Over there and over here

Phoenix Equity Partners is in the unusual position of being a UK-focused mid-market private equity business that invests most of its capital on behalf of US investors. David Gregson and Hugh Lenon, who have worked together since 1985, talk to Andy Thomson about the firm's complex past and contemplate what the future holds for the business.

David Gregson and Hugh Lenon, cofounders of Phoenix Equity Partners, are hoping to attract more European investors to their next fundraising effort. One reason is that the firm's current fourth fund received 65 per cent of its commitments from investors based in North America. It seems entirely logical that the firm would seek geographical diversification of its investor base. But another compelling motivation for mild-mannered Gregson is that he would rather avoid having to play the macho man.

When the firm was last fundraising in the US, where prospective limited partners possess the experience and know-how to be disarmingly to the point at times, Gregson was coached on how to present to a potential investor with a reputation for being rather aggressive. Fearful that Gregson would be consumed alive, a wellmeaning colleague advised him to adopt the type of attitude and posture associated with ‘ripping up telephone directories’. Quite aside from the grave physical consequences that could have ensued from the strain, it is easy to feel sympathy with Gregson when he says he didn't really feel cut out for the role. Although a co-founder of the business, he is always quick to point out that Phoenix is run by management committee, and stresses that he does not in any way see himself as a dominant figure – hailing instead the ‘collegiate ethos’ that prevails at 33 Glasshouse Street, W1.

Gregson and Lenon, who are chairman and managing partner respectively at Phoenix, have worked together since 1985, when they established a private equity operation on behalf of the listed Globe Investment Trust. Globe, which was then the largest vehicle of its kind in the UK, was sold in 1991 to British Coal Board Pension Fund. The duo soon decamped to corporate finance boutique Phoenix Securities to run a new private equity operation and the following year raised the Phoenix Development Capital Fund, which was then the second-largest fund in the UK at £50m. This month, Phoenix exited the last investment from that fund when it sold lifting and bathing equipment manufacturer Chiltern Invadex to Aberdeen Murray Johnstone Private Equity for £8.5m. The fund's 15 investments took 11 years to realise and delivered a gross IRR of almost 35 per cent. Lenon says he was surprised when told by advisers that overseeing a complete realisation of a private equity fund is actually a rather rare phenomenon.

Swallowed by DLJ
In 1996, the firm took the fateful decision of hiring US investment bank Donaldson, Lufkin & Jenrette (DLJ) as a placement agent for its second fund – Phoenix Equity Partners II – which went on to raise £133m. “They [DLJ] got to know us well, but we were not really giving much thought at that point to the possibility that they might want to buy us,” says Gregson. But the following year, Phoenix was indeed subsumed into the DLJ fold and effectively became the bank's European arm. The private equity operation was re-named DLJ European Private Equity. So began a period of investment bank ownership that is not fondly recalled by Lenon or Gregson, particularly as the second fund's performance is acknowledged to be something of a disappointment.

Lenon readily concedes the fund is not doing as well as the others under Phoenix' management. It is 50 per cent realised, and he describes the performance so far as ‘mediocre’. He explains: “Under the bank's ownership, we were less focused than we are now. We did large and small transactions, and international deals in addition to UK-based ones – basically, in hindsights, we did all sorts of things. My view now is that private equity houses should be ownermanaged because you need to be able to make decisions quickly, opportunistically and with the enthusiasm and focus that comes with owning your own business. Above all, you need to come across as entrepreneurial. This message can be difficult to convey when within a department of a large bank.”

We had persuaded our investors of the virtues of being part of an investment bank

David Gregson

In June 2000, the firm closed its third fund – DLJ Equity Partners III – at £430m. It included commitments from 32 institutional investors in all, with the top ten investors responsible for two-thirds of the total. The largest individual investor was Canada's Ontario Teachers Pension Plan, while other North American investors included the State of Michigan and Colorado Public Employees pension funds. Europe was represented by, among others, Pantheon Ventures and Wellcome Trust. According to a source close to the firm, at this stage the performance of the second fund was inconclusive and did not prove to be a hindrance to the fundraising.

