VENTURE CAPITAL - Hand over fist

In 1996, the average value of an institutional buy-out (IBO) soared to u94.9m. This astounding sum was up 55% on the year before and came to ten and a half times the average rise for all buy-outs. What’s more, while the number of traditional MBIs and BIMBOs (a combination of an MBO and an MBI) fell, there were 28 IBOs, ten more than in 1995.

An institutional buy-out is initiated by the venture capitalist rather than by management. It has a number of advantages over a trade sale or MBO, all familiar to both vendors and advisers, as these statistics from the Centre for Management Buy-Out Research demonstrate.

In a trade sale, vendors are obliged to expose details of their business to competitors because they are likely to pay a higher price than other buyers, due to the synergy benefits a takeover will give them.

In an MBO, vendors risk being held to ransom by the very management team that they rely on. That means it is often better to make it worth management’s while to sell the business to an institutional purchaser – as long as the institutional purchasers are forbidden from approaching the management team and the management team is itself barred from bidding.

By acting as an institutional buyer, the venture capitalist does miss out on the competitive advantage of direct knowledge of the business gained through association with the management team. But, in the latter stages of the deal, when terms have been agreed, the vendor will often give permission for the institutional purchaser to open negotiations with the incumbent management, effectively leading to a quasi BIMBO.

The added advantage of the IBO for venture capitalists is that, instead of competing with rivals for the MBO team’s mandate – which is usually won on the basis of the percentage of equity ceded to management – they can bid for the company and deal with management at leisure.

The buy-out structure is zero sum gain, since, at any given purchase price and transaction gearing, the more equity ceded to management, the lower the venture capitalist’s return. Conversely, by reducing the equity ceded, the venture capitalist can bid higher for a business and still generate the same rate of return.

In the present competitive buy-out market, every bit helps. Venture capitalists are under pressure to maximise returns in an increasingly competitive market. And vendors have come to recognise the advantages of dealing with an institutional purchaser, as opposed to a management team or trade buyer.

The IBO boom is also creating both greater responsibility and new opportunities for the accounting profession. It is now doubly important that due diligence is carried out to the highest standards because the institutional purchaser will lack the insight into the business and the market that the management team brings.

The buy-out market has come a very long way since its origins in the 1981 Companies Act, introduced by the then Chancellor Geoffrey Howe, which permitted organisations to pledge their assets as security for the finance to purchase their own shares.

Prior to this, an investor wishing to acquire a business using secured finance had to buy the company’s assets to avoid breaching the financial assistance prohibitions of the 1948 Companies Act.

In its early days, the venture capital industry was only able to raise relatively small amounts of money, which constrained the size of transactions.

To increase the value and to spread the risks at a time when the industry was vulnerable to failures, deals were syndicated. As the available funding has grown, the practice of syndication has fallen away, to leave the private equity house bidding on its own.

Statistics from the British Venture Capital Association and the performance of funds both demonstrated that MBOs offered higher returns than could be earned from investing in earlier-stage transactions.

As a result, the industry was able to attract sizeable sums from institutions which were often from the US and were accustomed to investing a higher percentage of their funds in private equity than comparable UK institutions.

From 1981 to 1986, the total value of larger buy-outs ran at a modest average of #750m a year. When the industry went through its well-documented boom and bust in 1988 and 1989, this shot up to #4.5bn and #5.9bn, respectively, before falling back again to a respectable annual average of #2.2bn between 1990 and 1994. In 1995 and 1996 the industry recovered dramatically, with the total value of larger buy-outs rising once again to #5.9bn a year.

The accepted wisdom in the early 1990s was that, with equity houses finding it increasingly difficult to raise new funds, the recession would kill off the buy-out market. Many banks pulled out and those that remained took a long, hard look at the gearing ratios they were willing to accept.

In order to edge out some of the problem MBOs of the late 1980s, the equity houses took the difficult decision to change incumbent management.

It is important to remember that the industry textbook at the time stated that the success of a buy-out depended upon three factors: management, management and more management.

For an investor to change the executive was a brave move. Those houses with greater industry experience were perhaps the first to bite this bullet, followed rapidly by the rest.

Based on this experience, equity houses made two vital discoveries: changing management can often make a dramatic difference to the performance of a business; a business has to be of a certain size to persuade quality management to leave their well-paid jobs for an uncertain future in a buy-out vehicle.

The venture capital industry began to develop programmes to identify management teams not only for work-outs but also for the management buy-in market. It soon found that there was a reservoir of talent, interested in the opportunity to make the capital gains that a buy-out afforded.

The effect of this was a new recognition that management was, to some extent, interchangeable and that venture capitalists did not have to rely upon the incumbent team.

The industry kept its head and survived the doldrums of the early 1990s because of the opportunities of a depressed stock market and a plethora of distressed sellers. Venture capitalists were able to purchase businesses in the depth of the recession of 1991 and 1992, then float them in the years between 1993 and 1996 on the back of a rising stock market.

During this period, some 150 MBO/MBIs went public in the UK, which enabled the venture capital industry to raise #5.7bn between 1994 and 1996. This massive fund-raising and the increase in availability of bank finance has boosted competition between the equity houses and trade buyers for businesses coming up for sale.

The private equity industry has become a credible buyer for a wide range of businesses and individual institutions are now able to purchase sizeable businesses on their own, without having to sell down their equity positions.

