The chart tracing buyout deal activity in the past few quarters closely resembles a double- black diamond ski slope. And with the third quarter of 1999 representing the peak of the mountain, the first quarter of 2001 may as well be sitting on the couch inside the lodge.
While many general partners chose to keep the prices of their first quarter transactions under wraps, therefore skewing the numbers a bit, the estimated total of majority stake transaction values hardly surpassed the $3 billion mark. According to Buyouts data, the deals with known values – 15 out of 37, with those undisclosed coming primarily from small to mid-market firms – added up to approximately $2.6 billion – an astoundingly low value, considering that buyout deal volume has stayed above $3 billion since the final quarter of 1994. Prior to that, surpassing $3 billion in buyout deals during a quarter was practically unheard of, but today, anything less than $8 billion or $9 billion worth of deals a quarter is downright odd.
To be sure, the restrictive debt market can’t take all the credit for this drop in deal flow. While sources are quick to put stingy lenders at the top of the problem list, they also place blame on the economy as a whole, trouble with portfolio companies, high seller prices and deal selectivity. The question is, where does one problem end and the other begin? They are tied to each other so closely that the line between them is almost indecipherable. And as obviated by the first quarter numbers, GPs are at somewhat of a loss, and have no choice but to take this market one day at a time.
I Love My Campbells
David Rudis, an executive vice president at LaSalle Bank in Chicago, calls the current state of the buyouts market a “dynamics soup,” the likes of which have never been seen before.
As a lender, he first points a finger at private equity firms as being “less active” in the first quarter, saying they have to come up with the deals before the banks can be blamed for not dishing out any debt. Finding out which came first – the deal problem or the debt problem – depends on who you ask, but there’s no question private equity firms have curbed their appetite for deals.
Rudis says buyout firms are having increasing problems with their portfolio companies, due to an overall market slowdown and uncertain economy, and are thus spending less time on new deal generation. As the domino effect goes, this, in turn, has led them to more aggressively seek add-ons to increase the value of their current holdings.
“You have to make hay while it rains wherever you can,” says David Schnadig of The Cortec Group. “We’re spending time on companies that actually are available for sale and that has tended to be, over the last six months, smaller businesses that make good add-ons.”
But this trend is not solely a way to keep away from starting new platforms in an environment where they could put around 50% of equity into a deal. GPs are looking farther down the road than that they have exit strategies on the brain as well.
“They realize in order to make their existing companies viable and be able to exit in a year or two, they need to be picking up strategic assets at this point,” says Ed Bagdasarian of Los Angeles investment bank Barrington & Associates. “They’re concerned about focusing on core competencies – much like strategic buyers right now – and are not being as aggressive about picking up more tangential operations.”
Along those same lines, Bagdasarian says he is seeing more and more distressed sales of portfolio companies come to market. Instead of throwing good money after bad money, especially when money is so precious, firms are less inclined to try and rescue lost-cause portfolio companies. He mentions a recent deal handled by his firm, in which a financial sponsor had to walk away from one of its companies because its equity was under water and resuscitating it was going to be too much work and take too much new money. The investment bank then had to market the deal to buyers just to rescue the bank and subordinated debt lenders, Bagdasarian says.
“In a more stable economic environment, you would have seen the financial group continue to inject equity in order to rescue their investments,” he adds. “But not right now. They have to be more careful.”
Passing the Blame
Now that lenders have been criticized and GPs accused, there is one corner of the deal triangle that has not received its proper rebuke: the seller.
Sources say sellers have waited a long time to bring their prices down and there was really no evidence of change until the very end of Q1. High prices in relation to an uncertain economy and stock market could have been predicted, but the length of time it took sellers to catch on this time was longer than necessary, says Rudis.
“The market was humming along at a nice clip and anybody that had a business to sell had a price in mind,” he says. “All of a sudden, May 2000 comes along, the stock market goes nuts, values go down, and sellers don’t change their prices because they think it’s an aberration.”
Now, because of shifts in the overall marketplace, it is evident that a new pricing structure has come into play. However, the re-adjusting has just begun to take place. While more buyout deals are likely to happen in the second quarter (it’s almost impossible for the situation to get worse), still all the pieces of the puzzle have to fall into place for a somewhat normal deal environment, and that is not likely to happen in the short term.
Until then, GPs will have to continue to be creative in their financing methods in order to complete deals. Bagdasarian says his firm recently completed a deal with a financial buyer that had a hard time finding bank financing and ended up completing the transaction with no senior debt – just a mezzanine piece and 50% equity. Evidently, the firm thought the company was growing rapidly enough that it could still make its returns, but the senior lender wouldn’t participate because it was not a company with a lot of assets – only cash flow.
There’s no argument to the fact that GPs are being especially selective with the deals they have chosen to do lately. While sources say the trend of staying away from companies that are more vulnerable to economic downturns is evident, they also have noticed the number of quality opportunities has declined.
“Many of the good companies that used to come to market because the valuation environment was robust are sitting on the sidelines, waiting for the rebound,” Bagdasarian says. “Buyout firms are hungry for high-quality deals.”
With 27 firms completing deals in the first quarter, two in particular stand out for completing at least three deals a piece. Both in the lower middle market, Cleveland’s Linsalata Capital Partners and Miami’s H.I.G. Capital Partners started new platforms and rounded up add-on acquisitions this quarter, despite market conditions.
Most notably, H.I.G. Capital entered into three new industries with three different platforms, but partners there say they don’t see this as such a feat.
“We’ve stuck to businesses with solid fundamentals regardless of the economic climate, and we find that good transactions are consistently financeable,” says Charles Hanemann, an H.I.G. managing director.
Hanemann says having a solid relationship with lenders doesn’t hurt in strained times, either.
“As we continue to execute against a strategy that works, lenders we work with appreciate that and are there for us,” he adds.