Crisis squeezes buyout market

The buyout market is facing a big test in the weeks ahead as the historic liquidity crisis on Wall Street threatens to deepen the credit crunch and deflate the fortunes of portfolio companies.

“We’re like everyone else, waiting to see what else happens, for the dust to settle,” says one industry observer. “There’s probably a lot of opportunity being created along with the turmoil. But right now, it’s still too early.”

Last week, Lehman Brothers went from potential acquisition target to filing for bankruptcy protection, while Wall Street rival Merrill Lynch & Co. was purchased by Bank of America for $ 50 billion. AIG teetered for days before a government bailout finally materialized. Taken in total, the firms’ exposure to private equity is extensive.

Factoring in the collapse of Bear Stearns from a few months ago, Wall Street’s five main independent investment banking firms have been whittled down to just two—Goldman Sachs and Morgan Stanley.

The concern now among other private equity investors is how they’ll be affected. Is the wise move to bide some time on the sidelines? Or will those with the courage to make deals during such dark days be rewarded?

The feeling among many in the industry is that the loss of such heavy hitters will extend the pullback in the credit markets, leading to less leverage and worse terms, since fewer lenders will be competing for business. Deal flow isn’t expected to seize up, especially in the more debt-friendly middle market, but buyout firms may have to spend a lot more time tending to their portfolios, rather than searching the landscape for new opportunities.

Josh Lerner, a professor at Harvard Business School, expects the takeouts of Lehman Brothers and Merrill Lynch to lead to less attractive financing terms for buyouts, adding fuel to a trend than began with the advent of the credit crunch in mid-2007.

“There’s been a real symbiosis between investment banking and private equity,” says Lerner. “In a world with fewer investment banks out there competing for business, there’s going to be less availability of capital on super-generous terms. The age of hyper-competition for business with LBO shops has gone away.”

The status of Lehman Brothers in particular may come into play here. The company’s private equity businesses include operations in European mezzanine debt and collateralized debt obligations as well as leveraged loans. The firm’s Loan Opportunity Fund closed in October 2007 with about $3 billion, inclusive of its targeted leverage.

As a result, Lerner expects to see more buyout firms bring some underwriting in-house. He also believes some firms might even be forced to hand some funds back to their limited partners. The feeling being, if they aren’t going to pull the trigger now, when will they do it? He likened the situation to what happened with many over-funded venture capital firms after the Internet meltdown in 2000-2001.

Steven Kaplan, the Neubauer Family Professor of Entrepeneurship and Finance at the University of Chicago, was blunt in his assessment of the situation.

“PE activity will not resume in earnest until the banks are lending in earnest,” he wrote in an e-mail. “And the Lehman/Merrill/AIG turmoil indicates that the banks are not going to be healthy anytime soon.”

Opportunities

Still, even as the crisis continues to play out, buyout professionals sounded at least two optimistic themes. Private sector purchase multiples, they point out, are bound to come down along with those in the public markets. And activity in the middle market should hold up because financing for these deals is less dependent on the big investment banks.

There is also still plenty of overhang from the high fund-raising levels of the past two years. For many firms, getting further limited partners commitments, at least in the near-term, isn’t a huge concern just yet.

“The best times to buy companies are when it’s dark and cloudy. Everybody knows it, but not everyone can do it,” says Bela Szigethy, the co-CEO of Riverside Cos., a Cleveland-based mid-market buyout shop that has stayed active this year despite the credit crunch. The firm is currently raising a new fund.

“I’ll be interested to see what opportunities there are,” says Larry DeAngelo, founder of Atlanta-based Roark Capital Group, who notes that the firm’s companies are fully financed and that the shop won’t need fresh capital any time soon.

Mark Bradley, the global head of Morgan Stanley’s Financial Sponsors Group, says that this meltdown will make for an interesting deal-making environment. Bradley sees the timeframe for a return of very large public-to-privates as anywhere from six months to two years.

“No matter how ugly it seems today, it [the deal market] will creep back and the survivors are going to come out of this with bigger market shares,” he says. “People will re-trench. Multiples will come down, and this will set the stage for the next cycle.”