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Private practice

A healthy equilibrium in the private equity market is creating a good supply of investment opportunities

There is a very promising outlook for investing in private companies.

At a macro level, there is strong demand for external equity investment. This desire will remain healthy while we have a stable low inflation, low interest rate economy which encourages large numbers of well-managed private companies to seek finance to expand.

Favourable conditions in the IPO market and higher levels of merger and acquisition activity are driving ambitious professional management teams to seek external finance. So why the higher levels of M&A activity? In recent years, companies have focused on getting their own house in order, concentrating on restructuring, cutting costs and improving efficiency. Rather than using cash for deals, they have tended to hand it back to shareholders in the form of share buybacks and dividends, both of which reached record levels over the past year. With weaker global demand hampering prospects for organic growth, acquisitions are increasingly seen as the best way to reach growth targets and private companies are often at the heart of these acquisitions.

The external environment will remain favourable but a number of opposing forces are affecting confidence. Looking at UK consumers, the housing market and high-street spending have slowed down, there has been a sharp drop in mortgage equity withdrawal, rising personal debt and we have a pension crisis. For UK plc, there are already huge pressures on raw material prices driven by the rising oil price and insatiable demand from the growth economies of China, India and Brazil. There are many bears out there on inflation, interest rates and the US economy.

Curiously, this is good news for the private equity investor because it caps the availability of debt to finance private companies and injects realism into private company owners’ expectations when valuing their company. We have a healthy equilibrium, creating a good supply of realistically priced investment opportunities that require external equity.

These conditions saw us completing seven new investments last year with an aggregate enterprise value of 57m, more than twice the level of 2004. I see this trend continuing in 2006 and favour four sectors in particular.

Within the IT sector, market sentiment has not fully recovered since the sharp falls in 2000 and 2001 and there are plenty of companies in the privately-owned sector whose full potential will be better realised over the coming year, with many exciting products coming on to the market.

I also like healthcare, including care homes, well-being, lifestyle, fitness and beauty, where there are the twin drivers of high Government spending and increasing levels of consumer interest.

The food production sector offers fundamental products but take care when considering its customers. Steer clear of companies that rely on the supermarkets. Tescos et al are just too powerful, making it almost impossible for suppliers to maintain pricing power. Look instead for the more attractive and maintainable margins in the food services industry that sells into pubs, cafes and restaurants.

Support services are interesting, particularly construction and utilities-related businesses in the South. There are some strong drivers here including John Prescott’s commitment to new social housebuilding, the 2012 Olympics and European laws imposing new standards on water quality, waste disposal and disabled access to public buildings. Look for businesses that can move quickly to capitalise on these changes.

What about the micro level? The indicator that is frequently overlooked is the risk/reward scenario, which is improving for private companies. The common thought is that investing in privately-owned businesses must be riskier than public companies. Perhaps not. With quoted companies seemingly being of higher quality and subject to closer scrutiny, the claim is looking thin in the light of Enron, Marconi and recent calamities at Livedoor and Langbar.

The MBO market is also looking buoyant, which is encouraging as these types of investments further improve the risk/reward scenario as one knows investors’ interests are aligned with the management team.

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