Investors: the catches for small firms

There are signs that the number of smaller quoted engineering companies going into private ownership may be starting to slow down. This is partly because the City has started to wake up to the value of small capitalisation companies, but it still leaves a problem for firms seeking capital to grow. Over the past few […]

There are signs that the number of smaller quoted engineering companies going into private ownership may be starting to slow down. This is partly because the City has started to wake up to the value of small capitalisation companies, but it still leaves a problem for firms seeking capital to grow.

Over the past few years, the stock market has not been the friendliest place for small engineering companies. Share prices fell and, until recently, stayed low. An increasing number looked for a way out, often through management buy-out deals, or were bought by larger UK or US-based companies.

However, this summer, smaller stocks have started to outperform blue-chip firms. This is good news for directors with share options and for company morale in general, but it also makes the company more expensive for possible investors.

Sukhbinder Heer, a corporate finance partner at Robson Rhodes, says: `Smaller companies are now less attractive for venture capital companies. We are seeing the tail end of the public-to-private deals.’

Small engineering companies still need to attract new investors if they are to flourish, he adds. `The whole point of being in the City is to issue paper in order to get funds to grow. If companies cannot do that, they will begin to wither away.’

Three possible sources for that investment are private investors, borrowing, and a new form of venture capital.

The private investors, which companies really want to find, tend to be ex-directors who may have resigned, been pushed out, or worked for companies that have been taken over.

Not all are at retirement age, and many have accumulated enough wealth to have a significant effect on a fledgling engineering company. As well as needing money, they will often have enough experience to advise or join the board.

The second possible source of investment is borrowing. Interest rates may have been raised last week, but they remain historically low, so raising finance is relatively inexpensive.

Andrew Raca, corporate finance partner at Arthur Andersen, says: `The first thing companies borrow against is their property, then stock, then work in progress and then debtors. If a company has a blue-chip client base then it can borrow against that.

`And if it is generating cash, that should help it put its case to a potential investor. Most lenders look for interest cover (that is, profits divided by interest) of between three and four.’

However, borrowing also has its drawbacks. A company that is excessively geared looks like it is in trouble. Any reduction in profits or further increase in the base rate could leave it looking over-exposed. And borrowing is generally more expensive than selling equity.

Some companies have raised capital by issuing convertible loan stock – a loan that can be converted to equity in the future. But this is not really an option for smaller listed companies, according to Raca.

`Existing shareholders don’t really like it, because it means their shareholding might become diluted,’ he says. `And investors who lend generally don’t want equity in a company anyway.’

Venture capitalists’ role

The third source of funding is the venture capital firm. According to Heer, there is still a role for them, even if they are less willing to participate in big management buy-outs.

`Venture capital companies still have a great deal of cash to invest,’ he says. `They could inject money to acquire a percentage, or they may lend development capital. However, they will not be able to dictate terms in the same way as they could in a private deal.’

Venture capital firms such as 3i and CinVen will not just be investing out of charity, of course. `They are looking for a balance between investment, an element of control and ease of exit,’ says Heer.

`I think they would be looking at a 20-30% stake. This would give them some sort of influence, and perhaps a seat on the board.’

A minority stake would give the investor less power than in a management buy-out or complete takeover. But industrial companies are regarded as being more sophisticated now than they were five years ago, and perhaps less in need of guidance.

While there are no examples yet of these hybrid deals among the smaller companies, US buy-out firm Kohlberg Kravis Roberts has taken a 5% share in TI Group, and KKR’s Henry Kravis sits on TI’s board of directors. So far, Kravis has not said that he has any intention of launching a complete takeover of TI.

Ultimately, though, venture capital companies invest to make money rather than manufacture goods, and the time will come when they want out. Selling a large share of a company can be tricky, especially if it makes the market think the company is in trouble.

`The problem they have is how to get out,’ says Heer. `It’s an area they are still looking at.’

Once the issues of investment, control and exit have been sorted out, Heer believes that deals of this nature are likely to become common. `It’s something all the larger venture capital companies are about to do, or are thinking about doing,’ he says.

Copyright: Centaur Communications Limited