Buyout firms weren’t supposed to be able to just walk away from big take-private deals. Their reputations were at stake, after all, and which board of directors would ever again trust an LBO firm that didn’t honor its commitment to see a deal through, that didn’t deliver on the promise of a premium to shareholders, that failed to fulfill its role in the very public kabuki theater that is a large-scale buyout?
“People never stepped away before,” said James Westra, co-head of the private equity practice for law firm Weil Gotshal & Manges. “Now some of the marquee names are pulling back. That shows the depth of concern. … The reputation of the industry has been hurt.”
With the credit markets shut down for mega-deals through at least the first part of 2008, it’s unclear what will happen when the music restarts. The prevailing assumption seems to be that when the hundreds of billions of dollars of hung debt is finally sold off, LBO firms will return to something resembling business as usual, routinely consummating deals north of $10 billion as banks look to get back into the secondary loan business. But it’s just as conceivable that the chill that’s settled on the market won’t go away anytime soon, especially if the economy stays bearish and sellers remain wary targets.
By all accounts, the mega-sized public-to-privates—those valued at more than $10 billion—won’t return until at least the second quarter and likely the second half of 2008. In the meantime, and perhaps for longer, expect mega-firms to put their money to work overseas and down-market, complimenting an uptick in minority-stake equity infusions.
Big Deals, Big Consequences
If nothing else, last year will certainly go down as the frothiest so far in the history of the buyout business, thanks primarily to the gusher of mega-deals signed up in 2006 and the first six months of 2007. The 1,016 control-stake deals closed by U.S.-based financial sponsors in 2007 represents a virtual reproduction of the 1,007 deals closed in 2006, according to research by Buyouts and its publisher, Thomson Financial. But consider the enormous increase in value of the 291 deals with disclosed price tags: a whopping $454.3 billion, up 42 percent from 2006’s total and more than double the disclosed deal volume of 2005.
However, the year’s legacy, especially as it affects deal-making in 2008, was sown in the final half of 2007, when the credit meltdown and weakening economy prompted a handful of brand-name firms to break off or walk away from their deals.
As August bled into September and October, and the secondary market for leveraged loans seized up,
Buyer’s remorse also struck
Cerberus wass also locked in litigation, in this case with United Rentals. Citing a fall-off in United Rentals’s performance, Cerberus decided to pay the deal’s $100 million reverse break-up fee and walk away from the equipment-rental company. United Rentals sued Cerberus, contending that the buyout shop has to see the deal through because the financing is still available. (In a decision late last month, Cerberus prevailed.) Cerberus also terminated deals for Affiliated Computer Services and OptionOne, the residential mortgage arm of H&R Block.
In all of these broken deals, target companies’ operating results were headed south, and buyout firms were looking at big paper losses if they completed the deals. Those paper losses were in many cases larger than the size of the break-up fee—$1 billion vs. $900 million for Sallie Mae, for example.
“Nobody wanted to do anything unethical or illegal, but within the four corners of a contract, everybody was trying to be a responsible fiduciary and do the right thing for their various constituencies,” said Mark Bradley, managing director and global head of financial sponsors coverage for Morgan Stanley.
Reverse Break-up Fees
Before this most recent cycle, reverse break-up fees didn’t even exist. They came about as sellers grew more confident of their position at the negotiating table. They insisted that sponsors agree to pay, typically, 2 percent of a deal’s equity value if they backed out of deals because they couldn’t line up financing or gain regulatory approval. Buyout firms willingly assumed that risk, precisely because it was unfathomable that they couldn’t get their hands on cheap and generously termed credit.
Banks, for their part, chipped in by waiving their market MACs—material adverse change clauses that allowed them to terminate financing agreements if the market entered a period of upheaval. “Those terms [built up] until the house of cards was too shaky to stand on its own,” Bradley said, adding that “it was just silly on the part of banks” to dismiss market MACs from credit agreements.
Once the credit market did freeze, chaos ensued. Banks frantically tried to get out of their commitments, or at least force buyout firms to accept new terms. LBO shops, meanwhile, were reluctant to give up the covenant-lite loans and PIK-toggle notes that made the gigantic take-privates possible. And with banks threatening to yank their debt agreements altogether, the reverse break-up fees that once felt to buyout firms like relatively inconsequential legalese suddenly had a palpable weight.
Now, while the market waits for the debt to clear, the buyout industry has entered an era of uncertainty, one in which both lenders and sellers will shore up their defenses to protect themselves to the greatest extent possible.
This isn’t just psychology. The caution of lenders and sellers will be written into contracts, putting buyout firms in a pickle. In the last half of 2007, and for the first time since at least 2005, banks have reinserted market MACs into their credit agreements, Westra said. They’re also charging more for money they do lend, and they’re requiring more restrictive covenants on that debt.
