Private equity provides an escape from regulatory woes

“It is quite possible that companies will delist because of the focus on short-term performance and governance issues becoming heavier and heavier,” says Sir Ronald Cohen, chairman of Apax Partners, one of the best-known private equity houses.

The upsides in terms of listing include the efficiency of accessing finance. Proponents say it gives companies a stable shareholder base made up of institutional investors, which is impossible if they are unlisted. It also can deliver a higher profile that serves as a marketing tool, along with the use of shares as an acquisition currency, a market price for employee stock and options and general liquidity for shareholders. But at least some of those upsides can now be provided by private equity. With reported estimates of around $100bn raised in private equity money but yet to be invested, and private equity deals of as much as €5bn or more, large companies as well as the more classic small to medium-sized ones can now look at de-listing. Woolworths, for instance, the iconic UK retail company, recently rejected an offer from Apax valuing it at £789m.

Coming back to market

That wall of money is likely to increase for three reasons. First, leading private equity houses are coming back to market to ask investors for more money. Warburg Pincus is planning to raise $8bn, which would make its latest fund the largest in the world, while CVC Capital, Blackstone, BC Partners and Apax are among those also reportedly raising new funds, although due to the need for discretion under Securities and Exchange Commission (SEC) regulations it is difficult to ascertain who is in the market. Still, insiders suggest most leading funds have been or will be coming back to market in 2005.

As the funds get larger, so do the deals they do. That implies more listed companies and more that are on the main markets, rather than just the smaller ones. Michael Dugan, a senior managing director at New York-based Blackstone, notes that, with $6.5bn to invest from BCPIV, its 2002 fund, it generally focuses on deals with a transaction value of $500m or greater.

The value of the largest deal announced in Germany last year, for example, was €3.5bn, which was US company Fortress Investment Group’s acquisition of GAGFAH, the German federal housing business. This is probably far from the largest deal Germany will see in the next few years when groups such as Lone Star, a US private equity house, have declared their interest in acquiring a German bank with assets of up to €10bn.

What is also interesting about Germany, the third largest market for private equity investments after the US and the UK, is that the lack of the initial public offering (IPO) exit strategy has not harmed business. Last year’s weak IPO market led to many more exits through private equity houses selling to each other.

Not only is that trend becoming more common in all markets, so is the refinancing route, which again avoids the IPO option and allows the company to stay within the same stable. For example, Kwik-Fit, a UK-based car parts retailer with an estimated enterprise value of up to £1bn, is due to be sold to a trade buyer or another private equity house this year. Yet commentators say that, if the offers are not high enough, CVC Capital, the owner of Kwik-Fit, would consider refinancing. With interest rates this low, loading a company up with debt is far from a disincentive.

Hedge funds move in

A second reason for an increase in the money available is that hedge funds are moving into private equity as results from their classic stock-market and macro strategy investments suffer. In 2004, the CSFB-Tremont hedge fund index rose 9.64%, less than the S&P 500 Index’s 11% rise and less than the MSCI World Index’s 15%. Considering the hefty fees that hedge funds charge and the extra risk that investors take on, their attractiveness is under question.

Hedge funds are also finding that more of them are looking at taking share bets on too many of the same listed companies, leading to a surge of interest in the next frontier.

“The line between private equity and hedge funds will become increasingly blurred. The test is going to be how many hedge funds can deliver private equity returns. Whether they will turn out to be good at it is another matter. I don’t think many will be successful so investors will look more closely at what they are investing in,” Sir Ronald told The Banker at the World Economic Forum in Davos earlier this year.

Although many would argue that the hedge fund time horizon is different from that of private equity – “they are basically traders, they have the wrong mentality,” in the words of a partner at a London-based private equity firm – this is not as large an impediment as it appears. In terms of talent, hedge funds will poach private equity teams; in terms of locking in money, hedge funds have already pushed lock-out periods to up to five years and could well move to 10-year lock-outs, more like those of private equity.

The US is where the hedge fund/private equity lines are becoming blurred fastest. DE Shaw, for example, one of the US’s top 20 hedge funds, bought New York’s toy store FAO Schwarz in 2004 for about $20m and is busy restructuring it – private equity in everything but name.

Institutional interest

The third reason for the surge in funds to private equity is that institutional investors are becoming more interested. Institutional investors invest only between 5% and 10% of their money in private equity. Sir Ronald estimates the 7% of institutional portfolios in the US that is currently invested in private equity will grow to 15% over this decade, while the 3.5% in European institutional portfolios will also grow.

Of course, endowment funds such as Harvard University’s have always been more aggressive in investing in alternative assets, a trend which is likely to continue. But investors that only manage money in public markets – such as Fidelity, the world’s largest fund management organisation – may find they need to change their trust deeds to invest in non-public assets, to avoid missing out on interesting opportunities and being beaten by their competitors. It is irritating for them to have to sell out of a company being taken private when they would much rather ride the upside.

