Seeking diversity

There's no denying that the mid-market remains the major talking point in a French private equity market wrestling with competition and overly aggressive leverage. But, just over the horizon, lies a vision of a mature industry populated by well-differentiated managers. Andy Thomson reports.

Paris and its inhabitants seem to be possessed of an uncanny ability to court favour against all odds. Strolling down the sun-drenched boulevards on a fine spring morning, with the Eiffel Tower glinting on the horizon, this Private Equity International journalist found it surprisingly easy to forgive the city its appalling traffic snarl-up that had prompted dark thoughts in the backseat of a taxi just minutes previously.

Twenty four hours earlier a mass gathering of protesting students had caused a major obstruction whilst still being hailed by visiting Olympics committee officials as representing democracy at its finest. The students even won plaudits for sporting “Paris 2012” t-shirts as they held their placards aloft – this was interpreted as evidence of how the country was pulling together in its efforts to host the Games in seven years' time. For whatever reason, Paris seems to be smiled upon by the gods.

As do its mid-market private equity firms. Every year – so the received wisdom goes – sales processes become more competitive, prices climb higher, leverage gets more aggressive, and the inevitable shakeout is coming a step closer. And yet it seems that every year, capital continues to flow into French midmarket funds with the same urgency as red wine into the glasses of Parisians at lunchtime.

Plus ca change, plus c'est la meme chose. The veracity of the saying is not lost on the resident private equity professional who decries: “Every year, mid-market funds that shouldn't get funded get funded – and are generally over-subscribed. Maybe it's because there's a lot of dumb money out there. The level of enthusiasm on the part of investors is still the same as it's always been – and I'm still amazed.”

Some observers think the market could hot up still further as a result of two recent developments affecting the buy side. Towards the end of 2004, former finance minister Nikolas Sarkozy extracted a commitment from French insurance companies to invest an extra €6 billion into unquoted companies over the next three years. Then in February the Fonds de Réserves pour les Retraites (FFR) – the €19 billion “buffer fund” established to meet shortfalls in the under-strain state pension scheme – announced it was tendering for a consultant to advise on a commitment to private equity that would equate to between five and eight percent of its total assets under management (around €950 million to €1.5 billion).

Taking up the theme of an over-funded mid-market, it's easy to envisage even more fuel being poured on an already raging fire. But resident professionals do not, it seems, live in fear of such a conflagration. “You won't change the mentality [of insurance companies] in a year,” opines Pierre-Michel Deléglise, president of Finama Private Equity, an affiliate of French insurance business Groupama. “They have been cautious in recent years because of the venture bubble, but have been edging back into the asset class because they are attracted by its complementarity to other asset classes. But it will take years. People don't invest just because of rule changes.”

Antoine Dréan, managing partner of Paris-headquartered placement agent Triago, agrees that the immediate effects will be muted – while eschewing the notion that insurers are being slowly won over. “Most insurance companies have always been reluctant to invest in private equity and they're not suddenly going to change their minds. By contrast, they are turning their thoughts to what they can invest in that qualifies as unquoted, whilst not being private equity.”

Edouard Boscher, head of investor relations at fund manager AXA Private Equity, points out that even if the full €2 billion does find its way into private equity coffers every year for the next three years, it would still represent a modest sum – roughly equivalent to the annual private equity commitment of just one institutional behemoth such as AlpInvest Partners. Hardly what you'd call a windfall: and not enough on its own to build up and sustain a mid-market bubble.

But is there in fact a bubble to sustain, or is the cynic's picture of the mid-market more akin to a crude caricature than an accurate portrayal? A recent set of statistics implies the doomsayers stand accused of over-egging the pudding. French industry group L'Association Française des Investisseurs en Capital (AFIC) found that private equity fundraising in France last year, at €8.8 billion, was actually five percent down on 2003 – and a full €5 billion less than the €13.8 billion invested in new deals. “It is nonsense to talk of a bubble in the market,” says Dominique Oger, chairman of AFIC. “Fundraising [in France] has declined every year since 2000, and has now reached a very low level.” Anticipating a strong fundraising year in 2005, Oger's view is that this is absolutely necessary to avoid a capital underhang.

If so, is it misleading to think of the typical business sale in France as an unseemly scrap between a phalanx of “me-too” investors seeking to outdo each other solely on the basis of the size of their cheques? It would be easy to say yes in light of the AFIC statistics (which imply that there is in fact little money left to throw around), but there's too much anecdotal evidence to simply dismiss the idea that exorbitant prices are being paid in certain instances. One source refers to a case in which a bank was asked for leverage at a multiple of around 3.5 times EBITDA and offered 5.5 times instead. If the midmarket is analogous to a runaway train, don't expect the banks – buoyed by the depth of the syndication market – to apply the brakes. One could argue that the effects are being seen in the emergence of a fledgling market for distressed investors (of which more later).

How large the “me-too” group may really be is a moot point, but what is not in doubt is that GPs in Paris will go to considerable lengths in order to avoid being bracketed as part of it. Niche strategies abound, and they are resulting in a complex and fragmented market some way removed from the homogenous entity the French mid-market is often assumed to be.

Chequers Capital acknowledges that in order to successfully raise the €500 million target fund it is planning to launch towards the end of this year (which would be €200 million larger than the one it is currently investing), it is imperative to seek the holy grail of proprietary deal flow. For this reason, according to managing director Denis Metzger, the firm eschews the secondary buyout market, which it says accounted for 24 of the 59 buyouts worth more than €20 million seen in France last year (source: Chequers Capital).

