Private Equity: SME Saviour?

Could private equity (PE) funds be the saviour of entrepreneurial businesses in the UK? With banks still nervous about lending (thanks to recessionary risks as much as the credit crunch) and market upheaval creating opportunities galore, I think PE might just come into its own.

But before we start cheerleading for a group of investors who have been (some might say fairly) tarred with the investment banking brush, a quick look at why this proposition is, at least partly, counter-intuitive. The fact is, private equity has taken a hammering over the past couple of years.

Big leveraged buy-outs (LBOs) that were all the rage in the middle of the decade are starting to unravel nastily. Former superstars of PE such as Guy Hands are now facing a dread reckoning on mega-deals like the acquisition of EMI. And having shaken off a slew of questions about ethics and disclosures a couple of years ago with a voluntary code of conduct (set out by the Walker Working Group), recession-hit companies owned by PE firms are re-igniting the debate about PE's civic duties by laying people off and slashing costs.

Meanwhile, the big banks are looking to shake up or ship out their in-house PE teams - Barclays being a prime example. (Ironically, of course, banks that lent vast sums of debt to the LBO players three or four years ago and starting to find that following defaults, they're now the proud owners of huge amounts of equity after the PE backers did the corporate equivalent of handing back the keys to a mortgage company.)

Fund-raisings are "non existent" right now, according to an institutional investor I spoke to a couple of weeks ago. And PE funds are largely stuck with all these problems: PE exits - selling their investments in order to generate returns for their own investors - are down 82% this year. Ouch.

So why the optimism for PE in the small and mid-market? Three simple reasons:

1. There's a bunch of cash out there. The PE overhang -- that is, money committed to funds by investors but as yet unused by those funds to buy companies -- is still huge. The big LBO players are in retreat, partly because shareholders in larger quoted companies can't stomach the idea of locking in their equity losses while the markets are so low. But for firms investing in nimbler, smaller businesses, opportunities still exist. In some cases, debt-for-equity swaps (wiping out existing PE backers, but smarting up the balance sheet) are making firms more attractive. That means they can deploy their cash reserves, if they can find businesses to invest in. (And remember: venture capital trusts, which have to invest in small businesses, have huge reserves of cash undeployed, and if they don't use it, they run into severe tax complications.)
2. PE firms are getting more creative. The mid-market and venture end of the PE industry has always prized business transformation over financial engineering. In other words, they make their money boosting earnings rather than using massive debts to leverage their equity stakes. So in the absence of bank debt, equity-only deals are becoming more common. (Check out this video where Jones Day partner Brette Simon explains how they're making that work.)
3. Business is changing. Big businesses are incredibly vulnerable at the moment. A combination of poor financing, rapid technological change, shifting global spending power, a new environmentalism and a deep recession means smaller, more flexible companies offer much more upside that they might once have done.

(Pic: Scragz cc2.0)