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14 REALDEALS 4 June 2009
cash&costs
WorkiNG cAPitAl hArdPrivate equity is already well known for its focus on cash. But when sales are down, and new finance a precious commodity, it is essential that every last drop of working capital is squeezed from investee companies. by richard young
You kNoW thiNGs Are GettiNG serious
when businessmen invoke the spectre of private
equity in order to ram home their point. “One
of my clients summed it up perfectly,” says Tom
Aldridge, a senior vice-president with Celerant
Consulting. “He said: ‘We will do unto our cash
flow what a private equity firm would do unto
us.’ Many company managers have traditionally
focused on earnings per share or profits,
because that’s the headline in the reports or
directors’ bonuses are linked to it. But private
equity knows the value of cash.”
A recession-induced decline in sales – allied
to a scarcity of capital, higher credit risks and
nervous suppliers – is driving every company
finance function back to basics in search of
cash, even if they don’t currently fear a buyout
bid from the private equity world.
But for private equity managers discovering
a renewed zeal for portfolio management in the
absence of deals, hammering away at cash is
probably old news. After all, the model relies
on driving cash flows as hard as possible, and
forcing out costs in a way that might make many
lily-livered public company directors queasy.
But good intentions and clear objectives
don’t automatically mean every private equity-
backed business is working as hard as it could
to produce an optimum cash flow.
“The fundamentals are as true as they’ve ever
been,” says Brian Shanahan, director of working
capital consultancy REL. “You have to be good at
the basics – receivables, payables and inventory.
In most private equity-owned businesses, that’s
clearly understood at the strategic level. But
there can be a disconnect between those
strategic intentions and the front-line processes.”
At a time when fresh capital is hard to come
by and deals are thin on the ground, taking a
fresh look at working capital and costs – both
strategically and tactically – is a no-brainer for
valuations. “A lot of the private equity guys we talk
to are keen to have as much tangible value in their
funds as possible,” says Shanahan. “Most valuation
models show cash on the balance sheet as straight
assets, so the more receivables and inventory you
can convert, the higher the value you can report.”
cash in: being right first time“The key area for companies that need fast
results on cash is undoubtedly receivables,”
says Shanahan. “That’s where you get the quick
wins.” But there’s a problem: it’s also where
the economic downturn most obviously puts
additional strain on working capital. “In a
recession, customers are more likely to look
for generous terms or be struggling to pay,”
portfolio FDs. And for private equity managers,
knowing your portfolio management teams are
delivering on cash flow is a crucial factor in
deciding whether or not scarce capital ought
to be allocated in support of their plans.
getting a grip on cashMany private equity-backed finance directors
are only too aware of the need to keep an iron
grip on the cash position, of course. But
passionate management working under duress
– dealing with falling sales, for example – can
lose focus. Knowing the finance function is
prioritising cash, then, is a massive reassurance.
As one private equity-backed finance director
in the retail sector says: “No one is in any doubt
now about the value of sound cash forecasting.
My previous job was helping a business out of
administration, so I know how important a 13-week
cash flow forecast is. In the current climate, my
team can also see why that discipline is vital. It
gives us more confidence to plan what we do next.”
“We are managing cash flow more
aggressively,” says Peter Hatherly, chief financial
officer of Duke Street-backed Simple Health &
Beauty. “Our skincare range is actually gaining
market share, and growing sales do put extra
pressure on working capital. But at the same
time, we know that customers and suppliers are
attempting to manage their own working capital
by trying to extend payment terms.”
Portfolio businesses that have been living the
private equity cash mantra are also in a better
position to weather the downturn. “Cash is very
nice to have when times are uncertain,” says
Hatherly. “And if you have debt at the moment,
you’d be crazy to lose it – so it’s not a question of
looking for early repayment. Hanging on to as much
cash as possible gives us real operational flexibility.”
It’s worth mentioning the other big benefit
of redoubling portfolio efforts to boost cash: Illu
stra
tio
ns:
Ian
Po
llock
www.realdeals.eu.com REALDEALS 15
cash&costs
says Peter Hodson, investment manager at NVM
Private Equity. “It just increases the need to be
disciplined on the debtors you do have.”
And while salesmen often instinctively start to
go easy on customers in trouble during a downturn
– they have real relationships with clients, it’s
not just about protecting volume commissions –
REL has noticed that the best working capital
performers are actually getting tougher in the
terms; and if the credit control function isn’t
at the top of its game (both in assessing
creditworthiness and chasing collections),
debt or days soon mount up.
The late George Moore, founder of the Society
of Turnaround Professionals, used to recommend
staff promotions in the credit control function,
elevating the best of them to “account directors”
to motivate them and make the most of their
skills. He would also advise management to
revisit their disputes policy. Elevating disputed
invoices more rapidly to director level – rather
than leaving them to fester in the inbox of a
manager too junior to agree a settlement – is
a great way to convert aged debtors into cash.
Systems matter, then, but so does culture.
In smaller portfolio businesses, for example,
where there might not be so much process around
accounts receivable, the very qualities that made
the management attractive to their backers
could create working capital problems.
“People within portfolio businesses
sometimes forget that they’re
running a commercial enterprise,”
says Hodson. “We cherish
emotionally engaged sales
managers in the front line, and
their commitment. But that
closeness to their business can
cause them to forget the fact
that customers aren’t going to
be surprised or offended if
they’re asked to pay for
goods and services on time.”
Even larger companies,
where the processes are more
developed, have options. “Customers
often manage their own cash by
pushing the working capital on to
suppliers like us, and to some extent
we have to pass that on,” says Hatherly. “But
there are smart ways to do that. If a customer
is looking for better terms, you can work with
them to get something in return for that –
perhaps open up new business opportunities
or get more predictability in your order book.”
cash out: how tough to getWhile receivables remain the fastest and most
reliable way to tune up the cash flow, companies
can also do a lot with their creditors. Pushing out
payment terms also delivers an immediate cash
boost, and many suppliers will be nervous of
refusing to play ball at a time when sales are weak.
On the flip side, aggressive late payment is
both unethical, potentially costly (depending
on the supplier’s willingness to invoke relevant
legislation) and could result in crucial suppliers
going out of business.
But while portfolio finance directors have
a duty to keep an eye on the viability of their
supply chain, the rewards for a creative and
intelligent approach to payables can be
recession. “It’s about being selective,” explains
Shanahan. “They do support those clients they
know are good prospects over the long run.
But they also recognise the need to aggressively
manage the less good ones. The below-par
companies start to feel sorry for everyone equally.”
Cash in is also about tight processes. If
invoices aren’t going out on time; if goods and
services aren’t meeting contractually agreed
“While the pain of poor working capital performance is seen and felt in the finance function, it’s really an operational issue”
16 REALDEALS 4 June 2009
cash&costs
impressive. In a recent KPMG study into working
capital, the firm revealed that private equity-
backed German mobile operator Tele Columbus
changed the payment terms on a ¤60m supplier
contract from yearly to monthly. The interest it
saved (by not having to take out debt to fund
the annual payment) delivered a 40 per cent
reduction in working capital immediately.
