CVC Capital

Pacific Brands is a classic of the golden era of private equity.

Bought out of the foundering conglomerate Pacific Dunlop for $730 million in 2001, its new private equity owners ripped out $100 million in cash, geared it up with mountains of debt and sold it back to the stock market in early 2004. They banked $1 billion from the public float.

It was a slick operation all round. The privateers from CVC Asia Pacific and Catalyst Investment Managers, and their investment bankers from Macquarie Bank who teed-up the float, slapped together an impressive board of directors. Fat with other peoples' money to spend, the big superfunds bought it with their ears pinned back, even though it had been loaded with debt to the tune of 3.5 times its earnings (before interest, tax and so on).

The success of the deal was not down to paper shuffling alone. The privateers had turned the manufacturer around. They fixed the supply side. They breathed new life into the brands. Blue collar marques such as Chesty Bonds and King Gee turned bogan into chic.

The irony won't be lost on the 1,850 real blue collar types who are losing their jobs to China - in a company which deployed dinkum Aussie multimillionaire Pat Rafter and billionaire Sarah Murdoch to spruik its products.

Golden era

From lawyers to bankers, management consultants to celebrities, private equiteers to company directors, PacBrands executives to independent experts - rich and super-rich alike - fed high on the hog on this old Aussie manufacturer and its employee battlers.

The brutal reality is that it is ten times cheaper to make a singlet or a pair of undies in China than it is in Australia. ''Offshoring'' of jobs is inevitable and PacBrands merely a high-profile case.

The fee-fest, the brand profiles and the magnitude of the job losses has made Pacific Brands a media event.

For the private equiteers, it was a beautiful thing. Almost any business sold in 2004 to 2006 delivered outstanding returns. This was the golden era and PacBrands was the quintessential private equity play - a three-year turnaround and an internal rate of return (IRR) of 141%.

There were plenty of ''three-bangers'' or threefold returns during these years. Think Just Group privatisation and refloat, the float of another Pacific Dunlop business Repco, the float of JB Hi-Fi, the purchase of Bradken from Smorgon Steel followed by its IPO, the privatisation of Ausdoc followed by breakup of the business.

These deals shone thanks to the buoyant economy and multiple expansion, that is, buying an unloved retail business on 4-5x EBITDA, sprucing it up and bringing it back to the share market on a multiple of 8x. As the great bull market progressed, private equity fund IRRs of 65%-plus were won by most of the players.

Insiders say some 40-odd private equity executives are swaggering around Sydney - it is mostly a Sydney game - each on average $20 million richer for the cause.

Just Jeans represented an IRR of 157%. Like JB Hi Fi it was also a winner for shareholders.

Momentum

It is always an interesting exercise to contemplate the economic benefit, or social benefit for that matter, of all this dealing. Now that Eastern suburbs and Palm Beach property prices are coming off the boil, has the money simply gone? The PacBrands jobs have gone, gone to China. The proceeds of the paper shuffling may have gone too, in luxury holidays, renovations and assorted assets now worth less than they once were.

During the golden era, major international private equity firms began to descend on Australia.

KKR and Carlyle Group among others both set up shop. The other trend was a mushrooming of domestic private equity managers. The superannuation industry was a buyer, a big supporter and most super funds have exposure to private equity funds.

Most rushed to allocate more of their funds under management to the sector as the boom was in full swing, and soon to end.

There is a natural tendency also for private equity managers to increase the size of the fund with each consecutive raising - hence the funds raised in 2006 tended to be about double the size of the preceding raisings in, say, 2002. The latter though was the ''vintage'' to enjoy, rather than the former. Anything bought in 2006 is likely to be a failure thanks to the downturn.

It is strange that super funds themselves were, until recently, not permitted to gear their investments at a super fund level, but there were no restrictions on investing in private equity funds whose outstanding IRRs were reliant on extreme levels of gearing.

Past the peak

With so much money sloshing around the private equity space from 2006 onwards, and with asset prices inflated by the bull market, there was no way that 2006 and 2007 vintage funds could ever compete with the returns achieved by the 2002 vintage.

For example, vendors of retail businesses that would have changed hands at 4-5 times EBITDA in 2002 now wanted to be paid 8-9x EBITDA to sell. A quick look at the history of retail IPOs over the past 20 years shows that it is a rare business that can command a valuation of more than 7x EBITDA on IPO.

