The point of known returns
When a Japanese merchant bank started buying up tenanted pubs three years ago it alerted investors to the charms of a sector that had previously been little-regarded.
The bank was Nomura International. The group's first deal was to buy more than 1,800 Phoenix Inns from Grand Metropolitan and Fosters for £249m, and a year ago it bought a further 4,300 pubs from the same owners for £1.2b.
Nomura was operating through its Principal Finance Group, set up by US financier Guy Hands in 1994. What Hands spotted was that businesses with unexciting but stable income can have considerable appeal for lenders.
The received wisdom has been that managed pubs are more profitable than tenanted estates in an area that is vulnerable to the continuing gradual decline of beer consumption, at least in terms of volume.
That has put off investors looking for fast growth and big profits, but for those who want a safe and steady return over the long term, the sector could be ideal. Assessed on their sheer predictability, tenanted pubs that are likely to be turning in a solid performance in 30 years' time are potentially more interesting than the managed sector, which is more vulnerable to changing fashions and economic downturns.
This kind of calculation has led Hands to invest in areas that others have not thought of looking. In the UK the group followed its purchase of Phoenix Inns with a buyout of rail-stock company Angel Trains and a huge purchase of 57,000 residential homes from the Ministry of Defence that made it one of the country's largest landlords. AT&T Capital leasing company and William Hill betting shops have been other recent acquisitions.
"What's nice is normally not profitable," Hands has been quoted as saying. "If something looks exciting and sexy we don't waste our time on it, because someone else will pay more."
Income-based
One of the ways that Nomura has turned this potential into actual cash is securitisation, which effectively mortgages not the assets but the income of the business. Bonds are raised on the strength of past and projected future performance, and are then sold to major financial institutions at relatively low rates.
In the USA during the 1980s securitisation became a viable means of financing in areas such as the care sector. Nursing homes are considered to be a pretty safe bet, because population trends and better medicine mean that increasing numbers of people will have a long old age, so demand is certain to be constant.
Securitisation has also been associated with credit cards, an activity that to lenders, curiously, is seen as more stable even than the banks.
"Banks do all kinds of dumb things. They invest in places like Russia where they are going to lose their investors' money," says Peter Hanson, a deal-maker who specialises in the pubs, brewing and leisure sectors. "But when banks issue credit cards to people like you and me who repay our debts, the known level of repayment and fraud is very predictable and you can raise more money against the cash-flows."
Although it established securitisation as a viable financing method in a number of its deals, Nomura has actually yet to carry out a securitisation in the pub sector. Only Inntrepreneur, which it acquired last year, may attempt it in order to refinance the original purchase.
However, securitisation can also be used to raise purchasing capital. The method enabled Wellington Investments, owned by PizzaExpress founder Hugh Osmond and Café Rouge entrepreneur Roger Myers, to found Punch Taverns, buying 1,400 pubs from Bass and another 800 from Nomura's Phoenix estate.
The pair raised an issue of £535m of bonds of investment-grade debt at 7.3% to finance the original purchase and provide £12m investment per year over the next four years.
Several other pub chains are thought to be considering securitisation as a means of raising investment capital. In a widely publicised deal, the Burton-based brewery Marston Thompson and Evershed, with Nomura acting as agent, hopes to find £135m by securitising most of its tenanted estates.
"The traditional route is to raise equity finance at two parts debt to three parts equity," Hanson says. "The best example would be the Enterprise Inns formation in 1991, which was financed by a banks syndicate with 60% debt to 40% equity, compared with eight parts debt to one part equity in the Punch securitisation deal.
"Pubs don't grow sustainably at 10-15% over five to 10 years, so they don't provide the growth that equity investors expect," Hanson says. "But for securitisation their stability is an advantage.
"By contrast, hi-tech industries, which are capable of much more interesting gains in the short term, cannot provide the long-term predictability that securitisation demands."
To the shareholder, securitisation is attractive because it increases the valuation of the company. The debt is also generally cheaper to finance, since it misses out the banks in the middle and goes directly to investors.
