Historically, private equity has played a pivotal role in the pub sector and it is likely to continue to do so going forward, argues Peter Hansen, founder of Sapient Corporate Finance.
A number of private equity firms made the mistake, like many others in the sector, of over-paying for assets at the height of the bull market in 2005 and 2006 - Charterhouse in relation to Barracuda and GI Partners in the case of Orchid, for example. But most people forget the key part that private equity has played in transforming the sector landscape.
One of the most successful deals of the last 15 years, for example, was the acquisition by Morgan Grenfell Private Equity (now Mid Ocean Partners) of Whitbread’s pub estate for £1.62bn in April 2001.
MGPE sold the business segment by segment over the next four years. First, MGPE sold Whitbread’s tenanted pub estate to Enterprise Inns in two transactions for £1.25bn, leaving a pure managed business, the Laurel Pub Company.
MGPE then sold the Laurel community estate to Greene King in 2004 for £654m, followed by selling the town centre business, including the Hogshead brand, in November 2004 to R20 for £151m. The outcome was that MGPE sold the assets for £2.1bn and made more than 2x its invested capital excluding the benefits it would have received from operating cashflow during the nearly four years of its ownership.
There are other examples, of course, of private equity having a transformative effect. Sun Capital acquired and broke up Allied Domecq’s pub business in 1999, adding the Allied tenanted estate to the existing Bass Lease estate to create Punch Taverns. The Allied managed pubs formed the nucleus of what is now Spirit Pub Company, itself under private equity ownership at the time, which then acquired S&N Retail in 2003.
It was these ground breaking transactions that transformed the retail pub sector.
The period between 2003 and 2006 was particularly active for private equity – and very profitable for investors. On average, there were £1.8bn per year of managed pub transaction 2003 and 2007. By contrast, since 2007, Mergers and Acquisitions volumes have declined 86% to £240m per year.
What caused the decline? Obviously, the smoking ban played a part. It has already proven to be a boon for the managed sector, which has performed very well in boosting its food turnover during the post-Lehman years. However, in the short term it was negative for the sector as investors were concerned about the damage it would cause to managed businesses with substantial wet income.
The recession, rising costs and duty and taxes have also played their part in damaging the sector. Wetherspoon recent trading statement demonstrated seven per cent turnover like-for-like growth but average outlet profits have been flat for the last decade and in marginal decline since 2007.
Debt conditions today are much more difficult than they were a decade ago when a typical transaction would have been funded by three parts debt (or more) and one part equity. Today, transactions are funded six parts debt to four parts equity or even 50/50. And debt is much more expensive today.
The other factor that has played a part in the decline of the market has been the mismatch between buyers’ and sellers’ price expectations. In a declining market sellers remember the good times and buyers focus on declining trading; buyers are just not prepared to meet the price sought by sellers. The result is that transaction volumes have declined sharply.
Nevertheless, if you look at the market in the last five years there has been approximately £1.2bn of total transactions.
Who has been buying? The split has been 60/40 in favour of private equity. Greene King has been the leading trade buyer, having acquired Realpubs, Capital Pub Company and several small portfolios from Punch. The trade’s focus has been food-led, London freeholds such as Young’s acquisition of Geronimo. The trade has paid eight to nine times outlet Ebitda for high quality, food-led assets.
What, though, attracts private equity to the pub industry? Private equity loves the steady cash generation of pubs. Pub companies are comprised of hard assets that throw off cash, and, compared to other asset classes, they are good value at the moment.
Private equity firms value businesses after deducting overhead because they need a management team to run the business, unlike the trade, which has the benefit of overhead savings. And private equity buyers are very aware of capital expenditure requirements. They work out what the actual cash generation of the pub is – and how much of it has to be ploughed back into capital expenditure. For example, Legal and General Ventures (LGV) and Hutton Collins Partners acquired Novus for less than 6x post-overhead EBITDA, but the cash flow multiple was actually over 8x after deducting capital expenditure.
Private equity is currently the driving force in the market for managed houses. The transformational deal of the last five years was TDR Capital’s acquisition of 333 pubs from Mitchells & Butlers in November 2010, which was followed last year by the successful merger with Town & City to create Stonegate Pub Company.
LGV has been very active over the last 20 years; it can claim to have been one of the most successful serial investors in the sector, if not the most successful. Since 2008 it has acquired Liberation Group, Amber Taverns and the aforementioned Novus in 2012.
LGV and TDR have a different focus than the trade. They like wet-led pubs, which are generally better value, require less capital investment and are unloved by trade buyers. They’re more relaxed about leaseholds as well because they generate a higher return on capital employed than freeholds.
The first thing that private equity buyers consider is the exit from the business – in particular, who might be the eventual buyer. They simply won’t buy a business unless they are satisfied they understand the answer to this question.
Their preferred buyer is the trade and, historically, most sales have been to existing operators - over half of all private equity disposals are to trade buyers with the remainder sold to other private equity firms in secondary buyouts. For example, Silverfleet sold Barracuda to Charterhouse Private Equity in 2005. There have been very few initial public offerings (IPO) of pub companies since 2000 – Punch Taverns, Inventive Leisure and Capital Pub Company are the exceptions.
It may come as a surprise to some but private equity currently owns managed pub businesses worth a combined £700m. Most of these businesses have been acquired post-Lehman although a few, including Inventive, Orchid and Bramwell (the rechristened Barracuda), were bought prior to 2007. We would expect these businesses to come back to the market during the next five years, either as a trade sale or as a platform for another private equity investor.
So, do we think private equity will continue to invest in the sector? We do. Private equity has a considerable amount of money to invest, what is commonly called “dry powder”. Private equity firms have several years of dry powder left at their current investment rate. If the money isn’t invested, it will to have to be returned to their limited partners who actually provided the money.
However, there are two main impediments to a more active investment market. Debt is simply not available in the amount and at a price required to support private equity. Each spring we think the debt market will open up only to be disappointed. Today, private equity can’t borrow more than about £25 to £40m from any one bank so several banks must be joined together to buy an asset requiring more than £50m of debt.
The second impediment is sellers’ expectations remain too high. Banks, in particular, focus on the historical multiples paid for managed pub companies, which are not realistic in today’s market. Also, banks have been slow to invest in the businesses they do own, and as a result, these businesses lack momentum. Potential trade buyers fear that there is a back log of “catch up” capital expenditure that they will incur just to return the business to growth.
The result is long, drawn out negotiations in an environment where performance is declining, leading to a breakdown in negotiations in many cases. (Novus Leisure may yet prove to be the only managed transaction completed this year.)
However, we still believe there are a number of private equity firms that will be tempted back into the sector as a result of the improving fundamentals of managed sector performance - and there are new arrivals too. Silverfleet has an active interest in the sector and it is only a matter of time before it buys something it likes. And, likewise, Varde, which is providing the equity for Bramwell’s growth, has decided that good assets are available at more realistic prices. With Roger Moxham and Adam Fowle, both ex-M&B, now running Bramwell, we suspect the company will have bigger ambitions now that it has a supportive investor behind it.
One thing is certain. The days of slick financial engineering that characterised the early 2000s are gone. Speculative break-up deals are too hard to finance and will be absent in today’s market. Buyers are very choosy. That puts the onus on the management team to deliver better returns through organic growth, and applying judicious use of capital expenditure to improve the performance of existing assets.
There are several excellent businesses that may well come to the market in the next three years – Inventive, Intertain and Liberation Group are quality businesses that come to mind. Any of these are capable of becoming platforms for consolidation or becoming bolt-on acquisitions for existing businesses to create larger platforms. In our view, Stonegate and Bramwell are likely to lead this consolidation.
