Current Financing Environment in Europe forEntrepreneurs & Investors

23 nov 2011

Bruno Deschamps

• Chairman & CEO of Entrepreneurs Partners LLP and EP Capital Ltd, an innovative business angel syndicate.

• Senior Executive Advisor to Arcapita, a global leading Private Equity, Infrastructure and Real Estate firm headquartered in Bahrain with investment activities in London, Atlanta and Singapore.

• 10 years in the Private Equity industry: Partner of 3i plc (London) and Clayton, Dubilier & Rice. Responsible for private equity investments in Europe, including companies such as Brakes Bros of which he was the Chairman and CEO, VWR, Culligan and Rexel.

• 20 years as Senior Executive of large int. corporations in the US and Germany: President and Chief Operating Officer of Ecolab Inc (Fortune 500 company headquartered in Minneapolis, USA). CEO of Henkel Industrial adhesives worldwide, CEO of Henkel Ecolab headquartered in Duesseldorf, Chairman & CEO Teroson Gmbh.

• Started career managing family-owned speciality chemical company in France: S.A.I.M

• President of the French Foreign Trade advisors in the UK, a Director of the Franco-British Chamber of Commerce, a member of the think tank le Cercle d’outre-Manche, a member of the Chatham House, the Institute of Directors London and the Institut Montaigne Paris. He is a Knight of the Legion d’honneur France.

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The outlook for European SMEs

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4

# firms 4 168 4 195 4 646 10 021 10 428

# employees 796 768 735 994 989

Average revenue (€M)

205 217 206 418 368

SMEs of 250+ employees in several EU countries

Source : Ernst&Young et ESCP-EAP, Grandir en Europe : hasard ou état d’esprit, 2008.

Europe needs SMEs…

M. Zuckerberg (30 Oct 2011, Y Combinator)

“We never went into this wanting to build a company. But a company is the best vehicle in the world to align a lot of people to achieve a mission”.

In a mature market (Europe), is there any other way to achieve economic growth and create jobs than through innovation/entrepreneurship?

The UK has historically been good at encouraging SMEs and today has a stronger network of large SMEs than other European countries.

In the 1970s (flat real GDP, declining living standards, high unemployment, social unrest) the West was saved by potent mix of technology and globalisation.

… and for growth, financing is key

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Evolution of average capital in €K for UK (in RED) and French (in BLUE) SMEs

Note : average capital of companies founded in year n, with an initial capital superior to €100KSource : (IFRAP), 2008

Evolution of jobs created by UK and French SMEs

Note : Jobs created in SMEs created in year n with an initial capital superior to €100KSource : (IFRAP), 2008

Survival rate after 3 years for firms created in 2006 depending on invested amount at launch

Source : France, Insee 2006 and 2009.

The probability of success of a SME is highly correlated to its access to financing.

Seven years after launch, a UK SME has on average 5x more capital than its French equivalent and creates 4x more jobs.

81%

74%

71%

66%

62%

60%

0% 20% 40% 60% 80% 100%

80k€ and more

40k€ to 80k€

16k€ to 40k€

8k€ to 16k€

2k€ to 6k€

Less than 2k€

The startup financing cycle should be Equity, Equity, Equity… then Debt

Seed stage: savings + FFF + (grants)

Early stage: business angels, small VC funds, (grants)

The “Valley of Death “ is not - and cannot - be financed through traditional banking services….even for tangible asset intensive SMEs which are increasingly less in the “start up blocks”.

By definition, traditional loans are not suitable for non-mature businesses: expose lenders to all the downside but only limited upside!

Only equity – or convertible loans (if valuation is really un-definable/agreeable) are adequate.

Who better than ex-entrepreneurs/corp. execs to allocate capital efficiently to new SMEs?

Besides finance, business angels may provide intangible capital (advice, contacts etc...).

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Fiscal incentives are crucial to encourage direct investment into SMEs… and the UK has understood it!

EIS(1)

Mechanism 1

Mechanism 2(2)

Launch date 1994 1994 2008

% Tax relief on invested amount

30% 22% 50%

Max investable amount £1 M(3)

€20k (3)

or €50k (3)

for seed (JEI)€90 k

Min Holding period 3 years 5 years 5 years

Tax relief if capital loss? YESNO

(unless classified as Jeune Entreprise Innovante)

Inheritance tax ? NO YES YES

OtherOngoing consultation in the UK to possibly

remove remittance tax for those repatriating funds to invest in UK SMEs (EIS eligible)

One of the main measures undertaken during the last UK Budget (announced on 23 march2011) has been the clear strengthening of the fiscal incentives (EIS) in favour of business angels investing in UK SMEs.

