by Real Business - Thursday, 30th August 2007

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You know the script. You build up a business. You work hard and struggle for capital. You wonder why your bank manager just can’t see it. Eventually you reach the promised land - the stock exchange flotation. It is the biggest milestone most entrepreneurs ever pass. Sucks to the bank. You park a line of noughts on your personal balance sheet. The FT wants to interview you. Acquisitions here we come.

Er, did someone switch the script? Why are businesses forsaking the stock exchange for a venture capitalist wanting a 30 per cent rate of return and a bank loan that would finance a small third-world country. Have they lost their minds?

The pioneers of reprivatisation sound remarkably sanguine. Michael Frye pondered the privatisation of B Elliott for almost two years. Maurice Henchey knew exactly what he was getting into. His firm, Healthcall, only cast off the chains of a management buy-out four years ago. Without any encouragement from a hostile takeover bid, they and five other firms announced a return from the promised land in the first four months of the year. What’s going on?

Michael Frye’s grandfather founded B Elliott before World War I; his father floated it after World War II. It made machine tools and its glory days were in the sixties and seventies. Even in 1980 - at least ten years after the Japanese began to knock everyone off the road with numerically controlled machines - Elliott made profits of over £11m. Frye served his business apprenticeship there but went off to run the second family company - light-fittings specialist, Rotaflex - in the mid-seventies.

This was a smart move, since Elliott’s £11m was, to all intents and purposes, the end of its road. By 1986, when Rotaflex disappeared down the maw of a US multinational for £60m, Elliott could boast cumulative profits since 1980 of minus-£1m. Its turnover was down by a third. “It was selling the businesses that were saleable to finance the closures of the ones that were unsaleable,” says Frye.

With the M Frye branch of the family pocketing £15m out of the Rotaflex sale, it’s not surprising that Michael Frye came back to Elliott very reluctantly. But within a couple of years Frye, whose famously heavyweight frame disguises a surprisingly vigorous spirit, was at the helm as chief executive. The game plan - he swears that he and Warburgs had shaken on it in advance of his appointment - was that he would do the clear-out and it would come up with the capital. Between them, Elliott would be restocked with businesses going in the right direction.

The middle chapters of the tale, featuring the recession, staff turnover at Warburg and the dream deal that got away, are not for the public record, but the outcome was that by 1991, Elliott had too many new businesses, too much debt and too much of its old portfolio still left. Much of the remaining detritus was pushed overboard in a hurry at huge cost - losses in 1992 were £29m - and Elliott’s share price fell from £15 to 50p.

Elliott teetered on the edge throughout 1992. Two days before the bank facility terminated, Scandinavian outfit AP Moller led a deal which put the bankers back in their box but still left borrowings uncomfortably high. Moller got 42 per cent of the share capital.

Earnings were back in the black by 1994, and usefully ahead by 1996. That signalled an effort to place half the Moller stake and fix the balance sheet once and for all - calling for £22m in total. This was spurned by the City. Then earnings faltered in 1997. The clear-out of Newall Aerospace - Frye insists he wanted to get shot of it back in 1992 but was overruled - inflicted a £4m exceptional debit. And the 1998 outlook was unexciting.

Elliott’s problems were clear. It was small. It had a big shareholder who, it was clear to all, wanted out but could not find an exit. It had a chequered history. It showed few signs of an exciting future. With 54 per cent of the shares held by two shareholders, the “free float” of shares was worth about £10m - hardly enough to excite the stockbrokers’ analysts.

In the end, none bothered. After all, the small free float made Elliott equally unattractive to fund managers. To the manager of a £200m fund, investing less than £2m in one company might not seem worth the trouble. If £2m represents 20 per cent of the free float, he really is going to need convincing.

A quoted share can cope with one or two of these millstones, but not the whole lot. While shares in general soared, Elliott’s sank. The company needed recycling. Frye puts no gloss on his conclusion. “We failed. I think I got more of the blame than I deserved, but the bottom line was that we failed. If we had stayed public, it would have taken three to five years to turn it round and shake off the history... all to be done with grudging shareholders and no fresh capital.”

