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While we are enduringly positive people, at times over the last few years we’ve had to somewhat squint our eyes (and blur the vision) in order to be very positive about the economic data that we have been presented – be it inflation, cost-of-living, consumer spending or many other leading indicators.
Over the past few months, we have needed to squint less. Inflation is back down around 2%. Wage inflation is running higher than overall inflation, so people hopefully now feel they've more money in their pockets. This is starting to feed through in consumer confidence. We have a new government and with it what seems a more stable political landscape. There has even been a boost from England reaching the final of the Euros, and the odd sunny day as well.
The last piece of this positivity puzzle had been interest rates; now the Bank of England has moved on that, too. All these indicators point to a period of stability, and a return to the right conditions for deal making in the sector; be it to fund growth, support management teams or give patient investors all-important exits.
Stepping back, it is worth reflecting on what has driven M&A transaction volumes over the past decade and more in the pub sector. We saw three prevailing trends in successful deals: a scale-and-exit to trade as large groups chased scale; creation and expansion of platforms fuelled by cheap debt; and investment in well-located pubs to create a premium property. This was what we saw through the 2010s, but now things have evolved.
We believe we've seen an end to the race for scale. Where we saw consolidation, we have now seen more rationalisation through estate churn. We have also seen record numbers of pubs being converted for alternate use which makes the market smaller, so the task of finding unpolished gems is that much harder.
In more recent times, we have seen more scrutiny applied to the strategic rationale driving M&A deals, beyond simply bigger being better. What does a deal bring in terms of the operational capability, the proposition, the geographic fit? There’s a real focus on synergy, and not just meaning what cost savings can a transaction deliver. For example, the merger of Cirrus Inns and Liberation Group – a deal we worked on – gave Liberation a geographic solution for part of the southern England market, but also significantly adding to its room capacity. The acquisition of Hickory’s Smokehouse meant Greene King could bring that proposition into a significant number of its existing sites materially increasing the average weekly revenue of those locations.
With debt costs now higher, we’re seeing more active portfolio management. Companies are forensically looking at where they deploy capital to identify ‘lazy’ capital that is tied up in the wrong assets. This is driving estate churn.
This can create win-win deals where new owners can implement operational and investment-led change to these sites to drive their returns and the seller can re-invest the proceeds to drive returns in their remaining portfolio. Recent examples of this have come from Fuller’s selling 37 sites to Admiral Taverns (and then effectively redeploying cash into the acquisition of Lovely Pubs – adding seven premium pubs with rooms), and Marston’s selling a handful of packages to Red Oak Taverns.
The opportunity to premiumise and reposition a business via investment-led upgrades has been a consistent theme in the market. We think this is now an even more far-reaching trend in UK pubs – and it’s not just about launching a more premium food-led proposition. It's about a combination of factors, including focusing on drink-led occasions and entertainment. Weighing on operators is a concern that the diminishing importance of alcohol to consumers (particularly younger cohorts) could lead to a fall in frequency of pub visits. We think it’s about building pub businesses that focus on being a place for people to socialise together, whether occasions involve alcohol or not. The demand and desire for that in-person experience remains huge for consumers, and so the investment-led proposition is critical.
With cost of debt at a generational-high point, profit growth and active asset management are more important than ever. The operating model is one of the first things investors look at when analysing an acquisition target; can better returns be unlocked via different operating models (franchises and pub partnerships are ever more popular) and is the right talent in the right pub?
Significant and targeted investment is being made in accommodation in the right pub sites, as operators and investors look to expand and develop footprints further. Heartwood Collection is a good example, and investors are looking to back high-quality management teams, who are strong operators, but also have the ambition to do more and to scale-up.
In terms of what we see driving M&A activity over the coming years, firstly we expect there to be more estate churn from some of the larger groups, with the capital repurposed to prioritize investment in their core estate. In the short and medium term, there is still a financing challenge in the sector caused by the cost and availability of debt. Debt capacity isn’t what it was, so this will require solutions; some businesses will have to put in additional capital to pay down debt, so that refinancing can be secured, and some businesses may have to sell assets in order to fund this. It may even be necessary to look for a sale of the business as a whole.
From a trade buyer perspective, we think there is still a desire to look at platforms where there is strong operational management, particularly in the premium part of the market.
We also expect to see new investors coming in for pub businesses, such as real estate backed funds. These funds have traditionally had a lot of money invested in retail or office assets and these investment classes are now challenged following the pandemic. In response to this, these investors are moving their gaze across to more operational real estate such as hotels and pubs where income has rebounded much more strongly. These funds often have lower cost of capital which can help to boost asset values.
What is required to truly underpin positive investor sentiment is a return to margin expansion. We see the customer’s desire to eat and drink out of the home is largely undiminished, although recent months have been a little bumpy for some, and we are starting to see some disinflation in certain categories of food and energy, which points to the opportunity of a return to profit margins expanding again on a more consistent basis.
Recent data suggests that consumer confidence is improving (if a little slower than people would hope). If interest rates do start to tick down further from the Bank of England’s initial 0.25% points cut, we will get to a position where many economic indicators are pointing in the right direction. That should provide a spur for more investment in the pub market, and so we certainly believe there's a lot more to be positive about at the moment (all eyes on post-summer trading). Some obvious operational challenges notwithstanding, we think – in the absence of any further geopolitical shocks – we can look forward to a period of increased M&A activity over the next 12 months, and hopefully some imaginative deals.
This article was first published in MCA
