Portfolio Management Special

Portfolio MANAGeMeNt

SPECIALIn association with

14 REALDEALS 4 June 2009

cash&costs

WorkiNG cAPitAl hArdPrivate equity is already well known for its focus on cash. But when sales are down, and new finance a precious commodity, it is essential that every last drop of working capital is squeezed from investee companies. by richard young

You kNoW thiNGs Are GettiNG serious

when businessmen invoke the spectre of private

equity in order to ram home their point. “One

of my clients summed it up perfectly,” says Tom

Aldridge, a senior vice-president with Celerant

Consulting. “He said: ‘We will do unto our cash

flow what a private equity firm would do unto

us.’ Many company managers have traditionally

focused on earnings per share or profits,

because that’s the headline in the reports or

directors’ bonuses are linked to it. But private

equity knows the value of cash.”

A recession-induced decline in sales – allied

to a scarcity of capital, higher credit risks and

nervous suppliers – is driving every company

finance function back to basics in search of

cash, even if they don’t currently fear a buyout

bid from the private equity world.

But for private equity managers discovering

a renewed zeal for portfolio management in the

absence of deals, hammering away at cash is

probably old news. After all, the model relies

on driving cash flows as hard as possible, and

forcing out costs in a way that might make many

lily-livered public company directors queasy.

But good intentions and clear objectives

don’t automatically mean every private equity-

backed business is working as hard as it could

to produce an optimum cash flow.

“The fundamentals are as true as they’ve ever

been,” says Brian Shanahan, director of working

capital consultancy REL. “You have to be good at

the basics – receivables, payables and inventory.

In most private equity-owned businesses, that’s

clearly understood at the strategic level. But

there can be a disconnect between those

strategic intentions and the front-line processes.”

At a time when fresh capital is hard to come

by and deals are thin on the ground, taking a

fresh look at working capital and costs – both

strategically and tactically – is a no-brainer for

valuations. “A lot of the private equity guys we talk

to are keen to have as much tangible value in their

funds as possible,” says Shanahan. “Most valuation

models show cash on the balance sheet as straight

assets, so the more receivables and inventory you

can convert, the higher the value you can report.”

cash in: being right first time“The key area for companies that need fast

results on cash is undoubtedly receivables,”

says Shanahan. “That’s where you get the quick

wins.” But there’s a problem: it’s also where

the economic downturn most obviously puts

additional strain on working capital. “In a

recession, customers are more likely to look

for generous terms or be struggling to pay,”

portfolio FDs. And for private equity managers,

knowing your portfolio management teams are

delivering on cash flow is a crucial factor in

deciding whether or not scarce capital ought

to be allocated in support of their plans.

getting a grip on cashMany private equity-backed finance directors

are only too aware of the need to keep an iron

grip on the cash position, of course. But

passionate management working under duress

– dealing with falling sales, for example – can

lose focus. Knowing the finance function is

prioritising cash, then, is a massive reassurance.

As one private equity-backed finance director

in the retail sector says: “No one is in any doubt

now about the value of sound cash forecasting.

My previous job was helping a business out of

administration, so I know how important a 13-week

cash flow forecast is. In the current climate, my

team can also see why that discipline is vital. It

gives us more confidence to plan what we do next.”

“We are managing cash flow more

aggressively,” says Peter Hatherly, chief financial

officer of Duke Street-backed Simple Health &

Beauty. “Our skincare range is actually gaining

market share, and growing sales do put extra

pressure on working capital. But at the same

time, we know that customers and suppliers are

attempting to manage their own working capital

by trying to extend payment terms.”

Portfolio businesses that have been living the

private equity cash mantra are also in a better

position to weather the downturn. “Cash is very

nice to have when times are uncertain,” says

Hatherly. “And if you have debt at the moment,

you’d be crazy to lose it – so it’s not a question of

looking for early repayment. Hanging on to as much

cash as possible gives us real operational flexibility.”

It’s worth mentioning the other big benefit

of redoubling portfolio efforts to boost cash: Illu

stra

tio

ns:

Ian

Po

llock

www.realdeals.eu.com REALDEALS 15

cash&costs

says Peter Hodson, investment manager at NVM

Private Equity. “It just increases the need to be

disciplined on the debtors you do have.”

And while salesmen often instinctively start to

go easy on customers in trouble during a downturn

– they have real relationships with clients, it’s

not just about protecting volume commissions –

REL has noticed that the best working capital

performers are actually getting tougher in the

terms; and if the credit control function isn’t

at the top of its game (both in assessing

creditworthiness and chasing collections),

debt or days soon mount up.

The late George Moore, founder of the Society

of Turnaround Professionals, used to recommend

staff promotions in the credit control function,

elevating the best of them to “account directors”

to motivate them and make the most of their

skills. He would also advise management to

revisit their disputes policy. Elevating disputed

invoices more rapidly to director level – rather

than leaving them to fester in the inbox of a

manager too junior to agree a settlement – is

a great way to convert aged debtors into cash.

Systems matter, then, but so does culture.

In smaller portfolio businesses, for example,

where there might not be so much process around

accounts receivable, the very qualities that made

the management attractive to their backers

could create working capital problems.

“People within portfolio businesses

sometimes forget that they’re

running a commercial enterprise,”

says Hodson. “We cherish

emotionally engaged sales

managers in the front line, and

their commitment. But that

closeness to their business can

cause them to forget the fact

that customers aren’t going to

be surprised or offended if

they’re asked to pay for

goods and services on time.”

Even larger companies,

where the processes are more

developed, have options. “Customers

often manage their own cash by

pushing the working capital on to

suppliers like us, and to some extent

we have to pass that on,” says Hatherly. “But

there are smart ways to do that. If a customer

is looking for better terms, you can work with

them to get something in return for that –

perhaps open up new business opportunities

or get more predictability in your order book.”

cash out: how tough to getWhile receivables remain the fastest and most

reliable way to tune up the cash flow, companies

can also do a lot with their creditors. Pushing out

payment terms also delivers an immediate cash

boost, and many suppliers will be nervous of

refusing to play ball at a time when sales are weak.

On the flip side, aggressive late payment is

both unethical, potentially costly (depending

on the supplier’s willingness to invoke relevant

legislation) and could result in crucial suppliers

going out of business.

But while portfolio finance directors have

a duty to keep an eye on the viability of their

supply chain, the rewards for a creative and

intelligent approach to payables can be

recession. “It’s about being selective,” explains

Shanahan. “They do support those clients they

know are good prospects over the long run.

But they also recognise the need to aggressively

manage the less good ones. The below-par

companies start to feel sorry for everyone equally.”

Cash in is also about tight processes. If

invoices aren’t going out on time; if goods and

services aren’t meeting contractually agreed

“While the pain of poor working capital performance is seen and felt in the finance function, it’s really an operational issue”


cash&costs

impressive. In a recent KPMG study into working

capital, the firm revealed that private equity-

backed German mobile operator Tele Columbus

changed the payment terms on a ¤60m supplier

contract from yearly to monthly. The interest it

saved (by not having to take out debt to fund

the annual payment) delivered a 40 per cent

reduction in working capital immediately.

