management buy-outs 1986-2006 past achievements, future

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Management Buy-outs 1986-2006

Past Achievements, Future Challenges1

Mike Wright

Andrew Burrows

Rod Ball

Louise Scholes

Margaret Burdett

Karen Tune

Centre for Management Buy-out Research

June 2006

1 The contributions and comments of Luc Renneboog, Tomas Simons, Deloitte Corporate Finance and Barclays Private Equity are also acknowledged with thanks.

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1. Executive Summary

Past Achievements

• Over the past two decades, management buy-outs have become a global phenomenon. Activity is especially prevalent in the US and UK but growing in continental Europe and Asia.

• In recent years, buy-out funds raised in both the UK and Continental Europe have exceeded funds invested, indicating a continuing overhang of finance for investment.

• Institutional investors in the UK indicate that they are likely to reduce their investments in all types of private equity in the future but that investments specifically in buy-outs will grow in importance. In contrast, evidence from Continental Europe indicates an intention by institutional investors to increase their commitment.

• Private equity firms from the United States have become much more prominent investors in European buy-out markets.

• Increased competition for traditional private equity players has come from hedge funds and new entrants such as government-sponsored operators, family offices and wealthy entrepreneurs.

• With traditionally dominant divestment activity having passed its peak, the major changes in deals have been the growth in importance of secondary buy-outs and public-to-private buy-outs (PTPs), and the shift of attention to larger deals.

• The percentage of debt in buy-out deals peaked in the late 1980s in the UK and sharply declined in the early 1990s but recent lower interest rates have been associated with a rise in debt, which now accounts for 51% of the average deal financing.

• Size of deal syndicates has fallen sharply since the mid-1980s but is recently increasing as club deals become more in evidence in very large deals.

• The average share price reaction to the PTP announcement of during the period 1997-2003 was 30%. The main factors influencing PTPs in the UK is management’s perception of undervaluation by the market, scope for increased incentive alignment post buy-out, higher concentration of insider ownership and separation of the functions of CEO and Chair of the board, the costs of maintaining a listing.

• Secondary buy-outs have become an important exit route, while stock market flotations, which were once frequent for buy-outs, have become rare. There is an increasing number of tertiary or quaternary buy-outs). At the end of 2005, a total of 41 companies had gone through at least three buy-outs.

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• Buy-outs have major positive effects on firm productivity, new product development and human resource management.

Future Challenges

• Continuing challenges to providing appropriate incentivisation for management of subsidiaries provides scope for further divestment buy-outs.

• With strong buying power at the disposal of specialised private equity firms and hedge funds and with the growing acceptance of club buy-outs, it may only be a matter of time before we see that FTSE 100 companies are taken private.

• The scope for restructuring of larger corporations is greater in Continental Europe and private equity firms are increasingly likely to look for attractive deals in this environment.

• Buy-out opportunities among family-owned firms may be enhanced through the encouragement of succession planning and addressing concerns of founders regarding their future involvement with the business.

• An important issue concerns how buy-out financiers can generate higher returns to satisfy the investors in their funds. Greater pressure to create upside gains in addition to making the operations more efficient suggests a need for further differentiation between private equity firms and segmentation of the market.

• The entry of hedge funds into the European buy-out market poses a competitive challenge to existing financiers. Different types of hedge funds are likely to emerge with different mandates and a focus on different types of buy-outs.

• Growing concerns about the medium term performance of European economies and trends in interest rates are likely to raise question marks about the degree of leverage in buy-out deals.

• As deals become larger, securitisation will become more important, and its impact on the future buy-out market will far-reaching.

• The growth in secondary buy-outs raises major issues relating to whether managers are buyers or sellers and hence their motivation to perform, the extent to which private equity firms will experience reduction in their control and influence, and the need to convince limited partners who may be asked by private equity firms to invest again in the same deal through a subsequent fund that further significant capital gains will be forthcoming.

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2. Introduction In early 1986 when CMBOR was created, the buy-out market had been developing for five years or so and much of the activity involved recession-related restructurings of failed or distressed companies. Total UK deal value in 1986 was still only £1.5 billion, yet the view that scope for buy-outs was strictly limited to these conditions was beginning to change. It was difficult to imagine at the time just how significant the management buy-out market would become. Buy-out markets in the UK and Continental Europe have developed substantially over the past twenty five years. The market appears to be entering its third period of significant growth, following those of the latter halves of the 1980s and 1990s. Successive records have been broken in terms of market value and the largest deal size. In 1997, the UK market broke the £10 billion barrier for the first time and only three years later in 2000 more than £20 billion worth of deals were completed. The first deal above £3 billion (MEPC) was completed in 2000. While the European buyout market is generally less advanced, in 2005, the 20,000th UK and European buy-out since the late 1970s of all types was completed. Over time, new deal types have emerged, while new players, most recently hedge funds, have entered the market as competitors for buyout investments. The growth in the buy-out deal volume for the UK and the Continental European countries has been steady (Panel A of Table 1). The largest number of buy-outs can be found in the UK but substantial buy-out activity is also taking place in France, Germany and the Netherlands. Panel B shows a more striking evolution in terms of value: the combined value of all buy-outs in Europe rose more than fivefold in the decade 1996-2005 to break through the Euro 100 billion mark in 2005.