“If you really understand which suppliers are
vital to the business, you can bring them into
your own decision-making processes,” says
Aldridge. “By making the supply chain more
transparent to them, you can work on ways to
optimise the outcomes – perhaps by agreeing
to share profits instead of making cash payments
to suppliers, or working on more constructive
approaches to phasing payments, making
everyone’s cash flow more predictable.”
“Cash out” doesn’t just mean supplier
payables. Costs more generally are a key
consideration at the moment. It’s hard to imagine
that any business is currently looking at major
capital investment; ongoing costs will already
have been trimmed back.
The good news for portfolio businesses is
that in some areas, the recession is forcing
costs down. As a retail finance director explains:
“Upwards-only rent reviews and quarterly
payments are a real headache. But we’re
starting to see that change already as a result
of pressures on landlords to keep tenants.”
And because the recession has been so
widespread, negotiations over headcount
reductions or other cuts to payroll costs have
actually been far easier. One European private
equity manager told us: “At one portfolio
business, we’re looking at a reduction in salaries
of ten per cent across the board. That’s going to
mean changing employment contracts, which is
normally difficult. But in this environment, where
the economy is obviously struggling globally,
people are more open to those tough decisions.”
inventory: stock answersAlthough cash tied up in inventory tends to
cause big problems for manufacturers –
particularly early on in a recession, when work
in progress just isn’t shifting and production
has yet to be scaled back – just-in-time policies
and slicker supply chains have made this less
of a problem than it used to be.
But that’s not to say investors shouldn’t look
again at the strategy of portfolio businesses.
Shanahan gives an interesting example. “How
many backers ask questions about working
capital when they make the decision to open
a facility in China?” he asks. “Offshoring looks
cheaper, but it means goods will be sat on a
ship for weeks at the end of the manufacturing
process. When the cost per unit was incredibly
low in the Far East – and money was relatively
cheap – that probably wasn’t an issue. But
production costs are creeping up and that
six-week voyage is now tying up valuable cash.”
Again, it’s worth assessing the inventory
culture of each portfolio business. “For example,
procurement directors are often incentivised to
chase volume discounts,” says Aldridge. “They
don’t necessarily see the working capital impact –
including extra stock on the books, for example.”
connecting the dotsAll these good intentions rely on management
being effective, ensuring that their teams are
properly motivated to drive out working capital
and boost cash flow. “While the pain of poor
working capital performance is seen and felt in
the finance function, it’s really an operational
issue,” says Aldridge. “It comes down to the
salesmen who extend generous terms and
conditions to secure a deal, for example. They
don’t necessarily see the cash flow impact of
their behaviour, but that’s where the sustainable
cash improvements will come from.”
Understanding who’s driving cash flow
helps. “Who are you relying on to deliver on
that cash focus?” asks Hodson. “Are you looking
to the people at the front line, the salespeople
and operational guys? Or is it the finance
department? A salesperson is torn between
getting the cash in quickly and maintaining
cordial relationships with clients. As an investor,
you’re entitled to ask whether the right people
are in control of the debtor book, and whether
they have the right skills to deliver the cash.”
A big question, then, is how well the CFO is
communicating with the operational managers.
“Everyone in the business needs to understand
the cash effect of the processes they undertake,
not just how efficient they think they are being,”
adds Aldridge. “The finance function can measure
it and identify areas that are in need of urgent
attention; but operational people have to live it.”
Finally, a crumb of comfort for private equity-
backed businesses from the latest REL survey
of working capital performance across Europe’s
largest companies. While the overall numbers
for 2008 are pretty much static compared to
2007 (once you strip out the oil and gas
companies), Shanahan has noticed the
emergence of two divisions.
“The good guys are getting better
at managing working capital,”
he says. “But the bad guys are
getting worse.” That means
the advantage for those
businesses with tight processes
and the right cash culture is
growing. For cash-minded,
private equity-backed
businesses in competition
with less disciplined rivals,
that can only be good news.
richard young is a freelance
business journalist.
cAsh floW suPPort for Portfolio busiNessesPeter hodson, investment manager of
NVM Private equity, explains how his firm
intervened to support one management
team facing inconsistent cash flows.
“We have been in a situation where a
portfolio business was finding cash flow
coming in waves – they would tighten up
every so often, but then things would slip
and working capital would creep up. that’s
an example of where we can get an expert
in to help – someone who understands cash
implicitly and had worked through that
kind of situation before. often you’ll find
with a bit of support, management teams
will quickly get a feel for the art of the
possible. When you have someone in there
who knows exactly how hard they can push,
you can remedy the problem quite quickly.
“in that case, our expert’s priority was
to get the 13-week cash flow forecast up to
scratch – there had been a lot of holes in it.
they redesigned the process of arriving at
the forecast, then made sure there were
specific targets for every debt and payable
on the books. each one was monitored on
a weekly basis and responsibility was
assigned to a named manager.
“then they looked at the creditors.
With their experience, they understood
how far they could push them, freeing up
working capital without causing major
problems. if the management team needs
support in a certain area – which is quite
reasonable, particularly in smaller
companies – we’d look to bring in a non-
exec with the right qualities. in this case,
we brought our expert in on a consultancy
basis initially, working one or two days
per week. After the cash disciplines
had tightened up, he reverted to
a more conventional non-exec
role to help the team on a
longer-term basis.
“to emphasise: this is
about providing support
for a management team.
Portfolio managers can
always pick up the phone and
know we’re here to offer guidance.
but having someone more intimate
with the situation, who can tackle any
slip in focus on cash very quickly, is useful
to us all. And we find this approach
always brings results.”
www.realdeals.eu.com REALDEALS 17
“credit iNsurers Are More to blAMe for
the mess private equity finds itself in than either
the banks or the credit rating agencies.” A bold
claim. But those are the words of the head of one
major UK buyout house, referring to the problems
being experienced at portfolio company level by
vast swathes of the private equity community.
Across Europe, extreme risk averseness is
leading credit insurers to withdraw their
provision of cover to legions of companies,
causing knock-on effects on working capital
facilities, and often leading to situations of
default. In some cases, otherwise healthy
companies are being brought to their knees
simply as a result of losing their cover.
Perhaps the most high-profile and extreme
example of this was Woolworths in the UK.
When insurers decided they could no longer
provide cover to the retailer’s suppliers last
autumn, suppliers insisted Woolworths pay them
upfront for goods, forcing the company to draw
creditinsurance
on its borrowing facilities. Shortly afterwards, an
historic high street name was forced to liquidate.
underpricing problemsWhile not a private equity-backed company,
Woolworths’ demise is illustrative of the problems
faced by the portfolio companies of buyout
houses, many of which treat credit insurance as
part of their working capital facilities – a strategy
that has proved highly dangerous in retrospect.
Part of the problem seems to have been
caused by insurers vastly underpricing their
cover. According to the Association of British
Insurers, there were £334m worth of premiums
written in 2008, covering £302.5bn worth of
sales by British companies. This meant that
insurers were in effect underwriting more than 20
per cent of the output of the entire UK economy
in return for a few hundred million in premiums.
To put it another way, the premiums were
equivalent to just 0.1 per cent of the insured risk.
