Can private equity help a business?

Laurie Freedman, the CEO of Perth-based Emeco, says his private equity backers didn't know much about the mining equipment industry when they supported a management buyout in 2004.

John Porter, the head of Austar, reports a similar lack of industry knowledge when his private equity supporters took control of his regional pay television company in 2002.

Not that it seemed to matter to either of them. Freedman and Porter had the industry expertise.

What they needed when private equity came aboard was expertise in financial markets and financial engineering: in Freedman's case to fund a grand expansion plan to take advantage of the resources boom; in Porter's case to extract his company from a financial crisis and to give him the space to develop the business.

Private equity has come to dominate the Australian corporate landscape in the past 12 months for two main reasons: the depth of private equity funds' pockets, and the scale of ambitions that seem to know no boundaries.

Some of Australia's biggest and best-known companies, such as Qantas and Coles, have found themselves the targets – willingly or not – of private equity funds.

But as the number and size of the private equity takeovers have increased, the headlines have been ringing, and so too has the criticism and the name-calling.

Private equity is accused of preying on the weak and the inefficient, of being predatory and self-serving. Bearing stylish haircuts and smart suits, private equity players do not have the conventional image of barbarians. But owning a reputation of investors prepared to slash and burn for the sake of an IRR of 20 per cent plus, the moniker has stuck.

Yet the experience of Freedman, Porter and Brian Hodges, the CEO of engineering firm Bradken, points to a different side of private equity. In all three cases private equity ownership was rewarding for the backers. Also noteworthy was that the companies' performance was greatly improved, and they have continued to show gains since returning to public ownership.

'Private equity gets a bad rap for looting and burning,' Porter says. 'They get criticised for coming in and not having a strategic plan, of having a goal just to accelerate the cashflow and get in and out. But that wasn't our experience. They were willing to invest for the long term, and to make strategic decisions that might not benefit the company until they were out.'

When CHAMP Private Equity and its strategic partner Liberty Global bought a controlling stake in Austar, the company was in a state of financial crisis. It had high-yield debt that it could not service. Vulture funds were buying its debt at a discount on capital markets.

Porter says the mere presence of private equity funds, and their reputation for conducting substantial amounts of due diligence and understanding of the prospects of a business, gave Austar an immediate re-rating.

'First and foremost they brought cash and market credibility so we could get back into the capital markets and restructure commercial debt,' Porter reveals. 'That gave us some head room, so that I and other key members of the management team could continue the operational turnaround.'

Freedman had a similar experience, albeit in different circumstances. Emeco had been part of a family-owned group based in the US. When its owners wanted out, Emeco engaged Deutsche Bank to find an appropriate shareholder.

Emeco is not a victim of private equity, but rather as a happy beneficiary of its deep pockets and intimate financial knowledge. Freedman says Emeco chose Archer Capital and Pacific Equity Partners not merely because of their money and ambitions for growth.

'It was more about the chemistry of the relationship,' he explains. 'They offered us a significant amount of skill in financial engineering, and dealing with major debt markets.

'They knew very little about mining equipment, but they were prepared to fund good ideas. They challenged us to articulate our vision, and they would run our ideas through their financial and strategic models.'

PEP and Archer bought Emeco in late 2004 for an estimated AUD$475 million, including debt. Management took a 25 per cent stake.

The new owners quickly arranged a AUD$225 million debt and bond raising, which allowed the company to launch an aggressive expansion strategy, buying local rivals in Australia, funding a bridgehead in Canada and expanding in Europe and Asia.

Bradken's Ebitda rose from AUD$73 million in 2004, to AUD$96 million in 2005, and AUD$142 million in 2006. It is forecast to grow to AUD$207 million in 2007.

The pace of expansion was so quick that even the private equity funds couldn't keep up, and the owners decided to sell the company to the public through an IPO to access more funds.

In July last year, the company was sold at an enterprise value of AUD$1.44bn. PEP and Archer made a return of 3.8 times their equity investment in 18 months.

'They and we thought it would be a more traditional three-to-five-year building program, but the opportunities to further deploy our business model meant we had to accelerate those plans,' Freedman says. 'It wasn't the intention from day one, it was success that drove that.'

Austar was different to most private equity examples because it remained a listed company, but the impact and influence of the private equity funds were no less compelling.

'It was a unique situation,' Porter says. 'We remained a public company with public accountability. But they were not worried about the stock price day today, or the results on a quarter-by-quarter basis. They were looking at a two-to-four-year horizon.'

