Opinion: Tim Evans

In my last blog entry, I talked about the spring 2010 re-emergence of M&A appetite on the part of many of the larger trade buyers.

Recent conversations that we have had with Private Equity suggest that they too are increasingly alive to the opportunity of buying recruitment businesses at the right time in the cycle. Here, the investment thesis involves "riding the wave" of an upturn in which the private sector reverses the human resourcing down-sizing of the last couple of years. My sense is that Private Equity sees this as a classic window of opportunity to be exploited before valuation multiples begin to rise.

One caveat here however; many of the Private Equity houses which are most open in principle to investing in recruitment businesses (and far from all houses are open!) are already, to different degrees, "over-weight in the sector", holding current investments in the sector which they have not been able to exit due to the lack of buyers in recent times.

Good news is that there remains a small number of mid-market Private Equity houses which are willing and able to invest in recruitment if they are offered the right business, in a sensible M&A process, and which has undertaken the requisite preparation for a management buy-out.

For private owners of recruitment businesses who are ready to sell now at a fair price (perhaps also retaining a small equity stake) rather than waiting a number of years more in anticipation of higher valuations, they can exploit the very same "window of opportunity" that Private Equity currently sees.

Recent announcements on trading performance released by larger, international quoted recruitment business paint an inconsistent and opaque picture of market health. While players such as Korn and Adecco can demonstrate a visible upturn in their 2009 Q4 results, many others can only talk anecdotally about a clear uptick for that period.

Helpfully, results for Q1 2010 due for release in a few months from now will provide us all with much greater transparency about overall recruitment market “condition”.

For now though, what is clear is that strengthening performance for most recruitment businesses is being/ will be driven individually by geographic exposure, sector focus, contract/ perm splits, as well as more operational factors such whether sales teams have been preserved at the end of a long, relatively barren period of activity (not to mention levels of morale).

And where does this all leave M&A appetite and activity?

In a nutshell, many buyers remain skittish when confronted by even the best acquisition opportunities. However, based on a number of recent meetings I have had, the "idea of acquisition" is finally and importantly re-entering the psychology and the lexicon of buyers. This is a critical stage for M&A markets to pass through on their way back to health and liquidity.

To adapt a timely spring metaphor, it seems that there may finally now be enough swallows in the sky to herald a summer ahead.

We are about to publish the 2009 Recruitment Fast 50 in collaboration with Recruiter magazine.

Fast 50 is a specialist UK recruitment league table which measures sales growth (and strictly according to audited accounts and not the self-certification of other league tables I could mention!), and together with our commentary will be available in the new edition of the Recruiter out on the 20th January 2010.

Our final Fast 50 preparations caused me to stand back and take stock of the results. Compared to last year, 29 companies in this year’s Fast 50 are new entrants. In other words, only just over 40% of firms managed to retain their top 50 position from last year. Why?

Firstly, there will always naturally be some ‘churn’ in the Fast 50 as percentage growth becomes more difficult with greater scale. So full credit and respect to the larger players which remained in the Fast 50 albeit with lower growth rates.

Of the league’s ‘fallers’, the global economic downturn has inevitably exposed some recruitment businesses as being of lower quality (client relationships, service levels, systems etc) than may have been believed when they were riding the 2004-7 economic wave. Some of these will regroup, reassess and return, other will not.

Elsewhere, better quality recruitment businesses have, in my view, been polarised between those which have intentionally “battened down the hatches” and intentionally foregone growth (thereby better preserving their core focus), and those which have entrepreneurially exploited niches with reducing competition to achieve growth. It is these dynamics in aggregate which has driven the high level of ‘positional movement’ within the new Fast 50.

And predictions for 2010?

Firstly, the impact of the recession will only be truly measured in next year’s Fast 50 due to accounting time-lags. Given this, my prediction is that next year’s Fast 50’s participants will continue to churn and that some individual growth rates will rise strongly as new entrants exploit the opportunities of returning recruitment markets. This will be felt most strongly where they bring a fresh approach to service delivery, team motivation, and the use of technology.

For now then, lets watch this space.

This week's rumours surrounding a possible offer for Spring plc has sparked a number of calls to us as to whether this represents the start of the return of the M&A market in recruitment?

Firstly (at the time of print), the Spring offer remains only a proposal. At any one time, there are many, many proposals being discussed and negotiated in the M&A market that come to nothing. The next few weeks will flush out the reality of interest in Spring.

To the question then of when will the M&A market return. Based on an analysis of historic down-turns, we know that the period between the high and low points in valuations for quoted recruitment stocks is usually between 25-27 months. From a known valuation high point back in July 2007, this would point to a rise in valuations in quarter 4 2009. This valuation turning point inevitably heralds confidence and M&A activity.

Rumours surrounding Spring may indeed prove to be an early signal of an active M&A environment returning. However, one swallow does not make the proverbial summer and in our view it remains just too early to call.

During the 2008/09 economic down-turn, the recruitment sector has thankfully seen a low rate of bankruptcies. This is testament to the sector’s owners and managers collective ability to down-size their businesses as efficiently as they can grow them. For those businesses which have survived fundamentally in tact and without cutting to the bone, the golden rewards of the economic upturn and its strong hiring trends await.

