The forgotten market

The second quarter of 2009 has proven the inflexion point the industry has awaited for a year. For a (very good) start, the last three months saw the first uptick in activity, up 38% on Q1 figures (see graph 1). What's more, the UK's share of the pie has resumed its top-of-the-class stance (see graph 2). Even more promising is that the major increase took place in deal sizes, indicating that purse strings are indeed opening up.

What's noteworthy is whose purses the money is coming from. Since Q2 not only saw an increase in activity, but also of equity cushions. Q2 marked the highest level of all-equity deals unquote" has ever recorded, with 50% of buyouts done in the UK in the three-month period involving no initial leverage (see graph 3).

Such an increase shows a true commitment from the mid-market to backing businesses they deem sound, whatever the cost. The most recent example is Gresham's £20.75m buyout of five of Formation Group's talent management agencies, which will see the sponsor provide the entire capital structure by utilising its debt underwriting facility (see page 43).

The merits are clear. Dealing with one funding source gives a vendor certainty of execution, as well as one party to deal with rather than a handful of bickering interests. The decreased risk for Formation's management was cited as a reason for providing 100% of the funding. In today's market, that is worth a lot. To boot, all-equity deals carry more risk, which should indicate higher reward potential. Earlier this year Dunedin proved how lucrative such risks can be when it generated a 92% IRR and 3x money multiple in the sale of Fernau Avionics, a company it backed with a £16m all-equity slice in 2007. As is typical in such deals, the capital structure was later bridged with debt, in that case 50% from Lloyds.

When structuring a deal in such a way so as to aide efficiency/appease a vendor, fair enough. But there is increasing suspicion that GPs are not bothering to consider banks as they deem it a waste of time.

This notion is outdated. In addition to our own figures proving that more LBOs are being done, most bankers now spend more time in the office and less in pubs. The difference is the terms and amount available, and some sponsors have yet to accept that if they want leverage, it will now be on the banks' terms.

In addition to coming with more strings attached, there is often also less leverage available. For example, whereas two years ago 5-6x earnings was what most banks were willing to lend, that is now down to 2.5x, corresponding to under a third of the capital structure in some cases. What's more, that is 2.5x forecast earnings, not historical, meaning that the absolute sum of debt coming on board is far less than half the amount sponsors could have achieved two years ago. Unsurprisingly, we have seen a corresponding increase in equity cushions in deals. This should be a good thing.

But is all-equity all good? Not necessarily, according to some. While many sponsors expect to simply bridge the gap in deals now, with a view to bringing leverage on board later, there is talk that the time to syndicate is now, while you can get it. True, terms are not necessarily what sponsors want; they are very different to what they were spoilt with two years ago. But the funding is usually available, unlike three months ago.

Not everyone knows this, with two bankers telling your editor they are baffled at how many deals are getting done without lenders being approached. What is more, when they revert to the sponsors querying why they weren't contacted, the common reply is, "We figured we couldn't get any backing and looked for other options." This indicates a defeatist attitude on the part of buyout houses, even as banks are willing at long last to open their cheque books again.

Says one banker: "Few, if any, UK banks will have come close to hitting their lending budget targets at the half year point due to deal volumes being so low. With the year-end approaching, sponsors should therefore find bankers more receptive than ever to put some debt to work into sensibly structured deals."

The moral is that after a long lull, it is again worth banging on banks' doors. You might be surprised at what you can get. And if you're declined, you must now consider it as a sign of a weak deal, rather than outright dismissing it as market conditions.

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• Topics
• Financing
• UK / Ireland