Events can move quickly in private equity. Less than a year ago, CVC Capital Partners was in charge of the largest European LBO fund ever raised. €6 billion ($7.7 billion) had been the hard cap on the vehicle, CVC's fourth in Europe. It seemed a very big number at the time. Weeks earlier, the firm had rounded up an additional $2 billion for its second Asia Pacific fund. Here was proof, if any was needed, that major buyout groups in Europe had the heft to invest globally and that CVC was one of the key players.
However, soon after CVC European Equity Partners IV closed in July 2005, big-ticket private equity practically exploded around it, with a number of extra-large fundraisings effortlessly setting new benchmarks.
Make no mistake: €6 billion of capital raised is still a big number. But it no longer differentiates the firm, and some industry professionals wonder why it did not raise an even larger pool when it had the opportunity.
In Europe, Permira is now at the top of the tree with the €11 billion vehicle it closed two months ago. New funds raised by US-headquartered groups Blackstone, Texas Pacific and soon Kohlberg Kravis Roberts are even larger: the major groups seem to be getting ever more muscular. But is it really a case of size mattering?
Michael Smith, CVC's chairman, says having the largest fund per se would not be compelling as a proposition to the firm's investors. Rather, the point is to compete. And compete the firm does. Recent investments include the acquisition last November of SLEC, the holding company that controls Formula One, for an undisclosed amount, as well as the $2.8 billion public-to-private of Skylark in June, Japan's largest restaurant chain and the biggest LBO in the country to date. The Asian and the European funds invested jointly in the deal. In August, the firm was linked to a syndicate reportedly lining up a $10 billion bid for Coles Myer, the Australian retailer.
On the exit side, the firm has had results this year as well, most notably the IPO of UK retailer Debenhams in May, which marked the partial realisation of an investment that including a recapitalisation and a sale and lease-back of Debenham's real estate is expected to return several times the firm's capital.
Debenhams won't be the first time that CVC has proven its ability to deliver compelling returns. Far from it: founded as part of Citigroup in 1981 and independent since a management buyout in 1993, the firm is one of Europe's longest established private equity providers. According to an investor familiar with Fund IV's placement memorandum, which was published in 2005, Funds I (1996), II (1998) and III (2001) achieved top quartile returns, with money multiples of 2.9x, 2.4x and 1.9x respectively.
With offices in Amsterdam, Brussels, Copenhagen, Frankfurt, Jersey, London, Luxembourg, Madrid, Milan, Paris, Stockholm and Zurich, CVC has a larger pan-European network than any of its rivals. “They have been everywhere in Europe as long as anyone, and I think it helps them on the large cross-border deals,” says one investor in CVC's funds.
In Asia, the set-up spans offices in Hong Kong, Tokyo, Sydney and Seoul. CVC has been active in Asia since 2000, when it became one of the first international private equity firms to expand into the region in a joint venture with Citigroup. Recalls Smith: “Our investors took a risk with us on Asia, it was a genuine start-up. We hadn't led a buyout in Asia, although we'd acquired a business in Australia. LPs were essentially backing CVC to do it properly, and touch wood, the team delivered on it.”
With two platforms in two continents, Smith is confident that CVC is well placed to make the most of the opportunities currently presenting themselves in Europe and Asia: opportunities that require not just capital heft but application too.
Sat in a small meeting room at the firm's offices on the Strand in London's Covent Garden (ironically just a couple of floors above SVG Capital, the largest limited partner in funds advised by rival and occasional partner Permira), Smith argues that now is the time to stay focused on the task at hand: “You have to say, the environment has never been better. The essential ingredients are all there: equity capital from very supportive LPs, low interest rates, deep liquidity in the debt market, little aggression from trade buyers and strong deal flow involving large, very high quality businesses. There is a lot we can do. Long may it continue.”
Will it though? Interest rates have started creeping upwards, and many observers share the view that aggressively financed portfolio companies will soon experience acute pain if funding costs continue to climb.
Smith, who flew in for the interview from CVC's Luxembourg headquarters, clearly is mindful of the hazard as it relates to his firm: “At the investment committee, we very seriously consider the current investment climate and any potential adverse changes. Sensitivity analyses and value creation strategies take up a lot of our time.”