Just three months later, with the fund already having made three investments, DLJ was acquired by CSFB. An overlap with the activities of CSFB Private Equity's European arm was immediately apparent, and DLJ European Private Equity took the opportunity to seek independence. It seems unlikely, taking into account Lenon's comments about the importance of being an owner-driver, that the team was inclined to dig in its heels in an attempt to stay put. Had it done so, it could have had a fight on its hands because Richard Winckles, then managing director of CSFB Private Equity in Europe, saw his team's future very much as part of the bank. Although a merger of the two operations was technically possible, it would have been complex, time-consuming and arguably superfluous.

Going it alone
In March 2001, the team's management buyout from CSFB was completed. Whilst a cause for celebration, the move also created complications. Says Gregson: “Six months before, we had persuaded our investors of the virtues of being part of an investment bank – such as global reach and access to broad deal flow – and now we had to win them over to the merits of being an independent.” Nearly all were convinced: some 90 per cent of the investors recommitted to the new fund, representing 96 per cent of the original capital raised. In order to provide a clean break from the past, the three investments totalling £71m made from the new fund while under DLJ ownership were ring-fenced and became the third fund. The fourth fund – known as the Phoenix Continuation Fund – comprised the re-committed capital and amounted to £303m, of which £283m was re-confirmed third party commitments and £20m came from the bank.

Having emerged from the clutches of a large US investment bank with a reputation for aggression, it is not surprising that Phoenix should choose to remind the market of its prior association with a small, niche and highly respected UK merchant bank. Some may also point out the additional connection – although not a deliberate one – with the mythical phoenix bird, which perished in flames before rising from the ashes, born again.

“We thought long and hard about it because it was tempting to say ‘this is a fresh start, let's have a new name’,” says Gregson. Given the firm's changes of ownership it was perhaps inevitable that there would be some confusion regarding its identity. “Intermediaries had a slightly inconsistent view of who we were,” says Lenon. “Some probably thought that we had always been called Phoenix. Others remembered the name but were not sure what it stood for. In going back to the old name, we realised that we had to freshen the image and convey a memorable message.” Lenon was personally responsible for the firm's new identity, with such things as ethos, logo and website top of the agenda. Gregson adds that the firm has been flattered by the subsequent appearance of what he terms ‘parody websites’.

Private equity houses should be owner-managed

Hugh Lenon

No doubt providing the market with a consistent message is an important aspect of gaining credibility, but perhaps of greater importance to investors is how team members have adapted to the change and how their roles and responsibilities dovetail. Gregson again baulks at the suggestion that there is a hierarchy in which he and Lenon occupy number one and two positions. Indeed, the very suggestion sees him at his most animated during the course of the conversation and he insists that the firm has moved from being part of a corporate hierarchy to a partnership. This is an important distinction for PEP as it seeks to emphasise differences with the recent past.

In terms of how the team fits together, Gregson and Lenon share responsibility for investor relations, while Lenon oversees public relations and the investment committee and Gregson has joint responsibility for the media sector with partner Kevin Keck. The two most senior members of the team after Gregson and Lenon are managing partners Sandy Muirhead and James Thomas, who oversee the firm's deal generation activities. The management committee comprises Gregson, Lenon, Muirhead and Thomas, together with Steve Darrington (partner and CFO) and David Burns (partner with responsibility for the leisure and retail sectors)

A team ethic
As part of this vigorous team ethic, Gregson maintains there is no succession issue at the firm. “We've dealt with the future,” he asserts confidently. “We are not faced with a situation where someone gets to a point where they want to stop, because we figure out what individuals want to do and meet or anticipate their aspirations.” Anecdotally, sources familiar with the firm say there has been a subtle shift, with Lenon being seen as more to the fore than in the past – he is the one expected to be the public face of PEP as it lines up its next fundraising. “He's in the right position to assume that role,” says one, “because he's seen as competent and is well respected.” Similarly complimentary remarks are attributed to the rest of the team, with Muirhead in particular identified as a key member for his impressive track record, which included a spell as managing director of Charterhouse Corporate Finance.

