Letter #286: Edward Gilhuly (1999)
KKR Managing Director and Sageview Founder | Private Equity Investors in the New European Marketplace
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Edward “Ned” Gilhuly is a Founding Partner of Sageview Capital, a private investment firm with over $2bn in AUM focused on software and tech-enabled businesses. Prior to founding Sageview, Ned spent nearly two decades at KKR, which he first joined in 1986, became a partner in 1994, from 1998-2004 established and oversaw all aspects of KKR’s business in Europe, and served on KKR’s Investment Committee from inception in 2000 through 2005 when he left to start Sageview. He started his career at Merrill Lynch in their M&A group.
Given I’m in London wrapping up a Europe trip (please reach out if you’re around or have recs), today’s letter is a fitting one: it is an essay Ned wrote in 1999 about Private Equity Investors in the New European Marketplace, just a year after he established KKR’s Europe business. In this essay, he lays out why the new European marketplace is creating exciting opportunities for investment in Europe, starting with an explanation of how a buyout works, then introducing KKR’s history and the opportunity in Europe. He then discusses exploding M&A volume, development of the capital markets, acceptance of private equity, the opportunity in Germany, and challenging markets.
I hope you enjoy this essay as much as I do! It’s a fascinating look at KKR’s original thesis for entering Europe, where they now have 8+ offices.
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Letter
The new European marketplace is creating exciting opportunities for investment as Europe undergoes a radical shift in capital and industrial markets as well as the regulatory framework that overlays them. Private equity investors will play an increasingly important role in this evolution. This may be surprising to some observers. Acquiring companies with private equity by means of a leveraged buyout has been seen as a typically American form of capitalization without much relevance for European industrialists. However, this perception stems in large part from a lack of understanding of the buyout and the constructive role it can play in helping to reshape and revitalize the European economic landscape.
In addition, the substantial amount of capital available for investment in private equity transactions will inevitably enhance the role of financial buyers in European acquisitions. Between 1996 and 1998 approximately 35 billion(euros) were raised for private equity investment in Europe. Assuming this equity capital is presently available and leveraged three to one, 140 billion(euros) of purchasing power is in the hands of private equity investors. In fact, private equity acquisitions activity in Europe has accelerated from approximately 13.5 billion(euros)of total transaction value in 1995 to almost 54.4 billion(euros) in 1998. In this context it is useful to take a look at the leveraged buyout and the ways in which private equity investors, like KKR, view European acquisition opportunities.
The Buyout
Before entering into a discussion of how the changes underway in the European economy are creating a favorable environment for this type of transaction, it is important to understand how a leveraged buyout works. LBOs, as they are known today, have a long pedigree. Once titled a bootstrap acquisition, this methodology came into common usage after World War II among small businesses in England and the United States. Much like today, the investor would seek out a company with strong cash flow characteristics and try to maximize the value of his investment in that business by pulling the company up by the bootstraps out of debt.
In essence, a modern leveraged buyout is simply a financing technique for acquiring a company. Its name is derived from the fact that the acquiror — often referred to as a private equity investor — usually borrows a large percentage of the purchase price, typically from a variety of sources, such as commercial banks, insurance companies and other sophisticated financial institutions and/or public purchasers of high-yield debt. Companies acquired in a leveraged buyout often go from being public to being privately held by a small group of investors. A buyout can also take the form of acquiring a private company or a division or subsidiary from a large company.
There is no set capital structure for a leveraged buyout. Each company is analyzed in detail and a structure is specifically designed to meet the unique characteristics of the business. Consideration is given to the overall investment strategy, the company’s existing and forecasted cash flow, the predictability of that cash flow, the likelihood of acquisitions, etc. The capital structure is designed to achieve the maximum return on equity while providing a financial foundation that gives the company the ability to implement its business strategy and permits flexibility in the event of changing circumstances.
At the very essence of the modern buyout is having management take an ownership stake, providing an incentive to build the business over time. In fact, KKR’s investment philosophy centers on the belief that companies perform better when all important parties to its success have the incentive of ownership in the business. Just as you are likely to take better care of a home you own versus one you rent, managers and boards with a financial commitment to their businesses are more effective in creating both short- and long-term value. Therefore, for us, management’s willingness to align its interests with those of shareholders has always been a prerequisite to an investment in any business.
