Buy-outs and the credit crunch
Article Date: Dec 12 2007There have been more than 600 private equity buy-outs each year in the UK since 2000, with the number of transactions and their values increasing annually. And 2007 was storming its way to yet another record until the collapse of the US sub-prime loan market pulled everyone up short, writes David McClelland, director of acquisition finance at Bank of Ireland.
During the first half of the year, it would have been a brave man who predicted when or how the brakes would be applied to what appeared to be an unstoppable bull market. Every buy-out in the UK was matched by at least as many across continental Europe and while private equity found itself in the headlines as its potential impact on the economy brought it under political scrutiny, this was no deterrent for those sucked into the feeding frenzy.
The ability of private equity bosses to use offshore tax structures to shelter their impressive buy-out earnings and the potential risks to the economy from the increasingly high levels of leverage have been identified as indications that the bubble was about to burst.
CDO funds
But while many suspected the market was approaching its zenith, few predicted the catalyst for the crash. US sub-prime housing loans together with collaterised debt obligations (CDOs) loaded with unidentifiable debt reared their ugly heads and suddenly the credit crunch was on.
The City’s response was rapid: CDO funds are now closed to business and the banks have reverted to type, reiterating their mantra of caution and moderation. That’s not to say, however, that the buy-out market has had its day. On the contrary, corporate earnings in the UK have continued to be strong and buy-outs that target robust earning streams continue apace.
For example, it’s hard to envisage that earnings might collapse at NCP – surely car parking will always be in demand. While of the smaller deals, Sovereign Capital’s investment in DC Group, a well-established gas maintenance provider, would seem to offer rock-steady earnings.
Deal stream
And of course I have confidence in our own Bank of Ireland deals, such as Electra’s £80 million buy-out of industrial fans manufacturer Nuaire, or Englefield’s £60 million buy-out of IT training business QA-IQ.
On the other hand, let’s be thankful that the market stalled before Qantas became fit for leverage; the point being that some businesses will continue to generate cash even in a downturn – and therefore be attractive buy-out targets – while others are less well-equipped to weather the storm.
A sector that did feature strongly in the first half of 2007 was retail, with deals such as Fat Face, Threshers, Jimmy Choo and Phase Eight. It will be interesting to follow the future fortunes of such well-known names as the credit squeeze tightens. The consumer is suddenly a threatened species and it’s possible that highly geared retail buy-outs like these will become vulnerable.
Smooth exit
One reason for the market’s enthusiasm in the early part of the year was the impressive returns being achieved on buy-out exits. Bridgepoint et al achieved a £116 million initial public offering (IPO) of consumer products business Norcros; Lyceum Capital sold Clinovia, a leading home healthcare provider, to BUPA for £88 million; and NBGI’s Superglass IPO at £135 million returned more than ten times its investment.
But if banks tighten lending, private equity investors will not be willing to put up as much money for deals and the number of deals will fall. It’s safe to say that there will be no more ‘jumbo’ deals for a while, and uncertainty clouds all decision making. Share prices in the banking sector have fallen and reflect continuing concerns that we don’t yet know how imprudent individual banks have been. Now many banks are caught with loans they failed to spread in time and no-one wants the syndication risk. So where do we go from here?
It is a great time to invest in smaller businesses, with plenty of solid banks still willing to back attractive buy-outs. Further, with Government and large enterprises continuing the trend of outsourcing non-core business functions, suppliers of these functions offer great buy-out potential and statistics confirm that the support services sector continues to be the single most active sector for UK buy-outs.
Software and IT services have seen a number of successful deals in 2007, after a spell when the sector seemed to lack activity. Healthcare, too, is attracting investment as it is recognised that governments cannot meet all needs, while the leisure sector is always a relatively safe bet as people buy the food and drink which drives them into healthcare.
Syndication slowdown
Perhaps the most difficult buy-out arena at present is the mid-market, in which syndication was formerly easy. Buy-outs here are taking longer, but will, with patience, come to fruition.
A friend was working on a deal recently with five lead banks where each was required to commit a significant sum before the deal could be concluded. Such developments mean more work as everyone takes a more cautionary approach to measuring their appetite for risk. That said, this approach ensures that only the better businesses become buy-out targets.
It’s possible that we can expect a flurry of buy-out activity ahead of the withdrawal of taper relief in April 2008 as its demise will effectively result in an increase in capital gains tax for many potential vendors from ten per cent to 18 per cent. Certainly, many will want to sell before the April 2008 cut-off date and some quality businesses are bound to become available, but if I were to be cynical, I’d predict that some less scrupulous buyers will price chip by marginally less than eight per cent just before the deadline.
The buy-out market over the past 12 months has changed considerably. It’s been in the public eye, generated wonderful successes and high returns, and come unstuck in a global banking crisis. There have been casualties, but the market has surely learned from its experiences, and those who have survived the challenges will emerge stronger.
Good quality businesses will continue to attract buy-out activity, so as we move forward into 2008, we can expect investors to be more adept – and vigilant – at sifting the wheat from the chaff, resulting in higher quality deals focusing on businesses that can demonstrate strong earning streams and exciting growth potential.
Click here to read more views on how the credit squeeze might affect the buy-out market.
