Most accountant firms agree that much of the year has been a challenging time for completing private equity deals. It’s not so much that the deal flow has dried up, but the challenge has been completing transactions regardless of the time scale. “The position in the last 18 months has been very different from the late 1990s when lots of PE houses were making money from arbitraging the market,” says Oliver Tant, head of private equity at KPMG. “I can think of some deals that have taken two years to complete and some that have taken two years and not completed.”
A large number of variables are at play that appear to have stalled the number of deal-completion levels this year. Vendors want the best price they can get and so do buyers. With that apparent standoff deal completions are experiencing softer levels with the pricing gap remaining seemingly inflexible.
Simon Hawes, head of the business services sector at PricewaterhouseCoopers in London, said his team completed a deal for Electra Partners in August for a distribution company called PWG, which took 12 months. “I thought that was a long time to complete a deal,” he says. “There’s a lot of caution in the market.” Hawes adds that in the first half of the year there has been a wide gap between vendor and buyer expectations. Lately, that gap seems to be closing.
Not only has the pricing gap been a cause for deal delay, PE players are generally much more cautious and are demanding deeper levels of due diligence, on a wider range of issues. Also, many accounting firms have also voiced a lack of larger deals for much of the year, but that could be changing. While the first half of the year has been quiet, Neil Patey, head of UK private equity at Ernst & Young, has noticed more activity in September, particularly in public-to-private deals.
“Larger deals, of GBP250 million plus, were suffering in the first half of the year but now they are coming back, while there appears to be a drop-off of the smaller deals,” he says. One of the reasons for this has been that corporates weathering the storm have started to shed non-core businesses to raise much-needed cash. The main trends seem to be in industrial (engineering), consumer products and distressed sales of some telecoms companies.
Due diligence and sector focus
The greater demand for a broad range of due diligence into a company, which might cover financial, commercial and IT, for example, should not be mistaken for turning over every single stone. “The issue here isn’t breadth, its depth,” said Tant. “The goal is to work out a value at any given time.” What should be focused on are the real opportunities and real risks of a business, not every minute detail. “My advice is that people need to make a decision on the risk spectrum and apply the level of due diligence in relation to this risk,” he added.
“In the past, due diligence was maybe a snap shot in time and did not take that much sector analysis into account,” said Patey. Add-ons are now provided which might cover pensions, IT and operational synergy due diligence, he explains. “We’ve moved now to more transaction support.”
What the increased level of due diligence really boils down to is a thorough understanding of the business in question, and the sector in which it operates. This focus on sector knowledge appears to be more acute than ever. “If you understand your sector and you’ve spoken to all the CEOs in it, you’ll be able to piece together opportunities for M&A,” says Martin Kitkat, corporate finance partner at Deloitte & Touche. “Driving origination down industry lines is the way forward. It can’t be done with a desktop approach.”
“Deal flow comes from sector knowledge,” says Hawes. But some accounting firms are finding they are not alone in providing this knowledge. “A number of PE houses realise they need deep sector knowledge themselves, and more are developing dedicated teams,” he adds. Sector knowledge obviously works at both ends of the PE cycle. Hawes explains that his team’s knowledge of the facilities management (FM) sector, for example, is helping in deal origination. Many of those FM companies have had high multiples until recently, but a general reduction is making some of those companies attractive targets for PE houses. Knowing the business and its opportunities leads to new deals.
At the other end of the spectrum, sector knowledge is just as invaluable for the swathe of exit activity. “There is a trend for mid-market companies to be unable to use the capital markets as an exit,” says Kitkat. Mid-market firm Grant Thornton’s buyouts this year include a US company exiting an exhibition business as part of a strategy of shedding European assets, a pan-European company, which is fairly mature, using a buyout strategy because the company was not suitable for a stock market listing.
Firms like KPMG note there are signs of growth in the last two years for buyouts in the financial services sector. Tant notes at the larger end of the scale, GBP400 million to GBP500 million, there has been less activity. However, taking a longer term view, Kitkat said there is some concern over whether there will be a lot of interest in exits of less than GBP500 million, when the market picks up once again.
Problem scenarios
Another aspect of deal activity has been in the corporate recovery area. According to Ascott: “There has been an increase in the number of corporate finance solutions for corporate recovery deals, such as debt-for-equity swaps. Also, banks are more ready to look at these deals rather than send in the receivers.”
Grant Thornton recently announced the appointment of Steve Akers to its London-based recovery and reorganisation practice, joining from Deloitte & Touche where he worked for 25 years, 13 as a partner. His credentials include acting as a liquidator of the Bank of Credit and Commerce International.
What a downturn in business has taught many houses is how to reassess their allocation of resources, which not only covers a greater understanding of the sectors in which they are investing, but also a greater ability to monitor the portfolio investments. “There has clearly been a change in emphasis in the way PE houses monitor their portfolio companies,” says Tant. These monitoring aspects are married with the way many houses have re-examined the way in which they balance their resources. In some cases it has, says Tant: “Led them to question their oversights.”
