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WAITING GAME

By Ian Fraser

Published: CA Magazine

Date: December 1st, 2009

Bank of Scotland’s office on the Mound remains fog-bound

Potential vendors are waiting for a recovery, potential acquirers are waiting for the bottom of the market and, as Ian Fraser reports, corporate finance professionals are waiting for dealflow to pick up

Scotland’s dealmakers have had plenty of time for quiet reflection in the past year. It’s been quite a change from the extraordinary credit-fuelled M&A party that they were all so enjoying until the credit crunch so rudely intervened last April. At first it seemed this might turn out to be a temporary lull. However, these hopes were dashed by the near-collapse of Scotland’s two largest banks, Royal Bank of Scotland and HBOS (the latter, of course, is now part of Lloyds Banking Group). Neither of these two is anywhere near full recuperation.

Few practitioners can recall a quieter time for dealmaking in Scotland and most believe that the current situation is even worse than at the height of the 1990-92 downturn.

There are two main factors weakening the market this time around, neither of which featured in the early 1990s recession: the lack of liquidity caused by the banking crisis, and the absence of forced sales. This time around, it seems that many potential vendors are clinging on in the hope that the current crisis turns out to be a “blip” rather than a prolonged “L-shaped” downturn.

Jason McBurnie, assistant director of corporate finance at PwC, characterises 2009 as “a year of expectation gaps”. By this, McBurnie, recently named as Scotland’s emerging dealmaker of the year, means that many vendors still harbour unrealistic price expectations. He says there is also an expectation gap between borrowers and lenders, with many corporates and entrepreneurs still expressing surprise at the cost and availability of bank debt – for example, as they come up to renegotatiate their bank facilities.

According to Scottish Business Insider, the volume and value of Scottish deals slumped by half in the first half of 2009 when compared with the first half of 2008. Transactions by small and medium-sized enterprises – including acquisitions, management buyouts and disposals – have been the hardest hit.

Kenneth Shand, head of corporate at law firm Maclay Murray & Spens, says: “The highly leveraged private equity-type work has just not been there. It’s not disappeared, but it’s way down.”

Nevertheless, several larger deals have been completed in Scotland. These have included the scheme of arrangement by which Lloyds TSB acquired the near-bankrupt HBOS in January 2009, on which Shand’s firm advised.

Other larger deals have included the £170m sale of Aberdeen-based rig services group Viking Moorings to HSBC Private Equity, the £553m sale of energy consultancy Wood Mackenzie to private equity firm Charterhouse.

So-called “strategic deals” by which trade buyers seek to consolidate their position by taking over a competitor have included Standard Life’s £225m sale of Standard Life Bank to Barclays and Centrica’s £1.3bn acquisition of Aberdeen-based exploration and production company Venture Production.

The latter was driven by Windsor-based Centrica’s desire to control a greater proportion of its own gas production, rather than rely on the vagaries of global spot markets. The inability of most private equity firms to raise their customary leverage has made it a perfect time for deep-pocketed trade buyers such as Centrica to swoop in this way.

David Leslie, head of corporate finance at PwC Scotland, says: “Larger corporates with cash who have managed to weather the storm because they’re in good condition are actively looking to do deals. I think that will feature of the next 12 months as well. They have obvious opportunities to consolidate markets and strengthen their positions. There will also be consolidating deals. You will still see people taking the opportunity to consolidate sectors, especially in the energy space.”

Sovereign wealth funds have similar opportunities and are widely expected to make their presence felt in the Scottish market over the next 12 months. Already Taqa Bratani, a subsidiary of the Abu Dhabi National Energy Company, has acquired the North Sea Brent system pipeline and facilities from Shell.

Smaller deals that did manage to get completed in the period included Souter Investments secondary buyout of the Lanarkshire-based biofuels company Argent Energy. Souter Investments, an investment vehicle of the Stagecoach boss Brian Souter, acquired Argent, which produces biodiesel from recycled cooking oil, for an undisclosed sum from London-based private equity house Cinven.

Overall, dealmakers stress that mergers and acquisitions are taking much, much longer to pull off than in the heady pre-credit crunch days. Inflexion Private Equity’s sale of Viking Moorings is a case in point. The deal, on which the vendors were advised by NM Rothschild, took 18 months to complete, largely as a result of fluctuations in the price of oil. In the end, Inflexion was unable to make a clean break, opting to retain 20 per cent of Viking’s equity.

Craig Campbell, a director with Deloitte, says: “2009 has undoubtedly been a tough year for dealmaking, with Scotland seeing a very significant drop in activity. Where deals have been done it is testament to management and the underlying robustness of the business that capital has been forthcoming.”

If they do deign to support traditional M&A activity banks are behaving in unpredictable and capricious ways that can make dealmakers’ lives difficult. Mary Campbell, founder and managing director of Edinburgh-based corporate finance house Blas, says: “We’re finding that bank executives are struggling to read what their credit committees will approve. This can mean that funding gets pulled and terms get changed at the last minute.”

Campbell says the banks are currently so focused on the “casino” end of their activities in order to “gamble themselves out of their difficulties and repair their balance sheets” they are neglecting funding dealmaking for SMEs.