Private equity ownership enabled Austar to move through what was seen as an inflexion point in the industry, focus attention on the core subscription TV business, and improve the key metrics of new subscriber growth, churn and revenue per user.

It proved a success. CHAMP and Liberty had bought the rights to 82 per cent of Austar's equity from US bondholders. When CHAMP sold its stake earlier this year, it had made a return of seven times its equity investment, and its shares have gained a further 50 per cent since then.

Interviewed separately, Porter and Freedman clearly agreed on several key points about the qualities of their private equity backers. The first was the issue of timing.

Says Porter: 'The main thing I learned is that private equity needs to be looked at as another form of capital. It has been a bit shrouded in mystery and sometimes gets a bad rap for doing things it doesn't necessarily do. It can be the right form of capital at certain stages of development.'

Freedman agrees. 'They [private equity] were right for Emeco just for that point of time, in bringing those additional resources and capabilities to a small and relatively inexperienced traditional management team,' he says.

The second point of agreement was the disciplined approach to business. 'They brought a high level of fiscal accountability,' Porter says. 'They quickly understood what the key metrics of the business were, and as long as they were tracking, they were happy.'Says Freedman: 'They were very active shareholders. They introduced a very formal corporate governance and board structure.'

The third point in common between Porter and Freedman was the complimentary remarks about the qualities of the private equity executives with whom they dealt.

'My experience is that they are people of integrity,' Porter says. 'They want to make good returns but they are not averse to investing and backing a successful management team. They were not going to come in and run the company for you.'

Says Freedman: 'You have got to acknowledge their intellect. They are smart guys. We learned a lot about financial structuring, how to bring efficient debt levels, how to manage highly geared companies. They had a high level of focus and energy. But they treated us like equals. There was never a blue, never a harsh word said during the period.'

Bradken was sold as a business because it had become surplus to requirements after Smorgon Steel bought Australian National Industries in 1999. In 2001, CHAMP Private Equity and Esco Corporation supported an AUD$186m management buyout.

During CHAMP's three-year ownership, new capital was invested to capture growth opportunities, and improve the efficiencies of it foundries. Bradken's EBITDA grew by more than 60 per cent in the three-year period before its IPO in 2004.

CHAMP realised more than three times its investment cost, with an IRR of 49 per cent. It retains a 10.1 per cent stake in Bradken, and the value of that investment has more than quadrupled since its public listing.

Hodges says private equity ownership brought many clear advantages: it enabled management to focus on value-adding work, it set clear targets for Ebitda, encouraged the promotion of its own brand, aligned the interests of employees to the company, and – like Austar and Emeco – taught the executive team how to manage higher debt levels.

'Private equity ownership improved the business in many aspects through its support for management, challenging the business strategy and bringing focus to the business,' Hodges says.

'It added a missing element – capital expenditure – and it created an ownership culture that was so critical for leadership. All these things flowed on to the public company.'

Hodges identified similar qualities in private equity as Freedman and Porter: 'They certainly didn't have any foundry expertise, but they were highly intelligent people who worked very hard and very long hours. They were very questioning and created a terrific, challenging environment. They challenged all our business theories. It meant either that those theories held true but we became stronger and better at it, or in a few cases we changed it.'

Hodges says the higher level of debt meant management had to be 'faster, sharper and quicker', but working for a focused company rather than being part of a bigger corporate group meant that decisions could be taken quickly.

He did not know what to expect before private equity ownership. 'I'd never heard of it,' he admits.

'We needed new owners, we were the unloved division of a bigger corporate. We learned as we went. But it proved to me that the link with management and equity is fundamental – and private equity is a great vehicle for achieving that.'

Porter, too, was unsure of what private equity was about before the arrival of CHAMP. 'When they first came in, I had a bit to learn about private equity and how they operated,' he says.

'I had a couple of conversations early on. They were quite forthcoming about what they wanted to accomplish. That was enough for me. They are not necessarily going to come in and run the company for you, but they didn't slow us down from the things we wanted and needed to do.'

Freedman is an interested observer of some of the private equity deals being concluded, or at least attempted, in the current market. Like many others, he notes that multiples are getting high, even if they are not meeting the expectations of some investors, who fret about the next port of call for their funds.

But Freedman says he would happily do it all again if the circumstances arose. 'My experience would be repeatable,' he says. 'It's been a great experience. I couldn't have hoped for a better group to work with.

Reference: June 2007, volume 77:05, p. 40-43

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