In a recent roundtable hosted by Real Deals, special situations specialists discussed deal volumes and reeling in opportunities in this segment of the market, valuations and the use of debt, growing competition at exit, among other key developments.

SPEAKERS:

Matthew Flower, FRP Advisory 

Matthew Hamilton-Allen, Rutland Partners

Michael Loizou, Ridgeway Capital

Samual Norris, Ropes & Gray

Will Stamp, Inspirit Capital

At the beginning of the pandemic, industry players assumed that there would be plenty of turnaround and special situations opportunities, when was it clear that this wasn’t going to be the case?

Will Stamp: I would probably say last Summer. What we saw when the pandemic first hit was a lot of turnaround opportunities, but many of them weren’t necessarily investable opportunities. Most were actually businesses that were already struggling and Covid was simply the straw that broke the camel’s back.

What we then observed following the summer months was a significant drop off in accelerated/turnaround M&A opportunities owing to the sheer level of Covid-related financial support measures from the Government - businesses, whilst perhaps not profit rich, were certainly rich with liquidity. At the moment, traditional turnaround activity is still very low - we haven’t seen it return to pre-pandemic levels yet and I don’t suspect we will until the middle of next year.

So, we’ve largely been focused on corporate carve-outs in recent times, which in themselves can be turnaround situations, but there is obviously not the same level of pressure time-wise to get the deal done when buying from a large corporate with deep pockets.

Matthew Hamilton-Allen: We never really expected there to be an increase in activity in our space following the pandemic. This is largely because if you have a fundamentally good business, why would you bring it to market in this period, where you’re going to inevitably have that discount, that uncertainty, unless it’s either thriving or you’re forced to. A good business should find its way through, particularly when you overlay government support, delays to VAT, rates holidays, and a lack of corporation taxes being paid. It was not an obvious time to sell. A lot of the businesses that did come to market were either phenomenally good, resilient businesses that were trying to take advantage of a quiet market and achieve a real premium valuation. Or it was a bit of a smokescreen for what were probably not great businesses anyway. As always it’s our responsibility to identify the situations we wanted to be involved in.

So, we didn’t go into it thinking that there would be a deluge of opportunities, we looked at the market and thought that, as and when the pandemic effect does taper, the types of special situations opportunities that we invest in will be part of what comes back. We didn’t really look at the market and think this is going to be rich pickings for where we like to invest.

One area that we believe a pickup is going to come from is around private or family-owned businesses. There are a lot of people out there who have owned businesses and have been through a horrible 24 months. So, we anticipate there’s been a lot of acceleration of private businesses looking for support now, those that have survived looking to de-risk and capitalise on the opportunity ahead, and that’s going to be a source of deal volume.

While government support schemes have been positive for businesses in these testing times, it also led to a significant reduction in turnaround investment opportunities. So, when will the turnaround investment market recover to pre- pandemic levels, and will it be a gradual recovery or a sudden spike?

Michael Loizou: The Government’s support is just another example of liquidity for distressed businesses. Over time, whether it’s a bank, or a mezzanine provider or another debt provider of some sort, there’s always been, in the last 10 years or so, that liquidity in the market, which I think reduces the number of distressed deals.

Personally, I don’t expect the boom and bust that we’ve had before. I suspect there will be spikes in activity every so often and I think these will be localised either by sector or region or both. You can always rely on ‘bad luck’ and/or the human factor where things go against plan due to wrong decisions or a skills gap, in particular when it is not ‘business as usual’, which is why there are opportunities regardless of the economic cycle. At the same time though, change does create both opportunities and threats often resulting in winners and losers.

When do you expect to see a recovery in this part of the market?

Matthew Flower: We’re starting to see some opportunities arise now. As a general indicator, the level of insolvencies has been at record lows, but they are now starting to increase.

I think as the Government’s support measures taper off, it will be a case of seeing when the tide goes out, who is wearing trunks! Those businesses who have been surviving up to now will see owners and management teams begin to assess whether they have traded through the pandemic well enough to survive, or need additional funding.