Table 1: Number and value of buy-outs/buy-ins in Continental

Europe (CE) andUK

Panel A: Number of Buy-outs/Buy-ins

Country Name 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Austria 1 2 2 1 2 1 4 0 1 0 Belgium 2 3 4 5 5 4 2 1 5 8 Denmark 3 2 3 3 5 2 2 1 2 6 Finland 1 3 6 3 2 3 4 5 5 6 France 26 25 48 64 38 19 25 35 22 63 Germany 17 21 22 18 15 21 8 11 17 22 Ireland 1 3 4 2 3 5 4 5 4 2 Italy 15 10 13 24 10 6 15 12 17 19 Netherlands 14 13 20 18 15 7 9 8 9 14 Norway 2 0 0 0 2 2 2 3 4 5 Portugal 4 2 3 3 3 0 1 1 0 2 Spain 3 8 20 11 10 12 11 11 9 22 Sweden 5 6 8 7 4 2 6 6 5 13 Switzerland 11 7 5 7 4 1 2 1 4 0

Total (CE) 105 105 158 166 118 85 95 100 104 182

UK 646 709 691 656 618 642 637 711 701 685

Total (inc UK) 751 814 849 822 736 727 732 811 805 867

Source: CMBOR/Barclays Private Equity/Deloitte

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Panel B: Value of Buy-outs/Buy-ins (€m)

Country Name 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Austria 72 128 95 680 734 47 154 303 88 28 Belgium 147 414 820 2595 337 1744 517 1448 2266 4057 Denmark 411 263 267 2173 1313 500 1391 848 260 7060 Finland 724 440 560 1085 675 1047 480 1039 977 2044 France 2189 5275 6198 8387 6503 6387 15557 8772 11489 20714 Germany 1704 3538 5265 4629 15084 7229 8143 11908 17915 11727 Ireland 116 119 244 1475 259 5021 4930 747 970 770 Italy 1146 3121 673 2756 2555 1002 3428 7773 3013 17512 Netherlands 1001 1059 3528 2906 1856 4433 1870 4958 7612 10256 Norway 315 180 22 225 1004 1370 142 308 455 426 Portugal 158 64 83 206 83 2 26 54 8 76 Spain 227 374 859 1715 941 1528 2069 934 2274 9391 Sweden 700 1375 928 2926 3169 3005 1116 2226 1701 4702 Switzerland 1316 2426 1347 1013 1772 715 2766 864 1570 563

Total (CE) 10226 18776 20889 32771 36285 34030 42589 42182 50598 89326

UK 12555 17114 23273 26864 38349 31343 24844 23570 30144 35406

Total (inc UK) 22781 35890 44162 59635 74634 65373 67433 65752 80742 124732


Buy-outs have also become a global phenomenon. Besides the US, where the market first took off and currently is enjoying a resurgence of activity, buy-out markets are developing in Japan and elsewhere in the Asia-Pacific region. The economies of Central and Eastern Europe are also witnessing the growth of a new phase of activity following the initial role of buy-outs in the transition from Communism. This worldwide activity demonstrates convincingly that the buy-out market has long ceased to be the “nine-day wonder” on which one of the founders of CMBOR was warned by a senior colleague he was wasting his career! It has become a major part of the takeover market and is also consistently the most highly performing sector of the venture capital and private equity market in terms of portfolio returns. Nevertheless, mid-way through the first decade of the third millennium, the buy-out market faces a number of challenges in terms of sourcing deals at attractive prices; finding novel ways to fund deals and compete with new market entrants; and effecting timely exits that will generate target rates of return. The 20th anniversary of CMBOR provides an opportunity both to undertake a retrospective review and to consider future prospects for the buy-out market:

• What have been the main developments and changes in the market over the last 20 years?

• What have been the effects of buy-outs in terms of wealth creation, corporate performance and the development of an entrepreneurial economy?

• What challenges are there for future market development?

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3. Buy-out Market Development

The UK market

The development of the UK buy-out market has been characterised by five distinct phases. Although there had been buy-out type deals stretching back to the nineteenth century, the first phase of the modern buy-out market in the UK began in the early 1980s (Figure 1). In the context of a deep recession, many deals involved failed firms or firms restructuring to avoid failure. Relaxation of the prohibition on firms providing financial assistance to purchase their own shares in 1981 reduced the barriers for lenders to obtain security for the funds they advanced. The introduction of a secondary tier stock market in 1980 (the Unlisted Securities Market) opened up the possibilities for realising exit gains from smaller management buy-outs (MBOs).

Fig. 1: UK Buy-outs/Buy-ins

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The second phase involved rapid market growth from the mid-1980s to the end of the decade. Buy-outs were increasingly the result of considered refocusing strategies and a first peak was reached in 1989. Buy-outs offered an alternative disposal route to a trade sale to a third party. A buy-out was especially attractive where the vendor sought a speedy low profile sale or when few external bidders were present. The advent of specialist private equity and mezzanine funds along with entry by US banks from the mid-1980s helped fund this development. The third phase involved the collapse of large deals and the resurgence of deals involving distressed firms in the recession of the early 1990s. Like in the US, both the number and value of management buy-ins (MBIs) fell sharply as it became apparent that, while there had been significant gains from a substantial proportion of early management buy-ins, those completed in the late 1980s with high leverage and requiring unbundling of assets were generally faring less well. It also became clear that the new management in buy-ins had often not been able to identify beforehand the full

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extent of the problems in the companies they acquired. Furthermore, the advent of the recession exacerbated these problems and made turnarounds longer and more difficult. Many foreign banks left the market and the clearing banks that remained active tightened their terms and covenants. Both private equity and debt providers were heavily involved in restructuring the problem cases in their portfolios and some disbanded their lending teams specialised in buy-out type transactions.

The ending of the recession in 1994 saw the emergence of a fourth phase involving rapid growth in market value, which reached a new peak in 2000. A greater focus on larger transactions by investing parties caused the number of deals to fall. The years after 2000 were initially marked by a major reassessment of the market in the wake of the collapse of the dot.com boom and its wider repercussions, but a subsequent resurgence began in 2004, the start of the current phase five. An overview of the major events in the evolution of the buy-out market over the past 20 years are presented in Table 2. Compared with the evolution of the Continental European market over the same period, the UK buyout market began to develop much earlier. The largest deals by year are presented in Table 3 for the UK and Table 4 for Continental Europe.

Table 2: Management Buy-outs 1986-2006: Major Highlights

UK Continental Europe 1986 Emergence of bought deals and US banks; First

going private buy-outs involving recommended offers (Gomme, Raybeck). First over £250 million UK Buy-out Fund.

CMBOR begins to record the deals across CE in earnest. There were 167 buy-outs with a combined value of €1 billion. First PTP recorded in France and Sweden.

