The rise of LBOs and implications for directors Leveraged buyouts

If non-executive directors on publicly-listed companies are doing it tough, then spare a thought for colleagues on the boards of companies that have gone through the process of a leveraged buy-outs or management buy-ins. Andrew Rothery explains.

The market for private equity and leveraged buyouts (LBOs) is experiencing a renaissance in Australia. Several high-profile deals in 2001 generated a level of LBO activity not seen since the heady 80s. More importantly, this activity has been characterised by a quality of business that bodes well for this relatively unsung member of the corporate finance family. For company directors, the growth in private equity-backed buyouts - including management buyouts (MBOs) and management buyins (MBIs) - is a significant trend because directors may well find themselves in the unaccustomed position of entertaining a bid from a private equity investor or considering an invitation to join the board of a company that has been the subject of a buyout. In an uncertain global economy, conglomerates will be looking to divest non-core assets, overseas-domiciled corporations will continue to exit the local market and beleaguered publicly listed minnows will be considering their options. These sellers will increasingly find that interest will come not only from other corporate buyers but also from private equity investors, often working with existing managers (MBOs) or external managers wanting to buy in (MBIs).

According to the 2001 Australian Venture Capital Journal/Investor Weekly Venture Capital Survey, the Australian and New Zealand private equity industry is capitalised at a record $9.26 billion, an increase of 8.7 percent on the previous year. Funds under management account for $6.85 billion - an increase of 18.1 percent on the previous year. In 2000-01, 41 private equity fund managers raised $1.43 billion. The increased buying power has clearly been translated into increased buying activity. In October, Smorgon Steel Group sold its Bradken heavy engineering division to a syndicate led by Castle Harlan Australian Mezzanine Partners (CHAMP), for $186 million. The syndicate included Bradken senior management, prompting CHAMP executive chairman Bill Ferris to remark: "It's great to see these relatively unloved businesses back in the hands of management who, motivated with equity in the business, can really crank up the running of the operations." The potential for optimal performance is enhanced when operating control is vested in those who actually work at the coal face, rather than in a remote corporate centre.

In September, GS Private Equity acquired Edwards Dunlop Paper and Commonwealth Paper Company from PaperlinX for $70 million. GS Private Equity has backed in a new CEO, Joe Foster, who will run the merged businesses. With experience of one previous buyout under his belt, Foster believes MBOs "invigorate" a business: "The excitement of actually backing a decision you as management have made through to fruition gives great professional and personal satisfaction." This year, Australia will likely see up to four times the number of buyouts experienced in any year during the past decade. In addition to those mentioned above, LBOs concluded this year include: Automotive Parts Group/Repco ($270m), Service Corp International Australia ($240m), Just Jeans ($108m), and Dun & Bradstreet Australia ($50m-plus). Other deals are in the pipeline, including Pacific Dunlop's sale of its Pacific Brands group for an estimated $650 million-plus. By international standards, the LBO market in Australia is still in its infancy. But if this year's activity is any indication, 2002 should see an even greater flow of private equity funds into corporate Australia.

As with LBOs around the world, debt remains the cornerstone of the deal - investee companies will usually have highly geared balance sheets and complex financial structures. It's not every director's cup of tea. There are increasingly diverse options for funding acquisitions, including the recent Automotive Parts Group (Repco) retail bond issue, with the bonds in that case supplanting traditional subordinated debt from banks and institutional investors. Expect to see more such issues in the case of LBO businesses possessing brands with strong recognition among retail investors. Businesses held by private equity investors are vastly different from most listed companies. Accordingly, the boardroom environments are worlds apart. Good corporate governance is of critical importance to private equity investees, but non-executive directors who successfully make the transition to LBO businesses understand the distinctive hallmarks of the private equity investee company. A critical and unique feature of a buyout company is the exit - the transaction by which an investment is realised. In Australia, the trade sale is the most favoured exit, ahead of IPOs.

