Keep out if you’re small

Small is getting bigger. According to the fund managers who play a vital role in shaping share prices in their corporate games, companies no longer need to have under 20 employees to be classed as small. In today’s economy, even a company valued at #500m may be faced with being ignored if it tries to raise public equity to fund growth.

KPMG, Close Brothers and Deloitte & Touche have all issued research carrying veiled warnings, as public-to-private finance deals, particularly among companies outside the FTSE-350, have accelerated over the past year and the issuing of new shares has been the weakest for almost a decade.

And the tough market conditions are forcing many to look elsewhere for funding as the traditional public route is turning its back on them.

Gone are the heady days of even five years ago when money raised through rights issues topped #10bn through 218 issues. The latest figures from last year show that only 68 issues were made, raising less than #4bn in total.

KPMG Corporate Finance head of new issues Neil Austin says that the situation is serious: ‘Small companies account for around 20% by employment so they are very important for our economy. If in the long term they have problems accessing public finance in order to grow, it will be a major brake on the UK market and that will affect all of us.’

According to Close Brothers, the main reason for this shift in emphasis from small companies is the adoption of a ‘size-ist’ approach to equity investment. This has left the stock market with little interest in companies outside the FTSE-350 due to their lack of market capitalisation (around only 4% while the FTSE-100 accounts for around 81%).

Coupled with the introduction of the euro, the focus is now moving away from the domestic-facing companies, making smaller players even less attractive as investors look to make money on pan-European stocks. This is because, on a European stage, smaller stocks are becoming marginalised as fund managers prefer to stick with the big players which are likely to suffer fewer price fluctuations.

On the other side of the fence, one leading investment broker says fund managers in smaller companies have become more proactive over the last eight to ten months, and in wishing to make their holdings liquid, they are forcing companies to put themselves up for sale or merge.

He comments: ‘It has been unusual for companies to do that in the past but now you are starting to see zero premium mergers on a much smaller scale and public-to-private deals are becoming more attractive for an MBO or MBI.’

He agrees the euro is making investors look further afield, prompting people to take more notice of the top 300 European companies and increasing the concentration of interest in overall performance, where it is much more important to pinpoint movements in the larger stocks.

The popularity of tracker funds – specifically designed to follow the larger players – has underlined a trend whereby fund managers are less likely to put in the research necessary to understand a smaller stock.

After all, why put resources into understanding such a tiny proportion of the total market when the returns are so insignificant?

As a result, many funds are changing the definition of a small company.

For example, Deloitte & Touche Corporate Finance defines a small to middle-sized player as valued up to #500m. Head of private equity Chris Ward says: ‘Particularly since the introduction of the euro, some now value small to mean anything up to #1bn.’

This underlying pressure has left many quoted companies being inadequately valued on the Stock Exchange while their weak share price has made it more or less impossible for them to issue new shares.

Companies hoping to float are being effectively barred from the stock market by being shunned by investors. KPMG says there were only 14 new listings in the final quarter of last year, 11 of which were venture capital trusts, investment trusts and demergers.

For most, the choice will ultimately lie between using private finance, debt, selling up to realise the investment or merging with another small company in order to achieve economies of scale.

But a shareholder wishing to keep their stake in the company and see the business continue is likely to see these choices reduced to debt or private finance and use the money to take the company out of the glare of the Stock Exchange. Indeed, venture capitalist Alchemy maintains that as many as 75% of companies outside of the FTSE-350 will have considered returning to private ownership.

Alchemy managing director Martin Bolland comments: ‘It is a very wide trend. We probably have four or five companies in here every week and there does not seem to be a predominance of any particular sector.’

Close Brothers’ analysis of equity and debt has also found that private equity is increasingly able to offer smaller companies a more cost-effective means of financing growth plans. And Chris Ward, corporate finance head of private equity at Deloitte & Touche, adds that some venture capitalists now offer development capital specifically designed to fund business growth.

One high-profile law firm which advises corporate finance clients also acknowledges that the full rigours of Stock Exchange compliance are far too burdensome and expensive for many smaller companies. They would not need to adhere to these rules as a privately owned institution.

But Bolland believes that the exclusion of smaller enterprises from public capital does not necessarily bode ill for UK business. ‘I do not see why taking businesses private should be a bad thing for the British economy. We are talking about an ownership structure and it is much easier to undertake a long-term strategy out of the public eye,’ he concludes.

BDO Stoy Hayward corporate finance partner Peter Hemmington takes a wider view of the process: ‘The small company sector goes in cycles. Small companies have a bad time in a recession. What is happening is very dramatic but it is a cyclical thing.’ He agrees there are also many benefits for owner-managers who can buy back their companies for private investors at a lower price than they are actually worth.

He argues that the Stock Exchange does not always work well for smaller companies and says that, in general, many underborrow and could easily sustain more debt – a cheaper source of finance.

So it would seem that, for the time being, smaller companies will be faced with little choice but to fund growth through private means. But as Hemmington says, this is not necessarily bad news. There is still work for accountants in the corporate finance arena.

‘This year is the corporate finance opportunity,’ he says. ‘It is the thing that everyone is chasing.’


The fluctuations of the stock markets and the economic turmoil in Asia last year have had widespread impact, writes John Carter.

Smaller quoted companies in particular have suffered as investors quickly sought to make their portfolios more risk averse.

Many of these smaller quoted companies have great potential but growth ambitions are restricted by lack of liquidity, causing frustration and disenchantment among management teams.

Taking a company back into private ownership through a venture capital backed MBO can reopen the door to expansion finance, but the pros and cons need careful scrutiny. It involves a complex legal process, considerable time and costs, and public scrutiny of the deal. And there is always the risk that the shareholders may say ‘no’.

Banner Homes, the regional house builder which recently returned to private ownership, in many ways typifies the ideal candidate. The company has a strong management team and clear growth prospects, making it ideally suited for a venture capital backed MBO. As a quoted company in an unloved market sector, Banner faced severe lack of liquidity in its shares and its inability to raise capital was restricting growth. These factors, coupled with a dominant shareholder wanting to liquidate his shares, turned the tables in favour of a return to private ownership.

In the words of Richard Werth, the new chief executive of Banner Homes: ‘The cyclicality of the market means that during a downturn, companies such as Banner Homes suffer doubly – we have to bear all the costs of being a quoted company but have none of the advantages in funding growth.

Going back to private ownership means our shareholders have been able to access their investment.’ For venture capital companies, the current state of the stock markets means there are opportunities to back public-to-private deals. But there is also a downside – it has become increasingly difficult to achieve an exit by way of flotation, something which in the past has brought some of the best returns for venture capital companies and management teams.

John Carter is a director of 3i in Watford

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