Roger Humm
GGI Associate

GEOGRAPHIC PERSPECTIVE
R. Humm - THE UK ‘CREDIT CRUNCH’ AND ITS EFFECT ON MID-MARKET M & A

Many trends make their way across the ‘pond’ to the UK, and the financial markets are no place for an exception to this general rule. The summer crisis in the US sub-prime mortgage market - which was initially marked in the US by the problems experienced by two hedge funds of investment bankers Bear Stearns – has been well publicised, and predicted to create a significant impact on the UK financial market. Indeed there can be no UK resident who is not aware of the subsequent run on one of the UK’s largest mortgage lenders.

Both the housing markets and the levels of personal debt exhibit similar worrysome characteristics in each of the UK and the US and these concerns potentially indicate a slowdown in economic growth. However, the recent turmoil in the stock markets has apparently more than recovered with London’s FTSE just 3% short of an all-time high - so what effect are these events having on mid-market M & A activity?

CREDIT SQUEEZE

In the US, the toll of big bank losses has been felt by many, amongst others Merryll Lynch and Washington Mutual have been recent sufferers. Merryll Lynch reported it will take a third-quarter write-down of $5bn, and Washington Mutual warned profits in the period would fall 75 per cent year on year (source: Financial Times). These announcements follow similar write-downs from Citigroup, Deutsche Bank, UBS and others.

However, in the UK few - if any - of the big banks have yet reported significant losses or write-downs. The experience of Northern Rock, a bank with already low credit ratings prior to the summer’s events, was quickly brought under control by the UK government’s agreement to provide full security to the bank’s depositors. Many commentators have noted that this is a welcome move as it will lead to enhanced security for depositors – in the UK, savers have less protection from bank default than their counterparts in the US.

The credit crunch is impacting the UK housing market. The ratio of average home prices to earnings has doubled in the last two years – with multiples now exceeding the previous all-time highs set before the house-price collapse of the mid-nineties. That the US sub-prime lending troubles have been a contributing cause to the number of mortgage application rejections in the UK rising by one-third compared to this time last year is in no doubt as lenders remove discount rates and general conditions tighten. Barratt Homes, one of the leading UK house builders, have recently indicated a slowdown in the UK housing market, and for a second month running house prices may have fallen in some geographies (source: BBC Radio 4).

However, control of an over-buoyant housing market is precisely what the UK government and Bank of England has been trying to achieve ahead of any sub-prime lending crisis. More recent trends in UK mortgage interest rates have been increases compared to the 50 basis point cut in US prime rate. The credit squeeze has seen mortgage lenders increase their margins, with borrowing rates increasing relative to depositors, whilst the Bank of England’s base rate has remained level in recent months. Its prime responsibility is to keep general inflation rates under control rather than act as an enforcer of government fiscal policy and caution will be exercised before base rates are lowered.

Personal debt in both the UK and the USA is growing to record levels, with an estimated 75% of UK GDP growth relying on spending funded by consumer debt. In the UK total personal debt is now approaching US$2.9 trillion and is growing at about 10% per annum. The average household debt level excluding mortgages is approaching $20,000, and including mortgages each UK adult is carrying an average debt in excess of $60,000 (source: www.creditaction.org.uk).

These figures compare to similar US statistics: total US consumer debt is reaching $2.5 trillion excluding mortgage debt (source: www.creditcards.com), or an average of about $24,000 per household. This compares to the median US household income of $43,200 – although this is slightly misleading as mean US household income is higher than this figure.

Further increases in household debt, and tightening of mortgage financing will undoubtedly lead to some slowdown in the consumer-fed element of economic growth - but will this lead to any significant impact on mid-market capital transactions?

Consumer finance may be tighter, but this does not seem to have impacted corporate borrowing rates. Whilst mortgage rates have increased relative to consumer deposit returns, the City’s base rate remains unchanged. One suggested affect of the ‘credit crunch’ may be that banks’ credit committees are reviewing client’s proposals more carefully. Post-acquisition financial models are perhaps subject to closer scrutiny and assumptions may be viewed more cautiously. However, I personally welcome a greater emphasis on the underlying financial fundamentals with a wider understanding of transaction risk and a more fully developed risk-mitigation plan!

There appears still to be more than sufficient credit around for well-researched, financially justified corporate transactions – and my banker and VC colleagues remain keen to review the next proposed transactions. In particular, we are becoming more aware of the wealth of investment resources arising from China – and as I finish this article I note that the Chinese investment bank, Citic is preparing a bid for US Bear Stearns – the starting point of this summer’s consternations.