French fireworks

Light the blue touch paper and retire a safe distance. Writing about the French middle market, you feel a little like the man that has returned to the firework only to discover that it is smouldering nicely and that the rocket is about to go off. But will it go off in your face, or worse, backfire completely? Or will it, as many believe and others hope, take off as intended and describe the perfect arc of a booming market?

Many limited partners believe they know where the heat is. The European middle market private equity firms are shipping in investor commitments as if they were the only viable game in town. One UK investor described a middle market firm's fundraising in almost mystical terms; he said it had ?an aura about it.?

Cory Pulfrey, managing director of Alternative Investment Partners of Morgan Stanley, is a firm advocate of the middle market philosophy. He says: ?European middle market buyouts with brand name managers with track record will succeed in fundraising. Small to mid cap buyouts have the potential for excess returns that you just don't get in the larger buy-outs, because those markets are more efficient.?

One outcome of this intense investor interest in European mid-market funds is that there are a slew of such funds, usually with a country-specific focus, being raised at present. One placement agent recently advised that he was aware of 28 UK mid-market funds being raised at present, ?and it doesn't take long to run out of fingers when counting French mid-market funds out there too.? So is it getting a bit crowded?

Too much too soon?
All the talk amongst private equity professionals is of a market reaching critical mass. According to figures from AFIC, the domestic private equity association, its members invested a total of €3.5bn in 2002, compared with €3.3bn in 2001. That was an increase of 7 per cent in a year when most other private equity markets stood still or contracted. The picture looked even rosier if the association included a handful of large deals, like KKR's Legrand acquisition, which were financed by nonmembers. Then, the total for 2002 was closer to €5.8bn. Buyouts accounted for more than 60 per cent of AFIC's total in 2002, and more than 75 per cent if the non-AFIC transactions were included.

This level of investment, although some way off the 2000 peak of €5.3bn, confirms the significant growth in the French private equity industry over the past few years. France has overtaken Germany as the largest private equity market in continental Europe.

And if a few large deals appear to skew the figures, bear in mind the fifth largest transaction in France last year was the €400m Legal & General Ventures acquisition of Moliflor Loisirs, the casino operator. The expectation for the middle market continues to grow. Just ask some of the people in the midst of this deal flow.

Jean Ducroux, a partner at Electra Partners in Paris, says: ?The middle market is very attractive and we should see more for sale this year than last.? George Pinkham, senior partner at SJ Berwin in Paris, ponders then declares: ?The French middle market? It seems to be the mantra that this is now the place to be. Larger investors were into larger buy-out funds for a long time. They would argue that this was the only place for investments of the size they want and that it gave them a view over the whole of Europe.? However, he says, investors, especially in the US, now see the UK as an entirely separate market and when they look at investing in Europe their options are restricted. Says Pinkham: ?Germany has cratered and almost by elimination the only thing left to buy is France.?

The right time and the right place
But the market has not come of age by default, at least not in the minds of its domestic players. Xavier Thoumieux, a director at CDC IXIS Equity Capital, says: ?The French market is a very good market. It has reached a level of maturity. The level of professionalism is high and there are lots of opportunities, especially in the large corporates that are looking to divest.?

Christophe Fercocq, managing director at Legal & General Ventures in Paris, says: ?In France, more and more people have an appetite for buy-outs and this has happened at the same time as the natural phenomenon of familyowned businesses developing succession issues. This has been underpinned by a fundamental change in shareholder culture.?

In essence, all of the key drivers that have excited private equity players for years in Germany, but which have so far delivered sporadically in that market, are coming good in France. The steady persistence of France's private equity community is beginning to bear fruit at just the right time. Tellingly also, France's major corporates are embracing the notion of shareholder value and are therefore acting to deliver on this (whether willingly or unwillingly). As a result vendor expectations on price have become more much more pragmatic.

Ducroux says: ?The old conglomerates have not changed a lot. Now they are in the process of complete transformation, because of the market situation, competition and debt problems. Some have to sell to survive.?

Thierry de Panafieu, investment professional at technology fund GMT, says: ?Vendors have waited one year and they are still in difficulty. Now they cannot wait any longer. Growth will slow; the government has revised the figures downward three times to just 1.3 per cent.?

The right environment
Culturally, the French market has moved on significantly in the last decade and dramatically so during the last three years. Thoumieux says of the French private equity landscape: ?It is a market with sophisticated players, experienced management teams and vendors in the habit of selling to financial buyers.? He says that even as recently as five years ago, if you asked a corporate vendor if it wanted to sell to a private equity house, the response would be ?Who?? The same management team would look blank if the idea of a leveraged buyout was raised.

Today, that management team is thinking about an LBO from the outset and hiring advisers to ensure they get the best deal from the finance houses. And there is little competition from other types of buyer: it seems to many that only the financial buyers have cash to spend with trade buyers all but wholly absent.