But as the share price got down below 60p last summer (and the price-earnings ratio below six - less than half the average for all shares), a silver lining came into view: Elliott was now so cheap that even with modest prospects, it was going for less than a song. Anyone who had confidence it would deliver at least the little it promised, could take on the risk of buying the whole company. Enter the privatisation option.

The deal wasn’t going anywhere without a nod from Moller. It took several months to bring it on-side at a price which Elliott’s advisers, Coopers & Lybrand, thought it could deliver - 110p, 38 per cent above the market price at the end of 1996. But the shares tumbled in the first half of 1997 and the Scandinavians eventually signalled green. So did the second largest shareholder, Foreign & Colonial, which volunteered the bonus that it would roll over its stake into the privatised Elliott. These two commitments meant that a majority of the share capital was accounted for.

That was an important element; the venture capitalists who finance buy-outs do not have the same feel for their takeover targets as industrial bidders. They therefore want to check the goods over more carefully. That costs money - which would have to be written off if they were outbid. “Having a majority of the capital isn’t a precondition for this type of transaction, but it does make it a lot easier,” explains Jerry Young of Coopers & Lybrand.

Young struck a deal with Toby Boyle of Morgan Grenfell Development Capital (MGDC). “We have looked at several of these public-to-privates, but this is the first we’ve done,” says Boyle. “You need three things, and we had them all here. First, a substantial base of shareholders who want to do the deal; checking out the details takes time and money, so you want to have the deal wrapped up in principle before you get into that. Second, you need the management to be behind it; sometimes we have thought the management was too wary. And third, you need access to carry out your due diligence.”

Boyle got all the access he needed. Young, who originally planned to announce the offer in early December, found himself dealing not only with MGDC’s own checker-outers, but hordes of advisors. Lawyers checked Elliott owned what it said it did. Strategic consultants checked the management wasn’t whistling in the wind. Insurers checked there were no unforeseen claims in the post. And environmental people checked that no nasties were buried in the ground.

And, when that little lot was done, the four sides locked horns to agree the fine details. Elliott, represented by directors who wouldn’t be joining the buy-out, had to be able to tell its shareholders that the deal was fair. The Royal Bank of Scotland, which would be lending the new company £50m (much more than its borrowings in the depths of 1992), wanted to ensure that it would get its money back even if it comes unstuck. MGDC wanted to make sure the management had the right balance of carrot and stick. The management team had the identical concern in reverse. They needed four firms of lawyers and two firms of financial advisers. Taking in MGDC’s due diligence investigators and the printer of the offer document, there were 15 separate fees to be paid, Young recalls. He’s shy about the precise total, but his steer points past £3m.

The last “i” was dotted at 5am on February 14, 1998, about the same time as the last revellers at the Coopers & Lybrand annual party got to bed. Young’s colleague Jerry Loftus, whose report to the banks had tossed Frye a lifeline back in 1992, volunteered to miss the bash in order to chair the completion meeting.

So what now for Frye’s offbeat collection of tube benders, hot metal measurers, battery chargers and a dozen other items of industrial arcana? A touch more reorganisation, for a start. The terms of the deal provide for a modest acquisition or two, and maybe there will be some small disposals. After that, it’s heads down until it’s time for MGDC to make its exit. For obvious reasons none of the participants emphasises returning to the stockmarket, but all acknowledge that it’s possible. “The company would have to be quite different if it was going to be refloated,” says Boyle. “I suppose that’s probably the most likely route, provided we can tell a story showing it has changed, that it has achieved things in private.”

Failing that, Elliott will be carved up. The businesses Frye and Warburg put into it in between 1989 and 1991 are probably too diverse to appeal to any one industrial buyer - if they weren’t, it would have been taken over long ago. Michael Frye suggests that Elliott would be attractive “to the right two buyers, in two chunks.” When pressed, he suggests a less final alternative: perhaps either its mechanical or its electrical grouping could be sold “and we could come back with one bit rather than two.” One suspects his favoured goal would be to return to the stockmarket with two bits. The vindication would be worth as much as the considerable amount he’d stand to collect.

