Opinion: Richard Sanders

Reinforcing the importance of the financial services sector to the UK economy is a recent survey undertaken by Investec that supports the theory that the UK is the most favourable market for managing private equity funds (encouragingly ahead of both Geneva and Frankfurt). These are both markets that commentators often, in my view mistakenly, see as a threat to London’s position.

There will be many reasons for this but most importantly there is an infrastructure in the professional services arena that cannot easily be replicated and this makes the Capital a particularly resilient market.

Obviously there are many challenges, not least of which is short term deal flow and potentially some over capacity in the market, however, the passage of time will address this. Importantly the report does comment on the notion that the industry does, however, need to improve its public perception. Private Equity is by and large a force for good in the UK market and the sooner the political classes get this message and the more succinctly it can be conveyed to the wider community then the better for UK plc.

News today that Europe's second largest tour operator, Thomas Cook, has delayed announcement of its results and disclosed it is in discussion with its bankers after what it described as a "serious slump in business" will send chill winds through the whole travel sector.

In recent years operators have faced a constant battle in balancing supply with demand as a combination of economic uncertainty and a shift to shorter lead times on bookings have caused real pricing issues in the market.

With the peak booking period now upon us for the winter season operators will be keen to ensure they are capturing as much of the market as they can, balancing promotional activity with margin management – a difficult task in these uncertain times.

Whilst there is a strong suspicion that the current spat going on in the US re debt levels is a case of political posturing which will ultimately resolve itself, I cannot help thinking that it may well start to impact on sentiment towards the US.

From an M&A perspective we have seen increasing cross border activity with our clients, with the US again being the most active buyer of UK assets. This stems from a number of reasons, which inclue a relatively competitive exchange rate, low borrowing costs and the US can do mentality.

The current situation however could start to erode some of these factors with a knock on impact to cross border dealflow.

Well one thing must now be abundantly clear.

The prospects of an interest rate rise this year look very slim.

With the ever increasing numbers of failures on the high street and evidence that the impact of public sector spend, especially at the Local Authority level, is beginning to bite in businesses outside the b2c market, the Bank of England needs to do all it can to limit the damage to the consumer.

The follow on from this in the M&A market remains unclear. Whilst transactions in the bricks and mortar space remain challenging, other sectors continue to perform robustly and trade interest in quality deals is still evident. The hope is that service industries and exporters can continue to prop up the rest of the ailing economy.

I read today that the Office of National Statistics (ONS) has revisited its views on construction output for the first quarter of 2011, revising its reduction to 4% from the previously quoted 4.7%.

However, I still can’t help feel that this doesn’t reflect sentiment on the ground.

There is no doubting that margins on tenders are being squeezed and that some of the oversupply in the subcontract sector is less prevalent than 12 months ago. However, the discussions I am having with clients indicates that business is holding up relatively well.

The real test will come in the next six months as Local Authority budgets come under significantly increasing pressure.

As I've previously touched on these are strange times indeed for the M&A market.

Corporates are faced with the challenge of building shareholder value at a time in the cycle when organic growth is at best anaemic, certainly within developed economies.

Such circumstances are, however, usually accompanied by high interest rates as governments fight off inflation. Things are clearly different this time - whilst higher interest rates look increasingly likely in the short term, I don't believe this is likely to derail the other trend in the Market, namely shareholder growth by acquisition.

At Catalyst we saw significant evidence of this in 2010 with a number of disposals going to strategic acquirers at very full prices (see the sales of Vision Security Group and FirstAssist as prime examples). And this trend appears to be continuing in 2011 with the recent stats from Dealogic showing 1,350 of deal announcements in the last couple of weeks at an eye watering level of $139 billion.

Whilst much of this is focused on the quoted markets we continue to see similar trends in the mid market and anticipate a strong start to 2011 in our M&A transactions.

News that Rok has entered administration is a further blow to the sector following hot on the heels of the Connaught failure.

Many will now be asking how much is this a result of the public sector squeeze and how much is derived from more fundamental issues within the businesses themselves.

The answer to this is not clear and some clarity in the findings of the administrators would be welcome by many operating in this market. Given the large number of contacts we have in the sector, not least of these will be finance providers, who are increasingly nervous about the security of operators in this space.

Interesting facts from seminal US magazine “Inc.” and this year’s crop of Inc. 500 fastest growing privately owned companies.

Who’d have thought that in one of the deepest recessions in modern US history, that the largest concentration of fast growing companies would be found in the advertising and marketing industries?

Albeit that the category is pretty wide in nature, (covering more ‘regular’ activities such as online marketing promotions, website design and brochure design to slightly more ‘unusual’ activities such as placing ads on New York taxis!), it does back up what I’ve been saying for months since we worked on the deal that created Inspired Thinking Group, namely that there is money to be made at present in the advertising/marketing industry by those with a clear strategy and a sales process to target companies seeking to differentiate in a tough climate.

