Bank of Scotland: flirting with private equity

Bank of Scotland’s Integrated Finance team was launched in February 2000 and has since funded 27 deals, with a mixture of senior debt, mezzanine financing, loan stock and equity, totalling GBP843 million. Drawing on the bank’s experience arranging debt for buyouts in the UK (64 deals last year totalling $3.5 billion) Integrated Finance was established to fill a gap in the market for funding UK businesses. Rather unusually, the model developed by the bank has a non-exit strategy and relies on long-term yields for profit, rather than capital growth. Graeme Shankland, who leads the team within the Integrated Finance group, talks to EVCJ about the one stop shop niche.

The Integrated Finance (IF) team was born out of a desire to broaden returns from the bank’s buyout business and expand the bank-borrower relationship. However, according to Shankland, who has been in corporate banking with Bank of Scotland for 11 years and with Deutsche Bank before that: “The one thing we didn’t want to set up was a private equity fund.” Despite the fact that IF does provide the equity in its deals the business claims not to be in competition with the venture capital houses that provide the bank with much of its bread-and-butter debt arranging business.

“We’ve always taken the view that private equity provides a market for senior debt and mezzanine which we value very highly.” Other factors that makes a Bank of Scotland private equity fund unlikely are the internal cultural difficulties structuring a fund could cause and a possible conflict of interest. Bank of Scotland is already involved in private equity through its GBP600 million fund-of-funds business and Shankland, referring to the funds in which the bank has an interest as “extended family,” says the bank finds this indirect route into private equity more appealing. He also cites some of the problems experienced by the captive funds of other banks at the moment as a good reason to steer clear of this arena.

Unique approach

Looking at the 550 buyout deals on its books Bank of Scotland initially perceived a funding gap at the bottom end of the market, as key private equity players drift upstream to larger deals. Despite launching the business with the intention of filling this gap IF has found itself caught in the current with the other players. “The quality of the deals at the bottom end of the market, GBP5 million to GBP25 million, is generally very poor and this has pushed up the size of the deals we’re doing.” However, the team does not want to replicate or repeat the existing model for mid-market deals and has chosen to focus on companies that would not ordinarily attract private equity interest.

The team’s core, but not exclusive, market will be GBP10 million to GBP30 million deals. Typically, target companies tend to be stable, low growth, old economy businesses that are cash generative, with low capital expenditure, a modest level of gearing and good long-term visibility. Such companies might also struggle to secure traditional private equity funding as there is no clear exit route but this does not worry Shankland, who is actually looking for “sticky assets.” Rather than competing with private equity houses, IF has positioned itself as providing them with an exit-facilitating service, as one of the deal strands it will focus on is secondary buyouts. (The others being primary MBOs, expansion finance, acquisitions, publics-to-privates, partial exits and re-capitalisations.) With exit routes limited at the moment IF has filled a gap in a way that is appealing to the private equity market. But this role doesn’t seem quite so altruistic when you consider the number of private equity funds (nearly 70) in which Bank of Scotland has an interest.

IF generally works as the sole financier on its deals, and its multi-disciplinary approach means it can provide a combination of senior debt, mezzanine financing, loan stock and equity. For the management of many companies the buyout is a one-off experience and for them the chance to rule-out the complications caused by negotiating with a number of financial partners must come as a welcome relief.

How it works

IF was set up with GBP100 million to invest in equity but it has already committed GBP140 million. Originally a team of 12, which has expanded to 28, the business is staffed with accountants, lawyers and bankers, rather than private equity veterans. Financing packages offered by IF are designed to de-emphasise equity growth and are instead centred on running yields. Shankland says the blended yield from the loan stock/senior debt/mezzanine mix should average 12 per cent per annum, with capital gains as an added bonus on top of this. A typical deal with a company that has an enterprise value of GBP20 million might comprise GBP3 million equity, including management rolling-over its stake, GBP11 million senior debt, GBP3 million mezzanine and GBP3 million loan stock. IF can finance 100 per cent of a deal and its equity participations range from GBP1 million to GBP20 million.

