Toasting profit

Not so long ago, a British pub fell into one of two categories: a franchise clone on a high street or a smoke-filled back-alley boozer offering only draft ale and packets of crisps.

But the British pub, one of the most enduring institutions in the UK, has undergone a significant transformation over the past few years. Nowadays, you are just as likely to be reclining on a leather couch, sipping red wine and munching on tapas.

While pubs have been redefined, investing in pubs continues unabated. Ever since the Beer Orders of 1984, when brewers were effectively prevented from owning the pubs that sold their beer, Britain's 60,000 pubs have changed hands numerous times over. Guy Hands and other financiers consolidated the sector in the 1980s and 1990s.

The high water mark most likely came in November 2003 when Spirit Group, whose investors included Blackstone, Texas Pacific Group, CVC and Merrill Lynch, became the UK's largest independently owned pub company through the acquisition of Scottish & Newcastle's retail division, including 1,400 pubs, for £2.5 billion ($4.9 billion; €3.7 billion). Spirit combined that portfolio with the 1,000 pubs it already owned.

Since then, property investors such as Robert Tchenguiz have continued to buy up estates, including Globe for £345 million, the Laurel Pub Company for £151 million and Yates for £202 million. Tchenguiz, in conjunction with Apax Partners, attempted to add to his pub investments early last year by bidding approximately £4 billion for Mitchells & Butlers, which owns 2,000 pubs. Though the approach was rejected, he subsequently bought 183 pubs, including Enterprise Inns' Scottish estate, for £150 million in November.

However, these private equity and real estate investors have not really changed the operating strategy of the pubs they acquired. Instead, they have moved to build up large portfolios in order to drive down supply costs through purchasing power.

But as every aspect of the property markets becomes more competitive, investors are finding that significant operating improvements are the key to driving returns, be it in an office building in London or the pub around the corner.

GOING GASTRO
In the UK pub industry, it still helps to have size, of course, but investors are increasingly focusing on two new fronts: altering pubs to meet Brits' changing tastes and coping with the impending smoking ban, which goes into effect on July 1.

“Now what we need to do is have operations running efficiently and provide the right product for the consumer,” says Phil Kaziewicz, managing director of GI Partners.

In June of last year, GI Partners, through its subsidiary Orchid Pubs, purchased 290 branded pubs from Punch for £571 million. The California- and London-based private equity firm reportedly bid around £50 million more than the second-highest offer, which led to subsequent carping that GI overpaid. However, the criticism could turn out to be hollow, as GI Partners is instituting a number of changes to its new portfolio of primarily suburban pubs.

Some British boozers have been mismanaged so badly that they have succeeded only in alienating their local customer base. But GI is hoping to avoid those mistakes by investing approximately £50 million to refurbish its estate. Details include uncovering fireplaces to give the room a cosier atmosphere, but also modernizing the pub by adding wireless computer connections, for example.

“We are trying to have the right look and feel to the pub for the people it should serve,” says Kaziewicz. “This is key to our investment, which relies upon improving business practices, because these components improve the value of the pub.”

GI is also looking to boost revenues by making their pubs more female-friendly, including adding a wider and higher-quality selection of wine. In addition, the firm is actively pushing the food business. For example, GI has 60 existing carveries—buffets serving freshly sliced meats to order—that it will improve through capital investment.

But the most interesting operating strategy employed by GI stems from the smoking ban, which has the potential to dampen sales at the traditional watering hole. From July 1, smoking inside pubs will be banned, but smoking will still be permitted at outside areas. To take advantage of that, GI is introducing comfortable outside areas in more than 95 percent of its pubs. “At the time of the acquisition we knew the smoking ban was coming in,” says Kaziewicz. “We want our pubs to be attractive to both smokers and non-smokers.”

With 24-hour drinking laws having just a modest effect— only a tiny proportion of pubs operate 24-hour licenses since drinking laws were liberalized in England in 2006—it is the smoking ban which is likely to have the greatest immediate impact on revenues.

The rewards for owners of well managed pub estates are clear. The average traditional “wet-led” pub—one that depends on beer sales—are generally said to generate an average weekly take (AWT) of less than £7,000 to £8,000. A well-managed pub will generate an AWT of £8,000 to £12,000. However, it is possible to push revenues up to £20,000 per week.

“Generally, the pubs that have gone from, say, £6,000 to £20,000 a week are more food-led gastro pubs,” says David Marks, a former director at Blackstone and the co-founder of Brockton Capital. “And [they] are likely to survive the impact of the smoking ban.”

SMALL IS BEAUTIFUL
Though a large pub estate has not been sold to a private equity firm or real estate investor since GI's acquisition, private funds have been busy buying up smaller properties in the hope of amassing sufficient bulk to attract larger companies.

One such example is London-based accountant Smith & Williamson, which last month launched British Country Inns III, its third fund focused on the pub and restaurant sector. Its first fund, BCI I, raised £7.5 million for acquisitions last year

Martin Sherwood, head of tax efficient solutions at the firm, says the model is geared towards running a restaurant rather than just a pub.

In 1990, he notes, just 7 percent of a pub's sales came from food. Nowadays that figure is approaching 25 percent. “In our pubs the food element is even higher, more like 50 percent,” he says. “That seems to be the pattern. Pubs becoming more and more like restaurants—the whole balance is changing.”

There are still risks to the pub business, of course. GI is investing £50 million to reposition its estate, a significant capital outlay that requires a significant increase in customer volume to recoup a return on equity. Pubs have long been lauded by financiers for their steady income, but this can also be the sector's albatross. Community pubs provide steady cash flow because of the steady numbers of customers spending roughly the same amount per visit. “You could apply a huge amount of effort into trying to bring the pub back to its natural core audience and they take forever to see it,” says Kaziewicz. “This is because they have already been alienated.”

To allow for the refurbishment of its pubs—and the possibility that it might take some time to increase the portfolio's revenues— GI leveraged the acquisition of the Punch portfolio at less than 80 percent. Because a number of pubs will have to be shut down for a few months, the portfolio's interest payments needed to be reasonably in line with the company's operating profile.

The other danger associated with pub investments involves, paradoxically, their size. Industry sources are suggesting that some prominent real estate investors are finding it tougher than they first imagined to run such a wide-ranging business. Managing anything more than 250 to 300 pubs is said to be a challenge because senior managers find it impossible to focus on any one asset. In some cases, the answer has been to split the portfolio into brands and delegate the management, but that also can risk alienating the pub's customer base.

Brockton's Marks, who bid on a mid-sized pub business last year, says he is not looking for a mass portfolio without a clear strategy. Instead, the firm is looking for the right pubs with good operations and strong management.

Building up a large portfolio of pubs now has an added attraction, according to some, because of a new exit route. Several pub operators are studying the potential of converting into a REIT, which could provide a safety net to pub investors if their initial operating strategies do not pan out as anticipated. At the very least, the introduction of REITs is certain to introduce extra liquidity into the sector

One of the benefits of the pub sector—and one of the reasons it has drawn so many property investors—is that a failed pub can typically be converted into another use, be it a restaurant, an entertainment venue or even a residential development.

Of course, none of the investors in the sector anticipate their strategies failing. And if they prove successful, well then, pub owners will have plenty of free booze to toast their newfound riches.