Credit Squeeze Leads Firms Down-Market

The credit scarcity of the last six months has forced firms of all sizes to adjust their price horizons downward. Mega-firms are pursuing deals they wouldn’t have touched a year ago, and likewise mid-market firms are looking to scoop up small companies that might not have previously qualified as prime buyout candidates.

Such a shift poses risks for firms. One is that deal prices remain artificially high as buyout firms all descend on the smaller end of the market that remains active. Another is that buyout firms find themselves understaffed as they’re forced to invest in more portfolio companies than they had originally anticipated. Finally, they make hear complaints from limited partners worried that they’re not getting the diversification by deal size that they had signed up for when putting their portfolios together.

But waiting out the storm won’t work, either. Coming off of two consecutive record-breaking fundraising years, buyout firms have more cash to spend than ever—nearly $500 billion by our estimate. But with equity to deploy but less to borrow, the LBO world is feeling “a little desperation,” said one buyout pro. Firms “can sit around and collect fees for nothing, or they can do smaller deals.”

To date, buyout firms haven’t cut a clear path downhill, and no straightforward pattern of deals has emerged. But testimonies from auction participants suggest that dealmakers up and down the market are seeing larger bidding pools populated with unfamiliar faces.

Warburg Pincus, for example, placed a first-round bid for Press Ganey, an Indiana-based health care outpatient survey company owned by American Security Capital, according to a knowledgeable source. The Lehman Brothers-run auction, still under way, has seen strong interest from several $10 billion-plus funds, sources say. Valued between $750 million and $800 million, and requiring an approximately $250 million equity check, the deal would not have attracted several “heavy hitters” pre-credit crunch, the source said.

Large-market LBO shops also populated the buy side in the auction of Spectrum Brands’s $800 million pet care business, put on the block in late fall. Of the 20-plus bidders, about half were buyouts firms drawn to a deal they “wouldn’t have bothered with a year ago,” a person familiar with the sale said. “It would have felt too small.” (Spectrum Brands ultimately pulled the deal after receiving unsatisfactory offers.)

Further down-market is the recent $285 million sale of ORS Nasco, an Oklahoma-based wholesale industrial supply distributor. The company ultimately went to a strategic buyer—United Stationers. But sell-side banker Rick Lacher at Houlihan Lokey Howard & Zukin said several unusually large LBO players inspected the deal. “We saw interest from a $5 billion fund, a $3 billion fund, and a few $1 billion funds,” he said. Interest in the Brazos Private Equity Partners-backed company, Lacher noted, came from large firms looking to create a consolidated company through several acquisitions.

Firms at the smaller end of the market are reporting similar pressures. A managing director of a mid-market buyout firm recently reported getting outbid by as much as 50 percent for a $10 million EBITDA business. Considering the fact that his firm submitted an offer valuing the company at 10x EBITDA, the managing director attributed the sky-high pricing to up-market competitors.

Firms justify their smaller deals by arguing that they’re buying fast-growing companies capable of generating strong returns despite heavy equity investments. CCMP Capital Advisors recently cut a $500 million equity check to kick-start Legacy Hospital Partners, a new platform company that is admittedly smaller in initial scale than the firm’s typical $500 million to $3 billion LBO deals. The firm is willing to go downstream in areas of expertise—like health care—for “transactions that are doable in this credit environment,” said Nancy-Ann DeParle, a CCMP managing director.

Firms can make the case that they’re playing in the same industry sector, if not the same market size, and implement a multi-year roll-up strategy that results in a much bigger company, added Nick Chini, a managing principal at midmarket investment bank Bainbridge. “They can’t go too far from home,” he said of the need to maintain sector focus. The sale of distributor ORS Nasco, for example, attracted larger firms because of the company’s roll-up potential, according to the deal’s banker.

Although they weren’t preparing specifically for a slowdown in the market, several firms have recently expanded their capacity for smaller deals. TPG, Silver Lake, and Goldman Sachs have each recently raised separate smaller-market funds to seize opportunities their respective multi-billion-dollar funds couldn’t handle. Each of these middle market funds was in the works long before the credit meltdown came into play, but they conveniently put the firms in a strong position to ride out the current environment. TPG recently closed on $1.5 billion for its middle market fund. Silver Lake is targeting $750 million for its Silver Lake Sumeru fund, and Goldman Sachs’s mid-market GS Direct will dedicate around $1 billion to the mid-market, according to published reports.

The debt dry-up may not last forever, but in the last six months, large-market deals have been rare, with only two control-stake deals of more than $1 billion announced by United States-based sponsors since the start of the year and 18 since Sept. 1, according to Thomson Financial, publisher of Buyouts. In the large market, the sluggishness of the secondary loan market has dried up available debt to back multibillion-dollar LBOs. And the same phenomenon is playing out in the middle market, where senior lenders must club together to produce credit facilities of more than $100 million. A debt package of $250 million is uncommon, and firms are fighting for every shred of financing they can get their hands on.