Scottish dealmakers — corporate finance and M&A practitioners — have had to learn to adapt to a new economic environment, and the lesson is sinking in that recovery will be a marathon, not a sprint, writes Ian Fraser
Scotland’s dealmakers have picked themselves up and dusted themselves down since the financial maelstrom of October 2008 eliminated the lifeblood on which their market previously depended – cheap, plentiful and readily available credit.
But while Scottish dealmakers have now overcome their shell-shock at what happened, some remain traumatised with others struggling to readjust to the new, more conservative, post-crisis environment.
“I don’t think we’re going back there [to the levels of M&A activity seen during the 2003-07 credit bubble] and if we do, it won’t be for a very long time,” says Andrew Blaine, Edinburgh-based corporate finance partner at Shepherd and Wedderburn. “I’d question whether we’ll ever go back there.”
The continuing credit drought, largely caused by the banks’ urgent need to rebuild their tattered balance sheets, has been acting as a massive brake on activity. Fears that the coalition Government’s hardline approach to reducing the structural deficit will tip the UK into a double-dip recession, coupled with suspicions that public sector cuts are going to hit Scotland harder than the rest of the UK, have further undermined confidence.
Calum Paterson, managing director and co-founder of Glasgow-based venture capitalists Scottish Equity Partners, says: “The economic outlook remains a major worry and there are legitimate concerns over heavy public sector spending cuts, job losses and VAT increases. I think that will have a serious impact on many companies. That said, we won’t be battening down the hatches. We are well-funded and this is a long-term game.”
“It’s been a very challenging year for corporate finance activity, not least because of the fall-out from the bank situation,” says Ewan Grant, Edinburgh-based head of corporate finance at Baker Tilly UK. “The spectre of unemployment is a very serious and very dangerous one. It might just be my natural pessimism, but it does feel as if this recession is going to be much longer-lasting than earlier ones.”
Many of the more highly geared deals put together prior to the credit crisis, especially in sectors such as property, construction, leisure, retail and consumer-related industries, have already come unstuck.
While painful for their creditors, equity holders and staff, this has ensured strong demand for people with such skills as the handling of restructurings, administrations, prepacks, refinancings, debt restructurings and independent business reviews. Although the spate of such assignments has not quite reached early 1990s levels, some industry players expect a second wave in 2011.
In some of the labyrinthine property groups backed by HBOS’s former head of corporate lending Peter Cummings, the same advisory firms that earned massive fees from putting together convoluted tax-efficient structures and joint ventures during the bubble years have been able to earn further crust from administrators, unpicking the arcane corporate structures.
David Leslie, head of corporate finance at PwC, says that the deal market has been “dominated by restructurings and independent business reviews (IBRs) over the past 12 to 24 months”.
Most of the large deals that have taken place in Scotland in the past 12 months have involved cash-rich overseas buyers taking advantage of weaker sterling, the lack of rival bidders, and the depressed state of the economy, to swoop on Scottish assets.
Leslie says: “We’re finding a lot of interest from North American, European and Asian buyers.”
Shepherd and Wedderburn’s Blaine says: “Cash-rich overseas companies are seeing value in the UK. They have a huge advantage if they have no requirement for third-party funding and can move quickly. They’re seeing opportunities to pick up companies or assets at good prices.”
An example came in September 2010, when the Korea National Oil Corporation (KNOC) acquired Aberdeen-based oil firm Dana Petroleum for £2.9bn. It was the first time a Korean company had made an unsolicited offer for a UK-based company.
KNOC was advised by the investment bank Merrill Lynch, law firm Linklaters and PR advisers Pelham Bell Pottinger while Dana was advised by Morgan Stanley, RBC Capital Markets, Allen & Overy and Brunswick.
Other “inbound” deals during 2010 have included private equity house PAI’s £215m sale of Kwik-Fit Insurance to Fortis Belgium; the £35m takeover of call centre company beCogent by French rival Teleperformance; the £40m acquisition of Motherwell-based fuel distribution business Brogan Holdings by Ireland’s DCC; and the £22m sale of Glasgow-based medical technology company Mpathy Medical to Danish healthcare manufacturer Coloplast.
Even so, advisers point out the traffic has not been all one way. Dana, for example, was making international deals right to the last. These included its £270m acquisition of PetroCanada Netherlands from Suncor, funded by a $900 million loan and revolving credit facility from Royal Bank of Canada. PwC’s David Leslie points out this was “Dana’s biggest ever deal”. In a similar vein, Aberdeen Asset Management bought RBS Asset Management for £85m in January.
Overall, however, the proportion of deals that are “inbound transactions” is rising sharply across the UK. According to figures from Deal Drivers UK, a report from accountants PKF and mergermarket, such deals accounted for 61.2 per cent of overall deal value in 2010, up from 48 per cent in the 2007/09 period, with weaker sterling being a key factor.
