Leisure: Playing hard

The leisure sector has already proved to be a fertile source of private equity activity this year. Deals have been either launched or anticipated in a wide variety of industries from health clubs to hotels to bookmakers and film studios. But in any examination of venture capital activity in this sector one business dominates the market and looks likely to continue to do so for some time: pubs.

Private equity interest in the UK brewing sector has steadily risen since legislation was brought in during the early 1990s to restrict the number of pubs that any one brewery can hold. Known as the “Beer Orders”, these new laws were designed to cut the automatic ties between the breweries and their pubs, which were duty-bound to purchase their beer from the brewery landlord. The result of the new rules was the forced sale by many of the large UK breweries of many of their pub holdings. This process is far from over, and has also created several new pub groups, formed to acquire the excess capacity that the breweries were holding. Most famous of these is Nomura Securities, which is the UK’s largest landlord with a portfolio of 5,585 pubs. The upheaval in this industry that was generated by the Beer Orders looks likely to continue for some time, and at the beginning of this year a full 10 per cent of the UK’s 60,000 pubs were up for sale.

Following Nomura’s successful bid for 988 Bass-owned pubs in mid-February, several large pub portfolios remain up for grabs. Scottish and Newcastle Breweries has decided to sell 740 of its 2,600 pubs and Whitbread is looking to offload its entire portfolio of nearly 3,000 premises. Regional brewer Wolverhampton and Dudley, which is the subject of a bidding war between leisure entrepreneur Robert Breare (backed by private equity firm Botts & Co, Merrill Lynch, Bank of Scotland and Donaldson Lufkin & Jenrette) and a UBS-backed MBO, also looks set to dispose of nearly 800 of its pubs. These deals follow on from a hectic couple of years in the market that have seen Pubmaster sold by Bridgepoint Capital, PPM Ventures and BC Partners, Punch Taverns acquire Allied Domecq’ pub estate, Scottish and Newcastle buy Greenalls managed pub business and Rank Group sell the Tom Cobleigh pub chain to Electra Partners.

When considering this sector, it is important to make the distinction between leased pubs and managed pubs. Leased pubs are, as their name would suggest, pubs that are simply leased to the tenant. The tenant pays rent to the owner and, in the case of a brewery landlord, buys beer from the owner. Revenues from such pubs consist of rent and any cut that the landlord might take from other business, such as fruit machines. Managed pubs are those for which the pub-owning company puts the management in place, runs the business and takes the profits. Managed pubs can be subdivided again into two types: branded and unbranded. Thus, there are two very different cash flows coming from these two different types of operations and they are approached in very different ways by potential investors.

The growth in large pub-owning groups following the shake-up in the pub sector has largely been driven by the economies of scale available with large portfolios. In addition to Nomura’s 5,000-plus portfolio, Punch Taverns has 5,250 pubs, Whitbread 2,978 (as at mid-February but up for sale), Scottish and Newcastle 2,680 (as at mid-February), Enterprise Inns 2,580 and Bass 2,060. One feature of these large portfolios is that they are almost always leased pubs rather than managed pubs. The reason for this is that they offer solid, predictable cashflows, which makes them cheap to finance. “Leased pub deals are really a financial engineering play,” explains Bill Priestley, associate director at Legal and General Ventures in London, which lost out to Nomura in the race to acquire the Bass portfolio.

“Nomura has advantages purely because of the size of their portfolio and the infrastructure that they have in place,” he admits. “They can probably extract more value per pub.” Nomura ended up paying GBP625 million cash for the 988 pubs, which had net assets of GBP622 million. Legal and General Ventures is understood to have bid GBP620 million for the portfolio but this has not been confirmed. “It was a very close run thing,” says Priestley.

Of the 988 pubs in the portfolio, 981 are managed and seven leased, but Nomura will now set about changing the managed pubs to leased pubs. This is a time-consuming and costly business, but one that Nomura is well placed to undertake because of the sheer size of its holdings in this sector. Once the pubs have been converted the estate will probably be folded in to Nomura’s existing Unique Pub Company subsidiary. This is not the last that shall be seen of Bass for a while as its Belgian owner Interbrew will probably be forced to put the company back on the market this year following an EC decision that its purchase of the brewer last year was anti-competitive.

Whitbread announced the sale of its 2,978-strong portfolio in January this year for around GBP1.5 billion. The sale is likely to be split between the managed pubs, for which Candover is a strong contender, and the leased pubs, which are again being chased by Nomura this time up against Enterprise Inns. Cinven is understood to have pulled out of the race for the managed pubs and Schroder Ventures from the leased sale. Neither is Legal & General Ventures in the frame for the Whitbread pub portfolio. Should the Robert Breare bid for Wolverhampton and Dudley prove successful that 800-strong pub estate will be sold to Enterprise Inns. Wolverhampton and Dudley has rejected Breare’s original offer of GBP472 million.

Nomura’s principal finance group seems to be an almost permanent fixture in any pub deal, and is always the bidder to meet for any private equity firms hoping to get into the market. The technical difference between principal finance and private equity is simply that Nomura is using its balance sheet to finance the deals rather than an external fund. But the interest from both types of bidder is the same: the huge potential for securitisation that exists from these leased pub portfolios.

The two main prerequisites for a successful securitisation are a portfolio of relatively homogenous assets and a steady, predictable cashflow. The pub estates easily meet both criteria. “The potential for securitisation is driving private equity interest in this sector,” says Priestley at L&G Ventures. “Over the next few years we expect to see a widespread movement from non-branded, managed pubs to leased pubs in order for owners to take advantage of this.” Leased pub portfolios trade at EBITDA multiples of around 8.5 to 9 times but can be financed via securitisation at around 7 to 8 times. Managed pubs trade at about 6 to 7 times.

