Capital idea

The Yates MBO is the latest in a series of private equity investments in pub companies. Bill Priestley, of Legal & General Ventures, examines the role of venture capitalists in the sector.

Venture capitalists (VCs) have a controversial reputation. Depending on who you speak to, they are either money-grabbing asset strippers who have demonised the pub sector, or saviours who have brought pubs kicking and screaming into the 21st century.

The truth is that there are plenty of disenfranchised tenants and poor managers ready to use VCs as a scapegoat for failure. However, there are also some VCs who have done nothing at all for their reputation by failing to invest in or engage with pub operators.

Since the early 1990s, VCs have come to dominate the sector. They have backed all of the major tenanted pubcos - Enterprise Inns, Unique, Punch, Pubmaster, Avebury, Inn Business, Inn Partnership - while in the managed sector Spirit, Laurel, Barracuda, Noble House and Mill House are all owned by VCs.

Yet, at first glance, the trade does not look promising. Beer consumption has been in long term decline and regulatory concerns beset the industry. What's more, there is clearly an over-supply of pubs and there are no material barriers to entry.

Faced with these issues in any other sector, a VC such as Legal & General Ventures would normally give up because of our strict investment criteria. However, we have invested in two pub companies: Enterprise Inns, backed when it was first set up in 1991, and more recently Unique, acquired through a joint venture with Enterprise and other private equity houses. These investments both proved extremely successful.

The first and overriding reason is management. Ted Tuppen and David George have been at the helm of Enterprise Inns for 13 years and have taken the business from start-up to FTSE 100. This is an extraordinary achievement and unique in the context of a mature industry sector. Similarly, Graham Turner and his colleagues at Unique were a first class management team, with a proven track record of delivery.

The second success factor is a simple business model. For VCs, cash really is king and tenanted pub companies produce lots of it, without huge central costs, vast capital expenditure programmes or aggressive discounting.

The third success factor is leverage or, more precisely, debt. VCs like debt because, in a business sector showing modest growth, it enables them to improve their return on equity. Most people borrow at least 70 per cent of the purchase price to acquire their homes; most investment property companies borrow a higher percentage. Why should freehold pubs be any different?

None of these success factors are rocket science. VCs generally make their best returns when they buy good businesses with good management teams at the right price.

Some VCs specialise in turnarounds or distressed sales but, in general, these are deals which have a high degree of failure. Assuming a new concept is going to be better than the existing brand is also a high-risk strategy.

The mechanics of the deal​

The mechanics of a VC-backed deal are far from straightforward and the process can be long and drawn-out.

Undertaking a management buy-out or buy-in presents tough challenges for a management team. On top of being asked for cash to invest in the enterprise, managers will have to commit time to attending a whole series of meetings with financial and legal professionals while running their existing business.

Buy-outs and buy-ins are often characterised as enriching opportunities for managers. But in most VC-backed businesses, executives are not paid market-leading rates, there are few chauffeur-driven cars and head offices are rarely lavish. It is for this reason that a number of businesses seem to experience a miraculous improvement in their performance following a venture capital-backed management buy-out.

Another contributing success factor is that VC-backed businesses are centred on management incentivisation. VCs often look to obtain a significant financial commitment to the business from the executive. The incentive for them is to multiply their investment sum in the event of a successful sale of the business.

VCs will continue to maintain a strong interest in the sector. However, rather like the situation with high street pubs, there are currently too many VCs with too much money chasing a relatively small number of quality deals.

This does not mean that mediocre businesses will find it easy to raise money, but it does mean that there is a danger of VCs overpaying.

VCs have not been the ultimate saviours of the pub industry. That accolade belongs to the pub managers, lessees and pub company management teams who have transformed the sector from its antiquated past to its current position. However, it is fair to say that VCs have facilitated this change and we should expect this trend to continue over the next few years.