At the same time as a generation of family owners are thinking of selling, the French tax regime makes the decision even easier. Pinkham says: ?It is a huge incentive. Capital gains tax (CGT) rates for an individual who sells a company is a flat rate of 26 per cent. If you earn a salary, income tax is around 60 per cent. Social charges come on top of that.? Of course, there are ways around such punitive rates, but the low CGT rate continues to be a significant driver to transactions actually completing. Compare and contrast this with Germany, where uncertainty about the status of capital gains has led to a marked degree of paralysis.

Pinkham says that among the vendors of family-owned businesses there has been a slow evolution over the years in their attitude to financial buyers. At the start there was a real wariness with very difficult negotiations about the balance of power and exits and drag-alongs. These are all now concepts and clauses that are now accepted as standard. He says: ?[French private equity practitioners] have almost 15 years under our belt and it shows. There has been a lot of pioneering worker by the older houses to get the middle market to accept private equity.?

Thus far the signs would suggest that the French private equity market will trace that metaphorical arc of success across the sky: management teams are ready and willing, the private equity houses are up to speed. Vendors have grown accustomed to financial buyers' ways and are increasingly in the mood to sell. So much for the good news. There are other reasons though to be more circumspect about the outcome and many are reserving judgement on how much will happen by when.

Crowd control
Panafieu of GMT thinks 2003 will be a good year for buying but a tough year for doing business. He says: ?If you have good assets on the market, if you had a choice you might wait, but you can't. And the valuations are good enough anyway.?

Ducroux says: ?We should see more for sale this year than last. But so far we have not seen a strong increase.? CDC IXIS Equity Capital's Thomieux says: ?The first three months of this year have been a strange period. Most investors are looking at potential deals but there is not much close to completion. It takes longer than six to eight months ago.?

Hervé Franc, managing director at L&G Ventures, says it will be a better year for volume operators at the lower end of the middle market scale in the €30m to €100m bracket. But he believes that pricing remains an issue and that it may in part be a consequence of the market's popularity. He says: ?If you compare EBIT multiples of quoted companies with the multiples paid by private equity investors, it is very illuminating. The private equity multiples have held firm, while the quoted multiples have dropped.?

The large number of cash-rich financial buyers which are competing in the French market has helped prices to remain stable. Franc says: ?Investment bankers have turned to us because we have become quite systematic acquirers and it is slightly distorting the market.?

And some believe that ultimately, it will impact on returns. Ironically, the very returns that investors had turned to for out-performance of large cap buy-out are beginning to look more like ?public-equity-plus.?

As one manager says: ?If everyone wants 25-30 per cent IRRs for our funds then the price at which transactions are currently completed will not deliver that performance.?

The situation is exacerbated by a number of relatively new entrants, who are eager to make their mark and bag their first deal; at any price. Here though the banks are playing a useful role. When they like a deal, they lend just as they always did. When they do not they drop the leverage and the cost of doing the deal comes at the equity investor's expense.

But perhaps it is worth paying a fuller price, occasionally. After all there is no more costly a deal than a bad one, no matter how cheaply it comes. And that truism holds good for France's middle market. Quality assets will always sell, but at a price.

Ducroux says: ?Prices are still a little high. But when you look at the stock exchange, the price levels are so low, they no longer represent a benchmark for us. Good companies are not sold cheap. Prices have declined compared to two years ago, but we are still talking an EBIT multiple of around eight or nine times for a decent company and as much as ten for a very good one.?

And when you find a good prospective investment, the heat of France's competitive environment means you have to work quickly. Fercocq says: ?You need to be able to offer something, sector expertise for example, that shows you could speed up the process. Because everyone else is taking longer. The investment banks like to see that the deal corresponds with something you have done before.? The banks it seems can afford to be very selective, even down to identifying those equity houses that can do the deal on their own, because consortia can slow down the process.

A partner at another private equity firm active in France comments: ?It is almost impossible to avoid the auction process too. The way the banking industry is structured in France; they are involved in even the smallest deals.?

Private equity with a french twist
If one looks at other subsets of private equity opportunity there are also still some structural impediments in France. Public-to-private transactions for example are still an issue. Ducroux says: ?It is not easy. We would like takeover rules to be changed. In order to consolidate for tax purposes you need 95 per cent [ownership]. In a public company it is always a question whether you are going to get through.?

And some non-domestic managers will be quick to tell you that France is still very much a local market for local players. The large French corporates are in control of the market and with the best assets, especially if it is a politically important asset, there is the lingering suspicion that such an asset will always go to a French player.

This is not a uniquely French phenomenon, although recent events on the world stage will encourage some to ascribe a particular degree of territorialism to this market. Look beyond such assumptions though and there is more than enough evidence to suggest that France will continue to sit at, or near, the top of the private equity transaction league tables for 2003. Expect more fireworks.