Private equity funds then which stumped up close to 9x EBITDA to purchase retail businesses in 2006 and 2007, and plenty of them did, were punting on being able to grow earnings fast enough to achieve an acceptable return despite there being little prospect for multiple expansion.

Moreover, they were gambling that multiples would hover at historically high levels for at least long enough for an exit to be achieved - say, three years.

Even then an IRR of more than 20 - 25% would be a hard-ask - a long way short of the stellar returns achieved by the previous generation of private equity assets. It seems reckless in retrospect, but then again the money was flowing into the funds, and the privateers get paid for that too.

Bad bets

We now know that neither of these requirements for investment success has held true. As a consequence, private equity in Australia is littered with assets that appear bent on losing money for their investors. Uncomfortable discussions between the lending banks and private equity managers over covenant breaches (ANZ and the Bank of Scotland were the two biggest lenders to private equity) are the order of the day.

There is also the prospect that most of the private equity managers in Australia are currently managing their last fund as the investors have been so badly burned that they will be loath to invest again.

The carnage in the sector has also left managers sitting on their hands, reluctant to draw down funds even if the funding has technically been committed by the fund investors as they know that investors have lost confidence in private equity. This is resulting in roll-up strategies being left in the lurch at just the time when there is value in the market again.

Which assets are in the worst shape? Anecdotally, it would seem the following rules apply: anything in retail is a dog, anything in NZ too, anything in mining services and anything exposed to the high-end consumer.

Retail - Australian Discount Retail has gone belly up for Catalyst and Champ. Gresham has Witchery and Mimco (no wonder Wesfarmers recently wrote down its stake in Gresham private equity), Ironbridge has BBQ Galore (the US arm of which is in administration) and Super A-mart. Archer Capital has Rebel Sport and Amart Allsports. Affinity has Colorado. TPG has Myer, Goldman has Kathmandu and PEP and CCMP bought Godfreys.

New Zealand - Catalyst has Metro Glasstech, Ironbridge has Envirowaste, Mediaworks and Base Backpackers.

Mining Services: There were a few exits here which suggest the PE investors got out just in time. Emeco for one. It was at least a 3x return for the privateers but its share price today is a fraction of its IPO price.

Getting it wrong

In other cases, private equity was left holding the baby.

In a game of pass the parcel between private equity firms, Catalyst bought Valley Longwall (a provider of specialist underground coal mining equipment) from Crescent Capital in 2007 - delivering Crescent 5.7x its original investment and an IRR of 300%. In the present market Catalyst is no hope of replicating that return, if anything.

High-end consumer - Riviera for Ironbridge is the standout here.

How did the private equity industry get it so wrong? Its practitioners are generally held to be as savvy as any in the finance world.

The industry incentive structures explain a lot. Most mid-cap funds pay 2% of committed capital to the management team as a management fee, together with 20% of any return achieved a benchmark annual return of 8% - a performance fee known in the industry as "carry".

For mid-cap funds of up to $500 million, the management team won't be making more than a good professional wage on the basis of the base fee alone. It is only if they earn "carry" that there are big dollars to be made. This structure encourages the manager (usually a team of about six people for a typical mid-cap fund) to "roll the dice", knowing that the payoff for success can be a carry cheque of tens of millions of dollars to divide among the team. The risk on the downside is that the manager does not get to manage another fund and members of the team find themselves looking a job. Assuming they were about during the golden era, they would hardly be queuing with a token at the local Centrelink.

Besides those privateers who didn't spend their winnings, the other beneficiaries of the boom were shareholders in listed companies which were taken over by private equity at a premium that was never justified.

Then there are the owners of private businesses that were purchased at prices that they could never otherwise have achieved - and of course, professional hangers-on such as investment bankers, lawyers and accountants. The frenzy threw up perhaps a billion in fees.

mwest@fairfax.com.au

Fletcher Building will not buy all the Carter Holt Harvey assets put on the block by billionaire Graeme Hart, but might acquire small parts of the businesses.  Speaking after yesterday's annual meeting in Auckland, Fletcher chief executive Jonathan Ling said the building materials manufacturer and distributor would not make any big acquisitions within the next three months.

