A REAL TEST OF PRIVATE EQUITY.
TERRA FIRMA AND EMI
In a previous article, Private equity is a superior model of capitalism - some things to think about, we differentiated between venture capital and private equity. Venture capitalists invest in start-up enterprises or businesses at an early stage in their development which need capital to help them grow. They often develop close relationships with the enterprises that they support and get to know their businesses well. Private equity investors buy mature businesses, and extract value by use of some or all of the techniques below:
Private equity: how do they do it?
An excellent example is what a private equity consortium did when it bought the UK retailing chain Debenham's for nearly £2 billion, putting in £500 million of capital from its own investors and borrowing £1.4 million, then delisting the company from the London stock exchange:
- Property was sold off and leased back to realize £400 million.
- Borrowings were boosted dramatically from the £100 million when it was a public company, to £1.9 billion.
- Huge "special dividends," believed to be between £200-300 million, were paid to the new owners, reducing their personal capital risk exposure.
- The three most senior employed managers were incentivized by being given 10 per cent of the shares (fairly described as "potentially life-changing rewards").
- About £100 million of tax was saved by the shift to debt financing (as such interest costs are a fully deductible expense, reducing taxable income), and some financial engineering making use of offshore companies.
- Cash flow was boosted by a sharp cutback in capex.
- Creditors were made to wait longer for their money and customers' discounts were cut, reducing working capital costs.
- Stockturn was improved.
The result? On sale of the restructured company, the owners completed a process that earned them about £1 billion - and the three top employee managers were personally worth £100 million.
(Thanks to Money Week)
PS: Debenhams was re-floated on the Stock Market and has since under-performed relative to its retailing sector.
Guy Hands of Terra Firma capital is a well-known exponent of the latter form of investment. In the good times, which may be passing, Mr Hands and many of his cohorts have made huge amounts of money, using cheap borrowing to leverage their investments. Now that cheap money is drying up, it will be interesting to see how the new Masters of the Universe fare.
The controversy about private equity investors and their impact on businesses remains unresolved. We really do not know the answers to a number of key questions, for example:
- Does private equity generally add value to the companies that pass through their hands - or do they simply extract value, leaving companies in a less robust state for the longer term?
- Is the private equity 'treatment' more appropriate for certain types of business than others? For example, how does the private equity approach suit businesses that depend on high knowledge, high technology and complexity or high creativity?
- Is private equity investment really another form of asset stripping and leveraged buyouts as practiced by KKR, Hanson Trust and such as Slater Walker, Goldsmith et al and brilliantly described in 'Barbarians at the Gate'? If so, whilst their results seemed to be brilliant for a period, their performance subsequently languished for lack of investment and it became apparent that companies such as Hanson really destroyed long-term value.
Terra Firma and EMI - a good test case
The answers to these questions may become a little clearer through the case of EMI, which was bought by Terra Firma for £3.2 billion in summer 2007.
This is a particularly interesting case, because EMI is a business based on the creative output of artists, some of whom are brands in their own right and not beholden to the wishes of financiers, for whom they have a fine contempt. (Tim Clarke, manager of Robbie Williams described Hands as behaving like a 'plantation owner' who picked up EMI as a 'vanity purchase'). Additionally, a typical private equity strategy of leveraging the music publishing part of EMI, based on past repertoire and copyright material, by raising borrowings against the value of these assets appears to be blocked because of the credit crunch.
Can Hands find financial engineering solutions, or will he be stuck with having to manage his way out of trouble?
This seems to leave Mr Hands in the position of having to manage the business in order to improve its performance, rather than practice financial engineering, asset extraction and cost reduction, the normal tools of the private equity industry. Managing is becoming a rather neglected art in the quoted sector of UK industry which is now dominated by investment institutions, which much prefer managements to deal their way to growth or out of trouble. Managing is particularly important to high technology and knowledge-intensive businesses, which respond best to a combination of consistent, long-term investment and a focus on dedicated leadership and developing the human potential of enterprises. This of course is of little concern to financial types, who prefer transactional strategies - M&A, buying external talent, re-structuring of portfolios, trading assets and swingeing cost reduction. The basic difference between managing and transactional approaches is that the former is essentially about long-term value creation, the other about relatively short term value extraction.
EMI's most successful turnround
EMI has been through it all before. In 1985, the business was becoming moribund. It had been acquired by Thorn, a parochial British engineering and consumer hardware group, which had little understanding or sympathy for the music industry.
Changes at the top of Thorn EMI brought in fresh leadership, including the author, who, with new CEO Colin Southgate, was intimately involved with the EMI turnround.
