The lifeblood of business?
If there was ever a sector looking for a transfusion of positive publicity it's venture capitalism (VC). But, despite the unions' complaints, how strong is the Midlands' VC market and does it really help businesses grow long term? Kurt Jacobs finds out
Who would have guessed that an effacing former Midlands schoolboy could be at the centre of an unholy row?
When the giant GMB union unleashed its campaign against private equity it clearly had in its sights set on Damon Buffini, formerly of Leicester's Gateway College, now head of Europe's biggest private equity (PE) firm Permira.
Such was the fury raised by Buffini and his Permira peers over rationalisations and redundancies at household names like the AA, Little Chef, Homebase and Bird's Eye, that the GMB launched a campaign of questionable taste, including stickers with Buffini's image and the caption Pass The Sickbag and placards comparing venture capitalist (VCs) with a swarm of locusts at its big jamboree in Germany.
Since then the GMB has widened its attack to include other VCs, such as 3i, Cinven and Investcorp. Others in the labour movement have jumped on the bandwagon, with the general secretary of the TUC, Brendan Barber, calling VCs "casino capitalists" and "amoral asset strippers".
And in March 2007 the union's campaign against private equity scored a notable success when Parliament's Treasury Select Committee announced an inquiry into the workings of the sector, which could see Buffini and 3i's Philip Yea, among others, quizzed by MPs.
It is understandable, then, why so many within the venture capital sector feel so defensive about their position.
The issue that's been given greater piquencey by the hostile £39.7bn bid for Nottingham-based Alliance Boost, launched by VC giant Kohlberg Kravis Roberts and the chemist's chain Boots deputy chairman Stefano Pessina.
Chris Hurley, investment director at LDC in Birmingham, says: "We have got a bad name because the industry has not set its stall out. We have not explained ourselves so people think we're bad. Although it's the really big VC houses that have taken the brunt of it, the bad feeling has filtered down.
"We are being targeted. Plcs make people redundant every day of week and that does not make it into the papers. A lot of people make a good living out of PE - stakeholders, banks and the like. It's notable that there have not been many people from those banks standing up and saying all the good things PE does." James Arrowsmith, of NVM, adds: "There's a big difference between what we're doing in the Midlands and what the very large VCs in London do. It is too simplistic to say these guys are just overgearing businesses, cutting costs and selling at a higher price. True, there are examples of business in which people invest because they see a lot of fat in it. But most venture capitalists are looking for growth and potential, putting on business.
"They incentivise the key people who run and manage the business and the performance on the basis they will be rewarded. That is you can just underestimate the impact that has. People talk about VCs being short term, but that's nothing compared with the treadmill of being a business on the stock markets."
Even the VCs' bitterest enemy is not against them, at least in principle. Paul Maloney, who has led the GMB's campaign, says: "We're neither for nor against any particular form of ownership. There are parts of the VC industry that do invest in staff and businesses. The idea that we're against this as an industry is wrong."
So the case against VCs, from the labour side at least, is not one of principle, it's one of structure. Their beef is not with venture capital, but venture capitalists, or at least some of them.
The argument against venture capitalists goes roughly like this: VCs and the management teams who use them are both prepared to take ever larger amounts of debt to pay for deals, but are looking for shorter timescales in which to part company.
If the debt is to be serviced and the VCs make their profit it means the company has to sweat harder while the VCs are on board.
This leads, so the argument continues, to a more aggressive management style focussed on strong growth and profitability or, say its detractors, VCs having, at best, an overbearing influence on the direction of the business, and, at worst, asset-stripping the company and laying off staff in preparation for a quick sale.
If PE is such bad news then it does not appear to have deterred the management teams who want access to ready capital and are prepared to had over equity for the privilege.
According to LDC, the total funding raised to support private-equity buyouts of mid-market Midlands firms rose 20 per cent in 2006 to the biggest total invested into the region for more than six years.
The research analysed deals worth between £35m and £3100m. It found that, in total, 29 companies raised a combined £31.237bn during the year, compared with £3994m in 2005.