“If you really understand which suppliers are

vital to the business, you can bring them into

your own decision-making processes,” says

Aldridge. “By making the supply chain more

transparent to them, you can work on ways to

optimise the outcomes – perhaps by agreeing

to share profits instead of making cash payments

to suppliers, or working on more constructive

approaches to phasing payments, making

everyone’s cash flow more predictable.”

“Cash out” doesn’t just mean supplier

payables. Costs more generally are a key

consideration at the moment. It’s hard to imagine

that any business is currently looking at major

capital investment; ongoing costs will already

have been trimmed back.

The good news for portfolio businesses is

that in some areas, the recession is forcing

costs down. As a retail finance director explains:

“Upwards-only rent reviews and quarterly

payments are a real headache. But we’re

starting to see that change already as a result

of pressures on landlords to keep tenants.”

And because the recession has been so

widespread, negotiations over headcount

reductions or other cuts to payroll costs have

actually been far easier. One European private

equity manager told us: “At one portfolio

business, we’re looking at a reduction in salaries

of ten per cent across the board. That’s going to

mean changing employment contracts, which is

normally difficult. But in this environment, where

the economy is obviously struggling globally,

people are more open to those tough decisions.”

inventory: stock answersAlthough cash tied up in inventory tends to

cause big problems for manufacturers –

particularly early on in a recession, when work

in progress just isn’t shifting and production

has yet to be scaled back – just-in-time policies

and slicker supply chains have made this less

of a problem than it used to be.

But that’s not to say investors shouldn’t look

again at the strategy of portfolio businesses.

Shanahan gives an interesting example. “How

many backers ask questions about working

capital when they make the decision to open

a facility in China?” he asks. “Offshoring looks

cheaper, but it means goods will be sat on a

ship for weeks at the end of the manufacturing

process. When the cost per unit was incredibly

low in the Far East – and money was relatively

cheap – that probably wasn’t an issue. But

production costs are creeping up and that

six-week voyage is now tying up valuable cash.”

Again, it’s worth assessing the inventory

culture of each portfolio business. “For example,

procurement directors are often incentivised to

chase volume discounts,” says Aldridge. “They

don’t necessarily see the working capital impact –

including extra stock on the books, for example.”

connecting the dotsAll these good intentions rely on management

being effective, ensuring that their teams are

properly motivated to drive out working capital

and boost cash flow. “While the pain of poor

working capital performance is seen and felt in

the finance function, it’s really an operational

issue,” says Aldridge. “It comes down to the

salesmen who extend generous terms and

conditions to secure a deal, for example. They

don’t necessarily see the cash flow impact of

their behaviour, but that’s where the sustainable

cash improvements will come from.”

Understanding who’s driving cash flow

helps. “Who are you relying on to deliver on

that cash focus?” asks Hodson. “Are you looking

to the people at the front line, the salespeople

and operational guys? Or is it the finance

department? A salesperson is torn between

getting the cash in quickly and maintaining

cordial relationships with clients. As an investor,

you’re entitled to ask whether the right people

are in control of the debtor book, and whether

they have the right skills to deliver the cash.”

A big question, then, is how well the CFO is

communicating with the operational managers.

“Everyone in the business needs to understand

the cash effect of the processes they undertake,

not just how efficient they think they are being,”

adds Aldridge. “The finance function can measure

it and identify areas that are in need of urgent

attention; but operational people have to live it.”

Finally, a crumb of comfort for private equity-

backed businesses from the latest REL survey

of working capital performance across Europe’s

largest companies. While the overall numbers

for 2008 are pretty much static compared to

2007 (once you strip out the oil and gas

companies), Shanahan has noticed the

emergence of two divisions.

“The good guys are getting better

at managing working capital,”

he says. “But the bad guys are

getting worse.” That means

the advantage for those

businesses with tight processes

and the right cash culture is

growing. For cash-minded,

private equity-backed

businesses in competition

with less disciplined rivals,

that can only be good news.

richard young is a freelance

business journalist.

cAsh floW suPPort for Portfolio busiNessesPeter hodson, investment manager of

NVM Private equity, explains how his firm

intervened to support one management

team facing inconsistent cash flows.

“We have been in a situation where a

portfolio business was finding cash flow

coming in waves – they would tighten up

every so often, but then things would slip

and working capital would creep up. that’s

an example of where we can get an expert

in to help – someone who understands cash

implicitly and had worked through that

kind of situation before. often you’ll find

with a bit of support, management teams

will quickly get a feel for the art of the

possible. When you have someone in there

who knows exactly how hard they can push,

you can remedy the problem quite quickly.

“in that case, our expert’s priority was

to get the 13-week cash flow forecast up to

scratch – there had been a lot of holes in it.

they redesigned the process of arriving at

the forecast, then made sure there were

specific targets for every debt and payable

on the books. each one was monitored on

a weekly basis and responsibility was

assigned to a named manager.

“then they looked at the creditors.

With their experience, they understood

how far they could push them, freeing up

working capital without causing major

problems. if the management team needs

support in a certain area – which is quite

reasonable, particularly in smaller

companies – we’d look to bring in a non-

exec with the right qualities. in this case,

we brought our expert in on a consultancy

basis initially, working one or two days

per week. After the cash disciplines

had tightened up, he reverted to

a more conventional non-exec

role to help the team on a

longer-term basis.

“to emphasise: this is

about providing support

for a management team.

Portfolio managers can

always pick up the phone and

know we’re here to offer guidance.

but having someone more intimate

with the situation, who can tackle any

slip in focus on cash very quickly, is useful

to us all. And we find this approach

always brings results.”


“credit iNsurers Are More to blAMe for

the mess private equity finds itself in than either

the banks or the credit rating agencies.” A bold

claim. But those are the words of the head of one

major UK buyout house, referring to the problems

being experienced at portfolio company level by

vast swathes of the private equity community.

Across Europe, extreme risk averseness is

leading credit insurers to withdraw their

provision of cover to legions of companies,

causing knock-on effects on working capital

facilities, and often leading to situations of

default. In some cases, otherwise healthy

companies are being brought to their knees

simply as a result of losing their cover.

Perhaps the most high-profile and extreme

example of this was Woolworths in the UK.

When insurers decided they could no longer

provide cover to the retailer’s suppliers last

autumn, suppliers insisted Woolworths pay them

upfront for goods, forcing the company to draw

creditinsurance

on its borrowing facilities. Shortly afterwards, an

historic high street name was forced to liquidate.

underpricing problemsWhile not a private equity-backed company,

Woolworths’ demise is illustrative of the problems

faced by the portfolio companies of buyout

houses, many of which treat credit insurance as

part of their working capital facilities – a strategy

that has proved highly dangerous in retrospect.

Part of the problem seems to have been

caused by insurers vastly underpricing their

cover. According to the Association of British

Insurers, there were £334m worth of premiums

written in 2008, covering £302.5bn worth of

sales by British companies. This meant that

insurers were in effect underwriting more than 20

per cent of the output of the entire UK economy

in return for a few hundred million in premiums.

To put it another way, the premiums were

equivalent to just 0.1 per cent of the insured risk.

