“We are now in the age of equity.” That’s the conclusion of Baker Tilly’s Rob Donaldson following in-depth analysis of funding options for mid-market owner-managed businesses.
There are more than 200 private equity firms with billions to invest, he told the 50-strong gathering of business owners at Baker Tilly’s recent Quest for Funding seminar.
Predictably, the news comes with a caveat, however. The environment may be ripe for private equity houses to loosen their purse strings, but only the most robust businesses are likely to feel the benefit.
Getting funds will also take longer and involve jumping through more hoops than the easy money days leading up to 2007.
Rich pickings
What is clear is that our collective ‘love affair’ with debt for growth finance is over for now. The pain the banks will suffer because of the mountains of dodgy debt sitting on their books plus the grip of recession have ensured that debt is significantly more expensive and far tougher to access.
“It’s fair to say nobody expects a quick solution,” says Chris Allner, Octopus Investments’ Head of Private Equity and Chairman of its investment committee. “We will be living in this environment for a long time.”
However, the need for capital is only likely to grow, even among stronger businesses, says Allner. “Be prepared for a working capital strain,” he warns. “In the early 1980s the businesses with the weakest models fell over very quickly and that’s been the case to date. But better businesses are starting to falter. And failures continue when an economy returns. In fact as many businesses go bust when the economy goes up as they do when the economy goes down.”
But there’s always something to fill a void. Recent history shows that when the economy is at its lowest ebb, private equity comes to the fore. “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 that point,” confirms Allner, who also spoke at the Quest for Funding event.
As Allner points out, the vintage investment years followed the high-tech collapse of 2001 and the deep recession of the early 1990s, before people began to feel the upturn. The reasons are plain. “Prices are low, competition for deals is less, businesses that are left are more robust, performance is more predictable,” he says.
What’s more, deals done for equity now can be part-refinanced with a larger debt element a couple of years down the line when banks regain their confidence. “IRR returns may be less but absolute money returns will be higher with arguably less risk,” adds Allner.
Tough love
While it appears likely that we will enter a period in which private equity houses will look to grow their portfolios, this is only part of the picture. It’s important to understand precisely where companies stand with the banks too, not least because owners will rely heavily on those relationships as the impact of the recession on business hits both trading performance and the ability to service existing debt.
According to the CBI’s Access to Finance Survey, two thirds of businesses have reported a reduction in credit availability. And 72% say there’s been a reduction in the availability of trade finance.
Donaldson says Baker Tilly has observed a significant reduction in the amount banks are willing to lend in new deals. The acceptable ratio of debt to operating earnings has fallen markedly with debt multiples down to 2-3*EBIT even for a good mid market deal from previous elevated levels of anywhere up to 5*EBIT in 2007.
Bank charges are up, the CBI has reported, for both ‘existing’ and new credit lines. Arrangement fees have typically increased and can now be as much as 3-4% of a transaction. As for banks’ required margin for senior debt this has moved from as little as 1-2% pre-crunch to around 3-5% now.
Put simply, “debt is less available and more expensive now and I don’t think that will change any time soon”, says Donaldson.
Coming or going?
The bleak situation certainly wasn’t aided by the disappearance of the international banks that had flocked to the UK when times were good. Icelandic, Irish and American players have departed these shores one way or another, leaving the weakened domestic players to fend for themselves. “Almost the whole weight of the UK economy now rests on UK banks’ shoulders,” says Donaldson. “For business it feels as if the tap has just been turned off.”
And these banks are being pulled in different directions.
On the one hand the Government is pressing them to increase lending and those banks bailed-out by the taxpayer have a legally binding agreement to increase lending. As well as these obligations they also need fees from new lending to sustain their overheads and to earn profits to cover the losses on their old debts.
On the other, the FSA is telling them to reduce their own leverage (in other words, shrink their balance sheets) and their own instinct is telling them now is not the time to be extending credit.
No wonder bankers don’t know if they’re coming or going.
Don’t just sit there
To give a company the best chance of maintain bank support, owners would be wise to get to grips with fluctuations in their trading performance, suggests Allner.
“Understand the impact of a shortfall in sales. What’s your break even position? What’s your shortfall likely to be? Know your key metrics. In the good times you can get away with it. In the bad times you are exposed for every weakness.”
It’s possible to allay banks’ fears of the unknown by getting a systems audit, revisiting financial projections, keeping the bank well informed of good and bad news, and being a stickler for punctuality in providing management information.
It’s also worth noting the Government has acted to make some of the banks’ decisions easier. Business Secretary Lord Mandelson and Chancellor Alastair Darling have been prominent in launching a frenzy of initiatives aimed at both stimulating the system and resolving the banks’ dilemma of being short of capital and yet terrified of risk.
Work in progress
There are too many to detail here, but the Enterprise Finance Guarantee (EFG) scheme is probably the most high profile of the lot. The Government has set aside £1.3 billion in an initiative designed to support lending to companies with turnovers of less than £25 million who find it hard to access the finance they need. Under the scheme, companies can access up to £1 million of new and refinanced loans, 75% of which is guaranteed by the Government.
However, while 26 lenders have signed up to the EFG scheme it remains a work in progress, says Donaldson, and not sufficient for many mid-market companies.
“I’m sure a few hundred businesses have been funded by the EFG, but it’s peanuts in the bigger scheme of things” he says. “All the other initiatives are not targeted at business owners; they’re targeted at making banks feel better.”
Concerns that there exists a disconnect between the banks and the Government over the scheme continue to linger, adds Donaldson, with many relationship managers either not fully briefed or unwilling to provide a facility even with the guarantee in place.
Other options
There are other ways to raise cash. Asset disposals can be a way of focusing upon the core business and releasing cash to ease the pressure. “Now might not seem the obvious time to consider disposals,” says Donaldson. “However, there are buyers out there and provided you prepare well and approach the market in the right way you can still secure a decent price for a business.”
Spend wisely
Once you’ve managed to overcome the hurdles and actually raised some money you have another challenge.
If you can lay your hands on it, spend wisely, counsels Donaldson. “There are some terrific bargains out there and many assets for sale. Lots of assets are effectively under bank or administrator control and need to be sold. Large corporates are selling off non-core assets. And many private businesses are looking for a safe home. In short, lots of keen sellers. Prices are substantially down for some businesses. If you do find money, don’t blow it.”
And if you are working in a business but are not shareholders, keep your eyes open; there are some fantastic management buy-out opportunities.