Private equity: Who's next?

The bull market has a lot to answer for. The 20% returns of the past few years have left a lot of capital washing around the market and some investors believing that the good times would just keep rolling. One sector keeping the dream alive is private equity, in which firms marshal enough capital from private investors to buy big companies then overhaul them before selling for fat profits.

The current $18 billion bid for Coles Myer might signal that hunting season has opened in Australia. A consortium of private equity firms led by Wall Street's Kohlberg Kravis and Roberts (KKR) is negotiating to buy the troubled retailer. If it succeeds, KKR would have the advantage over other investors of being able to influence the performance of its investment, by restructuring, changing management and devising an exit strategy '” all away from the glare of shareholders. The exit could mean separating and selling Coles Myer’s various retail divisions or refloating the revitalised operation after a couple of years.

So which company is the next target? Probably not Foster’s Group. On Wednesday, the brewer’s shares rose 10% (adding $1 billion to its market capitalisation) on speculation that a bid was in the offing. Foster’s chief executive Trevor O'Hoy was quick to scotch the rumour by branding such speculation as nonsense.

Still, analysts are running the numbers of potential private equity targets: a report from JP Morgan, dated August 3, said that poor results in a weaker market would more opportunities for these takeovers. The report ranked the 30 most likely candidates, the top 15 of which are included below.

The three criteria used by the report were net interest cover, net debt to equity and enterprise value to earnings before interest, tax, depreciation and amortisation (EBITDA). The companies have been ranked in order of most attractive proposition according to the screening criteria. Importantly, several of these companies are already in play. The merger and acquisition activity around BlueScope Steel, Commander, Colorado and iiNet is proof of that.

Andrew Green, chief executive of the Australian Venture Capital Association, sees plenty of value in information technology companies. “There are a lot of things going for IT, any business that’s scaleable is worth getting excited about.”

He dismisses the suggestion some of the companies on the list, such as Leighton, BlueScope Steel and Rinker, are too big to be targets. “There is no deal too big,” he says. “Nothing is off-limits.”

When it comes to retail, private equity players are attracted to the low volatility of the sector. The core stability in the businesses of Coles Myer and Woolworths are big selling points. But wait a minute '¦ isn’t Woolworths well run?

Perhaps, but even that might not act as a private-equity repellant. Retail industry expert Ross Honeywill sums it up perfectly. “When it comes to private equity, they're not just looking for an underperforming company. Sure it helps, but that’s not to say that private equity or someone with significant synergies couldn’t shake the company up and get it running more efficiently.”

Honeywill also points to the elephants in the room, the US-based Wal-Mart and Tesco of the UK. Both are expanding internationally at a rapid rate. Both could benefit from the purchase of all, or some, of either Coles Myer or Woolworths.

A report from Deutsche Bank says that over the past 10 years Wal-Mart has multiplied the number of its overseas stores ten-fold, from 225 to 2287. Over the next five years, Tesco is looking to take its number of overseas stores from 2365 to 4839.

But for investors with long memories, it hasn’t all been beer and skittles when private equity makes an exit. In the Australian consumer goods market, private equity has a history of disappointments.

Repco, for example, was listed in by private equity operators in September 2003 for $400 million. Today it’s capitalised at just $215 million. Retail Cube listed for $42 million in July 24, 2004. Today it’s worth $15 million. In the textiles and clothing sector, Pacific Brands hasn’t done too well either, after listing for $1.25 billion in April 2004, it is now worth $1.2 billion.

The UK experience has been different. The department store Debenhams was purchased for £1.9 billion in 2003. Private equity operators put up £600 million of their own money in and got back £1.3 billion in dividend payments. The exit came last May when Debenhams was placed back on the market for £1.7 billion.

Earlier this year in the United States, the biggest private equity deal to date was completed when Hospital’s Corporation of America (HCA) was bought for $33 billion, eclipsing the previous record by $2 billion.

Such examples suggest not only the kind of returns private equity groups can achieve outside the market, but the scale of things to come.

In 2004, the total value of leveraged buyouts in the US was $115 billion. In the six months to June this year there has been $152 billion worth of equity action. Private equity has only just started with Australia and there is no sign that it is going to stop.