Maurice Henchey’s motivation to take his company back into private ownership was almost identical to Michael Frye’s. Healthcall has for some time been the country’s number one doctor’s night-time deputising service. Henchey presided over a management buy-out in 1990 and delivered a tidy record running up to the 1994 flotation. Although that wasn’t a conspicuous success, profits continued to advance and looked set for a steep move upwards when in 1995 the government said that, to accommodate growing demand for night-time visits, it was upping the out-of-hours allowance for GPs by £140m nationally over three years.

Precisely what happened next is not crystal clear. Many local health authorities used the extra funds to set up deputising co-operatives in competition with Healthcall, which hurt its revenues instead of helping them. However, Healthcall had also been investing big bucks in a chain of “primary care centres” offering day-time deputising as well as eyecare, physiotherapy and chiropody. Henchey sees such centres as the solution to many of the challenges facing GPs and hospital accident and emergency units. They aren’t cheap. Healthcall already had five of these centres when it floated; by 1996 it had opened 20 more. Opening and operating expenses were heavy.

Between the deputising competition and the additional primary care centres, profits drooped from £8m in 1995 to £5m in 1996 and £3m in 1997. By last autumn, the shares were down to 59p from a 1996 high of 146p. Henchey makes all this sound like a little local difficulty. “I got the timing of a return to stability wrong by about six months,” he says.

When he did a trip around big shareholders last autumn to tell them that interim profits were down 40 per cent, he got short shrift. “I talked about the future with enthusiasm and belief but you could say I failed to persuade them. So I asked, ‘well, if there was a cash offer on the table, how would you respond’? They left me in no doubt they’d find that very appealing.”

Very appealing, however, does not mean “committed to a management offer.” By contrast with B Elliott, the Healthcall privatisation did not have a majority of the shares wrapped up before it was announced. Henchey and Natwest paid 90p - the 1994 flotation price.

So what are the conclusions? Are droves of small firms going to come off the stockmarket? Will droves of entrepreneurs who were heading for the stockmarket have to be diverted? Probably not. The last two years have seen a spectacular focus on large quoted companies at the expense of small ones. But these trends come and go. Ten years ago, small companies were all the rage. Even today, although small companies have been overlooked, people still find real bargains.

Most small quoted companies, delivering respectable sustained growth, don’t fall into the bargain category. The stockmarket’s advantages, in terms of management not having to account to a major shareholder and having ready access to new capital, have not disappeared. Most small companies will prefer to hang on to their quoted status. In any case, most small companies which are delivering the goods are not so outrageously cheap that venture capitalists will be willing to buy them.

And if they became so, the situation could be relied upon to reverse soon enough. As MGDC’s Toby Boyle says, “it might become a bit difficult if one of these deals proves very successful for us. Next time round, the institutions would probably want more than we’d be prepared to pay.”

The UK’s private elite
Few merchant bankers will have heard of the Cleveland Cable Company. Fewer, unless they are Middlesbrough fans, have been anywhere near the firm.

Yet Cleveland Cable is just the sort of company that any self-respecting merchant banker would die for. Profits have risen steadily through recession and recovery. The balance sheet is strong enough for the owning Powell brothers to set themselves up as merchant bankers - except that would not be profitable enough.

There are dozens of Clevelands up and down Britain, but we have picked out ten for our banking friends to chase. We take any wager that they will not snare one. How can they? These companies do not believe in borrowing money and do not need to. In total, our ten have net assets of over £520m, yet their total borrowings were just £658,000.

Even if a smooth-talking London banker made it into the chairman’s office, his difficulties would only just be beginning. These companies have none of the glamour and technological edge often found in the new issues market. They make lozenges and stairlifts and clean windows.

The only hope for the banker comes with a succession crisis. Yet our ten have not fallen into this trap. The second, third and fourth generations seem to inculcate the family business values and slot in as appropriate.

Only one of the ten is based in the centre of London. Far from the hurly-burly, they can quietly get on with what they known best - delivering profits and piling up the cash reserves in business. Good luck to them. They are the ballast of the British economy.

