Part Three
Private Equity
3.1
Trends in Private Equity
Michael Joseph
Lloyds TSB Development Capital
New sources of money
Over the past decade there has been increasing acceptance of private
equity as an asset class for fund managers. Although UK fund man-
agers have yet to commit as much as US fund managers to private
equity (private equity is 0.5 per cent of asset allocation in the UK
versus 2 per cent in the US), this recognition has created enormous
growth in the sector. It has been driven primarily by the very strong
returns made by private equity investors, particularly as a result of
seeing private equity funds buying cheap as the economy came out of
the last recession, then make fabulous returns on flotation or trade sale
at the top of the market. There is now £41billion worth of investment
under management in the private equity sector (according to the
British Venture Capital Association).
This growth has a number of implications:
1. There has been a tremendous swing towards managing money for
other people, as opposed to own-balance sheet finance. The differ-
ence between own-balance sheet funds and managed funds is that
managed funds have to be returned to their owners at some stage.
If a portfolio has to be liquidated according to a fixed timetable, then
those managing the investment will naturally want to pursue
opportunities which offer short-term gains rather than long-term
gains, and gains which can be easily realised.
2. Funds are getting bigger. The natural response to this is to look for
bigger opportunities. The result has been that competition for the
largest buy-outs is very tight.

funds will find it harder to make their targets. It should be remem-
bered that historically a downturn has been a very good time to invest
in private equity. The three to five year time horizon means that one is
buying at the bottom of the cycle and selling at the top.
The tax environment is now very much more favourable to
venture capital investment, both at the institutional level and
84 Private Equity
the individual level, than it was ten years ago. This alone may be
enough to ensure that private equity prospers in difficult times.
It is unlikely that fund managers will reduce the assets allocated to
private equity because of short-term conditions in the public markets.
There is now an awareness of entrepreneurialism. Most people now
want to work for themselves. There is no longer any security in a big
company. There is a wide appreciation of the benefits of equity own-
ership. It has been a quiet entrepreneurial revolution. It is not going to
turn back.
Trends in Private Equity 85
Case study
Lloyds TSB Development Capital (LDC) and SMEs
Lloyds Development Capital’s view of the market is different
from many of its competitors. It has concentrated on the UK and
on the SME market within the UK. It has no intention of raising
outside funds, so it can take a slightly longer-term view of its
investments than it would have to if it were operating a closed
end fund.
As part of its strategy of supporting SMEs, it has been diversify-
ing its activity outside London. It now has offices in Nottingham,
Reading, Leeds and Birmingham, as well as the capital.
Over the last few years, LDC has become one of the largest and
most active venture capitalists in the UK (it is the leading investor

The next three years (1988–90) were years of real achievement.
The manufacturing businesses produced quality products and
won market share in a tough sector. The Group also made a
number of acquisitions with the assistance of additional bank
funding. The largest of these helped to double the size of its dis-
tribution business to 20 depots. Encon’s first overseas depot was
also opened in France.
The business then grew rapidly:
£ million
y/e 31 August 1988 1989 1990
Sales 19.0 31.0 60.0
PBT 0.232 2.0 2.7
The benefits from rationalisation of the cost base following the
acquisitions were still to come through. The business looked to be
on track to achieve a full stock exchange listing in line with the
Trends in Private Equity 87
aspirations of Encon’s senior management and the investing
institutions.
By 31 August 1990, Bank of Scotland had increased its support
to £12 million (split equally between overdraft and term loan)
secured primarily by good book debts of £17 million.
To strengthen the balance sheet, the equity investors ‘followed’
their initial stake with a second stage capital injection of £3 mil-
lion in December 1990, which was used to reduce some of the
bank debt. The investors increased their equity stake to 32.5% in
the process.
The trading year 1990–91 proved to be the most difficult one in
the Group’s relatively short history. The UK economy weakened,
moving from ‘slowdown’ status to an ever deepening and seem-
ingly endless recession. The building construction sector suffered

