Taking the private line

News Analysis: The equity market is failing to meet the needs of many of the UK's smaller companies
LAST WEEK, Rebus, a computer services group trading in the FTSE SmallCap index, decided to go private. Announcing details of an agreed pounds 172m takeover by two US venture capitalists, Peter Presland, the Rebus chief executive, argued that the stock market simply wasn't interested in smaller companies.

Mr Presland isn't alone in his views. A recent study by the Centre of Management Buy-out Research at Nottingham University found the number of public to private deals more than quadrupled in 1998. All the evidence suggests that this trend is set to continue - the equity markets just aren't meeting the needs of many of the UK's smaller quoted companies.

"There is a mass of smaller public companies who are frustrated," said Chris Ward, head of the corporate finance advisory group at Deloitte & Touche. "There is a dwindling number of fund managers focused on the smaller end of the market."

For the larger institutional fund manager, investing in small -to-mid cap stocks can be uneconomical. Many are not tracked by City analysts, meaning it can be expensive and time-consuming to pull together company information. Institutional fund managers also find it more efficient to invest large blocks of cash in a single company, rather than putting in a couple of million pounds here and there.

But if you trade in pounds 100m blocks in the small to mid cap index, you end up owning the entire share capital of companies before you know it, something that does not appeal to your run-of-the-mill fund manager. These problems have always dogged small-to-mid cap stocks, and don't seem to have caused them major difficulties up until now. So what's changed?

One factor, according to Mr Ward, is the new European currency. He said: "It's been exacerbated by the euro - a number of larger fund managers have been rebasing their portfolios and need to get the correct weighting of European stocks."

Because liquidity - or the existence of many buyers and many sellers - is valued above all else in the world's capital markets, the exit of a few big players can spark a downward spiral. A few big players exit - the market becomes less liquid. A few more players exit - the market becomes even less liquid, and before you know it things have dried up altogether.

Enter the venture capitalists. These specialist firms are always on the look out for new investments. They are well-suited to dealing with smaller companies, tending to favour medium to long-term investments and active management of their portfolio. Many can hardly believe their luck at the valuations currently being put on smaller quoted companies by the UK stock market.

"With the low value being placed by the stock market on small cap companies, the trend towards public to private deals can only increase," said Anthony Fawcett, head of acquisition finance at Barclays. "There is more opportunity in this area than there has been for some time," said Ed McKinley, partner at Warburg, Pincus, one of the two US venture capital groups which plan to take over Rebus.

Going private is not the only solution for those smaller quoted companies which are struggling to raise capital cheaply on the equity markets. As Mr McKinley explained: "You can also bring to a public company a large committed shareholder that does not have the liquidity requirements of some of the institutions, and that shares the goals of the company's board."

The difficulty with involving venture capitalists - often the obvious candidates for public-to-private takeovers or for stumping up the cash for a long-term company stake - is that it means surrendering some degree of management control. However, there may be another answer - the bond market.

The same week that Rebus decided it had had enough of the equity market, Brixton Estate, a property developer in the FTSE 250, made its first unsecured bond issue. The result? An out-and-out success, according to Frank Kennedy, executive director of debt capital markets at Warburg Dillon Read, which acted with HSBC as joint book-runner for the issue.

Mr Kennedy explained: "The bond markets are in a very different state to the equity markets. There is a very strong appetite for corporate bonds."

There are numerous reasons for this - including strong investor demand for corporate bond PEPs and the desire of fund managers for higher yield from their fixed income portfolio. What's more, most sterling corporate bonds tend to be issued in Eurobond form. Unlike the equity market for small and mid cap stocks, the Eurobond market is highly liquid. "We'll see continued strong demand from institutions and a range of new names coming to the market," predicted Mr Kennedy.

One difficulty with corporate bonds - particularly those issued by smaller, less well-known companies - is that investor demand tends to dry up completely at times of market uncertainty. Last autumn, for example, investors shunned all sorts of high-yield offerings amid the financial market chaos triggered by the Russian debt default.

Moreover, corporate bonds are simply not suitable for the smallest quoted companies, which are unable to offer sufficient quality paper to attract the big investors. For some of these companies, therefore, it really does seem that the financial markets may have failed.

It is when markets fail that governments have a role to play. Introducing investment tax reliefs for a wide range of smaller quoted companies may not be a bad place to start.

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