UK: Private Equity: Mid-Market Remains in Vogue

Last Updated: 9 September 2004

By Mark Aldridge and Avent Grey

In May 2004, BDO Stoy Hayward undertook a research project based on interviews with 100 venture capitalists investing in companies with a turnover up to £200m. The aim of the survey was to gauge their views and expectations for the private equity market in the coming year and to understand their investment focus and motivation better.

Whilst the overall outlook is positive, it is interesting to see that private equity investors are less optimistic now than they had been two years ago – with 64 per cent now expecting activity in the private equity market to be on the increase, compared to 73 per cent in 2002. Although the actual number of private equity deals being done appears to be decreasing, the trend towards bigger deals continues, with the research indicating a current average deal size of around £14m for midmarket private equity houses.

Of the total deal size, approximately 50 per cent of the funding is currently being provided by private equity investors and 50 per cent through debt. The research does highlight some change of attitude taking place amongst the investors concerning the type of deals they intend to focus on in the near future. Although over half of those interviewed still expect the number of management buy-outs to increase, this has decreased from 67 per cent in 2002.

Conversely, development capital deals, in which private equity funds are used by the owners of the business as an alternate source of capital to fund growth and fuel expansion, are tipped by over 51 per cent of the respondents to be on the increase, compared to only 43 per cent in 2002. Management buy-ins remain reasonably steady, with only around 30 per cent in both 2002 and 2004 expecting an increase, highlighting the additional level of risk that is introduced when a new management team is brought into a business.

Sector specialisation

A trend that is becoming more apparent amongst private equity houses is a move away from the generalist approach and an emphasis on sector specialist knowledge. Through better understanding of the issues facing companies in a specific sector, private equity investors hope to secure the best deals and reduce their risk. Sectors that are currently attracting the most interest are healthcare, business services and financial services.

The IT/telecoms sector is splitting opinion, being ranked as the third most attractive sector as well as the third least attractive sector out of the 13 sectors identified. Manufacturing appears to be gaining ground with almost a quarter of those interviewed selecting it as a sector they were most likely to invest in, while property and construction was selected by two thirds of all respondents as the least popular sector for investment. Just over half of the investors questioned said they would be prepared to pay more or take greater equity risks to close a deal in their preferred sector.

Ultimately though, whichever sector a business is in, private equity investors will always seek quality businesses with good cash generation, the ability to scale quickly, strong growth potential and competitive advantage. According to the research, the key areas of interest when assessing new investments are the management team who will be responsible for driving the business and the exit route that will allow the investment to be realised within a specific timeframe.

Almost 80 per cent of respondents believe the number of exits will increase over the next few years with trade sales seen as the most important exit route, followed by IPOs and secondary buy-outs, in which one private equity house effectively sells its stake to another private equity house. Around 64 per cent of the investors view themselves as ‘very involved’ in their investment businesses and hold a board position, whilst the remainder say they are at least ‘partially involved’, with a non-executive director or third party having been appointed to keep an eye on the investment.

On a day-to-day basis, however, the executives within the private equity houses spend just over half their time focused on assessing investment opportunities and making new investments. They therefore rely on the management teams to run the businesses, which is why so much emphasis is placed on backing high quality management teams when making the initial decision to invest.

External influences

The external factor most likely to influence the decisions made by private equity houses in the next few years is interest rates. Although low interest rates in recent years have effectively allowed bank debt to compete with private equity and reduced the need for private equity funding, rising rates may slow the pace of recovery and in turn slow down the fast-track growth that private equity investors demand. Access to capital was viewed by almost one quarter of those interviewed as an important issue. This reflects the fact that the UK private equity market is facing increasing competition from abroad, especially Europe, with funds previously managed by UK private equity houses being distributed more widely. Only those private equity houses with a proven track record of profitable investments and successful exits will be able to attract the required capital.

The role of advisers

The final area on which the research focused was the role of advisers in private equity transactions. There was a high level of agreement amongst investors, with over two thirds saying that advised management teams achieve a better deal than those that are unadvised and many believing that deals involving advisers were completed more quickly than those without. A key area where advisers add value is at the initial introductory stage, with over 70 per cent of investors rating advisers as the best source of business plans and 78 per cent saying they would spend more time assessing a business plan that had been introduced by an adviser.

In conclusion

Private equity investors are now core players in the corporate finance market – providing core equity finance and actively competing against trade buyers for high quality businesses. They have money to invest and are able to make strategic acquisitions that will complement existing investments. Private equity must be seen as a viable option when planning for growth and assessing funding requirements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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