Mr Hart is selling building product makers and marketers Wood Products New Zealand and Wood Products Australia, the Carters building materials chain, and furniture and joinery business Interion.  Fletcher Building. advised by investment bank Goldman Sachs JBWere, is understood to have looked at these businesses.  However, Carter Holt owner Rank wants to complete any sale, which analysts expect to be about $2 billion, by the end of the year.

Asked about the potential for big acquisitions, Mr Ling said: "There's nothing of any size in the pipeline at the moment."  Asked specifically about the Carter Holt asset sale, he declined to comment, citing confidentiality obligations.  It is understood Fletcher could buy small parts of the businesses, possibly as part of a consortium.  However, international private equity group CVC Capital Partners is believed to be the frontrunner to acquire the Carter Holt assets. 

Mr Ling said Fletcher's current focus was integrating July's US$700 million (NZ$929 million) acquisition of benchtop group Formica from private equity groups Cerberus Capital Management and Oaktree Capital Management.  Mr Ling said the planned closure of a Formica factory in California and the doubling of production at an Ohio factory were running behind schedule.

Fletcher will pay Cerberus and Oaktree a further US$50 million if this restructuring is finished by June 30. Mr Ling said delays would affect this payment but, citing confidentiality agreements, he declined to say how.

Formica's Asian and European operations, which comprise about two-thirds of its business, were performing better than expected, helping to offset the slowing United States economy, he said.  Predicted savings from combining Formica with Fletcher's Laminex business, about $13 million in 2007-08, were on track.

Chairman Roderick Deane said Fletcher's net earnings for the first four months of 2007-08 were ahead of the same stage last year both with and without the inclusion of Formica.

Fletcher was "comfortable" with analysts' forecasts for annual earnings after tax and before unusual items of between $450 million and $460 million.  After removing one-off tax and insurance benefits, last year's profit rose 5 per cent to $399 million. At more than $1 billion, Fletcher's construction backlog was at record levels, Mr Ling said.

Fletcher shares rose 12 cents to $11.30 yesterday.

Fletcher Building is teaming up with Australian rival Boral to bid for Carter Holt Harvey's Wood Products, Carters and Interion businesses being sold by billionaire Graeme Hart in what is expected to be a $2 billion plus deal.

Indicative offers for the Carter Holt assets were due last week. Market sources said yesterday that the Fletcher-Boral combination was facing its main competition from international private equity fund CVC Capital Partners.

Mr Hart is selling wood-based building items manufacturer and marketer Wood Products New Zealand, which has 12 manufacturing sites, Wood Products Australia, which has six, New Zealand's Carters building materials chain and Interion, which markets and sells furniture, joinery and construction products. Combined, these assets are forecasting 2008 earnings before interest, tax, depreciation and amortisation of about $300 million.

Sources suggested that, if successful, Fletcher and Boral planned for the Kiwi firm to take the bulk of the New Zealand assets and Boral to pick up those in Australia. Mr Hart's Rank Group has told Carter Holt staff it wants to complete a sale by the end of the year.

Boral is Australia's biggest building and construction materials supplier and also has operations in the United States and Asia. Kylie FitzGerald, Boral's general manager of corporate affairs and investor relations, declined to comment on "market speculation".

Fletcher chief executive Jonathan Ling said he could not comment "at the moment".

Staff at CVC's Sydney office did not respond to requests for comment. CVC's history in the trans-Tasman building industry includes ownership of laminates and panels business Laminex and insulation, concrete and roofing group Amatek. Ironically, it sold both to Fletcher - Laminex for $754 million in 2002 and Amatek for $582 million - in 2005.

It was unclear whether Rank had received further offers. US forestry group Weyerhaeuser, which sold half of a 67,000-hectare Nelson forestry plantation to partner and fellow US firm Global Forest Partners in June, is touted as a potential bidder. Tasmania forest products group Gunns, which owns a veneer factory in Christchurch, is also a possible bidder. Gunns declined to comment.

Fletcher completed the $1 billion acquisition of US-based benchtop group Formica on July 2, issuing $328 million of new shares to help pay for the deal. It might issue shares to help fund another big buy.