1987 Emergence of large buy-outs and growth of going privates; Privatisation buy-outs record market share (10.3) per cent) and deal volume (32) but receivership buy-outs record low at 0.6 per cent; Strong growth in Western European market. 100th buy-out flotation.

First investment in CE firms by US financiers (in France and Spain).

1988 First mezzanine debt fund; buy-ins exceed 100 deals and £1 billion value in a year for the first time; peak year for subsequent buy-in failure.

First PTP in Denmark and the Netherlands. Market value exceeds €5 billion for first time. Beginning of first market boom due to rapid growth in the number and types of financiers and major growth in management buy-ins.

1989 Emergence of hostile LBOs and unbundling; Record total deal value £7.5 billion. First £2 billion transaction (Isosceles). First 500 MBIs; Record MBO trade sales; almost £1 billion raised for UK buy-out specific funds.

First investment in German buy-out by US financier. First use of mezzanine by 3i (investment in Lignotock in Germany).

1990 Collapse of large highly leveraged deal market; resurgence of smaller buy-outs and those from receivership; record total buy-out/buy-in deals volume (597) and of buy-outs (486). UK interest rates at their highest.

Deal numbers peak for the first time at 413. Europe-wide recession closes in.

1991 Buy-outs from receivership record 19.3 per cent of deals; record failures of buy-outs/buy-ins at 124.

A relatively quiet year for the buy-out market with deals numbers falling compared to previous years to 336 and value falling similarly to €5.5 billion.

1992 Buy-outs and Buy-in account for record 57 per cent of all takeovers and 35 per cent of their value; Emergence of Eastern European Buy-outs.

First PTP in Germany. Surge in buy-outs in Germany due privatisations by Treuhandanstalt post reunification. Basel I implemented in G-10 countries (risk management in banking). First secondary buy-out recorded by CMBOR.

1993 500th buy-out recorded by CMBOR; Buy-outs from receivership decline from earlier peak; Buy-outs from UK parents reach record low of 39 per cent; 200th buy-out flotation.

Second highest number of privatisations across Europe.

1994 Emergence of Serial Buy-out/Buy-in Entrepreneurs. All-time Privatisation buy-outs exceed 200. First

The number of buy-outs from foreign parent divestments peaked for the first time at 74; those

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1,000 MBIs; record buy-out fund raising; Record flotations of buy-outs/buy-ins at 48.

from privatisations fell from the year before but remained a significant source.

1995 Emergence of Investor Buy-outs (IBOs); Buy-ins account for a record 36 per cent of the buy-out/ buy-in market; Buy-outs of privately held/family businesses at record 40 per cent of market; record trade sales of buy-outs/buy-ins at 95; 10,000 buy-outs recorded by CMBOR. The Alternative Investment Market (AIM) was introduced.

SWX (Switzerland), the world’s first fully automated stock exchange, comes into operation.

1996 Total buy-out market at £7.8 billion exceeds previous 1989 record. Buy-ins rise to a record 55 per cent of total M&A. Rise of secondary buy-outs and a new record for exits.

The end of a Europe-wide recession leads to the second market boom and the buy-out market begins to take off again. Market value exceeds €10 billion for the first time.

1997 Another record year beats the £10 billion barrier. Exits down with flotations only two thirds of previous year. New trend of privately sourced deals exceed UK divestments. Continental buy-out market receives increasing focus.

Neuer Markt launched in Germany for smaller companies. Geberit Beteiligungs was Switzerland’s largest buy-out (€1.3 billion). Deal numbers across CE exceed 500 for first time.

1998 Growth of IBOs and MBIs lead the third successive record market value year at £14.5 billion. PTPs responsible for 20 per cent of value. Trade sales reach record high, but flotations continue to fall.

Tecnologistica (Italy) was the first tertiary buy-out in CE. Deal value exceeds €20 billion for first time. The second highest number of buy-outs from family firms is recorded. MBIs become a major feature of market.

1999 Buy-outs over £100 million reach record numbers to boost value to another record £16.8 billion. PTPs account for a quarter of market value; deals under £5 million drop by a third. Exits slow, particularly flotations. Emergence of US fund interest.

Andritz largest buy-out in Austria (€481 million)

2000 At £23.9 billion market is more than four times 1995 value, but depressed number of smaller and mid-market deals. Family/private deals lowest since 1986. PTPs smash previous record. Receivership show largest increase in exits. 15,000 buy-outs recorded by CMBOR. First £3bn deal (MEPC/Leconport, £3.5 billion)

Dyno Nobel was Norway’s biggest buy-out (€680 million). Alfa Laval was Sweden’s largest buy-out (€1.6 billion). Euronext formed in September in order to take advantage of the harmonisation of the European Union financial markets.

2001 Value falls 20% to £19.2 billion as mega deals disappear and PTPs slow. Big drop in trade sales emphasise exit difficulties but funds raised boom to an even higher amount.

Eircom Ireland’s largest buy-out (€4.8 billion). Cognis Holland’s biggest buy-out (€2.5 billion). Basel II deliberations begin. Kabel Deutschland CEs largest secondary (€2.1 billion).

2002 Further fall in volume, value down another 20 per cent. Large deals and PTPs disappearing. Buy-outs still account for nearly half of M&A activity. Trade sales continue to drop, but receiverships and secondary buy-outs increasing.

Neuer Markt closes after losing 95% of its value in 2.5 years. Legrand was largest buy-out in France (€5.1 billion). Telediffusion de France was largest privatisation (€2.4 billion). No. of buy-outs from the high technology sectors at their highest.

2003 Buy-out market stabilises: 6 percent increase in value; 8 per cent increase in volume. PTPs highest for three years. Exits still flat but secondary buy-outs almost equal to trade sales.

There were more buy-outs originating from the business services sector than in any other year.

2004 Year ends strongly with second highest ever value of £20.1 billion. Mega deals bounce back with 47 above £100 million. Record exits largely due to secondary buy-outs. Fund raising lowest since 1996. 20,000 buy-outs recorded by CMBOR.

Record value of buy-outs in Germany (€17.9 billion). Celanese was largest ever German buy-out (€3.1 billion). CBR first German buy-out over €1 billion. Deal value across CE exceeds €50 billion for first time.

