In 1987, LDC led an equity syndicate of five members which invested £2 million of risk capital in the Encon Group. Encon, a private company, was then a distributor of insulation materials with a small number of depots in the UK and a contracting/instal- lation subsidiary.
86 Private Equity
Encon’s trading track record, pre the equity investment, was as follows:
£ million
y/e 31August 1985 1986 1987
Sales 1.5 4.0 12.2
PBT 0.06 0.2 0.37
The equity funding of £2 million, along with £5 million of over- draft and loan funding provided by Bank of Scotland, enabled Encon to purchase the assets of two moribund insulation manu- facturing plants in Scotland. The plants were acquired for a knock-down price of £850,000 (the full replacement costs of the assets would have been many millions) and the balance of the total £7 million of funding was used to cover:
(i) re-start of the plants, including additional engineering capital expenditure;
(ii) working capital to cover the planned growth of stock and debtors for the expansion in group trading activities.
The equity investors obtained an equity stake of 22.5% in the Encon Group.
The next three years (1988–90) were years of real achievement.
The manufacturing businesses produced quality products and won market share in a tough sector. The Group also made a number of acquisitions with the assistance of additional bank funding. The largest of these helped to double the size of its dis- tribution business to 20 depots. Encon’s first overseas depot was also opened in France.
The business then grew rapidly:
£ million
y/e 31 August 1988 1989 1990
Sales 19.0 31.0 60.0
PBT 0.232 2.0 2.7
The benefits from rationalisation of the cost base following the acquisitions were still to come through. The business looked to be on track to achieve a full stock exchange listing in line with the
aspirations of Encon’s senior management and the investing institutions.
By 31 August 1990, Bank of Scotland had increased its support to £12 million (split equally between overdraft and term loan) secured primarily by good book debts of £17 million.
To strengthen the balance sheet, the equity investors ‘followed’
their initial stake with a second stage capital injection of £3 mil- lion in December 1990, which was used to reduce some of the bank debt. The investors increased their equity stake to 32.5% in the process.
The trading year 1990–91 proved to be the most difficult one in the Group’s relatively short history. The UK economy weakened, moving from ‘slowdown’ status to an ever deepening and seem- ingly endless recession. The building construction sector suffered enormously. Housing starts fell rapidly, new commercial builds halted and, not surprisingly, the price of building materials fell.
Encon fought hard to maintain its market share, but with prices falling and bad debts increasing it soon became impossible to make sufficient earnings to cover fixed overheads. A pro- gramme of rationalisation was begun during the trading year, but this involved closure costs of circa £1 million. In the year end 31 August 1991 the following trading result ensued:
Sales £71.0million Loss (£3.1million)
The compounding effect of very high interest rates on a highly geared business dependent on the construction sector during an economic recession was graphically illustrated in that result.
LDC, as lead investor, maintained its belief that Encon, by now a sizeable player in its market, still had considerable unrealised potential. With hindsight, Encon’s management had made some strategic errors during the previous growth phase. But the team were intelligent, receptive, hardworking and motivated to restore company performance – though it was recognised that any turnaround would take two to three years.
A series of meetings took place between management/
investors/Bank of Scotland and it became clear that Encon required a further capital injection to see it through the recession.
88 Private Equity
The Bank of Scotland exposure had, by now, increased to £13 mil- lion (split equally between overdraft and term loan) but Encon’s debtor book had fallen to £16 million, and the Bank’s cover was reducing.
LDC succeeded in arranging third-round funding of £3.5 mil- lion from the syndicate (although at this stage one investor dropped out). The total equity from the investors increased to
£8.5 million, and their equity stake rose to 85%. It was also acknowledged that Encon was unlikely to be in a position to pay any dividends for at least another two years.
Bank of Scotland agreed to suspend its scheduled loan capital repayments and also agreed to reduce its interest rate to a fixed charge of 5% for one year to assist cash flow.
As a condition of the new equity funding, the investors appointed a new non-executive Chairman with turnaround experience to assist the management team.
The trading year 1991–92 was another year of mixed fortunes.
The programme of rationalisation continued and exceptional costs that year from redundancies and closures totalled £1.8 mil- lion. Bad debt write-offs rose to £1 million as numerous customers
‘went under’.
In terms of the bottom line, the year ended 31 August 1992 was the nadir in Encon’s history:
Sales £67.0million Operating Profit (£1.1million)
Exceptionals (£1.8million) Bank Interest (£1.9million) Trading Loss for Year (£4.8million)
The reliance on Bank funding had increased to circa £15 million (£8 million on overdraft, £7 million on term loan). This was secured by debtors £12 million, stock £4 million, freehold £1 mil- lion, plant and machinery £6 million. On a forced sale basis, it was unlikely that Bank of Scotland would have fully recovered their lending and any shareholder value had gone completely.
Despite the trading results, the fundamental operations of the business were sound and improving all the time. Working capital was under firm control, stocks had been reduced, credit control
tightened and the product sales mix improved. The simple things were all being done well and it was possible to envisage a picture where rising sales and improved margins – as the UK moved out of recession – would restore profit to the bottom line.
LDC and two of the remaining four co-investors agreed upon a capital restructuring, and the management and Bank of Scotland were involved at every stage in the negotiations. The bank debt reduced by £5 million, and the balance sheet picture improved.
The investors injected a further £2.5 million of equity and retained a 60% equity stake. Bank of Scotland agreed to convert
£2.5 million of debt to preference share capital, and also obtained a 15% equity stake.
Management were incentivised by seeing their equity stake increase from 15% to 25%.
Between 1993 and 1997, Encon continued its recovery and the results speak for themselves:
£ million
y/e 31 August 1993 1994 1995 1996 1997
Sales 60.0 60.0 69.0 74.0 78.0
PBT (1.4) 0.4 2.3 3.6 4.2
No magic wand was involved – simply a combination of hard graft, innovation, and determination from a totally focused and dedi- cated management team. For their part, the investors and Bank of Scotland had kept their nerve in strengthening the Group’s capital base. As the economy in the UK improved, Encon’s board was able to focus more on future strategies rather than on fire fighting, which had been a feature for so long in the past.
Towards the end of 1996, the shareholders discussed the possi- bility of seeking an exit, probably by way of a trade sale. At this stage the company’s auditors, KPMG, were also brought into play through their corporate finance specialists and they indicated that Encon might be valued somewhere between £30 million to
£40 million. A discreet selling process was then begun.
In November 1997, the shareholders sold out their stakes to another institutional investor. Encon was valued at £35 million – not a bad result compared to the situation in 1992! The result was a good one for all classes of shareholder:
90 Private Equity
• The management team made a substantial capital gain.
• Those investing institutions which kept faith with the Group recovered all the cost of their investment plus a substantial capital gain.
• Bank of Scotland recovered all their debt, preference shares, and made a substantial capital gain.
At one stage, it had looked as if everyone might be a loser. By working together and understanding each other’s needs, the pain was shared by all the interested parties during Encon’s most difficult trading period. Ultimately, all the shareholders enjoyed the satisfaction and reward of a successful turnaround which had depended upon all round co-operation.