What has also happened with government support is that, in a lot of cases, it has increased the level of liabilities that need to be dealt with. So, we expect activity in this space to pick up next year, and we are very much hoping it’s a steady flow, rather than a deluge of distressed opportunities. If it’s the latter, then investors might miss out on opportunities because there’ll be too many at once.

I think that next year will also be interesting, because we think there will be a parallel M&A market, where mainstream activity will still be healthy, but we’ll have a distressed market that is active as well, as there’s still a lot of money out there looking for a home across both markets.

Samuel Norris: One of the reasons why a lot of our clients have not been active in the distressed space as much as we would have expected is because there’s been so much liquidity in the primary markets. If you look at the bigger end deals in particular, sponsors have been able to get par refinancings away with relative ease – even where the business may have some underlying issues. So that’s interesting what you’re saying, because we’re assuming that the liquidity has to be turned off before the distressed market comes back.

In what sectors or sub- sectors may new opportunities arise?

Norris: If I look at our clients who would traditionally have looked at distressed opportunities, 2020 was very much about secondary debt trading. That ended in December and since January, people have realised that they have had to look at more illiquid situations. But the fact is, there’s not been many opportunities. What we’ve seen is clients realise that there isn’t an obvious place where they can put distressed debt or rescue financing to work. So many of them have had to pivot to a different strategy. While this is varied, many have looked at more real estate deals, where we’ve seen distress in retail, hospitality, hotels, leisure, and even some office space.

Then, you have other sectors like airlines and travel. Some people have looked at more growth opportunities, or fintech businesses. Essentially they are trying to search for yield in different areas from where they typically invest. But really, their traditional, happy hunting ground of distress hasn’t been there, so they’ve had to be very flexible.

Stamp: We’ve seen opportunities across many different sectors without any identifiable trends. Instead, I think activity is more situation driven. On the turnaround side for example, we’re currently seeing businesses coming to market that are heavily exposed to fluctuating raw material prices, which has the potential to materially impact profits.

There have also been opportunities where businesses that are nestled away in big corporates and are no longer core to the wider strategic agenda - that’s been driving a lot of corporate disposals, particularly where there is a turnaround required. So it’s less about the sector from our perspective and more about situational trends.

Loizou: I think there will be new opportunities specifically in digitally-enabled businesses, content and data based businesses, recruitment, training and similar areas. However, these may become areas of opportunity for us, not because of the economic cycle specifically, but because they have now got to the point where they need money and help to take the business further.

When entering and/or diligencing deals today, is debt being perceived differently? If so, how is this impacting valuations?

Hamilton-Allen: While it is case- dependent, overall, we don’t think debt is being perceived differently. We bought a business back in February, and we had a few funds at the very end of the deal offering us more leverage than we wanted. So, we believe, on the good assets that have been showing good, promising performance, leverage is widely available.

For a time, a well-known debt fund threw Ebitda multiples out the window. They said, we don’t really care about LTM Ebitda, we want to know what’s your percentage of forward revenue coverage and that was the new metric they went to. However, I believe they have now reverted to Ebitda multiples again.

Stamp: There’s obviously more analysis you need to do given the events of the past year or so and you can’t necessarily just take the last twelve months earnings. In some cases, earnings have been inflated because of the Covid impact and so our job as the prospective investor is to try to determine a normalised level of earnings.

Conversely, there will be situations where there has been depressed earnings due to Covid. In this case, you’ve got to look further back to be able to work out what the normalised earnings really are. The fact that certain businesses did shut down for a number of months, particularly during that first lockdown, means it would be unfair to drive the valuation from that period. You’ve got to look further back, or at least at current run-rate earnings to be able to work out what a fair valuation is.

Where does equity value come into valuations based on today’s valuations?

Loizou: For me, it’s not changed. For our deals, we look at: What is the cost of us getting in in terms of the acquisition price, plus what is the working capital requirement to get the business to exit? This includes how much and for how long, and so we look to forecast at what point does the business become cash generative and has the ability to return our investment from working capital generated from trading. These are the metrics that we look at.

