Managing exits in a downturn

The private equity industry must put exits at the top of its agenda if it wants to successfully work its way through the difficult years ahead, says Michael O’Donnell, of Legal & General Ventures.

It’s no secret that the number of exits in the UK private equity market has fallen over the past few years. Those private equity firms that saw the writing on the wall in time have taken steps to change their strategy on exits, and to adopt a more pragmatic view on which companies to take on as investments in a less buoyant climate. Those that failed to predict the change are suffering from an overload of investments that are difficult, if not impossible, to exit successfully from. So what steps should private equity firms take to manage exits in a way that matches current economic trends?


Before answering that question, let’s look at the facts. In 2002, exits via trade sale in the UK fell from 137 in 2000 to just 78. This year has seen no improvement so far, with only 26 exits in the six months to 30 June.  Similarly, with the stock market going through a three-year bear period, flotations have been a rare event. From 16 in the UK in 2000, there were only two in the first six months of 2003. 

Nor has the growth in secondary buyouts compensated for the fall in trade sales. There were 65 such deals in 2002, up from 28 in 2000, but only 24 recorded in the first half of 2003. This helps to explain the findings of a recent British Venture Capital Association (BVCA) survey, which found 76 per cent of general partners thought the fundraising climate over the last three months had been either fairly unfavourable or very unfavourable.

The reasons for the fall in exits are well understood. General economic uncertainty and lack of earnings visibility has meant that many corporates have been distracted by their own performance, rather than pursuing acquisitions. The war in Iraq only added to the already gloomy economic picture that began unfolding with the bursting of the bubble and overall downturn in technology stocks in 2000/2001.

The effect on the private equity market has been severe. Firms are being forced to hold onto investments for a longer period, lowering IRRs with a knock on effect for fund raising. The Centre for Management Buyout Research (CMBOR) estimates that that at the start of 2003 some £7.5bn was tied up in unrealised investments from deals done before 1998. 

With current exit trends this figure is likely to increase over the next few years. Indeed many commentators believe that private equity firms are looking at a time-span of up to six years, compared with two to three years at the height of the boom. 

In the past, conditions were such that private equity firms placed greater emphasis on making an investment than developing and implementing an exit strategy. Given that conditions will be slow to improve, a more pragmatic and realistic approach needs to be taken. In the 1990s, for example, it was possible to exit from many companies through the IPO route, but this is no longer the case. In fact most buyout houses have now recognised that they need to change their traditionally relaxed attitudes towards exits, and move them up the agenda.

Things to do

So how do you prioritise the exit process? It is important to build an exit culture both within the firm and with investee company management support. This involves keeping senior management involved in regular exit brainstorming sessions, and ensures that exit strategies are on the agenda from the very first board meeting.

The second point is to ensure that any difficult issues are identified and solved early on in the process so there are no outstanding problems to solve when the moment of exit approaches. It is during the first year of ownership that management are particularly motivated, and this is when these difficult tasks can and should be completed. It’s good practice to set deadlines and be certain that non-core disposals are realised in line with predictions, so that management can concentrate on key value creation tasks.

But while it’s important not to take your eye off the core list of exit targets, it’s also good practice to remember that some exits may come from outside the preferred list. Keeping a careful eye on personnel or structural changes within all companies in the portfolio is vital, because exit incentives may need to be amended to keep management focused and motivated.

Operating in a difficult sector may well reduce the number of potential purchasers, and this means that a more creative solution often needs to be found. However, where there is an obvious growth story the full auction process is likely to create the most value. But it needs to be tightly controlled. Young's Bluecrest was one such deal where profits had grown to £14m following a programme of capital investment and factory rationalisation. The Young’s brand had grown in value by 20 per cent in response to a re-launch with new packaging and products coupled with an extensive advertising programme.

LGV ran an auction process with wide interest and secured 2.9 times the original investment and a 39 per cent IRR.  Keeping two parties in a dual track process with a cost underwrite was a key tactic to keep the pressure on the bidders.  But this is only possible with a clear story, realistic valuation and where key issues in the business are dealt with. An auction process without this in place is likely to distract management and reduce value in the eyes of purchasers.

Overall, it’s only by putting exits at the top of the agenda and establishing an exit culture that the private equity industry will be able to manage its way through the difficult years ahead. The economic climate is unlikely to improve significantly in the near future, and the IPO frenzy of the mid 1990s is unlikely to be repeated

It is important therefore that the exit strategy is well thought through at the time of making the initial investment. What is crucial in today’s climate is for the investment team to have the right attitude of mind in terms of making things happen.  This includes the ability to seize opportunities when they arise and to have realistic aspirations as to value. And lastly, a little bit of old-fashioned luck can be invaluable.

Michael O’Donnell is a director of Legal & General Ventures in London.