Only certain companies have the characteristics appropriate for a leveraged buyout. While investment firms’ criteria differ, our firm is interested in companies that have a sustainable comparative advantage with potential for long-term growth. Such companies usually have historically demonstrated profitability, with strong, predictable cash flows to service the financing costs related to the acquisition. Examples of comparative advantage could be a strong market position or status as a low-cost producer within an industry. By contrast, we are not interested in businesses that are subject to prolonged swings in profitability or manufacture products that can become obsolete as a result of rapid technological change.
KKR’S History
KKR is perhaps the most prominent private equity firm in the United States and we have been credited with greatly expanding the use of the leveraged buyout technique. While we cannot speak on behalf of other firms, we can speak from experience in describing our time-tested approach to investing and the principles that have influenced our success. Since our inception in 1976, we have executed management buyouts of large, mature companies; taken leveraged build-ups from having no assets at all into the Fortune 500; made acquisitions in traditional growth industries; pioneered leveraged investments in such novel fields as reinsurance and banking; created stand-alone companies by buying divisions from large corporate parents; and, made equity infusions to restructure highly leveraged public companies. In the process, we have exhibited creativity, innovation and flexibility.
Our success and endurance has stemmed from our longstanding recognition that closing the acquisition of a company is only the beginning of the process of delivering value to its investors. For us, success in private equity investing depends not only on identifying and consummating acquisitions, but also nurturing and building the acquired company.
As owners who exercise oversight from the board level working with a management team that has a substantial personal investment in a company, KKR has been motivated to fix problems in businesses with prospects of a turnaround and to provide good businesses with the resources to improve their competitive positions in their markets. Our goal is to make investments for long-term appreciation, by assisting management in increasing a company’s value over time. We are not overly concerned with quarter-to-quarter results, but rather focus on cash flow and profitable growth over a number of years.
We want our portfolio companies to invest for future competitiveness by: maintaining their business focus; managing the balance sheet as well as the income statement; making strategic acquisitions; motivating a wide range of employees by giving them a stake in the business; and, building for the future through prudent capital investment, research and development spending, and new product marketing. The average time period we own a company is five to seven years, although a number of our investments have exceeded ten years.
With that said, KKR does not engage only in leveraged buyouts. As a private equity investment firm, we also invest capital in other ways, such as infusing it into businesses to fuel long-term growth or to help early-stage companies finance their business plans. In exchange, we take stakes in those businesses and play an active role as owners/directors in their strategic development. However, no matter the financing, the characteristics we seek in investment opportunities remain the same, namely superior management teams and a clear comparative advantage or one that can be developed.
Opportunity in Europe
Based on the experience we have gained investing in and advising the management of nearly one hundred companies over the past thirty plus years, we are firmly of the view that Europe holds vast opportunity for private equity investors such as KKR for a number of reasons. First, increasing competition, deregulation and privatization have been and will continue to drive merger, acquisition and divestiture activity. Second, European capital markets are becoming deeper and more liquid, which is making it easier to execute investment transactions. Third, partnering with or selling a business to a private equity investor is increasingly viewed as an acceptable or desirable corporate strategy.
Exploding M&A Volume
Intensifying competition, both regionally and internationally, as well as privatization and deregulation in Europe have led to a dramatic increase in merger and acquisition activity. Total European M&A transaction volume in 1998 was $842 billion, up 58 percent over 1997. During the first half of 1999 European M&A volume totaled $644 billion, continuing to increase at a pace in excess of 50 percent over the comparable 1998 period. This increase in M&A volume in Europe is very important for private equity investors as it increases their range and scope of opportunity.
Increasing global competition and the formation of the European Monetary Union have resulted in new pressures on European companies. There are now a significant number of large conglomerate companies that are and will continue to be forced to spin off or sell substantial portions of their operations in order to streamline their businesses. These spin-off companies are often in and of themselves large, viable businesses, but often have not had the financial backing or the management focus to flourish, making them attractive investment candidates. This break-up of the conglomerates is not new to American investors, who saw a similar phenomenon in the1980s in the United States.
