Focus: Scotland – Private equity in Scotland

Along with tartan and smoked salmon, venture capitalists may well be another of Scotland’s finest exports – few English investment teams are complete without a canny Scot in their midst.

Those Scottish venture capitalists remaining north of the border tend to be based either in Glasgow, Edinburgh or Aberdeen. And although Edinburgh has traditionally been Scotland’s financial centre, it is Glasgow with its proximity to the region’s manufacturing heartland that has proved to have the greatest pull for mainstream private equity houses.

With offices in Glasgow, Aberdeen and Edinburgh, 3i has a dominant presence in Scotland. Other prominent players are NatWest Equity Partners (NWEP), Royal Bank Development Capital (RBDC) and Murray Johnstone. Dunedin Capital Partners, although based in Edinburgh, focuses primarily on deals in northwest England.

Despite this cast of contenders, however, 1999 was a relatively quiet year for deal completions in Scotland.

The largest private equity transaction in Scotland last year was the GBP65 million institutional buyout of Donprint from Leeds-based Jarvis Porter Group last November. Donprint, based in East Kilbride, is a leading supplier of product identification systems, components and service solutions to the electronics and telecoms industries.

The IBO was led jointly by Mercury Private Equity and NWPE with senior debt from Bank of Scotland following an auction sale conducted by PricewaterhouseCoopers.

“Deal flow was actually pretty good last year but, in terms of difficulty of delivery, the aggressive way auction sales are being run is becoming counter- productive,” says David Sneddon of NWEP in Glasgow. “Pricing is ever upwards, the auction process is very time consuming and makes it hard to get a real grip on what is happening,” he says, adding that YK2 concerns also slowed the market down at the end of last year.

Thanks largely to Donprint, however, 1999 was a good year for NWEP. “To put it in perspective, NWEP as a whole invests about GBP350 million in 30 deals each year across Europe. With a staff of two executives in Glasgow we aim to do one or two deals a year,” Sneddon points out. In 1998 NWEP led the GBP46 million buyout of PSL Group, an Aberdeen-based oil services company and put together a GBP36 million funding package to finance the IBO of Aberdeen-based JDI Cable Systems, a leading manufacturer of specialist cables for the offshore oil and gas industry, from BI Group.

January this year saw the IBO of Motherwell Bridge Information Systems (MBIS) from Motherwell Bridge Holdings (MBH) in an GBP84 million deal backed by 3i in Edinburgh.

MIS is a rapidly growing provider of IT solutions and services focused on the needs of manufacturing industries and utilities. MBH received GBP63 million in cash and provided a GBP12 million vendor loan note. 3i invested

GBP44 million for a majority equity stake having already had an equity stake in MBH. Royal Bank of Scotland and Bank of Scotland jointly underwrote a GBP27 million senior debt, mezzanine and working capital facility.

Says Paul Murray, director of transactions with 3i in Scotland: “The deal underlines our commitment to supporting high growth businesses with strong and committed management teams.”

Another sizeable Scottish deal last year was the GBP58 million buyout of Inveresk Research Group, a leading contract research organisation based near Edinburgh. This deal, however, was led by the London-based private equity house Candover. Local players were not best pleased to see such a large deal go to an outsider but Candover has a trail into Scotland through Iain Gray who was formerly with Bank of Scotland in Edinburgh and is now on the Candover team.

According to Graham McDonald of Bank of Scotland in Glasgow this year has so far been relatively steady with more activity than last year and an increasing emphasis on technology. “But, now that 3i is focusing on larger deals and technology-based transactions, there is a gap in the market for investors willing to back smaller deals in more traditional sectors,” he notes.

The venture capital community is also watching to see how 3i manages its portfolio under its new technology bias. “Sell-offs of non-technology investments are anticipated and with them comes the potential for secondary buyouts,” McDonald continues.

Ross Marshall of Dunedin Capital Partners in Edinburgh says his firm tends to focus on deals south of the border because the more traditional private equity market in Scotland will, on average, produce only about five mid-market deals in any one year.

“We focus on deals in the GBP10 million to GBP25 million bracket and there are simply not many deals of that size in Scotland – its commercial base is not developed enough. We find that there are more mid-market deals, by a factor of ten, in the northwest of England than there are in Scotland,” Marshall explains.

The stockmarket has been a popular source of deals for private equity houses in England over the last two years. However, public-to-privates (PTPs) are unlikely to become a real feature of the Scottish venture capital industry with relatively few smaller quoted companies based in Scotland.

The only PTP to complete in Scotland last year was the 3i-backed GBP24 million buyout of the steam and air soot equipment manufacturer Clyde Blowers.

There were also rumours last year that Devro, the Glasgow-based sausage skin maker which came to market in 1993 following a GBP108 million management buyout in 1991, would also be the subject of a management buyout or takeover bid.

And last September Highland Distillers, producer of Famous Grouse whisky, was taken private in a deal worth more than GBP700 million by Edrington, a private company owned by a charitable trust, and William Grant, the whisky distiller that makes Glendfiddich.