But some private equity experts question the growth in this type of business. “Nomura has been quite clever in identifying this financial arbitrage and demonstrating that they could finance a deal at a level that people thought was not possible,” says one. “But the role of private equity is to improve management and improve earnings. These pub deals are not influencing either they are purely financial arbitrage or property plays.” Charlie Green, director at Candover Partners in London disagrees. “The job of private equity houses should be to make money for their shareholders it doesn’t matter how they do it,” he says. “Pub securitisation may be a slightly riskier way to do it, that’s all,” he says. As Deng Xiaoping famously said: “It doesn’t matter if the cat is black or white as long as it catches the mouse.”

While leased pub securitisation deals may be of questionable merit to some private equity houses, managed pub deals do offer a true venture capital opportunity. But the sector is certainly overcrowded and for branded pub deals the product needs a strong angle in order to provide growth. The incentive of a branded pub deal for the investor is the roll-out potential as economies of scale will again come into play here and money will only start to be made after 20 or 30 sites are up and running.

In the branded sector it is very important to get the site right, and the pub must have a certain critical mass before it can be considered as a branded pub with minimum takings of between GBP8,000 and GBP10,000 a week. There has been huge growth in the branded pub concept, with several very successful chains such as All Bar One and O’Neills (both owned by Bass). Bass has sold its non-branded managed pubs in order to concentrate on the brands as the margins on offer are much higher. A large, central city branded pub can be taking in around GBP50,000 a week and have gross margins of 60 per cent to 70 per cent. “Nearly all unbranded managed pubs will disappear to become leased operations,” predicts Priestley at Legal and General. “Those that don’t fit the branded concept as they are because they are in the wrong place or too small will be converted to lease.”

Green at Candover, which is bidding for the Whitbread managed portfolio, warns that the most important issue with the pub sector is finding your exit. “All the deals that have happened will be looking for an exit,” he says. “There are only so many you can float [and not in current market conditions].” Current stock market sentiment is hostile to this sector as it simply does not produce the kind of margins that are needed. “Maybe the answer is just to keep releveraging,” says Green. “But will public investors accept the kind of leverage that private equity will?” Some feel that the managed pub sector is already overplayed and that further

good deals are unlikely to come along. “Too much money has already been pumped into the managed pub sector,” says one executive. “The sector is overcrowded. I have turned down a series of managed pub transactions as they simply don’t make sense.”

Private equity firms jaded with the pub story may now be turning their attentions to the health club sector. This is a sector that has so far been more talk than substance with most deals still at the planning stage. The private equity firm that seems to have made most headway in the sector is Compass Partners, which has built up a chain of fitness clubs across Europe known as Balance. Compass is now believed to be in discussions to buy Clubhaus, a golf and fitness group and a French fitness chain, Gymnase Club.

Compass is also top of the list of firms likely bid for the UK-based Cannons chain of health clubs after it decided against an IPO at the end of last year. Compass Partners is pursuing an aggressive strategy of buy and build in this sector and will benefit from being one of the first private equity firms off the block. But others are also looking closely at the potential of this market, not least Candover and Cinven who are both considering a rival bid for Cannons.

An attraction of the health club sector is that the product can be rolled out worldwide with very little regional adjustment. There can also be economies of scale once sizeable portfolios are achieved, but it could be expensive getting there. “The rollout of a health club brand will not be driven by economies of scale,” says Charlie Green at Candover. He explains that most of the cash generated has to go into investing in new sites. “Every time a new investment is made there has to be a fresh investment of equity which is an inefficient use of private equity,” he says. “It is a difficult call for private equity as you are effectively being asked to invest in start-up businesses.” The attraction is, therefore, the classic venture capital incentive, management and the growth potential of the sector.

“You need a quality management team, a business that is number one or two in its market and an exit,” says Green, explaining that it is the strength of Cannons management that is driving Candover’s possible bid for the company. But, like the pub sector, much more consolidation is expected in this market and there could be many more club chains up for sale. “The health club sector is trading on an EBITDA multiple of around 11, so if you are looking to buy to run for cash you should do so at about 5 or 6,” says Green.

The potential of the sector means that there is likely to be growing competition for any future health club deals. Whitbread, which already owns the David Lloyd chain of health clubs, is likely to devote some of the proceeds of the sale of its pub portfolio to buying further health club assets. Crown Sports, which was formed from the reverse takeover of Golf Club Holdings, is steadily building up assets and US-based chain Fitness Holdings is on the prowl for a UK acquisition.

Chains such as Cannons are situated at the luxury end of the market are the most likely targets as they are trading on much lower multiples and their languishing share prices have meant that expansion funding is hard to find. Clubs at the budget end of the market such as Fitness First have been performing much better. The Esporta chain, which was demerged from the First Leisure Group, is mooted as the next candidate for consolidation.

While pubs and health clubs may offer the best potential for deals going forward, there has been no shortage of activity in other sectors of the leisure industry. Both Candover and Legal & General Ventures backed the GBP700 million sale of Rank Group’s holiday division to Bourne Leisure at the end of September last year in what is a clear management play. The holiday business had seen profits slip from GBP4.5 million to GBP3.8 million. “The Rank business was unloved but there is good management and there was compelling logic for the merger of the two caravan businesses. The deal will incorporate some judicious buying and selling,” says Priestley at Legal and General.

Other recent leisure deals include the sale of Shepperton Film Studios (partly-owned by Candover) to Pinewood Studios in mid-February for GBP35 million in a 3i-backed deal. CVC and Cinven could also be looking to sell their interest in William Hill as an IPO seems out of the question. Rank Group is understood to have been in talks on the deal, which have now collapsed.