Cards on the table

We have been hearing that venture capital is about to return to the market ever since the credit crunch began. The time has come for it to show us what it’s made of.

In the worlds of corporate finance and venture capital they refer to “vintage years”. 2009, however, will go down as the deals equivalent of the 1860s French grape blight. With literally one or two notable exceptions the best deals done this year have all involved distressed companies, as sellers of profi table companies have sat on their hands while buyers... well, there haven’t really been any, have there?

That’s not quite true. Those with the foresight or good fortune to cash in before the end of 2007, or even during the early part of 2008, have been able to take their pick of non-core business units being put up for sale or assets being sold out of administration. But they needed a compelling reason to make such investments, and even these deals haven’t amounted to more than a trickle.

The rise of pre-pack administrations, under which existing directors retake control of a newly debt-free business overnight, has been controversial but in many cases it seems that when administrators do trade businesses in search of a third party buyer none is forthcoming.

Unless there is an obvious and straightforward management failing or balance sheet issue that can be corrected what canny entrepreneur would risk their hard-earned money on a distressed business right now?

The figures say it all. In the first nine months of 2008, a year we would at the time have described as pretty dire, the total value of buyouts taking place in the UK was £18.5bn. During the same period in 2009, fi gures from the University of Nottingham’s Centre for Management Buyout Research (CMBOR) show, the equivalent total was £4.3bn.

What has been most conspicuous in the deals landscape has been the absence of private equity. Some funds have quietly been carrying out bolt-on acquisitions for existing companies within their portfolios – often on a 100 per cent equity basis – but the classic leveraged buyout has all but disappeared.

While CMBOR fi gures show the total UK value of private equity-backed buyouts in 2007 was £43.4bn and in 2008 was £18.2bn, the fi rst three quarters of 2009 saw a total value of just £3.6bn. Even allowing for the three months’ fi gures for which we are still waiting, and the fact that 2007’s record-shatteringly good performance in terms of value marked the top of a debt-fuelled bubble, this is an astonishing collapse.

The disappearance of bank finance has been a major contributing factor. The private equity model – especially at the upper end of the market – has in recent years involved putting in less than 50 per cent of the sum invested as equity with the rest (often as much as 70 per cent) as debt, on an earnings multiple of around five times EBITDA. Post credit crunch these fi gures shrank considerably.

There is now a consensus among corporate fi nanciers that debt-toequity ratios of 50/50 lent on an earnings multiple of around three times EBITDA are achievable.

That said, we don’t know anyone who is actually doing deals on those terms – the only venture
capitalists we have spoken to who have made any investments this year seem to have been on more like a 25/75 debt/equity split and, in cases such as Zeus Private Equity’s acquisition of Air Energi in August, 100 per cent equity with any bank finance provided as working capital rather than senior debt.

The problem with the banks hasn’t just been the multiples and ratios on which they would lend money, but also the absolute amount available. This took a major knock with the onset of the credit crunch in late August 2007, leading to a period in which those deals that did get done were fi nanced using “club” arrangements – with four banks each putting in £20 million, say, rather than one stumping up £80 million itself.

Post Lehman Brothers and the “credit crisis”, however, even these dried up. Corporate financiers have been telling us for the last six months or more that banks will now provide senior debt for deals, albeit not in great amounts or on terribly attractive terms. They are still saying this. Let’s see whether this has come true yet in another six months’ time.

Another reason for hope that we’ve been hearing a lot is that the VCs are sitting on cash that they have to invest. Many exited the majority of their portfolios at the top of the market in 2006-07 and others have quietly been raising whopping funds. The likes of Blackstone and Carlyle Group, we understand, have literally billions burning holes in their pockets.

But before getting carried away we feel compelled to recall a conversation had a year ago with one of the region’s top bankers. He told us that a lot of private equity houses had been told by their investors that they could sit on their hands until Easter 2009. Now it’s Christmas, and those hands must be feeling pretty numb.

However, it’s unfair to say that nothing has changed. Finance drove the private equity boom and has led to its downfall – but, in a similar way to the housing market pre-crash, vendor expectations about value fuelled by seeing comparable companies sell for ridiculous earnings multiples three years ago have meant that non-forced sellers of decent businesses at an achievable price have been thin on the ground.