In the West Midlands, 16 companies raised a combined £3659m during the year, compared with £3461m the previous year. Meanwhile, in the East Midlands, 13 companies raised a total of £3578m, compared with £3533m in 2005.
However, figures from the Centre for Management Buyout Research, based at Nottingham University, show that, while more deals continue to done without VC backing, their average size is a fraction of those carried out with it.
So while some 74 buyouts and buy-ins were struck in the Midlands in 2006 without PE involvement, their average value was just £32.7m.
In contrast, while the number of PE-backed deals actually declined slightly, down four to 40, their average value rose more than fourfold to some £3120m.
Few in the sector were surprised by the results. Most believe that the price of VC-backed deals is being forced up by a number of factors.
Firstly is the sheer amount of money in the UK economy looking for businesses in which to invest. Despite recent interest rate rises, money remains relatively cheap, seducing VCs and their target companies to leverage ever greater amounts. A few years ago investments of three times EBIT (Earnings Before Interest & Tax) were standard. Now eight, nine and ten times EBIT are quite common.
Phil Griesbach, of Barclays Private Equity, says: "It's a very buoyant market in which to sell. Prices are very strong, partly because of the amount of money sloshing around and partly because of the number of trade sales. They tend to value businesses more than VCs because of the strategic element involved. Trade sales are on the rise, pushing up prices still further.
"It is self-perpetuating, or at least it will be as long as the wall of money keeps coming. But how long will such favourable lending from the bank continue?
"Businesses that are being sold to and by PE firms are doing relatively well and it's still possible to buy at six, seven times EBIT and sell at nine or ten times and so make a tidy sum."
Peter McLintock, head of corporate finance at lawyer Hammonds' Birmingham office, adds: "The big issue is the sheer scale of debt some of these companies are having to service.
"Just a few years ago three times EBIT was standard, now it's seven, eight, nine times. That's a lot of debt to be serviced and unless things change radically in the way a business is run it means the VCs can't exit for eight or nine years."
So does private equity encourage a short-term approach and heartless cost cutting to facilitate an easy exit for the VCs? It depends, say the pundits. Yes, some VCs are over-zealous in cutting costs, but the vast majority look to increase the values off their stakes by growing the businesses.
And if you think a three-year strategy is short term then try life on the stock market.
Gavin Cummings, partner at East Midlands law firm Browne Jacobson, says: "There has been a marked reduction in the length of time VCs are looking to stay involved. It is not unusual for them to be looking for an exit after just a couple of years, rather than five to seven."
Graham Elsworth, of BDO Stoy Hayward, adds: "Look at plcs with active investors who get very upset when performance slips in three months. Compared with them, VCs, who think in terms of three to four years, look like strategists.
"There seems to be resentment because VCs encourage businesses to be run efficiently, which can mean reducing costs, but the vast majority of VCs are thinking in terms of growth. If any one of them got tarred with the brush of asset stripper they wouldn't be in business for long. Reputation in this sector means a lot."
Phil Griesbach, of Barclays Private Equity, adds: "If you compare life with a VC with that on the stock market, where they crucify you if half-year reports are bad, then we're looking long term.
"Like most other VCs we're not looking to control businesses - that's the job of the management we've backed. They're the ones with the in-house knowledge.
"What we're doing is helping management run the business in a way that makes it more efficient, which means making it grow with ideas and acquisitions. We can bring in experience and ideas and concentrate on the banking relationship, keeping the banks satisfied that the finances are sound and so let the management concentrate on running the business."
Arrowsmith adds: "It's too simplistic to say these guys are just overgearing businesses, cutting costs and selling at a higher price. There have always been examples of businesses where people invest in them because they see a lot of fat to cut. But most VCs are looking for growth, for businesses that have potential to put on business. They're not looking to slim for sale, rather to build up.
"They incentivise the key people who run and manage the business and the performance on which they will be rewarded. People may talk about VCs being short term, but you can't compare it with the treadmill of being on the stock markets."
The feeling among most pundits is that, when it comes to VC-backed deals, the bigger the better.