Consequently, when the recession hit and
claims began to rise (see graph, page 19),
something had to give. This steep rise caused
credit insurers to reassess their exposures, and
to begin cancelling the contracts they perceived
to carry the highest risks. Unluckily for private
equity, this included anything with large amounts
of acquisition debt on its balance sheet. The
scaleback was so severe that in one case Atradius,
Britain’s second-largest credit insurer, withdrew
cover from suppliers to 12,000 companies in a
single week. It is a blanket approach that has
been heavily criticised across the buyout industry.
“The credit insurers decided they were not
going to cover high-risk groups, such as retailers
and highly leveraged businesses,” says Tim Syder,
deputy managing partner of Electra Partners.
“They effectively said: ‘If you’ve got acquisition
debt on your balance sheet, forget it.’ They’re
not insuring the debts of those companies that
are least able to survive the downturn.”
PulliNG the PluG
Private equity firms have cried foul as portfolio companies have suffered from the indiscriminate withdrawal – in some cases overnight – of credit insurance facilities. Buyout houses must now be constructive and communicative in order to help their businesses survive.by Samuel barton
18 REALDEALS 4 June 2009
creditinsurance
“The credit insurers are taking a blanket
approach,” adds John Harper, a partner at Duke
Street. “They’re looking at companies, and if
they’re private equity-backed – regardless of
what sector they’re in or how they’re performing
– they are withdrawing cover.”
The BVCA has also criticised the credit
insurers, accusing them of “unfairly targeting”
private equity-backed companies. “They have
been reducing and withdrawing cover for no
discernible reason other than the identity of
the private owner. This is bad business practice
and ultimately counterproductive,” says chief
executive Simon Walker.
While the major credit insurers declined to
be interviewed for this article, the Association of
British Insurers defended the industry, claiming
that private equity firms were at fault for their
lack of communication. “Credit insurers want to
be able to offer credit insurance and to continue
to offer it,” says Kelly Ostler-Coyle, a spokesman
for ABI. “But they need as much financial
information as possible. Some private equity
firms are not providing information, and
therefore it is very hard to understand and
underwrite the risk. We advise that firms
provide as much information as possible.”
high-profile victimsWhile private equity firms are understandably
keen not to highlight specific issues in their
portfolios, several examples have hit the
headlines already, including Focus DIY, the
retailer backed by US buyout house Cerberus
Capital Management; bingo group Gala Coral,
backed by Candover, Cinven and Permira; and
Brake Brothers, the food distribution company
backed by Bain Capital, to name just three.
“We have one portfolio company,” admits
Harper. “It has cash in the bank and is performing
well, but when we challenged the insurer, they
said ‘you’re a leveraged company’. It is quite
disappointing and somewhat arbitrary that
healthy businesses are having their cover
withdrawn. Credit insurers need to forget the fact
that it is private equity-backed or leveraged –
what matters is how the company is trading.”
“We had an issue in the portfolio caused by
a misunderstanding about the structure of the
deal,” adds Chris Warren, a director at ECI
Partners. “The business was performing well
and the balance sheet was fine, but it still took
a lot of time to sort out.”
In the case of Brake Brothers, more than
three weeks were spent attempting
to get insurance policies
reinstated. “I am absolutely
furious,” raged finance
director Matthew Fearn
in an interview with the
Financial Times. “We had
a good growth strategy in
2008 and strong cash flow,
The situation is a damning one for the
credit insurance industry, which is there to give
confidence to companies through difficult times,
but has instead scaled back at the first sign of
trouble in a way that is threatening the livelihood
of those businesses. “Credit insurers cutting cover
overnight has shocked businesses,” says Robin
Johnson, a private equity partner at Eversheds.
“These contracts will have to change. They have
become too standard and people have not looked
at them closely. No one looked at the terms.”
While a contractual overhaul of the industry
may be viable in the longer term, it is of little help
to businesses in trouble today. On a short-term
basis, governments across Europe have considered
While the uk government must be applauded
for coming to the aid of businesses struggling
as a result of the credit insurance crisis, many
have criticised the solution arrived at by the
department for business, enterprise and
regulatory reform (berr).
on the face of it, the scheme does not
sound comprehensive. first, it is only
operational between 1 April and 31 december
this year, meaning that any businesses
whose cover was removed before April will
have no help whatsoever. it will also only
“top up” the insurance for each business to
the amount previously covered, as well as
only equalling the amount of cover remaining.
in other words, businesses whose insurance
was reduced by up to 50 per cent will have
their full cover restored, whereas a business
whose cover was cut to ten per cent of its
previous level will find itself with just an
extra ten per cent from the government –
so 20 per cent of its previous level in total.
those whose policies have been cancelled
entirely will get nothing.
“the scheme will bring a measure of
relief to some sMes, but in many respects
it fails to go far enough,” says bVcA chief
executive simon Walker. “by excluding
suppliers which have had their credit
withdrawn rather than reduced, and offering
help only to businesses which had cover
reduced after 1 April, the scheme cannot
hope to capture those worst affected.”
the stance is justified by the government
on the grounds that the scheme is only
designed as a temporary buffer, and it would
be unfair for uk taxpayers to have to
underwrite a firm’s entire credit insurance
cover, as well as cover those businesses
perceived as the most risky and whose
cover was therefore cut earliest.
“this is intended only as a breathing
space,” says stuart shepley, a partner in
kPMG’s insurance risk and actuarial services
team, who worked with berr on the scheme.
“berr is keen to put in place a policy to
provide temporary support, but there is a
requirement to understand the balance
between achieving the benefit and the cost
to the taxpayer. the government is striving to
do that in a way that does not fundamentally
change the behaviour of the credit insurers
or the insurer/reinsurer relationship.”
Another area of the policy that has
attracted criticism is the upper threshold,
which is set at £1m (¤1.15m). Above this,
no cover will be available, meaning that
larger businesses will not be able to take
full advantage of the scheme. “it is trying
to do something to address a real practical
problem, but the devil is in the detail,” says
Alan hudson, a restructuring partner at ernst
& Young. “While for sMes it might be enough,
for larger businesses the £1m threshold will
be insufficient. it is better than nothing but
it is not a panacea for all ills.”
the top-up facility – access to which will
cost participating companies two to three per
cent of their insured risk, compared with
around 0.5 per cent under standard credit
insurance policies – will cost the uk taxpayer
a total of no more than £5bn.
and we don’t have to refinance the business for
a few years. But I have had to spend countless
hours trying to justify this to people.”
What can be most galling for buyout houses,
however, is the speed with which they can find
the plug pulled on them – in some
cases overnight. “What has
surprised companies is the
suddenness,” says Alan
Hudson, a restructuring
partner at Ernst &
Young. “Credit insurers
have been reducing their
exposure across the sector
with little, if any, forewarning.”
GriN ANd berr it
“The government’s top-up scheme is better than nothing, but it is not a panacea for all ills”
www.realdeals.eu.com REALDEALS 19
creditinsurance
the situation serious enough to step in, with
France working on a scheme whereby the
taxpayer will cover some of the costs of
providing cover, and UK chancellor Alistair
Darling announcing a “top-up” facility in
his latest Budget. The UK scheme has
been criticised for a variety of reasons,
including failing to provide sufficient cover and
having too short a shelf life, but it will doubtless
provide relief to some (see box, page 18).