Tower equities fund manager Paul Robertshawe said Fletcher should easily be able to convince investors of the merits of buying Carter Holt assets. Fletcher had a good five-year track record, had not overpaid for previous acquisitions and its finances, with gearing, or debt-to-equity, of 46 per cent were not stretched. "If they come to us with a deal that makes sense I don't think shareholders would be upset about the timing," Mr Robertshawe said.

However, a Fletcher purchase would need Commerce Commission approval as its businesses have significant crossover with Carter Holt, notably PlaceMakers and Carters. Since completing the $3.3 billion acquisition of Carter Holt in March 2006, Mr Hart has already recouped about $1.9 billion.

Private equity firm Bain has pulled out of the consortium looking at buying Australia's Coles Group, a source familiar with the matter said.

Coles' advisers have been told Bain was withdrawing, the source said. The source said there was no official word about the position of Blackstone Group, which is also reported to be considering withdrawing from the group.

The size of the group had shrunk to four after Kohlberg Kravis Roberts and CVC pulled out earlier this week, boosting the chances of a rival bid by conglomerate Wesfarmers.

The remaining partners in the private equity consortium are Texas Pacific Group (TPG) and Carlyle Group.

The City's new breed of wheeler-dealers, it is claimed, demoralise and devastate every company they buy - the AA among them. Danny Fortson spent a day on the road with the 'fourth emergency service' to see if that reputation can be rescued

As on most mornings, Vincent Rodriguez, a patrolman for the AA, was assigned last Tuesday to the London "posh patrol" starting out in Victoria. When the day's first call lit up his on-board computer at 6.58am, he had already been scouring the streets for an hour, on call for members of the UK's biggest auto club.

The dashboard console gives the vitals: Lots Road. Green Nissan. Won't Start.

As he wends his way through the deserted streets of Chelsea - with The Independent on Sunday in tow (thankfully, not literally) - it is rather less dramatic than the auto club's commercials, where patrol men and women appear from hillsides and glens to come together in an impromptu chorus singing "You've got a friend".

In a few minutes, he comes upon the stricken Figaro coupé parked at the roadside and its young female driver. The problem is, after a few cursory checks, quickly apparent: she forgot to put the automatic car in "park".

Vincent gently informs her of the problem. She chuckles meekly, signs a few papers, and just like that the job is done - another satisfied customer of the UK's so-called fourth emergency service.

Before she has even turned the corner, Vincent is punching a code into the computer to request the next job. By that time, the AA has already answered 3,315 roadside-assistance calls throughout the UK - well on the way towards the daily average of around 10,000.

But on this morning after the Easter bank holiday, there is no response to Vincent's request. So it's off to Starbucks.

As we sip coffees in the yellow van, the streets are eerily still. Watching the occasional jogger or dog-walker pass by amid the beeps and bleeps of the onboard computer, a couple of minutes turn into an hour, and Vincent reveals a few insights that he has gleaned on the job.

On dead batteries: "The husband blames the wife, the wife blames the kids."

On differences between the sexes - especially where stricken vehicles are being pulled on a towpole and the motorist has to steer in the same direction as the rescue van: "Women are the best to tow as they read the instructions. Men assume they know what they are doing and end up making the most mistakes."

On motors: "You buy a German car if you want something flashy. Get a Honda if you want something reliable."

It is a bubble of early-morning serenity, and it could not feel further removed from the firestorm that has raged over the AA in the past two and a half years. In 2004, private equity firms CVC and Permira bought the company for £1.75bn from its previous owner, Centrica.

Since then, it has been held up by unions as Exhibit A for everything that is wrong with private equity. These firms, claim trade unions, buy companies and then strip the assets with little regard for workers or customers. And then they sell them on for huge profits.

Long before the public furore over private equity erupted in the wake of the failed takeover of J Sainsbury earlier this year, the AA was the unions' cause célèbre. Nowhere is the clash between the two sides more emotionally charged.

It is not hard to understand why. Soon after the 2004 takeover, new management led by chief executive Tim Parker instituted a restructuring. As a result of redundancies and the disposal or closure of AA businesses such as garages and tyre-replacement services, 3,400 jobs were eliminated. The GMB union, which had represented the company's workers since the 1980s, was marginalised. In its place came the AADU, the group's newly recognised union which was set up by former GMB officers and took most of that union's members with it.

The GMB claims the AADU was welcomed by its private equity owners because it was weaker, making it easier for them to "bully and harangue" employees into longer hours and worse conditions.