Sellers, too, are responding. Reverse break-up fees, once nonexistent, will likely shoot up and constitute “real, real dollars,” said Mark Epley, global head of financial sponsors for Deutsche Bank.
Target companies could bring force to bear in other ways, said Gregory Gooding, a partner with law firm Debevoise & Plimpton. The Delaware courts have made it clear that a regular break-up fee—allowing a target to pay a penalty if it accepts a more lucrative offer form another party—can’t be more than about 3 percent of equity value. Since break-up fees and reverse break-up fees function in much the same way for both sides of a deal, reverse break-up fees can’t go much higher than they are already, Gooding said.
Instead, sellers are likely to insert more forceful language that tells sponsors, “‘You can’t just change your mind. I will have the right to compel you to close if the financing is there,’” Gooding said. “It’s easy to imagine a deal that has a financing condition and strong specific performance language that gives the target the contractual right to compel closing where financing is available.”
This would eliminate the ambiguity at the heart of the Cerberus-United Rentals case.
Sources said that certainty of close is going to be the trump card for buyers when it comes to mega-deals in 2008, and with financing shaky, buyout firms may not be able to bring it to the table. “Sellers will try to keep several buyers in the fire” during an auction, Deutsche Bank’s Epley said. “For buyers, it will be harder to argue for exclusivity. The job of being a buyer is going to be a lot harder.”
It’s also worth remembering that the conditions that led to the unprecedented LBO activity of the last two years represented a perfect alignment of cheap debt, CEO frustration and an upward-swinging, bull-market economy. Now that the economy appears to be slowing, lenders are more cautious and sellers are more gun-shy. It’s possible that the mega-market cycle that culminated with sales of blue-chip American corporations may be a distant, fading memory—one not likely to be repeated soon, and certainly not in 2008.
For starters, mega-firms will likely have to kick in more equity for deals. That, combined with more expensive debt, will translate into lower offering prices for public companies if buyout firms want to achieve historically comparable returns.
As a result, with take-privates more elusive, firms will pursue minority infusions, either as private investments in public equities—or PIPEs, as they’re known—or through growth investments that give them seats on boards of directors. On that front, however, LBO shops will have to compete against the new heavyweights: Deep-pocketed sovereign wealth funds, which are buying up small chunks of big American companies each day. “They’re looking at the same deal flow,” Morgan Stanley’s Bradley said. “I think a lot of sponsors looked at them as partners, and now they’re competitors.”
Firms will also chase yield overseas, particularly in the Middle East and Asia, although many of these deals will be growth plays since those markets haven’t yet grown fertile enough for full-scale LBOs.
Lastly, mega-firms will likely look downmarket for deal flow. That, too, can be perilous because mid-market firms know the terrain much better, and limited partners didn’t sign up with the likes of The
Wherever mega-firms look for deals, it’s clear the terrain will be very different from the landscape buyout shops have grown accustomed to. “We’ve rolled the clock back three or four years,” Morgan Stanley’s Bradley said.
Mid-Market In 2008: Slower Flow, Fewer Secondaries
The true measure of the mid-market’s resilience will start to become clear in the first quarter of 2008, when the deals that were struck in July and August begin to make their way into the sunlight. And it figures that there will be a drop-off.
More than half of 442 deal pros participating in a recent survey commissioned by sell-side adviser Edgeview Partners predicted that deal pace would slacken or remain the same in 2008. Slightly less than half, or 46 percent, said they expect the number of mid-market transactions to increase in the coming year.
Those deals will be done on different terms in 2008, as well. Debt will continue to be more expensive—with interest rates at least 150 basis points higher and more fees for closing debt agreements. It will also take longer to finalize a financing agreement because lenders will need time to assemble a club. “Last year, you could complete a syndication during a conference call,” said Drew Quartapella, managing director of Edgeview Partners. Adding to the longer horizon is the fact that LBO firms and debt providers are going to apply more intense scrutiny to every property.
The new uncertainty in the marketplace—yes, even in the mid-market—means that only the best companies are going to be put on the block in the near term. Those companies will fetch good valuations, but less presentable businesses will have much more difficulty finding buyers, Quartapella said.
And with debt available on less favorable terms, that will mean fewer secondary deals, said Gregg Smith, head of mergers and acquisitions for CIT Group. That would mark a big change, since sponsor-to-sponsor deals, once considered unsavory, are now often the preferred mode of exit for buyout firms. “It’s just harder to finance a deal as a sponsor,” Smith said.
It’s inevitable that deal pace will slow at least somewhat in 2008, said Frederick Tanne, a partner at law firm Kirkland & Ellis. But firms are still sitting on unprecedented piles of equity, and they’ll need to put it to work, regardless of whether debt is more expensive. “There’s a lot of money out there, deals have to get done, and pricing is still reasonable,” Tanne said.