dropped out). The total equity from the investors increased to
£8.5 million, and their equity stake rose to 85%. It was also
acknowledged that Encon was unlikely to be in a position to pay
any dividends for at least another two years.
Bank of Scotland agreed to suspend its scheduled loan capital
repayments and also agreed to reduce its interest rate to a fixed
charge of 5% for one year to assist cash flow.
As a condition of the new equity funding, the investors
appointed a new non-executive Chairman with turnaround
experience to assist the management team.
The trading year 1991–92 was another year of mixed fortunes.
The programme of rationalisation continued and exceptional
costs that year from redundancies and closures totalled £1.8 mil-
lion. Bad debt write-offs rose to £1 million as numerous customers
‘went under’.
In terms of the bottom line, the year ended 31 August 1992 was
the nadir in Encon’s history:
Sales £67.0million
Operating Profit (£1.1million)
Exceptionals (£1.8million)
Bank Interest (£1.9million)
Trading Loss for Year (£4.8million)
The reliance on Bank funding had increased to circa £15 million
(£8 million on overdraft, £7 million on term loan). This was
secured by debtors £12 million, stock £4 million, freehold £1 mil-
lion, plant and machinery £6 million. On a forced sale basis, it was
unlikely that Bank of Scotland would have fully recovered their
lending and any shareholder value had gone completely.
Despite the trading results, the fundamental operations of the
business were sound and improving all the time. Working capital

bility of seeking an exit, probably by way of a trade sale. At this
stage the company’s auditors, KPMG, were also brought into play
through their corporate finance specialists and they indicated
that Encon might be valued somewhere between £30 million to
£40 million. A discreet selling process was then begun.
In November 1997, the shareholders sold out their stakes to
another institutional investor. Encon was valued at £35 million –
not a bad result compared to the situation in 1992! The result was
a good one for all classes of shareholder:
90 Private Equity
•
The management team made a substantial capital gain.
•
Those investing institutions which kept faith with the Group
recovered all the cost of their investment plus a substantial
capital gain.
•
Bank of Scotland recovered all their debt, preference shares,
and made a substantial capital gain.
At one stage, it had looked as if everyone might be a loser. By
working together and understanding each other’s needs, the
pain was shared by all the interested parties during Encon’s most
difficult trading period. Ultimately, all the shareholders enjoyed
the satisfaction and reward of a successful turnaround which had
depended upon all round co-operation.
3.2
Shaping Up for the Market
Mike Stevens
KPMG Corporate Finance
While the economic environment will greatly influence the total value

will not attract the attention of buyers who themselves have access to
funds to pay for your business. Your size could hinder your organic
growth if customers regard you as too small to handle their contracts.
You are unlikely to retain good staff if you are unable to offer the same
career opportunities as larger competitors.
While you need to be achieving organic growth, an acquisition or
alliance is more likely to make the difference that you require in profit
multiples. The reduction in overheads and other savings that you can
shake out of the balance sheet, plus the increased volume of sales, will
help to progress your profits up the scale from £100,000 to your first
£1 million and onwards to £10 million. Each step up the scale will add
to the multiples used to value the business.
Thus, you must start thinking about possible acquisitions, or, alter-
natively, build up alliances with companies that you might subse-
quently acquire. Look at gaining greater geographic reach by aligning
yourself with a similar business in a different location. Another option
is to hook up with a company offering something slightly different but
drawing on the same customer base. Avoid at all costs an alliance with
a business that has a very different offering to your own or with com-
panies either up- or downstream from you in the process, for these
rarely work.
Geographic or sector coverage
This ties in very closely with focus – you need to know what sector
you are in and achieve good coverage. Concentrate on building sector
92 Private Equity
coverage – companies that have made it to number one or two in their
chosen market are far more attractive than those that are number
three or less.
Alternatively, you can achieve good geographic coverage with a
degree of monopoly wherever you are. Because the world is getting

Shaping Up for the Market 93