2005 Another strong year with highest ever value at £24.2 billion. Buy-outs over £100 million a record 49. Highest number of exits with secondary buy-outs highest recorded. First buy-out financed by Hedge Fund.

There were 694 buy-outs with a combined value of €88.7 billion. Record number of buy-outs in Germany (113). SBS Broadcasting Belgium’s largest buy-out (€2.1 billion). Wind Telecommunications was Italy’s largest buy-out (€12.1 billion). Amadeus was Spain’s largest buy-out (€4.3 billion). Sanitec was Finland’s biggest deal (€1 billion). Frans Bonhomme and Eau Ecarlate (both France) were the first quaternary buy-outs. Highest number of buy-outs from family firms.

2006 Slow start. TDC of Denmark becomes largest ever buy-out in the whole of Europe including the UK (€13 billion).


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Table 3: Largest Deal By Year: UK 1986-2005

Year Largest Deal Value/£m

1986 VSEL (£100 million) 100

1987 MFI (£717 million) 717

1988 Reedpack (£680 million) 680

1989 Isoscles/Gateway (£2.2 billion) 2200

1990 Del Monte Foods Int (£230 million) 230

1991 Bristow Aviation (£155 million) 155

1992 Gardner Merchant (£402 million) 402

1993 McBride (£282 million) 282

1994 The Magic Pub Company (£108 million) 108

1995 Integrated Transport Systems (£215 million) 215

1996 Angel Train Contracts (£672 million) 672

1997 William Hill (£700 million) 700

1998 IPC Magazines/IPC Media (£860 million) 860

1999 Avecia (£1.4 billion) 1400

2000 MEPC/Leconport (£3.5 billion) 3500

2001 Yell Group (£3.1 billion) 3100

2002 Unique Pub & Voyager Pub/The Pub Estate (£2 billion) 2000

2003 Spirit Amber (£2.5 billion) 2500

2004 The Automobile Association /AA (£1.8 billion) 1800

2005 Warner Chilcott plc (£1.6 billion) 1600


Table 4: Largest Deal by Year: Continental Europe 1986-2005

Year Name Country Value/€m*

1986 Draka Kabel Netherlands 96

1987 IDI France 261

1988 Darty France 1064

1989 Swedish Match Sweden 630

1990 Sicli France 384

1991 Elm Leblanc France 163

1992 Adrex\Neopost France 329

1993 Nordchoklad/Svea Choklad Sweden 359

1994 Nutreco Netherlands 563

1995 Tag-Heuer Switzerland 448

1996 Mettler Toledo Switzerland 552

1997 Seat Pagine Gialle Italy 2223

1998 Kappa Packaging Netherlands 1552

1999 Friedrich Grohe Germany 1372

2000 North Rhine Westphalia Cable Germany 2966

2001 Eircom Ireland 4810

2002 Legrand France 5130

2003 Seat Pagine Gialle Italy 3030

2004 Celanese Germany 3100

2005 Wind Telecommunications Italy 12100

Source: CMBOR/Barclays Private Equity/Deloitte * where Euro not established (pre 1998) an exchange rate for £/€ of 1.6 has been used.

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Fund raising

Fund raising in the UK has evolved significantly over time and has more recently grown substantially to a record high of £18.6 billion ($ 24 billion) in 2005. Over the period 2000-2003, buy-out funds raised in both the UK and Continental Europe exceeded funds invested in each year (Table 5). In contrast, this trend was reversed in 2004 as the amounts invested exceeded funds raised by a considerable margin.

Table 5: European Buy-out Funds Raised and Invested (€m)

2000 2001 2002 2003 2004

Funds Raised - CE (of which UK)

24,347 (12,265)

21,541 (14,286)

18,255 (12,323)

20,661 (13,732)

17,787 (7,975)

Funds Invested – CE (of which UK)

14,406 (6,871)

10,945 (3,863)

16,917 (7,519)

18,438 (9,446)

25,743 (15,128)

Source: EVCA. UK in parentheses

In the UK, the trend is for fewer funds each with more capital; institutional investors are persuaded of the attractions of private equity as an asset class. Institutional investors in the UK (pension funds, mutual funds, and insurance companies) indicate that they are likely to reduce their investments in all types of private equity in the future but that investments specifically in buy-outs will grow in importance. In contrast, evidence from Continental Europe indicates an intention by institutional investors to increase their commitment. In addition to the funds raised and invested within Europe, in recent years private equity firms from the United States have become much more prominent investors in European buy-out markets. Amongst the reasons for their international expansion are concerns about the returns on US private equity deals because: (i) the market becomes more competitive, (ii) the reluctance by institutional investors to commit to early stage funds has plummeted since the end of the dot.com era, and (iii) the opportunities for restructuring in the UK and Continental Europe - an environment of lower interest rates – are perceived to be greater. The amount invested in UK firms by US funds has risen from £1.6 billion in 1999 to £5.3 billion in 2005 (Figure 2).

Hedge funds have also emerged in the UK and provide an additional source of investment funds in the buyout market. Recently, hedge-fund returns have not been as attractive as those of buy-out firms such that last year more new money went into private equity than into hedge funds. Hedge-fund managers are now pushing into less liquid markets, such as mid-cap stocks, the traditional territory of private equity firms. The majority of hedge funds active in the leveraged buy-out (LBO) market have focused so far on providing subordinated debt, such as second-line and mezzanine debt, and payment-in-kind securities (PIKs). As such, they may represent more serious competition for providers of mezzanine and junior debt than the private equity funds themselves. Increased competition for traditional private equity players has also come from new entrants such as government-sponsored operators like Dubai International, family offices and wealthy entrepreneurs. These players led 33 per cent of transactions over £100 million in the UK during the first quarter of 2006, compared with only 8 per cent of these larger transactions for the whole of 2005 and none at all in 2001.

