Fed up with the stock market treadmill, health clubs quit for private equity

Venture capitalists prepared to take a long-term view reckon they're getting a bargain

It seems there is more to gym disillusionment than the classic post-New Year resolution syndrome, with the stock market proving as fickle as the most trainer-shy gymgoer when it comes to valuing the benefits of health and fitness clubs.

The decision this week by Holmes Place to pursue a £205m merger with Cannons, its privately owned rival, and delist its shares cements a growing trend that erupted from the pummelling that share prices of quoted fitness club operators have taken in recent months.

Where shareholders once clamoured for a stake in the future riches of groups like Esporta, Holmes Place and Fitness First, private equity firms now form an orderly queue to snap up the same companies at rock bottom prices. In short, the City's interest in future earning streams from health and fitness operators has faded faster than enthusiasm for a new training regime.

But what, then, explains the current rash of interest in the sector from the venture capitalists, who are hardly known for their sticking power? What makes them think they can succeed where the stock market failed?

Nick Irens, the leisure industry veteran who led Duke Street Capital's recent successful attempt to gain control of Esporta, thinks it is because health and fitness clubs can knuckle down and concentrate on their roll out programmes better away from the public arena than within it. "The problems faced by the likes of Cannons and Esporta to a large extent were driven by the need and desire from institutions to get short-term half-year results showing nice, steady growth, when if you're developing a business like health and fitness, that isn't necessarily the case," he says.

Mr Irens, the former chairman of Cannons, asserts that it is precisely because venture capitalists are willing to take a medium to longer-term view (for longer-term read three to five years) that fitness clubs are looking so attractive. "Venture capitalists are prepared to back [expansion] programmes without being too worried if one year they don't show 20 per cent growth on the previ- ous year," he says.

Tom Bayne, director at Hawkpoint Partners, a corporate finance advisory firm with experience in the health club sphere, agrees. He adds: "In the real world only one thing ever happens to health clubs in development. They get delayed. There are a multitude of reasons but to the City it just looks like the company is making excuses every six months and not delivering."

It was largely over-ambitious plans to expand by conquering the Continent that got Esporta and Holmes Place into the position that led to their stock market demise. Both clubs operate at the premium end of the market, which makes opening new clubs a costly business. Where budget operators such as Fitness First and LA Fitness typically spend up to £1.5m on a new club, it costs players at the upmarket end up to £5m to fit out their swankier models. Moreover, it can take premium operators up to five years to recoup their investments while the budget players see profits coming through within about two years.

In part, the current interest from private-equity companies stems from their ability to drive consolidation – a growing necessity at the premium-end of the market, which is teetering on saturation.

With trade buyers few and far between – Whitbread, the owner of David Lloyd Leisure, has shown no interest in acquiring the clutches of clubs on offer – and no independent operators of any real size, the venture capitalists have had the show to themselves. The trend started in March 2001, when Royal Bank Private Equity, backed by Royal Bank of Scotland, funded the £365m management buyout at Cannons. That Duke Street Capital is planning to buy Invicta Leisure from Electra Partners Europe to combine with Esporta in a secondary buyout only continues this pattern.

Analysts point out that Cannons' plans to combine with Holmes Place, backed by the financial muscle of RBPE and PPM Ventures, the Prudential's private equity arm, enabled it to trump existing bids for Holmes with its 200p-a-share offer. Although cost savings from joining two fitness club operators are small compared with those lurking behind other mergers, there are cost advantages to being a larger player. These range from greater marketing clout to having one head office.

Nick Pattie, director of travel, leisure and tourism at KPMG, the accountants, says that combining two groups at different stages of the development process should bring down central overheads from 10 per cent of overall revenues for immature operators to just 2 per cent. "It's clear that from a consolidation point if you put a larger number of clubs together you can find synergies at the centre," he says.

Size also confers better access to the debt markets, allowing future growth to be funded by high-yield bonds and securitisation rather than the rights issues favoured in the past.

Mr Irens, who tried to spearhead the current wave of health group alliances two and half years ago when he attempted to merge his Cannons Group with Esporta, says that at the time he was looking for cost savings of £4m to £5m from a combined cost base of £12m. He adds his attempts to drive consolidation failed at the time because "companies were still very highly rated" and "management egos were too big. A lot more realism has come into the market place today. It's the pure economics of running companies that are coming through and I'm glad to see it happen," he adds.

As well as having deeper pockets than rival trade buyers, private-equity companies are attracted to backing health and fitness clubs because they suit their business objectives. Away from the qualms of City investors, who get nervous when gearing soars beyond 100 per cent, venture capitalists can load up their investments with plenty of debt to fund future expansion.

Greg Feehely, leisure analyst at Old Mutual Securities, said: "What venture capitalists can do is bash businesses together, run them for cash, pay down debt and get to the situation where the expansion programme is self-funding and [mature] UK clubs will create the cash to fund European expansion."

Which, inevitably, will bring the cycle full circle come 2006/07 when the private-equity houses will be queuing up once more – this time to float their creations. But the difference then will be one of size. While initially the untested sector prospered because it promised heady future earnings streams, with price/earnings ratios as high as 50 times, it later fell out of favour because the operators grew too small to feature on the radar screens of most fund managers.

Private-equity executives promise that next time round, health and fitness groups will feature in the FTSE 250 not the Alternative Investment Market, with valuations topping £1bn. Until then there's all to play for in the sector that the City never quite understood. Maybe fund managers should rethink their resolutions next January and appoint a different sort of personal trainer.