They say that what starts in the US ends up in the UK – whilst maybe not a direct comparable, it does back up to some degree my own faith in the sector here, and my thinking that there are opportunities to be had.

When any market turns, history tells us that the fittest will survive.

Further testament to this is the M&A activity in the social housing sector in recent weeks. Firstly we had the news that Morgan Sindall was acquiring the Powerminster, MJ Gleeson’s maintenance business. The quoted construction business has been struggling in this sector for some time and this was seen as an obvious candidate for disposal.

We then had the collapse of Connaught and again Morgan Sindall appears to be the winner here, picking up much of its social maintenance businesses. And now, not wishing to be left out, we have news that Mears has stepped in to acquire Jackson Lloyd, a business which has now changed hands 3 times in recent years. With the Comprehensive Spending Review now only a couple of weeks away our view is that this is only the first real stages of the consolidation to come in this market as the public sector looks to manage on ever tighter budgets.

The last couple of years should have reinforced the benefits to all FDs and CEOs of a robust forecasting model which allows you to stress test your business model under many different scenarios.

The importance of this is only brought into sharper focus by the news that the Bank of England is about to embark on a significant investment in updating its own forecasting model having finally recognised that its current solution failed spectacularly.

In what is likely to be a period of low/no economic growth, the management teams of businesses we are advising can no longer set out aggressive organic growth plans as a basis for delivering shareholder returns.

With current market conditions highlighting the perils of operating with significant leverage the art of accurately forecasting has never been more beneficial.

There is increasing evidence that the housing industry is taking action to facilitate the delivery of the UK’s housing needs in coming years and that this might create opportunities for funders active in the market.

Firstly, Catalyst 4 Homes has announced its plans for raising third party funding from the market, including private equity houses and pension funds and we understand that they are well advanced with their discussions towards raising a fund of c£200m.

Secondly, CIH has launched its Housing Pact, a key part of which is the commitment to identify additional sources of finance to supplement public sector finance. We await to see the final outcome of these and their impact on the market but it is an encouraging step in the right direction.

Graphite Capital has announced that it has provided significant funding support to a new business targeted at the development of London residential property. Whilst this could be seen as an indication that land prices and the housing market in general has bottomed, it could equally be seen as confirmation that there is a two speed market in the UK – London property prices have remained robust despite the turmoil whilst other regions have seen significant falls in pricing in all but the most attractive of markets.

It also confirms the widely held view that there is an over supply of funds in the private equity market with many looking at increasingly unusual ways of putting their capital to work. Whilst investing at the bottom of the cycle is by no means a new phenomenon, looking at significant start ups on this scale is more unusual.

Barratt’s recent public announcements seem to indicate a significant recovery is underway in the housing sector and they are by no means alone. Year on year prices up 15%, a return to profits and a much increased order book all seem to be supportive of that theory.

That, however, is not the whole story. From our ongoing dialogue with the regional players we still see an industry that is struggling with overall volumes and a lack of liquidity in the mortgage market. Coupled to this is the fact that the independents have the added frustration of their own lack of liquidity – the debt markets have not only constrained the ability of the homeowners to raise finance – the same impact has happened with the housebuilders with loan to values significantly reduced.

We have, however, started to see examples of the funding market, and particularly the private equity markets, recognizing the opportunity in this sector with land prices having fallen significantly. Whilst this has yet to feed through to an increase in M&A activity we do believe that in the next 12 months the strongest independents will be able to access new sources of capital and ensure they participate in the next stage of the recovery.

Does the successful completion of the United House deal by LDC mark a return to the sector by the private equity market?
In part yes, although what is clear here is that United House has a number of strengths that will have protected it from some of the issues in the wider market, namely its geographic focus, contract book and spread of services. The business has also come to market at a time when there are limited high quality mandates in the mid-market and hence competition for such assets can be fierce.

The jury is still out though in my opinion as to whether the sector as a whole will be seen as one attractive for M&A, and whether more similar deals will get done.

These are strange times for private equity. Historically investing at the bottom of the cycle has reaped rich rewards for those with the funds to invest. People in the industry still talk about the success of those investments made in the early 90's and indeed subsequent realisations demonstrated that this was a vintage period.

This time, however, it feels a little different. The key issue we currently see is an acute imbalance between supply and demand – too many funders chasing too few deals. Any basic understanding of economics will lead you to one conclusion - prices for those deals that are getting done are extremely robust. And whilst the banking market is undoubtedly extremely challenging, even this is failing to put any significant damper on prices, with evidence that many funds are prepared to bridge the funding gap to secure deals.

