Creating a clearer picture

Author: | Published: 1 Apr 2007
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A quick glance through the national newspapers gives more than a hint that the private equity and venture capital industry is going through a big step change and facing exciting challenges in the years ahead. To someone outside the industry, this interest and coverage, and indeed the response it has evoked, appears to have developed overnight.

A look at the events of the last 12 months helps to make the picture a little clearer. First, there is the sheer growth of the industry. The last two years have seen unprecedented development in all aspects of the industry's activities – fundraising, investment and exits.

Industry growth

2005 was a record year for UK private equity firms. Funds raised from investors reached £27.3 billion ($52.7 billion), compared to just £3.3 billion in 2004. Investments reached £11.7 billion, up from £9.7 billion in 2004. The number of companies financed worldwide once again exceeded the 1,500 mark at 1,535, of which over 1,300 companies were backed in the UK alone.

Over the last five years, UK private equity firms have invested £33 billion. This investment has taken place across all sectors of the economy, across all regions of the UK. In 2005 there were about a dozen big deals done, while most investment, over 80%, was of £2 million or below. These are the thousands of smaller businesses that private equity backs every year.

The UK is now firmly established as the centre of the European industry, accounting for over 50% of the European market. It is second in size only to the US. The BVCA (The British Private Equity and Venture Capital Association) represents over 95% of all UK-based private equity and venture capital firms, speaking and negotiating on behalf of the industry with media, regulators and government at home, across Europe and around the world.

Investment activity by BVCA members

 Source: BVCA Report on Investment Activity 2005

Economic impact

With this growth in the size of the industry has come greater economic and social impact. It is well established and broadly acknowledged that, from the specialist venture managers through to the largest buyout houses, the industry invests, builds businesses and creates employment across the country.

It is estimated that 1.2 million people, 8% of UK private sector employees, are employed by companies that are backed by private equity.

A recent BVCA report, The Economic Impact of Private Equity in the UK 2006, found that private equity-backed companies create jobs at a considerably faster rate than other private sector companies. Over the five years to 2005/6, the number of people employed worldwide by UK private equity-backed companies increased by an average of 9% a year. The rates for FTSE 100 and FTSE Mid-250 companies were 1% a year and 2% a year respectively. And nearly three-quarters of companies said their growth was organic, rather than by acquisition, since they had private equity backing.

These findings are also reinforced by a recent European-wide study. The report examined the contribution by private equity to employment growth in Europe. It concluded that not only did private equity have a positive impact on employment, but also "the value generated by PE is reflected in rapid sales growth, healthy margins, larger investment budgets, accelerated globalization" and that "PE-financed firms develop more rapidly after the investment, clearly outperforming their competitors and other traditionally financed firms" (Niewiem, Popp, Rothenbucher and Scheiter, Private Equity Creates Employment & Value, 2006). The study attributes this out performance to the value creation strategies adopted by PE-backed firms and investors.

The UK also demonstrates this positive contribution to the economy by private equity-backed firms. Over the five years to 2005/6, on average private equity-backed companies' sales rose by 9% a year, compared with FTSE 100 companies (7% a year) and FTSE Mid-250 companies (5% a year). Exports grew by 6% a year, compared with a national growth rate of just 2% and investment rose by 18% a year, compared with 1% nationally.

In the BVCA survey of businesses that have received private equity funding, over 90% of owners said that without private equity the business would not have existed at all or would have developed less rapidly.

Private equity is more than just the provision of capital. Around two-thirds of businesses surveyed identified strategic direction, financial advice and help with contacts as being ways in which private equity houses had helped with the development of their business.

The industry is a main factor in keeping the UK and wider European economy flexible and dynamic. Private equity creates strong and competitive companies that generate employment and drive investment. The UK's global competitiveness depends on its ability to be innovative and foster entrepreneurialism. Private equity is an important driver of innovation and change throughout the life cycle of a company.

Non-financial contributions to private equity-backed companies

 Source: The Economic Impact of Private Equity in the UK 2006

Impact as a financial service

The UK, and London in particular, is arguably the world's pre-eminent financial centre, providing a global hub for international institutions, firms and investors. The UK private equity industry is playing an increasingly important role as a profit centre within the financial services industry.

The UK private equity industry's role as a source of revenue for firms operating within the broader financial and professional services industry is increasing, contributing to the overall impetus that these industries provide to the UK economy.

Over 10,000 highly skilled professional staff work in or support the UK private equity industry. There are around 5,500 individuals directly employed, over 3,500 of which are investment professionals.

During 2005, financial and professional services firms generated an estimated £3.3 billion in revenue through the provision of services to the private equity community, representing around 7% of the total turnover of the UK financial services industry.

UK private equity fund managers have long attracted capital investment from outside their own shores, with an annual average of £8 billion of funding flowing into UK funds from abroad over the past six years. This represents almost £50 billion of foreign investment over the past six years, representing over 70% of the total capital raised by the UK industry in that time.

Furthermore, 67% of the total capital invested by UK private equity and venture capital firms over the past six years was committed to companies within the UK, demonstrating a positive net inflow of capital into the UK economy.

PE as an asset class

A driver of the industry's growth and impact is its success as an asset class. Private equity has continued to outperform total UK pension funds assets and the FTSE 100 and FTSE All-Share over the medium to long term, delivering demonstrable long-term out performance.