The UK government therefore chose to acknowledge the value added of business angels in the financing of SMEs and the important risk inherent to this asset class (long holding period, lack of liquidity, uncertainty).

The survey undertaken by NESTA et BBAA(a) shows that in the UK, 80% of investors use the EIS and 53% state they would be doing less investment without this fiscal incentive (and naturally these statistics should further increase following this strengthening of the EIS programme).

Via an important ‘PR effect’ these fiscal incentives encourage citizens to discover business angel investing and thus bring the overall population closer to SMEs/innovation.

The maximum annual relief for a French business angel is €45k, vs £300k (i.e. €340k) in the UK.

As of today, the maximum loss that a UK business angel (taxed at 50% level) may incur is 35% of invested capital.

(a)  Sources: BBAA, May 2009, Business angel investing – promising outcomes and effective strategies

Number of business angels 50k 8k

Average amount by business angel and by project

£77k €16k

Source s: BBAA, PBA, Centre d’Analyse Stratégique, Sept 2011

But UK still needs to close the gap with the US: 250k BA, ~£18bn pa, £72k pa per capita, 3.5x more BA investment per capita

Entrepreneurs turned ‘Super Angels’An efficient re-allocation of savings

Jon Moulton, Better Capital, Alchemy

100+ investments

Stake in Ashmore Plc, for example, initially an angel investment, is worth ~ £70m and he admits that “he has made more money as an angel than through working”.

However, keen to stress the risk involved: “lost at least a third of the cash put into angel deals, while a handful of investments have made over a thousand times the money”.

Xavier Niel, Free, through Kima Ventures

‘Officially The Most Active Angel Investor In The World’

‘100 tech startups each year, every year. Forever. In any country in the world.’

Reid Hoffman, Cofounder of LinkedIn; former exec at PayPal

80+ investments

‘After five minutes of a pitch, I know if I’m not going to invest, and after 30 minutes to an hour, I generally know if I will’.

And hundreds of other prominent ex-entrepreneurs/senior execs turned full-time business angels: - Europe: Kevin Eyres (ex MD Linkedin Europe) for tech, Sir Terry Leahy (ex CEO Tesco) for retail. - Silicon Valley: Peter Thiel, Jeff Clavier, Dave McClure (Paypal)...

The outlook for EU start-ups is good….We are the ‘BRIC’ of entrepreneurship

In its infancy, an innovative startup’s results are not correlated to the overall macro environment eg. Did Facebook/Linkedin etc.. stop growing because of economic slowdown in 2008/09/10?

Mature EU markets (low growth, high trade deficits). Recovery can only come from innovation.

“FB effect”: drastic change of mentality towards entrepreneurship, visible esp. in Continental Europe.

EU full of large/mature firms, who want/need to acquire growth : strong M&A exit potential for SMEs.

Less advanced innovation market logically means “catch-up” to come, more opportunities for current entrepreneurs/investors + EU start ups have learnt to be capital effective (at least a pro to absence of capital!).

In Tech, strong consensus that Silicon Valley is becoming overpriced. EU stands a chance for new global hub.

The outlook for EU start-ups is good….esp. in the UKWe are the ‘BRIC’ of entrepreneurship

UK focused on encouraging enterprise: Improved EIS + Improved Entrepreneurs relief + TechCity + SU Britain.

Ecosystem: Effective ‘Cluster’ model has emerged in the UK: Cambridge (~24% of UK VC) + Silicon Roundabout.

Attractive and recognised business-friendly environment + low bureaucracy + int. language + soon lowest corp. tax rate among G7 countries (@23% in 2013) -> 16% less than US, 11% less than France, 7% less than Germany!

UK government is proving to be very reactive: UK determined to get away from high historical dependence to Financial Services sector + Incentivise ‘create-your-own-job’ approach to unemployment.

Relayed by organised mid-stage finance: £2.5bn BGF by 6 high street banks + £1.4bn UK RGF.

UK government is listening to entrepreneurs to make their life easier: will soon launch ‘one-click’ platform for SMEs + ‘Asking to tell where rules and regulations get in the way of innovation’.