The focus on debt makes it possible for management to take a larger equity stake than might be expected in a traditional buyout. Management teams have operational control and the bank takes a passive role in running of the company, appointing an independent non-executive director to the board. IF works with a group of 80 to 90 directors, who also help originate transactions and provide due diligence advice. “It’s a young scheme but it’s already clear it’s going to be a tremendous help,” says Shankland.

As IF is not reliant on an exit for its return Shankland says management teams will determine the timing of any sale and that the bank is happy to keep companies on its books for the long term. However, he expects to see management-led exit opportunities emerging in the next 18 months. He also says it’s possible the bank could refinance some of its own deals, as a partial exit.

The deals

So far IF has backed 27 deals, 11 last year and 16 so far this year. Financing for these deals totals GBP843 million, of which GBP140 million was equity. The transactions fall into two categories, “core” deals, such as the MBO of bed manufacturer VI-Spring last October and large more unusual deals such as the GBP134 million acquisition of Deutag by drilling services company, Abbott Group, in August 2001. Shankland described this deal as “unique and interesting” and is keen to do more like it. As well as senior debt and long term committed loan stock the deal included a public rights issue. Abbott placed 29,306,041 new shares at 155 pence per share, underwritten by Cazenove, to raise approximately GBP44.3 million, net of expenses. Other deals outside IF’s GBP10 million to GBP30 million remit include the GBP68.7 million PTP of property development company, Moorfield Group, and the GBP105 million funding package arranged for the partial MBO and restructuring of house builder, Octagon Developments.

Deals that Shankland describes as “fitting perfectly” with IF’s strategy and of the type he hopes will become typical for IF, include VI-Spring and a tertiary buyout of HM Plant, which supplies machinery to the construction industry. This MBO in May 2001, which Bank of Scotland supported with GBP36 million, provided Alchemy Partners with an exit from its 1999 investment, which was itself a secondary buyout. Other deals of the same type include the MBO of the pub and hotel division of Bett Brothers. This GBP13 million deal included all IF components, senior debt, mezzanine financing, loan stock and equity.

Looking forward

On average it takes seven months to close an IF deal, some of which have been delayed by disagreements over enterprise values. Shankland says: “We’re beginning to see more sense around business valuations.” This time-scale means the team has already committed time to building up the work in progress for next year, with six or seven transactions scheduled to complete in February or March. The bank has budgeted for 18 IF deals next year. Of these, 15 are likely to be traditional primary or secondary buyouts in the GBP10 million to GBP30 million target bracket and the remaining three will be GBP75 million to GBP200 million deals along the lines of the Abbott, Octagon or Moorfield transactions.

Shankland says IF has no plans for deals outside the UK at the moment: “The European market isn’t as mature as the UK, it’s not really ready yet.” He also thinks there are enough opportunities in the UK to keep the team occupied, particularly with 1,600 private equity-backed buyouts, which by his reckoning are ripe for secondary pickings. “I think the level of secondary buyouts will increase significantly next year, to maybe 50 or 60.” However, expanding the IF idea into Europe is not permanently ruled out. The team has looked at deals outside the UK and might consider such a transaction with an existing bank client. Next year’s transactions will not include any management buy-ins, which IF judges as too risky but PTPs may feature again, although Shankland cautions: “It’s going to be more difficult for private equity houses to do public-to-privates in volume, as the real gems have already been done.”

Shankland is happy with the way IF is developing: “The portfolio is in great shape, we’re very encouraged by what we see. There are no difficulties with credit and none of the companies are worrying us.” However, it’s clear that the team won’t be standing still for long as he says the bank is always looking for new areas into which it can take its risk appetite and financial structuring. Plans for the future of Integrated Finance are subject to regular review: “In the first year we re-wrote the business plan three times,” says Shankland.