Lenon relates that, with 12 British nationals in the London-based investment team, PEP ‘had no option’ when it came to focusing its attention on the UK market rather than adopting a pan-European strategy. There is little regret that this is the way things have worked out, though Lenon suggests that the popularity of individual funds among investors is not related to ‘the segment they operate in but rather to the qualities of the individual managers’. Nevertheless, he also refers in passing to the successful closing of Graphite Capital's sixth fund earlier in the year (which closed £75m above target at £375m) and is clearly aware that the UK mid-market is far from unattractive to institutions.

It's been hard this year, and what's likely to change?

Hugh Lenon

Despite the mid-market's apparent allure, Lenon indicates there should be no illusions about the degree of competition in the UK. “The middle-market is certainly competitive. Even small businesses are being marketed far and wide,” he says. He believes proprietary deal flow is something of an illusion, and that if such deals really do exist, they are at the lower end of the market. In the genuine middle ground, he says, ‘you do get auctions but not broad auctions – normally two or three private equity firms and some trade bidders’. He stresses the need to have an angle – such as the ability to bring in a good management team or combine the target with an existing portfolio company – in order to pay a winning price. He also stresses the importance of deal origination, with Muirhead and Thomas pitched into a ‘subset’ of the market that is hotly contested. PEP is not the only UK mid-market firm to recognise the importance of building links directly with companies in an attempt to play a proactive role in the sale of subsidiaries.

But hard work alone will not necessarily bring rewards. This year has been a tough one in which to put money to work, and at the time of going to press PEP had not completed any new investments in the second half of 2003. It was an unsuccessful bidder for TJ Hughes, the discount retailer sold to PPM Ventures for £56m last month, and MORI, the 3ibacked market research business that entered exclusive talks with ISIS Equity Partners in September. The firm's most recent deal was the £70m buyout in June of HPI, the vehicle information provider, with three other deals completed earlier in the year: the £62m buyout of toy developer Vivid Toys and Games; an acquisition of eight pubs by existing portfolio company Mill House Inns, the freehold pub operator; and the £15m acquisition of London's Gainsborough Clinic on behalf of another portfolio business, Covenant Healthcare, the private hospitals operator.

Lenon does not see conditions becoming any easier in the near term: “It's been hard this year, and what's likely to change? A stronger stock market doesn't necessarily help. Parent companies may take the view that if the stock market is low they need to make strategic disposals but when it goes up again the pressure is off. Some of course will sell businesses in an attempt to extract higher prices as stock market bench market valuations go up, but overall I think we're facing more of the same over the next 12 months.”

Even if listed firms were to increase their rate of disposals, PEP would probably not be at the front of the queue. In common with industry peers, it has concluded that prices paid for many public-to-privates have been excessive and now has a sceptical view. Gregson says the firm is also ‘increasingly cautious’ of secondary buyouts, even though its two major deals so far this year, Vivid and HPI, were acquired from fellow private equity firms (Jordan Group and 3i respectively). Lenon adds: “You could argue that a good deal is a good deal and it doesn't matter what the source is. But if you are in front of investors and all you've done is secondary deals, they'll say ‘what about that broad network of deal flow contacts you told us about?’”

Clearer exit signs
When it comes to exit opportunities, there appear to be more encouraging signs. Lenon says PEP is currently in discussions about the possibility of floating ‘one or two’ of its businesses that were deemed too small a year ago but are now in demand as fund managers switch their focus from the FTSE 100 to growth companies. It is also about to witness the listing in New York of reinsurance underwriter Aspen Re (formerly Wellington Re). It backed the firm as part of a large private equity syndicate led by Candover and Blackstone Group in June 2002 in a £448m deal. The issue is due to be priced imminently but on account of Securities and Exchange Commission (SEC) restrictions, PEP will be prevented from selling any of its shares for a 180-day period.

