Did Market Top Out In 2007?

Anyone in the habit of calling market tops and bottoms inevitably needs to develop a self-deprecating sense of humor—you know, the kind where one boasts of having predicted, say, six of the last three recessions.

Nevertheless, I can’t resist the temptation to predict that 2008 will finally be the year we see a drop in both annual deal-making and fundraising tallies in the United States. This and other predictions listed below are mine, though informed by the wisdom of several sources (listed at the end of the piece), by trends reported in Buyouts this year, and by recent market surveys.

* Big Take-Privates Stay Dormant. Wall Street has a famously short memory, but what about corporate America? How soon are directors of public companies likely to forget that LBO firms don’t always follow through on their generous buyout offers? Unless amnesia sets in, buyout firms will have to find a way to virtually guarantee that they can bring these deals to close at their agreed-to price. And that may require buyout firms to shoulder more risk than they’re comfortable taking. Mega-firms will find ways to put money to work this year—on the debt side of the market, in large-scale consolidations, in PIPE deals, in foreign deals. But my bet: It will take more than a return to credit frothiness to bring back the golden age of take-privates.

* Mid-market Pace Slows. Yes, the middle market has been less bothered by the credit crunch than the big market. But it hasn’t been immune. Those in the trenches will tell you that it’s gotten tougher to finance healthy deals. And lenders aren’t going anywhere near unhealthy ones. Not surprisingly, deal professionals participating in the year-end installment of the bi-annual ACG/Thomson Financial survey were decidedly less optimistic about the strength of the M&A market than they had been just six months earlier. (Thomson Financial is the publisher of Buyouts.) More than one in three (38 percent) believes the number of M&A transactions will drop over the next six months. In the mid-year 2007 survey, just 16 percent anticipated that M&A volume would drop.

* Fundraising Market Slows. No one’s reporting a slackening in the fundraising pace just yet. But at the end of most years during the past decade, buyout firms out raising money during the previous year usually came very close to hitting their collective targets. Last year at this time, for example, buyout firms in the market with 2006 funds had raised $232.9 billion, slightly above their collective targets. But by year-end 2007, the collective targets of funds in the market in 2007 had ballooned to $445.0 billion, nearly $100 billion above the $350.2 billion that they’ve raised to date. One possible explanation: The supply of mega-funds in the market is temporarily outstripping demand. And since mega-funds account for such a large part of the fundraising market, a slowdown may loom ahead.

* Turnaround Firms Get Busy. One thing everyone seems to agree on is that turnaround investors will see an upturn in opportunities in the months ahead, thanks to a cooling economy and moribund debt markets. Through November, just 13 U.S. issuers had defaulted on their outstanding corporate bonds in 2007, according to Standard & Poor’s. But S&P is projecting that number to rise to at least 40, and as many as 73 in 2008. At the end of every quarter, Buyouts has also been examining the S&P monthly “weakest links” list—a list of global companies judged most vulnerable to default by dint of their highly speculative ratings. Since S&P broadened its definition of weakest links in early February, the number of companies on the list dropped from the low 100s to the high 80s this summer, but then rose back to the low 100s at year-end. Buyout-backed companies have accounted for about a third of the list in recent months.

What other trends should you keep an eye out for in 2008? Look for more money from overseas buyout firms to be invested in the United States as they rush to take advantage of favorable currency exchange rates. Look for the Services Employees International Union to get more aggressive in its campaign against buyout firms, making it more difficult for firms to close deals and to raise money from public pensions and union pensions. And look for more partners to sell minority interests in their management companies, both as a way to achieve liquidity for founders, and to secure more permanent sources of funding.

For help formulating my predictions, though they wouldn’t necessarily agree with them, I’d like to thank Steven Costabile, managing director, global head of private equity funds group at AIG; Michael Harrell, partner, Debevoise & Plimpton; Terrence Mullen, managing director, Arsenal Capital; Clint Harris, founder and managing partner, Grove Street Advisors; J. Mark Jones, partner, River Associates Investments; Dale Meyer, director, KRG Capital; Frederick Tanne, partner, Kirkland & Ellis; and Charles H. van Horne, managing director, Abbott Capital.