CONTENTS Europe

A very private problem

The Covid-19 pandemic has thrown the UK education sector into a state of flux, as providers face a cash crunch that could prove fatal for some. Deal flow has dried up, and buyout houses with hundreds of millions of pounds invested in the market are bracing for widespread losses, writes Josh O’Neill

These are peculiar times for private equity funds with eyes on the UK’s education arena.

Businesses across the sector are facing significant liquidity issues as the economic shutdown brought on by Covid-19 has crippled cash flows. On the one hand, such conditions present opportunities for bold buyers to snag undervalued companies, as periods of economic tumult always do. But on the other hand, it is extremely difficult to execute deals at present because organisations whose revenue channels are in flux are nigh on impossible to value accurately. Plus, private equity investors tend to at once own several businesses in numerous industries. Most are too preoccupied with the performance of their existing portfolios to think seriously about expanding them.

“Our most pressing concerns are the well-being of staff at portfolio companies, their ability to handle operations remotely if working from home, and cash monitoring if revenues are hit,” says Rob Simpson, partner at Apiary Capital, a Londonbased private equity house that owns Bertram Nursery Group, a chain of more than 35 nurseries in Scotland and the north of England. The UK government ordered most nurseries and schools to close on 20 March for an indefinite period as part of a wider measures intended to curb the spread of Covid-19. “Once the level of revenue hit can be estimated, our attention would turn to strategies to reduce cost in order to manage cash,” Simpson explains.

Like many other UK business, education providers and the supply chain supporting them are facing a cash crunch, as economic inertia has prompted individuals and organisations to reassess their spending on education and training amid a nationwide lockdown. Nurseries, schools, tutoring networks, colleges, pathway companies, universities – all are bracing for losses, as widespread closures and social distancing measures have prevented them from delivering their products for months.

As fund managers try – along with hundreds of thousands of other business owners across the country – to get a handle on their companies’ hammered financials, the education industry can expect a significant lull in private equitybacked transactions in the weeks and months to come. As the coronavirus pandemic shows no signs of abating, buyout houses are busy working on business interruption plans and deciding into which portfolio companies to inject life-saving capital. This is weighing on their ability to do deals.

Several transactions that were in play have stalled. Sources say that the sale of Oxford International, the pathway provider owned by mid-market buyout house Bowmark Capital, has been shelved until the impact of the ongoing pandemic on the organisation’s bottom line is known. Other private equity-owned education businesses that were brought to market last summer, such as the British Institute of Modern Music and apprenticeship provider Lifetime Training, are yet to secure buyers. ▶

“No one wants to catch a falling knife; there is a lot of fear in the market,” says Martin Luen, managing director at Baird’s European investment banking division, who has advised on a number of leveraged buyouts in the sector. “Private equity buyers are still worried we have not yet hit the bottom. This concoction of low buyer confidence and uncertainty around timing of a recovery means M&A volumes in the next three months will be very thin.”

Private equity’s plate is full. At the heart of this economic rut is a paralysed labour market. Through their portfolio companies, private equity investors indirectly employ thousands of staff in the UK education sector, many of whom are being cut loose or furloughed so that government funding can be accessed. Externally, education providers are being bombarded by clients – be that fee-paying parents or large corporations – that have seen their incomes shrivel up in recent weeks and are thus seeking reimbursements or trying to cancel contracts entirely.

“The number-one priority right now is cash flow,” says Luen. “Most education businesses are receiving fewer deposits and receipts and less cash than they would ordinarily expect, but at the same time, they still need to pay their teachers or instructors, rent, bills and, in some cases, offer cash refunds. Their private equity investors are critically focused on having enough cash to continue to operate for the next six months, especially as most of them will have interest and debt repayments they need to make during this period as well.”

Bullish buyout funds on the prowl for undervalued businesses amid a recession could have difficulty accessing debt at an acceptable price. Banks’ appetite for risk has quickly diminished (see page 14) in correlation with the pandemic’s upward trajectory. This is evidenced in the residential mortgage market, where some lenders are now requiring home buyers to put down as much as 40% of a property’s value to get a mortgage.

Restricted access to cheap debt is problematic for the private equity investment model, which relies on high levels of leverage, or debt, to generate outsized returns for deal orchestrators. According to management consultancy Bain, more than 75% of private equity buyouts executed last year had debt multiples higher than six-times target companies’ earnings. This ratio had increased every year since the 2008 recession.