Suppliers’ marketSadly for those companies not falling under
the terms of the various government schemes,
constructive routes out of trouble are few and
far between. The first problem faced by private
equity firms trying to get policies reinstated is
that the credit insurance market is dominated by
just three suppliers – Euler Hermes, Atradius and
Coface – which control around 80 per cent of the
market. This makes it extremely difficult to find
alternative insurers, and brings that private equity
Achilles heel – communication – back into play.
“Once you lose your cover it can be very
hard to get it reinstated,” says Hudson. “Some
are saying that the credit insurers are acting
arbitrarily, but there are instances where
companies aren’t helping themselves, and are
not treating the insurers as an important part
of the business. Firms should be more proactive
in terms of working with the insurers – this
requires engagement.” He cites one example of
a company that continually cancelled meetings
with its credit insurer, and one day found that the
insurer had run out of patience and removed the
cover instantaneously. “Credit insurers can feel
that they have been excluded from restructuring
discussions, therefore they may assume the
worst and protect their position,” says Hudson.
However, much empirical evidence points to
the fact that, once involved in the discussions,
their attitude is often not much better.
“Credit insurers do not like changing their
minds – there is very little flexibility,” says
Johnson. “They also do not assess businesses on
a case-by-case basis – they rely on credit ratings
agencies to tell them what the creditworthiness
of a company is.”
Unfortunately for private equity firms, if there is
no communication, and no attempt to bring credit
insurers into discussions, it can be an easy decision
for the credit insurers to make. “If you’re the boss
of a credit insurer and capacity restrictions mean
you need to get your underwriting down, the first
place you will look is 2005 to 2007 leveraged
buyouts – it’s understandable,” says Syder.
Johnson, meanwhile, talks of an issue at a
client where credit insurance was withdrawn, and
after lengthy discussions it was agreed that the
facility would be reinstated for three months.
There followed a frantic period of renegotiation
with suppliers, clients and banks, before the
cover was withdrawn again. The few months’
should consider. They may be able
to unlock a restructuring instead of
having to throw away their investment
altogether,” advises Hudson.
Fair-weather coverLooking to the longer term, there is no question
in most people’s minds that the supply of
finance to small and medium-sized businesses
will have to be overhauled. For some, the entire
credibility of the credit insurance industry is at
stake, and a big question mark remains over
whether companies will again put themselves in
a position where their viability is dependent on
insurance that is only available when the sun is
shining. “If at the first sign of trouble the credit
insurers run for the hills, questions have to be
asked,” says Warren. “If they fail to provide the
cover that the premiums have been paid for,
then it is clearly not an insurance cover at all.”
Some believe that an entirely new model for
the industry will emerge, with a far smaller role
for credit insurers. “Most companies will learn to
live without it,” says Harper. “Most companies
and suppliers cannot afford not to trade, so there
will be a move towards suppliers starting to
supply without it. Companies are getting more
used to it and becoming more pragmatic.”
“Given there are so few players, a new model
may emerge,” agrees Hudson, emphasising that,
when the market starts to turn, the first issue people
will look at is the terms of the contracts. “If people
get used to a world without credit insurance, will
they go back to it? People may start to look at
how they can deliver a better solution, but it will
have to be made on committed contracts. There
will be far more emphasis on looking at terms and
ensuring the umbrella is still there when it rains.”
For now, however, private equity firms must
forget any potential new paradigm, and work with
their current portfolio companies on the matter in
hand. For many, there is not much light at the end
of the tunnel. “Credit insurers have been badly
burned by all the retail problems,” says Syder.
“There is no doubt there will be more leveraged
private equity deals going belly up. Most firms will
have some deals that are overleveraged and were
overpriced when acquired, and I can’t see any
reason in the short term why any of the insurers
will come out and start covering again.”
The key point to emphasise is one of being
upfront early on. “You have to sort out the other
problems – you have to get the balance sheet and
working capital in order,” says Malcolm McKenzie, a
managing director at specialist turnaround adviser
Alvarez & Marsal. “And everyone has to respond
early to the problems. There is no point trying to
fix the hole in the tent after it has started raining.”
For many private equity firms, openness
and communication may, once again, be the
only way forward.
Samuel barton is managing editor of Real Deals.
stAteMeNt of clAiM
grace proved invaluable in terms of resolving
financing issues – and the company is “limping
along”, according to Johnson – but this kind of
flexibility from the insurers is rare.
If discussions regarding reinstatement fail,
the next option is to approach the banks, but if the
portfolio company in question has no headroom
left in their banking facilities, their backs are well
and truly against the wall. “If there is a working
capital squeeze and the banks won’t step in,
there’s little else that can be done,” says Harper,
emphasising the danger of companies using credit
insurance as part of their working capital facilities.
“Companies have to get away from using their
credit insurance as a working capital tool,” adds
Johnson. “The days where you can do this are over.”
If all else fails, assuming the private equity
firm wants to hang on to its investment, more
equity is the last resort. “For businesses that are
otherwise sound that the banks won’t lend to,
you may see private equity firms stepping in
with equity,” Johnson says.
“If a private equity firm is prepared to roll
the dice again, then it is a position that they
150
120
90
60
30
0
Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08
source: The Association of British Insurers
Gross uk trade credit insurance claims incurred (¤m)
20 REALDEALS 4 June 2009
interims to the rescueWhen smoothing over a transition period in a successful firm, interim managers can be important. But during a recession, as portfolio company valuations plummet, bringing in an experienced head who is unafraid to make tough decisions could be the difference between financial freefall or a soft landing. by Peter bartram
the rules of the game fundamentally
changed for private equity when the credit
crunch struck. Portfolio company management
teams in particular – which had rode the surf
of unending growth for years – suddenly crashed
to earth. As the recession lengthens, more
management teams will fall into the “needs
attention” category. So how do investors deal
with these situations?
The first point to explore with an
underperforming management team is the
reason for the underperformance, says Paul
Marson-Smith, chief executive of Gresham
Private Equity. “Are they doing everything
possible? If the market is simply not there,
no amount of changing the management
team will solve the problem.”
However, when a change needs to be made in
a management team, it’s better to make it sooner
rather than later, he adds. “One thing I’ve learnt in
private equity is that if you delay changes, it just
makes them more difficult. Encouraging managers
to think of themselves as shareholders helps them
to understand when a change is necessary.”
When faced with an underperforming
management team, it’s important to resist the
temptation to jump to conclusions, adds Simon
Wildig, a partner at CBPE Capital. “You have to
analyse the situation very carefully,” he says.
“Try to work out what your options are and
act on them as sensibly as you can. Disruption
to a team, even if it is obvious that it’s
interimmanagers
underperforming, is going to be difficult. It can
create perceptions in the marketplace, in the
team itself and with employees. You have to
be very careful – but by the same token, you
cannot let things fester.”
One way to spot whether a management
team may be losing its touch is to view it with
a cold and objective eye. “We tend to rotate
our deal team members,” says Louis Elson,
co-founder and managing partner at Palamon
Capital Partners. “By rotating them and adding
a fresh perspective to our deal team, we can
begin to look through our own emotional bonds
to people and be objective about whether they
can really do the job.”
Elson believes the best way to replace
managers is to focus on the needs of the
company first and the individual second.
“Typically, when you’re in this situation, you
spend a lot of time worrying about the individual.
You need to get back to what the company is
going to do.”
He also believes that time must be invested
into replacing members of a management team.