It's partly about wise investment of time - a £3100m deal takes only a little longer to sort out than, say, a £310m management buyout (MBO), though the fees are far, far larger. Time is money, and big deals zepresent a better return on investment per hour of midnight oil burnt.
But bigger deals are also more attractive to VCs in the security that they offer. Bigger companies tend to have more experienced, cynical, seen-it-all-before management. Smaller businesses are run by less tested management, and are more subject to the fickle moods of the market.
Hurley says: "The number of Midlands deals in the £310m plus range has remained consistent for the past few years. What has radically changed is the typical size of those deals.
"Very small businesses are very fragile; if their biggest customer gets a cold they get pneumonia.
There is often a lack of focus on financial systems and controls so they don't see if they have loss making ventures or products. Going for larger business is partly avoiding being high on the risk curve."
Mark Audin, dealmaker at Grant Thornton adds: "The race for deals of £350m plus is becoming increasingly competitive. Everyone is looking for the large deals, although there's still a lot of competition in the £310m to £350m sector.
"However, drop below that and it becomes more difficult to get some VCs involved. It's partly because there's a greater risk and less reward, but also because the area is more competitive with other sorts of finance, like asset-based lending."
However, it is this sub-£310m level where some of the most interesting work being done by VCs occurs.
And, although it may not have the glory of the big blockbuster deal, this area remains the bread and butter of the sector.
Roger Blears, senior partner at lawyer Martineau Johnson, says: "Over 95 per cent of deals in the Midlands are less than £310m. Most people in the sector like to talk about being mid-market PE dealers, but by volume the sector is being done at sub-£310m level.
"The average expansion deal is about £33.4m.What you have is the revolution in the capital markets now being made available to ever smaller businesses. It's this area that keeps the wheels on the VC sector in the Midlands turning."
And amen to that say those tending the roots of venture capitalism.
Midven, like NWM and Catapult Venture Managers, makes a good living looking after businesses that, arguably, need a good slug of capital more than the big boys do.
Catapult's managing director, Rob Carroll, says: "The government and regional development agencies have become involved as catalysts to set pump priming for early stage businesses.
"It means there's no shortage of capital between £3100,000 and £3500,000 available. The constraint on new businesses gearing access to this capital is the strength of the propositions and quality of management teams. Public to private transactions tend to perform better than floated business due to the ability of VC funds to grasp the nettle, which results in changes for the better."
NVM's investment director, Roger Wood, adds: "I think at our end of the market deal flow will continue at good levels - it's at the big end of market which will be pretty static.
"If you went back five years there was a lot of low-hanging fruit that has now been plucked - parts of plcs that were begging to be bought out. They've now been acquired."
All this brings us back to the fundamental issue, which the GMB, despite its rather crass campaign, has legitimately raised. Is venture capital actually good for business? The overwhelming opinion is that, rogues and blatant asset strippers apart, yes it is.
According to the The Sunday Times, Deloitte Buyout Track 100, the region's top PE-backed performers make a substantial contribution to the local economy, employing nearly 16,000 people and generating more than £3120m of profits in their latest financial year.
Martin Cordey, director of Lloyds TSB Corporate Markets' acquisition finance in the Midlands, says: "The results reflect the positive impact of PE on the Midlands' corporate landscape.
"The region has a solid base of strong performing business, which is attracting investors keen to drive further growth.
James Grenfell, of corporate finance practice Orbis Partners, says: "Of course there are rogues in the market, performing what's politely called arbitrage, whose sole idea is to pump up the value of a business as quickly as possible before selling it on. But they're the exceptions. Most VCs look for growth, but even with that it's possible to make a huge amount of money."
Matt Waddell, head of corporate finance at lawyer Pricewaterhouse-Coopers, concludes: "VC houses back a good management team rather than the business. Ultimately, the greatest correlation between results and quality is the management team. PE allows top management teams to make a lot of money, but it does cruelly expose mediocre ones. With private equity there is no hiding place. Venture capitalism is Darwinian evolution with a vengeance."
