The history of private equity starts from 1955, when first LBO transaction was completed, using a publicly traded holding company as an investment vehicle to borrow money and then acquire a portfolio of investments in corporate assets. During the 1970s a group of bankers completed a number of leveraged investments. After then many companies formed and transactions took place, initially in USA then spread the trend to Europe and other regions of the world. Between 2002 and mid 2007, a remarkable number of transactions were completed, many of which were in excess of $30 billion. Unfortunately, the credit crises started initially from mortgage markets spilled over into the junk bond and leveraged loan markets, substantially reducing the appetite of the debt markets for private equity transactions.
In UK, the Private Equity initiated in the late 18th century, when wealthy individuals backed the business of some entrepreneurs on temporary basis. This informal method of financing became an industry in the late 1970s and early 1980s when a number of private equity firms were founded. Private equity is now a recognized asset class. There are over 470 private equity firms in UK, financing billions of pounds each year to unlisted companies. Private Equity in UK has become an industry in which hundreds of companies with thousands of professionals are making efforts to benefit the overall economy.
DEFINATION
Money invested in the companies, which are not listed on a stock exchange or invested as part of buyouts in listed companies in order to make them private companies refers to Private Equity.
Most common investment strategies are venture capital, leveraged buyouts (LBO), growth capital, mezzanine capital and distressed investments.
Private equity firms are considered financial buyers, because they do not bring synergies to an acquisition, as opposed to strategic buyers, who are generally competitors of a target company and will benefit from synergies when they acquire or merge with the target. As a result, in auctions conducted by targets, strategic buyers are usually able to pay a higher price than the price offered by financial buyers.
Private equity firms are usually organized as management partnerships or limited liability partnerships that act as holding companies for several private equity funds run by general partners.
Some of the benefits of private equity
The companies often financed by Private Equity have been made known to grow faster than other types of companies. This is because of the combination of capital and special input from private equity experts. Since investors from Private equity funds invest their money in companies, therefore, they work closely with the management of the business. It helps achieving ambitious targets of the companies and provides a stable base for strategic decision making.
1. CODE OF CONDUCT
Old Code of Conduct
The British Private Equity and Venture Capital Association (BVCA) was formed almost 25 years ago with the aim to aid understanding, clearity and transparancy around the activities of its members. Currently it has over 470 member firms with an accumulated total of approximately £32 billion funds and other stakeholders such as pension funds, trade unions and employer representatives. During the quarter history, the industry has been transformed from a cottage industry into part of the mainstream economy; as one of the leading private equity association in the world. For any organization, the code of conduct are inevitable to set rules outlining its responsibilities or ethical practices. BVCA also had its code of conduct but as such no information is available as when these were first defined. However, for the purpose of more secrutiny of its member firms and transparancy of its operations, a need was felt to revise the code of conduct. Hence, the Combined Code was revised and issued in July 2003 following the publication of the Higgs Review of the Role and Effectiveness of Non-Executive Directors. The first revision was effective for UK incorporated, London listed companies beginning on or after 1 November 2003. Whilst the Code applies to listed companies, its provisions are relevant for private equity-backed companies in providing a framework for corporate governance issues in the private arena, which hopefully will help companies in the successful management of their businesses, ensuring that companies follow best corporate practice and prepare them for entry into the public arena.
The Higgs Review
The Code of Conduct was independentaly reviewed by Higgs, therefore it is know as Higgs Review, which was published on 20 January 2003. In contrast with previous corporate governance reviews, namely the Cadbury, Greenbury and Hampel Reports, the Higgs Review focused on the role which NEDs can play in promoting good corporate governance and wealth creation for UK companies.
Higgs clearly focused on radical change in the role of NEDs. He was of the view that past reliance on case law to clarify the roles and responsibilities of NEDs had only created uncertainty. He wanted to ammend the Combined Code to address the role of an NED, covering in detail area to include constructively challenging executive directors, monitoring financial control, assisting in the development of strategy, risk management systems and taking a key role in the appointment and removal of executive directors. He further wished to see greater board transparency and accountability and recommended more detailed disclosure by a board to its shareholders including a requirement for companies to make clear which decisions are to be taken by a board and which are to be delegated to management. Obviously, in the case of private equity-backed companies, these issues are covered in the shareholders' agreement (www.bvca.co.uk).
Reforms Proposed
In July 2007, the private equity industry proposed measures to make it more transparent as it tries to fend off mounting political criticism.
