Oftentimes, when something is described as “more of the same,” it is in reference to stagnation or boredom. But when a general partner borrows that phrase to describe today’s buyout market-which quite a few have-it becomes synonymous with record-breaking deal volume and a continued frenetic pace for as far as the eye can see.
But regardless of how one chooses to describe it, the facts cannot be disputed. The disclosed $77 billion of capital deployed during the first half of 2005 is the largest mid-year sum spent by buyout shops in private equity’s history. The anticipated summer slowdown has thus far gone by the wayside as buyout shops closed at least another 210 control-stake transactions, bringing the yearly total to no less than 426 closed deals. The amount of dollars invested in Q2 peaked at $38 billion, a smidgen south of Q1’s $39 billion.
Comparably, the first six months of 2004 saw a combined 331 deals completed for a disclosed total of $58.8 billion. That said, if the remainder of this year keeps pace with the first half, then 2005 is well on par to breaking the $136.5 billion record that was set just last year.
“We’re seeing a frenzy of activity,” says Jeff Rosenkranz, a managing director at Piper Jaffray. “The level across the board is extremely strong. We are seeing continued strong deal flow from private equity players, many of whom have recognized the market environment we’re experiencing now may not last much longer. A lot of firms are looking to take advantage of the current environment, and are cycling through or selling portfolio companies sooner than they might have otherwise.”
On the buy side, private equity players continue to take advantage of the abundant financing that is spread market-wide, and the general consensus is that, as long as the lenders remain aggressive, sponsors will persist to be just as bullish. And aside from the recognition that private equity is a cyclical industry, deal pros say there is no reason to believe that anything will markedly change on the lending front for the remainder of 2005 and perhaps even the whole of 2006.
In terms of transaction size in 2005, Apax Partners, Apollo Management, Madison Dearborn Partners and Permira still hold the record-though only by a thread-with the $5 billion Intelsat deal that closed in Q1. In Q2, a consortium comprised of Providence Equity Partners, Texas Pacific Group, DLJ Merchant Banking and Sony Corp. fired a shot directly across Intelsat’s bow with its $4.94 billion acquisition of film production studio Metro-Goldwyn-Mayer in April. Kohlberg Kravis Roberts & Co.’s $3.1 billion acquisition of Masonite International Corp., the global manufacturer of interior and exterior doors, clocked in as Q2’s second largest acquisition, while GTCR Golder Rauner’s and Goldman Sachs’ $2.4 billion taking-private of Ford Motor Co.’s Triad Financial Corp. was the third largest deal in the last three months.
Undying Debt
Even though there was a slight pullback in the debt market thanks to March’s high-yield downgrades, private equity sponsors and those on the ancillary side of the market all seem to agree that aggressive lending continues to be a key theme in 2005’s deal market. Anecdotally, when asked the open-ended question of what they’re noticing in today’s buyout arena, a majority of pros interviewed for this article mentioned the words “debt” or “financing” in the first sentence.
“There is aggressiveness from financing sources that is as strong as I’ve seen in many, many years,” says Kevin Evanich, a senior partner at Kirkland & Ellis LLP.
Justin Wender, a senior managing director and chief investment officer at Castle Harlan, observes that intermediaries continue to play their part in keeping the financing multiples high. “We’ve been seeing continued stapled financings even though the debt market-and certainly the high-yield market-is not as strong as it was in Q1. I think investment banks are competing on how much debt they’ll lend a business in order to get M&A assignments, so you continue to see staples at very high multiples.”
He added that for a “relatively straight forward transaction” with a stapled financing, intermediaries generally insist on debt multiples to the tune of at least 5x EBITDA. “What it’s doing is driving up the prices of businesses that may not warrant that high of a price,” Wender says. He noted that it is not difficult for buyers to rationalize purchase price multiples as high as 8x EBITDA because they still have room to get a return on their equity as long as debt providers continue lending at 9 percent.
But given the warning shot that came in the form of a slight pull-back in lending after the March high-yield downgrades, some GPs are calling for a level of prudence that was not necessary in Q1. “There is a need to be a little more careful around the willingness to commit toapurchase price in what is still a recovering financing market,” says Jonathan Lynch,a generalpartner at JPMorgan Partners. “You can’t lead with your chin with respect to your ability to finance a transaction as opposed to three or fourmonths ago,” when putting together a debt package was morea question of just optimizing the cost of that capital.
For firms like Questor Management Co. that focus on turnarounds and special situations, the tremor in the financing market was a welcome sign of the industry’s cyclicality. “Some firms are finding the need to provide more equity to get deals done these days. That creates opportunities for us, because companies that were once able to buy more time through a refinancing or capital infusion are now running out of that option,” says Dean Anderson, a Questor managing director. “There is a lot of shaky high yield debt due in the next couple of years, and coming out of the bubble that could lend itself to more distressed prospects down the road,” he added.
But any major change in the debt market, be it the fabled soft landing or something a little more painful, cannot be seen in anybody’s crystal ball for the moment. The high-yield market is still enjoying record-low defaults-dangling in the 2% region-while the banks are still happy to lend minimums of 5x EBITDA for run-of-the-mill transactions.
“If you had asked me three or four weeks ago, I might have said that the financing marketspeakedin March,” Lynch says. “But the reality is that fundflowsinto the high-yield market over the last few weekshave improved thewillingness of institutionstoprovidefinancing. There just aren’t a lot of alternate uses for that capital. As a result, the markets are opening back up.”
Great Expectations?
With general partners invoking copious amounts of debt to finance today’s transactions, where is the recoil being felt? The answer, according to some, lies in the coveted 30% return expectation.
“Based on how firms are bidding for deals, I think they are definitely lowering expectations,” says Kevin Landry, CEO of TA Associates, who adds that this phenomenon has a long history. “I would maintain that, if you look at any two- to three-year period starting in the late 90s until today, the private equity community has lowered its targeted rates of return through each increment. Today, I’d say that they’re down to the 16% to 22% range.”
Piper Jaffray’s Rosenkranz concurs, noting that in particularly aggressive auction processes in the last 18 months he’s seen “numerous examples” of private equity firms targeting return percentages in the high teens and low 20s. “What’s been interesting to us is that it now seems to be happening without regard to fund size or deal size,” he says.
Of course, some deal makers beg to differ. “I can’t speak to other people’s thresholds, but we continue to keep ours the same. We shoot for a 30% return,” Castle Harlan’s Wender says. Lynch offered that, depending on the amount of risk involved in the investment, JPMP targets returns between 20% and 30%-plus.
Landry was the only deal pro to admit to his firm having lowered returns, saying that 37-year-old TA originally targeted returns between 35% and 40% and has since come down to between 25% and 32 percent. “We’re still out of step with the market,” he says, “but you can only be so out of step if you’re going to get anything done.”
As an aside, of the 48 private equity funds with vintage years of 1995 or earlier that CalPERS invested in, only 11 are listed as having earned net IRRs of 30% or higher, according to the pension’s Website. The average net IRR of said 48 funds is 20.9 percent.
And Still, A Rosy Tomorrow
It’s difficult to find a pessimist in today’s private equity market. Short of any exogenous shock, private equity profiteers expect the second half of the year to unfold in much the same fashion as the first half. Some even make the case that the market may open up even more. “Being that a lot of hedge funds are getting into the lending game, my guess is there’s still room to go up because you have increased sources of financing,” says Steve Dubow, a partner at law firm Blank Rome LLP, who focuses on M&A and capital formation.
One certainty is that, with $86.4 billion in disclosed live buyout deals already agreed to, things will remain busy.
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