In for a penny and out for a pound

The sale last week of Eversholt, the railway rolling stock leasing company (Rosco), was rather more than a tale of greed and glory on a dingy side street near Euston station.

The company, named after the thoroughfare on which it is based, on the eastern side of the London terminus, has become notorious for producing lottery-like rewards for a handful of former British Rail managers and staff who invested in the shares.

The pounds 386m profit on the sale, little more than a year after privatisation, also made clear to the world at large - as if we needed to be reminded of it again - that government sell-offs are invariably underpriced.

Something approaching pounds 1bn of profit appears to have been made by the new owners, on a sale price for the three companies of pounds 1.8bn. So far, two of them, Eversholt and Porterbrook, have been disposed of, but there is little doubt that Angel, the third, has also produced a pot of gold for its shareholders.

The original underpricing can easily be explained. The Government rushed the sales timetable for political reasons, the Labour Party spent a year rubbishing the privatisation, and the City talked the price down. It is tempting to say good luck to those who were smart enough to pick a winner under the noses of the transport department and the Treasury.

There was, nevertheless, another side to this story of windfall rewards. It is also a rare glimpse of the techniques used by venture capitalists, who are expert in structuring the finances of the companies they back to make substantial profits for the management and for themselves.

The Roscos have been made out to be high-risk projects that deserve high rewards. But this is hardly an accurate description. Their revenues are essentially guaranteed by contracts with train-operating companies that last until well past the end of the decade. The train-operating companies are, in turn, subsidised by the Government.

Even the risk that some of the franchises will go bust is largely underwritten by the Treasury, which is obliged to make up 80 per cent of the revenues lost by the Roscos in the event of a default by a customer.

With guaranteed cash flows in their early years, the main uncertainty about the value of the Roscos was how much new business would be available after the contracts run out.

The risk was, therefore, not of insolvency if things went wrong but of not making enough profit in the first decade of the next century if managements ran out of ideas. It is hard to describe these investments as great entrepreneurial ventures.Yet they are typical of the projects at which the British venture capitalist industry excels. Management buy- outs of the kind that made the Eversholt directors millionaires are as often as not in mature industries where the skill lies in picking good managers to continue the development of the business.

It would be wrong to devalue that expertise. But it is not quite the same as picking a real winner in a new and fast-growing industry, or putting money behind the next Bill Gates, something most British venture capitalists know little about.

The three Roscos are now worth around 60 per cent more than the Government sold them for. This is not an extravagant increase, given that a raging bull market is capable of producing comparable rewards over a couple of years for an investor in a simple unit trust.

But in the case of the Roscos, the returns have risen to as high as 15,000 per cent for those involved in the privatisation.

This has been achieved by structuring the deals so that the great bulk of the financing is in the form of loans from banks and preference shares bought by institutions. Yet the company is owned by the holders of a tiny pounds 2.5m of ordinary shares, a minute amount of equity on which an enormous financial structure is built.

The entire pounds 386m of profits belongs to these ordinary shareholders. Each pounds 1 invested is now worth pounds 150. This is how Andrew Jukes, the managing director of Eversholt, turned a pounds 110,000 investment into pounds 16.5m. Three other directors of Eversholt made similar 150-fold profits.

Corporate and institutional investors, who bought into the ordinary shares, took a different scale of risk. In addition to ordinary shares, they also bought more than pounds 60m worth of preference shares. They sold out their holdings for just under pounds 330m. This was, in comparison, a modest profit of under six times their total investment.

It is clear the bulk of the risk was borne by institutions, together with the banks that provided the rest of the pounds 580m financing. Yet the deal was structured to bring higher proportionate rewards to private investors.

Among the personal investors in the ordinary shares were executives of Candover and other venture capital firms closely involved in setting up the buy-out.

There are good reasons why venture capitalists should put their own cash into the same projects as their clients. This "coinvestment", as it is called, is routine, and it ensures that the venture capitalists' interests coincide with those of their clients.

It is normal practice to allow the gearing-up of the profits made by the managers involved in buy-outs, who are unlikely to be rich to start with, and so cannot build significant stakes in their companies unaided.

But the Roscos seem to have taken normal practice in the venture capital industry to extremes. Indeed, how do the executives of a company such as Candover justify taking a slice of the ordinary shares, the juiciest bits of the deals, while their clients supply the bulk of the finance for the buy-out in the form of preference shares and loans?

Imro, the investment management regulator, has no detailed rules on how venture capitalists should share out the spoils of their investments. Perhaps it is time for a closer look.