Consequently, when the recession hit and

claims began to rise (see graph, page 19),

something had to give. This steep rise caused

credit insurers to reassess their exposures, and

to begin cancelling the contracts they perceived

to carry the highest risks. Unluckily for private

equity, this included anything with large amounts

of acquisition debt on its balance sheet. The

scaleback was so severe that in one case Atradius,

Britain’s second-largest credit insurer, withdrew

cover from suppliers to 12,000 companies in a

single week. It is a blanket approach that has

been heavily criticised across the buyout industry.

“The credit insurers decided they were not

going to cover high-risk groups, such as retailers

and highly leveraged businesses,” says Tim Syder,

deputy managing partner of Electra Partners.

“They effectively said: ‘If you’ve got acquisition

debt on your balance sheet, forget it.’ They’re

not insuring the debts of those companies that

are least able to survive the downturn.”

PulliNG the PluG

Private equity firms have cried foul as portfolio companies have suffered from the indiscriminate withdrawal – in some cases overnight – of credit insurance facilities. Buyout houses must now be constructive and communicative in order to help their businesses survive.by Samuel barton


creditinsurance

“The credit insurers are taking a blanket

approach,” adds John Harper, a partner at Duke

Street. “They’re looking at companies, and if

they’re private equity-backed – regardless of

what sector they’re in or how they’re performing

– they are withdrawing cover.”

The BVCA has also criticised the credit

insurers, accusing them of “unfairly targeting”

private equity-backed companies. “They have

been reducing and withdrawing cover for no

discernible reason other than the identity of

the private owner. This is bad business practice

and ultimately counterproductive,” says chief

executive Simon Walker.

While the major credit insurers declined to

be interviewed for this article, the Association of

British Insurers defended the industry, claiming

that private equity firms were at fault for their

lack of communication. “Credit insurers want to

be able to offer credit insurance and to continue

to offer it,” says Kelly Ostler-Coyle, a spokesman

for ABI. “But they need as much financial

information as possible. Some private equity

firms are not providing information, and

therefore it is very hard to understand and

underwrite the risk. We advise that firms

provide as much information as possible.”

high-profile victimsWhile private equity firms are understandably

keen not to highlight specific issues in their

portfolios, several examples have hit the

headlines already, including Focus DIY, the

retailer backed by US buyout house Cerberus

Capital Management; bingo group Gala Coral,

backed by Candover, Cinven and Permira; and

Brake Brothers, the food distribution company

backed by Bain Capital, to name just three.

“We have one portfolio company,” admits

Harper. “It has cash in the bank and is performing

well, but when we challenged the insurer, they

said ‘you’re a leveraged company’. It is quite

disappointing and somewhat arbitrary that

healthy businesses are having their cover

withdrawn. Credit insurers need to forget the fact

that it is private equity-backed or leveraged –

what matters is how the company is trading.”

“We had an issue in the portfolio caused by

a misunderstanding about the structure of the

deal,” adds Chris Warren, a director at ECI

Partners. “The business was performing well

and the balance sheet was fine, but it still took

a lot of time to sort out.”

In the case of Brake Brothers, more than

three weeks were spent attempting

to get insurance policies

reinstated. “I am absolutely

furious,” raged finance

director Matthew Fearn

in an interview with the

Financial Times. “We had

a good growth strategy in

2008 and strong cash flow,

The situation is a damning one for the

credit insurance industry, which is there to give

confidence to companies through difficult times,

but has instead scaled back at the first sign of

trouble in a way that is threatening the livelihood

of those businesses. “Credit insurers cutting cover

overnight has shocked businesses,” says Robin

Johnson, a private equity partner at Eversheds.

“These contracts will have to change. They have

become too standard and people have not looked

at them closely. No one looked at the terms.”

While a contractual overhaul of the industry

may be viable in the longer term, it is of little help

to businesses in trouble today. On a short-term

basis, governments across Europe have considered

While the uk government must be applauded

for coming to the aid of businesses struggling

as a result of the credit insurance crisis, many

have criticised the solution arrived at by the

department for business, enterprise and

regulatory reform (berr).

on the face of it, the scheme does not

sound comprehensive. first, it is only

operational between 1 April and 31 december

this year, meaning that any businesses

whose cover was removed before April will

have no help whatsoever. it will also only

“top up” the insurance for each business to

the amount previously covered, as well as

only equalling the amount of cover remaining.

in other words, businesses whose insurance

was reduced by up to 50 per cent will have

their full cover restored, whereas a business

whose cover was cut to ten per cent of its

previous level will find itself with just an

extra ten per cent from the government –

so 20 per cent of its previous level in total.

those whose policies have been cancelled

entirely will get nothing.

“the scheme will bring a measure of

relief to some sMes, but in many respects

it fails to go far enough,” says bVcA chief

executive simon Walker. “by excluding

suppliers which have had their credit

withdrawn rather than reduced, and offering

help only to businesses which had cover

reduced after 1 April, the scheme cannot

hope to capture those worst affected.”

the stance is justified by the government

on the grounds that the scheme is only

designed as a temporary buffer, and it would

be unfair for uk taxpayers to have to

underwrite a firm’s entire credit insurance

cover, as well as cover those businesses

perceived as the most risky and whose

cover was therefore cut earliest.

“this is intended only as a breathing

space,” says stuart shepley, a partner in

kPMG’s insurance risk and actuarial services

team, who worked with berr on the scheme.

“berr is keen to put in place a policy to

provide temporary support, but there is a

requirement to understand the balance

between achieving the benefit and the cost

to the taxpayer. the government is striving to

do that in a way that does not fundamentally

change the behaviour of the credit insurers

or the insurer/reinsurer relationship.”

Another area of the policy that has

attracted criticism is the upper threshold,

which is set at £1m (¤1.15m). Above this,

no cover will be available, meaning that

larger businesses will not be able to take

full advantage of the scheme. “it is trying

to do something to address a real practical

problem, but the devil is in the detail,” says

Alan hudson, a restructuring partner at ernst

& Young. “While for sMes it might be enough,

for larger businesses the £1m threshold will

be insufficient. it is better than nothing but

it is not a panacea for all ills.”

the top-up facility – access to which will

cost participating companies two to three per

cent of their insured risk, compared with

around 0.5 per cent under standard credit

insurance policies – will cost the uk taxpayer

a total of no more than £5bn.

and we don’t have to refinance the business for

a few years. But I have had to spend countless

hours trying to justify this to people.”

What can be most galling for buyout houses,

however, is the speed with which they can find

the plug pulled on them – in some

cases overnight. “What has

surprised companies is the

suddenness,” says Alan

Hudson, a restructuring

partner at Ernst &

Young. “Credit insurers

have been reducing their

exposure across the sector

with little, if any, forewarning.”

GriN ANd berr it

“The government’s top-up scheme is better than nothing, but it is not a panacea for all ills”


creditinsurance

the situation serious enough to step in, with

France working on a scheme whereby the

taxpayer will cover some of the costs of

providing cover, and UK chancellor Alistair

Darling announcing a “top-up” facility in

his latest Budget. The UK scheme has

been criticised for a variety of reasons,

including failing to provide sufficient cover and

having too short a shelf life, but it will doubtless

provide relief to some (see box, page 18).