Who are they?
1. Cleveland Cable Company
Line of business: Electrical cable distributor
Based in: Middlesbrough
Owners: Alastair and Michael Powell

The Powell brothers vie with the late Howard Hughes when it comes to keeping a low profile. It’s easy to see why. When one is making £13m pre-tax profits on a £70.6m turnover (in the 1997/ 98 financial year) with £61.6m of net assets and £38m in the bank, there is little point in shouting about success. Alastair and Michael Powell distribute electrical cable. Their secret? The quality of their customer care. While big cable distributors refuse to offer off-cuts or short lengths to clients but insist on a whole drum, Cleveland will offer smaller lengths. It works. Year on year, its profits advance by a couple of million pounds or so and it adds more money to the cash pile, while drawing modest salaries and no dividends.

2. Trailfinders
Line of business: Travel agency
Based in: London
Owner: Michael Gooley

After 12 years in the army including a stint as an SAS member in troublespots such as Oman, Borneo and Aden, Michael Gooley was desperate to start his own business. That was in 1970. Today Gooley, 61, owns and runs Trailfinders, the London-based travel company. Its reputation for getting good deals for independent travellers on long-haul flights and in catering to those who want to visit more exotic locations has paid off handsomely. By the year to February 1997, pre-tax profits had reached £7m on sales of £229m. Borrowings are virtually zero, and the company only paid £13,567 in interest in the year, less than many annual mortgage payments by its clients.

3. Stannah Family Holdings
Line of business: Stairlifts
Based in: Andover
Owner: The Stannah family

To the elderly, they are a godsend. The Stannah stairlift helps elderly people move from one floor to the next in comfort and with no pain. To the Stannah family, led by Brian, 62, and his brother Alan, 58, it is a thriving business making £2.3m profit on sales of £71.9m in 1996. Again borrowings are negligible.

4. Fenwick
Line of business: Department stores
Based in: Newcastle
Owner: The Fenwick family

Fenwick’s is famed in polite London society for its elegant store in Bond Street, though its headquarters are in the north-east. There is nothing gritty about the department store operation which can trace its history back to 1882. Still in family hands, and run by 65-year-old John Fenwick, great-grandson of the founder, the business simply piles up profits. In the year to January 1997, it made £25m pre-tax profits on sales of £231.2m. Fenwick’s balance sheet is one of the healthiest around. With no borrowings, it has over £173m of net assets.

5. W Baxter & Sons
Line of business: food producer
Based in: Scottish Highlands
Owner: The Baxter family

By contrast with the Powells, the Baxter family are positively media stars. Ena Baxter, the matriarch of the family, has starred in television commercials. Her husband is the formidable Gordon Baxter, now retired at 80. He built up the business into a multi-million pound concern still based in the Highlands town of Fochabers, where it was started in 1868 by his grandfather, a humble gardener. Gordon handed over the reins to his daughter and ex-merchant banker, Audrey Baxter, six years ago. On his retirement, Gordon had turned down nearly 200 takeover offers. Audrey seems determined to maintain the firm’s independence. There is simply no need to do anything else. One of Gordon’s proudest boasts was that he had never borrowed a penny in developing the business. The same applies today. In 1996, the company made £4.1m profits on sales of £46.3m, while its net assets stand at £24.2m.

6. Lofthouse of Fleetwood
Line of business: Lozenge manufacturer
Based in: Fleetwood, Lancashire
Owner: The Lofthouse family

From her headquarters in Maritime Street, Fleetwood, Doreen Lofthouse says her ambition is to sell the famous Fisherman’s Friend throat lozenge in every country in the world. Over 100 countries now suck the little brown lozenge that packs a punch as strong as a North Sea gale. It was concocted in 1865 by local chemist James Lofthouse to help local trawlermen combat throat and bronchial ailments at sea. But the firm was only dragged into the 20th century in 1963 when Doreen Lofthouse joined the business. As managing director, she has built the company to achieve pre-tax profits of £10.7m on £30.5m sales in 1996. Borrowings are virtually non-existent, while the Lofthouse family have piled up net assets of nearly £27m.

7. OCS Group
Line of business: cleaning, security and hygiene services for industry
Based in: Sanderstead, Surrey
Owner: the Goodliffe, Bowthorpe and Cracknell family (all one big happy family)

In 1900, the New Century Window and General Cleaning Company was formed when Frederick Goodliffe, then 25, set off armed with a pail, a ladder and truck to clean Holborn’s windows. Now called OCS, the company is one of the largest private companies in Britain, with 44,500 employees in 1996 when it made £11.2m profit on sales of £297m. With £64m of net assets, it had no borrowings. The fourth generation is now running the company in the shape of Chris Cracknell.