The downside of listing

The negative side of listing is also becoming more apparent. Take the banking industry. The increasing burden of domestic and international listing is the biggest risk facing global banks in 2005, according to financial executives in an annual study put out by the Centre for the Study of Financial Innovation (CSFI). A year earlier, regulation had been only number six in the survey. And let us not forget that Sarbanes-Oxley, the US corporate governance legislation, and the plethora of EU regulations, do not only apply to banks.

Admittedly, businesses such as banking, even if private, would still be subject to regulatory requirements of some sort. But not those of a public company.

Tony James, president of Blackstone, says: “We hear complaints all the time from CEOs about being public. The regulatory requirements are increasingly burdensome but, in their view, have no real value in helping them run their companies better. At the same time, hedge funds have become so dominant in the equity markets that investment horizons are microscopic and stock price volatility has escalated alarmingly.

Tony James: ‘The regulatory requirements are increasingly burdensome’

“Finally, the assault on Wall Street has had the perverse effect of significantly reducing research and trading support for most medium-sized companies. All in all, the benefits of being public no longer outweigh the burdens the way they once did. This is good for private equity but there are legitimate questions about its longer-term impact on the global competitiveness of American business.”

Lessening the load

William Donaldson, chairman of the SEC, was forced to announce in January that he was considering allowing more time for foreign companies with US listings to comply with new corporate governance rules. This was in response to a backlash that has seen foreign companies threaten to delist. Reportedly half of the largest German firms want to delist, while China Construction Bank, one of China’s Big Four state banks, is looking at listing only in Hong Kong to avoid the weight and cost of US corporate governance rules.

The US is not the only country suffering from the weight of regulation. The roll-out of the International Financial Reporting Standards in Europe in 2005 is also taking its toll on the 7000 listed companies in the EU, as are other pieces of legislation.

Meanwhile, the focus on short-term performance shows no signs of abating. Although most major stock markets stick to six-month reporting – bar the American ones – it is investors who call the tune. And those fund managers are ever more subject to short-term pressures. An added twist is that hedge funds’ creep into private equity terrain may result in shorter turnarounds, although it is too early to tell.

Optimism for 2005

Despite all this, 2005 still looks like being a good year for the London Stock Exchange and the main US stock markets. There are still companies that want to list on the most prestigious markets, be they emerging market issuers looking to raise more funds, companies hiving off divisions or private equity groups exiting investments. Still, it is worth noting that the number of international companies listed on the main LSE has dropped from a peak of 553 in 1990 to 381 in 2003.

Another caveat is that the private equity route may represent only a short-term solution for a company. After all, the new owners will want to exit the company at some point and an IPO is still one of the most popular routes. Also, the sale of a company to another private equity fund may prove less than ideal: new owners tend to demand new strategies. Changing strategies every five to 10 years as a company gets passed on may be frustrating. On the other hand, it may be better than having to list and cope with institutional fund managers and their quarterly performance obsessions.

The UK’s fourth-largest womenswear retailer New Look delisted in April 2004 in a £700m deal, using funds from private equity houses Permira and Apax. Chief executive Phil Wrigley says that regulation is something one gets used to, but “having said that, life has become easier in a number of ways, for example not having to make six trading statements in a year and all that entails”.

Phil Wrigley: ‘Raising capital for the right deal is not tricky in today’s markets’

He also points out that the major transformation plan currently undertaken at New Look is easier to do “away from the public arena,” especially with two supportive shareholders who have bought into the company for a number of years.

Grey areas

Another reason to delist – governance and transparency – may not be as clear cut as first appears. While it is doubtful private equity funds will have to match the requirements of publicly listed companies, as more pension fund money goes into them, the chances that they will have to be more transparent increase. It is also a mistake to believe regulators can be kept from extending their reach into non-public investments.

A central argument in why delisting is harmful for acquisitive companies is that, without listed shares, they lack an acquisition currency. While it certainly eliminates one option, there are many others. Private equity firms have a large amount of capital and are experts at raising debt.

“Raising capital for the right deal is not tricky in today’s markets,” says Mr Wrigley.

Meanwhile, as Deutsche Bank recently pointed out in a report, prices being paid for companies to go private are “skyrocketing” as competition increases, making it more difficult to maintain existing private equity returns. But those results are driven by timing flexibility. If the market doesn’t look good for an IPO, or a worthwhile price for a trade sale does not appear, the private equity investors can wait for a more auspicious time.

Future predictions

All in all, convincing reasons for delisting of increasingly larger companies are present. Regulation and listing requirements are not going to lighten up. Sir John Bond, chairman of HSBC, last year complained about spending $400m on regulation. Jon Moulton, the outspoken founder of Alchemy Partners, says it certainly is a trend that ever larger companies will delist, “especially dual-listed companies with [the] Sarbanes rubbish”.

Short termism is not a temporary phenomenon; neither is the beady-eyed scrutiny of campaigning NGOS and the press. The attractions of private equity are looking irresistible.