Fool's Eye View

[ June 16, 2000 ]

Heading For Private Parts

By Stuart Watson (TMFTiger)

Great Titchfield Street, London -- Yesterday the venerable TMFEssex examined an odd situation that currently exists in the stock market. On the one hand we have businesses like Standard Life that are being pushed towards a listing, as well as numerous technology companies coming to the market. But we also have some businesses heading in the opposite direction. Kelda (LSE: KEL) is considering a plan to turn its Yorkshire Water subsidiary into a mutual organisation. We also have a number of small companies that are being taken back into the private sector by their own directors. The latest company to head down this path is the Irish company, Adare Printing Group (LSE: ADP).

But why?

Why would a company wish to go back into private hands? It is easier to ask why they come to the market in the first place. Most companies go public so that they can raise money by issuing shares to investors. Private companies only have a limited ability to do this. However, many companies have seen their share prices fall to very low levels. So low in fact it would be uneconomical to raise money by issuing new shares. The existing investors get frustrated and begin to look for a better home for their money. There are also costs associated with being a listed company and the strain of being publicly accountable. For increasing numbers of small companies the pros of a listing no longer outweigh the cons.

This is when the directors of the company may step in and offer to take the company private. Existing investors will demand a premium over the current share price and then they can take their cash away and invest it elsewhere.

Hang on a minute...

But isn't there something a little sneaky about the directors buying their own company? After all they know more about the company than anyone else and would only offer to buy it if they saw the potential to make some profit out this. Well, yes and no.

In such situations a group of directors, independent of the team proposing to buy the company, is effectively put in charge whilst this process goes on. They have to make recommendations to the shareholders as to whether the proposed price represents a fair deal. Come to think of it, I can't recall any occasion where these independent directors did not recommend their recent colleagues' offer. But I'm sure that's just me being overly cynical. There are also other, limited forms of protection within the Takeover Code. Any information made available to the buy-out team and their advisers also has to be made available to any other party interested in buying the company. Quite often there are indeed other interested parties as they see this as an opportune moment to strike a deal.

The buy-out process

In most cases the directors won't have enough money of their own to buy the company outright. They will go along to a venture capital firm to raise some more. However, most of the money will come from a bank. Let's say the directors offer to buy an imaginary company for £100m. Between them they may have £2m. Off they go to the venture capital firm who offer to fund £18m. But they still need £80m. That is where the bankers come in.

Here's the trick. The company's shares will just be owned by the directors and the venture capital company. Over the next few years they plan to pay down as much debt as possible from cash generated by the business. Then they will sell the firm, perhaps to a company in the same business, or another venture capitalist. Say they manage to pay down £30m of debt over the next five years. But the business grows and they sell it for £150m. After the remaining bank debt of £50m is paid off the directors and venture capitalist are left with £100m between them. Not bad for a £20m investment five years earlier.

So despite the slow growth in the value of the company, the value of the shares has gone up fivefold. You may recognise this process. It is exactly what happens to your equity when you buy a house. Naturally there are complications. There are no guarantees that the company will be able to pay down its debt. The business may not increase in value at all.

Nevertheless, many venture capital firms make a tidy return from their investments. In practice their returns reflect the experience of private investors buying a handful of shares on the market. Some will be duds, some will perform OK, but there will be a few stars that account for the majority of the profits.

Two factors means that we are likely to see the number of deals like this increase. Fund managers, and funds themselves, are becoming bigger. It is becoming uneconomic for them to analyse and hold smaller companies. The continuing interest in technology companies means that many traditional firms are finding to hard to grab investors' attention. So should we try to sniff out opportunities on this basis? I think not. Venture capitalists are not going to buy any old pile of poo. The same basic rules of investing apply. Look for strong businesses at sensible valuations and try not to second guess what might happen in the short term.