8. Draper Tool Group
Line of business: Tools wholesaler
Based: Outside Southampton
Owner: The Draper family

Draper Tool Group started life in 1919 when Bert Draper started supplying hand tools. Today it is run by John Draper, 47, Bert’s grandson, and appears to be thriving in its core tool supply business. In 1996, pre-tax profits came in at £6.7m on £43.4m of sales. Its asset base stood at £52.2m, while borrowings are negligible.

9. Marshall Amplification
Line of business: Manufacture of electronic and amplification equipment
Based in: Milton Keynes
Owner: Jim Marshall (largely)

After training as an engineer during World War II, Jim Marshall, 74, went into the music business and started his own dance band, playing the drums. He eventually opened a drum shop. By the early sixties he was making his own amplifiers. Today Marshall Amplification is a world leader in supplying specialist amplification equipment to the world’s super-groups. As a result, it made £3m profits on sales of £30.7m in 1996, with no borrowings recorded in the past three years.

10 Jenners, Edinburgh
Line of business: Department store
Based in: Edinburgh
Owner: The Douglas Miller family

Jenners, the Edinburgh store, was founded in 1838, but was acquired by the Douglas Miller family in 1867. Today it is run by Robert Douglas Miller and his two sons are being groomed to take over. The family owns virtually all the shares. In the year to January 1997, it made a £4m profit on sales of £46m. Net assets stood at £20.2m and total interest payments in the previous three years amounted to just £5,000.

Take my company public? No thanks
Clive Jacobs almost took his company public. But he pulled back from the brink. And he won’t be heading down that path again.

Every year, Clive Jacobs looks through the Sunday Times’ “Rich list” and breathes a huge sigh of relief. On paper, at least, he’s worth well over £25m - they just haven’t cottoned onto him yet.

Jacobs is chairman and chief executive of Holiday Autos, a business he set up with two friends in 1988. Now the Surrey-based leisure car-hire broker is the biggest in the world. Were it to go public this year, it would have a market capitalisation of between £50m and £60m. And Jacobs owns 50 per cent of it.

But flotation is not on the agenda. Not in 1998. Probably never. Of course, Jacobs says he’ll do whatever’s best for the business - for example, it might in the future need funding for a big acquisition. But you know he’ll try every other avenue first. Clive Jacobs’ attitude is: if you’re passionate about your business, if you love it, don’t go public. Not if you can avoid it.

He knows what he’s talking about. Holiday Autos had a near-float experience back in 1993. Always looking for new business, NatWest Markets approached the company with the offer to help it go public. At the time, one of Jacobs’ partners was keen to cash up. And the lure of financial rewards (the bankers put a notional value on the company of £28m), as well as public recognition, sucked in Jacobs too.

The partners decided to sell 40 per cent on the main London stock exchange. They assembled a heavyweight team. Travers Smith Braithwaite were to be the lawyers; Price Waterhouse audited the books and restructured the partnership into a limited company. Meters were running in the City, clocking up hundreds of thousands in fees.

The next step was to sign up a stockbroker and publish the prospectus. “And then one day I woke up.” With eight weeks to go, Jacobs pulled the plug on the flotation.

“Maybe I did it the wrong way round,” he admits. “But I actually spoke to chairmen and chief executives of public companies and they all told me the same thing - don’t do it, it’ll be a big mistake.”

It wasn’t just the prospect of being outed as a multi-millionaire by the Sunday Times - “it’s not something I wish to gloat about. I’ve created my wealth because I want it for me and my family to live a comfortable life.” And he didn’t mind that the sudden free-flow of information into the public arena would have given competitors a new edge. It wasn’t even the pressure of conforming to stringent corporate governance rules - though he’s both chairman and chief executive, Jacobs claims that the company already runs to plc standards, a legacy from 1993.