Suppliers’ marketSadly for those companies not falling under

the terms of the various government schemes,

constructive routes out of trouble are few and

far between. The first problem faced by private

equity firms trying to get policies reinstated is

that the credit insurance market is dominated by

just three suppliers – Euler Hermes, Atradius and

Coface – which control around 80 per cent of the

market. This makes it extremely difficult to find

alternative insurers, and brings that private equity

Achilles heel – communication – back into play.

“Once you lose your cover it can be very

hard to get it reinstated,” says Hudson. “Some

are saying that the credit insurers are acting

arbitrarily, but there are instances where

companies aren’t helping themselves, and are

not treating the insurers as an important part

of the business. Firms should be more proactive

in terms of working with the insurers – this

requires engagement.” He cites one example of

a company that continually cancelled meetings

with its credit insurer, and one day found that the

insurer had run out of patience and removed the

cover instantaneously. “Credit insurers can feel

that they have been excluded from restructuring

discussions, therefore they may assume the

worst and protect their position,” says Hudson.

However, much empirical evidence points to

the fact that, once involved in the discussions,

their attitude is often not much better.

“Credit insurers do not like changing their

minds – there is very little flexibility,” says

Johnson. “They also do not assess businesses on

a case-by-case basis – they rely on credit ratings

agencies to tell them what the creditworthiness

of a company is.”

Unfortunately for private equity firms, if there is

no communication, and no attempt to bring credit

insurers into discussions, it can be an easy decision

for the credit insurers to make. “If you’re the boss

of a credit insurer and capacity restrictions mean

you need to get your underwriting down, the first

place you will look is 2005 to 2007 leveraged

buyouts – it’s understandable,” says Syder.

Johnson, meanwhile, talks of an issue at a

client where credit insurance was withdrawn, and

after lengthy discussions it was agreed that the

facility would be reinstated for three months.

There followed a frantic period of renegotiation

with suppliers, clients and banks, before the

cover was withdrawn again. The few months’

should consider. They may be able

to unlock a restructuring instead of

having to throw away their investment

altogether,” advises Hudson.

Fair-weather coverLooking to the longer term, there is no question

in most people’s minds that the supply of

finance to small and medium-sized businesses

will have to be overhauled. For some, the entire

credibility of the credit insurance industry is at

stake, and a big question mark remains over

whether companies will again put themselves in

a position where their viability is dependent on

insurance that is only available when the sun is

shining. “If at the first sign of trouble the credit

insurers run for the hills, questions have to be

asked,” says Warren. “If they fail to provide the

cover that the premiums have been paid for,

then it is clearly not an insurance cover at all.”

Some believe that an entirely new model for

the industry will emerge, with a far smaller role

for credit insurers. “Most companies will learn to

live without it,” says Harper. “Most companies

and suppliers cannot afford not to trade, so there

will be a move towards suppliers starting to

supply without it. Companies are getting more

used to it and becoming more pragmatic.”

“Given there are so few players, a new model

may emerge,” agrees Hudson, emphasising that,

when the market starts to turn, the first issue people

will look at is the terms of the contracts. “If people

get used to a world without credit insurance, will

they go back to it? People may start to look at

how they can deliver a better solution, but it will

have to be made on committed contracts. There

will be far more emphasis on looking at terms and

ensuring the umbrella is still there when it rains.”

For now, however, private equity firms must

forget any potential new paradigm, and work with

their current portfolio companies on the matter in

hand. For many, there is not much light at the end

of the tunnel. “Credit insurers have been badly

burned by all the retail problems,” says Syder.

“There is no doubt there will be more leveraged

private equity deals going belly up. Most firms will

have some deals that are overleveraged and were

overpriced when acquired, and I can’t see any

reason in the short term why any of the insurers

will come out and start covering again.”

The key point to emphasise is one of being

upfront early on. “You have to sort out the other

problems – you have to get the balance sheet and

working capital in order,” says Malcolm McKenzie, a

managing director at specialist turnaround adviser

Alvarez & Marsal. “And everyone has to respond

early to the problems. There is no point trying to

fix the hole in the tent after it has started raining.”

For many private equity firms, openness

and communication may, once again, be the

only way forward.

Samuel barton is managing editor of Real Deals.

stAteMeNt of clAiM

grace proved invaluable in terms of resolving

financing issues – and the company is “limping

along”, according to Johnson – but this kind of

flexibility from the insurers is rare.

If discussions regarding reinstatement fail,

the next option is to approach the banks, but if the

portfolio company in question has no headroom

left in their banking facilities, their backs are well

and truly against the wall. “If there is a working

capital squeeze and the banks won’t step in,

there’s little else that can be done,” says Harper,

emphasising the danger of companies using credit

insurance as part of their working capital facilities.

“Companies have to get away from using their

credit insurance as a working capital tool,” adds

Johnson. “The days where you can do this are over.”

If all else fails, assuming the private equity

firm wants to hang on to its investment, more

equity is the last resort. “For businesses that are

otherwise sound that the banks won’t lend to,

you may see private equity firms stepping in

with equity,” Johnson says.

“If a private equity firm is prepared to roll

the dice again, then it is a position that they

150

120

90

60

30

0

Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08

source: The Association of British Insurers

Gross uk trade credit insurance claims incurred (¤m)


interims to the rescueWhen smoothing over a transition period in a successful firm, interim managers can be important. But during a recession, as portfolio company valuations plummet, bringing in an experienced head who is unafraid to make tough decisions could be the difference between financial freefall or a soft landing. by Peter bartram

the rules of the game fundamentally

changed for private equity when the credit

crunch struck. Portfolio company management

teams in particular – which had rode the surf

of unending growth for years – suddenly crashed

to earth. As the recession lengthens, more

management teams will fall into the “needs

attention” category. So how do investors deal

with these situations?

The first point to explore with an

underperforming management team is the

reason for the underperformance, says Paul

Marson-Smith, chief executive of Gresham

Private Equity. “Are they doing everything

possible? If the market is simply not there,

no amount of changing the management

team will solve the problem.”

However, when a change needs to be made in

a management team, it’s better to make it sooner

rather than later, he adds. “One thing I’ve learnt in

private equity is that if you delay changes, it just

makes them more difficult. Encouraging managers

to think of themselves as shareholders helps them

to understand when a change is necessary.”

When faced with an underperforming

management team, it’s important to resist the

temptation to jump to conclusions, adds Simon

Wildig, a partner at CBPE Capital. “You have to

analyse the situation very carefully,” he says.

“Try to work out what your options are and

act on them as sensibly as you can. Disruption

to a team, even if it is obvious that it’s

interimmanagers

underperforming, is going to be difficult. It can

create perceptions in the marketplace, in the

team itself and with employees. You have to

be very careful – but by the same token, you

cannot let things fester.”

One way to spot whether a management

team may be losing its touch is to view it with

a cold and objective eye. “We tend to rotate

our deal team members,” says Louis Elson,

co-founder and managing partner at Palamon

Capital Partners. “By rotating them and adding

a fresh perspective to our deal team, we can

begin to look through our own emotional bonds

to people and be objective about whether they

can really do the job.”

Elson believes the best way to replace

managers is to focus on the needs of the

company first and the individual second.

“Typically, when you’re in this situation, you

spend a lot of time worrying about the individual.

You need to get back to what the company is

going to do.”

He also believes that time must be invested

into replacing members of a management team.

