Barely a week passes without another announcement about a private equity deal. The week of writing this, it’s Melbourne private equity firm Jolimont Capital and senior managers proposing a buyout of ICT company HumanWare.

Last year, private equity was hotter and quicker than a Ruapehu lahar, sweeping through New Zealand business. More than $1 billion of deals was struck in 2006, up 250% on the previous year.

For all the headlines, misunderstanding lingers. Many people don’t comprehend the mechanics of private equity, and the debt levels used to leverage these deals scare some. Questions remain over how successful they have been and what becomes of a company once the private equity investors depart?

The sector knows it has to deal with those issues and the suspicion. “There’s a myth that private equity [firms] are asset strippers,” says Clark Perkins, of Goldman Sachs JBWere. “In fact, there’s a strong commitment to investment in people and growth.”

It’s a common refrain. All private equity players will tell you adding value is in their interests: without growth, there’s less chance of a decent return.

Ernst & Young director Jon Hooper keeps track on the sector through the annual Venture Capital & Private Equity Monitor. This year’s report reveals growing activity in the middle market, which accounted for 43 of the 64 deals in the past two years. It’s in this area, says Hooper, where most care is needed.

“The top end will take care of itself. The middle’s where we need, from an economic sustainability perspective, to get it right.” But for medium-sized companies, private equity has not traditionally been an option, and they’ve relied on other funding options, such as bank debt — a less aggressive proposition.

“With debt, it’s more about the money. With private equity, they want to work with you to grow that business so that ultimately everyone gets more value out of it,” Hooper says.

A private equity investor will seek efficiencies through centralising administration, removing duplication and standardising processes. And it will seek growth through new markets, products or acquisitions.
Simon Pillar, of Sydney-based Pacific Equity Partners (PEP), one of the most active buyers in New Zealand, says it’s important to leave the management to the managers. But it’s equally important managers and shareholders have a clear view of what needs to be done. Through due diligence, PEP studies not only the strength of the company, but what opportunities are available.

The firm will go away with the management (who are always invited to invest, too) to discuss the future. “We’ll draw up a road map for the business as to where all those opportunities and pockets of value sit,” says Pillar. “Then we’ll set out a plan of how it can be done.”

Often the change in ownership will, of itself, make a big difference. “We’re finding very often that the businesses are in a form of ownership where the existing management team, for one reason or another, is constrained from maximising the value of the business.” This could be because it’s foreign owned, or because it’s a division of a much larger group, which is focusing its attention elsewhere, or a private owner with limited capital.

As if to prove the point about adding value, Pillar says PEP is committed to investing an additional $100 million in Griffin’s alone, acquiring Nice ’n Natural, expanding capacity and upgrading packing lines.

Pillar says PEP has had a “wholly positive” experience in New Zealand, where its investments have included Frucor, Vertex, Guardian Healthcare, Independent Liquor, Whitcoulls, Tegel and Griffin’s. But it did come under criticism from some market commentators that the float forecasts for Frucor (its first New Zealand investment) were too high. Similarly, PEP’s 2002 float of plastics company Vertex came under Securities Commission scrutiny. PEP made more than $60 million off the move but investors who bought into the float were warned by the company just two months later that it would miss the earnings forecast by 10%.

PEP cites Frucor, acquired in 1998 from the Apple and Pear Marketing Board, as one of its stellar investments. It owned the company privately for two years, floated it in 2000, then sold it to Groupe Danone in 2002. During PEP’s involvement, the firm says, Frucor’s revenue and profits tripled and it added new products, expanded into new markets and bought the assets of an Australian competitor with distribution strengths.

Frucor Group managing director Mark Cowsill says PEP “offered a different point of view and different ways of looking at the business that maybe when you are inside the tent you might not see”.
Frucor did grow spectacularly under PEP’s ownership, but Cowsill says a number of factors were at play.

“They were very fortunate the business was growing rapidly at the moment they bought us. They did fall on their feet to a large extent.” (It’s a point acknowledged by Pillar who says PEP came along at the right time.)

“I think what they did,” says Cowsill, “was embellish to a degree what management was doing or trying to do.”

At ANZ Capital, which has been operating for six years, head Mike Bradley says the firm is more active than it used to be. “Initially, we were very much hands-off, very passive,” says Bradley. “That was largely because in the early days, our investment strategy was more around buying well and on-selling at a slightly better multiple.” But with competition heating up, prices have risen. “So therefore if you are not in there in more of a hands-on way pushing some of the initiatives, you aren’t going to get the returns.”

ANZ Capital’s advantages include the bank’s broad network of business customers, and giving companies the financial oomph of being backed by a large institution. It also appoints non-executive directors to help — people such as former Navman CEO Jim Doyle. “They’re the sort of people who don’t just turn up at board meetings,” says Bradley. “They’re there for the MDs of these mid-market businesses to use as a sounding board.”

Bradley says the key to making a deal work is the relationship between the investor and management, a point emphasised by the New Zealand Private Equity and Venture Capital Association. “The core ingredient is a true alignment of interests,” says association executive director Christopher Twiss. “Deals go wrong when interests aren’t aligned.”

Association chairman Hamish Bell says it’s like a marriage. “There’s a courtship phase, then you go through development, and then hopefully it ends up with grandchildren and not divorce.” As a result, PE firms will look just as closely at the people as the numbers, doing psychometric testing and other checks.

