There’s been real progress on reducing the sector’s debt burden, but the problem needs to be resolved in full before ‘normal’ deal markets return, argues Peter Hansen, founder of Sapient Corporate Finance. The debt hangover It’s been a good four years for the sector in one sense – debt has reduced sharply. We estimate that total debt, from both banks and capital markets, has reduced by £5bn in the period post-Lehman crisis. Almost half of this (£2.4bn) has been achieved through disposals (see figure 1). We advised on the two largest and most significant transactions: the sale of Mitchells & Butlers’ (M&B’s) 333 wet-led pubs to the TDR Capital-backed Stonegate for £373m; and the sale of RBS’s Galaxy tenanted pub estate to Heineken for £422m. We believe the banks have done well so far to reduce debts by almost £3bn, albeit aided by almost £1bn of debt write-downs. So far so good, but how big is the problem that we are still facing? We estimate there is a further £1bn of debt overhang for the banks to clear. This will not be easy given that it includes a number of complex opco/propco transactions undertaken at the top of the market. However, the current deal pipeline suggests the momentum and desire exists to clear the backlog in the next 24 months. Although the banks would prefer to have all their debt repaid, it’s more likely we’ll see a mix-and-match approach with private-equity investment allowing a degree of debt retirement and cash for capital investment, as well as some debt rollover. In our view, the banks still have more pain to take, but can now see the light at the end of the tunnel. While they will not immediately re-lend to the sector, overall this is good news. In many ways the capital markets represent the key challenge for the industry. Between Punch, Enterprise and Wellington there is more than £5bn of securitised debt with leverage levels of almost nine times EBITDA. If M&B and Greene King (GK) are sensibly leveraged companies, then five times EBITDA should be the target debt level. This will require in excess of £2bn of deleveraging, more than has been achieved so far post-Lehman. Achieving this debt reduction will be the subject of much discussion between companies and their bondholders in the coming 12 to 24 months. Deleveraging further How can the pub companies and their lenders continue to delever? As mentioned above, further write-downs for the banks are likely (although less than before), and bondholders need to face reality and ‘rightsize’ their debts. While £800m was raised in 2009 through rights issues by GK (portfolio acquisitions), Punch Taverns (debt reduction) and Marston’s (individual acquisitions/debt reduction), we see little prospect for further rights issues in the sector. We expect that M&A will be key to deleveraging further, with well-capitalised buyers such as GK and private equity leading the way. GK has been the most active trade buyer since the debt crisis. Last year, it spent £200m acquiring three managed pub companies in a seven-month period – Cloverleaf, Realpubs and Capital Pub Company. The deals were underpinned by two key business objectives: increasing value-food exposure and increasing central London penetration. Indeed, acquisitions of managed pubs have been the key area of activity since 2008, with TDR’s acquisition of Stonegate creating a new consolidator in the sector. This marks a re-entry for TDR into the pub sector, having successfully backed Punch in the late ’90s. Private-equity activity has not been limited to TDR and in 2010 LGV Capital completed a secondary management buy-out of Amber Taverns. Piper Private Equity has completed two deals in the past six months, investing approximately £25m to acquire minority stakes in B@1 and, most recently, Loungers. With significant financial backing, all of these companies are ones to watch. The only significant tenanted deal has been the aforementioned Heineken deal with RBS. This is the only large tenanted transaction since May 2007 when we advised Punch in selling 869 tenancies to Admiral Taverns. The Galaxy deal was helped by the appetite of Heineken to secure the freeholds of pubs it was already operating and supplying, combined with Galaxy being the best quality tenanted estate to come to market since 2002. The RBS deal was, in many senses, a unique situation, and there remains little demand for tenanted portfolios at present. With this lack of portfolio demand, tenanted pub companies continue to focus on individual disposals. At the bottom end assets typically sell for real-estate value with vacant possession. This market has exceeded the portfolio M&A market since 2008 (£1.5bn of transactions). At the high end are pubs that are coveted by the regional family brewers or multiple operators looking to release the tie. Enterprise is selling between 200 and 300 pubs from the upper end of its estate at between 12 and 14 times EBITDA to reduce its debt. So far, Fuller’s, Shepherd Neame and Arkell’s have added Enterprise pubs to their portfolios. Fuller’s paid a price that looked high at 13 times, but the multiple reduces significantly if it can convert these pubs to managed when they reach the end of their current lease period. Given the number of 20-year leases entered into in the early ’90s, Fuller’s may not have long to wait and it will have acquired the income enjoyed by the tenant for free. There’s a further opportunity for smaller entrepreneurial operators to buy in their tied leases and build a freehold business. Thorley Taverns acquired three Enterprise pubs just before Christmas. Deals like this make particular sense when the tied operator’s income exceeds the pub company’s income, as is particularly likely with food-driven pubs. In spite of high prices, significant value creation is achievable for good operators. Package solutions So, how do we see the immediate road ahead? The two major tenanted pub companies, Punch Taverns and Enterprise Inns, will continue with more of the same, but at some point a package solution will become possible for sustainable, lower profit pubs that generate average EBITDA in excess of £40,000. Both companies and their stakeholders need the package market to return for tenancies. The pipeline of transactions from the banks remains strong. The key targets are managed companies with good-quality assets and strong market positions, such as Novus, Inventive and Orchid. Finally, smaller managed companies, particularly those with a south or south-east focus will continue to be attractive to both trade and private-equity buyers. In our opinion, this presents a clear opportunity for private equity over the next two or three years. With asset prices depressed, it’s the correct time in the cycle, and for firms with a good track record in the sector the timing feels right. But what about debt? Until the overhang clears, the debt markets are likely to remain in a moribund state. Raising new debt for amounts exceeding £25m continues to be difficult, and requires the participation of a multi-banking syndicate. A prominent property investor recently pointed out that the market for property finance is “tighter than it was after the Lehman default in 2008, and is the worst financing market since 1973-1974”. On the positive side, we are seeing more involvement from non-bank direct lenders (although the first cheque has still to be signed) and increasing activity from the major brewers (Molson Coors, C&C). It is a long road to recovery, but we are on the right track.

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