Holding the Fort

UK mid-market sponsors, their bankers and associated professionals are keen to stress that this private equity space looks set to continue with resilience in the face of the global credit crunch and the threat of weakening fundamentals in the UK economy. They also agree that UK mid-market activity, although worlds apart from the highly leveraged mega LBO space, cannot avoid these macro issues. However, the great expectation is that the UK mid-market will be sufficiently immune to these macro effects to weather the worst of the storm, should it hit the country this year.

The UK mid-market is by various definitions a vast part of the economy with companies valued at as little as £10m and in excess of £500m included in this category. At the lower end of the market, that is, companies with an enterprise value of £10m to £100m, it is estimated that as many as 50,000 companies are actively trading in the UK.

As buyouts have grown in recent years some private equity sponsors started to focus on deals well above the £100m mark, buoyed by the liberal lending of bank debt in one of the longest sustained bull markets the UK economy has experienced in the last 80 years. Nevertheless, the present market correction is resulting in another shift in focus as sponsors look to smaller deals once more.

“During 2006 and 2007 a number of firms at the smaller end of the mid-market, active in deal sizes of around £35m to £75m, trained their sights to higher-value deals. We’re now seeing some of the larger firms training their sights down, so there is a lot of congestion in the middle market,” says Simon Tilley, managing director at Close Brothers Corporate Finance in London.

“There is a smaller group of investors active in the £10m to £50m space, but this is likely to be filled with larger investors looking at smaller deals. Such companies tend not to be market leaders in their respective industries. They are often price takers rather than price setters and are more exposed to competitive pressures. Buying and lending decisions at the smaller end of the mid-market need to be evaluated carefully,” he says.

In fact, it would seem that 2008 will be a very lean year indeed for consumer-focused businesses looking to tap private equity funds and bank debt, according to market participants.

“When you’re looking at backing growth assets, by definition they are growing ahead of the economy at large, like some areas of the IT sector which have a different growth path from the wider economy. Other sectors that are showing interesting growth paths in the UK market include healthcare & life sciences, companies targeting the ageing population and businesses which are benefiting from the continued growth in the Internet channel,” says Sean Whelan at ECI Partners in London.

“We live in absolutely fascinating times, more so than in any other market dislocation in living memory,” says Paul Marson-Smith, managing partner at Gresham Private Equity in London. “Personally, I think it will get worse before its gets better. I would say that a lot of financial institutions are still pregnant with bad news. Overall, I would say the UK mid-market has been relatively resilient, but it is not immune.”

“Surprisingly, we have seen little change in debt pricing and we don’t expect to see much of a change,” says Marson-Smith.

“We’re quite pessimistic about the market; we don’t think all of the credit issues are over yet. We do think there will be a slowdown in the UK, and fuel price and food price inflation will take their toll. However, any market situation offers opportunities for private equity and we haven’t seen any slowdown in deal flow,” says Buchan Scott, partner, investor relations at Duke Street Capital in London.

Everyone is understandably focusing on how the banking market will react to UK mid-market deals should more financial institutions record losses for the last three months of 2007 and subsequent quarters. But whether it will be business as usual or a reduction in bank lending is probably too hard a call to make at this stage.

“The mainstream banks are still operating in our segment and we haven’t really seen other players like hedge funds become active. In fact, some of the mainstream banks see that the recent turmoil is offering good opportunities,” says Marson-Smith.

While the banks are still lending into deals, they are taking a more conservative approach than they have for some time.

“Investec typically talks to three or four for a transaction as it sources senior debt from them. The amount of people who can provide up to £100m of debt without recourse to syndication is much tighter, but deals are getting done,” says David Currie, head of investment banking at Investec in London.

“The debt market is a lot tighter in the UK mid-market and banks are looking to syndicate ahead of closure, reflecting the fact that people are less willing to underwrite than they were just four months ago,” says David Silver, managing director, European investment banking at Baird in London. “Banks are increasingly clubbing together, but they are doing a lot of work to syndicate upfront.”

“More deals are being structured on a club basis now, in comparison to 2006 and 2007 when banks were happy to be sole underwriters. It’s a different credit market now. We’ve recently seen three banks working together on a £50m ticket. Right now, the underwriting environment is much more difficult than it was at the end of 2007,” says Tilley.

Also, banks have generally been looking at more advantageous terms since the start of the year, says Silver, including charging higher margins because of the increased cost of liquidity and applying market standard fees. Nevertheless, there is a perception that the smaller leverage levels in the UK mid-market may be one reason to have maintained relationships between sponsors and bankers.

“There are more relationships in the UK mid-market with bankers than in the large LBO space. Banks are increasingly looking to go into deals on a club basis. Before, you might have gone to three or four banks but now it’s more like five or six banks in the hope that two or three of them will finance a deal,” says Scott.

