Value creation – a delicate balance By Andrew Tottenham, Managing Director, Tottenham & Co January 23, 2019 at 3:00 am Private equity (PE) has been quite active in the gambling market in the last year. This represents a change from a decade ago, when gambling became persona non grata for private equity due to profitability not coming anywhere near the expected returns. Gambling companies were awash with red ink and investors all but wrote off any chance that they might get any of their money back. Since that time, gambling revenues have stabilised and grown, and companies have shown there can be significant returns on investments. However, valuations have continued to be depressed. It is very difficult for privately-owned land-based gambling businesses in Europe to command valuations above or even approaching seven times EBITDA. There are a number of ways to create additional value: to grow revenues, to squeeze costs, to do financial engineering, or to create what I call “hope value”- value that is attributed to what a business might become. Two acquisitions during last year, Blackstone acquiring Cirsa and Novalpina acquiring Olympic Entertainment Group (OEG), are likely part of a roll up strategy to build a larger business and at the same time put a squeeze on costs. Acquirers promote the synergies they think they can achieve in order to support the price they plan to pay, but how many companies actually attain the cost savings which they project at the time of the acquisition or merger? Few, I am sure. Given the timelines that private equity funds work to, developing new projects from the ground up rarely figure in their plans; such projects take too long to get across the finish line and revenues are always going to be uncertain until they open for business. When you buy an operating business, you think you know what you are getting. Revenues and expenses can be audited and the risks to the business quantified. Due diligence should (but does not always) rule out major surprises. Revenue flows are immediate and ongoing. The challenge to businesses like Cirsa and OEG is that these companies are the dominant or number two operator in their geographical markets, so acquisitions within those markets could be delayed or blocked by antitrust proceedings. Therefore, the natural route to expansion is buying into interntional markets where the businesses do not yet operate. I am not certain how much economy of scale can be achieved from a multi-country approach taken by a land-based gambling company. There are not that many departments that can be entirely removed from the national level and pushed up into an international head office: perhaps accounting (though not entirely), treasury, and planning and analysis. Marketing can potentially be removed from the operating unit and moved to or taken over by head office, but each European country has its own laws and regulations. Some allow for loyalty programs, others do not; some allow text message promotions or general advertising, others do not. Cultural differences need to be taken into consideration, as a campaign that is successful in one jurisdiction might not work in another. And on it goes. Who is best to judge – a person sitting in an office perhaps one thousand kilometres away or someone at the coal face who has direct experience of the impact? Some roles become duplicated and managing the business can become cumbersome. What used to be a fleet-of-foot business becomes a turgid bureaucracy. Head offices can set limits and require a certain discipline, but managers should be allowed to manage their businesses, otherwise there is little accountability. I remember being walked through the back office by the CEO of one of the large US operators. As we walked through open-plan office after open-plan office, all filled with people, he asked “What do all these people do?” I had no idea, and it wouldn’t surprise me if he didn’t either. True, a multinational strategy can reduce regulatory risk for a company. And a tax increase or an operating restriction in one country is unlikely to devastate the company, so earnings can become more stable. However, there is likely to be additional costs because it is a multinational company: for example, compliance oversight will need to increase. A company cannot afford to have a “mistake” in one jurisdiction lead to the loss of licenses in others. Perhaps one gain to be had is the implementation of best practice across the group but is this enough to justify a global approach? Another cost saving could be through group-wide agreements with suppliers, but, given the fractured nature of Europe, how many products would be covered by these agreements and, if a capital item, what percentage of investments would make sense to purchase in larger quantities? Without sufficiently large economies of scale, private equity owners will seek to buy low and sell high, with a bit of financial engineering in the middle. Gains to be had from restructuring the balance sheet are fairly immediate, but one-off; once achieved they are hard to replicate. Creating value can involve a delicate balance. Owners cannot be too successful, because if all the costs have been squeezed out and opportunities for revenue growth have been maximised through efficient marketing programs and the like, what is left on the table to be had by the buyer? If there are no organic EBITDA growth opportunities, all they are buying is the equivalent of an annuity, a promise of a stable cash flow. That’s hardly something that is going to set the world on fire. Buyers want to see that they can improve the business and see additional cash flow from their efforts, so management cannot appear to be too good but need to be good enough for the acquiror to want to buy them. The buyer may believe that further profit growth can be achieved with more investment, but this begs the question why didn’t the existing owner put the money in? An argument could be made that the required investment was at the wrong part of the investment cycle for that particular private equity fund. But against that, buyers rarely want to pay for all of what they see as their effort or additional investment to realise that potential gain. There are ways to add value, by showing a management’s success at implementing their strategy. However it must not be fully implemented, just somewhere along the road that demonstrates management has the skills and experience to continue to successfully implement on that strategy. So ultimately the additional value one can argue that exists involves a balance between gains had (existing profits) and the gains that remain to be had. That’s a tricky balance to achieve.