Andrew Ewing, a partner at accountants and advisors Springfords, says: “Securing bank funding has become more difficult and any funding deal now takes significantly longer than before, at higher interest margins and with a lot more due diligence and scrutiny. This is good for the accountants but not so good for businesses looking for a speedy solution to funding issues.”

However, observers detect marginal improvements in debt finance availability recently -– especially for stable and reliable deals.

It also seems that a small band of mid-market private equity houses are gearing up to pounce on mid-sized Scottish corporates once vendors realise they’re going to have to drop their prices. The players concerned are said to include Graphite Capital, Close Brothers Private Equity and HIG Europe.

The continuing scarcity and expense of bank funding is causing deal structures to evolve. “Most companies are looking to reduce their debt exposure rather than increase it,” says Deloitte’s Campbell. “What this means for deals is that earn-out structures and performance ratchets are back in the dealmaker’s tool box; both seek to address in the future disagreement over value today.”

“Minority stake investments are also increasingly being made to satisfy companies’ demands for growth capital or to reduce their leverage. They also have the advantage of eliminating owners’ need to sell too much equity at a time when valuations are felt to be low.”

Given the rally in share prices that kicked in last March, it is likely that Scottish corporates will once again start looking to the stockmarket to raise capital. “We expect to see several stock-market flotations in the March, April and May window next year”, says David Leslie of PwC Scotland. “There’s a queue of companies starting to formulate plans for both IPOs and rights issues in the energy or financial services sectors.”

Leslie says asset-based funding is another alternative means of raising finance and alludes to an increase in “stock-based lending”. He also says that some vendors are effectively funding portions of their own deals, for example, retaining 30 per cent of the equity.

However, he does not believe that business angels are currently in a fit state to step in where others fear to tread. “Some of those guys have had their fingers burnt,” says Leslie. “My experience isn’t that there’s a whole host of angels waiting to come into the market. I think they’ll be careful in their investing and quite demanding.”

A pool of public sector funding remains available for growth capital and to fund deals. Vehicles include the Scottish Co-Investment Fund, Scottish Venture Fund and the Capital for Enterprise Scheme. The latter, launched in January 2009 to combat the credit crunch, is a £75m fund supported by the government to allow access to equity for small to medium-sized firms.

The downturn in Scottish M&A activity has not been easy for Scotland’s professional services firms and it small troupe of boutique advisory firms, some of which resent the increased payments they are having to make to the Financial Services Compensation Scheme. Some firms have been forced to make layoffs.

Generally, however, they have sought to cushion the blow by redeploying staff previously focused on corporate finance and transactional activities into the currently busier areas of corporate restructuring and corporate recovery.

Craig Campbell says: “The flexibility and speed of response of professional services firms have been tested by the changing requirements of the market. Redeploying of resource from traditional M&A activity to, for example, debt advisory and restructuring, has been successfully implemented by several of the active advisory firms in Scotland.”

For a while after their near collapses last year, Lloyds and RBS were struggling to deal with the crisis, and they were initially preoccupied with survival and then with rebuilding their capital bases.

But the banks have in recent months started to take a more proactive approach to addressing the toxic legacies of their go-go lending in the bubble years. This leads professionals to expect a pick up in refinancing and restructuring work in coming months.

Bruce Minto, founder of law firm Dickson Minto, says: “There was a sea change in September or October when the banks started making some decisions again. They are definitely moving more things forward now.”

Lloyds Banking Group, for example, recently opted for debt-for-equity swaps for the troubled and over-borrowed housebuilders, Gladedale and Cala.

Maclays’ Shand says: “With Gladedale, on which we advised, it was a question of getting the thing onto a more even, stable keel. Some situations in the property sector were so highly leveraged they just didn’t really stack up with the change of circumstances.”

Where traditional M&A is concerned, the best some professional advisers can hope for are incremental improvements over the next 24 months.

PwC’s Leslie says: “2010 is not going to a huge improvement, but we do predict a steady uptick. We don’t feel we are going to go lower than where we are today. Over the next two years we expect to see slow but steady improvements punctuated by a few large deals in the energy, utilities and financial services sectors.”

“We’re cautiously optimistic -– it’s still a tough market and there’s a lot of uncertainty out there but it’s better than it was six months ago. We’re working with a lot of people who are waiting to do deals and we’re waiting for the confidence to return to the market.

Charles Barnett, corporate finance partner with PKF, says: “There is very little evidence of corporate finance activity in Scotland at the moment. There do appear to be some signs that the corporate finance market is stirring in London and the South East [of England] and this is usually a sign that activity will start again soon in Scotland. I do believe that we are over the worst but there will not be a sudden jump of activity.”

Others are marginally more optimistic. Peter Lawson, corporate partner at law firm Burness, says: “Dealflow is now on the up. Corporates can remain static only for so long.

“The distress deals have been with us for a while but there is a definite increase in strategic deals. The increased dealflow will be across all sectors, but financial services will be a prime sector for deals.”

“As M&A activity will generally lag the improvement in business confidence, we do not expect activity to pick up until the second half of 2010,” says Craig Campbell. “Businesses which have had a difficult 2009 as a result of their market or business model being seriously weakened by the recession will be forced to find a solution for their stakeholders.”

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