The rise of private equity - and how to get a piece of the action

These days, it is impossible to open a newspaper without reading about the takeover of a well-known company by some obscure private-equity firm. Private equity now seems to threaten even the biggest of firms.

Rumours have just emerged, for example, of a private-equity bid that could "top $11bn". The possible bid for NTL, the UK's largest cable-television provider, and its smaller rival, Telewest Global, came just days after the two announced a merger. Yet the companies said to be involved are hardly ordinary household names - Blackstone Group, Cinven Group, BC Partners and Permira Advisors.

So what exactly has brought private equity to the forefront of the market over the last few years? Private equity refers in general to the business of buying up companies, listed or unlisted, and transforming them before selling them on. The idea is to extract value from languishing firms by restructuring them, selling off their assets, or reorganising their cash flows, or to add value to fast-growing firms by providing them with cash flow and then to exit at a huge profit - listing or relisting the company on a stock exchange at a higher price than originally paid. A classic example of value extraction would be the purchase by Blackstone of the Savoy Group in 1998, when the outlook was not good for the hotel group. Blackstone then renovated the hotels and sub-let their restaurants to famous chefs (Gordon Ramsey took over at Claridges, for example), before selling them on for £110m more than they paid in 2004. Overall, says the FT, an index of the world's 50 largest liquid private-equity groups in the private-equity sector (the LPX50) has returned, on average, 11% a year since 1994. Conversely, the MSCI world index has returned 7% over the same period. Between 2003 and 2005, private equity has also trumped straight-forward equity investing, outperforming the FTSE by 22% and the MSCI by 37%.

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Part of this outperformance, say private-equity managers, is down to the fact that when they do a deal, they manage it very proactively, implementing change, managing cash flows and cutting costs on an ongoing basis. They also tend to give management a stake in the firm, something that can serve as a great incentive to them to get their act together. The other part of the equation over the last decade, however, has been the unusually low level of interest rates across the world. Private-equity deals tend to be highly leveraged (around 70% of their financing is usually debt, says the FT). In order to boost their returns, companies borrow heavily to finance their deals, and the lower interest rates are, the more debt-fuelled deals look good: if you can borrow money at 5% on a deal you think will return you 15%, it looks a lot better than if borrowing will cost you 10%. In the low interest-rate period of 2002, for example, retail guru Philip Green borrowed £808m to buy out Arcadia Group (owners of Topshop and Burton, among others). He then famously paid it back within two years, thanks largely to his skillful management of his acquisition's cash flow. Given the opportunities on offer, and the returns made so far, it should come as no surprise that globally the money invested in the private-equity market doubled from 2003 to 2004 and this year to date has already overtaken 2004's total - in August, it stood at $170bn.

On the downside, the fact that there is this kind of cash knocking around looking for investments (the private-equity industry is thought to have about $1trn in cash, according to Private Equity Intelligence) means that competition is on the up. As a rule of thumb, private-equity investors expect to make a return of 25% on their investments, but as the big private-equity firms - such as Terra Firma, Apax Partners and BC Partners (see below) - all compete against each other to pick up vulnerable firms, they bid up entry prices and cut their eventual returns. This explains why the mergers and acquisitions (M&A) market has been flourishing in recent months. It has traditionally been driven by competitors buying each other - or merging with each other - in order to create long-term synergies and strategic growth. But now the private-equity companies, equipped with their eye for a deal and their fat cheque books, are getting in on the act, buying up listed takeover targets, taking them into private-equity deals and running the companies themselves: in the UK, private-equity firms accounted for 50.2% of M&A activity in the first six months of this year, the first time it has ever notched up over half, says the Centre for Management Buyout Research.

However, the party doesn't seem to be over yet. Large companies are repeatedly being targeted - one high-profile attack that has been rumbling all year is that on listed supermarket chain Somerfield. This is excellent news for shareholders. As soon as even a sniff of a private-equity bid appears for a firm, its shares rise, as investors know the plan is to take the company private and that the private equity funds will have to pay a premium to the market price to do so. And it is not only obvious takeover targets that benefit. In the current climate, all companies' share prices ended up being supported to a degree: anything that looks too cheap will immediately be thought of as a potential target and bid right up again. So for as long as private equity is long on money and short on deals, stockmarket investors are set to profit from high prices. The good news for stockmarket investors is that deal-hungry private-equity groups are having to look at ever-more ambitious deals, including bids for some of the FTSE's biggest companies. That should help put a floor under share prices for the time being - "at least until the first big private-equity deal blows up", says Simon Nixon in The Fleet Street Letter.

As yet, there are no signs of the industry blowing up - if anything the deals are getting bigger and bolder - as though nothing is out of reach. This is having a good effect on companies. They know they have to be on their toes, or risk being caught off guard. With the vast amounts of money floating about that private-equity houses can raise, no company can afford to look like it isn't trying, be seen as cheap, or even as having untapped potential. Investors benefit from all this in general, thanks to the supportive effect on the overall market. But how can they take specific advantage of the boom in private equity? The obvious answer is to invest in the listed private-equity investment trusts (PEITs) in the UK: these are simply listed companies whose stated business is to operate in the private-equity market. Most of them are doing well at the moment, but not all make good investments.

Investment trusts tend to trade at a discount to the net values of the assets they hold, to reflect the risk inherent in their debt levels and the illiquidity of their assets. However, today several of the PEITs now trade not at a discount, but at a premium, suggesting that investors have so much confidence in the management's ability to continue to create extraordinary growth that they are willing to pay more for the shares than the assets are actually worth. Shares in Candover are currently trading at a 30% premium to their net-asset value and those in Private Equity Investor PLC trade at a 12% premium. That said, there are some trusts that still look reasonable value, and there are a few other ways into the market.