The private equity investor makes its money by buying a business, improving it, and then selling it, usually within three to five years. Once an investment is made, exit planning starts immediately. The shareholders and board of an investee company lead the exit planning. For directors, the defined exit period requires a different, sharper focus than they might be used to in a public company. Directors will always have a keen eye on how companies can generate shareholder value, but in the case of an investee company it requires a keener eye in a compressed time. Investee companies don't have the benefit of many years stretching out before them to make the company work. Non-executive directors need to understand the financial imperatives of private equity investors and how such investors differ from other institutional shareholders. Private equity investors have a razor sharp focus on maximising internal rates of return on investments - within certain risk parameters - over investment holding periods. Unlike publicly listed companies, the ownership of private equity investees is concentrated in the hands of a few. The controlling shareholders - the private equity investors - are vitally concerned about the fortunes of the company.

As such, the relationship between a company's owners and its directors is intense. External non-executive directors will spend a considerable amount of time sitting in a room with the people to whom they're ultimately accountable - the owners of the business. Reflecting these unique characteristics, private equity investees are best served by a small board of five to seven directors. The board of a private equity investee will probably have a small number of external non-executive directors (ie, non-executive directors other than the executives of the private equity firm who sit on the investee board), one of whom will likely be the chairman. It is irrelevant whether or not there is a majority of non-executive directors on the board of an investee. The far more important consideration is the quality of the individuals serving on the board. The notion of the "independence" of non-executive directors does not have the same applicability as in a traditional public company with a large, diverse register of retail and institutional shareholders who expect their interests to be represented by people who are independent of management.

In the case of a very closely held company there might be very little difference between a gathering of the board and a gathering of shareholders. In such an environment the success of the board in performing its role will be dependent on an element of goodwill existing between the shareholders and the board. An awareness of the special circumstances of private equity investees is a critical attribute of directors sitting on an investee company board. Financial literacy is also essential. As mentioned above, the capital structures of bought out businesses are invariably more highly geared that those of traditional public companies. Leverage is an important contributor to the returns from LBO investments. Those afraid of leverage, even in prudent doses, need not apply to join the board of an investee company. Also appreciated is a willingness on the part of directors to roll up their sleeves and help the investee management team above and beyond the basics of board meeting participation. While such willingness should be the hallmark of any good company director it is doubly important in the close confines of the boardroom of the bought out business.

Overseas, a growing number of professional non-executive directors are choosing to specialise in sitting on the boards of businesses owned by private equity firms. As private equity activity in Australia grows, it's specialisation will develop here.

* Andrew Rothery is managing director of GS Private Equity.

Australian private equity firms 2001

TOP 10 FUND MANAGERS & LISTED FIRMS CAPITAL ($) DB Capital Partners 668.40 Castle Harlan Australian Mezzanine Partners 550.00 Catalyst Investment Managers 350.00 AMP Henderson Global Investors Private Equity 343.00 GS Private Equity 289.20 Macquarie Direct Investment 289.00 Westpac Development Capital 230.00 Colonial First State Private Equity 222.00 Allen & Buckeridge 220.00 Technology Venture Partners 209.00 Source: GSPE, AVCJ (October 2001)

GROWTH OF THE AUSTRALIAN & NZ VENTURE CAPITAL INDUSTRY 1993-2001 Year No. of Firms Total Capital $m 1993 46 4,423.0 1994 54 4,345.9 1995 62 4,592.3 1996 56 4,186.6 1997 68 4,916.8 1998 73 4,857.3 1999 96 5,865.3 2000 135 8,525.8 2001 148 9,238.9 Source: Australian Venture Capital Journal (October 2001)

VENTURE CAPITAL RAISED 1993-2001 IN AUSTRALIA & NZ Year No. of Firms Total Capital $m 1992-93 13 299.00 1993-94 9 201.10 1994-95 12 224.41 1995-96 15 296.90 1996-97 19 701.80 1997-98 18 426.93 1998-99 21 844.70 1999-00 44 1,954.37 2000-01 41 1,431.98 Source: Australian Venture Capital Journal (October 2001)

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