The Reckoning

The credit crunch has had a surprisingly positive impact on the UK-based managers ploughing the specialist furrow of applying private equity techniques to quoted equities. As well as the fall in equity valuations, which has led to reduced entry prices, the decline in the availability of credit for corporate borrowers means that investors like SVG Investment Managers, Acuity Capital and 3i QPE receive a positive reception from quoted companies in need of expansion capital.

“We have seen more cyclical opportunities coming on to our radar screen over the last six months,” confirms Bruce Carnegie-Brown, managing partner of 3i Investments, the adviser to 3i Quoted Private Equity Ltd. “There are some obvious sectors where rates are depressed at this point in the cycle, such as financial services, software, real estate and credit businesses.”

When the 3i QPE fund was conceived 15 months ago, the market was a lot stronger than it is today, he adds. “We are trying to find 10 investment opportunities that for one reason or another have been neglected, or are undervalued by the market. And we believed those opportunities existed 15 months ago. The credit crunch has created more volatility, and a number of companies have seen a reduction in their market value, for a variety of sentiment reasons not necessarily supported by underlying trading. And of course many of the things that might previously have got funded in the debt markets are now coming to the equity markets.”

M&A activity

Adam Steiner, head of research, public equities, at SVG Investment Managers, says the mega buy-out market is still closed as banks are unable to syndicate loans, but smaller deals below $1 billion are continuing, as banks can do these on a solo basis. He is upbeat about the prospects for M&A activity in the small and mid-cap arena and sees private equity playing a significant role. “The high funding levels of private equity firms and the reduced availability of debt means that equity will represent a greater proportion of these deals,” he points out. In addition, as prices have come down, private equity groups can afford to put in more equity.

But Acuity’s Judith Mackenzie, who will manage the upcoming Real Active Management Fund, stresses the importance of doing your homework on stocks that have de-rated badly: “Sometimes that’s completely warranted because they have messed up badly and the fundamentals have been wrong in the first place, but more often it’s because of a relatively naive management team who haven’t been well-versed by the broker as to what the market wants. Yet the fundamentals of the company tend to be quite strong.”

Steiner says that SVG looks for a small number of companies that create a lot of value. “It’s a seven month process to research companies, and we analyse the company’s customers, suppliers and competitors, as well as using industry experts to undertake ad hoc research.” A strategic advisory board will also look at a prospective investment and give its view.

In terms valuations, Steiner says that traditional asset managers will look at P/E ratios and compare those with a company’s peers. “We don’t really do that. Instead we look at buy-out models and try to work out how much money we would make if we took the company private. We also look at transactions done in the sector and what P/E multiple they were done at.” Cash flow yield is also important as this attracts buyers for companies in the mid-market buy-out space.

Unlocking value

Once the company is in the portfolio, Mackenzie says that the assistance provided by Acuity might include identifying acquisitions or partial disposals, but she expects to have about 10 to 15 stocks where not too much needs to be done: “The company may just be unrecognised by the market, so it might need a few tweaks like a new investor alongside ourselves, or a new broker. It’s about looking for unlocked value and finding out where the trigger points are going to be over the next 12 to 18 months.”

Steiner adds that SVG will speak to the company management regularly, and help them improve the value of the company. “For example, if they need to make an acquisition and do a fund-raising, we will put some of the money in to help them place that fund-raising. We will also help them find better non-executives, and will urge them to introduce private equity style incentive schemes for management if they create value for investors.”

3i’s Carnegie-Brown says that this more intensive investment approach can offer companies an appealing alternative to delisting after a disappointing or bruising experience on the AIM. “Delisting is quite hard to do. If you’ve brought your company to the market and then delist it within two or three years, then institutional investors get pretty ticked off,” he warns.

“Also, if you delist and go private, you are essentially putting yourself up for auction and there is a risk that the winner will have a different business plan than the one you envisaged. But if you’ve got someone who is interested in minority positions and committed to keeping the company quoted, it’s a much more benign and supportive model. We can help the management team drive the business the way they want to go.”

He cites the example of Jelf Group, a UK insurance broking and wealth advisory business aiming to be a leader in the consolidating regional commercial insurance sector. It has made 15 acquisitions over the last two years and QPE has helped finance five of the most recent of these. Also supportive is the fact that with its previous investments in asset management and insurance brokers, 3i has already accumulated a range of skills and expertise in this area.

Exit strategies

When the time comes to exit an investment, Carnegie-Brown says there may be several options such as selling to a private equity firm or trade buyers, or back into the market. “But the idea is to keep the company in the portfolio for a meaningful period of time. It’s a constraint on private equity funds because they need to return cash to shareholders to show the value they’ve created, but with this you can see the value at any time.”

The average investment period is expected to be about five years, and 3i QPE is looking at a number of other investments in the UK, France, and Germany. “The Nordics are also interesting because they have an international perspective and it’s a strong region for 3i,” says Carnegie-Brown. “But there are more opportunities coming out of the UK because the concepts are generally better understood.”

If you want to read more about how this approach differs from traditional asset management, and where managers are finding opportunities in this space, please visit:

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