How to get into the market

Getting into the private-equity market doesn't necessarily mean buying into huge firms. At the smaller end of the market, UK investors can buy into venture capital trusts - or VCTs (usually listed on the Aim market), and the alluring tax advantages that accompanies them. In the 2004 budget, the venture-capital arena got a "much-needed shot in the arm" from the chancellor, says Jennifer Hill in The Scotsman. He doubled the level of tax relief to 40% on investments of up to £200,000 a year - on top of the existing tax-free dividends and capital growth. This sounds great, but it does come with risk: of the 75 VCTs launched in the past nine years, 22 stood below their starting price in March 2005, even after taking the tax relief into consideration. Experts generally recommend not putting more than 10% of your portfolio into the sector - and certainly not to invest that which you can't afford to lose. But that does not mean there are no good VCTs available.

It's a good idea to look at VCTs that have been around for longer than three years. One such is Foresight Technology, which has paid out over 165p tax-free "against an original £1 subscription", says Stephen Ellis in The Daily Telegraph, and which trades at a 10% discount to the net value of its assets (its NAV). Ben Yearsley of Hargreaves Lansdown likes the £30m C-share issue by Northern Venture Trust, one of the first VCTs in the UK. Since 1995, the trust has averaged a tax-free annual income of 4.7p in the pound, says Magnus Grimond in The Times, and it boasts an experienced management team. Another promising VCT is the C-share issue by Baronsmead VCT 3, reckons Martin Churchill, of Tax Efficient Review, also in The Times: it has good managers who should help the fund to "prosper in most economic circumstances."

Those wanting to get into the bigger end of private equity, as discussed above, are best off turning to personal equity investment trusts, known as PEITs. These are only just hitting investors' radars as they were originally designed primarily for pension funds and institutional investors, but private investors are able to access these funds simply by buying and selling them like any other share on the stockmarket - and they can be held in both Isas and Sipps. Some PEIT fund managers, such as Standard Life European and Kleinwort Capital Trust, also allow regular savings schemes in PEITs - for as little as £30 per month. Over the last decade, the average PEIT has seen uninterrupted excellent performance, month by month, says Malcolm Craig in the Zurich Club newsletter. The sector has risen 316% in the last decade and has consistently outperformed the FTSE All-Share index over one, three, five and ten years. Of course, past performance is no guide to the future, says Craig, and not all PEITS are cheap enough to consider buying - top-performer Candover is, for example, "hardly a bargain". However, PEITS do offer a low-risk way into a high-risk sector and one that looks good is Mithras, which trades on a 10% discount to its net-asset value, says Craig. The company operates entirely in the UK and aims to invest in firms worth between £50 and £250m, "large enough to provide substantial future profits, but small enough to monitor effectively in a hands-on relationship".

Just how powerful are these firms?

If you're unsure how powerful private-equity firms are, perhaps this will put things in perspective: this year alone, the top five private-equity firms completed deals together worth some £17.3bn - the equivalent of buying Rolls-Royce more than four times over. That means there is a lot of money in the hands of the men at the top of the business. Indeed, there is, says Tom Bawden in The Times. Guy Hands, who runs the Terra Firma private-equity business, has completed transactions worth £5bn so far this year, making him Europe's top private-equity dealmaker. Hands is currently bidding £774m for van-leasing business Northgate and ranks 16th on the Sunday Times 2005 City Rich List, with a personal fortune of £175m. Just behind Hands, as Europe's second-highest dealmaking firm this year, is BC Partners, which recently bought health-club company Fitness First for £835m. BC, formerly a buyout unit of Barings Bank, has made its five directors substantial amounts of money, too, with the directors sharing in £1.9m in salaries in 2002. Senior managing partner Simon Palley made The Sunday Times City Rich List last year with a fortune of £25m.

Next up is Cinven, Britain's oldest private-equity firm, says Bawden, with £3bn worth of deals. Under the management of Robin Hall, Cinven has recently picked up Gala Group, the bingo and casino operator. Hall owns 13% of Cinven, and was thought to be worth £48m in 2004. In fourth place comes Goldman Sachs's private-equity arm, Capital Partners, which completed deals worth £2.9bn. Finally, there is Apax Partners, which completed deals in Europe worth £2.8bn, including the takeover of Travelex. Sir Ronald Cohen, who set up Apax in 1972 and retired in the summer, ranked sixth in the 2005 City Rich List, with a personal fortune of £260m. He recently treated some 200 guests at his 60th birthday party, hiring the National Gallery in London for the occasion, says The Economist.

How Harold Macmillan plugged the equity gap

Even though the first private-equity company officially came about in 1945, the concept of private equity has been around for a long time: before a formal market existed, entrepreneurs looking for cash simply turned to wealthy individuals who were willing to back their ventures on an ad-hoc basis. Then, in 1929, Harold Macmillan, later to become the foreign secretary and prime minister, formed the Macmillan Committee, which identified the lack of opportunities small and medium-sized firms had to raise finance to get their businesses off the ground.

This shortage of capital became known as the Macmillan Gap' - and finally led to the creation of a firm called the Industrial and Commercial Finance Corporation (ICFC). ICFC was set up by the Bank of England in 1945 to play its part in post-war reconstruction, says Robert Cole in The Times. It was given the task of finding financial solutions to fill the Gap', investing money provided by the top five clearing banks. In 1973, ICFC merged with the Finance Corporation for Industry (FCI) - a firm that was charged with channelling funds into larger enterprises. The result was a group called Investors in Industry (III), or the forerunner of 3i, the grandfather of the UK venture capital industry, says Cole, which was floated on the stock exchange in 1994 by the government. Today, 3i is one of the some 170 private-equity firms in the UK providing billions of pounds to unquoted companies each year.