Sir David Walker presented a report, recommended how firms disclose information and communicate with staff, stressing on they must "be more open". There was a takeover of £11bn of Alliance Boots by a private equity consortium, which prompted need for the industry to be more open about how it funds large takeovers. The ultimate purpose of improving its corporate governance was to ensure the UK was a "centre of excellence" for private equity. Thus, a newer code, yet final to date, was introduced in November 2007.
New Code of Conduct
Under a new code of conduct, the UK buyout firms were held responsible to disclose more information about their activities. It mostly depends on voluntary measures and does not advocate any new legislation or regulation for the industry. The new code of conduct received great criticism from politicians that the original proposals did not go far enough. Sir David has responded to criticism by dropping some of the more draconian measures. It has been suggested to provide the detail that how much they have gained from financial engineering, operational improvements and multiple expansion for the entire industry as a whole, instead of producing "attribution.
Under the code of conduct private equity portfolio companies should:
Are bound to publish its annual report and accounts on its website within 6 months of the year-end;
No later than 3 months after mid-year, publish a summary half yearly update on major developments in the company;
Provide data to the BVCA on regularly basis to support its objective of gathering and aggregation of data and associated economic impact analysis;
Publish either in the form of an annual review or through regular updating of its website: a description of its own structure and investment approach and of the UK companies in its portfolio; an indication of the leadership of the firm in the UK and confirmation that arrangements are in place to deal with conflicts of interest; a commitment to conform to the guidelines on a comply-or-explain basis; and a categorization of its limited partners by geography and by type.
Follow established guidelines in reporting to limited partners and in the valuation of their assets;
Provide data to the BVCA in support of its enlarged role in data gathering and economic impact analysis, in part as the means of appropriately attributing private equity returns on an industry-wide basis respectively to financial structuring, market movements and operational improvement.
In particular at a time of strategic change, ensure timely and effective communication with employees, either directly or through its portfolio company, as soon as confidentiality constraints are no longer applicable.
It was further recommended that the BVCA strengthen its capability in particular:
To represent more effectively the larger buyout end of private equity;
To undertake rigorous evidence-based analysis of the economic impact of private equity activity and;
To engage proactively with private equity-like entities to promote their commitment to the guidelines, and with other private equity and professional groups to develop improved standards for fund performance measurement.
Source: Research Recap.com
Criticism on new rules:
Independent News says, that new rules for private equity funds failed to appease the criticism of industry with MPs and trades unions. John McFall, the chairman of the cross-party Treasury Select Committee was also disappointed by the new rules.
The new rules will require private equity companies to publish accounts for the larger companies they own no later than six months after financial year-ends. However, Sir David originally suggested a four-month deadline and has also dropped proposals to force individual private equity firms to detail what profits they make from financial engineering. Mr McFall said: "I want people in the industry to be alive to the public interest and ensure they're going more than half way to meet it" (Independent 2007).
Brendan Barber, general secretary of the TUC, said, improved disclosure was a vague designed to head off criticisms of private equity firms' approach to cost-cutting, and of their tax breaks. "The truth is that they have chosen this ground on which to make limited concessions,".
The rules won support from business groups and investors. Richard Lambert, director general of the CBI, said: "The recommendations will place considerable extra reporting burdens on the industry which are not shared by other large private business or by their peers in other countries - it is to the credit of the industry that it voluntarily requested a review."
David Paterson, head of corporate governance at the National Association of Pension Funds, added: "We believe that these proposals will support the success of the industry by encouraging an appropriate level of transparency, reporting to investors and improved performance reporting" (Independent 2007).
Paul Kenny, general secretary of the GMB, complained that the industry should face more scrutiny. He said: "Are the Government not listening when Guy Hands - a top private equity man - says that the losses racked up by the financiers in the sub-prime debacle will amount to more than £140 billion. These are the people who brought us the Northern Rock fiasco and their reckless and heedless pursuit of multimillion bonuses could spill over into a recession" (Timesonline 2007).
2. INDUSTRY PERFORMANCE
Background
Private equity firms in UK provide billions of pounds to almost 1,600 firms each year to form, develop and reshape their businesses through a wide range of sources, types and styles of funding catering their requirements. The BVCA is the industry body for the private equity and venture capital in UK with over 470 firms as its members. Apart from private equity firms, there are some government sources of finance for SMEs and growing business in UK. However, private equity held a large portion of financing in overall financing portfolio. Private equity firms often retain their investment for three to seven years or more. They have a variety of investment preferences and/or type of financing required. However, each firm designs its own products, mostly within the mainframe of private equity products, as explained below:
Leveraged Buyouts (LBO): It refers to the acquisition of all or most of a company unit by using equity from a small group of investors in comination with a significant amount of debt. The targets of LBOs are typically mature companies that generate strong operating cash flow.