It all came down to control. Jacobs hasn’t had a boss since he was 21. He is a very dominant person - so much so, he admits, that despite his best efforts the other two may have found him a difficult partner. All of which bodes ill for a successful relationship with the City, particularly when you hear his views on his potential masters.

“The whole thing about being public is increased profits, increased profits, the City expects...the City expects... The investors are expecting this sort of dividend and the shares to go up in value.” And so on and so forth. “People that invest in businesses are looking for short-term gains,” he adds.

They’re also risk-averse and have very very long memories. Even though the travel industry is flying high at the moment, shares still get marked down as commentators hark back constantly to the slump of 1995 and issue warnings about the strong pound. The situation drives Jacobs wild.

In his view, there are only three reasons to go public. The first is to fund expansion. To date, this has never been necessary. In the last 12 months alone, Holiday Autos has bought its Scandinavian operation, the remaining 25 per cent in Germany and formed a 50/50 joint venture in the US, with others in Asia, Australia and New Zealand. The investment was in the millions and has all come from cash flow and bank debt based on projected profitability.

The second reason for floating is to provide an exit for venture capitalists. Holiday Autos did get help to buy out one of Jacobs’ partners in 1994 but there’s no exit clause in the contract. ECI Ventures appears happy to stay put and, with only 25 per cent of the company, its clout is limited anyway.

Third - and Jacobs actually thinks a trade sale is better in this case - the business owner may want to realise his or her wealth. But Jacobs is way past that. He has been ever since his night-time revelations five years ago.

“It’s one of those barriers you cross. Quality of life is so much more important. I have a fairly balanced life, a very good salary, all the things I want. It becomes about different goals. And mine are the success of the business - that is, to make it bigger than any other leisure car rental company, not just the brokers.”

No entrepreneur likes to let go. But it’s more than that for Jacobs. When he was only 11, his mother dropped dead in front of him. His father later remarried and took his son to live in Israel. Aged 19, he arrived back in the UK, having borrowed the fare, with 50p in his pocket. He couldn’t afford to eat and was close to sleeping on the streets.

Now he’s a respected industry figure (and this year’s president of the Institute of Travel & Tourism), with a Porsche in his driveway and a company that will turn over more than £130m this year.

Calls still come through from the likes of NatWest Markets. And the wildness of the US exchanges does appeal to him (but New York has mammoth listing criteria and it will be ten years before Holiday Autos qualifies). But selling out would be like leaving home all over again.

“I’d have nothing. If you took away Holiday Autos and put £50m, £100m, in my bank account I would be very, very upset.” That’s putting it mildly.

Venture capital? No thanks
by Luke Johnson

You can tell the venture capitalists are booming. Everything you read is littered with tombstone adverts boasting of their latest killing.

In fact, they no longer like being called venture capitalists. They prefer the phrase private equity because we all know they do not really back risky ventures, but simply re-engineer the finances of the company in which they invest. If they fail, the cause is almost always the mountainous debt they force companies to assume. They are rarely interested in backing new ventures. They try to buy companies on the cheap and expand their profit margins by cutting costs rather than build sales, which is too chancy and takes time. In truth, they hardly provide equity at all - they just arrange expensive debt.

Today, the private equity firms in London have access to total financing of more than £70bn. They achieved spectacular returns by buying cheap in the early nineties and selling into the bull markets of the past few years. If leveraged buy-outs (LBOs) perform, the returns are always much higher than ordinary equity investments due to their financial gearing. Introducing fundamental improvements to businesses is irrelevant, since all LBOs are tax plays, as the interest on their vast debts are tax-deductible. This is buying low and selling high at its simplest.

The torrent of private equity funding has already started to erode the stockmarket. Some half a dozen bids for public companies by private equity groups have been launched in the past couple of months. The offer documents talk about investing for the long term and avoiding the pressures of the stockmarket. This is all bull. Private equity investors have subscription agreements and preferential rights for their investment instruments. They can change management with far more ease than institutional investors can in quoted companies.

The argument that private equity-financed businesses do not have to worry about share prices so they can plan properly is ridiculous. Just try running a company buried by debt and see whether it allows you to plan for the long term and invest in new projects and development. Buy-out funds want an early exit; and can be ruthless in achieving one.