A key element was the introduction of new leadership at the top of EMI. Jim Fifield, EMI's most successful manager in recent times, was recruited in early 1986, and extensive management changes were made at the international and country business levels. Most of these appointees were young managers from inside the business. The crucial feature of the new management was a happy combination of passion for music combined with rigorous professionalism. Jim Fifield loved popular music and was passionate about creativity in music acquisition and artist development. But he had also been classically trained as a manager in the food industry - his speciality was marketing, but he also possessed a rounded business education. With full understanding and support of Thorn EMI corporate management, Fifield led his managers through a rigorous review of the strengths and weaknesses of the EMI business and organisation. This resulted in a radical review of international marketing, artists' rosters and a strengthening of the artists and repertoire capability. Then he led the organisation through a series of rigorous planning and action cycles, using the planning process as a means of educating his managers about what he wanted from them. This was supported by extensive development programmes.
Jim Fifield had a number of powerful ways of expressing himself. He frequently declared that he was not interested in numbers for their own sake - only as a derivative of actions - so he was most interested in words - and the words he liked best were verbs - he wanted to know in some detail what his subordinates were going to do. Just to make sure they took this seriously, he reviewed their plans with great rigour and woe betide anybody who failed to keep to their word. Agreement on actions being reached, 'JFDI' was his maxim. However, once trust was established with a subordinate, he gave them great freedom to act.
The results were dramatic. Helped by the growing CD market, EMI moved from losses of about £50 million to profits of some £300 million over a period of five years. Its world ranking moved from number six to number two in terms of market share and profitability.
Jim Fifield was CEO of EMI for about 10 years, but the latter stages of his tenure were marred by increasing conflict with the board. Some of the friction was initiated by Fifield himself - he reckoned that the changing Thorn EMI board had little understanding of the industry and didn't hide his lack of respect. He was not a man to suffer fools gladly, and eventually the Thorn EMI directors decided to replace him. From that time EMI has had an unhappy history of incompetent management, or of a lack of cohesion between management and corporate directors.
This left a business in need of a serious overhaul in the midst of a growing industry crisis driven by the internet and increasing difficulty in protecting intellectual property.
So EMI needs excellent marketing skills, a capacity to be creative in acquiring and developing talent and operational efficiency. An additional challenge is the need to master a rapidly changing technical and market environment.
Jim Fifield possessed many of the skills required to cope with these challenges.
Hands is reported to have recruited an array of talent to help him - Mike Clasper, ex of BAA, Pat O'Driscoll, ex-CEO Northern Foods, Allen Leighton, Chair of the Royal Mail and ex- ASDA and Lord Birt, who developed quite a reputation with creative types in the BBC. We know nothing of their knowledge of or empathy with the music industry, but already ironic jokes are spreading.
Can private equity manage and develop businesses?
The future of EMI as one of Britain's last large creative companies is important, but how Terra Firma develops the business is even more significant, because it is a real test of whether the essentially financially driven, value extracting approach that is now dominant in larger public and privately financed companies can actually really create competitively sustainable enterprises. So far, it is more than clear that membership of the FTSE 100 is tantamount to the kiss of death for high-tech and innovation-led enterprises. There are virtually none left, having failed through a lack of investment and competitive stamina or by simply being sold to foreign buyers.
Now it's the turn of private equity to show what they can do. We should keep an eagle eye on what happens, maybe with the following questions in our minds:
- Will Terra Firma stick with the business or try to deal its way out of trouble?
- What will the artists do?
- What will happen to EMI's market shares?
- Can EMI develop new revenue streams?
- Are profit improvements a result of cost reduction or improvements in the top line revenues?
Amongst those who ought to join us in our vigil are the editorial staff of 'The Economist' which declared private equity to be 'a superior version of capitalism', Shadow Chancellor George Osborne, who asserted, "Private equity is a beacon of British excellence" and Gordon Brown, who seems to have followed Tony Blair in having a very favourable view of the industry and its benign impact on Britain.
Two investment banking friends are firmly of the belief that Hands will come to grief, as they think he has attributed success in benign market conditions to his own genius, and become arrogant and sloppy in his appraisal of acquisitions, believing that he can finagle his way out of any trouble. This time, they think he will fail.
What do you think?
One friend who has inside contacts in EMI reckons that Terra Firma's exit strategy may already be emerging:
There is absolutely no doubt that EMI needs a thorough shake-up and a totally new business model to face the future and Guy Hands has the stamina, intellect and clout to do it. Unfortunately it's for all the wrong reasons as far as the artists and artist managers are concerned. However, he has retained Roger Ames (I believe to head up A&R globally) - no doubt with an enticing share of the business - nevertheless Roger is (or was) highly respected in the artist community and can be termed a "music man". He's also "the link" with Warner Music which is probably Guy's ultimate plan for EMI.
So the strategy may be to clean out as much cost as possible, slim the organisation thus improving profitability and again seek a merger with Warner, which may also be exploring de-listing.
Watch as the game unfolds.......