Opinion: Richard Sanders

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