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Fig. 2: US-Based Buy-out Funds Raised, 1999 – 2005 (£billion)

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Sources of buy-outs

There are multiple sources of management buy-outs of which the trend over the five yearly periods covering the life-cycle of the UK market is shown in Figure 3. In contrast to the US, the main reason for buy-outs in the UK has traditionally been the divestment of part of a local company. Divestment induced buy-outs were prevalent in the late 1980s as large conglomerates frequently divested their non-core activities (although this phenomenon has declined in the second half of the 1990s).

Fig. 3: Sources of UK Management Buy-outs/Buy-ins (Volume %)

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State sector privatisation gathered pace during the second half of the 1980s and produced a sharp increase in management-employee buy-outs. In these privatisations, the specific skills of the incumbent management was key to the value of the business, trade union influence remained particularly strong and trading relations were to continue with the former parent. New opportunities were also created in management buy-ins which matched experienced entrepreneurial outside managers with underperforming businesses where poor internal management made a management buy-out infeasible and where problems emerged selling to corporate acquirers. Buy-outs of listed companies also began to develop, but few involved buy-outs as a hostile bid defence. In the recession of the early 1990s, specialist buy-out acquirers became one of the main purchasers of companies in an environment where reduced corporate profits both provoked sell-offs and adversely affected the ability of established groups to make acquisitions. The pressures on senior corporate managers to maximise shareholder returns in their disposal programmes meant that in the second half of the 1990s, incumbent managers of subsidiaries were no longer seen as the preferred bidder especially for larger transactions. The difficulties in completing traditional divestment management buy-outs, were accompanied by the growth of externally-generated buy-out acquisitions of subsidiaries, notably the investor-led or institutional buy-out (IBO), as well as leverage build-ups. More recently, family firms (and those in private hands) have provided the majority of buy-outs, reflecting the need of founding owners for a successor and/or wealth diversification, as well as a greater effort by intermediaries and financiers to target these kinds of companies given the increasing difficulties with divestment cases. The last major privatisations in the late 1990s involved the further sale of bus services and the break-up of the state-owned rail industry, which alone produced 33 management buy-outs and buy-ins. Since the late 1990s, the major changes in the prominence of deal types have been the growth in importance of secondary buy-outs and public-to-private buy-outs (PTPs), and the shift of attention to larger deals caused by the severe challenges in exiting smaller deals. The reason why so many secondary management buy-outs and buy-ins emerged reflected the pressures on closed-end funds established during the boom years of the late 1980s to repay cash to funds' providers. Although private equity providers had previously been reluctant to purchase companies from each other, the pressing need for existing institutions to obtain an exit due to the limited life of their fund had changed the attitudes. The propensity for private equity providers to buy portfolio companies from other financial investors has been catalysed by difficulties in finding attractive deals from other sources as corporate restructuring programs had passed their peak and auctions had pushed up prices. Over a third of the total UK market value is now accounted for by secondary buy-outs. There were 91 secondary buy-outs in 2005 compared to merely 29 in 1995. PTPs have developed over the life-cycle of the market’s growth, starting somewhat later than general activity in 1985 and with a marked resurgence from the second half of the 1990s. Due to the high costs and risks involved, initial public-to-private deals were relatively small and involved incumbent management. However, as the process became better understood and those initial deals were successfully completed, there was a growing tendency towards investor-led or institutional buy-outs (IBOs) of larger public companies. Although they remain relatively few in number, PTPs have become larger, suggesting that the opportunities to restructure listed corporations by taking them private may be greater than once thought. Both in terms of volumes and values PTPs have been far greater in the recent period than in the top deal years of the 1980s, reaching a peak in 1999-2000, subsequently easing before

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recovering in value terms in 2005 (Figure 4). The Continental European trend is similar.

Fig 4: PTP Numbers and Values as Share of Total Market

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Financial structure of buy-outs

In contrast to US experience, UK buy-outs during the 1980s became increasingly important relative to the overall private equity market and accounted for more than half of the value of UK PE investments since 1987. Significant entry by US banks boosted the provision of senior debt and mezzanine finance, while a number of new specialist funds for investment in buy-outs were launched. Although domestic UK lenders appeared reluctant to become involved in transactions where asset sell-offs were necessary to repay debt, such approaches applied by US entrants to UK buy-outs became gradually an accepted feature of the larger end of the UK market. As deal size increased from the mid-1990s, innovations in the use of financial instruments also grew. Most significantly for the development of the larger end of the buy-out market was the emergence of a European subordinated high yield debt market involving buy-outs. The initial demand for greater amounts of financing in larger buy-out transactions could not be met with traditional senior debt or privately-placed mezzanine such that prior to 1997 UK buy-outs resorted to the US high yield bond market. Although non-amortising senior debt instruments were introduced at this time primarily by market entrants from the US, a demand for a European currency-denominated high-yield instruments buy-out financiers in the UK emerged. Such high-yield instruments enable buy-out financiers to manage the risks between cash flows and highly geared capital structures without creating foreign exchange risks. Importantly, from 1997 onwards, financial institutions grew eager to invest in these kinds of instrument. The reason why this increased appetite for high-yield paper arose was the search for higher-yielding securities in an environment of low nominal yields and a dampening of volatility in traditional asset classes. Securitisation, already popular in the US buy-out market, also gained momentum in the UK and Continental Europe during this period.

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The proportion of debt in UK buy-outs has varied over the past 20 years. While the percentage of debt in buy-out deals peaked in the late 1980s in the UK and sharply declined in the early 1990s, recent lower interest rates have been associated with the relative rise debt, which now accounts for 51% of the average deal financing (Figure 5).

Fig. 5: Average Deal Structures and UK Interest Rates

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Equity Mezzanine Debt Other UK Interest Rates


The number of equity, mezzanine and debt providers which participate in any one buy-out has evolved also over time. In the early years (1985-89), when the market was immature, syndication was more common. The top ten buy-outs during this period were funded by, on average, ten equity providers, 11 debt providers and two mezzanine providers. These high numbers are indicative of the - at that time - relatively smaller, less experienced fund providers and their desire to spread risks. As the UK buy-out market has matured the number of providers involved in buy-outs has fallen. For the top ten buy-outs over the period 2001-5, there were on average three equity providers, four debt providers and one mezzanine provider.