The paucity of deals has meant it’s been a buyer’s market for advisory services. Any company that’s doing a deal has the pick of the bunch as well as being in a position to exert downwards pressure on fees. Maven’s Nixon says some of the law firms that moved into swanky new office buildings at the height of the boom are regretting it: “The lawyers in some of those firms have discovered they’re working to pay the rent”.
Nixon added: “The advisory community is definitely feeling the pinch; there’s evidence to suggest it is shrinking. There’s a much more value-focused climate. Some Scottish law firms still have people in their teams who were earning big bucks in the highly leveraged deal market, handling highly geared transactions for the likes of BoS Integrated. But that market has disappeared and it’s not coming back.
“Anybody who’s hanging around expecting those days to return is deluding themselves,” says Nixon, “We’re in the new normal now. It’s not going to change. We’ve had a paradigm shift in corporate finance in the last three years and this is how it’s going to be in the long term.”
Nixon welcomes the fact excess and hubris have been purged from the system. It has forced many Scottish-based advisory firms to look to do deals in the more buoyant London market and to build on international networks and links to pursue deals elsewhere beyond Scotland’s borders.
“And do you know what? It’s actually not a bad thing. There will be a shakedown in the sector but there will be less excess, there’ll be better deals done at more sensible prices with optimum structures and it will end up being better for our industry.”
The area where deal flow has been most resilient is energy – especially deals involving the North Sea oil and gas firms. Aberdeen-based advisers are reporting a steady flow of deals, sustained by the recent recovery in the global oil price and Aberdeen’s position as a global centre for deepwater exploration technology and expertise.
Malcolm Laing, head of corporate at Aberdeen-based law firm Ledingham Chalmers, says: “The oil services sector is pretty buoyant and in confident mood. Aberdeen and the North-East are in a unique position.
“The high oil price and local world-leading expertise in deepwater exploration and production has led to a growing confidence in the market. Deal flow was certainly at a low level in the first half of 2010, but since mid-August, it has really taken off. We’ve been having a very, very busy period since mid-August.”
Bob Ruddiman, head of energy at McGrigors, says: “The demand for energy has not gone away. Even in the darkest days of the crisis, in the spring of 2009 when the oil price fell to $35 a barrel – down from $147 the previous July – the oil platforms in the North Sea still had to be maintained.”
Ruddiman says McGrigors has been advising on a steady stream of oil and gas deals, including “the swapping of assets, farming in, and farming out.” Each such deal, even though it may not necessarily hit the headlines, requires legal and advisory work. One such came in March when Perth-based Scottish and Southern Energy bought some gas assets in the North Sea from the US oil firm Hess for £278m.
Maven has found rich pickings among Aberdeen-based SMEs serving the oil and gas sector in the past 18 months. Companies in which it has invested its own and Capital for Enterprise funds, often alongside private equity partner Simmons Parallel Equity, have included XPD8 Solutions, Electro-Flow Controls, and Walker Technical Resources.
But few deny that, outside the energy sector, Scotland’s dealmaking market remains subdued. Leslie admitted that this is partly because so many of the more conventional M&A deals have “fallen over”. The deals that do fly appear to be taking much, much longer to complete.
Blaine says: “A deal that would have taken six to ten weeks before the crisis is now taking many, many months.”
PKF’s Deal Drivers report is downbeat about Scotland. It says uncertainty over the economic outlook, coupled with unpredictable and sometimes seemingly arbitrary credit decisions from the banks had led to a “flat period” for Scottish dealmaking. The report added that, even though there has been a revival of M&A activity in the UK during 2010, this has not been mirrored north of the border.
Frank Paterson, corporate finance partner at PKF, says: “While banks are lending to the right businesses the process is slow and they are focusing on cash-generative businesses.”
It seems that the banks have swung from the irrational exuberance of the pre-crisis years, to an era of Kafkaesque bureaucracy that is putting many off borrowing money at all.
Many advisers seem to be privately exasperated by the current belt-and-braces approach towards due diligence and credit checking by some banks – especially when combined what they describe as their seemingly quixotic lending decisions.
Whereas banks were prepared to lend at multiples of seven to ten times EBITDA on Scottish deals prior to the crisis, they will today only lend up to three times earnings. Banks are also taking advantage of the lack of competition in the market to ratchet up their fees. Sources say 4 per cent arrangement fees, and interest rates of 4 per cent over Libor (the London Interbank Offered Rate) are increasingly common.
Nixon says that people just need to face facts and accept that we’re in a more conservative banking climate. However, it does seem that some are struggling to come to terms with this radical change in bank behaviour.
Baker Tilly’s Grant says: “The lending bar has been raised significantly. For a deal to qualify, it has to tick an awful lot of boxes. Deals that were possible 18 months ago are not getting done now.”
