Buyout Shops Bulk Up Portfolios, Eyes On Exits

Many buyout shops continue to take the strategic route through the economic downturn, focusing their buy-side activities on add-on acquisitions rather than chasing after larger, more complex platform deals in a market crippled by a lack of leverage. Doing so sets the stage for general partners to put vast caches of companies on the market once the deal market begins its recovery.

Roughly half (48 percent) of all control-stake deals closed by U.S.-based sponsors in the first nine months of 2009 qualified as add-on acquisitions, up from 38 percent in the same period in 2008. In the quarter just ended, add-on acquisitions accounted for 52 of the total 111 deals closed, according to Thomson Reuters, publisher of Buyouts.

The frequency of add-on deals—which often can be financed through a platform company’s own balance sheet or by an additional equity slug from the sponsor—has risen ever since the loan origination markets collapsed alongside Lehman Brothers and a host of other financial giants roughly one year ago.

“It’s not that add-ons have suddenly become more important; it’s just that they are easier to do right now,” said Norman Selby, a senior managing director at buyout and growth capital firm Perseus LLC. “Prices are low right now because there’s no shortage of companies that need capital.” And those companies are willing to become parts of larger entities to get it.

Indeed, Washington, D.C.-based Perseus, which rarely uses leverage in its deals, has snapped up three add-ons so far this year, two of which closed in the third quarter. They included the addition of medical communications company Skyscape Inc. to Physicians Interactive LLC, a provider of digital sales and marketing to the health care industry, and the add-on of oilfield services provider Transgulf Technologies LLC to Houston-based Seismic Equipment Solutions LP.

Gridiron Capital is another firm that closed a pair of add-on deals last quarter—choosing to tackle the current market as a strategic investor searching for synergies rather than as a financial buyer looking for new portfolio companies. “New platform acquisitions have been difficult to do, largely because company performance is suffering and there is still a significant disconnect in valuation expectations between buyers and sellers,” said Thomas Berger Jr., a co-founder and managing director at Gridiron Capital.

“On the strategic side, it’s just more clear-cut,” Berger added. “You already know the industry. You know the impact the economy has had on it. You already have a trusted management team in place, and the synergies are lined up.”

In August, New Canaan-Conn.-based Gridiron Capital acquired commercial landscape maintenance company Dolphin Landscape Inc. through its portfolio company Yellowstone Landscape Group. The following month, the firm’s McKenzie Sports Products platform acquired Van Dyke Supply Co Inc. a producer and online supplier of taxidermy products. Both acquisitions were financed completely with revolver debt and excess cash at the company level, Berger said.

Other firms that closed multiple add-on acquisitions in the third quarter include Francisco Partners, which closed three add-ons in as many months, and Apollo Management and HM Capital, both of which notched off two add-ons for their portfolio companies (see accompanying “Closed Deals” table for more details).

Add-ons will arguably continue to make up a large portion of deal volume as long as the chasm between what sellers are asking for new platform deals and what sponsors are willing to pay for them is left relatively un-bridged by a senior cash-flow lending market still largely moribund.

According to Timothy Clifford, executive vice president and director at Amalgamated Capital, a senior lending arm of Amalgamated Bank focused on sponsor-backed deals in the mid-market, multiples on senior cash flow loans tend to run between 1.5x to 2.5x EBITDA. (For companies with EBITDA less than $5 million it tends to be at the lower end of the spectrum while larger companies are trusted with higher multiples.) Subordinated debt can add another 1x to 1.25x EBITDA on top of that, allowing for total purchase price multiples these days to range anywhere between 4.5x and 9.0x EBITDA. But even if leverage is available at those levels, the terms on the paper can be daunting enough to make a sponsor think twice. Pricing on senior cash-flow loans can range as high as 8 percent to 10 percent, while mezzanine providers can happily aim for returns in the upper teens or low 20s in the current market.

Hitting Bottom

In all, U.S. sponsors closed a total of 111 control-stake transactions in the third quarter, roughly on par with the 114 that they pulled off in the second quarter. Year-over-year, however, the most recent quarterly total fell about 47 percent shy of the 210 transactions that U.S. sponsors completed in the third quarter of 2008, according to Thomson Reuters data.

By disclosed deal value, the 13 deals with announced valuations in the quarter just ended accounted for a total of about $2.9 billion, about equal to the second quarter’s $2.9 billion total that was spread across 22 deals. By contrast, the third quarter of 2008 saw a disclosed deal total of $52.9 billion from 52 transactions, according to Thomson Reuters.

The largest deal of the third quarter—Kohlberg Kravis Roberts & Co.’s $1.8 billion acquisition of Oriental Brewery Co. from Anheuser-Busch InBev—came as part of the latter’s program to sell off assets in order to pay down debt. Alhough it’s a modestly-sized deal compared to those in the peak-period frenzy, the Oriental Brewery deal could serve as a welcome sign of improvement considering that not even a single deal broke the billion-dollar threshold in the second quarter.

The second largest disclosed deal of the quarter was Golden Gate Capital’s $286 million acquisition of bankrupt outdoor clothing provider Eddie Bauer. The company had been overcome by a crushing debt load and filed for Chapter 11 bankruptcy protection in June. CCMP Capital made a $202 million stalking horse bid for the company, but ultimately lost out to the San Francisco based buyout shop.

The most active overall investor in the third quarter was Washington, D.C.-based heavyweight The Carlyle Group, which closed five control-stake deals in the three-month period, according to Thomson Reuters. Next in line were Golden Gate Capital, New York’s Palladium Equity Partners, and Rosemont, Ill.-based Wynnchurch Capital, each of which closed three deals.

Overall, buyout shops continued to favor the same core industries they had all year, including high technology (23 control-stake deals in the third quarter,) consumer products and services (16 deals,) and industrials (16 deals.) Those three categories, on a quarterly basis, have been the three most popular investment areas for U.S. sponsors all year, though not always in that order.

All told, 35 deals were agreed to in the third quarter that have yet to close. Combined, the 15 deals in that group with disclosed valuations add up to $6.3 billion, more than twice the amount that actually closed in the three month period.

“I’m not saying we’re out of the woods and everything is peachy, but the market does have a positive feel to it,” said Hiter Harris III, co-founder of mid-market investment bank Harris Williams & Co.

Books On The Shelf

Looking into the pipeline, expect some larger deals to close in the months ahead. In September, Silver Lake led a group of investors that struck a pending $2 billion deal to acquire a 65 percent interest in Internet communications provider Skype from eBay. eBay acquired Skype in 2005 for $3.1 billion only to find that the intended synergies between the two companies would not come to fruition. The Silver Lake consortium is lining up a $600 million term loan and a $125 million bond offering to get the deal done.

The pace of deals could also quicken. Investments bankers say they are amassing extensive libraries of books that they will start handing out to potential buyers as soon as the sell-side market begins to make a come-back. “There are a lot of private equity guys that want to engage somebody this year to think about shopping a company sometime in 2010,” said Robert Brown, a managing director at mid-market investment bank Lincoln International. He said the Chicago-based firm has already signed up “a number of them.”

Harris Williams & Co. also has stacks of books waiting for the economic winds to change. And it’s important for hopeful sellers to be prepared because, he said, “when deal flow comes back, you really want to be at the front of the line, not the back.”

Perseus is one buyout shop that subscribes to that strategy. The firm recently engaged an investment bank to prepare the sale process for one of its technology-related investments, although the firm is prepared to be patient.

“I’d rather sell in a year or two if we can get an additional 30, 40, 50 percent higher price,” said Perseus’s Selby. “That adds enormous return to our investors.”