As Adam Smith observed, ‘in order for markets to set prices and values, two conditions are necessary: willing buyers and sellers, and those same participants’ possessing perfect knowledge.’ Should one side possess more information than the other, then that side has a tremendous advantage. Therefore, the holder of the information can utilise this additional knowledge to extract ‘undeserved profits.’
Although private equity companies would protest that their profits are far from underserved, the very nature of their operations depends on making optimum use of all available information. As a result, the logic follows that the most informed companies are those that possess not necessarily the most information on target acquisitions, but the most relevant.
However, anyone who has knowledge of market theory will also be aware that as more companies look to join the party, prices inevitably rise as a result of increased demand. With HULT PRIVATE CAPITAL potential profit margins being limited due to the sheer number of active players in the sector, the boom time experienced in private equity throughout 2005 is logically expected to be followed by a sharp downturn in 2006 as private equity companies shy away from paying over-inflated prices that do not justify the return on risk. Too many private equity companies are now seemingly possessing similar knowledge leading to no competitive advantage. Deals of the magnitude of SunGard, Hertz, Cadbury Schweppes and Wind, supposedly picked up because of the value that lies behind them, could well become relics of a nostalgic golden age. 2006 may be a more conservative year with fewer bargains to be had.
Yet to write 2006 off already may be slightly myopic. There still remains an opportunity for private equity firms when looking at targets and running existing portfolios to optimise or approach the common knowledge they have at their disposal in a different way.
As with the opaque nature of the private equity world, the potential for profit and acquisition optimism could depend upon the equally (yet perhaps unfairly) enigmatic world of working capital. Identifying the working capital strategies and processes in place at certain target companies and comparing these to what are conceivably ‘best practice’ in the field can prove to be revealing and financially rewarding. With the boom time expected to sharply fade away, private equity groups should quite rightly make their portfolio companies work for every penny to ensure value is delivered. This should be underpinned by a sound knowledge of and in-depth attention to their current working capital strategies and those being used by sector competitors.