In tandem with deconglomeratization, a number of privately owned businesses will be seeking investors to ensure the continuation of their businesses. These companies, often owned and managed by families, were created during the post-World War II economic boom. Today, many of these companies are facing succession issues, which are compounded by their need for additional capital to fund future growth within today’s fiercely competitive international economy. The increasing acceptance of private equity has made the management buyout or a capital infusion from a private equity firm attractive solutions for companies like these.
Along with the EMU has come the need for member countries to divest inefficient state-owned companies in order to stay within the parameters of the Union’s annual budget deficit and public debt level limits and to compete effectively in a global marketplace. This has come in conjunction with the rise of Europe’s new and younger generation of politicians, who favor expansionary governmental philosophies and generally freer markets. The confluence of these developments has led to two key changes in policy — deregulation and privatization.
With deregulation of many industries now underway, newly liberated companies are being forced to adjust to free market dynamics. Industries such as telecommunications, financial services, transportation and utilities are going through tumultuous change. Many of these industries are rapidly consolidating as market forces reshape the competitive environment.
Development of the Capital Markets
The continued development of the European capital markets has been stimulated by several factors. Most notably, the introduction of the euro has led to the removal of the frictional costs related to currency exchange, allowing capital to flow more easily throughout and into Europe. Moreover, with interest rates at post-war lows, fixed-income investors who had once sought profit by arbitraging currencies are now beginning to look to increase their yields in the capital markets by taking higher credit risk than they had in the past. They are beginning to buy more corporate and high-yield bonds as a result. In addition, the interest in new securities has been helped by U.S. players, who have also begun to invest more in European instruments, both from the U.S. and as in-country participants as a result of bringing their investment businesses directly to Europe.
Accordingly, the condition of these markets has started to facilitate more efficient and favorable capital structures to fund buyout opportunities. In addition, in terms of long-term benefits, the improved efficiency and liquidity of capital markets will make exiting private equity opportunities more viable.
Acceptance of Private Equity
Until recently, there was an underlying misperception that private equity investors were only interested in buying wholesale and selling retail, or worse, that they bought companies with the intention of slashing costs for short-term gain. These issues would, of course, be of serious concern to European business owners and executives who have no interest in destroying what has taken generations to build. Fortunately, these misperceptions are waning as private equity is becoming more prevalent and industrialists are recognizing the constructive role private equity investors can have in helping make local companies and economies more competitive.
Opportunity in Germany
At present, Germany is the focus of a great deal of activity related to these trends. As Europe’s largest market — comprising approximately one-third of the European gross domestic product — it has a large number of businesses working to adjust rapidly to more lenient government regulation and the evolving national and international marketplace.
Over the last couple of years, facing pressure from both the marketplace and shareholders demanding better performance, many German companies have begun to restructure. This is evidenced by an unprecedented number of large merger and acquisition transactions, which in turn lead to attractive opportunities for private equity investors such as KKR. Given the number of conglomerates and the unyielding pressures from the marketplace, we believe this restructuring process is in its early stages.
Public company restructuring is only part of the story in Germany, however. Germany’s stock market capitalization is still small in relation to the country’s gross domestic product. There are a large number of privately owned companies, many of which are of significant size and internationally active. A growing number of these private companies are looking for outside capital, motivated by either a desire to grow more aggressively or by necessity as a result of generational change. In these situations, private equity investors can be the perfect bridge between family ownership and the public equity markets.
We at KKR have recognized the opportunities in Germany and have assembled a highly qualified team of German speaking professionals that will further our activities in Germany. Presently we are acquiring Siemens Nixdorf Retail and Banking Systems GmbH from Siemens. It is our expectation that we will partner with local managements to acquire many more businesses in Germany over the coming years.
Challenging Markets
Despite the opportunity that exists and the rising acceptance of private equity funding, investors still face hurdles investing in the diverse countries that make up Europe. These range from cultural familiarity, language barriers and political differences to limited financial disclosure, varying tax regimes, and unfriendly takeover codes. In addition, while many of the trends are positive — capital markets are deepening, government interference in markets is diminishing, private equity is becoming more accepted, etc. — we are still in the early stages of this change and there will be many detours in what promises to be a long process. No doubt, the face of the European economy will continue to be drawn well into the next century. With new corporate structures, evolving markets and increased need for investment in many companies, industries and countries, there will be excellent investment opportunity for those who successfully build the expertise to manage Europe’s complexities.
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