Pricing multiples (e.g. P/EBIT) have followed a generally upward trend since the late 1980s. Mid-sized buy-outs were generally purchased on average multiples of between eight and ten until the mid 1990s, but have risen to 12 and 13 over the past decade. Similarly, buy-outs over £100 million, which were few in number up until the late 1990s, initially had average multiples of below ten but have since risen sharply to over 15. With competition for mega buy-outs remaining high it remains to be seen whether the scope for value uplifts can continue to justify this trend.

The buyout bid

In order to gain control of a buy-out target, investors usually pay a premium to the market value. Our recent study on UK PTPs from 1997-2003 shows that the average premium is 41% (measured over 1 months prior to the announcement), with a share price reaction to the PTP announcement of up to 30%.

Consistent with most US evidence, our analysis indicates that pre-transaction shareholders in the UK share in the value created by taking undervalued companies

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private. An important driver of PTP deals appears to be that management believes that the market has incorrectly valued the company’s prospects. Going private enables management to realise perceived opportunities that could not be exploited while being listed. The potential for increased incentive alignment in the private firm also seems an important source of value creation in PTPs. Additionally, UK evidence shows that firms with outside blockholders (especially corporations and financial institutions), enjoy lower benefits from going private as the more effective monitoring in place before buy-out leaves less scope for operating performance improvements subsequent to the PTP transaction. Our evidence also shows that PTPs have on average a higher concentration of insider ownership and tend to separate the functions of CEO and Chair of the board more often (as suggested by the Combined Code). Additionally, there is some evidence that the costs of maintaining a listing is a reason for companies to go private.

Most buy-outs are profitable and are not bought out as a consequence of financial distress. Our study shows that, in a sample of 182 UK PTPs over the period 1997-2003, only 5 firms were in financial distress before the transaction and dependent on the benevolence of banks for the continuation of their operations. In three of these five cases, the banks had actually announced that they were terminating their investments, such that these firms had to seek a new life-line. As the bidders in these transactions have to supply the company with additional funds and assume a high risk of failure, they usually pay a discount to the going-concern market value.

PTPs are costly to undertake and the risk of bid failure is significant. Private equity bidders for listed companies may use irrevocable commitments in an attempt to ensure the success of a PTP proposal and reduce the costs associated with failure, as well as avoiding a bidding contest that would potentially reduce their returns from the investment. Irrevocable commitments are widely used in UK PTPs: 23.40% of a sample of 155 PTPs completed in the period 1998-2003, gained up to 20% irrevocables and some 60% achieved at least 50.06% support from shareholders prior to the bid announcement. Private equity firms use their expertise to obtain higher irrevocable commitments to the deal from significant shareholders in order to accept the bidder’s bid before the offer is made public. This approach is especially relevant where the incumbent management holds significant stakes and existing institutional shareholders are locked in. The announcement of irrevocable commitments may make other potential bidders less likely to enter the contest with an alternative bid as the commitment ensures that, without any higher alternative bid, the agreement to sell the share becomes binding. Those proposing a PTP are more likely to gain the backing of other shareholders the greater the bid premium and the more likely the private equity backer is to be reputable.

Exiting

Private equity firms are under significant pressure to achieve their target returns and hence work towards a timely exit. The type of exit has varied over the lifetime of the UK buy-out market as shown in Figure 6. In the UK, trade sales have always been the most common form of exit except over the recessionary period 1990-1994 when receivership occurred more frequently. Initial public offerings (IPOs) were often chosen in the late 1980s while the percentage of exits accounted for by trade sales has been fairly stable since 1985.

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Fig. 6: Exits of UK Buy-outs and Buy-ins (%)

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Secondary buy-outs have gained importance since the early 1990s and now account for almost a third of all exits. A number of factors have driven the need of financial investors to sell of their portfolio firms to other PE firms. These reasons include the difficulties in exiting buyouts via IPOs, the reduced acquisition appetite by corporations seeking to refocus (especially for smaller deals), and the need for private equity firms to exit from deals when PE funds come to the end of their life.

An increasing number of buy-outs have had several subsequent private equity owners (sometimes referred to as tertiary or quaternary buy-outs). At the end of 2005, a total of 41 companies had gone through at least three buy-outs. These tend to be mid-range deals that are cash generative in mature sectors which can be easily re-leveraged. Exit values in the UK were at record levels in 2005, driven largely by major exits through secondary buy-out. The total value of exits reached a record of £18 billion in 2004 and remained high at £15 billion in 2005; this is more than twice the total value of exits that took place a decade earlier.

In recent years, with the traditional forms of exit proving somewhat difficult, refinancings and partial sales have become a popular way for private equity houses to cash in on part of their investment but at the same time keep control of their portfolio company. There are two common methods of refinancing. First, the PE house can refinance a business they own by getting it to borrow more money and then paying themselves special dividends from the cash raised. Second, the PE house can sell some of their property assets to a third party (for example to an insurance company) and then lease the property back. The lump sum raised can then be transferred to the PE firm. In 2005 refinancings accounted for a third of the total value realised in the UK compared to about a tenth in 1997 (Table 6). A partial sale of the portfolio company provides another means of realising part of the initial investment without losing control and these sales made up just under a third of the total value realised in the UK in 2001, coinciding with the falling value of the FTSE 100, but have since become less popular and now account for less than 10% of the total.

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Table 6: Total Value Realised for UK Buy-outs/Buy-ins

Year Total Exit

Value

(£m)

Total

Refinance

Value

(£m)

Total

Partial

Exit Value

(£m)

Total

Value

Realised

(£m)

1997 5890 856 55 6801 1998 4433 1742 108 6283 1999 6502 1042 927 8471 2000 9854 4234 2648 16736 2001 8451 4194 5534 18179 2002 10844 3663 3080 17587 2003 8852 2508 2057 13417 2004 18213 10294 5751 34258 2005 21705 12589 6239 40533


Financial distress represents a negative aspect of exit. Over the last twenty

years, there have been 12,267 UK buy-outs of which 1,431 have so far entered receivership.2 The largest buy-out failures in the UK are shown in Table 7.

