Richard Inder: Hirepool price shows private equity pitfalls

Glamour couple Tenby Powell and Sharon Hunter are the latest beneficiaries in the private equity boom.

With Goldman Sachs JBWere's private equity arm, Powell and Hunter - who made her first fortune setting up and then selling the computer company PC Direct - bought the equipment rental firm Hirepool from transport group Owens in 2003 for $46.6 million.

Powell and Hunter's 24.5 per cent share at the time was worth $11.65 million. Yesterday, Hirepool confirmed Goldman Sachs JBWere and transport group Mainfreight had quit the business in a deal that valued the firm at $172 million. Mainfreight inherited Owens' residual stake when it took over its rival in 2003.

At this price, Powell and Hunter's stake in the venture was worth $43 million - a quadrupling in the value of their holding.

It is hard to say just how much Hunter and Powell - who will retain a 20 per cent stake in the business - have made. Neither their borrowings nor their subsequent equity investments in the business have been disclosed.

But their paper gain still looks chunky - some have even gone as far to say it looks ridiculous.

According to a source familiar with the situation, the deal values Hirepool at eight times its June 2006 trading profits.

Compare this with Hirepool's local rival Hirequip, which is in many respects an analogous business, yet trades at a multiple of around 6.3 times.

To put it another way, if Hirequip were valued in a similar way to Hirepool it would be worth around $176 million or equal to around $1.50 a share, a value well ahead of last night's close of $1.10.

Hirepool has over the last year benefited from the construction boom that is now beginning to tail off. If the firm was valued off next year's earnings the price may look even more rich.

Sure its potential for growth remains strong.

It has benefited from industry consolidation and there are perhaps gains still to be made. Porter Hire, owned by the Porter Group, is one company named as a potential target.

It is perhaps not without justification that Powell, who remains as Hirepool's managing director, this week told the Australian Financial Review he planned to float Hirepool on the NZX once he had doubled its size.

But Australia's Coates Group trades at just over seven times trading profits, operates in a much larger market and has greater potential to grow.

Hirepool's prospects alone do not seem to be enough to justify the price. The missing piece of the jigsaw may be found in its buyer, the private equity firm Next Capital.

The firm - set up by three top-ranking Macquarie Bank executives - is one of the burgeoning number of private equity firms setting up across the Tasman.

Next and its ilk owe their existence to the river of cash flowing from Australia's compulsory superannuation schemes and the growing recognition of this specialist type of fund as an asset class.

In the UK and the US private equity accounts funds figure in 30 per cent to 40 per cent of all merger and acquisition transactions.

In Australia, the figure is 10 per cent and continues to grow. In New Zealand the trend has been felt through a raft of takeovers including biscuit maker Griffins, and chicken producer Tegel.

Private equity funds are seen as strong bidders for the Hansells and Healtheries food businesses, just put up for sale by their multi-millionaire owner Gary Lane.

The firms typically buy underperforming businesses, drive out costs, merge them with rivals then float or sell them on to trade buyers after two to four years.

Acquisitions are highly leveraged and as a result generate returns for the funds even if the investments themselves show only modest growth.

The less charitable view is that these funds have cash to burn and as a result are doing just that. If cash sits on their balance sheet unused, it becomes a cost. So it is more than likely that some are investing simply to avoid the costs of not investing.

Next's acquisition will be judged by history, but it is inevitable that some of these deals will come back to haunt the funds.

If the prices they have paid are ridiculous, they may have to sell for less than they have paid. Worse still the businesses could be buffed up and then sold to unsuspecting share market investors, with inevitable results.

Carpet maker Feltex - spun out of private equity firm Credit Suisse First Boston Asian Merchant Partners and now in a state of what may be terminal decline - is one such business that may fall into this category.

The boom creates a conundrum. Ultimately those who are putting up the cash for private equity funds are retail investors, the mums and dads who depend on prudent investments to pay for retirement. They will weather any losses.

But it is also important not to take fright. The latest sale was engineered by a private equity fund (Goldman Sachs JB Were's Hauraki No1 Fund) that has - in this transaction at least - done a superb job for its investors.

And the trend should not be dismissed.

Hirequip's shares have already benefited from the Hirepool sale. However, it is still trading at a discount of 35 per cent to its rival and this gap may be too large to ignore.