A capital idea for Europe
Why should investing in the European private equity market be a priority now for
institutional investors, especially those based in Europe itself, asks John Barber
Over the last five years, a substantial part of the capital committed to European private equity funds – especially larger, Pan-European, buy-out oriented ones – has come from investors outside Europe. Many funds have raised as much as 75% of their capital from endogenous sources, particularly from US investors. At the same time, many indigenous institutions have avoided the asset class, despite their proximity to local funds and their familiarity with the European scene and its trends.
Recent private equity industry statistics have demonstrated that international investors’ commitments to Europe in the late 1990s have been rewarded generally by good and improving returns. In some categories, such as large buy-out funds, the returns achieved by top performing European managers have even exceeded comparable American ones. At the start of a new decade, can a case be made for institutional investors either to continue or to start investing here in private equity?
In making this case, it is necessary to focus primarily on the corporate buy-out and development capital sectors of the market, rather than on venture capital and technology investing. While there are encouraging signs of progress, Europe still lags the US dramatically in its level of ‘new economy’ investment, experience and expertise. ‘Pure’ venture capital in Europe consequently is less proven, whereas the following factors argue for new or renewed allocations by mainstream institutions to traditional European corporate private equity funds.
Maturity: Contrary to many new investors’ expectations, there are numerous high quality, successful firms operating here that are long-established. The origins of several household names – Apax, BC, Charterhouse and Schroders among the big firms, for example – date from the early- to mid-1980s. These firms have experienced economic cycles and market fashions, have refined their strategies and developed their teams, and in the main have generated strong results over sustained periods. Some firms’ results have been extraordinary, whether measured by IRRs (a number in Europe have earned 70%-plus returns on capital) or multiples of investor capital returned (one major firm has produced six-fold gains through the 1990s, while investing substantial funds). Thus investors have access to proven talents now playing at the peak of their game. Meanwhile, measured from a macro perspective, the European private equity market remains immature, especially when compared to the US. Levels of private equity investment in relation to GDP on the Continent, for example, are a small fraction of those seen in the US or UK. Equally, many obstacles to the free flow of deals – some cultural (the social prestige accorded to life-long corporate employment versus entrepreneurship, for instance) and some commercial – are only now eroding rapidly.
Markets: In the past, European private equity managers have often lacked the innovative tools necessary either to undertake particularly large or difficult deals, or to realise the full potential of their investments through IPO exits; in both cases, the lack of depth and breadth in their domestic capital markets has been a major limitation. This is no longer the case: the continental equity markets have grown at an Internet-like pace (IPOs in Germany totalled r13bn last year, up 300% over 1998) and high yield bond offerings are now a relatively routine means of financing large buy-outs (overall r17.6bn of high yield issues were launched in Europe in 1999; Goldman Sachs projects that the current US annual issuance of r100bn will be reached in Europe within five years).
Migrants: The arrival of American houses like Hicks Muse and KKR has generated diverging views among their European competition. Some players fear the US firms’ skills and capital, while others are convinced that the Americans, lacking European expertise, will experience more than their fair share of failure before retreating home. The Americans do, however, have three advantages – for now. First, since the US bull market is of longer duration, they have more experience in negotiating its shoals and in dealing with high entry prices. Second, generally they have responded to tough competition at home by differentiating their strategies, and are able to export sector expertise or add-on acquisition abilities relatively easily to Europe. Finally, and less tangibly, they often have the confidence that comes from dealing in and succeeding with bigger numbers – both larger deals and funds – for longer. The half-life of these advantages, however, is short, and the best European firms are already sharpening their strategies in reaction.
Multiples: Both press and public may be fixated by the enormous gains from the latest young and yet-unproven dot-com venture, but meanwhile publicly quoted shares of many old economy companies are languishing at prices and earnings multiples not seen since the early 1990s. These are often perfectly good companies with strong market positions and stable cash flows: in other words, they have leverageable assets. High profile, billion pound-plus ‘public to privates’ have already been completed in the UK, and a myriad of smaller transactions await an infusion of private equity capital. The purchase prices for these unfashionable but readily financeable deals should seem remarkably attractive when sentiments and cycles no longer favour current obsessions with technology so exclusively.
Mannesmann: On a grand scale, Vodafone’s recent success in its hostile takeover of one of Germany’s industrial bastions confirms that Anglo-Saxon concepts of shareholder value, financial transparency and industry consolidation are here to stay on the continent as well. On a smaller, day-to-day scale, these same concepts are generating better and broader deal flow for private equity firms as corporate Europe restructures. Tax law changes are also contributing to an improved investment environment. The proposed German roll-back of capital gains taxes on long-held corporate cross-shareholdings may have received the most attention, but at the same time Spanish capital gains taxes on private holdings have dropped by 50%, and the UK has borrowed more and more pages from the US tax code in encouraging entrepreneurship through rate reductions and incentives.
Model: Simply put, the management buy-out/buy-in concept has been demonstrated time and again to work in Europe. Most European economies have a well-functioning market for corporate control, executives have observed their peers’ success with the MBO/MBI transactions and understand their virtues, and the industry’s players – investors, advisers and lawyers – are skilled and experienced. Certainly there is still considerable room for growth,
especially on the continent, yet Europe’s level of development stands in marked contrast to Asia and Latin America, where the private equity model is just beginning to function.
Money: The European private equity market is often considered too well-financed, with too much money chasing too few deals. Clearly some parts of the market – large, auctioned transactions in the UK, for example – display the heated competition among investors that an oversupply of capital produces. Nonetheless, even in the UK, the aggregate capital raised by private equity funds over the last five years only marginally exceeds the capital they have deployed. Equally, private equity investors’ share of all M&A activity in Europe has remained a remarkably constant (and low) percentage of the total; arguably, if private equity investors were paying too much for transactions, their market share versus corporate buyers would rise, which it has not. Finally, while in many cases purchase prices and cash flow multiples for deals have indeed risen over the last five years, simultaneously interest rates across Europe have fallen dramatically. Given these declines, private equity investors can afford to pay more for transactions without destroying value, since their acquisitions’ cash flows can now support higher levels of debt.
Consequently, it is unlikely that today’s European private equity market – in macro terms – suffers from an excess of available capital. If the long-term trends described above persist and have the expected, profitable effects on deal flow, industry professionalism and, ultimately, investment returns, over the years to come then the European private equity market will require more, not less, capital from institutional investors to take full advantage of its potential.
John Barber is a director at Helix Associates in London