The new buyout market, which gained momentum in the late s and early s, thus involved recession-related restructurings of failed or distressed companies Wright et al. These examples were fairly isolated, and further reform at institutional level was needed to give substantive impetus to the developing wave of buyouts. The introduction of the unlisted securities market provided greater liquidity, and in parallel deregulation promoted the new entrants and greater shareholder activism. Banks, particularly those new to London and unconstrained by the traditional practices of the City, led the way in developing venture capital funds.
Citicorp Venture Capital CVC , a subsidiary of the US commercial banking giant Citicorp developed strong links with Silicon Valley and expanded into Europe in and subsequently into London in , thereby becoming the first of such organizations to begin operations in the UK. These prohibitions had been enshrined in the Companies Act , founded on the principles of minority and creditor protection.
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The provisions had also limited the scope for the use of the assets of target firms as security for debt-financed takeovers. Pressure to relax these provisions began with the Jenkins Committee in , with an argument that private businesses should be exempt, and the increased perception in the s that the restrictions limited the opportunities to rescue otherwise viable businesses see Gilligan, Chapter 2 this volume.
The Companies Act , extended into the EU Second Directive and Companies Act , relaxed these rules, offering safeguards to minority shareholders and creditors through statutory declarations by directors. An important reason for the failure of the conglomerate model had been the exhaustion of scale economies. These methods now facilitated the exploitation of scope as opposed to scale economies.
These changes explain some of the outstanding features of the earliest MBOs after The impetus for these sales came from the increasing fragmentation of vertical supply and value chains. MBO companies were characterized by stronger monitoring by investors, notably through direct board representation combined with managerial equity stakes and incentives.
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Structured debt finance was a significant proportion of the whole package, thereby reducing free cash flow. Taken together, these factors created pressure for further divestment, including pressure to repay debt leading to the divestment of less productive activities.
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For example, the successful hostile leveraged buyout of Gateway Superstores in was accompanied by significant divestment of unwanted stores and divisions Wright et al. In such fashion, the MBO model assisted firms that wished to change strategy and refocus their activities.
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Financial pressures led to the appointment of a new Chief Executive, and a new focus on becoming a brand-led international services business. In short, the MBO wave assisted the unlocking of the conglomerate discount, often to the benefit of both parties. In contrast to the earlier forms of entrepreneurial finance, the new waves of MBOs were a significant financial innovation in their own right. Some aspects, such as participating preferred ordinary shares and structured debt finance, were not new, indeed they had been important features of many industrial and other companies floated in the booms of the late nineteenth century.
However, the new legal framework allowing redemption and convertibility, allowed sufficient flexibility to establish strong equity-based incentives, underpinned by tailored incentive-adjusted mezzanine finance another leading feature of the earlier Gateway example and covenants linked to performance monitoring mechanisms. Where appropriate, these incentives could also be linked to employee share ownership plans. These structures also promoted product, organizational, and administrative innovation.
MBO structures created an increased probability of new product development, improved customer relations, and offered better control systems and cost control. Taken together, all these innovations led to a revival in entrepreneurial opportunity Wright et al. As such, it could be said that the disparate functions of entrepreneurs, product development, finance, company promotion, as traditionally carried out by separate individuals, were effectively institutionalized by the development of MBOs. The validity of this conclusion can be supported by a comparison with the experience of the US, which developed buyouts in parallel with the UK, but with some strikingly different features.
However, the buyout wave that appeared in the US during the s had some important distinguishing features. The KKR case also exemplified a second important feature: the use of sometimes excessive leverage, which certainly reached levels much higher than in the UK. Transactions in the US were more frequently contested and hostile, and there was a clearer separation between the buyout and venture capital markets than in the UK, where they rapidly integrated.
Figure 3. As the figure shows, from small beginnings in the late s, the number of transactions expanded rapidly up to In value terms the growth was less pronounced before the mids and finally peaked in , long after the growth cycle in the number of buyouts had reached its mature phase. The late s and early s were thus characterized by higher value transactions.
A useful illustration of the emergence of the larger-scale MBO during this period is provided by the beer and pub industry. An important initial reason for the involvement of buyout teams was specific regulation against anti-competitive behavior. Following an investigation in , the Monopolies and Mergers Commission concluded that vertically integrated brewing firms controlled too much of the retail public house market. The MBO was an obvious vehicle for this, and as with the earlier buyout waves, both parties stood to gain.