Private equity may be the hot thing in the markets, but to Auckland University finance professor Jerry Bowman it has a ring of familiarity. That’s because he thinks many deals are similar to the leveraged buyouts (LBOs) of old (the association defines private equity as including LBOs, management buyouts and buy-ins, and the provision of expansion and development capital).

“There’s a lot of sense to LBOs in the right situation and they can create value,” he says. The classic LBO will involve a company with stable earnings in a mature industry. “You buy that company, lever it to the hilt, bring in manage-ment, give them a large compensation package and say, ‘have at it’.”

The LBO model is a transition phase for a company. “It forces you to go through a process, but once you’ve been through it, there’s no longer any particular reason to have the LBO structure.

“Like anything, there are always failures, but the basic model is a sensible one.”

Failure is not a topic the industry likes to discuss. About the closest you’ll get is Mike Bradley admitting: “The business has been successful by all measures. We’ve made 20 investments and 19 of those are successful.” He won’t discuss the 20th, Chequer Packaging, citing confidentiality clauses.

Chequer, bought by a consortium which included ANZ Capital for about $60 million in 2004, was placed into receivership in January. A report by receivers Ferrier Hodgson shows the company had a negative equity position of $26 million. Advances by lenders ANZ National and HBOS Australia were $44 million.

The report also shows the company was marketed for sale immediately before its collapse.

There’s nothing to indicate what brought about the receivership, although it’s understood competition from cheap imports was a major issue. A spokeswoman for the receivers says the Auckland factory has closed with the loss of about 120 jobs, but it’s hoped the Christchurch branch, with about 120 staff, could be sold as a going concern.

One of the most high-profile business casualties linked to private equity is Feltex, purchased in 1996 for $22 million by Credit Suisse First Boston Asian Merchant Partners (CSFB). Feltex acquired Australian company Shaw Industries about five years later, leaving it debt laden with a gearing ratio of 87%.

In 2003 Feltex was publicly listed, giving CSFB a healthy profit. The new shareholders weren’t so lucky, and the company went under last year.

Commentator Brian Gaynor called the saga the lowlight of the 2006 corporate year and said it sounded a warning about private equity, “which is on a world-wide, debt-fuelled spending spree”.

Debt is the sector’s raw nerve. The VC & PE Monitor says in some deals debt levels are 75%, although Bell and Twiss insist the average is in the 30–40% range.

Hooper is confident debt levels are not overbearing. “My position is, there’s no issue here [in New Zealand], move along,” he says. Even if the debt ratio was 75%, that would only represent about $3 billion of debt tied up in private equity. “That’s a drop in the ocean when you look at it from the financial stability standpoint.”

Mike Bradley says ANZ Capital has strategies to deal with the risk. The bank’s lending arm will look at any deal separately from the equity arm, apply-ing credit criteria before deciding to loan.

ANZ Capital will not allow any individual investment to be more than 5% of the total portfolio, and it won’t invest more than 15% in one sector.

Of its 20 investments, it has exited eight, most through management buyouts. Over the six years, its internal rate of return has been 30–40%.

PEP’s Simon Pillar says private equity firms need a long-term view and to be mindful of what will become of their investee companies. “We would not be in business in the long term if every time we bought a business we squeezed everything out of it,” says Pillar. Instead, it seeks to ensure companies which buy from PEP have success, too, “so they’ll buy from us again”.

Goldman’s Clark Perkins agrees a long-term view is vital and he’s happy to stand by his firm’s record. Of its three funds used in New Zealand (Hauraki 1, Hauraki 2 and the new A$415 million Trans Tasman fund), Hauraki 1 is all but completed. Through it, Goldmans invested in ten Kiwi businesses in four deals. Three have been sold, and the fourth is under consideration. Perkins says the internal rate of return on the fund will be more than 70%.

One of Goldman’s former investee companies was Hirepool, which had 14 Auckland branches when it invested in 2003. “When we sold that business, there were effectively 52 branches. We had grown it to a national franchise.”

Operating earnings increased 250% by the time it was sold in 2006, although he declined to disclose the figures.

In another of Goldman’s investments, Kathmandu, Perkins says “we’ve doubled the size of the marketing team, and the product and merchandising teams, and we’re investing in R&D.
“It’s about taking a business to the next level of growth.”

For Pumpkin Patch, the involvement of PE firm Quadrant, which paid $9 million for a 20% stake in 1999, allowed it to accelerate its Australian roll-out. Pumpkin Patch managing director Maurice Prendergast says the deal provided financing and financial skills, as well as expertise when the company was floated in 2004. “For us, it was about timing and the cycle the business was in,” says Prendergast. “There are lots of variations of private equity and it can — or might not be — successful. But for us it worked.”

Biochemical maker New Zealand Pharmaceuticals, part-owned by Direct Capital, says the involvement of private equity has been part of the “evolutionary process”. It allowed management some liquidity, and capital to fund a new factory. But next year it plans an IPO to raise even more capital, enabling it to expand production.

From the modest offices of the PE and VC Association, Twiss and Bell hope to commission research on the economic impacts. Studies in Britain have shown employment, sales and export levels for PE-backed companies are higher than for other firms. They are also about to embark on an education campaign, particularly targeting New Zealand’s thousands of medium-sized companies.

“Private equity is just one of the pots of capital that’s available,” says Bell. “It’s a great thing for New Zealand, an exciting thing, not something to be scared of. There are no barbarians at the gate.”