Global recession rocks financing for security industry

A special report from the SSN Europe office
Tuesday, June 30, 2009

With the global economy battling recession, it will come as no surprise that the market for financing for the security industry is a challenging one, to say the least. As the past year has shown, despite some wishful thinking, the security industry is far from immune to factors that affect the broader economy. At the same time, however, security is a market that is holding up better than others, and can still attract investors. 

From a global perspective, numbers from Venture Business Research (VBR), A UK-based research and intelligence firm that tracks venture capital and private equity funds and their investments along with merger and acquisition activity, provide some context. According to VBR, private companies in the security (IT and homeland) and defense sector saw investment of just over USD 2bn in 1Q 2009, a 20 percent decline from 4Q 2008 and a 79 percent decline from 1Q 2008. Of the USD 2bn invested in 1Q 2009, early-stage investment accounted for USD 514mln or 25 percent of the total, late-stage for USD 395mln (19 percent) and private equity buyouts, the majority at USD 1.1bn (54 percent).

Private equity buyout investment in 1Q 2009 in the security and defense sector stood at USD 1.1bn, according to VBR, a decline of 34 percent from 4Q 2008 and nearly 90 percent from 1Q 2008.  Excluding private equity buyouts, investment in the security and defense sector amounted to just over USD 0.9bn in 1Q 2009, an increase of 6 percent over 4Q 2008 and a three percent increase from 1Q 2008. 

Early and late-stage investment in the European security and defense sector in particular declined steadily over the last four quarters according to VBR, falling from USD 213mln in 2Q 2008 to USD 93mln in 1Q 2009. The decline was due primarily to a “sharp drop” in late-stage investment, from USD 108mln in 2Q to USD 23mln in 1Q 2009.

“In terms of investment levels, yes, they are down, but there are still a lot of active investors out there,” said VBR founder and CEO Douglas Lloyd. Like other sectors, security is suffering, Lloyd said, though in general less so, a fact he attributed in large part to government defense and security programs, which are perennial and long term. 

The general assertion that the security industry is definitely affected, but to a lesser extent than some, is seconded by Bill Polk, managing director of Capital Source, a U.S.-based commercial finance company that also operates in Europe from its London headquarters. European capital markets are facing at least the same predicament as the U.S. markets are, said Polk, and they may even be worse off. “The security industry is not immune from the impact of the rest of the capital market condition,” said Polk, “but it’s more buoyant than other sectors.” 

Polk pointed to some meta-level things happening that may drive security investing down the road in light of the way capital markets in Europe are shaping up. There’s generally a greater sense of nationalism in European capital markets, which comes to the fore when public money is being used to prop up banks. That leads to people questioning why they should be investing cross-border. “There’s more of that now, which focuses key state institutions on national priorities, which suggests that security, being a national priority, may drive state-specific investing in security,” said Polk. 

When it comes to late-stage investment in the broader security industry, physical security companies are expected to dominate for the remainder of this year, according to VBR, accounting for 62 percent of the companies in the sector that are seeking funding. Within the physical security sub-sector, VBR identifies five areas it expects to show the greatest late-stage investment activity this year: detection, sensor and imaging technology (28 percent); energy storage (17 percent); visual surveillance (17 percent); guarding (5 percent); and system integration and installation (5 percent).

Merger and acquisition activity is still “very active” in the sector, said Lloyd. “Bullish would be the wrong way to describe how we see the sector, but when we look at all the sectors out there and we talk about where the money is going, where it’s likely to go, there’s no doubt there are still significant opportunities for investments.” 

Lloyd said that with their generally more reliable revenue stream, the system integration and installation should hold up relatively well in terms of attracting investment. There’s more activity going on in this segment of the market for two basic reasons, according to Lloyd. For one thing, many of the smaller companies here have grown to a point where they’re an attractive acquisition target. At the same time, as they’re more service based, investors may be more comfortable putting their money here as opposed to areas like biometrics, where the technology may still be undergoing development. “The nice thing about this part of the sector is you don’t have to deal with technology issues, which removes one of the big risks of being involved in the sector,” said Lloyd. 

According to a report on the security industry from the UK-based market research firm Plimsoll Publishing, the economic downturn has actually resulted in some of the biggest investment opportunities “in a generation” for those with “the courage and the capital.” The study, which rated 908 leading security companies in the UK on their acquisition attractiveness by evaluating their overall financial strength, ownership value and future potential, found 71 companies that are “ripe for the picking.” David Pattison, senior analyst at Plimsoll, has termed this group as “wounded animals”—companies with a long, distinguished history that have sustained recent deterioration prompted by the recession, such as the loss of a key client or a big deal or project cancellations. 

These “wounded animals,” which are hurting now but have real promise in terms of prospects for successfully turning them, run the gamut from CCTV companies to electronics to guarding to integration and installation firms, according to Pattison. 

When it comes to consolidation, one problem is that those with the cash to take advantage of the current situation may be unlikely to do so. “Those that have a lot of cash in their business didn’t get it by accident—they made a strategic decision to collect that and retain it,” said Pattison. “As a result, the last thing you’re going to see is those businesses splash that cash; they’re too nervous.” Basically, there’s been such a hit on prices that buyers literally want these businesses for nothing. “They’re prepared to walk in and spend a pound,” said Pattison. 

One interesting trend Pattison sees on the horizon involves expansion through acquisition but not necessarily through investment in the security industry. With facilities management services increasingly sought after, security companies are looking to provide a full package of services to clients, not just security. “They’re looking at new services, effectively, so they’re bolting on acquisitions to try to broaden their customer proposition, Pattison said. 

Looking ahead, Matthew Rogers, the chairman of Verifier Capital, a finance firm specializing in the security industry, said that while he doesn’t expect much improvement in the financing market in the near term, “the world isn’t going to end the way it looked like it might end in the fourth quarter of last year. That doomsday scenario seems off the table.” 

Capitol Source’s Polk said the capital markets should continue to be challenged, particularly in Europe, over the next year to 18 months. “I don’t expect to see a sudden explosion of prosperity within the security industry, but I don’t expect it to deteriorate radically, either,” he said.

Lloyd echoed that sentiment, suggesting that things may be bottoming out. “My overall feeling for the market is that I found the security and defense sector really moribund at the end of last year and beginning of this year,” he said. “But I’ve seen more [activity] since April than I have in the last few months,” he continued, adding that it wasn’t just due to the fact that the stock market had come back a bit. “Overall, I think it’s a good time to be a corporate in this sector—there’s a truly unique opportunity to capitalize on the scarcity of credit.”