“You need to be patient as you determine what

the best course of action is. Sometimes private

equity resorts to a knee-jerk reaction.”

Interim interestIf a member of the team has to be replaced in a

hurry, one option might be to bring in an interim

manager until a more permanent employee can be

found. An interim manager – here today and gone

in a few months’ time – could have the detachment

to make unpopular changes. But he will need to

be a manager with turnaround experience.

Wildig agrees that an interim manager

could be used to “plug a gap” when building

a management team. “It’s a fact of life that

changes made to management teams are

usually made fairly quickly,” he says. “You might

find it necessary to replace somebody or remove

somebody from a particular position to limit

damage. Or, if they are told they are

no longer needed, they may choose

to go quickly and you might not

have an immediate replacement.

In that case, an interim holder of

a post can be useful.”

Anne Beitel, managing

director of Executives Online,

which specialises in interim

management and executive recruitment, sees

interim managers potentially playing the role

of catalyst in making changes when a portfolio

company management team is failing. The key

is finding an interim who has had experience

of turnaround situations before. Beitel believes

it doesn’t necessarily matter whether that

experience has been in the same

industry. It’s the ability to take a

difficult situation by the scruff of the

neck and deliver the treatment that’s needed.

“If a portfolio company is in a hard or damaged


state and in a real rescue situation,

I think the skills for affecting that

are quite transferable,” she says.

As the recession has deepened,

Beitel has noticed a growing demand

for interim finance directors,

supply chain and procurement

professionals, as well as sales

and marketing staff. Beitel

believes that in the appropriate

circumstances, an interim

manager could be the right

choice to make much-needed

changes at a portfolio company

that is underperforming.

“In the case of a private equity

backed-business, an interim

manager can shake things up and

challenge preconceptions – and

will not care too much if they are

not universally liked because they

are there to do a task, deliver a

result and move on to the next

assignment,” she says.

But if the interim is going into a

well-performing company to plug a

gap between permanent appointments,

industry experience may be more

important than a turnaround track record,

Beitel argues. “You’d be looking for a

strong match between the candidate’s

background and the domain in which the

target company operates,” she says.

Beitel warns private equity firms thinking

of hiring an interim manager for a portfolio

company not to treat it like a permanent

post. “When you’re recruiting a person for

the long term, cultural fit and

meshing with the management

team are important drivers for the

candidate’s success in the job. An

interim is not there to be cosy

with the folks around them –

they’re there to deliver results.

“But you must be really

clear what you want them

to come in and do. To bring in a highly

qualified and expensive person and not to

brief and focus them is a waste of everyone’s

time and money. So be clear on what you want

them to accomplish and put them to it.”

Hiring an interim need not be a lengthy

process. Beitel says that her clients typically

want a shortlist of possible candidates within

a few days of giving her the brief. The chosen

manager is expected to be at their desk a few

days after being chosen. “A typical timescale

from brief to placement is measured in days, not

weeks,” she confirms. Once they’ve got their feet

under the desk, a typical interim manager could

be in place for around six to nine months.

Beitel adds that interim executives tend to

be people who are used to delivering results in

a short timescale – a quality which certainly

makes them highly suitable for posts in private

equity portfolio companies. “They’ve got to climb

up whatever learning curve there is very quickly.

But we try to select them so that they have

experience of similar organisations, which

minimises the learning curve.”

Beitel says that she sees some common traits

in the most effective interim managers. “They

have a real independent-minded streak and a

distaste for corporate politics. In some cases,

that’s why they became interim executives.

They were interested in doing their work,

contributing their expertise, not being nice to

everyone in the office and worrying about who

is going to stab you in the back.”

Private equity-owned companies, with their

emphasis on hard-edged regular measurements

of fundamentals such as cost reduction or top-

line revenue improvement, ought to be effective

at measuring whether an interim manager has

contributed what’s required. “You will know

from your figures whether they have done their

work,” argues Beitel.

ambition and objectivityBut although interim managers undoubtedly

have a role to play, the deal-makers say their

primary focus when considering an investment

is on whether the company already has a quality

management team – or the potential to build one.

Marson-Smith is in no doubt about what

makes a great management team in a portfolio

company. “The most important quality is a track

record through good times and bad,” he says.

“In the current environment, one of the most

demonstrable attributes is the ability to be a

scrapper. Faced with a requirement, they take

the necessary action.” It’s important when

business is plain sailing, but even more so when

the economy is wallowing in troubled waters.

Getting the right management team into

a portfolio company has always been a key

element of success in private equity investing.

When times are tough, that’s even more

important. “First of all, an outstanding

“You need to be patient as you determine what the best course of action is. Sometimes private equity resorts to a knee-jerk reaction”

In association with


management team has to have a fire inside them

to be successful,” says Elson. “They are highly

ambitious and they want to win – they want to

succeed for themselves in some way. Secondly,

they are objective. They have the ability to look

at the world with a very clear set of perspectives.

Some people get those other perspectives by

bringing other people around them to get

different points of view – some are able to do

it themselves. But the ability to have different

perspectives allows them to see in 3D.”

Wildig says that in a recession, there is value

in having managers on board who’ve been there

before. “It’s valuable to have some experience

and awareness of the sort of difficulties that

times like these can throw at you,” he says.

“You can learn a lot from hard times rather

than when things are going well.”

The managers in private equity portfolio

companies are a different breed to the kind

you find in public companies, argues Andrew

Priest, a partner at Skillcapital, which recruits

management teams for private equity-backed

portfolio companies. He points out that when a

company is acquired by private equity, there’s

often a change in capital structure and an

infusion of debt. “That creates a pressure to

perform and manage for cash which won’t be the

same in a normal corporate,” he says. “Whether a

manager is going to be a success or not depends

on whether they can adapt to an environment in

which there will be clear-cut objectives in the

frame and shorter communications paths to the

business’s owners.”

The trick is spotting the managers who have

demonstrable ambition and a results-driven

way of working, argues Priest. “They should

show evidence of being willing to move out of

their comfort zone, of having been promoted

quickly and of working hard and long hours.

They’ll also often be people who’ve worked in

challenging situations, such as restructurings

and turnarounds.”

Priest says that when Skillcapital is recruiting

for its clients, which include Cinven, Candover,

Sovereign Capital and HgCapital, it often looks

for more experienced managers. “We bring in

people who are used to working in bigger

companies and are further down their career

tracks. They’ve been exposed to a lot of different

business situations and they’re persuaded to

move into a private equity portfolio company

because there’s an opportunity to make

some money for themselves, as well as to

achieve the investment’s aim.”

But the recession might weed out some of

the less resilient managers who, naively, saw

private equity as a way of making easy money.

As Priest points out, a characteristic of private

equity is that portfolio companies have

“stretched business plans”. He adds: “In a

recession, the business case is even more

stretched and challenging.”

Being able to achieve highly ambitious

targets, sometimes without the support

infrastructure that’s commonplace in big

corporates, requires go-getters with extra

resilience. Priest gives the example of the

management team that brought the ironmonger

chain Robert Dyas back from the brink of

administration following a management buyout

from Change Capital in April. “People who are

good at working in those kinds of environments

show incredible resourcefulness,” he adds.

executive decisionsBut in a climate in which private equity investing

is tougher, how does the canny deal-doer

ensure that the management team in the target

company can deliver? For Elson, it’s all about

the qualities of the chief executive. “It’s really

about whether we’ve assessed the programme

that the company needs to execute and matched

it to the skillset and demeanour of the chief

executive,” he says.

