Opinion: Richard Holden

The last few months have made interesting reading for those who follow the outsourcing sector here in the UK.

With over £6 billion of cuts targeted by central government, the quoted markets have been understandably jittery. The established outsourcing operators such as Serco and Capita are under pressure whilst the mid-caps, most notably Connaught have fallen prey to speculation that the new age of austerity will have a deleterious effect on profitability as contracts are cancelled and margins are squeezed yet further.

However, in my opinion, there is still huge opportunity for private sector outsourcers to flourish in this 'brave new world'. Whilst there will no doubt be a short-term impact as a number of contracts are terminated for projects that get the chop, in the medium-term intelligent outsourcers will benefit from the structural changes shaking up the public sector.

And that is why I'm upbeat about the M&A prospects for the smaller, privately owned operators in the UK. As the government seeks to implement its programme of cost-savings, larger operators will need to acquire to protect margins and adjust their business models to suit the new order.

Facilities Management (FM) providers have been quick to respond to both the economic and legislative drivers that have pushed resource, energy and carbon management high up the list of priorities in British boardrooms. A combination of rising commodity and energy prices forces companies to manage their resources more intelligently, and from the meetings I've had over recent months it is clear to me that most are exploiting the green PR that this creates to the full.

The majority of FMs now offer a range of environmental services. With industrial energy bills projected to rise by as much as 17% over the next three years, it is an easy way to generate cost-savings for clients and is a demonstrable added value service. The most prevalent service is resource management, followed by energy and carbon management and then environmental risk assessments.

Many FMs claim to offer waste management advice to clients, but in reality this is often subcontracted to a third party waste specialist. Intelligent FMs will understand that waste is also a resource and that large cost savings can be generated through clever waste management. Self-delivering this service is not too far removed from many existing carbon management skills. With the steep rises in landfill tax, implementing recycling schemes can generate significant cost savings, but the trick is to have the reporting capability to prove this.

The additional benefit is to align the different ‘green’ services so that the client can report on its carbon footprint. This is particularly important for larger businesses now that the government’s mandatory energy saving scheme, the Carbon Reduction Commitment (CRC), has come into force. FMs should play a key role in helping companies navigate the legislation.

What does all this mean in M&A terms? Energy and carbon management service companies will continue to be sought-after acquisition targets for the large FM providers as well as utilities and the private equity community. In addition, recycling collection companies with strong systems have a window of opportunity to transition from solely being waste management companies to support service companies.

The news is currently dominated by two topics: the forthcoming General Election and likely cutbacks within the Public Sector. Unusually the subject of the Election is less prominent whilst the press enjoy the initial public sector budget skirmishes between ministers and shadow ministers.

When to cut Britain’s huge deficit is the big question and the major parties naturally disagree. They do however agree that it needs to be cut, and that the public sector overhead will have to be severely reduced, against a backdrop of recent government studies which show that outsourcing has on average saved the public purse 10 - 20% of costs.

As I write, I am part of the team putting the finishing touches to our Facilities Management (FM) sector report, examining the major trends in the industry and the impact of these on M&A and private equity activity. One of the key FM growth drivers over the next economic cycle will be a step change in public sector outsourcing, with the greatest increase coming in local government.

Central government has already embraced outsourcing, with Serco for example running prisons and VT Group providing support services to the armed forces. Local government IT, back office and property management currently have the lowest penetration of private sector outsourcing and therefore there are large gains to be made. Facilities management is a tried and tested outsourced service and should be an easy win for councils that are nervous about the concept.

Not all FMs will benefit, as any outsourcing proposition carries risk and councils are naturally prudent when it comes to the delivery of front-line services. The larger companies with public sector experience will snap up managed service contracts and will experience a period of high growth. Their capacity to manage this growth and deliver new services is however limited and they will turn to partnerships and acquisitions to fulfil their contractual duties. In addition, public sector specialists will become targets for those private sector FMs trying to tap into the key growth market.

Regulation can force change and the Ofwat final determination for AMP 5 is no exception. The price setting for 2010 to 2015 was preceded by weeks of intense lobbying by the water companies, both in the press and to the regulator, and the final outcome is fairly tough for the licence holders.

The headline dynamics of the sector are straight-forward. The water companies get their income from the consumer through water and sewerage bills and in return have a responsibility to supply clean water, operate and maintain the infrastructure, and treat sewage. They have to pay for this from their income, all of which adds up to an equation that needs to be balanced every five years.

In the last AMP period, roughly £16 billion was spent in the sector. For AMP5, Ofwat has just signed off investments of £22 billion over the five years; a 38% increase. This is more than the water companies expected and is seen as positive for the water industry as a whole.

There is however a sting in the tail of the determination. Household bills will remain broadly flat over the period which means that the water companies’ income will remain flat, even though they have to spend more money than before. This puts them in the uncomfortable situation of telling shareholders they will receive lower dividends for the next few years, or alternatively finding significant efficiencies in their operations.

This is good news for the water supply chain. The need to find greater efficiencies will undoubtedly lead to increased price pressure, however there is also a huge opportunity for clever outsourcers to deliver cost-saving solutions to their clients and take market share from less agile or innovative competitors.

I expect there to be more significant outsourcing by the water companies over the coming months and another shift in supply chain market shares as the AMP5 bidding process comes to a close towards April 2010. All of this should lead to a renewed focus on M&A and reinforce the strong private equity interest I am seeing in the sector.

The Infrastructure Planning Commission came into being this month. This is a welcome step from the government and the commission will be responsible for considering and making decisions on significant infrastructure planning applications. This will lend oversight to what has been a series of disjointed developments so far. What this means is that key energy projects can be ‘fast-tracked’ through the planning system. This helpful move will not however solve the issue of how to meet the UK’s aspirational renewable energy targets for 2020.

Catalyst has not been shy in commenting on what we see as unachievable targets (see our Clean Technology report). A cynic would say that the targets hit the right note with the green lobby and are far enough away that no-one in government will ever have to be responsible for their delivery. In the report, our research showed that the principal reason why the targets will not be met is because of a funding gap. Investment by the private sector is significant yet insufficient. Given the cross-party unanimity that significant spending cuts need to be made, the public sector will not be able to fill the gap either.

I see the Infrastructure Planning Commission more as a way of waving through a number of nuclear power projects than necessarily speeding up construction of wind farms and other more green forms of power generation.

The energy debate in the UK has been focused on energy security and how to reduce emissions. The complexity of global energy politics is impenetrable for most of us, but we all have opinions on whether we should build more nuclear power stations, or whether wind farms should be built in our countryside. Most of us shrug our shoulders and assume that the government will sort it out and carry on with our daily lives. That is until we find out that someone is planning to stick a nuclear reactor in our back garden. The rise of NIMBYs and 'special interest groups' in Britain has made obtaining planning permission for anything other than a new garden shed all but impossible. Consider the headache of trying to restructure the long-term energy infrastructure of a country.

The debate over how to replace the fossil fuel burning power stations continues, but this all seems to be happening too late if we are to hit our various green targets - 34% reduction in carbon emisisons and 15% of all energy to be generated from renewable sources by 2020 to name but two.

Catalyst's recent research report on Clean Technology comes to the conclusion that the renewable energy target in particular will be missed, as there is still a funding gap from the major players.

These targets are often replaced by new targets before they are missed, but it is clear that investment in the renewable energy industry will have to increase if Britain wants to have any say in the ongoing important environmental debate.