Benefit from network’s expertise and credibility

Proactive investors focused on nurturing tomorrow’s leaders

Benefit from full tax relief

UK: 30% on day 1 + no CGT + deductibility on any loss+ inheritance tax relief

Build a diversified portfolio of SME investments

Widely regarded as the winning strategy

Tax-free capital gainsLimited and fair transaction costs

Premium EP offeringFocused screening and facilitated 

investment process

You only ‘lock-in’ what you invest

No committed funds, therefore low opportunity cost of capital

Access to an attractive asset classAverage 22% IRR(a) on UK angel deals 

www.entrepreneurspartners.com 11

(a) As shown by May 2009 study published by Nesta and BBAA, surveying 158 UK-based angel investors who have invested £134m into 1,080 angel investments between them.

EP Capital: UK/France venture syndicate

The financing environment for larger companies

Private Equity : how we work, what happened, what is likely to happen

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The PE industry

Private Equity: 80 years of history< 1970

•1934: Launch of Charterhouse Development Capital

•1945/46: Launch of

- ICFC (Industrial and Commercial Finance Corporation), ex 3i in the UK

- ARD (American Research and Development Corporation) in the US

•1958: Small Business Act (US)

•1964: First LBO by bankers from Bear Stearns (MM. Kohlberg, Kravis and Roberts)

1970 -1979

•1971: Launch of Nasdaq.

•1972: Launch of Kleiner Perkins, Sequoia Capital, Sofinnova Partners and Adam Street Partners.

•1973: Launch of USNVCA.

1980 -1989

•1983: Launch of EVCA

•1985/1987: Launch of Blackstone Group and Carlyle.

•1988: KKR LBO of RJR Nabisco.

•1989: High Yield market crisis.

1990 -1999

•1990: Launch of ILPA.

•1995: Launch of AIM.

•1997: Asian financial crisis.

•1998: Russian financial crisis.

2000s

•2001: Burst of internet bubble.

•2002: Legrand taken over by KKR and Wendel. Brakes is taken over.

•2004: Rexel taken over by CD&R, Eurazeo and Merrill Lynch.

•2007: Largest European buyout, €14.1bn (Alliance Boots).

•2007: Walker recommendations on transparency for PE.

•2007: Sub-prime crisis.

•2007 : CD&R sells Brakes.

•2008-2009: Economic crisis spreads.

•2010: Short-term boom of High Yield debt market, replaces loan market for refinancings and allows PE to generate some returns in unconventional ways (eg « dividend recaps »).

Many different types of Private EquityDifferentiating between VC and Buyouts

Venture Capital: Seed to Late(ex: Balderton, Index, Accel ...

Unilever Ventures, Google Ventures)

Growth Private Equity (ex: Carlyle, Summit, TA, GA ...)

Buyouts, LBO : small ,mid or large cap(ex: Blackstone, KKR, Apax, CVC,

CD&R, TPG, 3i, Arcapita ...) Minority stakes

Majority stakes

Main Focus is growth

Main Focus is efficiency

Look for firms with: innovation, IP, potential to scale, revenue

Look for firms with predictable,

recurring cash flows,

optimisation potential

The PE Buyouts industry

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as % of amount

United Kingdom27%

France16%

Germany13%

Netherlands7%

Italy6%

Spain6%

Sweden5%

Rest of Europe15%

Rest of world5%

European Buyouts historical geographic split

Source: PEREP_Analytics for 2007 & 2008; Thomson Reuters/PwC for previous years

€1 400bn invested between 2004 and 2008 globally, inc €280bn in Europe

33 000 companies in Europe Cumulatively 6 million jobs in Europe

The UK has historically been the leading recipient of PE Buyouts investment in Europe, despite an economy that is mainly services focused (although it brielfy lost to France this year).

This is largely thanks to a business friendly environement.

The PE Buyouts industry: LPs FundingFrom FI to PE

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Fundraising from financial institutions (fund life expectancy: c.10 yrs)

3-4 years: investment in unlisted businesses

Return funds to financial institutions

with gain/loss

Value creation in 6-7 years

Typical fee structure for PE Buyout firms• 1.5% to 2% of invested funds (‘management

fee’)• 15% to 20% of realised capital gains…if gain

above 8% IRR, cash to cash (‘carried interest’)

Provenance of PE funds (LPs)

PE Buyouts : value creation 1/2

Buyouts are an ‘efficiency mechanism’ for the corporate world

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1. Strong focus on OPERATIONAL performance and OPTIMISATION of resources (eg Working Capital).