The only conceivable reason why management and venture capitalists try to take public companies private is because they believe they are cheap and that they can make lots of money. Remember that buy-out funds expect to get better returns than quoted investors. Is this all through the magic of debt financing?

Not entirely. For a start they only focus on a few deals a year, and they do extensive due diligence from the inside. They end up by knowing the target company better than its existing shareholders. The staff of the private equity firms normally get bonuses in the form of sweet equity, so they are hugely driven to make their investments pay off. And they buy the souls of management wholesale. They offer them the chance to make millions and steal their business. The publicity put out by some private equity houses is encouraging them to do just that - “Why not buy your own business?” Well, they’re not going to overpay if they can help it, are they?

I recall a particular buy-out where the management stuffed all the stock into various lorries. These then circled the town while the auditors came to do the stocktake. The result was that the assets were understated and the deal was cheaper.

LBO mania has let a genie out of the bottle. Investors must stop it before it gobbles up billions of pounds of their money in buy-outs, buy-ins and the rest.

Luke Johnson is chairman of Belgo. This is an edited extract from an article that first appeared in the Sunday Telegraph on February 22, 1998.

Venture capital? Yes please
By Norman Murray

While there may be some transactions with the elements Luke Johnson describes, the venture capital industry can demonstrate that this type of deal is the exception, rather than the rule.

Commentators are all too easily captivated by the headlines of large deals and the recent funds raised by the UK venture capital industry. As a result, the industry is frequently derided for “only focusing now on management buy-outs (MBOs)”, for being risk-averse and short-termist. The facts are to the contrary - of the 1,200-plus financings in 1996, 67 per cent of them were in start-ups, early stage or expanding companies. Each year 85 per cent of the investments done by the UK venture capital industry are in new opportunities. Over 60 per cent of all the companies that received venture capital in 1996 obtained sums of under £1m - far from the “mega-deals” and far from low risk. Venture capital investments are generally held for between three to seven years or more - which rarely can be described as short term.

If venture-backed companies fail, it is seldom due to “mountainous debt.” In fact, as venture capital tends to improve cash flow and over-gearing constraints, failure is more often due to management, sales or other problems arising in relation to the economy or the sector. All venture capital firms aim to structure a financing that best suits the current and future needs of the company and its management so that it can achieve a high level of growth and success. After all, the principal returns on a venture capital investment are achieved generally through realising a capital gain - which would not be possible if the company were driven to bankruptcy or struggling with cash-flow problems.

The accusation that profit margins are expanded by cutting costs rather than building sales is quickly dismissed by independent research in 1996 into more than 200 venture-backed companies. Over a four-year period, these companies grew turnover by 34 per cent per annum, profits by 35 per cent per annum, exports by 29 per cent per annum, employment by 15 per cent per annum and investment by 28 per cent per annum. These growth levels far exceed those shown by other types of companies - and they weren’t just in their early and expanding stages of development; 43 per cent were management buy-outs.

As Luke Johnson points out, there have recently been a number of cases where small public companies have been taken private by management with venture capital backing. In the context of the whole stockmarket, these transactions can hardly be described as “eroding the stockmarket.” In fact, these deals encourage a more efficient market, where public shareholders received value for their shares at a premium above the quoted price. The management and the venture capital firm can then refinance the company including the provision of capital for future growth. Venture capitalists do not run companies - management teams do. In the event of under-performance, venture capitalists may find it easier to initiate management changes in a private company than shareholders in a public company, but fortunately radical changes are rare.

Far from being seen to be the “bullies” that Luke Johnson seems to have encountered, 88 per cent of venture-backed companies surveyed said that they had benefited from their venture capital backers providing more than just money. In any relationship there will be disagreements, but major ones should rarely arise, as the proposed exit method and timing is discussed and agreed in principle at the outset when structuring the deal. Also, it is not always the venture capital firm that wins disagreements!

Norman Murray is chairman of the British Venture Capital Association and chief executive of Morgan Grenfell Development Capital.

Contacts
Alistair Blair is an award-winning financial and investment journalist. Contact him at ablair@pobox.com.

Harriot Lane Fox is a business journalist.

Philip Beresford is a business journalist, wealth expert and author of the Sunday Times’ “Rich List”.

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