The net returns of private equity funds measured to the end of December 2005 were: 21.1% over three years; 11.9% over five years; 16.4% over 10 years and since inception 14.4%. Private equity funds outperformed total UK pension funds assets over the same periods and also outperformed the FTSE 100 and the FTSE All-Share indices over the three time spans (BVCA, Venture Capital and Private Equity Performance Measurement Survey 2005, PricewaterhouseCoopers).

The superior returns generated for investors, who are predominately pension funds and other institutional investors, have guaranteed the continuing acceptance of the asset class. The recent FSA review of the industry (FSA Discussion Paper 06/6 Private Equity: a discussion of risk and regulatory engagement) highlights that a "considerable proportion" of funds come from overseas and that only 5% of the funds raised by UK private equity firms come from UK pension funds.

The BVCA has long campaigned to see a greater allocation by UK institutional investors to the asset class.

Current issues

When taking a broader view of the success and establishment of private equity as a mainstream asset class, the growth of the industry, and its economic and financial importance to the UK economy as a whole, the reasons for the increased interest in and scrutiny of the industry become clearer.

This success and the scale of the private equity industry mean that it of course attracts the attention of the regulatory authorities.

The BVCA welcomed the FSA review of the industry that was published towards the end of 2006. It is a timely and serious contribution to assessing the role of the industry. Its findings have implications not only for the UK but also for regulators across Europe and around the world.

The review was generally positive about the industry, its role and how it conducts itself. It stated:

"Private equity is an important component of a dynamic and efficient capital market. Private equity offers a compelling business model with significant potential to enhance the efficiency of companies both in terms of their operation and their financial structure. This has the potential to deliver substantial rewards both for the companies' owners and for the economy as a whole. This positive contribution to capital markets is expected to increase over time as the private equity market continues to grow and mature" (Private Equity: a discussion of risk and regulatory engagement).

The FSA believes that the regulatory regime is effective, proportionate and adequately well resourced.

Of course the FSA did highlight potential areas of concern, particularly around the issue of leverage. The fact that the review highlighted that some PE-backed businesses might collapse was not a new statement. The industry is involved in the provision of risk capital and inevitably there will be losses. Debt levels are increasingly receiving more attention. Appropriate leverage in a particular deal is a function of the outlook for interest rates and the economy generally and the robustness of the company's earnings. Misjudgements in the investment process will be made in particular cases. Individual failures are not symptomatic of a fundamental weakness in the private equity model. Nor indeed are such occurrences unique to the private equity industry, but rather a feature of the risk of entrepreneurial business as a whole. What is important is that these isolated failures not obscure the positive benefits brought by the industry to the large numbers of businesses it invests in and the excellent returns generated for the pension funds that back private equity.

The BVCA will continue to work closely with the FSA to ensure that the regulatory regime is appropriate and light-touch.

The picture that all of this creates is of an industry that, with its increasing size and reach, is affecting an ever-widening base of interested parties. And this goes some way to explaining the hype and headlines.

As fund sizes increase, naturally so do the sizes of businesses that private equity can back. Equally it is important to distinguish between deals actually done and market speculation about possible opportunities. But there is a wider stakeholder base with legitimate interest in what the industry does and how it does it.

The BVCA has established an independent high-level working group under the chairmanship of Sir David Walker to review issues of disclosure and transparency with a view to producing a voluntary code in the Autumn.

Despite the weight of research that highlights the important economic contributions made by the private equity industry, some negative perceptions exist. The UK has seen a number of criticisms that seem strange for an industry that is about creating jobs and value.

Value creation

Value creation is at the heart of what private equity does. Its success is driven not by leverage or financial engineering but by creating long-term sustainable value.

The specific strategies adopted by private equity firms have been shown to systematically generate value. In its study of employment creation by private equity-backed firms in Europe, AT Kearney has attempted to identify exactly how value and employment is enhanced by private equity (Private Equity Creates Employment & Value, 2006). Its conclusion is that success is achieved by focussing on strategies, that improve the performance of the business by: examining internal operations; re-engineering and focusing the existing business by reducing complexity and concentrating on core businesses; and by examining how synergies can be created perhaps by acquisition or strategic alliances.

Obviously these strategies are not just available to private equity, but what has been evidenced is that the unique combination of factors that private equity brings: a spirit of entrepreneurialism and the alignment of management interests and funding, allows the adoption of these strategies extremely successfully.

The last 12 months have seen the private equity industry undergo some fundamental changes. Its move in to the public arena through its success and growth has meant that the industry has had to explain itself to an ever-widening base of stakeholders. This attention is welcome. It gives the industry a chance to champion the benefits private equity brings to the economy – and the UK's success in building world-class industry.

Peter Linthwaite is chief executive of the BVCA - The British Private Equity and Venture Capital Association

Author biography

Peter Linthwaite

BVCA – The British Private Equity and Venture Capital Association

Peter Linthwaite was appointed chief executive of the BVCA – The British Private Equity and Venture Capital Association in September 2005. He has been involved in the private equity industry for over 17 years.

Before his appointment as chief executive, Linthwaite was a founding director of Royal London Private Equity Limited, the UK mid-market private equity house.

Previously he has served as executive director of Murray Johnstone Ltd, during which time he was managing director, Murray Johnstone Asia Ltd, Singapore, 1995-2001 and director, Murray Johnstone Private Equity Ltd, London, heading up the London operations, 1990-1995.

Linthwaite had an early career in banking and corporate finance after reading law at New College, Oxford. He is married with two children.