2. Alignment of incentives on a medium term partnership between investors and management.

3. Away from the distraction of the « short-termism » of public markets, PE implies strong relationship with limited number of shareholders.

4. Knowledge, network from PE investors (eg Operating Partners). PE Investors use all available resources to help management team achieve its objectives.

5. Efficiency : « back to basics », needed after long periods of time focusing on growth.

6. Some leverage increases discipline (eg constant focus cash flow) and debt is inherently tax-efficient (deductibility of interest payment).

7. Frequent comprehensive strategic review with Management and potential acquisitions or disposal of « non-core » assets

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Growth in profit, employment and productivity vs. public companies: PE exits 2006-2008N = 149 (profit), 110 (employment), 109 (productivity)

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46

4

1

3

15

5

9

0

2

4

6

8

10

12

14

16

18

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Profit Employment Productivity

CAGR

Equivalent public companies PE outperformance Total

Source: Thomson Reuters/EVCA

E&Y recent study hows better OPERATIONAL performance of PE in Europe relative to average of equivalent listed businesses , with annual growth of:

– 15% of operating income– 5% of employment– 9% of productivity

In an LBO situation, most value creation comes from growth in operating results.

Equity value atentry

Earnings growth Marketenhancement

Strategicrepositioning

Debt reduction Equity value atexit

58%

15%

17%

10%

Contribution of value creation to LBO performance for the 59 exits of 3i since 2001 (completed exits)

PE Buyouts : value creation 2/2

Buyouts are an ‘efficiency mechanism’ for the corporate world

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PE Buyouts Case Study Brakes (LBO CD&R, 2002-07)

Brakes : First LBO with CD&R Different steps we used to create operational value

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2002 - 2004•Strategic repositioning•Start thinking about growth initiatives

•Crisis situation•Integration of past acquisitions•Turnaround of company (near bankruptcy)

2004- 2006•Crisis situation – Turnaround•Big Bang IT / Logistics•Regional P&L

•Consolidation•Rationalisation of activities•Management team strengthening•Profitization

2006-2007•Stabilisation•Growth•Acquisitions

•Growth•Preparation for future acquisitions

Goal was to reach perfect equilibrium between offensive and defensive measures …

Brakes : First LBO with CD&R Strong operational improvements achieved under LBO

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1.600

1.800

2.200

0.000

0.500

1.000

1.500

2.000

2.500

2003 2007 2009

Val

ue (

£mio

s)

80.0

130.0

150.0

0

20

40

60

80

100

120

140

160

2003 2007 2009

Val

ue (

£mio

s)

60.0

106.0

144.0

0

20

40

60

80

100

120

140

160

2003 2007 2009

Val

ue (

£mio

s)

Sales turnover EBITDA Cash Flow

Brakes : First LBO with CD&R Positive experience for all actors

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Staff

Clients

Suppliers

• Stabilised future• Healthy corporate culture implemented• Rigorous and ethical standards

• A unique offering of « one-stop shopping » in multi-temperature• Important and needed innovations in Quality, Traceability• Improved service to restaurants

• Having been rescued, Brakes is a ‘healthier’ client to deal with.• Bargaining power re-equilibrated with suppliers (bargaining power -> working

capital.

PE Buyouts : Many Strengths and Weaknesses but the rationale still holds

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+ - Effective governance mechanism.

Alignment of incentives between management, employees and investors.

Additional expertise, particularly useful for « Buy & Build ».

Medium to long term horizon useful to implement change.

Long term operational performance > listed companies.

Remuneration of investors directly linked to investment performance.

Suitable for some companies and situations but not all companies (need for recurring and predictable cash flows, low and predictable Capital Expenditure).

High dependence to debt market.

History shows many excesses + bubbles due to:

– a surplus of capital on the market (which has pushed investors to use financial engineering techniques rather than operating work).

– pressure for PE managers to invest once funds have been raised.

1. An excellent solution for some companies, but not suitable to all.2. The industry is young and still learning/adjusting.3. ‘Do not throw the baby out with the bath water’.

