Private Equity

  • Date:01 Sep 2007
  • Type:CompanyDirectorMagazine

Well-heeled private equity raiders no longer have it all their own way, but this is no time to drop your guard. As Alan Deans reports, company directors still need to be prepared if private equity comes knocking at their door.

Guarding the gates against the barbarians


Could it be that directors and investors have found a means to repel the high-powered advance of private equity? The shareholder decision that recently brought an end to the contentious leveraged takeover bid for Qantas, combined with Orica’s board decision to dismiss a similar offer and Wesfarmers’ victory in the grab for Coles Myer, at the very least suggests that well-heeled private corporate raiders no longer have it all their own way. But boards would be foolhardy if they believed that they could drop their guard. Private equity funds are not going away. Directors will remain under relentless pressure to ensure that management lifts its game so that their corporation thrives and can stand on its own.

“Private equity funds are set to continue to be a major part of the scenery,” says Pacific Equity Partners (PEP) founder Tim Sims. “A fundamental shift is occurring in the way companies need to behave.”

A private equiteer would say that. But evidence is emerging that private equity is becoming more flexible in the type of dealings that it is having with Australian corporations. Private equity is much more than a brash share raider. Its involvement in the corporate scene is deepening, often making it partner with a company’s management and board rather than being a hostile force. Certainly, that is a view held by some influential company directors.

“Private equity players don’t have it all their own way,” says John Story, chairman of AICD and Suncorp-Metway. “But I think that they play a very useful part in our market place. I believe that it’s an added incentive for boards to maintain the efficiencies, rigour and discipline needed in governing a corporation.

“They provide a really useful purpose in the instance of a company that has been chronically under-performing. They are the right people to take it over. But private equity also provides a means whereby companies can dispose of under-performing assets.”

Sims argues that private equity has been demonised for too long and that the argument about mutual benefit needs to be better understood. PEP was a partner in the rival private equity consortium that lost to Wesfarmers in the fight for Coles Myer, and was recently successful in buying business data group Veda Advantage and alcoholic beverages manufacturer Independent Liquor. “Boardrooms are in a very difficult place right now. They sit on the top of perception management structures.”

Sims’ lengthy argument is that listed companies manage their financial performance outcomes to meet agreed perceptions or expectations. Senior managers don’t want to surprise investors and financial analysts because that can upset their share price. So they establish a set of goals that can be readily achieved by the company, benchmarked against competitors and provide steady and satisfying growth. If they meet these expectations year after year, they will be viewed as highly successful executives regardless of whether they could have produced better numbers by driving the business harder. It’s a case of fatter profits need not be best. Sims reasons that private equity does away with such a system by delisting a business and removing short-term expectations. It then focuses on longer term performance and pays managers more to generate value.

“Directors are faced with the challenge of how to change the status quo [of perception management] without looking dysfunctional,” Sims says. “They are spending more time on regulation, they are always under pressure not to rock the boat and they are surrounded by elaborate expectation management structures. At the gate are people who can promise more efficient capital structures, a different pay structure and different time horizons. Directors can do very little about all of that.

“They can look for more efficient capital structures themselves, but aggressive ideas are often punished by investors who do not want to rock the boat. They can’t do anything about the short-term time horizon of the investment markets, which wants performance now. Also, it’s hard to do anything about lifting the remuneration of managers. That’s a sure-fire way of being criticised.

“But people will find ways to do that. We have seen some already – hybrid structures that combine the best of both worlds. The capital structure of a business can be altered, for instance, by putting some assets into a joint venture that takes them off the balance sheet. Such a non-recourse alternative can then provide incentives to management. We have seen that with Publishing & Broadcasting and its sale of 75 per cent of its media business, and also with Flight Centre.” PEP has been negotiating to put a large share of the business into a joint venture in return for cash.

In addition, Qantas is moving along a similar course. As Company Director was going to press, the airline’s board was reported to be considering a range of options to boost financial performance, including the formation of a separate company to own its fleet of aircraft, another to run its freight operations and a third company for its frequent flyer program. If enacted, this would draw from ideas that the jilted private equity players, Airline Partners Australia (APA), were considering. It is also possible that some of the players in APA would be involved.

Explosives manufacturer Orica is believed also to be considering a range of options after it rejected a bid last April from a private equity consortium led by Morgan Stanley and including PEP. At the time, it said the offer significantly undervalued the company and its growth prospects. Central to directors’ deliberations is how they can best use the company’s financial strength to further expand the business, return funds to shareholders or a mix of both. Orica has already acted in part by lifting interim dividend by 38 per cent after reporting a bumper earnings result in its half-year result to March 31, 2007. In the meantime, however, individual investors who bought Orica shares near the $32 offer price have been agitating for quick action after the price fell below $31.