Both Gregson and Lenon acknowledge that the need to do more deals and exit existing ones is paramount as it begins to contemplate its next fundraising campaign. The firm currently has around £180m still available for investment and will seek to put another £75m to £100m to work before talking to investors again. Asked what timescale this implies, Lenon says he anticipates pre-marketing next year prior to a formal launch of the next fund in the first quarter of 2005 with a target of around £400m. He is under no illusions about the task: “In an ideal world you go out fundraising when nobody else is, but that's an impossible trick to pull off these days. It's unrealistic to either delay or accelerate the process and you have to accept that you'll be overlapping with numerous others competing for cash. What you need is a clear differentiated message which stands up to scrutiny.”

PEP knows it will no longer be able to draw any capital from the CSFB balance sheet, but is hopeful that it may still receive a contribution from that organisation's fund of funds. CSFB as a whole accounts for around seven per cent of the current fund. Whether other existing investors will remain loyal to the firm remains to be seen. There is of course the issue of the 1996 vintage Phoenix Equity Partners II and whether it will recover lost ground or continue to struggle. Much will depend on whether investors can be convinced that PEP has returned to form with its fourth fund. There is certainly plenty of confidence emanating from the firm itself with regard to the deals it has been involved in so far.

We've dealt with the future

David Gregson

Another factor influencing PEP's future prosperity could be its close relationship with the US buy side. Although US pension funds are less cash-rich than they used to be, many are expressing a keen interest in the European mid-market. Being able to present a firm that is already tried and tested amongst the US LP community will be a significant advantage and there is every possibility that PEP will therefore continue to attract sizeable amounts of US capital. Lenon says that diversification of the investor base means that he would be pleased to see more European investors, but admits the ability to pick and choose would be a luxury. Perhaps he should concentrate on the investor base that is most familiar with PEP – even if that means asking Gregson for a few of those tips on how to project himself as mean and moody.

Phoenix: A potted history
1985: David Gregson and Hugh Lenon set up a private equity firm to invest in unquoted companies for Globe Investment Trust, then the largest investment trust in the UK. Globe is a FTSE 100 company and at that time larger than 3i. Lenon recalls it was a time when syndicates reigned supreme, with deal completion meetings characterised by a large group of venture capital firms gathered together to ‘write out cheques for one or two million pounds’.

1991: Globe Investment Trust is taken over by the British Coal Board Pension Fund. Gregson and Lenon are headhunted by Martin Smith, founder of Phoenix Securities, an investment banking boutique specialising in the media sector that bought itself out of Morgan Grenfell in 1990. For the second time, the two men set about establishing a fledgling private equity business.

1992: The Phoenix Development Capital fund raises £50m and becomes the second largest private equity fund in the UK. The fund makes investments of £2m to £5m, and is seen as conservative for its avoidance of high-tech and start-up deals. Notable features of the fund are the presence of Japan's Mitsubishi as the largest investor and its specialisation in financial services deals due to the knowledge and experience of its parent.

1996: The second Phoenix fund – Phoenix Equity Partners II – raises £133m. DLJ is used as the placement agent for the fund, which closes on schedule and exceeds its £100m target. DLJ's influence is apparent as the fund draws in a host of North American investors including Ontario Teachers Pension Plan and Colorado PERA. Fourteen of the 21 investors in the fund are backing Phoenix for the first time.

1997: Having acquainted itself with Phoenix, DLJ decides to buy it and Phoenix effectively becomes DLJ's European arm. The price of the deal is undisclosed, but rumoured to be around £50m. The private equity arm becomes DLJ Phoenix European Private Equity and says it will continue to focus on the UK mid-market, but may look at larger deals alongside the $3bn DLJ Merchant Banking Partners II fund.

2000: The group raises its third fund – DLJ Phoenix Equity Partners III – at £430m. There are 32 institutional investors in the fund. Three months later, DLJ is swallowed by Credit Suisse First Boston, which already operates a European buyout business. Gregson, Lenon and colleagues decide there isn't enough room for both of them and set about buying themselves out.

2001: The buyout is complete: by March, Phoenix is called Phoenix again, and is once more operating as an independent entity.