To those original shareholders, the opportunity to re-invest must have
seemed as appetising as salad-bar lettuce at the end of a hot day. And all of this encapsulates the problem for private investors: how do you avoid getting stuffed by cheap private-equity buyouts, while trying to make a crust from overpriced flotations?
Buyouts and flotations have certainly been the order of the day in the City of late. Some, like Pizza Express and IG Index, are flotations or reflotations of former buyouts — and just as hard to swallow. Take, for example, the latest offering: QinetiQ — the recently sanitised name for the defence research establishment that once served up noxious concoctions at Porton Down. Partly bought out from the government by US private equity firm Carlyle Group in 2002 for £42 million, it is due to float later this year for £1.1 billion — making Carlyle £341 million, and only allowing private investors to buy into what is effectively a privatisation after the event. Most buyouts, though, are of larger companies that do not want to come back to the market so quickly, and most flotations are of smaller companies with a lot less to offer.
Combine these two ingredients and you are left with a particularly unpalatable end product: ‘de-equitisation’. This recent coinage may sound reminiscent of that mangler of pizzas, pretzels and language — and friend of the Carlyle Group — George W. Bush, but it is in fact a particularly British phenomenon. As our blue chips are bought out, but small fry offer themselves for flotation, our stock market is actually shrinking.
It’s been happening faster in recent months, too, as private equity bids provoked a feeding frenzy. In November Citigroup calculated that one week’s takeover speculation alone could have taken £23 billion worth of shares out of the London market, many of them going to private equity buyers. In the first nine months of 2005, actual buyout activity was only £17.5 billion, but that was still up 24 per cent on 2004. Among those devoured were Big Food Group, Xenova, PHS and British Vita. This leads the private equity consultants Equus to suggest that de-equitisation had already caused equity markets ‘to shrivel ... the first time this has occurred in living memory’.
Most of the companies taken off the market are not likely to return, either, given the advantages private equity ownership brings them. By replacing public equity — your shareholdings — with cheap debt, the newly privatised companies can set about increasing cash flow, and then use the extra cash flow to pay the debt. That debt is cheap because much of it is ‘subordinated’ — it comes from the private equity shareholders, who don’t collect the interest, rather than from banks. But if the total interest — collected or not — consumes all the operating profits, then the company pays no tax. A prime example is Gala Group, the bingo halls operator which was bought by Cinven and Candover: after interest charges of £140 million in 2004 it made a pre-tax loss of £29 million, but it actually only paid interest of £52 million and had operating profits of £109 million. So, no tax, no interest bills and no outside shareholders to share the profits. No wonder private equity bidders are so keen on UK public companies.
If it seems unfair, there’s not much you, the public, can do about it. Of course private investors can turn down a bid they consider too cheap. But all too often they have little choice but to sell out, as majority shareholders vote for jam today.
Those who want to re-invest into growth stocks, to make up for being short-changed, are then drawn towards the bottom end of the market. It is here, on the Alternative Investment Market (Aim) especially, that there has been most flotation activity in the past 12 months. On Aim alone, there were 318 initial public offerings (IPOs), which raised over £5.2 billion — a big increase on the 243 IPOs that raised £2.8 billion in 2004. Inevitably, though, the quantity has raised questions about the quality. In a tenday period in August and September, 11 new companies were floated on Aim, and a further seven announced their float plans. Six of these were natural resources companies, one an online gaming company and one a telecoms firm targeting China. Given the hype surrounding all those sectors in 2005, it’s difficult not to detect opportunism — and a lack of genuine investment opportunity. So if the private equity firms are enjoying the richest pickings, does that leave private investors with just the overpriced, underperforming scraps? Fortunately not. Evidence from the past year suggests four ways to take advantage of the shrinking market.
First, spot the buyout targets early. Buying shares in companies before private equity firms bid for them can deliver small, but consistent, returns. Look for the sectors that private equity firms are targeting. Adam Steiner of SVM Asset Management suggests mobile telecoms, healthcare, leisure and manufacturing. Merrill Lynch also mentions telecoms, as well as chemicals and retailers. Then look at individual companies’ cash flow and assets the lower the price-to-cash-flow ratio and price-to-book value, the more attractive the target. Tips for 2006 include WH Ireland, Dart Group, Invox, JJB Sports and Morgan Sindall.
Secondly, if you can’t beat ’em, join ’em. It’s now possible to invest in private equity directly and indirectly. Buying shares in 3i will give you exposure to private equity holdings in Europe, US, China and India. Alternatively, you can invest through specialist funds, such as Standard Life European Private Equity and F&C Private Equity, which back private equity firms including CVC, Cinven and Candover. My tip for 2006 would be Standard Life European Private Equity.
Next, buy selected Aim shares after flotation, when their prices have stabilised. Screening recently floated Aim companies to identify those with strong fundamentals and reasonable share prices — using criteria such as those in Jim Slater’s Company REFS website — can help sort the wheat from the chaff. Here my tip for 2006 is Goals Soccer Centres, which floated a year ago. Alternatively, ignore Aim floats and buy main market dropouts instead. Buying into listed companies that drop down from the main market to Aim has proved more profitable than buying into new flotations. In fact, if you had bought shares in every company that moved to Aim in 2005, on the day they dropped down, you would have made a 22 per cent annual return. My tips for 2006 (but only to be bought on the day they drop to Aim) are Applied Optical Technologies, Christie Group and Sirdar.
And if you are going to play this shrinking market, it’s worth doing it before the tax breaks shrink too. At present, the capital gains tax on Aim-listed shares falls from 40 per cent to 10 per cent after you’ve held them for just two years, and they’re free of inheritance tax after the same period. But, as in Basil Fawlty’s restaurant, you’re best advised to get in early — if the Treasury gets its way, the tax breaks could soon be off the menu.
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