The recent offer by Catalyst Investment Managers for Just Jeans has sparked renewed interest in the role of venture capital providers in 'public to private' transactions and management buy-outs. Katherine Sainty, a partner in our Emerging Technologies and Private Equity practice group and Gerry Cawson, a senior associate in the group, consider the implications of this deal for the private equity market.
- Just Jeans
- Private equity for MBOs
- Management's relationship with private equity providers
- Conclusion
The Australian Bureau of Statistics in their report on the venture capital industry for 1999/2000 indicated that more that $2.6 billion had been invested by some 127 venture capital investment vehicles in 651 target companies. This level of activity suggests that there is a significant pool of private equity capital which companies seeking funds should consider.
Just Jeans
Catalyst Investment Managers' recent $180 million bid for Just Jeans has been heralded as the first transaction in Australia where a public company is being privatised in a leveraged transaction. However 'public to private' buyouts are common in the US and Europe where smaller, low growth companies with solid cash flows, low leverage and low liquidity face restricted access to additional capital. The principles behind this sort of transaction are not unique to publicly listed companies and apply equally to deals involving private companies. One key element of the Just Jeans transaction is the stated intention of Catalyst to retain the Just Jeans management team. Numerous surveys by business analysts have indicated that continuity of management is one of the single most important factors in making an acquisition successful. From an equity provider's perspective the ability to acquire a significant interest in a pre-existing business with a settled management team would appear to increase the chances of a successful acquisition. An acquisition is generally judged successful by an equity provider's ability to obtain a rate of return on its investment in excess of the expected rate of return in the market of 30-40%.
Private equity for MBOs
Private equity providers have identified the management buy-out (or MBO) as having the potential to provide such significant returns on their investment. An MBO results in the owners of a business, typically a larger corporate group, divesting its ownership to investors including the incumbent management team. A private equity investor, in return for an equity stake in the business may provide a significant amount of the purchase price and funds for growth.
Notwithstanding that the availability of funds for this type of investment appears to be growing, year on year, the number of transactions that have been completed is relatively low. One reason put forward for this by private equity providers is the lack of management awareness or appetite in relation to advantages and disadvantages of MBOs. This lack of awareness, combined with the increasing weight of funds focussing on the MBO market creates a mismatch in the demand and supply of MBO funding. This suggests that for the right management team and the right company, the terms upon which such funding may be available could be more favourable than was previously the case.
Benefits of an MBO
MBOs offer potential benefits to vendors and management alike. In any sale the vendor is expected to make confidential information available to a prospective purchaser. In an MBO a vendor would be unlikely to have to make confidential information available to third parties who may be competitors of the business. In addition, a vendor may be able to complete the sale without giving certain of the usual warranties as the management team will be familiar with the state of the business. For the management team an MBO offers the security of continued involvement in the business, removing the uncertainty that may arise following an acquisition by a third party trade buyer. Their participation in the equity capital of the target also provides them with the potential rewards of ownership and gives them greater influence over and commitment to the business' future direction.
Management's relationship with private equity providers
Having said all this, the providers of private equity do not want to throw their money away! The value of deals closed by venture capitalists still represents only a small proportion of the money raised by them, showing the care with which investments are made.
Management incentives
After being so careful in their investment decision, it is hardly surprising that private equity providers seek to protect that investment and maximise its value. With an MBO the interests of the private equity provider are fairly closely aligned to those of the management team, which itself has a significant stake in the successful operation of the business. However, private equity providers will generally seek to provide additional performance incentives to the management team. These seek to increase the return on capital for both the management team and the capital provider both throughout the life of the investment and upon an exit.
The more traditional incentive arrangements primarily revolved around the service agreements entered into with the management team. This is now giving way to more direct incentive mechanisms such as share option schemes and 'ratchets'. The basic operation of a ratchet is to alter the proportion of the ordinary share capital held by the management team to reflect an increase in the company's value on exit by the private equity providers. The ratchet will be triggered by performance of the company in excess of certain agreed parameters. Generally these parameters will be linked to an internal rate of return received by the private equity provider. As the private equity industry as a whole seeks to achieve internal rates of return in excess of 30%, it is evident that even in those businesses that merely reach but do not exceed this target, the benefit to the management team, in terms of equity value, may be significant.
Business controls
Of course the fact of life is that private equity providers having made the significant decision to invest in an entity wish to protect their investment. While the day to day freedom to run the business is generally left with the management team, an equity provider will normally seek protection by requiring specific veto rights over certain decisions relating to the strategic management of the company. Different venture capital providers will seek different rights to protect their capital.
Even before the deal is completed, exist strategies are uppermost in a capital provider's contemplation. Trade sales or IPOs are the favoured exit mechanisms for private equity providers. The vetos and other protections that a private equity provider seeks are designed to protect the value of its investment and maintain the opportunities for a successful exit.
Security for private equity providers
While the potential benefits to a management team of a MBO transaction are clear it is common for the team to be provided with a 'stick' to go with the 'carrot' of capital appreciation. It is usual for management team members to be obliged to mortgage their property in order to borrow the sum required for them to subscribe for an interest in the equity of the target company. This in itself provides an incentive to ensure that the business performs. In addition, private equity providers often require particular rights over the shares of a management team in circumstances where a member of that team ceases to be actively involved in the business. The specific terms of these rights vary from provider to provider and from deal to deal but would, generally, provide an equity provider with the pre-emptive right to acquire the shares of a member of management in advance of the other members of the management team. They would also generally allow the equity provider to direct to whom such shares should be transferred and include rights allowing an equity provider to tag along to any sale by a member of the management team or drag along the management team in any sale by the equity provider of its shares. Each of these mechanisms is designed to assist the private equity provider to exit the target business.
Conclusion
Historically, venture capitalists have found that members of Australian management teams lack appetite for the potential financial benefits of MBO transactions and have a fairly conservative attitude to risk. It may be that the publicity surrounding the Just Jeans deal will stimulate the interest of both managers and vendors in seeking to pursue the exciting opportunities for MBO funding that exists and become a catalyst for activity in the industry.