However, to qualify there are some quite tight requirements. "The cash-flows need to be stable, non-cyclical and not dependent on management influence," says brewery analyst Stuart Price at Credit Suisse First Boston. "A lot has been said about the potential of securitisation for regional brewers, but to be viable they need to be of a certain size, at least £100m."
Long maturity
Assuming the critical mass is there, the method offers a number of advantages, says Price. First, it appeals to investors because the debt has a long maturity period and has a financial safety net which pays out in the event of a downturn that reduces income. This means it could appeal to a broader section of the investment community.
Also it allows the company to get high levels of debt at lower cost, because the debt has a long maturity period and is supported by cash-flow, not underlying assets. Thirdly, the long-term debt allows it to lower the cost of the capital, increasing the value of the firm and boosting shares.
For deal-makers like Nomura, securitisation is a way of refinancing the original acquisition prior to streamlining the business and selling it on for a profit. Although, with 7% of the country's pubs, it is the biggest owner, it has no interest in being a long-term player in the leisure sector and expects to sell an acquisition when the opportunity arises to cash in on its new value.
But securitisation is no picnic, warns Punch Taverns' finance director Alan McIntosh. "People think they can get it just by going down to the local investment bank, but it's not that simple. This is not just an audit; it involves far more due diligence than floating a company, even.
"The rating agencies do an incredible amount of work before they decide to rate your bonds, as their reputation absolutely depends on the company not going bust."
And securitisation may not be the answer for all pub companies. "It's very expensive and takes up a lot of management time, which makes it difficult for the weaker and smaller ones," McIntosh says.
Cash-flows are also subjected to stress tests to establish whether they will survive the inevitable downturns in the economy. In the case of Punch Taverns, rating agency Moody's factored in two bad recessions in which income was projected to halve.
"You need significant headroom to sustain that kind of testing," McIntosh says. "Our average barrellage is the highest in the industry. If it was only half the size it would significantly erode our headroom."
This kind of analysis has become something of a science in itself, and Nomura largely depends on it to evaluate the likely profitability of a target acquisition. It has what it calls a Cyber-room: a computer studio staffed by young whizz-kids who work late into the night to analyse every possible indicator about a business, and who often end up knowing more about it than the people who own and run it.
Steady cash-flow
The original Phoenix deal exceeded Nomura's profit expectations and whetted its appetite for the acquisition of Inntrepreneur. Again, a main attraction was the potential mortgageability of a secure and steady cash-flow, although there is no hurry to securitise.
"We have a term of five years for the bank facility, which is reasonably long-term. Also, the markets are not ideal at the moment, though the prognosis for the medium term is better," says Giles Thorley, leader of the Nomura team that made the pub purchases and now chief executive officer of Inntrepreneur.
But he, too, warns about the downside. "Securitisation is one of many forms of finance and needs to be looked at in the proper context. You have to have a pretty fixed business and there are considerable penalties if you wanted to sell before the end of the term, which inhibits flexibility."
In the current financial climate, deals of this kind may seem to have lost their allure. Nomura's Tokyo head office announced serious losses recently, and although Hands says his Principal Finance Group will not be affected, he plans to suspend activity for the next year or two.
And Punch Taverns' McIntosh argues that the cost of debt from securitisation - now closer to 8% than the 7.3% he was able to achieve - makes the method less attractive.
"You have to remember that when markets are risky it becomes more expensive and the yield you have to give to the bondholder is bigger, so it can be better to go for conventional means," he says.
But Hanson disagrees. "This method is not black magic, it's sound, sensible financing. There is no question that we are going to see more deals of this kind," he insists.
"Equity markets are virtually closed off to the pub industry and regional brewers, because they aren't expected to grow dramatically. Also, equity investors are nervous that too much money is being spent on high-street pubs.
"The City still believes that tenanted pubs don't have a future and that only Yates's Wine Lodges and JD Wetherspoon will survive." But that's not the case, he argues. "There are 60,000 pubs in this country. Pubs are remarkably resilient and stable; people like to socialise and drink beer with their friends. Also, consumers want diversity; not everyone wants to walk in and have the exact same experience."