“You need to be patient as you determine what
the best course of action is. Sometimes private
equity resorts to a knee-jerk reaction.”
Interim interestIf a member of the team has to be replaced in a
hurry, one option might be to bring in an interim
manager until a more permanent employee can be
found. An interim manager – here today and gone
in a few months’ time – could have the detachment
to make unpopular changes. But he will need to
be a manager with turnaround experience.
Wildig agrees that an interim manager
could be used to “plug a gap” when building
a management team. “It’s a fact of life that
changes made to management teams are
usually made fairly quickly,” he says. “You might
find it necessary to replace somebody or remove
somebody from a particular position to limit
damage. Or, if they are told they are
no longer needed, they may choose
to go quickly and you might not
have an immediate replacement.
In that case, an interim holder of
a post can be useful.”
Anne Beitel, managing
director of Executives Online,
which specialises in interim
management and executive recruitment, sees
interim managers potentially playing the role
of catalyst in making changes when a portfolio
company management team is failing. The key
is finding an interim who has had experience
of turnaround situations before. Beitel believes
it doesn’t necessarily matter whether that
experience has been in the same
industry. It’s the ability to take a
difficult situation by the scruff of the
neck and deliver the treatment that’s needed.
“If a portfolio company is in a hard or damaged
www.realdeals.eu.com REALDEALS 21
state and in a real rescue situation,
I think the skills for affecting that
are quite transferable,” she says.
As the recession has deepened,
Beitel has noticed a growing demand
for interim finance directors,
supply chain and procurement
professionals, as well as sales
and marketing staff. Beitel
believes that in the appropriate
circumstances, an interim
manager could be the right
choice to make much-needed
changes at a portfolio company
that is underperforming.
“In the case of a private equity
backed-business, an interim
manager can shake things up and
challenge preconceptions – and
will not care too much if they are
not universally liked because they
are there to do a task, deliver a
result and move on to the next
assignment,” she says.
But if the interim is going into a
well-performing company to plug a
gap between permanent appointments,
industry experience may be more
important than a turnaround track record,
Beitel argues. “You’d be looking for a
strong match between the candidate’s
background and the domain in which the
target company operates,” she says.
Beitel warns private equity firms thinking
of hiring an interim manager for a portfolio
company not to treat it like a permanent
post. “When you’re recruiting a person for
the long term, cultural fit and
meshing with the management
team are important drivers for the
candidate’s success in the job. An
interim is not there to be cosy
with the folks around them –
they’re there to deliver results.
“But you must be really
clear what you want them
to come in and do. To bring in a highly
qualified and expensive person and not to
brief and focus them is a waste of everyone’s
time and money. So be clear on what you want
them to accomplish and put them to it.”
Hiring an interim need not be a lengthy
process. Beitel says that her clients typically
want a shortlist of possible candidates within
a few days of giving her the brief. The chosen
manager is expected to be at their desk a few
days after being chosen. “A typical timescale
from brief to placement is measured in days, not
weeks,” she confirms. Once they’ve got their feet
under the desk, a typical interim manager could
be in place for around six to nine months.
Beitel adds that interim executives tend to
be people who are used to delivering results in
a short timescale – a quality which certainly
makes them highly suitable for posts in private
equity portfolio companies. “They’ve got to climb
up whatever learning curve there is very quickly.
But we try to select them so that they have
experience of similar organisations, which
minimises the learning curve.”
Beitel says that she sees some common traits
in the most effective interim managers. “They
have a real independent-minded streak and a
distaste for corporate politics. In some cases,
that’s why they became interim executives.
They were interested in doing their work,
contributing their expertise, not being nice to
everyone in the office and worrying about who
is going to stab you in the back.”
Private equity-owned companies, with their
emphasis on hard-edged regular measurements
of fundamentals such as cost reduction or top-
line revenue improvement, ought to be effective
at measuring whether an interim manager has
contributed what’s required. “You will know
from your figures whether they have done their
work,” argues Beitel.
ambition and objectivityBut although interim managers undoubtedly
have a role to play, the deal-makers say their
primary focus when considering an investment
is on whether the company already has a quality
management team – or the potential to build one.
Marson-Smith is in no doubt about what
makes a great management team in a portfolio
company. “The most important quality is a track
record through good times and bad,” he says.
“In the current environment, one of the most
demonstrable attributes is the ability to be a
scrapper. Faced with a requirement, they take
the necessary action.” It’s important when
business is plain sailing, but even more so when
the economy is wallowing in troubled waters.
Getting the right management team into
a portfolio company has always been a key
element of success in private equity investing.
When times are tough, that’s even more
important. “First of all, an outstanding
“You need to be patient as you determine what the best course of action is. Sometimes private equity resorts to a knee-jerk reaction”
In association with
22 REALDEALS 4 June 2009
management team has to have a fire inside them
to be successful,” says Elson. “They are highly
ambitious and they want to win – they want to
succeed for themselves in some way. Secondly,
they are objective. They have the ability to look
at the world with a very clear set of perspectives.
Some people get those other perspectives by
bringing other people around them to get
different points of view – some are able to do
it themselves. But the ability to have different
perspectives allows them to see in 3D.”
Wildig says that in a recession, there is value
in having managers on board who’ve been there
before. “It’s valuable to have some experience
and awareness of the sort of difficulties that
times like these can throw at you,” he says.
“You can learn a lot from hard times rather
than when things are going well.”
The managers in private equity portfolio
companies are a different breed to the kind
you find in public companies, argues Andrew
Priest, a partner at Skillcapital, which recruits
management teams for private equity-backed
portfolio companies. He points out that when a
company is acquired by private equity, there’s
often a change in capital structure and an
infusion of debt. “That creates a pressure to
perform and manage for cash which won’t be the
same in a normal corporate,” he says. “Whether a
manager is going to be a success or not depends
on whether they can adapt to an environment in
which there will be clear-cut objectives in the
frame and shorter communications paths to the
business’s owners.”
The trick is spotting the managers who have
demonstrable ambition and a results-driven
way of working, argues Priest. “They should
show evidence of being willing to move out of
their comfort zone, of having been promoted
quickly and of working hard and long hours.
They’ll also often be people who’ve worked in
challenging situations, such as restructurings
and turnarounds.”
Priest says that when Skillcapital is recruiting
for its clients, which include Cinven, Candover,
Sovereign Capital and HgCapital, it often looks
for more experienced managers. “We bring in
people who are used to working in bigger
companies and are further down their career
tracks. They’ve been exposed to a lot of different
business situations and they’re persuaded to
move into a private equity portfolio company
because there’s an opportunity to make
some money for themselves, as well as to
achieve the investment’s aim.”
But the recession might weed out some of
the less resilient managers who, naively, saw
private equity as a way of making easy money.
As Priest points out, a characteristic of private
equity is that portfolio companies have
“stretched business plans”. He adds: “In a
recession, the business case is even more
stretched and challenging.”
Being able to achieve highly ambitious
targets, sometimes without the support
infrastructure that’s commonplace in big
corporates, requires go-getters with extra
resilience. Priest gives the example of the
management team that brought the ironmonger
chain Robert Dyas back from the brink of
administration following a management buyout
from Change Capital in April. “People who are
good at working in those kinds of environments
show incredible resourcefulness,” he adds.
executive decisionsBut in a climate in which private equity investing
is tougher, how does the canny deal-doer
ensure that the management team in the target
company can deliver? For Elson, it’s all about
the qualities of the chief executive. “It’s really
about whether we’ve assessed the programme
that the company needs to execute and matched
it to the skillset and demeanour of the chief
executive,” he says.
