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From the jaws of defeat

The term ‘credit crunch’ has been aligned with the word ‘crisis’ enough times
in the past few months to become a very tired mantra. But whether or not it is a
crisis depends on your point of view.

Take, for example, the big banks – those that have built businesses on
packaging up bad debts in the form of complex products like collateralised debt
obligations and various exotic derivatives. They’re now suffering from the
seizure of the global credit markets, with billions lost to investments in bad
US mortgage debt products that have lost their value. But for the buy-side of
some of these products, it’s boom time. Hedges against bad debts of this kind,
like futures and options, are hitting the money as the ‘crisis’ unfolds, and
will most likely keep doing so for most of 2008. In particular, derivatives
exchanges are enjoying themselves. “Last year saw Eurex’s fixed income
derivatives segment reaching 771 million contracts traded, compared to 731
million in 2006,” says Paul Francis-Grey, editor of derivatives newspaper
Futures and Options Week. “Contracts measuring equity market volatility have
surged, although credit derivatives, which have recently gone on-exchange at
Eurex, have suffered and London International Financial Futures Exchange was
going to follow, but hasn’t rolled anything out to date, which is probably
fortunate at this stage.” Meanwhile, those who created this market have somewhat
fallen on their sword.

Entrepreneurial opportunities
That said, the crunch has proven an opportunity for the entrepreneurial, not
least private equity firms – big users of debt markets – who have been buddying
up with their rivals to spread the risks and costs to take swift advantage while
company valuations are driven down. The availability of cheap debt is, of
course, down too, so the fact that some large deals are going through is a ray
of light in an otherwise rather moribund UK pipeline.

The acquisition of waste management company Biffa demonstrates the power of
the relationship in getting deals done amid tough conditions. The £1.2bn
acquisition, mostly financed by debt, is being bought by a bunch of small, but
well-backed private equity funds; MBO specialist Montagu leads the consortium,
with General Electric-owned fund Global Infrastructure Partners, and an
HBOS-owned vehicle, Uberior Co-Investments. Bank of Scotland, Barclays Capital,
Credit Suisse, HSBC and RBS are underwriting the consortium’s finance facility,
while Montagu and GIP Funds are putting up £306m of their own cash each and
Uberior will bring £100m from its own coffers. Biffa management accepted the
deal, but it won’t be a surprise if one or more counter-bids are tabled before
the day is done, since deals of this kind of value and potential are in short
supply. Reportedly, private equity house Terra Firma and Suez, the industrial
waste management group, for which Biffa would be a perfect fit, have requested a
look at due diligence paperwork on the company.

Similarly, there’s Apax acquiring LSE-listed publishing group Emap, in a deal
that values the business at about £1bn at the time of completion. The
acquisition is funded with a mixture of equity and debt – nothing so special
there – but more interestingly has been done as a 50/50 joint venture with
Guardian Media Group.

“If the deal goes through, it will be the single largest debt-backed
acquisition done by a private equity firm in European media since last August,”
a source at Apax says.

It no doubt helped Apax (which owns Incisive Media, publishers of Financial
Director) and GMG that they had no rival bidders to contend with for the
business; not because the business isn’t attractive, but most likely because
other types of bidders – standalone ones, for example, that would shoulder the
debt burden alone and thus carry higher default risk – would have had a hard
time securing that finance in the current climate.

Scared off
Deals of this size have simply scared off the stricken lending industry during
the credit crunch, and debt markets are obviously highly volatile now – but
these sorts of deals have the fundamentals to reassure more visionary backers.

“Market turbulence in August and September led to fewer deals being completed
at the top end of the market as banks look to steer clear of post-deal
syndication risk,” says Jon Broach, corporate finance partner at BDO Stoy
Hayward.

“A reduction in debt levels as a multiple of EBITDA across all deal sizes has
forced a reduction in the price private equity buyers will pay on acquisitions.
Speed and deliverability are now big plus points in auction processes, which
play to the strengths of trade buyers with cash – and to private equity houses
who have pre-arranged banking or can write a cheque for the entirety of the
financing and sort out their banking post-deal.”

Then there’s the Mitchells & Butlers offer from arch-rival Punch Taverns.
What a juicy example of the credit crunch swallowing a perfectly good company
whole – and a pretty good example of deal frenzy fuelled by lack of pipeline
because of the crunch. In late January, the firm said its FD Karim Naffah was
gone following the firm’s £274m loss from its disastrous property hedge (see
‘Taming the crocodile’ below); by the first week of February, rival Punch
Taverns confirmed it had tabled a takeover offer to buy M&B; and by
mid-February, the papers were full of unsubstantiated reports that private
equity big-boys Cinven, Blackstone, CVC and TPG were going to place
counter-bids. Don’t be surprised to hear of a tie-up of any combination of
these, and/or other names, as hungry private equity firms survive an
ever-deepening credit hole by holding hands as they jump over it.

Taming the crocodile
“It couldn’t have been worse.” He’s quite cheery about it now, but Craig Smith,
FD of Management Consulting Group plc, remembers the struggle of trying to raise
finance late last summer to complete a deal it had been chasing for ages.

MCG had been talking to US consultancy Kurt Salmon Associates for about three
or four years with a view to buying the business from the principals. “What you
have to understand about acquisitions of people businesses is you can’t decide
when they happen,” Smith says. “They have to be when the selling company wants
to sell. If you try to buy a business that is just human capital and they’re not
happy to be bought, it’s a recipe for disaster.”

Early in 2007 KSA succumbed to MCG’s wooing, leaving Smith to spend a fairly
miserable summer as the credit crisis imploded, trying to get the £110m finance
to pay the $125m purchase price and to refinance the business. In the end, Smith
put together a three bank deal with Barclays, HSBC and Lloyds TSB.

You might think that three banks would simply cube the problems, but Smith
says that that wasn’t the case. “I think you reach a point of size in the
business where you can’t just work with one bank. If the markets had been
better, Barclays would have taken the whole of this deal, but then you’ve got
nowhere to go with one bank. You’re absolutely at your limits and if you want to
do anything else, you’ve got to bring in somebody who doesn’t know you,” he
says. This, then, was the right moment to bring in new banks.

Weight in gold
Smith sings the praises of investment bank Rothschild’s debt advisory team,
which guided him through the process. “They were worth their weight in gold,” he
says. “They knew how to work with the banks. They knew where I was getting a
good deal and where perhaps we might be able to improve the deal. So that was
money well spent.”
• Housing association Circle Anglia raised a fantastic amount of money in
mid-February when it secured £1.7bn from eight lenders – said to be the
largest-ever social housing finance deal. Roughly half that cash was new money
to help fund a five-year expansion and refurbishment programme, while the
balance was a refinancing of existing debt, resulting in interest savings of £1m
a year. The deal was structured using a special purpose vehicle that used the
rental income stream and asset backing of the group to improve the funding
terms.
• Here’s how not to do a deal: on the advice of their banks, Mitchells &
Butlers put in place interest rate and inflation rate hedges as a condition to
securing debt finance to complete property deals in a joint venture with hedge
fund operator Robert Tchenguiz. The argument was that the inflation rate swaps
market is relatively illiquid, so it seemed like a good idea to get that part of
the deal sorted out first.

Unfortunately, as credit markets started to dry up, the banks withdrew the
offer of funding. This left M&B with a hedge, but no deal. Alternative deals
were sought, but as credit markets worsened, not even a heavily scaled-down
property transaction could secure funding. At the end of January 2008, M&B
conceded that its hedges were useless and were closed out, at a loss after tax
of £274m. FD Karim Naffah resigned, the share price took a knock – and now the
vultures are circling over the company.

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