However, some Scottish dealmakers argue the banks are agonising for so long on due diligence it’s causing credible deals to fall over. “Deals tend to have a shelf life and the danger is that all that extra due diligence means they get past their sell-by date,” says corporate partner at Glasgow-based law firm McClure Naismith, George Frier. “The banks are taking a far more rigorous view of quality and affordability. The days of the large, debt-funded deal are gone.”
Blaine says: “There is funding available, but it takes time to get it through the bank. The pricing of loans has risen due to a less competitive banking market. Only really, really strong credit proposals are getting through.”
Chris Horne, managing partner with Campbell Dallas, says: “I feel the central belt has too many companies that have fuelled their acquisition and growth strategy on the back of cheap bank debt and these will struggle to maintain their momentum.
“In Aberdeen, companies appear more prepared to engage with the private equity industry and this is the reason why, in some cases, the Aberdeen market is more buoyant at the moment – the companies up there are better capitalised. I feel that deal flow will not return to the corporate finance market until the majority of Scottish companies make themselves more investor-ready.”
Malcolm Laing says that, even in Aberdeen, plenty of companies with potential are struggling to obtain the finance they require to “get themselves out of recession”. He says banks were traditionally willing to extend this sort of working capital. But Laing says that source has dried up, which “has left a big void”. That has created scope for private equity funds and possibly also business angel type funders to put their capital to good use.
The words “flight to quality” are used by Scottish-based advisers to describe the banks’ current behaviour – they mean the banks are reducing their lending to risky businesses, assets and deals, and putting their money into safer bets like FTSE 100 companies and the bonds of safer sovereign nations.
Blaine says: “Most banks are being sensible about the new business they write. Given the scarcity of finance they are able to be pickier about which companies and deals they support.”
Frier says the humbling of RBS and Lloyds/HBOS has created the opportunity for new players to step in. “Clydesdale is making very positive noises about increasing lending; Clydesdale and other players are seeking to fill the void. However, it takes a lot of pebbles to fill such a big hole.” Santander, HSBC and some European banks are also making their presence felt in the Scottish market.
Some government initiatives designed to kick-start lending to SMEs are considered to have been damp squibs. Baker Tilly’s Grant says the UK Government’s Enterprise Finance Guarantee scheme has not been a success. “It is tortuous to get; they’re still looking for massive personal guarantees. On the face of it, that has not done a huge amount to stimulate lending.”
What about alternative sources of finance? Advisors made clear there is no Holy Grail here. Ledingham Chalmers’ Laing believes that private equity firms are, to some extent, stepping in where bankers fear to tread. Blaine says: “It is early days for alternative sources of finance.”
And Kenneth Shand, partner and head of Maclay Murray & Spens corporate department, says: “A number of larger companies are seeking greater certainty around long-term funding requirements through bonds or debt placements. The venture capitalists and angel community has, to some extent, stepped into the funding breach. There’s also Scottish Enterprise funds, including its Co-investment Fund.”
Shand also says that “forward funding” of transactions is also becoming more prevalent, particularly the forward funding of property development projects by institutional investors. Frier has detected a greater use of “vendor finance” – which means when the selling entity accepts a deferred payment – say 60 per cent down with 40 per cent of the balance deferred. Frier has advised on two deals structured this way in the past six months.
So what of the future? SEP’s Paterson does not believe 2011 is going to be hugely different from 2010. He says that, since SEP is a VC house with limited need for leverage, it has been able to make good deals even in a more subdued environment.
“Our portfolio is doing broadly very well. The assets we’ve acquired in 2009 and 2010 have proven to be some of the best deals we’ve done in the last ten years. We’re able to get access to good businesses on very attractive terms.”
Chris Horne argues: “Everything moves in cycles and I am sure during dramatic events in history we couldn’t have imagined things getting back to normal. In recent times in Scotland we have seen the closure of vast industrial concerns such as the shipyards. I’m sure at these times people thought the end was nigh, but things recover and a new norm is created.
“This is a time when business should hold its nerve. Surround yourself with people you can trust and rely on, and you will be OK. What has changed is the cost and access to bank debt, and I feel that the change will be with us for a while until the banks identify a new way to make money quicker.”
PwC’s Leslie detects light at the end of the tunnel, including greater certainty about obtaining bank finance and a greater number of corporates with cash who are willing to throw their weight around. He also foresees some sizeable refinancings by FTSE100 companies as well as more restructurings ahead.
Overall, Leslie believes dealmaking will continue to pick-up on the back of the four pillars of global consolidation, more bank liquidity, greater realism on pricing from vendors, and more forced situations. “But I’m not predicting a return to the pre-2008 euphoria. It will be a balanced period of more transactions, but there’s still a significant amount of pain to take.”
This article was published in CA Magazine on 23 November 2010