In Elson’s book, the right chief executive can

make up for gaps in the rest of the management

team. That’s because Palamon is a growth

investor seeking under-scaled companies with

potential. “We’ll often expect holes in the

management team,” says Elson. “We won’t

necessarily not do a deal because of that.

There could be management posts to fill and

we’ll work out with the CEO how to fill them.”

But Elson is clear that it’s the chief

executive’s job to build the team. “Our role

is to be a second set of eyes and a facilitator

in any way we can,” he says. “For example,

Palamon may do an initial trawl of the market

to winnow down a long list of 30 or 40

potential candidates for a key management

post in a portfolio company to a final shortlist.

Elson explains: “We would present the

candidates we think could do the job, but leave

it to the CEO to decide which is the one with the

right chemistry that he’d want to work with.”

Marson-Smith believes the right chemistry is

crucial in portfolio company management teams.

“Individuals can have tremendous track records

and skills but they need to work as a team and,

ultimately, the power will be in the team,” he

says. “The beauty of the best team is that the

whole is greater than the sum of the parts, and

you are able to harness that team energy.”

But structure is also important, as Wildig

points out. CBPE Capital typically invests in

businesses with £25m (¤28.5m) to £250m

turnover. “Even though they might be

multinational businesses, because of the scale

the senior management team are pretty

intimately involved with the day-to-day running.

You want them to be involved because you may

want to make changes to what is happening

fairly regularly. In our view, you don’t want

layers of hierarchy to get in the way of that

happening. We like businesses that have a

relatively flat structure – a team of four or five

guys at the top who can quickly put their finger

on something that needs to happen further

down the business.”

A key figure in the management team could

be the chairman. “We are big fans of involved

chairmen,” says Marson-Smith, who is not

interested in the kind of chairman who turns up

once a month for tea and biscuits. In general, he

favours a part-time, non-executive chairman who

has the ability to support the management team:

“The chairman can be a valuable conduit between

the management team and the investor.”

In Marson-Smith’s book, a key requirement of

a good chairman is experience of the relevant

industry sector. “Beyond that, leadership skills

so that they can harness the skills of the people

in the management team and help them to

perform better.”

Elson sees an important role for the chairman

when there’s a difference of opinion between

the portfolio management team and the backer

on how the company should approach a key

issue. “This is a great place where the chairman

can weigh in with an objective, unaffiliated,

unaligned voice.”

It is results that private equity firms are going

to be looking at with an ever more critical eye

in the recessionary months ahead – the pressure

on management teams to perform has never

been greater. But when asset values recover,

the rewards could be greater too. In the

meantime, the key qualities for portfolio

company management teams are a clear eye,

a stout heart and more than a little bit of luck.

Peter bartram is a freelance

business journalist.

“An outstanding management team has to have a fire inside them to be successful. They are highly ambitious and they want to win”

interimmanagers


many highly leveraged, private equity-

backed companies that changed hands during

the credit boom are already undergoing

restructuring. For many more it is a fast-

approaching reality.

Restructuring is predominantly a zero-sum

game, in which different stakeholders in a

business struggling to meet its financial

commitments negotiate how the pain will be

shared among them. The process, however, is

complicated by the variety of different agendas

of sponsors, management, banks and other

capital providers, many of which are struggling

to repair their own balance sheets. Sorting out

the mess from a deal that has turned sour can

prove more difficult than putting the transaction

together in the first place.

But when should sponsors and the

management of portfolio companies tell their

bankers that a problem is looming? For

transactions with relatively benign covenants that

are not yet in breach, there can be a temptation

not to deal with a deteriorating situation that

under stricter covenants would require attention.

For their part, at the start of the year many

banks were scrambling to reorganise and

increase their restructuring resources, focusing

on the most urgent problems rather than future

breaches. Part-way through the year, the trading

outlook for 2009 is now more visible, and for

many companies the prospect of whether

covenants will be breached or not is becoming

more clear-cut. More restructuring activity

appears unavoidable. Deals completed a couple

of years ago often had capital structures that

required continued growth in Ebitda to generate

sufficient cash flow to service the debt. With

Ebitda now more likely to be contracting than

growing, covenant breaches are only a matter of

time, and there is a growing realisation among

sponsors and management that the problem

needs to be addressed sooner rather than later.

“There has been a change in attitude,” says

Ian Bagshaw, partner in the private equity

practice of law firm Linklaters. “Management

is now looking at the possibility of a breach in

the budgeting process. Managers are more aware

of their personal liability – they are the ones

carrying the can if they get the cash flow analysis

wrong.” Identifying problems early can mitigate

this risk, so there is a growing trend for

management to be the ones looking to instigate

a restructuring process.

Management also has a further financial

incentive to address the problem early. “If a private

equity deal is underwater, the management deal

that ranks behind it will also be underwater,”

says Paul Canning, managing director at HIG

European Capital Partners, which invests in

distressed situations. “We have been contacted by

disaffected management teams who are having

to work harder in a tougher environment and feel

as if they are working to repay the bank, with no

return to them.” Canning also notes that there is

an increased focus by more financially aware

corporates on the balance sheets of their suppliers

and customers – debt has become a consideration

in evaluating long-term customer relationships.

Ignorance: not blissA lack of skilled restructuring resources remains

an issue for some banks and is contributing to

the length of the process, but this should not be

a reason for companies to ignore the problem. “I

have no sympathy for complaints that the process

pull yourself togetherRestructuring a company that is on the ropes can be a battle of wills between warring interests, but overcoming these struggles could lead to triumph in the face of adversity. by vInce heaney


takes three or four months,” says Hugh Brown,

senior partner in the debt advisory team at

PricewaterhouseCoopers. “It’s better to engage

in a long, but positive process than to wait until

the problem needs to be dealt with tomorrow.”

Where value has not dropped precipitously,

it may be possible to remedy the situation by

resetting covenants. Banks, however, are acting

swiftly – and sometimes harshly – when faced

with clients in breach of covenants. “In order to

reset covenants, the banks are hitting you with

large charges and are acting in a similar fashion

over missed interest payments. Working capital

lines can also be pulled if there is a technical

breach,” says the managing partner of a lower

mid-market private equity house. There is also

anecdotal evidence that some banks are using

breaches as a means of weeding out the clients

they no longer want in their portfolios.

“The current restructuring environment is very

adversarial,” agrees Brown. “Lenders are taking a

more robust position on pricing and requirement

for new equity when loans go into default.”

These concerns are serious enough that the

BVCA has taken up the fight on the industry’s

behalf, and is collating data to ensure that the

banks are acting responsibly and pragmatically

in their dealings with private equity clients.