Table 7: Largest buy-out failures: UK 1986-2005

Year of

Buy-out

Deal name Initial Deal

Value (£m)

Receivership

Year

1989 Magnet 630.7 1992

1988 Lowndes Queensway 446.8 1990

1999 Greycoat/G2 Estates 282.5 2004

2000 First Leisure (Nightclubs)/Whizalpha 210.5 2004

2000 Finelist/Europe Auto Distribution 159.2 2000

1990 Landhurst 157 1992

1987 International Leisure Group 155 1991

1995 The Sweater Shop 150 1998

1999 Lambert Fenchurch/HLF Insurance/Heath 130.9 2003

1999 Tempo/KF Group 130 2001


Buy-outs in Continental Europe

Despite the growth in UK and Continental European markets noted earlier, the maturity of the various buy-out markets differs markedly. An indicator of the relative market maturity is the ratio of the value of buy-out transactions to a country’s GDP across Europe (Figure 7). The UK is by far the largest single buy-out market as a proportion of GDP while the French and German markets, fare less well compared to their overall buy-out market size. Most notably, Spain and Italy have, as relatively large economies, undeveloped buy-out markets.

2 The receivership rates varies according to vintage year, peaking at 21% for buy-outs completed in the

boom years of 1988-1990 which subsequently encountered problems in the recession of the early 1990s (see CMBOR, Management Buy-outs Quarterly Review, Autumn 2005 Table A39 p.73). The failure rate of buy-outs completed during the first half of the 1990s was approximately 12% by Sept. 2005.

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Fig. 7: Buy-outs as a Percentage of GDP

0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% 4.50%

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Netherlands

Germany

Belgium

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Sweden

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2004 2003 2002

Source: CMBOR/Barclays Private Equity/Deloitte and OECD

There are important differences between countries across Europe in terms of

the supply of buy-out opportunities. In the UK most opportunities came from the restructuring of diversified groups, with going private transactions becoming more important latterly. In France, deal opportunities initially arose from a need to sell businesses by the owners of family firms facing succession problems. Succession and

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portfolio reorganisation issues in the large number of family controlled listed companies in France also contributed to a marked growth in buy-outs. Divestments from corporations have currently become a major part of the French private equity market and are stimulated by growing competitive pressures on French industry and an increasing focus on corporate governance and shareholder value. In contrast, reluctance by founders of small and medium sized firms in countries like Germany, Spain and Italy, both to let go and to sell to private equity firms has restricted market growth. Buy-outs from family firms have become relatively less important as divestments have become more important alongside secondary buy-outs. The European market for PTP transactions is still small, in part because Continental European countries have fewer listed companies. Culture may also be important, with in some countries managers wishing to avoid the burden of a listing in the first place while in others managers may be too proud of their listing to even rationally consider going private. In CEE, the transition from communism initially created opportunities to privatise state owned assets but subsequent restructuring is also generating new opportunities as Western European corporations undo some of their previous acquisitions, private firms created post-communism begin to look for an exit, domestically based firms begin to restructure and listed corporations seek funding for growth in an environment of relatively weak capital markets.

Differences in attitudes to entrepreneurial risk and the willingness of management to undertake a buy-out are also important. The most notable distinction is that in the UK, managers are much more prone to take risks than other countries. In the mean time, growth in France is fuelled by a more positive entrepreneurial culture towards buy-outs. In contrast, the willingness of German managers to undertake buy-outs has traditionally been low but is changing as a high number of corporate restructurings has significantly reduced managerial security of tenure.

The infrastructure to complete buy-out deals differs significantly across countries. Again, the UK has more developed private equity and debt markets, better intermediary networks and more favourable legal and taxation frameworks. It is notable that in the other countries, changes are underway to improve their institutional and regulatory infrastructure. The French private equity industry grew rapidly from the mid-1980s, with law firms playing a particular important role in the diffusion of the buy-out concept. The infrastructure to complete German deals was for a long time less than favourable – few intermediaries, an under-developed private equity market and high rates of taxation. Many of these restrictions did not begin to ease until the mid-1990s, such as relaxation of the capital gains tax regime relating to share disposals.

There are notable differences in the role of stock markets in facilitating IPOs as exit routes for private equity firms. However, even developed stock markets provide limited opportunities to exit buy-out investments, unless these buyouts are larger, fast growing businesses. Accordingly, M&A markets assume an important role to enable businesses to be sold to other corporations. As many corporations complete their restructuring and as markets become more concentrated and global, there is less scope for the trade sale exit route, especially for smaller deals. This shift has seen the emergence of the secondary buy-out or buy-in. This option is important in the more developed UK market but as the other markets become more mature and need to seek exits, the ability to achieve a secondary buy-out may be useful in an environment of relatively weak stock and markets for corporate control. In France, the development of the Second Marché and the Nouveau Marché enhanced the scope for the realisation of buy-out investments although partial sales have provided a frequent exit route for investors.

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4. Effects of Buy-outs

Buyouts are a means for refocusing the strategic activities of the firm. Our evidence shows that buy-outs are followed by significant increases in new product development and other aspects of corporate entrepreneurship that would not otherwise have occurred.

Buy-outs improve productivity. In the largest buy-out study to date, we assessed the total factor productivity (TFP) of plants before and after management buyouts (MBOs), using a longitudinal dataset of approximately 36,000 U.K. manufacturing establishments. Some 4,877 of these plants experienced an MBO during 1994-1998. The results suggest that MBO establishments were approximately two per cent less productive than comparable plants before the transfer of ownership. After the MBO, plants experienced a substantial increase in productivity of approximately 90 per cent.

Buy-outs have also been found to have an important effect on human resource management processes in the firm. In particular, buy-outs report an increase in high commitment management practices, with this change being more likely where existing managers and employees are involved in ownership. UK buy-outs also upgrade HRM practices where appropriate to support corporate and business strategies, suggesting that buy-outs release managers from complex corporate level structures that may have been inappropriate for the particular enterprise that was bought out.

