A Balancing Act

“Borrowing money to drive growth can make you rich, if you don’t take on too much risk.”


Terra Firma Capital Partners, led by Guy Hands, is a London based private equity firm that specialises in leveraged buyouts of asset-rich businesses with complex structural or regulatory issues. However, its acquisition of EMI, for £4.7bn in 2007, was a very public proof that not all venture capital deals work out. By the time it was unwound Terra Firma had lost about a third of its investors’ capital and Guy Hands is reported to have lost 60% of his own money too.

Although it can’t have been that easy to attract fresh cash after EMI, Mr Hands is still raising money and making bold investments confident that portfolio investing will pay off in the end, which appears to be true as long as you limit the scale of your failures. EMI was a big one. Admittedly, it is hard to assess the risk of a one-off deal like EMI, but arguably easier if you do a lot of them.

A leveraged buyout is simply a deal where you buy a business with a significant chunk of debt. Not using all your own money is where the leverage comes in.  Providing the investment grows the owners keep all the increase in value which, even after you have subtracted the interest cost of the debt, can leave you with a very much higher return on capital than you would get if you used all you own money. You not only stand to make a bigger return but you are taking on less risk too as you aren’t risking all your own money. That is why this sort of financial structure is so popular with investors like Mr Hands, but not necessarily so with employees or other interested parties. The acquisition of Manchester United by the Glazers in 2005 was a classic leveraged buyout and look at the controversy that caused amongst fans.

Mr Hands is now buying the Four Seasons Healthcare Group, with £300m of his investors’ money, in a deal that values the debt and equity at £825m. It is significantly smaller beer than EMI although Four Seasons is the largest independent healthcare provided in the UK with 445 care homes and 61 specialist care centres and something like 24,000 beds in all. It is now the UK’s market leader after the failure of Southern Cross Last year. The Royal Bank of Scotland took control of the business in 2009 in a debt for equity swap after it was unable to service £1.6bn of debt that it had built up in a period of rapid expansion before the financial crisis. This is Terra Firma’s second recent acquisition of a company that was taken over by its lenders after it failed to service its debt during the financial crisis.  Last month it bought the UK’s largest garden centre business The Garden Centre Group in a £279m deal with Lloyds.

If you are a venture capital firm you can do this sort of thing. You can restructure the balance sheets of businesses that have got the balance of reward and risk, which comes with all debt, a little wrong. It doesn’t seem to matter that is just what Mr Hands did himself with EMI because if you keep flipping the coin some of the time it will come up heads. As long as you don’t make too big a mistake you’ll come out ahead in the end.  EMI though is beginning to push the boundaries of what a big mistake might be.

This isn’t the same if you are a business owner who wants to borrow money because you want to grow your businesses. You often have just one crack at it and if you get it wrong you won’t find it as easy to keep trading as Mr Hands did. However, leverage, borrowing money, is vital at certain stages of the growth of any business. Debt is hard to avoid in a growing business, but making huge errors and taking on too much risk is.

Venture capital is a lot more speculative than even the venture capitalists admit and if it’s your business you should avoid as much speculation as possible. How? Well, if you haven’t done it before make sure you get advice from someone to help you to get the balancing act, between risk and reward, right for you.

Mark

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