In Elson’s book, the right chief executive can
make up for gaps in the rest of the management
team. That’s because Palamon is a growth
investor seeking under-scaled companies with
potential. “We’ll often expect holes in the
management team,” says Elson. “We won’t
necessarily not do a deal because of that.
There could be management posts to fill and
we’ll work out with the CEO how to fill them.”
But Elson is clear that it’s the chief
executive’s job to build the team. “Our role
is to be a second set of eyes and a facilitator
in any way we can,” he says. “For example,
Palamon may do an initial trawl of the market
to winnow down a long list of 30 or 40
potential candidates for a key management
post in a portfolio company to a final shortlist.
Elson explains: “We would present the
candidates we think could do the job, but leave
it to the CEO to decide which is the one with the
right chemistry that he’d want to work with.”
Marson-Smith believes the right chemistry is
crucial in portfolio company management teams.
“Individuals can have tremendous track records
and skills but they need to work as a team and,
ultimately, the power will be in the team,” he
says. “The beauty of the best team is that the
whole is greater than the sum of the parts, and
you are able to harness that team energy.”
But structure is also important, as Wildig
points out. CBPE Capital typically invests in
businesses with £25m (¤28.5m) to £250m
turnover. “Even though they might be
multinational businesses, because of the scale
the senior management team are pretty
intimately involved with the day-to-day running.
You want them to be involved because you may
want to make changes to what is happening
fairly regularly. In our view, you don’t want
layers of hierarchy to get in the way of that
happening. We like businesses that have a
relatively flat structure – a team of four or five
guys at the top who can quickly put their finger
on something that needs to happen further
down the business.”
A key figure in the management team could
be the chairman. “We are big fans of involved
chairmen,” says Marson-Smith, who is not
interested in the kind of chairman who turns up
once a month for tea and biscuits. In general, he
favours a part-time, non-executive chairman who
has the ability to support the management team:
“The chairman can be a valuable conduit between
the management team and the investor.”
In Marson-Smith’s book, a key requirement of
a good chairman is experience of the relevant
industry sector. “Beyond that, leadership skills
so that they can harness the skills of the people
in the management team and help them to
perform better.”
Elson sees an important role for the chairman
when there’s a difference of opinion between
the portfolio management team and the backer
on how the company should approach a key
issue. “This is a great place where the chairman
can weigh in with an objective, unaffiliated,
unaligned voice.”
It is results that private equity firms are going
to be looking at with an ever more critical eye
in the recessionary months ahead – the pressure
on management teams to perform has never
been greater. But when asset values recover,
the rewards could be greater too. In the
meantime, the key qualities for portfolio
company management teams are a clear eye,
a stout heart and more than a little bit of luck.
Peter bartram is a freelance
business journalist.
“An outstanding management team has to have a fire inside them to be successful. They are highly ambitious and they want to win”
interimmanagers
24 REALDEALS 4 June 2009
many highly leveraged, private equity-
backed companies that changed hands during
the credit boom are already undergoing
restructuring. For many more it is a fast-
approaching reality.
Restructuring is predominantly a zero-sum
game, in which different stakeholders in a
business struggling to meet its financial
commitments negotiate how the pain will be
shared among them. The process, however, is
complicated by the variety of different agendas
of sponsors, management, banks and other
capital providers, many of which are struggling
to repair their own balance sheets. Sorting out
the mess from a deal that has turned sour can
prove more difficult than putting the transaction
together in the first place.
But when should sponsors and the
management of portfolio companies tell their
bankers that a problem is looming? For
transactions with relatively benign covenants that
are not yet in breach, there can be a temptation
not to deal with a deteriorating situation that
under stricter covenants would require attention.
For their part, at the start of the year many
banks were scrambling to reorganise and
increase their restructuring resources, focusing
on the most urgent problems rather than future
breaches. Part-way through the year, the trading
outlook for 2009 is now more visible, and for
many companies the prospect of whether
covenants will be breached or not is becoming
more clear-cut. More restructuring activity
appears unavoidable. Deals completed a couple
of years ago often had capital structures that
required continued growth in Ebitda to generate
sufficient cash flow to service the debt. With
Ebitda now more likely to be contracting than
growing, covenant breaches are only a matter of
time, and there is a growing realisation among
sponsors and management that the problem
needs to be addressed sooner rather than later.
“There has been a change in attitude,” says
Ian Bagshaw, partner in the private equity
practice of law firm Linklaters. “Management
is now looking at the possibility of a breach in
the budgeting process. Managers are more aware
of their personal liability – they are the ones
carrying the can if they get the cash flow analysis
wrong.” Identifying problems early can mitigate
this risk, so there is a growing trend for
management to be the ones looking to instigate
a restructuring process.
Management also has a further financial
incentive to address the problem early. “If a private
equity deal is underwater, the management deal
that ranks behind it will also be underwater,”
says Paul Canning, managing director at HIG
European Capital Partners, which invests in
distressed situations. “We have been contacted by
disaffected management teams who are having
to work harder in a tougher environment and feel
as if they are working to repay the bank, with no
return to them.” Canning also notes that there is
an increased focus by more financially aware
corporates on the balance sheets of their suppliers
and customers – debt has become a consideration
in evaluating long-term customer relationships.
Ignorance: not blissA lack of skilled restructuring resources remains
an issue for some banks and is contributing to
the length of the process, but this should not be
a reason for companies to ignore the problem. “I
have no sympathy for complaints that the process
pull yourself togetherRestructuring a company that is on the ropes can be a battle of wills between warring interests, but overcoming these struggles could lead to triumph in the face of adversity. by vInce heaney
www.realdeals.eu.com REALDEALS 25
takes three or four months,” says Hugh Brown,
senior partner in the debt advisory team at
PricewaterhouseCoopers. “It’s better to engage
in a long, but positive process than to wait until
the problem needs to be dealt with tomorrow.”
Where value has not dropped precipitously,
it may be possible to remedy the situation by
resetting covenants. Banks, however, are acting
swiftly – and sometimes harshly – when faced
with clients in breach of covenants. “In order to
reset covenants, the banks are hitting you with
large charges and are acting in a similar fashion
over missed interest payments. Working capital
lines can also be pulled if there is a technical
breach,” says the managing partner of a lower
mid-market private equity house. There is also
anecdotal evidence that some banks are using
breaches as a means of weeding out the clients
they no longer want in their portfolios.
“The current restructuring environment is very
adversarial,” agrees Brown. “Lenders are taking a
more robust position on pricing and requirement
for new equity when loans go into default.”
These concerns are serious enough that the
BVCA has taken up the fight on the industry’s
behalf, and is collating data to ensure that the
banks are acting responsibly and pragmatically
in their dealings with private equity clients.