So, why are the private equity houses driving so hard for deals? Well, the simple answer is that they are under pressure to do so. In recent years many billions have been raised in the mid-market alone and the equity houses are keen to demonstrate they can put these funds to work. If they don’t then they risk funding commitments being withdrawn and the management fees on these funds falling away. This has the potential to have a significant impact on the individual houses and not surprisingly is something they are keen to avoid. So, where in the bull market we were used to seeing returns expectations in the mid 20's, it is not uncommon to see some funds priced at sub 20% returns. Supporting this is the view of a number of mezzanine providers who are increasingly seeing their main competition as being the private equity houses themselves!

As ever, the wisdom of this approach will only be known in a number of years time but in the meantime we still see significant scope for a shake up in the industry and a return to a more balanced supply and demand equation. The reason for this lies with those funds that are significantly invested and have assets acquired at the peak of the market. They find themselves in a catch 22 position – insignificant funds to participate in deals at the bottom of the market and an economic environment that sees many of their own businesses performing well below expectations set at the time of doing the deal.

Now is not a time to be looking to sell many of these assets, as a look at the latest industry statistics would reveal, but the knock on effect is that without an established history of successful realisations the funds are restricted in their ability to raise new money. Our view is that this will, over the medium term, see some funds depart the scene completely and others consolidate into other more successful operators. Only then will we be able to see the market functioning more normally.

Evidence that private equity is seen as an attractive investment opportunity has been reinforced by the statement that the Pension Protection Fund (PPF), possibly one of the UK’s biggest investors, is now looking at direct investment in to private equity opportunities.

But following the trend set by a number of the significant pension funds that have already chosen this approach does this indicate a growing threat to the traditional private equity market? The answer to that, in the mid market at least, is not yet.

However, with many mid market funds likely to be fund raising in coming years it will bring added focus to both the costs of administering those funds and their ability to source deals ahead of the competition.

One of the key activities in the housing market has been a recapitalisation of the quoted groups, enabling them to repair their balance sheets after significant write downs and trading losses.

In 2009 alone house builders have raised in excess of £1.5bn in new money. This begs the question “How can the private sector compete?” Without access to new capital the return to financial health is inevitably going to take the private sector longer to address and the risk is that this means that they are unable to participate fully in any recovery as land starts to trade hands again.

The private sector currently faces two choices; consolidation to create the scale to allow finance to be raised in the private markets; or a focus on real niches where the nationals are unable to compete. Either way our view is that a choice needs to be made in the short term or the current market opportunity will be lost.

Over recent days property and construction businesses have announce plans to raise in excess of £1 billion of new capital, with Barratts and Redrow being two of the most notable recent announcements.

It is clear that they now see the opportunity to re-enter the land market and prices and volumes have stabilised despite the lack of liquidity in the mortgage market.

Interestingly where the boom was partly fuelled by cheap money we are now seeing the recovery driven by a lack of supply – at some point the market must return to equilibrium but what that means for house prices, and correspondingly for the value of housebuilders and their businesses remains unclear.

There is speculation today that Gladedale is about to announce a debt for equity swap with its major funder, Lloyds HBOS. This has to be an inevitable outcome for many in this sector, with several private housebuilders suffering under a debt burden well beyond their means and limiting their ability to trade out of the crisis. With the greater visibility in the public markets driving solutions much more quickly, the private sector is only just now catching up.

This has to be good news for the sector in the longer term, allowing businesses to go back to the market and develop their landbanks for the next few years. Those with longer memories will recall the same process happening in the early 90's with a number of banks taking equity for debt and many of these resulted in the institutions recovering their positions and the businesses thriving.

Today's headlines in the Taylor Wimpey announcement, coupled with Halifax joining with Nationwide in recording an increase in house prices, have added weight to the view that housing has in fact turned the corner. I for one remain to be convinced. Currently the lack of supply of property, both new and existing stock, has acted as a dampener on price falls. I know of a number of people who would be interested in moving but bemoan the lack of stock. The next phase of the recovery is therefore critical - any significant rise in stock levels and overly ambitious build programmes could be counter prodcutive and see a double dip in house pricing. My view is we won't have real clarity on the house market position until the second quarter of 2010, when potentially volumes return to more normal levels and we understand where mortgage finanice markets sit.

The extent of the issues in the public sector are rapidly becoming increasingly evident in the building sector. Until recently this sector was seen as highly attractive to some investors with the much publicised shortfall in social housing and the Labour government's desire to rebuild a large proportion of the infrastructure assets across health, education and the prison sector amongst others being key drivers to M&A activity.

Now we are facing the harsh reality of an over committed public sector with the latest announcement from the Learning and Skills Council that c90% of new projects up for approval in the education sector have been declined. Watch this space for developments in the health market particularly as many are forecasting a huge fall in the new builds planned under these frameworks