Once bitten…The difficulties faced by many companies,

however, are too severe to be solved with covenant

resets, and instead require fresh cash injections –

but sponsors, sensibly, are wary of throwing good

money after bad. “I find it very ironic that sponsors

don’t want to exercise the equity cure rights that

so many of them fought for because the value

has dropped so far, whereas banks, which were

so reluctant to give equity cure rights, now want

them to be exercised,” says Mike Barnes, head of

debt advisory at Hawkpoint. “The two scenarios

to distinguish between are whether a company

needs new money for operational restructuring,

or whether new equity is simply being sought

by banks to pay down debt. Sponsors will

often offer new money only if banks accept a

writedown of the debt, and banks are generally

reluctant to accept that if the writedown isn’t

strictly necessary from a valuation perspective.”

Sponsors must also take into account their

obligations to LPs. “As sponsors look at their

portfolios and the IRR they expect to generate,

they have to decide whether to try and save a

business or redeploy the capital to a different

business,” says Geoffrey Richards, co-head of

special situations and restructuring at William Blair.

Equity cures may also only stave off a problem

that is likely to recur. “During the documentation

stage of the primary deal process, there can be

much debate about equity cures between banks

and sponsors,” adds Ian Sale, managing director

at Lloyds TSB Corporate Markets, responsible for

the bank’s mid-market leveraged finance team in

London. “Generally, if banks go for equity cures

it’s because they provide a clear mechanism for

private equity to cure potential covenant breaches.

There may be downsides though, as they can

sometimes just be quick fixes solving the

immediate covenant problems, but not really

addressing underlying or longer-term problems in

a business. Banks will normally want any related

cash injection to lead to a permanent reduction in

debt rather than just being added back to earnings,

which is a route sponsors frequently push for.”

Sponsors may be willing to put in more cash

to avoid an alternative that preserves even less

value – such as a fire sale or even administration

– but the decline in equity values has in some

cases been so sharp and severe that the gap can

be difficult to bridge. “Banks are now only willing

to lend about three to four times cash flow, and

when there is a covenant breach are looking to

‘right-size’ their loans to that new lower level,”

says Brown. “For transactions done late in the

boom with debt of seven to eight times cash

flow, it’s difficult for sponsors to put in sufficient

cash to make up the difference.”

“The equity cure is almost certainly dead,”

says Bagshaw. “If there is no equity value left,

then generally there is no point putting more

in. The landslide of value since the collapse

of Lehman Brothers means that for some

companies there is a point where there is no

economic value in anything other than the

senior debt. If you are a company in that

position, there is no point in an equity cure.”

Debt-for-equity dilemmasDeeper restructurings, such as debt-for-equity

swaps, therefore look set to become more

prevalent, bringing with them a whole new

level of complexity. Unlike the well-trodden

M&A process, each restructuring is different

and can be highly complex and time-consuming.

The situation is not made any easier by the fact

that banks are not natural equity stakeholders.

“Banks are good at lending, not owning

companies,” says Richards. “Commercial banks

are not organised to take on ownership and

the fiduciary responsibilities that entails.”

This would be obstacle enough with just a

small number of banks involved, but for many

2006/2007 vintage deals, bank syndicates were

very large and the different constituents all have

their own agendas, which may not be aligned.

Recently, for example, McCarthy & Stone, the

UK’s largest retirement homebuilder, agreed a

debt-for-equity swap with its senior lenders.

The bank syndicate for this comprised around

60 financial institutions.

In such a large syndicate there can be

distressed debt traders, which have bought into

the debt at a deep discount and are looking to

make a quick turn. They may be willing to agree to

a settlement at a lower price than a longer-term

lender looking to minimise the write-down. Adding

further complications, the syndicate’s members

may change over the course of the restructuring

as different members trade in and out of the debt.

“In a syndicate you can have ‘freeriders’,

‘holdouts’ and ‘terrorists’,” says Richards.

“Freeriders sit back and let the larger

constituents negotiate, riding on their coat tails.

Holdouts try to achieve a better deal by refusing

to agree to the offered terms – and may even on

occasion be paid to agree. Terrorists are those

who use a controlling or blocking position in the

debt to extract additional value for themselves,

which may impact on the recovery of others.”

Given the difficulty of reaching a unanimous

agreement in these circumstances, court-

approved schemes of arrangement, which require

75 per cent by number and value to agree, are

becoming more common in the UK. Some other

European jurisdictions, however, do not enjoy this

luxury – in Italy, for example, unanimous creditor

agreement is still needed.

Opportunities aboundBut as well as a source of problems, restructuring

can also offer opportunities for inventive

investors willing to participate in different parts

of the capital structure. “Buying businesses, or

parts of businesses, out of restructuring is a key

area of focus for us,” says Canning, whose

company HIG Capital has a mandate that allows

both debt and equity investment. “We have

been flexible in approaching any or all of the

stakeholders – sponsors, management and

banks. Our message to the banks is that we

have capital and liquidity if new money is

needed, as well as the practical operational

capability [that the banks sometimes lack].”

Bagshaw also sees the potential for new

opportunities: “I think we’ll see boutiques

established to act as intermediaries between

the banks and the management teams in the

companies they now own.”

For an industry accustomed to adapting to new

circumstances, adversity brings opportunity.

vInce heaney is a freelance business journalist.

restructuring

“It’s better to engage in a long, but positive restructuring process than to wait until the problem needs to be dealt with tomorrow”


porous pensionsDuke Street’s chastening experience with Focus DIY means that private equity investors must make their portfolio companies’ defined benefit pension schemes watertight. by nicholas neveling

pensions

in 2004, just days before Christmas,

Duke Street Capital announced that it had

agreed to sell DIY chain Wickes, part of portfolio

company Focus Wickes Group, to Travis Perkins

for the handsome sum of £950m (¤1.08bn).

The deal marked a major landmark for Duke

Street, which had been growing the company

for almost 20 years. Duke Street first backed

Focus in 1987, building it into a DIY empire

with a host of subsequent acquisitions.

Following the sale of Wickes, a large dividend

was paid to Duke Street and the remaining

companies, renamed Focus DIY, were refinanced.

At the time, Duke Street could never have

imagined that four years later the transaction

would come back to haunt it, or that the

deal would ultimately push pension schemes

to the top of the private equity portfolio

management agenda.

When Wickes was sold, there were two

under-funded defined benefit pension schemes

within the remaining Focus group, with a

combined deficit of £26m. Following the sale of

Wickes, Focus DIY began to experience trading

difficulties and was unable to support its capital

structure. In July 2007, the struggling company

was sold to Cerberus Capital for a pound.

With the deficit of the Focus schemes sitting

at £32m when Cerberus came to the rescue,

the pensions regulator, wary that the burden

of funding the schemes would now fall on the

Pension Protection Fund (PPF), stepped in.

A year later, following a series of negotiations,

Duke Street paid £8m into the schemes of a

business it had sold 12 months earlier. The case

sent shudders of fear through the private equity

community. “The regulator is now starting to

throw its weight around in a wholly unacceptable

way,” BVCA chief executive Simon Walker

commented. “We have a very deep concern.”

The Duke Street case showed that the

regulator was willing to cast its net

retrospectively in order to shore up pensions

funds at risk, and that any dividends or sales

would be looked at if prior clearance had not

been sought – or if the transaction was seen to

neglect the interests of the pension fund. With

more private equity portfolio companies facing

financial pressure – many that were refinanced

or exited for massive multiples just a few years

ago – the possibility of facing a Focus DIY

scenario is more real than ever.