To say that we would not raise a public vehicle would be wrong because a number of people in the industry have looked at it and it remains an option
He says that in the event of an interest rate hike or a credit squeeze, CVC will be fine as long as it can protect the equity value in its portfolio. “If multiples go down or there is a liquidity crunch, that's when you get hit with a leveraged portfolio. The trick for us is never to become a forced seller and always have additional capacity to finance good quality companies through a crisis – because you know that ultimately, you are going to get an opportunity to exit.”
Avoiding meltdown not only requires a disciplined approach to leveraging balance sheets. It also means sponsors have to have intimate knowledge of trends in the debt market and manage relationships with creditors. Says a London-based banker accustomed to servicing the buyout community: “In the big deals, you can now easily have 70, 80 different parties in the loans alone. When things start to go wrong with the deal, you want to know who they are. Private equity firms have started to manage these relationships actively, and CVC appears to be taking it especially seriously.”
Like other houses, CVC has inhouse leveraged finance specialists such as Mark Boughton, who stay close to debt-related trends at all times. Smith also points to the format ion in May of Cordatus, an independent affiliate run by former investment banker David Wood and set up to provide capital to LBOs, as further evidence of the firm's focus on the credit markets.
In addition to sourcing attractive deal flow and ensuring speedy access to appropriate financing, buyout firms need cohesive teams of well incentivised dealmakers.
CVC has a large, layered group of investment professionals, and the senior executives know each other well. There are nine managing partners who have an average of nearly 15 years of service with the firm. Beneath this top group are tiers of partners, managing directors, directors, investment directors and investment executives. Chairman Smith, who is 53, has been with CVC since 1983. People familiar with the group often cite low people turnover as one of the firm's defining characteristics.
Fundamental to any private equity team's durability is staff compensation, and here CVC's approach differs from that of many peers. To label the model “eat-what- you-kill” would be crude, but Smith confirms that effective investing is the key determinant of how CVC professionals get paid: “Philosophically, we're of the view that we're in business to do deals successfully for investors, so there is a large degree of meritocracy in terms of recognising actual deal contribution. But it's a fairly sophisticated approach.”
This means that depending on their level of seniority, working on a particular transaction may be a colleague's main source of compensation. A more senior individual may also qualify for a slice of the carry generated by the European or the Asian fund (or both), and the top group participate as shareholders in the management company as well. “We have a multiplicity of ways of involving people, and the economics are spread quite widely within CVC. That isn't the case with some other firms”, points out Smith.
Given how large a territory the firm covers out of just two funds, CVC's emphasis on deal contribution may seem surprising. Despite its best efforts, a country team in Continental Europe for instance may not have an opportunity to present a compelling opportunity to the investment committee for months if not years, which could have a serious impact on their compensation. An alternative model traditionally used in the industry therefore is to allocate carry upfront, so that a person's pay becomes a function of the fund's overall performance as opposed to an individual's contribution to its success.
Is it fair to say that we underpaid for something if it was sold in a fair process and through management's effort improved its performance such that the deal we did at the time now looks like a very good deal? That rather presumes you could have done the same thing with it
Says a investor who knows the firm well: “CVC's model is a little idiosyncratic in this regard, but when you look at how stable the team has been over the years, people seem to be comfortable with it.” He also says other firms are now using similar methods as well: “Five years ago what CVC was doing was fairly unique, but as GPs have come to realise that it's not just about going into the deal but what you do with the business afterwards, upfront carry allocation is becoming less common.”
Smith is of course no stranger to this debate. He says getting compensation right is a fundamentally important factor for any private equity investor: “It's not the only one, but if you get it wrong, you will have a lot of problems. We've seen examples of that. No scheme is perfect, but given the track record and longevity of our people, we must be doing something right in this area. It is something we constantly think about and try to refine going forward.”
Armed with plenty of capital and a large team of wellincentivised people, CVC is trawling Europe and Asia. Along with Permira, it is the only European LBO firm to pursue billion dollar investments outside Europe. Smith is bullish about opportunities on both continents, and predicts both M&A and public-to-privates (PTPs) will remain stable sources of deals for the industry.
Picking up on the point about PTPs, I put it to him that public market shareholders appear increasingly reticent about selling businesses to financial sponsors for fear of leaving money on the table. Smith is aware of such seller concerns. When CVC took Debenhams out of the public market along with Texas Pacific Group and Merrill Lynch in 2003, he says the firm was criticised for ostensibly having run out of private companies to buy. Three years later, when Debenhams relisted, CVC was criticised once again for having booked a substantial profit – unfairly so, Smith argues, stressing that profit is what the firm is obliged to generate for its investors.
