Give more, take less

There are signs of life again emerging in the UK mid-market, with GPs and advisers indicating some activity in their long-dormant pipelines. Good thing, since the UK clocked up only 14 buyouts in the first three months of this year worth a total EUR252m, according to unquote" data. In fact the numbers have been in spectacular descent since September 2008, prior to which they had remained relatively steady.

"We have seen prices adjusting since the New Year," says Paul Marson-Smith of Gresham. "There was a misplaced hope of private owners last year that problems would melt. They've come back after Christmas to realise it's a new world. We've seen prices come down a couple of ticks - from around 8x to 6x, (both for new deals as well as bolt-ons). We're convinced it's still got further to go."

But while decreasing entry prices are beginning to attract investors, many of the best opportunities are for acquisitions to existing portfolio companies, rather than new deals altogether. "We have a great portfolio of investments and we are spending a lot of our time nurturing that value and looking to bolster it through acquisitions," says Marson-Smith. "There's been a shift of emphasis from new deals to bolt-ons for existing deals. A third of our portfolio is actively looking for acquisitions."

The first quarter saw nine bolt-ons, according to unquote", the largest being Sovereign Capital-backed maintenance service provider LPM's £12m acquisition of security services business Temple Security. More recently, the buy-and-build specialist just completed three add-ons for fostering agency portfolio company NFA in just five weeks. Gresham currently has around five bolt-ons in its pipeline worth around £80m.

When you can't bank on banks

Pipelines are helped by vendor price expectations coming down, but that's only been half the problem since September. The other half has been leverage. Though lending woes are mitigated farther down the enterprise value spectrum, they are not entirely eradicated, with uncertainty exacerbated by an increasing number of indecisive approval committees (at least one major mid-market lender is said to have four "juries" a target must win over). Thus many are avoiding the banks altogether, or fully underwriting deals at the onset, with a view to possibly bringing on debt later.

Gresham has introduced a formal debt underwriting facility. It may be used for deals at the lower end of Gresham's sweet spot, in deals up to EUR40m EV, and if the debt cannot be syndicated then it will convert to equity. The underwriting facility has yet to be utilised, though a public company currently in Gresham's sights may prove the first.

Before formalising the underwriting facility, the mid-market player did some test driving: in December 2007 Gresham backed 7city: "We were aware of the banking uncertainty so we pursued an un-geared strategy. It was a young company with huge growth potential so it made sense." RBS later provided debt. Prior to that Gresham completed the 2003 buyout of 2e2 in an all-equity deal before refinancing it. It proved a roaring success: Three years and nine acquisitions later, with revenues soaring from £15m to £155m over the holding period, Gresham sold 2e2 to Duke Street Capital, netting 3.6x its original investment.

Dunedin has also capitalised on all-equity deals, with Fernau Avionics sold earlier this year to a Canadian trade buyer, generating a 92% IRR and 3x money multiple for Dunedin. The exit was a classic case of fortune favouring the brave: the original Fernau buyout was structured in June 2007 as an all-equity deal, with the sponsor providing £16m, later reducing its exposure to £8m after Lloyds took over the debt.

Dealing with debt

When pursuing all-equity deals, Nick Soper of Investec Debt Advisory suggests engaging with the bank(s) while completing the deal: "If bridging an all-equity deal, the sponsor should make it clear to the bank that it is not planning a dividend recap, it will simply be replacing the current capital structure with what could have been implemented at the outset if time had permitted." This will give the sponsor more certainty of the ultimate funding structure, and give the banks more time to put facilities in place.

Adding new debt to an existing structure can also be a source of dealflow for banks at the moment - yes, some banks are indeed still open. For example, Soper explained that he was advising on a private equity-backed company that has utilised the capex facility established at its 2006 buyout, as planned. While the company has also traded strongly, as intended in the original projections, overall leverage levels remain at high single digit levels delivered - down from the low teens when the buyout was conducted. Accordingly, to leave the existing debt undisturbed while still allowing new money to be pumped in, Investec defined a structure whereby a new ring-fenced development company would be funded to conduct the continuing capex programme.

The current market is all about innovation. "There has been a severe contraction of the major lenders in the market," says Bill Crossan, founder of Close Growth Capital, a provider of single-source funding for small UK businesses. "It's had a significant impact on the availability of debt for deals and the market is trying to cope. But this significant change poses a great opportunity for deal doers. The UK mid-market private equity players are experienced and practical so they are well placed to adapt to market conditions." As Crossan warns, however, there is a learning curve, meaning that ploughing into all-equity deals without the appropriate care and attention is ill-advised.

"These last six months have been very good for us actually," Crossan continues, citing companies' struggle to access bank funding, as well as buyout houses' ability to secure leverage as two ways of increasing demand for the Close Growth Capital product. "We've undoubtedly seen more dealflow - of a very high quality - in the last six months because of this," he says. Interestingly, he suggests deals done this year will be syndicated with other GPs as a way of de-risking.

Grow up

With all the unleveraged buyouts on the cards, the line between mid-market buyouts and growth capital is blurring. In fact some buyout houses had tiptoed around the area this time last year, even before the true impact of the credit crunch became apparent. Indeed Q2 2008 saw an uptick in the number of growth capital deals, even as buyouts fell.

Growth capital - with no consensus on definition - is roughly taking smaller stakes in targets than buyout houses would, and with little or no debt to support the deal. It has long been cast aside to the corner of the industry as Europe's buyout market began its lofty ascent, though in reality, it's how many of Europe's most successful buyout houses cut their teeth. But are they necessarily two different things?

"Adding value is all about growth," Marson-Smith says. "Whether you call it growth capital or growth buyouts, it's adding value." Less than 10% of the growth achieved in Gresham's portfolio is through financial engineering.

Thus the debt side of things is converging: in Q4 unquote" recorded 40% of UK buyouts contained no leverage, if only temporarily. What about stakes? "Being able to approach a vendor and offer to take only a minority stake is very attractive to entrepreneurs, especially in Europe," says Christian Strain, a principal at Summit Partners. As both a buyout and growth capital investor, Summit has benefited from the lack of debt of late: "Many companies are taking a more conservative approach to financing at the moment, especially when existing shareholders are retaining significant equity stakes after the transaction, and hence have an interest in the future equity value of the company," Summit's managing director Sotiris Lyritzis explains. "In this environment, transaction structures based on pure, or predominantly, equity funding are appreciated by the vendors."

Not only are growth investors better suited to today's deals, they're also in favour with institutional investors, which have been reassessing their exposure to heavily levered private equity deals.

Being a growth-capital player and all it entails - lack of perceived reliance on leverage, and taking smaller stakes than traditional buyout firms - can really help persuade vendors. "Family-owned businesses generally prefer to go for the "best partner" and not necessarily the "highest price", particularly as they will often retain a significant ownership stake, say 30% such that their private equity partner will significantly impact their life," says A Michael Hoffman, chairman of Palamon Capital Partners. So it is less about price than in a buyout, where the vendor often sells 90-100% of the business. He continues: "Growth capital can allow a family-owner to retain an ongoing interest in the business they built while also being able to achieve some liquidity today. This makes a lot of sense to many in this position."

"People are beginning to realise that providing more of the capital structure is the method of the future," Crossan says, indicating that he expects competition to heat up in the sweet spot his firm has occupied for a decade - but he's not anxious. "More players creates a bigger market and we're already beginning to see signs of movement."

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• Topics
• Financing
• UK / Ireland