Once bitten…The difficulties faced by many companies,
however, are too severe to be solved with covenant
resets, and instead require fresh cash injections –
but sponsors, sensibly, are wary of throwing good
money after bad. “I find it very ironic that sponsors
don’t want to exercise the equity cure rights that
so many of them fought for because the value
has dropped so far, whereas banks, which were
so reluctant to give equity cure rights, now want
them to be exercised,” says Mike Barnes, head of
debt advisory at Hawkpoint. “The two scenarios
to distinguish between are whether a company
needs new money for operational restructuring,
or whether new equity is simply being sought
by banks to pay down debt. Sponsors will
often offer new money only if banks accept a
writedown of the debt, and banks are generally
reluctant to accept that if the writedown isn’t
strictly necessary from a valuation perspective.”
Sponsors must also take into account their
obligations to LPs. “As sponsors look at their
portfolios and the IRR they expect to generate,
they have to decide whether to try and save a
business or redeploy the capital to a different
business,” says Geoffrey Richards, co-head of
special situations and restructuring at William Blair.
Equity cures may also only stave off a problem
that is likely to recur. “During the documentation
stage of the primary deal process, there can be
much debate about equity cures between banks
and sponsors,” adds Ian Sale, managing director
at Lloyds TSB Corporate Markets, responsible for
the bank’s mid-market leveraged finance team in
London. “Generally, if banks go for equity cures
it’s because they provide a clear mechanism for
private equity to cure potential covenant breaches.
There may be downsides though, as they can
sometimes just be quick fixes solving the
immediate covenant problems, but not really
addressing underlying or longer-term problems in
a business. Banks will normally want any related
cash injection to lead to a permanent reduction in
debt rather than just being added back to earnings,
which is a route sponsors frequently push for.”
Sponsors may be willing to put in more cash
to avoid an alternative that preserves even less
value – such as a fire sale or even administration
– but the decline in equity values has in some
cases been so sharp and severe that the gap can
be difficult to bridge. “Banks are now only willing
to lend about three to four times cash flow, and
when there is a covenant breach are looking to
‘right-size’ their loans to that new lower level,”
says Brown. “For transactions done late in the
boom with debt of seven to eight times cash
flow, it’s difficult for sponsors to put in sufficient
cash to make up the difference.”
“The equity cure is almost certainly dead,”
says Bagshaw. “If there is no equity value left,
then generally there is no point putting more
in. The landslide of value since the collapse
of Lehman Brothers means that for some
companies there is a point where there is no
economic value in anything other than the
senior debt. If you are a company in that
position, there is no point in an equity cure.”
Debt-for-equity dilemmasDeeper restructurings, such as debt-for-equity
swaps, therefore look set to become more
prevalent, bringing with them a whole new
level of complexity. Unlike the well-trodden
M&A process, each restructuring is different
and can be highly complex and time-consuming.
The situation is not made any easier by the fact
that banks are not natural equity stakeholders.
“Banks are good at lending, not owning
companies,” says Richards. “Commercial banks
are not organised to take on ownership and
the fiduciary responsibilities that entails.”
This would be obstacle enough with just a
small number of banks involved, but for many
2006/2007 vintage deals, bank syndicates were
very large and the different constituents all have
their own agendas, which may not be aligned.
Recently, for example, McCarthy & Stone, the
UK’s largest retirement homebuilder, agreed a
debt-for-equity swap with its senior lenders.
The bank syndicate for this comprised around
60 financial institutions.
In such a large syndicate there can be
distressed debt traders, which have bought into
the debt at a deep discount and are looking to
make a quick turn. They may be willing to agree to
a settlement at a lower price than a longer-term
lender looking to minimise the write-down. Adding
further complications, the syndicate’s members
may change over the course of the restructuring
as different members trade in and out of the debt.
“In a syndicate you can have ‘freeriders’,
‘holdouts’ and ‘terrorists’,” says Richards.
“Freeriders sit back and let the larger
constituents negotiate, riding on their coat tails.
Holdouts try to achieve a better deal by refusing
to agree to the offered terms – and may even on
occasion be paid to agree. Terrorists are those
who use a controlling or blocking position in the
debt to extract additional value for themselves,
which may impact on the recovery of others.”
Given the difficulty of reaching a unanimous
agreement in these circumstances, court-
approved schemes of arrangement, which require
75 per cent by number and value to agree, are
becoming more common in the UK. Some other
European jurisdictions, however, do not enjoy this
luxury – in Italy, for example, unanimous creditor
agreement is still needed.
Opportunities aboundBut as well as a source of problems, restructuring
can also offer opportunities for inventive
investors willing to participate in different parts
of the capital structure. “Buying businesses, or
parts of businesses, out of restructuring is a key
area of focus for us,” says Canning, whose
company HIG Capital has a mandate that allows
both debt and equity investment. “We have
been flexible in approaching any or all of the
stakeholders – sponsors, management and
banks. Our message to the banks is that we
have capital and liquidity if new money is
needed, as well as the practical operational
capability [that the banks sometimes lack].”
Bagshaw also sees the potential for new
opportunities: “I think we’ll see boutiques
established to act as intermediaries between
the banks and the management teams in the
companies they now own.”
For an industry accustomed to adapting to new
circumstances, adversity brings opportunity.
vInce heaney is a freelance business journalist.
restructuring
“It’s better to engage in a long, but positive restructuring process than to wait until the problem needs to be dealt with tomorrow”
26 REALDEALS 4 June 2009
porous pensionsDuke Street’s chastening experience with Focus DIY means that private equity investors must make their portfolio companies’ defined benefit pension schemes watertight. by nicholas neveling
pensions
in 2004, just days before Christmas,
Duke Street Capital announced that it had
agreed to sell DIY chain Wickes, part of portfolio
company Focus Wickes Group, to Travis Perkins
for the handsome sum of £950m (¤1.08bn).
The deal marked a major landmark for Duke
Street, which had been growing the company
for almost 20 years. Duke Street first backed
Focus in 1987, building it into a DIY empire
with a host of subsequent acquisitions.
Following the sale of Wickes, a large dividend
was paid to Duke Street and the remaining
companies, renamed Focus DIY, were refinanced.
At the time, Duke Street could never have
imagined that four years later the transaction
would come back to haunt it, or that the
deal would ultimately push pension schemes
to the top of the private equity portfolio
management agenda.
When Wickes was sold, there were two
under-funded defined benefit pension schemes
within the remaining Focus group, with a
combined deficit of £26m. Following the sale of
Wickes, Focus DIY began to experience trading
difficulties and was unable to support its capital
structure. In July 2007, the struggling company
was sold to Cerberus Capital for a pound.
With the deficit of the Focus schemes sitting
at £32m when Cerberus came to the rescue,
the pensions regulator, wary that the burden
of funding the schemes would now fall on the
Pension Protection Fund (PPF), stepped in.
A year later, following a series of negotiations,
Duke Street paid £8m into the schemes of a
business it had sold 12 months earlier. The case
sent shudders of fear through the private equity
community. “The regulator is now starting to
throw its weight around in a wholly unacceptable
way,” BVCA chief executive Simon Walker
commented. “We have a very deep concern.”
The Duke Street case showed that the
regulator was willing to cast its net
retrospectively in order to shore up pensions
funds at risk, and that any dividends or sales
would be looked at if prior clearance had not
been sought – or if the transaction was seen to
neglect the interests of the pension fund. With
more private equity portfolio companies facing
financial pressure – many that were refinanced
or exited for massive multiples just a few years
ago – the possibility of facing a Focus DIY
scenario is more real than ever.
