Private Equity: why so shy?
Private equity has invested heavily in other areas of the leisure industry, and several key European markets are poised on the brink of regualatory openings that bode well for the sector. So why is private equity still reluctant to invest in the industry?
THE NEWS THIS month that legendary UK financier Hugh Osmond has been suggesting Gala Coral as a possible target for his new investment vehicle aimed at turning around private equity deals which have gone sour indicates the ongoing relationship between private equity and the leisure sector.
However, despite escaping the mass redundancies and solvencies of other sectors to emerge in relatively strong shape from the recession, and promising signs on the regulatory front in Europe and the US, egaming is still struggling to attract the attention of private equity houses for anything beyond small amounts of venture capital.
So why is private equity, which has invested heavily in other areas of the leisure industry, still apparently shying away from egaming?
Regulation is the first word out of most industry experts’ mouths. Although changes on this front are obviously ahead, it appears something more concrete needs to happen before private equity comes to the party.
“The regulatory situation remains a major factor,” says Mervyn Metcalf, managing director at Global Leisure Partners. “In the UK, you’ve got private equity companies looking at the online gaming industry, but their interest is in companies operating in licensed markets, with legal due diligence being the key area of focus. They are particularly cautious about anyone who has done anything in the US, for instance, if a company has done business in the US and hasn’t yet agreed a settlement with the authorities.”
Paul Janson, president and chief operating officer of Headwaters MB, the US investment bank that brokered the recent sale of 35% of software firm CyberArts to Greek lottery systems provider Intralot, says they approached about 20 middle-market private equity houses in the US with little success. “The response we consistently came away with was: ‘Wow, both the company and the opportunity are really exciting, but we are hesitant to get involved until it becomes legal in the US’. That was surprising to us because regulation is clearly coming, but they were reluctant either to get involved at all or to provide a reasonable valuation until the US became a reality.”
Risky business
Deutsche Bank analyst Richard Carter says the risks are simply too high for private equity. “If there is an Italian business or a UK business operating only in a fully regulated market then I think private equity would look at that. But look at what has just happened, with the UK Department for Culture, Media and Sport suddenly announcing it was to change the UK online gaming regulations “ that is quite scary for private equity. It shows there is still a lot of risk out there in the industry.”
So does this mean that the sector simply has to wait it out; that long-anticipated US and European regulatory changes need to come to fruition before anything happens? Not necessarily, says Nicholas Batram, leisure analyst at KBC Peel Hunt. Although he doesn’t see private equity currently taking an interest in operators themselves, they may be more open to investing in service providers such as those providing software platforms, payment services or fraud detection technology.
“I don’t think online gaming operators are a natural private equity investment. I’ve spoken to a number of private equity houses and their interest is more focused towards the B2B side of the industry rather than the operators themselves,” he says. “Technology companies are not the ones operating in the grey environment; they are just supplying the operators.”
But Metcalf (pictured right) says these B2B companies still need to stand out. “If investors are looking at a B2B provider, they want to 
know how accessible their technology is and whether someone else could just come along and replicate their software. Scalability and the uniqueness of the company are key concerns.”
He adds that the increased success of the sector is also bringing it to investors’ attention. “Historically, many companies were operating in a grey area and were not really making that much money. But there are a lot more players of scale now.”
But isn’t this success a deterrent for private equity? With news reports focusing on deals surrounding businesses that need restructuring, such as the current battle for control of heavily indebted Gala Coral, it appears egaming may not be distressed or undervalued enough for investors. “Gala Coral is a different situation to purely online operators because you’ve got a significant bricks-and-mortar business in there with associated assets. Gala Coral is a low-growth, but cash-generative established business. It is typical private equity territory,” explains Batram.
Another major problem in attracting private equity is the difficulty of obtaining credit, particularly in the current economic climate. Carter says one major operator has spent two years trying to obtain bank backing without success, suggesting the private equity model of putting in a small equity stake, gearing this up and borrowing the rest from banks is unlikely to be viable. After all, if operators can’t obtain backing, investors are unlikely to be able to either.
But he adds there is still interest in firms that are performing well and that private equity does not only go for distressed firms. “There are private equity houses that specialise in taking businesses and turning them around, but there are just as many looking to buy growth businesses. Private equity houses have been looking closely at the sector, but getting from there to actually investing are two different things.”
Show me the money
So everyone is interested it seems, if more in the service providers than the operators, but the question remains as to why this interest isn’t translating into cold, hard cash. The answer is far from clear.
Janson says that although many investors were tempted by CyberArts, none were convinced of the urgency to invest now. “The middle-market PE guys like the space. We heard time and again they think the opportunity is going to be terrific when a regulatory environment in the US comes into play,” he explains. “But they said: ‘CyberArts would have been great. We’ll be sorry we missed this investment but as soon as the US becomes an open market, there will be 50 other plays within the online market we will be able to go after’. There was nothing driving them to invest now.”
Metcalf says the financial crisis may also be holding them back. “Last year was a tough year for M&A generally. Deals just weren’t getting done across any sector but there is now more time being spent looking at egaming. It is however currently unclear to which extent it is down to the wider market or the sector itself as to why deals are not happening.”
Egaming always has to operate with the uncertainty of regulation, and this also seems the main reason for its current inability to attract private equity funding. The plentiful interest in the sector currently appears to be outweighed by regulatory risk when it comes to weighing up the pros and cons for investors. Only once the possibility of the US market opening turns into a reality, it seems, will the balance shift towards the former and PE will finally be willing to take a gamble on the industry.