Friday Letter: Diamonds in the rough

The barbarian hordes are sweeping once more across Europe. Only this time they are heading East and are flying first class.  

Permira is the latest of the big Western buyout groups to look East for new investment targets. Earlier this week the firm received acceptances from 52 percent of shareholders for a €815 million takeover bid for BorsodChem, an Hungarian chemicals business. If the transaction succeeds, the firm will be providing a sweet exit for Firthlion, a London-based investment entity owned by Russian businessman Medget Rahimkulov, and Austrian private equity firm Vienna Capital Partners.

It is of course a coincidence of timing that Permira’s Hungarian success came just a week or so after it lost out on a very public public-to-private bid for De Vere, a UK chain of hotels. But the contrasting fortunes of the two efforts are illuminating and perhaps provide a taste of tomorrow.

As many sponsor groups are finding, it is becoming much harder in Western Europe to find deals that make sense at this point in the cycle – in part because assets are more expensive than ever before. Indeed, firms that felt the market had peaked 18 months ago have watched prices climb even higher while they sat on the sidelines.

Permira can hardly be accused of sitting idly by and waiting for a heated market to come off the boil. The firm has raised a mega fund and just held a first close on its fourth fund with over €10 billion ($12.7 billion) of commitments .

Neither has it stinted in trying to buy assets, thereby ducking any charge of sitting on a healthy management fee from its third fund, Permira III, which raised €5.3 billion in 2003. As investors are wont to observe, it is good for managers not to over-pay for assets. But they are also not paid to keep the money on account. To the contrary: they need to invest right through the cycle.

As competitive pressure mounts in Western markets, it seems sensible, even inevitable, that firms look East. As Kohlberg Kravis Roberts, with its investment in Flextronics, an electronics manufacturing firm in Sinagpore, and Texas Pacific Group with its purchase of Mey, a Turkish drinks company, have both demonstrated recently, it is possible to put large amounts of equity capital to work in territories that were previously uncharted by them.

In the past, the relatively small size of deals in these newer markets inhibited the larger sponsor groups. But now attractive and sizeable assets are available and local competition is scant in the segment of the market trawled by the mega funds.

Equally important to the big players is the improving regulatory environment in the emerging markets as well as a growing awareness of the value of good corporate governance among managers of target companies. And the due diligence is now far more likely to involve GAAP-based numbers.

But the real secret to these types of deal, at least according to one senior executive at a global buyout firm, is that sometimes the vendors may be a little naïve, a little less savvy and a little more malleable on some of the terms that can add an extra turn to the money multiple on exit.

This is not to suggest for a second that any of the businesses mentioned in this column were bought on the cheap or that vendors were duped for less than the best deal. But as asset-hungry GPs will be quick to remind you, there is real value to be had if you move off the well worn tracks and into those markets where a leveraged buyout is still a novel proposition and where experienced private equity firms can bring their wealth of expertise to bear. That’s where you’ll find the diamonds in the rough.