Some changes have included augmenting board representation of portfolio companies and also, bringing on board in-house industrialists, with knowledge and experience to help manage the PE firm’s portfolio. Corporate governance issues are also a very hot topic for many PE players and their accounting firms are keen to provide advice.
For the accounting profession, changes for their PE clients can roughly be translated into areas they have had to re-examine: funds environment financial services; corporate finance (deal origination) and due diligence; and services to acquired companies. Not only are the PE houses changing due to economic and industrial cycles, their own structures will inevitably lead to changes in the way they do deals and source professional services. “There aren’t many institutionally owned PE houses anymore,” says Kitkat. But many feel it may be too soon to see how new ownership changes will have an impact on the PE arena.
Changes in the accountancy firms
The ongoing reorganisation of the big four accountancy firms will also impact on the way the PE market uses their services, and has already resulted in some shifts in activity. Deloitte & Touche’s assumption of the Andersen’s team is one of the most high profile reorganisations in the market. “There are no cultural differences. Everyone in the corporate finance team is amazingly close,” said Kitkat. The teams are split along colour-coded names. Deloitte & Touche is referred to as the blue team, and the former Andersen employees as the orange team. And in order to integrate fully both teams, they are seated in alternate colours. Apparently, mention of previous company affiliation is not encouraged in the firm.
With one less accountancy firm to use, there has been debate about conflict of interest if different teams, says due diligence or corporate finance, in the same firm are used on the same deal. However, departmental separation and Chinese walls are the response. KPMG, explains Tant, has five physically separate transaction services groups: three in different buildings and two separate but in the same building.
“In big deals all of the big four accountancy firms will be represented. One will do the vendor due diligence, the auditing will be done by another, and so on,” says Kitkat. “What I can guarantee is there are very strong Chinese walls in place. I can’t go upstairs to my colleagues in due diligence and they can’t come down here to me in corporate finance.”
There is the inevitable trickle-down to the next tier of accountancy firms, who are seeing business opportunities only usually secured by the top tier. “When Orange was acquired by Deutsche Telecom all four were acting for some part of the transaction,” says Ascott. Grant Thornton was approached. “You could argue that for the four that remain there is more business. However, we have seen some of the second-tier firms taking up some of the business,” adds Patey.
What has changed in the accountant firms’ service provision is the willingness, and ability, to offer a broader range of services that not only focus on a transaction or narrow practice areas, but also offer a wide range of professional services. This approach is sometimes known as a one-stop service. “We call it a bid support product,” said Kitkat. “London VCs tend to keep themselves very lean and mean. They need to leverage their own resources, so we provide them with corporate advisory advice, for example.” Other services they may use include tax advice and financial due diligence. “PE houses like to come to one-stop shops with all the financials and commercials in one place,” he added.
Looking at what the client needs and providing them with the most appropriate skills and services available to the individual firm seems to be the most commonly used mission statement. It’s all about focusing on the long-term relationship. Tant says it would make more sense to advise a client to take expert services from other companies if, in his view, the other service provider were more skilled or experienced in the area.
Not every VC or PE house will be attracted to one-stop service provision, preferring to rely on more traditional approaches. “Some PE houses see two advisers and like to have separate accountancy and legal advice,” says Patey. KPMG’s KLegal accounts for about 10 per cent of the total staff in the PE group and is an added service that other accountancy firms have tried but not retained. Andersen Legal has not been incorporated into the new Orange-Blue team, for example. “We are pleased with the level of take up and interest in KLegal. We also realise we have important relationships with law firms,” said Tant. However, he says, reaction from some law firms has been “sensitive”.
The inevitable question is whether greater levels of due diligence and longer transaction times have helped boost accountancy firm fee earning power. There is the view that fees have not shown any dramatic improvement because competition is stiff and deal completions are limited. However, fees have gone up, says Patey. “PE houses are prepared to pay more for added value, especially if a transaction is successful.” That said, many accountancy firms and PE houses are looking at greater details of deals much earlier so that expensive advisory bills do not amass for a series of aborted deals.
Perhaps one of the pressures on fees has been the added competition from a number of banks on the corporate advisory side, looking for business, but now working on deals sizes much smaller than they used to. It is not uncommon to see some of the big investment banking names competing for deals below the GBP100 million mark. “On the sale mandate side, we’ve seen more banks becoming involved,” says Patey. “Compared with two years ago it is noticeable that they bare lowering their criteria to sub GBP250 million deals.” Ascott says he is seeing competition from many banks, using their second-tier corporate finance teams to compete for deals his firm typically bids for.
While much of 2002 has been a thin year marked by expectation rather than activity, most accountancy firms agreed the start of next year will bring a fresh flow of deals, and a greater number of completions. Many PE houses are sitting on funds, which they must deploy. “Because we see things in advance of the VC world, it could mean they will become busier towards the end of the year or early next year,” said Kitkat.
While there is a mood of expectation that France and Germany will generate more attractive levels of deal activity over the next 18 months, the money and the focus is still primarily on the London market. However, things are not likely to be as good as they used to be. “We won’t get back to peak levels of 2000/ 2001 for a very long time,” said Ascott. “Mid-1990s levels are more expected.”
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