Portfolio priorityDefined benefit schemes can no longer be

left to the actuaries and accountants to deal

with. Managing the risk that comes with

portfolio companies which have final salary

schemes has become a crucial element of

sound portfolio management.

The top priority for private equity firms

managing portfolio company pensions will be

to ensure that pension liabilities are priced

accurately and funded sufficiently. The slump

in equity markets, increasing life expectancy

and quantitive easing have all combined to

swell deficits. According to the PPF, the value

of pension scheme assets fell 9.8 per cent to

£772.3bn in the year to April 2009, while

liabilities during the period increased 15.8

per cent to £960.7bn.

These shifts have not gone unnoticed by

general partners. A survey of private equity

firms conducted by pension consultant Punter

Southall found that more than half of the

respondents were worried that changes in future

life expectancy predictions would increase

liabilities during ownership and cause a loss on

exit. In addition, the study showed that private

equity firms were very cautious when pricing

liabilities, with almost 90 per cent of respondents

valuing liabilities more conservatively than public

companies do. Yet even making a conservative

pricing of pension liabilities in the current

economic environment is proving tricky.

Pricing pressurePension liabilities are valued using the FRS 17

accounting standard, which values pension

schemes against the returns of an AA-rated

bond. When AA bonds prices were stable at

around 75 basis points above gilts, the measure

was accepted as accurate, but post-2007,

the spreads on AA bonds have expanded

substantially, up to 275 basis points above gilts.

The effect of this is that in accounting terms,

schemes look to be sufficiently funded, when in

reality there are doubts about whether current

credit spreads are genuine or just a reflection of a

credit-constrained market. A pension scheme that

looks funded on paper could just as easily be in

deficit given how unpredictable spreads are.

Pricing uncertainty has been exacerbated by

a lack of deal flow. With very few transactions

taking place, there is no benchmark or pricing

for how buyers and sellers are valuing schemes

when companies change hands. Dipping pension

asset values and uncertainty around pricing

liabilities mean that firms should be paying more

attention to pension funds within their portfolios.

“All businesses should be looking at their

schemes and assessing their appetite for risk,

how they should be investing assets, what they

can do with liabilities, and how much cash they

are prepared to put into a scheme,” says Richard

Jones, a principal at Punter Southall.

There are a number of options open to

portfolio companies to manage schemes. On

the asset side, companies can adjust their

investment strategy when investing pension

assets. More risk offers the possibility of higher

returns and smaller deficits – less risk will deliver

smaller returns but more certainty on what the

shortfall will be, and how much cash will be

needed to fund that gap.

On the liability side, portfolio companies can

change benefit structures by closing the scheme

to new entrants, reducing benefits when a

member retires early or cutting the total pension

payout by paying a pension in a tax-free lump

sum instead of over a number years.

funding Comparisons

end april 2009

end march 2009

one year ago –

end april 2008

Number of schemes in deficit 6,429 6,637 4,815

Funding gap of schemes in deficit £204.8bn £253.1bn £55.9bn

Number of schemes in surplus 953 774 2,596

Value of schemes in surplus £16.4bn £11.1bn £83.0bn

Aggregate balance -£188.5bn -£242.0bn £27.1bn

source: Pension Protection Fund


“Investment strategies and benefit structures

need to be negotiated with trustees and will vary

depending on a company’s situation. The most

important thing is to try and have an element of

flexibility that allows a company to adapt to

changing circumstances,” Jones says.

For some firms, however, the uncertainty and

complexity of fiddling with investment strategies

and benefit structures, coupled with fraught

negotiations with trustees, is too risky and time-

consuming. So seriously do some firms take these

risks that they will not acquire a target company

with a defined benefit scheme unless they are

able to buy it out and remove all the risk.

“The only time we will buy a company with a

defined benefit pension scheme is if we are able to

buy the scheme out as part of the deal,” Alchemy

Partners managing partner Jon Moulton says.

The buyout option involves a firm paying an

insurer to take on liabilities of the scheme,

normally at a premium to what the liabilities are

valued at. A scheme buyout removes the pension

risk for a portfolio company, and more private

equity firms are considering this option, but the

cost of doing so remains prohibitive.

“An insurer will want more than the FRS17

value to take on a scheme, and many private

equity firms will feel that they can pass on the

scheme for a lower cost when they sell on or

float a company,” says Jones.

Punter Southall’s survey revealed that private

equity firms would be willing to pay up to 125

per cent of a pension scheme’s market value to

pass it on, but with insurers demanding between

130 per cent and 150 per cent of market value to

take on schemes, most private equity firms have

been prepared to take their chances.

Moulton, however, maintains that the best

option is to stay away, or take the buyout cost

on the chin and move on without having to

worry about the risk. “The expense and changes

to the rules regarding defined benefit schemes

are frightening,” he says.

Transaction troublesBut it is not just the day-to-day funding and

management of pension schemes that need

to be considered. As demonstrated in the Focus

DIY case, private equity firms also need to be

aware of the risks posed by a pension scheme

when executing an exit or refinancing.

Any kind of transaction where a private equity

firm takes money out of a company with an under-

funded final salary scheme is likely to attract the

attention of the pensions regulator, which is tasked

with ensuring that under-funded schemes do not

fall in the PPF – the pool of funds set aside to

fund defined schemes as the last resort.

The regulator has the power to look back at

transactions and decide whether the pension

scheme was neglected when transactions were

completed. If it feels more funding should go into

the scheme, it has the power to serve a company

or previous owners with a financial support

directive or contribution notice, requiring parties

to put cash back into a scheme.

However, private equity firms can take steps

to protect themselves from a financial support

directive or contribution notice. The first step

is to request clearance from the regulator for a

transaction. This typically involves presenting it

with a trustee agreement, prepared beforehand.

If the regulator is happy with the deal for the

scheme, it will grant clearance and will not be

able to demand future payments into a scheme.

Obtaining trustee approval and regulatory

clearance can be costly and onerous.

“Trustees can easily demand more than you

think is required. They can keep saying no.

Negotiating payments can involve a bunfight

before reaching an agreement,” says Jones.

The other option open to firms and portfolio

companies is to make a statutory defence. When

considering a transaction, a firm can decide not

to go to the trustees, do due diligence on the

impact of a transaction on the pension scheme

and, if it concludes that the pension scheme will

not be negatively impacted, it can go ahead with

the deal. If in later years the regulator looks back

at the transaction, the owners can show that the

pension scheme was looked at and that, at the

time, there was no adverse effect on it.

be preparedThe key to avoiding unwelcome calls from the

regulator for scheme top-ups, and making sure

that trustees are happy with investment

strategies and benefit structures, is planning.

“You need to spend time working out your

numbers, be prepared and have very strong

arguments for making your case to trustees

and the regulator,” says Jones.

Pensions are now a priority, and the threat

of enduring the lengthy negotiations and

punitive penalty experienced by Duke Street

are a salutory warning. However, private equity

investors that are aware of the risks and plan

accordingly can avoid a visit from the regulator

further down the line.

nicholas neveling is a reporter for Real Deals.

In association with

Portfolio Management Special

Documents

Transcript of Portfolio Management Special