When you look at it like that, then the funding need, and therefore investment, will take into account the balance sheet at the time, whether you keep it, restructure it or do something in between. Whether it’s bank debt, crown debt, or long-term supplier debts, I class them all as the same. It’s a case of: What is needed to drive the business forward?

When opportunities do arise, is it likely that there will be a significant legacy to fund?

Stamp: In certain cases, yes. There’s been a lot of businesses that haven’t been paying VAT, possibly haven’t been paying their landlords and so investors need to dig deeper into the balance sheet to determine whether there is further stretch in the creditor base.

I’ll be interested to see, particularly as certain moratorium periods come to an end, how investors in those businesses deal with the legacy liabilities. We’ve seen, certainly in the early months post-pandemic, some mainstream PE firms making use of formal restructuring tools to deal with legacy issues, which they are unlikely to have done in years gone by. And, I think we might see more of that. As an investor in this situation, you need to make a decision on whether you can hold the business for longer to address those legacy issues over time or, do you need to go down the route of using one of the restructuring tools to in the hope you can address the issues in a way that is actually financially viable.

Are people put off by legacy funding?

Flower: To an extent, and if circumstances dictate, some legacy liabilities can be dealt with by going through an insolvency process. But the shift in preference for HMRC has made what used to be quite an easy decision as to whether you can pre- pack a business, now become less of a clear-cut decision.

The position with landlords is also interesting. We’ve seen some scenarios where insolvency has been considered due the high level of rent arrears. There was a general perception that landlords had very little leverage and there was an expectation of rent concessions and forgiveness or deferral of arrears. But that is not always the case. For example, if it’s a large unit that could be turned into an Amazon warehouse, then the landlord has more options and leverage. As we move towards a new normal the dynamic is shifting and I think landlords will be trying to bare their teeth where possible because they’ve spent two years having to deal with lower levels of rental income.

Norris: There is also definitely this theme of backlog capex where businesses simply haven’t had the revenue over the last 18 months to keep up the capex spend. Some of our distressed and special situations clients are therefore finding opportunities with businesses, which don’t necessarily have a problem right now, but they are likely to within the next 12 to 24 months. That is definitely creating opportunities.

Given the uncertainty of the last 18 months, has the way you budget for deals changed? Hamilton-Allen: There are two ways in which we think our budgeting processes have now changed. The first is around the ‘jumping off point’ and what happened last year. We’ve spent a lot more time looking back and trying to work out where we have been and what our underlying starting point is.

Secondly, when we’re budgeting we’re probably paying proportionally more attention to the supply side than we have done before. We’re looking at ‘what’s the demand in the market’ and ‘what do our customers want’, but also can we supply this or find the resources to deliver it. This is more of a consideration now.

Flower: I think it is way more challenging at the moment to peer into the future because we don’t really know what the new normal looks like just yet. So there’s a lot more sensitising of management forecasts required along with looking at them on a much more granular level.

It’s obviously so much easier to sell or buy a business when the market and everything else is moving in the right direction. Right now a big part of diligence is about understanding what potential shocks may be out there and how a business is placed to cope with them. On the flip side, there are some businesses that have performed tremendously well over the last 18 months but the question then is more around is that performance really sustainable? Do forecasts need to be adjusted downwards and by how much?

We are in a better place than 12 months ago but it’s still tough to predict what the future will hold, and we could be another 18 months away from any real position of stability.

When it comes to creating value, do firms have to work harder to achieve pre- pandemic results/returns?

Stamp: I think it depends partly on the market backdrop. We’ve seen situations where businesses have benefited from a sudden rebound in performance due to market forces and serving that demand has been the tricky part, often due to supply chain challenges and lack of staff.

In other cases, value creation does require more work, particularly if the pandemic has meant that the business is in significant need of repair.

If you’ve got a good management team though, you will often get through these issues and this is obviously much more important where the situation is more marginal and you don’t have the luxury of a buoyant market.