Portfolio priorityDefined benefit schemes can no longer be
left to the actuaries and accountants to deal
with. Managing the risk that comes with
portfolio companies which have final salary
schemes has become a crucial element of
sound portfolio management.
The top priority for private equity firms
managing portfolio company pensions will be
to ensure that pension liabilities are priced
accurately and funded sufficiently. The slump
in equity markets, increasing life expectancy
and quantitive easing have all combined to
swell deficits. According to the PPF, the value
of pension scheme assets fell 9.8 per cent to
£772.3bn in the year to April 2009, while
liabilities during the period increased 15.8
per cent to £960.7bn.
These shifts have not gone unnoticed by
general partners. A survey of private equity
firms conducted by pension consultant Punter
Southall found that more than half of the
respondents were worried that changes in future
life expectancy predictions would increase
liabilities during ownership and cause a loss on
exit. In addition, the study showed that private
equity firms were very cautious when pricing
liabilities, with almost 90 per cent of respondents
valuing liabilities more conservatively than public
companies do. Yet even making a conservative
pricing of pension liabilities in the current
economic environment is proving tricky.
Pricing pressurePension liabilities are valued using the FRS 17
accounting standard, which values pension
schemes against the returns of an AA-rated
bond. When AA bonds prices were stable at
around 75 basis points above gilts, the measure
was accepted as accurate, but post-2007,
the spreads on AA bonds have expanded
substantially, up to 275 basis points above gilts.
The effect of this is that in accounting terms,
schemes look to be sufficiently funded, when in
reality there are doubts about whether current
credit spreads are genuine or just a reflection of a
credit-constrained market. A pension scheme that
looks funded on paper could just as easily be in
deficit given how unpredictable spreads are.
Pricing uncertainty has been exacerbated by
a lack of deal flow. With very few transactions
taking place, there is no benchmark or pricing
for how buyers and sellers are valuing schemes
when companies change hands. Dipping pension
asset values and uncertainty around pricing
liabilities mean that firms should be paying more
attention to pension funds within their portfolios.
“All businesses should be looking at their
schemes and assessing their appetite for risk,
how they should be investing assets, what they
can do with liabilities, and how much cash they
are prepared to put into a scheme,” says Richard
Jones, a principal at Punter Southall.
There are a number of options open to
portfolio companies to manage schemes. On
the asset side, companies can adjust their
investment strategy when investing pension
assets. More risk offers the possibility of higher
returns and smaller deficits – less risk will deliver
smaller returns but more certainty on what the
shortfall will be, and how much cash will be
needed to fund that gap.
On the liability side, portfolio companies can
change benefit structures by closing the scheme
to new entrants, reducing benefits when a
member retires early or cutting the total pension
payout by paying a pension in a tax-free lump
sum instead of over a number years.
funding Comparisons
end april 2009
end march 2009
one year ago –
end april 2008
Number of schemes in deficit 6,429 6,637 4,815
Funding gap of schemes in deficit £204.8bn £253.1bn £55.9bn
Number of schemes in surplus 953 774 2,596
Value of schemes in surplus £16.4bn £11.1bn £83.0bn
Aggregate balance -£188.5bn -£242.0bn £27.1bn
source: Pension Protection Fund
www.realdeals.eu.com REALDEALS 27
“Investment strategies and benefit structures
need to be negotiated with trustees and will vary
depending on a company’s situation. The most
important thing is to try and have an element of
flexibility that allows a company to adapt to
changing circumstances,” Jones says.
For some firms, however, the uncertainty and
complexity of fiddling with investment strategies
and benefit structures, coupled with fraught
negotiations with trustees, is too risky and time-
consuming. So seriously do some firms take these
risks that they will not acquire a target company
with a defined benefit scheme unless they are
able to buy it out and remove all the risk.
“The only time we will buy a company with a
defined benefit pension scheme is if we are able to
buy the scheme out as part of the deal,” Alchemy
Partners managing partner Jon Moulton says.
The buyout option involves a firm paying an
insurer to take on liabilities of the scheme,
normally at a premium to what the liabilities are
valued at. A scheme buyout removes the pension
risk for a portfolio company, and more private
equity firms are considering this option, but the
cost of doing so remains prohibitive.
“An insurer will want more than the FRS17
value to take on a scheme, and many private
equity firms will feel that they can pass on the
scheme for a lower cost when they sell on or
float a company,” says Jones.
Punter Southall’s survey revealed that private
equity firms would be willing to pay up to 125
per cent of a pension scheme’s market value to
pass it on, but with insurers demanding between
130 per cent and 150 per cent of market value to
take on schemes, most private equity firms have
been prepared to take their chances.
Moulton, however, maintains that the best
option is to stay away, or take the buyout cost
on the chin and move on without having to
worry about the risk. “The expense and changes
to the rules regarding defined benefit schemes
are frightening,” he says.
Transaction troublesBut it is not just the day-to-day funding and
management of pension schemes that need
to be considered. As demonstrated in the Focus
DIY case, private equity firms also need to be
aware of the risks posed by a pension scheme
when executing an exit or refinancing.
Any kind of transaction where a private equity
firm takes money out of a company with an under-
funded final salary scheme is likely to attract the
attention of the pensions regulator, which is tasked
with ensuring that under-funded schemes do not
fall in the PPF – the pool of funds set aside to
fund defined schemes as the last resort.
The regulator has the power to look back at
transactions and decide whether the pension
scheme was neglected when transactions were
completed. If it feels more funding should go into
the scheme, it has the power to serve a company
or previous owners with a financial support
directive or contribution notice, requiring parties
to put cash back into a scheme.
However, private equity firms can take steps
to protect themselves from a financial support
directive or contribution notice. The first step
is to request clearance from the regulator for a
transaction. This typically involves presenting it
with a trustee agreement, prepared beforehand.
If the regulator is happy with the deal for the
scheme, it will grant clearance and will not be
able to demand future payments into a scheme.
Obtaining trustee approval and regulatory
clearance can be costly and onerous.
“Trustees can easily demand more than you
think is required. They can keep saying no.
Negotiating payments can involve a bunfight
before reaching an agreement,” says Jones.
The other option open to firms and portfolio
companies is to make a statutory defence. When
considering a transaction, a firm can decide not
to go to the trustees, do due diligence on the
impact of a transaction on the pension scheme
and, if it concludes that the pension scheme will
not be negatively impacted, it can go ahead with
the deal. If in later years the regulator looks back
at the transaction, the owners can show that the
pension scheme was looked at and that, at the
time, there was no adverse effect on it.
be preparedThe key to avoiding unwelcome calls from the
regulator for scheme top-ups, and making sure
that trustees are happy with investment
strategies and benefit structures, is planning.
“You need to spend time working out your
numbers, be prepared and have very strong
arguments for making your case to trustees
and the regulator,” says Jones.
Pensions are now a priority, and the threat
of enduring the lengthy negotiations and
punitive penalty experienced by Duke Street
are a salutory warning. However, private equity
investors that are aware of the risks and plan
accordingly can avoid a visit from the regulator
further down the line.
nicholas neveling is a reporter for Real Deals.
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