In today’s leveraged buyout market, letters of intent issued by buyout groups are being used as recycling paper, more often than not, because of the inability to close deals in a conservative debt market.
Buyout pros who invest in the smaller end of the middle market and the middle market are capitalizing on the space left behind by their mega-fund brethren, and are seeing more deal flow than taxis on the streets of New York City.
It’s an ideal environment for middle market and lower middle market fund managers to deploy capital and acquire businesses with growth potential and good cash flow. General partners who play in these segments of the marketplace claim very active deal flows for their firms, which is not surprising given the two dozen or so $1 billion funds that are currently looking to put their capital to work in the face of a hostile debt market.
Under the Radar Screen
Peter Brockway, whose firm Brockway, Moran & Partners invests in deals that are between $50 million and $150 million, says his firm’s current deal flow is “excellent”. The firm recently completed three add-on acquisitions for its Gold’s Gym platform as well as the acquisition of Dynamic Cooking Systems, a high-end distributor of outdoor barbecue grills, for an undisclosed amount (Buyouts, Oct. 9, p. 14). Brockway attributes his firm’s deal flow to the fact that many of Brockway Moran’s investments fall under the radar screen of larger funds that are hunting for bigger companies as well as the fact that some of the firms that used to invest in the smaller end of the middle market have moved up market in terms of funds as well as deal size.
“I think there is plenty of activity down here, but many of these companies are strategic types of buy and unless you had a company in that industry, you just wouldn’t be that interested in them,” Brockway says.
Other GPs share his sentiment.
Rodney Goldstein, a managing general partner at Frontenac Company, which usually commits $25 million to $75 million of equity per deal and invests in companies with $25 million to $200 million in revenue, says his firm at present is “highly active” across its industries – telecom, infrastructure services, and business services.
Goldstein also says deal flow for his firm is a combination of industry research and executive recruitment. “When we make acquisitions, we are making them as an operating buyer in support of a CEO 1st executive team as opposed to looking at deals in a conventionally defined sense,” Goldstein says. “Many firms in our industry pay lip service to the concept that they build successful companies around the CEO. At Frontenac, CEO 1st really means we start with the executive team. We pay more focus in identifying and attracting top-flight CEO candidates than we do on any aspect of origination of opportunities. The management teams that we recruit and with whom we partner with are typically comfortable in an acquisition environment,” he says.
As part of its CEO 1st strategy, Frontenac recently partnered with Terence Graunke, an executive with whom the firm has partnered with twice before, in the acquisition of DVC Group, a marketing services company for $100 million (see story p. 9)
Other GPs who invest in the middle market segment where transaction values can range from $100 million to $700 million, also say their current deal flow has been exceptional.
“I would say we’re seeing a fair amount of deal flow right now and of higher quality than what we saw 24 months ago,” says Tim Mayhew, a partner at Palladium Equity Partners.
Palladium Equity invests in middle market industrial companies. The firm recently completed the acquisition of Wise Snacks from Borden Capital Management for approximately $100 million.
“Clearly, basic industrial companies in the last 12 months were trading down in the public markets so we have certainly been looking very closely at some of those and talking to certain sellers there,” Mayhew says.
According to Buyouts data, the average deal size of leveraged buyouts with disclosed values in the third quarter was $202.2 million. An estimated 46% of deals with disclosed values in the third quarter were under $50 million, while approximately 4% were greater than $1 billion. These numbers eclipse those of last year’s third quarter statistics where only 15.4% of deals were under $50 million and 9.6% were over $1 billion.
Jeff McKenzie, head of the M&A group at Houlihan, Lokey, Howard & Zukin’s West Coast office, says most of Houlihan’s deals are in the $50 million to $500 million range where the market is very, very active right now both on the buy side and the sell side.
“The strongest demand is for transactions $50 million and above, but there is still demand below $50 million when there is a strategic fit, i.e. it is a good add-on for an existing portfolio company,” McKenzie says. “The middle market has been a source of deals for sponsors for quite some time and continues to be because they see a lot of value in mid-market companies relative to larger public companies in terms of the prices these companies trade at. We expect it to continue to be a driving force in the market for quite some time.”
However, actually buying a company lock, stock and barrel is much more difficult today than it was 12 months ago because the debt market is so difficult, Mayhew notes.
“You really have to pick your places quite carefully and be quite certain that you have a very good opportunity and be able to present that credibly to the marketplace to make sure you can get it financed,” he says.
Challenging Debt Market
GPs say that because of the tight credit crunch, consolidation among the major senior lenders, as well as possible problems with some of the banks’ portfolio companies under performing, credit is a source of problems in all segments of the marketplace. Some investors have had to be more creative on the financing front injecting more mezzanine debt into deals while others have had to find more than one syndicate bank for their deals.
