Funding Q&A
We asked two experts in the field to answer your questions on funding.
About the experts
Rob Donaldson is Baker Tilly’s head of M&A and Private Equity, having joined in 1999. He has more than 15 years’ experience, specialising in mergers and acquisitions, business disposals, management buy-outs and fund raising. He has personally led over 30 completed deals with a combined value of over £700 million since he has been with the firm
Chris Allner is Octopus Investments’ Head of Private Equity and Chairman of its investment committee. He has more than 25 years’ private equity experience and has previously been a director at Proven and Bridgepoint. He joined Octopus (which has close to £1 billion under management in the SME space) in 2004.
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RD: Debt, of course, is worth the effort. It is still cheaper than equity. But businesses have to get used to the fact that building a business on a mountain of debt is not the way forward. There is so little visibility on trading and financial performance. Until 2007, you could feel comfortable that things would generally move north. Debt is inflexible when times are bad. So it’s time to look upon the next few years as the age of equity. Banks will slowly heal and become more confident and aggressive in lending. But for the next three or four years debt funding will be expensive and what you can raise will be limited compared to the past.
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CA: When margins were 1.5% or 2% banks could not afford to lose any investments. You have to lend to 50 companies to make up for one loss. At a 4.5% margin this ratio improves. We will have to wait to see if this pricing works, but historically excess competition has driven margins down to unsustainable levels over a cycle.
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RD: Yes but only if you are absolutely sure you have enough headroom and it’s not holding the business back. Next year will be a little easier than this year. People with money value it highly and will expect a bigger equity stake.
CA: It’s a matter of expected returns on money raised. It’s likely that if companies wait for equity funding, pricing may be more attractive and come off the floor. However, the company might miss out on a significant opportunity. So it’s all about whether the return expected from investing the new funds outweighs the cost. The opportunities available for investment are attractively priced at the moment (e.g. buying distressed competitors), but this is unlikely to continue.
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RD: Anecdotally, the Government schemes are not directly benefiting any but the smallest businesses. I’m sure a few hundred businesses have been funded by the Enterprise Finance Guarantee (EFG) scheme, but it’s peanuts in the context of the economy as a whole.
The other bank initiatives are not targeted at business owners; they’re targeted at making banks feel better. The effect of the Asset Protection Scheme (APS), which closed in March, is only starting to feed through now. It has allowed RBS and Lloyds TSB to resume lending.
The new £150 million innovation fund is effectively re-announcing schemes from the Budget. My own view is that the Government should stay out of it. It should instead focus on red tape and business taxation. Using public money to invest in private enterprise has never had a great track record.
CA: Capital for Enterprise is working but still early in the programme for deals to have completed. I have not personally seen much evidence of the EFG working at all.
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CA: I would be surprised if this much private sector money comes in and I didn't realise this was the plan. The prospect of £100 million per annum over the next ten years from the private sector is significant, particularly if it is targeted at companies that would not otherwise raise money.
If you split the ventures market into quartiles, the top quartile, where the proposition is fully investment ready with all the right ingredients, will always get money from the private sector. However, the second quartile struggles. Even though most of the ingredients are there, it is not yet perfect. What needs to be provided is money plus the skills to make the proposition work.
This is the same in the lower mid-market. Too many reasonably good businesses fail to raise funding because the providers of money do not have either the skills or resources to turn these propositions into do-able deals. £100 million per annum could support 50-100 companies and this could be significant.
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RD: There were banks that had been charging into the stratosphere in the year leading up to 2007. They were going ‘up-market’ and international and had abandoned mid-market UK business. This created the opportunity for other financial institutions from around the world, such as Investec and Kaupthing, to enter the UK market.
Now those same big banks are knocking on the door of the mid-market as they no longer have the appetite or capital to fund mega deals. Politically, it would also be naive to try. They now favour writing smaller cheques as part of a club of bankers in a deal.
If I were to put a figure on it, I’d say mega deals are down by around 80%, while mid-market deals are probably down by only around 40%.
CA: I agree, the upper mid-market deals are the most attractive prospects. There will probably be the occasional mega deal but most money will go into less highly geared mid-market companies.
The issue is the lower mid-market where it is difficult to access private equity funds as the banks are not lending.