Growth Capital: In Growth Capital, the minority equity investments in mature companies that need capital to expand or restructure operations, finance an acquisition, or enters a new market, without a change of control of the company.
Venture Capital: Venture capital refers to equity investments in less mature non-public companies to fund the launch, early development or expansion of a business.
Mezzanine Capital: Mezzanine capital refers to an investment in subordinated debt or preferred stock of a company, without taking voting control of the company. Often these securities have attached warrants or conversion rights into common stock.
Other External Sources of Finance for SMEs
Apart from Private Equity firms, there are some government sources, who fund businesses in private sector. These include the following:
Enterprise Finance Guarantee (EFG)
Regional Venture Capital Funds (RVCFs)
Enterprise Capital Funds (ECFs)
Early Growth Funds
Grants for Business Investment (GBI)
University Challenge Seed Fund Scheme
UK Innovation Investment Fund (UKIIF)
Enterprise Investment Scheme
Venture Capital Trusts (VCTs)
In this section, we will review industry's investment and its performance in general, as well as a few individual cases to know exact status of industry's and members performance in the field of private equity.
Investment by Industry
In 2009, Private Equity and Venture Capital firms have altogether invested £7.5 billion in 987 companies world over. It shows the confidence of BVCA members' on active portfolio management beside the fact that credit conditions were worse through 2009. Venture capital investment in the UK fell to £296m in 2009, a drop from the £359m invested in 2008.
Table 1. Global investment activity of BVCA members
2009 2008 2007 2006 2005
Number of BVCA members 193 208 214 192 179
Total amount invested (£m) 7,505 20,025 31,634 21,853 11,676
Number of companies financed 987 1,672 1,680 1,630 1,535
Industry Performance
It was feared that the private equity-backed companies were posing a great risk to the economy during great economic recession. It has been observed that the general conditions for private equity investments were challenging for some time. During 2008, there has been the liquidity crisis through the banking system significantly reduced the confidence in the capital markets and led to a broader economic slowdown in most of the world's major economies. However, the results have proved otherwise. They are less likely to default.
The BVCA, in conjunction with PricewaterhouseCoopers LLP, has published its Performance Measurement Survey for 2009 which demonstrates venture capital and private equity's continued outperformance of other asset classes over the long term. A total of 470 UK-managed independent private equity and venture capital funds were covered in survey. The results show that the combined ten-year internal rate of return (IRR) stood at 13.1% for 2009, against 3.1% for total pension fund assets and 1.2% for the FTSE all-share over the same ten-year period.
The data also shows that superior returns were achieved by the investors which committed to private equity during past economic downturns and recovery periods.
Returns continue to display notable stability over the long term. The annual IRR per annum on a since-inception basis from December 2001 has ranged from a low of 13% to a high of 17.3%, with a 15.9% overall long-term net return to investors as of 31 December 2009. The long term nature of the asset class determines that value is built over a period of time.
Simon Walker, Chief Executive of the BVCA, said:
"Despite the challenges of the past year, private equity and venture capital once again prove their worth to investors. As a long-term asset class it continues to outperform pension funds and the FTSE all-share, putting the industry in great shape for the future" (BVCA Performance Measurement Survey 2009).
According to the data compiled by Bloomberg, the private equity firms are facing problems in getting finance for their investments, hence selling their assets as the supply of debt they use to finance their acquisitions remains limited. This year the acquisitions in Europe by leveraged buyout firms have been estimated at $23 billion, down 76 percent on the same period a year earlier (Bloomberg 2010).
3. CASE STUDY OF 3i
Though the industry overall outperformed during last year. However, there are always cases of few weak players in a team. During my reasearch, it has been found that a bulky investment was written off by 3i. We will review its reasons and impact on company's financial statements.
The Company earned a net profit of £828 million in 2008. However, the Company has ended with a net loss of £1,948 million in last financial year (2009), mainly due to reduction in its unrealized investments in three main portfolios by £2,440 millions. "Thisismoney" announced that top 50 investments of 3i crashed by 21%. Due to this, the net asset value per share of 3i fell from £10.77 to £4.96. This has noted the most rapid economic downturn in 3i's history.
As a result, the value of the Company's assets dropped by half, therefore, it had to sell off its assets, shut divisions and raised £700 million by issuing right share to cut debt. Net funds gained from these steps, helped to boost the firm's cash flow, subsequently, it managed to reduce its borrowings to £854 million at the end of September (Bloomberg 2010).
Reasons:
This is the policy of 3i to revaluate its investment portfolio at fair value each year. They revaluate individual investments on an appropriate basis using a consistent methodology across the portfolio. For this purpose, they have proper guidelines for the valuation methods used.
