European mid-market review
Equity International – Annual Review 2008
undoubtedly turned in 2007, but the good times are far from over
for European buyouts in the Euro100 million to Euro1 billion enterprise
value range. The mid-market wasn't hit as hard by the credit crunch as
was the larger LBO market and, while the worst may be yet to come for
the wider economy, many GPs are optimistic about the opportunity for
attractively priced buyouts.
The first half of the year continued the boom of the previous few years, with plentiful debt and a relatively benign economy keeping deal numbers and values close to record highs. Intense competition and high leverage kept prices at an equally high level. "A lot of deals were very expensive in my view, " says Javier Loizaga Jiménez, executive partner at Mercapital. "The 12 months finishing last summer were really the peak of the buyout cycle in Europe."
The crunch, when it came in late summer, was hardly unexpected. Nor was it entirely unwelcome for mid-market GPs.
"The banking market was beyond the levels of common sense, and being driven by syndication capability not by credit assessment," says Jonathan Russell, head of buyouts at 3i. "That's a dangerous place for a banking market to be."
The crunch put the brakes on deals as banks withdrew from the market, but this slowdown proved short-lived. "Autumn was a return to the normality of 2003-04," says Bridgepoint partner Kevin Reynolds. "The banks did return to the market, but the balance of power changed a little bit."
Surviving the crunch
GPs remain confident that mid-market deals can still be done, but with two major shifts. The first is less overall availability of debt, with what debt there is having to be split between an ad hoc club of cautious lenders. "More and more, we see banks not being willing to underwrite a whole position, so we have to create our own syndicates at completion," says Reynolds.
In some areas, the largest mid-market deals are facing the same problems as the big league with regards to raising debt. While many GPs say that debt syndication problems only start above Euro1bn enterprise value, Mercapital in Spain says that the cut-off is around the Euro300-400m mark.
The second effect is the slashing of leverage ratios available for buyouts. While there's still a range of multiples between deals and sectors, the default is now typically four to six times Ebitda, down from seven or eight times at the start of the year.
Less debt inevitably means that investors will have to adjust their return expectations unless prices fall to compensate. That makes private equity less attractive when compared to resurgent returns in other classes.
At the start of 2007, returns on mezzanine finance had fallen to just 13-14%, notes Simon Henderson, head of buyouts at mezzanine and integrated finance provider European Capital, but that's since bounced back to 16-18%. Equity returns from buyouts are meanwhile floating around 20%. "On risk and reward, you're better off with mezzanine," says Henderson. "Prices have to come down so that 20% on equity can go back to 25%."
But as in the aftermath of any bubble, vendor expectations last thing to adjust when the crunch comes. Some GPs do say vendors are already adjusting their expectations. "I think the growing conviction that this is a longer-term cycle and that the economic prospects are not as good as they were means that the price expectations of sellers are already adjusting," says Jiménez.
The weight of money remaining in the mid-market houses may counter any downward pressure on prices, however. Most GPs report that competition for good buyouts is still high, and even increasing for the best defensive assets.
Another effect of the credit crunch is more domestic banks stepping into the gap left by the more leveraged international lenders. "Some banks have taken the opportunity to regain market share that they'd lost," says Jiménez.
The one-stop-shop providers of integrated finance, which have established themselves in the UK and French markets in recent years, are also bullish about growing their market share as third party lenders remain wary. "This whole credit crunch has played into our hands," says Henderson. "I imagine that'll spread throughout Europe, as it has in the US."
Despite the credit crunch and squeezed margins, LPs have not lost their appetite for the European mid-market. GPs at Gilde Buy Out Partners say that that return expectations have decreased substantially after a few very good years, but investors are generally increasing their private equity allocation.
In areas such as Spain, where allocations still lag the rest of Europe, appetite remains strong. "In this environment you might think that they'd be reducing allocations, but we haven't seen that," says Jiménez, who describes the fundraising environment as "perfect".
Short-term economic worries may restrict current fundraising, however. "Although theoretically allocations are growing, people may be keeping their hands in their pockets," says Reynolds. Those worries may also signal a return to quality for LPs, he notes: "The good houses will continue to get money, but one of the benefits of a shakeout is that the fringe players might find it a bit harder."
The other big story over the past two years has been the increasing public interest in private equity. In several territories, notably the UK and Germany, the media, trade unions and politicians have lined up to blame the industry "locusts" and "vulture capitalists" for various woes.
The new limelight is not necessarily a bad thing, however. "You can't go and buy businesses like Boots or the AA and assume you can do things behind closed doors - there is a public interest and you have to learn how to communicate," says Russell. "It's a good development phase for private equity as it moves on and becomes more significant in the world economy."
It's hard to point at any specific deals that have been sunk by media or political attention and, despite some grandstanding on all sides about increased tax and regulation, there's little real fear of intervention harming the industry.
But much depends on the macroeconomic situation for 2008. As with the credit crunch a year ago, the question's not whether the world is heading for a downturn, but rather when and how bad will it be.
"We're in for a tough time, there's no doubt about that," says Henderson. "There will be clear winners and clear losers. But the second half of 2008 will present very nice buying opportunities for buyout firms."
Jiménez agrees that 2008 could be a good year for buyers: "Maybe the number and value of deals isn't going to be as big as it was, but we will see a number of opportunities at prices significantly below last year's." One fruitful source of deals may be companies which are in no hurry to sell in a declining market, but which fear the climate could be even worse a few years down the line.
GPs are also cautiously optimistic about continuing strength in the exit market after several very strong years in which some major houses took the opportunity to streamline their portfolios and realise substantial value. The IPO market looks less friendly, but trade appetite remains strong.
2008 looks to be another interesting year. "We're playing in a period where the certainties that existed 12 months ago have been removed," says Reynolds. What the new certainties will be remains to be seen.