With the Scottish economy in such rude health, some of the decline in MBOs in Scotland last year can almost certainly be attributed to the pre-occupation of local deal originators and investors with their own internal issues rendering them unable or less inclined to initiate or pursue prospective deals.

3i made its well-publicised shift into the technology sector. NWEP was distracted by the need to secure its own future through a buyout, RBDC was hit by staff defections while Penta Capital – formed by the five venture capitalists who left RDDC in August – was busy obtaining regulatory approval and raising a fund. Last year also saw Aberdeen Asset Managers merge with Clydesdale Bank Equity.

Among the deal funders and advisers, RBS and Bank of Scotland were unsettled by their hostile bids for NatWest, accountants PwC are now perceived to be interested only in larger deals and technology deals while Edinburgh-based accountants Rutherford Manson Dowds was acquired by Deloitte & Touche.

Billy Gilmore of Murray Johnstone in Glasgow also puts the quiet market last year down to the continued contraction of Scotland’s industrial base. “We saw the removal of several companies from the market through takeovers – such as Stakis and Kwikfit – plus the closure of the Continental Tyre plant near Edinburgh, Levi Strauss’ operations near Glasgow and a spate of other textiles closures. These are companies which might previously have spawned buyouts,” he says. “The industrial landscape in Scotland is changing, with fewer traditional businesses and a major transition to a service and technology-based economy,” Gilmour continues.

Gilmour believes that only a few equity houses are willing or able to transact deals successfully in these new industries, adding that a number of venture capitalists are spending more time deal-hunting south of the border.

“Some advisers have also shifted their sights leaving a gulf in deal origination by size and by sector and, due to all the internal restructuring at many firms, there has been a degree of inertia,” he says.

While private equity investment activity has been at a relatively low ebb over the last year or so, Scotland has also experienced a decline in its business birth rate’.

The latest figures for business start-ups in Scotland – released in February this year -showed that the number of new businesses formed in Scotland in the third quarter of 1999 was nearly 20 per cent down on the year before and at its lowest level for five years.

These figures probably made rather depressing reading for Crawford Beveridge, the former chief executive of Scottish Enterprise, Scotland’s development agency. His stated aim was to close the gap between Scotland and the rest of the UK in terms of business start-ups by creating an extra 25,000 businesses and at least 50,000 jobs each year. These latest figures deepened a downward trend that began in early 1998.

Raising Scotland’s business birth rate was one of the policies Beveridge, who stepped down at the beginning of this year after eight years heading the agency, most closely identified with.

Much of the problem stems from the fact that a large part of Scotland’s population lives in the Central Belt. This used to be dominated by heavy industry and a small number of large employers – a pattern that has produced low levels of entrepreneurship in other parts of the UK.

But, through its efforts and initiatives, Scottish Enterprise can claim, justifiably, that there is now much greater public understanding of the importance of entrepreneurship and that the mechanisms for stimulating it have improved enormously.

Scotland’s TECs now run programmes to train entrepreneurs and regular business forums are held. A related initiative has begun to encourage academics to become entrepreneurs.

Scottish Enterprise has also pioneered the formation of industry clusters in sectors such as IT, software and biotechnology in a sustained attempt to enliven Scottish entrepreneurial culture.

Through Locate in Scotland, it recently persuaded Cadence, a big US software company, to locate a design centre for system chips at the Alba Centre in Livingston, West Lothian. The project should provide 1,800 jobs for well-paid software designers by 2002.

Much is also made of Silicon Glen’, a neologism for the raft of IT suppliers on the M8 corridor between Glasgow and Edinburgh and a growing clutch of smaller Scottish software and IT companies such as Voxar, Quadstone, Kymata and KSCL are producing sprinting growth.

Scotland’s technology sector received a big boost in March this year when Atlantech, one of the brightest Scottish software houses, was acquired for GBP180 million by Cisco Systems, the US network systems group. The deal was seen by many Scots as a coming of age for the country’s technology sector, demonstrating its ability to produce world class technology and a new breed of entrepreneur.

For the mainstream private equity and venture capital houses, however, technology’ has yet to replace bread and butter transactions although, as David Sneddon says: “We are all very conscious of new technology coming through in early-stage business and keep our eye on what is happening.”

Sneddon remarks that because most of these companies are graduating quickly from early stage finance straight to the stockmarket, the development capital houses are being missed out in between. “We are quite happy about this – we are really interested to see what happens with these companies and their business models two or three years down the line,” he says.

But, in terms of existing private equity investment portfolios, technology is extremely important. “It will impact on all areas of business and we are working to ensure that all our investee companies are alert to that and reacting to it. It can also put a premium rating on a business at exit if it has access to proprietary technology,” Sneddon observes.

“Technology start-ups will obviously help boost the business birth rate in Scotland and fuel the Silicon Glen concept but it is also important for existing businesses to adapt technology to their own operations,” McDonald agrees.

Scotland may have been uncharacteristically quiet over the last year or so on the private equity front. But, with a strong venture capital community and advisory infrastructure, a commitment to the emerging e-business economy and a heritage in traditional manufacturing; it is likely to remain an important regional centre for private equity deals going forward.