The return of the turnaround merchants

With credit in short supply, private equity is having to stump up more of its own money and take a back-to-basics approach, says Mark Leftly

The much-maligned, but hugely successful, private equity industry is at a crossroads. If 2007 was the year that its executives were forced by political and media pressure to open up their companies, 2008 is when they have been forced to rethink their whole business model.

All the problems that have surfaced in the financial world in the past nine months – the credit crunch, debt market turmoil and market meltdown – have been ranged against private equity. Earlier this decade, easy access to cheap debt, strong economic growth and general confidence dovetailed so perfectly that, by 2007, the industry owned an estimated $1,160bn (£588m) of assets worldwide, according to research firm Private Equity Intelligence.

With economic conditions reversed, finance – which private equity firms raise through a combination of money received from investors and borrowed from banks – is hard to come by. There are fears that investors are growing impatient, and the suggestion is even being made that private equity will return to its roots, investing in small businesses with high growth potential.

Private equity's raison d'être is to do deals. Although there was a recent rush of sales by the owners of companies keen to cash in ahead of the near-doubling of capital gains tax on 6 April, this has disguised a downward trend.

One private equity executive describes how, at the end of the last year, he had not completed a deal for months. He was due to meet one of the investors in the fund that he managed and used to buy companies, and worried that he would be grilled on why the capital was not being deployed. Instead, the investor greeted him warmly, adding: "We understand. Don't worry." Recalling the incident, the executive now believes that "fund investors are sensible. I don't think anybody in the private equity industry is under pressure to get capital to work."

However, the executive's trepidation demonstrates the difficulties the industry is facing and which have changed the economics of its purchases.

With banks either unwilling or unable to lend, there has been a transformation in the debt-to-equity structure of buyouts since August. Whereas private equity injections were at one point as low as 20 per cent equity, there are rumours that this has in effect now reversed and in some cases is as high as 80 per cent. The lower the equity investment, the better return private equity can expect. If only 20 per cent of a £100m company is equity and that business is later sold for £200m, private equity will make £120m after repaying the debt (not including interest) – six times its original investment. If it stumps up 80 per cent of equity, the return is little over double. And with less capital committed, so private equity had more available to spend on other businesses.

What is important about the debt-to-equity change is that it is having an impact on mid-market takeovers, those worth up to about £250m. Up until now, attention has been focused on the effect of the credit crunch on mega deals – as, for example, when mining giant Anglo American had to pull the £6bn sale of its Tarmac subsidiary because private equity simply couldn't raise the billions the company needed from the market.

It had been thought that mid-market buyouts were less affected, as banks were still willing to lend a few tens or even a couple of hundred million. However, Torquil Macnaughton, founding director of the mid-market buyout house Penta Capital, now says: "There's definitely a tightening of credit available."

More often than not, debt-to-equity structure has fallen to a 50:50 split. Exponent Private Equity, for example, is understood to have stumped up half the cash for Radley, the luxury handbags manufacturer, in a £130m deal last month. The same group then bought Dreams, the beds chain, for a price tag believed to be around £250m, again under the same arrangement.

Exponent's founding partner, Chris Graham, declines to comment on those deals. However, he does concede that buyouts completed before the credit crunch were 60 to 75 per cent funded through debt, compared to 50 to 60 per cent today. "It makes those marginal low-risk businesses more difficult [to justify buying]," he says.

So, in the past, a private equity fund was less exposed with its own money if a business failed or could not meet its growth targets. As a result, it could take risks. But the gamble is less attractive if there is more to lose.

This is thought to have been the reason behind the infrastructure group AWG's failed sale of Morrison, one half of Facilities Services, the utilities and facilities management business. AWG had wanted to sell the facilities arm of Morrison beside its utilities division, but managed to get only the latter off its hands. The private equity firms Cognetas and Englefield Capital spent £135m on that division and are known to be still keen on the facilities arm. However, facilities had lost two major contracts, and given that private equity is again believed to have provided half the cash, the two groups went for the safer option and took over just the utilities arm.

Jonathan Mussellwhite, the partner at Cognetas who led on the deal, would not comment on Morrison, but emphasises how the cost of borrowing has shot up: "Average pricing is 25 to 50 basis points [0.25 to 0.5 per cent] up across the board."

One of his rivals adds that some banks are offering debt on even higher percentages, and that the reason for this is a Machiavellian one: "Banks are deliberately pricing at such levels so that private equity firms won't choose to borrow from them. The thing is, the banks don't want to admit that they are no longer in the market for lending."

Simon Tilley, a managing director at the investment bank Close Brothers, explains that the banks are under extreme pressure because of a "double whammy" – the first part being the constraints placed on them by the credit crunch. The second is this year's introduction of a EU banking rule known as Basel II.

"Basel II ensures that risk is more accurately reflected on the banks' balance sheets," explains Mr Tilley. "For every £100 they lent, they previously had to have £8 on their balance sheet to cover the risk. That figure could now be many times higher. If banks make risky loans, they must have more capital to take that risk." And if banks can't find more capital, the natural result is that they won't be able to cover the same number of deals as in the past.

All of this might take mid-market private equity back to its roots. Oliver Tant, global head of private equity at accountants KPMG, says he knows of funds looking to invest in turnaround and venture capital projects. Underperforming businesses should still offer high returns, provided private equity can introduce better operational systems and business strategies. As the industry's ambitions grew in the late 1990s, deals of this type tended to be neglected.

Edinburgh and London-based Dunedin Capital Partner specialises in this area, and in takeovers in the £10m-£75m range. Its chief executive, Ross Marshall, thumbs through the details of three deals he has completed in the past two years, confirming that Dunedin has always provided about 50 per cent of the equity. He then points out that this can be an advantage: "You can refinance quickly with a high level of equity. If, after 12 to 18 months, the business is performing ahead of expectations, you can then bring in more debt and get the refinancing gains."

But Mr Marshall is in a minority: most private equity executives are not pleased. One grumbles that funds raised in the past few years will not make the same returns as those at the start of the decade. And if returns are lower, investors will greet private equity fund managers with scowls, not friendly handshakes.