Clubbing is not to everyone’s taste though. Marson-Smith says club deals can be a “cumbersome” approach to finance, but Gresham Private Equity is adopting an approach for some deals where it effectively seeks over-subscription of finance commitments so that deals are sufficiently funded. “Provided the banks know that they won’t go away empty-handed, this approach will be OK,” he says.

Banks facing liquidity constraints will also be forced to choose among their favourites, the parvenus and the marginal sponsors, and it looks like comfort will be found in the familiar this year.

“I think what will happen is groups with strong relationships, particularly with their banks, will close some good deals this year,” says Simon Turner, managing partner at Inflexion Private Equity in London. “I think there is a lot of power sitting with the banks right now and the banks are asking who they are going to work with. It will be difficult for some sponsors that have treated banks like a commodity; in the second half of 2007 relationships with the banks counted for everything.”

There is more interest in deals where people are looking at over-funding the equity in transactions in an attempt to encourage more banks to finance certain deals, according to Charles Barter, head of private equity at Travers Smith in London. Deals look likely to be structured by combining 50% equity and 50% debt, for example, but the equity sponsor places an additional 10% equivalent of equity into a ring-fenced account should the acquired company require further funds in the short-to-medium term.

“There are also funds looking at doing 100% equity deals. There have been one or two of these deals so far and we’ll be seeing quite a few more,” says Barter.

3i’s November 2007 acquisition of the luxury brand lingerie retailer Agent Provocateur, for an undisclosed sum, is thought to be one recent example of a 100% equity deal. Such transactions are put together with a view to refinancing in time, or have a loan note included in the acquisition documentation. Either way, the 100% equity approach is considered a bridging activity in tight finance markets.

Another set of opportunities for UK mid-market sponsors is likely to focus on some public companies looking to be taken private. But this segment is not without challenges for the banking market.

“There are a lot of take-privates being looked at now, not surprisingly with share prices off 35% to 40% from last summer. Just 12 months ago there were not many take-privates being done,” says Currie.

The inherent nature of locked-in financing for public-to-private deals may run into some problems. When a bid for a public company is made in the UK, the sponsors are obliged to send a letter to the stock exchange, from which the company plans to delist, that outlines the funding commitments the company has in place. Known as The Certain Funds Period, all a take-private company would have to do is apply for the funds in writing without any renegotiation taking place with the financiers.

“You just can’t launch the deal if there is any part of the financing that is uncertain,” says Barter.

Other forms of financing commitment are also becoming restricted as the banks generally shy away from locking-in finance agreements.

“Banks are pretty reluctant now to provide full stapled finance commitments but what we are seeing is a reduced-commitment form of finance called paper-clip financing where banks have the opportunity to talk to the company’s management and make other considerations before deciding to offer financing,” says Tilley.

Not surprisingly, with pressure on senior debt provision, this year looks set to be an active one for the mezzanine finance providers that have been somewhat marginalised by strong bank debt supply until this point in the cycle.

“Because of the aggressiveness of banks in UK mid-market deals in recent years, mezzanine has been disintermediated until recently,” says Nathalie Faure Beaulieu, regional managing director – Northern Europe, European Capital. “We are focusing on deals with enterprise values between €100m to €700m as the mid-market has been less affected by the credit crunch. Since the beginning of the credit crunch we have completed a couple of mid-market deals in each of France, the UK and Germany.”

“Total leverage for UK mid-market deals, including mezzanine, is likely to be between four times to six times, with equity levels between 35% and 50%. The level of mezzanine has increased to about 1.5 times EBITDA, up from about one times EBITDA prior to the credit crunch,” says Beaulieu.

“I don’t think mezzanine is the most difficult slice of the capital structure to find finance for – the most difficult element is the senior debt. Structures are becoming much simpler as institutional investors appetite has greatly decreased.”

“Sponsors are coming to us much earlier than they used to; it is returning to how it was about four or five years ago. It’s a question of balance. Today we’re in a position of regaining some of the influence we had in structuring deals, the market remains competitive and we don’t call the shots.” she says.

According to Investec’s Currie, the seven times (and higher) EBITDA senior debt multiples in the last few deals of last summer now centre around four times with a wide range between deals. Total debt multiples including mezzanine are also significantly reduced around the five to six times range.

The first few months of 2008 look set to result in a healthy flow of deals, which could make up for those deals stalled as vendors hanker after acquisition valuations achieved up to mid-2007. Combined with a sense that the UK economy will become tougher, private vendors are looking to take advantage of the current capital gains tax regime and some will sell before the end of the UK tax year, which ends on April 5. The UK’s capital gains tax regime changes from 10% to 18% in the next tax year (starting on April 6 2008).

This deadline has resulted in a flurry of activity with many deals being agreed ahead of the February 22 cut-off date as sponsors applied for monopoly clearance (which takes 25 business days) from the European Commission’s European Merger Regulation Clearance (EMRC) scheme.