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PE industry, what’s happening

Growth / bubble creation(volume,

leverage, valuations)

Financial crisis (Volumes drop

drastically)

Transition from financial crisis to economic crisis

Hopes and uncertainities

Private Equity BuyoutsAn industry which has gone through important cycles

Source: Mergermarket26

Evolution of the Buyouts industryValuation multiples, Debt/Equity split

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2002 – 2004 2005 - 2007 2008-2010 Today

Senior Leverage max (xEBITDA)

3.5x 6.0x 3.0x /3.5x 2.5x / 4x

Total leverage max (xEBITDA)

4.5x 7.0x / 8.0x + 4.0x 4.0x / 5.0x

% of debt 60% 80% 50% 40-55%

Any Covenant? Yes No Yes Yes

Deb

t fi

nan

cin

g

Fair to say PE investors became somewhat ‘greedy’. Used excessive leverage thanks to low interest rate environment and open bank debt market.-> Implied very high ‘entry ‘valuations during 2005-08 : 10x + EV/EBITDA...-> Breach of covenants: Hard/impossible to keep up interest repayment if economic assumptions don’t hold up eg EMI, Terra Firma, Citi drama 

eg Icelandic generic drugmaker Actavis and DB drama

Impact of the economic/financialcrisis on PE Buyouts

Holding period for PE Buyouts is logically trending up

Source: Grant Thornton, Private Equity News

1. Difficult to exit 200X vintage. Longer holding period. Unstable IPO market + trade buyers ‘wait & see’.

2. Operating results correlated to weak economic outlook.

3. High leverage -> renegotiation with banks and leveraged loans investors.

4. Little refinancing debt available. HY market reopened aggressively in early 2010 but HY is expensive and unstable (eg closed since summer 2011).

5. Commodities markets have further impacted operating results. 1 2.5

8

22

37

0

10

20

30

40

2011 2012 2013 2014 2015

Dette LBO en Europe (€bn) par maturité

LBO debt (€bn) by maturity: the liquidity wall

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€67bn Liquidity wall

Current crisisLBO valuations are still high, in an uncertain environment

US mid-capSource: S&P LBO Quarterly Review. Q3 2011.

Europe mid-capSource: European S&P LBO Quarterly Review. Q3 2011.

US Europe

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Current crisis Absence of visibility on macro outlook changes the game

More than ever, seek top management team for portfolio companies.

Use international expansion to seek growth.

Large ‘public-to-privates’ are clearly out of question.

Imperative to create value through operational efficiency only. Leverage

‘kicker’ is gone and need to compensate for high entry prices.

Some large corps are offloading non-core assets to focus on emerging

markets.

Many restructuring, secondary buyout/distressed debt opportunities.

Work on PE PR. 30

Current crisisDisequilibrium between univested capital and

availability of debt financing

Access to debt financing still

compromised, expensive and unstable.

Substantial portion of capital raised by

PE yet to be invested.

Yet still high valuations and

competition between funds for strong

assets.

Weak fundraising outlook given

increasing pressure on LPs (eg Basel III

for banks, Solvency II for insurance

companies).31

Conclusion Outlook for the PE Buyouts industry

Painful but natural/healthy readjustment of the industry following excessive profitability in 2005-07.

Role of new emerging actors : strategics, SWFs.

Increasing regulation: pressure on funds and their LPs.

New type of relationship between PE funds, LPs and managers is emerging.

-> Changing fee structure? (eg Apax has compromised). Longer fund life than 10/12 years?

Lenders to PE have changed. Substantial leveraged debt writedown for some banks so institutional

investors, inc. hedge funds are taking over as top debt providers now -> higher debt prices.

Clear evolution of the PE Buyouts business model: some (major) actors disappear (eg Candover officially

in run off mode), less competition means more opportunities.

Move away from returns creation through financial engineering and more than ever, imperative to focus

on operational improvements for old and new buyouts. Therefore, probably less financiers and more ex

senior corporate executives at the helm of large PE houses.

Careful not to ‘throw the baby out with the bath water’. Basic rationale still very much makes sense.32

Benefit from network’s expertise and credibility

Benefit from full tax relief

Build a diversified portfolio of SME investments

Tax-free capital gainsPremium EP offering

You only ‘lock-in’ what you invest

Access to an attractive asset class

www.entrepreneurspartners.com 33

Your Entrepreneurs Partners

Presentation uploaded on our website: www.entrepreneurspartners.com

Get in touch:nboublil@entrepreneurspartners.com