Private equity could prove to be a cash cow for Australian SMEs, but not without a few key precautions.
By Deborah Tarrant
Shrewd private equity players with dollars-to-go are looking their way to sniff out deals, eager to generate many happy and hopefully high returns. And Australia's smaller business should be preparing for a slice of the action.
The headline focus of private equity investors has been big business. As major international private equity firms homed in on corporate Australia's iconic brands in the past year, and our own investment houses began to burgeon with billion-dollar funds, owners and managers of small-to-medium enterprises (SMEs) might have been forgiven for assuming they'd been counted out. Not so, say the investment experts.
While the noise has been about leveraged buyouts and public-to-private transactions, a whole section of the market has been ignored in the media frenzy. There's a far smaller market coming through, and the current rush of funds is expected to find its way to SMEs. 'In the mid-sized market, there are a lot of private equity funds that have $200 million $400 million to invest that are looking at writing out $20 million $40 million cheques for the right transaction,' says Ian Knight CPA, who heads KPMG's private equity division.
Privately owned medium-sized businesses are a typical target for private equity investors. Even smaller companies are expected to see a knock-on effect, as cashed-up investors scramble for opportunities and adopt new strategies for the smaller end of town.
While the minnows may get a look-in with venture capital, and start-ups continue to source seed capital (often through government bodies), others will be getting lucky with business angels (individual high-net-worth investors).
As the catch cry of 'too much money and too few deals' is echoing through the investment community, private equity firms have already begun broadening their scope.
That Australian private equity players are feeling comfortable enough to buy part of private companies rather than wanting to own and control the lot is a sign of the times, says Professor Tom McKaskill of Swinburne University's Graduate School of Entrepreneurship and author of Finding the Money: How to Raise Venture Capital (Wilkinson Publishing).
Recent notable transactions have included $5 million of expansion capital for juice company Nudie, and a substantial investment by Ironbridge Capital in prepared chilled foods business Mrs Crocket's Kitchen.
Veteran private equity player Bill Ferris points out that for many businesses private equity has historically been the only choice in raising capital. He says these are risk-equity transactions that won't work on public markets, and that traditional lenders (banks) wouldn't want to shoulder unguarded. For example, CHAMP Ventures, one of the private equity firms Ferris formed with business partner Joe Skrynski, led a syndicate in the mid-90s to inject $15 million into Austal Ships, a company originally formed to build lobster-fishing craft in Western Australia.
Using the funds, entrepreneur John Rothwell revolutionised the economics of transport, with high-speed jet-propelled ferries. The deal was also nice work on the part of the private equity players, who had reaped a 40 per cent annual rate of return by the time Austal was floated on the ASX in 1998.
The past year's excitement has raised awareness among small-cap businesses who now see the value of going with a private equity group. 'There won't be many transactions where PE won't be invited in as a potential bidder, compared with four years ago when you had to bang on the door to be invited into processes,' confirms Mark Rigotti, private equity specialist with law firm Freehills. He says companies selling assets now may meet with four or five, perhaps 10 private equity houses.
Major beneficiaries of the private equity upsurge are expected to be Baby Boomer businesses, as they desperately seek succession strategies. A large number expected to change hands in the next decade. Andrew Mackie CPA is a director of Incite Management, a Sydney-based SME advisory company. Mackie finds his clients are increasingly asking questions about private equity: How can they access it? What does it do? How much they can get? He's currently working with four managing directors who are itching to retire, but don't yet have the right management teams in place to entice investors.
Although Mackie believes the much-reported abundance of funding will flow to smaller enterprises, experience tells him it will only go to those who are investor ready. 'The reason large, long-established businesses find it easier to attract equity,' he says, 'is because they tend to have the systems and management in place.'
According to McKaskill, a new tactic for private equity firms making investments in larger family companies is the sell-down strategy. Effectively, this means investors buying in and helping the founders of high-potential enterprises ready their businesses for sale. 'This will increase, as there are fewer deals suitable for conventional PE,' he tips.
Despite the anticipation of the availability of funds and business growth potential, it should be remembered that private equity firms are highly selective. According to Knight, they might look at 150 companies a year and end up buying between one and three. 'Good deals are hard to come by,' he says. 'But there are plenty out there.'
