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Strategic Finance

Private-equity groups become the new conglomerates

Monday, 27 November 2006

Matthew Goodman suggests that sector specialisation could destroy the received wisdom about private-equity groups. When gas company Centrica decided to auction the AA, the motoring organisation it had owned for the previous five years, the deal-hungry private-equity community began licking its lips in collective anticipation.

High-quality assets such as the Automobile Association, with its wide brand recognition, massive membership-base and predictable income streams from annual subscriptions - as well as the opportunity for cross-marketing and growing sales - do not come up for sale very often. It was therefore inevitable that the queue of potential buyers was going to be a lengthy one and that buy-out firms would figure prominently in the auction. As has been well documented, the world's private-equity firms are awash with cash, many of them having raised multi-billion pound funds, and they are finding it increasingly difficult to invest their money. Even at the £1.75bn asking price, the AA would have seemed an ideal opportunity to lavish some of their cash.

Centrica, however, had other ideas - it did not want a protracted auction with endless rounds of bidding as the many buy-out houses slugged it out. A short, sharp process would be much more appealing, but it needed a way to ensure that those who were competing to buy the AA were serious.

The answer seemed to be to invite bids from those firms that had investments in businesses related to or complementary to the AA. Therefore Kohlberg Kravis Roberts, the US firm that has done a number of insurance deals, was a participant. So, too, was CVC Capital Partners, a British firm that had recently floated Halfords, the car accessories retail chain, and which counted Kwik-Fit, the auto-repair centre, among its investments.

Those firms that did not have the requisite expertise found it frustrating. One person close to Cinven, one of the UK's largest buy-out houses, says: "We wanted to get involved but we couldn't. We made an offer informally and maybe it was too little too late. But we had not been allowed in and could not do due-diligence."

The logic of preferring bids from those with existing expertise in the motoring or insurance sectors seems to be to ensure attracting a higher offer. Those who can create synergies and cost-savings can surely afford to outbid those who cannot do so. As it turned out, CVC, in partnership with Permira, won the day. It had been tracking the AA for 20 months, feeling its experience from Halfords and Kwik-Fit would help clinch a deal, and on acquisition, it announced it would install Kwik-Fit boss Tim Parker as the new Chief Executive of the motoring group.

But the logic of the approach apparently taken by Centrica towards the AA auction - which may have achieved the result of securing the best offer - raises interesting questions about how private-equity firms should be regarded. If this kind of industry specialisation is the way forward, then it serves to destroy the received wisdom that the private-equity houses are the modern-day versions of the corporate conglomerates that were so fashionable up to the 1980s.

Jonathan Kaye, an investment executive at CVC who worked on the AA transaction, concedes that it does appear that there is a degree of sector specialisation at the firm, with its emphasis in recent times on automotive-related deals and retail investments. "We aren't sector-focused at CVC," he says. "We don't have a retail team or an automotive team. We see ourselves as opportunistic. I don't think sector specialisation is the way forward."

However, with the deal-making environment hardening, some experts believe that maybe this is the way forward. Michael Moriarty, a management consultant at AT Kearney, who advises private-equity groups, says that while private-equity firms currently share many of the same features as the old-style conglomerates, the former could be looking to evolve still further away from the conglomerate structure. He says that both are "very good ways of moving capital around different sectors to take advantage of different weighted average cost of capital figures".

Moriarty thinks buy-out houses could be doing more to combine their divergent investee companies when those businesses are in the same sector, further moving firms away from the conglomerate model: "Take a firm like Permira, which has invested in retail. There is a chance to really think about supply chain management and change the economics and business model. They haven't done it but they could."

While it is resistant to the idea of formally combining the AA with Kwik-Fit, Kaye says CVC is already examining ways the two companies can cross-market and enjoy certain synergistic benefits. One example is that if a car breaks down by the road-side and needs a new exhaust, it could be taken to a Kwik-Fit to be repaired rather than the regular mechanic the group uses.

Of course, as Moriarty says, with this kind of thinking in place and a more sector-orientated approach to investments, "the less you are like a conglomerate".

For some in the private-equity community, shaking off the comparison with the likes of conglomerates such as Hanson, Williams and BTR cannot come soon enough, and the description of the private-equity houses as "the new conglomerates" has become something of an anathema.

It is not hard to see how the comparison has come to be drawn. Lord Hanson and his fellow corporate swashbucklers built up hugely diverse business empires in the 1970s and 1980s. The portfolio approach was intended to smooth out the inevitable ups and downs of different businesses and so reduce risk. If one division was underperforming, another part of the empire would be faring better. The conglomerates had got started in the 1960s when restrictions on currency trading and interest rates were far tougher; they were the most effective means for corporates to move capital around while avoiding the restrictions. Common ownership of a raft of disparate operations led to cost cutting and improved management. By the 1990s, however, the conglomerates had had their day. Acquisitions became harder to come by and the City demanded more specialist skills to run the businesses they controlled. Diversity went out and focus became more fashionable.

Just as the conglomerates did, so do private-equity groups take a similar portfolio approach to investing. Their influence and power in Britain today is staggering. British firms have invested more than £40bn in the UK over the past six years, and according to the British Venture Capital Association, 2.7m people, or 18 per cent of the private-sector workforce, now work for companies controlled by private-equity firms. The industry is also maturing, having gone through a phase when private-equity investors were not such a common feature of the M&A landscape as they are today. Many professionals note that the days of financial engineering are over, when all they had to do was buy on the cheap, strip out some cost to get the profits up and sell the asset on a few years later at vast profit. Such easy pickings have long since disappeared, leaving the private-equity investors having to work harder for their juicy returns. But unlike the conglomerates, they seem to be learning. One lawyer who specialises in advising on private-equity transactions describes the old conglomerates as dinosaurs and says that the most successful buy-out firms are highly evolved. One facet that has always been true of the private-equity industry and could not be said of the conglomerates is that they are adept sellers of businesses as well as buyers of them. Indeed, it is their raison d'etre - without the sale, there would be no exit and therefore no return for their investors.

Whether the comparison is a fair one or not, and whether the approach taken by Centrica and CVC regarding the AA is the sign of things to come, there is one theme that is common to both the conglomerates and their more modern brethren.

It bought about the demise of the old-style and is one of the biggest challenges facing private equity. As one seasoned investor succinctly puts it: "Making money is more difficult today."

Matthew Goodman has worked for the Sunday Times Business section for three years, covering private-equity, leisure and retail businesses. He was a member of the team that launched Sunday Business in 1998 and spent four years there, reporting on the business of sport, leisure and private equity. Prior to that, he was a legal journalist at Legal Business magazine and The Legal 500 directory for three years.