But there is, apparently, some evidence of a shift in attitudes. Christian Mayo, partner in the corporate fi nance team at accountancy fi rm KPMG, says, “A lot of private equity houses are under pressure to invest but up to now nobody has been selling. Now, though, people are starting to see that they won’t be able to get a higher multiple by hanging on for two years. The price isn’t going to get better so they might as well sell now if that’s what they want to do.”

Darryl Cooke, head of corporate fi nance at law firm Hill Dickinson and an EN columnist, echoes this sentiment, saying, “A congested pipeline of vendors has been developing, and valuations are becoming a little more sensible.”

Working out what that valuation should actually be has been another stumbling block. With revenues and profi ts in freefall and uncertainty reigning supreme, it would have been a brave venture capitalist who put a value on any business outside booming sectors like energy over the last year or so.

But this could be changing. Dave O’Hare, a director at the Manchester offi ce of Barclays Private Equity – which only did one deal in 2009, the 100 per cent equity bolt-on acquisition of Instone for existing portfolio company ATP – says, “We don’t have a fi rm view on the economy but think there will be more deals in 2010 than 2009. There has been a realignment of values in businesses as owners see no point in waiting for prices to come back because there is no sign of them doing so.

“Importantly we have also seen stability in trading in the last three-to-six months so businesses can actually make confident forecasts and we can make an investment decision – which you couldn’t do when everything was in chaos.”

On the question of whether BPE is feeling any pressure to invest, or to sell, he says, “We aren’t coming under pressure from investors either to invest or to realise. But, that said, it’s always a good idea to return money to investors.”

The story is similar at the independent end of the market. Gary Tipper, who founded Zeus Private Equity in 2007, says, “Banking is still diffi cult but if you have a good business you can still get funding.

“Uncertainty is the biggest impediment. People aren’t confi dent going forward, and we don’t think it will get much better next year – the consumer is going to have a tough 12 months.”

But one reason for VCs to be cheerful could be the return of the stock markets to relative strength in the second half of 2009. If you’re going to buy a company then you want to be able to sell it in future –and stock market flotation has traditionally been one of the favoured exit routes for private equity.

Aziz Ul-haq, director in the corporate finance advisory team at accountants Deloitte, is relatively optimistic about prospects for private equity investment next year. However, he cautions that the ability to exit with an initial public offering shouldn’t be overstated as a factor likely to drive VCs’ investment decisions.

“There hasn’t been a single private equity-backed IPO since 2007,” he points out. “There is some talk of carrying out twin track processes – preparing for a float while also looking for a sale – and there will be some but it won’t be for everyone.

“You have got to be of a certain size and scale, and for an IPO the business needs to have a strong story –a VC can’t just go to the market saying it wants to make a return. Also, just because the VC is exiting that doesn’t mean the other shareholders want to – so it depends on what everyone wants.”

The regional “mid-market” (sub-£500 million buyouts of, usually, mature companies, as opposed to early stage funding) held up the longest as the credit crunch hit and most commentators expect it to be the first to come back – at least at the sub-£100 million level.

However, willing sellers and buyers need to find each other first and, traditionally, both have relied on the corporate finance houses to act as matchmakers.

This could be a fl y in the ointment, as Darryl Cooke points out: “Many of the corporate fi nance houses have moved people from their dealmaking teams into other aspects of their business like restructuring, so there are fewer people out there in the market originating transactions, and the VCs will need to go out and do more prospecting themselves.”

He also says, however, that his firm has “picked up quite a few deals” in the couple of weeks before we speak.

Christian Mayo, probably the most bullish person we spoke to on the subject, says his firm has five private-equity deals in the pipeline including two secondary buyouts (one VC buying from another). But even he is cautious about the long term: “Private equity firms need to churn and there is pent-up supply from entrepreneurs needing to sell, so I think the next six months will be good for private equity – as good as it has been in three or four years.

“But what happens going forward from that is anybody’s guess. As long as the economy stays flat it should be enough for deals to get done but I think the underlying dynamics in the market, once the supply glut works through, will be similar to last year.”

This magazine doesn’t believe in counting chickens before they are hatched but, as more than one
person has said to us, “It couldn’t get any worse, could it?”

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