)

Southern Cross Healthcare

Shares up 79% since float

Under private ownership Southern Cross consolidated the care homes sector at a time the sector was unloved by the equity market. The company has been through two private equity owners with Blackstone Capital Partners purchasing it off West Private Equity in 2004. Under Blackstone, Southern Cross made its biggest acquisitions – 186 homes with the purchase of Highfield Group in 2005 and then another 193 homes later that year when it bought Ashbourne Healthcare.

Sahill Shan, analyst at Brewin Dolphin, believes the company would not have been able to raise the money for these acquisitions on the public markets: ‘If you look back to 1994 to 1996 there were about ten quoted care home companies and all came a cropper. The history of the industry over the last ten years is over supply and private equity spotted the opportunity.’ Despite the recent share price correction, Southern Cross, at today’s 402p, is still well up on the float price of 225p in 2006. (SK)

Admiral

Shares up 196% since float

With shares tripling since their floatation price of 287p in September 2004 stock market investors have benefited handsomely from the groundwork put in by Barclays Private Equity and management. Chief executive Henry Engelhardt led the Barclays-backed buy-out from Lloyd’s insurance market business Brockbank Group in 1999.

Without the financial backing of private equity Shore Capital analyst Eamonn Flanagan says the company would never have been able to set up outside of Lloyd’s, a move that allowed it to compete with the established motor insurers.

‘To move the business outside Lloyd’s required someone with nerve and an appetite for risk,’ comments Flanagan. ‘For Admiral to do what it did, it had to find a partner who was not only willing to commit capital and also willing to take the risk that a business outside Lloyd’s would go smoothly. It is quite expensive to do motor insurance inside Lloyd’s because of the cost structure.’

The gamble paid off with annual turnover doubling between 1999 and 2003 from £200 million to £400 million as the Admiral model took market share. (SK)

Intertek

Shares up 145% since float

Intertek was spun out of Inchcape in 1996. Deputy chairman Richard Nelson, who at that time was the chief executive, led the management buy-out with the backing of Charterhouse Group. Two underperforming divisions were disposed of and the Oil, Chemical & Agri division moved into analytics, including laboratory testing of crude oil, alongside its core business of cargo inspection.

Vice president Aston Swift, who joined Intertek as corporate treasurer just ahead of the buy-out, says the strategy was to expand into high-growth, high-margin businesses creating a ‘lean’ organisation able to service its debt. Capital expenditure was capped at £15 million a year, a third of today’s levels. Having refined the business model Charterhouse was instrumental in establishing the infrastructure for public life, strengthening the secretariat and communications department as well as appointing non-executive directors. (SK)

Halfords

Shares up 6% since float (versus 26% decline in the sector)

A share price rise of 6% since floating at 260p in June 2004 may not seem like much to shout about. However, when this return is set against a 26% decline in the FTSE All-Share General Retailers index over the same period it looks pretty good.

Under private ownership management, backed by CVC Capital Partners, unlocked the value in Halfords’ out-of-town superstores by introducing mezzanine floors and then ‘supermezzanines’ to increase retail space. Marketing was given higher priority and during 2004 management renegotiated terms with about 350 suppliers resulting in cost reductions of about £4 million.

The result of these initiatives was a 10% increase in sales between 2003 and 2004 (£523.8 million to £578.6 million) while operating margins went from 9.7% to 13.7%. Since floating, revenues have continued to grow between 8% to 9% as management has built on ideas introduced during the period of private ownership including further roll-out of mezzanine floors.(SK)

Punch Taverns

Shares up 128% since float

It is probably fair to say that Punch Taverns would not have been able to raise the £2.75 billion it needed to acquire 1,802 pubs from Allied Domecq in 1999 via the public markets – this was a super-strength reverse acquisition.

Given Punch was a private company at the time we can only guess as to its value but assuming a multiple of two times sales (that is what it is currently trading on and sentiment towards pub companies back then was not much better) then on 1999 sales of £134 million a number in the region of £300 million wouldn’t be far wrong.

Most analysts would probably agree that public companies can use their shares to buy comparably sized rivals (‘It is possible to double in size’ – Kate Pettem, travel and leisure analyst, Landsbanki) but nailing something ten times your worth is just inconceivable. Since Texas Pacific Group floated Punch in 2002 shares have risen 128%. (SK)