We haven’t fallen off a cliff

Eyebrows were raised last week as the figures for European private equity in the first quarter were released. Deals were down 59 per cent on the fourth quarter of last year, according to Venture Economics.

But the private equity investors PEO spoke to weren’t glugging the prozac just yet. Instead, they believe the downturn is a normal reaction to the market correction and won’t last that long. Some of them haven’t even noticed it.

“I haven’t seen a significant difference between Q1 this year and Q1 last year,” says private equity lawyer Simon Tinkler of law firm Clifford Chance.

Neither has Morgan Grenfell’s Jon Macintosh. “We’ve been reading information memoranda like they’re going out of fashion,” he says. “We’ve only done one deal (this quarter), but we’ve turned down hundreds.” The deal was Morgan Grenfell’s $2.5bn acquisition of brewer Whitbread – “by far the biggest we’ve ever done”.

This is because the figures exaggerate any decline in investment activity. Deal size fell by about a third to $20.4m from $32.7m as a result of the correction in prices. Although Venture Economics reported a 59 per cent decline in activity, the actual number of deals only fell by a third to 270 from 406.

“You’ve got a 20 per cent differential in the figures anyway because of the pricing,” says David Thorp, managing director at Friends, Ivory & Sime and this year’s BVCA chairman. “Q4 was a corker, but Q1 contains the market correction.”

Tinkler also makes an important point about comparing like with like. “Comparing Q1 to Q4 in any year will be misleading,” he says. “The last is always the busiest: September tends to be the peak origination time, so deals come to fruition in the last quarter and people want them done before the year ends.” Venture Economics do not have any figures for the first quarter of last year.

Not a big deal market

But activity has fallen away: the number of buyouts and acquisitions fell 25 per cent to 35 (worth $2.9bn) in the first quarter from 48 (worth $10bn) in the fourth. “We’re not in a big deal market,” says Martin Bolland of Alchemy Partners. “A big stock market move up or down is usually followed by a period of not much activity. It doesn’t usually last that long.”

The key to getting deals done again is stability. “Difficulties come when you don’t know whether the price you are paying is 20 per cent too high because the market will continue down or from a seller’s point of view whether the price you get is 20 per cent too low because the markets will bounce back,” says Tinkler.

A period of stability would help buyers’ and sellers’ expectations come together, and could unleash a wave of deals. “When this delay comes to an end there will be a terrific upsurge in activity because there is a lot of pent up demand,” predicts Tinkler. “I expect more deals from the team here in the next six weeks than in the past three months.”

What are we waiting for?

Three factors may however postpone such convergence. As Europe has not been hit as hard by an economic downturn, companies can hold out longer before cutting deals; the prices of old economy companies are going up, not down; and the banking market is nervous.

“How long the delay lasts depends on the urgency of the vendor,” says David Thorp, managing director at Friends, Ivory & Sime and this year’s BVCA chairman. “In the UK – and this is also probably true of Euroland – I don’t sense that product sales levels are falling rapidly the way they are in the US.”

Secondly, although prices in general have come down, some have risen, notably among last year’s ugly old economy ducklings. “The large buyout houses are typically buying old economy businesses,” says Mark Advani of Friends, Ivory & Sime in Birmingham. “Last year the market hated them. Now we have a flight back to cash flow.”

Advani believes the banking market needs to steady before the big deals can return. “For £100m plus deals, the banking market needs to be seriously robust,” he says. “If I look coldly, banks are saying to me they are on a downturn in confidence and I sense it has further to go. It will be quiet until the final quarter at the earliest.”

Tinkler echoes these sentiments. “I think the tightening in the debt markets will mitigate against the bigger deals,” he says, “although there may be a few because of the corporate shakeout.”

“It’s a horrible combination,” laughs Advani. “Prices have picked up in the companies the large buyouteers want and they can’t get their debt in. 2001 looks bad…”

Smaller deals

The smaller end of the market might bounce back sooner. According to Venture Economics, 64 early stage investments worth $290m were made in Europe in the first quarter, compared to 114 worth $859m in the fourth.

“It’s just a correction and will sort itself out,” says Thorp breezily. “We at the BVCA know from our members that most people have money to invest, but they aren’t going to do it at the prices that ruled three months ago.

“In technology companies, most people will recognise the new market level sooner rather than later,” he continues. “Most tech companies have an important spending plan. Falling prices will make their investors hesitate but it will put a three month delay into things rather than a 12 month delay.”

The knock-on effect

So things aren’t as dire as the figures suggest. But the price correction carries a warning for private equity firms. “What the stock market is really signalling is that in 12 months’ time the levels of economic activity within our portfolio companies themselves will be down,” says Thorp. “In most of the companies we are backing there has hardly been any change yet.”

That does not mean investors should go into hibernation. “It is important to keep investing through the cycle,” says Thorp. “We are really trying to invest in sectors that are not going to be savaged if a downturn does come. For example, in the US, capital goods sectors are being savaged. Yet certain consumer markets are experiencing relatively higher spending.”

Macintosh takes the opposing view. “If we don’t do a deal for the rest of the year we’re really not that bothered,” he says. “We don’t have to keep spending money so volumes don’t matter to us. Investment banks make money on a deal by deal basis. We get paid for doing good deals rather than lots of deals.”

However Thorp suggests it won’t come to a full-blown recession. “Some say the second quarter will be the bottom in the US and then off we go again,” he says. “If that happens it would suggest that the UK and Europe will get going again in Autumn 02.”

Overall, investors remain optimistic. “There is less happening on the exit side,” says Tinkler. “But the fundamental economic drivers are still there – European consolidation, the German tax reform. People see this as a temporary downturn rather than the beginning of a 10 year bear run.”