You can't have it both ways: if you want the benefits of the private market, you're entitled to it. But if you go public, you have to play by different rules
“The problem lies with hindsight here. When you buy a public company, you're typically dealing with a pretty well informed board. They have a due process, they take advice.” Smith warms to the theme: “Fundamental to Debenhams for us was to have Rob Templeman and Chris Woodhouse manage the business. Is it fair to say that we underpaid for something if it was sold in a fair process and through management's effort improved its performance such that the deal we did at the time now looks like a very good deal? That rather presumes you could have done the same thing with it.”
This leads to a discussion about private equity's public image more generally. In the media, CVC is often described as one of private equity's more secretive firms, and Smith acknowledges that as a young industry, private equity is having to learn how to best communicate with a wider audience. The implication is that CVC, like other GP groups acquiring large, high profile assets, has had to start to deal with matters previously outside its purview.
Smith insists that CVC's primary responsibility is to deliver the best results possible to investors, and that the firm's resources to communicate are limited. He says: “The industry is private, and as per our limited partnership agreements, we are contractually bound to concentrate on managing the fund to the exclusion of all other activities. But we also have a responsibility to people outside our contractual community, and like most specialised industries, private equity isn't well understood by a number of people. We have to decide how to handle this, and this is an ongoing debate. The advent of publicly quoted private equity accelerates this debate, because there anyone who buys a share has a right to come to the annual meeting and ask any question they want.”
This last comment refers to the formation of Euronextlisted investment vehicles sponsored by Kohlberg Kravis Roberts and Apollo Management earlier this year. According to Smith, time will tell whether their arrival heralds a significant change in the way private equity procures capital. He says CVC still has plenty of capital to invest at this point, and it also has the support of its limited partners should it want to raise new money at some point.
However, tapping the public markets is also a possibility: “To say that we would not raise a public vehicle would be wrong because a number of people in the industry have looked at it and it remains an option. But it's very much a function of the public markets, and it brings with it a whole lot of other issues. You can't have it both ways: if you want the benefits of the private market, you're entitled to it. But if you go public, you have to play by different rules.”
While Smith and his colleagues are mulling these options, there is plenty of work to do on the deal side. Despite his 25th anniversary in the industry approaching, Smith does not appear to have given much thought to early retirement. He says he is fortunate to have seen the European LBO market expand so dramatically, and now to witness the rate of change in markets such as China and other parts of Asia as well as the US: “Seeing the dynamism of businesses in these parts is incredible.”
By contrast, Smith sees Europe as a static, low-growth environment – and one that is facing intense competition from Asia and North America. As a result European businesses must constantly reinvent themselves and to help their cause, says Smith, European politicians should endorse private equity as an agent of change rather than fight it.
“I am utterly convinced that more productive businesses will bring broader economic benefits, and so the challenge to us is to get across the benefits of what we do. I'd describe us more like grasshoppers than locusts: destroying companies is not what we're about at all, we're in the business of improving them. I think there is some pretty good alignment of interest in our deals. People are pretty focused.”
Therein lies the key to CVC's future. Right now the deal machine is humming. But ongoing success will ultimately be judged by the returns the firm can deliver on its funds. Success here requires dedication, not just the muscle born of fund size. Because that can buy you nothing but trouble.
CVC CAPITAL PARTNERS
Year of inception: 1981
Funds being invested:
CVC European Equity Partners IV, €6 billion, 2005
CVC Asia Pacific II, $1.975 billion, 2005
Other funds under management:
CVC European Equity Partners I, $840 million, 1996
CVC European Equity Partners II, $2.5 billion, 1998
CVC European Equity Partners III, $3.7 billion, 2001
CVC Asia Pacific I, $750 million, 2000
Offices: Amsterdam, Brussels,
Copenhagen, Frankfurt, Honk Kong, Jersey, London, Madrid, Milan, Paris, Tokyo, Stockholm, Sydney, Seoul, Zurich.
Michael Smith (Luxembourg)
Javier de Jaime (Madrid)
Steven Koltes (Frankfurt)
Donald MacKenzie (London)
Hardy McLain (London)
Iain Parham (Luxembourg)
Rolly van Rappard (Brussels)
Maarten Ruijs (Tokyo)
Jonathan Feuer (London)
Robert Lucas (London)
Number of staff: 148