For the large vertically integrated brewers, the MBO provided a ready means to comply with the new legislation and refocus on specific areas of the value chain. The bought-out pub estates were now effectively pub-owning companies Pubcos , and they recognized that higher market share would increase both their bulk buying power and their ability to control the margins of pub managers.
To achieve this quickly they sought PE backing. Their rationale was that pubs could be bundled together and their cash flow securitized, providing access to cheap debt finance. Risk, meanwhile, could effectively be transferred to pub managers through fixed rent and beer charges Higgins et al. The model worked well for the Pubcos, but at some cost to other stakeholders, including entrepreneurs.
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As a consequence, they have been subject to scrutiny from parliamentary committees of enquiry, amid claims of abuse of tenants and failures to maintain pubs of community value. To limit the possibility of power abuses, there have been attempts to secure appropriate codes of conduct through legislation. To some extent the criticisms levelled against PE-backed Pubcos are also valid in terms of the effectiveness of entrepreneurial finance.
In the beer and pub industry, the entrepreneurial function operated precisely at this meso-level, successfully raising substantial financial resources to transform an industry. The problem, however, was the strangulation of micro-level entrepreneurial initiative. Although it was true that pub landlords had some freedom to innovate under Pubco tenancies, their complaint was that any hint of success would be rewarded with an upward rent revision.
As a result, lack of incentive structures, exposure to risk, and lack of control over margins and investment, meant that pub licensees were reduced to custodians of a shrinking and impoverished estate, which Pubcos could continue to exploit through asset sales against a backdrop of rising property values Higgins et al. Free of tie pubs, for example, offer greater scope for entrepreneurship at the micro business level. More generally, however, there is evidence that the supply of finance into smaller businesses via MBOs has reduced since the late s. The trend in Figure 3. In value terms, there was a very substantial fall from the peak achieved immediately before the crisis of This downward correction was much more significant and persistent than the aftermath of the dot.
Following the financial crisis, MBOs appear no longer to address the equity gap as they once did. In the wider economy, particularly after , and notwithstanding the substantial developments of the preceding three decades, there is evidence of the persistence of the equity gap. Firms located in the London and the South East appear to have less of a problem accessing capital, but smaller peripheral firms face substantial barriers Rowlands, ; Amini et al.
Empirical evidence for smaller firms suggest that the buyout surge that rejuvenated much of UK industry has run out of steam and there were signs of this even before the financial crisis Figure 3. Investors meanwhile, favor larger sizes, thereby avoiding the relatively high transaction cost of smaller opportunities, whose lack of performance track record also accentuates perceived risk Rowlands, Taken together, the trends in Figures 3. Recent trends in buyout activity beg the question of their future role as investment vehicles capable of sustaining economic growth.
If history is any guide, it is clear from the discussion in this chapter that structural changes are perhaps more important than cyclical trends. The structural changes in the early s, including company law reform and the deregulation that facilitated the entry of new financial institutions and innovative financing, were of the utmost importance in energizing the wave of buyout activity that followed.
That upsurge was strongly characterized by smaller entrepreneurial buyouts, at least until the peak of the dot. The cyclical downturn that impacted the wider economy had little effect on the level of buyout activity in value terms. In parts of the economy, like the beer and pub industry, the move to larger transactions stifled entrepreneurship at the micro-business level. More generally the number of PE-backed buyouts for small firms declined significantly from the early s.
As in the nineteenth century, the preference of investment funds for larger deals with relatively lower risk and transaction costs, has led to a divergence between entrepreneurial opportunity and financial provision. The significant consequence of all this then appears to be a return to the long-run problem of the equity gap. Further research is needed to assess how this challenge might be met, for example identifying firms and sectors that can be turned around and how the investment needed can be suitably tailored and incentivized. Certainly, the buyout waves of the s and s offered some interruption of the otherwise persistent problem of the equity gap, particularly for smaller, potentially innovative firms, which has now re-emerged in most sectors and regions following the global financial crisis.
A final question therefore is whether the underlying features of the buyout model, explored elsewhere in this book, can once again be adapted to respond to the opportunities and threats of new and challenging economic circumstances. The Supply of Beer , Cm. Leveraged Buyouts Private Equity Investment i Management Buyouts.
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