The emergence of the IBO is closely allied to this shift in perception of the venture capital industry in the eyes of vendors and their advisers.

There is no doubt that the institutions have changed the face of buy-outs in the UK, to the extent that they have brought about the coming of age of the market.

But the IBO is facing competition. The most effective rival currently comes from trade buyers who have an advantage over an institutional purchaser.

By running a similar business, they understand the sector and have the potential to achieve savings on overheads through merging two similar businesses.

The conventional view used to be that such a bid would always beat one from management. But the ready availability of funding and the speed with which the buy-out industry can act often tips the balance against a trade buyer, who may need to raise funds through a rights issue.

Even so, it remains to be seen whether or not the IBO will prove to be as profitable for the institutional investor as the larger MBOs have proved to be in the past.

Anton Fawcett is corporate banking director of Barclays Acquisition Finance

CASE STUDY: ROSS VEGETABLE PRODUCTS

On 17 December 1996, blue chip food manufacturer United Biscuits completed the sale of its frozen vegetable products business (Ross Vegetable Products) to RVP Foods Ltd which paid #44m in cash, #2m of which is deferred and payable by installments up to 1 July 1998. The acquirer was a new company led by the incumbent management and supported by Phildrew Ventures, the private equity investment arm of Union Bank of Switzerland. Barclays Acquisition Finance underwrote the senior debt.

The Ross Vegetable Products division, which had a turnover of #56.1m and operating profits of #6.2m in 1995, includes the Ross Frozen Vegetables and Oriental Express brands. Its origins lie in Ross Young, which Hanson sold in 1988. United Biscuits merged the company into its own frozen and chilled foods business before a re-structuring in 1994.

The sale of Ross followed a re-organisation of all United Biscuits’ chilled food businesses earlier in the year. Although performing well, the frozen vegetable products division was regarded as non-core. Press rumours at the time suggested it was ‘reasonably widely marketed’ to potential buyers and the Phildrew/management group beat off a number of other offers.

Five members of management were invited to subscribe for a total of 15% of the equity in RVP Foods Ltd, with the remainder of ordinary and preferential shares held by Phildrew.

Arthur Andersen, the accountancy firm which United Biscuits had appointed to run the sale process, introduced Phildrew to the RVP Foods transaction.

The venture capitalist had backed the MBO of another frozen food company in December 1995, which had established its appetite for businesses in this sector.

Henry Gregson of Phildrew takes up the story: ‘While this previous experience probably got us onto the bid list, it didn’t give us an exclusive position.

We knew from the outset that we would be in competition with both financial and trade bidders, although their number and identity were always closely guarded.’

In this case, a condition of entering the bidding was that Phildrew structure the deal as an IBO rather than an MBO. The thinking was very straightforward:

Vendors and their advisors have long realised that financial bidders can afford to pay more if they offer management less equity in the target company. Hence they don’t like to allow their managers to negotiate with several venture capitalists for the best deal as this can lower the price offered.

Vendors fear, sometimes rightly, that trade bidders might be put off if they know that a management team has its heart set on an MBO and the risks it might bring.

The sale process might be delayed by protracted haggling between the MBO team and venture capitalists.

While Phildrew is happy to approach this kind of transaction either as an IBO or as an MBO, its preference is for the latter. According to Gregson, there are two reasons for this: ‘Where vendors insist on an IBO approach, they normally restrict the access that financial bidders need to management.

We need this access as our investment decision, and the price we pay, rest on two key planks – our view of management and our understanding of the business and its market. If we cannot come to a clear view on these two points – and this normally means spending a lot of time with the key managers – we are much less likely to feel confident paying a full price and, in the extreme, may decide not to bid at all.

‘We also like to forge business partnerships with management teams and like them to see themselves, like us, as owners of their businesses rather than ’employees with a few shares’.

‘It is this point which, from a venture capitalists point of view, causes the greatest concern with IBOs. We are not business managers. We rely on the managers we back, excited by the prospect of significant equity ownership, to produce the kinds of returns which our own investors have come to expect.’

CASE STUDY: NEWMOND

At #360m, last year’s buy-out of 15 businesses from Williams Holdings was the largest in the whole of the UK. The management team, lead by main board director Mike Davies, took a 15% stake in Newmond in return for an investment of just over #1m. The new company comprises such household names as Rawlplug, bespoke kitchen business Smallbone, Polycell and Valor gas fires. Williams retains a 26% stake.

Equity finance came from a consortium of Candover, Electra Fleming and Alpinvest Holding NV which have taken a 59% share. Deutsche Morgan Grenfell and NatWest Markets underwrote the senior debt facility.

In the year prior to the buy-out (1995) the Newmond businesses had combined sales of #266m on which they made a pre-tax profit of #32m. The assets were valued at #99m.

Former financial controller of building and security products at Williams Mark Edwards is Newmond finance director, and David Goddard, ex-divisional managing director of European building products, is operations director. Also on the Newmond board are Stephen Curran and Hugh Mumford, CEOs of Candover and Electra Fleming respectively.

The buy-out vehicle, which ranks among the UK’s top-20 building products companies, will probably float within the next two to four years. Earlier this year, it sold off one of its 15 constituent parts, garage and greenhouse manufacturer Compton Buildings, to a buy-out team backed by 3i.