The Orica board confronts a similar dilemma to that already played out at building materials company Rinker. That company was caught out when the US housing market, a core purchaser of its quarry and concrete products, sharply weakened. Former chairman John Morschel says that the board foresaw such an occurrence and was planning to use Rinker’s strong balance sheet to make strategic acquisitions of its own when prices of rival businesses fell to acceptable levels.

“With share markets performing the way that they have been, it was increasingly difficult for us because growth options would not add value to shareholders,” he says. “If we had rushed into making acquisitions, it would have been dilutive to earnings. With hindsight, we might have been more aggressive. But we had very strict rules that we would not make acquisitions that were dilutive and shareholders had supported the company in that regard.”

Rinker was hit with a takeover offer from a Mexican-based rival, Cemex, which finally won the day after the Mexican company raised its bid price to meet the lower end of a valuation range determined by an independent experts’ report. It didn’t help that Rinker’s own share price had already fallen as investors became spooked by the softness in US housing commencements.

“Rinker had performed excellently,” Morschel says. “I don’t think that there was a lot of room for the board or management to lift their game. We could have been more effective with capital management, but we had done the maximum return of capital that we could get approval for from the Australian Taxation Office. We increased gearing significantly, but not up to what private equity would have done.”

In their search to defend the company against Cemex and increase the price for Rinker shareholders, the board looked for other bidders, including private equity funds. “We worked closely with private equity to get a better offer, but we could not get one. That was because the company was very efficiently run. It was not obvious where they could extract more value. Also, private equity was not able to achieve the advantages or synergies of an industry player (such as Cemex). They could not see a lot of room for improvement. The only way to do that was to increase gearing,” says Morschel.

So what was the outcome? Private equity funds did submit offers, but none matched the Cemex price. Rinker was taken over, but not by the usual barbarians at the gate.

Suncorp’s Story believes that boards have a lot to learn about private equity. “The central premise is that they drive capital very hard. Therefore, there’s a high level of intolerance to under-performance in any area of operations. But they are prepared to invest and accept that the capital expenditure may not have an immediate payback. There’s a strong discipline, however, about getting a return within five years. That’s a weakness of our capital markets. As far as the markets are concerned, if payback is any longer than 12 months, then there is a high level of intolerance.”

Morschel agrees. “I thought that shareholders would take both sides into consideration before letting the share price drop to a point where it opened the door to predators. Shareholders complain [now] about having a huge capital gains tax bill to pay and say that maybe Rinker was worth more. But they really should have taken more of an interest in the stock in the first place.”


We don’t need more regulation

AICD –?along with the Reserve Bank, the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority –?recently told a senate inquiry that there was no need to inflict further regulation on private equity companies.

Instead, AICD CEO Ralph Evans told the inquiry into private equity that the Government should focus on reducing the red tape and regulation.

He said regulation was hindering the ability of public companies to effectively compete against private equity funds by distracting the attention of directors and making management risk averse.

“In response to the growth of regulation of public companies, their boards tend to adopt a conformance and compliance focus, rather than a performance focus,” he said.

“This detracts from the board’s important role of oversighting the strategic direction of the company. It also reduces the board’s ability to encourage the company to undertake reasonable commercial risks. This can have the undesirable outcome of reducing the possible return to shareholders.

“More consolidation and streamlining of regulation is possible in order to make the public company entity a more attractive investment vehicle. After all, it is the vehicle that provides the broadest investment opportunities for all market participants.”

Evans noted that while regulation served a legitimate purpose to provide common parameters for businesses to operate within, too much regulation worked against that. It created costly hurdles that distracted from its primary goal, to build jobs, wealth and a stable economy.

On the issue of regulating private equity companies, Evans noted: “Nobody has been prosecuted for doing wrong in the course of the private equity boom of the last year and there is clearly a plus side for the economy. The efficiency of capital markets is increased if the valuation of companies more accurately reflects their intrinsic value (an outcome of the Qantas case). Private equity constitutes an additional means by which companies can be restructured and be made more efficient.”

He added that the UK Financial Services Authority concluded after an enquiry last November that: “the biggest firms and their lenders warrant close surveillance in several areas but pose no broad risk for the financial system”. “The European Central Bank formed a similar view at about the same time. We have no reason to doubt that they are right,” he said.

To view AICD’s submission to the Senate Standing Committee on Economics Committee’s inquiry into private equity, visit the Policy & Advocacy section on the AICD’s website at www.companydirectors.com.au

In this section of the website, you can also find AICD’s paper on directors’ obligations during boom time activity. It details how to deal with and manage the potential conflicts of interest that can arise for boards in relation to private equity investments. The recently released protocols in Takeovers Panel Guidance Note 19 also provides support (see: www.takeovers.gov.au/display.asp?ContentID=1225).