UK: United Kingdom Market Trends Influence Exit Strategies

The private equity markets in the United Kingdom and across Europe have changed in the last three to four years. Gone, for the time being at least, are the days when private equity firms and venture capital funds could expect a quick and profitable exit in return for a minimum effort. Investors are now finding that they need to become more involved and work longer with their portfolio companies if they are to realize a successful return on their investments within a reasonable time frame.

The lack of appetite from trade buyers and an only gradual increase of activity in the initial public offering (IPO) market in the United Kingdom show that it remains important for private equity firms and the management of their portfolio companies to be flexible in their joint strategies. Both sides must work with each other to ensure there is a shared understanding of each other’s motives and ambitions for the business. This is important if maximum value for both sides is to be realized when the investor exits.

Broadly there are four main exit routes available to the private equity investor: trade sale, flotations/IPO, secondary sales and write-offs. Trade sales involve a sale of either the company or its business to another company, most often in the same sector or with complementary businesses. The consideration offered by the purchaser can be in the form of cash, shares (listed or unlisted), loan notes or a combination of different forms. Where the sale is a business disposal, the original company will subsequently be liquidated, having taken any creditor or other liquidation preferences into account. The realized value or consideration for the business (net of any liabilities) can then be distributed to shareholders.

On an IPO or flotation, the private equity firm will attempt to exit its investment at the same time as the portfolio company is floated on a stock exchange. Most often this will be through the exercise of the private equity firm’s unfettered right to sell its shares on an IPO — a right that will be contained in the original investment documentation. The shares held by the private equity firm will most likely be placed by the company’s brokers as part of the IPO rather than selling its shares in the market following the IPO.

The statistics suggest that secondary sales (otherwise know as second-stage buyouts), by which the private equity firm sells its aging investment to another investment or private equity firm, are slowly growing in popularity. However, secondary sales are only attractive when the second-stage investor believes it will be able to extract more value from the investment than the original private equity firm had been able to or was prepared to wait to realize.

While not necessarily the cornerstone of any private equity firm’s investment strategy, it is worth remembering that write-offs have been and remain one of the most prevalent ways in which private equity firms exit from their investments. Portfolio companies should always be mindful that the private equity firm has its own business to consider. For those whose businesses under-perform, for example by requiring a disproportionate amount of investor involvement for the size of the return on the investment, the willingness of private equity firms to continue to expend valuable resources is not without limit.

Figure 1 provides some recent statistics on each of the four exit routes over the past three years: It would be easy to assume from the statistics that they demonstrate the effect of relatively little activity or appetite in the equity capital markets over recent years, with some evidence of a gradual strengthening in the market as a whole as the total value and percentage contribution of write-offs decreases. However, this may be too simplistic an approach to understanding ultimately what drives the exit strategy of private equity firms. For the most part, they are looking for a clean break on exit from their investments at the point at which they are able to deliver maximum value for their original investment in a way that is consistent with their overall investment strategy.

Figure 1 - A sampling of statistics regarding the four main exit routes employed in the United Kingdom over the past three years according to the British Venture Capital Association.

According to the British Venture Capital Association, in the buoyant equity capital markets in the United Kingdom of 2000 there were 44 flotations of private equity-invested companies and only 14 the following year. The figures for 2002 and 2003 of 26 and 10, respectively, show that although the total value of investments realized through flotation has appeared to grow steadily over the past three years, the number of companies in which flotation has provided the investor exit has fluctuated considerably. This makes it difficult to identify a trend in this area.

One reason for this is that flotation is not always the preferred exit route for the private equity investor, although management may have a different view. Potential institutional investors in the to-be-floated company are often concerned about how the incumbent management will sustain the existing track record when the private equity firm’s influence and management input is pulled out of a company it has been helping to run and grow over a number of years. To address this concern, there is often pressure from the incoming institutional investors on the exiting private equity investors to maintain a minority stake following the flotation, ensuring they have a continued financial interest in the success of the business. Although this scenario offers the private equity firm the possibility of participating in any future growth, it does not provide the clean break a firm may be looking for.

As the statistics show, the trade sale route remains the most common and often most preferred exit route even in the improving market in the United Kingdom in 2004. Some commentators argue that the trade sale route is inherently less attractive as the vendors can never be certain that they, or their advisers, have captured the buyer prepared to offer the best price. In their view, a price derived from a series of road shows in front of institutional investors is the only reliable way to ensure an asset has been properly priced. This, together with the desire of the business’s management to run a quoted company and the continued existence of the business after flotation instead of being subsumed by a larger organization, may be sufficient to persuade the private equity firm to opt to exit through flotation rather than a trade sale. However, while these business development motives undoubtedly have some merit, it would seem unlikely that they alone would be enough to sway the balance in favor of flotation unless the private equity investors can be persuaded that a continued involvement in the company following flotation is the best way to achieve maximum value.

It is difficult to predict likely trends in the various forms of exit routes, not least because there is little evidence of previous trends. What would seem likely (given the activity so far in the first half of 2004) is that the figures for the current year will show an increase in the overall value of divestments and a larger number, if not necessarily a greater aggregate value, of those exits being by flotation. In addition, more buoyant markets suggest there should be a decrease in the number and value of write-offs. 

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