How are unquoted investments valued?
IPEVC valuation guidelines suggest a number of different valuation methods to valuate unquoted investments:
- Cost;
- Earnings;
- Net assets;
- Price of recent investment; or
- Imminent sale or IPO.
3i only uses cost valuation method, effective 31 March 2009, as the most appropriate estimate of fair value until the first update on an investment's trading performance, given the conditions that there is not a significant downward movement in public markets.
So what actually happened, that due to market panic and financial performance of these companies, almost 50 in numbers, their market price went down. Subsequently, when 3i revaluate its assets as per its policy, it ultimately reduced the overall value of unrealized investments portfolio of 3i. The fall in quoted market multiples used to value most of their unrealized investments was the main reason of the decline in the value of their investments.
The Chairman justified that the prices at which their investments were realized have been depressed by the collapse in mergers and acquisitions activity during economic fall back.
4. THE IMPACT OF PRIVATE EQUITY ON UK ECONOMY
There have been a lot of studies conducted on the impact of private equity not only on global level but also on UK's economy as well as on various sectors stretching to the individual companies. BVCA being a recognized body in UK to control the private equity and venture capital activities in the country has arranged various studies to assess the impact of private equity in UK. One report was published by Arbor Sequare Associates in October 2006 and the other report by IE Consulting in 2007. Further, there are many other independent reports, articles, newspaper clips and news on this issue. In this section, we will study the latest impacts on various sectors of the economy with the help of these reports and information from other sources.
Investment Industry
The private equity industry has contributed 57% of total European investment and has been an important contributor to UK investment. In 2006, BVCA full members invested £21.6 billion in 1,630 companies worldwide (£10.2 billion in 1,318 UK companies). Of those UK businesses invested in, 68% received amounts of less than £1 million. There is also the economic impact of the private equity industry itself to take into account. The firms in the industry have over 9,000 employees. Out of this some 5,000 professional executives actively invest in unquoted companies. There is a considerable infrastructure of firms supporting the industry. Very significant revenues (over £5bn in 2006) are generated in fees for accountants, lawyers, banks and other professional advisers through the industry's fundraising, investment and divestment activities. A recently published report, The Impact of Private Equity as a UK Financial Service, shows the full extent of the UK private equity industry's impact on the UK economy.
UK Economy
It has been found that private equity-backed companies significantly strengthen the UK economy since its inception in the country. This sector has beaten other investment sectors in all areas. In the five years to 2006/7, the annual sales growth rate for private equity-backed companies was 8% p.a., whereas FTSE 100 had 6% and FTSE Mid-250 had 5% growth rates. Similarly exports grew by 10% p.a. over the five years, compared with a national growth rate of 4% and investment rose by 11% p.a., compared with the overall national level of 3%. In addition, R&D expenditure increased by 14% p.a., compared with national growth of 1% p.a. Public revenues receive significant contributions from private equity-backed firms. It is estimated that, during the last tax year, they collectively contributed £4.6 billion in corporation tax, £13.8 billion in PAYE & NIC, £11.9 billion in VAT and a further £4.6 billion in excise, etc - a total of nearly £35 billion in taxes. In aggregate, in the last financial year, private equity-backed companies generated an estimated £310 billion in sales revenue and £60 billion in export sales. Accumulated over five years, total sales revenue of these companies adds up to an estimated £1,331 billion, with export value of £188 billion and tax contributions totaling £140 billion. There are also the additional economic benefits resulting from increased competition such as economic efficiency, flexibility, innovation and capital investment. Furthermore, there is the second-order impact of purchases of goods and services by private equity-backed companies, which amount to a substantial proportion of aggregate turnover.
Venture companies are at the start-up to expansion stage of their
lives and therefore have huge growth potential. They use venture
capital funding for product development and marketing, to set
up their manufacturing and sales operations and to expand their
business by employing new staff.
Economic Impact of Venture Companies
Of the companies that responded to the survey, 489 (51%) were venture-backed (non-MBOs).
Over the five-year period to 2006/7, venture firms in the sample increased their worldwide employment by 8% p.a., a much higher rate of growth than FTSE Mid-250 companies (at 3% p.a.). Their UK employment also grew by 6%, compared to a national rise in employment of 1% p.a.