However, the summer slow-down may well provide a final and ultimate test for some weaker recruitment businesses. With revenues slowing while HR decision-makers, sales consultants and contractors take their much needed summer breaks, cash pressure will mount on already drained bank account and ID facilities. An unwinding of working capital may provide some respite but the loss of revenues during high summer will be brutal. Some of the weaker recruitment businesses, like bloodied boxers already on the ropes, may finally feel the canvas and be counted out.

This week we release our summer/ autumn update on the recruitment sector and its many issues. Topics covered include valuations, trade buyer behaviour, the state of private equity, and our predictions on the re-emergence of a meaningful level of M&A.

One of our headline predictions in this report is that trade buyers will increasingly look for a new set of ?‘value’ characteristics in their future acquisitions.

Firstly though, it is worth saying that there are a number of recruitment business characteristics which will always attract premiums from buyers. These are unlikely to change and include having strong and focused sector specialisms, overseas operations of critical mass, stable management teams underpinned by structured succession plans, and clear growth opportunities ahead.

However, as a result of the lessons learned from M&A errors made by buyers over the recent ‘bull’ periods, we believe that a new suite of ‘value characteristics’ is now likely to emerge and be sought after. In our view these characteristics will include:

• Proof of trading and profit resilience during 2008/09, with a focus on senior management behaviour and decision-making in the period

• Focus on visibility of forward earnings achieved through protected client relationships and genuinely differentiated service offerings

• Proof of established and proprietary systems and recruitment methodologies which demonstrate the ‘substance’ of recruitment businesses

• Fixed cost base efficiency (conversion rate metrics will be looked at by buyers with higher scrutiny) and its flexibility (operational gearing metrics are most relevant here)

Any owner of a recruitment business who is preparing for an exit should have a close focus on these characteristics as a way of maximising valuation. Developing a business with these characteristics is likely to be the key to achieving the highest valuations in the future.

In a recent meeting, the canny owner of a recruitment business asked me about the differences, from an M&A practitioner’s view point, between doing deals in the recruitment market compared to in other sectors. Great question. My response was two-fold.

Firstly, recruitment has a well-above-average number of entrepreneurs, many of whom have followed the classic recruitment route to ownership of having been top biller at someone else’s firm, parted company with that firm (usually with some acrimony), and started a business which has grown faster than they ever expected. These owner- entrepreneurs combine great ambitious, a keen nose for profit, and an impressive ability to dismiss any of the obstacles in their way. Working closely with such individuals in a range of M&A contexts is highly challenging and commensurately rewarding.

Secondly, and for all their strengths, recruitment owners can at times be more difficult to advise than their counterparts in other sectors. My own view is that this often a direct function of how many recruitment businesses operate commercially. Many recruitment businesses operate relatively autonomously within their market as part of short and simple value chains. Save for those players who are pursuing RPO strategies that require more client- integrated delivery models, many recruiters do not need to ‘partner’ as closely with complex supply chains, regulators, or end-users as do businesses in many other sectors. For recruiters, this can mean that partnering with external parties including M&A advisors is not a natural instinct.

Yet there is a strong and proven correlation between successful M&A deals and the ability of the business owner and their advisors to closely work together, at times over a period of years. Equally and opposite, where any M&A advisor is held at arms length and treated as a service provider rather than a key partner, outcomes tend to be less favourable.

For most owners, exiting a business often happens only once in a lifetime. Therefore selecting the right advisor is one of their biggest calls. A key criterion in selecting an advisor should always be “who do I feel comfortable to partner with closely towards my exit”

From the perspective of any M&A advisor who is able to be selective, choosing to work with owners who understand the importance of partnering and to take advice and is our biggest decision.

With many deals being deferred because of difficult M&A market conditions, we are increasingly being asked for advice from business owners on the best timing for a deal at some time in the future. In giving our advice, we look with them at the ‘cycles’ involved; those of the macro-economy, the sector, the business and the owner’s own personal time horizons. The convergence of more than two of these cycles often points to it being a good time for a deal (equally waiting for all four cycles to align perfectly often proves to be an over ambitious and unfulfilled exit strategy).

And a new fifth cycle to consider is emerging – that of taxation, specifically capital gain tax. At 18% the CGT rate is well below income taxation (including NI contributions) of over 50%, and for good reasons because of the risks undertaken by entrepreneurs. Yet many commentators believe that the wide differential between capital and income taxation rates is unsustainable in an economy where public spending remains bloated and the UK’s national debt as a percentage of GDP is one of Europe’s highest. Many are predicting a closer alignment of rates whichever party wins the next general elections.

Completing an M&A deal before any changes to CGT may come into force should be a consideration for owners albeit alongside the many other timing considerations.

Tax planning & reduction solutions that may or may not be available depending on individual shareholder circumstances can also be relevant to a debate on exit timing.

In the meantime, we at Catalyst are closely tracking the mood, views and proposals in the area of changes to CGT as they evolve and eventually crystallise.