Instead, says Metzger, the firm has opted to attempt identifying “problem- solving situations”. Asked for an example he references International Metal Service (IMS), a Euronext-listed steel distribution business acquired from steel giant Arcelor for an undisclosed sum in July 2004. The business, which faced management succes s ion issues, was experiencing waning profits in a cyclical industry. Not a mouth-watering prospect prima facie, made less appetising still by the high due diligence costs associated with quoted companies. Given the company's difficulties – which Arcelor did not wish to highlight in public – a full auction process could not be countenanced. Metzger says Chequers ended up “one of a small number of firms working hard to find a solution.”

There are indeed more and more troubled LBOs which could be interesting targets for financial investors specialised in distressed companies, without waiting for the opening of a bankruptcy procedure

Alexandra Bigot

Strategic differentiation was also very much on the minds of veteran pairing Eric de Montgolfier and Erick Fouque when they quit Astorg Partners to launch mid-market fund Edmond de Rothschild Capital Partners in 2003. The duo had invested in some successful buy-and- builds and rollouts with their former fund – and decided to concentrate their efforts solely in that arena. “For others such deals were opportunistic – we decided to focus on them, ”says de Montgolfier. It was a story that investors bought into: seeded by €30 million from sponsor LCF Rothschild, the fund closed €10 million ahead of target on €210 million in October last year.

There are plenty of other examples of firms marking out niche territory. From its offices surrounded by the chic designer boutiques on Avenue Montaigne, LVMH-sponsored L Capital Management casts around for minority investments in luxury goods businesses. Meanwhile, on the other side of the Seine, LBO France is busy underlining the potential in real estate through its sector-focused Nexstar Capital fund. Completed deals include property developer Nexity, whose IPO in October 2004 delivered 6.4 times cash invested, while still leaving LBO France holding a 10 percent interest.

The examples outlined above indicate diversity in the private equity market rather than anything so dramatic as a paradigm shift. That's not to say there's no whiff of revolution in the air. As mid-market funds grow larger, so they begin to encroach into the bigger deal arena, where few French funds have thus far trod. Some say this is explained by a reluctance to take on the labour unions in situations where radical action is required – a function that has so far been happily left to the Anglo-Saxon groups that currently dominate the French mega-deal arena.

But observers say opportunities at the larger end of the market are increasing, fuelled by a plethora of corporate spin-offs and public-to-privates. A hint of this potential was provided in November 2004, when Paris-based Eurazeo joined lead investor Clayton, Dubilier & Rice and Merrill Lynch Global Private Equity to agree the €3.7 billion purchase of French electrical distributor Rexel in Europe's largest leveraged buyout of last year. One of the predictions most frequently voiced today is that one or two over-subscribed upper mid-market funds will in the years ahead find themselves able to join the likes of Eurazeo, PAI Partners and Wendel Investissement in flying the French flag in the LBO arena.

One of the other hot tips is that distressed and turnaround investment will become a more regular feature of the deal landscape in France. The extent to which this happens will reveal much about whether talk of a credit bubble is justified or not. There's no doubt where Jean-François Borde, managing partner of EOF Partners, stands on the issue: “The French buyout market is saturated and many companies are overleveraged,” he says.

His views on the subject are perhaps not surprising given a vested interest: EOF has just launched a fund aiming to raise up to €100 million by the end of this year for investment in distressed situations. But it is a view backed up by Alexandra Bigot, a partner in the Paris office of law firm Willkie Farr & Gallagher, who says: “There are indeed more and more troubled LBOs which could be interesting targets for financial investors specialised in distressed companies, without waiting for the opening of a bankruptcy procedure.”

EOF is not alone is scouring the French market for troubled LBO companies. French specialists such as Caravelle, AXA's Renaissance Investissements and T'NT/Finactive – a €150 million fund launched last year – are all active, as are more mainstream investors such as Apax Partners, who target distressed situations on an opportunistic basis. (Apax, whose France operations are led by Maurice Tchénio, is currently launching a new €700 million fund dedicated to the country.)

Butler Capital Partners, meanwhile, has been trawling the French market for turnarounds, underperforming companies and complex situations since it was founded in 1991 and has made 17 investments, 15 as lead investor. The firm's managing partner Walter Butler says it targets companies that have a “strong market share in solid industries”. Recent investments have included Flo, the themed restaurant chain, and France Champignon, a mushroom production business.

Encouraged by proposals currently before the French Parliament, which are designed to bring more of a Chapter 11-style framework to business restructurings, there are also signs that US distressed giants may be circling the French market. Matlin Patterson raised a few eyebrows last year when it teamed up with French logistics group Mory to submit an offer for ailing cash transportation specialist Valiance Fiduciaire, which was ultimately defeated by a rival bid from Sweden's Securitas. With the likes of Gores Technology Group and HBK Investments also reportedly conducting scouting missions, it may not be long before distressed debt is a more regular feature of the French private equity scene.

If so, one could interpret this as vindication for those who have stood firm in their belief that excessive leverage would eventually be the downfall of many a French mid-market investment. Equally, it might be seen as evidence of growing maturity in a private equity market that – a handful of long-established investors aside – only really came to prominence in the mid- to late- 1990s. The Parisian buyout village may well be a crowded place: but ultimately, you suspect, it will find a way of triumphing even in adversity.