Our evidence shows that IPOs of UK buyouts result in positive and highly significant initial share price premia. MBOs (partially) controlled by private equity firms are more underpriced than MBOs without private equity. Private equity backed MBOs in the UK tend to go public at an earlier stage than their non-private equity backed counterparts. UK PTP MBOs that are backed by more active private equity firms tend to exit earlier and to perform better than those backed by less active private equity firms.

Private equity returns have been declining in recent years which is not surprising considering the negative trend in the stock market over the period 2000-2004. Yet, fund level data published by national venture capital associations and the European Venture Capital Association (EVCA) consistently show that the internal rates of return (IRRs) on buy-out funds outperform early stage and all stage venture capital funds. Our analysis of buy-out firm level data relating to the IRRs on enterprise value and invested equity for on 321 exited buy-outs in the UK for years 1995 to 2004 shows that the average stock market index-adjusted Enterprise Value (EV) has an IRR of 22.2% and that the average equity IRR is 70.5%. As might be expected, IPO exits outperform trade sales and secondary buy-outs. Larger buy-outs, those with an initial transaction value above £100 million, have greater returns than medium or smaller buy-outs. The study shows that the self-monitoring effects of managerial equity stakes and their high incentives is one of the main drivers of increases in enterprise value. However, the effect reverses when management controls the majority of equity. This managerial entrenchment effect is limited to very small buy-outs that fall outside the target size range of most financial sponsors. In the average UK buy-out, leverage and interest coverage are also positively related to value increases.

In UK buy-outs that fail, secured creditors recover on average about 60 per cent of their investment. Higher amounts of debt are associated in the UK with an increased probability of failure or restructuring need. However, many of these firms may be restructured and sold as going concerns.

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5. Prospects and Challenges

Finding buyout deals

Data on buy-outs of subsidiaries and parent-to-parent sales suggest that divestment activity by UK corporations has passed its peak. However, as corporations continue to make acquisitions, opportunities for divestment buy-outs are likely to remain, especially where post-acquisition integration issues are not adequately addressed. Furthermore, if corporates continue to face difficulties in providing appropriate incentivisation for management of subsidiaries there may also be scope for divestment buy-outs. The scope for restructuring of larger corporations seems to be greater in Continental Europe and private equity firms are increasingly likely to look for attractive deals in this environment.

While there is a vast swathe of family-owned firms, many of which have an ageing founder, little active succession planning is undertaken. A central issue concerns the views of founders regarding their future involvement with the business, which may have important implications for the negotiation of the deal, especially the price at which they are willing to sell. Owners of private businesses in the UK seem in general to be more willing to sell than their counterparts in Continental Europe.

In the context of declining average buy-out returns, greater prevalence of auctions, record levels of fund raising and difficulties in identifying attractive new deals, an important issue concerns how buy-out financiers can generate higher returns to satisfy the investors in their funds.

The development of corporate governance codes has meant that there is little difference in the board structures of firms that are bought out and those that remain listed. Nevertheless, private equity firms are able to provide more active governance and advice than public markets. However, with high entry multiples, there is greater pressure to create upside gains in addition to making the operations more efficient. This suggests a need for further differentiation between private equity firms and segmentation of the market.

Competiton for traditional private equity financiers

The entry of hedge funds into the Continental European buy-out market poses a competitive challenge to existing financiers. The expectation is that, while hedge funds may have a role as a trigger for restructuring, their emphasis may be on relatively shorter term cost reduction. The extent to which they can effect upside developments may be limited. Similarly, the approach of hedge funds once an investee becomes distressed is unclear. Will they be more likely to walk away or be more focused on generating fees when approving recapitalisations? We expect that different types of hedge funds will emerge with different mandates and a focus on different types of buy-outs. The presence of hedge funds also has implications for the approach adopted by existing debt providers in the market. As deals become larger, securitisation will become more important, and its impact on the future buy-out market will far-reaching.

Exiting

The recent record growth in secondary buy-outs may help fulfil the desires of management to remain independent and enable private equity firms to obtain at least a partial exit. For the incoming investors it is evident that management have a proven track record, but a major question needs to be answered: will managers be buyers or sellers in the deal. This raises a further number of issues. First, when management are seeking to increase their equity stake, there may be a corresponding reduction in

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control by private equity firms. This may be problematical if it means that management are able to embark on risky growth strategies with little monitoring. When management are able to realise significant gains, motivating them to perform in the subsequent deal may also be problematical. A final, unresolved issue about secondary buy-outs concerns the possibility that limited partners may be asked by private equity firms to invest again in the same deal through a subsequent fund but at a higher price than the first time around. While exit from the first buy-out provides for realisation of capital gains, limited partners may take some convincing that further significant capital gains will be forthcoming.

6. Conclusions

Over the past two decades, European buy-out markets have continuously adapted to changing conditions. These markets have faced challenges relating to deal sourcing, the entry of new players, and the generation of returns.

Competition for larger buy-outs has forced prices higher but with record amounts of capital raised in 2005, it seems that large deal flow will continue to grow over the coming years. With strong buying power at the disposal of specialised venture capital, private equity firms and hedge funds and with the growing acceptance of club buy-outs, it may only be a matter of time before we see that very large firms (e.g. FTSE 100 companies) are taken private.

With the higher profile of the private equity asset class enabling buy-out funds to attract the best managers to target companies, banks have been more willing to gear up deals and even refinance them after a short period of time. Although, this strategy entails significant risks, it can also bring higher returns if it is successful. Growing concerns about the medium term performance of European economies and trends in interest rates are beginning to raise question marks about the degree of leverage in buy-out deals.

The UK market has become quite mature and has one of the highest proportions of buy-out values to GDP. If this remains at around 1.5 to 2 per cent, as it has over several years, then the buy-out market should grow at least in line with the UK economy. Elsewhere in Europe, pressures on larger corporations to restructure likely will lead to increased deal activity, notably divestments. The growing number of large secondary buy-outs provides useful liquidity for the buy-out market at a time when exits have become difficult. Currently, trade sale opportunities are growing once again and stock markets have become more benign, which help to allay building concerns from institutional investors over the recycling of capital seen in recent years.

management buy-outs 1986-2006 past achievements, future

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