Anyone who saw tearful and bewildered employees of i-level wandering out into Great Titchfield Street a couple of weeks ago will understand the grief that a company failure can bring.
Inevitably, attention has now turned to the causes of failure and, in particular, the role of private equity fund managers who invest in ambitious young marketing businesses. Those concerns were heightened further this week with the news that the private equity-backed Loewy Group has had to restructure its balance sheet after losing £31 million over three years.
In essence, private equity investors trade in companies - buying their shares with the express intention of selling them on again at a profit within three to five years.
Private equity investors talk about the need to have a mutuality of interests with businesses in which they invest. It's a seductive chat-up line: wouldn't any enterprising entrepreneurs who are managing a successful business wish to share in the financial spoils?
There's an ever-growing list of UK marketing and media businesses to prove they would - such as Mori, Billington Cartmell, AKQA, Gyro International, RSA Advertising and, more recently, The Engine Group and ILG Digital (the former parent of i-level).
That's not a complete list, but it illustrates how pervasive private equity investment has become, especially in funding management buyouts such as Bounty Group and partial ownership succession schemes like that of i-level.
The pickings have been rich too. Unconfirmed estimates suggest that Electra Partners made about £26 million out of its investment in Blenheim Exhibitions, Permira made about £49 million from RSA Advertising, ECI Ventures made about £43 million out of Bounty Group and an ISIS EP consortium made £20 million out of Mori.
But not every private equity deal has been so profitable. Vitruvian Partners is thought to have lost the best part of £22 million on its investment in Latitude Group when it went into administration at the turn of the year, although the fund has retained a stake in the successor company. ECI Ventures appears to have lost about £6 million after backing Amaze and it's almost inconceivable that ECI will have made anything out of its i-level foray - despite having secured much of its investment.
No reasonable person should begrudge marketing entrepreneurs realising their share of the value they create. But it is difficult for the founders of a business to get the best price for their shares if they would like the long-term ownership of the enterprise to pass on to the continuing management team.
Superficially, private equity finance ticks all the boxes that trade buyers or a public listing cannot. The continuing management usually stays in day-to-day control. There is none of the public accountability and administrative cost burden of a stock market listing. And there are often new opportunities for key employees to become shareholders along the way. What could be better?
For a start, it would be nice to think that the company could enjoy an indeterminate or at least long-term relationship with its new investor. But that does not fit the framework on which private equity funds are built. The funds are obtained - often from institutions as well as from individuals - on the understanding that they will usually get a return within about five years or so. So private equity managers will invest those funds for a similar timespan. The consequence? They will be agitating for the business to be sold on again within the five-year term or, occasionally if it is big enough, they might recommend a public share offering.
To the hard-working management, an exit with a swag bag filled with cash by a trade buyer after five years will probably seem an entirely reasonable objective. But what about the business itself? The danger is that no ownership bonds will remain to bind the next tier of management to the business and to each other. And in a people business, this matters far more than most investors (or even trade buyers) are prepared to contemplate.
Even more important are the practicalities of private equity funding. There are serious risks that need to be understood. Very few private equity deals involve the simple purchase of shares by the private equity fund from an existing shareholder. In such a transaction, the risk would be taken by the investor. But private equity deals commonly involve the injection of debt as part of a complicated ownership structure.
Bank debt is relatively cheap and, after paying any interest, it allows the balance of any profit growth to accumulate to the shareholders. This, in turn, enhances the future sale value of the shares and may encourage a private equity investor to offer a juicy price to secure an investment. There can be tax advantages too.
But private equity deals are not always as simple as that. Sometimes the private equity fund provides the loans itself. These are channelled through other companies that, in turn, buy the shares from the sellers. Thereafter, the companies are, in effect, merged into one with the result that the target company finishes up owing money to replenish the funds used to buy the shares. This is what happened at i-level and has happened at other companies before it.
Thus the term private "equity" is something of a misnomer as the investee company may also often find itself heavily indebted and its assets mortgaged as security. That would be fine if profits always went up, but such optimism depends a lot on the economy and on client loyalty - as i-level discovered. So the risk of hitting a financial crisis is heightened, along with the potential damage to the long-term prosperity of the business.
If the financial performance of a company is depressed, the position will be exacerbated by the cost of interest on the loans which, in turn, may affect its credit rating. At Loewy, £3.5 million of the £23 million it lost in the two years to December 2008 was attributed to interest charges. Billington Cartmell ran up interest costs of £4.6 million in 2008 alone, resulting in a loss of £5.9 million. Most of the interest has been deferred and added to the outstanding loan.
Why private equity investors should be permitted to use the assets of target companies to secure or eventually finance their deals is hard to understand. Governments have always been uncomfortable about such practices where the solvency of the company might be prejudiced, and the law prevents the giving of financial assistance by public companies except in limited circumstances. An innocent former shareholder in i-level might be upset to discover that, in effect, his company's money had been used indirectly to buy his shares in circumstances that unwittingly may have contributed to its downfall.
- Bob Willott is the director of Fintellect.
RECENT TOP PRIVATE EQUITY DEALS IN THE MARKETING SECTOR
YEAR INVESTEE PRIVATE EQUITY INVESTED REALISED
INVESTED COMPANY INVESTORS (pounds m) (pounds m)
2005 Gyro Intl Beringea, Electra Matrix,
Eclipse 9.0 21.0
2005 Loewy Group Risk Capital Partners 1.0 2.5
2006 Perfiliate DFJ Esprit 4.9 n/a
2007 AKQA General Atlantic Partners 87.5 *
2007 Loewy Group Veronis Suhler Stevenson,
ABRY 16.0 *
2007 Engine Loudwater Trust and others 12.0 *
2007 Latitude Group Vitruvian Partners 22.4 0
Cartmell Hutton Collins Capital
Partners 25.2 *
2008 ILG Digital ECI Partners 17.9 n/a
YEAR INVESTEE PRIVATE EQUITY GAIN YEAR
INVESTED COMPANY INVESTORS (pounds m) realised
2005 Gyro Intl Beringea, Electra,
Matrix, Eclipse 12.0 2008
2005 Loewy Group Risk Capital Partners 1.5 2006
2006 Perfiliate DFJ Esprit n/a 2008
2007 AKQA General Atlantic Partners * *
2007 Loewy Group Veronis Suhler Stevenson,
ABRY * *
2007 Engine Loudwater Trust and others * *
2007 Latitude Group Vitruvian Partners -22.4 2010
Cartmell Hutton Collins Capital
Partners * *
2008 ILG Digital ECI Partners n/a 2010
Source: Fintellect. Notes: *Not realised.