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Home / Business / Personal Finance

<i>Christopher Niesche:</i> Plumbing the power of private equity

Christopher Niesche
By Christopher Niesche,
Business Writer·
9 Feb, 2007 04:00 PM5 mins to read

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Christopher Niesche
Opinion by Christopher Niesche
Business Writer
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KEY POINTS:

If 2006 was a big year for private equity in New Zealand, 2007 looks even bigger.

The healthy prices paid for companies last year are expected to flush out more sellers, meaning we'll see Australian private equity firms pick more companies off the sharemarket or buy them before
they even get that far.

Already this year, private equity is in the thick of the bidding for two high-profile assets - Telecom's Yellow Pages and CanWest MediaWorks, owner of TV and radio stations, including TV3 - and is said to be running the ruler over anything that moves.

This raises the obvious question of why private equity investors are prepared to pay so much more for an asset than sharemarket investors or listed companies are.

Take the sale of Independent Liquor at the end of last year. On face value, brewer Lion Nathan had the most to gain by purchasing the drinks company - analysis by one investment bank suggests $30 million a year of synergy benefits alone.

Yet Australian private equity firms Pacific Equity Partners and CCMP Capital Asia paid nearly $200 million more than Lion's $1.07 billion bid, prompting observers to wonder how they could afford so much.

Private equity refers to the private ownership of companies, in contrast to publicly owned companies which are listed on the sharemarket. Essentially private equity firms pay more because they believe they can get better returns out of an asset than do other potential buyers.

There are two reasons for this: management and debt.

Everything about the way a private equity-owned company is run is about delivering returns. One investment banker describes it as "a laser-like focus on operational performance".

Private equity investors buy an asset with the aim of selling it for a hefty profit three to five years later, so they have a concrete, time-limited plan to maximise returns. There's none of the "minding the shop" attitude that the managers of some listed companies could be accused of.

Also, private equity-owned companies have only one owner and stakeholder: the investor. Contrast this with listed companies, who have a raft of people to keep happy: retail and institutional investors, analysts and brokers, and the media. Private equity can make the major changes it needs to away from the glare of publicity and the governance rules that are said to constrain listed companies.

Private equity funds like to claim they can get the best and sharpest managers for the companies they own. A decade ago, the pinnacle of business achievement for a manager was to be the chief executive of a listed company.

Now many of the best and the brightest aspire to run private equity-owned companies. This is because while the pay for heading a listed company isn't too bad, private equity managers can make a fortune.

The chief executive of a private equity-owned company usually has a stake in the business and can walk away with tens of millions of dollars when it's sold if all has gone to plan - not bad for three to five years' work. Rewards abroad can be much larger.

The fact that private equity players believe they can get better returns means they're prepared to take on more debt - the second reason why they can pay so much.

They need only a small proportion of equity - cash - to buy an asset as they're prepared to borrow the rest and have become much more aggressive in the past couple of years. They're prepared to borrow nine or more times trading profits - earnings before interest, tax, depreciation and amortisation - up from about the seven or so times they were prepared to pay only a couple of years ago.

They can do this in part because, unlike investors in public companies, private equity investors don't need dividends, freeing up more cash to pay back debt. Pay day comes later.

And they don't have analysts and investors telling them they've got too much debt on the books.

This means private equity's growing pool of money can be stretched further. But it also means they're banking on wringing better returns out of their buys than previous owners to fund the higher debt.

So, it's better management and more debt. But maybe that's not all.

Catalyst Investment Managers paid $360 million for Metropolitan Glass last year. This was $100 million more than Fletcher Building - itself fairly aggressive - was prepared to pay. Even with the advantages private equity has over public ownership, would the New Zealand glazier have done so much better under Catalyst's stewardship than former Fletcher Building chief executive Ralph Waters' to justify the huge premium?

Sometimes you have to wonder if buyers are asking themselves these sort of questions.

The rise of private equity in Australasia over the past few years has been extraordinary. Mirroring the global figures, private equity firms bought less than US$1 billion ($1.45 billion) worth of assets in Australia and New Zealand in 2000, representing less than 1 per cent of total merger and acquisition activity. Last year, private equity made acquisitions worth US$10 billion, nearly 20 per cent of total Australasian M&A.

It's not just the buyers who like private equity.

In an initial public offering an investment bank usually likes to leave some upside in the share price to give investors a quick premium from the float. That way the brokerage can go back to those investors next time they've got an IPO to get away.

So why would a seller want to leave some money on the table when they could get a full price from private equity bidders without all disclosure and regulatory hoops of an IPO?

The rise of private equity presents a stark challenge to the managers of sharemarket-listed businesses - to focus on value and growth. There is no reason why many of the factors that make private equity so successful can't be emulated in listed companies.

Their future may depend on it.

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