Banks are factoring in inflated risk levels by attaching a premium to loans, according to Chris Smith, partner at Clearwater International’s debt advisory unit. “The cost of funding from banks has gone up by 100-150 basis points,” he says. This could prompt private equity investors to lean harder on debt funds, which over the past decade have taken a growing share of the credit market from banks. Debt funds have a mandate to make loans, otherwise they do not earn management fees. Therefore, they are more willing than banks to lend capital to finance leveraged buyouts during a crisis, according to Smith. They are also able to provide more money. A private equity buyout that might require capital from two or three banks, which seek to spread risk, could be financed by a single debt fund, meaning they are nimbler in a deal process. But they tend to like larger value deals, and their loans come at a premium: “Minimum 6% [interest], plus fees,” says Smith. Higher interest rates and a lack of readily available debt are not conducive to fast deal flow.

“It’s going to be really difficult to do deals in the next three-to-six months,” he says. “We’re going to see quite a significant drop in deal volume.” Once the pandemic subsides, there will likely be a significant adjustment in the levels of debt used in leveraged buyouts, he adds, which could require private equity funds to put in more of their own money – something they don’t like to do. “Leverage multiples will go down and pricing [of debt] is likely to go up,” he says. “Utilising debt only to fund acquisitions will probably cease as lenders will want additional equity investment.” An industry built on debt That covers the near future in terms of deal flow – but what about the present? How will private equity-owned education businesses fare between now and the end of the pandemic?

Leveraged buyouts, as the name would suggest, place large sums of debt on acquired companies’ balance sheets. Debt isn’t necessarily bad; world economies feed on credit. But during periods of recession, vast debt obligations can be dangerous if money isn’t coming in. The UK government has stepped in to keep the country’s economy afloat by guaranteeing citizens’ incomes and extending favourable loans, grants and tax holidays to businesses. But the reality is, most businesses – education providers included – will end up taking on more debt of some form.

“We could see a situation at the end of all this in which there are businesses with more debt than they are worth,” said Simon Hitchcock, managing partner of Horizon Capital, a London-headquartered private equity firm that owns education software and services provider Juniper Education. ▶ We could see a situation at the end of all this in which there are businesses with more debt than they are worth

A cautionary tale of such a scenario lies in Laureate Education, a university operator once controlled by a private equity firm. In 2015, under the ownership of KKR, Laureate’s debt-to-equity ratio reached 12.62. Now, as a publicly listed company, this figure stands at 0.74 after the firm spent three years selling off large assets (see page 16) across the world in order to clear debt from its balance sheet.

High levels of leverage, particularly during a recession, exacerbate cash flow issues and heighten short-term operating risks. Arun Kanwar, partner at London-based education consultancy Cairneagle Associates, says: “A frightening number of education businesses are leveraged to the hilt and are in danger of running out of cash and/or breaching their covenants. No doubt, we will see a number of these get close to the wire. We are already hearing about a number of businesses which are in trouble.” The government is pressuring banks to be extra-lenient with debtors, but private debt funds are largely unregulated and could act forcefully if covenants are broken. Depending on the terms of a contract, banks and debt funds could have the right to seize equity stakes or entire companies in the event of a defaults, if all other refinancing options have been exhausted.

These are sombre prospects. But there is also reason for optimism.

Operating conditions in the UK education market, combined with downward pressures in the credit market and lacklustre demand from investors, should lead to corrections in asset pricing in certain sub-sectors. For instance, the private school sector, which in the past 24 months has seen several organisations sell for more than 20-times their earnings, is now facing headwinds as fee-paying parents seek refunds and discounts (see news section). This could translate to widespread revenue losses across the sector, which in turn would bring down the value of school operators. Good news for buyers, bad news for vendors. But many argue that such a correction is long overdue.

“Pricing must equalise,” said Jason Zemmel, partner at law firm CMS, who specialises in private equity transactions. “But, actually, pricing will be but one aspect of the brave new world. M&A is always about risk allocation. How parties address that – with the proverbial sword hanging over future profitability and returns – means that investors will look to share the risks inherent in any future transactions,” suggesting funds may increasingly look to invest alongside others in joint acquisitions.

Once normality resumes and financiers can once again act with confidence, private equity investors will undoubtedly look for cut-price businesses that survive this economic apocalypse, as they did in the wake of the last global crisis.

But for now, the immediate future for deal-making in the education sector looks bleak. Most – if not all – of the UK’s largest professional services firms and legal houses are looking at ways to shore up their balance sheets by furloughing staff or putting them on unpaid leave. When transaction-hungry advisors are left twiddling their thumbs, one knows there is something seriously wrong. n