In the long-term, once banks start lending again for buy-outs, the mid-market will be the main beneficiary as these deals are better priced for private equity and offer more growth opportunities. Differential performance between funds will depend more on the added value brought to these deals and less on financial engineering.
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RD: The further away from the discretionary spending of consumers, the better. The more protected your revenue, the better. Companies with long-term contracts and no significant customer, such as those in maintenance, healthcare, education, established tech companies, business services, outsourced services, cleaning, and security are more likely to get backing.
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RD: It’s all about growth and not leveraged buy-outs. Leveraged buy-outs have gone from 20% of the global M&A market to 3%. Where we are selling for clients, we are selling to trade buyers now. I think there will be lots of buy-outs, but they won’t be so heavily geared, the private equity funds will have to write a bigger proportion of the deal.
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RD: I wouldn’t attempt to raise funds from multiple equity funds. It isn’t necessary. I’d certainly look and talk to different sources of funding but would only do one deal.
Clients always underestimate the time it takes. And now investors and lenders are being even more cautious. Come and talk to us early and we’ll have the best chance of getting the deal.
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CA: There are also lots of similarities with 1929/1930. We could be in for a period of fairly flat growth in living standards after ten years of excess. There is a lot of debt to unwind, personal, corporate and Government. Taxes will have to go up when the economy starts to recover and a return to growth is unlikely to make people feel any better off.
We are unlikely to be helped by the global environment through export growth. To me it seems likely that there will be an increase in inflation, which if managed (a big ‘if’) could actually help make it feel more buoyant and reduce the debt burden quicker. There is a fine balance to tread. In financial markets there will be an improvement in M&A activity once everyone adjusts their valuation expectations.
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RD: We look at the situation before taking a project on. It is about gently encouraging the client to actually get at the real picture. At the beginning they tend to give you the sales talk because they seem to forget which side we are on. We’re on theirs! Then you get to the reality of future trading prospects.
For some businesses, in some situation we will tell them straight ‘don’t even try going for debt, you need equity’. If there are cash constraints and it is not a bankable deal it is not worth gambling the future of the business by wasting six months to get a no from the debt market. There will be far more equity and growth capital deals.
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CA: Very difficult but it is about getting companies to look forward further by understanding their customers’ markets better, to gain more visibility of orders. In the mid-market we expect businesses to be volatile in their financial projections. Investors are expecting to underperform on their forecasts.
Also, we have to ask companies to take action earlier than they might otherwise have done. It is easier to recruit in the future than cut costs.
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CA: Once confidence is achieved that the bottom has been reached there will be a pick-up in activity as private equity houses want to invest at the bottom. We know that vintage investment years were 2001/2002/2003 and 1991/1992/1993, before people generally felt the upturn.
Prices are low, competition for deals is less, businesses that are left are more robust, performance is more predictable. The lack of debt should not be a barrier, as higher equity levels can be invested with plans to refinance part of the investment in two years or so when the banks are back. IRR returns may be less, but absolute money returns will be higher with arguably less risk. I expect the change to happen in the autumn or early 2010.
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RD: Start with choosing your adviser carefully. Pick one you believe will tell you straight what you can achieve. Be confident that they will tell you what they think rather than what you want to hear. And don’t fall for cheap quotes and over optimistic promises of raising money. It’s easy to waste a lot of time. Unfortunately some corporate financiers share characteristics with estate agents. We see some businesses choosing the adviser that promises the highest price at the lowest cost. You are doing a life changing deal – do you really want to cut corners?
Secondly, people do have to assume funding will take longer and be more expensive than they’d hope. Start early, it could take nine months.
Thirdly, banks are looking for a reason to say ‘no’, so you absolutely need to prepare the business and the proposition well.
CA: First of all, prepare thoroughly and get the house in order. Information has to be 100% accurate and systems have to be strong. If in doubt, get external help to make sure the business is properly controlled. If investors get information that proves to be wrong they will walk.
Secondly, have a strong method for predicting sales accurately over the next few months. Investors hate businesses with unpredictable sales or short order books. Get an adviser to help you prepare as early as you can. They can help you achieve investment readiness.
Thirdly, strengthen the management team so that you can run the business and raise money. The process is hugely time and resource consuming. Make sure you are not running out of money when you start the process.