86% of responding venture firms said that the growth of the business had been organic since receiving venture capital funding. Sales growth over the five years was 12% p.a., again a higher rate
of growth than FTSE Mid-250 companies (5% p.a.). Venture firms grew their levels of corporate investment by 14% p.a. and R&D expenditure increased by 12% p.a. (compared with national growth rates of 3% and 1% p.a. respectively). The average value of exports from the UK increased by 14% p.a. (compared with 4% nationally). 69% of venture companies have introduced new products or services in the past two years and the majority thought that their level of investment was higher as a result of venture capital funding. 91% said that venture capital was responsible for the existence/ survival of their businesses and allowed them to grow more rapidly. Over half of venture companies felt that corporate investments and R&D expenditure were higher as a result of venture backing (57%
and 54% respectively) and nearly half (49%) said that their levels of employment had been higher.
Economic Impact of MBOs
MBOs in the sample accounted for 72% of aggregate turnover and 80% of UK employment reported by respondents. They increased their worldwide employment over the five years to 2006/7 by 8% p.a., outstripping those of FTSE 100 and Mid-250 companies (each at 0.4% and 3% p.a. respectively). UK employment also grew by 4% p.a., compared to the 1% p.a. national increase. MBOs increased their sales revenue over the period by 8% p.a., also higher than those of FTSE 100 and Mid-250 companies (at 6% and 5% respectively). R&D expenditure and investment by MBO companies increased at an average annual rate of 17% and 11% respectively (compared to national rises of 1% and 3%). 75% of respondents thought that their MBO had had either a positive or a very positive impact in terms of more effective management and 68% thought that the MBO had given them more freedom to innovate. Furthermore, our sample indicated that MBOs had a further impact at a micro-economic level in terms of providing more effective management and better incentives for their staff. For instance, only 22% of firms had an employee share ownership scheme before the MBO against 55% after. The proportion of employees participating in the share ownership schemes more than doubled during the period, from 9% to 22%. In addition to the provision of finance, exactly half of MBOs considered that 'financial advice' was the most important contribution from their private equity investor.
Public Markets
In the ten years to 2006, approximately 30% of UK companies that floated on the London Stock Exchange (LSE) main market were private equity-backed. Furthermore, recent research commissioned by the BVCA and the LSE showed the after-market performance of private equity-backed IPOs was better than for those that did not receive private equity funding.
Since its establishment in 1995, the relative importance of the Alternative Investment Market (AIM) has also been increasing, with more and more companies choosing to list on it. 241 companies
(including those backed by private equity) were admitted onto AIM in 2006, accounting for over a third (37%) of total IPOs in Europe, compared to 53 companies on the LSE Main Market1. The public-to-private market is also strong and is expected to remain so for the foreseeable future. Private equity firms took 21 companies private during 2006. Of the private equity-backed companies responding to the survey, 27% said they were anticipating obtaining a stock exchange quotation. Of these, 25% expected to list within two years and a further 24% in three years. Asked on which stock market they would pursue a listing, 57% of respondents expected to seek quotation on AIM, 21% on the Main Market of the London Stock Exchange and 5% on NASDAQ. Figure 5. Preferred Stock Market of Private Equity-backed Respondents Expecting to List
Employment
During the five-year period to 2006/7, UK private equity-backed companies increased their worldwide staff levels by an average of 8% p.a. This is a significantly faster rate of growth than FTSE 100 and FTSE Mid-250 companies, at 0.4% and 3% respectively. In the UK, we estimate that companies that have received private equity backing account for the employment of approximately 3 million people. This is equivalent to 21% of UK private sector employees. The average annual growth in UK staff levels of private equity-backed companies was 4% p.a., compared to the overall national level of 1%. This year we have again estimated the number of people employed by companies that are currently backed by private equity. This figure stands at 1.1 million for the UK - 8% of UK private sector employees.
Public Markets
In the ten years to 2006, approximately 30% of UK companies that floated on the London Stock Exchange (LSE) main market were private equity-backed. Furthermore, recent research commissioned by the BVCA and the LSE showed the after-market performance of private equity-backed IPOs was better than for those that did not receive private equity funding. Since its establishment in 1995, the relative importance of the Alternative Investment Market (AIM) has also been increasing, with more and more companies choosing to list on it. 241 companies (including those backed by private equity) were admitted onto AIM in 2006, accounting for over a third (37%) of total IPOs in Europe, compared to 53 companies on the LSE Main Market1. The public-to-private market is also strong and is expected to remain so for the foreseeable future. Private equity firms took 21 companies private during 2006. Of the private equity-backed companies responding to the survey, 27% said they were anticipating obtaining a stock exchange quotation. Of these, 25% expected to list within two years and a further 24% in three years. Asked on which stock market they would pursue a listing, 57% of respondents expected to seek quotation on AIM, 21% on the Main Market of the London Stock Exchange and 5% on NASDAQ.
