The big rewards of risk

THEY wield enormous power in industry, they make spectacular profits and they employ nearly a fifth of private sector workers. The names of venture capitalists such as Charterhouse, CVC and Permira litter the financial pages - and never more so than when they pay themselves hefty dividends.

Yet their secrecy has left many puzzled about how they make their money.

According to the British Venture Capital Association, private equity firms achieved a return of more than 14% a year in the decade to 2004, compared with 6% a year the FTSE All-share index showed.

How do they do it? And can the stock market really be working properly if the performance of some companies can be so rapidly improved under private ownership?

Jonathan Feuer, a partner at CVC Capital Partners, has been involved in several deals where firms have been taken into the private sector, including cycle and car-parts retailer Halfords and department stores firm Debenhams.

Feuer says that far from asset stripping, CVC's ownership put the running of the businesses into sharper focus. Halfords was part of Boots until CVC took it private in August 2002 for £427m.

CVC recruited a management team under former PC World chief David Hamid and ex-Homebase boss Rob Templeman. A new business plan was approved within a month.

Feuer says: 'We gave them the financial incentives to drive the business. We also have a much closer involvement with our companies and their managements and can act quickly.'

At Halfords, this meant new stock, replacing the stock more quickly, adding more space and stronger promotion. For the year to April 2004, pre-tax profits rose from £11.6m to £27.8m on sales of £579m.

Cheap debt has also helped by allowing much of the takeover price to be funded by borrowing. As cashflow improves, the debt is paid off, leaving the owners with equity returns of three or four times their initial investment.

John Cole, a partner at consultancy Ernst & Young, explains that it is similar to buying a house. 'You put down a deposit and finance the rest through a mortgage, and try to make the house worth more by redecorating it or extending. If house prices continue to rise, the value you have added to your house is magnified.'

But the question remains, if a company's performance can be so dramatically improved under private ownership why can that not be done on the stock market where it would benefit a larger number of shareholders?

Jonathan Rowland, managing director of investment bank Citigroup, says that public companies are more conservative in their borrowing. Keith Hamill, who chairs Travelodge, the budget hotels chain backed by Permira, says the markets reward predictable earnings and dividends rather than supporting entrepreneurial behaviour.

In private ownership, companies can pay management much more in the hope of better performance. And they are often well rewarded for their faith.