An upshot of the escalating activity is the proliferation of intermediaries. Typically, the first stop for a capital-seeking SME owner is an accountant, lawyer or industry association. While the Big Four professional services firms play a prominent matchmaking role between private equity firms and businesses, second-tier accounting firms are also developing a strong understanding of the sector. There is also an increasing number of professional advisers playing the field.
The adviser's role is crucial, says McKaskill, 'not only for finding the best investors, but because the PE investors are very skilled negotiators'. But McKaskill, a recognised world authority on exit strategies for high-growth enterprises, is cautious about promoting private equity to small business. 'The probability of any private company in Australia having venture capital or PE investment is about four in 10,000,' he says. 'So it's a tiny part of business funding, and somewhat overrated as a growth strategy. Few businesses that seek PE ever get it.'
According to Damian Chown of Strategon, a consulting firm specialising in private equity matchmaking, stumbling blocks begin at the angel investing level (under $1 million). They usually involve a disparity between the valuation of a business and a failure to put the right management team in place. 'Most business owners have unrealistic expectations,' Chown says.
And Chown is sceptical about how far this latest surge of private equity investment will flow, and thinks investors may not bother below the $3 million $5 million investment level.
Many medium-sized businesses are not in the right shape for investors, either, Mackie says. It's not unusual for businesses with 100200-plus employees to be lacking in vital functions, such as sales and marketing, research and development or production. Financially, they may also be messy. 'Many don't do proper budgets or cashflows, or are missing the latest accounts,' he says. 'They have no business plans or goals for the future. Without these they won't go anywhere with a private equity investor.'
Investors, after all, are known for playing hardball. Their initial focus is risk, but this soon changes. 'They are not really in the risk business,' McKaskill says. 'They want to hit the bull's-eye on every dimension of the investment. If they can't fix a weakness they will walk away.' Even so, about 30 per cent of private equity investments are written off.
They rely on meticulous due diligence to uncover liabilities. They are also sticklers for compliance, ratios and deal structure, and use a formal evaluation process to ensure they don't miss anything.
Half of the business owners and managers who attend McKaskill's seminars on private equity for SMEs leave when they hear what's involved. 'Either they can't meet the conditions, or they don't want to give up part of their business,' McKaskill says. 'A 2003 survey by RMIT University found that 28 per cent of Australian family businesses were willing to offer part-ownership of their business to secure growth funding.
The killer news for some is that the inevitable end of the process is the sale of the business, usually a trade sale, with IPOs about 20 per cent. Just as private equity firms are notoriously picky about where they put their money (many investors are cashed-up entrepreneurs), wise investees might take the same approach to choosing business partners: these commercial marriages of convenience tend to last a minimum of three to five years.
Beyond risk, investors' decisions are determined by the strength of the business model, the willingness of shareholders and key executives to work with institutional investment, and the right fit. Some investors have expertise in particular sectors and predetermined ROI targets and timescales. They reserve the right to monitor and intervene in business activities when necessary. Paramount, though, is the exit can the investor be reasonably certain of leaving with acceptable values and time scales?
Most off-putting for a business is the loss of control. External private equity investment may substantially change the business' 'vision', and usually requires a formal board of directors. Out go family, friends and partnerships, and there's the threat of what happens if the management team fails to meet agreed targets and is dismissed.
On the upside, McKaskill says, 'Private equity is risk money that's not available in any other way. And, a lot of people have made a lot of money on the back of private investors.
'Good private equity investors have done lots of deals and seen lots of mistakes. They bring not only capital but also a wealth of knowledge, can help source executives, strategic partners and customers, and provide facilities and infrastructure.'
Strategon's Chown cites instances of small businesses that have enjoyed such successful investor experiences, they keep coming back for more. One client, he says, now has some 20 investors.
McKaskill believes there's a vital three-step process for raising private equity. 'First, understand how it works,' he says. 'Then build a robust, compelling business concept and establish the right base business. Lastly, establish the right relationships.'
Types of Private equity funding
Professor Tom McKaskill of Swinburne University's Graduate School of Entrepreneurship advises businesses looking for growth capital to spend a year preparing and auditioning advisers and potential investors. It's vital to understand how much funding is needed and how different types of funding are classified. The first two tend to be the most difficult to source:
'Seed and R&D capital' is used to turn an idea into a saleable product or service
'Start-up capital' is for commercialising a business concept
'Early expansion capital' is growth funding for a young business
'Expansion capital' is growth capital for an established business
'Buy-out capital' funds the existing management team to buy the business.