Meanwhile, CVC and Permira loaded the company with debt and paid themselves a £500m special dividend.

However, some three years on, profits have nearly doubled and turnover has increased. An aggressive marketing campaign, including the "You've got a friend" commercials, has succeeded in increasing membership.

But the AA did recently lose its position as preferred breakdown service to rival RAC, as ranked by researcher JD Power. The GMB says this is further evidence of the company's decline.

Indeed, since the takeover, a very public and vicious debate has raged about the AA, with both sides rolling out wildly diverging numbers to back their arguments. At times, it is as if they are speaking of different companies. The GMB, for example, says that 1,400 patrols have been eliminated; the AA says there are only 600 less than before the takeover. The GMB says waiting times have increased; the AA says they are slightly less. The GMB claims it represents around a third of the company's 7,200 workers; the AADU says it only has a handful on its rolls and thus its claims, motivated by bitterness at losing hundreds of thousands of pounds in union fees, should be summarily dismissed as "complete rubbish".

Rumours bubble up regularly about CVC and Permira looking to float the company or sell it for as much as £3.5bn. Finance director Paul Woolf said, however, that the company does not plan to look at such options until next year. But what will the next owner, or the stock market get - a hollowed-out husk of its former self, or a leaner, more efficient group thanks to a much- needed dose of tough love from its private equity backers?

The AA earnt £251m on £794m in turnover last year. Those numbers are up on the £129m profit and £742m in turnover delivered before the 2004 takeover.

The view of the GMB is decidedly different. Paul Maloney, the GMB national secretary who has led the union's campaign against private equity, says: "They have got 1,400 patrols less than when they bought it, but they have a bigger customer base. Members are having to wait longer and pay more for services. The AA is a failing company. Despite the best efforts of its staff, that's what it is."

In an effort to tell its side of the story, the company invited The Independent on Sunday to ride with a typical patrol to get a better sense of how things truly are at the company. To avoid accusations that the AA had hand-picked a patrolman to represent the firm, it was agreed that the AADU should select the driver.

The early-morning Starbucks reverie is interrupted by the next call: Brompton Road, Seat Ibiza, Black. Won't start. Vincent Rod- riguez puts his now-empty latte in the cup holder and is off to help another of the group's 15 million members. This time it's a dead battery. He attaches jumper cables from a suitcase-sized charger, and waits as the contraption breathes life back into the battery.

He has been at the AA for five years. A former GMB member and current AADU member, Vincent is an earnest employee who clearly loves his job. He paints the changes that have swept through the company as a necessary house-cleaning. "Hand on heart, I think that most of the [workers made redundant] couldn't be bothered. You have two types of people, the 'can't dos' and the 'won't dos'. The patrols that moan are the ones that preferred the old ways, where they could sit in the caff all day drinking tea. I don't understand all the screaming and crying. Now people are having to earn their wage, and that's what I tell the lads," he says.

On this day, Vincent has a light load. But he admits that generally he works harder.

"Those old eight-hour shifts used to take for ever. But in the last 18 months we have been so busy. Now it is job after job after job. I just get on with it. It is more financially rewarding now. There is more opportunity for bonuses."

One way to hit bonuses is to try to recruit new members to the rescue service. Patrolmen are encouraged to spend down-time between jobs in petrol station forecourts or supermarket car parks pitching memberships to passers-by.

Vincent says cold-selling isn't his strong point, but he has caught on. "I picked up on it pretty fast."

It is little surprise that the AADU chose him to represent the company: he is extremely dedicated. A trainer of fellow patrolmen, he tells his team of 55 workers that they can call him any day, holiday or not, from 6 am to midnight on the mobile if they ever have any questions.

Paul Maloney at the GMB describes Vincent as a "stooge" and alleges that inviting along a journalist to shadow a member of the AADU on a traditionally slow day is part of an elaborate ruse to craft a falsely positive image of the AA.

"They set you up with an AADU stooge patrol on a cushy day to show that everything was relaxed. We don't believe in fiction," he comments.

Whatever the truth may be, CVC and Permira are in line to trouser what will surely be a massive profit when they decide to unload the business. That is based purely on the willingness of a buyer, or the public markets, to value the company at more than what it was worth before.  For now, that is exactly what seems likely will happen.