Norris: I think it goes back to a point made earlier around the fact that management is very much a key part of the investment strategy.

Loizou: The other thing to bear in mind is the GP’s ability to help. If you are a majority shareholder and you have got control via your loan notes and/or equity position, you can work hard and make a difference. I think it is harder when you do not have that influence and have more of a minority influencer role.

Either way, you can’t ignore the fundamentals that private equity and special situations are reliant on working closely with people and aligning interests to create value in a mutually beneficial way. For this reason, our priorities have not changed and we continue to work in the same way with management and staff to achieve growth across the board whilst ensuring personal aspirations are also met. The pandemic has, however, highlighted further the relevance of how personal factors outside of the work environment can impact the success or otherwise in delivering your value creation plans.

Have there been any new entrants in the special sits space?

Norris: In Q2 and Q3 2020, we saw a lot of established distressed and special situations firms raise big funds in record time. There was clearly a gravitational pull towards the more established players who had strong track records over a number of cycles. This was probably to the detriment of newer funds, who in many cases struggled to fundraise during the same time.

Stamp: Not that many as far as I am aware. It can be very difficult to raise a first time fund in the best of times, let alone during the middle of a pandemic. My firm was very lucky in that we completed our first time fundraising just before the pandemic hit. Raising a first time fund in an environment where you can’t meet your investors face to face must be quite difficult and so the lower number of new entrants is somewhat understandable.

In addition, given the low level of activity in the special situations and turnaround market at present, I don’t think the market will be suddenly flooded with new entrants anytime soon.

Have any existing managers repositioned themselves either towards special situations and turnarounds or away from it? What are their reasons?

Hamilton-Allen: There are more participants around and capital ready to be deployed. Plus, you do question why certain funds are doing certain deals. Some managers that are not going to pay 25x for a software business or 20x for a healthcare business for example haven’t been able to deploy so they may be expanding their parameters.

They are stretching their boundaries a bit, but that is purely due to discipline versus deployment.

Flower: Some of the conversations we had early on in the pandemic involved generalist funds saying that they were interested in distressed opportunities for their portfolio companies as part of a buy-and-build strategy. In this scenario, investors can buy cheaply, integrate the business and capture synergies, thus driving growth in the portfolio company.

The challenge for advisors dealing with distressed scenarios, however, is often around execution and deliverability when you’re up against time constraints. If there is a seasoned distressed investor in a process, against a more mainstream investor who may not have the skill set to really analyse and quantify the risks quickly, then as an advisor you will probably focus more on the specialist investor with the expertise and experience.

Where exits of these businesses were previously to another sponsor, now sophisticated trade buyers are entering the market too. Are transactions changing as a result and becoming more competitive?

Loizou: I think the perception that “trade will never be able to get there in time for a distressed deal”, is becoming less common now. There are now businesses that do have the necessary skill sets and do understand buying and looking at these opportunities. There are also lots of larger corporates that will have an in-house, kind of VC or acquisition team, which has people like us doing the work for them to source and buy opportunities, so I believe the competition has been around for a while regardless of whether it is trade or private equity.

Hamilton-Allen: A lot of opportunities we look at involve private vendors who do not want to sell to trade and want to remain part of the business. Instead, they are looking for a partner to help them drive growth. Nonetheless, considerations around whether we are preparing our businesses to be attractive to trade at exit are coming to the fore; more so than previously. It was always there, but it appears that it is now getting a bit more attention.

Flower: Yes, there are interested trade buyers in this part of the market, but it is very much asset or situation specific. In competitive processes, you can’t ignore trade buyers, because trade will usually be competitive in terms of value and ultimately, all other things being equal, a decision as to who to sell to is going to be value driven.

However, not all trade buyers have the ability to move quickly, but that doesn’t mean trade deals can’t happen.

Generally speaking, it’s still a pretty good market if you’re looking to exit a good underlying business, but the fact is that there aren’t that many distressed assets on the market at the moment. But, one would expect that when they do inevitably come in greater volumes, there will be plenty of demand.