Private equity investors are snapping up listed companies at an unprecedented rate with far-reaching implications for treasury teams. With private equity in charge speed is key; sacred cows are challenged, value creators prioritised and balance sheet efficiency, cash generation and return pushed centre stage.
Awash with trillions of dollars in capital to put to work, private equity investors are snapping up listed companies like UK supermarket chain Morrisons, German pet group Zooplus, US-listed Chinese recruitment group 51jobs or the ongoing circling of Toshiba. Once private equity takes the helm, treasury must buckle up for a new strategic, hands-on direction driven by balance sheet efficiency and a greater focus on working capital that puts conventional treasury on steroids. “Treasury has to respond under private equity and align to a new culture of business change and things done at speed,” says Ian Fleming, Treasurer at the UK’s now defunct department store Debenhams when it was under private equity ownership between 2003 and 2007. “Be quick, be good and be gone,” he says, recalling his mantra at the time.
Years of central bank quantitative easing and rock bottom interest rates have created a world awash with capital that has private equity investors currently sitting on an estimated US$1.32trn of dry powder. “Private equity is a cyclical market that is the function of the price of assets, debt service costs and the availability of credit,” says Fleming, referencing the factors linked to today’s demand which although exacerbated by pandemic policy, also drove the boom in the asset class in the mid-2000s until the market crashed after the GFC.
Important other factors are also driving demand. Private equity houses target companies with robust cash flows and significant growth potential that they aim to sell within three to five years. UK listed companies, hit by low valuations compared to public markets in the US (and to a lesser extent Europe) due to Brexit and the fall in the pound, have attracted the keenest interest, but low public market valuations relative to private valuations are not unique to the UK.
Take two companies, one public and one private and both in the same industry going through a sale process, the listed company will have a lower multiple than the private one. “There used to be a premium for being listed but now the premium isn’t there and even a discount may apply,” explains Alvaro Membrillera, a partner in law firm Paul Weiss’s corporate department and head of the firm’s London office. “If you have a company going through a dual-track sale process, it is no longer a surprise that a trade sale achieves a higher valuation than the IPO.”
The reason? Rigorous prepping and readying of private companies to optimise sale value leaves private firms with less value extraction down the line. Private owners have already addressed problematic issues like underperforming assets, litigation or jurisdictions that don’t contribute to the bottom line.
Private equity ownership brings a whole new angle to balance sheet efficiency that transforms cash management and working capital at a cultural, strategic, and operational level. It results in a heightened emphasis on cash and pressure on treasury to improve cash forecasting, generation and return. The cash buffers that provide comfort to many listed companies’ balance sheets are quickly optimised, often replaced with a revolving credit facility to fund operations, says Membrillera. “We see this across the board.” Fleming recalls that Debenhams cash profit and cash reporting strategy released £103m in working capital in the company’s first year under private equity ownership.
Effective cash management opens the door to another key characteristic of private equity. Private equity investors deliberately favour robust, operational, cash flows because they allow the highest levels of financial risk. “If you have robust cash flows you can better leverage the business,” explains Fleming. “Strong cash flows allow for greater financial engineering.”
Cue adjustments and optimisation of the relationship between debt and equity, all spurred on by tax breaks – like the ability to offset the cost of debt against the company’s tax burden – today’s low borrowing costs and using assets as collateral. “When interest rates are low there is an incentive to raise more debt than equity,” says Clive Black, a director at investment group Shore Capital. “Private equity investors are after the maximum internal rate of return. By injecting debt into the financial equation rather than just being equity funded, they can get a higher return on invested capital.”
Treasury becomes responsible for ensuring that the operating company can service the debt and managing the relationships with debt providers. Treasury will provide updates and rigour around communication, understand how the assets support the level of debt and be across ongoing debt refinancing of the initial take-out financing, repayment, and solvency ratios.
When interest rates are low there is an incentive to raise more debt than equity.
Clive Black, Director, Shore Capital
And now the added risk of rising borrowing costs is also in the mix, warns Black, who argues that today’s private equity’s tailwind is linked more to low interest rates and central bank largesse than investor talent and corporate entrepreneurship. “No doubt, as interest rates rise, we are going to see poorer investment decision and the risk of debt and leverage come to the fore.”
Fleming also notes that for companies with an international footprint and revenues, treasury teams will often match the debt financing currency with the currency of its net inflows. “This can often create an overlay of hedging complexity not previously experienced or understood by management,” he says.
The focus on cash and a strong cash control function often manifests in private equity investors having little enthusiasm for best practice. Providing more colour from his days at Debenhams, Fleming observes demand for treasury systems and process improvements was capped at robust, fit-for-purpose frameworks only. “Why invest £100,000 in a new TMS when you can invest in something else with an IRR of 25%?” he asks.
Treasury teams won’t have to get involved in public reporting anymore but they should expect a new, proactive kind of governance shaped by strong board views on strategy that bring strategic, operational and personnel change. “It’s nothing short of revolutionary,” says Membrillera. Treasury in a listed company is one step removed from shareholders, and governance is balanced between executive and non-executive directors: shareholders don’t ask to see management accounts and represent permanent capital, unlike private equity, where the joke goes, managers walk in backwards because they are looking to the exit.
Listed companies comprise a diverse group of stakeholders including activist investors seeking change but also passive investors tracking an index or those just wanting yield and a steady dividend rather than bells and whistles restructuring. This diverse stakeholder base means public companies often face resistance to close stores, move manufacturing facilities or consolidate business lines.
In contrast, private equity has much more freedom to support a company through a transition. It means treasury teams under private equity ownership are frequently called on to accelerate strategies that were impossible when the company was listed. It could be around a significant capex programme, revamping operational logistics, opening new sales lines, or refurbishing stores, all requiring capital and leverage.
Private equity ownership can trigger changes in banking relationships. On one hand, large companies taken private with solid and deep banking relationships will likely keep those ties. Yet new banks coming in to finance the acquisition will also remain in the relationship going forward, and in most cases, private equity’s own corporate teams design the initial financing. It leaves treasury teams with a pre-set financing package to manage including complex debt structures within a leveraged business.
Similarly, middle-range banking partners of a listed entity are often hoofed out by global players with more experience around securitisation or asset backed lending, who will then scoop up the ancillary business. “For example,” says Membrillera, “a suite of regional Italian banks with long-dated and deep ties to an Italian company taken private may be displaced by large global financial institutions.”
Still, it is not always the case. When the new treasurer of recently re-listed shoemaker Dr. Martens began exploring the bank relationships spilling over from the company’s days under Permira’s private equity ownership, he unearthed a surprisingly long list of banks: some he’d never dealt with before; a handful outside the UK and one private equity-owned lender.
The specialist skills and relentless pace required of treasury under private equity ownership has led to a spike in demand for service providers. Treasury skills in the mid cap space, a rich hunting ground for private equity firms and where companies often lack a treasury operation or specialism and everything is done by the CFO, are in demand. Skills like re-listing for example, an ordeal at Debenhams that Fleming recalls as one of the most challenging periods of his career. “Any one of the three main work streams related to the exit strategy (IPO, IAS adoption and a refinancing) would be challenging but all together, it was hard work!”
This is made easier, perhaps, by a final key characteristic of private equity and consequence of the employee mentality of old getting binned in favour of one of ownership: treasury and the finance team can expect much more generous compensation. “A Management Equity Plan will generally be more generous than the typical stock options of a listed company. The bad news is, in some cases, they will have to work much harder,” concludes Membrillera.