Balancing the food and drinks portfolio

Finding an edge is the often-quoted discipline of the private equity industry and nowhere is it more appropriate than in the food and drinks business. While the industry is insulated from the cyclicality that characterises some other sectors, finding the right niche is crucial in this environment.

The frozen foods area is expected to generate interest in this respect and there are several deals in the pipeline. These include EQT’s sale of Findus, the sale of Heinz’s frozen food division and possibly Unilever’s disposal of Bird’s Eye.

Interest from the buyout firms is expected because food and drinks companies have delivered healthy returns generally speaking in recent years. Doughty Hanson made a 3.4x return on UK food group RHM when it was floated in the summer. There have also been other successful exits this year by houses such as Montagu, Bridgepoint and 3i.

“Food and drink is an attractive area for many buyout houses because it’s a pretty defensive sector that can form a key part of a balanced portfolio and it’s a steady business as people will always need to eat,” said Keith Ellis, global head of food and drink at 3i.

Despite this, the food and drinks business is clearly a diverse market, where some sub-sectors are in decline or on a plateau. Others are growing more rapidly.

There is a lack of consensus as to where the best opportunities can be found. One investor argued that, while a lot of private equity funds are looking to the potential benefits of consolidation in frozen foods, that market is declining.

“In acquiring a frozen food asset, you could end up running hard to stand still and while corporate owners can stand a few years of static growth, buyout owners demand much higher growth levels,” he said.

Others are more bullish on the potential to link frozen food brands with chilled foods, which are among the fastest-growing parts of the market. “We could see a migration of frozen brands to the chilled arena,” said Neil Sutton, head of the food and drink practice at PricewaterhouseCoopers.

He conceded, however, that this trend is stymied to a degree in the UK by the dominance of the supermarkets’ own-label brands. Against this backdrop, buyout firms can either invest in own-label suppliers or expand into chilled foods in Europe, where the supermarkets business is less concentrated and holds a lower share of the food retailing market overall. “In France we’re already seeing that happen,” Sutton said.

The chilled food market is also attractive due to the potential of exporting UK expertise to Continental Europe. Dominated by the likes of Marks and Spencer, the UK chilled food market is mature and sophisticated.

While there has been volume growth, it has been difficult for manufacturers to turn this into profit because of price pressure from the big retailers, said Colin Curvey, investment director at Duke Street Capital. He said that large own-label chilled food manufacturers such as Uniq, Northern Foods and Geest were very successful in the 1990s. “They have struggled in recent years to turn turnover growth into profits growth,” Curvey said.

While changing eating habits suggest there is considerable potential to raise chilled food consumption, this should not be overestimated, according to Curvey. There are significant cultural differences in eating habits, particularly in southern Europe, which makes the take-up of chilled food limited.

“There is also the importance of the supply chain, because with chilled you need to get the product from the manufacturer to the shelves within a couple of days. With the longer distances involved in much of Europe, that can be much harder than in the UK,” he said.

Future targets

When it comes to future targets in the chilled food area, manufacturers such as Uniq and Northern Foods are often cited. But both those companies appear to be problematic when it comes to acquisitions. Uniq was approached by private equity firms in early 2005, but the deal is thought to have fallen through because of opposition from the company’s pension fund trustees. Price was also an issue.

Northern Foods, meanwhile, is described as a “challenged business” by one buyout investor. “It is going through a ‘profit improvement programme’ at the moment and also a lot of its business is in biscuits, which is a slow-growth area,” he said.

Despite this, there have been deals in niche chilled food products, such as Montagu’s exit from Noon. Kerry Group’s acquisition of the Indian chilled food product offers the trade buyer a high-margin brand to add to its range. Similarly, trade group Premier’s acquisition of Marlow Foods, which manufactures meat-free Quorn, gives it a high-growth product to add to its stable of lower-growth brands.

The activity of trade buyers such as Premier and Kerry Group is having an impact on the buyout firms, particularly in the UK, believes PwC’s Neil Sutton. “In the last 12 months it’s been quite tough because trade buyers have returned and it’s got harder for buyout houses to win some of these assets,” he said.

He added that this has probably led to a slowdown in the UK in the last 12 months but that, in the less consolidated Continental European market, buyout activity has remained strong.

Guy Weldon, a partner at Bridgepoint, said that the importance of trade buyers in food and drink was the reverse of what is happening in other markets. “The main reason for this is that the manufacturers are under huge price pressure from supermarkets and they are anxious to consolidate the food categories that they operate in to cut costs and gain economies of scale and maintain profitability,” he said.

In spite of the competition from trade, there have been some significant deals in the UK, such as last month’s €1.85bn Blackstone/Lion Capital acquisition of Cadbury Schweppes’ European beverages division. The Anglo-US consortium beat rivals PAI Partners and Permira, while trade buyer PepsiCo failed to make the final round.

A key attraction for the buyout houses was the stable of well-known brands included in the deal, such as Schweppes, Orangina and Oasis.

Bridgepoint’s Weldon said that, generally, branded businesses were more attractive to investors because own-label manufacturers were more beholden to supermarkets in areas such as price and could always be threatened with the business being moved to a different supplier.

“The food sector is characterised by huge price pressure from the supermarkets and there has actually been price deflation in real terms because of consumer pressure,” he said.

Sutton agreed with the attraction of branded food and drink products over own-label businesses. “If you buy a good business with the protection of a good product that is already established, then you face less threat from new entrants,” he said.

Not everyone agrees. 3i, for example, has invested in one of Europe’s largest fruit juice suppliers, Refresco, and in French own-label dessert manufacturer Senoble. Keith Ellis said the house was “agnostic” on the brand versus own-label issue.

“Private label businesses can be attractive especially if they have the scale that makes market entry for others difficult and the geographical reach that enables them to follow their customers,” he said. “This is important because retailers are becoming pan-European or even global these days.”

For Ellis, if a private equity-backed own label business has the resources and the expertise to expand alongside its retail customers, which might mean making further acquisitions, then it can be highly successful.

Senoble, in which 3i is a minority shareholder, has helped resolve some family shareholdings, brought someone on to the board to advise on strategy and provided funds for acquisitions in Spain and Slovakia.

Senoble’s acquisition of a factory in Slovakia to support its expansion into Germany shows the potential of manufacturing sites in Central and Eastern Europe. But investing in this region should be done with caution, said 3i in its latest food and drink research.

The study argued that it was a common mistake to group the countries of Central and Eastern Europe together and that it was crucial to understand the market dynamics of each country before committing investment.

In wider terms, when it comes to future buyout investments in food and drink, it will be important for investors to understand changing consumer habits, according to Weldon.

He highlighted a resistance by a sizeable group of consumers to the relentless price pressure on products, which has led to constant pressure on the quality of ingredients.

“Consumers have a more questioning attitude about the source of products, whether it’s organic or home-grown, and the quality of ingredients,” he said, adding that it was interesting that the UK’s fastest-growing supermarket chain was the upmarket Waitrose. “It will be interesting to see how manufacturers respond to this trend,” Weldon added.

Another important trend that will influence investments is consumers’ growing recognition of health issues, such as a move among some consumers towards organic food. Heinz, for example, predicts annual growth rates of 15%–20% in Western Europe for the nutritional and organic food segments.

3i, which recently published research on health and wellness products, says this area presented an opportunity for private equity investors. There were clear similarities with the pharmaceuticals industry, in which a growing proportion of produce innovation was effectively outsourced, it said.