But, financing a deal usually depends on the appetite of certain lenders for a particular deal, sources say.
“We have not had any problems financing any of our transactions to date,” says Lew Davies, a principal at the Cambria Group. “You find that different deals will have different appeals to lenders and that is probably true to a greater degree, and you don’t have a relationship with any single lender because their appeals are different.”
“It is a very challenging environment in today’s debt market,” says Stewart Kohl, managing general partner at The Riverside Co. “Interestingly, I think it is a little less difficult on the small end of the middle market because our deals can typically be done with one to three banks and they don’t have to syndicate it to a large group. Syndication is where some of the difficulties are. We’ll typically have one big bank hold all of the debt or we’ll organize a little club of perhaps three banks.”
The Riverside Co. invests in companies that can be acquired for between $10 million and $100 million with its average deal size of about $30 million. While his firm has been able to close on every deal for which it has signed a letter of intent, Kohl admits that it has been a lot more work to get them financed. “We’re cautious when we bid on companies not to bid too much because we know it is going to be a challenge to finance those deals.”
But after more than a dozen years and 44 acquisitions, Kohl says the Riverside Co. has no plans to change its market focus at all. “In fact, we think that our opportunities in this size arena are as attractive as ever,” he says.
Some Big Deals Getting Done
To be sure, the industry did see a few large leverage transactions get done this summer in Old Economy industries such as manufacturing, automotive and the sexy telecommunications sector. Some of the more notable deals include the Carlyle Group’s acquisition of commercial aerostructures division of Northrop Grumman Corp. for $1.2 billion; Heartland Industrial Partner’s partnership with Credit Suisse First Boston Private Equity to recapitalize metal manufacturer MascoTech Inc. for $2.2 billion; and the buyout of Callahan Associates International LLC by The Blackstone Group and Capital Communications CDPQ for over $1.83 billion.
However, the lack of credit in the debt market made some of these deals very difficult to close and, in some cases, forced buyout firms to withdraw their offers. An investor group’s recent planned buyout of Rescare Inc., a provider of educational services to people suffering from developmental disabilities, tanked because of concerns over debt financing. Elsewhere, an investor group comprised of Blackstone, Apollo Management LP and Bain Capital withdrew their offering of a $1.28 billion buyout of Border’s Group Inc., a national company, because of low valuations of the company, which priced its stock at $16 per share instead of the anticipated $20 to $25 per share by Border’s board of directors. More recently Bear, Sterns Merchant Banking and Hicks Muse Tate & Furst’s acquisition of Johns Manville, a building products manufacturer, for $3 billion fell into troubled waters as the investors had to restructure the terms of the deal because of the company’s poor earnings.
But it is important to note that not all investors who play in the upper middle market where investments range from $500 million to $1 billion are seeing insufficient deal flow. Dan Tredwell, a senior managing director at Heartland Industrial, says his firm has a “very healthy deal flow.” In general, Tredwell says he is “positively surprised” at the amount of deals that have been made available to the firm.
“The lending market isn’t great but we’re doing quite well,” Tredwell says. “I expect that we’ll announce at least one or two more deals in the next six months.”
The public market’s lack of appetite for industrial companies has improved Heartland’s deal flow dramatically, Tredwell says, because a lot of executives are searching for ways to get value for their shareholders rather than just watching stock prices. “I don’t see a reason why this trend won’t continue into next year,” he says.
Tredwell notes that a lot of executives that the firm is talking to have moved from the state of denial to the state of acceptance of public market valuations for their companies and “are willing to try something new”. In the case of MascoTech, Tredwell says the management team was very disappointed in the way the public markets were affording them and wanted to find a way to get a premium over that.
Smaller market players say that the awareness level of executives concerning the options of a management buyout is getting better, but still not quite that high. “In our segment, it takes more education on the part of the management teams about the prospects of a buyout because it is just not well known,” says Cambria’s Davies. The Cambria Group recently acquired a majority stake in Bacrac Supply Co., (see story p. 18).
“In the case of Bacrac, we’re working with an existing management team and just have to go through with them the economics of a leverage buyout, the structure and the process, etc. It is just more of an education process in this segment than it is with larger companies.”
“Most of our clients don’t necessarily understand the buyout groups and what they do,” says Houlihan’s McKenzie. “But upon educating them to the alternative, many like the opportunity to have some degree of liquidity and to what we refer to as the second bite at the apple’, which is the ability to have a partner come in, provide capital for growth and acquisitions, continue to build the company, and then have a second liquidity scenario where they can make quite a substantial return on the money they already have in the company.”