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With many companies sporting valuations well below their 'true worth', there is now lots of cheap cash readily available for management buy-outs and buy-ins. If you spot the right target early, you can turn a handsome profit. Christopher Spink outlines his strategy for success

After years of doubt and fear, there is now a very different atmosphere developing in the market, which some claim is proof that events really are on the turn.

The bulk of the evidence for this is the recent spate of bids by management to take their companies private.

22 of these transactions were completed in 2002, according to the Centre for Management Buy-out Research at the University of Nottingham. Four were completed in the first quarter but in the first half of April, no less than a dozen companies announced that they were exploring the possibility of going private via buy-out deals backed by private equity syndicates.

This recent flood is no real surprise. Many chief executives have been complaining for a long time that their company's share price was failing to reflect the true value and potential of their businesses. So, supported by venture capitalists awash with cash to back such deals, they have been putting their money where their mouths are and bidding for the company.

These bids are usually at healthy premiums to the prevailing share price, which presents opportunistic investors with a wonderful chance to turn a profit.

Likely Candidates

Prime candidates are businesses whose customers are principally consumers, such as companies running hotel, catering and leisure facilities as well as retailers. Iain Daly, an analyst with Charles Stanley, says financiers like the fact that these businesses 'all produce strong cashflow'.

Deals can be arranged relatively easily on the security of this steady flow of cash into the business from many sources.

By contrast, companies such as set-top box maker Pace Micro, whose share price has fallen more than two-thirds over the past year, would have problems attracting financial backing for a buy-out, because it only has five customers, all broadcasters.

If one of these major customers was to cancel its orders then Pace's business would be drastically affected and its cashflow would be reduced quite severely, restricting its ability to service any debt taken on by the buy-out deal.

As well as having an ambitious management and a business producing strong cashflow, other good ingredients for a likely buy-out are the executive team holding a reasonable stake in the company and the balance sheet being in decent shape, with plenty of liquid assets.

This will allow a deal to go through more easily, since the management already has a large interest in the company and increasing the gearing will not hamper the group's position too greatly.

Charles Stanley's Daly says 'the key to spotting a possible management buy-out is to find a company whose trading performance has been OK but whose share price has cratered.'

A company should also be trading at a significant discount to net assets, so that financiers have some security when backing a buy-out.

Andy Yeo, head of research at Evolution Beeson Gregory, explains that venture capitalists expect these deals to be split ten-to-one between debt and equity. If a company already has lots of debts it is unlikely to be able to take on much more to finance a buy-out.

Potential rewards

Spotting potential deals before they happen can prove very beneficial.

A buy-out waiting to happen usually involves a business that has fallen in value substantially since flotation.

Undoubtedly there are risks in following this investment strategy. If management wants to conduct a buy-out, this plan will be kept top secret until it is unveiled. You must be prepared to sit and wait until this happens.

In the meantime, you will have little control over the process and the share price may not recover if the deal does not transpire. However, by choosing undervalued companies that have fundamentally sound operations, you can reduce your risk exposure.

Po Na Na

Nightclub operator Po Na Na has endured a tough year or so, principally caused by the difficulties it encounted getting rid of its unbranded clubs. These 15 outlets have had trading problems during this uncertain period.

This meant that the group made a £233,000 interim loss against a £688,000 pre-tax profit last time as sales fell seven per cent to £16 million. However, the core business continues to produce steadily growing profits. During the same period it made a £697,000 profit.

Between them, the management, led by founder Christian Arden, own nearly a third of the shares and must be tempted to take the group private — particularly as tangible net assets stand at £9.6 million, against a market value of just £2.3 million. Gearing is a relatively modest 61 per cent.

Po Na Na's share price sits at a 52-week low of 8p, down 89 per cent over the year and 95 per cent off the 175p post-float price of 2000. Most of the underperforming sites have now been sold, making Po Na Na a prime candidate to go private, freshly stripped of its non-core clubs.

The remaining business managed to sustain trading over the vital Christmas period at similar levels to the previous year, despite the current tough environment. If this proves to be the case for the full-year to the end of March, then earnings per share should come in at 9p or so for this division, putting the continuing business on a p/e ratio of less than one!

Chorion

Almost a year ago Chorion was demerged from its bar-nightclub division Urbium. This left the group with reduced debts and the rights to various literary properties. The principal ones are the estates of all-time best-selling crime novelist Agatha Christie, prolific French detective author Georges Simenon and ever-popular children's writer Enid Blyton, who created Noddy and the Famous Five amongst other characters.

However, the depressed media environment has not helped the sales of licences of these rights to broadcasters. Consequently, the shares have fallen 71 per cent to just 3.63p, valuing the entire company at less than £20 million. But the group has used this fallow period to lay foundations for future progress in the estate and it should not take much to revive the fortunes of these famous creations.

For instance, analyst Adrian Kearsey of Evolution Beeson Gregory says merely changing the covers on some of the books has increased sales of these items by 25 per cent. Furthermore, four million Agatha Christie novels were sold last year. This shows that there is financial life yet in these supposedly stale tales. The underlying assets of the company, which Evolution Beeson Gregory values at £50 million minimum or 9.6p per share, should attract offers in the long run.

Engineering a buy-out may take some time, but the group produces sales, even in a bad year, of at least £9 million and remains profitable. One possible rainmaker is former executive chairman Nick Tamblyn who resigned in December, after fighting off a bid for the whole group from Entertainment Rights. He may be keen on bidding for the Enid Blyton business.

Ted Baker

Most retailers have enjoyed a reasonable year, despite fears that the retail consumer boom might be drawing to a close because of wider economic gloom and war sentiment. Clothing specialist Ted Baker, which also sells a third of its stock wholesale to other outlets, is no exception.

In the year to this January the group reported a 13.8 per cent rise in profits before tax (and a £1.6 million one-off charge) £11 million on turnover ahead 13 per cent to £70.2 million. During this period, the group opened its largest store yet, which has 7,500 sq ft of retail space in Covent Garden. Expansion into the US, airports and other overseas outlets continues.

Despite this progress Ted Baker's shares trade at just above 200p, which is substantially below the 500p mark they changed hands for three years ago. At this level they trade on a prospective p/e of just ten and offer a dividend yield above four per cent, which is better than the base interest rate.

Chief executive Ray Kelvin retains a 45 per cent stake in the group and might fancy using some of his healthy dividend payments, which amounted to £1.62 million last year, to take the group private, especially if the share price remains at this level. After all, he would still be able to pay himself a decent income and grow the business from its own cashflow, which rose to £13.6 million last year.